MM5006 Business Economics

CHAPTER 10:
Special Pricing
Practices
Syndicate Group 4
 TEAM MEMBERS

Matheo Pranoto Taufiq Wicaksana Sasti Pretita Vinsensius Michael

(29320432) (29320523) (29320366) (29320369)

Tri Aldityo Kharisma Valeria Christie Ayu Zulfikar Satriatama

(29320510) (29320415) (29320306)
 06 multiproduct
01 cartel pricing
arrangements
07 transfer
02 price pricing

Table leadership
08 other pricing
practice
of 03 revenue
maximization 09 the decline of
contents 04 price
european cartels

descrimination 10 airline pricing

example
05 non-marginal
pricing 11 lesson
learned
 01. Cartel
Arrangements
a collusive arrangement in oligopolistic
markets where firms agree on unified pricing
and production actions to maximize profits and
to eliminate the rigors of competition, which
might be done secretly (tacit) or through
formal agreement.
 Reason of existence

1. The existence of a small number of large firms

facilitates the policing of a collusive agreement
2. Geographic proximity of the firms is favorable.
3. Homogeneity of the product makes it impossible
for cartel participants to cheat on one another
4. cartels are often established during depressed
industry conditions, when companies attempt to
forestall what they consider to be ruinous price
cutting
5. Difficult entry into the industry
6. Having similar and profitability cost conditions
between cartel
Ideal cartel studies
Cartel output (QT) is the firm's total
output where their total marginal
revenue equals their total marginal
cost (MRT = MCT).

Cartel price (point A) is the market

demand curve at the level of output
chosen by the cartel.

AC is The profit that each firm would

earn depends on the level of the
average cost
 02. Price
leadership
a pricing practice initiated by a firm where
there is no formal or tacit agreement among
the oligopolists to keep prices at the same
level or change them by the same amount,
while the other firms will just follow.
 Types of Price leadership

Barometric price Dominant price

leadership leadership

One or more firms initiating price change in A pricing practice where one firm (the leader)
response to economic conditions without any dominates the industry and acts as a
success guarantee monopolist by setting price at the point
where it will maximize its profits while
other small firms are allowed to sell as much
as they want at the price set by the leader.

DT:demand curve for the entire industry

MCD:Marginal cost curve of the dominant firm
MCR:Sum of all the marginal cost curves of the follower firms is
represented
DD:Demand curve for the leader
DT:total demand curve
03. Revenue
Maximization
 REVENUE MAXIMIZATION

The Arguments

1. More Realistic
Goal of maximisation of sales is a more realistic goal, because
success of a firm is generally judged from its total sales.
2. More Practical
It is so because goal of revenue (Sales) maximisation leads to
William J. Baumol
more production which, in turn, leads to fall in price.
3. More Availability of Loans
Baumol’s Book: Business Behavior, Prospects of loans are bright for such firms as have large total
Value & Growth (1967)
sales.
4. Strong Position in The Market
A managerial theory of the firm based on sales maximization Sales of a firm will be large only in that situation when
by William Baumol in his book Business Behavior, Value & consumers like its production, firm has more competitive power
Growth (1967). and has been expanding.
5. More Advantageous to The Managers
A firm’s primary objective, rather than profit maximization, Maximum sales is a reflection of the competence of the
can be the maximization of revenue, subject to satisfying a managers It has a favorable effect on their wages.
specific level of profits.
 $ = Profit

Qπ refers to profit maximization, because it corresponds

to the highest point of Total Profit (π).

The sales maximization output is Qs, where total

revenue is maximum at the highest point of TR. But, it
is subject to minimum profit constraint- does not cover
the minimum profits (πA).

The acceptable level of revenue/sales maximization is

πA = Minimum QA, because it achieves the highest revenue possible and
profit satisfies the profit requirement.

π = Total
Profit One important question remains:
Are corporate owners (stockholders) more concerned—and thus
Q = Output determine the market value of a corporation—with revenue or
profitability?
Implications: Change in in fixed cost in short-run for profit
maximization won’t affect price and quantity, then MR = MC
rule remains. In Baumol Model, when the fixed cost Baumol Model itself is not fully accepted/validated because in
increased, the TC and profit (π) curve will be shifted. (see the long run, profit and growth maximization are more preferred.
dotted line in graph).
04. Price
Discrimination
 PRICE DISCRIMINATION

Price discrimination is practiced based on the seller's

belief that customers in certain groups can be asked to pay
more or less based on certain demographics or on how they
Condition Requirements
value the product or service in question.
1. The two or more markets in
Also means one of the following: which the product is sold must
be capable of being separated.
1. Products with identical costs are sold in different
markets at different prices. 2. The demand curves in the
2. The ratio of price to marginal cost differs for similar segmented markets must have
products. different elasticities at given
prices.
The existence of price discrimination is caused by
differing demand conditions, not by differences in cost.
 Types of Price Discrimination

First-Degree price SECOND-Degree price THIRD-Degree price

discrimination discrimination discrimination

The seller charges a different

The seller can identify The monopolist segregates
price for different quantities
where each buyer lies on the customers into
consumed. It involves
the demand curve and can different markets and
differential prices charged by
charge each buyer the charges different prices in
blocks of services. They will
price it is willing to pay. each. This is the most
charge the highest unit price
common practice.
for small quantities and lower
prices as the rate of
consumption per period
increases.
 Third-degree price discrimination

Homogeneous product is (c) is the Total Market

being sold in Market A graph. Because we
and Market B with assume the products
different elasticity. sold in the two markets
Market A is more are homogeneous, we
inelastic compared to can draw a marginal
Market B. cost curve for the firm
as a whole.

The allocation of price and quantity of each market can be determined by

drawing horizontal line from MRT = MCT intersection point.
 Third-degree price discrimination

This is an example of demand schedule for two markets,

as well as the combined schedule for the entire market.
Total market

Market A

Assume that fixed costs are $12,000 per period, and, to

simplify the analysis we assume constant per-unit cost
of AVC = MC = $3.
Market B
 Fixed Cost = $12,000 Total Market AVC = MC = $3

If the company were to sell at a uniform price in both markets, it would maximize its profits at a price of
$18. At that point, its profit would be $10,500.
 Market a

Ifour company can separate

the two markets, it can
increase its total profit. If
it charges $24 per unit in
market A and $12 per unit in
market B, its profits will be
Market B $12,900 and $300,
respectively. Thus, it will be
able to increase its profit by
$2,700.

Total Market profit = $10,500.

Third Degree Price Discrimination profit = Market A profit + Market B profit = $12,900 + $300 = $13,200
Increase in Profit = $2,700
 Profits from First-degree price discrimination

If the company been able to carry out first-degree

discrimination and sold to all potential customers
at the prices they were willing to pay (with the
exception of the last 500 units, which would not
have been produced), its profits would have risen
to $25,500, as shown in table, assuming that all
sales occur at these discrete price points.
 EXAMPLES of price discrimination practices

SEnior citizen public utilities Tourist ticket fare to national Last-minute plane tickets
fare parks
Public transportation commonly National Parks offer different pricing We usually offered best deals from
offered deducted price for seniors for Domestic and Foreign visitors online platform

HIgher university enrollment Weekdays-weekend theatre Business industry public

fee for out-of-state students tickets service bill
Although there are no cost On the weekends, the ticket price will Businesses charged higher than
differentials increased quarter to double from its residential bill
weekdays price
 EXAMPLES of price discrimination practices:
Hotel Inudstry

Often a hotel will have several

different rates, and the actual rate
charged to a particular guest will
depend on the bargaining skill of
the customer and the knowledge of
the innkeeper in estimating the
highest price the potential patron
is willing to pay. Thus, the revenue
Business Leisure of the hotel may be found along
travellers travellers the demand curve (if the manager
Public transportation They want is really proficient at estimating
commonly offered comfortable and the customer’s willingness to pay),
deducted price for longer stay. So, the and the result may approach
first-degree discrimination.
seniors willingness to pay for
leisure abide
 Price discrimination: TYING arrangements

Tying Arrangements (tie-in sale) exists when buyer of a product is obligated to also buy a
related/complementary product from the same supplier.

Characteristics of Tying Arrangements:

● Most of this practices deemed to be illegal by violating antitrust law
● Utilize strong market power to lift the second item market power, then extending to firm
Monopoly (but this argument appeared and proven to be flawed)
● The tied product price need to be lowered

Tying Arrangement Purposes other than price discrimination/monetary profit:

● Evasion of Price Control - evade price control when price ceiling on the goods exists on
Most prominent case in
the market
litigation of U.S. antitrust law
● Efficiencies in Distributions - Reduce shipping costs history is the Government suit
● Quality Control - keep away from being blamed when other cheaper complementary goods against IBM.
are used
Social welfare implications of price
discrimination
● If Price Discrimination increases
output, it is likely beneficial for
society.
● If output isn’t increased, social
welfare is reduced.
 05.
NonMarginal
pricing
 Nonmarginal pricing

There are two types of nonmarginal pricing:

Cost-plus pricing Incremental pricing and costing analysis

 cost -plus pricing

VC + FC + MARKUP

❖ Price is set by calculating the variable cost, ❖ The mark-Up:

adding an allocation for fixed costs, and then ★ Markup applied to obtain a ‘fair’ profit→
adding a profit percentage or markup . it’s vary with the demand elasticity.
★ Strong competition with almost or nearly
❖ Both variable cost and fixed overhead are horizontal demand curve→ Won’t be able
to afford large markup
historical cost which not include opportunity ★ Markup will be changed from time to
cost. time due to change in demand or cost.
 Cost-plus pricing in practice

Wall street Journal article - Parker Hannifin Corp.

Managers at the 89-year-old company used the same simple formula to determine prices of its
products by calculating how much it cost to make and deliver a part and then add a
percentage, much of the time 35 percent.

In 2001, a new executive, Donald Washkewicz decided that prices should be set based on what
customers would be willing to pay.

With the help of consultants the company classified its products by the amount of competition
it faced. It found that there were a large number of products which must to increase by an
average of 5 percent because the uniqueness of the product and didn’t have much competition.

This story want to tell us that in using the formula of cost-plus pricing in this era, we must to
see many factors of our products, such as what customers willing to pay, the uniqueness of our
products and also the competition it faced.
 An arithmetic reconciliation of
cost-plus and marginal pricing

The mathematical relationship among price, marginal revenue, and demand elasticity is:

As profit is maximized when MR=MC, we can rewrite the equation as:

Under certain conditions, marginal cost will equal average cost (AC):

=
 An arithmetic reconciliation of
cost-plus and marginal pricing

It can be shown that there is an inverse relationship between markup and demand elasticity.
For example:
If Ep = -2, then (1+M) = -2/-1 = 2 and M = 100%
If Ep = -5, then (1+M) = -5/-4 = 1.25 and M = 25%
The less elastic the demand curve, the larger will be the markup.
 Incremental pricing and costing analysis

Change in total revenue (TR) and total costs (TC) If there is a change in revenues or costs of
resulting from a particular decision to: another product (complimentary or substitute
❏ Change prices good), it must be included in the analysis.
❏ Introduce a new product
❏ Discontinue an existing product Usually use for analyzing long-term investments.
❏ Improve a product
❏ Acquire additional machinery or plant
 06.
Multiproduct
pricing
 Multiproduct Pricing

There are four types of Multiproduct pricing:

Products complementary in demand Products substitute in demand
Increase in demand of a product
will affect another product; In reverse to Complementary, the
Fixed proportion; Inverse Effect plays role. If the
quantity of bought of product A rise,
By setting the price and quantity there will be decrease in revenue
to be produced using When A firm produces two or more products, the various and profit of product B;
MR of each products = MC products Can be independent from one another so the demand
(demand curve must include both and cost of product a wont affect product b The sales of one product will have
price of products), will maximize negative impacts on the sales of
the profit; others;

By using trial and error process Example: A manufacturer produced

will maximize the profit if different automobiles, A softdrink
theres less information about company produced different
demand and cost function; beverages

Example: personal computer pairs

with software, hamburger pairs
with softdrinks
 Multiproduct Pricing

Cont.

Joint products with fixed proportion

Produce two or more products from one set of
input:
Product A: principle product
Product B: by-product

Example: coconut water and meat, cow skin and

beef

Only constructed one cost curve (combination of

product A and B cost with two independent
demand curve)

By products may faces negative in revenue so

better to keep it within the graph
 Multiproduct Pricing
Cont.
Joint products with variable proportion
Two products are produced from similar resources in
variable proportion:
- Must allocation of cost and quantity to be
produced between the products (depends on
the demand in the market)
- If the company chooses to produce more of
product A, they have to produce less of
product B (due to limited resources)
To optimize, company produces between isorevenue
and isocost curve (point M)
Company can move from I1 to I2 or I3 once they get
additional variable resource means they can produce
more quantity

Example: car manufacturer using steel as resource,

the company must allocate the cost between car A
and Preludes because it cannot produce in the same
amount due to limited resources
07. transfer
pricing
 TRANSFER PRICING

As a product moves from its early stages to the point where it is ready to be sold to consumers,
it is passed from one operating division of the company to another.
The price set by the division transferring the intermediate product becomes the cost of the
division receiving this product.
Each stage of production must measure its costs and then establish a price at which it will
“transfer” its product to the next stage.

We will assume the existence of just two divisions, one that

manufactures components (division C), and another that assembles
them into the final product and sells it (division A).
 No External Market

If there is no possibility for division A to

buy components from a competing firm and
no possibility for division C to sell
components to other companies, then the
two divisions must deal with equal
quantities.

Transfer Pricing with No Market for Intermediate Product

 External markets

It may be possible for division C to sell its (intermediate) product in a competitive market and
for division A to purchase division C’s product (an identical product) in a competitive market.

In that case, the pricing of the product will proceed as follows:

1. Division C will produce at the point where its marginal cost equals the market price
2. The cost of the intermediate product to division A is the market price.
3. Production will take place at the quantity where the total marginal cost equals the
marginal revenue for the final product.
Shows a case where there is a competitive
market for the intermediate product, and
division C produces components in excess of
those used by division A. Assume the market
price for division C’s product is P.
08. Other pricing
practice
 Other pricing practices

Price Limit Predatory Prestige Psychological

skimming pricing pricing pricing pricing

The practice of A monopolist will Setting price below A perception that The practice of
charging a higher price set price below MR marginal cost to charging a higher charging, for ex- ample,
than indicated by = MC to prevent drive competitors price will increase $9.95 rather than $10
economic analysis when potential customers out of the market quantity sold for a product, in the
a company introduces a from entering the because of the belief that such pricing
new product and market. prestige obtained will create the illusion
competi- tion is weak. by the buyer of significantly lower
price to the consumer.
09. The decline
of european
cartels
 tHE EUROPEAN CARTON-BOARD CARTEL

A case involving nineteen carton-board producers in ten

European countries actually resembles the electrical
manufacturers’ case discussed previously. In July 1994,
the European Commission imposed record fines of $159
million on nineteen producers. The cartel involved a
market-sharing agreement and orchestrated 6 to 10
percent price increases each 6 months from 1987 to 1990.

In 1991, officials of the commission staged simultaneous

raids on the producers and found private notes
documenting the dates and amounts of price increases.
One of the companies decided to admit to the conspiracy
and aided the probe, which resulted in heavy fines.
 tHE EUROPEAN VITAMIN CARTEL

In November 2001, the European Commission imposed

fines totaling more than € 850 million (approximately
$747 million) on thirteen pharmaceutical companies for
price fixing of vitamins that had spread over 9 years.
Most of the fine was levied on Roche of Switzerland and
BASF of Germany.

It was said that the companies had virtually operated as

a single company. The cartels met each month or quarter,
exchanged sales and price data, and reviewed quotas
allotted to each company. In some cases, participants
even prepared an annual ‘budget’ to adjust sales
according to each company’s.
 Some recent case of
price fixing

European & European Memory chips P&G and

Steel
japanese eng Elevator produces Unilever
companies
manufacturers
maker

In January 2007, the Five European elevator Ten producers of memory Seventeen steel The European
European Commission makers was fine €992 chips were fined a total of manufacturers were Commission fined
fined ten of these million “for operating €331 million for operating Procter & Gamble €211.2
cartels for the
assessed a total of
companies total of €751 as a price-fixing cartel. The million and Unilever
million for price fixing installation and €518 million; Arcelor
cartel appeared to operate €104 million for fixing
of switchgear used to maintenance of lifts from 1998 to 2002. It Mittal incurred the
and escalators in
the prices of laundry
control electricity to shared information to set largest fine of €276
homes, offices, and Germany, Belgium, detergents during the
prices for dynamic random million. The price period 2002–2005.price
factories. Luxembourg, and the access memory chips
Netherlands. fixing lasted from to the consumer.
(DRAMs) in Europe.
1984 to 2002.
 Price Discrimination by airlines

In December 2003, the European Commission asked

eighteen European airlines whether they charge different
fares on the same flights to residents of different
European Union countries. Most of these price
differentials occurred in tickets ordered on the Internet
and were not connected with different dates of purchase,
possibility of changing reservations, or other features
that could affect cost.

Another case of price discrimination by an airline was

reported in 2003. Apparently, foreigners flying domestic
routes in Vietnam were charged considerably more (as
much as 50 percent) than local fliers.
10. An airline
pricing
example
International sales are seasonal, not weekly, and often route-by-route
rather than global. Sales for travel in the fall are often announced in
late summer. The cheapest fares of the year are in February and appear
in late November and early December. Trips on Tuesday, Wednesday,
and Thursday are usually cheaper than weekend trips.

For every route, airlines load a dozen or more different fares into
reservations systems and then pick which one applies to a specific
flight at a specific time. The fares are set based on the demand for
that flight. The best time to purchase tickets for peak periods is April.

AN AIRPLANE PRICING EXAMPLE

These pricing methods do not necessarily represent

examples of price discrimination (they follow demand
patterns
11. Lesson
learned
 Lesson learned
● Cartels are formed to avoid the uncertainties of a possible reaction by one competitor to
price and production actions by another.
● Price leadership exists when one company establishes a price and others follow
● Baumol’s model describes the actions of a company whose objective is to maximize
revenue subject to a minimum profit constraint.
● Price discrimination exists when a product is sold in different markets at different prices.
● Cost-plus pricing appears to be a very common method. Multiproduct pricing was
examined, because most firms and plants produce more than one product at the same time.
● Several other pricing practices were summarized. One was transfer pricing, which is used
to determine the price of a product that progresses through several stages of production
THANK
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