Pricing and Non-price decisions Flashcards
Explain the conditions for effective price discrimination and its impact on profit levels of monopolistic firms.
Mkt power - to satisfy the next 2 requirements
identify/segment market based on differences in PED among consumers
able to prevent resale and arbitrage (buying a good at a lower price and reselling it at a higher price, simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset’s listed price. It exploits short-lived variations in the price of identical or similar financial instruments in different markets or in different forms)
Explain the different types of price discrimination
First-degree/Perfect PD
Charging consumer the maximum price that he is willing to pay for each unit such that the firm is able to capture all consumer surplus, leaving consumers with zero surplus (DD=MR)
The less price-sensitive consumers are, the more willing they are to pay a higher price and vice versa.
Occurs during auctions but is usually impractical to charge each and every customer a different price as the customer will not, under normal circumstances, reveal the maximum price that he is willing to pay)
Second-degree PD (quantity discounts, concert ticket pricing)
Charging a different price to different groups of customers buying the same product by offering them various pricing choices and allowing them to choose among the different options
It is undertaken when firms are unable to segregate customers based on observable characteristics that are elaborated below.
Third-degree PD
Charging different prices to different groups of consumers by segmenting the market based on identifiable characteristics of these groups that make the PED (proportion of income, number of substitutes available, time horizon) different (Customer characteristics, location, past purchase behaviour - new vs existing customers)
Explain how price discrimination can be desirable and undesirable
It increases a firm’s profits. Companies practicing price discrimination aims to charge a buyer based on an approximation of his or her willingness to pay. This naturally increases the company’s profit because it can charge customers as much as their willingness to pay, which may be higher than a previously set uniform price. Moreover, contradictory as it may seem, price discrimination is not necessarily harmful to consumers. Because companies or organizations engaged in price discrimination offer discounts for more price-sensitive customers, buyers who would be otherwise excluded from various goods and services are able to benefit from those goods and services. For example, financial aid for colleges is a form of price discrimination because different students pay different prices to attend a college or university, but the policy actually benefits students who cannot afford full tuition. Similarly, price discounts for senior citizens benefit them as well by providing them access to various goods and services. Thus, price discrimination can provide benefits to consumers, such as potentially lower prices and rewards for choosing less popular services.
Under price discrimination, some consumers will end up paying higher prices (e.g. people who have to travel at busy times). These higher prices are likely to be allocatively inefficient because P > MC. Decline in consumer surplus.
Explain uniform pricing.
Uniform pricing (Charging the same price for the same good sold to all customers) TR max when MR=0 (P0) Profit max when MR=MC (P1) Profit satisficing (between P0 and P1)
Explain price discrimination.
Price discrimination occurs when a producer sells the same good at different prices whereby the price difference does not reflect the differences in cost of supplying the customer - note link to the different non-price determinants of PED and whether it is a more than proportionate increase in revenue
Explain the motivations of firm’s to employ price and non-pricing strategies.
mC = MR Lower costs Increase revenue Competitors actions Business risks and uncertainty considerations
In deciding on the strategy to implement, the firm has to consider its objectives (depends on its market structure, various constraints it may face and the cost it has to incur in implementing these strategies as well as any other unintended consequences.
State the various pricing and non-pricing strategies used by firms.
PRICING STRATEGIES
1) Uniform pricing - Charging the same price for the same good sold to all customers
2) Price discrimination - Occurs when a producer sells the same good at different prices whereby the price difference does not reflect the differences in cost of supplying the customer
3) Price competition
Predatory pricing - deliberate strategy of driving competitors out of the market and scaring off potential entrants by setting very low prices or selling below its average variable costs in the short run.
Price wars - a situation wherby suppliers attempt to undercut one another’s prices in an attempt to achieve a greater share of the market
Limit pricing - pricing by the incumbent firm (s) to deter entry or the expansion of fringe (smaller) firms by setting a price below the profit-maximising price but above the competitive level.
NON-PRICING STRATEGIES include non-price competition which is a marketing strategy that involves marketing a firm’s brand and quality of products rather than lowering prices. It includes:
1) Advertising and Promotion
2) Research and Development leading to product and process innovation
Cost-reducing strategies include:
1) Moving to a cheaper lcoation to reduces its fixed costs, leading to a fall in AC and an increase in profits, ceteris paribus. Its profit-maximising price and output level does not change as the MC curve does not fall due to it being a variable cost concept
2) Sourcing for cheaper inputs and reducing its varaible costs, leading to a fall in both its AC and MC. Ceteris paribus, this will be lead to a lower profit-maximising price and a higher output, leading to an increase in profits.
3) Increasing its scale of production so that it can more fully exploit EOS
4) Band together or set up jointly owned enterprises to source for raw materials, allowing them to obtain iEOS enjoyed by larger firms
5) Businesses of the same industry tend to cluster together so that they can enjoy economies of concentration
Growth strategies include: 1) Mergers and acquisitions Horizontal Integration Vertical Integration - forward and backward integration Conglomeration
2) Franchising
3) Alternative models on pricing
Mark-up pricing used to retailing where the retailer wants to know with certainty what the gross profit margin of each sales unit is. It allows the firm to know that all its costs are being covered.
Explain predatory pricing.
A deliberate strategy of driving competitors out of the market and scaring off potential entrants by setting very low prices or selling below its AVC in the short run (must draw MC, DD=AR, MR, AVC curves)
P1 and Q1 are profit-maximising price and output levels respectively. P2 and Q2 are the predatory price and output levels respectively and the firm makes a loss equal to the area XXXX (using AC curve which is below the AVC curve) and this might force one or more of the competitors to leave the market if the competitors cannot match the price reduction over the long run. A firm’s ability to do so depends on its past/retained profits that it can tap on to cover its losses. Once existing firms have been driven out and the entry of new firms is deterred, the incumbent can raise prices back to profit maximisation levels.
Mostly illegal, difficult to prove
Explain limit pricing.
Limit pricing refers to the pricing of incumbent firms to deter the entry and expansion of fringe firms (firms that follow the price leadership of the dominant firm in the market) by setting a price below the profit-maximizing price but above the competitive level.
Being a short-run departure from profit-maximisation, the incumbent firm is willing to sacrifice profits in the short run to prevent entry. It lowers prices to e.g P2 and increases output where total profit is now lesser compared to before (quote in the diagram drawn where there is downward movement along the demand curve)
Potential firms may decide that the risks of entering the industry are too high as they tend to start on a smaller scale of production and may incur higher unit costs. Hence, potential firms will make a sizeable loss and might not have the resources to sustain those losses until they can reach a competitive level of average cost through scale economies. If limit pricing is successful, the incumbent firm can retain its market power and continue to retain its supernormal profits in the long run.
Explain how (a) Advertising and Promotion and (b) Research and development can benefit a firm and its limitations.
(a) Advertising and Promotion increase demand for a firm’s product and help to increase revenue as they create perceived differences that persuade and convince consumers to purchase their products hence, increasing demand and revenue (rightward shift of the AR and MR curves). By stressing specific qualities of the product over its rivals, hence creating brand loyalty, decreasing substitutability, demand becoming relatively price inelastic, giving firms greater leeway to raise prices without fearing a loss of market share. (Can be persuasive or informative)
By reducing the substitutability of its products, the absolute value of CED is lowered. When the price of the rival’s good decreases, the firm only experiences a less than proportionate decrease in quantity demanded, ceteris paribus. Hence, this reduces the extent of the leftward shift of the firm’s demand curve, the extent of fall in Qdd and hence cushions the fall in TR and profits.
However, these incur fixed costs and is only successful when the increase in TR outweighs the increase in TC. The outcomes are also uncertain and usually, only firms in an oligopoly or monopolists have substantial funds to do larger scale advertising campaigns due to the high BTEs and supernormal profits in the long run.
(b) Research and development leading to product and process innovation
R&D includes activities that companies undertake to innovate and introduce new products and services. Product innovation involves researching the market and the needs of customers and developing new products/services to meet those needs. This allows the firm to capture a larger share of the market and hence increase TR and ceteris paribus, increase its profits since it may be some time before rivals respond with a similarly improved product.
However, spending more time and money doing so may not guarantee that it will be successful and extensive market research is required and the firm must review its research regularly. (Upward shift of the firm’s average fixed costs and average total cost curves)
Process innovation includes activities to develop existing and new business processes. It involve changes made to equipment, tools, techniques and technology used in manufacturing, software solutions used to help in the supply chain, delivery systems and customer services. These changes can improve productivity, increasing the output per unit of input, reducing the average cost of production and ceteris paribus, increase profits. (downward shift of the LRAC and LRMC curves)
Explain the growth strategies of a firm.
Growth strategies include:
1) Mergers and acquisitions: Mergers and acquisitions are forms of external growth that occur when a firm combines with one or more existing firms to form an entirely new enterprise or buys over another firm. To obtain funds for growth, firms can reinvest profits, borrow from banks and initial public offering (IPO) on the stock exchanges.
Horizontal Integration - occurs when a firm combines with or takes over a similar firm at the same stage of production to form a single entity. By expanding its scale of production towards MES, it enjoys lower AC since it can now fully exploit iEOS.
Examples include Grab’s acquisition of Uber (South East Asia). The cost advantage arising here will be the different forms of internal economies of scale that enable the new firm to lower its LRAC. Overall, internal EOS gives the merged firm lower AC and can be seen in the downward movement along the LRAC, towards the Minimum Efficient Scale.
Vertical Integration - occurs when a firm combines with or takes over another firm at a different stage of production, controlling more than one stage of production. This allows the firm to set itself apart from its rivals (e.g Apple VS Microsoft which could not cater to its customers as Apple does)
Forward integration occurs when a firm moves into succeeding stages of production. This lowers the uncertainty with regards to access to markets hence improving supply chain coordination as it enables the firm to have more control over the price of the product, the way the product is presented and distributed. This is crucial for companies in industries that lack qualified distributors which can adversely affect demand for its product and in turn, its revenue and profits. By ensuring the independence of the firm from third parties, it removes the cost paid to distributors who may charge significant costs, saving on middlemen costs. In order to reach out to a larger consumer base, firms may engage the service of middlemen. These middlemen may charge high fees and may be unreliable. If the firms merged with the firms selling the final output, this will enable the firms to cut down on the middlemen fees, thereby reducing cost. For instance, a durian plantation owner may pay commissions/fees to durian retailers in Singapore to sell their durians.
Backward integration occurs when one firm merges with another firm involved in the previous/earlier stage of production. The cost advantages of backward integration include:
(i) Providing certainty in the cost of factor input
By acquiring the supplier, the firm will be able to produce one of its factor inputs directly. The supplier firm which may have substantial market power may push up the prices of factor input to sell at P > MC, selling at a profit-maximising price. Now, the firm can acquire factor inputs at cost price instead. It can also prevent fluctuations in prices in times of shortages in the market. For example, when the market supply falls or market demand rises, the ensuing shortage will cause the market price of factor inputs to rise. But by having its own supply, the firm is less likely to face such price changes that may impinge on its production cost.
(ii) Certainty in quantity & quality of factor input, thus, improving supply chain coordination as the firm is able to gain control over the quantity and quality of scarce FOP, ensuring priority access to these raw materials which determine the firm’s final product’s quality and in turn, its demand and revenue. This ensures that the firm will not be hurt by suppliers providing materials of inferior quality which can lead to a fall in demand and in turn its revenue and profits.
(iii) It also has the aim of entry deterrence as it can restrict the availability of critical FOPs to a potential competitor, keeping them out of the market and preventing the demand for its product, in turn its revenue and profits from falling.
Conglomeration: Conglomerates are companies that sell goods that are not directly related to one another. The firm may choose to grow and expand into conglomerates for diversification purposes so that its revenue will be overly affected by a decrease in demand for any of its goods and services, reducing uncertainty and risks.
2) Franchising - a form of internal growth which entails the practice of selling the right to use a firm’s successful business mode and brand for a prescribed period of time.
It is a way for firms to quickly expand by building chain stores and avoid the risk of investing significant amounts of capital. By proliferating its brand, the firm can also build brand presence, reduce search costs for customers and increase revenue by collecting fees from franchises. It can also reap iEOS.
Explain the benefits of price discrimination.
1st degree price discrimination can help a price-setting firm survive a recession as the DD curve becomes the new MR curve and the firm is making more revenue. AE is also achieved and the output is higher under this form of price discrimination compared to uniform pricing.
There is also greater equity with price discrimination as consumers from lower income groups who are more price sensitive benefit from the relatively lower prices charged as they can consume a good or service that could not previously consume.
Higher profits may facilitate research and development which leads to product improvement and cost reductions as the price-discriminating producer is able to extract consumer surplus and add to its revenue and thus earn higher profits, ceteris paribus.
However, it may be less equitable as producer surplus increases at the expense of consumer surplus and producers benefit at the expense of consumers.
It may also be an unfiar strategy to keep potential entrants out as the price-discriminating monopolist may use its higher profits to set up its strategic barriers to keep potential entrants out.
