2Total costs of production are a function of quantity produced Once production decisions have been made, a firm can be represented by it’s cost functionTotal costs of production are a function of quantity producedMCFor pricing decisions, we focus on marginal cost$1.5056An increase in production increased total costs by $1.50
3Next, we need to know something about the demand the firm faces. Demand refers to quantity as a function of priceInverse demand refers to price as a function of quantity
4Now, the firm takes it’s costs and consumer as given and chooses a quantity (or price) to maximize profitsTotal Revenues equal price times quantityTotal CostsProfitsYour costs will be influenced by your production levelsYour price will be influenced by your sales target
5Firms are choosing a sales target to maximize profits First Order Necessary ConditionsMarginal Revenue (MR)Marginal Cost (MC)
6Initially, you have chosen a price (P) to charge and are making Q sales. Total Revenues = PQDSuppose that you want to increase your sales. What do you need to do?
7Your 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 customersThis area represents the revenues that you gain from attracting a new customerD1
8If 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
9Market Structure Spectrum MonopolyPerfect CompetitionThe market is supplied by many producers – each with zero market shareOne Producer Supplies the entire MarketFirm Level Demand DOES NOT equal industry demandFirm Level Demand EQUALS industry demand
10Suppose there is a monopolist that faces the following demand Further, the monopoly has a linear cost function$40Can this firm do better?D20
11First, 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 = -$10Again, this is a loss because we lowered our price to our existing customers!$40(1)($39.50)The additional sale!$39.50MR = $29.50MC = $10DWe should lower price!2021
12Suppose there is a monopolist that faces the following demand Further, this monopolist has a cost function given byMarginal Cost
15Now, suppose this market is serviced by a large number of identical firms – each with marginal costs equal to $10Firm LevelIndustryDDLowest price among firm i’s competitors
16Is 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.
17Competitive Market equilibrium IndustryFirm LevelProfit = 0D$10SDAs 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.
18Perfectly competitive firms face demand curves that are perfectly elastic (infinite elasticity. Hence, the markup (and profits) are zero)IndustryFirm LevelDMCDNote: Industry elasticities in competitive industries are always less than 1 (industry profits could be increased by raising price!)
19Measuring 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 Share100AC80B4020Size Rank12345671020
20Measuring Market Structure – Concentration Ratios Cumulative Market Share100AC80B4020Size Rank12345671020Measures the cumulative market share of the top four firms
21Concentration Ratios in US manufacturing; 1947 - 1997 Year1947172330195838196725334219772444198743199232199740Aggregate manufacturing in the US hasn’t really changed since WWII
22Measuring Market Structure: The Herfindahl-Hirschman Index (HHI) = Market share of firm iRankMarket Share1256252345678HHI = 2,000
23The HHI index penalizes a small number of total firms Cumulative Market Share100A80HHI = 500BHHI = 1,000402012345671020
24The HHI index also penalizes an unequal distribution of firms Cumulative Market Share10080HHI = 500HHI = 555A40B2012345671020
25Concentration Ratios in For Selected Industries IndustryCR(4)HHIBreakfast Cereals832446Automobiles802862Aircraft2562Telephone Equipment551061Women’s Footwear50795Soft Drinks47800Computers & Peripherals37464Pharmaceuticals32446Petroleum Refineries28422Textile Mills1394
26Another way to measure competition is by the outcome. The Lerner index measures the percentage of a product’s price that is due to the markupPerfect CompetitionMonopoly
27Lerner index in For Selected Industries IndustryLICommunication.972Paper & Allied Products.930Electric, Gas & Sanitary Services.921Food Products.880General Manufacturing.777Furniture.731Tobacco.638Apparel.444Motor Vehicles.433Machinery.300
28Consider the Following Two Industries Canned Fruits/Vegetables (SIC 2033)$15B in Annual Sales500 FirmsCR4 = 27, CR8 = 42HHI = 300LI = .243Canned Specialty Foods (SIC 2032)$6B in Annual Sales200 FirmsCR4 = 69, CR8 = 84HHI = 2000LI = .446
29Market Size and Market Structure CostsACMCIf 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!
30Consider the Following Two Industries Pharmaceutical Preparations (SIC 2834)$50B in Annual Sales583 FirmsCR4 = 26, CR8 = 42HHI = 341Aircraft (SIC 3721)$65B in Annual Sales151 FirmsCR4 = 79, CR8 = 93HHI = 2717
31Globally 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.CostsCostsACACMCMC
32Monopoly Market Characteristics Small market sizeScale 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.
33Long Run Industry Dynamics As an industry ages, three things happen….Short RunLong RunDDAs more alternatives become available, consumer demand becomes much more price responsive
34Long Run Industry Dynamics As an industry ages, three things happen….Short RunLong RunMCMCAs production techniques become more flexible, marginal costs drop and become much less sensitive to input prices
35Long Run Industry Dynamics As an industry ages, three things happen….Market Structure SpectrumPerfect 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
37Most firms face the a downward sloping market demand and therefore must lower its price to increase sales.Loss from charging existing customers a lower priceGain from attracting new customersIs it possible to attract new customers without lowering your price to everybody?D
38Price Discrimination D If this monopolist could lower its price to the 21st customer while continuing to charge the 20th customer $15, it could increase profits.Requirements:IdentificationNo Arbitrage$15$12D2021
39Price 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 SalesEuropean Sales
40If 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 MarketWorldwideUS Market$36$36$24$24$24DDD315639
43If you can distinguish between the two markets (and resale is not a problem), then you can treat them separately.US Market$20MCMRD49
44If you can distinguish between the two markets (and resale is not a problem), then you can treat them separately.European Market$14MCMRD2.56
45Price Discrimination (Group Pricing) European MarketUS Market$20$14MCMCMRDMRD492.56
46Suppose you operate an amusement park 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:OldYoungYou have a a constant marginal cost of $2 per rideCan you distinguish low demanders from high demanders?Can you prevent resale?
47If you could distinguish each group and prevent resale, you could charge different prices OldYoung$100$80$51$41DD4939
48Two Part PricingFirst, lets calculate a uniform price for both consumers$100$80$70$60MRD2090180
50Can we do better than this? First, you set a price for everyone equal to $46. Young people choose 54 rides while old people choose 34 rides.OldYoung$100$80$46$46DD5434Can we do better than this?
51Note that the young consumer pays $46 for the 54th ride Note that the young consumer pays $46 for the 54th ride. However, she was willing to pay more than $46 for all the previous rides. We call this consumer surplus.$55This 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.$46D4554
52The young person paid a total of $2,484 for the 54 rides The young person paid a total of $2,484 for the 54 rides. However, this consumer was willing to pay $3942.$100$1,458$46How can we extract this extra money?$2,484D54
53Could you do better than this? 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 YoungP = $46/RideEntry Fee =$578 OldOldYoung$100$1458$80$578$46$46$1564$2484DD5434Could you do better than this?
54Suppose that you set the cost of the rides at their marginal cost ($2) 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 YoungP = $2/RideEntry Fee =$3042 OldOldYoung$100$4802$80$3042$2$2DD9878
56Suppose that you couldn’t distinguish High value customers from low value customers: Would this work?YoungOld$100$4802$80$3042$2$2DD9878$2(98) = $196$2(78) = $15678 Ride Coupons: $31981 Ticket Per Ride98 Ride Coupons: $4998
57We 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$3042If the high value customer buys the 78 ride package, she keeps $1560 of her surplus!$22$171678
58This is known as Menu Pricing 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 = $1,560Package Price = $3,438$4802This is known as Menu Pricing$2$196D98
59Block Pricing: You can distinguish high demand and low demand (1st Degree Price Discrimination) 78 Ride: $3198 ( $41/Ride)1 Ticket Per Ride98 Rides: $4998 ( $51/Ride)Menu Pricing: You can’t distinguish high demand from low demand (2nd Degree Price Discrimination)78 Ride: $3198 ($41/Ride)1 Ticket Per Ride98 Rides: $3438 ($35/Ride)Group Pricing: You can distinguish high demand from low demand (3rd Degree Price Discrimination)Low Demanders: $41/RideNo Entry FeeHigh Demanders: $51/Ride
60Bundling Consumer Product 1 Product 2 Sum A $50 $450 $500 B $250 $275 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)ConsumerProduct 1Product 2SumA$50$450$500B$250$275$525C$300$220$520D
61If you sold each of these products separately, you would choose prices as follows Product 1 (MC = $100)Product 2 (MC = $150)PQTRProfit$4501$350$3002$600$400$2503$750$504$200-$200PQTRProfit$4501$300$2752$550$250$2203$660$210$504$200-$400Profits = $450 + $300 = $750
62Consumer Product 1 Product 2 Sum A $50 $450 $500 B $250 $275 $525 C Pure Bundling does not allow the products to be sold separatelyProduct 1 (MC = $100)Product 2 (MC = $150)ConsumerProduct 1Product 2SumA$50$450$500B$250$275$525C$300$220$520DWith a bundled price of $500, all four consumers buy both goods:Profits = 4($500 -$100 - $150) = $1,000
63Consumer Product 1 Product 2 Sum A $50 $450 $500 B $250 $275 $525 C Mixed Bundling allows the products to be sold separatelyProduct 1 (MC = $100)Product 2 (MC = $150)ConsumerProduct 1Product 2SumA$50$450$500B$250$275$525C$300$220$520DPrice 1 = $250Price 2 = $450Bundle = $500Consumer A: Buys Product 2 (Profit = $300) or Bundle (Profit = $250)Consumer B: Buys Bundle (Profit = $250)Profit = $850or $800Consumer C: Buys Product 1 (Profit = $150)Consumer D: Buys Only Product 1 (Profit = $150)
64Consumer Product 1 Product 2 Sum A $50 $450 $500 B $250 $275 $525 C Mixed Bundling allows the products to be sold separatelyProduct 1 (MC = $100)Product 2 (MC = $150)ConsumerProduct 1Product 2SumA$50$450$500B$250$275$525C$300$220$520DPrice 1 = $450Price 2 = $450Bundle = $520Consumer A: Buys Only Product 2 (Profit = $300)Consumer B: Buys Bundle (Profit = $270)Profit = $1,190Consumer C: Buys Bundle (Profit = $270)Consumer D: Buys Only Product 1 (Profit = $350)
65Tie-in SalesSuppose that you are the producer of laser printers. You face two types of demanders (high and low). You can’t distinguish high from low.$16$12Price for 1,000 printed pagesQuantity of printed pages (in thousands)DD1216You 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.
66Tie-in SalesYou 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$2DD10121416A monthly fee of $50 will allow you to sell to both consumers. Can you do better than this? Profit = $50*1000 = $50,000
67Tie-in SalesSuppose 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)$12D
68Tie-in Sales$16$12$72$32$4$4DD8121216By forcing tie-in sales. You can charge $4 per cartridge and then a monthly fee of $32.Profit = ($4 - $2)*(8 + 12) + 2($32) = $104*500 = $52,000
69Suppose that the demand for Hot Dogs is given as follows: Complementary GoodsSuppose that the demand for Hot Dogs is given as follows:Price of a Hot Dog BunPrice of a Hot DogHot 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.
70Complementary GoodsEach firm must price their own product based on their expectation of the other firmBun CompanyHot Dog Company
71Complementary GoodsEach firm must price their own product based on their expectation of the other firmBun CompanyHot Dog CompanySubstitute these quantities back into the demand curve to get the associated prices. This gives us each firm’s reaction function.
72Any equilibrium with the two firms must have each of them acting optimally in response to the other. Hot Dog Company$12$6$4Bun Company$4$6$12
73Complementary GoodsNow, suppose that these companies merged into one monopoly
74Case 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 powerThe browser and the operating system were, in fact, two distinct products that did not need to be integratedMicrosoft’s behavior was an abuse of power that hurt consumersWhat should Microsoft’s defense be?
75Case Study: Microsoft vs. Netscape Suppose that the demand for browsers/operating systems is as follows (look familiar?). Again, Assume MC=0Case #1: Suppose that Microsoft never entered the browser market – leaving Netscape as a monopolist.
76Case Study: Microsoft vs. Netscape Case #2: Now, suppose that Microsoft competes in the Browser marketWith 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 browser’s price of zero, Microsoft will sell its operating system for $6
77Spatial Competition – Location Preferences When you purchase a product, you pay more than just the dollar cost. The total purchase cost is called your opportunity cost20 miles2 milesConsider two customers shopping for wine. One lives close to the store while the other lives far away.The opportunity cost is higher for the consumer that is further away. Therefore, if both customers have the same demand for wine, the distant customer would require a lower price.
78Spatial Competition – Location Preferences Gucci currently has 31 locations in the USStarbucks currently has 5,200 locations in the USHow can we explain this difference?
79Consider a market with N identical consumers Consider a market with N identical consumers. Each has a demand given byWe must include their travel time in the total price they pay for the product. The firm can’t distinguish consumers and, hence, can’t price discriminate.Distance to StoreTravel CostsDollar Price
80What fraction of the market will you capture? There is one street of length one. Suppose that you build one store in the middle. For simplicity, assume that MC = 0X = 1X = 1/2X = 1/2With a priceWhat fraction of the market will you capture?This is the “marginal customer”To capture the whole market, set x = 1/2
81Now, suppose you build two stores… X = 1X = 1/4X = 1/4X = 1/4X = 1/4With a priceWhat fraction of the market will you capture?To capture the whole market, set x = 1/4
82Now, suppose you build three stores… X = 1X = 1/6X = 1/6X = 1/6X = 1/6X = 1/6X = 1/6With a priceWhat fraction of the market will you capture?To capture the whole market, set x = 1/6Do you see the pattern??
83With ‘n’ stores, the price you can charge is As n gets arbitrarily large, p approaches VFurther, profits are equal toTotal SalesPriceTotal Costs
84Maximizing ProfitsNumber of locations is based on:Size of the market (N)Fixed costs of establishing a new location (F)“Moving Costs” (t)
85Horizontal Differentiation Baskin Robbins has 31 Flavors…how did they decide on 31?t = Consumer “Pickiness”N = Market sizeF = R&D costs of finding a new flavor