CHAPTER 11 Foreign Exchange, Trade, and Bubbles ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images ● In the market for foreign exchange, the supply of pounds includes everyone in Britain who wants to buy Icelandic goods, or invest in Iceland. To do so, they must “sell pounds to buy krona.” The supply of pounds is also equal to the demand for krona. ● In the market for foreign exchange, the demand for pounds includes everyone in Iceland who wants to buy British goods, or invest in Britain. To do so, they must “sell krona to buy pounds.” The demand for pounds is also equal to the supply of krona. ● The so-called “carry trade,” borrowing in foreign currencies to spend or invest domestically, increases demand for the domestic currency, appreciating the domestic currency. However, borrowing in foreign currency to buy imports or ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 2 • continued ● Currency devaluations help suppliers because they make exports less expensive in the foreign currency; but they hurt consumers because they make imports more expensive in the domestic currency. ● Once started, expectations about the future play a role in keeping bubbles going. If buyers expect a future price increase, they will accelerate their purchases to avoid it. Similarly, sellers will delay selling to take advantage of it. ● You can potentially identify bubbles by using the “indifference principle” of Chapter 9 to tell you when market prices move away from their long-run equilibrium relationships. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 3 Iceland ● In 2003, Iceland’s three banks borrowed from other banks and began investing in foreign assets. • Icelandic banks borrowed as much as they could, as fast as they could – and used the money to buy as much as they could ● By 2006 it was becoming difficult for Icelandic banks to borrow. So they began accepting internet deposits – essentially borrowing money from British residents. • They offered the highest interest rate available and British consumers sold pounds to buy krona to deposit in Icelandic banks. ● The expansion of the financial sector created a domestic consumption spree – mostly of imports. • And if Icelandic citizens didn’t have the cash to buy goods, they simply borrowed (from foreign banks because foreign interest rates were 3% versus domestic rates of 15.5%) ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 4 Iceland (continued) ● Normally, gov’t insurance prevents bank runs, but in this case, Iceland’s deposit guarantees were several times greater than its entire national income. ● When the British depositors finally became concerned about repayment, the resulting bank run devastated the country. • The krona fell dramatically in value and domestic prices soared. • Today, Iceland is broke. Consumer debt is 8x the national income, and because the krona has depreciated, paying back foreign loans will be difficult for Iceland’s citizens. ● This chapter develops tools to allow us to understand what happened in Iceland. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 5 Foreign Exchange ● Why trade one currency for another? • To invest in a foreign country, or to buy exports from a foreign country. • This increases demand for the foreign currency. ● British consumers “sold pounds to buy krona” so they could deposit krona in Icelandic banks. ● Example: An Icelander buys American real estate. The krona used to purchase the house must be exchanged for dollars in order to complete the transaction • An easier way to think of this is that foreign goods can be bought only with foreign currency. The buyer must sell krona to buy dollars in order to buy the house. • Model this as an increase in Icelandic demand for dollars. • The exchange rate of krona to dollars is an equilibrium price set so that the supply of dollars equals the demand for dollars ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 6 Exchange rate ● Example: price of a British pound measured in krona, i.e., how many krona are needed to buy one pound. The appreciation of the pound is equivalent to a devaluation of the krona. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 7 Carry trade ● The Carry trade: (from Iceland’s point of view) Icelanders borrow pounds in order to invest domestically. • Why? • When the cost of borrowing domestically (domestic interest rates) increases, Icelanders find a cheaper source of funds – they borrow from foreign countries with lower interest rates. ● They then sell the borrowed pounds to buy krona • The supply of pounds in Iceland increases, and the pound depreciates. • Looking back at the graph though, the pound never fell versus the krona. • Why not? ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 8 Krona vs. Pound ● The missing piece: Iceland’s foreign borrowing was occurring at the same time as increased import consumption. • To consume imports, Icelanders sold krona to buy pounds. ● The exchange rates did not change because demand for the pound was increasing at the same time supply was increasing. ● The fall: In 2008, however, after the run on the Icelandic banks, many investors sold krona to buy pounds. • Demand for pounds increased – an increase in demand leads to higher prices – the pound appreciated ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 9 The long-run: purchasing power parity ● Definition: purchasing power parity means that exchange rates and/or prices adjust so that tradable goods cost the same everywhere. • If they didn’t, there would be a higher-valued use for the good, i.e., importers could make money by buying the good in one country and selling it in another. An act sometimes referred to as arbitrage. ● The Economist’s Big Mac index: In July 2007, a big mac cost $7.61 in Iceland, $3.41 in the US, and $1.45 in China. • The theory of purchasing power parity says these prices should move closer together. • Here is the mechanism: to buy Chinese Big Macs, US consumers would sell dollars to buy yuan. The yuan appreciates, and it would then take more dollars to buy a Big Mac in China. • The index thus shows which currencies are over- or under-valued relative to the dollar ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 10 Effects of a currency devaluation ● Example: golf in Tijuana and San Diego (sister towns on either side of the Mexico/US border – making golf in one city a substitute for golf in the other) • Demand for golf in Mexico: • Two sets of consumers: American and Mexicans • When the peso devalues, demand for golf in Mexico increases for both groups. – Mexicans see an increase in price of golf in the US, it takes more pesos to buy one dollar – Americans see a decrease in the price of golf in Mexico, one dollar can buy more pesos ● Currency devaluations help suppliers because they make exports less expensive in the foreign currency; but they hurt consumers because they make imports more expensive in the domestic currency. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 11 Effects of a dollar appreciation on golf markets in Tijuana and San Diego ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 12 Currency appreciation ● Example: Icelandic fish • There are two sets of consumers: • Domestic buyers and exporters – total demand = domestic demand + export demand • When the pound appreciates, export demand increases – fewer pounds can now buy more krona which equals more fish. • Total demand increases, so the price of fish in Iceland rises. • Icelandic producers benefit because fish are cheaper in the foreign currency (representing an increase in demand for Icelandic fish), but Icelandic consumers are hurt because fish are more expensive in the domestic currency. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 13 Bubbles ● Definition: bubbles (if they exist) are prices that cannot be explained by normal economic forces. ● Here is what economists think they know about bubbles: • expectations about the future play a role in keeping bubbles going: • If buyers expect a future price increase, they will accelerate their purchases to avoid it. • Sellers will delay selling to take advantage of it. • Both changes increase price. • In this sense, expectations are self-fulfilling. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 14 Bubbles (cont.) ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 15 Bubbles (cont.) ● When buyers expect prices to increase faster than the interest rate, it makes sense to borrow money to expand buying now in order to sell in the future. • This contributes to the demand increase. ● There are certain features of bubbles that economists have documented. • Bubbles emerge at times when investors disagree about the significance of a big economic development. Because it's more costly to bet on prices going down than up, the bullish investors dominate. • Financial bubbles are marked by huge increases in trading ● Bubbles persist because no one has the firepower to successfully attack them. Only when skeptical investors act simultaneously ―a moment impossible to predict― does the bubble pop. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 16 Bubble example: US housing ● In 1993, government policies began encouraging low-income citizens to buy houses – by reducing qualifications for home borrowing from government-sponsored lenders like Fannie Mae. ● This led to an increase in demand for houses – the “big economic development” that started the bubble ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 17 US housing (cont.) ● Housing prices increased dramatically, especially where supply was limited. • Frequently in areas with strict zoning - zoning laws make supply less elastic (a steeper supply curve) which exacerbates price increases when demand increases ● Many investors expected prices to continue to rise– buying continued and lenders did not seem concerned. ● Two well-known economists disagreed about the existence of a housing bubble: • David Lereah believed the house price increase could be explained rationally - low inventories, low mortgage rates, and favorable demographics caused by a big increase in boomers and retirees, who often buy second homes. • Robert Shiller was wary of a bubble. He identified the bubble by noting that house prices were becoming very expensive relative to rents. In long-run equilibrium, homeowners should be indifferent between renting and buying. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 18 US housing (cont.) ● In the end, Professor Shiller was right – prices peaked in 2006 then fell dramatically ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 19 Popping bubbles ● Why did the housing bubble pop? • If you believe the bubble-ologists, because there were enough skeptical investors who, like Professor Shiller, started betting on house prices to fall. • But the truth is that we don’t know. ● Professor Shiller also predicted the internet/tech bubble in 2000 • He identified the bubble by looking at the long-run equilibrium relationship between stock prices and earnings (profit). If prices are rational, then they should equal the discounted flow of future earnings. • Obviously, we cannot observe future earnings, so Professor Shiller plotted current stock prices against a 10-year trailing average of past earnings. We update his analysis using a 10-year trailing average of earnings. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 20 Stock price/Earnings ratio Price/Earnings Ratio of U.S. Stocks, 1881–2008 (Using 10-Year, Inflation-Adjusted Earnings) 50 45 40 35 P/E 30 25 20 Average: 16.3 15 10 5 18 81 18 86 18 92 18 97 19 03 19 08 19 14 19 19 19 25 19 30 19 36 19 41 19 47 19 52 19 58 19 63 19 69 19 74 19 80 19 85 19 91 19 96 20 02 20 07 0 Year Data and concept: Professor Robert J. Shiller, http://www.econ.yale.edu/~shiller/data.htm. Graph suggested by Shayne & Co., LLC. The graph shows the monthly value of the U.S. stock market as measured by the S&P 500 (and comparable predecessor indices) divided by the average of the earnings per share for the prior ten years. Graph ends at December 2008. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 21 Back to Iceland ● Looking at Shiller’s graph, we see that from 2003–2007, the stock market was very expensive. • There are only two other episodes in history where stock prices have been this high, 1929 and 2000. In both of these cases, prices crashed after reaching these heights. ● Shiller’s methodology says that Icelandic banks began borrowing to invest when asset prices were very expensive. ● Once the asset prices began to come down, depositors lost faith in the banks’ ability to pay them back, leading to the run on the banks. ● This caused the depreciation of the krona ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 22 CHAPTER 12 More Realistic and Complex Pricing ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images ● After acquiring a substitute product, • raise price on both products to eliminate price competition between them. • raise price more on the low-margin (more price elastic demand) product. • reposition the products so that there is less substitutability between them. ● After acquiring a complementary product, reduce price on both products to increase demand for both products. ● If fixed costs are large relative to marginal costs, capacity is fixed, and MR > MC at capacity, then set ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 2 ● If demand is unknown, and the costs of underpricing are smaller than the costs of over-pricing, then underprice, on average, and vice-versa. ● If promotional expenditures make demand more elastic, then reduce price when you promote the product, and vice-versa. ● Psychological biases suggests “framing” price changes as gains rather than as losses. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 3 Harry Potter ● When Scholastic Publishing released the final Harry Potter, sales expectations were through the roof – the previous HP had sold over 7M copies in the first 24 hours alone. • Scholastics suggested selling price was $34.99, and they sold the book to wholesale retailers for $18.99 • Instead of following the advice in chapter six and pricing the book at the point where the markup equals the inverse demand elasticity (P-MC)/P = 1/|e|, Barnes and Noble, Amazon, Costco, and Walmart all priced the book at less than $20 • These retailers are clearly interested in maximizing profit, so why were prices so low? ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 4 Realistic Pricing ● In this chapter, we move beyond the simple, singleproduct analysis of Chapter 6 to more realistic settings. In fact, the MR=MC pricing rule applies only to a single-product firm setting a single price. For firms that sell multiple products, or those who use low prices to win new customers, the rule does not hold. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 5 Pricing schemes ● We have seen this kind of pricing before, the low price for 3-liter Coke used merely to attract customers to a grocery store. Whatever the grocery store lost on 3-liter Cokes, it made up in sales on other items. ● Amazon was following a similar tactic. By pricing low, Amazon sold over two million copies of HP. • Some were new customers, who would purchase books from Amazon in the future; and some purchased additional items at the same time they purchased The Deathly Hallows. • In fact, Amazon estimates that about 1% of its $2.89 billion second-quarter revenue was due to added sales from customers who also purchased The Deathly Hallows. ● Both the grocery store and the bookstore were pricing where MR < MC, or equivalently where (P-MC)/P < 1/|e|. They did so because they were trying to maximize total profit, not profit on their individual product lines. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 6 Pricing commonly owned substitutes ● To price commonly owned products, use marginal analysis ● Discussion: Purchasing a nearby, rival video store • How does this change the price of video rentals at each store? • If there were only one store, marginal analysis finds the point where MR=MC to maximize profits, BUT common ownership of two substitutes changes the calculation • Reducing price at one store steals sales from the other (reduces MR at both) • To counter the falling MR, raise prices at both stores to maximize profits ● Consider your product portfolio as a “bundle” of goods • Demand for a bundle of substitutes is less elastic than demand for the individual products - less elastic demand implies a higher optimal price • Raise the price more on the more elastic product (try to push pricesensitive customers to the higher-margin product) ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 7 Another option for substitutes ● After acquiring a substitute product, you can reposition the products so they don’t directly compete with each other. ● For example, you might want to stock multiple copies of the most popular videos at one of the stores (add depth) but stock a wider range of titles (add breadth) at the other. ● Moving the products farther apart can further increase profit after acquiring a substitute product. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 8 Pricing commonly owned complements ● Again, use marginal analysis to determine pricing. ● Discussion: Purchasing a parking lot adjacent to video store • Common ownership means pricing decisions must consider the effects on movie rentals as well as parking lot use. • Reducing price at one increases demand at the other, i.e., common ownership increases MR at both ● With bigger MR, reduce price (sell more) to maximize profits ● Again, consider your product portfolio as a “bundle” of goods • Demand for a bundle of complements is more elastic than demand for the individual products • More elastic demand implies a lower optimal price ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 9 Revenue or yield management ● Products such as cruise ships, hotels, stadiums, commercial parking lots, etc. have similar characteristics. • The costs of building capacity are mostly fixed or sunk • And, these businesses face capacity constraints ● The first decision for these firms is how much capacity to build – because this is an extent decision, marginal analysis can be used. • Keep adding capacity until LRMR = LRMC ● Once capacity is built, firms make pricing decisions, ignoring the sunk or fixed costs of building capacity. • Relevant costs are now short-run MR and MC • If MR>MC at capacity, price to fill available capacity – because the capacity is fixed the firm cannot sell more by reducing price. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 10 Revenue management example ● Example: designing a new hotel • keep adding rooms to the design plan, as long as LRMR > LRMC • Suppose that the optimal size is 300 rooms. At the optimal size, annualized LRMC of building, cleaning, and heating the room is about $400 per day. ● Once the rooms are built/the costs have been sunk, the hotel’s owners must decide what to charge for the rooms. Suppose that 90% of the annualized LRMC are fixed or sunk and that the relevant marginal cost is just $40 per day. ● Since capacity decisions are determined by all costs, and the pricing decision only by short-run MC, it ’s likely that MR > MC at the capacity of the hotel. If so, then the hotel’s owner should price to fill capacity (sell all available rooms). ● Choose a price that matches expected demand to capacity • In some industries, like parking lots, stable demand and the daily observation of realized demand make this relatively easy to do • In other industries, like cruise ships, this is much more difficult ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 11 Revenue or yield management (cont.) ● When demand is difficult to predict, pricing to fill capacity is also difficult. ● To maximize profits, balance the cost of over-pricing (lost profit on unsold capacity) against the cost of underpricing (lower margins on capacity sold) ● Optimal price minimizes the expected costs of these two mistakes. ● In general, if the lost profit from over-pricing (unused capacity) is bigger than the lost profit from under-pricing (lower margins), then price lower than would fill capacity, and vice-versa. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 12 Advertising and promotional pricing ● Combines two of the “Four P’s of marketing,” Pricing and Promotion ● Promotional spending affects demand in different ways • Price-related promotions (coupons, end-of-aisle displays, etc.) tend to make demand more elastic • If promotion makes demand more elastic, it makes sense to reduce price concurrently ● Product-related promotions (quality advertising, celebrity endorsements, etc.) tend to make demand less elastic • If promotions make demand less elastic, it makes sense to raise price concurrently ● Caveat: Prices can affect customer perception of quality – i.e. higher price equals higher quality in the mind of the consumer ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 13 Psychological Pricing ● Biases can affect optimal pricing decisions. • Example: Airline snacks • In 2008, some airlines began charging for snacks • It seems like a good idea because those who value an in-flight snack could buy one and those who didn’t didn’t have to buy. • Many passengers, though, viewed the change negatively and changed airlines as a result. ● Research in the field of behavioral economics says that this reaction was predictable using “prospect theory” • The way a decision is framed matters a great deal to the decisions that consumers make, i.e. consumers feel losses more than gains – so decisions should be framed in such a way to highlight a gain not the loss of an in-flight snacks. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 14 Psychological pricing (cont.) ● Consumers are also very sensitive to fairness. ● Many retailers make deliberate pricing decisions so as not to appear unfair • Home Depot didn’t raise prices after Katrina, though demand did increase; hardware stores don’t increase the price on snow shovels following a big winter blizzard • In 2008, when gas prices rose to meet consumer demand, many US citizens were outraged and heavily criticized oil companies for profiting “unfairly.” ● To avoid looking unfair, companies must come up with creative solutions. • In the music industry, performers set concert ticket prices below the market price. People buy up the low priced tickets and sell them on secondary markets, which consumers don’t subject to rules of fairness. • Often, artists also sell tickets on secondary sites, sharing in the profits but avoiding the label of “unfair” ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 15 Title? ● American Airlines pioneered the development of sophisticated reservation management systems, launching SABRE in 1968 ● Without overbooking practices like those instituted through SABRE, AA estimates that 15% of the seats on sold out flights would be unused. ● This overbooking process was the first element in developing a “yield management” system. ● With additional industry changes in the 1970’s, AA moved to develop a yield management system with the goal of “selling the right seat to the right customer at the right time.” ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 16 Title continued? ● The yield management system helps determine • How many seats to allocate initially to each fare category • How to dynamically adjust this allocation as reservations come in and the date of the flight approaches. • Accurate forecast of demand and cancellations are critical ● The complexity of the problem eventually led to the development in 1988 of an automated system for yield management, DINAMO. The system's net impact was estimated be $1.4 billion in additional revenues over a three year period. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 17 Las Vegas Casinos ● Las Vegas Casinos • Offer both hotel rooms and gaming • Prices on rooms are often set at “sub-optimal” levels • Casinos plan to more than make up for the room profit shortfall with gaming profits ● Similar to grocery store loss leader concept • Get people in the door ● Goal is to maximize total profit, not individual product profit ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 18
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