HBX- Economics 5 Flashcards
Pricing Power
The ability of a firm to set prices above cost without meaningful competitive retaliation from other firms.
Ex: When you’re considering having Malaysian food for dinner or joining a gym, you’re not going to drive 15 miles every time. In effect, that firm in your area or neighborhood enjoys pricing power over its customers.
Two fundamental concepts in business strategy:
pricing and product differentiation.
What are some considerations that went into pricing decisions about the pricing of Epogen (a life prolonging drug)?
How to tackle hard pricing decisions like this?
- what it cost to make the product,
- patient WTP,
- government insurance, and
- fairness.
- the incentive for producers to price appropriately (balancing access, fixed cost recovery, and profit),
- the incentives for governments to step in, and
- the incentives of other players in the health care system (for-profit versus non-profit delivery providers)—and how these various parties interact.
Start simple and then see how each relevant factor might affect your decision.
What happens when there is no differentiation between firms?
(If companies are providing the same product, get into a price war and are selling at variable cost)
no firm creates any unique value. As a result, no firm captures any.
Compare the two situations you’ve just analyzed. Why exactly are prices different in a competitive market than for a monopolist?
- A monopolist has different objectives than a competitive firm does.
- A monopolist doesn’t face the risk of a price war, so it can price higher and increase profits.
- A monopolist faces a tradeoff between pricing for volume and pricing for profit, whereas a competitive firm does not.
- A monopolist doesn’t care about access and fairness, but a competitive firm does.
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.
What is a general principle that might help a firm figure out its optimal price?
Marginal Revenue!
What’s Average Revenue?
The revenues received per unit sold; mathematically, the total revenues for a business, divided by the total volume of goods sold; average revenue is equal to price unless there is price discrimination.
(revenue that you get
from customers who you currently serve)
What’s Marginal Revenue?
The additional revenue earned by producing extra unit(s) of a product or service.
Where are profits maximized for a monopolist?
- A monopolist should price at the point on the demand curve where its marginal revenue is zero.
- A monopolist should price at the point on the demand curve where its marginal revenue is equal to its average revenue.
- A monopolist should price at its variable cost.
- A monopolist should price exactly halfway down the demand curve, where elasticity is equal to 1.
- A monopolist should price at the point on the demand curve where its marginal revenue is equal to its variable (or marginal) cost.
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.
Also… Why this one (D) isn’t right!!!
A monopolist should price exactly halfway down the demand curve, where elasticity is equal to 1.
- Pricing where elasticity is equal to 1 will maximize revenues, but will not necessarily maximize profit.
The price at which total profits are maximized for a company can be determined in two ways- what are they? Which one is smarter/easier?
- First, you can compute total revenues and total costs corresponding to different prices and quantities. If you approach the problem this way, you’d set a price where the difference between total revenue and total cost– or your total profits– were maximized.
- But you can also approach the problem in a different way. Rather than try to figure out revenues and costs for every single price, at whatever price you’re charging or whatever output you’re producing, simply ask the question, “Is my marginal revenue from producing one extra unit greater than my marginal cost?” And if it is, keep dropping the price or increasing production until that’s no longer the case.
THE 2ND ONE IS EASIER
Instead of looking at the demand curve in its entirety and knowing all the data, all you need to do is figure out whether small changes in prices and output can additionally help you. That decision approach will lead you to the same result.
The MR = MC pricing principle is one of the most important ideas in economics and strategy.
Is MR = MC great for monopolies or competitive markets?
For competitive markets is that, for a competitive firm, its marginal revenue is just equal to the demand curve!
You’ll notice this also means that competitive firms price where marginal revenue equals marginal cost, just as a monopolist does.
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?
- $0
- $250
- $500
- $1000
$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.
A firm sells a smartphone. At a price of $500, there is only one customer. At prices above $500, no one purchases the phone. If the firm reduces its price slightly, it finds that there are no additional customers willing to purchase a phone at $490, or $450, or $400, etc. At a price of $200, however, two new customers would buy the smartphone (in addition to the customer with a WTP of $500).
What is the firm’s revenue at a price of $200?
- $100
- $200
- $400
- $600
$600
- There are three customers who each purchase the phone at a price of $200. Revenue = $200*3=$600.
A firm sells a smartphone. At a price of $500, there is only one customer. At prices above $500, no one purchases the phone. If the firm reduces its price slightly, it finds that there are no additional customers willing to purchase a phone at $490, or $450, or $400, etc. At a price of $200, however, two new customers would buy the smartphone (in addition to the customer with a WTP of $500), making its new revenue $600. What is the firm’s change in revenue when the it reduces prices from $500 to $200?
- -$300
- $100
- $400
- $600
$100
- At a price of $500, the firm sold one phone and earned revenues of $500. At a price of $200, the firm gains $400 in revenues from new customers, but loses $300 that it could have earned by charging the first customer a higher price. The change in revenue = $400 - $300. It could also simply be calculated as the difference in revenue: $600 (revenue after the price change) - $500 (revenue before the price change) = $100. The MR would then be the change in revenue ($100) divided by the change in units sold (2)= $50.
Say an airline has 100 tickets for sale for a flight from Boston to New York. At a price of $130, only 70 people would be willing to buy tickets. The airline would generate revenues of $9,100. The airline could, instead, offer the tickets for $115 and sell 80 of them.
What are revenues at a price of $115?
Also, What is the airline’s marginal revenue when it decreases price from $130 to price of $115?
The airline earns $115*80 = $9,200 in revenue.
Although the airline has gained $115*10 = $1150 in revenue from new customers, it has lost $15*70 = $1050 on the higher-WTP customers. A simpler way to look at it is that the firm made $9,100 at a price of $130, and $9,200 at a price of $115. The marginal revenue is the difference in revenue divided by the increase in tickets sold: $100/10=$10.
We know that the airline could sell 80 seats at a price of $115. Now, say the airline can lower its price further, to $100, and sell 90 seats.
What is the airline’s marginal revenue when it lowers price from $115 to $100?
- 20
At a price of $115, the airline was earning $9,200 in revenue. At a price of $100, it earns $9,000. The marginal revenue is the difference divided by the increase in seats: -$200/10=-$20. With this price reduction, the airline went too far, and actually lost money.
Why don’t real world situations constantly chase demand?
In the real world, you don’t always see firms perfectly adjusting price to demand every instant. The reason is that there are longer-run considerations as well. For example, a Four Seasons Hotel would not offer its empty rooms at $20, even if that covered variable costs. Doing that might encourage customers to do unpleasant things like always wait until the very last moment to make reservations. The extra $20 would hardly be worth the damage to the company’s long-term fortunes.
Most pricing decisions—whether being made by a competitive firm or by a monopolist—confront a simple tradeoff: between what two things?
Most pricing decisions—whether being made by a competitive firm or by a monopolist—confront a simple tradeoff: between volume and profit.
Price lower, and a firm might gain more customers. But lower prices also mean lower profits from its existing customers—those who were willing to pay a higher price.
What are two rules that are useful to follow in determining optimal prices (whether for a competitive firm or a monopolist)???
- Price where the difference between total revenue and total cost is greatest (notice that this is just another way of saying “maximize profits”).
- Price where marginal revenue is equal to marginal cost. (this is different from the above for a monopolist- for a monopolist- do the 2nd one)
For a monopolist, is the marginal revenue (MR) curve the same as the demand curve??
For a monopolist, the marginal revenue (MR) curve is NOT the same as the demand curve. Intuitively, MR accounts for not only the marginal (or incremental) customer’s willingness to pay, but also the lost profits from inframarginal customers.
In other words, the reason that monopolists price differently than competitive firms do is not because they have different objectives, different values, or different preferences, but simply because they have different incentives: a decrease in price by a competitive firm results in greater revenue from new customers (it not only grabs the customers who never bought earlier but also steals market share from other firms), but fewer lost profits on existing customers (since it has fewer customers to begin with than a monopolist does).
How would fixed costs affect the optimal quantity produced by a monopoly versus a competitive firm?
- Fixed costs reduce the optimal quantity and price of the drug for both competitive firms and monopolies.
- Fixed costs reduce the optimal quantity and price for a monopolist, but not for a competitive firm.
- Fixed costs reduce the optimal quantity and price for a competitive firm, but not for a monopolist.
- Fixed costs have no effect on the optimal price and quantities produced for either a competitive firm or a monopolist.
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.
Are revenues directly affected by fixed cost?
NOOOO - Revenues are not directly affected by fixed cost.
And what about marginal cost? Again, fixed costs at the firm level have no effect on the marginal costs of producing another unit.
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.
For monopolists, why aren’t profits just high enough that firms cover these fixed costs—but no more? Why, after all, are returns so high for pharmaceutical firms?
To understand this, we need to return to our analysis so far and two remarkable results that it reveals—results that are often misunderstood in casual debates.
- First, fixed costs have no effect on the optimal price. (Remember, the reason is that fixed costs affect neither a firm’s marginal revenue nor its marginal cost.)
- Second, the incentive to price higher than marginal cost arises even if there are no fixed costs at all. The reason a monopolist priced higher than marginal cost in our earlier analysis was simply because of the volume-profit tradeoff. Since reducing price not only gains new customers but loses profits on existing ones, a monopolist has a greater incentive than a competitive firm would to price higher than marginal cost and restrict access to its products more.
- High monopoly profits don’t just reflect fixed costs, but also pricing power (The ability of a firm to set prices above cost without meaningful competitive retaliation from other firms).
- On top of this, there’s one last (and somewhat more subtle) reason for high prices in the pharmaceutical industry. One factor to consider is the risk that firms bear in the R&D process. Not every research project or drug development effort, after all, is successful; indeed, the odds of success are often remarkably low.