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Transport Economics and ManagementMarket structures and pricing
Eric Pels
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TEM2
This lecture
Market structures Revenues
Strategies Pricing
Learning objective Repetition of basic economic concepts.
Know different market structures from economic theory, andknow how to apply them in the transport sector.
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TEM4
Strategies
Profit maximization
Marginal profits equal to 0 (MR=MC). Why?
Classic economic theory: entrepreneurial capitalism Owner makes strategic decisions
Managerial capitalism. Ownership changed (shareholders)
Control changed (board rooms) Potential conflicts between shareholders and management
Firms got bigger: coordination difficulties
So other strategies than profit maximization?
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TEM5
Strategies
Revenue maximization (Baumol, 1959)
Decreasing revenues bad for image?
Financial institutions want certainty
Low revenues mean relatively high risk for suppliers
Low revenues may lead to budget cuts, including management
Bonus!
MR=0 Marketing effort
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TEM6
Strategies
Managerial utility maximization (Williamson, 1963)
Managers maximize own satisfaction
Not efficient; not only expenditures for production. Examples?
Growth maximisation (Marris, 1964)
Long term strategy
Profit constraint
Behaviourhal theories Different groups, satisfy all groups to survive: satisficing
Altruistic objectives: public interest Welfare maximization
E.g. NS?
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Strategies
What strategy is relevant?
Quince and Whittaker survey (2003)
Autonomy and income advancement Profit maximization
Sucessful business is most important personal objective
Profit maximization
Growth objective
Profit maximization Model!
Economic profit accounting profit
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Market structures
Perfect competition
Monopolistic competition Oligopoly
Monopoly
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Perfect competition
Many (small) suppliers and buyers: price takers. Demand function for individual company?
Price = marginal revenue. Why? Price level?
Products are perfect substitutes
Free entry and exit
Information is perfect (available to all at no cost) Free movement of products: Supply responsive to market
forces
Innovation exogenous: producers reactive rather than
proactive
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Perfect competition
TEM10
P
Q0
Marginal costs
Inverse demand
Average costs
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Perfect competition
Benchmark: Welfare is maximized (p=mc, lecture 1)
Efficiency Productive efficiency: AC cannot be lower
MC curve passes through minimum of AC
Allocative efficiency: resources are distributed and used as preferred by
consumers: P=MC
Pareto efficiency: no one can be made better off without making
anyone else worse off.
Realistic?
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Marginal revenues
P
Q
Inverse demand ( a/b-1/b*Q )
Marginal revenues:
{(Q*a/b-1/b*Q2)}/Q=a/b-2/b*Q
What does this tell us?(M+G, p81)
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Monopoly
TEM15
P
Q0
Marginal costs
Inverse demand
Marginal revenues
Average costs
Qm
Pm
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Oligopoly
A few sellers.
Homogeneous or heterogeneous products. Barriers to entry and exit (e.g. sunk costs).
Limited information for consumer (price, quality, cost).
Oligopolists may have monopoly (or market) power:
they may be able to influence the price.
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Barriers to entry
Anything that physically prevents entry to or exit from a
market help to sustain monopoly or oligopoly
Government policy: regulation
Spatial pre-emption: new entrants do not have access to
necessary inputs
Cost barriers
Reputation: customer loyalty, safety. Exit barriers: shrinking a firm is expensive (labor, capacity).
Entry-deterring strategies: pricing, spare-capacity,
corporate deals (price discrimination).
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TEM19
Oligopoly: non-cooperative behavior
Competition based on output (quantity) or price.
2 basic oligopoly models: Cournot (quantity competition)
Bertrand (price competition)
Cournot: firms determine output simultaneously, and
then bring this to the market Bertrand: firms announce prices. Demand is allocated
to low-price firm(s), who then produce(s) demand
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TEM20
Cournot competition
Assume that firms produce identical products
Demand: Q=a-b*PInverse demand: P=a/b-1/b*Q
Now we have 2 producers (duopoly):P=a/b-1/b*(Q1+Q2)
Profits maximized when MR=MC (equivalent tomonopolist), taking the competitors actions asgiven.
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TEM21
Cournot competition
Inverse demand:
P=a/b-1/b*(Q1+Q2)
Revenues firm 1:
R1=Q1*[a/b-1/b*(Q1+Q2)]
Marginal revenues:
MR1= a/b-1/b*(2*Q1+Q2) Equilibrium: MR1=MC1
Expression in Q1and Q2
Similar expression for company 2
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TEM22
Cournot competition (2 companies)
Q2
Q1
MR1=MC1
MR2=MC2
Cournot-Nashequilibrium
See last slide for calculation of equilibrium
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TEM24
Bertrand oligopoly
Price competition (again assume identical goods).
Firms announce prices. Demand is allocated to low-pricefirm(s), who then produce(s) demand.
If a firm sets its price above its competitors prices, clients
will prefer the competitors (identical goods).
Bertrand equilibrium is therefore equivalent to competitiveequilibrium: price equals marginal cost.
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TEM25
Oligopoly strategies in e.g. aviation
strong evidence ... against the highly competitive
Bertrand hypothesis (Brander and Zhang, 1990) overall results indicate that the duopolists conduct may
be described as somewhere between Bertrand and
Cournot, but much closer to Cournot (Oum et al., 1993)
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TEM26
Price discrimination
Conditions:
Market power
Different groups of consumers (based on willingness-to-
pay, demand elasticity etc.) segmentation.
Resale not possible.
Cost of discrimination may not exceed additional profits
Markets should be transparent Charge different (groups of) consumers different prices to
maximize profits price discrimination.
First, second and third degree.
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TEM27
First degree price discrimination
Perfect discrimination: each unit of output sold at different
price.
Price determined by inverse demand curve.
What is the optimal output?
profits
Q*
Q
MC
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TEM28
Second-degree price discrimination
Non-linear pricing: price depends on
how much you buy. Fundamentals.
Application (as in Mallard and Glaister)
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TEM29
Second-degree price discrimination
Consumer decides on how much to
buy: Self selection constraints.
2 consumers; each spends ri to receive Xi
buy Xi if benefitsi(Xi)-ri>0 benefits1(X1)-r1> benefits1(X2)-r2
benefits2(X2)-r2> benefits2(X1)-r1
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TEM30
Second-degree price discrimination
Consider an individualdemand function (for convenience,
marginal cost are 0)
Monopolists wants to supply X1 at a total price of A.
p
X
A
X1
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TEM31
Second-degree price discrimination
Now consider two individualdemand functions
Monopolist would like to supply X1 at A+B+C and X2
at A
p
X
A
X1
B
C
X2
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TEM32
Second-degree price discrimination
But: if consumer 1 also purchases X2 at a price of A,
he/she will get surplus B (self selection).
If the monopolist would charge A+C for X1,
consumer 1 get surplus B and the monopolist higher
profits. Can the monopolist get higher profits?
Make X2 unattractive for consumer 1.
Offering less of X2 (loss for monopolist) allows for
higher profits from X1.
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TEM33
Second-degree price discrimination
p
X
A
X1
B
C
X2
Extra profit
(increase inC)
Loss (reduction
in A)
p
X
A
X1
B
CX2D
Equilibrium: marginalbenefit in reduction of
X2 = marginal cost
Consumer 2pays A for X2
Consumer 1 paysA+D+C for X1
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TEM34
Second-degree price discrimination
Examples?
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TEM35
Third degree price discrimination
Set prices for different groups of consumers: examples?
p*
p*
Q* Q*
Segmentation based on willingness-to-pay and elasticity
MCMC
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TEM36
Summary
Profit maximization
Monopoly, perfect competition: two extremes.
Regulation of monopoly: incentives.
Cournot oligopoly: decide on production, then price determined in market
Cournot ologipolist has monopoly power (p>mc)
Bertrand: decide on price, then output determined in market; p = mc
Price discrimination Higher profits
Market power
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Cournot competition: equilibrium
MR1= MC1: [a/b-1/b*(2*Q1+Q2)]=MC1
a/b-2/b*Q1-1/b*Q
2=MC
1 a/b-1/b*Q2-MC1=2/b*Q1
Q1=a/2-1/2*Q2-MC1*b/2
Q2=a/2-1/2*Q1-MC2*b/2
Q1=a/3+b*MC2/3-2*b*MC1/3 Q2=a/3+b*MC1/3-2*b*MC2/3
Q1=Q2=a/3-b*MC/3 (MC1=MC2)
P=a/b-1/b*(Q1+Q2) = a/3b+2*MC/3