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Road Map for Prices and Markets

- Demand and Supply Analysis
- Demand and Revenue
- Elasticity of demand
- Costs
- Marginal costs fixed costs variable costs
- Competitive Markets
- Pricing under competition (P MR MC)
- Short run and long run decisions
- Strategies to survive in a competitive market
- Forecasting in the context of entry decisions
- Pricing with market power
- Pricing by a monopolist (MR MC)
- The trade off between high price and low

quantity (MR lt P) - Some pricing fallacies

TOOLS

Understanding Cost (session 3)

Revenue Understanding Demand (session 2)

Profit Revenue Cost

Pricing

Monopoly Trade off b/w high P and low Q

(session 6)

Perfect Competition Supply and entry decisions

(session 4 5)

What if we can price discriminate? (i.e.,

different consumers pay different

prices) (session 9 10)

How pricing depends on demand through the

elasticities (session 7)

Strategic Competition Solving for the NE

price and quantity competition (session 12)

How timing matters Stackelberg (session 14)

Exotic topics Strategic Demand Network

externalities and Auctions. (session 15)

Tools Games Theory (session 11)

Externalities and Strategic interaction

Collusion (session 13)

Today Pricing with Market Power

- Monopoly Pricing
- The rule of profit maximization MC MR.
- The relationship between marginal revenue and

price. - Graphical and algebraic solutions to the

monopoly pricing problem. - Some pricing fallacies
- The midpoint pricing rule
- Not all gains from trade realized or extracted
- How pricing depends on the demand curve
- How elasticity relates to revenue
- How elasticity relates to pricing
- Implications of the mark up elasticity formula

Next Sessions

Price Discrimination (Explicit and Implicit

market segmentation)

Role of Fixed Costs

Fixed costs did not appear in our discussion of

pricing. Why?

AC

AC AFC AVC

P

P

AC

AC

MC AVC

MC AVC

Q

MR

Q

MR

Positive Net Profit

Net loss

Fixed cost determines whether the business is

profitable or not, but not how the pricing

decision should be made

Sunk Cost Fallacy Revisited

Business looks unprofitable. Temptation (1)

close it (2) raise prices to bring in more

revenues. But From the perspective of

relevant (forward looking) costs and

revenues, it is profitable!! And, there is no

way to improve things by charging higher

(or lower) prices.

P

AC SC/Q

AC

MC AVC

Q

MR

- Positive profits
- Sunk cost not recovered

Fallacies

- Monopoly power fallacy
- monopolist can charge any price she likes -

Microsoft - Imitation fallacy
- price to match competitors - Eurotunnel
- Fixed cost fallacy
- pass on fixed cost increases to consumers -

Seagram - price to recover fixed costs
- Sunk cost fallacy
- take into account costs that decisions cannot

possibly impact

Lesson so Far

- All questions about pricing have the same

answer (although it may not - always be a helpful one) MR MC.
- The equality of MR and MC gives us a systematic

way to understand - what determines optimal pricing
- For a monopolist MR lt P.
- Cost is a dynamic concept. Make sure you avoid

cost fallacies - The monopolist prices charges a higher price

(lower output) than - that which maximizes revenue.

Shortcuts Monopoly optimal pricing Price Choke

and midpoint pricing rule

2

- Q(P) a bP
- P(Q) (a/b) (1/b)Q (inverse demand)
- ? P(Q) Pchoke (1/b)Q (inverse demand)

P

Pchoke

The choke price (i.e, Pchoke) is the price for Q

0

Example Q(P) 12 2P P(Q) 6 (1/2)Q

Pchoke

Q

Shortcuts Monopoly optimal pricing Price Choke

and midpoint pricing rule (cont.)

R P(Q)Q (Pchoke (1/b)Q)Q (revenue) R

PchokeQ (1/b)Q (revenue) MR

Pchoke (2/b)Q (marginal revenue)

2

- Profit maximizing quantity (MC is constant)?
- MR MC ? Pchoke (2/b)Q MC ? (2/b)Q P MC

? Q (Pchoke MC)b/2 - Profit maximizing price (MC is constant)?
- Plug back for Q in inverse demand
- P Pchoke (1/b)Q ? P Pchoke (1/b)

(Pchoke MC)b/2 - P Pchoke (Pchoke MC) /2 ? P (Pchoke

MC) /2

Shortcut for linear demand curves and constant

MC Midpoint pricing rule P (Pchoke MC)/2

Summary Solving the monopolists pricing problem

- Option I
- Obtain the inverse demand and the MR curves
- Equate MC MR ? obtain Q
- Plug in Q into the inverse demand to obtain P
- Option II (linear demand, constant MC)
- Use theMidpoint pricing rule
- P (Pchoke MC)/2
- Plug in P into the demand to obtain Q

Assume FC 0

Consumer surplus

Deadweight loss

gain

loss

Perfect Price Discrimination

If every consumer could be made to pay their

maximum willingness to pay, the monopolist can

extract all the potential profits. Q What is the

deadweight loss?

Price

mc (Q)

Potential Profit

d (P) mv(Q)

Quantity

Q

Wrap Up session 6

- A profit maximizing firm produces up to the

point where MC MR. - The equality of MR and MC gives us a systematic

way to understand - what determines optimal pricing
- For a monopolist MR lt P.
- Cost is a dynamic concept. Make sure you avoid

cost fallacies - Be able to solve the monopolists pricing

problem numerically and - graphically.
- Be able to use the Midpoint pricing rule P

(Pchoke MC)/2 - Monopoly pricing implies substantial consumer

surplus and a deadweight - loss ? Antitrust Law

How pricing depends on the demand curve

- How elasticity relates to revenue
- How elasticity relates to pricing
- Implications of the mark up elasticity formula
- Rule of thumb for monopoly pricing
- How to price in different markets
- Effect of an exogenous demand shift

Evaluate

- After a advertising campaign, the cost of the

advertising is sunk. Hence, the advertising

campaign should have no effect on the firms

pricing. - What happened to airline prices just after

September 11, 2001?

Recall Elasticity

- The elasticity of demand measures demand

responsiveness - Or

Elasticity and Revenue

- If P decreases (i.e., Q increases), what is the

effect on Revenue?

Marginal revenue and elasticity

- What is the effect on revenue from selling one

more unit of output? - Effect 1 You sell one more unit of output for P
- Effect 2 You have to decrease your price by dP/

dQ for all Q units you could have sold at higher

price (the adjustment term) - Net Effect MR P (dP/dQ)Q

E ? MR ?

Elasticity and Revenue (cont.)

E 1

Revenue

E lt 1

E gt1

A

Revenue

Quantity

Q

MRgt0

MRlt0

MR0

Elasticity and Revenue (cont.)

Punch-line Elasticity allows you to maximize

revenue even when you do not know all of your

demand, but you have only local information.

E 1

Revenue

E lt 1

E gt1

A

Revenue

Quantity

Q

MRgt0

MRlt0

MR0

Price and elasticity

At the profit maximizing quantity MR MC

E ? P ?

Lesson so Far

- For profit maximization we need

- The Mark-up elasticity formula

- How may I use this?

A monopolist operates on the elastic portion of

the demand.

Implication of the mark up elasticity formula

(I) Rule of thumb for monopoly pricing

Price

E gt 1

E 1

E lt 1

Demand

quantity

MR

From a 2001 study on telecom privatization in Peru

Price Elasticities of the Use Demand 1990s data

City Services

Elasticity

Lima 1/ Local

-0.494 Domestic Long Distance

-0.478 International Long Distance

-1.095 Province 2/

Local

-0.689 Domestic Long Distance

-0.548 International Long Distance

-1.585

1/ Lima Metropolitana 2/ Cusco, Arequipa,

Trujillo and Chiclayo

Elasticity and Linear Demand

Price (1000s)

30

25

20

15

10

5

d(P)

0

0

2

4

6

8

10

12

14

16

18

Demand for Minivans (100,000s)

For a given Price the demand curve with the lower

Pchoke is the more elastic

Implication of the mark up elasticity formula

(II) How to price in different markets

- Assume that a firm sells in US and Canada. Where

should you charge a higher price?

Price

Demand US

Demand Canada

Quantity

The higher the elasticity, the lower the price.

Implication of the mark up elasticity formula

(II) How to price in different markets (cont)

Price

Demand B

Demand A

Quantity

Implication of the mark up elasticity formula

(II) An exogenous demand shift

Price

MC

Demand before 09/11

Demand after

quantity

Implication of the mark up elasticity formula

(II) An exogenous demand shift

P

P

MC

MC

P1

P

D2

D1

P2

D1

D2

MR2

MR2

MR1

MR1

Q

Q

Q

Q1

Q2

- The effect of exogenous demand shifts on price is

ambiguous.

Determinants of elasticity

- The more close substitutes a good has, the _____

elastic is demand. - Demand for a particular brand (Hitachi) or (17

flat panel) is _____ elastic than demand for the

entire category (computer displays). - The more differentiated the brand, the ____

elastic is demand. - Advertising usually both increases demand and

makes it _____ elastic. - Demand is _____ elastic in the long run (after

consumers have time to adjust). - Demand is typically ____ elastic for people with

lower income.

Implications of the mark up elasticity formula

- A monopolist operates in the elastic part of his

demand. - The higher the elasticity the lower the price.
- The effect of exogenous demand shifts on price is

ambiguous.

Wrap up Session 7

- Elasticity and marginal cost determine the price

not supply and demand. - The profit maximizing price satisfies
- Be able to interpret the mark-up elasticity

formula and its implications. - The more elastic the demand is, the lower the

price is. - The effect of a demand shift on price is ambiguous

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