Mba1014 oligopoly & monopolistic competition 250513
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Oligopoly, Monopolistic Competition

Oligopoly, Monopolistic Competition

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Mba1014 oligopoly & monopolistic competition 250513 Presentation Transcript

  • 1. Go Global !Go Global !Managerial Economics :Managerial Economics :Oligopoly & MonopolisticOligopoly & MonopolisticCompetitionCompetitionByStephen OngStephen OngVisiting Fellow, Birmingham City UniversityVisiting Fellow, Birmingham City UniversityVisiting Professor, College of Management,Visiting Professor, College of Management,Shenzhen UniversityShenzhen UniversityMay 2013May 2013
  • 2. AgendaAgenda1.1. Market CharacteristicsMarket Characteristics2.2. Monopolistic PricingMonopolistic Pricing3.3. Non-price CompetitionNon-price Competition
  • 3. Learning objectivesLearning objectivescontrast monopolisticcontrast monopolisticcompetition and oligopolycompetition and oligopolydescribe the role that mutualdescribe the role that mutualinterdependence plays in settinginterdependence plays in settingprices in oligopolistic marketsprices in oligopolistic marketsexplain how non-price factorsexplain how non-price factorshelp firms to differentiate theirhelp firms to differentiate theirproducts and servicesproducts and services
  • 4. 11Oligopoly & MonopolisticOligopoly & MonopolisticCompetitionCompetition
  • 5. OverviewOverviewMonopolistic competitionMonopolistic competitionOligopolyOligopolyPricing under oligopolyPricing under oligopolyCompeting in imperfectlyCompeting in imperfectlycompetitive marketscompetitive marketsStrategy: the challenge forStrategy: the challenge forfirms in imperfect competitionfirms in imperfect competition
  • 6. IntroductionIntroductionImperfect competitionsome market power but not absolutemarket powerfirms have the ability to set priceswithin the limits of certainconstraintsmutual interdependence: interactionamong competitors when makingdecisions
  • 7. IntroductionIntroductionPerfectPerfect Monopoly Monopolistic OligopolyMonopoly Monopolistic OligopolyCompetition CompetitionCompetition CompetitionMarket power?Market power? NoNo Yes* Yes YesYes* Yes YesMutual interdependence No No No YesMutual interdependence No No No Yesamong competingamong competingfirms?firms?Non-price competition? No Optional Yes YesNon-price competition? No Optional Yes YesEasy market entry Yes No Yes NoEasy market entry Yes No Yes Noor exit ?or exit ?* subject to government regulation* subject to government regulation
  • 8. Monopolistic CompetitionMonopolistic CompetitionA market structureA market structurecharacterized by acharacterized by a largelargenumber of small firmsnumber of small firmsthat have some marketthat have some marketpower from producingpower from producingdifferentiated productsdifferentiated products..
  • 9. Characteristics ofCharacteristics ofMonopolistic CompetitionMonopolistic CompetitionProduct differentiationProduct differentiation existsexistsamong firmsamong firmsThere are aThere are a large numberlarge number ofoffirms in the product groupfirms in the product groupNo interdependenceNo interdependence existsexistsamong firmsamong firmsEntry and exit by new firmsEntry and exit by new firms isisrelatively easyrelatively easy
  • 10. Monopolistic competitionMonopolistic competitionMonopolistic competition:Monopolistic competition:characteristicscharacteristicsmany firmsmany firmsrelatively easy entryrelatively easy entryproduct differentiation: can setproduct differentiation: can setprice at a level higher than the priceprice at a level higher than the priceestablished by perfect competitionestablished by perfect competitionuse MR = MC rule to maximize profituse MR = MC rule to maximize profit
  • 11. Monopolistic competitionMonopolistic competition If earning above-normal profits,If earning above-normal profits,newcomers will enter the marketnewcomers will enter the market market supply curve shiftsmarket supply curve shiftsout and to the rightout and to the right firm’s demand curve shiftsfirm’s demand curve shiftsdown and to the leftdown and to the left ultimately, in the long run,ultimately, in the long run,firms earn onlyfirms earn only normal profitnormal profit
  • 12. Monopolistic Competition –Monopolistic Competition –Short-RunShort-RunAt QAt Q11::MR = MCMR = MCP > ATCP > ATCP > MCP > MCATCATC Not atNot atMinimum PointMinimum Point$$QQMRMRMCMCDDATCATCPP11QQ11
  • 13. Monopolistic Competition –Monopolistic Competition –Long-RunLong-RunAt QAt Q22 ::MR = MCMR = MCP = ATCP = ATCP > MCP > MCATCATC Not atNot atMinimum PointMinimum PointMCMC ATCATCDDMRMRPP22QQ22
  • 14. Examples of MonopolisticallyExamples of MonopolisticallyCompetitive BehaviourCompetitive BehaviourDrugstoresDrugstoresHardwareHardwareStoresStoresBookstoresBookstores
  • 15. OligopolyOligopoly Oligopoly is a market dominated by a relativelyOligopoly is a market dominated by a relativelysmall number of large firmssmall number of large firms Herfindahl-Hirschman index (HH)Herfindahl-Hirschman index (HH)measures market concentrationmeasures market concentration(max HH = 10,000;(max HH = 10,000;unconcentrated markets have HH < 1,000)unconcentrated markets have HH < 1,000)n = number of firms in then = number of firms in theindustryindustrySSii = firm’s market share= firm’s market share∑==niiSHH12
  • 16. Examples of OligopolisticExamples of OligopolisticIndustriesIndustriesAirlinesAirlinesSoft DrinksSoft DrinksDoughnutsDoughnutsParcel andParcel andExpress DeliveryExpress Delivery
  • 17. Oligopoly ModelsOligopoly ModelsNoncooperativeNoncooperativeoligopoly models areoligopoly models aremodels of interdependentmodels of interdependentoligopoly behaviour thatoligopoly behaviour thatassume that firms pursueassume that firms pursueprofit-maximizingprofit-maximizingstrategies based onstrategies based onassumptions aboutassumptions aboutrivals’ behaviourrivals’ behaviour andandthe impact of thisthe impact of thisbehaviour on the givenbehaviour on the givenfirm’s strategies.firm’s strategies.CooperativeCooperativeoligopoly models areoligopoly models aremodels ofmodels ofinterdependentinterdependentoligopoly behaviouroligopoly behaviourthat assume that firmsthat assume that firmsexplicitly orexplicitly orimplicitly cooperateimplicitly cooperatewith each other towith each other toachieve outcomes thatachieve outcomes thatbenefit all the firms.benefit all the firms.
  • 18. NoncooperativeNoncooperativeOligopoly ModelsOligopoly ModelsThe Kinked Demand Curve ModelThe Kinked Demand Curve ModelGame Theory ModelsGame Theory ModelsStrategic Entry DeterrenceStrategic Entry DeterrencePredatory PricingPredatory Pricing
  • 19. Kinked Demand CurveKinked Demand Curve The kinked demandThe kinked demandcurve model ofcurve model ofoligopoly incorporatesoligopoly incorporatesassumptions aboutassumptions aboutinterdependentinterdependentbehaviour andbehaviour andillustrates whyillustrates whyoligopoly prices mayoligopoly prices maynot change in reactionnot change in reactionto either demand orto either demand orcost changes.cost changes.MC$QD2: Rivals don’tfollowD1: Rivals do followMR1MR2P1Q1
  • 20. Pricing in an oligopolisticPricing in an oligopolisticmarketmarketMutual interdependence:Mutual interdependence: relativelyrelativelyfew sellers create a situation wherefew sellers create a situation whereeach is carefully watching the otherseach is carefully watching the othersas it sets its priceas it sets its priceImplication:Implication: kinked demand curvekinked demand curvemodelmodel Basic assumption is thatBasic assumption is thatcompetitor willcompetitor will follow a pricefollow a pricedecreasedecrease but will not make a changebut will not make a changein reaction to a price increasein reaction to a price increase
  • 21. Pricing in an oligopolisticPricing in an oligopolisticmarketmarketIf reduce price andIf reduce price andcompetitors match thecompetitors match theprice cut then moveprice cut then movealong more inelasticalong more inelasticdemand segment Ddemand segment DiiIf increase price andIf increase price andcompetitors do notcompetitors do notfollow then move alongfollow then move alongthe more elasticthe more elasticsegment Dsegment Dff marginal revenuemarginal revenuecurve has kink (at A)curve has kink (at A)Competitors do notmatch price increasesCompetitorsmatchprice cuts
  • 22. Pricing in an oligopolisticPricing in an oligopolisticmarketmarketPrice leader:Price leader: one firm in theone firm in theindustry takes the lead in changingindustry takes the lead in changingprices, and assumes that otherprices, and assumes that otherfirms:firms:• will follow a price increasewill follow a price increase• but will not go even lower in orderbut will not go even lower in ordernot to trigger a price warnot to trigger a price warNon-price leader:Non-price leader: firm that leadsfirm that leadsthethe differentiationdifferentiation of products onof products onother, non-price attributesother, non-price attributes
  • 23. Game Theory ModelsGame Theory ModelsA set of mathematical toolsA set of mathematical toolsfor analyzing situations infor analyzing situations inwhich players make variouswhich players make variousstrategic moves and havestrategic moves and havedifferent outcomes ordifferent outcomes orpayoffs associated withpayoffs associated withthose moves.those moves.
  • 24. Dominant Strategies andDominant Strategies andthe Prisoner’s Dilemmathe Prisoner’s DilemmaThis payoff matrixThis payoff matrixshows the variousshows the variousprison terms forprison terms forBonnie and ClydeBonnie and Clydethat would resultthat would resultfrom thefrom thecombination ofcombination ofstrategies chosenstrategies chosenwhen questionedwhen questionedabout a crimeabout a crimespree.spree.
  • 25. Prisoner’s Dilemma –Prisoner’s Dilemma –Dominant StrategyDominant StrategyA dominantA dominantstrategy is onestrategy is onethat results in thethat results in thebest outcome orbest outcome orhighest payoff tohighest payoff toa given playera given player nonomatter whatmatter whataction or choiceaction or choicethe other playerthe other playermakes.makes.
  • 26. Nash EquilibriumNash EquilibriumNash equilibrium isNash equilibrium isa set of strategiesa set of strategiesfrom which allfrom which allplayers areplayers arechoosing their bestchoosing their beststrategy,strategy, given thegiven theactions of the otheractions of the otherplayers.players.
  • 27. Strategic Entry DeterrenceStrategic Entry DeterrenceLimit pricingLimit pricing isisa policy ofa policy ofcharging acharging aprice lowerprice lowerthan the profit-than the profit-maximizingmaximizingpriceprice to keepto keepother firmsother firmsfrom enteringfrom enteringthe market.the market.$QDMRMCATCPπmaxQπmaxPLP =ATCENQLP
  • 28. Predatory PricingPredatory PricingPredatory pricing:Predatory pricing:Japanese share ofJapanese share ofmarket Qmarket QPP - Q- QUSUS ==NM = RGNM = RGLoss per unit toLoss per unit toJapanese firmsJapanese firmsPPCC - P- PPP = NR= NRTotal loss toTotal loss toJapanese firmsJapanese firmsNRGMNRGM$QPUSPJPCPPQUS QcQJ QPKLJ GMNER ST
  • 29. Cooperative Oligopoly ModelsCooperative Oligopoly ModelsCartelsCartelsTacitTacitCollusionCollusion
  • 30. Cartels - ExamplesCartels - ExamplesOPECOPECDiamondDiamondCartelCartel
  • 31. Cartel BehaviourCartel BehaviourA cartel is an organizationA cartel is an organizationof firms thatof firms that agree toagree tocoordinate their behaviourcoordinate their behaviourregarding pricing and outputregarding pricing and outputdecisions in order todecisions in order tomaximize the joint profitsmaximize the joint profitsfor the organization.for the organization.
  • 32. Model of Joint Profit MaximizationModel of Joint Profit MaximizationMC2DMCMC11$$ $$$$QQ QQ QQMCMC22MCMCccMCMCccMCMC11PPCCMRMRQQCCQQ2*2*QQ1*1*Firm 1Firm 1 Firm 2Firm 2 CartelCartel
  • 33. Success in CartelsSuccess in CartelsA cartel is likely to be the mostA cartel is likely to be the mostsuccessful when:successful when:It canIt can raise the market priceraise the market price withoutwithoutinducing significant competition frominducing significant competition fromnoncartel members.noncartel members.The expectedThe expected punishmentpunishment for forming thefor forming thecartelcartel is lowis low relative to the expectedrelative to the expectedgains.gains.TheThe costs of establishing and enforcingcosts of establishing and enforcingthe agreement are lowthe agreement are low relative to therelative to thegains.gains.
  • 34. Tacit CollusionTacit CollusionBecause cartels are illegal inBecause cartels are illegal inthe United States due to thethe United States due to theantitrust laws, firms mayantitrust laws, firms mayengage in tacitengage in tacit collusioncollusion,,coordinated behaviour thatcoordinated behaviour thatis achieved without a formalis achieved without a formalagreement.agreement.
  • 35. Practices that facilitatePractices that facilitatetacit collusiontacit collusionUniform pricesUniform pricesA penalty for price discountsA penalty for price discountsAdvance notice of price changesAdvance notice of price changesInformation exchangesInformation exchangesSwaps and exchangesSwaps and exchanges
  • 36. Competing in imperfectlyCompeting in imperfectlycompetitive marketscompetitive marketsNon-price competitionNon-price competition: any effort: any effortmade by firms in order to change themade by firms in order to change thedemand for their product (other thandemand for their product (other thanthe price)the price)Non-price determinants of demand:Non-price determinants of demand:tastes and preferencestastes and preferencesincomeincomeprices of substitutes and complementsprices of substitutes and complementsnumber of buyersnumber of buyersfuture expectations of buyersfuture expectations of buyersfinancing termsfinancing terms
  • 37. Competing in imperfectlyCompeting in imperfectlycompetitive marketscompetitive markets ExamplesExamples: of efforts by managers to: of efforts by managers toinfluence non-price demand influences:influence non-price demand influences:advertising and promotionadvertising and promotionlocation and distribution channelslocation and distribution channelsmarket segmentationmarket segmentationloyalty programsloyalty programsproduct extensions and new productsproduct extensions and new productsspecial customer servicesspecial customer servicesproduct ‘lock-in’ or ‘tie-in’product ‘lock-in’ or ‘tie-in’pre-emptive new productpre-emptive new productannouncementsannouncements
  • 38. Competing in imperfectlyCompeting in imperfectlycompetitive marketscompetitive marketsEqualizing at the margin: economicEqualizing at the margin: economicconcept which managers can use toconcept which managers can use tohelp make an optimal decisionhelp make an optimal decisionegeg MR = MC is an example ofMR = MC is an example ofequalizing at the marginequalizing at the margincan be used to decide the optimalcan be used to decide the optimalexpenditure level on a non-priceexpenditure level on a non-pricefactorfactormay occur over amay occur over a long period of timelong period of timefirm must adjustfirm must adjust MR, MC for the timeMR, MC for the timevalue of moneyvalue of money
  • 39. Competing in imperfectlyCompeting in imperfectlycompetitive marketscompetitive marketsExamplesExamples: the: thereality of ‘imperfectreality of ‘imperfectcompetition’competition’auto industryauto industrysmall retailerssmall retailersglobal credit cardglobal credit cardissuersissuers
  • 40. Strategy for firms inStrategy for firms inimperfectimperfectcompetitioncompetitionHow doesHow does industry concentrationindustry concentrationaffect the behaviour of firmsaffect the behaviour of firmscompeting in the industry?competing in the industry?Strategy: the means by which anStrategy: the means by which anorganization uses its scarceorganization uses its scarceresources to relate to theresources to relate to thecompetitive environment in acompetitive environment in amanner that is expected to achievemanner that is expected to achievesuperior business performance oversuperior business performance overthe long runthe long run
  • 41. Strategy for firms inimperfectcompetitionStrategy is important when firms areStrategy is important when firms areprice makersprice makers and are faced with priceand are faced with priceand non-price competition as well asand non-price competition as well asthreats from new entrants into thethreats from new entrants into themarketmarketMore important for firms inMore important for firms inimperfectly competitive markets thanimperfectly competitive markets thanthose in perfectly competitive marketsthose in perfectly competitive marketsor monopoly marketsor monopoly markets
  • 42. Strategy for firms inStrategy for firms inimperfectimperfectcompetitioncompetitionManagerial economics:Managerial economics: the use ofthe use ofeconomic analysis to make businesseconomic analysis to make businessdecisions involving the best use of andecisions involving the best use of anorganization’s scarce resourcesorganization’s scarce resourcesIndustrial organization:Industrial organization: studies thestudies theway that firms and markets areway that firms and markets areorganized and how this organizationorganized and how this organizationaffects the economy from theaffects the economy from theviewpoint of social welfareviewpoint of social welfare
  • 43. Strategy for firms inStrategy for firms inimperfect competitionimperfect competition Structure-Conduct-Performance (S-C-P)Structure-Conduct-Performance (S-C-P)paradigm: says structure affects conductparadigm: says structure affects conductwhich affects performancewhich affects performancestructure: number of firms in industry,structure: number of firms in industry,conditions of entry, productconditions of entry, productdifferentiationdifferentiationconduct: pricing strategies, advertising,conduct: pricing strategies, advertising,product development, legal tactics,product development, legal tactics,collusioncollusionperformance: maximization of society’sperformance: maximization of society’swelfarewelfareCriticismCriticism: weak empirical evidence of relationship: weak empirical evidence of relationshipbetween observed concentration and profit levelsbetween observed concentration and profit levels
  • 44. Strategy for firms inStrategy for firms inimperfect competitionimperfect competition ‘‘New’ Theory of Industrial Organization: saysNew’ Theory of Industrial Organization: saysthere is no necessary connection betweenthere is no necessary connection betweenobserved industry structure and performanceobserved industry structure and performancethat uniquely leads to maximum socialthat uniquely leads to maximum socialwelfarewelfare theory of contestabletheory of contestablemarkets: performance bymarkets: performance byfirms is ultimately influencedfirms is ultimately influencednot by actual competition,not by actual competition,but by thebut by the threat of potentialthreat of potentialcompetitioncompetition
  • 45. Strategy for firms in imperfectStrategy for firms in imperfectcompetitioncompetitionPorter’s Five Forces model: illustratesPorter’s Five Forces model: illustratesthe various factors that affect thethe various factors that affect theability of any firm in the industry toability of any firm in the industry toearn a profitearn a profit
  • 46. Strategy for firms inStrategy for firms inimperfect competitionimperfect competitionPorter’s generic strategies forPorter’s generic strategies forearning above-average return onearning above-average return oninvestmentinvestmentDifferentiationDifferentiation approachapproach: for a: for amonopoly or monopolisticallymonopoly or monopolisticallycompetitive marketcompetitive market  following MRfollowing MR= MC rule, firm sets a= MC rule, firm sets a price on theprice on thedemand line that is above ACdemand line that is above AC
  • 47. Strategy for firms inStrategy for firms inimperfect competitionimperfect competitionPorter’s generic strategies for earningabove-average return on investmentCost leadership approach: forperfect competition maintain cost structure lowenough so when P = MC, there isa positive difference between Pand AC
  • 48. Global applicationGlobal application ExampleExample: world beer: world beermarkemarke neither pureneither puremonopoly nor puremonopoly nor purecompetitioncompetition US market leaderUS market leaderAnheuser BuschAnheuser Buschcontrols 50% ofcontrols 50% ofmarketmarket mature market, withmature market, withmerger activitymerger activity
  • 49. 22Monopolistic Pricing PoliciesMonopolistic Pricing Policies
  • 50. OverviewOverviewCartel arrangementsCartel arrangementsPrice leadershipPrice leadershipRevenue maximizationRevenue maximizationPrice discriminationPrice discriminationNonmarginal pricingNonmarginal pricingMultiproduct pricingMultiproduct pricingTransfer pricingTransfer pricing
  • 51. Cartel arrangementsCartel arrangementsA cartel is an arrangement whereA cartel is an arrangement wherefirms in an industry cooperate andfirms in an industry cooperate andact together as if they were aact together as if they were amonopolymonopoly• cartel arrangements may be tacit orcartel arrangements may be tacit orformalformal• illegal in the US: Sherman Antitrustillegal in the US: Sherman AntitrustAct, 1890Act, 1890• examplesexamples: OPEC, IATA: OPEC, IATA
  • 52. Cartel arrangementsCartel arrangementsConditions that influence the formationof cartelssmall number of large firms in theindustrygeographical proximity of the firmshomogeneous products that do notallow differentiationstage of the business cycledifficult entry into industryuniform cost conditions, usuallydefined by product homogeneity
  • 53. Cartel arrangementsCartel arrangementsIn order to maximize profits, the cartelIn order to maximize profits, the cartelas a whole should behave as aas a whole should behave as a‘monopolist’‘monopolist’ the cartel determines thethe cartel determines the outputoutputwhich equateswhich equates MR = MCMR = MC of the cartelof the cartelas a wholeas a whole the MC of the cartel as a whole is thethe MC of the cartel as a whole is thehorizontal summation of the members’horizontal summation of the members’marginal cost curvesmarginal cost curves price is set in the normal monopolyprice is set in the normal monopolyway, by determining quantityway, by determining quantitydemanded wheredemanded where MC=MRMC=MR and derivingand derivingP from the demand curve at that QP from the demand curve at that Q
  • 54. Cartel arrangementsCartel arrangementsMCMCTT is the horizontal sum of MCis the horizontal sum of MCII and MCand MCIIIIQQTT is found at the intersection of MRis found at the intersection of MRTT and MCand MCTT price is found from the demand curve at Qprice is found from the demand curve at QTT ……this is the price that maximizes total industrythis is the price that maximizes total industryprofitsprofits
  • 55. Cartel arrangementsCartel arrangements to determine how much each firm should produce, draw ato determine how much each firm should produce, draw ahorizontal line back from the MRhorizontal line back from the MRTT/MC/MCTT intersectionintersection where this line intersects each individual firm’s MCwhere this line intersects each individual firm’s MCdetermines that firm’s output, QI and QII. Note that thedetermines that firm’s output, QI and QII. Note that thefirms may produce different outputsfirms may produce different outputsKey point: the MC of the last unit produced is equatedKey point: the MC of the last unit produced is equatedacross both firmsacross both firms
  • 56. Cartel arrangementsCartel arrangementsProfits for each firm are shown as rectanglesProfits for each firm are shown as rectanglesin bluein blueFirms may earnFirms may earn different levels of profitdifferent levels of profit,,though combined profits are maximizedthough combined profits are maximized
  • 57. Cartel arrangementsCartel arrangements Problem: incentive for firms to cheat onProblem: incentive for firms to cheat onagreement, thus cartels are unstableagreement, thus cartels are unstable Additional costs facing the cartelAdditional costs facing the cartelformation costsformation costsmonitoring costsmonitoring costsenforcement costsenforcement costscost of punishment by authoritiescost of punishment by authorities weigh the benefits against theseweigh the benefits against thesecostscosts
  • 58. Cartel arrangementsCartel arrangementsExamples: pricefixing by cartelsGE,WestinghouseArcher DanielsMidland CompanySotheby’s,Christie’sRoche HoldingAG, BASF AG
  • 59. Price leadershipPrice leadershipBarometric price leadershipBarometric price leadershipone firm in an industry willone firm in an industry willinitiate ainitiate a price changeprice change ininresponse to economic conditionsresponse to economic conditionsthe other firms may or may notthe other firms may or may notfollow this leaderfollow this leaderleader may varyleader may vary
  • 60. Price leadershipPrice leadershipDominant price leadershipDominant price leadershipone firm is theone firm is the industry leaderindustry leaderdominant firm sets price with thedominant firm sets price with therealization that the smaller firmsrealization that the smaller firmswill follow and charge thewill follow and charge the samesamepricepricecan force competitors out ofcan force competitors out ofbusiness orbusiness or buy them outbuy them out underunderfavourable termsfavourable termscould result in investigation undercould result in investigation underSherman Anti-Trust ActSherman Anti-Trust Act
  • 61. Price leadershipPrice leadershipDDTT = demand curve= demand curvefor entire industryfor entire industryMCMCDD = marginal cost= marginal costof the dominant firmof the dominant firmMCMCRR = summation of= summation ofMC of follower firmsMC of follower firms in setting price,in setting price,dominant firm mustdominant firm mustconsider the amountconsider the amountsupplied by all firmssupplied by all firms
  • 62. Price leadershipPrice leadershipDemand curve facing theDemand curve facing thedominant firm is founddominant firm is foundby subtracting MCby subtracting MCRR fromfromDDTT dominant firmdominant firmequates its MC with MRequates its MC with MRfrom its ‘residualfrom its ‘residualdemand curve’ Ddemand curve’ DDD the dominant firmthe dominant firmsells A units and the restsells A units and the restof the demand (Qof the demand (QTT – A)– A)is supplied by theis supplied by thefollower firmsfollower firms
  • 63. Revenue maximizationRevenue maximization Baumol model:Baumol model: firms maximize revenuefirms maximize revenue (not(notprofit) subject to maintaining a specific level ofprofit) subject to maintaining a specific level ofprofitsprofitsRationaleRationalea firm will become more competitivea firm will become more competitivewhen it achieves awhen it achieves a large sizelarge sizemanagement remuneration may bemanagement remuneration may berelated to revenue not profitsrelated to revenue not profitsImplicationImplication: unlike the profit maximization case,: unlike the profit maximization case,aa change in fixed costs will alter price andchange in fixed costs will alter price andoutputoutput (by raising the cost curve and lowering(by raising the cost curve and loweringthe profit line)the profit line)
  • 64. Price discriminationPrice discrimination Price discrimination: products with identicalPrice discrimination: products with identicalcosts are sold in different markets at differentcosts are sold in different markets at differentpricesprices the ratio of price to marginal cost differs forthe ratio of price to marginal cost differs forsimilar productssimilar productsConditions for price discriminationConditions for price discriminationthe markets in which thethe markets in which theproducts are sold must byproducts are sold must byseparated (separated (no resaleno resale betweenbetweenmarkets)markets)the demand curves in thethe demand curves in themarket must havemarket must have differentdifferentelasticitieselasticities
  • 65. Price discriminationPrice discriminationFirst degree price discriminationFirst degree price discriminationseller can identify where eachseller can identify where eachconsumer lies on the demand curveconsumer lies on the demand curveand charges each consumer theand charges each consumer thehighest price the consumer is willinghighest price the consumer is willingto payto payallows the seller to extract theallows the seller to extract thegreatest amount of profitsgreatest amount of profitsrequires arequires a considerable amount ofconsiderable amount ofinformationinformation
  • 66. Price discriminationPrice discriminationSecond degree priceSecond degree pricediscriminationdiscriminationdifferential prices charged bydifferential prices charged byblocks of servicesblocks of servicesrequiresrequires meteringmetering of servicesof servicesconsumed by buyersconsumed by buyers
  • 67. Price discriminationPrice discriminationThird degree price discriminationThird degree price discriminationcustomers are segregated intocustomers are segregated intodifferent marketsdifferent markets and chargedand chargeddifferent prices in eachdifferent prices in eachsegmentationsegmentation can be based on anycan be based on anycharacteristic such as age, location,characteristic such as age, location,gender, income, etcgender, income, etc
  • 68. Price discriminationPrice discriminationThird degree discrimination:Third degree discrimination:• assume the firm operates in two markets, A and Bassume the firm operates in two markets, A and B• the demand in market A is less elastic than the demandthe demand in market A is less elastic than the demandin market Bin market B• the entire market faced by the firm is described by thethe entire market faced by the firm is described by thehorizontal sum of the demand and marginal revenuehorizontal sum of the demand and marginal revenuecurves …curves …
  • 69. Price discriminationPrice discrimination• the firm finds the total amount to produce by equatingthe firm finds the total amount to produce by equatingthe marginal revenue and marginal cost in the market asthe marginal revenue and marginal cost in the market asa whole: Qa whole: QTT• if the firm were forced to charge a uniform price, it wouldif the firm were forced to charge a uniform price, it wouldfind the price by examining the aggregate demand Dfind the price by examining the aggregate demand DTT atatthe output level Qthe output level QTT• the firm can increase its profits by charging a differentthe firm can increase its profits by charging a differentprice in each market …price in each market …
  • 70. Price discriminationPrice discrimination• in order to find the optimum price to charge in each market, drawin order to find the optimum price to charge in each market, drawa horizontal line back from the MRa horizontal line back from the MRTT/MC/MCTT intersectionintersection• where this line intersects each submarket’s MR curve determineswhere this line intersects each submarket’s MR curve determinesthe amount that should be sold in each market: Qthe amount that should be sold in each market: QAA and Qand QBB• these quantities are then used to determine the price in eachthese quantities are then used to determine the price in eachmarket using the demand curves Dmarket using the demand curves DAA and Dand DBB
  • 71. Price discriminationPrice discriminationExamplesExamples of priceof pricediscriminationdiscrimination• doctorsdoctors• telephone callstelephone calls• theaterstheaters• hotel industryhotel industry
  • 72. Price discriminationPrice discrimination Tying arrangement: a buyer of one productTying arrangement: a buyer of one productisis obligatedobligated to also by a related productto also by a related productfrom the same supplierfrom the same supplierillegal in some casesillegal in some casesone explanation: a device toone explanation: a device to‘meter’ demand for tied product‘meter’ demand for tied productother explanations of tyingother explanations of tyingquality controlquality controlefficiencies in distributionefficiencies in distributionevasion of price controlsevasion of price controls
  • 73. Nonmarginal pricingNonmarginal pricing Cost-plus pricing: price is set by firstCost-plus pricing: price is set by firstcalculating the variable cost, adding ancalculating the variable cost, adding anallocation for fixed costs, and thenallocation for fixed costs, and thenadding a profit percentage or markupadding a profit percentage or markupProblems with cost-plus pricingProblems with cost-plus pricingcalculation of average variablecalculation of average variablecostcostallocation of fixed costallocation of fixed costsize of the markupsize of the markup
  • 74. Nonmarginal pricingNonmarginal pricing Incremental pricing (and costing) analysis:Incremental pricing (and costing) analysis:deals with changes in total revenue anddeals with changes in total revenue andtotal cost resulting from a decision tototal cost resulting from a decision tochange prices or productchange prices or productFeatures:Features:incrementalincremental, similar to marginal, similar to marginalanalysisanalysisonly revenues and costs that willonly revenues and costs that willchange due to the decision arechange due to the decision areconsideredconsideredexamples of product change: newexamples of product change: newproduct, discontinue old product,product, discontinue old product,improve a product, capital equipmentimprove a product, capital equipment
  • 75. Multiproduct pricingMultiproduct pricingWhen the firm produces two or moreWhen the firm produces two or moreproductsproductsCase 1Case 1: products are: products are complementscomplements ininterms of demandterms of demand  an increase inan increase inthe quantity sold of one will bringthe quantity sold of one will bringabout an increase in the quantityabout an increase in the quantitysold of the othersold of the otherCase 2Case 2: products are: products are substitutessubstitutes ininterms of demandterms of demand  an increase inan increase inthe quantity sold of one will bringthe quantity sold of one will bringabout a decrease in the quantity soldabout a decrease in the quantity soldof the otherof the other
  • 76. Multiproduct pricingMultiproduct pricingWhen the firm produces two or moreWhen the firm produces two or moreproductsproductsCase 3Case 3: products are joined in production: products are joined in productionproducts producedproducts produced from one set offrom one set ofinputsinputsCase 4Case 4: products: products compete for resourcescompete for resources using resources to produce oneusing resources to produce oneproduct takes those resources awayproduct takes those resources awayfrom producing other productsfrom producing other products
  • 77. Transfer pricingTransfer pricing Internal pricingInternal pricing: as the product moves: as the product movesthrough these divisions on the way to thethrough these divisions on the way to theconsumer it is ‘sold’ or transferred from oneconsumer it is ‘sold’ or transferred from onedivision to another at a ‘transfer price’division to another at a ‘transfer price’Rationale:Rationale:• firm subdividedfirm subdivided into divisions, each may beinto divisions, each may becharged with a profit objectivecharged with a profit objective• without any coordination, the final price ofwithout any coordination, the final price ofthe product to consumersthe product to consumers may not maximizemay not maximizeprofitsprofits for the firm as a wholefor the firm as a whole
  • 78. Transfer pricingTransfer pricingDesign of the optimal transferDesign of the optimal transferpricing mechanism is complicatedpricing mechanism is complicatedby the fact thatby the fact thateach division may be able to selleach division may be able to sellits product inits product in external markets asexternal markets aswell as internallywell as internallyeach division may be able toeach division may be able toprocure inputs from externalprocure inputs from externalmarketsmarkets as well as internallyas well as internally
  • 79. Transfer pricingTransfer pricingCase ACase A: no external markets: no external marketsno division can buy from or sell to anno division can buy from or sell to anexternal marketexternal marketthe selling division will producethe selling division will produceexactly the number of componentsexactly the number of componentsthat will be used by the purchasingthat will be used by the purchasingdivisiondivisionone demand curve and two MC curvesone demand curve and two MC curvesMC curves are summed verticallyMC curves are summed verticallyset production whereset production where MR = Total MCMR = Total MC
  • 80. Transfer pricingTransfer pricingCase BCase B: external markets: external marketsdivisions have the opportunity to buydivisions have the opportunity to buyor sell in outside competitiveor sell in outside competitivemarketsmarketsif selling division prices above theif selling division prices above theexternal market price, the buyingexternal market price, the buyingdivision will buy from outsidedivision will buy from outsideif selling division cannot produceif selling division cannot produceenough to satisfy buying divisionenough to satisfy buying divisiondemand, the buying division will buydemand, the buying division will buyadditional units from the externaladditional units from the externalmarketmarket
  • 81. Other pricing practicesOther pricing practicesPrice skimmingPrice skimmingthe first firm to introduce a productthe first firm to introduce a productmay have amay have a temporary monopolytemporary monopolyand may be able to charge highand may be able to charge highprices and obtain high profits untilprices and obtain high profits untilcompetition enterscompetition entersPenetration pricingPenetration pricingselling at a low price in order toselling at a low price in order toobtainobtain market sharemarket share
  • 82. Other pricing practicesOther pricing practicesPrestige pricingPrestige pricingdemand for a product may be higherdemand for a product may be higherat aat a higher price because of thehigher price because of theprestige that ownershipprestige that ownership bestows onbestows onthe ownerthe ownerPsychological pricingPsychological pricingdemand for a product may bedemand for a product may be quitequiteinelasticinelastic over a certain range but willover a certain range but willbecome rather elastic at one specificbecome rather elastic at one specifichigher or lower pricehigher or lower price
  • 83. Global applicationGlobal applicationExample: declineof Europeancartels carton-board vitamin copper pipe elevatoroperators
  • 84. 22NonPrice CompetitionNonPrice Competition
  • 85. BundlingBundlingPractice of selling two or more products as a package.Practice of selling two or more products as a package.To see how a film company can use customer heterogeneityTo see how a film company can use customer heterogeneityto its advantage, suppose that there are two movie theatersto its advantage, suppose that there are two movie theatersand that their reservation prices for our two films are asand that their reservation prices for our two films are asfollows:follows:If the films are rented separately, the maximum price thatIf the films are rented separately, the maximum price thatcould be charged forcould be charged for WindWind is $10,000 because chargingis $10,000 because chargingmore would exclude Theatermore would exclude Theater BB. Similarly, the maximum. Similarly, the maximumprice that could be charged forprice that could be charged for GertieGertie is $3000.is $3000.But suppose the films areBut suppose the films are bundledbundled. Theater. Theater AA values thevalues thepair of films at $15,000 ($12,000 + $3000), and Theaterpair of films at $15,000 ($12,000 + $3000), and Theater BBvalues the pair at $14,000 ($10,000 + $4000).values the pair at $14,000 ($10,000 + $4000). Therefore,Therefore,we can charge each theater $14,000 for the pair of filmswe can charge each theater $14,000 for the pair of filmsand earn a total revenue of $28,000.and earn a total revenue of $28,000.GONE WITH THE WINDGETTING GERTIE’SGARTERTheaterTheater AA $12,000$12,000 $3000$3000TheaterTheater BB $10,000$10,000 $4000$4000
  • 86. Relative ValuationsRelative ValuationsWhy is bundling more profitable than selling the filmsWhy is bundling more profitable than selling the filmsseparately? Because theseparately? Because the relative valuationsrelative valuations of the twoof the twofilms are reversed.films are reversed.The demands areThe demands are negatively correlatednegatively correlated—the—the customercustomerwilling to pay the most forwilling to pay the most for WindWind is willing to pay theis willing to pay theleast forleast for GertieGertie..Suppose demands wereSuppose demands were positively correlatedpositively correlated——thatthat is,is,TheaterTheater AA would pay more forwould pay more for bothboth films:films:If we bundled the films, the maximum price that couldIf we bundled the films, the maximum price that couldbe charged for the package is $13,000, yielding a totalbe charged for the package is $13,000, yielding a totalrevenue of $26,000, the same as by renting the filmsrevenue of $26,000, the same as by renting the filmsseparately.separately.GONE WITH THE WINDGETTING GERTIE’SGARTERTheaterTheater AA $12,000$12,000 $4000$4000TheaterTheater BB $10,000$10,000 $3000$3000
  • 87. RESERVATION PRICESRESERVATION PRICESReservationReservationpricesprices rr11 andand rr22for two goods arefor two goods areshown for threeshown for threeconsumers,consumers,labeledlabeled AA,, BB, and, andCC..ConsumerConsumer AA isiswilling to pay upwilling to pay upto $3.25 for goodto $3.25 for good1 and up to $6 for1 and up to $6 forgood 2.good 2.
  • 88. CONSUMPTION DECISIONS WHENCONSUMPTION DECISIONS WHENPRODUCTS ARE SOLD SEPARATELYPRODUCTS ARE SOLD SEPARATELYThe reservationThe reservationprices of consumersprices of consumersinin region I exceed theregion I exceed thepricesprices PP11 andand PP22 forforthe two goods, sothe two goods, sothese consumers buythese consumers buyboth goods.both goods.Consumers in regionsConsumers in regionsII and IV buy onlyII and IV buy onlyone of the goods,one of the goods,and consumers inand consumers inregion III buyregion III buyneitherneither good.good.
  • 89. CONSUMPTION DECISIONS WHENCONSUMPTION DECISIONS WHENPRODUCTS ARE BUNDLEDPRODUCTS ARE BUNDLEDConsumersConsumerscompare the sumcompare the sumof theirof theirreservation pricesreservation pricesrr11 + r+ r22, with the, with theprice of theprice of thebundlebundle PPBB..They buy theThey buy thebundle only ifbundle only if rr11 ++rr22 is at least asis at least aslarge aslarge as PPBB..
  • 90. RESERVATION PRICESRESERVATION PRICESIn (a), because demands are perfectly positivelyIn (a), because demands are perfectly positivelycorrelated, the firm does not gain by bundling: It wouldcorrelated, the firm does not gain by bundling: It wouldearn the same profit by selling the goods separately.earn the same profit by selling the goods separately.In (b), demands are perfectlyIn (b), demands are perfectly negatively correlated.negatively correlated.Bundling is the ideal strategyBundling is the ideal strategy—all the consumer—all the consumersurplus can be extracted.surplus can be extracted.
  • 91. MOVIE EXAMPLEMOVIE EXAMPLEConsumersConsumers AA andand BBare two movieare two movietheaters. Thetheaters. Thediagram showsdiagram showstheir reservationtheir reservationprices for the filmsprices for the filmsGone with the WindGone with the Windandand GettingGettingGertie’s Garter.Gertie’s Garter.Because theBecause thedemands aredemands arenegativelynegativelycorrelated,correlated,bundling pays.bundling pays.
  • 92. MIXED VERSUS PURE BUNDLINGMIXED VERSUS PURE BUNDLINGMixed BundlingMixed BundlingSelling two or more goods both as a package andSelling two or more goods both as a package andindividually.individually.Pure bundlingPure bundling : Selling products only as a package.: Selling products only as a package.With positive marginal costs,With positive marginal costs,mixed bundling may be moremixed bundling may be moreprofitable than pure bundling.profitable than pure bundling.ConsumerConsumer AA has a reservationhas a reservationprice for good 1 that is belowprice for good 1 that is belowmarginal costmarginal cost cc11, and consumer, and consumerDD has a reservation price forhas a reservation price forgood 2 that is below marginalgood 2 that is below marginalcostcost cc22..With mixed bundling, consumerWith mixed bundling, consumerAA is induced to buy only good 2,is induced to buy only good 2,and consumerand consumer DD is induced tois induced tobuy only good 1, thus reducingbuy only good 1, thus reducingthe firm’s cost.the firm’s cost.
  • 93. Let’s compare three strategies:Let’s compare three strategies:1. Selling the goods separately at prices1. Selling the goods separately at prices PP11 = $50 and= $50 and PP22 =$90.=$90.2. Selling the goods only as a bundle at a price of $100.2. Selling the goods only as a bundle at a price of $100.3. Mixed bundling, whereby the goods are offered separately3. Mixed bundling, whereby the goods are offered separatelyat pricesat prices PP11 == PP22 = $89.95, or as a bundle at a price of $100.= $89.95, or as a bundle at a price of $100.TABLE 4 BUNDLING EXAMPLEPP11 PP22 PP33 PROFITPROFITSoldSoldseparatelyseparately$50$50 $90$90 —— $150$150PurePurebundlingbundling—— —— $100$100 $200$200MixedMixedbundlingbundling$89.95$89.95 $89.95$89.95 $100$100 $229.90$229.90As we should expect,As we should expect, pure bundling is better than sellingpure bundling is better than sellingthe goods separately because consumers’ demands arethe goods separately because consumers’ demands arenegatively correlatednegatively correlated. But what about mixed bundling?. But what about mixed bundling?
  • 94. MIXED BUNDLING WITH ZERO MARGINALMIXED BUNDLING WITH ZERO MARGINALCOSTSCOSTSIf marginal costs are zero, and ifIf marginal costs are zero, and ifconsumers’ demandsconsumers’ demands are not perfectlyare not perfectlynegatively correlated, mixednegatively correlated, mixedbundling is still more profitable thanbundling is still more profitable thanpure bundling.pure bundling.In this example, consumersIn this example, consumers BB andand CC arearewilling to pay $20 more for the bundlewilling to pay $20 more for the bundlethan are consumersthan are consumers AA andand DD..With pure bundling, the price of theWith pure bundling, the price of thebundle is $100. With mixed bundling, thebundle is $100. With mixed bundling, theprice of the bundle can be increased toprice of the bundle can be increased to$120 and consumers$120 and consumers AA andand DD can still becan still becharged $90 for a single good.charged $90 for a single good.TABLE 5 MIXED BUNDLING WITH ZERO MARGINAL COSTSPP11 PP22 PP33 PROFITPROFITSoldSoldseparatelyseparately$80$80 $80$80 —— $320$320PurePurebundlingbundling—— —— $100$100 $400$400MixedMixedbundlingbundling$90$90 $90$90 $120$120 $420$420
  • 95. MIXED BUNDLING INMIXED BUNDLING INPRACTICEPRACTICEThe dots in this figure areThe dots in this figure areestimates of reservation pricesestimates of reservation pricesfor a representative sample offor a representative sample ofconsumers.consumers.A company could first choose aA company could first choose aprice for the bundle,price for the bundle, PPBB, such, suchthat a diagonal line connectingthat a diagonal line connectingthese prices passes roughlythese prices passes roughlymidway through the dots.midway through the dots.The company could then tryThe company could then tryindividual pricesindividual prices PP11 andand PP22..GivenGiven PP11,, PP22, and, and PPBB, profits can, profits canbe calculated for this sample ofbe calculated for this sample ofconsumers. Managers can thenconsumers. Managers can thenraise or lowerraise or lower PP11,, PP22, and, and PPBB andandsee whether the new pricingsee whether the new pricingleads to higher profits. Thisleads to higher profits. Thisprocedure isprocedure is repeated until totalrepeated until totalprofit is roughly maximized.profit is roughly maximized.Bundling in PracticeBundling in Practice
  • 96. THE COMPLETE DINNER VERSUS À LA CARTE:THE COMPLETE DINNER VERSUS À LA CARTE:A RESTAURANT PRICING PROBLEMA RESTAURANT PRICING PROBLEMFor a restaurant, mixed bundling means offering bothFor a restaurant, mixed bundling means offering bothcomplete dinners (the appetizer, main course, andcomplete dinners (the appetizer, main course, anddessert come as a package) and an à la carte menudessert come as a package) and an à la carte menu(the customer buys the appetizer, main course, and(the customer buys the appetizer, main course, anddessert separately).dessert separately).This strategy allows the à la carte menu to be priced toThis strategy allows the à la carte menu to be priced tocapture consumer surplus from customers who valuecapture consumer surplus from customers who valuesome dishessome dishes much more highlymuch more highly than others.than others.At the same time, the complete dinner retains thoseAt the same time, the complete dinner retains thosecustomers who have lower variations in their reservationcustomers who have lower variations in their reservationprices for different dishes (e.g., customers who attachprices for different dishes (e.g., customers who attachmoderate values to both appetizers and desserts).moderate values to both appetizers and desserts).
  • 97. THE COMPLETE DINNER VERSUS À LA CARTE:THE COMPLETE DINNER VERSUS À LA CARTE:A RESTAURANT PRICING PROBLEMA RESTAURANT PRICING PROBLEMFor a restaurant, mixed bundling means offering complete dinners and anFor a restaurant, mixed bundling means offering complete dinners and an àà la carte menu. Thisla carte menu. Thisstrategy allows the à la carte menu to be priced to capture consumer surplus from customersstrategy allows the à la carte menu to be priced to capture consumer surplus from customerswho value some dishes much more highly than others. Successful restaurateurs know theirwho value some dishes much more highly than others. Successful restaurateurs know theircustomers’ demand characteristics and usecustomers’ demand characteristics and use thatthat knowledge to design a pricing strategy thatknowledge to design a pricing strategy thatextracts as much consumer surplus as possible.extracts as much consumer surplus as possible.TABLE 6TABLE 6 MIXED BUNDLING AT MCDONALD’S (2011)MIXED BUNDLING AT MCDONALD’S (2011)INDIVIDUAL ITEMINDIVIDUAL ITEM PRICEPRICEMEAL (INCLUDESMEAL (INCLUDESSODA AND FRIES)SODA AND FRIES)UNBUNDLEDUNBUNDLEDPRICEPRICEPRICE OFPRICE OFBUNDLEBUNDLE SAVINGSSAVINGSChicken SandwichChicken Sandwich $5.49$5.49 Chicken SandwichChicken Sandwich $10.07$10.07 $7.89$7.89 $2.18$2.18Filet-O-FishFilet-O-Fish $4.39$4.39 Filet-O-FishFilet-O-Fish $8.97$8.97 $6.79$6.79 $2.18$2.18Big MacBig Mac $4.69$4.69 Big MacBig Mac $9.27$9.27 $6.99$6.99 $2.28$2.28Quarter PounderQuarter Pounder $4.69$4.69 Quarter PounderQuarter Pounder $9.27$9.27 $7.19$7.19 $2.08$2.08Double QuarterDouble QuarterPounderPounder$6.09$6.09Double QuarterDouble QuarterPounderPounder $10.67$10.67 $8.39$8.39 $2.28$2.2810-piece Chicken10-piece ChickenMcNuggetsMcNuggets$5.19$5.1910-piece Chicken10-piece ChickenMcNuggetsMcNuggets $9.77$9.77 $7.59$7.59 $2.18$2.18Large French FriesLarge French Fries $2.59$2.59Large SodaLarge Soda $1.99$1.99
  • 98. TyingTyingPractice of requiring a customer to purchase one goodPractice of requiring a customer to purchase one goodin order to purchase another.in order to purchase another.Why might firms use this kind of pricingWhy might firms use this kind of pricingpractice?practice?1.1.One of the main benefits of tying is that itOne of the main benefits of tying is that itoften allows a firm tooften allows a firm to meter demandmeter demand andandthereby practice price discrimination morethereby practice price discrimination moreeffectively.effectively.2.2.Tying can also be used to extend a firm’sTying can also be used to extend a firm’smarket power.market power.3.3.Tying can have other uses. An important oneTying can have other uses. An important oneis to protect customer goodwill connected withis to protect customer goodwill connected withaa brand namebrand name. This is why. This is why franchisesfranchises are oftenare oftenrequired to purchase inputs from therequired to purchase inputs from thefranchiser.franchiser.
  • 99. EFFECTS OFEFFECTS OFADVERTISINGADVERTISINGAdvertisingAdvertisingAR and MR are average andAR and MR are average andmarginal revenue when themarginal revenue when thefirm doesn’t advertise,firm doesn’t advertise,and AC and MC are averageand AC and MC are averageand marginal cost.and marginal cost.The firm producesThe firm produces QQ00 andandreceives a pricereceives a price PP00..Its total profitIts total profit ππ00 is given byis given bythe gray-shaded rectangle.the gray-shaded rectangle.If the firm advertises, itsIf the firm advertises, itsaverage and marginal revenueaverage and marginal revenuecurves shift to the right.curves shift to the right.Average cost rises (to AC′)Average cost rises (to AC′)but marginal cost remains thebut marginal cost remains thesame.same.The firm now producesThe firm now produces QQ11(where MR′ = MC), and(where MR′ = MC), andreceives a pricereceives a price PP11..Its total profit,Its total profit, ππ11, is now, is nowlarger.larger.
  • 100. The priceThe price PP and advertising expenditureand advertising expenditure AA totomaximize profit, is given by:maximize profit, is given by:The firm should advertise up to the point thatThe firm should advertise up to the point that== fullfull marginal cost of advertisingmarginal cost of advertisingAdvertising leads to increased output.Advertising leads to increased output.But increased output in turn means increasedBut increased output in turn means increasedproduction costs, and this must be taken into accountproduction costs, and this must be taken into accountwhen comparing the costs and benefits of an extrawhen comparing the costs and benefits of an extradollar of advertising.dollar of advertising.
  • 101. First, rewrite equation as follows:First, rewrite equation as follows:Now multiply both sides of this equation byNow multiply both sides of this equation byAA//PQPQ, the advertising-to-sales ratio., the advertising-to-sales ratio.Advertising-to-sales ratioAdvertising-to-sales ratioRatio of a firm’s advertising expenditures to its sales.Ratio of a firm’s advertising expenditures to its sales.Advertising elasticity of demandAdvertising elasticity of demandPercentage change in quantity demanded resulting from a 1-percentPercentage change in quantity demanded resulting from a 1-percentincrease in advertising expenditures.increase in advertising expenditures.A Rule of Thumb for AdvertisingA Rule of Thumb for Advertising
  • 102. ADVERTISING IN PRACTICEADVERTISING IN PRACTICEConvenience stores have lower price elasticities ofConvenience stores have lower price elasticities ofdemand (around −5), but their advertising-to-salesdemand (around −5), but their advertising-to-salesratios are usually less than those for supermarketsratios are usually less than those for supermarkets(and are often zero).(and are often zero). Why?Why?Because convenience stores mostly serve customersBecause convenience stores mostly serve customerswho live nearby; they may need a few items late at nightwho live nearby; they may need a few items late at nightor may simply not want to drive to the supermarket.or may simply not want to drive to the supermarket.Advertising is quite important for makers of designerAdvertising is quite important for makers of designerjeans, who will havejeans, who will have advertising-to-sales ratios asadvertising-to-sales ratios ashigh as 10 or 20 percent.high as 10 or 20 percent.Laundry detergentsLaundry detergents have among the highest advertising-have among the highest advertising-to-sales ratios of all products, sometimesto-sales ratios of all products, sometimes exceeding 30exceeding 30percentpercent, even though demand for any one brand is at, even though demand for any one brand is atleast as price elastic as it is for designer jeans. Whatleast as price elastic as it is for designer jeans. Whatjustifies all the advertising? A very large advertisingjustifies all the advertising? A very large advertisingelasticity.elasticity.
  • 103. ADVERTISING IN PRACTICEADVERTISING IN PRACTICETABLE 7TABLE 7 SALES AND ADVERTISINGSALES AND ADVERTISINGEXPENDITURES FOR LEADING BRANDSEXPENDITURES FOR LEADING BRANDSOF OVER-THE-COUNTER DRUGS (INOF OVER-THE-COUNTER DRUGS (INMILLIONS OF DOLLARS)MILLIONS OF DOLLARS)SALESSALES ADVERTISINGADVERTISINGRATIORATIO(%)(%)PainPainMedicationsMedicationsTylenolTylenol 855855 143.8143.8 1717AdvilAdvil 360360 91.791.7 2626BayerBayer 170170 43.843.8 2626ExcedrinExcedrin 130130 26.726.7 2121AntacidsAntacidsAlka-SeltzerAlka-Seltzer 160160 52.252.2 3333MylantaMylanta 135135 32.832.8 2424TumsTums 135135 27.627.6 2020
  • 104. ADVERTISING IN PRACTICEADVERTISING IN PRACTICETABLE11.4SALES AND ADVERTISINGEXPENDITURES FOR LEADING BRANDSOF OVER-THE-COUNTER DRUGS (INMILLIONS OF DOLLARS) (continued)SALESSALES ADVERTISINGADVERTISINGRATIORATIO(%)(%)Cold Remedies (decongestants)Cold Remedies (decongestants)BenadrylBenadryl 130130 30.930.9 2424SudafedSudafed 115115 28.628.6 2525CoughCoughMedicineMedicineVicksVicks 350350 26.626.6 88RobitussinRobitussin 205205 37.737.7 1919HallsHalls 130130 17.417.4 1313TABLE 7TABLE 7 SALES AND ADVERTISINGSALES AND ADVERTISINGEXPENDITURES FOR LEADING BRANDSEXPENDITURES FOR LEADING BRANDSOF OVER-THE-COUNTER DRUGS (INOF OVER-THE-COUNTER DRUGS (INMILLIONS OF DOLLARS)MILLIONS OF DOLLARS) (continued)(continued)
  • 105. ConclusionConclusion““It is in rare moments that I seeIt is in rare moments that I seemy business clearly … why do Imy business clearly … why do Istill lie awake at night? I’mstill lie awake at night? I’mtrying to figure the damntrying to figure the damnstrategies of my competitors!”strategies of my competitors!”A ManagerA Manager
  • 106. Core ReadingCore Reading• Keat, Paul G. and Young, Philip KY (2009)Managerial Economics, 6thedition, Pearson• Samuelson, William F. and Marks, Stephen G.(2010) Managerial Economics, 6thedition, JohnWiley• Pindyck, Robert S. and Rubinfeld, Daniel L.(2013)Microeconomics, 8thedition, Pearson• Samuelson, P.A. and Nordhaus, W. D.Samuelson, P.A. and Nordhaus, W. D.(2010)(2010)“Economics”“Economics” Irwin/McGraw-Hill, 19Irwin/McGraw-Hill, 19ththEditionEdition• Porter, Michael E. (2004)Porter, Michael E. (2004)“Competitive Strategy –“Competitive Strategy –Techniques for Analyzing Industries and Competitors”Techniques for Analyzing Industries and Competitors”Free PressFree Press
  • 107. Questions?Questions?