CHAPTER 9 | Pricing Strategy and Price Discrimination 1

CHAPTER 9 | Pricing Strategy

Chapter Outline

Getting into Walt Disney World: One Price Does Not Fit All

Walt Disney World and many other firms charge consumers different prices based on
their willingness to pay for their products. Disneyland and Disney World charge a high
price for admission, but rides inside the parks are free. Other firms use a similar pricing
strategy to increase their profits.

9.1 Pricing Strategy, the Law of One Price, and Arbitrage

Define the law of one price and explain the role of arbitrage.

 Arbitrage limits the ability of firms to charge different prices to different

consumers.

9.2 Price Discrimination: Charging Different Prices for the Same Product
Explain how a firm can increase its profits through price discrimination.

 Successful price discrimination requires: that a firm possess market

power; that some consumers have greater willingness to pay for the
product than other consumers and that the firm be able to know what
prices customers are willing to pay; and that the firm be able to segment
the market to prevent arbitrage.

9.3 Other Pricing Strategies

Explain how some firms increase their profits through the use of odd pricing,
cost-plus pricing, and two-part tariffs.

 Firms use odd pricing when, for example, they charge $4.95 instead of
$5.00.
 Many firms use cost-plus pricing, which involves adding a percentage
markup to average cost.
 Some firms require consumers to pay an initial fee for the right to buy their
product and an additional fee for each unit of the product purchased.
Economists refer to this as a two-part tariff.

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 CHAPTER 9 | Pricing Strategy and Price Discrimination 2

Pricing Strategy, the Law of One Price, and Arbitrage

9.1
Learning Objective: Define the law of one price and explain the role of arbitrage.

Many firms practice price discrimination by charging different consumers different

prices. Some firms use technology to gather information on the preferences of
consumers and their responsiveness to price changes. This information is used to
adjust the prices of goods and services. This practice of rapidly adjusting prices is called
yield management.

A. Arbitrage
According to the law of one price, identical products should sell for the same price
everywhere. Arbitrage, buying in one market at a low price and reselling it in another
market at a high price, is the reason that the law of one price usually holds if
transactions costs are zero. Transactions costs are the costs in time and other
resources that parties incur in the process of agreeing to and carrying out an
exchange of goods or services.

B. Why Don’t All Firms Charge the Same Price?

The law of one price may appear to be violated even when transactions costs are
zero and a product cannot be resold. This contradiction can be resolved by
examining the “product” sold by online book sellers. Firms may appear to charge
different prices for the same product when the services they offer explain these
differences. Some customers prefer to buy a book online at a greater price from
Amazon.com than from another online bookstore because Amazon delivers the book
quickly to their homes and accepts payment using a secure method that protects
their credit card numbers.

Arbitrage explains why differences in prices for stocks, commodities, and foreign
exchange in different markets are short lived. Trades in these markets are made quickly
and transactions costs are relatively small.

9.1.1 According to the law of one price, identical products usually sell for the same
price everywhere. Arbitrage is the practice of buying a product in one market at a
low price and reselling it in another market at a high price.

9.1.2 When arbitrage can easily occur, the law of one price will hold, but if transactions
costs are high, the law of one price needn’t hold.

9.1.3 If New York residents are buying goods at a low price in New Jersey, but they
are not re-selling them at a higher price in New York. So they are not, strictly
speaking, engaged in arbitrage.

9.2 Price Discrimination: Charging Different Prices for the Same Product

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 CHAPTER 9 | Pricing Strategy and Price Discrimination 3

Learning Objective: Explain how a firm can increase its profits through price
discrimination.

Charging different prices to different customers for the same product when the price
differences are not due to differences in cost is called price discrimination.

A. The Requirements for Successful Price Discrimination

Successful price discrimination has three requirements:
(1) A firm must possess market power.
(2) Some consumers must have a greater willingness to pay for the product than other
consumers, and the firm must be able to know what prices customers are willing to
pay.
(3) The firm must be able to divide up—or segment—the market for the product so that
consumers who buy the product at a low price are not able to resell it at a high price.
Price discrimination will not work if arbitrage is possible.

Because most firms do not sell in perfectly competitive markets, they have some market
power and can set the price of the good they sell. When firms can price discriminate,
they will charge customers who are less sensitive to price—those whose demand for
the product is less elastic—a higher price and charge customers who are more sensitive
to price—those whose demand is more elastic—a lower price.

B. Airlines: The Kings of Price Discrimination

Once a plane has taken off for its destination, any seat not sold on that flight will
never be sold. In addition, the marginal cost of flying one additional passenger is
low. This gives airlines an incentive to manage prices so that as many seats as
possible are filled on each flight. Airlines will maximize their profits by charging
business travelers higher prices than leisure travelers, but airlines need to determine
who is a business traveler and who is a leisure traveler. Some airlines identify
business travelers by requiring people who buy at the leisure price to buy fourteen
days in advance and stay at their destination over a Saturday night. Anyone unable
to meet these requirements must pay a much higher price. The airlines also use
computer models to calculate a suggested price each day for each seat. The
practice of continually adjusting prices to take into account fluctuations in demand is
called yield management.

C. Perfect Price Discrimination

If a firm knew every consumer’s willingness to pay—and could keep consumers who
bought a product at a lower price from reselling it—the firm could charge every
consumer a different price. In this case of perfect price discrimination—also known
as first-degree price discrimination—each consumer would have to pay a price equal
to her willingness to pay and would receive no consumer surplus.

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D. Price Discrimination across Time

Firms sometimes charge a higher price for a product when it is first introduced and a
lower price later. Some consumers are early adopters who will pay a high price to be
among the first to own certain products. Book publishers routinely use price
discrimination across time to increase profits. Hardcover editions of novels have
much higher prices and are published months before paperback editions. A
publisher will maximize profits by segmenting the market across time and by
charging more to the less elastic market segment and a lower price to the more
elastic segment.

E. Can Price Discrimination Be Illegal?

The Robinson-Patman Act of 1936 outlawed price discrimination that reduced
competition if its effect is to reduce competition in an industry. But the act contained
language that could be interpreted as making illegal all price discrimination not
based on differences in cost. In recent years, the courts have interpreted Robinson-
Patman narrowly, allowing firms to use the types of discrimination described in this
chapter.

9.2.1 Price discrimination is charging different prices to different customers for the
same product when the price differences are not due to differences in cost. A firm
can successfully practice price discrimination if it possesses market power, if
some consumers have a greater willingness to pay than others, if the firm knows
what prices customers are willing to pay, and if the firm can divide up (or
segment) the market so that consumers who buy the product at a low price
cannot resell it at a high price (in other words, consumers cannot practice
arbitrage).

9.2.2 U.S. Airways and other airlines use the strategy of yield management as a way of
segmenting the market. Those travelers who can plan to buy tickets in advance
are generally leisure travelers who aren’t willing to pay as much for their flights.
Those travelers who cannot plan as far in advance are generally business
travelers who are willing to pay more.

9.2.3 Yield management is the use of sophisticated models of demand and pricing
strategies to maximize revenue and profits. One example of yield management is
the practice of airlines varying ticket prices based on the season, length of route,
day of the week, time of day, and type of passengers on the flight.

9.2.4 Perfect price discrimination (also called first-degree price discrimination) is the
practice of charging each consumer a price equal to the consumer’s willingness
to pay. It is not likely to ever occur in practice because firms cannot know the
exact amount most customers are willing to pay. It is economically efficient
because output is increased to the point where marginal cost equals marginal
benefit. However, all consumer surplus is eliminated.

9.2.5 An example of price discrimination across time is when early buyers, whose price
elasticity is lower, are charged more than later buyers—whose price elasticity is

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higher. This type of price discrimination occurs in the market for hardcover fiction
books and in the markets for many consumer electronics products.

Examples of Price Discrimination Strategies.

Example 1. A “road warrior” is a person who travels extensively on business. These

are people who are not likely to be in any one location for more
than one or two days at a time. A company may put restrictions on a
service that make that service less desirable to some of its customers if
those customers do not have any viable alternative to using the
service, and if the restrictions increase the profitability of the
company.

Example 2. AMC( a movie theatre) is attempting to price discriminate between those

willing to pay a high price and attend a movie during the normal
afternoon and evening hours and those not willing to pay high prices.
The second group, whose price elasticity of demand for seeing movies
will be relatively high, are charged a lower price during less convenient
morning shows. Audiences that AMC may reach in this way include
senior citizens and families with small children who may not have
otherwise attended the movies at all.

Other Pricing Strategies

9.3 Learning Objective: Explain how some firms increase their profits through the use
of odd pricing, cost-plus pricing, and two-part tariffs.

Firms use different pricing strategies that depend on the nature of the products, the
level of competition, and the characteristics of their customers.

A. Odd Pricing: Why Is the Price $2.99 Instead of $3.00?

Many firms use what is called odd pricing—charging $4.95 instead of $5.00 or $199
instead of $200. Surveys show that over 80 percent of supermarket prices end in “9”
or “5” instead of “0.” The origins of odd pricing are not known for certain. One reason
that odd pricing is used today is that the odd price seems cheaper than it really is.
Market researchers have surveyed consumers about their willingness to purchase
different products at a series of prices. Nine of ten odd prices resulted in an odd-
price effect, with the quantity demanded being greater than predicted using an
estimated demand curve. But the study was not conclusive since it relied on surveys
rather than actual purchasing behavior and used only a small number of products.

B. Why Do Some Firms Use Cost-Plus Pricing?

Many firms use cost-plus pricing, which involves adding a percentage markup to
average cost. The firm calculates average cost, usually at a level of production equal
to its expected sales. It then increases average cost by a percentage amount to
arrive at the price. A firm selling multiple products uses the markup to cover all its

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costs. A difficulty with cost-plus pricing is that it does not appear to maximize profits
unless the cost-plus price turns out to be the same as the price causing the quantity
sold to be where marginal revenue is equal to marginal cost. Economists have two
views regarding cost-plus pricing. One is that cost-plus pricing is simply a mistake
that firms should avoid. The other view is that cost-plus pricing is a good way to
come close to the profit-maximizing price when either marginal revenue or marginal
cost is difficult to calculate. The most obvious problems with cost-plus pricing are
that it ignores demand and that it focuses on average cost rather than marginal cost.
Despite these problems, cost-plus pricing is used by some large firms. Cost-price
pricing may be the best way to determine the optimal price in two situations. The first
situation is when marginal and average costs are roughly equal, and the second
situation is when the firm has difficulty estimating its demand curve.

C. Why Do Some Firms Use Two-Part Tariffs?

Some firms require consumers to pay a two-part tariff, which means that
consumers pay one price (or tariff) for the right to buy as much of a related good as
they want at a second price. Note that when a firm uses an optimal two-part tariff:
(1) The outcome is economically efficient because price equals marginal cost at the
level of output supplied.
(2) All consumer surplus is transformed into profit.

9.3.1 Odd pricing is the practice of charging prices that aren’t round numbers,
especially prices ending in 9 or 5 rather than 0. One important reason for odd
pricing is to give buyers the illusion that they are paying significantly less: $99.99
seems significantly less than $100 to some people.

9.3.2 Cost-plus pricing involves setting prices by adding a percentage markup to

average cost. It does not seem to be consistent with profit maximization in most
cases—unless marginal cost and average cost are roughly equal and the firm
has trouble estimating its demand curve.

9.3.3 A two-part tariff exists when consumers pay one price for the right to buy a good
and another price for each unit of the good itself. An example is cell phone
companies, who sometimes charge both a monthly fee and a per-minute charge;
or country clubs, which have annual membership fees and also charges
members each time they use the tennis court or golf course.

9.3.4 Disney switched because they thought the two-part tariff pricing strategy would
increase revenues and profits, as shown in Figure 16.5 (kindly refer to the PPT
slides). The switch probably reduced their costs as well because tickets did not
have to be collected at the entrance to each ride.

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Review Questions

1) If a price discriminating monopoly charges a higher price to students, it is likely that the
firm:
a) believes that student demand is relatively elastic.
b) believes that student demand is relatively inelastic.
c) wants to shift student demand.
d) is primarily concerned about the well-being of students.

2) Price discrimination generally

a) increases consumer surplus and producer surplus.
b) increases consumer surplus and total surplus.
c) increases producer surplus and total surplus.
d) reduces consumer surplus and producer surplus.
e) reduces consumer surplus and total surplus.
f) reduces producer surplus and total surplus.

3) One difference between perfect competition and monopolistic competition is that

a) a perfectly competitive industry has fewer firms.
b) in perfect competition, firms slightly differentiate products.
c) monopolistic competition has no barriers to entry.
d) firms in monopolistic competition have market power.

4) Competition authorities are unlikely to regulate monopolistically competitive industries

because:
a) monopolistically competitive firms are allocatively efficient.
b) monopolistically competitive firms are productively efficient.
c) monopolistically competitive firms earn zero profits, so cannot be required to reduce
prices.
d) monopolistically competitive firms are too numerous to regulate.

5) Which of the following is NOT a feature of oligopoly:

a) firms in an oligopolistic market must take account of the effects of their actions on
other firms in the market.
b) there are effective barriers to entry.
c) there are few firms in an oligopolistic market.
d) the firms in an oligopolistic market are price takers.
e) collusion is a problem in oligopolistic markets.

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