Pricing Strategies A Fixed Price A fixed price is a price that is set and known. Everyone would pay the same price. A fixed price is usually what we think about in economics as resulting from the interaction of supply and demand. A fixed price is not so much a pricing strategy than is a condition that can’t be avoided. In a competitive setting, it’s set by Supply and Demand and reflects the marginal cost of production. In the long run, it should be equal to the average cost of production. In an imperfectly competitive industry, price will reflect not only marginal cost and average cost but also elasticity of demand, the more inelastic the demand, the higher the price. In oligopolistic industry, pricing depends on the nature of firms’ interactions (game theory). A common fixed price eliminates gains from arbitrage. A fixed price is fixed only within a specific time frame. Fixed prices do change over time. Some change more rapidly than others. Variable Prices Definition: Variable prices are prices that change from buyer to buyer within the same time frame. Examples: Negotiated prices, for example how most people buy a car (new or used). Auctions. There are different types of auctions: Open ascending-bid (what most people think of as an auction) First-price sealed bid (people submit only one bid, it’s is sealed, highest wins) Second-price sealed bid (Vickrey auction, the highest bidder wins, but pays what the second highest bidder bid) Reserve auctions (a reserve is an amount that the auction price must match or exceed or the seller has a right to withhold the good from sale) Open descending-bid (Dutch auction, price starts high and declines. First person to bid gets the good.) All-pay auctions (everyone must pay the price) Reverse auctions (where sellers bid to supply, instead of buyers bidding). Price Discrimination Definition: Price discrimination is charging different prices to different people for the same good. Traditionally, economists see the goal as a way for the firm to increase profits by expropriating the consumer surplus of high value (inelastic) buyers through higher prices. Economists describe three different “degrees” of price discrimination. First degree price discrimination is impossible. This is when sellers would charge the maximum the consumer would be willing to pay for each good sold. This would require the seller to know the mind perfectly of every consumer. Theoretically, this would be efficient and would expropriate all consumer surplus to the producer. Second degree price discrimination is quantity based price discrimination, when price is reduced for larger quantities. Frequent buyer clubs (such as frequent flyer miles) can be a method of quantity discounting. Though, not all quantity discounts are necessarily forms of price discrimination. Quantity discounts can also reflect a lower cost of goods. Third degree price discrimination is when sellers attempt to segment consumers into groups and charge each segment different prices based on their elasticity of demand. Separating or segmenting the consumers is one of the big obstacles. To overcome this obstacle, firms employ strategies to segment the market. They can include: Using time. This is called intertemporal price discrimination. The most common is “priority pricing”, also called “skimming” or “skim pricing”. This is when you sell something initially at a high price, then lower it later. People who are more insensitive to the price or are not willing to wait will pay more. Some books are sold in both hardback and paperback versions, but they don’t release the paperback, the lower priced version, at that same time as the hardback, often waiting a year. Consumers can start acting strategically if firms attempt to charge higher prices early and predictably lower them later. Consumers may begin “game” this behavior and wait for the price to drop later, not purchasing the good when it first comes out. Another way of using time is having periodic sales. Sophisticated, price sensitive consumers will learn to time their purchases to the sales. Price insensitive buyers or occasional buyers unfamiliar with the market will not be aware of the sales and often pay a higher price. Using specialized, inside knowledge. Using coupons, rebates, or “club cards”. Use of age or verifiable conditions of the buyer. For example, the consumer is a student, in the military, a senior citizen, or a member of AAA. Using location or geography. Some goods are sold at lower prices in certain countries. Ski lift tickets are cheaper bought away from the ski resort. Gasoline companies will set higher prices on gas stations near freeway off-ramps. Versioning or Premium Pricing or Quality discrimination: Offering a more expensive versions of the same good at a price that does not reflect differences in cost. If the price only reflects differences in cost of production, then this isn’t price discrimination. If consumers believe that price reflects quality, then a premium price can be a way to signal quality. Versioning can include altering features or performance of the good. Some software comes in “professional” versions and “home” versions. The professional version offers more features and greater performance. The software company creates the “home” version by turning off some of the features of the software. HP wanted to produce a lower-cost version of one of their printers. They decided to have the low-cost version print more slowly. To achieve that, they had to add a circuit that would slow the printer down. Price discrimination is susceptible to arbitrage where low-price consumer buy and resell the goods to high-price consumers. It’s important for price-discriminating firms to erect “fences” that prevent high-price consumers from finding a way to pay the lower price. Economists often speculate that certain conventions or practices by some firms are a veiled form of price discrimination. This means not all forms of price discrimination are easily identifiable. Price discrimination was originally seen as a method a monopoly could increase profits by capturing more consumer surplus for itself. However, price discrimination can exist in competitive environments if there is “excess capacity” or large fixed costs that need to be covered. In monopolistic competition model, firms end up with an excess of capacity: average cost is falling. Because of the large fixed cost, the firm can’t lower the price on all the goods, but the firm could profitably produce a few extra goods which have a low marginal cost, charging a lower price for only those additional goods. The result would be greater profits and greater consumer surplus which means the economy becomes more efficient. The only way to reach these additional gains is to price discriminate. Airlines are employ many strategies to price discriminate, but it wasn’t monopolization that pushed them to be so inventive. Many of the strategies came about as a result of increased competition which resulted from the deregulation of the airline industry. Initially, price discrimination was seen as a way of capturing consumer surplus. In the competitive case, it’s a way of increasing quantity and possibly selling to customers who might not otherwise be customers. Premium Decoy Pricing or Goldilocks Pricing In the strategy of price discrimination, a premium priced version of a good may get price- insensitive consumers to pay more for a good, but it can have another benefit. It may get consumers to value a mid-priced good even more. A very high priced good could get consumers to buy a mid-priced version instead of a bargained price version. For example, let’s say a company offers two computers, one with 1 gigabyte of storage for $500 and another with 1.5 gigabytes of storage for $600. Consumers tend to opt for the cheaper, $500, computer. Now the company adds a third computer with 2 gigabytes of storage. They have it priced at $900. The purpose is not just to sell those computers at a very high price to price insensitive buyers. It may also get consumer who originally would have bought the $500 computer to now spring for the $600 (the middle one is just right, which is why it’s called “Goldilocks” pricing). With the added $900 computer as another comparison point, the $600 now may appear to some as the better deal. Flanking Goods The point of premium goods is to get some people to pay more for the goods. Flanking goods are the opposite. It’s to retain customers by offering them a lower priced good. A successful, established firm may eventually face competition from firms who enter the market, offering lower price alternatives. One option is for the established firm to lower the price on their traditional good. However, this might not be the best alternative. Another option is for the established firm to create a new good which is priced lowered than the traditional good they sell (the original good will now take on the characteristics of a premium priced good). The new “flanking good” will be sold to compete against the new market entrants. Membership Pricing or Subscription Pricing A membership is a fixed price that does not relate to the quantity purchased. Gym memberships are an example. Two people may pay the same monthly fee, but one person goes for a few hours a month and the other for dozens of hours. The cost per hour ends up being very different. Instead of charging a fixed hourly rate, it charges a flat subscription rate. Some phone service internet service is offered as a subscription rate. It doesn’t matter how much you use the phone or the internet, you pay the same flat rate. Ski lift tickets are another example. People may pay the same rate for a ski lift ticket, but one person may us the lift a few times while another uses is many, many times. This means the cost per lift will vary depending on how many times the person takes the lift up the hill. In a recent news report on the large number of people going to Disneyland during the Christmas season, a consumer was interviewed and stated that they paid $100 to get into Disneyland and could only ride 4 rides because lines were so long. That’s $25 per ride. Thus, Disneyland effectively raised the price of rides in the high demand Christmas season. Peak pricing, Congestion Pricing, Yield Management, Dynamic Pricing, real-time pricing These types of pricing strategies mean to alter prices to reflect changes in demand, especially if supply is very inelastic (airlines: there so many seats on each plane; hotels: there are so many rooms). Peak pricing and congestion pricing (assumed to be the same) means to set a price higher during high demand times. Everyone buying at the high demand time pays more. Yield Management is similar to Peak Pricing except that the price evolves over time as demand becomes known. Prices are changing constantly as demand is revealed. This is the idea of dynamic pricing or real-time pricing. With Yield Management, prices may start out the same for all goods or there may be some peak pricing built in, but as demand appears to be greater for certain goods, the price will rise for those goods. New buyers will have to pay the higher price while people who bought earlier will pay a lower price. This means there is price discrimination. People are paying different prices for the same good. Airlines use some peak pricing by setting the initial price on some flights higher than others when they know there’s higher demand. Airlines also use dynamic or real-time pricing. As a particular flight begins to fill, the airlines (computer programs) will raise the price on that particular flight. This means on a given flight, there can be a wide variety of prices paid for the same flight. This “yield management” is a way they can try to get as many people on their planes and get as much revenue as they can. Governments are now using congestion pricing on some roads, charging more when traffic is heavy. Two-Part Pricing or Affine Pricing Two-part pricing is when the price has a fixed component plus a variable component Examples: A rental car charges a fixed day rate plus a rate for mileage A bar charges for every drink (variable cost) but also charges a cover charge (fixed) Costco charges for every good (variable) but also charges an annual membership fee (fixed, you pay it even if you don’t buy anything from Costco). If the point of the two-part pricing is to expropriate more consumer surplus, then it becomes a “two-part tariff”. Two part tariffs are used in place of monopoly pricing. Instead of setting a high monopolistic price where there’s a corresponding reduction in quantity, the firm keeps price low, but recoups those monopoly profits with the additional fixed charge. Fixed pricing and membership pricing are subsets of two-part pricing. Fixed pricing is two- part pricing when the fixed component is zero. Membership pricing is two-part pricing when the variable component is zero. Tie-Ins Tie-Ins or Tying Contracts are when one purchase is tied to the purchase of another good. The tie can be contractually mandated, such as the purchase of a cell phone requires a service contract. The tie can be design dependent, such as certain razors requiring specific blades made by the same company. Computer printer companies have attempted to create tie-ins by designing ink cartridges that are very specific to that printer. However, the ink cartridge business is so large, third party companies created knock-offs. One use of tie-ins is as a two-part pricing system. There’s a good that’s bought only once, and then something else bought which reflects a quantity of usage. For example, you buy a single printer, that’s the fixed cost. The number of ink cartridges you buy is dependent upon how much printing you do and that’s the variable cost. You buy the razor handle which is a fixed cost and then buy blades as a variable cost. The video game market can be looked at as either tie-in or two-part: the console is the fixed price, each video game is a variable price. The Amazon Kindle is a tie-in that also functions like two part pricing. Buying the Kindle itself is a fixed cost. Buying each book for the Kindle is the variable. With tie-ins and/or two-part pricing, one question is how much is the fixed price and how much is the variable. There are two different strategies. The first strategy is to lower the price to high volume buyers. This is the idea of second-degree price discrimination. In this case, you’d keep the fixed component higher, capturing consumer surplus, and the variable component lower encouraging larger quantity purchases. The second strategy is the reverse. You keep the fixed cost low to encourage people to adopt the good with variable component priced higher to capture revenue and profits. In the video game market, the choice seems to have been to keep the fixed price low (the cost of the console) but make it up by selling more games. While with the Kindle, the early strategy seemed to be the opposite. The strategy was that by buying the Kindle and paying a fixed cost up front, consumers would have access to cheaper books. The variable cost would be lower. Using tie-ins as a two-part pricing system is one usage. Another use of tie-ins is to leverage monopoly power that a firm has in one market into another market. Microsoft had monopolistic control over operating systems for most non-Apple personal computers. Microsoft required computer makers to buy and equip computers with their internet browser (Explorer) and no other if they wanted to have the computer loaded with the Microsoft operating system. Microsoft transferred their monopolistic power in the operating system into the browser market and dominated that market. Tie- ins that function like this are very likely illegal under anti-trust laws. Free (Gratis) & Freemium Most free goods/services aren’t. You pay in some other format. Typically, one must look at ads. Some times free goods/services are offered in conjunction with another good. Free chips and salsa are often offered for free to people buying food and/or drinks at a Mexican restaurant. “Freemium” pricing is when some level of services is provided for free, but then additional “premium” services are not free. There is a lot of software that’s distributed this way. A limited feature version of the software is provided for free with options to buy premium versions with additional features. Performance or Result-based Pricing There are a limited number of examples where the price is based on the results. Some lawsuits are priced based on the results of the suits (contingency fee). Agents charge a percentage fee of the bookings they get. Several weight loss programs experimented with charging customers for the weight they lost. An energy-usage reduction company would charge its business customers based on the energy savings their program generated. Some internet advertising is sold on a performance basis. Instead of charging for how many people see an ad, the price is set by how many people click on an ad to go to the advertiser’s website (called “click-throughs”). Performance based pricing is rare because measuring outcomes is often difficult. It would be very difficult to measure the results, the enjoyment, of a consumer eating a scoop of ice cream or listening to a song. In the case of the agents, performance pricing is used to provide incentives for performance and reducing the cost of the principal-agent problem. Add-On Pricing or Menu Pricing In a general sense, most pricing is add-on. If you go to a grocery store, every additional good you buy is added onto your bill. However, historically, some goods/services included a number of different components that are all provided under a single price. A change will take place in the market where the different components become priced separately. For example, airlines provided meals, blankets and pillows, and transportation of two bags as part of a basic fare. Now, some airlines charge separately for those things. You also have situations where firms start offering new additional services as an add-on. For example, hotels began to offer gyms at an additional fee or in-room bars with candy bars at very high prices, in room movies, or internet access. The notable thing is that the add-on seems to be priced very high (though, perception may not be reality). One theory of add-on pricing suggests that it’s most effective when there is poor information and the add-on prices are less apparent. Savvy buyers will know or quickly learn the price of add-ons, but less-savvy buyers will not. Printers and ink cartridges might be an example. Everyone knows the price of the printer they buy, but studies have suggested consumers don’t have a good notion of the cost (especially per page) of ink cartridges. Add-on pricing becomes a form of price discrimination. Savvy buyers pay less by making choices so as to avoid the add-ons. Less-savvy, or price insensitive, buyers won’t care and will pay the higher price. A business is able to get some people to pay more than others. Bundle Pricing Bundle pricing is when you price an entire bundle of goods/services instead of charging for individual goods/services. It’s the opposite of add-on pricing. Bundling can be a method of offering a quantity discount (second-degree price discrimination). If you buy more, it will get cheaper. Bundling can also be a way of extracting more revenue and consumer surplus if consumer like one good much more than the others, but each consumer likes a different good the most. Examples: cable television where you don’t pay for each channel (except premium channels) Resorts who provide rooms and food (but seldom provide alcohol in the bundle). Fast food restaurants of “meal deals” where goods are bundled. Note: cruise ships do both bundle pricing and add-on. The food and room is bundled, but there are plenty of add-ons including beverages (alcoholic for sure, but also possibly non-alcoholic), snacks or food outside of specific meals, and excursions/land trips. Restaurants offer a variety pricing options. Some restaurants offer everything a la carte where you pay for any sides to the entrée separately. While other restaurants offer prix fixe pricing which is a fixed bundle price for numerous courses and in some cases accompanying wine. Some restaurants do membership pricing (an all-you-can-eat buffet). For a business that has the ability to alter the mix of goods, a fundamental question is whether they should create bundles or follow more menu pricing. Conditions may favor bundles or add-ons. Penetration Pricing This is the opposite of “skimming”. This is when you launch a new good or service with a low price, hoping to expand market share. This would be important if there are positive network externalities (the more people that use your good, the more valuable the good is). Pay What You Want / Donations There are a few examples of businesses not putting a price on a good or service, instead asking consumer to pay whatever they think is appropriate. Since this is so rare and has not been replicated to any significant extent, it makes one think this might be more of a marketing gimmick than a real pricing strategy. Some charities or non-profits use a donation system where people can pay what they want, but even in these cases, the size of the donation is usually suggested. The reason for the donation instead of a specific price is that it allows the charity/non-profit to circumvent certain laws. That is, the laws for accepting “donations” are different than for “selling” a good. Honor System The honor system isn’t a pricing strategy but a collection strategy. A price is usually set, but paying is upon the honor of the consumer. Light rail systems in San Jose, Los Angeles, and San Diego all use the honor system (they require you to hold onto your proof of payment – but passengers are only occasionally audited). The rationale is simple: the cost of having transit employees making sure everyone has paid is more than the loss as a result of cheating. Some shareware software is distributed on the honor system. People who use the software are expected but not required to make a payment to the software developer. Predatory Pricing Predatory pricing is well known, but economists question whether it really exists. There is a strong argument that it’s ineffective. Predatory pricing is the theory that a firm will offer a low price to put everyone else out of business, and then monopolize the industry and charge monopolist prices. The argument that it’s ineffective shows that the loss the firm suffers by pricing so low to drive the other firm out of business is never re-cooped by their later higher prices. That is, the firm will end driving itself out of business. People, not economists, confuse low prices with predatory pricing. For example, people have accused Walmart of predatory pricing because they charge low prices and cause “mom and pop” stores to go out of business. However, Walmart doesn’t raise their price after other stores close. Walmart does not offer low prices to force others out of business. They offer low prices because they have lower costs. Intent Matters A confusing part of the analysis of pricing strategies is that several different pricing strategies may appear to be the same, that the difference is only in the intent of the seller. For example, a firm may offer a quantity discount. This could be interpreted as an example of second degree price discrimination. However, it might also be a simple fixed price scheme. When ordering products that are produced in “runs” there’s a fixed set-up fee. Ordering larger runs results in a lower average cost, so firms will offer a quantity discount. For example, you want to order some custom silk-screened t- shirts. Every firm that does this has quantity discounts because of the fixed set-up costs. The quantity discount doesn’t reflect difference in demand but differences in cost. Another example would be two-part pricing. Some two-part prices may be two-part tariffs where firms are attempting to expropriate consumer surplus, turning it into profit. However, if there are fixed and variable costs, like with rental cars, it may not be a true two-part tariff. With car rentals, there is the cost of the car itself, and the cost of the mileage put on the car. The two part pricing is reflecting the different costs of the good. Is it always obvious which pricing strategy is being employed in the real world? No. Economists often have to dig for evidence. For example, when HP offered a slower printer at a lower price, that turned out to be price discrimination because there wasn’t a cost difference. It wasn’t that the slower printer was cheaper to make. It was eventually discovered that HP had to add a circuit (a wait state) to create the slower printer. Economists will speculate on why a pricing strategy is the way it is which later may turn out to be wrong. Or newer explanations may be more persuasive. Pricing Anomalies Given all the above different pricing strategies, there are real-world examples where economists are not sure why a certain price is the way it is. These are pricing anomalies, and economic research attempts to explain these. A classic example is why does movie popcorn cost so much? A traditional argument is that this is an example of a monopolist charging a non-competitive price, but some economists have argued that though the movie theater has a monopoly once inside the theater, the theater has to be competitive before you buy a ticket. Everyone knows going into the theater it will be high. Another famous anomaly also concerns movie theaters. Why don’t movie theaters charge more for popular movies? They charge the same price whether the movie is wildly popular and sold-out or a complete flop. One of my favorite anomalies is why do some restaurants offer buffets? And, why are they so common in Las Vegas? Looking at anomalies: if there is a pricing anomaly, the simplest assumption is the firm is acting stupidly and not profit maximizing. Making that leap, however, provides no insight. Instead, economist start by assuming the firm is doing something smart, and we don’t understand the context that makes their decision optimal and appropriate. The firms using the strategy may not understand why it works. A process of trial and error of different strategies might have been tried and one worked best. Other firms duplicate the successful strategy. Even though many firms may use the strategy, no one may know why it works. This becomes a job of economics, to explain why a particular strategy works.
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