PRICING PRACTICES

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PRICING PRACTICES
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CARTEL ARRANGEMENTS

• When there is competition a company must operate
  at its most efficient cost point.
• In the long run, the company will only earn a
  normal profit.
• Companies always have a motivation to increase
  their market power and act like a monopoly.
• In an oligopoly, a firm cannot act without being
  noticed by others in the market.

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• A monopoly has the benefits of higher profits,
  stable market share and stable market prices.
• In an oligopoly, it may be to the benefit of all
  firms in the market if they act together as if
  they formed a monopoly.
• When the firms in an oligopoly all agree to
  cooperate with one another, they form a cartel.

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Examples of Cartels

• OPEC (Organization of Petroleum Exporting
  Countries) is the most famous cartel.
• IATA (International Air Transport Association) is
  another frequently encountered cartel.

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Factors Influencing Formation of Cartels

• Existence of a small number of firms facilitates
  the policing of a cartel agreement.
• Geographical proximity of the firms is favorable.
• Homogeneity of the product makes it impossible
  for cartel participants to cheat on one another
  by emphasizing product differences.
• Entry into the industry must be difficult.
• If cost conditions for the cartel members are
  similar and profitability does not differ among
  members, cartels will be easier to maintain.

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• If the economy is in a recession, there is going
  to be a stronger motivation to form a cartel so
  that the members can fight the depressed prices.
• Following a recession, when the market demand
  shrinks, there is motivation to break from the
  cartel since firms usually believe that they can
  do better outside the cartel.
• The cartel may be formed again when the economy
  goes into recovery.

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Pricing in Cartels

• The ideal cartel will charge monopoly prices and
  earn maximum monopoly profits for all the members
  combined.
• The industry as a whole will maximize profits by
  using the MR MC rule.
• Each firm will produce part of the market demand
  depending on the level of its marginal cost and
  will earn a profit depending on the level of its
  average total cost.

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MC1
MCT
MC2
P
ATC1
ATC1
ATC2
DT
ATC2
MRT
QT
Q1
Q2
Individual marginal cost curves are added
horizontally to arrive at the total marginal
cost curve (MCT). Industry output is where MRT
MCT. Individual firms will produce at the
point where the intersection of MRT MCT
corresponds on their individual MC curves. This
is done so that the combination of the outputs
will be sufficient to supply the entire market
demand.
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• The lower cost company will usually be the more
  profitable one.
• Such a company may find it very profitable to
  cheat by offering its product at a lower price
  and capturing a larger share of the total
  business.
• Hence, cartels will be unstable and usually
  short-lived.

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Costs to Forming a Cartel

• There is a cost associated with forming a cartel.
• There is a cost associated with monitoring the
  actions of the cartel members and of enforcing
  the rules to minimize cheating.
• There is the potential cost of punishment by
  authorities.

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Other Methods of Distributing Market Share

• Cartels may have agreements specifying the market
  share of each participant.
• Distribution may be based on
• history
• geographical area
• Collusion can also be done on an informal basis.
• E.g. Physicians within a geographical area may
  charge similar prices for their services.

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PRICE LEADERSHIP

• When collusive arrangements are not easily
  achieved, price leadership may emerge in
  oligopolistic markets.
• In price leadership, there is no formal
  agreement.
• Firms informally agree upon keeping the prices at
  the same level and changing them by the same
  amount.
• When a price movement is initiated by one of the
  firms, the others follow.

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• E.g. Appliance companies usually follow each
  other in offering promotions as a way of price
  discounts Beko and Arçelik start, Bosch
  follows.
• Automobile companies also follow each other in
  offering promotions.
• IBM was a price leader in the computer industry
  during the 1950s and 1960s since it was the most
  powerful and most preferred manufacturer at the
  time.

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Types of Price Leadership

• Price leadership can be practiced on the basis of
  two factors
• Barometric Price Leadership
• One firm initiates a price change in response to
  changing economic conditions and the others
  follow.
• Dominant Price Leadership
• One company may have market power as a result of
  its size and economic power this company sets
  the price and the others follow.

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Barometric Price Leadership

• One of the firms in the market initiates the
  price change in response to changing economic
  conditions.
• Different firms may be barometric price leaders
  at different times.
• If the barometric price leader misjudges the
  economy, the others in the market may not follow
  the price change.
• If the leaders economic judgements are correct,
  all others will willingly follow.

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Dominant Price Leadership

• One of the firms in the industry will have power
  as a result of sheer size or economic power.
• This firm may be the most efficient (lowest cost)
  firm.
• The lowest-cost firm may easily force its
  competitors out of the market by undercutting
  their prices.
• The dominant price leader will usually act as a
  monopolist and set the price to maximize its
  profits.

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• The smaller companies will continue to exist and
  sell as much as they wish at the price set by the
  leader.
• Therefore, the followers will be acting as price
  takers in a perfectly competitive market.

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SMCF
MCD
P
(Also MRF)
DT
DD
MRD
QD
QF
SQT
Demand curve for the dominant firm is derived by
subtracting the SMCF for the followers from the
total demand curve. If the small firms supply
the product along their combined marginal cost
curve, then the dominant firm will be left with
the demand shown along DD.
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Why do the followers supply along their combined
MCT curve?
MCT
P4
MR4
P3
MR3
P2
MR2
P1
MR1
Q1
Q2
Q3
Q4
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Non-Marginal Pricing

• It is often claimed that businesses are not
  really profit-maximizers and that they have other
  objectives.
• Other objectives could be achieving
• a desired market share,
• a target profit margin,
• a target rate of return on assets,
• a target rate of return on equity.
• One common method used for pricing purposes is
  cost-plus (full-cost).

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Cost-Plus Pricing

• Most businesspeople are found to be pricing their
  products by applying cost-plus
• Calculate the variable cost of the product
• Add an allocation of fixed costs
• Add a profit percentage or markup
• E.g. Variable cost 8.00
• Allocated overhead 6.00
• Desired markup 25
• Price 8.00 6.00 (8.00 6.00) (0.25)
• 17.50

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Important Questions

• How are the variable costs calculated?
• Do they include the opportunity cost?
• How are fixed costs allocated?
• Is the firm using long-term costs? Are all the
  costs variable?
• How is the size of the markup determined?
• Does it reflect the demand conditions and the
  competitive environment?

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Under cost-plus, P AC (1 Markup)

• There is an inverse relationship between markup
  and price elasticity
• The less elastic the demand curve, the larger
  the markup will be.
• When the average cost curve is constant,
  cost-plus pricing may give results identical to
  those that would be obtained if the managers were
  pursuing profit maximization.

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• E.g.
• If EP -1.5, M -1.5/(-1.51)-1 2.0.
• If EP -4.0, M -4.0/(-4.01)-1 0.33.
• If EP -1.0, M is undefined (division by 0).
• If -1 lt EP lt 0, M becomes negative.
• Both cases are irrelevant because
• A profit-maximizing firm will never operate on
  the inelastic portion of its demand curve.
• When MR gt 0, demand is elastic.
• For profit-maximization, MR MC.
• MC is always gt 0 (i.e., positive).
• Then, MR is always gt 0 (i.e., positive).
• So, at the profit-maximizing output, the firm is
  always on the elastic portion of its demand curve.

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Joint Products

• Products may be related in production.
• Joint products are produced in fixed proportions.
• Jointly produced products may be thought of as a
  product package.
• Cost allocation is meaningless since one cannot
  be produced without the other.
• Cost considerations are valid for the product
  package.

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MRT
MC
PA
DA
PB
DB
Q0
MRA
MRB
MRT is the vertical sum of MRA and MRB. There is
a single MC curve to represent the joint
production. Profit-maximizing quantity (Q0) is
determined by MRT MC. At this quantity, both
MRA and MRB are positive. Individual prices are
determined by the individual demand curves.
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MRT
MC
PA
DA
PB
DB
MRA
QB
Q0
MRB
At the profit-maximizing quantity, MRB is
negative. Firm should not produce and sell all
units when one of the products causes the total
revenues to decrease. Firm will produce Q0 units
and sales will be in the following amounts Q0
units of A at PA QB units of B at PB
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• E.g. An oil refinery produces products A and B.
  The two products are produced jointly. The
  marginal cost equation for A-B production is
  given as the following
• MC 30 5Q.
• The demand and marginal revenue equations for the
  two products are the following
• Product A P 60 Q and MR 60 2Q
• Product B P 80 2Q and MR 80 4Q
• What prices should be charged for products A and
  B? How many units of the product package should
  be produced?
• Sum the two marginal revenue curves MRT 140
  6Q
• Set MRT equal to MC 140 6Q 30 5Q
• Q 10 units.
• PA 60 10 50 (MRA 40)
• PB 80 (2)(10) 60 (MRB 40)

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Transfer Pricing for Intermediate Goods

• Some firms operate at more than one stage of the
  production process for the finished good
  (vertical integration).
• Pricing intermediate goods is problematic
• high prices increase profitability for earlier
  stages and decrease profitability for later
  stages
• if each stage aims to maximize its own profits,
  total profits of the firm may be reduced

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Transfer Pricing When There is an External Market
for the Intermediate Product

• E.g. Department A produces Good A (intermediate)
  and can sell it to Department B (producing the
  finished good) or to outside buyers.
• Department B can obtain Good A from Department A
  or from outside suppliers.
• External market is perfectly competitive
• Price for Good A is given.
• Dept A will produce the good until P MC and
  will sell either to Dept B if they are willing
  to pay this price or to outside buyers.
• Dept B will buy the good from Dept A if they
  charge the market price it will buy the good
  from the market if Dept A tries to charge a price
  higher than the market price.

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Transfer Pricing When There is No External Market
for the Intermediate Product

• Problematic Dept A benefits from a high price,
  Dept B benefits from a low price.
• Firm determines the price to maximize total
  profits.

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MCBMCA MCTr
MCA
PB
MCTr
DB
PA
MRB
QB
MCA marginal cost of intermediate product MCTr
marginal cost of transforming the intermediate
product into the finished good MCB firms
overall marginal cost of producing each
additional unit of the finished good
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• QB units of the finished good will maximize
  profits for the firm.
• Dept A must supply an amount of Good A consistent
  with producing QB units.
• If Dept A sets its price (PA) equal to its
  marginal cost (MCA), then Dept B will view its
  own marginal cost as MCTr MCA MCB.
• PA will also ensure that Dept A supplies the
  exact amount of Good A necessary to produce QB
  units of the finished good.
• In the absence of an external market for the
  intermediate good, profit maximization requires
  that the price of each intermediate good be set
  equal to its marginal cost.