Economics of the Firm

Economics of the Firm Competitive Pricing Techniques

When making pricing decisions, you need to be aware of what your market structure is Market Structure Spectrum Monopoly Perfect Competition The market is supplied by many producers – each with zero market share One Producer With 100% market share Firm Level Demand DOES NOT equal industry demand Firm Level Demand EQUALS industry demand

Recall the characteristics we laid out for a competitive market #1: Many buyers and sellers – no individual buyer/firm has any real market power #2: Homogeneous products – no variation in product across firms #3: No barriers to entry – it’s costless for new firms to enter the marketplace #4: Perfect information – prices and quality of products are assumed to be known to all producers/consumers #5: No Externalities –ALL costs/benefits of the product are absorbed by the consumer #6: Transactions are costless – buyers and sellers incur no costs in an exchange Can you think of situations where all these assumptions hold?

Measuring Market Structure – Concentration Ratios Suppose that we take all the firms in an industry and ranked them by size. Then calculate the cumulative market share of the n largest firms. Cumulative Market Share 100 A C 80 B 40 20 # of Firms 0 0 1 2 3 4 5 6 7 10 20

Measuring Market Structure – Concentration Ratios Cumulative Market Share 100 A C 80 B 40 20 # of Firms 0 0 1 2 3 4 5 6 7 10 20 Measures the cumulative market share of the top four firms

Concentration Ratios in US manufacturing; 1947 - 1997 Aggregate manufacturing in the US hasn’t really changed since WWII

Measuring Market Structure: The Herfindahl-Hirschman Index (HHI) = Market share of firm i HHI = 2,000

The HHI index penalizes a small number of total firms Cumulative Market Share 100 A 80 HHI = 500 B HHI = 1,000 40 20 0 0 1 2 3 4 5 6 7 10 20

The HHI index also penalizes an unequal distribution of firms Cumulative Market Share 100 80 HHI = 500 HHI = 555 A 40 B 20 0 0 1 2 3 4 5 6 7 10 20

Concentration Ratios in For Selected Industries

Recall that in a perfectly competitive world, price equals marginal revenue Individual Market Dollars Dollars Supply MC 1.44* MR $1.44* Demand 0 400 0 400,000* The market determines the equilibrium price of $1.44 and 400,000 fish sold by the 1,000 fishermen At the prevailing market price of $1.44, each fisherman supplies 400 fish

In a monopolized market, the single firm in the market faces the industry demand curve Individual Market Dollars Dollars MC 1.44* $1.44* Demand Demand 0 400,000 0 400,000* 400,000 fish are sold at a market price of $1.44 The single firm in the market has chosen that price of $1.44 based off of industry demand

We will be assuming that pricing decisions are being made to maximize current period profits Total Costs (note that total costs here are economic costs. That is, we have already included a reasonable rate of return on invested capital given the risk in the industry) Profits Total Revenues equal price times quantity

As with any economic decision, profit maximization involves evaluating every potential sale at the margin How do my costs change if I increase my sales by 1? (Marginal Costs) How do my profits change if I increase my sales by 1? How do my revenues change if I increase my sales by 1? (Marginal Revenues)

In a world where firms have market power, they control their level of sales by setting their price. Suppose that you have the following demand curve (A relationship between price and quantity): Your listed price Total Sales For example: If you were to set a price of $20, you can expect 60 sales

We could also talk about inverse demand (a relationship between quantity and price): Your target for sales A price that will hit that target For example: If you wanted to make 40 sales, you could set a $30 price

Either way, if we know price and total sales, we can calculate revenues Total Revenues = Price*Quantity Total Revenues =($30)(40) = $1200 Can we increase revenues past $1200 and, if so, how?

Either way, if we know price and total sales, we can calculate revenues Total Revenues =($35)(30) = $1050 Total Revenues =($25)(50) = $1250 Turns out lowering price was the right thing to do to raise revenues.

Initially, you have chosen a price (P) to charge and are making Q sales. Total Revenues = PQ D Suppose that you want to increase your sales. What do you need to do?

Your demand curve will tell you how much you need to lower your price to reach one more customer This area represents the revenues that you lose because you have to lower your price to existing customers This area represents the revenues that you gain from attracting a new customer D

Your demand curve will tell you how much you need to lower your price to reach one more customer Revenues =($30)(40) = $1200 • $29.50 From additional sale • $20 loss from lowering price • $9.50 increase in revenues ($.50)(40) =$20 Revenues =($29.50)(41) = $1209.50 ($29.50)(1) =$29.50 D

Demand curves slope downwards – this reflects the negative relationship between price and quantity. Elasticity of Demand measures this effect quantitatively Price $2.75 $2.50 Quantity 4 5

Note that elasticities vary along a linear demand curve Price $35 $20 Quantity 80 30 60

Let’s calculate the elasticity of demand at a quantity of 40 (a.k.a. a price of $30) At a quantity of 40, the elasticity of demand is bigger that 1 in absolute value

Let’s calculate the elasticity of demand at a quantity of 40 (a.k.a. a price of $30) If I want to increase my sales target, I need to lower my price to all my existing customers Total Revenues =($30)(40) = $1200 Total Revenues =($29.50)(41) = $1209.5 % Change in revenues = .80%

An elasticity of demand that is greater than 1 in absolute value indicates that lowering price will increase revenues .80% -1.70% 2.5% Total Revenues =($30)(40) = $1200 Total Revenues =($29.50)(41) = $1209.5 % Change in revenues = .80%

An elasticity of demand that is less than 1 in absolute value indicates that raising price will increase revenues 3.75% 5.00% -1.25% % Change in revenues = 3 .75% Total Revenues =($10.50)(79) = $829.50 Total Revenues =($10)(80) = $800

Revenues are maximized when the elasticity of demand equals -1 Elasticity is less than -1: raise price Elasticity is greater than -1: lower price Quantity = 50 Price =$25 Elasticity = -1 Max Revenues Quantity = 50 Price =$25 Revenues = $1,250

Because you must lower your price to existing customers to attract new customers, marginal revenue will always be less than price Q = 40 P = $30 Revenues = ($30)(40) = $1200 Q = 41 P = $29.50 Revenues = ($29.50)(41) = $1209.50 P = $30 Marginal Revenues = $9.50 MR = $9.50 P MR

Note that because we have ignored the cost side, we are assuming marginal costs are equal to zero! Revenues = $1250 P = $25 P MR = MC = $0 MR

Now, let’s bring in the cost side. For simplicity, lets assume that you face a constant marginal cost equal to $20 per unit. Continuing on down…

A profit maximizing price sets marginal revenue equal to marginal cost. Marginal revenue is the change in total revenue (i.e. the slope) Slope = 20 Profits = $450

A profit maximizing price sets marginal revenue equal to marginal cost Price = $35 Quantity = 30 Elasticity = -2.36 P = $35 Profit = ($35-$20)*30 = $450 This is not a coincidence. A monopoly sets a markup that is inversely proportional to the elasticity of demand!

Markups for Selected Industries Suppose that we assumed the automobile industry were monopolized… So, a 1% increase in automobile prices will lower sales by 2.3%

Is it possible to attract new customers without lowering your price to everybody? Loss from charging existing customers a lower price Gain from attracting new customers D

Let’s suppose that Notre dame has identified three different consumer types for Notre Dame football tickets. Further, assume that Notre Dame has a marginal cost of $20 per ticket. Dollars Alumni $120 Faculty $80 If Notre Dame had to set one uniform price to everybody, what price would it set? Students $40 0 40,000 70,000 80,000

Let’s suppose that Notre dame has identified three different consumer types for Notre Dame football tickets. Further, assume that Notre Dame has a marginal cost of $20 per ticket. Dollars Alumni $120 Faculty $80 Students $40 $20 MC 0 40,000 70,000 80,000

Now, suppose that Notre Dame can set up differential pricing. • Pricing Schedule • Regular Price: $120 • Faculty/Staff: $80 • Student: $40 Dollars Alumni $120 Faculty $80 Students $40 $20 MC What would Notre Dame need to do to accomplish this? 0 40,000 70,000 80,000

Example: DVD codes are a digital rights management technique that allows film distributors to control content, release date, and price according to region. DVD coding allows for distributors to price discriminate by region.

Why is movie theatre popcorn so expensive? Dollars General Public $15 This would be an easy price discrimination problem… Senior Citizens $8 • Pricing Schedule • Regular Price: $15 • Senior Citizens: $8 0 200 300

Now, suppose that the identities are unknown? How can the theatre extract more money out of the avid moviegoer? Dollars Avid Moviegoer $15 Occasional Moviegoer As long as the total price (popcorn + ticket) is $15 or less, avid moviegoers will still go $8 0 200 300 Which pricing option would you choose?

Suppose that Disneyworld knows something about the average consumer’s demand for amusement park rides. Disneyworld has a constant marginal cost of $.02per ride Dollars .50 Demand 0 50

As a first pass, we could solve for a profit maximizing price per ride Dollars .51 Profit = $24.01 .02 MC Demand 0 49 MR

If all Disney does is charge a price per ride, they are leaving some money on the table Dollars $1 CS = (1/2)($1-.51)*49 = $12.00 .51 Profit = $24.01 We are charging this person $24.01 for 49 rides when they would’ve $36.01! .02 MC Demand 0 49 MR

Like the movie theatre, Disney has two prices to play with. We have a price per ride as well as an entry fee. For any price per ride, we can set the entry fee equal to the consumer surplus generated. Dollars Fee = (1/2)($1-P)*Q $1 $P Profit = (P-.02)*Q .02 MC We are still looking to where marginal revenues equal marginal costs. Demand 0 Q Total Profit = $48.02

The optimal pricing scheme here is to set a price per ride equal to marginal cost. We then set the entry fee equal to the consumer surplus generated. • Pricing Schedule • Entry Fee: $48.02 • Price Per Ride: $.02 Dollars Fee = (1/2)($1-.02)*98 = $48.02 $1 Or, we could combine the two Entry Fee: $48.02 + Ride Charges: $1.96 98 Ride Package = $49.98 .02 MC Ride Revenue = .02*98 = $1.96 Demand 0 98 Total Profit = $48.02

Now, suppose that we introduced two different clientele. Say, senior citizens and Non-seniors. We could discriminate based on price per ride (assume there is one of each type) Non-Seniors Seniors Dollars Dollars $1 $.80 .51 .41 Profit = $24.01 Profit = $15.21 .02 MC .02 MC Demand Demand 0 49 0 39 MR MR Total Profit = $24.01 + $15.21 = $39.22

Alternatively, you set the cost of the rides at their marginal cost ($.02) for everybody and discriminate on the entry fee. $48.02 Young P = $.02/Ride Entry Fee = $30.42 Old Non-Seniors Seniors Dollars $1 $.80 Fee = (1/2)($.80-.02)*78 = $30.42 Fee = (1/2)($1-.02)*98 = $48.02 .02 MC .02 MC Ride Revenue = .02*98 = $1.96 Demand Ride Revenue = .02*78 = $1.56 Demand 0 98 0 78 Total Profit = $48.02 + $30.42 = $78.44

Or, you could establish different package prices. Regular Admission (98 rides): $49.98 Pricing Schedule= Senior Citizen Special (78 Rides): $31.98 Non-Seniors Seniors Dollars $1 $.80 Fee = (1/2)($.80-.02)*78 = $30.42 Fee = (1/2)($1-.02)*98 = $48.02 .02 MC .02 MC Ride Revenue = .02*98 = $1.96 Demand Ride Revenue = .02*78 = $1.56 Demand 0 98 0 78 Total Price = $48.02 + $1.96 = $49.98 Total Price = $30.42 + $1.56 = $31.98

Suppose that you couldn’t distinguish High value customers from low value customers: Would this work? Dollars $1 $.80 Fee = (1/2)($.80-.02)*78 = $30.42 Fee = (1/2)($1-.02)*98 = $48.02 .02 MC .02 MC Ride Revenue = .02*98 = $1.96 Demand Ride Revenue = .02*78 = $1.56 Demand 0 98 0 78 Regular Admission (98 rides): $49.98 Pricing Schedule= “Early Bird” Special (78 Rides): $31.98

Economics of the Firm