9781118041581

Demand Analysis and Optimal Pricing 101

Like the method just described, a second approach to price discrimina-

tion treats different segments as distinct markets and sets out to maximize profit

separately in each. The difference is that the manager’s focus is on optimal

sales quantities rather than prices. The optimal sales quantity for each market

is determined by setting the extra revenue from selling an extra unit in that

market equal to the marginal cost of production. In short, the firm sets MR 

MC in each market.

Multinational

Production and

Pricing Revisited

In the first example in Chapter 1, an automobile producer faced the problem

of pricing its output at home and abroad. We are now ready to put demand

analysis to work to determine the firm’s optimal decisions. The facts are as

follows: The producer faces relatively little competition at home; it is one of the

most efficient domestic producers, and trade barriers limit the import of

foreign cars. However, it competes in the foreign market with many local and

foreign manufacturers. Under these circumstances, demand at home is likely

to be much more inelastic than demand in the foreign country. Suppose that

the price equations at home (H) and abroad (F) are, respectively,

,

where price is in dollars per vehicle and quantities are annual sales of vehicles

in thousands. Automobiles are produced in a single domestic facility at a mar-

ginal cost of $10,000 per vehicle. This is the MC relevant to vehicles sold in the

domestic market. Shipping vehicles to the foreign market halfway around

the world involves additional transport costs of $1,000 per vehicle. What are the

firm’s optimal sales quantities and prices?

Addressing this question is straightforward, but the answer may come as a

surprise. The quantities of cars sold to the respective markets are determined

by the conditions MRHMCHand MRFMCF. Therefore, 30,000 100QH

10,000 and 25,000 140QF11,000. The optimal quantities and prices

(after substituting back into the demand curves) are QH200 thousand and

PH$20,000 in the domestic market and QF100 thousand and PF

$18,000 in the foreign market. The surprise comes when we compare domes-

tic and foreign prices. Even though the marginal cost of vehicles sold in the for-

eign market is 10 percent higher than that of cars sold domestically, the foreign

price is lower—by some 10 percent—than the domestic price. Why is it prof-

itable for the company to sell on the foreign market at a much lower price than

at home? It must be because demand is much more elastic abroad than it is

domestically. Accordingly, the company’s pricing policy is a textbook case of

an optimal dual-pricing strategy.

DEMAND-BASED PRICING As these examples indicate, the ways in which firms

price discriminate are varied. Indeed, there are many forms of demand-based

PH30,00050QH and PF25,00070QF

c03DemandAnalysisAndOptimalPricing.qxd 8/18/11 6:48 PM Page 101