PricingProfit Maximizing Markup, Networks, Penetration Pricing, Transfer Pricing, Limit Pricing, Predatory Pricing, Raising Rivals Costs, Price Matching, and Randomized PricingBy Carter Sprunger
Pricing is an extremely relevant force in the world of managerial economics. In perfect competition, the market determines prices. However, in markets where firms have market power (i.e. monopoly, monopolistic competition, and oligopoly), those firms must determine what price to charge in order to maximize profits (Baye 396). This wiki examines the following strategies and topics related to pricing: profit maximizing markup, networks, penetration pricing, transfer pricing, limit pricing, predatory pricing, raising rivals costs, price matching, and randomized pricing.
Profit Maximizing Markup (Baye 398-400)
Profit-Maximizing Markup for Monopoly and Monopolistic Competition= P = [Ef/(1+Ef)]*MC
Where Ef is the own-price elasticity of demand for the firm's product and MC is the marginal cost.
Profit-Maximizing Markup for Cournot Oligopoly= P = [NEm/(1+NEm)]*MC
Where Em is the market elasticity of demand and N is the number of firms
Multiplying the profit maximizing markup factor (K) by the firm's Marginal Cost gives you the profit-maximizing price for that product.
Two important aspects of Profit Maximizing Markup:
The more elastic the demand for a product, the lower the markup. This means if there are a lot of substitutes, the firm will not be able to mark up the price as much.
The higher the marginal cost, the higher the markup. In other words, if the firm's marginal costs are high, the firm needs to mark up the price more in order to make a profit.
One study examined how effective profit-maximizing markups actually are in practice. Pasche discovered that markup pricing is more resistant to errors and estimation risk than that of rational decision-making (Pasche 1). After reading this, I believe the issue lies in the lack of information. It may be that sticking to the mark-up formula outperforms rational decision making, but in order to do that, the firm needs to have the correct information with regards to the elasticity of the product. Elasticity is dependent on the demand for a product and demand is notoriously difficult to accurately depict.
Networks (Baye 494)
"A network consists of links that connect different points (called nodes) in geographic or economic space."
An example the textbook gives of one type of network (one-way network) is a local water company. By building a network, they benefit from economies of scale. This creates a barrier to entry for other firms looking to enter the industry because there is a firm already in place that has built up a network.
Network externalities (Baye 495)
Direct – “The direct value enjoyed by the user of a network because others also use the network.”
The number of potential network connections is measured by the equation n(n–1).
Indirect – “The indirect value enjoyed by the user of a network because of complementarities between the size of a network and the availability of complementary products or services.”
Bayer and Chan of the University of Adelaide addressed the effect of network externalities on prices, using an experimental oligopoly market. Their findings were that as a network grows, it becomes more valuable to customers. Keeping this in mind, is has been believed by many that network firms begin offering their services at a low introductory price, providing them leeway to charge higher prices as the networks become larger and more valuable. However, Bayer and Chan’s findings show that the opposite is true. Firms tend to reduce the price of their services, as the network gets larger (Bayer & Chan 1). This is a result of network externalities. It turns out that in markets with network externalities, more competition exists. More competition normally translates into lower prices as firms compete for customers (Bayer & Chan 23).
Penetration Pricing (Baye 498)
“Charging a low price initially to penetrate the market and gain a critical mass of customers: useful when strong network effects are present”
An example of penetration pricing can be found in the case of Sprint’s provision of the Apple iPhone 4S. Sprint announced that "the Apple iPhone 4S will have access to all of the same voice and data plans at the same rates that Sprint's current smartphones do -- including unlimited 3G data and the 5GB mobile hotspot cap (Zeman, 2011)." AT&T and Verizon, the other two carriers of the popular smartphone, have transitioned to tiered data plans in the past year, meaning that if you want unlimited data, it's going to cost you quite a bit more than in previous years. Below is a comparison of Verizon and Sprint.
Sprint - 450 minutes, unlimited texting, unlimited data plan - $69.99/month
In order to get a smartphone with a data plan from Verizon that would cost $69.99/month, all you would get would be 450 minutes, a 2GB data allowance, and no texting plan, whatsoever.
I see this as a form of penetration pricing on Sprint's end, the new kid on the block to carry the iPhone. Verizon and AT&T have had previous versions of the iPhone for a while now and have a strong base, or network, of loyal iPhone customers. By choosing to keep their data plans at the same price, Sprint is undercutting AT&T and Verizon and are likely to attract new customers.
However, penetration pricing is normally used as a short-term marketing objective to gain customers and isn't normally used with the intent of making much of an immediate profit. Sprint isn't creating new prices, but rather extending their current prices to the iPhone, so obviously they have been making a profit using this same pricing structure in the past.
Transfer Pricing (Baye 417)
“Pricing Strategy in which a firm optimally sets the internal price at which an upstream division sells an input to a downstream division”
Essentially, in larger firms, divisions interact with other divisions as if they were interacting with a different firm because each division is concerned with their own profits. These prices need to be set so that managers of each division act in the best interest of the firm at large and not their specific division (tmkern, 2009).
Some firms actually use transfer pricing to benefit them in the way of reduced taxes. Bloomberg reports that Cisco Systems Inc. recently reduce the amount of income tax it had to pay by $7 billion since 2005. This was achieved by using transfer pricing to shift profits to lower-taxed regions of the world, specifically the Swiss Alps. How does this work? Through transactions between subsidiaries, Cisco allocates the majority of the company's expenses to countries whose income tax rates are higher. Conversely, profits are allocated to subsidiaries in countries whose tax rates are lower, such as Switzerland. Sounds like tax evasion to me. However, John Earnhardt, a spokesman for Cisco, claims that "Cisco complies with all global tax laws (Drucker 2011)."
Limit Pricing (Baye 475)
When a firm with market power sets a price below the monopoly price to prevent new entrants.
A recent article investigates the use of a vertical contract to enhance a firm’s ability to use limit pricing. Semenov and Wright argue that if a firm is able to obtain an optimal vertical contract with its supplier through quantity discounting, costs would be reduced, putting the firm in a better position to charge an even lower limit price while staying away from the realm of predatory pricing (Semenov & Wright 29).
Predatory Pricing (Baye 483)
Temporarily pricing below the marginal costs to drive competitors out of the market
A firm looking to use this strategy needs to be in a financially healthy position, as it hurts them as well as the other companies.
It was recently uncovered by iSuppli that Amazon's new $79 Kindle actually costs $84.25 to make (Fiegerman, 2011). In other words marginal costs exceed marginal revenue from the sale of the device alone. Why on Earth would Amazon do this? Ceteris paribus, it would seem like this was a prime example of predatory pricing. Selling below marginal costs does not yield economic profits! However, mutatis mutandis, there is more to the story. There are additional sources of revenue for this device through the way of advertisements. Though it may be annoying to consumers, many are willing to pay less ($79 vs. $99) for the device in exchange for being hassled by the occasional advertisement. The high demand for this low-priced product means that there will be quite the market that advertisers could target. Amazon receives revenue from all of these advertisements. In essence, this Kindle would be considered a "loss leader". However, it is not the only loss leader in the world of consumer electronics.
When Sony's Playstation 3 was released, people went nuts. As well they should have. The fact is that the original PS3 had computing power well in excess of many PCs at the time. Sure, it was expensive, starting at $499. However, many didn't realize how much of a bargain that actually was. The $499 PS3 was estimated by iSuppli to cost Sony $805.85 to produce (Edge Staff, 2006). Sony's game division even posted a loss of $1.97 billion for the fiscal year ending March 2007. Sony's hopes were that as popularity of the console grew, they would be able to recoup those losses in the form of gaming software. By the third quarter of 2008, those hopes were realized. Also, thanks to advances in technology leading to decrease production costs, in August of 2009, the PS3 only cost Sony roughly $240 to produce (Bailey, 2009).
Essentially what I am getting at is that sometimes companies do price their products below marginal costs and it is not necessarily considered predatory pricing. If Sony would have priced their product to cover their marginal costs of ~$800, the demand would have been much lower, given that competing gaming systems (substitutes) were priced around the $300-$400 range.
Raising Rivals Costs (Baye 486)
Gaining advantage over competitors by increasing their costs.
An example of this from the textbook is Microsoft allegedly paying PC suppliers not to load Netscape’s Internet browser onto new computers, raising Netscape’s distribution costs.
Though this is not always illegal, some cases do require legal action by the affected firm. For example, on October 20, 2011, a Papa John's franchise was burnt down. After investigating, police arrested two Domino's Pizza managers and charged them with arson. The two confessed, claiming that they were trying to run Papa John's out of business in their region so that they could gain sales (Wright, 2011). I would surmise that the plan backfired, increasing Domino's costs of litigation instead.
Price Matching (Baye 420)
Advertising a price and promising to match any lower price offered by a competitor.
This is a key strategy in various retail outlets today.
Consumer electronics companies, such as Best Buy or hhgregg, often advertise price-matching programs, especially around holidays. My family and I went to hhgregg and had a specific Samsung TV in mind that we knew we were going to purchase. We mentioned that we were going to shop around to be sure that that was the best price and the sales associate offered to look it up online for us. To his surprise, Best Buy offered the same exact TV for $300 less. Initially, he tried to persuade us by saying that Best Buy’s website said the TV was backordered and would not be available for a week. After we told him that we had no problem waiting a week to save $300, he went to his supervisor and came back offering the same price that Best Buy was offering and we left with the TV that night.
With the advent of smartphones, prices are even more accessible to consumers. Android phones, iPhones, and Windows phones all have barcode scanner applications, which can be used to scan nearly any product’s barcode, which returns a list of prices that other stores are offering that product for. Price matching policies seem to be vital to many retail firms’ survival.
However, the textbook offers an argument that this type of strategy may be detrimental to consumers. If all competing firms offer price matching, no firm has an incentive to offer a lower price. All firms will be charging a high monopoly price (Baye 420). This suggests that in the case of our new television, we may have actually paid a lower price if there were no price matching programs in the consumer electronics market. Instead, competitors would have actually had to compete by offering lower prices to entice our purchase.
I feel as though price matching could be demonstrated using a kinked demand curve. The graph below illustrates the market demand for the cheapest Apple iPad 2. The demand curve D1 represents the demand without price matching. D2 is the demand curve with price matching. At the set price of $499, ten thousand iPad 2s will be purchased. If the firm, let’s say Best Buy, raises their price to $599, the quantity purchased goes down to five thousand. With no price matching from competing retailers, if Best Buy were to lower the price to $399, fifteen thousand would be purchased. However, with price matching, Best Buy would only sell twelve thousand because competing retailers would match that price and some people would go to that retailer instead of Best Buy. This graph also illustrates why a high monopoly price is set when price matching is present. At $599, Best buy would sell eight thousand iPad 2s when price matching is present, compared to five thousand without price matching.
In summary, when price matching is present, there will be a higher monopoly price. Firms have less incentive to offer lower prices because other firms may match that price, forcing consumers to split their demand between the two firms. Thus, both firms are worse off if the price is set below the equilibrium compared to a situation where price matching did not exist.
However, looking at the graph, it would appear that producer surplus (blue) is unaffected, where as consumer surplus increases (from just green to green+yellow), drastically. This goes against the notion that consumers are actually worse off when price matching is present. Note that I did not illustrate the deadweight loss in these scenarios, but total surplus appears to increase regardless of the deadweight loss.
Randomized Pricing (Baye 422)
Attempting to hide pricing information from consumers and competitors by intentionally varying the price.
This is attempting to reduce the customer’s incentive to try and find the best price.
A classic example of this is newspaper circular ads. For instance, if Best Buy were to release an advertisement in the newspaper, depicting numerous sales, hhgregg and other consumer electronic companies may lose sales because they cannot match those prices quick enough. On the other hand, it is possible that randomized pricing could lead to a reduction in consumer trust. If consumers become frustrated by the fact that they never know what price the firm will charge, they may go to a more stable firm.
1. Remark Engineering has an own price elasticity of 1.5 and marginal costs of $200. What price should the firm charge in order to maximize profits?
a. $750.00
b. $120.00
c. $300.00
d. $133.33
2. AT&T, Verizon Wireless, Sprint, and T-Mobile have the majority of the market share in the cellular phone service market. Verizon Wireless's marginal cost of providing mobile broadband service is $60. If the market elasticity is 1.9, what price should Verizon charge for it's mobile broadband service?
a. $53.02
b. $39.31
c. $51.30
d. $60.00
3. McDonald's sells cheeseburgers at a price lower than the anticipated marginal costs of Dan's Burger Bistro, a new local restaurant that will be opening next month, but above McDonald’s own marginal costs. What pricing strategy would they be using?
a. Predatory Pricing
b. Limit Pricing
c. Penetration Pricing
d. Raising Rivals Costs
4. Which of the following would be considered an indirect network externality resulting from increased Internet usage in the past 15 years?
a. Social Media
b. Video conferencing
c. Blackboard Inc.
d. All of the above
5. Kohl’s advertises a new sale starting on Monday in the Sunday newspaper. What pricing strategy is Kohl’s using?
a. Limit Pricing
b. Pricing Matching
c. Penetration Pricing
d. Randomized Pricing
Answers:
b. $120.00 – P = [Ef/(1+Ef)]*MC = [1.5/(1+1.5)]*200 = 120
a. $53.02 – P = [NEm/(1+NEm)]*MC = [4*1.9/(1+4*1.9)]*60 = 53.02
b. Limit Pricing – By charging below the competitor’s marginal costs, they are inhibiting entrance. They are able to do this largely because of economies of scale. However, if McDonald’s were to price below their own marginal costs, it would likely be viewed as predatory pricing.
d. All of the above – All three are examples of valuable things created as a result of the Internet.
d. Randomized Pricing – Weekly sale events inhibit competitors’ abilities to compete because they do not know what prices to advertise.
(END OF GRADED SECTION)
Summaries
1.Supply and Demand (Also, include private goods vs. public goods, marginal analysis, producer and consumer surplus and how it applies to perfect competition)- Thaddeus Bogardus
Your supply and demand overview was laid out in a way that was easy to follow and understand. Having all the information together in one place makes it easier to follow than the textbook.
I enjoyed looking over your real world applications. One that particularly interested me was your discussion of the firesale of the HP tablets (and inevitable firesale of the BlackBerry Playbook). It was obvious to me that since people didn’t want it, HP lowered the price to the point where they would be able to clear their inventory. However, I never really thought about it in the realm of economics. Now visualizing a supply and demand graph, it is obvious that since demand decreased, the price that HP was able to charge for the tablet decreased as well.
The rest of the applications seemed equally helpful and pertinent. Also your questions seemed well thought out.
2.Prices, exchange, knowledge, and Markets- Also, discuss money, futures markets Gresham's law etc from The Economics of a POW camp. Why is diversity important in a market?– James Crews
As you noted in your final wiki, this is a very broad topic. I think that your choice to start your wiki by discussing money was helpful to understanding the remainder of your article.
Though there is a plethora of information regarding markets, I think that you summed of the key aspects of the various types of markets fairly well. However, the inclusion of monopolistic competition may have strengthened your wiki a bit.
I found your discussion of the POW camp economics to be very interesting. I never heard of such bartering going on, but it makes sense that different prisoners would have different indifference curves, wanting the bundle that maximizes their utility. What I really found interesting was the fact that the prisoners went so far as to purchase futures.
One criticism is that your explanation of the answer to question two is incorrect. The correct answer would be asymmetric information, not moral hazard. For instance, a patient has more (hidden) information than the physician knows about, thus causing an issue with asymmetric information. Moral hazard would occur when that patient consumes more health care than needed because they have insurance with a 0% coinsurance rate.
3. Using regression analysis to derive a demand curve, also t-stats, R-squared, F-stat, adjusted R-square) - Anya DeVoss
You did a great job covering what I view to be a very dry topic. I have not taken statistics since my sophomore year in undergraduate, so this article gave me a valuable refresh before I take statistics in the Summer semester.
I like how you laid out the definitions of many of the core measurable in a regression analysis. Anyone can run a simple regression in Excel, but to understand what each of the different values mean is entirely different.
Your examples in Excel were very helpful in showing how everything comes together in an actual regression. Also, your questions were very relevant to one’s understanding of regression.
4.Elasticity: elasticity of demand including Marginal revenue and the relationship with elasticity of demand. Also, elasticity of supply, cross price elasticity, income elasticity - Anqi Fang
Elasticity is an extremely important tool in economics as well as managing a firm. I found that your explanation of how the elasticity of demand is related to marginal revenue was very helpful. You even took it a step further to show the graph for the market for eggs. I, personally, learn better when I can see a graph depicting the topic, so thank you for including that.
Furthermore, your brief discussion of the price elasticity of supply, income elasticity, and cross-price elasticity were helpful in my understanding of this topic.
Your questions were easy to understand, but took a bit of knowledge to answer. I appreciate your descriptions of the answers, especially for the problems that required calculations.
5. Monopolistic Competition – Dan Kreitl
Your article was very helpful to my understanding of Monopolistic competition. Thinking of it as a cross between monopoly and perfect competition helps me to remember key aspects a little better. You also did a great job of describing the various characteristics of Monopolistic Competition.
The graph was very helpful in visualizing how firms offer products where MR=MC. Furthermore, it shows that that area between AR (or D) and AC is the profit. Thus, if a firm would price below average cost, they would incur a loss and would likely have to exit the industry.
I found your questions to be quite challenging. However, they helped in my understanding of your overall topic. 12/1/11
It was recently uncovered by iSuppli that Amazon's new $79 Kindle actually costs $84.25 to make. In other words marginal costs exceed marginal revenue from the sale of the device alone. Why on Earth would Amazon do this? Ceteris paribus, it would seem like this was a prime example of predatory pricing. Selling below marginal costs does not yield economic profits! However, mutatis mutandis, there is more to the story. There are additional sources of revenue for this device through the way of advertisements. Though it may be annoying to consumers, many are willing to pay less ($79 vs. $99) for the device in exchange for being hassled by the occasional advertisement. The high demand for this low-priced product means that there will be quite the market that advertisers could target. Amazon receives revenue from all of these advertisements. In essence, this Kindle would be considered a "loss leader". However, it is not the only loss leader in the world of consumer electronics.
When Sony's Playstation 3 was released, people went nuts. As well they should have. The fact is that the PS3 had computing power well in excess of many PCs at the time. Sure, it was expensive, starting at $499. However, many didn't realize how much of a bargain that actually was. That $499 PS3 was estimated by iSuppli to cost Sony $805.85 to produce. Sony's game division even posted a loss of $1.97 billion for the fiscal year ending March 2007. Sony's hopes were that as popularity of the consol grew, they would be able to recoup those losses in the form of gaming software. By the third quarter of 2008, those hopes were realized. Also, thanks to advances in technology leading to decrease production costs, in August of 2009, the PS3 only cost Sony roughly $240 to produce.
Essentially what I am getting at is that sometimes companies do price their products below marginal costs and it is not necessarily considered predatory pricing. If Sony would have priced their product to cover their marginal costs, the demand would have been much lower, given that competing gaming systems (substitutes) were priced around the $300-$400 range.
11/17/11 Questions: 1. Remark Engineering has an own price elasticity of 1.5 and marginal costs of $200. What price should the firm charge in order to maximize profits? a. $750.00 b. $120.00 c. $300.00 d. $133.33
2. AT&T, Verizon Wireless, Sprint, and T-Mobile have the majority of the market share in the cellular phone service market. Verizon Wireless's marginal cost of providing mobile broadband service is $60. If the market elasticity is 1.9, what price should Verizon charge for it's mobile broadband service? a. $53.02 b. $39.31 c. $51.30 d. $60.00
3. If McDonald's sold cheeseburgers at a price lower than the anticipated marginal costs of Dan's Burger Bistro, a new local restaurant that will be opening next month, what pricing strategy would they be using? a. Predatory Pricing b. Limit Pricing c. Penetration Pricing d. Raising Rivals Costs
4. Which of the following would be considered an indirect network externality resulting from increased Internet usage in the past 15 years? a. Social Media b. Video conferencing c. Blackboard Inc. d. All of the above
11/9/11 In my last post, I mentioned that price matching, may in fact, raise prices to the consumers because no firm has an incentive to offer lower prices. I do better with visuals, so I attempted to create a graph illustrating price matching. If I’m way off or if anyone has any input on this, please comment.
I feel as though price matching could be demonstrated using a kinked demand curve. The graph below illustrates the market demand for and cheapest Apple iPad 2. The demand curve D1 represents the demand without price matching. D2 is the demand curve with price matching. At the set price of $499, ten thousand iPad 2s will be purchased. If the firm, let’s say Best Buy, raises their price to $599, the quantity purchased goes down to five thousand. With no price matching from competing retailers, if Best Buy were to lower the price to $399, fifteen thousand would be purchased. However, with price matching, Best Buy would only sell twelve thousand because competing retailers would match that price and some people would go to that retailer instead of Best Buy. This graph also illustrates why a high monopoly price is set when price matching is present. At $599, Best buy would sell eight thousand iPad 2s when price matching is present, compared to five thousand without price matching. In summary, when price matching is present, there will be a higher monopoly price. Firms have less incentive to offer lower prices because other firms may match that price, forcing consumers to split their demand between the two firms. Thus, both firms are worse off if the price is set below the equilibrium compared to a situation where price matching did not exist. However, looking at the graph, it would appear that producer surplus (blue) is unaffected, where as consumer surplus increases (from just green to green+yellow), drastically. This goes against the notion that consumers are actually worse off when price matching is present. Again, if anyone has any input, please comment.
10/27/11 Consumer electronics companies, such as Best Buy or hhgregg, often advertise price matching programs, especially around holidays. My family and I went to hhgregg and had a specific Samsung TV in mind that we knew we were going to purchase. We mentioned that we were going to shop around to be sure that that was the best price and the sales associate offered to look it up online for us. To his surprise, Best Buy offered the same exact TV for $300 less. Initially, he tried to persuade us by saying that Best Buy’s website said the TV was backordered and would not be available for a week. After we told him that we had no problem waiting a week to save $300, he went to his supervisor and came back offering the same price that Best Buy was offering and we left with the TV that night.
With the advent of smartphones, prices are even more accessible to consumers. Android-based phones, the iPhone, and Windows phones all have barcode scanner applications, which can be used to scan nearly any product’s barcode, which returns a list of prices that other stores are offering that product for. Price matching policies seem to be vital to many retail firms’ survival.
However, the textbook offers an argument that this type of strategy may be detrimental to consumers (Baye 420). If all competing firms offer price matching, no firm has an incentive to offer a lower price. All firms will be charging a high monopoly price. This suggests that in the case of our new television, we may have actually paid a lower price if there were no price matching programs in the consumer electronics market. Instead, competitors would have actually had to compete by offering lower prices to entice our purchase.
10/20/11 Limit Pricing (Baye 475)
When a firm with market power sets a price below the monopoly price to prevent new entrants.
Predatory Pricing (Baye 483)
Temporarily pricing below the marginal costs to drive competitors out of the market
A firm looking to use this strategy needs to be in a financially healthy position, as it hurts them as well as the other companies.
Raising Rivals Costs (Baye 486)
Gaining advantage over competitors by increasing their costs.
An example from the textbook is Microsoft allegedly paying PC suppliers not to load Netscape’s Internet browser onto new computers, raising Netscape’s distribution costs.
Price Matching (Baye 420)
Advertising a price and promising to match any lower price offered by a competitor.
This is a key strategy in various retail outlets today.
Randomized Pricing (Baye 422)
Attempting to hide pricing information from consumers and competitors by intentionally varying the price.
This is attempting to reduce the customer’s incentive to try and find the best price.
10/13/11 (Edited 10/27/11)
I realized that I don't really know what all of the above terms are, so this week will consist of defining/explaining some of them.
Profit Maximizing Markup (Baye 398-400)
Profit-Maximizing Markup for Monopoly and Monopolistic Competition = P =[Ef/(1+Ef)]*MC
Where Ef is the own-price elasticity of demand for the firm's product
Profit-Maximizing Markup for Cournot Oligopoly= P = [NEm/(1+NEm)]*MC
Where Em is the market elasticity of demand
MC is Marginal Cost
N is the number of firms
Multiplying the profit maximizing markup factor (K) by the firm's Marginal Cost gives you the profit maximizing price for that product.
Two important aspects of Profit Maximizing Markup:
The more elastic the demand for a product, the lower the markup. This means if there are a lot of substitutes, the firm will not be able to markup the price as much.
The higher the marginal cost, the higher the markup. In other words, if the firm's MC are high, they need to markup the price more to make a profit.
Networks (Baye 494)
"A network consists of links that connect different points (called nodes) in geographic or economic space."
An example the book gives of one type of network (one-way network) is a local water company. By building a network, they benefit from economies of scale. This creates a barrier to entry for other firms looking to enter the industry because there is a firm already in place that has built up a network.
More on other types of networks and network externalities at a later date.
Penetration Pricing (Baye 498)
“Charging a low price initially to penetrate the market and gain a critical mass of customers: useful when strong network effects are present”
I discussed this last week in relation to Sprint’s offering of the iPhone 4S
Transfer Pricing (Baye 417)
“Pricing Strategy in which a firm optimally sets the internal price at which an upstream division sells an input to a downstream division”
10/5/11
Sprint and the iPhone 4S
Sprint announced that "the Apple iPhone 4S will have access to all of the same voice and data plans at the same rates that Sprint's current smartphones do -- including unlimited 3G data and the 5GB mobile hotspot cap." AT&T and Verizon, the other two carriers of the popular smartphone, have transitioned to tiered data plans in the past year, meaning that if you want unlimited data, it's going to cost you quite a bit more than in previous years. Let's compare Verizon to Sprint.
Sprint - 450 minutes, unlimited texting, unlimited data plan - $69.99/month
In order to get a smartphone with a data plan from Verizon that would cost $69.99/month, all you would get would be 450 minutes, a 2GB data allowance, and no texting plan whatsoever.
I see this as a form of penetration pricing on Sprint's end, the new kid on the block to carry the iPhone. Verizon and AT&T have had previous versions of the iPhone for a while now and have a strong base of loyal iPhone customers. By choosing to keep their data plans at the same price, Sprint is undercutting AT&T and Verizon and are likely to attract new customers.
However, penetration pricing is normally used as a short-term marketing objective to gain customers and isn't normally used with the intent of making much of a profit. Sprint isn't creating new prices, but rather extending their current prices to the iPhone, so obviously they have been making a profit using this same pricing structure in the past.
AT&T switched to tiered data plans just prior to the release of the iPhone 3GS. Verizon switched to tiered data soon after it started carrying the iPhone 4. Let's hope Sprint doesn't follow suit.
Pricing is an extremely relevant force in the world of managerial economics. In perfect competition, the market determines prices. However, in markets where firms have market power (i.e. monopoly, monopolistic competition, and oligopoly), those firms must determine what price to charge in order to maximize profits (Baye 396). This wiki examines the following strategies and topics related to pricing: profit maximizing markup, networks, penetration pricing, transfer pricing, limit pricing, predatory pricing, raising rivals costs, price matching, and randomized pricing.
Profit Maximizing Markup (Baye 398-400)
One study examined how effective profit-maximizing markups actually are in practice. Pasche discovered that markup pricing is more resistant to errors and estimation risk than that of rational decision-making (Pasche 1). After reading this, I believe the issue lies in the lack of information. It may be that sticking to the mark-up formula outperforms rational decision making, but in order to do that, the firm needs to have the correct information with regards to the elasticity of the product. Elasticity is dependent on the demand for a product and demand is notoriously difficult to accurately depict.
Networks (Baye 494)
Bayer and Chan of the University of Adelaide addressed the effect of network externalities on prices, using an experimental oligopoly market. Their findings were that as a network grows, it becomes more valuable to customers. Keeping this in mind, is has been believed by many that network firms begin offering their services at a low introductory price, providing them leeway to charge higher prices as the networks become larger and more valuable. However, Bayer and Chan’s findings show that the opposite is true. Firms tend to reduce the price of their services, as the network gets larger (Bayer & Chan 1). This is a result of network externalities. It turns out that in markets with network externalities, more competition exists. More competition normally translates into lower prices as firms compete for customers (Bayer & Chan 23).
Penetration Pricing (Baye 498)
An example of penetration pricing can be found in the case of Sprint’s provision of the Apple iPhone 4S. Sprint announced that "the Apple iPhone 4S will have access to all of the same voice and data plans at the same rates that Sprint's current smartphones do -- including unlimited 3G data and the 5GB mobile hotspot cap (Zeman, 2011)." AT&T and Verizon, the other two carriers of the popular smartphone, have transitioned to tiered data plans in the past year, meaning that if you want unlimited data, it's going to cost you quite a bit more than in previous years. Below is a comparison of Verizon and Sprint.
- Verizon - 450 minutes, unlimited texting, 10GB data allowance - $139.99/month
- Sprint - 450 minutes, unlimited texting, unlimited data plan - $69.99/month
In order to get a smartphone with a data plan from Verizon that would cost $69.99/month, all you would get would be 450 minutes, a 2GB data allowance, and no texting plan, whatsoever.I see this as a form of penetration pricing on Sprint's end, the new kid on the block to carry the iPhone. Verizon and AT&T have had previous versions of the iPhone for a while now and have a strong base, or network, of loyal iPhone customers. By choosing to keep their data plans at the same price, Sprint is undercutting AT&T and Verizon and are likely to attract new customers.
However, penetration pricing is normally used as a short-term marketing objective to gain customers and isn't normally used with the intent of making much of an immediate profit. Sprint isn't creating new prices, but rather extending their current prices to the iPhone, so obviously they have been making a profit using this same pricing structure in the past.
Transfer Pricing (Baye 417)
Some firms actually use transfer pricing to benefit them in the way of reduced taxes. Bloomberg reports that Cisco Systems Inc. recently reduce the amount of income tax it had to pay by $7 billion since 2005. This was achieved by using transfer pricing to shift profits to lower-taxed regions of the world, specifically the Swiss Alps. How does this work? Through transactions between subsidiaries, Cisco allocates the majority of the company's expenses to countries whose income tax rates are higher. Conversely, profits are allocated to subsidiaries in countries whose tax rates are lower, such as Switzerland. Sounds like tax evasion to me. However, John Earnhardt, a spokesman for Cisco, claims that "Cisco complies with all global tax laws (Drucker 2011)."
Limit Pricing (Baye 475)
A recent article investigates the use of a vertical contract to enhance a firm’s ability to use limit pricing. Semenov and Wright argue that if a firm is able to obtain an optimal vertical contract with its supplier through quantity discounting, costs would be reduced, putting the firm in a better position to charge an even lower limit price while staying away from the realm of predatory pricing (Semenov & Wright 29).
Predatory Pricing (Baye 483)
It was recently uncovered by iSuppli that Amazon's new $79 Kindle actually costs $84.25 to make (Fiegerman, 2011). In other words marginal costs exceed marginal revenue from the sale of the device alone. Why on Earth would Amazon do this? Ceteris paribus, it would seem like this was a prime example of predatory pricing. Selling below marginal costs does not yield economic profits! However, mutatis mutandis, there is more to the story. There are additional sources of revenue for this device through the way of advertisements. Though it may be annoying to consumers, many are willing to pay less ($79 vs. $99) for the device in exchange for being hassled by the occasional advertisement. The high demand for this low-priced product means that there will be quite the market that advertisers could target. Amazon receives revenue from all of these advertisements. In essence, this Kindle would be considered a "loss leader". However, it is not the only loss leader in the world of consumer electronics.
When Sony's Playstation 3 was released, people went nuts. As well they should have. The fact is that the original PS3 had computing power well in excess of many PCs at the time. Sure, it was expensive, starting at $499. However, many didn't realize how much of a bargain that actually was. The $499 PS3 was estimated by iSuppli to cost Sony $805.85 to produce (Edge Staff, 2006). Sony's game division even posted a loss of $1.97 billion for the fiscal year ending March 2007. Sony's hopes were that as popularity of the console grew, they would be able to recoup those losses in the form of gaming software. By the third quarter of 2008, those hopes were realized. Also, thanks to advances in technology leading to decrease production costs, in August of 2009, the PS3 only cost Sony roughly $240 to produce (Bailey, 2009).
Essentially what I am getting at is that sometimes companies do price their products below marginal costs and it is not necessarily considered predatory pricing. If Sony would have priced their product to cover their marginal costs of ~$800, the demand would have been much lower, given that competing gaming systems (substitutes) were priced around the $300-$400 range.
Raising Rivals Costs (Baye 486)
Though this is not always illegal, some cases do require legal action by the affected firm. For example, on October 20, 2011, a Papa John's franchise was burnt down. After investigating, police arrested two Domino's Pizza managers and charged them with arson. The two confessed, claiming that they were trying to run Papa John's out of business in their region so that they could gain sales (Wright, 2011). I would surmise that the plan backfired, increasing Domino's costs of litigation instead.
Price Matching (Baye 420)
Consumer electronics companies, such as Best Buy or hhgregg, often advertise price-matching programs, especially around holidays. My family and I went to hhgregg and had a specific Samsung TV in mind that we knew we were going to purchase. We mentioned that we were going to shop around to be sure that that was the best price and the sales associate offered to look it up online for us. To his surprise, Best Buy offered the same exact TV for $300 less. Initially, he tried to persuade us by saying that Best Buy’s website said the TV was backordered and would not be available for a week. After we told him that we had no problem waiting a week to save $300, he went to his supervisor and came back offering the same price that Best Buy was offering and we left with the TV that night.
With the advent of smartphones, prices are even more accessible to consumers. Android phones, iPhones, and Windows phones all have barcode scanner applications, which can be used to scan nearly any product’s barcode, which returns a list of prices that other stores are offering that product for. Price matching policies seem to be vital to many retail firms’ survival.
However, the textbook offers an argument that this type of strategy may be detrimental to consumers. If all competing firms offer price matching, no firm has an incentive to offer a lower price. All firms will be charging a high monopoly price (Baye 420). This suggests that in the case of our new television, we may have actually paid a lower price if there were no price matching programs in the consumer electronics market. Instead, competitors would have actually had to compete by offering lower prices to entice our purchase.
I feel as though price matching could be demonstrated using a kinked demand curve. The graph below illustrates the market demand for the cheapest Apple iPad 2. The demand curve D1 represents the demand without price matching. D2 is the demand curve with price matching. At the set price of $499, ten thousand iPad 2s will be purchased. If the firm, let’s say Best Buy, raises their price to $599, the quantity purchased goes down to five thousand. With no price matching from competing retailers, if Best Buy were to lower the price to $399, fifteen thousand would be purchased. However, with price matching, Best Buy would only sell twelve thousand because competing retailers would match that price and some people would go to that retailer instead of Best Buy. This graph also illustrates why a high monopoly price is set when price matching is present. At $599, Best buy would sell eight thousand iPad 2s when price matching is present, compared to five thousand without price matching.
In summary, when price matching is present, there will be a higher monopoly price. Firms have less incentive to offer lower prices because other firms may match that price, forcing consumers to split their demand between the two firms. Thus, both firms are worse off if the price is set below the equilibrium compared to a situation where price matching did not exist.
However, looking at the graph, it would appear that producer surplus (blue) is unaffected, where as consumer surplus increases (from just green to green+yellow), drastically. This goes against the notion that consumers are actually worse off when price matching is present. Note that I did not illustrate the deadweight loss in these scenarios, but total surplus appears to increase regardless of the deadweight loss.
Randomized Pricing (Baye 422)
A classic example of this is newspaper circular ads. For instance, if Best Buy were to release an advertisement in the newspaper, depicting numerous sales, hhgregg and other consumer electronic companies may lose sales because they cannot match those prices quick enough. On the other hand, it is possible that randomized pricing could lead to a reduction in consumer trust. If consumers become frustrated by the fact that they never know what price the firm will charge, they may go to a more stable firm.
References:
Bailey, K. (2009, July 31). Playstation 3 production costs slashed 70 percent. Retrieved from http://www.1up.com/news/playstation-3-production-costs-slashedBaye, M. (2010). Managerial economics and business strategy. (7th ed.). New York, NY: McGraw-Hill Irwin.
Bayer, Ralph-C and Chan, Mickey, (2004), Network Externalities, Demand Inertia and Dynamic Pricing in an Experimental Oligopoly Market, Experimental, EconWPA, http://econpapers.repec.org/RePEc:wpa:wuwpex:0412004
Drucker, J. (2011, June 28). Biggest tax avoiders win most gaming $1 trillion u.s. tax break. Retrieved from http://www.bloomberg.com/news/2011-06-28/biggest-tax-avoiders-win-most-gaming-1-trillion-u-s-tax-break.html
Edge Staff. (2006, November 16). iSuppli: 60gb ps3 costs $840 to produce. Retrieved from http://www.next-gen.biz/news/isuppli-60gb-ps3-costs-840-produce
Fiegerman , S. (2011, November 9). Exclusive: Amazon’s $79 kindle costs $84 to make. Retrieved from http://www.mainstreet.com/article/smart-spending/technology/exclusive-amazon-s-79-kindle-touch-costs-84-make
Pasche, Markus, (1998), Markup Pricing and Demand Uncertainty, Working Paper Series B, Friedrich-Schiller-Universität Jena, Wirtschaftswissenschaftliche Fakultïät, http://econpapers.repec.org/RePEc:jen:jenavo:1997-08
Semenov, Aggey and Wright, Julian, (2011), Vertical Limit pricing, No 1104E, Working Papers, University of Ottawa, Department of Economics, http://econpapers.repec.org/RePEc:ott:wpaper:1104e
tmkern. (2009, October 31). Transfer pricing. Retrieved from http://www.wikicfo.com/Wiki/Default.aspx?Page=Transfer Pricing&NS=&AspxAutoDetectCookieSupport=1
Wright, J. (2011, November 7). Raising rivals’ costs, pizza edition. Retrieved from http://truthonthemarket.com/2011/11/07/raising-rivals-costs-pizza-edition/
Zeman, E. (2011, October 5). Sprint confirms that iphone will have unlimited data. Retrieved from http://www.phonescoop.com/articles/article.php?a=9005
Questions:
1. Remark Engineering has an own price elasticity of 1.5 and marginal costs of $200. What price should the firm charge in order to maximize profits?a. $750.00
b. $120.00
c. $300.00
d. $133.33
2. AT&T, Verizon Wireless, Sprint, and T-Mobile have the majority of the market share in the cellular phone service market. Verizon Wireless's marginal cost of providing mobile broadband service is $60. If the market elasticity is 1.9, what price should Verizon charge for it's mobile broadband service?
a. $53.02
b. $39.31
c. $51.30
d. $60.00
3. McDonald's sells cheeseburgers at a price lower than the anticipated marginal costs of Dan's Burger Bistro, a new local restaurant that will be opening next month, but above McDonald’s own marginal costs. What pricing strategy would they be using?
a. Predatory Pricing
b. Limit Pricing
c. Penetration Pricing
d. Raising Rivals Costs
4. Which of the following would be considered an indirect network externality resulting from increased Internet usage in the past 15 years?
a. Social Media
b. Video conferencing
c. Blackboard Inc.
d. All of the above
5. Kohl’s advertises a new sale starting on Monday in the Sunday newspaper. What pricing strategy is Kohl’s using?
a. Limit Pricing
b. Pricing Matching
c. Penetration Pricing
d. Randomized Pricing
Answers:
(END OF GRADED SECTION)
Summaries
1. Supply and Demand (Also, include private goods vs. public goods, marginal analysis, producer and consumer surplus and how it applies to perfect competition)- Thaddeus Bogardus
Your supply and demand overview was laid out in a way that was easy to follow and understand. Having all the information together in one place makes it easier to follow than the textbook.
I enjoyed looking over your real world applications. One that particularly interested me was your discussion of the firesale of the HP tablets (and inevitable firesale of the BlackBerry Playbook). It was obvious to me that since people didn’t want it, HP lowered the price to the point where they would be able to clear their inventory. However, I never really thought about it in the realm of economics. Now visualizing a supply and demand graph, it is obvious that since demand decreased, the price that HP was able to charge for the tablet decreased as well.
The rest of the applications seemed equally helpful and pertinent. Also your questions seemed well thought out.
2. Prices, exchange, knowledge, and Markets- Also, discuss money, futures markets Gresham's law etc from The Economics of a POW camp. Why is diversity important in a market? – James Crews
As you noted in your final wiki, this is a very broad topic. I think that your choice to start your wiki by discussing money was helpful to understanding the remainder of your article.
Though there is a plethora of information regarding markets, I think that you summed of the key aspects of the various types of markets fairly well. However, the inclusion of monopolistic competition may have strengthened your wiki a bit.
I found your discussion of the POW camp economics to be very interesting. I never heard of such bartering going on, but it makes sense that different prisoners would have different indifference curves, wanting the bundle that maximizes their utility. What I really found interesting was the fact that the prisoners went so far as to purchase futures.
One criticism is that your explanation of the answer to question two is incorrect. The correct answer would be asymmetric information, not moral hazard. For instance, a patient has more (hidden) information than the physician knows about, thus causing an issue with asymmetric information. Moral hazard would occur when that patient consumes more health care than needed because they have insurance with a 0% coinsurance rate.
3. Using regression analysis to derive a demand curve, also t-stats, R-squared, F-stat, adjusted R-square)
- Anya DeVoss
You did a great job covering what I view to be a very dry topic. I have not taken statistics since my sophomore year in undergraduate, so this article gave me a valuable refresh before I take statistics in the Summer semester.
I like how you laid out the definitions of many of the core measurable in a regression analysis. Anyone can run a simple regression in Excel, but to understand what each of the different values mean is entirely different.
Your examples in Excel were very helpful in showing how everything comes together in an actual regression. Also, your questions were very relevant to one’s understanding of regression.
4. Elasticity: elasticity of demand including Marginal revenue and the relationship with elasticity of demand. Also, elasticity of supply, cross price elasticity, income elasticity - Anqi Fang
Elasticity is an extremely important tool in economics as well as managing a firm. I found that your explanation of how the elasticity of demand is related to marginal revenue was very helpful. You even took it a step further to show the graph for the market for eggs. I, personally, learn better when I can see a graph depicting the topic, so thank you for including that.
Furthermore, your brief discussion of the price elasticity of supply, income elasticity, and cross-price elasticity were helpful in my understanding of this topic.
Your questions were easy to understand, but took a bit of knowledge to answer. I appreciate your descriptions of the answers, especially for the problems that required calculations.
5. Monopolistic Competition – Dan Kreitl
Your article was very helpful to my understanding of Monopolistic competition. Thinking of it as a cross between monopoly and perfect competition helps me to remember key aspects a little better. You also did a great job of describing the various characteristics of Monopolistic Competition.
The graph was very helpful in visualizing how firms offer products where MR=MC. Furthermore, it shows that that area between AR (or D) and AC is the profit. Thus, if a firm would price below average cost, they would incur a loss and would likely have to exit the industry.
I found your questions to be quite challenging. However, they helped in my understanding of your overall topic.
12/1/11
It was recently uncovered by iSuppli that Amazon's new $79 Kindle actually costs $84.25 to make. In other words marginal costs exceed marginal revenue from the sale of the device alone. Why on Earth would Amazon do this? Ceteris paribus, it would seem like this was a prime example of predatory pricing. Selling below marginal costs does not yield economic profits! However, mutatis mutandis, there is more to the story. There are additional sources of revenue for this device through the way of advertisements. Though it may be annoying to consumers, many are willing to pay less ($79 vs. $99) for the device in exchange for being hassled by the occasional advertisement. The high demand for this low-priced product means that there will be quite the market that advertisers could target. Amazon receives revenue from all of these advertisements. In essence, this Kindle would be considered a "loss leader". However, it is not the only loss leader in the world of consumer electronics.
When Sony's Playstation 3 was released, people went nuts. As well they should have. The fact is that the PS3 had computing power well in excess of many PCs at the time. Sure, it was expensive, starting at $499. However, many didn't realize how much of a bargain that actually was. That $499 PS3 was estimated by iSuppli to cost Sony $805.85 to produce. Sony's game division even posted a loss of $1.97 billion for the fiscal year ending March 2007. Sony's hopes were that as popularity of the consol grew, they would be able to recoup those losses in the form of gaming software. By the third quarter of 2008, those hopes were realized. Also, thanks to advances in technology leading to decrease production costs, in August of 2009, the PS3 only cost Sony roughly $240 to produce.
Essentially what I am getting at is that sometimes companies do price their products below marginal costs and it is not necessarily considered predatory pricing. If Sony would have priced their product to cover their marginal costs, the demand would have been much lower, given that competing gaming systems (substitutes) were priced around the $300-$400 range.
http://www.mainstreet.com/article/smart-spending/technology/exclusive-amazon-s-79-kindle-touch-costs-84-make
http://www.next-gen.biz/news/isuppli-60gb-ps3-costs-840-produce
http://www.1up.com/news/playstation-3-production-costs-slashed
11/17/11
Questions:
1. Remark Engineering has an own price elasticity of 1.5 and marginal costs of $200. What price should the firm charge in order to maximize profits?
a. $750.00
b. $120.00
c. $300.00
d. $133.33
2. AT&T, Verizon Wireless, Sprint, and T-Mobile have the majority of the market share in the cellular phone service market. Verizon Wireless's marginal cost of providing mobile broadband service is $60. If the market elasticity is 1.9, what price should Verizon charge for it's mobile broadband service?
a. $53.02
b. $39.31
c. $51.30
d. $60.00
3. If McDonald's sold cheeseburgers at a price lower than the anticipated marginal costs of Dan's Burger Bistro, a new local restaurant that will be opening next month, what pricing strategy would they be using?
a. Predatory Pricing
b. Limit Pricing
c. Penetration Pricing
d. Raising Rivals Costs
4. Which of the following would be considered an indirect network externality resulting from increased Internet usage in the past 15 years?
a. Social Media
b. Video conferencing
c. Blackboard Inc.
d. All of the above
11/9/11
In my last post, I mentioned that price matching, may in fact, raise prices to the consumers because no firm has an incentive to offer lower prices. I do better with visuals, so I attempted to create a graph illustrating price matching. If I’m way off or if anyone has any input on this, please comment.
I feel as though price matching could be demonstrated using a kinked demand curve. The graph below illustrates the market demand for and cheapest Apple iPad 2. The demand curve D1 represents the demand without price matching. D2 is the demand curve with price matching. At the set price of $499, ten thousand iPad 2s will be purchased. If the firm, let’s say Best Buy, raises their price to $599, the quantity purchased goes down to five thousand. With no price matching from competing retailers, if Best Buy were to lower the price to $399, fifteen thousand would be purchased. However, with price matching, Best Buy would only sell twelve thousand because competing retailers would match that price and some people would go to that retailer instead of Best Buy. This graph also illustrates why a high monopoly price is set when price matching is present. At $599, Best buy would sell eight thousand iPad 2s when price matching is present, compared to five thousand without price matching. In summary, when price matching is present, there will be a higher monopoly price. Firms have less incentive to offer lower prices because other firms may match that price, forcing consumers to split their demand between the two firms. Thus, both firms are worse off if the price is set below the equilibrium compared to a situation where price matching did not exist.
However, looking at the graph, it would appear that producer surplus (blue) is unaffected, where as consumer surplus increases (from just green to green+yellow), drastically. This goes against the notion that consumers are actually worse off when price matching is present. Again, if anyone has any input, please comment.
10/27/11
Consumer electronics companies, such as Best Buy or hhgregg, often advertise price matching programs, especially around holidays. My family and I went to hhgregg and had a specific Samsung TV in mind that we knew we were going to purchase. We mentioned that we were going to shop around to be sure that that was the best price and the sales associate offered to look it up online for us. To his surprise, Best Buy offered the same exact TV for $300 less. Initially, he tried to persuade us by saying that Best Buy’s website said the TV was backordered and would not be available for a week. After we told him that we had no problem waiting a week to save $300, he went to his supervisor and came back offering the same price that Best Buy was offering and we left with the TV that night.
With the advent of smartphones, prices are even more accessible to consumers. Android-based phones, the iPhone, and Windows phones all have barcode scanner applications, which can be used to scan nearly any product’s barcode, which returns a list of prices that other stores are offering that product for. Price matching policies seem to be vital to many retail firms’ survival.
However, the textbook offers an argument that this type of strategy may be detrimental to consumers (Baye 420). If all competing firms offer price matching, no firm has an incentive to offer a lower price. All firms will be charging a high monopoly price. This suggests that in the case of our new television, we may have actually paid a lower price if there were no price matching programs in the consumer electronics market. Instead, competitors would have actually had to compete by offering lower prices to entice our purchase.
10/20/11
Limit Pricing (Baye 475)
- When a firm with market power sets a price below the monopoly price to prevent new entrants.
Predatory Pricing (Baye 483)- Temporarily pricing below the marginal costs to drive competitors out of the market
- A firm looking to use this strategy needs to be in a financially healthy position, as it hurts them as well as the other companies.
Raising Rivals Costs (Baye 486)- Gaining advantage over competitors by increasing their costs.
- An example from the textbook is Microsoft allegedly paying PC suppliers not to load Netscape’s Internet browser onto new computers, raising Netscape’s distribution costs.
Price Matching (Baye 420)- Advertising a price and promising to match any lower price offered by a competitor.
- This is a key strategy in various retail outlets today.
Randomized Pricing (Baye 422)10/13/11 (Edited 10/27/11)
I realized that I don't really know what all of the above terms are, so this week will consist of defining/explaining some of them.Profit Maximizing Markup (Baye 398-400)
- Profit-Maximizing Markup for Monopoly and Monopolistic Competition = P =[Ef/(1+Ef)]*MC
- Where Ef is the own-price elasticity of demand for the firm's product
- Profit-Maximizing Markup for Cournot Oligopoly= P = [NEm/(1+NEm)]*MC
- Where Em is the market elasticity of demand
- MC is Marginal Cost
- N is the number of firms
- Multiplying the profit maximizing markup factor (K) by the firm's Marginal Cost gives you the profit maximizing price for that product.
- Two important aspects of Profit Maximizing Markup:
- The more elastic the demand for a product, the lower the markup. This means if there are a lot of substitutes, the firm will not be able to markup the price as much.
- The higher the marginal cost, the higher the markup. In other words, if the firm's MC are high, they need to markup the price more to make a profit.
Networks (Baye 494)- "A network consists of links that connect different points (called nodes) in geographic or economic space."
- An example the book gives of one type of network (one-way network) is a local water company. By building a network, they benefit from economies of scale. This creates a barrier to entry for other firms looking to enter the industry because there is a firm already in place that has built up a network.
- More on other types of networks and network externalities at a later date.
Penetration Pricing (Baye 498)- “Charging a low price initially to penetrate the market and gain a critical mass of customers: useful when strong network effects are present”
- I discussed this last week in relation to Sprint’s offering of the iPhone 4S
Transfer Pricing (Baye 417)10/5/11
Sprint and the iPhone 4SSprint announced that "the Apple iPhone 4S will have access to all of the same voice and data plans at the same rates that Sprint's current smartphones do -- including unlimited 3G data and the 5GB mobile hotspot cap." AT&T and Verizon, the other two carriers of the popular smartphone, have transitioned to tiered data plans in the past year, meaning that if you want unlimited data, it's going to cost you quite a bit more than in previous years. Let's compare Verizon to Sprint.
In order to get a smartphone with a data plan from Verizon that would cost $69.99/month, all you would get would be 450 minutes, a 2GB data allowance, and no texting plan whatsoever.
I see this as a form of penetration pricing on Sprint's end, the new kid on the block to carry the iPhone. Verizon and AT&T have had previous versions of the iPhone for a while now and have a strong base of loyal iPhone customers. By choosing to keep their data plans at the same price, Sprint is undercutting AT&T and Verizon and are likely to attract new customers.
However, penetration pricing is normally used as a short-term marketing objective to gain customers and isn't normally used with the intent of making much of a profit. Sprint isn't creating new prices, but rather extending their current prices to the iPhone, so obviously they have been making a profit using this same pricing structure in the past.
AT&T switched to tiered data plans just prior to the release of the iPhone 3GS. Verizon switched to tiered data soon after it started carrying the iPhone 4. Let's hope Sprint doesn't follow suit.
http://www.phonescoop.com/articles/article.php?a=9005
https://www.verizonwireless.com/b2c/plans/?page=single
http://shop.sprint.com/mysprint/shop/plan/plan_wall.jsp?INTNAV=ATG:HE:Plans