Peak-Load PricingWhen demand is not evenly distributed, a firm needs to have facilities to accommodate periods of high demand.Even with large facilities, the firm may experience times when the demand is greater than can be handled. Then the firm may experience costly computer system crashes.During off-peak times (periods of lower demand), there is excess capacity.The firm charges less at off-peak times.Example: More phone calls are made during business hours than in the evenings and on weekends. So the phone companies charge more during business hours.
Peak load pricing• The effect of peak-load pricing is to induce some consumption to shift, away from the times of• peak demand, and toward times of lower demand. Consumers are rewarded -- in the sense that they pay• less -- for using the service when there is ample unutilised capacity, rather than when demand takes up• or even exceeds all the capacity. This makes for more efficient use of existing capacity.
Peak load pricing• Telephone service providers, for instance, charges a lower call rate from 11:00 pm to 6:00am. Long distance calls made during off-peak periods also cost less. Some “decongestion” results from this practice.• The same outcome happens when airlines charge higher fares during the tourist season.
Peak load pricing• This shifting of consumption creates what economists call “efficiency gains.” If airfares were kept uniform, airlines would forego profits because they have to turn away passengers when flights are fully booked, while other flights take off with a lot of empty seats.• The “average” price has the effect of encouraging higher consumption during peak periods and lower consumption during off-peak periods -- which producers and consumers don’t really want.
Peak load pricing• The high demand at certain hours would compel the producers to install additional capacity. Producers would have to pump in additional capital, and pass the cost on to consumers. However, the increased capacity becomes even more under-utilized during the off-peak hours.
Peak load pricing• The effect of peak-load pricing is to induce some consumption to shift, away from the times of peak demand, and toward times of lower demand. Consumers are rewarded -- in the sense that they pay less -- for using the service when there is ample unutilised capacity, rather than when demand takes up or even exceeds all the capacity. This makes for more efficient use of existing capacity.
Two- Part Tariffs• Two- Part Tariffs Consumers pay a one-time access fee (T) for the right to buy a product, and a per-unit price (P) for each unit they consume.• Examples: Amusement parks, Golf Clubs, T-passes,• Necessary conditions for Two-Part Tariff implementation:• Firm must have market power• Firm must be able to control access• Homogeneous consumer demand (all the consumers within the same segment have the same demand curve)
Example• Some video game stores offer customers two ways to rent cds:• (i) Pay an annual membership fee (e.g., $40), and then pay a small fee for the daily rental of each film (e.g., $2 per film per day) (Two part Tariff)• (ii) Pay no membership fee, but pay a higher daily rental fee (e.g., $4 per game per day) (Simple rental fee) Why might it be more profitable to offer consumers a choice of two plans, rather than a single plan for all customers?•
Example• A classic price discrimination example. The store has created a menu of choices where each plan appeals to a different group of consumers that will self select into the option designed for them. The high demand consumer will probably choose the two-part tariff, while the casual consumer will prefer the simple rental fee.• Profits will be greater with price discrimination than with a single pricing scheme for all customers
The “Two-Part Tariff”• There are two components to the price: a unit price (P) for each unit consumed, & a “tariff” (T) for entry into the market.• Examples include telephone service, health clubs, etc.• The tariff enables the firm to capture some consumer surplus.
Suppose that a firm has constant average and marginal costs asshown. Also, each customer has the indicated demand curve. Suppose that the firm charges price P* per unit. P Based on the per unit charge, the firm earns revenues equal to the area of the blue box. P* ATC=MC D Q Q*
The firm can also pick up the consumer surplus, if it charges a membership fee equal• P to the area of the green triangle. P* ATC=MC D Q Q*
Bundling• Bundling is packaging two or more products to gain a pricing advantage.• Conditions necessary for bundling to be the appropriate pricing alternative:• Customers are heterogeneous.• Price discrimination is not possible.• Demands for the two products are negatively correlated.
Bundling• Bundling Bundling refers to selling more than one product at a single price.• When is bundling applicable:• The firm has market power• Price discrimination is not possible (inability to offer different prices to different customers or segments)• Demand for two or more goods to be sold is negatively correlated (the more consumers demand one good, the less they will demand of the other good)
Types of bundling• Pure Bundling: Consumers must buy both goods together; the choice of buying one good without buying the other is NOT given.• Mixed Bundling: Consumers have the choice of buying both goods or buying one good without the other.
Consider the following reservations prices, for two buyers: Alan and Beth Sum of Stereo TV reservation prices Alan $225 $375 $600 Beth $325 $275 $600 Maximum price for $225 $275both to buy the goodTo get both people to buy both goods without bundling, you canonly charge $225 + $275 = $500, & each person would haveconsumer surplus of $600 – $500 = $100.If you bundle, you can charge $600 & consumer surplus = 0.
Transfer Pricing• Sometimes firms are organized into separate divisions.• One division may produce an intermediate product and supply it to another division to produce the final product.• How does the firm determine the efficient price at which the intermediate product should be sold. That is, what is the transfer price?
The Simplest Case• The firm has 2 divisions: E and A• Division E produces the intermediate product (engine) for Division A which produces the final product (automobile).• Division E does not sell engines to anyone but division A, and division A does not buy engines from anyone but division E.• Each unit of output (automobile) requires one unit of the input (engine).• The goal is to maximize the firm’s profit.
How do we determine the optimal quantity & price for the final product (the auto)?•First, find the company’s (total) marginal cost MCT, which isthe marginal cost of division E’s producing an engine (MCE)plus the marginal cost of division A’s producing an auto(MCA).•That is, MCT = MCA + MCE .•Then, produce the amount of output (autos) so that themarginal revenue from selling an auto (MR) is equal to themarginal cost of production (MCT).•The appropriate price of the auto for that quantity ofoutput is determined from the demand curve for the firm’sautos.
Transfer pricingTransfer Price is: the internal price charged by one segment of a firm for a product or service supplied to another segment of the same firmSuch as:• Internal charge paid by final assembly division for components produced by other divisions• Service fees to operating departments for telecommunications, maintenance, and services by support services departments 20
Transfer Pricing• The transfer price creates revenues for the selling subunit and purchase costs for the buying subunit, affecting each subunit’s operating income• Intermediate Product – the product or service transferred between subunits of an organization 21
Effects of Transfer PricesPerformance measurement:• Reallocate total company profits among business segments• Influence decision making by purchasing, production, marketing, and investment managersRewards and punishments:• Compensation for divisional managersPartitioning decision rights:• Disputes over determining transfer prices 22
Three Transfer Pricing Methods1. Market-based Transfer Prices2. Cost-based Transfer Prices3. Negotiated Transfer Prices 23
Market-Based Transfer Prices• Top management chooses to use the price of a similar product or service that is publicly available. Sources of prices include trade associations, competitors, etc. 24
Market-Based Transfer Prices• Lead to optimal decision making when three conditions are satisfied: 1. The market for the intermediate product is perfectly competitive 2. Interdependencies of subunits are minimal 3. There are no additional costs or benefits to the company as a whole from buying or selling in the external market instead of transacting internally 25
Market-Based Transfer Prices• A perfectly competitive market exists when there is a homogeneous product with buying prices equal to selling prices and no individual buyer or seller can affect those prices by their own actions• Allows a firm to achieve goal congruence, motivating management effort, subunit performance evaluations, and subunit autonomy• Perhaps should not be used if the market is currently in a state of “distress pricing” 26
Cost-Based Transfer Prices• Top management chooses a transfer price based on the costs of producing the intermediate product. Examples include: – Variable Production Costs – Variable and Fixed Production Costs – Full Costs (including life-cycle costs) – One of the above, plus some markup• Useful when market prices are unavailable, inappropriate, or too costly to obtain 27
Negotiated Transfer Prices• Occasionally, subunits of a firm are free to negotiate the transfer price between themselves and then to decide whether to buy and sell internally or deal with external parties• May or may not bear any resemblance to cost or market data• Often used when market prices are volatile• Represent the outcome of a bargaining process between the selling and buying subunits 28
Comparison of Transfer-Pricing Methods Criteria Market- Cost- Negotiated Based Based Achieves Goal Yes, when Often, but not Yes Congruence markets are always competitive Useful for Yes, when Difficult unless Yes, but transferEvaluating Subunit markets are transfer price prices are affected Performance competitive exceeds full cost by bargaining strengths of the buying and selling divisions 29
Comparison of Transfer-Pricing Methods Criteria Market- Cost- Negotiated Based Based Motivates Yes Yes, when based on Yes Management budgeted costs; Effort less incentive to control costs if transfers are based on actual costsPreserves Subunit Yes, when No, because it is Yes, because it is Autonomy markets are rule-based based on competitive negotiations between subunits 30
Comparison of Transfer-Pricing Methods Criteria Market- Cost- Negotiated Based BasedOther Factors No market may Useful for Bargaining and exist or determining negotiations markets may full cost of take time and be imperfect or products; easy may need to be in distress to implement reviewed repeatedly as conditions change 31
Minimum Transfer Price• The minimum transfer price in many situations should be: Incremental cost per unit Minimum incurred up to the point of Opportunity Cost per unit Transfer Price = transfer + to the selling subunit – Incremental cost is the additional cost of producing and transferring the product or service – Opportunity cost is the maximum contribution margin forgone by the selling subunit if the product or service is transferred internally 32
Transfer Pricing for International TaxationWhen products or services of a multinational firm are transferred between segments located in countries with different tax rates, the firm attempts to set a transfer price that minimizes total income tax liability.Segment in higher tax country: Reduce taxable income in that country by charging high prices on imports and low prices on exports.Segment in lower tax country: Increase taxable income in that country by charging low prices on imports and high prices on exports. 33