# Market Structures and Pricing sample essay

Market structures and pricing

Revenues

Consumers

* 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

Strategies

* 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.

Monopoly

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

Revenues

* 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?

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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