Competition and Differentiation

Question 1

“Monopoly” refers, strictly, to a situation where

Answer 1

there is a single firm (or producer) in a market. The analysis of monopolies is more generally useful for understanding situations when firms have substantial pricing power: that is, the ability to set prices above cost without meaningful competitive retaliation.

Question 2

In a perfectly competitive market, price typically falls to

Answer 2

where firms earn zero profits (that is, prices equal marginal costs).

Question 3

monopolists typically price above

Answer 3

marginal cost. The reason is that a monopolist has the ability to set prices above cost without meaningful competitive retaliation.

Question 4

Optimal pricing requires that firms price where

Answer 4

Marginal Revenue = Marginal Cost.

Question 5

In a competitive market, the marginal revenue curve is the same as the demand curve. For a monopolist, the marginal revenue curve is___

Answer 5

lower than the demand curve. The marginal revenue that a monopolist generates by lowering its price reflects both the gain from attracting new customers (the “volume” effect) and the loss from lowering prices to existing or inframarginal customers (the “price” effect).

Question 6

Just as a monopoly has power to raise prices, a buyer can have power to___

Answer 6

to reduce prices if it is the sole buyer in the market.

Question 7

The analysis of monopoly pricing rests on the assumption that the firm charges the same price for every unit of the good, to every customer. In practice, firms are often able to “price discriminate” – that is, ___

Answer 7

charge different prices to different consumers, or set different prices for different units of a product.

Question 8

Perfect (or first-degree) price discrimination involves

Answer 8

setting a different price for each consumer, or for each unit of the product. Perfect price discrimination eliminates deadweight loss and consumer surplus, and the producer captures all of the value.

Question 9

Two-part tariffs involve firms setting ___

Answer 9

a per-unit price for a product (sometimes equal to $0) and charging a fixed fee to capture additional surplus. Two-part tariffs are an effective (and relatively easy) way for firms to price discriminate.

Question 10

Firms charging different prices based on observable characteristics of consumers: example

Answer 10

e.g., whether the consumer is a student or senior

Question 11

firms relying on self-selection to price discriminate: example

Answer 11

For example, firms can create separate versions of a product (business class versus coach for an airline) or offer discounts to consumers who buy in bulk.

Question 12

In order to price discriminate, a firm must be able to

Answer 12

prevent buyers with high WTP from purchasing at the lower prices. If consumers are indistinguishable, this can be challenging. Price discrimination could also be prevented by competition from other firms, or if customers with low WTP could purchase the product and resell it to customers with higher WTP.

Question 13

Price bundling is another way for firms to effectively price discriminate. Price bundling is more effective when

Answer 13

consumers’ preferences for the products are heterogeneous.

Question 14

“Vertical” differentiation occurs when firms differ

Answer 14

in attributes that all customers value similarly – that is, when some firms produce a version of the product that is perceived as “better” by all customers, or when firms differentiate by lowering prices.

Question 15

Horizontal” differentiation occurs when firms differ in

Answer 15

attributes that different customers value differently (e.g., location, color, etc). If firms are horizontally differentiated, some customers will prefer a product from one firm and others will prefer the product from another.

Question 16

3 Effective principles of competitive differentiation include:

Answer 16

• Differentiating on factors that matter either to a firm’s consumers or its suppliers (thereby creating more value, or creating value for a different set of consumers, than its competitors);
• Searching for ways to differentiate horizontally, not only vertically
• Differentiating in ways that are robust to competitor reaction.

Question 17

Why exactly are prices different in a competitive market than for a monopolist?

Answer 17

A monopolist doesn’t face the risk of a price war, so it can price higher and increase profits.
A competitive firm would be undercut by its competitors if it raised prices.

Question 18

Where are profits maximized for a monopolist?

Answer 18

A monopolist should price at the point on the demand curve where its marginal revenue is equal to its variable (or marginal) cost.
Profits are maximized when MR = MC. If marginal revenue is greater than marginal cost, you can increase profits by producing and selling an additional unit of the good. Note that the quantity produced is determined by the quantity at which MR = MC. The price is determined by the price on the demand curve that corresponds to this quantity.

Question 19

A firm sells a smartphone. At a price of $500, there is only one customer. At prices above $500, no one purchases the phone. What is the firm’s marginal revenue at a price of $500?

Answer 19

$500
Lowering the price of the phone from $501 to $500 will bring in one new customer, and $500 in new revenues. Since there are no customers who would buy the phone at any price higher than $500, the firm doesn’t lose revenue on any inframarginal customers. MR = $500 - $0.

Question 20

There are two rules that are useful to follow in determining optimal prices (whether for a competitive firm or a monopolist):

Answer 20

a. Price where the difference between total revenue and total cost is greatest (notice that this is just another way of saying “maximize profits”).
b. Price where marginal revenue is equal to marginal cost.

Question 21

How would fixed costs affect the optimal quantity produced by a monopoly versus a competitive firm?

Answer 21

Fixed costs have no effect on the optimal price and quantities produced for either a competitive firm or a monopolist.
A monopolist’s optimal price is not affected by the fixed costs it incurs. Also, in the short run, competitive firms are willing to price as low as their variable costs, regardless of what fixed costs are.

In other words, even with very high upfront fixed costs, the optimal quantity and price shouldn’t change at all—whether we are talking about competitive markets or monopolies. As long as the firm makes profits from producing where MR=MC, then it can’t do better by altering its price, regardless of whether fixed costs are low or high!

Question 22

What is the impact of downstream consolidation on our pricing analysis? [3] Amgen Example

Answer 22

It makes the demand curve that Amgen faces more elastic.
Since Amgen is dependent on the buyers, they have the power to threaten not to purchase at high prices.

Amgen is no longer a “price-setter” on a demand curve; instead, prices are determined through negotiation.
When a firm has many buyers, it can typically set a price and force consumers to take it or leave it. If there is, say, only one buyer, the consumer and the producer have a similar degree of power and prices may be set through negotiation.
It reduces the prices that Amgen can charge for Epogen®.
Since buyers have power to negotiate with Amgen, prices will probably fall.

Question 23

Originally, the furniture producer sold furniture to individual students in the college town. However, the college has decided to purchase furniture for its students (increasing college tuition to cover the cost!), and the furniture producer now sells to a single customer. How is this change likely to impact the furniture producer’s profits?

Answer 23

Profits will likely fall
Since the firm now has only one customer, that customer has significant negotiating power. Prices and Profits will likely drop.

Question 24

Examples of two-part tariffs:

Answer 24

Some examples of two-part tariffs are subscriptions by media firms, “membership fees” by warehouse clubs, or “entry fees” by theme parks.

Question 25

True or False: All that is required for first degree price discrimination is knowledge of each consumer’s WTP for each marginal item.

Answer 25

False
First degree price discrimination also requires the ability to charge different consumers at different rates. This may not be feasible if, for example, competing firms have already driven prices down to cost, or if consumers eligible for the low price buy large quantities of the product and resell it to customers with high WTP.

Question 26

“even though the two products are unrelated in use, and even though the bundled product is being priced at a 40% discount relative to the sum of the two individual product prices ($12 versus $10+$10), total revenues are higher than before!” - what concept does this showcase?

Answer 26

The Magic of Bundling

Question 27

Explain “firm clusters.”

Answer 27

The phenomenon of firms locating right next to each other is seen elsewhere too: for example, gas stations (usually located at the corners of a traffic light), fast food restaurants (they’re usually on the same exit off the highway), furniture manufacturers (they’re mostly in North Carolina), technology firms (they’re usually clustered in regions like Silicon Valley), or the auto industry (concentrated around Detroit).