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Market Structures and Pricing sample essay

Market structures and pricing

* Inverse demand curve gives willingness-to-pay
* Benefit consumer(s) derive(s) from additional good;
* Area under inverse demand curve measures total willingness-to-pay, total benefit or total surplus. * Maximum price I can charge as producer determined by inverse demand function * Marginal revenues; revenue of next unit I sell

* Profit maximization
* Marginal profits equal to 0 (MR=MC)
* Classic economic theory; entrepreneurial capitalism
* Owner makes strategic decisions
* Managerial capitalism;
* Ownership changed
* Control changed
* Potential conflicts between shareholders and management * Firms got bigger: coordinate difficulties
* Revenues maximization
* 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
* Managerial utility maximization
* Managers maximize own satisfaction
* Growth maximization
* Long term strategy
* Behavioral theories
* Different groups, satisfy all groups to survive: satisfying * Altruistic objectives: public interest
* Welfare maximization
* What strategy is relevant?
* Autonomy and income advancement
* Successful business is most important personal objective * Growth objective
* Profit maximization
* Model
* Economic profit ≠ accounting profit

Market structures
* Perfect competition
* Monopolistic competition
* Oligopoly
* Monopoly

Perfect competition
* Many (small) suppliers and buyers: ‘price takes’
* Demand function for individual company
* Products are perfect substitutes
* Free entry and exit
* Information is perfect (available to all no cost)
* Free movement of products: supply responsive to market forces * Innovation exogenous: producers reactive rather than proactive.

* Benchmark: Welfare is maximized (p=mc)
* Efficiency
* Productive efficiency: AC cannot be lower
* MC curve passes though 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.

One seller; can influence price (output)
Price > marginal cost: economic inefficiency (although the firm itself may be
efficient) * Barriers to entry
* Initial costs
* Sunk costs
* Brand loyalty
* Economies of scale
* Patents and licenses
* Anti-competitive behavior

* Demand: Q
* Inverse demand: P=a/b-1/b*Q
* Revenues: R = P*Q = Q*a/b-1/b*Q₂
* Marginal revenue: ∂R/∂Q
* Additional revenues from next unit sold
* ∂R/∂Q = a/b-2/b*Q
* Twice as steep as inverse demand
* Positive if εр < -1 * Demand is elastic (point-elastic) Natural monopoly * Market can only sustain 1 producer * Competition (P=MC): all competitors make a loss * P>MC: loss when P 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)

Oligopoly: non-corporate behavior
* Competition based on output (quantity) or price.
* Two basic oligopoly models:
* Cournot (quantity competition)
* Bertrand (price competition)
* Cournot: firms determine output simultaneously, and the bring this to the market; * Bertrand: firms announce prices. Demand is allocated to low-price firm(s), who then produce(s) demand

Cournot competition
* Assumes that firms produce identical products
* Demand: Q=a-b*P
* Inverse 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 to monopolists), taking the competitors action as given. * 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 Q1 and Q2
* Similar expression for company 2

* MR1: ∂R1/∂Q1 =
* P*∂Q1/∂Q1 + Q1*∂P/∂Q1
* P + ∂P/∂Q1*Q1
* 1 + (∂P/∂Q1*Q1/P)*P
* (1+1/εp)*P
* MR1=MC1: (1+1/εp)*P=MC1
* P=MC1/(1+1/εp)
* Cournot oligopolist sets price above MC!
* –Same for monopoly

Bertrand oligopoly
* Price competition (again assume identical goods)
* Firms announce prices. Demand is allocated to low-price firm(s), who then produces demand. * If a firm sets above its competitor’s price, clients will prefer the competitors (identical goods). * Bertrand equilibrium is therefore equivalent to competitive equilibrium: price equals marginal cost.

Price discrimination
* Conditions:
* Market power
* Different groups of consumers (based on willingness-to-pay, demand elasticity etc.) -> segmentation * Resale is not possible
* Cost of discrimination may not exceed additional profits * Market should be transparent.
* Charge different (groups of) consumers different prices to maximize profits -> price discrimination * First, second and third degree

First degree pricing discrimination
* Perfect discrimination: each unit of output sold at different price; * Price determined by inverse demand curve;
* What is the optimal output?

Second degree price discrimination
* Non-linear pricing: price depends on how much you buy;
* Fundamentals;
* Application;
* 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
* Benefits 1 (X1)-R1> benefits1 (X2)-r2
* Benefits 2 (X2)-R2> benefits2 (X2)-r1
* Consider an individual demand function (for convenience, marginal costs are 0) * Monopolists want to supply X1 at a total price of A

* Consider two individual demand functions
* Monopolist would like to supply X1 at A+B+C and X2 at A

* But: if consumer 1 also purchase X2 at a price of A, he/she will get surplus B (self selection) * If the monopolists would charge A+C for X1, consumer 1 gets surplus B and the monopolist higher profits. Can the
monopolist get higher profits? * Make X2 unattractive for consumer 1`

* Offering less of X2 (loss of monopolist) allows for higher profits from X1.

Third degree price discrimination
* Set prices for different groups of consumers: examples?

* 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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