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PRICING AND PRODUCT DIFFERENTIATION, Lecture notes of Managerial Economics

University of PortsmouthManagerial Economics

pricing and product differentiation

Typology: Lecture notes

2021/2022

Available from 06/20/2022

Ludovicamazzocchi
Ludovicamazzocchi 🇬🇧

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Lecture 3
MANAGERIAL AND DECISION ECONOMICS
PRICING AND PRODUCT DIFFERENTIATION
COST PLUS PRICING: price is determined by adding a percentage markup to average variable cost.
Price = AVC + % markup
Under cost plus pricing firms calculate/ estimate AVC [Average Variable Cost; so we’re talking about short
run] and then add a mark up to determine price.
P = (1 + m) AVC
The profit margin tends to be higher when demand conditions are strong, and lower when demand is weak.
-The more price inelastic the firm’s demand, the larger is the markup.
•When competition is weak, the markup will be large.
-The more price elastic the firm’s demand, the smaller is the markup.
•When competition is intense, the markup will be small.
Pricing practice often depends on whether a firm operates in a highly competitive market or in an
uncompetitive market.
EVIDENCE: Alvarez and Hernando (2006) survey Euro area firms to find out what kind of pricing rules
are being used. They classify pricing practices in three groups: cost plus pricing, prices set according to
competitors’ prices, and other.
Generally, in a place where there is more
competition, you decide to look at Rivals’
Price, as we can see do Italy and France
(following the same thought US and UK too).
For Germany and Netherlands, there the details
of CAPITALISM [less competition but more
control], that permit, for instance at Germany,
to choose anyways Cost Plus Pricing also in an
High Competition situation.
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Lecture 3 MANAGERIAL AND DECISION ECONOMICS PRICING AND PRODUCT DIFFERENTIATION COST PLUS PRICING : price is determined by adding a percentage markup to average variable cost.

Price = AVC + % markup

Under cost plus pricing firms calculate/ estimate AVC [Average Variable Cost; so we’re talking about short run] and then add a mark up to determine price.

P = (1 + m ) AVC

The profit margin tends to be higher when demand conditions are strong, and lower when demand is weak.

- The more price inelastic the firm’s demand, the larger is the markup.

  • When competition is weak, the markup will be large.

- The more price elastic the firm’s demand, the smaller is the markup.

  • When competition is intense, the markup will be small. Pricing practice often depends on whether a firm operates in a highly competitive market or in an uncompetitive market. EVIDENCE : Alvarez and Hernando (2006) survey Euro area firms to find out what kind of pricing rules are being used. They classify pricing practices in three groups: cost plus pricing, prices set according to competitors’ prices, and other. Generally, in a place where there is more competition, you decide to look at Rivals’ Price , as we can see do Italy and France (following the same thought US and UK too). For Germany and Netherlands, there the details of CAPITALISM [less competition but more control], that permit, for instance at Germany, to choose anyways Cost Plus Pricing also in an High Competition situation.

PRICE DISCRIMINATION:

We assumed so far: firm sets a uniform price which is the same for all consumers. However, a firm that enjoys some market power might consider adopting a more complex pricing policy. The policy of selling different units of output at different prices is known as price discrimination. A firm to decide to choose a price discrimination, must have two necessary conditions: 1)Firm must possess some degree of market power 2)The market must be divisible into submarkets with different demand conditions. These must be separate through time or space so that secondary market or resale between consumers won’t be possible. Price discrimination is divided in three degree:

  1. First degree price discrimination: also referred to as perfect discrimination. Each consumer pays his or her reservation price for the good. (reservation price is the highest price you are willing to pay for a good)
  2. Second degree price discrimination: a firm offers all consumers the same price schedule and consumers self-select into different price categories. [it is look like if the firm doesn’t “care” about different type of customers, but it actually know that this different types of customer exist.]
  3. Third degree price discrimination: depends on the firm’s ability to effectively separate consumers into two or more groups according to their demand elasticities. Unlike second degree, in third degree price discrimination, consumers are put into a group by the firm and cannot self-select into another group. [The customers are taking into account with all their different type of needs, in this way the firm can understand what type of price discrimination would be useful for each type of customers’ needs] - FIRST - DEGREE PRICE DISCRIMINATION First-degree price discrimination a.k.a. perfect price discrimination involves making the price per unit of output depend on the identity of the purchaser.
    • (^) Every unit is sold for the maximum price the consumer is willing to pay Allow the firm to capture entire consumer surplus - SECOND - DEGREE PRICE DISCRIMINATION Firms use second degree price discrimination when they know there are different groups of consumers with different reservation prices but they are unable to identify, or it is too costly to identify each consumer type.

NOTE (?) :

You discrimination people in base of the price that they can or want to spend.

“Market” in previous slide shows the market demand function (sum of the two submarkets) and the profit maximising output and price when the monopolist charges a uniform price to all consumers. In the case where there are two submarkets, one price will always be higher and the other price lower than the uniform monopoly price that would exist in the non-discriminating case. PRODUCT ANALYSIS: According to neo - classical analysis, consumers will choose different quantities of different products on the basis of their budget, prices and preferences. I. LANCASTER’S CHARACTERISTICS MODEL Lancaster’s (1966) product characteristics model assumes that consumers derive utility from the characteristics or attributes embodied in goods, as opposed to the goods themselves. Goods are viewed as bundles of characteristics. Differentiated goods are goods that contain the same characteristics in different proportions. A consumer seeks to buy goods with the most desirable set of characteristics according to their income and the price of characteristics. Model Assumptions:

  • (^) Each product has more than one characteristic.
  • (^) Each product will combine characteristics in different ratios.
  • Characteristics are objectively measurable.
  • Goods are divisible and part units can be purchased.
  • (^) Products (or brands) are substitutes for each other despite containing differing mixes of characteristics. EXAMPLE: For products such as cereals or curry sauces, it is easy to imagine purchasing two different brands and mixing together in order to achieve the desired ratio of the product’s characteristics. If it is not possible to consume combinations of alternative brands in varying proportions, the consumer would stick to another brand that delivers his/her desired ratio of product’s characteristics, unless its price increases beyond consumer’s budget set.
  1. CHARACTERISTICS OF BRANDS 1 & 2 The line between points AI^ and AII^ is the efficiency frontier (think of this as the counterpart of the budget constraint) is indifference curve: more of each characteristic is always preferred to less

2. CHARACTERISTICS OF BRANDS A, B, C & D

, , , and are affordable units of brands A, B, C, and D that can be purchased using a certain budget. is how much of brand C can be purchased when its price increases. Note that can also be attained using a linear combination of and. [If C1 became more expensive, it will called C2. But C can be mixed from B1 and D1, so it has no much value and consequently it makes no sense to buy it. If brand C2 decide to grow up the price again, it becomes C3, but its value will be lower than the mix choice of C2, so the product will have difficulties to be sold].

  1. INTRODUCING A NEW BRAND B Suppose there are currently two brands (A and C) on the market and a consumer can buy or units of A and C, respectively, using his/her budget. Given the efficiency frontier between and , and also given this individual’s preference structure, is attainable where he/she enjoys a higher level utility than at or. This represents an opportunity for the creation of a new brand B. If B can be priced so that the consumer can attain a position such as the consumer will switch from the combined purchase of brands A and C at to the sole purchase of brand B at. [B1 can be sold because its price will be right for its characteristics, if it will be the result of a mix of two brands, it has no sense create a brand. For instance, if C1 is a big and slow car and A1 is a small and fast car, you can’t physically mixed, but if you create a brand B2 that combine the two good characteristics of the brands nominated before, the product B2 will work (see slide 21, lecture 3) ].
    • CRITICISM OF THE LANCASTER MODEL Hence the Lancaster Model makes use of the difference between combinations of the same or similar characteristics contained in differentiated products to explain variations of demand for different brands and the emergence of new brands. As most models, Lancaster Model also faces criticism: - (^) Characteristics cannot necessarily be measured objectively. - Consumers may or may not perceive products with different characteristic combinations as different.

4. LOCATIONS ENDOGENOUS, PRICES EXOGENOUS

Each firm chooses location so as to maximise its own profit Each firm’s profit is a linear function of the number of consumers it serves

- (^) Where should the firms locate? If Firm A locates at 0.25 and Firm B locates at 0.75, each serves half of the market However, this is not an equilibrium… A stable equilibrium is found where both firms locate in the centre of town In terms of characteristic space, brands can have similar or identical characteristics Is this applicable to real life? - ‘Districts’: petrol stations, charity shops, fast food restaurants - Politics