Week 6 managerial economics

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Chapter Ten
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Chapter 10
Special Pricing Policies
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Chapter Ten
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Overview
Cartel arrangements
Price leadership
Revenue maximization
Price discrimination
Nonmarginal pricing
Multiproduct pricing
Transfer pricing

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Chapter Ten
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Cartel arrangements
A cartel is an arrangement where firms in an industry cooperate and act together as if they were a monopoly

cartel arrangements may be tacit or formal
illegal in the US: Sherman Antitrust Act, 1890
examples: OPEC
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Chapter Ten
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Cartel arrangements
Conditions that influence the formation of cartels
small number of large firms in the industry
geographical proximity of the firms
homogeneous products that do not allow differentiation
stage of the business cycle
difficult entry into industry
uniform cost conditions, usually defined by product homogeneity

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Chapter Ten
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Cartel arrangements
In order to maximize profits, the cartel as a whole should behave as a ‘monopolist’
 the cartel determines the output which equates MR = MC of the cartel as a whole
 the MC of the cartel as a whole is the horizontal summation of the members’ marginal cost curves
 price is set in the normal monopoly way, by determining quantity demanded where MC=MR and deriving P from the demand curve at that Q
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Chapter Ten
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Cartel arrangements

MCT is the horizontal sum of MCI and MCII
QT is found at the intersection of MRT and MCT
 price is found from the demand curve at QT … this is the price that maximizes total industry profits
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Chapter Ten
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Cartel arrangements

 to determine how much each firm should produce, draw a horizontal line back from the MRT/MCT intersection
 where this line intersects each individual firm’s MC determines that firm’s output, QI and QII. Note that the firms may produce different outputs
Key point: the MC of the last unit produced is equated across both firms
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Chapter Ten
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Cartel arrangements

Profits for each firm are shown as rectangles in blue
Firms may earn different levels of profit, though combined profits are maximized
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Chapter Ten
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Cartel arrangements
Problem: incentive for firms to cheat on agreement, thus cartels are unstable

Additional costs facing the cartel
formation costs
monitoring costs
enforcement costs
cost of punishment by authorities
 weigh the benefits against these costs
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Chapter Ten
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Cartel arrangements
Examples: price fixing by cartels

GE, Westinghouse
Archer Daniels Midland Company
Sotheby’s, Christie’s
Roche Holding AG, BASF AG

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Chapter Ten
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Price leadership
Barometric price leadership
one firm in an industry will initiate a price change in response to economic conditions
the other firms may or may not follow this leader
leader may vary

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Price leadership
Dominant price leadership
one firm is the industry leader
dominant firm sets price with the realization that the smaller firms will follow and charge the same price
can force competitors out of business or buy them out under favorable terms
could result in investigation under Sherman Anti-Trust Act

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Chapter Ten
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Price leadership
DT = demand curve for entire industry
MCD = marginal cost of the dominant firm
MCR = summation of MC of follower firms
 in setting price, dominant firm must consider the amount supplied by all firms

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Price leadership

Demand curve facing the dominant firm is found by subtracting MCR from DT
 dominant firm equates its MC with MR from its ‘residual demand curve’ DD
 the dominant firm sells A units and the rest of the demand (QT – A) is supplied by the follower firms

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Revenue maximization
Baumol model: firms maximize revenue (not profit) subject to maintaining a specific level of profits
Rationale
a firm will become more competitive when it achieves a large size
management remuneration may be related to revenue not profits
Implication: unlike the profit maximization case, a change in fixed costs will alter price and output (by raising the cost curve and lowering the profit line)
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Price discrimination
Price discrimination: products with identical costs are sold in different markets at different prices
 the ratio of price to marginal cost differs for similar products
Conditions for price discrimination
the markets in which the products are sold must by separated (no resale between markets)
the demand curves in the market must have different elasticities

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Price discrimination
First degree price discrimination
seller can identify where each consumer lies on the demand curve and charges each consumer the highest price the consumer is willing to pay
allows the seller to extract the greatest amount of profits
requires a considerable amount of information

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Chapter Ten
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Price discrimination
Second degree price discrimination
differential prices charged by blocks of services
requires metering of services consumed by buyers

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Chapter Ten
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Price discrimination
Third degree price discrimination
customers are segregated into different markets and charged different prices in each
segmentation can be based on any characteristic such as age, location, gender, income, etc

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Chapter Ten
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Price discrimination

Third degree discrimination:
assume the firm operates in two markets, A and B
the demand in market A is less elastic than the demand in
market B
the entire market faced by the firm is described by the horizontal sum of the demand and marginal revenue curves …
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Chapter Ten
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Price discrimination

the firm finds the total amount to produce by equating the marginal revenue and marginal cost in the market as a whole: QT
if the firm were forced to charge a uniform price, it would find the price by examining the aggregate demand DT at the output level QT
the firm can increase its profits by charging a different price in each market …
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Chapter Ten
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Price discrimination

in order to find the optimum price to charge in each market, draw a horizontal line back from the MRT/MCT intersection
where this line intersects each submarket’s MR curve determines the amount that should be sold in each market: QA and QB
these quantities are then used to determine the price in each market using the demand curves DA and DB
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Chapter Ten
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Price discrimination

Examples of price discrimination

doctors
telephone calls
theaters
hotel industry
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Price discrimination
Tying arrangement: a buyer of one product is obligated to also buy a related product from the same supplier
illegal in some cases
one explanation: a device to ‘meter’ demand for tied product
other explanations of tying
quality control
efficiencies in distribution
evasion of price controls

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Chapter Ten
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Nonmarginal pricing
Cost-plus pricing: price is set by first calculating the variable cost, adding an allocation for fixed costs, and then adding a profit percentage or markup

Problems with cost-plus pricing
calculation of average variable cost
allocation of fixed cost
size of the markup

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Nonmarginal pricing
Incremental pricing (and costing) analysis: deals with changes in total revenue and total cost resulting from a decision to change prices or product
Features:
incremental, similar to marginal analysis
only revenues and costs that will change due to the decision are considered
examples of product change: new product, discontinue old product, improve a product, capital equipment
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Multiproduct pricing
When the firm produces two or more products

Case 1: products are complements in terms of demand  an increase in the quantity sold of one will bring about an increase in the quantity sold of the other
Case 2: products are substitutes in terms of demand  an increase in the quantity sold of one will bring about a decrease in the quantity sold of the other
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Multiproduct pricing
When the firm produces two or more products

Case 3: products are joined in production 
products produced from one set of inputs
Case 4: products compete for resources  using resources to produce one product takes those resources away from producing other products
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Transfer pricing
Internal pricing: as the product moves through these divisions on the way to the consumer it is ‘sold’ or transferred from one division to another at a ‘transfer price’

Rationale:
firm subdivided into divisions, each may be charged with a profit objective
without any coordination, the final price of the product to consumers may not maximize profits for the firm as a whole
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Chapter Ten
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Transfer pricing
Design of the optimal transfer pricing mechanism is complicated by the fact that

each division may be able to sell its product in external markets as well as internally
each division may be able to procure inputs from external markets as well as internally

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Chapter Ten
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Transfer pricing
Case A: no external markets
no division can buy from or sell to an external market
the selling division will produce exactly the number of components that will be used by the purchasing division
one demand curve and two MC curves
MC curves are summed vertically
set production where MR = Total MC

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Chapter Ten
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Transfer pricing
Case B: external markets
divisions have the opportunity to buy or sell in outside competitive markets
if selling division prices above the external market price, the buying division will buy from outside
if selling division cannot produce enough to satisfy buying division demand, the buying division will buy additional units from the external market

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Other pricing practices
Price skimming
the first firm to introduce a product may have a temporary monopoly and may be able to charge high prices and obtain high profits until competition enters
Penetration pricing
selling at a low price in order to obtain market share

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Other pricing practices
Prestige pricing
demand for a product may be higher at a higher price because of the prestige that ownership bestows on the owner
Psychological pricing
demand for a product may be quite inelastic over a certain range but will become rather elastic at one specific higher or lower price

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Chapter Eleven
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Chapter 11
Game Theory
and
Asymmetric Information
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Chapter Eleven
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Overview
Game theory
Game theory and auctions
Strategy and game theory
Asymmetric information
Reputation
Standardization
Market signaling

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Chapter Eleven
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Game theory
Economic optimization has two shortcomings when applied to actual business situations

assumes factors such as reaction of competitors or tastes and preferences of consumers remain constant
managers sometimes make decisions when other parties have more information about market conditions

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Chapter Eleven
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Game theory

Game theory: is concerned with “how individuals make decisions when they are aware that their actions affect each other and when each individual takes this into account”

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Chapter Eleven
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Game theory
Fundamental aspects of game theory
players are interdependent
uncertainty: other players’ actions are not entirely predictable
Types of games
zero-sum or non-zero-sum
cooperative or non-cooperative
two-person or n-person

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Chapter Eleven
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Games in economics
Prisoners’ Dilemma
two-person, non-zero-sum, non-cooperative
always has a dominant strategy
equilibrium is stable

 confessing is dominant strategy for each player, no matter what other player chooses

 each player has no incentive to unilaterally change his strategy

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Chapter Eleven
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Games in economics
Oligopoly pricing using
prisoners’ dilemma
(Low/Low) is a stable equilibrium … no incentive for either firm to deviate
better off at (High/High) but it is not stable … each firm has an incentive to deviate
(High/High) would be an equilibrium … if the firms were allowed to cooperate

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Chapter Eleven
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Games in economics
Example: Beach Kiosk Game: a two-person, zero-sum, non-cooperative game

Suppose two companies provide snacks and sunscreen on a beach
beachgoers will spread themselves out evenly along the beach
both companies ultimately locate at the midpoint of the beach, otherwise the other company has an advantage (closer to more beachgoers
Real life example: location of gas stations
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Chapter Eleven
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Games in economics
Repeated Game: game is played repeatedly over a period of time

in a perpetual repeated game, equilibria that are not stable may become stable due to the threat of retaliation
however, if number of periods is fixed, players will have incentive to ‘cheat’ in the last period due to lack of threat of retaliation, which will then allow them to cheat in all periods
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Chapter Eleven
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Games in economics
Example: assume (High, High) equilibrium reached and both firms start off charging the high price

in the next period, if one firm cheats (charges low price), it receives 600 in that period
other firm will change to low prices in the next period to ‘retaliate’ and both will end up at (Low, Low) equilibrium
thus, incentive exists not to cheat in a perpetual repeated game and (High, High) is a viable equilibrium (unlike in the short game)
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Chapter Eleven
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Games in economics
Simultaneous games are games in which players make their strategy choices at the same time
Sequential games are games in which players make their decisions sequentially

In sequential games, the first mover may have an advantage
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Chapter Eleven
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Games in economics
Consider the following payoff matrix in which firms choose their capacity, either high or low. Suppose firm C has the ability to move first

 C would choose Low, then D would choose High
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Chapter Eleven
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Game theory and auctions
Dutch auction (a non-cooperative, non-zero-sum game):
each buyer describes the quantity demanded and price to pay
starting at highest price, sum quantity demanded up to the supply available
all product is sold at the highest price that clears the market
Seller wants to sell at highest price, buyer wants to buy at lowest price

Solution: every player’s dominant strategy is to bid as late as possible
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Chapter Eleven
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Strategy and game theory
Problem: in Prisoners’ Dilemma, players have a dominant strategy that leads to suboptimal results

Commitment, explicit or implicit, can be used to achieve preferred outcomes. It must be credible:
burn bridges behind you
establish and use a reputation
write contracts

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Chapter Eleven
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Strategy and game theory
Incentives also can be used to change the game to achieve preferred outcomes
Illustration: GM card. GM came up with a strategy where customers could apply 5% of their purchases to a GM vehicle
Illustration: Health insurance. Firms provide a menu of care levels.
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Chapter Eleven
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Strategy and game theory

PARTS: paradigm for studying a situation, predicting players’ actions, making strategic decisions
Players: Who are players and what are their goals?
Added Value: What do the different players contribute to the pie?
Rules: What is the form of competition? Time structure of the game?
Tactics: What options are open to the players? Commitments? Incentives?
Scope: What are the boundaries of the game?

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Chapter Eleven
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Asymmetric information
Asymmetric information: market situation in which one party in a transaction has more information than the other party. Leads to many problems in markets:
too much or too little production
difficult contracting
possible fraud
market may disappear

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Chapter Eleven
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Asymmetric information
Adverse selection: prior to transaction, one party may know more about the value of a good than the other

Example: ‘lemons’ (bad used cars)… seller knows the vehicle well, but buyer does not, yet market does not divide in two
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Chapter Eleven
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Asymmetric information
Moral Hazard: transaction changes the incentives of a party because it cannot be monitored after the transaction

Example: insurance industry … poor information takes place after the sale, not before
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Asymmetric Information
Market responses:

obtaining information from third parties
relying on reputation of the seller
standardization of products
market signaling: demonstrated success in one activity provides information about success/quality in another
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Chapter Eleven
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Asymmetric Information

Example: education as a signal
attending college demonstrates certain traits
employers see this a screening device

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Asymmetric Information

Example: warranties
more costly on low quality goods than high quality goods
consumers see them as a screening device

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Asymmetric Information

Example: banking systems
banks know less about the borrower’s ability to repay than the customer
arms length banking: US
relationship banking: Japan

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Problem 1

Two projects have the following

NPV

s and standard deviations:

Project A	Project B
NPV	200	300
Standard deviation	75	100

Which of the two projects is more risky?

Problem 2

Your firm has an opportunity to make an investment of $50,000. Its cost of capital is 12 percent. It expects after-tax cash flows (including the tax shield from depreciation) for the next five years to be as follows:

Year 1

$10,000

Year 2

$20,000

Year 3

$30,000

Year 4

$20,000

Year 5

$ 5,000

a. Calculate the NPV.

b. Calculate the IRR (to the nearest percent)

c. Would you accept this project?