PRICING WITH MARKET POWER

PRICING OBJECTIVE

Market Power: When a firm has market power, it means that it has the ability to influence prices
in the market. This happens when the firm faces a demand curve that slopes downward. In other
words, the firm can raise prices without losing all its customers to competitors.

Objective of Pricing: The main goal of a firm with market power is to choose a pricing strategy
that maximizes its overall value. Usually, managers aim to maximize profits over a single period,
although the ideal objective is to maximize the present value of all future profits.

Demand Curve: The demand curve represents what consumers are willing to pay for a product. In
most cases, it is not in the firm's best interest to sell a product below its marginal cost because they
can do better by not producing the product at all. The maximum potential gains from trade are
represented by the shaded triangle. If the firm sells the product at marginal cost, all the gains go to
consumers in the form of consumer surplus.

Consumer Surplus: Consumer surplus is the difference between what a consumer is willing to pay
for a product and what they actually pay when purchasing it. Profit-maximizing managers try to
develop pricing policies that capture as much of the available gains from trade as possible. Ideally,
they would want to capture all the potential consumer surplus as company profit.

Benchmark Pricing: We start by looking at a scenario where the firm charges the same price to all
customers. In this case, the firm captures some, but not all, of the potential gains from trade. This
scenario was discussed in previous chapters. Later, we explore more complex pricing strategies.

By understanding these concepts, we can gain useful insights into pricing decisions and how firms
aim to maximize their profits or overall value.

Demand Curve: The demand curve shows what consumers are willing to pay for a product. It's
important because it helps firms understand how much people value their product.

Selling Below Marginal Cost: Firms usually shouldn't sell a product for less than what it costs to
produce. It's not a good strategy because they would be better off not producing the product at all.
Maximum Gains from Trade: The shaded triangle represents the highest potential gains a firm can
achieve through trade. These gains come from pricing the product in a way that captures as much
value as possible from consumers.

Firm's Objective: The firm's main goal is to choose a pricing strategy that allows them to maximize
their share of the gains from trade. In other words, they want to capture as much profit as they can
by finding the right price for their product.

By understanding the demand curve and avoiding selling below cost, firms can strive to maximize
their profit by selecting a pricing policy that allows them to capture a significant portion of the
potential gains from trade.

BENCHMARK CASE: SINGLE PRICE PER UNIT

PROFIT MAXIMIZATION

Scenario: Imagine a company called Intuit that sells a software product called Checkware. Intuit
pays $10 in royalties per copy to the software developer. The company wants to decide on the
price to charge for the software. All customers will buy the software at this price, regardless of the
quantity they purchase. The demand curve, which shows the relationship between price and
quantity demanded, is given as P = 85 - 0.5Q, where P is the price and Q is the quantity (in
thousands of copies).

Maximizing Profits: To maximize profits, Intuit needs to find the right price and quantity
combination. Chapter 6 explains that profits are maximized when the marginal revenue (change in
revenue from selling one additional unit) equals the marginal cost (incremental cost of producing
one additional unit). In this case, the marginal revenue is 85 - Q, and the marginal cost is $10. By
equating these, we find that the optimal quantity is 75,000 copies and the price is $47.50. With this
pricing strategy, Intuit can maximize its profits, which would be $2,812,500.
Simplifications: It's important to note that this analysis simplifies the pricing problem in a few
ways. First, it assumes that all customers are charged the same unit price, regardless of the quantity
they purchase. More complex pricing strategies are not considered here. Second, the company sells
only one product, so interactions between different products are not taken into account. Third, the
demand curve represents a single period, focusing on maximizing profits within that period and
not considering long-term effects on demand or costs. Finally, the demand curve assumes that the
prices of competing products remain constant, regardless of the price set by Intuit. In reality,
pricing decisions of other companies in the industry may interact with Intuit's pricing decisions.
These assumptions are important to consider, and we'll explore their implications later in the
chapter.

By understanding these concepts and finding the optimal price and quantity combination, Intuit
can aim to maximize its profits.

Relevant Costs: When making pricing decisions, managers should focus on relevant costs, not
sunk costs. Sunk costs, like past investments or expenditures, are not relevant because they can't
be changed. Only incremental costs, which are the additional costs incurred by producing and
selling one more unit, matter for pricing decisions. For example, if Intuit spent $100,000 on
website development and promotion in the past, that cost is sunk and should not affect their current
pricing decisions.

Opportunity Costs: Managers should consider opportunity costs rather than accounting costs.
Opportunity cost refers to the value of the next best alternative foregone. For example, if Intuit has
Checkware packages in inventory that were purchased for $18 per copy, that historical cost is not
relevant for pricing decisions. What matters is the current cost of replacing the inventory, which
is $10 per copy.
Price Sensitivity: Price elasticity is a measure of how sensitive the quantity demanded is to changes
in price. The higher the price elasticity, the more responsive customers are to price changes. The
monopolist's optimal pricing policy, which sets marginal revenue equal to marginal cost, can be
expressed as P* = MC*/[1 - 1/n*]. Here, P* is the profit-maximizing price, MC* is the marginal
cost, and n* is the elasticity of demand at the optimal output level.

Example of Economic Profit: Suppose Intuit sells a package for $16, but it originally cost them
$18. Based on accounting, they would report a loss of $2. However, if Intuit needs to replace the
unit in inventory for $10, the economic profit would actually be $6. This is because the wholesale
price fell from $18 to $10, resulting in a loss of $8 per unit in inventory.

By considering relevant costs, opportunity costs, and price sensitivity, managers can make
informed pricing decisions to maximize profits. It's important to focus on the costs and factors that
directly impact the current pricing situation, rather than past or irrelevant costs.

Elasticity of Demand: The elasticity of demand measures how responsive the quantity demanded
is to changes in price. It ranges from 0 (totally inelastic) to ∞ (infinitely elastic). Market power,
which is the ability to influence prices, decreases as demand becomes more elastic (higher
elasticity) at the optimal price.

Inelastic Portion of Demand Curve: No firm should operate on the inelastic portion of its demand
curve (n < 1). This means that the profit-maximizing price should not be on the inelastic portion.
If it were, increasing the price would result in higher total revenue due to inelastic demand.
However, with fewer units sold and reduced production costs, profits would increase, contradicting
the assumption of maximum profit. Therefore, the optimal price (P*) must lie on the elastic portion
of the demand curve, ensuring n* > 1 and the optimal price is greater than marginal cost.

Market Power and Elasticity: If a firm has substantial market power, its demand will be less elastic
at the optimal price, resulting in a high markup (difference between price and marginal cost).
Conversely, if a firm has limited market power (many substitutes available), elasticity will be high,
and the markup will be low.

Checkware Example: In the Checkware example, the markup is $37.50 ($47.50 - $10). The
elasticity at the optimal price and quantity combination is 1.27. This means that demand is
relatively elastic. In comparison, a different software product called Illustrator has a more elastic
demand curve, with an optimal output and price of 65,000 and $26.25, respectively. The elasticity
at this combination is 1.62, and the corresponding markup is lower at $16.25.

Estimating the Profit-Maximizing Price:

In theory, managers should set their prices so that marginal revenue equals marginal cost to
maximize profits. However, in practice, managers often lack precise information about their
demand curves and marginal revenue. To overcome this, they can use approximations like cost-
plus or markup pricing as rules of thumb when better information is unavailable.

Linear Approximation:

One method to estimate the demand curve with limited information is the linear approximation.
Let's consider an example with Intuit's pricing manager, Sally McGraw. Suppose Sally is currently
pricing the product at $70 and selling 30,000 units. She estimates that if she lowers the price by
$5 to $65, she will sell 40,000 units. Using these two points, she assumes a linear demand curve
and solves for it. The estimated slope of the line is -0.5, and the intercept is 85. Hence, the estimated
demand curve is P = 85 - 0.5Q. With this estimated demand curve and a known marginal cost of
$10, Sally can determine the "optimal" price.

Cost-Plus Pricing:

Cost-plus pricing is a common method used by firms. It involves calculating the average total cost
and adding a markup to achieve a target rate of return. For example, if a product's cost is $50 and
the firm wants a 20% return, the price would be set at $60 ($50 + 20% markup).

By using techniques like linear approximation and cost-plus pricing, managers can make pricing
decisions even when precise demand curve information is unavailable. These methods provide
useful approximations to help guide pricing strategies and maximize profits.