Competitive Pricing Techniques Economics of the Firm Competitive Pricing Techniques

Every business has a goal. What’s the goal of your business? Maximize Profits Maximize return on investment “To Make Money!!!” Increase Market Share Maximize Shareholder Value To be a leader in technology To be “Green” Optimal decision making (for example, pricing) depends crucially on what your goal is!

We will be assuming that pricing decisions are being made to maximize current period profits Total Costs (note that total costs here are economic costs. That is, we have already included a reasonable rate of return on invested capital given the risk in the industry) Profits Total Revenues equal price times quantity

As with any economic decision, profit maximization involves evaluating every potential sale at the margin How do my costs change if I increase my sales by 1? (Marginal Costs) How do my profits change if I increase my sales by 1? How do my revenues change if I increase my sales by 1? (Marginal Revenues) Lets take this piece by piece

We will treat costs as a given. Every firm has a total cost function. Total costs of production are a function of quantity produced For pricing decisions, we focus on marginal cost TC $310 $300 56 57

Next, we need to know something about the consumer the firm faces Next, we need to know something about the consumer the firm faces. Every firm should have an estimated demand curve. We can think about a demand curve in one of two ways For every price I could charge, my demand curve tells me what my sales will be. For any sales goal that I set, my demand curve will tell me what price I can charge to obtain that goal

So, we can get firm revenues one of two ways: My demand curve will tell me the price I can charge to hit that target Revenues equal price times quantity I select a sales target My demand curve will tell me the sales I will achieve at that target Revenues equal price times quantity I select a price target

In either case, higher sales will be associated with a lower price OR If I want to increase my sales target, I need to lower my price to all my existing customers I need to drop my target price if I want to reach new customers

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?

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

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

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

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

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! $40 (1)($39.50) The additional sale! $39.50 MR = $29.50 MC = $10 D We should lower price! 20 21

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

Let’s check… $30.50 30 $29.50 10 MC=$10 D 39 40 41

The markup formula works! 30 10 MC D 40 MR

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

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.

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.

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!)

Measuring Market Structure – Concentration Ratios Suppose that we take all the firms in an industry and raked 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 1 2 3 4 5 6 7 10 20

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

Concentration Ratios in US manufacturing; 1947 - 1997 Year 1947 17 23 30 1958 38 1967 25 33 42 1977 24 44 1987 43 1992 32 1997 40 Aggregate manufacturing in the US hasn’t really changed since WWII

Measuring Market Structure: The Herfindahl-Hirschman Index (HHI) = Market share of firm i Rank Market Share 1 25 625 2 3 4 5 6 7 8 HHI = 2,000

The HHI index penalizes a small number of total firms Cumulative Market Share 100 A 80 HHI = 500 B HHI = 1,000 40 20 1 2 3 4 5 6 7 10 20

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

Concentration Ratios in For Selected Industries Industry CR(4) HHI Breakfast Cereals 83 2446 Automobiles 80 2862 Aircraft 2562 Telephone Equipment 55 1061 Women’s Footwear 50 795 Soft Drinks 47 800 Computers & Peripherals 37 464 Pharmaceuticals 32 446 Petroleum Refineries 28 422 Textile Mills 13 94

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

Lerner index in For Selected Industries Industry LI Communication .972 Paper & Allied Products .930 Electric, Gas & Sanitary Services .921 Food Products .880 General Manufacturing .777 Furniture .731 Tobacco .638 Apparel .444 Motor Vehicles .433 Machinery .300

An industry’s cost structure will influence an industry’s competitive nature 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!

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

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.

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

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

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

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

Price 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: Identification No Arbitrage $15 $12 D 20 21

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

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

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

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

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

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

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

Suppose 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: 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?

If you could distinguish each group and prevent resale, you could charge different prices Old Young $100 $80 $51 $41 D D 49 39

Two Part Pricing First, lets calculate a uniform price for both consumers $100 $80 $70 $60 MR D 20 90 180

$100 $46 $2 MC MR D 88 180

Can 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. Old Young $100 $80 $46 $46 D D 54 34 Can we do better than this?

Note that young consumer was willing to pay exactly $46 for the 54th ride. However, she was willing to pay more than $46 for all the previous rides. We call this consumer surplus. $55 This 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. $46 D 45 54

The 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 $46 How can we extract this extra money? $2,484 D 54

Could 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 Young P = $46/Ride Entry Fee = $578 Old Old Young $100 $1458 $80 $578 $46 $46 $1564 $2484 D D 54 34 Could you do better than this?

Suppose 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 Young P = $2/Ride Entry Fee = $3042 Old Old Young $100 $4802 $80 $3042 $2 $2 D D 98 78

Block Pricing involves offering “packages”. For example: Young Old $100 $4802 $80 $3042 $2 $2 D D 98 78 $2(98) = $196 $2(78) = $156 “Geezer Pleaser”: Entry + 78 Ride Coupons (1 coupon per ride): $3198 ($3042 +$156) “Standard” Admission: Entry + 98 Ride Coupons (1 coupon per ride): $4998 ($4802 +$196)

Suppose that you couldn’t distinguish High value customers from low value customers: Would this work? Young Old $100 $4802 $80 $3042 $2 $2 D D 98 78 $2(98) = $196 $2(78) = $156 78 Ride Coupons: $3198 1 Ticket Per Ride 98 Ride Coupons: $4998

We 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 $3042 If the high value customer buys the 78 ride package, she keeps $1560 of her surplus! $22 $1716 78

This 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 = $1,560 Package Price = $3,438 $4802 This is known as Menu Pricing $2 $196 D 98

Block Pricing: You can distinguish high demand and low demand (1st Degree Price Discrimination) 78 Ride: $3198 ( $41/Ride) 1 Ticket Per Ride 98 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 Ride 98 Rides: $3438 ($35/Ride) Group Pricing: You can distinguish high demand from low demand (3rd Degree Price Discrimination) Low Demanders: $41/Ride No Entry Fee High Demanders: $51/Ride

Bundling 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) Consumer Product 1 Product 2 Sum A $50 $450 $500 B $250 $275 $525 C $300 $220 $520 D

If you sold each of these products separately, you would choose prices as follows Product 1 (MC = $100) Product 2 (MC = $150) P Q TR Profit $450 1 $350 $300 2 $600 $400 $250 3 $750 $50 4 $200 -$200 P Q TR Profit $450 1 $300 $275 2 $550 $250 $220 3 $660 $210 $50 4 $200 -$400 Profits = $450 + $300 = $750

Consumer Product 1 Product 2 Sum A $50 $450 $500 B $250 $275 $525 C Pure Bundling does not allow the products to be sold separately Product 1 (MC = $100) Product 2 (MC = $150) Consumer Product 1 Product 2 Sum A $50 $450 $500 B $250 $275 $525 C $300 $220 $520 D With a bundled price of $500, all four consumers buy both goods: Profits = 4($500 -$100 - $150) = $1,000

Consumer Product 1 Product 2 Sum A $50 $450 $500 B $250 $275 $525 C Mixed Bundling allows the products to be sold separately Product 1 (MC = $100) Product 2 (MC = $150) Consumer Product 1 Product 2 Sum A $50 $450 $500 B $250 $275 $525 C $300 $220 $520 D Price 1 = $250 Price 2 = $450 Bundle = $500 Consumer A: Buys Product 2 (Profit = $300) or Bundle (Profit = $250) Profit = $850 or $800 Consumer B: Buys Bundle (Profit = $250) Consumer C: Buys Product 1 (Profit = $150) Consumer D: Buys Only Product 1 (Profit = $150)

Consumer Product 1 Product 2 Sum A $50 $450 $500 B $250 $275 $525 C Mixed Bundling allows the products to be sold separately Product 1 (MC = $100) Product 2 (MC = $150) Consumer Product 1 Product 2 Sum A $50 $450 $500 B $250 $275 $525 C $300 $220 $520 D Price 1 = $450 Price 2 = $450 Bundle = $520 Consumer A: Buys Only Product 2 (Profit = $300) Consumer B: Buys Bundle (Profit = $270) Profit = $1,190 Consumer C: Buys Bundle (Profit = $270) Consumer D: Buys Only Product 1 (Profit = $350)

Consumer Product 1 Product 2 Sum A $300 $200 $500 B C D Bundling is only Useful When there is variation over individual consumers with respect to the individual goods, but little variation with respect to the sum!? Consumer Product 1 Product 2 Sum A $300 $200 $500 B C D Product 1 (MC = $100) Product 2 (MC = $150) Individually Priced: P1 = $300, P2 = $200, Profit = $1,000 Pure Bundling: PB = $500, Profit = $1,000 Mixed Bundling: P1 = $300, P2 = $200, PB = $500, Profit = $1,000

Tie-in Sales Suppose 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 $12 Price for 1,000 printed pages Quantity of printed pages (in thousands) D D 12 16 You 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.

Tie-in Sales You 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 $2 D D 10 12 14 16 A monthly fee of $50 will allow you to sell to both consumers. Can you do better than this? Profit = $50*1000 = $50,000

Tie-in Sales Suppose 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) $12 D

Tie-in Sales $16 $12 $72 $32 $4 $4 D D 8 12 12 16 By 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

Suppose that the demand for Hot Dogs is given as follows: Complementary Goods Suppose that the demand for Hot Dogs is given as follows: Price of a Hot Dog Bun Price of a Hot Dog Hot 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.

Complementary Goods Each firm must price their own product based on their expectation of the other firm Bun Company Hot Dog Company

Complementary Goods Each firm must price their own product based on their expectation of the other firm Bun Company Hot Dog Company Substitute these quantities back into the demand curve to get the associated prices. This gives us each firm’s reaction function.

Any equilibrium with the two firms must have each of them acting optimally in response to the other. Hot Dog Company $12 $6 $4 Bun Company $4 $6 $12

Complementary Goods Now, suppose that these companies merged into one monopoly

Case 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 power The browser and the operating system were, in fact, two distinct products that did not need to be integrated Microsoft’s behavior was an abuse of power that hurt consumers What should Microsoft’s defense be?

Case Study: Microsoft vs. Netscape Suppose that the demand for browsers/operating systems is as follows (look familiar?). Again, Assume MC=0 Case #1: Suppose that Microsoft never entered the browser market – leaving Netscape as a monopolist.

Case Study: Microsoft vs. Netscape Case #2: Now, suppose that Microsoft competes in the Browser market With 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