Recognizing Rivals: Market Structures & the Decision-Making Environment Determining price based upon the number of rivals a \Monopolistic Competition Competitors, Competitors Everywhere + Understanding the impact of competition + Setting price with many rivals + Disappearing profit in the long run + Advertising ideals“Just worry about yourself.” + Alarge number of firms producing differentiated products (similar, slightly different but not identical) + used in similar ways (standardized type of commodity) + some small difference, such as flavor, color, and/or branding + There are so many firms, you can’t pay attention to all of them, so you need to focus on your own actions. + Product differentiation gives firms some degree of monopoly power so they can establish the good’s price. + Example: Pizza « it’s a standardized type of product + not all pizzas are identical; hence, you probably have a favorite, higher WTP. ~ . SS te f/~y QRSCharacterizing Monopolistic Competition + Large number of firms + provide a fairly small percentage of the good available in the market + have limited influence on the commodity’ price + don't regard themselves as being mutually interdependent and don't take into account how rivals respond to their actions. + prevent collusive behaviour + Standardized type of commodity with interfirm differentiation + product differentiation: quality, location, type of service « interfirm differences in promotion and packaging + Easy entry and exit + Monopolistically competitive firms have relatively small fixed costs QsSetting Price with Many Rivals + Interfirm differentiation allows to set price. Degree of influence on price is limited since a large number of rival firms are producing similar products. + Recognizing the importance of product differentiation + The degree of influence on the good’s price is dependent on the price elasticity of demand for the firm's good. The more elastic the demand, the less influence the firm has on price. + Two factors that influence the monopolistically competitive firm’s price elasticity of | demand are the number of firms (more firms more alternatives), and the degree of product differentiation among firms (smaller degree, more similar products, less ability to charge a higher price) = + To have the greatest influence over price: fewer rivals & a lot different from your rivals. ~ AS QRSSetting Price with Many Rivals + Making use of advertising and product differentiation + Monopolistically competitive firms engage in non-price competition, such as advertising and innovation. + To increase the degree of differentiation that exists between the good you produce and the goods produced by your rivals. + For exampl + advertising “freshest ingredients” pizza + innovation “anchovy and spinach’ pizza to attract new customersMaximizing short-run profit MC + Differentiation leads toa downward-sloping demand curve + firm must lower price in order to sell more of the good Age + marginal revenue is lower than the price of the last unit sold + marginal-revenue curve lies below the demand curve + Profit-maximization: MR = MC 1 = (Py ~ AT Cy) X do %W % % quantityExample + Your monopolistically competitive firm’s + Demand: P = 40 —0.0005q + Total cost: TC = 168,000 + 10q + 0.0005q? + Determine MR, MC, qo, Po, ATC, n/q,0 MR =40—0.001qg MC = 10+ 0.001q q = 15,000 P=325 ATC = 28.7 1/q =38 \ m= 57,000 ~Adjusting to the Long-Run Tendency of Profit Elimination uc + Monopolistically competitive firm's: Easy entry and exit + Opportunity to earn economic profit: enter the market. + Some customers switch to new firm, demand decreasing for other firms + Continues until typical firm’s demand | decreases to where the firm earns zero economic profit (a normal rate of return) + New firms no longer have incentive to quantity enter ATC not at its minimum (exce = capacity) NOS /, yf Y ~~Determining the Ideal Amount of Advertising + Advertising — product differentiation + Advertising’s affect on consumer taste and preferences > demand + Inctease in advertising increases demand + Increase in advertising expenditures increases cost + Advertising increases your profit + MR> MC + MCgas Additional profit of the production & sale of one more output unit: P— MC Change in gross 7 with an additional dollar spent on advertising: Aq x (P — MC) \ Net 7 increases as long as Aq x (P — MC) > 1, maximized at Aq x (P — MC) an additional dollar's worth of advertising adds one dollar to gross profit, resulting in no gain in the firm’s net profit.Manipulation + Aq x (P = MC) = 1 Aq = 1/(P - MC) i AIX P = Goh + MReavertising = 11 + MRaavertising: Marginal revenue of an additional dollar’s worth of advertising + n: negative price elasticity of demand + Example: + =-20 + Advertising department: $50,000 of advertising —> increase sales by $80,000 + Whether or not to support the request? MRadvertising = 1.6 < In] QRS aIncreasing Revenue with Advanced Pricing StrategiesSimplifying Price Determination by Using the Price Elasticity of Demand : mr = P(1+2) + MR=MC >P=MCx—, pres + Profit-maximizing price: P = MC x —- Pret + Example: + Your firm constant MC = 6 \ + Price elasticity of demand: y = —4.0 + Profit-maximizing price: P = 6 x (<4) =8 SePricing Based upon Cost: Cost-Plus Pricing and Breakeven Analysis + Simple pricing strategies based upon production costs. + The advantage: easily calculating price + The disadvantage: ignore the demand + What circumstances these simple methods of price determination help you reach your goal of maximum profit? sin IOSCost-plus pricing + Cost-plus pricing: determine price by starting with the good’s cost and then adding a fixed percentage or amount to that cost. + MR and MC is difficult to obtain with precision + Simply include a desired rate of return in the mark-up. + This pricing technique provides an obvious rationale for price increases when cost increases occur. + First, determines the per unit cost or ATC of producing the good + Requirement: the specification of an output level + Second, adds a mark-up to the per unit cost, typically a percentage P = ATC x (1+ mark — up)Cost-plus pricing P = ATC X (1+ mark — up) + Cost-plus pricing + may not result in profit maximization. + ignores demand conditions. If P > Pr: firm doesn’t sell all the units it produces + Whether cost-plus pricing ever maximizes profit? MR = MC? + Inthe short-run, the difference between MC and ATC may be sizeable + Long-un A7C is typically constant for many firms, implies constant MC = ATC, + Then P = MC x (1 + mark — up) \ + Also when profit maximization: P = MC x 7a + if1+ mark — up = ae or mark — up = a then profit maximized QsCost-plus pricing example + Your company determines that the price elasticity of demand for its product is -4. + Determine the profit-maximizing mark-up + Answer: ~33%Breakeven analysis + The smallest output level that leads to zero economic profit. + Receiving exactly as much as they would in next best alternative + Breakeven pricing: zero profit, TR = TC + Breakeven analysis is a useful managerial tool. Determine how a price change affects profit: “If you lower price, how many more units do you have to sell in order to achieve zero profit?” If fixed cost is large, determine the quantity of output you must sell in order to avoid losses. Determine whether or not sales of that amount are feasible.Breakeven analysis example + Your company: TFC = $300,000, and AVC = $2.00 + In addition, you sell the good at a P = $5.00. + Determine the breakeven point. + TR=TC orP Xq =TFC +TVC =TFC + AVC Xq + (P-AVC) xq = TFC + q=>< = 100,000 PoreDiscriminating among Customers + Price discrimination: the same good is sold to different groups of consumers for different prices. + The couple sitting next to you at the movie paid a lower price to get in because they're senior citizens. + You get a student discount at a local restaurant that non-students don’t get. + Different degrees of price discrimination to reflect the various situations associated with this pricing policyfor price discrimination + Conditions: + You can segment the market into customers who have different price elasticities of demand. + The firm possesses some degree of monopoly power and can set price. + Customers can’t resell the good. + If customers are able to resell the good, those who pay a lower price can buy the good and sell it for a higher price, but not as high as the \ firm charges, to customers willing to pay the high price. This process is 1 called arbitrage, and it limits the firm’s ability to benefit from price discrimination.Assessing price discrimination’s impact + Firms that engage in price discrimination generally + Produce a greater quantity of output. + Because the firm is able to charge different prices to different groups of consumers, it can attract more buyers who are willing to pay a low price without sacrificing revenue from buyers willing to pay a higher price. By selling to both groups at different prices the firm increases the quantity of the good it sells. + Increase their profit. + By charging different prices, the firm is able to capture more consumer surplus —the difference between the price a consumer is willing to pay and the price \ the consumer actually pays. This additional consumer surplus adds to the firm's producer surplus. . QRSIdentifying Who Wants to Pay More: Types of Price Discrimination + As a business owner, you want customers to pay higher prices. + Obviously, those same customers want to pay lower prices. + The prices some customers are willing and able to pay are much higher than the prices others are willing and able to pay. + You can increase your profit if you're able to separate customers who are willing to pay higher prices from those willing to pay lower prices. + Tips: + Charge customers who have a less elastic demand a higher price to have 1 higher revenue. + Charged customers have more elastic demand a lower price in order to get them to buy a lot more. S a QOSWishing for first-degree price discrimination + First-degree price dis ination (perfect price discrimination): firm charges a different price for each unit of the good sold. + Price: the maximum price each customer is willing & able to pay | -MR=P=d + Profit equals the revenue for each unit minus the average D-d=-mR total cost per unitFirst-degree price discrimination + First-degree price discrimination is virtually impossible to implement + The firm must know exactly the maximum price each consumer will pay for each unit of the good purchased. + Even when you survey each consumer for their own WTP, it’s less likely you could know their true values. + The firm must negotiate separately with each individual consumer, and be able to prevent resale between consumers \ + Nevertheless, the closer your firm gets to first-degree price \ discrimination, the greater the benefits QsUsing second-degree price discrimination + Charging different prices for different ranges or blocks of output: second-degree price discrimination or declining block pricing + One price for the first, small block of output, lower prices for additional ranges or blocks of output. + Example: Electric prices in the US (reversely in Vietnam) ‘9 cents per kWh for the first 300 kWhs, 5 cents per kWh for the block 301 to 1,000, and 4 cents for each kWh over 1,000. A consumer using 1,200 kWhs will pay $70.00 = $0.09 x 300 + $0.05 700 + $0.04 = 200. A firm engaging in second-degree price discrimination faces a MR a curve that appears as a series of steps. The MR curve is a horizontal line corresponding to the price for that block of output. SS QsSecond-degree price discrimination MR each block equals price your charge for that block. Profit-maximizing output: go for each unit is P— ATC Smaller than first-degree price discrimination profit.Applying third-degree price discrimination + Partition the market into two or more different groups of consumers based upon different price elasticities of demand. + The differences in elasticity enable you to charge customers in each group purchasing the good different prices. + Groups possess different price elasticities of demand + Due to differences in income, tastes or availability of substitutes + Example: different prices for senior citizens, variation in airline ticket prices depending upon when the ticket is purchased, student discounts. + Steps: + Separate potential consumers into groups with different price elasticities of deman| + Determine quantity to sell to each group and the good’s price for each group a Sra YRS UfThird-degree price discrimination + To maximize profit: allocate output in order to satisfy 2 criteria + sell the quantity of output that results in the MR of the last unit sold to each group equal for all groups MR = MRy = MRz = ~- = MRy, + the MR of the last unit sold to any group must equal the MC of the last unit your firm produces MR = MC. + If MR isn't equal for all groups, you can increase profit by reallocating units of the good to the group that has the higher MR. + If MR is greater than marginal cost, you're able to increase profit by producing more units of output. QsThird-degree price discrimination $ mc" " | \mr, \ Go Group A Consumers a wo Group B Consumers Ww 7. |Active learning + Demand for your firm’s product for 2 different groups of customers + Py = 100 - 0.244 + Pp =80-0.1qp + Your firm’s total cost estimated: + TC = 14,000 + 5q + 0.05q? + Determine the price to charge each group of consumers, how much to sell each group of consumers + MRq = 100 —0.4qq + MRg = 80 -0.2qp + MC =5 +0144 + qs) + MRq = MRg = MC > qa = 150, gp = 200, Py = 70, Py = 60Pricing coupons + Coupons: effective way to price discriminate. + Customers who are very responsive to price changes — very elastic demand — ate likely to take time to find coupons that effectively lower the good’s price. + Customers less responsive to price changes because of their less elastic demand aren't as likely to take the time to find coupons. + Strategy: + Customers not using a coupon pay the price P + Customers using the coupon pay the price P-C ' + C represents coupon’s value. = QsPricing coupons + Profit-maximization rule: MR, = MRz = MC + Remember: 1 MR = P(L+— ¢ ? + Assume group A customers have less elastic demand than group B, then bsg )-¢-o(r+3) \ P(1+—)=(P-c)(1+—])=mc ' Na "NeActive learning + You own a restaurant at a vacation destination with two major groups of customers: + vacation travelers who must eat out and have a less elastic demand ny =-15 + local residents who can stay home and eat and thus have a more elastic demand for restaurant meals 7, = —3 + Your cost: + MC of providing a meal, including labor, ingredients, and so on, is $6.00 + Determine the price to charge for a meal & the coupon’s value.Active learning + Profit-maximization 1 p(142)=@-0(1+ MW, +P =18,C =9 + $18.00 for a meal + $9.00 coupons to local residents + Use advertising mailers delivered to local addresses or publish coupons \ in local newspapers to exclude vacation travelers. QRS aPerfecting price discrimination A pharmacy | go to has a nifty little card that gives me discounts when | use it to make purchases. The store scans the card with every purchase, collecting information on what products | buy. This information is used to determine my price elasticity of demand for products | purchase. It's also used to determine what products are complements or substitutes for the things | buy. Perhaps the most important use is to move toward perfect price discrimination. When my receipt prints out, it usually includes one or more coupons giving me price discounts on various items. Because the coupons appear on my receipt, coupons are tailored to individual customers for both the items and coupon amount, moving closer to. perfect price discrimination. . \ 5 —S te /, yf SY n>Making a Bundle through Bundling + Bundling: package two or more goods together and sell them as a single unit. + Firms use bundling to increase profit — make a bundle. + A fast food restaurant may bundle a sandwich, French fries, and soft drink, selling all three bundled together for a single price. + Increase profit by bundling goods that have large differences in the prices customers are willing to pay. + Reservation price: the price where the consumer is indifferent between purchasing the good or continuing to search for a lower > price. It is the maximum price the consumer is willing to pay.Making a Bundle through Bundling + Effective bundling: package goods that are negatively correlated across consumers + good A has a high reservation price, and good B has a low reservation price for some consumers, and reversely for others. + both sets of consumers purchase the bundle consisting of goods A and B. + all customers buy both goods instead of having only the consumers with high reservation prices buying the good. QsUsing pure bundling + Pure bundling: consumers can only purchase the goods together. It isn’t possible to purchase the goods separately. + Examples: + The entrée and side dish at restaurant can't be purchased separately. + Satellite and cable television: you can't pick and choose the channels you want; you must choose among the packages offered by the service + Microsoft office package: Word, Excel, Powerpoint QsUsing pure bundling $40.00 T A ' B gon $20.00 } -------- SSeeeeER58 ' Do! | ' \ | 0 $15.00 Reservation Price Software X + Assume 1,200 customers uniformly distributed over the range of possible reservation prices for both software + If you charge $20.00 for Software W and $15.00 for Software X + 300 customers purchase only W (block A) + 300 customers purchase only X (block C) + Customers in block B buy both W and X + Customers in block D buy nothing + Your total revenue when pricing each software program separately + Rw = 300 x 20 = 6,000 $30.00 - Ry = 300 x 15 = 4,500 300 x (20 + 15) = 10500 + Rwx + TR=Using pure bundling $40.00 er) Reservation Price g>mo9 | Software W T b i i i i i 1 + Py = 20,Py = 15 + Pure bundling: + Ps = $24 for a package containing both ‘Software W and Software X + If'a customer has reservation price of $22 for W and $46 for X: buy the bundle + If'a customer has reservation price of $48 for W and $10 for X: neither buy any program if sold separately but the bundle + This enables to sell pure bundle to customers who purchase nothing if th programs are priced separately $15.00 $24.00 $30.00 Total revenue: Reservation Price Software X TR = 912 x 24 = 21,800Allowing mixed bundling + Allows customers to purchase the goods either together as a bundle or separately. + Some customers purchase only a single item. + Their reservation price is greater than the actual price for one item + But they don’t buy the bundle because the difference between the bundle price and the price of the first item is less than their reservation price for the second item. + Remember: ; ‘Customers only add another good to the bundle if the actual price \ difference between the bundle and buying an item separately is less than the additional item’s reservation price.Allowing mixed bundling a + Pw = 20, Py = 15, Py = 24 + IfWTPy = 30,WTP, = 2:in comparison to buying W alone, Bundle you have to pay Py — Py more to have the bundle, higher than WTP, — not worth buying the bundle + IEWTPy, = 30, WTP, = 7: add $4 to buy the bundle is worthy $90.00 . TR = (80 x 20) + (135. x15) + Reservation Price 5.5 4 5 atone (745.5 x 24) = 21,517 Reservation Price Software W 2.00 $4.00 $15.00 te ys QNSThe War: Pricing for Business Battles + In the real world, businesses are always at war fighting battles with one another. + They compete for resources and customers + The wages one business pays for labor affect what other businesses have to pay, and the price one business charges its customers affects the price other businesses charge. + Three weapons that help you fight these battles.Penetration pricing: Here | come Firms use penetration pricing to quickly establish a large market share with a very low price. This is a useful strategy for a new firm entering a market. Effective penetration pricing requires a very elastic demand for the good, leads to a large increase in quantity demanded. Later, if successful in establishing customer loyalty, raise the price. Effective penetration price -> lower ATC if economies of scale: barrier to entry for other firms Penetration pricing is also used to sell complementary products. For example, low penetration price on a game console can lead to more sales of compatible games that have high mark-ups. QsPenetration pricing + Factors to consider: + Whether your firm is able to produce enough output to satisfy customers. Customers are likely to be dissatisfied with your out of product. + Price can't be associated with quality. Customers won't buy a low price product with poor quality. + Ifrivals meet the lower price you charge, the advantages of penetration pricing are negated. QsLimit pricing: Keep out Limit pricing is used to prevent other firms from entering the market by establishes a price below the profit-maximizing level Lower price > higher quantity demanded — little residual demand for anew firm Common at the early stage of a monopolistic market. The monopolist's positive economic profit attracts new firms + fnew firms enter the market, the existing firm's profit decreases or pethaps even disappears. + To discourage entry, the monopolist charges a lower price, attract more customers.| The potential demand for entering firm is decreasing and zero profit -> new firm has no incentive to enter the market, original firm succeeded in keeping rivals out 7. QRSLimit pricing + Initially: * qo Po + Keep rivals out: + Original firm: P, < P,41 > qo + Entering firm: dg = d — q, + tee, Pe) = 0 |Predatory pricing: Get out + Predatory pricing is used to drive existing rival firms out of a market by setting a price below its marginal cost. + After the rival leaves the market: raises price to increase its profit. + Trading a temporary short-run loss for higher future profit. + Need the correct assessment of the relative health of the predator and prey. + The predator is assuming that it's healthier than the prey and can withstand the temporary losses better than the prey. + If the predator is wrong in this assessment, predatory pricing can backfire and leave the predator vulnerable + Successful predators establish a reputation as tough/ruthless, rivals. This = reputation is likely to deter future entry so that you can realize additional benefitsPredator and prey: Which is which? A price war between the owner of the New York Central Railroad, Commodore Cornelius Vanderbilt, and the Erie Railroad’s owners, Jay Gould and Jim Fisk. The price war concerned eastbound livestock traffic between Buffalo and New York City and the normal freight rate $125 a carload. Vanderbilt initiated a price war by lowering the New York Central's rate to $100 carload Gould and Fisk responded by lowering the Erie Railroad's rate to $75. + Vanderbilt then reduced the New York Central's rate to $50, and Gould and Fisk dropped to $25. In a final effort to ruin the Erie Railroad's livestock trade, Vanderbilt set his rate at $1 per carload, and as a result, the New York Central cars were full while the Erie’s cars ran empty. NS SS Ss SY n>Predator and prey: Which is which? + However, as Vanderbilt enjoyed his victory, Gould and Fisk bought every steer in Buffalo and shipped them to New York via the Central. + Asa result, Gould and Fisk enjoyed great profit, while Vanderbilt and the New York Central carried their cattle at tremendous cost. Sometimes, the right price is as simple as the price associated with a mutually beneficial exchange. Both the customer and the firm are willing to buy and sell ~ at that price. But as a business manager, you want to find the price that maximizes profit — that is, your right price. —S Qs