Topic 9:
Pricing Decisions: Theoretical
Aspects
Davies: Chapter 12
Objectives:
1. To review the implications of the simple profit-maximising model for
pricing decisions
2. To identify the implications of different market structures for
pricing
3. To introduce the concept of limit-pricing
4. To identify how price discrimination may increase profits
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Pricing in the Simple Model
• REVIEW:
• What is the equilibrium condition for maximum profit?
• What is the relationship between price, marginal cost and elasticity in
the profit-maximizing position?
– ( can you derive that result from the basic calculus?)
• Draw the diagram showing profit-maximising price for a monopolist
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Pricing in the Simple Model
• REVIEW:
• What is the equilibrium condition for maximum profit? MC=MR
• What is the relationship between price, marginal cost and elasticity in
the profit-maximizing position? (P-MC)/P = (-) 1/Ed
•
•
•
•
•
•
How to derive that?
$ = p(q).q - c(q);
to maximise $
d$/dq = dp/dq.q + p(q) - dc/dq = 0:
OR P-MC = -dp/dq.q
Divide both sides by P gives (P-MC)/P = -dp/dq.q/p = -1/Ed
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Pricing in the Simple Model
• REVIEW:
• Draw the diagram showing profit-maximising price for a monopolist
$
Marginal
Cost
Optimal
Price
Demand =AR
MR
Output
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Pricing and Market Structure
• In PERFECT COMPETITION, Ed = infinity, P=MC
• MONOPOLY, Ed depends on closeness of substitutes
– the value of (P-MC)/P = (-) 1/Ed is sometimes referred to as
“Lerner’s Index of Monopoly Power”
• In OLIGOPOLY, the best price to set depends on the
behaviour of rivals. They may react in a number of ways
– independent
– leader/follower behaviour
– collusion
• The most productive approach to pricing in oligopoly has
been through GAME THEORY
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Pricing and Barriers to Entry
•
When deciding on prices, firms may find it profitable to set price below the
short-run profit-maxing level, in order to DETER ENTRY.
•
THREE ISSUES TO CONSIDER
•
WHAT ARE ENTRY BARRIERS, AND HOW DO THEY ARISE?
•
WHAT IS THE MAXIMUM PRICE WHICH WILL DETER ENTRY?
•
WHEN WILL IT BE PROFITABLE TO SET THE ENTRY-PREVENTING
PRICE INSTEAD OF THE SHORT RUN PROFIT-MAXING PRICE?
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What Are Entry Barriers?
• In some simple cases, entry to an industry may be BLOCKADED. (as
in the pure monopoly model). Entry is not possible because of
government regulations or some other absolute barrier.
• In most cases, entry is not blockaded but existing firms - ‘incumbent’
firms - have some advantage over new entrants
• ENTRY BARRIERS are advantages which incumbent firms have over
new entrants
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What are the Sources of Entry
Barriers?
• Absolute Cost Advantages
– patented technology
– uniquely favourable location, not available to entrants
– learning effects - those who start first may have lower cost
• Economies of Scale
– large amounts of capital need to be raised
– entry must EITHER take place at a low level of output, in which case the
entrant has a cost disadvantage OR at a high level of output which
requires taking most customers from the incumbent firm/s.
• Product Differentiation
– brand loyalty to incumbents means that entrants have to spend more to
secure the same sales volume (a kind of absolute cost advantage)
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Can We Identify the Limit Price?
• The Limit Price is the “highest price which can be charged by
incumbent firms without inducing new entry”.
• New firms will enter if they believe that they can make a profit after
they enter.
• This depends on what entrants believe about the actions of the
incumbent firms after entry takes place.
– will they attack the new entrant by cutting prices and increasing output (as
Oriental Press did)?
– will they ‘make room’ for the entrant, reducing output so that prices can
remain about the same?
– will they keep output the same, accepting some reduction in prices
• Again, game theory offers an analytical tool
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A Simple Approach is Offered
by the ‘Sylos Postulate’
•
The Sylos Postulate is the assumption that incumbents will keep their output
constant when entry takes place. Entrants know that and incumbents know that
they know it.
•
In that case, for an undifferentiated product, the demand-curve facing an
entrant is the ‘unused’ portion of the industry’s demand-curve
P1
P2
Dindustry
Dentrant
x
x
Q1
Q2
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A Simple Approach is Offered
by the ‘Sylos Postulate’
•
•
•
In the diagram. If existing firms set the price at P1, total demand is Q1. If the entrant
sets a price P1, demand for his product will be zero because the incumbent firms are
supplying all customers.
If the entrant sets a price P2 total demand at that price is Q2. As existing firms keep their
output constant, they only supply Q1, leaving x as the demand for the entrant.
Incumbents can shift the demand-curve for the entrant by shifting their own price
P
1
P
Dindustry
2
Dentrant
x
x
Q1
Q2
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So Where is the Limit Price?
•
The case of Absolute Cost Advantages
–
–
If incumbents set the price at PH, the demand curve for the entrant will be D entry encouraged. An
entrant can make a profit with any level of output between 0 and Q1. Entry will take place. PH is
too high to be the limit price
If incumbents set price PL, the entrant’s demand curve is always below his cost curve. No profit
can be made. No entry will take place. PL is the limit. price
ATC entrant
PH
PL
Dentry encouraged
ATC incumbent
Dentry discouraged
x
x
Q1
Q2
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So Where is the Limit Price?
•
The case of Economies of Scale
This price is
too high
This gap is
infinitely small
This is the
Limit Price
This Price is
Too Low
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How Useful is This Analysis?
• It shows the importance of entrants’ expectations of incumbents
behaviour
• BUT, it only covers the case where incumbents leave output
unchanged
• A more rational approach for incumbents would be for them to set a
monopoly price but to THREATEN to cut that price and increase
output if other firms try to enter. For that to be effective, the threat
must be CREDIBLE. For that reason, firms sometimes build plants
which are bigger than they need (or exaggerate their production
capacity).
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Will the Limit Price Be Set?
• If the limit price is below the short-run profit-maxing price the firm
must make a choice. This depends upon:
– the speed of new entry
– the amount of extra profit which can be made by charging the profitmaxing price
– the discount rate which represents the relative valuation of future profits
versus present profits
• If entry is slow, AND a large amount of extra short-term profit can be
made by charging a higher price and allowing entry, AND the discount
rate is high, it will be better to ignore the limit price - set the profitmaxing price. If entry is quick, higher price gives little extra profit and
discount rate is low, better to charge the limit price
15
Price Discrimination
• REVIEW:
• What is price discrimination?
• What are the conditions which must exist for price discrimination to be
possible and profitable?
16
Price Discrimination
• REVIEW:
• What is price discrimination? Where different customers are
charged different prices for the same product
• What are the conditions which must exist for price discrimination to be
possible and profitable?
• 1.It must not be possible for buyers to re-sell the product. If it were
possible, no-one would need to buy at higher prices.
• 2. Elasticities in the different sub-markets must be different or it
would be most profitable to charge the same price in all markets
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Two Forms of Price Discrimination
• 1.First degree price discrimination. Every buyer may be charged a different price for the
product. Personal, or domestic or professional services may be an example.
–
The demand curve is also the marginal revenue curve (notice also that this produces an
economically efficient result because output is where MC = marginal valuation by
consumers.However, all of the surplus is producer surplus).
• 2. Third degree price discrimination. There are sub-markets, each containing a
significant number of buyers. Markets may be segmented by:
• AGE of buyers - e.g. Student discounts - but how to prevent re-sale? Most useful for nonstorable goods or services - public transport is the most common example
• TIME of purchase - non-storable products (or are they different products at different
times)
• LOCATION - cars in UK cost 30% more than in Europe
• FAMILY STATUS - Railcards
• In this case, produce the level of output where MC = MR1 = MR2. Price will be higher in
sub-markets having lower elasticities of demand
•
NOTE THAT PRICE DISCRIMINATION IS CHARGING DIFFERENT
PRICES FOR THE SAME PRODUCT , WHERE THE DIFFERENCE IS
NOT ACCOUNTED FOR BY DIFFERENT COSTS
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Seminar Work
•
What are the entry-barriers into the following industries? How significant are
they?
– Internet service provision
– Operating systems for personal computers
– Daily newspapers
•
Evaluate the behaviour of the major newspapers in Hong Kong before the
entry of Apple Daily. Did they set entry-preventing prices? Did they do
anything to deter Apple’s entry? What could they have done to deter Jimmy
Lai? Do you think it would have been effective?
19
Review Questions
•
What is the Sylos Postulate and what are the limitations of the entry-pricing
theory based on it? Consider what might happen if the Sylos Postulate is not
valid.
•
What recommendations would you make with respect to the pricing of MTR
journeys at different times of day? Provide a full theoretical justification for
your answers and consider the objections which might be made to your
proposals.
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