Topic

10

Pricing
Techniques
and Analysis

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.

Discuss a value-based pricing conceptual framework;

2.

Apply pricing discrimination techniques to maximise shareholders

wealth;

3.

Apply the optimal pricing techniques in large firms such as multiproduct pricing and transfer pricing; and

4.

Apply the concept of pricing throughout the product life cycle

including cost-plus and full-cost pricing, penetration pricing, price
skimming and prestige pricing.

INTRODUCTION
This topic builds on the output and price determination developed in Topics 8
and 9. It examines pricing decisions made in specific situations under imperfectly
competitive markets. Value-based over cost-based pricing is advocated in this
topic. Also, firms charge different customers different prices; which is known as
price discrimination. Price differences tend to be set with respect to their price
elasticity. This topic also looks at pricing within a firm, called transfer pricing.
Pricing techniques that are used by many multi-product firms, such as full-cost
pricing and price skimming are also discussed in this topic.

TOPIC 10 PRICING TECHNIQUES AND ANALYSIS

10.1

153

COST-PLUS AND VALUE-BASED PRICING

The price of the product cannot be the last item to be determined in the design
and cost-specifications of a product or service. This is because if the price does
not meet what customers are willing to pay, it may not be worthwhile to produce
the product or service..
In Topics 8 and 9, the product pricing is cost-based. The optimal output is when
MR = MC.
Given TR = Q times P(Q), the MR can be expressed in terms of price elasticity of
demand, ED.
dTR/dQ = MR = P + (dP/dQ)Q
= P [1 + (dP/dQ)(Q/P)]
= P[1 + 1/ ED]
Optimality is obtained where MR = MC, so
P[1 + 1/ ED] = MC
Notice that as EP goes towards negative infinity, MR approaches P, which occurs
in pure competition.
Often, firm uses markup or cost-plus to determine the price for its product. It
computes the cost of production (variable costs plus an allocation for fixed costs)
and then adds some profit percentages (say 10 % or 20 %) to set its price.
The optimal markup can be found using the above formula.
P = [ED /(ED+1)] x C.
The optimal markup m is:
(1+m) = [ED /(ED+1)]
For example, if ED = -3, the markup is 50%, since = [-3/( -3 +1)] = 1.5.
If ED = -4, the markup is 33.3%, since his is where [-4/( -4 +1)] = 1.333.
If the price elasticity is infinite, the markup is zero. This occurs in competition.

154 TOPIC 10 PRICING TECHNIQUES AND ANALYSIS

In value-based pricing, customers value is the focus for pricing, not just the costs
associated with the product. The pricing of Apple computers, for example, was
above other computers, even as their market share continued to decline. The
Ford Mustang was a success, as Ford found that people wanted a sports car, but
did not want it to be too expensive. Based on the consumers responses, Ford
started with a price and designed the car. The Mustang used value-based, not
cost-plus pricing.
Sometimes it may be more profitable to refuse some orders and accept others by
differentially pricing products. Pricing peak demand above off-peak demand is a
simple form of differential pricing. For example, toll roads and bridges could
charge more during the rush hour. Similarly, popular holiday resorts could
charge more during the holiday seasons. The conditions for peak load pricing
include:

The product or service is not storable.

The same facilities are being used.

There is a variation in the demand.

Suppose we have a traffic situation as shown in Figure 10.1. What price should
we charge for peak and off-peak users?

Figure 10.1: Peak and off-peak demand

Source: McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2005) Managerial economics:
Applications, strategy and tactics (10th ed.). Mason, Ohio: South-Western.
Educational Publishing.

The general solution is:

P(peak) = variable costs + capital costs
P(off-peak) = variable costs only

TOPIC 10 PRICING TECHNIQUES AND ANALYSIS

155

However, some argue that off-peak users benefit from capacity. In the
amusement park, for instance, the off-peak users enjoy more space. In the case of
road traffic, the off-peak road users enjoy less congestion. As such it can be
argued that the off-peak users should also pay for some part of the capital costs.
SELF-CHECK 10.1
1.

What is the difference between cost-plus pricing and value-based

pricing?

2.

Provide examples of cost-plus pricing and value-based pricing.

10.2

PRICE DISCRIMINATION

Price discrimination happens when goods are not priced in proportion to their
marginal costs, even though they are technically similar. Necessary conditions
for price discrimination are:
(a)

One must be able to separate customers or segment to prevent arbitrage;

that is, buying cheaply in one market segment to sell at higher prices in
another market segment.

(b)

Differences in price elasticity must exist in different markets.

(c)

There must be some monopoly power, otherwise P = MC in all markets

would effectively eliminate price discrimination.

Price discrimination is hard to accomplish with goods, since arbitrage of goods is

easy. Hence, it is difficult to segment markets of goods. However, services are
easier to price discriminate. For example, it is impossible to sell a low price
dental operation you received at the Student Health Centre to another person.

10.2.1

Ways of Separating Customers

McGuigan et al. (2005) identified the following to separate customers for price
discrimination:
(a)

Geography; as when the price in the East-side and West-side differ;

(b)

Income; as the American Economic Association charges more to professors

than students;

(c)

Gender; as when jeans for women are priced higher than similar jeans for
men;

156 TOPIC 10 PRICING TECHNIQUES AND ANALYSIS

(d)

Age; as when kids get in at lower prices for movies;

(e)

Time of day or season;

(f)

Race; as when shampoos targeted for African-American hair are priced

differently than other shampoos, though technically they are the same;

(g)

Language; as when products labels

differently than those in English;

(h)

Transient/Resident; as when contractors pay less at hardware stores than

other customers; and

(i)

Ability to Haggle when those who ask for a lower price, get it.

10.2.2

printed in Spanish are priced

Consumer Surplus

The purpose of price discrimination is to earn greater profits by selling at the

highest price that a customer would be willing to pay for each item. By doing
this, the firm will be able to take away the consumer surplus.
Consumer surplus is the difference between the price the consumer is willing to
pay and the actual price. As shown in Figure 10.2, the area below the demand
curve and above the market price is the consumer surplus. It represents the
amount the consumer saves in a transaction if he pays less than the price he is
willing to pay for the given quantity.

Figure 10.2: Consumer surplus

Source: McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2005) Managerial economics:
Applications, strategy and tactics (10th ed.). Mason, Ohio: South-Western. Educational
Publishing

TOPIC 10 PRICING TECHNIQUES AND ANALYSIS

157

In a simple monopoly, the price is the same for all customers. Consumers do
receive a consumer surplus, CS (Figure 10.3), but this is much less than the
situation under pure competition.

Figure 10.3: Simple monopoly and consumer surplus

Source: McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2005) Managerial economics:
Applications, strategy and tactics (10th ed.). Mason, Ohio: South-Western.

A perfectly price discriminating monopolist can charge different prices to

different customers, thus scooping out the entire consumer surplus. There are
three types of price discrimination.

10.2.3

First-degree Price Discrimination

In this type of price discrimination, the seller can identify where each consumer
lies on the demand curve and charges each consumer the highest price the
consumer is willing to pay. This strategy allows the seller to extract the greatest
amount of profits. It results in zero consumer surplus although it requires a
considerable amount of information. The result of first-degree price
discrimination is more production and more profits. The output is the same as
pure competition.
First degree price discrimination may work in used cars and insurance markets.
While looking for a used car, the salesman might ask you how much do you
plan to pay per month? If you inadvertently reply RM 500, you have revealed
to him how much you are willing to pay. He will then find one that fits your
budget and scoop the entire consumer surplus from you!

10.2.4

Second-degree Price Discrimination

The conditions for perfect price discrimination are seldom met, but some close
approximations do exist. With second-degree price discrimination, units are

158 TOPIC 10 PRICING TECHNIQUES AND ANALYSIS

"grouped" and prices are set for groups of units. There are a variety of ways to
group units to scoop out consumer surpluses. Some examples are discussed
below.
(a)

Two-Part Pricing
Two-part pricing refers to charging a price for the privilege of buying
certain product or services PLUS a price per item. The first part of the
pricing strategy is the cover charge and it represents the consumer surplus
that is being scooped out by the firm.
Examples of two-pricing strategy include the followings:

Car rental per day with additional mileage charges per mile

Amusement parks with entrance fees and charges per activity

Country club membership monthly dues and greens fees per golf
game

Cover charge to enter a bar and a price per drink

Figure 10.4: Two-part pricing

Source: McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2005) Managerial economics:
Applications, strategy and tactics (10th ed.). Mason, Ohio: South-Western. Educational
Publishing.

(b)

Unlimited Access
Here, a specified price is charged for an unspecified quantity of the product
or service. Examples include:

Streamyx unlimited access for RM 88 per month

Salad bar at Pizza Hut and soft drink at Burger King

Buffet lunch or dinner at restaurants

TOPIC 10 PRICING TECHNIQUES AND ANALYSIS

159

During the month of Ramadhan, customers are somehow tempted to break

their fast in fancy restaurants and hotels. They pay RM 75 per head. How
much can they really eat and whether that amount is really worth paying
for? Surely it is much less than RM 75. But yet they are willing to pay for it!
(c)

Bundling and Mixed Bundling

Often the pricing arrangement includes purchasing groups of dissimilar
products. The products are bundled or sold as a block. Consider ASTROs
packages. Suppose Roslan loves to watch golf live on TV, he has to buy the
whole sport package which includes the live golf channel but also four
other channels that show all sorts of games which Roslan is not interested
in. By doing that, ASTRO is able to scoop the consumer surplus from
Roslan.
McDonalds sells Extra Value Meals, as a bundle of beef burger, French fries,
and a soft drink for less than it sells them separately. Selling both bundles
and items separately is mixed bundling. If Bob would pay RM 6 for a
burger and RM 2 for a soft drink, and if Mary would pay RM 4 for a burger
and RM 4 for a soft drink, a bundle of RM 8 for both a burger and soda will
work for both customers as a bundle. But if the price of a burger
individually were RM 5 and a soft drink RM 3, then Bob would buy only a
burger and Mary only a soft drink. Hence, as not everyone is alike, mixed
bundles succeeds with more customers.

(d)

Block Rate Setting

Another example of second-degree price discrimination is "block rate
setting". The price for the first group is greater than the next group. Some
telephone companies charge a different price for the first few minutes and
subsequent minutes of long distance calling.

(e)

Other Examples
Other examples include all-or-nothing offers that make customers purchase
large quantities of a product or none at all. An example of this is candy bars
and pop corn sold at movie theatres: notice that only large bars and large
size orders are available!

10.2.5

Third-degree Price Discrimination

For third-degree price discrimination, customers are segregated into different

markets and are charged different prices, based on each groups elasticity of
demand. As discussed earlier, segmentation can be based on any characteristic
such as age, geographic location, gender, income, etc. Price setting is illustrated
graphically in Figure 10.5.

160 TOPIC 10 PRICING TECHNIQUES AND ANALYSIS

Figure 10.5: Third-degree price discrimination

Source: McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2005) Managerial economics:
Applications, strategy and tactics (10th ed.). Mason, Ohio: South-Wester.

Suppose a firm operates in two markets, A and B. The demand in market A is less
elastic than the demand in market B. The entire market faced by the firm is
described by the sum of the demand (DT = DA + DB) and marginal revenue
curves (MRT = MRA + MRB). This is illustrated in the graph at the far right.
The firm finds the total amount to produce by equating the marginal revenue
MRT and marginal costs MCT in the market as a whole. This is labeled as QT.
If the firm is forced to charge a uniform price, it would find the price by
examining the aggregate demand DT at the output level QT. This is represented
by point C in the graph. However, the firm can increase its profits by charging a
different price in each market.
To find the optimum price to charge in each market, draw a horizontal line back
from the MRT/MCT intersection. Where this horizontal line intersects each submarkets MR curve determines the amount that should be sold in each market;
QA and QB. These quantities are then used to determine the price in each market
using the demand curves DA and DB. The price in Market A and Market B is PA
and PB respectively.
Mathematics of Price Discrimination
The marginal revenue is a function of the price elasticity. Optimisation is when
MR = MC. Therefore,

MR = P(l + 1/ED) = MC

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161

If the marginal cost is the same in two markets, then:

P1(1 + l/ED1) = P2(1+/1ED2) = MC

Consequently, the ratio of their prices is a function of their respective elasticities:

P1/P2 = (l +1/ED2)/(1 + 1/EDI)

If ED1 = -1.25 and if ED2 = -2.5, then

P1/P2 = (1 + l/ED2)/(l + l/EDl)

= (1 + l/-2.5)/(l + l/-1.25)
=3
Therefore,

P1 = 3P2.
The price is three times higher in region 1, which less elastic.

SELF-CHECK 10.2
1.

Define price discrimination and state the necessary conditions for

it to work.

2.

Discuss the ways to separate customers for implementing price

discrimination.

3.

What is consumer surplus and in what circumstances does it

influence a firms pricing policy?

4.

Compare and contrast the three types of price discrimination.

5.

Give four examples of second-degree price discrimination.

6.

Discuss how a firm determines quantities and prices of the same

product in different markets under third-degree price
discrimination.

162 TOPIC 10 PRICING TECHNIQUES AND ANALYSIS

10.3

MULTIPLE PRODUCTS PRICING

More often than not, firms produce and sell multiple products that may be
related either on the demand side or on the cost side. Choosing to produce one
more product is an economic decision based on the expected revenues and
expected added costs of the new product. Some new products induce customers
of the firm's old products to switch to the new and more stylish products. In this
case, the demand for the several products is highly interdependent. These effects
w i l l be examined.
In general, there are four types of relationships:
(a)

(b)

(c)

(d)

Products are complements in terms of demand

(i)

An increase in the quantity sold of one will bring about an increase

in the quantity sold of the other.

(ii)

A fast-food restaurant sells both hamburgers and soft drinks.

Products are substitutes in terms of demand

(i)

An increase in the quantity sold of one will bring about a decrease in

the quantity sold of the other.

(ii)

Proton produces both Iswara and Wira.

Products are joined in production

(i)

Products produced from one set of inputs.

(ii)

Cocoa butter and cocoa powder; soybean meal and soybean oil; beef
and leather.

Products compete for resources

(i)

Using resources to produce one product takes those resources away

from producing other products.

(ii)

Proton using steel to produce either Iswara or Wira.

With two products: TR = TRA + TRB.

When the products are interdependent,

MRA = TRA/QA + TRB/QA, and

MRB = TRA/QB + TRB/QB

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163

The interdependency terms are TRB/QA and TRA/QB. When the signs of these
partial derivatives are positive, the products are complementary. When the signs
are negative, the products are substitutes. When they are zero, the products are

independent.

10.3.1

Independent Products

For the moment, assume that the demand for each product in the firm is
independent: the products are neither substitute nor complementary.

For firms with excess capacity, one option is to find new markets.

Entering new markets is in the order of their profitability.

A firm will continue to enter new markets until the marginal profitability of a
new product is zero.

With multiple products, the firm w ill set the firms marginal cost to be equal to
the firms marginal revenue. This equal marginal revenue (EMR) acts like the
marginal costs for the firm. For each product, the firm produces where the EMR
equals the product's marginal revenue.

10.3.2

Joint Products

Joint products are interdependent in the production process, as in producing

beef and hides from slaughtered cattle.
Some joint products occur in fixed proportions, as in one hide and 250 kg of beef
from a steer. Since there are separate demands for the two products, the demand
for "steers" is the vertical sum of the demand for hides and 250 kg of beef.
(a)

The marginal revenue for steers, therefore, is the sum of the MR for hides
and the MR for beef. The profit-maximising quantity of steers is where this
total MR intersects the MC of steers.

(b)

The price for each product is the highest that would be paid for that profitmaximising quantity of steers.

(c)

Sometimes the MR of one of the products is negative at the profitmaximising quantity of steers. Suppose hides have negative MR, then the
firm should sell only the number of hides up to the point where MR equals
zero and hold some of the hides back as excess product.

Some joint products occur in variable proportions, as when the output of a

chemical process is the various proportions of product X and Y.

164 TOPIC 10 PRICING TECHNIQUES AND ANALYSIS

(a)

If the products X and Y are sold in competitive markets, their prices are fixed.
Hence, in product space, the firm will know its isorevenue lines, which will be
straight lines.

(b)

The firm also knows the output combinations available at a given cost, its
isocost lines.

(c)

Therefore, the objective for any given isocost line is to find the maximum
isorevenue line obtainable. This w i l l maximise profits. These points occur
where the ratio of the product prices equals the ratio of their marginal
products. The point of tangency between the isocost and isorevenue curve
that has the highest profit is the one the firm should select.

SELF-CHECK 10.3
1.

List and discuss four types of multi-product relationship.

2.

Discuss the optimal strategy in the production of independent

and joint products.

10.4

TRANSFER PRICING

Large firms which are subdivided into several groups or divisions, have an
exceedingly complex problem of coordination and communication. Each of these
divisions may be charged with a profit objective. As the product moves through
these divisions on the way to the consumer it is sold or transferred from one
division to another at a transfer price. If each division is allowed to choose its
own transfer price without any coordination, the final price of the product to
consumers may not maximise profits for the firm as a whole.
Disagreements between divisions on transfer prices are natural. The division
"selling" a product wants a high price; the "buying" division wants a low price.
Therefore, firms must pay special attention toward designing a transfer pricing
mechanism that is geared toward maximising total company profit. Design of the
optimal transfer pricing mechanism is complicated by the fact that:

Each division may be able to sell its product to external markets as well as
internal ones..

Each division may be able to procure inputs from external markets as well as
internal ones.

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165

Charging "prices" for goods transferred from one division to another in a

vertically integrated line serves several functions:
(a)

A measure of marginal value of the resource: a product that is broken will

"cost" the division that breaks it, the price of the product. So, there is no free
goods.

(b)

A performance measure of the total value of resources used: each division

can be profit centred and evaluated, when appropriate transfer prices exist.

The correct transfer price is the one that would occur if there had been a
competitive market price for the good or service transferred:

If external markets for the good exist, the transfer price typically should be the
price the buying (or selling) division could buy (sell) it for externally. This
procedure tends to be somewhat objective and tends to reduce disagreements
across divisions.

If no external markets exist, then the marginal cost of production of the good
should be the transfer price.

Examples
Assume that a firm has two divisions:

Division P manufactures components.

Division M assembles the components into a final product and sells it.

Case 1: No External Markets

The two divisions must deal with equal quantities. Division P will produce
exactly the number of components that will be used by division M. In this case,
we have one demand curve and two marginal cost curves as shown in Figure
10.6.
The firms total marginal cost is found by vertically adding the marginal costs
from the two divisions. Production should occur where marginal revenue equals
the firms total marginal cost; Point A.

166 TOPIC 10 PRICING TECHNIQUES AND ANALYSIS

Figure 10.6: Transfer pricing No external market

Source: McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2005) Managerial economics:
Applications, strategy and tactics (10th ed.). Mason, Ohio: South-Western.

The final price is determined from the demand curve at this quantity. The
optimal transfer price is given by division Ps marginal cost at the optimal output
level. Thus, the optimal transfer price is P*t.
Case 2: With External Markets
In this case, Division P has the opportunity to sell its intermediate product in a
competitive market. Division M also has the opportunity to purchase the
intermediate product in the same market as well as directly from division P.
Division P produces at the point where MCp intersects Dp. As shown in Figure
10.7, it is Q*p. The transfer price should reflect the competitive price P*t.

TOPIC 10 PRICING TECHNIQUES AND ANALYSIS

167

Figure 10.7: Transfer pricing With external market

Source: McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2005) Managerial economics:
Applications, strategy and tactics (10th ed.). Mason, Ohio: South-Western.

Division Ms total marginal costs becomes

MCt = MCm + Pt.

Optimal production of the firms final output is found by equating MC with MR
in the market for the final product. It is Q*m.

SELF-CHECK 10.4
1.

Explain the concept of transfer pricing.

2.

Based on (a), use graphs to discuss how two divisions within the same
firm determine optimal quantities and prices when there is:
(a)

No external market.

(b)

External market.

168 TOPIC 10 PRICING TECHNIQUES AND ANALYSIS

10.5

OTHER PRICING PRACTICES

In this section, we look at some of the common pricing techniques in practice.

10.5.1 Cost-plus Pricing and Full-cost Pricing

In practice, pricing strategy involves the whole life-cycle pricing of the product.
Managers report wide use of cost-plus pricing methods because it streamlines
pricing of multiple products and streamlines pricing of retail prices. As discussed
earlier in the topic, it is a common practice for manufacturing firms to charge a
markup over ATC at a normal level of capacity, (ACn) or standard costs:

P = ACn + Markup
or

P = ACn(1 + m)
where ACn is the average cost at a normal output and m is a percentage markup.
This is the simplest version of a markup pricing method, which does not look at
all like marginal costs pricing.
In full-costs pricing, the price should cover all costs at a standard or normal output
plus a return on the investment made in the business. If a return on ownersupplied resources is considered an implicit costs, then the price covers the fullcosts of the products.
For example, a full-costs price may attempt to achieve a target return on investment,
which is given in the following target pricing rule:

P = VCl + VCm + F/Q + K / Q

Where

VCl
VCm
K

K
Q

=
=
=
=
=
=

unit labour costs,

unit material costs,
the target amount of profit,
the desired profit rate,
gross operating assets, and
the number of units expected to be produced over this
time orizon.

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169

The advantages of cost-plus pricing are:

Cost-plus is simple

It is easy to delegate to others

Easy to apply to many items (can use categories of markups for different
classes of products)

The disadvantages include:

Cost-plus ignores demand changes

Pricing may be based on poor costs data

Output varies in business cycle

10.5.2

Others Pricing Techniques

(a)

Price Skimming
The first firm to introduce a product may have a temporary monopoly and
may be able to charge high prices and obtain high profits until competition
enters. Examples include PDAs and computers.

(b)

Penetration Pricing
Firm sells its product at a low price in order to obtain market share.

(c)

Prestige Pricing
Demand for a product may be higher at a higher price because of the
prestige that ownership bestows on the owner. Examples include Mercedes,
BMW and Cartier jewellery. However, the firms typically have to spend a
great deal in promotional activities to convince customers that the product
is prestigious.

SELF-CHECK 10.5
1.

What is full-costs pricing?

2.

Discuss briefly price skimming, penetration prices and

prestige pricing. Provide examples of each.

170 TOPIC 10 PRICING TECHNIQUES AND ANALYSIS

ACTIVITY 10.1
Price discrimination is often defended on the basis of equity. What
is meant by this statement? Ask your classmates or friends opinion
about the statement and finally give your comment on its validity

ACTIVITY 10.2
Cost-plus pricing is commonly used by managers.
Is cost-plus pricing inconsistent with marginal pricing?
Does cost-plus pricing necessarily ignore the demand curve?

All pricing decisions should be proactive, systematic, value -based.

Price discrimination is the act of selling the same good and service produced
by a given firm at different prices to different customers. Two conditions are
required for effective price discrimination:

One must be able to segment the market and prevent the transfer of the
product (or service) from one segment to another.

There must be differences in the elasticity of demand at a given price

between the market segments.

To maximise profits using price discrimination, the firm must allocate output
in such a way that marginal revenue is equal in the different market
segments.

Price discrimination is often implemented through two-part pricing. Optimal

two-part prices entail a lump-sum access fee and a user charge that exceeds
marginal cost and varies per unit consumed.

Bundling is another way to price discriminate while charging the same price
to different customers.

For firms selling multiple products with interdependent demands, decisions

to add or withdraw products from existing product lines may have (positive

TOPIC 10 PRICING TECHNIQUES AND ANALYSIS

171

or negative) impacts on the sales of the firms current outputs. In the analysis
of such decisions, it is necessary to include the costs of these impacts in the
marginal costs calculations.

Many actual business pricing practices, such as cost-plus and full-costs

pricing are consistent with the marginal pricing rules of economic theory.

When new products are introduced, firm may use the skimming strategy to
price the product and increase total profits. Prestige pricing is often used in
segmenting markets.

Cost-plus pricing

Price discrimination

Full-cost pricing

Price skimming

Multiproduct pricing

Transfer pricing

Penetration price

Two-part prices

Prestige pricing