Finance 30210: Managerial Economics

1. Finance 30210: Managerial Economics Competitive Pricing Techniques

2. Once production decisions have been made, a firm can be represented by it’s cost function Total costs of production are a function of quantity produced MC For pricing decisions, we focus on marginal cost $1.50 56 An increase in production increased total costs by $1.50

3. Next, we need to know something about the demand the firm faces. Demand refers to quantity as a function of price Inverse demand refers to price as a function of quantity

4. Now, the firm takes it’s costs and consumer as given and chooses a quantity (or price) to maximize profits Total Revenues equal price times quantity Total Costs Profits Your costs will be influenced by your production levels Your price will be influenced by your sales target

5. Firms are choosing a sales target to maximize profits First Order Necessary Conditions Marginal Revenue (MR) Marginal Cost (MC)

6. 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?

7. 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

8. If we are maximizing profits, we want marginal revenues to equal marginal costs: Firm’s will be charging a markup over marginal cost where the markup is related to the elasticity of demand

9. 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

10. 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

11. First, to increase sales by one, by how much does this firm have to lower it’s price? A $0.50 price drop would increase sales by one -$.50*20 = -$10 Again, this is a loss because we lowered our price to our existing customers! (1)($39.50) The additional sale! $40 $39.50 MR = $29.50 MC = $10 D We should lower price! 20 21

12. Suppose there is a monopolist that faces the following demand Further, this monopolist has a cost function given by Marginal Cost

13. 30 10 MC=$10 D 40 MR = 50-Q

14. The markup formula works! 30 10 MC D 40 MR

15. 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 i’s competitors

16. Is it possible for Industry Firm Level Profit > 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.

17. Competitive Market equilibrium Industry Firm Level Profit = 0 D $10 S 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.

18. 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!)

19. Measuring Market Structure – Concentration Ratios Suppose that we take all the firms in an industry and ranked 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 2 3 4 5 6 7 10 20

20. Measuring Market Structure – Concentration Ratios Cumulative Market Share 100 A C 80 B 40 20 Size Rank 0 0 1 2 3 4 5 6 7 10 20 Measures the cumulative market share of the top four firms

21. Concentration Ratios in US manufacturing; 1947 - 1997 Aggregate manufacturing in the US hasn’t really changed since WWII

22. Measuring Market Structure: The Herfindahl-Hirschman Index (HHI) = Market share of firm i HHI = 2,000

23. 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 2 3 4 5 6 7 10 20

24. The HHI index also penalizes an unequal distribution of firms Cumulative Market Share 100 80 HHI = 500 HHI = 555 A 40 B 20 0 0 1 2 3 4 5 6 7 10 20

25. Concentration Ratios in For Selected Industries

26. Another way to measure competition is by the outcome. The Lerner index measures the percentage of a product’s price that is due to the markup Perfect Competition Monopoly

27. Lerner index in For Selected Industries

28. Consider the Following Two Industries • Canned Fruits/Vegetables (SIC 2033) • $15B in Annual Sales • 500 Firms • CR4 = 27, CR8 = 42 • HHI = 300 • LI = .243 • Canned Specialty Foods (SIC 2032) • $6B in Annual Sales • 200 Firms • CR4 = 69, CR8 = 84 • HHI = 2000 • LI = .446

29. Market Size and Market Structure 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!

30. Consider the Following Two Industries • Pharmaceutical Preparations (SIC 2834) • $50B in Annual Sales • 583 Firms • CR4 = 26, CR8 = 42 • HHI = 341 • Aircraft (SIC 3721) • $65B in Annual Sales • 151 Firms • CR4 = 79, CR8 = 93 • HHI = 2717

31. Globally scale economies 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

32. 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.

33. 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

34. 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

35. 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 Rowling’s 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 don’t 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 3 15 6 3 9

41. $36 $24 $18 $12 MR D 3 15

42. $36 $17 $4 MC MR D 3 6.5 15

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 MR D 4 9

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 MR D 2.5 6

45. Price Discrimination (Group Pricing) European Market US Market $20 $14 MC MC MR D MR D 4 9 2.5 6

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 MR D 20 90 180

49. $100 $46 $2 MC MR D 88 180

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?