Economic environment of business

1
Economic environment of business

• Lecture 5
• Pricing Strategies for Firms with Market Power

2
Overview

• I. Markups
• II. Extracting Consumer Surplus
• Price Discrimination ? Two-Part Pricing
• Block Pricing ? Commodity Bundling
• IV. Pricing in Markets with Intense Price
  Competition
• Price Matching ? Randomized Pricing

3
Pricing Markups

• Monopolistically competitive markets
• I.e. car industry, Alfa Romeo is not perfect
  substitute for Opel
• Markup charge x times (MC), xgt1
• Unique cars, charge higher markup
• P(EF/(1EF)) x MC
• EF is own price elasticity of demand

4
First-Degree or Perfect Price Discrimination

• Practice of charging each consumer the maximum
  amount he or she will pay for each incremental
  unit
• Permits a firm to extract all surplus from
  consumers
• Examples

5
Perfect Price Discrimination
Price
Profits .5(4-0)(10 - 2) 16
10
8
6
4
Total Cost
2
MC
D
Quantity
1 2 3 4 5
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Caveats

• In practice, transactions costs and information
  constraints make it very difficult to implement
  (but car dealers and some professionals come
  close).
• Price discrimination wont work if consumers can
  resell the good.

7
Second Degree Price Discrimination
Price

• The practice of posting a discrete schedule of
  declining prices for different quantities.
• Example
• Electric utilities
• mobile phone minutes

MC
10
8
5
D
4
2
Quantity
8
Third Degree Price Discrimination

• The practice of charging different groups of
  consumers different prices for the same product
• Examples include student discounts, senior
  citizens discounts, regional international
  pricing, airline tiket discounts for weekend trips

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Implementing Third Degree Price Discrimination

• Suppose the total demand for a product is
  comprised of two groups with different
  elasticities, E1 lt E2
• Notice that group 1 is more price sensitive than
  group 2
• Profit-maximizing prices?
• P1 E1/(1 E1) ? MC
• P2 E2/(1 E2) ? MC

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Two-Part Pricing

• When it isnt feasible to charge different prices
  for different units sold, but demand information
  is known, two-part pricing may permit you to
  extract all surplus from consumers.
• Two-part pricing consists of a fixed fee and a
  per unit charge.
• Example Athletic club memberships

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How Two-Part Pricing Works

• 1. Set price at marginal cost.
• 2. Compute consumer surplus.
• 3. Charge a fixed-fee equal to consumer surplus.

Price
10
8
6
Fixed Fee Profits 16
Per Unit Charge
4
MC
2
D
1 2 3 4 5
Quantity
12
Block Pricing

• The practice of packaging multiple units of a
  product together and selling them as one package.
• Examples
• Toilet Paper
• Six-packs of drinks
• Different sizes of cans of green beans

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ExampleConsumers demand is P 10 - 2QC(Q)
2QOptimal number of units in a package? 4 Units
Optimal package price?
Price
10
8
6
4
MC AC
2
D
1 2 3 4 5
Quantity
14
Optimal Price for the Package 24
Price
Consumers valuation of 4 units .5(8)(4)
(2)(4) 24
10
8
6
4
MC AC
2
D
1 2 3 4 5
Quantity
15
Costs and Profits with Block Pricing
Price
10
8
Profits 16
6
Costs 8
4
MC AC
2
D
1 2 3 4 5
Quantity
16
Commodity Bundling

• The practice of bundling two or more different
  products together and charging one price for the
  bundle
• Examples
• Vacation packages
• Computers and software
• Film and developing

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Example Valuations for Kodak Film and
Developing (by buyer type)
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Optimal Film Price?Assume no cost
Optimal Price is 8, to earn profits of 8 x 2
million 16 Million
At a price of 4, only first three types will buy
(profits of 12 Million)
At a price of 3, all types will buy (profits of
12 Million)
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Optimal Price for Developing?
At a price of 6, only D type buys (profits of
6 Million)
At a price of 4, only D and FD types buy
(profits of 8 Million)
At a price of 2, all types buy (profits of 8
Million)
Optimal Price is 3, to earn profits of 3 x 3
million 9 Million
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Total Profits by Pricing Each Item Separately?
16 Million Film Profits 9 Million Development
Profits 25 Million
Surprisingly, the firm can earn even greater
profits by bundling!
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Consumer Valuations for the Bundle
Pricing a Bundle of Film and Developing
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Optimal Price for a Bundle?What profits obtain?
Optimal Bundle Price 10 (for profits of 30
million)
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Pricing in Markets with Intense Price Competition

• Price Matching
• Advertising a price and a promise to match any
  lower price offered by a competitor.
• No firm has an incentive to lower their prices.
• Each firm charges the monopoly price and shares
  the market.
• Randomized Pricing
• A strategy of constantly changing prices.
• Decreases consumers incentive to shop around as
  they cannot learn from experience which firm
  charges the lowest price.
• Reduces the ability of rival firms to undercut a
  firms prices.

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Recap of Pricing Strategies

• First degree price discrimination, block pricing,
  and two part pricing permit a firm to extract all
  consumer surplus.
• Commodity bundling, second-degree and third
  degree price discrimination permit a firm to
  extract some (but not all) consumer surplus.
• Simple markup rules are the easiest to implement,
  but leave consumers with the most surplus and may
  result in double-marginalization.
• Different strategies require different
  information.

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Summary of the last 5 weeks
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Transaction Costs

• Costs of acquiring an input over and above the
  amount paid to the input supplier.
• Includes
• Search costs
• Negotiation costs
• Other required investments or expenditures

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The hold-up Problem

• SIMPC is computer language only used by CPB
• Cost to learn 100, benefits, 1000
• Worker can earn 200 in- and outside CPB
• Assume that worker learns SIMPC and becomes worth
  to the firm, 1000
• How does firm respond when worker asks for a
  raise?

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The Hold-up Problem

• Firm will refuse
• Workers outside option has not changed
• Workers anticipate this and will not pay for
  specialized investments

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Optimal Input Procurement
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Transaction Costs

• Costs of acquiring an input over and above the
  amount paid to the input supplier.
• Includes
• Search costs
• Negotiation costs
• Other required investments or expenditures

31
The hold-up Problem

• SIMPC is computer language only used by CPB
• Cost to learn 100, benefits, 1000
• Worker can earn 200 in- and outside CPB
• Assume that worker learns SIMPC and becomes worth
  to the firm, 1000
• How does firm respond when worker asks for a
  raise?

32
The Hold-up Problem

• Firm will refuse
• Workers outside option has not changed
• Workers anticipate this and will not pay for
  specialized investments

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Optimal Input Procurement
34
The Principal-Agent Problem

• Occurs when the principal cannot observe the
  effort of the agent
• Example Shareholders (principal) cannot observe
  the effort of the manager (agent)
• Example Manager (principal) cannot observe the
  effort of workers (agents)
• The Problem Principal cannot determine whether
  a bad outcome was the result of the agents low
  effort or due to bad luck

35
Solving the Problem Between Owners and Managers

• Internal incentives
• Incentive contracts
• Stock options, year-end bonuses
• External incentives
• Personal reputation
• Potential for takeover

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Solving the Problem Between Managers and Workers

• Profit sharing
• Revenue sharing
• Piece rates
• Time clocks and spot checks

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Why dont we observe piece rates more often?

• incomplete contracts, requires relative
  performance pay (i.e. tournaments)
• multiple tasks
• measurement costs
• risk averse workers

38
Industry Concentration

• Four-Firm Concentration Ratio
• The sum of the market shares of the top four
  firms in the defined industry C4 w1 w2
  w3 w4
• Herfindahl-Hirschman Index (HHI)
• The sum of the squared market shares of firms in
  a given industry, multiplied by 10,000 HHI
  10,000 ? S wi2
• Limitations
• Market Definition National, regional, or local?
• Global Market Foreign producers excluded
• Industry definition and product classes

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Pricing Behavior

• The Lerner Index
• L (P - MC) / P
• A measure of the difference between price and
  marginal cost.
• An index from 0 to 1.
• Markup Factor
• Rearranging the above formula,
• P (1/(1-L)) MC
• 1/(1-L) is the markup factor.

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Perfect Competition

• Characteristics
• Many buyers and sellers
• Homogeneous product
• Perfect information
• No transaction costs
• Free entry and exit

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Setting Price
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Setting Output

• Profit ?(Q) Revenue (Q) Costs (Q) PQ
  C(Q)
• Profit maximization produce up to the point
  where marginal benefit is zero, or marginal
  revenue is equal to marginal cost
• MR MC
• But MR P
• Therefore, set P MC to maximize profits

Welfare is maximized!
43
Effect of Entry on Price?
S
Entry
Pe
Df
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Long-run competition

• Existence of short-run profits leads to entry
• Entry increases market supply, drives down the
  market price, and increases the market quantity
• Demand for individual firms product decreases
• Individual firm reduces output to maximize
  profit, or exits
• Process goes on till long-run profits are zero
  for all firms, which operate with the same
  technology.

45
Monopoly

• Market structure where a single firm serves the
  entire relevant market
• Firm has control over price
• But the price charged affects the quantity
  demanded of the monopolists product

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Consequences of market power
Deadweight loss
Quiet life hypothesis (managers shirk)
Economic effort of firms to acquire and maintain
monopoly position.
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Monopoly Profit Maximization
Produce until marginal (net) benefit 0, where
MR MC. Charge the price on the demand curve
that corresponds to that quantity.
Monopolist Profit
PM
ATC
Market Demand
QM
MR
48
Deadweight Loss of Monopoly
Deadweight Loss of Monopoly
PM
PC
D
MC
QC
QM
MR
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Monopolistic Competition

• Numerous buyers and sellers
• Differentiated products

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Key Implications

• Since products are differentiated, each firm
  faces a downward sloping demand curve firms have
  limited market power.
• Free entry and exit, so firms will earn zero
  profits in the long run.

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Monopolistic Competition Profit Maximization

• Maximize profits like a monopolist
• Produce where MR MC
• Charge the price on the demand curve that
  corresponds to that quantity

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Graphically...
Profit
PM
ATC
D
Quantity of Brand X
QM
MR