Market Structure and Simple Pricing Strategies Learning Unit 4 Market Structure and Simple Pricing Strategies

MARKET STRUCTURE Perfect competition: When there are many firms that are small relative to the entire market and produce similar products Firms are price takers. Products are standardized (identical). There are no barriers to entry. There is no nonprice competition.

MARKET STRUCTURE Imperfect competition Firms have some degree of market power and can determine prices strategically. Products may not be standardized. Firms employ nonprice competition. Product differentiation Advertising Branding Public relations

MARKET STRUCTURE Monopolistic competition: When there are many firms and consumers, just as in perfect competition; however, each firm produces a product that is slightly different from the products produced by the other firms. There are no barriers to entry. Monopoly: Markets with a single seller Barriers to entry prevent competitors from entering the market. Oligopoly: Markets with a few sellers There are significant barriers to entry.

MARKET STRUCTURE Barriers to entry Barriers that determine how easily firms can enter an industry, depending on the market structure

MARKET PRICE IN PERFECT COMPETITION Market price is determined by the intersection of the market demand curve and the market supply curve.

MARKET PRICE IN PERFECT COMPETITION Example Demand: P = 22 - 0.5QD Supply: P = 4 + 0.25QS Equilibrium: P = $10 and Q = 24 thousand units If there are 1,000 firms in the market, each produces twenty-four units. If one firm alters output, there will be virtually no effect on market price, so each firm faces a nearly horizontal demand curve.

SHIFTS IN SUPPLY AND DEMAND CURVES It is important for managers to understand the factors that cause supply and demand curves to shift. Advances in technology cause supply to increase. Increasing input prices cause supply to decrease.

THE OUTPUT DECISION OF A PERFECTLY COMPETITIVE FIRM Profit maximization example Market price (P) = $10 Total revenue (TR) = PQ Total cost (TC) = 1 + 2Q +Q2 Profit () = PQ – TC = 10Q – (1 + 2Q + Q2) Table 6.2: Cost and Revenues of a Perfectly Competitive Firm Figure 6.2: Relationship between Total Cost and Total Revenue of a Perfectly Competitive Firm Figure 6.3: Relationship of Profit and Output of a Perfectly Competitive Firm

THE OUTPUT DECISION OF A PERFECTLY COMPETITIVE FIRM Profit is maximized at the quantity of output (Q) where marginal revenue equals marginal cost and marginal cost is increasing /Q = TR/Q – TC/Q = 0 Marginal revenue (MR) = TR/Q = P Marginal cost (MC) = TC/Q

THE OUTPUT DECISION OF A PERFECTLY COMPETITIVE FIRM Profit maximization example continued MR = 10 MC = 2 + 2Q MR = MC => Q = 4 Table 6.3: Marginal Revenue and Marginal Cost: Perfectly Competitive Firm Figure 6.4: Marginal Revenue and Marginal Cost of a Perfectly Competitive Firm

SETTING THE MANAGERIAL COST EQUAL TO THE PRICE Shutdown point: When the price equals the minimum average variable cost If price is greater than average variable cost, produce a level of output in which marginal cost is equal to price, even if this results in negative profit. Profit will exceed that which would result from shutting down.

SETTING THE MANAGERIAL COST EQUAL TO THE PRICE Shutdown point: When the price equals the minimum average variable cost (Continued) If price is less than average variable cost, shut down and produce no output. Negative profit will be equal to total fixed costs. Figure 6.5: Short-Run Average and Marginal Cost Curves

ANOTHER WAY OF VIEWING THE PRICE EQUALS MARGINAL COST PROFIT-MAXIMIZING RULE If a firm has one fixed input (say capital) and one variable input (say labor, L), how much of its variable input should it utilize? Marginal revenue product (MRP): The amount an additional unit of the variable input adds to the firm's total revenue Marginal revenue product of labor = MRPL MRPL = TR/L = (TR/Q)(Q/L) = (MR)(MPL)

ANOTHER WAY OF VIEWING THE PRICE EQUALS MARGINAL COST PROFIT-MAXIMIZING RULE Marginal expenditure on labor (MEL): The amount an additional unit of labor adds to the firm's total costs MEL = TC/L = (TC/Q)(Q/L) = (MC)(MPL) Profit is maximized when the employment of the variable input is such that marginal revenue product is equal to marginal expenditure. Equivalent to MR = MC in terms of output.

PRODUCER SURPLUS IN THE SHORT RUN Producer surplus: The difference between the market price and the price the producer is willing to receive for a good or service (the producer's reservation price) A firm's reservation price is the marginal cost of production above the shutdown point. Producer surplus is a firm's variable cost profit: TR – TVC. Producer surplus is the difference between a firm's supply curve and the market price under perfect competition.

PRODUCER SURPLUS IN THE SHORT RUN Examples Figure 6.6: Producer Surplus and Variable-Cost Profit Figure 6.7: Market Social Welfare (A + B) of a Perfectly Competitive Price Policy, P*

LONG-RUN EQUILIBRIUM OF A PERFECTLY COMPETITIVE FIRM Conditions Quantity produced is such that profit is equal to zero and price is equal to The lowest point on the long-run average (total) cost curve and the relevant short-run total cost curve Long-run marginal cost and short-run marginal cost

LONG-RUN EQUILIBRIUM OF A PERFECTLY COMPETITIVE FIRM Adjustment to equilibrium If firms are earning negative profits, then firms will exit the industry, market supply will decrease, and price will rise to the long-run equilibrium level. If firms are earning positive profits, then firms will enter the industry, market supply will increase, and price will fall to the long-run equilibrium level.

THE LONG-RUN ADJUSTMENT PROCESS: A CONSTANT-COST INDUSTRY Constant-cost industry: An industry in which an increase in output does not lead to an increase in input prices Horizontal long-run supply curve Figure 6.9: Long-Run Equilibrium in a Constant-Cost Industry

THE LONG-RUN ADJUSTMENT PROCESS: AN INCREASING-COST INDUSTRY Increasing-cost industry: An industry in which an increase in output leads to an increase in input prices Upward-sloping long-run supply curve Some industries are decreasing-cost industries. Downward-sloping long-run supply curves Figure 6.10: Long-Run Equilibrium in an Increasing-Cost Industry

HOW A PERFECTLY COMPETITIVE ECONOMY ALLOCATES RESOURCES Example: Demand for corn increases and demand for rice decreases. Short-run equilibrium The price of corn will increase, the quantity of corn produced will increase, and corn producers will earn positive economic profits. The price of rice will decrease, the quantity of rice produced will decrease, and rice producers will earn negative economic profits.

HOW A PERFECTLY COMPETITIVE ECONOMY ALLOCATES RESOURCES Example (Continued) Long-run equilibrium Firms will reallocate resources away from the production of rice and toward the production of corn. The price of corn will decrease from its high, the quantity of corn produced will increase further, and corn producers will find that their economic profits decline to zero. The price of rice will increase from its low, the quantity of rice produced will increase from its low, and rice producers will find that their economic profits rise to zero.

PRICING AND OUTPUT DECISIONS IN MONOPOLY Example Demand: P = 10 – Q Total revenue: TR = PQ = 10Q – Q2 Marginal revenue: MR = 10 – 2Q Total cost: TC = 1 + Q + 0.5Q2 Marginal cost: MC = 1 + Q MR = 10 – 2Q = 1 + Q = MC => Q = 3 P = 10 – 3 = 7 Profit = Q(P – ATC)

PRICING AND OUTPUT DECISIONS IN MONOPOLY Marginal revenue Unlike perfect competition, MR is less than price and depends on Q. MR = P[1 + (1/)] = P[1 – (1/||)] = P – P/||

PRICING AND OUTPUT DECISIONS IN MONOPOLY MR = P[1 + (1/)] = P[1 – (1/||)] = P – P/|| (Continued) A profit-maximizing monopolist will not produce where demand is inelastic; that is, where || < 1, because MR < 0. MC = MR = P[1 – (1/||)]; so the profit-maximizing price is

COST-PLUS PRICING Cost-plus pricing: Simplistic strategy that guarantees that price is higher than the estimated average cost Studies of pricing behavior suggest that many managers who use cost-plus pricing do not price optimally. Markup = (Price – Cost)/Cost Price = (Cost)(1 + Markup) Example: Price = 6, Cost = 4, Markup = 0.50

COST-PLUS PRICING Profit margin: The price of a product minus its cost Profit margin = Price – Cost

COST-PLUS PRICING Target Return: What managers hope to earn and what determines the markup P = L + M + K + (F/Q) + (A/Q) L = unit labor cost M = unit material cost K = unit marketing cost F = total fixed costs Q = units to produce A = gross operating assets  = desired profit rate (%)

COST-PLUS PRICING Allocation of indirect cost among products Often done on the basis of average variable costs Example Indirect costs = $3 million Variable costs = $2 million Indirect cost allocation = 3/2 = 150 percent of variable cost. If a product's variable cost is $10, then the allocated indirect cost is ($10)(1.5) = $15. If there is a 40 percent markup, then the product price is ($10 + $15)(1.4) = $25.

COST-PLUS PRICING AT THERMA-STENT Factory cost = $2,300 Markup = 40% = $920 Price = $3,220

COST-PLUS PRICING AT THERMA-STENT Cost-plus pricing is widely used in medical group purchasing organizations. Factory cost = $2,300 40 percent Markup = $920 Price = $3,220 Using the heuristic eases the complexity of setting price by ignoring market considerations.

COST-PLUS PRICING AT INTERNET COMPANIES AND GOVERNMENT-REGULATED INDUSTRIES Cost-plus pricing is used often used by Internet companies and government-regulated industries. The danger of such a pricing scheme in a government-controlled industry is that, when the profit is guaranteed, firm managers may lose the incentive to be cost efficient.

CAN COST-PLUS PRICING MAXIMIZE PROFIT? Optimal markup = 1/(|| - 1) Optimal markup is higher is demand is less elastic Table 7.3: Relationship between Optimal Markup and Price Elasticity of Demand

THE MULTIPLE-PRODUCT FIRM: DEMAND INTERRELATIONSHIPS Multiple-product firm (Good X and Good Y) Total revenue = TR = TRX + TRY MRX = TR/QX = TRX/QX + TRY/QX MRY = TR/QY = TRX/QY + TRY/QY If the two goods are substitutes, then TRX/QY and TRY/QX are negative. If the two goods are complements, then TRX/QY and TRY/QX are positive.

THE MULTIPLE-PRODUCT FIRM: DEMAND INTERRELATIONSHIPS Pricing of Joint Products: Fixed Proportions Total marginal revenue curve: The vertical summation of the two marginal revenue curves for individual products Figure 7.5: Optimal Pricing for Joint Products Produced in Fixed Proportions (Case 1) Marginal revenue of both products is positive at the optimal level of output.

THE MULTIPLE-PRODUCT FIRM: DEMAND INTERRELATIONSHIPS Figure 7.6: Optimal Pricing for Joint Products Produced in Fixed Proportions (Case 2) The marginal revenue of one product is negative at the optimal level of output. If a product's marginal revenue is negative, then the firm will dispose of a quantity sufficient to bring marginal revenue to zero and thereby maximize revenue on that product.

THE MULTIPLE-PRODUCT FIRM: DEMAND INTERRELATIONSHIPS Output of Joint Products: Variable Proportions Isocost curve: Curve showing the amounts of goods produced at the same total cost. Isorevenue lines: Lines showing the combinations of output of products that yield the same total revenue.

THE MULTIPLE-PRODUCT FIRM: DEMAND INTERRELATIONSHIPS Output of Joint Products: Variable Proportions (Continued) Optimal combinations of goods are found where isocost and isorevenue lines are tangent. Optimal total production is found where profit is maximized, which occurs at a point of tangency where the difference between cost and revenue is maximized.

MONOPSONY Monopsony: Markets that consist of a single buyer Contrast with monopoly markets that consist of a single seller Buyers on a competitive market face a horizontal supply curve; they are price takers.

MONOPSONY Monopsony: Markets that consist of a single buyer (Continued) There is only one buyer on a monopsony market, and this buyer faces the upward-sloping market supply curve, which means that marginal cost is above the supply price. Under monopsony, the buyer will purchase a quantity where marginal cost is equal to marginal revenue product and pay a price below marginal cost.

MONOPSONY Example: Monopsony labor market Labor supply: P = c + eQ Total cost: C = PQ = (c + eQ)Q Marginal cost: C/Q = c + 2eQ = MC Figure 7.8: Optimal Monopsony Pricing The wage (P) and quantity hired (Q) are both less than at the competitive equilibrium

MONOPOLISTIC COMPETITION Characteristics of monopolistic competition Product differentiation—products are not perceived as identical by consumers Managers have some pricing discretion, but because products are similar, price differences a relatively small. Competition takes place within a product group. Product group: Group of firms that produce similar products

MONOPOLISTIC COMPETITION Conditions that must be met, in addition to product differentiation, to define a product group as monopolistically competitive There must be many firms in the product group. The number of firms in the product group must be large enough that each firm expects its actions to go unheeded by its rivals and unimpeded by possible retaliatory moves on their part.

MONOPOLISTIC COMPETITION Conditions that must be met, in addition to product differentiation, to define a product group as monopolistically competitive (Continued) Entry into the product group must be relatively easy, and there must be no collusion, such as price fixing or market sharing, among managers in the product group.

MONOPOLISTIC COMPETITION Price and Output Decisions under Monopolistic Competition Figure 7.9: Short-Run Equilibrium in Monopolistic Competition. Identical to short-run equilibrium under monopoly Figure 7.10: Long-Run Equilibrium in Monopolistic Competition Entry and exit of firms from the product group shifts individual firms' demand curves. Long-run equilibrium occurs where profit is equal to zero.

ADVERTISING EXPENDITURES: A SIMPLE RULE How much should a profit-maximizing manager spend on advertising? Assume diminishing returns to advertising expenditures Assume that quantity demanded depends only on price and advertising expenditures Table 7.4: Relationship Between Advertising Expenditures and Quantity Illustrates diminishing marginal returns (see below) between advertising expenditures (A) and quantity demanded (Q)

ADVERTISING EXPENDITURES: A SIMPLE RULE Derivation Net profit = P – MC (omitting advertising expenditures) Advertising expenditures are optimal if the increase in net profit from an additional dollar spent on advertising is equal to one dollar.

ADVERTISING EXPENDITURES: A SIMPLE RULE Derivation (Continued) If Q is defined as the number of extra units sold as a result of an additional dollar of advertising expenditures, then advertising expenditures are optimal when Q(P – MC) = 1 The above implies that the marginal revenue from an extra dollar of advertising = || when advertising expenditures are optimal. Managers should therefore increase advertising expenditures until this condition is reached.

USING GRAPHS TO HELP DETERMINE ADVERTISING EXPENDITURE Figure 7.11: Optimal Advertising Expenditure Curve A: Relationship between advertising expenditures and the absolute value of the price elasticity of demand—higher expenditures cause demand to become less elastic. Curve B: Relationship between marginal revenue from an extra dollar of advertising expenditures and total advertising expenditures

USING GRAPHS TO HELP DETERMINE ADVERTISING EXPENDITURE Figure 7.11: Optimal Advertising Expenditure (Continued) The intersection between Curve A and Curve B defines the optimal level of advertising expenditures. Curve B' represents a shift in Curve B due to increasing advertising effectiveness. It results in an increase in advertising expenditures.

ADVERTISING, PRICE ELASTICITY, AND BRAND EQUITY: EVIDENCE ON MANAGERIAL BEHAVIOR Promotions Appeal to price sensitivity Price-oriented message Attempt to erode brand loyalty Attempt to increase price elasticity and limit the premiums consumers are willing to pay for brand-name products

ADVERTISING, PRICE ELASTICITY, AND BRAND EQUITY: EVIDENCE ON MANAGERIAL BEHAVIOR Attempts to build brand loyalty Loyalty is measured as the frequency of repeat purchases Product-quality oriented message

ADVERTISING, PRICE ELASTICITY, AND BRAND EQUITY: EVIDENCE ON MANAGERIAL BEHAVIOR Promotions do increase the price elasticities of consumers. Promotions have less effect on brand loyalists. The effects of promotions decay over time. Price elasticity of non-loyalists was found to be four times that of loyalists in one study. The effects of advertising on brand loyalty erode over time and price becomes more important to consumers.