Economics of the Firm

1
Economics of the Firm

• Competitive Pricing Techniques

2
Every business has a goal. Whats the goal of
your business?
Maximize Profits
Maximize return on investment
To Make Money!!!
Increase Market Share
Maximize Shareholder Value
To be a leader in technology
To be Green
Optimal decision making (for example, pricing)
depends crucially on what your goal is!
3
We will be assuming that pricing decisions are
being made to maximize current period profits
Total Costs (note that total costs here are
economic costs. That is, we have already
included a reasonable rate of return on invested
capital given the risk in the industry)
Profits
Total Revenues equal price times quantity
4
As with any economic decision, profit
maximization involves evaluating every potential
sale at the margin
How do my costs change if I increase my sales by
1? (Marginal Costs)
How do my profits change if I increase my sales
by 1?
How do my revenues change if I increase my sales
by 1? (Marginal Revenues)
Lets take this piece by piece
5
We will treat costs as a given. Every firm has a
total cost function.
Total costs of production are a function of
quantity produced
For pricing decisions, we focus on marginal cost
TC
310
300
56
57
6
Next, we need to know something about the
consumer the firm faces. Every firm should have
an estimated demand curve. We can think about a
demand curve in one of two ways
For every price I could charge, my demand curve
tells me what my sales will be.
For any sales goal that I set, my demand curve
will tell me what price I can charge to obtain
that goal
7
So, we can get firm revenues one of two ways
Revenues equal price times quantity
My demand curve will tell me the price I can
charge to hit that target
I select a sales target
My demand curve will tell me the sales I will
achieve at that target
Revenues equal price times quantity
I select a price target
8
In either case, higher sales will be associated
with a lower price
OR
If I want to increase my sales target, I need to
lower my price to all my existing customers
I need to drop my target price if I want to reach
new customers
9
Initially, you have chosen a price (P) to charge
and are making Q sales.
Total Revenues PQ
D
Suppose that you want to increase your sales.
What do you need to do?
10
Your demand curve will tell you how much you need
to lower your price to reach one more customer
This area represents the revenues that you lose
because you have to lower your price to existing
customers
This area represents the revenues that you gain
from attracting a new customer
D
1
11
If we are maximizing profits, we want marginal
revenues to equal marginal costs
Firms will be charging a markup over marginal
cost where the markup is related to the
elasticity of demand
12
Market Structure Spectrum
Monopoly
Perfect Competition
The market is supplied by many producers each
with zero market share
One Producer Supplies the entire Market
Firm Level Demand DOES NOT equal industry demand
Firm Level Demand EQUALS industry demand
13
Suppose there is a monopolist that faces the
following demand
Further, the monopoly has a linear cost function
40
Can this firm do better?
D
20
14
First, to increase sales by one, by how much does
this firm have to lower its price?
A 0.50 price drop would increase sales by one
-.5020 -10
Again, this is a loss because we lowered our
price to our existing customers!
40
(1)(39.50)
The additional sale!
39.50
MR 29.50 MC 10
D
We should lower price!
20
21
15
30
MC10
10
D
40
MR 50-Q
16
Lets check
30.50
30
29.50
MC10
10
D
40
41
39
17
The markup formula works!
30
MC
10
D
40
MR
18
Now, suppose this market is serviced by a large
number of identical firms each with marginal
costs equal to 10
Firm Level
Industry
D
D
Lowest price among firm is competitors
19
Is it possible for
Industry
Firm Level
Profit gt 0
D
10
D
As long as price is above marginal cost, there is
an incentive for each firm to undercut its
rivals. This incentive disappears when price
equals marginal cost.
20
Competitive Market equilibrium
Industry
Firm Level
Profit 0
D
S
10
D
As long as price is above marginal cost, there is
an incentive for each firm to undercut its
rivals. This incentive disappears when price
equals marginal cost.
21
Perfectly competitive firms face demand curves
that are perfectly elastic (infinite elasticity.
Hence, the markup (and profits) are zero)
Industry
Firm Level
D
MC
D
Note Industry elasticities in competitive
industries are always less than 1 (industry
profits could be increased by raising price!)
22
Measuring Market Structure Concentration Ratios
Suppose that we take all the firms in an industry
and raked them by size. Then calculate the
cumulative market share of the n largest firms.
Cumulative Market Share
100
A
C
80
B
40
20
Size Rank
0
0
1
3
2
4
5
6
7
20
10
23
Measuring Market Structure Concentration Ratios
Cumulative Market Share
100
A
C
80
B
40
20
Size Rank
0
0
1
3
2
4
5
6
7
20
10
Measures the cumulative market share of the top
four firms
24
Concentration Ratios in US manufacturing 1947 -
1997
Year
1947 17 23 30
1958 23 30 38
1967 25 33 42
1977 24 33 44
1987 25 33 43
1992 24 32 42
1997 24 32 40
Aggregate manufacturing in the US hasnt really
changed since WWII
25
Measuring Market Structure The
Herfindahl-Hirschman Index (HHI)
Market share of firm i
Rank Market Share
1 25 625
2 25 625
3 25 625
4 5 25
5 5 25
6 5 25
7 5 25
8 5 25
HHI 2,000
26
The HHI index penalizes a small number of total
firms
Cumulative Market Share
100
A
80
HHI 500
B
HHI 1,000
40
20
0
0
1
3
2
4
5
6
7
20
10
27
The HHI index also penalizes an unequal
distribution of firms
Cumulative Market Share
100
80
HHI 500
A
HHI 555
40
B
20
0
0
1
3
2
4
5
6
7
20
10
28
Concentration Ratios in For Selected Industries
Industry CR(4) HHI
Breakfast Cereals 83 2446
Automobiles 80 2862
Aircraft 80 2562
Telephone Equipment 55 1061
Womens Footwear 50 795
Soft Drinks 47 800
Computers Peripherals 37 464
Pharmaceuticals 32 446
Petroleum Refineries 28 422
Textile Mills 13 94
29
Another way to measure competition is by the
outcome.
The Lerner index measures the percentage of a
products price that is due to the markup
Perfect Competition
Monopoly
30
Lerner index in For Selected Industries
Industry LI
Communication .972
Paper Allied Products .930
Electric, Gas Sanitary Services .921
Food Products .880
General Manufacturing .777
Furniture .731
Tobacco .638
Apparel .444
Motor Vehicles .433
Machinery .300
31
An industrys cost structure will influence an
industrys competitive nature
Costs
AC
MC
If market size is small, this industry
experiences decreasing costs (big firms have an
advantage over small firms)
However, if the industry gets big enough, costs
start to increase and the size advantage becomes
a disadvantage!
32
Industries with globally scale economies tend to
develop as natural monopolies (the market should
and will be serviced by one producer). This
can happen if production exhibits increasing
marginal productivity, or if there are large
fixed costs.
Costs
Costs
AC
AC
MC
MC
33
Monopoly Market Characteristics

• Small market size
• Scale economies (Network Externalities, Learning
  by Doing, Large Fixed Costs)
• Government Policy (Protected Monopolies)

Any one of these characteristics suggest that the
market structure could be monopolistic.
34
Long Run Industry Dynamics
As an industry ages, three things happen.
Short Run
Long Run
D
D
As more alternatives become available, consumer
demand becomes much more price responsive
35
Long Run Industry Dynamics
As an industry ages, three things happen.
Short Run
Long Run
MC
MC
As production techniques become more flexible,
marginal costs drop and become much less
sensitive to input prices
36
Long Run Industry Dynamics
As an industry ages, three things happen.
Market Structure Spectrum
Perfect Competition (Long Run)
Monopoly (Short Run)
As new firms enter the industry (i.e. no
artificial or natural barriers), the industry
becomes more competitive and markups fall
37
Most firms face the a downward sloping market
demand and therefore must lower its price to
increase sales.
Loss from charging existing customers a lower
price
Gain from attracting new customers
Is it possible to attract new customers without
lowering your price to everybody?
D
38
Price Discrimination
If this monopolist could lower its price to the
21st customer while continuing to charge the 20th
customer 15, it could increase profits.

• Requirements
• Identification
• No Arbitrage

15
12
D
20
21
39
Price Discrimination (Group Pricing)
Suppose that you are the publisher for JK
Rowlings newest book Harry Potter and the
Deathly Hallows
Your marginal costs are constant at 4 per book
and you have the following demand curves
US Sales
European Sales
40
If you dont have the ability to sell at
different prices to the two markets, then we need
to aggregate these demands into a world demand.
European Market
Worldwide
US Market
36
36
24
24
24
D
D
D
15
3
6
9
3
41
36
24
18
12
D
MR
15
3
42
36
17
MC
4
D
MR
15
3
6.5
43
If you can distinguish between the two markets
(and resale is not a problem), then you can treat
them separately.
US Market
20
MC
D
MR
9
4
44
If you can distinguish between the two markets
(and resale is not a problem), then you can treat
them separately.
European Market
14
MC
D
MR
6
2.5
45
Price Discrimination (Group Pricing)
European Market
US Market
20
14
MC
MC
D
MR
D
MR
9
4
6
2.5
46
Suppose you operate an amusement park. You know
that you face two types of customers (Young and
Old). You have estimated their demands as
follows
Old
Young
You have a a constant marginal cost of 2 per ride
Can you distinguish low demanders from high
demanders?
Can you prevent resale?
47
If you could distinguish each group and prevent
resale, you could charge different prices
Old
Young
100
80
51
41
D
D
49
39
48
Two Part Pricing
First, lets calculate a uniform price for both
consumers
100
80
70
60
D
MR
180
20
90
49
100
46
MC
2
D
MR
180
88
50
First, you set a price for everyone equal to 46.
Young people choose 54 rides while old people
choose 34 rides.
Old
Young
100
80
46
46
D
D
54
34
Can we do better than this?
51
Note that young consumer was willing to pay
exactly 46 for the 54th ride. However, she was
willing to pay more than 46 for all the previous
rides. We call this consumer surplus.
55
This consumer would have paid up to 55 for the
45th ride. If the going market price was 46,
consumer surplus for the 45th ride would have
been 9.
46
D
54
45
52
The young person paid a total of 2,484 for the
54 rides. However, this consumer was willing to
pay 3942.
100
1,458
46
How can we extract this extra money?
2,484
D
54
53
Two Part pricing involves setting an entry fee
as well as a per unit price. In this case, you
could set a common per ride fee of 46, but then
extract any remaining surplus from the consumers
by setting the following entry fees.
1458 Young
Entry Fee
P 46/Ride
578 Old
Old
Young
100
1458
80
578
46
46
1564
2484
D
D
54
34
Could you do better than this?
54
Suppose that you set the cost of the rides at
their marginal cost (2). Both old and young
people would use more rides and, hence, have even
more surplus to extract via the fee.
4802 Young
Entry Fee
P 2/Ride
3042 Old
Old
Young
100
4802
80
3042
2
2
D
D
98
78
55
Block Pricing involves offering packages. For
example
Old
Young
100
4802
80
3042
2
2
D
D
98
78
2(98) 196
2(78) 156
Geezer Pleaser Entry 78 Ride Coupons (1
coupon per ride) 3198
(3042 156)
Standard Admission Entry 98 Ride Coupons (1
coupon per ride) 4998
(4802 196)
56
Suppose that you couldnt distinguish High value
customers from low value customers Would this
work?
Old
Young
100
4802
80
3042
2
2
D
D
98
78
2(98) 196
2(78) 156
78 Ride Coupons 3198
1 Ticket Per Ride
98 Ride Coupons 4998
57
We know that is the high value consumer buys 98
ticket package, all her surplus is extracted by
the amusement park. How about if she buys the 78
Ride package?
Total Willingness to pay for 78 Rides 4758
-
78 Ride Coupons 3198
100
1560
3042
If the high value customer buys the 78 ride
package, she keeps 1560 of her surplus!
22
1716
78
58
You need to set a price for the 98 ride package
that is incentive compatible. That is, you need
to set a price that the high value customer will
self select. (i.e., a package that generates
1560 of surplus)
Total Willingness 4,998
100
- Required Surplus 1,560
Package Price 3,438
4802
This is known as Menu Pricing
2
196
D
98
59
Block Pricing You can distinguish high demand
and low demand (1st Degree Price Discrimination)
78 Ride 3198 ( 41/Ride)
1 Ticket Per Ride
98 Rides 4998 ( 51/Ride)
Menu Pricing You cant distinguish high demand
from low demand (2nd Degree Price Discrimination)
78 Ride 3198 (41/Ride)
1 Ticket Per Ride
98 Rides 3438 (35/Ride)
Group Pricing You can distinguish high demand
from low demand (3rd Degree Price Discrimination)
Low Demanders 41/Ride
No Entry Fee
High Demanders 51/Ride
60
Bundling
Suppose that you are selling two products.
Marginal costs for these products are 100
(Product 1) and 150 (Product 2). You have 4
potential consumers that will either buy one unit
or none of each product (they buy if the price is
below their reservation value)
Consumer Product 1 Product 2 Sum
A 50 450 500
B 250 275 525
C 300 220 520
D 450 50 500
61
If you sold each of these products separately,
you would choose prices as follows
Product 1 (MC 100)
Product 2 (MC 150)
P Q TR Profit
450 1 450 350
300 2 600 400
250 3 750 450
50 4 200 -200
P Q TR Profit
450 1 450 300
275 2 550 250
220 3 660 210
50 4 200 -400
Profits 450 300 750
62
Pure Bundling does not allow the products to be
sold separately
Product 1 (MC 100)
Product 2 (MC 150)
Consumer Product 1 Product 2 Sum
A 50 450 500
B 250 275 525
C 300 220 520
D 450 50 500
With a bundled price of 500, all four consumers
buy both goods
Profits 4(500 -100 - 150) 1,000
63
Mixed Bundling allows the products to be sold
separately
Product 1 (MC 100)
Product 2 (MC 150)
Consumer Product 1 Product 2 Sum
A 50 450 500
B 250 275 525
C 300 220 520
D 450 50 500
Price 1 250
Price 2 450
Bundle 500
Consumer A Buys Product 2 (Profit 300) or
Bundle (Profit 250)
Profit 850 or 800
Consumer B Buys Bundle (Profit 250)
Consumer C Buys Product 1 (Profit 150)
Consumer D Buys Only Product 1 (Profit 150)
64
Mixed Bundling allows the products to be sold
separately
Product 1 (MC 100)
Product 2 (MC 150)
Consumer Product 1 Product 2 Sum
A 50 450 500
B 250 275 525
C 300 220 520
D 450 50 500
Price 1 450
Price 2 450
Bundle 520
Consumer A Buys Only Product 2 (Profit 300)
Consumer B Buys Bundle (Profit 270)
Profit 1,190
Consumer C Buys Bundle (Profit 270)
Consumer D Buys Only Product 1 (Profit 350)
65
Bundling is only Useful When there is variation
over individual consumers with respect to the
individual goods, but little variation with
respect to the sum!?
Consumer Product 1 Product 2 Sum
A 300 200 500
B 300 200 500
C 300 200 500
D 300 200 500
Product 1 (MC 100)
Product 2 (MC 150)
Individually Priced P1 300, P2 200, Profit
1,000
Pure Bundling PB 500, Profit 1,000
Mixed Bundling P1 300, P2 200, PB 500,
Profit 1,000
66
Tie-in Sales
Suppose that you are the producer of laser
printers. You face two types of demanders (high
and low). You cant distinguish high from low.
16
12
Price for 1,000 printed pages
Quantity of printed pages (in thousands)
D
D
12
16
You have a monopoly in the printer market, but
the toner cartridge market is perfectly
competitive. The price of cartridges is 2 (equal
to MC) a toner cartridge is good for 1,000
printed pages.
67
Tie-in Sales
You have already built 1,000 printers (the
production cost is sunk and can be ignored). You
are planning on leasing the printers. What price
should you charge?
16
12
98
50
2
2
D
D
12
16
10
14
A monthly fee of 50 will allow you to sell to
both consumers. Can you do better than this?
Profit 501000 50,000
68
Tie-in Sales
Suppose that you started producing toner
cartridges and insisted that your lessees used
your cartridges. Your marginal cost for the
cartridges is also 2. How would you set up your
pricing schedule?
(Aggregate Demand)
12
D
69
Tie-in Sales
16
12
72
32
4
4
D
D
12
16
8
12
By forcing tie-in sales. You can charge 4 per
cartridge and then a monthly fee of 32.
Profit (4 - 2)(8 12) 2(32) 104500
52,000
70
Complementary Goods
Suppose that the demand for Hot Dogs is given as
follows
Price of a Hot Dog Bun
Price of a Hot Dog
Hot Dogs and Buns are made by separate companies
each has a monopoly in its own industry. For
simplicity, assume that the marginal cost of
production for each equals zero.
71
Complementary Goods
Each firm must price their own product based on
their expectation of the other firm
Bun Company
Hot Dog Company
72
Complementary Goods
Each firm must price their own product based on
their expectation of the other firm
Bun Company
Hot Dog Company
Substitute these quantities back into the demand
curve to get the associated prices. This gives
us each firms reaction function.
73
Any equilibrium with the two firms must have each
of them acting optimally in response to the other.
Hot Dog Company
12
6
4
Bun Company
4
6
12
74
Complementary Goods
Now, suppose that these companies merged into one
monopoly
75
Case Study Microsoft vs. Netscape
The argument against Microsoft was using its
monopoly power in the operating system market to
force its way into the browser market by
bundling Internet Explorer with Windows 95.

• To prove its claim, the government needed to
  show
• Microsoft did, in fact, possess monopoly power
• The browser and the operating system were, in
  fact, two distinct products that did not need to
  be integrated
• Microsofts behavior was an abuse of power that
  hurt consumers

What should Microsofts defense be?
76
Case Study Microsoft vs. Netscape
Suppose that the demand for browsers/operating
systems is as follows (look familiar?). Again,
Assume MC0
Case 1 Suppose that Microsoft never entered the
browser market leaving Netscape as a monopolist.
77
Case Study Microsoft vs. Netscape
Case 2 Now, suppose that Microsoft competes in
the Browser market
With competition (and no collusion) in the
browser market, Microsoft and Netscape continue
to undercut one another until the price of the
browser equals MC ( 0)
Given the browsers price of zero, Microsoft will
sell its operating system for 6