Market Structures and Pricing Essay

Market structures and pricing Revenues Consumers * Inverse demand curve gives willingness-to-pay * Benefit consumer(s) derive(s) from additional good; * Area under inverse demand curve measures total willingness-to-pay, total benefit or total surplus. * Maximum price I can charge as producer determined by inverse demand function * Marginal revenues; revenue of next unit I sell Strategies * Profit maximization * Marginal profits equal to 0 (MR=MC) * Classic economic theory; entrepreneurial capitalism * Owner makes strategic decisions * Managerial capitalism; * Ownership changed * Control changed * Potential conflicts between shareholders and management * Firms got bigger: coordinate difficulties * Revenues maximization * Decreasing revenues bad for image * Financial institutions want certainty * Low revenues mean relatively high risk for suppliers * Low revenues may lead to budget cuts, including management * Bonus * MR=0 * Marketing effort * Managerial utility maximization * Managers maximize own satisfaction * Growth maximization * Long term strategy * Behavioral theories * Different groups, satisfy all groups to survive: satisfying * Altruistic objectives: public interest * Welfare maximization * What strategy is relevant? * Autonomy and income advancement * Successful business is most important personal objective * Growth objective * Profit maximization * Model * Economic profit ≠  accounting profit Market structures * Perfect competition * Monopolistic competition * Oligopoly * Monopoly Perfect competition * Many (small) suppliers and buyers: ‘price takes’ * Demand function for individual company * Products are perfect substitutes * Free entry and exit * Information is perfect (available to all no cost) * Free movement of products: supply responsive to market forces * Innovation exogenous: producers reactive rather than proactive. * Benchmark: Welfare is maximized (p=mc) * Efficiency * Productive efficiency: AC cannot be lower * MC curve passes though minimum of AC * Allocative efficiency: resources are distributed and used as preferred by consumers: P=MC * Pareto efficiency: no one can be made better off without making anyone else worse off. Monopoly One seller; can influence price (output) Price > marginal cost: economic inefficiency (although the firm itself may be efficient) * Barriers to entry * Initial costs * Sunk costs * Brand loyalty * Economies of scale * Patents and licenses * Anti-competitive behavior Revenues * Demand: Q * Inverse demand: P=a/b-1/b*Q * Revenues: R = P*Q = Q*a/b-1/b*Qâ‚‚ * Marginal revenue: ∂R/∂Q * Additional revenues from next unit sold * ∂R/∂Q = a/b-2/b*Q * Twice as steep as inverse demand * Positive if ÃŽ µÃ'€ < -1 * Demand is elastic (point-elastic) Natural monopoly * Market can only sustain 1 producer * Competition (P=MC): all competitors make a loss * P>MC: loss when P help to sustain monopoly or oligopoly * Government; policy regulation * Spatial pre-emption; new entrants do not have access to necessary inputs * Cost barriers * Reputation: customer loyalty, safety * Exit barriers: shrinking a firm is expensive (labor, capacity) * Entry-deterring strategies; pricing, spare-capacity, corporate deals (price discrimination) Oligopoly: non-corporate behavior * Competition based on output (quantity) or price. * Two basic oligopoly models: * Cournot (quantity competition) * Bertrand (price competition) * Cournot: firms determine output simultaneously, and the bring this to the market; * Bertrand: firms announce prices. Demand is allocated to low-price firm(s), who then produce(s) demand Cournot competition * Assumes that firms produce identical products * Demand: Q=a-b*P * Inverse demand: P=a/b-1/b*Q * Now we have 2 producers (duopoly): P=a/b-1/b*(Q1+Q2) * Profits maximized when MR=MC (Equivalent to monopolists), taking the competitors action as given. * Inverse demand: P=a/b-1/b*(Q1+Q2) * Revenues firm 1: R1=Q1*[a/b-1/b*(Q1+Q2)] * Marginal revenues: MR1=a/b-1/b*(2*Q1+Q2) * Equilibrium: MR1=MC1 * Expression in Q1 and Q2 * Similar expression for company 2 * MR1: ∂R1/∂Q1 = * P*∂Q1/∂Q1 + Q1*∂P/∂Q1 * P + ∂P/∂Q1*Q1 * 1 + (∂P/∂Q1*Q1/P)*P * (1+1/ÃŽ µp)*P * MR1=MC1: (1+1/ÃŽ µp)*P=MC1 * P=MC1/(1+1/ÃŽ µp) * Cournot oligopolist sets price above MC! * –Same for monopoly Bertrand oligopoly * Price competition (again assume identical goods) * Firms announce prices. Demand is allocated to low-price firm(s), who then produces demand. * If a firm sets above its competitor’s price, clients will prefer the competitors (identical goods). * Bertrand equilibrium is therefore equivalent to competitive equilibrium: price equals marginal cost. Price discrimination * Conditions: * Market power * Different groups of consumers (based on willingness-to-pay, demand elasticity etc.) -> segmentation * Resale is not possible * Cost of discrimination may not exceed additional profits * Market should be transparent. * Charge different (groups of) consumers different prices to maximize profits -> price discrimination * First, second and third degree First degree pricing discrimination * Perfect discrimination: each unit of output sold at different price; * Price determined by inverse demand curve; * What is the optimal output? Second degree price discrimination * Non-linear pricing: price depends on how much you buy; * Fundamentals; * Application; * Consumer decides on how much to buy; * Self selection constraints * 2 consumers each spends Ri to receive Xi * Buy Xi if benefitsi (Xi)-Ri >0 * Benefits 1 (X1)-R1> benefits1 (X2)-r2 * Benefits 2 (X2)-R2> benefits2 (X2)-r1 * Consider an individual demand function (for convenience, marginal costs are 0) * Monopolists want to supply X1 at a total price of A * Consider two individual demand functions * Monopolist would like to supply X1 at A+B+C and X2 at A * But: if consumer 1 also purchase X2 at a price of A, he/she will get surplus B (self selection) * If the monopolists would charge A+C for X1, consumer 1 gets surplus B and the monopolist higher profits. Can the monopolist get higher profits? * Make X2 unattractive for consumer 1` * Offering less of X2 (loss of monopolist) allows for higher profits from X1. Third degree price discrimination * Set prices for different groups of consumers: examples? Summary * Profit maximization * Monopoly, perfect competition: two extremes. * Regulation of monopoly: incentives. * Cournot oligopoly: * decide on production, then price determined in market * Cournot ologipolist has monopoly power (p>mc) * Bertrand: * decide on price, then output determined in market; p = mc * Price discrimination * Higher profits * Market power