Market Pricing DecisionsMarket Pricing Decisions – Travel – Travel to M.E. Porter's Modelto M.E. Porter's Model

Presentation byPresentation by

Prof.K.PrabhakarProf.K.Prabhakar

prabhakar.krishnamurthy@gmail.comprabhakar.krishnamurthy@gmail.com

Introduction Introduction

It was always tough task for me It was always tough task for me teach pricing decisions to teach pricing decisions to management students. management students.

In this presentation we will discuss In this presentation we will discuss some issues. some issues.

MARKET STRUCTURE AND MARKET STRUCTURE AND OUTPUT-PRICING DECISIONSOUTPUT-PRICING DECISIONS

Firms output and pricing decisions Firms output and pricing decisions depend on the depend on the currentcurrent market market structure in which the firm is structure in which the firm is operating i.e. operating i.e.

MARKET STRUCTURE AND MARKET STRUCTURE AND OUTPUT-PRICING DECISIONSOUTPUT-PRICING DECISIONS

““How much control over price the How much control over price the firm have”firm have”

whether the firm is competing in whether the firm is competing in perfect competition, monopoly, perfect competition, monopoly, monopolistic competition or oligopoly monopolistic competition or oligopoly situation depends on this condition of situation depends on this condition of controllability. controllability.

Competition vs. MonopolyCompetition vs. Monopoly

One useful way in which issues One useful way in which issues of competition and monopoly of competition and monopoly can be investigated is called the can be investigated is called the Structure, Conduct and Structure, Conduct and Performance Model.Performance Model.

A Model to Start Analysis A Model to Start Analysis

MarketStructure Conduct Performance

e.g. number ofbuyers and sellers(the size of firms)

e.g. firm's goals,pricing and output,their investments

e.g. efficiency,profitability and growth

Firms are price takersFirms are price takers– they face a perfectly elastic demand they face a perfectly elastic demand

curvecurve

– market price changes only if demand or market price changes only if demand or supply changessupply changes

Given the market price, what is the Given the market price, what is the appropriate level of production?appropriate level of production?

AC

P*

Output

MC

D=MR=AR

q*

Since market price will settle at the point where only normal Since market price will settle at the point where only normal profits are earned profits are earned output will settle where output will settle where

price= Marginal Cost = Average Cost = Marginal Revenue price= Marginal Cost = Average Cost = Marginal Revenue

Industry Demand Increase and Industry Demand Increase and The Long-Run Industry Supply The Long-Run Industry Supply

CurveCurve

S1S2

D1D2

Long-run S

P

Q

a) Constant industry costs

a

b

c

Industry Demand Increase and Industry Demand Increase and The Long-Run Industry Supply Curve The Long-Run Industry Supply Curve

continuedcontinued

S1 S2

D1D2

Long-run S

P

Q

b) Increasing industry costs: external diseconomies of

scale

a

b

c

Industry Demand Increase and Industry Demand Increase and The Long-Run Industry Supply Curve The Long-Run Industry Supply Curve

continuedcontinued

S1 S2

D1 D2

Long-run Supply

P

Qc) Decreasing industry

costs: external economies of scale

a

b

c

Why is perfect competition so rare in Why is perfect competition so rare in the real world - if it even exists at the real world - if it even exists at

all?all?

One important reason for this has to do with One important reason for this has to do with economies of scale:economies of scale:

Perfect competition requires there to be many Perfect competition requires there to be many firms. Firms must therefore be small under firms. Firms must therefore be small under perfect competition - too small for economies perfect competition - too small for economies of scale.of scale.

DLAC1

LAC2

LAC3

Output

BUTBUT

once a firm expands sufficiently to once a firm expands sufficiently to achieve economies of scale, it will achieve economies of scale, it will usually gain market powerusually gain market power

it will be able to undercut the prices of it will be able to undercut the prices of smaller firms and so drive them out of smaller firms and so drive them out of business business perfect competition will be perfect competition will be destroyeddestroyed

perfect competition could only exist in perfect competition could only exist in an industry, therefore, if there were no an industry, therefore, if there were no (or virtually no) economies of scale(or virtually no) economies of scale

Perfect Competition and Perfect Competition and Public InterestPublic Interest

Possible good points :Possible good points :

the fact that p = mc leads to efficient resource the fact that p = mc leads to efficient resource allocationallocationcompetition between firms will spur to competition between firms will spur to efficiency efficiency

Perfect Competition and Perfect Competition and Public InterestPublic Interest

will encourage the development of new will encourage the development of new technologytechnologythere is no point in advertising (Reflect)there is no point in advertising (Reflect)in long-run equilibrium: LRAC at its minimum, in long-run equilibrium: LRAC at its minimum, so company producing at the least-cost outputso company producing at the least-cost outputconsumers gain from low pricesconsumers gain from low pricesquick response to changed consumer tastesquick response to changed consumer tastes

Perfect Competition and Public Interest Perfect Competition and Public Interest continuedcontinued

Pitfalls of perfect competition: Pitfalls of perfect competition:

firms may be too small to afford R & D!firms may be too small to afford R & D!

produces only undifferentiated produces only undifferentiated productsproducts– how about the taste of variety!how about the taste of variety!

MonopolyMonopoly

Demand function facing a monopoly is the Demand function facing a monopoly is the market demand for the productmarket demand for the product

Monopoly firm’s ability to set its market Monopoly firm’s ability to set its market price is limited by the demand curve price is limited by the demand curve (demand elasticity)(demand elasticity)– downward sloping demand and MR-curvesdownward sloping demand and MR-curves

But supernormal profits may be earned But supernormal profits may be earned even in the long run even in the long run – depends on how contestable the market depends on how contestable the market

isis

Graph- Reflect on the slideGraph- Reflect on the slide

P1

Q1

MCAC

D = AR

MR

Monopoly and Public InterestMonopoly and Public Interest

Disadvantages of monopoly:Disadvantages of monopoly:

– higher prices and lower output than higher prices and lower output than under perfect competition under perfect competition

– possibility of higher cost curves due possibility of higher cost curves due lack of competitionlack of competition

– unequal distribution of incomeunequal distribution of income

Monopoly and Public Interest Monopoly and Public Interest continuedcontinued

Advantages of monopoly:Advantages of monopoly:

– economies of scaleeconomies of scale

– possibility of lower cost curves due to possibility of lower cost curves due to more research and development and more research and development and more investmentmore investment

– competition for corporate controlcompetition for corporate control

– innovation and new productsinnovation and new products

Monopolistic CompetitionMonopolistic Competition

Firms have some degree of market powerFirms have some degree of market power– but demand curve typically flatter than in monopoly but demand curve typically flatter than in monopoly

since there is more competitionsince there is more competition

Output-pricing decision is defined by MR = MC as Output-pricing decision is defined by MR = MC as alwaysalways

– the absence of entry barriers means that super normal the absence of entry barriers means that super normal profits are competed away...profits are competed away...

– firms end up producing where p = AC, but AC not at its firms end up producing where p = AC, but AC not at its minimum as in perfect competition, also p > MCminimum as in perfect competition, also p > MC

OutputD

MR

ACMC

FP = AC1

Q1

Graph-Reflect and think Graph-Reflect and think

OutputD

MR

ACMC

F

Limitations of Monopolistic Limitations of Monopolistic Competition ModelCompetition Model

Information may be imperfect;Information may be imperfect;firms will not enter an industry if they are unaware firms will not enter an industry if they are unaware of the supernormal profits currently being madeof the supernormal profits currently being made

Firms are likely to be different from each other not Firms are likely to be different from each other not only in the product they produce or the service only in the product they produce or the service they offer, but also in their size and in their cost they offer, but also in their size and in their cost structure. Also the entry may not be completely structure. Also the entry may not be completely unrestrictedunrestricted

The model concentrates on price-output decisions; The model concentrates on price-output decisions; in practice the profit-maximizing firm under in practice the profit-maximizing firm under monopolistic competition will also need to decide monopolistic competition will also need to decide the exact variety of products to produce and how the exact variety of products to produce and how much to spend on advertisingmuch to spend on advertising

Limitations of Monopolistic Limitations of Monopolistic Competition Model Competition Model continuedcontinued

Compared to perfect competition:Compared to perfect competition:– less will be sold at a higher priceless will be sold at a higher price– firms will not be producing at the least-cost point firms will not be producing at the least-cost point

= firms have excess capacity= firms have excess capacity

On the other hand it is often argued that On the other hand it is often argued that these wastes are insignificant (since highly these wastes are insignificant (since highly elastic demand curves and some scale elastic demand curves and some scale economies gained) and perhaps well economies gained) and perhaps well compensated to the consumer by the great compensated to the consumer by the great variety of products to choose fromvariety of products to choose from

OligopolyOligopoly

The essence of an oligapolistic The essence of an oligapolistic industry is the need for each firm to industry is the need for each firm to consider how its own actions affect consider how its own actions affect the decisions of its relatively few the decisions of its relatively few competitorscompetitors

Oligopoly may be characterized by Oligopoly may be characterized by collusioncollusion or by or by non-co-operationnon-co-operation

Collusion and CartelsCollusion and Cartels

COLLUSIONCOLLUSION– an explicit or implicit agreement an explicit or implicit agreement

between existing firms to avoid or limit between existing firms to avoid or limit competition with one anothercompetition with one another

CARTELCARTEL– is a situation in which formal is a situation in which formal

agreements between firms are legally agreements between firms are legally permittedpermitted e.g. OPECe.g. OPEC

Collusion is difficult if:Collusion is difficult if:

There are many firms in the industryThere are many firms in the industry

The product is not standardizedThe product is not standardized

Demand and cost conditions are Demand and cost conditions are changing rapidlychanging rapidly

There are no barriers to entryThere are no barriers to entry

Firms have surplus capacityFirms have surplus capacity

Tacit Collusion: Price LeadershipTacit Collusion: Price Leadership

Dominant firm price leadershipDominant firm price leadership

Sall other firms

Dmarket

DleaderP1

P2

Q

•Followers, like in perfect competition, accept the price as given their joint supply is the sum of their MC curves (like in perfect competition)

•The leader’s D-curve can be seen as that portion of market demand unfilled by the other firms

a

b

MRleader

MCleader

PL

QL QF QT

PS. An other form of price leadership is barometric firm price leadership

figfig

Kinked demand for a firm under oligopolyKinked demand for a firm under oligopoly

QO

P1

Q1

D

so demand in response to a price reduction is likely to be relatively inelastic

The firm may expect rivals to respond if it reduces its price, as this will be seen as an aggressive move

…but for a price increase rivals are less likely to react,so demand may be relatively elastic above P1

Demand curve kinked at current price:

Stable price under conditions of Stable price under conditions of a kinked demand curve a kinked demand curve

QO

P1

Q1

D ARa

MR

When Q < Q1, the MR curve corresponds to the shallow part of the AR curve

Stable price under conditions of Stable price under conditions of a kinked demand curve a kinked demand curve

continuedcontinued

QO

P1

Q1MR

a

b

D AR

At Q > Q1, the MR curve will correspond to the steep part of the AR curve

Note the cap between points a and b

Stable price under conditions of Stable price under conditions of a kinked demand curve a kinked demand curve

QO

P1

Q1 MR

a

bD AR

•Price will tend to be stable, even in the face of an increase in marginal cost:if MC lies anywhere

between a and b the profit-maximizing price and output will be P1 and Q1

Stable price under conditions Stable price under conditions of a kinked demand curve of a kinked demand curve

continuedcontinued

QO

P1

Q1

MC2

MC1

MR

a

bD AR

Non-Collusive Oligopoly: Non-Collusive Oligopoly: Game TheoryGame Theory

A method of analyzing strategic behaviorA method of analyzing strategic behavior– behavior of a firm will depend on how it thinks its behavior of a firm will depend on how it thinks its

rivals will react to its policiesrivals will react to its policies

Invented by John von Neuman (1937)Invented by John von Neuman (1937)– and extended with Oskar Morgenstern (1944)and extended with Oskar Morgenstern (1944)

John Nash: Nash equilibrium (1949-1950)John Nash: Nash equilibrium (1949-1950)– a dominant strategy equilibriuma dominant strategy equilibrium

Prisoner’s Dilemma: Payoff MatrixPrisoner’s Dilemma: Payoff Matrix

Kannan’s strategies

Confess Deny

Confess

Deny

Ara

si’

s

str

ate

gie

s

3 years

3 years

2 years

2 years

10 years

10 years

1 year

1 year

A Strategic Game ExampleA Strategic Game Example

Detergent Wars Detergent Wars You can take price wars in detergent You can take price wars in detergent market in India and design a model. market in India and design a model.

Duopoly Payoff Matrix: The equilibrium is a Nash equilibrium in which both firms cheat

Company A’s strategies

Cheat Comply

Com

pan

y B

’s

str

ate

gie

s

nil

Cheat

Comply

Nil

-Rs1.0m

-Rs1.0m

+Rs4.5m

+Rs4.5m

+Rs2m

+Rs2m

Oligopoly and Public InterestOligopoly and Public Interest

If oligopolists act collusively and jointly maximize If oligopolists act collusively and jointly maximize industry profits, they will in effect be acting industry profits, they will in effect be acting together like a monopoly and then the together like a monopoly and then the disadvantages to society would be the same as disadvantages to society would be the same as under monopolyunder monopoly

Further more, in two respects, oligopoly may be Further more, in two respects, oligopoly may be more disadvantageous than monopoly:more disadvantageous than monopoly:– Oligopolists are likely to engage in much more Oligopolists are likely to engage in much more

extensive advertising than a monopolistextensive advertising than a monopolist– Depending on the size of individual oligopolists, Depending on the size of individual oligopolists,

there may be less scope for economies of scale there may be less scope for economies of scale to decrease the effects of market powerto decrease the effects of market power

Advantages of oligopoly to Advantages of oligopoly to society over other market society over other market

structures:structures:Can use part of the supernormal Can use part of the supernormal profits for R&D (incentive to do so profits for R&D (incentive to do so higher than in monopoly)higher than in monopoly)

Non-price competition through Non-price competition through product differentiation may result in product differentiation may result in greater choice for the consumersgreater choice for the consumers

Non-Price CompetitionNon-Price Competition

Product DevelopmentProduct Development– aims to develop products which will sell well and aims to develop products which will sell well and

which are different from rivals' productswhich are different from rivals' products– leads to less elastic and potentially high demandleads to less elastic and potentially high demand

AdvertisingAdvertising– to increase demand and to make demand curve to increase demand and to make demand curve

less elasticless elastic

Advertising and product development not only Advertising and product development not only increase a firm's demand and hence revenue, they increase a firm's demand and hence revenue, they also involve increased costs. So how much to spend also involve increased costs. So how much to spend in order to maximize profit?in order to maximize profit?

The Changing Nature of The Changing Nature of Market StructureMarket Structure

the market types that actually exist the market types that actually exist in business situations are not always in business situations are not always clear-cut or stableclear-cut or stable

the type of market in which a firm the type of market in which a firm competes may change over the life of competes may change over the life of the products being soldthe products being sold

Prof. Michael Porter has introduced a Prof. Michael Porter has introduced a useful way to incorporate the useful way to incorporate the possibility of change in market possibility of change in market structure into the analysis of structure into the analysis of business decision making business decision making

the model of "five competitive forces"the model of "five competitive forces"

The Porter Competitive FrameworkThe Porter Competitive Framework

Intra-Market Rivalry

Potential Entrants

Customers

Substitute Markets

Suppliers

Threat of new entrants

Bargaining power of buyers

Bargaining power of suppliers

Threat of substitute products or services

SummarySummary

You have to travel from various You have to travel from various points to ME.Porter’s Model.points to ME.Porter’s Model.

Reflect on all that has been Reflect on all that has been discussed. discussed.