Managerial Economics
Some Final Thoughts
Aalto University
School of Science
Department of Industrial Engineering and Management
January 12 – 28, 2016
Dr. Arto Kovanen, Ph.D.
Visiting Lecturer
Importance of Pricing …
 Pricing is often considered as one of the most
important element in economics
 This is why we study demand and cost theories
 For managers, price is just one of many decisions
 Pricing decisions are made in a broader context
 Competitive Advantage provides a useful means
of analyzing corporation’s success in a market
 This involved analyzing corporation’s non-price
decisions and explaining price decisions in this
context
Competitive Advantage …
 As we have discussed during this course, profitability
of a firm depends in general on two factors:
 Market conditions
 Competitive advantage
 Market conditions relate to external factors, as we
have seen, not just for the firm, but for the industry
 Industries’ profitability varies considerably
 Banks and technology firms have done well
 Traditional industries, such as steel and transportation,
performed less well
 Recall Porter’s paper on 5 forces shaping industries
Competitive Advantage (cont.)
 As we have discussed, there are important external
factors in play:
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Internal competition between firms in a market
Restrictions for entry of new players in the market
Possible substitutes and complements
Supplier power
Pricing power of buyers
 Competitive advantage relates to internal factors and
determine a firm’s ability to create more value than
its competitors
 These factors are within the control of the firm
Competitive Advantage (cont.)
 A useful concept for this purpose is value creation
where V = B – C
 V = value created
 B = perceived benefit to customers
 C = cost of inputs
 If we examine the standard supply – demand curves,
we can identify consumer surplus (CS) and producer
surplus (PS) where
 CS = B – P
 PS = P – C
 Then V = CS + PS = (B – P) + (P – C) = B - C
Competitive Advantage (cont.)
 An example illustrates this:
 A consumer is prepared to pay $250 for a VCR whose
price is $200; hence CS = $50
 The marginal cost of producing a VCR is $130 and hence
PS = $70
 Consequently V = $50 + $70 = $120
 If a firm has a competitive advantage, it is possible to
make more profits than its competitors
 This is not only limited to cost advantage (i.e., being
able to produce at a lower cost), but also includes a
benefit advantage
Competitive Advantage (cont.)
 Cost advantage is obvious, but benefit advantage has
to do with the ability to achieve higher perceived
benefits to the consumer than the competitors, while
maintaining a similar level of costs
 Recall that we assumed earlier:
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Firm produces a single product for a single market
Firm charges the same price throughout the market
Price is the only variable in the marketing mix
Pricing is considered from a static, single-period point of
view
Competitive Advantage (cont.)
 Positioning in the market is the most fundamental
aspect of a firm’s marketing strategy
 Cost advantage:
 Object is to achieve lower cost while maintaining level of
benefits (services) relative to competition
 Examples: Woolworth, Wal-Mart and McDonalds
 Cost advantage can be achieved through economies of
scale, the learning curve, production efficiency, control
over inputs (and their costs), and so on
 Examples: Hyundai (lower cost production of adequate
quality), British sport car (TVR; sharing of components,
simplified production process, etc)
Competitive Advantage (cont.)
 Benefit advantage:
 Many car manufacturers pursue this strategy
 BMW and Lexus (provide same level of technology and
comfort than higher-priced competitors, but at a lower
sticker price)
 Porsche (higher price, but significantly greater quality)
 Ferrari and Aston Martin (charge a very high price, but
promise top line performance and quality)
 There is also perceived value associated with the name
(there are no substitutes for Ferrari, Aston Martin and
Porsche), which means that customers are willing to
pay a higher price for the product
 Apple versus Samsung is a similar story
Competitive Advantage (cont.)
 Benefit advantage can be achieved in a number of
ways
 Reputation counts for a large part in the luxury car
market (e.g., German engineering, or in the 1970s it
was common to hear that do not purchase British
cars)
 An issue to consider by a firm is how to distribute the
competitive advantage between consumer / producer
surplus
 Cost advantage can be given to customers in the form
of lower price
 This might help increase market share and profits
Competitive Advantage (cont.)
 This, however, depends:
 On the price elasticity of the consumer demand (is the
demand elastic or inelastic) and
 How other producers in the market react (would they
also lower their prices to protect market share even if
that means lower profit margins)
 Alternatively, the increased value can be translated to
higher producer surplus and higher profit margin, as
the company would charge the same price as others
 In principle, the choice depends on the elasticity of
the demand and whether this benefits the firm
 The same applies to benefit advantages
Competitive Advantage (cont.)
 Market segmentation and targeting consumer groups
are important for companies
 A market segment refers to a group of consumers in a
broader market that have homogeneous features (for
instance, income, age, location, lifestyle, and so on)
 Firms use marketing to target specific groups:
 For instance, adequate quality at reasonable prices (WalMart, targeting consumers at lower income brackets)
 Sport equipment (for young professionals)
 Expensive, luxury cars (for wealthy)
 Vacation packages
 Pricing is an outcome of other strategic decision!
A Brief Review of the
Course Material
Review of Material
 In this course we have covered a broad range of
issues related to decision-making in a company
 We structured the course in the following way:
 Decision-making within the firm:
 Use of marginal analysis
 Understanding production processes and marginal
products
 Understanding costs using marginal analysis
 Understanding consumer demand
 Some discussion and examples of empirical estimation of
cost and demand functions
Review of Material
 The role of markets:
 We discussed different market structures (basically ranging
from a perfectly competitive market to a monopoly)
 Although not necessarily realistic, they helped illustrate the
key elements of the pricing behavior of a firm
 We also discussed alternative strategies that have been
developed to characterize interaction in a market where
there are few players
 We also discussed briefly:
 The role of government in the market
 Market failure and incomplete information, and
 Issues with public goods
Review of Material
 Selected other issues useful for firms:
 Linear optimization
 Asymmetric information
 Uncertainty and risk, and how it affects firm’s decisionmaking
 And today we talked about the importance of utilizing
firm’s competitive advantage in its pricing
Thank you!