1. Managerial Economics Some Final Thoughts
Aalto University
School of Science
Department of Industrial Engineering and Management
January 10 – 26, 2017
Dr. Arto Kovanen, Ph.D.
Visiting Lecturer

2. Importance of Pricing …
Pricing is often considered as one of the most important element in economics
This is why we study demand and cost theories
For managers, price is just one of many decisions
Pricing decisions are made in a broader context
Competitive Advantage provides a useful means of analyzing corporation’s success in a market
This involved analyzing corporation’s non-price decisions and explaining price decisions in this context

3. Competitive Advantage …
As we have discussed during this course, profitability of a firm depends in general on two factors:
Market conditions
Competitive advantage
Market conditions relate to external factors, as we have seen, not just for the firm, but for the industry
Industries’ profitability varies considerably
Banks and technology firms have done well
Traditional industries, such as steel and transportation, performed less well
Recall Porter’s paper on 5 forces shaping industries

4. Competitive Advantage (cont.)
As we have discussed, there are important external factors in play:
Internal competition between firms in a market
Restrictions for entry of new players in the market
Possible substitutes and complements
Pricing power of suppliers
Pricing power of buyers
Competitive advantage relates to internal factors and determine a firm’s ability to create more value than its competitors
These factors are within the control of the firm

5. Competitive Advantage (cont.)
A useful concept for this purpose is value creation where V = B – C
V = value created
B = perceived benefit to customers
C = cost of inputs
If we examine the standard supply – demand curves, we can identify consumer surplus (CS) and producer surplus (PS) where
CS = B – P
PS = P – C
Then V = CS + PS = (B – P) + (P – C) = B - C

6. Competitive Advantage (cont.)
An example illustrates this:
A consumer is prepared to pay $250 for a VCR whose price is $200; hence CS = $50
The marginal cost of producing a VCR is $130 and hence PS = $70
Consequently V = $50 + $70 = $120
If a firm has a competitive advantage, it is possible to make more profits than its competitors
This is not only limited to cost advantage (i.e., being able to produce at a lower cost), but also includes a benefit advantage

7. Competitive Advantage (cont.)
Cost advantage is obvious, but benefit advantage has to do with the ability to achieve higher perceived benefits to the consumer than the competitors, while maintaining a similar level of costs
Recall that we assumed earlier:
Firm produces a single product for a single market
Firm charges the same price throughout the market
Price is the only variable in the marketing mix
Pricing is considered from a static, single-period point of view

8. Competitive Advantage (cont.)
Positioning in the market is the most fundamental aspect of a firm’s marketing strategy
Cost advantage:
Object is to achieve lower cost while maintaining level of benefits (services) relative to competition
Examples: Woolworth, Wal-Mart and McDonalds
Cost advantage can be achieved through economies of scale, the learning curve, production efficiency, control over inputs (and their costs), and so on
Examples: Hyundai (lower cost production of adequate quality), British sport car (TVR; sharing of components, simplified production process, etc)

9. Competitive Advantage (cont.)
Benefit advantage:
Many car manufacturers pursue this strategy
BMW and Lexus (provide same level of technology and comfort than higher-priced competitors, but at a lower sticker price)
Porsche (higher price, but significantly greater quality)
Ferrari and Aston Martin (charge a very high price, but promise top line performance and quality)
There is also perceived value associated with the name (there are no substitutes for Ferrari, Aston Martin and Porsche), which means that customers are willing to pay a higher price for the product
Apple versus Samsung is a similar story

10. Competitive Advantage (cont.)
Benefit advantage can be achieved in a number of ways
Reputation counts for a large part in the luxury car market (e.g., German engineering, or in the 1970s it was common to hear that do not purchase British cars)
An issue to consider by a firm is how to distribute the competitive advantage between consumer / producer surplus
Cost advantage can be given to customers in the form of lower price
This might help increase market share and profits

11. Competitive Advantage (cont.)
This, however, depends:
On the price elasticity of the consumer demand (is the demand elastic or inelastic) and
How other producers in the market react (would they also lower their prices to protect market share even if that means lower profit margins)
Alternatively, the increased value can be translated to higher producer surplus and higher profit margin, as the company would charge the same price as others
In principle, the choice depends on the elasticity of the demand and whether this benefits the firm
The same applies to benefit advantages

12. Competitive Advantage (cont.)
Market segmentation and targeting consumer groups are important for companies
A market segment refers to a group of consumers in a broader market that have homogeneous features (for instance, income, age, location, lifestyle, and so on)
Firms use marketing to target specific groups:
For instance, adequate quality at reasonable prices (Wal-Mart, targeting consumers at lower income brackets)
Sport equipment (for young professionals)
Expensive, luxury cars (for wealthy)
Vacation packages
Pricing is an outcome of other strategic decision!

13. A Brief Review of the Course Material

14. Review of Material
In this course we have covered a broad range of issues related to decision-making in a company
We structured the course in the following way:
Decision-making within the firm:
Use of marginal analysis
Understanding production processes and marginal products
Understanding costs using marginal analysis
Understanding consumer demand
Some discussion and examples of empirical estimation of cost and demand functions

15. Review of Material The role of markets:
We discussed different market structures (basically ranging from a perfectly competitive market to a monopoly)
Although not necessarily realistic, they helped illustrate the key elements of the pricing behavior of a firm
We also discussed alternative strategies that have been developed to characterize interaction in a market where there are few players
We also discussed briefly:
The role of government in the market
Market failure and incomplete information, and
Issues with public goods

16. Review of Material Selected other issues useful for firms:
Linear optimization
Asymmetric information
Uncertainty and risk, and how it affects firm’s decision-making
And today we talked about the importance of utilizing firm’s competitive advantage in its pricing

17. Thank you!