1. Competitive Pricing Techniques
Economics of the Firm
Competitive Pricing Techniques

2. 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!

3. 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

4. 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

5. 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

6. 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

7. 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

8. In either case, higher sales will be associated with a lower priceOR
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

9. 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?

10. 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

11. 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

12. 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

13. 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

14. 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

15. 30 10
MC=$10 D 40
MR = 50-Q

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

17. The markup formula works!30 10 MC D 40 MR

18. 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

19. 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.

20. 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.

21. 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!)

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. An industry’s cost structure will influence an industry’s competitive natureAC 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!

32. 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

33. 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.

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. $36
$24
$18
$12 MR D 3 15

42. $36
$17 $4 MC MR D 3
6.5 15

43. 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

44. 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

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

46. 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?

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

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

49. $100
$46 $2 MC MR D 88
180

50. 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?

51. 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

52. 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

53. 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?

54. 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

55. 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)

56. 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

57. 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

58. 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

59. 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

60. 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

61. 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

62. 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

63. 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)

64. 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)

65. 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

66. 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.

67. 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

68. 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

69. 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

70. 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.

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

72. 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.

73. 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

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

75. 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?

76. 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.

77. 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