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Finance 30210: Managerial Economics Strategic Pricing Techniques.

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1 Finance 30210: Managerial Economics Strategic Pricing Techniques

2 Market Structures Recall that there is an entire spectrum of market structures Perfect Competition Many firms, each with zero market share P = MC Profits = 0 (Firm’s earn a reasonable rate of return on invested capital) NO STRATEGIC INTERACTION! Monopoly One firm, with 100% market share P > MC Profits > 0 (Firm’s earn excessive rates of return on invested capital) NO STRATEGIC INTERACTION!

3 Most industries, however, don’t fit the assumptions of either perfect competition or monopoly. We call these industries oligopolies Oligopoly Relatively few firms, each with positive market share STRATEGIES MATTER!!! Mobile Phones (2011) Nokia: 22.8% Samsung: 16.3% LG: 5.7% Apple: 4.6% ZTE:3.0% Others: 47.6% US Beer (2010) Anheuser-Busch: 49% Miller/Coors: 29% Crown Imports: 5% Heineken USA: 4% Pabst: 3% Music Recording (2005) Universal/Polygram: 31% Sony: 26% Warner: 25% Independent Labels: 18%

4 The key difference in oligopoly markets is that price/sales decisions can’t be made independently of your competitor’s decisions Monopoly Oligopoly Your Price (-) Your N Competitors Prices (+) Oligopoly markets rely crucially on the interactions between firms which is why we need game theory to analyze them!

5 Market shares are not constant over time in these industries! Airlines (1992)Airlines (2002) American Northwest Delta United Continental US Air American United Delta Northwest Continental SWest While the absolute ordering didn’t change, all the airlines lost market share to Southwest.

6 Another trend is consolidation Retail Gasoline (1992)Retail Gasoline (2001) Shell Exxon Texaco Chevron Amoco Mobil Exxon/Mobil Shell BP/Amoco/Arco Chev/Texaco Conoco/Phillips Citgo BP Marathon Sun Phillips Total/Fina/Elf

7 Jake Clyde ConfessDon’t Confess Confess Don’t Confess -8 0 The prisoner’s dilemma game is used to describe circumstances where competition forces sub- optimal outcomes Recall the prisoners dilemma game…

8 Price Fixing and Collusion Prior to 1993, the record fine in the United States for price fixing was $2M. Recently, that record has been shattered! DefendantProductYearFine F. Hoffman-LarocheVitamins1999$500M BASFVitamins1999$225M SGL CarbonGraphite Electrodes1999$135M UCAR InternationalGraphite Electrodes1998$110M Archer Daniels MidlandLysine & Citric Acid1997$100M Haarman & ReimerCitric Acid1997$50M HeereMacMarine Construction1998$49M In other words…Cartels happen!

9 Suppose that we have two firms in the market. They face the following demand curve… Firm 1’s outputFirm 2’s output Each has a marginal cost of $80. If these firms formed a cartel, they would operate jointly as a monopolist. Each firm agrees to sell 20 units at $240 each. Each firm makes $3200 in profits

10 However, given that firm 2 is producing 20 units, what should firm 1 do? Firm 1’s outputFirm 2’s output Firm 1 cheats and earns more profits!

11 But if they both cheat and produce 30 units…

12 Cartels - The Prisoner’s Dilemma Jake Clyde CooperateCheat Cooperate$3200 $2400 $3600 Cheat$3600 $2400$2400 The problem facing the cartel members is a perfect example of the prisoner’s dilemma ! Cheating is a dominant strategy!

13 Cartel Formation While it is clearly in each firm’s best interest to join the cartel, there are a couple problems:  With the high monopoly markup, each firm has the incentive to cheat and overproduce. If every firm cheats, the price falls and the cartel breaks down  Cartels are generally illegal which makes enforcement difficult! Note that as the number of cartel members increases the benefits increase, but more members makes enforcement even more difficult!

14 Perhaps cartels can be maintained because the members are interacting over time – this brings is a possible punishment for cheating. Time Make Strategic Decision Jake Clyde Make Strategic Decision Jake “I plan on cooperating…if you cooperate today, I will cooperate tomorrow, but if you cheat today, I will cheat forever!” CooperateCheat Cooperate$3200 $2400 $3600 Cheat$3600 $2400$2400

15 Time Make Strategic Decision Jake “I plan on cooperating…if you cooperate today, I will cooperate tomorrow, but if you cheat today, I will cheat forever!” Clyde Cooperate: Cheat: $3200 $3600$2400 Cooperate: $19,200 Cheat: $15,600 Clyde should cooperate, right? CooperateCheat Cooperate$3200 $2400 $3600 Cheat$3600 $2400$2400

16 JakeClyde We need to use backward induction to solve this. Time Make Strategic Decision What should Clyde do here? Regardless of what took place the first four time periods, what will happen in period 5? CooperateCheat Cooperate$3200 $2400 $3600 Cheat$3600 $2400$2400

17 JakeClyde We need to use backward induction to solve this. Time Make Strategic Decision What should Clyde do here? Cheat Given what happens in period 5, what should happen in period 4? CooperateCheat Cooperate$3200 $2400 $3600 Cheat$3600 $2400$2400

18 JakeClyde We need to use backward induction to solve this. Time Make Strategic Decision Knowing the future prevents credible promises/threats! Cheat CooperateCheat Cooperate$3200 $2400 $3600 Cheat$3600 $2400$2400

19 Where is collusion most likely to occur? High profit potential Inelastic Demand (Few close substitutes, Necessities) Cartel members control most of the market Entry Restrictions (Natural or Artificial) Low cooperation/monitoring costs Small Number of Firms with a high degree of market concentration Similar production costs Little product differentiation

20 Price Matching: A form of collusion? High PriceLow Price High Price$12 $5 $14 Low Price$14 $5$6 Price Matching Removes the off-diagonal possibilities. This allows (High Price, High Price) to be an equilibrium!!

21 The Stag Hunt - Airline Price Wars $500 $ Suppose that American and Delta face the given demand for flights to NYC and that the unit cost for the trip is $200. If they charge the same fare, they split the market P = $500P = $220 P = $500$9,000 $3,600 $0 P = $220$0 $3,600 $1,800 American Delta What will the equilibrium be?

22 The Airline Price Wars P = $500P = $220 P = $500$9,000 $3,600 $0 P = $220$0 $3,600 $1,800 American Delta If American follows a strategy of charging $500 all the time, Delta’s best response is to also charge $500 all the time If American follows a strategy of charging $220 all the time, Delta’s best response is to also charge $220 all the time This game has multiple equilibria and the result depends critically on each company’s beliefs about the other company’s strategy

23 The Airline Price Wars: Mixed Strategy Equilibria P = $500P = $220 P = $500$9,000 $3,600 $0 P = $220$0 $3,600 $1,800 American Delta Charge $500: Charge $220: Suppose American charges $500 with probability Charges $220 with probability (75%) (25%) (56%)(19%) (6%)

24 Continuous Choice Games Consider the following example. We have two competing firms in the marketplace.  These two firms are selling identical products.  Each firm has constant marginal costs of production. What are these firms using as their strategic choice variable? Price or quantity? Are these firms making their decisions simultaneously or is there a sequence to the decisions?

25 Cournot Competition: Quantity is the strategic choice variable D There are two firms in an industry – both facing an aggregate (inverse) demand curve given by Total Industry Production Both firms have constant marginal costs equal to $20

26 Consider the following scenario…We call this Cournot competition Two manufacturers choose a production target Q2 Q1 P Q1 + Q2 Q S D P* A centralized market determines the market price based on available supply and current demand Two manufacturers earn profits based off the market price Profit = P*Q1 - TC Profit = P*Q2 - TC

27 For example…suppose both firms have a constant marginal cost of $20 Two manufacturers choose a production target Q2 = 2 Q1 = 1 P 3 Q S D $60 A centralized market determines the market price based on available supply and current demand Two manufacturers earn profits based off the market price Profit = 60*1 – 20 = $40 Profit = 60*2 – 40 = $80

28 From firm one’s perspective, the demand curve is given by Treated as a constant by Firm One Solving Firm One’s Profit Maximization…

29 In Game Theory Lingo, this is Firm One’s Best Response Function To Firm 2 0 If firm 2 drops out, firm one is a monopolist!

30 What could firm 2 do to make firm 1 drop out?

31 3 1 Firm 2 chooses a production target of 3 Firm 1 responds with a production target of 1

32 The game is symmetric with respect to Firm two… Firm 1 chooses a production target of 1 Firm 2 responds with a production target of 2

33 Firm 1 Firm 2 Eventually, these two firms converge on production levels such that neither firm has an incentive to change We would call this the Nash equilibrium for this model

34 Recall we started with the demand curve and marginal costs

35 The markup formula works for each firm

36 Had this market been serviced instead by a monopoly…

37 Had this market been instead perfectly competitive,

38 MonopolyPerfect Competition 2 Firms

39 D $ CS = (.5)(120 – 70)(2.5) = $62.5 $62.5 What would it be worth to consumers to add another firm to the industry? Recall, we had an aggregate demand and a constant marginal cost of production. Monopoly $120

40 D $ CS = (.5)(120 – 53)(3.33) = $112 $112 Recall, we had an aggregate demand and a constant marginal cost of production. Two Firms

41 Suppose we increase the number of firms…say, to 3 Demand facing firm 1 is given by (MC = 20) The strategies look very similar!

42 D $ CS = (.5)(120 – 45)(3.75) = $140 $140 With three firms in the market… Three Firms

43 Expanding the number of firms in an oligopoly – Cournot Competition Note that as the number of firms increases: Output approaches the perfectly competitive level of production Price approaches marginal cost. N = Number of firms

44 Increasing Competition

45

46 Firm 1 Firm 2 The previous analysis was with identical firms. Suppose Firm 2’s marginal costs increase to $30 50%

47 Firm 2 Suppose Firm 2’s marginal costs increase to $30 If Firm one’s production is unchanged

48 Firm 1 Firm 2 Firm 2’s market share drops Firm 1’s Market Share increases 42% 58%

49 Market Concentration and Profitability Industry Demand The Lerner index for Firm i is related to Firm i’s market share and the elasticity of industry demand The Average Lerner index for the industry is related to the HHI and the elasticity of industry demand

50 (42%) (58%) Industry Firm 1 Firm 2

51 The previous analysis (Cournot Competition) considered quantity as the strategic variable. Bertrand competition uses price as the strategic variable. D Q* P* Should it matter? Just as before, we have an industry demand curve and two competing duopolies – both with marginal cost equal to $20. Industry Output

52 D Quantity Strategy D Bertrand Case Firm level demand curves look very different when we change strategic variables If you are underpriced, you lose the whole market If you are the low price you capture the whole market At equal prices, you split the market

53 Price competition creates a discontinuity in each firm’s demand curve – this, in turn creates a discontinuity in profits As in the cournot case, we need to find firm one’s best response (i.e. profit maximizing response) to every possible price set by firm 2.

54 Firm One’s Best Response Function Case #1: Firm 2 sets a price above the pure monopoly price: Case #3: Firm 2 sets a price below marginal cost Case #2: Firm 2 sets a price between the monopoly price and marginal cost Case #4: Firm 2 sets a price equal to marginal cost What’s the Nash equilibrium of this game?

55 However, the Bertrand equilibrium makes some very restricting assumptions…  Firms are producing identical products (i.e. perfect substitutes)  Firms are not capacity constrained MonopolyPerfect Competition 2 Firms

56 An example…capacity constraints Consider two theatres located side by side. Each theatre’s marginal cost is constant at $10. Both face an aggregate demand for movies equal to Each theatre has the capacity to handle 2,000 customers per day. What will the equilibrium be in this case?

57 If both firms set a price equal to $10 (Marginal cost), then market demand is 5,400 (well above total capacity = 2,000) Note: The Bertrand Equilibrium (P = MC) relies on each firm having the ability to make a credible threat: “If you set a price above marginal cost, I will undercut you and steal all your customers!” At a price of $33, market demand is 4,000 and both firms operate at capacity. Now, how do we choose capacity? Back to Cournot competition!

58 With competition in price, the key is to create product variety somehow! Suppose that we have two firms. Again, marginal costs are $20. The two firms produce imperfect substitutes. D Example:

59 Recall Firm 1 has a marginal cost of $20 Each firm needs to choose price to maximize profits conditional on the other firm’s choice of price. Firm 1 profit maximizes by choice of price D Firm 1’s strategy $30 Firm 2 sets a price of $50 Firm 1 responds with $55

60 Firm 1 Firm 2 With equal costs, both firms set the same price and split the market evenly

61 MonopolyPerfect Competition 2 Firms

62 Firm 2 Suppose that Firm two‘s costs increase. What happens in each case? Bertrand $30 With higher marginal costs, firm 2’s profit margins shrink. To bring profit margins back up, firm two raises its price

63 Firm 1 Firm 2 Suppose that Firm two‘s costs increase. What happens in each case? With higher marginal costs, firm 2’s profit margins shrink. To bring profit margins back up, firm two raises its price A higher price from firm two sends customers to firm 1. This allows firm 1 to raise price as well and maintain market share!

64 Cournot (Quantity Competition): Competition is for market share  Firm One responds to firm 2’s cost increases by expanding production and increasing market share – prices are fairly stable and market shares fluctuate  Best response strategies are strategic substitutes Bertrand (Price Competition): Competition is for profit margin  Firm One responds to firm 2’s cost increases by increasing price and maintaining market share – prices fluctuate and market shares are fairly stable.  Best response strategies are strategic complements Firm 1 Firm 2 Firm 1 Firm 2 BertrandCournot

65 Stackelberg leadership – Incumbent/Entrant type games In the previous example, firms made price/quantity decisions simultaneously. Suppose we relax that and allow one firm to choose first. Both firms have a marginal cost equal to $20 Firm 1 chooses its output first Firm 2 chooses its output second Market Price is determined

66 Firm 2 has observed Firm 1’s output decision and faces the residual demand curve: Firm 2’s strategy

67 Knowing Firm 2’s response, Firm 1 can now maximize its profits: Firm 1 produces the monopoly output!

68 MonopolyPerfect Competition 2 Firms (67%) (33%)

69 Sequential Bertrand Competition We could also sequence events using price competition. Both firms have a marginal cost equal to $20 Firm 1 chooses its price first Firm 2 chooses its price second Market sales are determined

70 Recall Firm 1 has a marginal cost of $20 From earlier, we know the strategy of firm 2. Plug this into firm one’s profits… Now we can maximize profits with respect to firm one’s price.

71 Sequential Bertrand Competition MonopolyPerfect Competition 2 Firms

72 Cournot vs. Bertrand: Stackelberg Games Cournot (Quantity Competition):  Firm One has a first mover advantage – it gains market share and earns higher profits. Firm B loses market share and earns lower profits  Total industry output increases (price decreases) Bertrand (Price Competition):  Firm Two has a second mover advantage – it charges a lower price (relative to firm one), gains market share and increases profits.  Overall, production drops, prices rise, and both firms increase profits.

73 Suppose that a Cournot competitor decides to exploit the first mover advantage to drive its competitor out of business… Both firms have a marginal cost equal to $20, each also has a fixed cost equal to $5 Firm 1 chooses its output first Firm 2 chooses its output second Market Price is determined Predatory Pricing: A pricing strategy that makes sense only if it drives a competitor out of business.

74 Knowing Firm 2’s response, We can adjust the demand curve: This demand curve incorporates firm two’s behavior.

75 Now, we want to create firm 2’s profits: MC = $20, FC = $5

76 We want to find the level of production by firm 1 that lowers Firm 2’s profits to zero…

77 Now, we can calculate profits… Note: This was by design! Firm one sacrifices some profits today to stay a monopoly!

78 There have been numerous cases involving predatory pricing throughout history. There are two good reasons why we would most likely not see predatory pricing in practice 1.It is difficult to make a credible threat (Remember the Chain Store Paradox)! 2.A merger is generally a dominant strategy!!  Standard Oil  American Sugar Refining Company  Mogul Steamship Company  Wall Mart  AT&T  Toyota  American Airlines

79 The Bottom Line with Predatory Pricing… There have been numerous cases over the years alleging predatory pricing. However, from a practical standpoint we need to ask three questions: 1.Can predatory pricing be a rational strategy? 2.Can we distinguish predatory pricing from competitive pricing? 3.If we find evidence for predatory pricing, what do we do about it?


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