Pricing, Competition and

Market Structure
BUSI 7130 / 7136

How does our pricing strategy fit into this
framework? What economic principles apply?
Porters Five Forces Model
Supplier Power
Substitutes and Complements
Internal Rivalry Buyer Power
New Entrants
Market Structure Internal rivalry
Market structure and pricing decisions are closely
related. But how to define the market?
The degree to which the firm gets to choose price
is determined in large part by market structure.
There are two extreme cases: perfect competition
and monopoly.
Perfect Competition
Conditions necessary:
Large numbers of buyers and sellers
Homogeneous product
Free entry and exit
Perfect information
Perfect Competition cont.
Demand curve for any given firm is
horizontal. Price is set by market at P
e







Firm can sell as much or as little as desired
at market price, but nothing if they raise P.
P
e
S
D
D P
e
Monopoly
Conditions necessary
Single seller of product
No close substitutes
Significant barriers to entry
There are few examples of perfect
competition and pure monopoly.
Most firms have a differentiated product,
and there are substitutes.
Pricing in Perfect Competition
Do not choose price.
Choose output quantity. TC includes
opportunity cost of capital invested.
What will be our profit (loss) from our
output decision?
Should we produce now? (SR)
Should we stay in the industry? (LR)
Pricing in a Monopoly
Profit maximization will be achieved by
setting price so that MC=MR.
It is not reached by setting price as
high as possible.
Like any firm, the monopolist is
constrained by their demand curve.
One cannot choose both P and Q.
The Shut-Down Rule
At what point should the firm cease
production of a certain item?
When might it pay to produce at a loss?
In SR, many costs are fixed. Just because a
firm is making losses, it does not necessarily
mean it should shut down (short run), or even
go out of business (long-run).
The Shut-Down Rule cont.
Profit = TR TC; TR=P*Q, TC = VC + FC
(TR - VC) - FC = [(P - AVC)Q] FC
Separate out fixed costs, focus on variable elements
As long as P>AVC, there is a positive contribution to
fixed costs.
If firm shuts down (Q = 0), then Profit = - FC
If shut down: Firm has a loss of fixed costs.
The Shut-Down Rule cont.
In SR, firm may minimize losses by continuing to
produce.
If losses are expected permanently, get out.
Case of multiple products:
C = FC + VC
1
+ VC
2
The Shut-Down Rule cont.
1. H = (TR
1
- TVC
1
) + (TR
2
- TVC
2
) - FC
2. H = (P
1
*Q
1
- AVC
1
*Q
1
) + (P
2
*Q
2
- AVC
2
*Q
2
) - FC
3. H = [(P
1
- AVC
1
)*Q
1
]+ [(P
2
- AVC
2
)*Q
2
] - FC
Results:
1. SR - each product should be produced if P
i
>AVC
i

2. In LR, the firm should continue operating only if
expected H>=0 (Profits are non-negative)
Price Discrimination
Selling the same good to different people at
different prices
Conditions necessary:
Identifiable customer groups with differing
price elasticities
Maintain separation of groups--prevent
resale.
Types of Price Discrimination
First degree
Identify and charge each customer
what they are willing to pay. Limit:
D = MR, no consumer surplus.
Second degree
Quantity discounts. Volume
purchases are given lower prices.
Need to measure goods and
services bought by consumers.
Types of Price Discrimination
Third degree
Segment markets in some way. Charge
all in the segment the same prices.
Treat each segment as a separate
market then do MR=MC in each
Are coupons as a price discrimination
mechanism?
Oligopoly Strategies
Common theme - Rivalrous behavior
Pricing - limit pricing - set prices low as
signal to possible entrants or other
competitors your willingness and ability
to defend your market share.
Must have credibility.
Trading SR profit for more profits later
Oligopoly Strategies cont.
Use the legal / regulatory systems
File patent application
Challenge business charter application
File regulatory challenge
Pre-emptive entry - Wal-Mart
Oligopoly Strategies cont.
Capacity and production
Announce capacity expansion
Revise/modify products - more
difficult to copy
Advertising
Raise cost of entry for others
Oligopoly and Monopolistic Competition
Oligopoly
Few sellers - usually large ones
Recognized interdependence in
pricing and output decisions
Need to consider response of rivals in
pricing decisions
Typically significant barriers to entry
Oligopoly and Monopolistic Competition
Monopolistic Competition
Large number of interdependent
sellers
Differentiated product
Good substitutes
Easy entry and exit
Oligopoly and Monopolistic Competition
Most U.S. industries are one or the other
Oligopoly: many heavy manufacturing
Autos, steel, chemicals, pharmaceuticals
Monopolistic Competition
Service companies, retail stores, large
corporations (McDonalds, Wendys)
The important point is that demand is
downward sloping
Cartels
Illegal in the U.S. - encouraged in much
of the world.
Conditions helpful:
Small number of firms
Homogeneous product
Entry barriers
Similarity of members
Cartels cont.
Problems with cartels:
Cheating on agreement
Price cutting behavior
Tend to fall apart
Note: When might firms in an industry
ask for (demand) regulation?
Pricing Strategies
Profit maximizing rule:
Set production at level where MR = MC
Non - Maximizing pricing rules
there are a variety of these
Cost-Plus Pricing
Many forms and widespread
Markup = P = cost (1 + X%)
X can range widely - 33% to 150%
Cost could be MC, AVC, or estimated
constant. It would be best if Markup was
determined via the rule
P - cost
cost
p
p
1 c
c
+
Pricing Example:
Birds Eye Case of frozen salmon. Suppose
their cost function was: TC($)=20000+75Q
Fixed cost is _______, MC is_________
Marketing study estimates price elasticity of
demand is more elastic (-2.5) for one group
(ex: caterers), lower for other (-2.0)
Optimal Price Markup rule
Optimal markup is a function of price elasticity
P = MC *


P
1
= $124.99 (Group 1 price)
Next, consider customers in group 2
p
p
1 c
c
+
66 . 1 75
1.5 -
2.5 -
75 = P1 - =
|
.
|

\
|
Optimal price markup example cont.
Use optimal markup rule again
P = MC

P
2
= $150 to group 2 customers
p
p
1 c
c
+
0 . 2 75
1.0 -
2.0 -
75 = P2 - =
|
.
|

\
|
Optimal Price markup conclusion
General rule: Managers should charge lower price to
customers with more elastic demand (Give them
bigger discounts)
Charge higher price to those with lower price elasticity
those with more inelastic demand
So Group 1 (elasticity of -2.5) is charged a lower price
($125) than group 2 (elasticity of -2.0, price of $150)

Positioning psychology: List price is X, discount from
that.
Cost-Plus Pricing cont.
Example: Winston Co. produces specialized
fishing equipment fly fishing rods; multiple
segments (Introductory to high-end)
Production cost $200 - $300
Markup 50-100% $100 - $300
List price $300 - $600
How does pricing affect image in marketplace?
What are estimated underlying price elasticities?
What about out-sourcing? Which parts?
Markup Pricing in Groceries
Source: Mansfield, p.464 (1992) industry averages
Product Markup Product Markup
Coffee 5% Cold Cuts 30%
Soft Drinks 5% Fresh Fruit 45%
Cereal 10% Fresh Veg. 45%
Soup 10% Spices 50%
Ice Cream 20% Proprietary
Drugs
50%


Pricing for Multi-Product Firm
Two products, x and y. TR
firm
= TR
x
+ TR
y
If there are any spillovers from x to y, then
you may get complications.
MR =
TR
Q
TR
Q
TR
Q
x
x
x
x
y
x
d
d
d
d
d
d
= +
MR =
TR
Q
TR
Q
TR
Q
y
y
y
y
x
y
d
d
d
d
d
d
= +
Multi-Product Firm cont.
The two terms on the right side of the
equation represent interactions. They can be
either positive or negative.
If x and y are complementary goods, the
effect is positive.
If x and y are substitutes, the effect is
negative. One units gain is the others loss.
Two part pricing
Charge P = MC
charge a fixed fee to extract some of the
consumer surplus
Examples:
country clubs
health clubs
electricity providers
Declining block pricing
Charging different prices according to
how much is purchased
Attempt to extract consumer surplus
and transfer value to company

Auction pricing models
Standard auction model
multiple bidders compete with each other
start at some low price, then successive bids
raise price until someone wins
Dutch auction model
start at a high price, lower it until someone bids
ex: dutch flower auctions
How to extract consumer surplus?

How does the development of online business
affect this analytic tool? How does the Internet
change the economic principles that apply?
Porters Five Forces Model
Supplier Power
Substitutes and Complements
Internal Rivalry Buyer Power
New Entrants
Market structure and the Internet
Traditional industry structure paradigm?
Structure, time and place?
Firm size, customer access and service?
Pricing, and reputation online:
Music for Econ, link below:
Music For Econ
who is competing with whom?

Internet and demand issues
Role of customer service and customer
loyalty online: e-loyalty?
Consumer demand issues - which goods
to buy online, which in person?
How to price online?
Does this signal the end of the Brand?


Pricing and the Internet
Traditional pricing paradigm?
Access to demand data...
Measurement of demand elasticities?
Ability to conduct pricing experiments
Ability to spot market changes - and
move quickly (perhaps)
Access to bigger customer base
Will prices be lower online?
Firm structure and the Internet
Are traditional firm structure concepts
now irrelevant?
Economies of scale? Scope?
How does this affect firm incentives to
vertically integrate (or de-integrate)?
Central role of transaction costs...