Managerial Economics Ch 7

Dr. Karim Kobeissi

C h a p t e r 7 : P r i c i n g D e c i s i o n

The Four Models of Market Structure 1) Perfect or Pure Competition• Many sellers of an identical product (e.g., sugar, salt), “price

takers”.

2) Pure Monopoly• One firm -sole seller of a specific product (e.g., electricity), the price is usually

regulated by the government.

3) Oligopoly• Few sellers (e.g., cars producers), differentiated products, must take prices of

others into account when determining its own price and strategies.

4) Monopolistic Competition• Many sellers (e.g., clothes producers), who trade over a range of prices.

• Sellers can differentiate their offers to buyers .

Efficient Markets Mean Loss of Pricing Control

The market structure distinction is extremely important for sellers because if price transparency eventually results in a completely efficient market, sellers will have no control over prices (they become price takers)—the result will be pure competition.

How Price is Determined in Each of

These Four Market Structure?

I - Perfectly Competi ti ve Market

Factors That Make a Market Perfectly Competitive

1) Very large number of sellers: examples include milk, yogurt,

sugar, salt….

2) Standardized product: A “homogeneous” product.

3) “Price Takers”: Individual firms exert no significant control

over price. The price is the same everywhere; and buyers

will be indifferent about which seller they buy the product

from.

4) Free entry and exit: no obstacles to entry--legal,

technological, financial etc.

A Competitive Firm

Demand Curve of a Competitive Firm

A competitive firm has a perfect demand curve:

For any price increase Demand will drop to zero, because

customers will buy from somewhere else at the equilibrium

price The firm cannot obtain a higher price by restricting

its output; nor does it have to lower price (although it may)

to increase its sales volume.

Although, the demand for the INDIVIDUAL firm in a

purely competitive industry is PERFECTLY ELASTIC.

However, this does NOT mean that the MARKET

demand is perfectly elastic. In fact, TOTAL-DEMAND

curves for most agricultural products is very INELASTIC.

• A firm’s profit function:Profit (q)= Π(q) = Total revenue(q) - Total cost(q)Or, a function is maximum when its derivative is equal to zero λ Π / λq = 0

• The firm maximizes its profit by producing q* where:[Total revenue(q)]’-[Total cost(q)]’=0Marginal Revenue – Marginal Cost =0 Marginal Revenue=Marginal Cost MR = MC Or MR = Price MR = MC = Price

Short Run Profit Maximization (Accounting Perspective)

Economic Vs Accounting Profit

Economic profit is the difference between total

monetary revenue and total costs, but total costs

include both explicit and implicit costs. Economic

profit includes the opportunity costs associated

with production and is therefore lower

than accounting profit.

• IF WE HAVE AN ACCOUNTING LOSS (implicit costs are not taken into

consideration) WE HAVE AN ECONOMIC LOSS (implicit costs are

taken into consideration) .

• IF WE HAVE AN ECONOMIC LOSS WE HAVE AN ACCOUNTING LOSS

• IF WE HAVE AN ECONOMIC PROFIT (implicit cost are taken into

consideration) WE HAVE AN ACCOUNTING PROFIT (implicit costs

are not taken into consideration).

• IF WE HAVE AN ACCOUNTING PROFIT (implicit costs are not taken

into consideration) WE HAVE AN ECONOMIC PROFIT (implicit costs

are taken into consideration).

Economic Profit

The competitive firm will make an economic profit

(AT PROFIT MAXIMIZING QUANTITY) whenever:

Price = MR > ATC

IN THE LONG TERME. Profit (∏) = (P – ATC) Q OR P = ATC E. Profit (∏) = 0

Economic Loss

The competitive firm will have an economic loss (AT

PROFIT MAXIMIZING QUANTITY)whenever:

Price = MR < ATC

Loss Minimizati on & Shut-Down Rule

Suppose that P < ATC. Since the firm is experiencing an

economic loss ( accounting loss), should it shut down?Let us compare the profits of producing and selling (Q) to

the profits when the firm shuts down:When the firm shut down: Π (0) = - Fixed CostWhen the firm produce and sell Q: Π (Q) = [(P×Q) – (FC + VC)]Therefore, Π(Q) > Π(0) when P×Q > VC.Divide both sides by (Q): P > AVC.• If P > AVC, then producing and selling (Q) is better than

shutting down Stay in business . • If P < AVC then it is impossible to do better than shutting

down.

II- Monopoly

Factors That Make a Market a Monopoly

1) Single seller

2) No close substitutes

3) “Price maker” (…..not “price taker”)

4) Blocked entry

5) No price competition

In a MONOPOLY, the “firm” and the “industry” are the same.

MR < P

MC < P

Q*

MR = MC < P

IN THE SHORT TERME. Profit (∏) = (P – ATC) Q E. Profit (∏) > 0 if P > ATC E. Profit (∏) < 0 if P < ATC

IN THE SHORT TERME. Profit (∏) = (P – ATC) Q E. Profit (∏) > 0 if P > ATC E. Profit (∏) < 0 if P < ATC

IN THE SHORT TERME. Profit (∏) = (P – ATC) Q E. Profit (∏) > 0 if P > ATC E. Profit (∏) < 0 if P < ATC

IN THE SHORT TERME. Profit (∏) = (P – ATC) Q E. Profit (∏) > 0 if P > ATC E. Profit (∏) < 0 if P < ATC

IN THE LONG TERME. Profit (∏) = (P – ATC) Q OR P = ATC E. Profit (∏) = 0

So far, we have been assuming that the monopoly firm charges the same price to all consumers. In many cases, however,

monopolist will use PRICE DISCRIMINATION, or sell the same good to

different customers for different prices.

This practice is not possible in competitive markets where there are many firms selling

the same product at competitive prices.

How Does the Monopolist Decide Why and How to Price Discriminate?

Suppose you are President of Books-R-Us. The newest

publication can be sold at differing prices to 2 types of

readers:

1)100,000 die-hard fans who will pay $30 /book, and

2)400,000 less enthusiastic readers who will pay $5/book

There are 2 Options to Consider:

Option 1

100,000

X $30

$ 3 million (revenue)

- 2 million (cost)

$1 million (profit)

Option 2

500,000

X $5

$ 2.5 million (revenue)

- 2 million (cost)

$500,000 (profit)

Books –R-Us will choose option 2 since it yields more profits (1 m)

Examples of Price Discrimination include:

1) Movie tickets

2) Airline tickets on particular destinations

3) Discount coupons

4) Financial aid

5) Quantity discounts

III- Oligopoly

Factors That Make a Market an Oligopoly

1. Relatively few sellers,

2. Relatively differentiated products,

3. Price interdependence

4. Relatively difficult entry into and exit from the industry

Price Interdependency

• The distinguishing feature of oligopolistic market structures it is the degree

to which the output, pricing and other decisions of one firm affect, and are

affected by, the similar decision made by other firms in the industry.

• What is important is the interdependence of the managerial decisions

among the various firms in the industry. The analysis oligopolistic behavior

may be modeled as a non-cooperative game in which the actions of one

firm to increase market share will, unless countered, result in a reduction of

the market share of other firms in the industry. Thus, action will be followed

by reaction. This interdependence is the essence of an analysis of

oligopolistic market structures.

G a m e T h e o r y

Game theory is perhaps the most important tool in

the economists analytical kit for analyzing the

strategic behavior. Strategic behavior is concerned

with how individuals make decisions when they

recognize that their actions affect, and are affected

by, the actions of other individuals or groups.

Game Theory can also be illustrated by what is called THE PRISONER’S DILEMMA.

The police have enough evidence to convict Bonnie and Clyde of possession of an illegal firearm so that each would spend 1 year in jail. But they suspect that the two have pulled off some bank robberies but they have no evidence. They put

Bonnie and Clyde in separate rooms and offer a deal.

“Right now, we can lock you up for one year. But if you testify against your partner, we will set you free and your partner will get 20 years in prison. If you

both confess to the crime, we can avoid the cost of a trial and you both get 8 years.”

THE PRISONERS’ DILEMMA GAME AND THE REAL WORLD

• The Prisoner’s Dilemma is an example of a two-person, non-cooperative, simultaneous-move, one-shot game in which both players have a strictly dominant strategy.

• A player has a strictly-dominant strategy if it results in the largest payoff regardless of the strategy adopted by other players.

• A Nash equilibrium occurs in a non-cooperative game when each player adopts a strategy that is the best response to what is believed to be the strategy adopted by the other players.

• When a game is in Nash equilibrium, neither player can improve their payoff by unilaterally changing strategies.

THE PRISONERS’ DILEMMA GAME AND THE REAL WORLD (con)

• The key insight of the prisoners’ dilemma game is the tension between the equilibrium outcome (in which both players’ best strategy is to confess because they can’t trust each other) and the fact that both players could make themselves better off if only they would cooperate. This tension helps explain complex events in the real world.

• The Organization of Petroleum Exporting Countries (OPEC) provides a classic example of this tension. OPEC is a cartel that controls a large fraction of the world’s oil. Looking at OPEC as a whole, restricting the supply of petroleum and keeping the price of petroleum high is in OPEC’s interest. Keeping the price of petroleum high, perhaps near $40 a barrel, which was the price about 20 years ago, would maximize the total revenues and profits of the OPEC nations. But when the price is this high, the individual interest of each nation lies in pumping more oil than the amount allocated to it under the OPEC agreement. Each nation figures that if it — and it alone — cheats on the output restriction imposed by the cartel agreement, the effect on the world price of oil would be small but the positive impact on its profit from selling more oil would be large. So each nation is tempted to cheat on the cartel.

N o n - c o o p e r a ti v e O l i g o p o l y / D u o p o l y

Four popular models of firm behavior in oligopolistic industries are:

1) The Cournot Model is an economic model used to describe an industry structure in which the two companies compete on the quantities of output they will produce (to maximize profits), which they decide on independently of each other and simultaneously.

2) The Stackelberg Model is an economic model used to describe an industry structure in which the two companies compete on the quantities of output they will produce (to maximize profits), which they decide on independently of each other and consecutively (Leader firm and Follower firm).

Non-cooperati ve Ol igopoly/Duopoly (con)

3) The Sweezy Model is an economic model used to

describe an industry structure in which the two

companies compete on the price they will set to maximize

profits. Each firm will follow a price decrease by other

firms in the industry, but will not follow a price increase.

4) The Bertrand Model is an economic model used to

describe an industry structure in which each firm sets the

price of its product to maximize profits and ignores the

price charged by its rival.

C o u r n o t M o d e l F o r a D u o p o l yFive Assumptions: 1) The two firms produce a homogeneous product, i.e.

there is no product differentiation (e.g., water).2) The two firms do not cooperate.3) The two firms have market power, i.e. each firm's

output decision affects the product's price.4) The firms are economically rational and act

strategically, usually seeking to maximize profit given their competitors' decisions.

5) The two firms compete on quantities, and choose quantities simultaneously (each firm take the output quantity of the other as a given constant).

Cournot Model of an Airlines Market

• Example: American Airlines and United Airlines compete for customers on flights between Chicago and Los Angeles.

• Cournot equilibrium (Nash-Cournot equilibrium) - a set of quantities sold by firms such that, holding the quantities of all other firms constant, no firm can obtain a higher profit by choosing a different quantity.

Cournot Model of an Airlines Market (cont).

Residual Demand Curve

The market demand that is not met by other

sellers at any given price.

Cournot Model of an Airlines Market (cont).

• Market demand function isQ = 339 − p

– p - dollar cost of a one-way flight– Q total quantity of the two airlines (thousands of

passengers flying one way per quarter).

• Each airline has a constant marginal cost, MC, and average cost, AC, of $147 per passenger per flight.

Cournot Model of an Airlines Market (cont).

• Residual demand American Airlines faces is:

qA = Q(p) − qU = (339 − p) − qU.

– rewriting

p = 339 − qA − qU

• The marginal revenue function is:

MRr = 339 − 2qA − qU

Cournot Model of an Airlines Market (cont).

• American Airlines’ best response is the output that equates its marginal revenue, and its marginal cost:

MRr = 339 − 2qA − qU = 147 = MC

– and rearranging

qA = 96−1/2 qU

Cournot Model of an Airlines Market (cont).

• United Airlines best-response function is

qU = 96−1/2 qA

– This statement is equivalent to saying that the Nash-Cournot equilibrium is a point at which the best response curves cross.

Cournot Model of an Airlines Market (cont).

• To solve the model:qA = 96−1/2 (96−1/2 qA)

– and solve for qA.

• Doing so, we find that – qA = 64; qU = 64

– Q = qA + qU = 128.

– Nash - Cournot equilibrium price is $211.

IV- Monopolisti c Competi ti on

Factors That Make a Market a Monopolistic competition

1- There are a large number of firms (Many Sellers).

2- The products produced by the different firms are

differentiated (e.g., video games).

3- Entry and exit occur easily (There are few

barriers to entry or exit).

1- Many Sellers

• When there are many sellers, they do not take into

account rivals’ reactions.

• The existence of many sellers makes collusion

difficult The “many sellers” characteristic gives

monopolistic competition its competitive aspect.

2 - P r o d u c t D i ff e r e n ti a ti o n• Product differentiation implies that the products are

different enough (e.g. by branding or quality) Product

differentiation gives monopolistic competition its

monopolistic aspect.

• The firms compete more on product differentiation than

on price.

• Entering firms produce close substitutes, not an

identical or standardized product Firms have a degree

of control over price.

Differentiated Products

• Differentiation exists so long as advertising

convinces buyers that it exists.

• Firms will continue to advertise as long as the

marginal benefits of advertising exceed its

marginal costs.

Multiple Dimensions of Competition

• One dimension of competition is product differentiation.

• Another is competing on perceived quality.

• Competitive advertising is another.

• Others include service and distribution outlets.

3- Easy Entry of New Firms in the Long Run

• There are no significant barriers to entry.

• Ease of entry limits long-run profit.

Characteristics of a Monopolistic Competitor

Like a Monopoly,

* At profit maximizing output, marginal cost will be equal to marginal revenu and less than price MR = MC < P

* Marginal revenue is below price : MR< P

Like a Perfect Competitor,

* zero economic profits exist in the long run.

* The monopolistic competitive firm has some monopoly power so the firm faces a downward sloping demand curve.

Comparing Monopolistic Competition with Monopoly In The Long Run

• It is possible for the monopolist to make economic

profit in the long-run (AS LONG AS PATENT EXIST).

• No long-run economic profit is possible in

monopolistic competition.