Note on Pricing and Public Policy

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Surveys a number of essential issues related to pricing and public policy in market economies. Begins with a brief review of the price-determination process in competitive markets, then examines a range of topics involving pricing and public policy in monopoly and oligopoly markets. Includes a number of graphs that illustrate the relationship between costs, demand, price, efficiency, and profitability under various market conditions.

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Note on Pricing and Public Policy

  1. 1. NOTE ON PRICING AND PUBLIC POLICY A Harvard Business School Case Study
  2. 2. Introduction     Prices determine the functioning of market economies. Under perfect competition, firms are price takers. Situation is different in many real world markets. Different market structures : Perfect competition  Monopoly  Monopolistic competition  Oligopoly   Market structure models help us organize and understand apparent chaos of real-world markets.
  3. 3. The Concept of Imperfect Competition  Refers to market structures between perfect competition and monopoly  Types of imperfectly competitive markets  Monopolistic  Oligopoly competition
  4. 4. Monopolistic Competition  Hybrid of perfect competition and monopoly, sharing some of features of each A monopolistically competitive market has three fundamental characteristics  Many buyers and sellers  Sellers offer a differentiated product  Sellers can easily enter or exit the market
  5. 5. Pricing | Competitive Markets  Price charged equals MC & AC at equilibrium output level.  When production costs are reduced, excess profits are obtained as rents(Price – AC) PRICE PRICE MC AC pcomp Deman d Economi c Rent MC pcomp AC Deman d qcomp qinnov QUANTITY QUANTITY
  6. 6. Pricing | Natural Monopoly     An industry in which economies of scale are so important that only one firm can survive. Its average cost are downward slopping over the whole output. Society benefits from allowing the natural monopoly to occur. As it can increase output and allow prices to be lower due to economies of scale It would not be efficient to encourage competition as it would mean creating duplicate networks that could not gain economies of scale  Examples:     Distribution of Electricity Railways Pipelines Fixed- line telephone networks
  7. 7. Economies of Scale | Natural Monopolies  Economies of Scale occur because of two factors  High Fixed Cost  Costs  Low involved in setting up business Marginal Cost  Cost of adding new consumers to the network is low
  8. 8. Potential Competition And Natural Monopolies      In case of negligible barriers to entry and exit, natural monopolies charge prices that lead to no more than normal profits by lowering prices in face of entry. Franchise is not the best solution in terms of inefficiencies! Franchising in this context is the competitive bidding (of some form) for a long term contract to operate a monopoly. Natural Monopoly may eventually become Artificial Monopoly. Competition would lead to innovation at a much quicker pace. The incumbent faces possibility of losing market while entrant foresees prospect of sharing!
  9. 9. Pricing | Oligopoly Markets      Pricing depends on cost, demand characteristics and ability of firms to collude Cartels are unstable because there is an incentive to cheat Significant decline in industry demand may lead to price wars Price wars may lead to firms requesting assistance from govt. in the form of subsidies/ setting minimum and target prices Govt. intervention might reduce allocative efficiency Oligopoly firm faces market power in certain geographic markets, consumer groups, product lines, but also faces constraints similar to those faced by monopolists.
  10. 10. Oligopoly vs. Other Market Structures Oligopoly presents the greatest challenge to economists.  Essence of oligopoly is strategic interdependence.  Need new tools of modeling.  One approach—game theory—has yielded rich insights into oligopoly behavior. 
  11. 11. Conclusion  The combination of market imperfections, strategic actions on the part of the firms and interest groups, and intervention by the policy makers will shape the levels, structure and dynamics of prices in any given market.

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