managerial economics | unit 3

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Market Defined as the institutional relationship between buyers and sellers.

Market refers to the interaction between buyers and sellers of a good (or service) at a mutually agreed upon price. ◦Such interaction may be at a particular place, or maybe over the telephone,

or even through the Internet!

Sellers and buyers may meet each other personally, or may not ever see each other, as in E-commerce.

Thus, the market may be defined as a place, a function, and a process. 2

Typology of markets

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Monopoly

oligopoly

Monopolistic/

PerfectCompetition

BilateralMonopoly

monopsony

Number of buyersN

um

ber

su

pp

liers

One A few Many

One

A few

Many

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MARKET STRUCTURES AND PRICING

Market Morphology Markets may be characterized on the basis of:

Number, size and distribution of sellers in any market

Whether the product is homogeneous or differentiated

Number and size of buyers: large number of buyers but small size of individual buyer, the market will be evenly balanced between buyers and sellers.

small number of buyers but their size is large, the market is driven by buyers’ preferences.

Absence or presence of financial, legal and technological constraints

Thus we have: Perfect Competition Monopoly 5

Monopolistic competition Oligopoly

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Type of market Number of firms

Nature ofproduct

Number of buyers

Freedom of entry and exit

Examples

Perfectcompetition

Very Large Homogeneous(undifferentiated)

Very Large Unrestricted Agricultural commodities, unskilled labour

Monopolisticcompetition

Many Differentiated Many Unrestricted Retail stores, FMCG

Oligopoly Few Undifferentiatedor differentiated

Many Restricted Automobiles, computers, universities

Monopoly Single Unique Many Restricted Indian Railways, Microsoft, Intel

Monopsony Many Undifferentiatedor differentiated

Single Not applicable Arms manufacturers and Defense industry

Market Morphology

Features of Perfect Competition

Perfect competition may be defined as that market where infinite number of sellers sell homogeneous good to infinite number of buyers while buyers and sellers have perfect knowledge of market conditionsFeatures Presence of large number of buyers and sellers Homogeneous product Freedom of entry and exit Perfect knowledge Perfectly elastic demand curve No governmental intervention Price determined by market and Firm is a price taker.

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Features of MonopolySingle sellerThe entire market is under control of a single firm.

Single productA monopoly exists when a single seller sells a product which has no

substitute or, at least, no close substitute in the market.

No difference between firm and industry There is a single firm in the industry

Independent decision making Firm is regarded as a price maker

Restricted entryExistence of barriers leads to the emergence and/or survival of a monopoly 8

Types of Monopoly

Legal MonopolyCreated by the laws of a country in the greater public interest.

Economic Monopoly Created due to superior efficiency of a particular player.

Natural MonopolyFormed when the size of the market is so small that it can

accommodate only one player.

Regional MonopolyGeographical or territorial aspects also help in creation of monopolies.

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Price and Output Decisions in Short Run

In order to maximize profit a monopoly firm follows the rule of MR=MC when MC is rising. A monopoly firm may earn supernormal profit or normal profit or even subnormal profit in the short run. In the short run, the firm would reap the benefits of supplying a product which unique.

Firm maximizes profit where (i) MR=MC (ii) MC cuts MR from below, at

point E.

Supernormal profit= AEBPE,

since price (AR) > AC

BPE

QE

E AR

MR

Quantity

Price, Revenue, Cost

O

MC

AC

A

AR>AC

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Firm makes normal profit. Firm makes loss.

Price and Output Decisions in Short Run

B

E

PE

QE

AR

AC

MR

MC

QuantityO

Price, Revenue, Cost

MRAR

MC AC

E

Quantity

Price, Revenue, Cost

O

B

QE

ACPE

AR=AC AR<AC

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A monopolist is in full control of the market price

It would not continue to incur loss in the long run.

It would try to reduce cost of production

Otherwise it would close down in the long run.

Monopolist would try to earn at least normal profit in the long run and may earn supernormal profit due to entry restrictions in the market.

If in the long run a monopoly firm earns supernormal profit This would attract competition and high price would make it possible for a new entrant to

survive.

To retain its monopoly power, the firm may have to resort to a low price and earn only normal profit even in the long run to create an economic barrier to new entrants.

Price and Output Decisions in Long Run

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Price Discrimination

Discrimination among buyers on the basis of the price charged for the same good (or service).

Preconditions of Price DiscriminationMarket controlMarket imperfection and control are necessary

Division of marketwhen the whole market can be divided into various segments, and

transfer of goods between the markets is not possible, i.e., paying capacity, demography.

Different price elasticities of demand in different markets

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Bases of Price Discrimination

PersonalOn basis of the paying capacity and/or the intensity of needs.

GeographicalPeople living in different areas are required to pay different prices for

the same product.

TimeThe same person may be required to pay different prices for the same

product, e.g. off season discounts.

Purpose of useCustomers are segregated on basis of their purpose of use.

E.g. electricity rates are lower for domestic purpose and higher for industrial purpose.

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Degrees of Price Discrimination

Pigou has identified three degrees of price discrimination. First Degree

Seller is able to charge different prices for different units of the same product from the same consumer.

Joan Robinson referred to it as perfect discrimination.

Second Degree

Divides consumers in groups on the basis of their paying capacities; a person with lower paying capacity is charged a lower price and vice versa

Third Degree

Segregates consumers such that each group of consumers is a separate market, and charges the price on basis of price elasticity of different groups.

Different rates of ticket for different seats in theatre.

Features of Monopolistic Competition

Chamberlin:“Monopolistic competition is a challenge to the traditional viewpoint of economics that competition and monopoly are alternatives…By contrast it is held that most economic situations are composites of both competition and monopoly.”

Features: Large number of buyers and sellers:..

◦Heterogeneous products.

◦A differentiated product enjoys some degree of uniqueness in the mindset of customers, be it real, or imaginary.

◦Selling costs exist.

◦Independent decision making. •Imperfect knowledge.•Unrestricted entry and exit.

Price and Output Decisions in Short Run

Joan Robinson said: Each firm has a monopoly over its product.

Firms have limited discretion over price, due to the existence of consumer loyalty for specific brands.

The reason for supernormal profit in short run, is supplying a product which is differentiated, or at least perceived to be different by the consumer.

Total revenue = OPEBQE

Total cost =OAEQE

Supernormal profit =APEBE

since price OPE > OA

(AR>AC)

Price & Output Decisions in Short Run

Firm maximizes profit where (i) MR=MC; (ii) MC cuts MR when MC is rising.Profit maximising output OQE and Price OPE

MC A

C

EA

Quantity

Price, Revenue, Cost

MR

AR

O

PE

QE

B

Total revenue = OPEBQE

Total cost =OAEQE

Loss =APEBE

since price OPE < OA

(AR<AC)

Price & Output Decisions in Short Run

Firm maximizes profit where (i) MR=MC; (ii) MC cuts MR when MC is rising.Profit maximising output OQE and Price OPE

MC A

CEA

Quantity

Price, Revenue, Cost

MR

AR

O

PE

QE

B

Total revenue = OPEBQE

Total cost =OAEQE Normal profit = No loss no gainsince AR=AC

Price & Output Decisions in Long RunFirm maximizes profit where (i) MR=MC; (ii) MC cuts MR when MC is rising.Profit maximising output OQE and Price OPE

MC A

C

Quantity

Price, Revenue, Cost

MR

AR

O

PE

QE

B

•Just like perfect competition, in monopolistic competition too all the firms would earn normal profits in the long run.

•In the long run supernormal profit would attract new firms to the industry till all the firms earn only normal profits.

•Losses, will force firms to exit the industry till remaining firms in the market earn only normal profits.

•If all the firms earning only normal profit there will be no tendency to enter or exit the market.

Price & Output Decisions in Long Run

Features of Oligopoly

Derived from Greek word: “oligo” (few) “polo” (to sell)

Few Sellers: small number of large firms compete

Product: Some industries may consist of firms selling identical products, while in some other industries firms may be selling differentiated products.

Entry Barriers: No legal barriers; only economic in nature ◦Huge investment requirements

◦Strong consumer loyalty for existing brands

Duopoly

Duopoly is that type of oligopoly in which only two players operate (or dominate) in the market. ◦Used by many economists like Cournot, Stackelberg, Sweezy, to explain the

equilibrium of oligopoly firm, as it simplifies the analysis.

Price and Output Decisions

No single model can explain the determination of equilibrium price and output◦Difficult to determine the demand curve and hence the revenue curve of

the firm

Kinked Demand Curve

Paul Sweezy (1939) introduced concept of kinked demand curve to explain ‘price stickiness’.

Assumptions

◦If a firm decreases price, others will also do the same. So, the firm initially faces a highly elastic demand curve.

◦A price reduction will give some gains to the firm initially, but due to similar reaction by rivals, this increase in demand will not be sustained.

◦If a firm increases its price, others will not follow. Firm will lose large number of its customers to rivals due to substitution effect.

◦Thus an oligopoly firm faces a highly elastic demand in case of price fall and highly inelastic demand in case of price rise.

A firm has no option but to stick to its current price.

At current price a kink is developed in the demand curve

The demand curve is more elastic above the kink and less elastic below the kink.

Kinked Demand Curve(price and output determination)

• Discontinuity in AR (D1KD2) creates discontinuity in the MR curve.

• At the kink (K), MR is constant between point A and B.

• Producer will produce OQ, whether it is operating on MC1 or MC2, since the profit maximizing conditions are being fulfilled at points S as well as T.

• If MC fluctuates between A and B, the firm will neither change its output nor its price.

• It will change its output and price only if MC moves above A or below B.

• D1K = highly elastic portion of the demand curve (AR) when rival firms do not react to price rise

• KD2 = less elastic portion, when rival firms react with a price reduction.

• Kink is at point K.

D1

D2

K

QuantityO

Price, Revenue, Cost

A

B

MR

MC2

MC1P

S

T

Q

Centralized Cartels

∑MCMCA

MCB

P

QQAQB

O

MRAR=D

Price, Cost, Revenue

Quantity

• Assuming the case of a cartel with two firms facing same MR and AR

• MCA = Firm A’s marginal cost

• MCB = Firm B’s marginal cost

• ∑MC = industry marginal cost

• OQ = profit maximizing output because (MR=∑MC).

• OQA = A’ output

• OQB = B’s output

• OQ=OQA + OQB; OQA > OQ B

• OP = price at which both firms can sell their output. Price will be determined by summation of all firms’ costs and demand.

• In a cartel an individual firm is just a price taker.

Market Sharing Cartels

Quantity

Price, Cost, Revenue

O

ARA

MRA

ACMC

ARB

MRB

PB

QB QA

PA

• Firms decide to divide the market share among them and fix the price independently.

• All firms have the same cost functions because they are producing a homogenous product but have different demand functions.

• Due to different demand functions, at equilibrium total output = OQA+ OQB, where OQA> OQB.

• The quantity of output produced and sold would depend upon the terms of agreement among the firms in the cartel.

Factors Influencing Cartels

Number of firms in the industry: Lower the number of firms in the industry, the easier to monitor the behaviour of other members.

Nature of product: Formed in markets with homogenous goods rather than differentiated goods, to arrive at common price. But if goods are homogeneous, an individual firm may gain larger market share by cheating, i.e. by lowering the price.

Cost structure: Similar cost structures make it easier to coordinate.

Characteristics of sales: Low frequency of sales coupled with huge amounts of output in each of these sales make cartels less sustainable, because in such cases firms would like to undercut the price in order to gain greater market share.

◦with large number of firms and small size of the market some firms may deviate from the cartel price and thus cheat other members.

Price Leadership

Dominant Firm: a leader in terms of market share, or presence in all segments, or just the pioneer in the particular product category.

◦Either a benevolent/ kind firm or an exploitative firm.

Benevolent leader

◦Allows other firms to exist by fixing a price at which small firms may also sell.

◦so that it does not have to face allegations of monopoly creation;

◦Earns sufficient margin at this price and still retains market leadership

Price Leadership

Exploitative leader: fixes a price at which small inefficient players may not survive and thus it gains large share of the market.

Barometric Firm: has better industry intelligence and can preempt (being pioneer) and interpret its external environment in a more effective manner than others.

◦No single player is too large to emerge as a leader, but there may be a firm which has a better understanding of the markets.

◦Acts like a barometer for the market.

| Pricing | Price denotes two aspects:

•It is revenue to the seller and •It is the perceived value of the good (or service) to the buyer.

Market structure also affects pricing decisions.

Change in government policy regarding taxation, subsidies and administered prices would also lead to change in existing price.

Pricing Strategies

Penetration Pricing

Penetration Pricing Price set to ‘penetrate the market’

‘Low’ price to secure high volumes

Typical in mass market products – chocolate bars, food stuffs, household goods, etc.

Suitable for products with long anticipated life cycles

May be useful if launching into a new market

Market Skimming

Market Skimming High price, Low volumes

Skim the profit from the market

Suitable for products that have short life cycles or which will face competition at some point in the future (e.g. after a patent runs out)

Examples include: Playstation, jewellery, digital technology, new DVDs, etc.

Many are predicting a firesale in laptops as supply exceeds demand.Copyright: iStock.com

Value Pricing

Value Pricing Price set in accordance with customer perceptions about the value of the product/service

Examples include status products/exclusive products

Companies may be able to set prices according to perceived value.

Copyright: iStock.com

Loss Leader

Loss Leader Goods/services deliberately sold below cost to encourage sales elsewhere◦Typical in supermarkets, e.g. at Christmas, selling bottles of gin at `300 in the hope that people will be attracted to the store and buy other things

Purchases of other items more than covers ‘loss’ on item sold

Psychological Pricing

Psychological Pricing

Used to play on consumer perceptions Classic example - `499! Links with value pricing – high value goods priced according to what consumers THINK should be the price

Going Rate (Price Leadership)

Going Rate (Price Leadership)

In case of price leader, rivals have difficulty in competing on price – too high and they lose market share, too low and the price leader would match price and force smaller rival out of market

May follow pricing leads of rivals especially where those rivals have a clear dominance of market share

Where competition is limited, ‘going rate’ pricing may be applicable – banks, petrol, supermarkets, electrical goods – find very similar prices in all outlets

Tender Pricing

Tender Pricing

Many contracts awarded on a tender basis Firm (or firms) submit their price for carrying out the work Purchaser then chooses which represents best value Mostly done in secret

Price Discrimination

Price Discrimination Charging a different price for the same good/service in different markets Requires each market to be impenetrable Requires different price elasticity of demand in each marketPrices for rail travel differ for the same journey

at different times of the day

Copyright: iStock.com

Destroyer Pricing/Predatory Pricing

Destroyer/Predatory Pricing

Deliberate price cutting or offer of ‘free gifts/products’ to force rivals (normally smaller and weaker) out of business or prevent new entrants Anti-competitive and illegal if it can be proved

Absorption/Full Cost Pricing

Absorption/Full Cost Pricing Full Cost Pricing – attempting to set price to cover both fixed and variable costs Absorption Cost Pricing – Price set to ‘absorb’ some of the fixed costs of production

Marginal Cost Pricing

Marginal Cost Pricing Marginal cost – the cost of producing ONE extra or ONE fewer item of production

MC pricing – allows flexibility

Particularly relevant in transport where fixed costs may be relatively high

Allows variable pricing structure – e.g. on a flight from London to New York – providing the cost of the extra passenger is covered, the price could be varied a good deal to attract customers and fill the aircraft

Marginal Cost Pricing

Example:

Aircraft flying from Delhi to Mumbai– Total Cost (including normal profit) = `1,50,000 of which `1,30,000 is fixed cost*

Number of seats = 160, average price = `937.5

MC of each passenger = 20,000/160 = `125.0

If flight not full, better to offer passengers chance of flying at `125.0 and fill the seat than not fill it at all! *A

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Contribution Pricing

Contribution Pricing Contribution = Selling Price – Variable (direct costs)

Prices set to ensure coverage of variable costs and a ‘contribution’ to the fixed costs Similar in principle to marginal cost pricing Break-even analysis might be useful in such circumstances

Target Pricing

Target Pricing Setting price to ‘target’ a specified profit level Estimates of the cost and potential revenue at different prices, and thus the break-even have to be made, to determine the mark-up Mark-up = Profit/Cost x 100

Cost-Plus Pricing

Cost-Plus Pricing

Calculation of the average cost (AC) plus a mark up AC = Total Cost/Output

Influence of Elasticity

Influence of Elasticity

Any pricing decision must be mindful of the impact of price elasticity The degree of price elasticity impacts on the level of sales and hence revenue Elasticity focuses on proportionate (percentage) changes

% Change in Quantity demandedPED = -----------------------------------------------

% Change in Price

Influence of Elasticity Price Inelastic: % change in Q < % change in P e.g. a 5% increase in price would be met by a fall in sales of something less than 5% Revenue would rise A 7% reduction in price would lead to a rise in sales of something less than 7% Revenue would fall

Influence of Elasticity

Price Elastic: % change in quantity demanded > % change in price e.g. A 4% rise in price would lead to sales falling by something more than 4% Revenue would fall A 9% fall in price would lead to a rise in sales of something more than 9% Revenue would rise

Demand Interdependence: A firm may produce goods which can either be substitutes or complementary in demand.

In case of substitutes, Seller has two options: ◦Charge the same price for the two goods or ◦Differentiate the products from each other and take advantage of perceived

value pricing.

In case of complements, suitable strategy would be either◦Product bundling or ◦Loss leader, depending upon company’s objective and market conditions.

Multi Product Pricing/ Product Line Pricing

Supply (or Production) Interdependence: Some goods are jointly produced as an outcome of production process.

The firm has to first decide whether to sell only the primary product or both the products.

For the primary product it can adopt any of the pricing strategies depending upon the market structure or life cycle stages of the product.

Alternatively it may adopt full costing for the primary product and marginal costing for the joint product.

Multi Product Pricing/ Product Line Pricing