PRICE STRATEGY AND MONOPOLISTIC COMPETITION Afonso Sebastião Feliciano Grosso Joana Fernandes Ricardo Costa Susana Serôdio Lisbon, February 2006

THE IMPORTANCE OF PRICE Price means one thing to the consumer and something else to the seller. CONSUMER The cost of something SELLER Price is revenue, the primary source of profits WHAT IS PRICE? Price is that which is given up in an exchange to acquire a good or service. Price is typically the money exchanged for the good or service. Prices are the key to revenues, which in turn are the key to profits for an organization. PRICE STRATEGY

REVENUE Revenue is the price charged to customers multiplied by the number of units sold. It’s what pays for every activity of the company: production, finance, sales, distribution, and so on. PROFIT What’s left over is profit. Managers usually strive to charge a price that will earn a fair profit. To earn profit, a managers must choose a price that is not too high or too low, a price that equals the perceived value to customers. If a price is set to high in consumers’ minds, the perceived value will be less than the cost, and sales opportunity will be lost. PRICING OBJECTIVES To survive in today’s highly competitive marketplace, companies need pricing objectives that are specific, attainable, and measurable. Realistic pricing goals then require periodic monitoring to determine the effectiveness of company’s strategy. PRICE STRATEGY

Long-term pricing framework for a good or service should be a logical extension of the pricing objectives. It is necessary to choose a price strategy that defines the initial price and gives direction for price movements over the lifecycle. Lifecycle of the product: Introductory stage – management usually sets prices high during the introductory stage. But, if the target market is highly sensitive, management often finds it better to price the product at the market level or lower. Growth stage – Prices generally begin to stabilize as the product enters the growth stage. Maturity stage – Maturity usually brings further price decreases as competition increases and inefficient, high-cost firms are eliminated. Decline stage – The final stage of the lifecycle may see further price decreases as the few remaining competitors try to salvage the last vestiges of demand LONG-TERM PRICING

Price Skimming Selling at a high price, sacrificing high sales to gain a high profit, therefore “skimming” the market. This strategy is often used to target “early adopters” of a product/service. These early adopters are relatively less price sensitive because either their need for the product is more than others or they understand the value of the product better than others. This strategy is employed only for limited duration to recover most of the investment made to build the product. LONG-TERM PRICING

Diário de Notícias, 26 de Junho de 2005 Price Skimming LONG-TERM PRICING

Penetration price Is the pricing technique of setting a relatively low initial entry price, a price that is often lower than the eventual market price. The expectation is that the initial low price will secure market acceptance by breaking down existing brand loyalties. The advantages of penetration pricing to the firm: It can result in fast diffusion and adoption; It can create goodwill among the all-important early adopter segment; It creates cost control and cost reduction pressures from the start, leading to greater efficiency; It discourages the entry of competitors; It can be based on marginal cost pricing; LONG-TERM PRICING

Penetration price The main disadvantages with penetration pricing is that: It establishes long term price expectations for the product; Image preconceptions for the brand and company; It’s difficult to eventually raise prices. Penetration pricing attracts only the switchers (bargain hunters) It is most appropriate when: Product demand is highly price elastic; Substantial economics of scale area available; The product is suitable for a mass market – sufficient demand; The product will face stiff competition soon after introduction. LONG-TERM PRICING

Penetration price This strategy is particularly adequate to introduction of products of regular buying, because the difference between them and the existent products is not obvious. For example, in the 80’s CP announced the intercity service. As a promotion, the second class tickets suffered a substantial discount relatively to the usual price. This way CP could attract potential clients that didn't use the train regularly. LONG-TERM PRICING

With a fixed price structure the company leaves a potential surplus of the market to appropriate Distinct prices to different clients We will now study other ways of appropriating the surplus, from more complex price structures NON-LINEAR PRICES (NLP)

Companies P = f ( Q ) throw offers of quantity discount One of the reason is the existence of scale economies on processing the goods Discount for segment the demand Another reason of quantities discounts passes throw the possibility of discriminating prices between different groups If the company identifies which consumers belong to which group, they can establish different prices NLP - QUANTITY DISCOUNT

Sometimes the companies can make their clients reveal to which group they belong CM g Q P D1D1 D2D2 P2P2 P1P1 Q2Q2 Q1Q1 B E P1P1 P2P2 (to who buys at least Q 2 ) It's obvious that clients of type 2 will use the discount and Clients of type 1 will prefer not use the discount because B + little triangle < E NLP - QUANTITY DISCOUNT Discount for segment the demand

Rappel discount The discount depends on the total volume of goods bought, and not from the expense of one time. Discount for homogeneous clients Only one consumer with demand D CM g Q P P2P2 P1P1 Q2Q2 Q1Q1 B AC E P 1, Q 1 Maximizes the revenue of the company Company can improve his situation by offering a quantity discount offering P 2 to who buys at least Q 2 Consumer B + little triangle > E Company A + C + E > A + B NLP - QUANTITY DISCOUNT

D PmPm P2P2 QmQm Q2Q2 PmPm QmQm REVENUE A + B A CM g B C P2P2 Q2Q2 A + B + C Unity above Q m Consumer QmQm Q2Q2 E Surplus Q P in E Company can do better then P 2 and P M NLP - PREÇOS POR BLOCOS

D P1P1 P2P2 Q1Q1 Q2Q2 CM g P 2 only when Q > Q 1 F E Q P E > FThe consumer will prefer buying Q 2, then Q x QxQx Revenue of the company by: Initial price (P 1 ) > P M Q in which the price becomes P 2 > Q M It's possible to In both cases the P 2 must go down for the consumer to buy NLP - PREÇOS POR BLOCOS

Price equal to a fixed price plus a variable part (proportional to quantity bought ) - Fixed net signature - Some sport clubs - Cellular phones price plans Revenue of the company by making the consumer to consume more than he would do with a constant price - Internet Example of Portugal Telecom CM g Q P P1P1 D A BC Q1Q1 Initially: P1,P1, Q1Q1 Rate of activation With this tariff it's cheaper to talk after Q 1 A and P 2 for each more minute P2P2 Q2Q2 The client will keep talking until he reaches Q 2 minutes of conversation Revenue of company NLP - TWO PART TARIFF

Heterogeneous clients Two groups with identical number and distinct demand CM g Q P D1D1 D2D2 Q1Q1 Q2Q2 B A - A fixed price higher than A + B tends to the exclusion of consumers 1 Company offer a package of Q 1 at a global price of A + B, which extracts the surplus of clients 1. They will not buy any additional goods Nevertheless, consumers 2 still demand more quantity, that will be offered at P 2 P2P2 Revenue of company = 2 x A + C C NLP - TWO PART TARIFF

Heterogeneous clients Other ways of rising the profit CM g Q P D1D1 D2D2 Q1Q1 Q2Q2 B A P2P2 Instead of offering additional units at P 2, the company could offer an additional package of P + E price E P 1st package at 2st package at A + B A + B + P + E of Q 1 units of Q 2 units F If F > A then by ignoring consumers 1, the company would increase their profit by selling only one package of Q 2 units at a price of: A + B + P + E + F NLP - TWO PART TARIFF

Different elasticity's of the demand, the company decides to offer the product at different prices CM g Q P D1D1 D2D2 Q1Q1 Q2Q2 A B C D F E G - Package with Q 1 units at global price of: A + B + C - Company would like to sell Q 2 units at: (to extract all surplus) B + C + D + E + F + G At this price consumer 2 would buy package 1. For him package 1 would cost: A + B + C And his utility would be: B + C + D Since D > Asurplus NLP - QUANTITY AND BLOCK DISCOUNT

CM g Q P D1D1 D2D2 Q1Q1 Q2Q2 A B C D F E G The company needs to sell package Q 2 for less than A + B + C + E + F + G For the company this price means a revenue bigger in E to the revenue of consumer 2 buying package 1 Revenue of company: - Consumer buying package 1 - Consumer buying package 2 A + B A + B + E NLP - QUANTITY AND BLOCK DISCOUNT

Price discrimination exists when sales of identical goods or services are transacted at different prices from the same provider. lower prices for some consumers Price discrimination higher prices for others. Price discrimination conditions: Monopoly power Firms must have some price setting power, monopolies or oligopolies Elasticity of demand There must be a different price elasticity of demand for the product from each group of consumers. Separation of the market The firm must be able to split the market into different sub-groups of consumers and then prevent discount customers from becoming resellers, and so competitors. PRICE DISCRIMINATION

The purpose of price discrimination is to capture the market's consumer surplus and turn it into producer surplus. The aims of price discrimination: To increase the total revenue and/or profits of the supplier! Some consumers do benefit from this type of pricing - they are "priced into the market" when with one price they might not have been able to afford a product. For most consumers however the price they pay reflects pretty closely what they are willing to pay. PRICE DISCRIMINATION

A single price (P) is available to all customers. The revenue is represented by area P,A,Q,O. Consumer surplus: area above line segment P,A. P1 is charged to the low elasticity segment, and P2 is charged to the high elasticity segment. The total revenue from the first segment is equal to the area P1,B,Q1,O. The total revenue from the second segment is equal to the area E,C,Q2,Q1. The sum of these areas is greater than the area without discrimination. The more prices that are introduced, the greater the sum of the revenue areas, and the more of the consumer surplus is captured by the producer. PRICE DISCRIMINATION

Types of price discrimination First-degree price discrimination The monopolist sells different units of output for different prices and these prices may differ from person to person. Second-degree price discrimination The monopolist sells different units of output for different prices, but every individual who buys the same amount of the good pays the same price. Thus prices differ across the units of the good, but not across people. Third-degree price discrimination The monopolist sells output to different people for different prices, but every unit of output sold to a given person sells for the same price. PRICE DISCRIMINATION

First-degree price discrimination Under first-degree price discrimination, each unit of the good is sold to the individual who values it most highly. The value of goods is subjective. It is assumed that the consumer passively reacts to the price set by the seller, and that the seller knows the demand curve of the customer. In practice there is a bargaining situation: the customer may try to influence the price, such as by pretending to like the product less than he or she really does, and by "threatening" not to buy it. A customer with low price elasticity is less deterred by a higher price than a customer with high price elasticity of demand. As long as the price elasticity for a customer is less than one, it is very advantageous to increase the price: the seller gets more money for less goods. With an increase of the price elasticity tends to rise above one. PRICE DISCRIMINATION

quantity willingness to pay MC Here are two consumers’ demand curves for a good along with the constant marginal cost curve. The producer sells each unit of the good at the maximum price it will command, which yields it the maximum possible profit. quantity willingness to pay MC PRICE DISCRIMINATION First-degree price discrimination

The producer’s goal is to maximize its profits subject to the constrain that the consumers are just willing to purchase the good. The outcome will be the Pareto efficiency!! The producer’s profit can’t be increased, since it’s already the maximal possible profit, and the consumer’s surplus can’t be increased without reducing the profit of the producer. PRICE DISCRIMINATION First-degree price discrimination

Examples: Bargaining for carpets in Turkey Flower markets in Amsterdam. In a Dutch auction the price starts very high and gradually falls until the first bidder bids and takes the good or service. This means that the price paid is going to be very close to the maximum price the consumer is willing to pay, thereby allowing the producer to extract as much consumer surplus as it possibly can. A doctor in a small town who charges his patients different prices, based on their ability to pay. image58.webshots.com PRICE DISCRIMINATION First-degree price discrimination

In perfect price discrimination (First Degree Discrimination): To set the right prices the monopolist has to know the demand curves of the consumers. Not enough: Consumers of one type may pretend to be consumers of another type; No effective way to tell them apart Construct price-quantity packages that will induce the consumer to choose the package meant for him: Self-selection. In the First Degree it’s Hard to discriminate… Alternative Method: PRICE DISCRIMINATION Second-degree price discrimination

Price per unit is not constant but depends on how much is bought; Non-linear pricing; Commonly used by public utilities; Price per unit of electricity; Sometimes available in other industries; Bulk discounts for great quantities. PRICE DISCRIMINATION Second-degree price discrimination

quantity willingness to pay x01x01 A C B x02x02 Quantity: x 0 2 Price: A+B+C Quantity: x 0 1 Price: A High end customer would choose to buy x 0 1 at price A with a surplus of B instead of x 0 2 with no surplus. One solution: Offer x 0 2 at price A+C Customer - 2 High-end Customer - 1 Low-end PRICE DISCRIMINATION Second-degree price discrimination “Self-selection problem”

quantity willingness to pay x01x01 A B x03x03 Decreasing x 0 1 : A decreases; C increases Profits increase: The decrease of A is smaller than the increase of C. C x02x02 Customer - 2 High-end Customer - 1 Low-end PRICE DISCRIMINATION Second-degree price discrimination “Reduction of output for consumer 1”

quantity willingness to pay x0mx0m x02x02 Low-demand costumer: Quantity: x 0 m Price: A Surplus: 0 High-demand costumer: Quantity: x 0 2 Price: A+C+D Surplus: B A B D Point where marginal benefits and costs of quantity reduction balance C Customer - 2 High-end Customer - 1 Low-end PRICE DISCRIMINATION Second-degree price discrimination “Profit maximization solution”

Self-selection encouraged by adjusting the quality of the good instead of its quantity. Example: Airline companies: Business tickets:  No restrictions; Other tickets:  Stay over Saturday night, buy 14 days in advance, etc; Business travelers are willing to pay for business tickets; Tourists consider the restrictions acceptable; Company profits more than by selling tickets at a flat price. PRICE DISCRIMINATION Second-degree price discrimination “In practice”

Different prices for different people Same price for a given group student’s discounts; senior citizen’s discounts,...; Profit maximization: max y 1,y 2 p 1 y 1  y 1  p 2 y 2  y 2  cy 1  y 2   MR 1 y 1   MCy 1  y 2  MR 2 y 2   MCy 1  y 2  The marginal cost of producing one extra unit of output must be equal to the marginal revenue in each market PRICE DISCRIMINATION Third-degree price discrimination

The market with the higher prices must have the lower elasticity p 1 y 1 1  1  y 1   p 2 y 2 1  1  y 2  IFp 1  p 2   1  1  1 y 1   1  1  2 y 2   1 y 1   2 y 2  Standard elasticity formula for marginal revenue PRICE DISCRIMINATION Third-degree price discrimination

Output PRICE D1 P1*P1* D2 P2*P2* q1*q1* If the monopolist can charge only one price, he will charge p 1 *, but he sells only to Market 1 With price discrimination, it will also sell at p 2 * to Market 2 Example – movie tickets D1 - Ordinary citizen D2 - Students, Senior citizens PRICE DISCRIMINATION Third-degree price discrimination

Packages of related goods offered for sale together cost savings Complementarities Dissiminate products ( software – the many people use it, the better ) Consumers with different preferences good 1good 2price = 100bundle type A x 1001 x 300 type B x 1001 x PRICE DISCRIMINATION Bundling

Definition  a market structure in which many firms sell products that are similar but not identical. Characteristics of Monopolistic Competition Many Sellers - Firms Compete Product Differentiation - Each firm faces downward-sloping demand curve. Free Entry - Economic Profits are zero Examples of monopolistic competition: Books, CDs, movies, computer software, restaurants, sodas MONOPOLISTIC COMPETITION

A firm has its own product portfolio and its own market demand. Each firm tries to differentiate its product. The position and the elasticity of the search directed to each product are influenced by the portfolio of existing products in the market. Demand of each product faces downward-sloping demand curve. When a new product get into the market, the demand of each initial product it’s modified. D’ y’y P P’ y’’ P’’ D’’ MONOPOLISTIC COMPETITION Demand directed to the firm

The market power allows the company to practice prices above the marginal costs (MC), and act like a monopolistic firm. Product quantity that a firm sells depends on the price they established to the product, like a monopolistic firm. The presence of other substitute products in the market, make demand more elastic than in the monopolistic market. The firm has a limited market power. MONOPOLISTIC COMPETITION Managing in a Monopolistic Competition Market

Each firm in monopolistically competitive market follows the monopolist's rule for maximizing profit It chooses the output level where marginal revenue (MR) is equal to the marginal cost (MC) It sets the price using the demand curve (D) to ensure that consumers will buy the amount produced: y’ – Firm product amount P’ – Firm Price D – Market Demand MR – Marginal Revenue MC – Marginal Costs ATC – Average Total Costs ATC MC D D’ MRy’y P P’ ATC MONOPOLISTIC COMPETITION The Short-Run Equilibrium

Profit Losses We can determine whether or not the monopolistically competitive firm is earning a profit or loss by comparing price and average total cost (ATC) If P > ATC, the firm is earning a profit If P < ATC, the firm is earning a loss If P = ATC, the firm is earning zero economic profit y’ – Firm product amount P’ – Firm Price D – Market Demand MR – Marginal Revenue MC – Marginal Costs ATC – Average Total Costs ATC MC D D’ MRy’y P P’ ATC MONOPOLISTIC COMPETITION The Short-Run Equilibrium

When firms in monopolistic competition are making profit, new firms have an incentive to enter the market This increases the number of products from which consumers can choose. Thus, the demand curve faced by each firm shifts to the left. When firms monopolistic competition are incurring losses, firms in the market will have an incentive to exit Consumers will have fewer products for each to choose. Thus, the demand curve for each firm shifts to the right. MC ATC D MRy’y P P’ y’ – Firm product amount P’ – Firm Price D – Market Demand d – Firm Demand MR – Marginal Revenue MC – Marginal Costs ATC – Average Total Costs d MONOPOLISTIC COMPETITION The Long-Run Equilibrium

MC ATC D MRy’y P P’ y’ – Firm product amount P’ – Firm Price D – Market Demand d – Firm Demand MR – Marginal Revenue MC – Marginal Costs ATC – Average Total Costs d The process of exit and continues until firms are earning zero profits. This means that the demand curve and the average total cost curve are tangent to each other At this point, price is equal to average total cost (ATC) and the firm is earning zero economic profit. MONOPOLISTIC COMPETITION The Long-Run Equilibrium

Product Differentiation: Publicity Introduction of new products Costumer loyalty Innovate to prevent the appearing of long-term Entry barriers Keep “business secret” and “strategic plans”, in a way to delay the necessary time to competition copy our product MONOPOLISTIC COMPETITION Strategies to prevent (or to postpone) the result of Null Profits

Example - The MEGT Company has estimated the following demand equation to its product: - The firm Total Costs are 4000€ when noting is produced. This costs increases by 0,5€ for each unit produced. 2 – Specify the marginal cost function 3 – Write an equation for total revenue in terms of output 4 – Specify the marginal revenue function 1 – We are facing a short-run or a long-run scenario?Short-Run MONOPOLISTIC COMPETITION

Example (cont.) 5 – At what level of output will profits be maximized? 6 - What price will be charged? 7 – What will total profits or losses be? - The MEGT Company has estimated the following demand equation to its product: - The firm Total Costs are 4000€ when noting is produced. This costs increases by 0,5€ for each unit produced. MONOPOLISTIC COMPETITION

BIBLIOGRAPHY Varian, H. (2003), Intermediate Microeconomics: A Modern Approach, 6th ed., W. W. Norton & Co Mata, J. (2001), Economia da empresa, 2th ed., Fundação Calouste de Gulbenkian, pp Images