Question

In recent years, U.S. car manufacturers have charged lower prices for cars in western states in an effort to offset the competition from Japanese cars. This twotier pricing scheme has upset many car dealers in the eastern states. Many have called it discriminatory and illegal. What conditions are necessary for this pricing scheme to be profitable to the U.S. companies?

Short answer

Short Answer: For the two-tier pricing scheme to be profitable for U.S. car manufacturers, the following conditions must be met: (1) the demand for U.S. cars in the western states should be price elastic, (2) the cost structure should allow manufacturers to absorb lower prices without significant losses, (3) the scheme should result in a significant increase in market share in the western states, and (4) there should be limited market spillover, where customers from eastern states do not take advantage of the lower prices in the western states. Additionally, potential legal implications and backlash from dealers in eastern states should be assessed, as they may undermine the scheme's profitability.

Step-by-step solution

Identify the purpose of the two-tier pricing scheme

The two-tier pricing scheme is implemented by U.S. car manufacturers to offset the competition from Japanese cars in the western states. The lower prices in western states aim to attract buyers who would otherwise purchase Japanese cars, thus increasing U.S. companies' market share in that region.

Define profitability

For the two-tier pricing scheme to be profitable, the extra revenues generated from increased sales in the western states must exceed the lost revenues from charging lower prices. Mathematically, this can be represented as: P = (Increased Sales * Lower Price) - (Original Sales * Original Price) > 0 where P is the profit from the two-tier pricing scheme.

Discuss the necessary conditions for profitability

To ensure that the two-tier pricing scheme is profitable, the following conditions must be met: 1. Elasticity of demand: The demand for U.S. cars in the western states should be price elastic, meaning that a decrease in price results in a proportionally greater increase in sales volume. This will ensure that the revenues generated from increased sales in the western states can offset the lost revenues from charging lower prices. 2. Cost structure: The cost structure of U.S. car manufacturers should allow them to absorb the lower prices in the western states without incurring significant losses. In other words, the variable cost of producing and distributing an additional car should be lower than the price charged in the western states. 3. Market share: The U.S. car manufacturers should be able to achieve a significant increase in their market share in the western states as a result of the two-tier pricing strategy. This will help ensure that enough sales volume is generated to make the scheme profitable. 4. Limited market spillover: The two-tier pricing scheme must not result in a significant number of customers in the eastern states purchasing cars from western states to take advantage of the lower prices. Otherwise, the lost revenues in the eastern states would outweigh the increased revenues in the western states, resulting in a net loss for U.S. car manufacturers. This can be accomplished by strategically limiting the availability or promotion of lower-priced cars in the western states or imposing restrictions on cross-state sales.

Assess the legality and potential backlash

While focusing on the profitability aspect of the two-tier pricing scheme, it is also necessary to consider the potential legal implications and the backlash from car dealers in the eastern states. While it is not within the scope of this exercise to provide a comprehensive legal analysis, it is important to recognize that successful profitability may be undermined by potential legal challenges and negative public relations.

Key concepts

Elasticity of Demand

Understanding the concept of elasticity of demand is crucial in analyzing the effectiveness of any pricing strategy, including the two-tier pricing strategy used by U.S. car manufacturers. Demand elasticity refers to how sensitive the quantity demanded of a good is to a change in its price. In this context, demand is described as 'elastic' if a small reduction in price leads to a significant increase in the quantity demanded.

For U.S. car manufacturers employing a two-tier pricing strategy, it's ideal for the demand in western states to be highly elastic. This means that the reduced price of cars in these areas should cause a larger percentage increase in sales volume.

Hence, if the quantity demanded rises significantly more than the price falls, the company's overall revenue could increase, offsetting any losses from reduced prices. Simply put, the greater the elasticity, the more effective the pricing strategy.

Key Points

• Elastic demand means price changes lead to larger changes in sales volume.
• U.S. manufacturers need elastic demand in west to benefit from price cuts.

Market Share

Market share is a measure of a company's sales in relation to the total sales in the market. For the two-tier pricing strategy of U.S. car manufacturers to work, it should ideally lead to a significant increase in their market share in the western states.

By offering lower prices in the west, U.S. car manufacturers aim to attract customers who might otherwise buy Japanese cars.

Capturing a larger slice of the market is critical because it not only increases the sales volume but also establishes a stronger presence against competitors.

Ultimately, an increase in market share means more cars sold relative to total sales in that region, which translates to higher company revenue even with lower individual prices.

The Importance of Market Share

• Larger market share equals more sales volume compared to competitors.
• Facilitates stronger brand recognition and influence in the region.

Cost Structure

The cost structure of a company refers to the types and proportions of costs it faces. It's important for U.S. car manufacturers to have a flexible cost structure to ensure the success of the two-tier pricing strategy.

A flexible cost structure allows companies to absorb the impact of lower prices without incurring significant losses. This typically requires a low variable cost per unit, meaning the cost of producing and selling additional cars should be lower than the selling price in the western states.

Efficient cost management would mean that the profit from increased sales quantity can balance out the lower unit prices. This would involve factors such as manufacturing efficiency, economies of scale, and effective distribution networks.

Managing Costs

• Keep variable costs per car low to maintain margins.
• Leverage efficiencies in manufacturing and distribution.

Two-Tier Pricing Strategy

A two-tier pricing strategy involves setting different prices for the same product in different markets. For U.S. car manufacturers, this means one price level for western states and another for the rest of the country.

This strategy is used to capture market segments with different price sensitivities and to combat regional competition effectively. In the case highlighted, it aims to fend off competition from Japanese car manufacturers by offering lower prices in areas where they are particularly strong.

The key to success in a two-tier pricing strategy involves ensuring that the lower-priced market does not undermine sales in the higher-priced market, through tactics like geographic sales limitations or product differentiation.

Key Considerations

• Different pricing intended to match regional customer value perception.
• Mitigates risks of customer migration to cheaper regions.