Economic
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Title: Pricing Strategies for Firms with Market Power
Contents
Introduction ................................................................................................................................ 3
Check Your Understanding ........................................................................................................ 3
Question 1 ................................................................................................................................................. 3
Question 2 ................................................................................................................................................. 3
Simple Pricing Rule for Monopoly and Monopolistic Competition ............................................... 3
Simple Pricing Rule for Cournot Oligopoly ................................................................................. 4
Check Your Understanding ........................................................................................................ 4
Question 3 ................................................................................................................................................. 4
Question 4 ................................................................................................................................................. 5
Strategies that Yield Greater Profits ........................................................................................... 5
Price Discrimination .................................................................................................................................. 5
Two-Part Pricing ........................................................................................................................................ 5
Block Pricing ............................................................................................................................................. 5
Commodity Bundling ................................................................................................................................. 6
Check Your Understanding ........................................................................................................ 6
Question 5 ................................................................................................................................................. 6
Question 6 ................................................................................................................................................. 6
Pricing for Special Cost and Demand Structures ........................................................................ 6
Peak-load Pricing ...................................................................................................................................... 6
Cross-subsidy pricing ................................................................................................................................ 7
Transfer pricing ......................................................................................................................................... 7
Check Your Understanding ........................................................................................................ 7
Question 7 ................................................................................................................................................. 7
Question 8 ................................................................................................................................................. 7
Pricing Strategies in Markets with Intense Price Competition ..................................................... 7
Price Matching .......................................................................................................................................... 8
Inducing Brand Loyalty .............................................................................................................................. 8
Randomized Pricing .................................................................................................................................. 8
Check Your Understanding ........................................................................................................ 8
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Question 9 ................................................................................................................................................. 8
Question 10 ............................................................................................................................................... 8
Problem Statements .................................................................................................................. 9
Problem 1 .................................................................................................................................................. 9
Problem 1: Solution ................................................................................................................................... 9
Problem 2 .................................................................................................................................................. 9
Problem 2: Solution ................................................................................................................................. 10
Problem 3 ................................................................................................................................................ 10
Problem 3: Solution ................................................................................................................................. 10
Summary ..................................................................................................................................10
Review Questions .....................................................................................................................11
Question 1 ............................................................................................................................................... 11
Question 2 ............................................................................................................................................... 12
Question 3 ............................................................................................................................................... 12
Question 4 ............................................................................................................................................... 12
Question 5 ............................................................................................................................................... 12
Reference .................................................................................................................................13
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Introduction
Firms in monopolistic, monopolistic competition, and oligopolistic market structures have some level of say in terms of prevailing market prices because they have some measure of market power.
The optimal pricing strategy or decision generally varies by firm and by market structure.
Check Your Understanding
Question 1
Is the following statement true or false?
Firms with some market power dictate quantity demanded.
Answer
The statement is false. Firms with market power have some influence over the prices they charge.
Question 2
If the optimal pricing decision for a particular firm is to match its price with the market, which market structure does that firm operate in?
Monopolistic competition
Perfect competition
Monopoly
None of the above
Answer
If the optimal pricing decision for a particular firm is to match its price with the market, then that firm operates in a perfect competition market structure.
Simple Pricing Rule for Monopoly and Monopolistic Competition
The price that represents where marginal revenue is equal to marginal cost is the unit profit maximizing price for monopolies and firms in monopolistic competitive markets.
Though firms have some pricing power, they are still subject to the law of demand. In other words, consumers are responsive to higher prices (they generally buy less), as they are to lower prices (they generally buy more). The degree to which consumers respond to a firm’s product price changes (own-price elasticity), and the resulting impact on marginal revenue is given by:
where E base F is the own-price elasticity.
So at the profit maximizing level,
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which can be written as:
which suggests that:
a higher marginal cost will necessitate a higher profit maximizing price
the profit maximizing price is some markup factor multiplied by the marginal cost
The markup factor,
is a function of the responsiveness of consumers to changes in the price of the product.
The larger the own-price elasticity, the lower the markup factor. In other words, if there are factors in that market that make consumers more responsive to high prices, then the firm does not have as much flexibility to increase prices without affecting profit significantly.
Simple Pricing Rule for Cournot Oligopoly
A firm that is operating in a Cournot oligopoly maximizes profit where marginal revenue equals marginal cost. Suppose there are a number of firms who are Cournot oligopolists, who produce relatively similar products and have the same technologies that result in identical cost structures. The profit maximizing price for each Cournot oligopolist would be,
where E base M is the market elasticity and is the number of firms.
Note that if is equal to 1, that market structure is a monopoly.
As
gets closer 1, MC gets closer to price.
gets closer to 1 as:
market elasticity increases
N increases
Check Your Understanding
Question 3
For monopolies and monopolistic competitive firms, if their own-price elasticity increases, then:
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Their marginal cost will increase
An increase in price will increase quantity demanded
Their marginal cost will decrease
The profit maximizing markup decreases
Answer
For monopolies and monopolistic competitive firms, if their own-price elasticity increases, then the profit maximizing markup decreases.
Question 4
What will happen if the number of Cournot oligopolists in a particular market increases?
Answer
If the number of Cournot oligopolists in a particular market increases, price will get closer to marginal cost.
Strategies that Yield Greater Profits
In some markets, managers can enhance profits above those they would earn by simply charging a single per-unit price to all consumers.
Common strategies to extract surplus from households are: price discrimination, two-part pricing, block pricing, and commodity bundling.
Price Discrimination
Price discrimination happens when the consumers are charged different prices for the same good or service. Types of price discrimination include:
First-degree price discrimination: This requires the identification of the maximum willingness to pay for each customer and charging each customer that amount. In this way, a firm will extract the surplus for each customer and generate as much revenues as there is to earn.
Second-degree price discrimination: This is the practice of stratifying price by ranges of quantity whereby a schedule of declining prices is posted for different blocks of quantities.
Third-degree price discrimination: This is the practice of stratifying price by different demographic groups of consumers.
Two-Part Pricing
Two-part pricing occurs when households pay a fixed fee for the right to purchase a good or service on top of a per-unit fee for the number of units that each household or consumer purchases. As opposed to just charging one price for each unit, the firm can charge a unit price plus a fee that extracts more revenue from consumer surplus.
Block Pricing
Block pricing is the practice of packaging identical products and offering them for sale as a bundle at a price that represents the full value of each product. Here, consumers do not have
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the option to purchase those products individually and since the full value of each product is capitalized into the price, the consumer surplus is necessarily extracted by the seller.
Commodity Bundling
Commodity bundling is the practice of packaging two or more products from the same firm and selling them at an aggregated price. This could help increase profits if a firm produces more than one product and consumers tend to purchase varying amounts of units from that firm. By making consumers purchase a product they really want along with another product at a bundled price, the firm sells more units of the products it produces.
Check Your Understanding
Question 5
Is the following statement true or false?
Commodity pricing, block pricing, two-part pricing and price discrimination extract value from producer surplus and shift it to consumer surplus.
Answer
The statement is false. Commodity pricing, block pricing, two-part pricing and price discrimination enhance profits by enabling a firm to extract additional surplus from consumers.
Question 6
Which of the following strategies can a perfectly competitive firm enact to extract surplus from consumers?
Price discrimination
Two-part pricing
Block pricing
None of the above
Answer
None of the options are strategies that a perfectly competitive firm can enact to extract surplus from consumers.
Pricing for Special Cost and Demand Structures
Pricing strategies such as peak-load pricing, cross-subsidization, and transfer pricing enhance profits for firms that have special cost and demand structures.
Peak-load Pricing
Peak-load pricing is a strategy of pricing whereby prices vary according to the volume of demand for a good or service, i.e., prices are higher during the hours of higher demand from consumers and lower during hours or times of lower demand from consumers. For example, hotels in vacation destinations charge higher prices during peak tourism seasons.
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Cross-subsidy pricing
This is a pricing strategy that could arise when:
there are cost complementarities in production; and,
demand drivers for a group of products produced by the same are interdependent. In this pricing strategy, if a company produces two related goods, profits generated from the sales of one of the goods or services are used to subsidize prices for the other good or service.
Transfer pricing
Transfer pricing is a strategy where a firm sets an internal price at which its downstream departments will “purchase” an input for from its upstream departments. The price is set with the goal of profit maximizing in mind.
Check Your Understanding
Question 7
Which of the following price strategies is often used by utility companies that distribute electricity?
Transfer pricing
Cross-subsidy pricing
Peak-load pricing
None of the above
Answer
Peak-load pricing is a price strategy that is often used by utility companies that distribute electricity.
Question 8
Is the following statement true or false?
Internal input prices are set with the goal of cost minimization, not profit maximization.
Answer
Internal input prices are set with the goals of cost minimization and profit maximization.
Pricing Strategies in Markets with Intense Price Competition
The pricing strategies that are particularly useful for mitigating the price wars that frequently occur in markets with intense price competition are: price matching, inducing brand loyalty, and randomized pricing.
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Price Matching
Price matching is a strategy in which a firm guarantees that it will match a price for a product it produces that differs from its own price.
Inducing Brand Loyalty
The idea behind brand-loyalty is to engender consumer loyalty to a brand in order to reduce the probability that consumers would shift consumption to another firm that lowers its price. Firms typically try to achieve this through advertising and promotions to generate loyalty.
Randomized Pricing
A randomized pricing strategy is intended to mask price information from competitors and consumers on purpose. This could benefit the firm by making it hard for competitors to figure out how to undercut a firm pricewise. For consumers, it would be harder to develop a sense of what a reasonable expectation of what the product’s price should be; which increases the probability that a firm can subtly capture consumer surplus.
Check Your Understanding
Question 9
Which of the following is true about randomized pricing?
It leads to imperfect price information
It creates imperfect information between sellers
It could extract surplus from consumers
All of the above
Answer
Randomized pricing leads to imperfect price information, creates imperfect information between sellers, and could extract surplus from consumers.
Question 10
Is the following statement true or false?
Price matching is a strategy in which a firm guarantees that it will match a price for a product it produces that differs from its own price.
Answer
The statement is true. Price matching is a strategy in which a firm guarantees that it will match a price for a product it produces that differs from its own price.
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Problem Statements
Problem 1
Suppose your firm produces two goods—X and Y— in fixed proportions, and goods X and Y have interdependent demands. The senior management has asked you to tell them how you would go about determining the profit maximizing output for good X. What would you do to determine that?
Tip 1
Peer 1:
Andy: I think you should consider how much it costs to make each product and then determine how much to produce good X based on production costs.
Peer 2:
Sandra: You need to figure out how much you will earn from producing good X and compare it to the cost of producing it and decide the quantity.
Tip 2
Watch the instructional video, Marginal revenue and marginal cost to find your solution.
Tip 3
Refer to the Lecturette section on Pricing for Special Cost and Demand Structures.
Problem 1: Solution
You would have to find sum of the marginal revenues from sales of goods X and Y, expressed in terms of good Y, and equate that to the marginal cost of producing goods X and Y jointly. Solving for that equation would give you the profit maximizing quantities of X and Y.
Problem 2
Suppose your firm operates in a monopolistic competitive market. Your firm’s marginal cost of production is $35 and your own-price elasticity of demand is +4.0.
How much should your firm charge for its good?
Tip 1
Peer 1:
Andy: Your firm should charge where marginal cost is equal to price.
Peer 2:
Sandra: Your firm should determine the marginal revenue equation, equate it to the marginal cost and solve for price.
Tip 2
Watch the instructional video, Profit maximization to find your solution.
Tip 3
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Refer to the Lecturette section on Basic Pricing Strategies to find your solution.
Problem 2: Solution
Recall, at profit maximizing price:
Problem 3
Suppose your firm operates in a perfectly competitive market and its marginal cost dropped to $25, but everything else remained constant.
How would you price your product?
Tip 1:
Peer 1:
Andy: You should keep the price as in Scenario 2, since the costs have decreased.
Peer 2:
Sandra: Since your costs have decreased by $10, you can decrease your price by $10 as well and maybe get more customers.
Tip 2:
Watch the instructional video, Marginal cost and average total cost to find your solution.
Tip 3:
Refer to Lecturette section on the Basic Pricing Strategies to find your solution.
Problem 3: Solution
Since your firm operates in a perfectly competitive market, it does not have any market power and is a price taker. Therefore, it cannot charge a markup, because it takes the market determined price as the prevailing price of its product.
Summary
Key learning points in this module include:
Firms in monopolistic, monopolistic competition, and oligopolistic market structures have some level of say in terms of prevailing market prices because they have some measure of market power.
The profit maximizing markup factor for monopolies and monopolistic competitive firms depends on own-price elasticity.
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As elasticity (own-price or market) changes, the profit maximizing price changes as well.
If the number of Cournot oligopolists in a particular market increases, price gets closer to marginal cost.
Common strategies to extract surplus from households are: price discrimination, two- part pricing, block pricing, and commodity bundling.
Price discrimination happens when the consumers are charged different prices for the same good or service.
Types of price discrimination include: first-degree price discrimination, second- degree price discrimination, and third-degree price discrimination.
Two-part pricing occurs when households pay a fixed fee for the right to purchase a good or service on top of a per-unit fee for the number of units that household or consumer purchases.
Commodity bundling is the practice of packaging two or more products from the same firm and selling them at an aggregated price.
Block pricing is the practice of packaging identical products and offering them for sale as a bundle at a price that represents the full value of each product.
Peak-load pricing is a strategy of pricing whereby prices vary according to the volume of demand for a good or service.
Transfer pricing is a strategy whereby a firm sets an internal price at which its downstream departments will “purchase” an input for from its upstream departments.
Price matching is a strategy in which a firm guarantees that it will match a price for a product it produces that differs from its own price.
The purpose behind brand-loyalty is to engender consumer loyalty to a brand in order to reduce the probability that consumers would shift consumption to another firm.
A randomized pricing strategy is intended to mask price information from competitors and consumers on purpose.
Review Questions
Question 1
Suppose the demand for a firm’s product is given by P = 20 minus 4 times Q and the cost function is C = 4Q.
What is the profit-maximizing level of output and price for this firm?
Answer
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Question 2
A firm operating in a monopolistic competitive market produces a particular good. If the market price of that good is $15, and the firm’s own-price elasticity is 0.5, what is the firm’s total revenue equation?
Answer
Given the market structure, that firm’s MR is:
Since MR is the first derivative of the total revenue equation, then given MR above, the total revenue equation must be:
Question 3
Explain why the profit-maximizing markup factor would decrease in a Cournot oligopoly as the number of firms increase.
Answer
This would happen because as the number of firms increase, competition would increase as well. Thus, the market elasticity would increase; which would reduce the size of the premium over marginal cost that firms can charge because of the potential of losing customers to other firms.
Question 4
Which form of price discrimination would a firm likely deploy if it was able to determine consumer preferences by demographics accurately?
Answer
Most likely, the firm would deploy third-degree price discrimination if it was able to determine consumer preferences by demographics accurately.
Question 5
How does brand loyalty affect own-price elasticity?
Answer
Since brand loyalty engenders consumer loyalty to a brand, price increases may not have as much of an effect on consumer behavior (with regard to decreasing quantity demanded) as would be the case without brand loyalty.
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Reference
Baye, M. R., and Prince, J. T. (2013). Managerial economics and business strategy (8th edition). New York, NY: McGraw-Hill Education.