Pricing in Economics


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Pricing in Economics and ME Porter's Model

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  • Pricing in Economics

    1. 1. Market Pricing Decisions – Travel to M.E. Porter's Model <ul><li>Presentation by </li></ul><ul><li>Prof.K.Prabhakar </li></ul><ul><li>[email_address] </li></ul>
    2. 2. Introduction <ul><li>It was always tough task for me teach pricing decisions to management students. </li></ul><ul><li>In this presentation we will discuss some issues. </li></ul>
    3. 3. MARKET STRUCTURE AND OUTPUT-PRICING DECISIONS <ul><li>Firms output and pricing decisions depend on the current market structure in which the firm is operating i.e. </li></ul>
    4. 4. MARKET STRUCTURE AND OUTPUT-PRICING DECISIONS <ul><li>“ How much control over price the firm have” </li></ul><ul><li>whether the firm is competing in perfect competition, monopoly, monopolistic competition or oligopoly situation depends on this condition of controllability. </li></ul>
    5. 5. Competition vs. Monopoly <ul><li>One useful way in which issues of competition and monopoly can be investigated is called the Structure, Conduct and Performance Model. </li></ul>
    6. 6. A Model to Start Analysis
    7. 7. <ul><li>Firms are price takers </li></ul><ul><ul><li>they face a perfectly elastic demand curve </li></ul></ul><ul><ul><li>market price changes only if demand or supply changes </li></ul></ul><ul><li>Given the market price, what is the appropriate level of production? </li></ul>
    8. 8. Since market price will settle at the point where only normal profits are earned  output will settle where price= Marginal Cost = Average Cost = Marginal Revenue AC P* Output MC D=MR=AR q*
    9. 9. Industry Demand Increase and The Long-Run Industry Supply Curve S 1 S 2 D 1 D 2 Long-run S P Q a) Constant industry costs a b c
    10. 10. Industry Demand Increase and The Long-Run Industry Supply Curve continued S 1 S 2 D 1 D 2 Long-run S P Q b) Increasing industry costs: external diseconomies of scale a b c
    11. 11. Industry Demand Increase and The Long-Run Industry Supply Curve continued S 1 S 2 D 1 D 2 Long-run Supply P Q c) Decreasing industry costs: external economies of scale a b c
    12. 12. Why is perfect competition so rare in the real world - if it even exists at all? <ul><li>One important reason for this has to do with economies of scale: </li></ul><ul><li>Perfect competition requires there to be many firms. Firms must therefore be small under perfect competition - too small for economies of scale. </li></ul>D LAC 1 LAC 2 LAC 3 Output
    13. 13. BUT <ul><li>once a firm expands sufficiently to achieve economies of scale, it will usually gain market power </li></ul><ul><li>it will be able to undercut the prices of smaller firms and so drive them out of business  perfect competition will be destroyed </li></ul><ul><li>perfect competition could only exist in an industry, therefore, if there were no (or virtually no) economies of scale </li></ul>
    14. 14. Perfect Competition and Public Interest <ul><li>Possible good points : </li></ul><ul><li>the fact that p = mc leads to efficient resource allocation </li></ul><ul><li>competition between firms will spur to efficiency </li></ul>
    15. 15. Perfect Competition and Public Interest <ul><li>will encourage the development of new technology </li></ul><ul><li>there is no point in advertising (Reflect) </li></ul><ul><li>in long-run equilibrium: LRAC at its minimum, so company producing at the least-cost output </li></ul><ul><li>consumers gain from low prices </li></ul><ul><li>quick response to changed consumer tastes </li></ul>
    16. 16. Perfect Competition and Public Interest continued <ul><li>Pitfalls of perfect competition: </li></ul><ul><li>firms may be too small to afford R & D! </li></ul><ul><li>produces only undifferentiated products </li></ul><ul><ul><li>how about the taste of variety! </li></ul></ul>
    17. 17. Monopoly <ul><li>Demand function facing a monopoly is the market demand for the product </li></ul><ul><li>Monopoly firm’s ability to set its market price is limited by the demand curve (demand elasticity) </li></ul><ul><ul><li>downward sloping demand and MR-curves </li></ul></ul><ul><li>But supernormal profits may be earned even in the long run </li></ul><ul><ul><li>depends on how contestable the market is </li></ul></ul>
    18. 18. Graph- Reflect on the slide P 1 Q 1 MC AC D = AR MR
    19. 19. Monopoly and Public Interest <ul><li>Disadvantages of monopoly: </li></ul><ul><ul><li>higher prices and lower output than under perfect competition </li></ul></ul><ul><ul><li>possibility of higher cost curves due lack of competition </li></ul></ul><ul><ul><li>unequal distribution of income </li></ul></ul>
    20. 20. Monopoly and Public Interest continued <ul><li>Advantages of monopoly: </li></ul><ul><ul><li>economies of scale </li></ul></ul><ul><ul><li>possibility of lower cost curves due to more research and development and more investment </li></ul></ul><ul><ul><li>competition for corporate control </li></ul></ul><ul><ul><li>innovation and new products </li></ul></ul>
    21. 21. Monopolistic Competition <ul><li>Firms have some degree of market power </li></ul><ul><ul><li>but demand curve typically flatter than in monopoly since there is more competition </li></ul></ul><ul><li>Output-pricing decision is defined by MR = MC as always </li></ul><ul><ul><li>the absence of entry barriers means that super normal profits are competed away... </li></ul></ul><ul><ul><li>firms end up producing where p = AC, but AC not at its minimum as in perfect competition, also p > MC </li></ul></ul>P = AC 1 Q 1 Output D MR AC MC F
    22. 22. Graph-Reflect and think Output D MR AC MC F
    23. 23. Limitations of Monopolistic Competition Model <ul><li>Information may be imperfect; </li></ul><ul><li>firms will not enter an industry if they are unaware of the supernormal profits currently being made </li></ul><ul><li>Firms are likely to be different from each other not only in the product they produce or the service they offer, but also in their size and in their cost structure. Also the entry may not be completely unrestricted </li></ul><ul><li>The model concentrates on price-output decisions; in practice the profit-maximizing firm under monopolistic competition will also need to decide the exact variety of products to produce and how much to spend on advertising </li></ul>
    24. 24. Limitations of Monopolistic Competition Model continued <ul><li>Compared to perfect competition: </li></ul><ul><ul><li>less will be sold at a higher price </li></ul></ul><ul><ul><li>firms will not be producing at the least-cost point = firms have excess capacity </li></ul></ul><ul><li>On the other hand it is often argued that these wastes are insignificant (since highly elastic demand curves and some scale economies gained) and perhaps well compensated to the consumer by the great variety of products to choose from </li></ul>
    25. 25. Oligopoly <ul><li>The essence of an oligapolistic industry is the need for each firm to consider how its own actions affect the decisions of its relatively few competitors </li></ul><ul><li>Oligopoly may be characterized by collusion or by non-co-operation </li></ul>
    26. 26. Collusion and Cartels <ul><li>COLLUSION </li></ul><ul><ul><li>an explicit or implicit agreement between existing firms to avoid or limit competition with one another </li></ul></ul><ul><li>CARTEL </li></ul><ul><ul><li>is a situation in which formal agreements between firms are legally permitted </li></ul></ul><ul><ul><ul><li>e.g. OPEC </li></ul></ul></ul>
    27. 27. Collusion is difficult if: <ul><li>There are many firms in the industry </li></ul><ul><li>The product is not standardized </li></ul><ul><li>Demand and cost conditions are changing rapidly </li></ul><ul><li>There are no barriers to entry </li></ul><ul><li>Firms have surplus capacity </li></ul>
    28. 28. Tacit Collusion: Price Leadership <ul><li>Dominant firm price leadership </li></ul>S all other firms D market D leader P 1 P 2 Q <ul><li>Followers, like in perfect competition , accept the price as given  their joint supply is the sum of their MC curves (like in perfect competition) </li></ul><ul><li>The leader’s D-curve can be seen as that portion of market demand unfilled by the other firms </li></ul>a b PS. An other form of price leadership is barometric firm price leadership MR leader MC leader P L Q L Q F Q T
    29. 29. Kinked demand for a firm under oligopoly Q O P 1 Q 1 D so demand in response to a price reduction is likely to be relatively inelastic The firm may expect rivals to respond if it reduces its price, as this will be seen as an aggressive move … but for a price increase rivals are less likely to react, so demand may be relatively elastic above P 1 Demand curve kinked at current price:
    30. 30. Stable price under conditions of a kinked demand curve Q O P 1 Q 1 D  AR a MR When Q < Q 1, the MR curve corresponds to the shallow part of the AR curve
    31. 31. Stable price under conditions of a kinked demand curve continued Q O P 1 Q 1 MR a b D  AR At Q > Q 1 , the MR curve will correspond to the steep part of the AR curve Note the cap between points a and b
    32. 32. Stable price under conditions of a kinked demand curve Q O P 1 Q 1 MR a b D  AR <ul><li>Price will tend to be stable, even in the face of an increase in marginal cost: </li></ul>if MC lies anywhere between a and b the profit-maximizing price and output will be P 1 and Q 1
    33. 33. Stable price under conditions of a kinked demand curve continued Q O P 1 Q 1 MC 2 MC 1 MR a b D  AR
    34. 34. Non-Collusive Oligopoly: Game Theory <ul><li>A method of analyzing strategic behavior </li></ul><ul><ul><li>behavior of a firm will depend on how it thinks its rivals will react to its policies </li></ul></ul><ul><li>Invented by John von Neuman (1937) </li></ul><ul><ul><li>and extended with Oskar Morgenstern (1944) </li></ul></ul><ul><li>John Nash: Nash equilibrium (1949-1950) </li></ul><ul><ul><li>a dominant strategy equilibrium </li></ul></ul>
    35. 35. Prisoner’s Dilemma: Payoff Matrix Kannan’s strategies Confess Deny Confess Deny Arasi’s strategies 3 years 3 years 2 years 2 years 10 years 10 years 1 year 1 year
    36. 36. A Strategic Game Example <ul><li>Detergent Wars </li></ul><ul><li>You can take price wars in detergent market in India and design a model. </li></ul>
    37. 37. Duopoly Payoff Matrix: The equilibrium is a Nash equilibrium in which both firms cheat Company A’s strategies Cheat Comply Company B’s strategies nil Cheat Comply Nil -Rs1.0m -Rs1.0m +Rs4.5m +Rs4.5m +Rs2m +Rs2m
    38. 38. Oligopoly and Public Interest <ul><li>If oligopolists act collusively and jointly maximize industry profits, they will in effect be acting together like a monopoly and then the disadvantages to society would be the same as under monopoly </li></ul><ul><li>Further more, in two respects, oligopoly may be more disadvantageous than monopoly: </li></ul><ul><ul><li>Oligopolists are likely to engage in much more extensive advertising than a monopolist </li></ul></ul><ul><ul><li>Depending on the size of individual oligopolists, there may be less scope for economies of scale to decrease the effects of market power </li></ul></ul>
    39. 39. Advantages of oligopoly to society over other market structures: <ul><li>Can use part of the supernormal profits for R&D (incentive to do so higher than in monopoly) </li></ul><ul><li>Non-price competition through product differentiation may result in greater choice for the consumers </li></ul>
    40. 40. Non-Price Competition <ul><li>Product Development </li></ul><ul><ul><li>aims to develop products which will sell well and which are different from rivals' products </li></ul></ul><ul><ul><li>leads to less elastic and potentially high demand </li></ul></ul><ul><li>Advertising </li></ul><ul><ul><li>to increase demand and to make demand curve less elastic </li></ul></ul><ul><li>Advertising and product development not only increase a firm's demand and hence revenue, they also involve increased costs. So how much to spend in order to maximize profit? </li></ul>
    41. 41. The Changing Nature of Market Structure <ul><li>the market types that actually exist in business situations are not always clear-cut or stable </li></ul><ul><li>the type of market in which a firm competes may change over the life of the products being sold </li></ul><ul><li>Prof. Michael Porter has introduced a useful way to incorporate the possibility of change in market structure into the analysis of business decision making </li></ul><ul><ul><ul><li>the model of &quot;five competitive forces&quot; </li></ul></ul></ul>
    42. 42. The Porter Competitive Framework Intra-Market Rivalry Potential Entrants Customers Substitute Markets Suppliers Threat of new entrants Bargaining power of buyers Bargaining power of suppliers Threat of substitute products or services
    43. 43. Summary <ul><li>You have to travel from various points to ME.Porter’s Model. </li></ul><ul><li>Reflect on all that has been discussed. </li></ul>