5

Pricing and Output

Decisions: Imperfectly
Competitive Markets
 Alternative Market Structures

• Classifying markets (by degree of

competition)
– number of firms
– freedom of entry to industry
• free, restricted or blocked?

– nature of product
• homogeneous or differentiated?

– nature of demand curve

• degree of control the firm has over price
 Alternative Market Structures

• The four market structures

– perfect competition

– monopoly

– monopolistic competition
– oligopoly
Features of the four market structures
Features of the four market structures
Features of the four market structures
Features of the four market structures
Features of the four market structures
Features of the four market structures
 Alternative Market Structures

• The four market structures

– perfect competition

– monopoly

– monopolistic competition
– oligopoly

• Structure → conduct → performance

 Monopoly

• Defining monopoly
– importance of market power
• Barriers to entry
– economies of scale
– economies of scope
– product differentiation and brand loyalty
– lower costs for an established firm
– ownership/control of key factors or outlets
– legal protection
– mergers and takeovers
 Monopoly
• The monopolist's demand curve
– downward sloping
• the greater the market power, the less elastic the
demand curve
– MR below AR
 AR and MR curves for a monopoly
8 Q P
(units) =AR
1 (£)
8
2 7
6 6
3
4 5
5 4
AR, MR (£)

4 6 3
7 2

2 AR

0
1 2 3 4 5 6 7 Quantity

-2

-4
 AR and MR curves for a monopoly
8 Q P TR MR
(units) =AR (£) (£)
1 (£)
8 8
6
2 7 14
6 6 18
4
3
2
4 5 20
0
5 4 20
-2
AR, MR (£)

4 6 3 18
-4
7 2 14

2 AR

0
1 2 3 4 5 6 7 Quantity

-2

-4 MR
 Monopoly
• The monopolist's demand curve
– downward sloping
• the greater the market power, the less elastic the
demand curve
– MR below AR
• Equilibrium price and output
– Equilibrium output, where MC = MR
 Profit maximising under monopoly
£ MC

MR
O Qm Q
 Monopoly
• The monopolist's demand curve
– downward sloping
• the greater the market power, the less elastic the
demand curve
– MR below AR
• Equilibrium price and output
– Equilibrium output, where MC = MR
– Equilibrium price, found from D curve
 Profit maximising under monopoly
£ MC

MR
O Qm Q
 Profit maximising under monopoly
£ MC

AC

AR

AC

AR
MR
O Qm Q
 Monopoly
• The monopolist's demand curve
– downward sloping
• the greater the market power, the less elastic the
demand curve
– MR below AR
• Equilibrium price and output
– Equilibrium output, where MC = MR
– Equilibrium price, found from D curve
• Profit
– Measuring profit
 Profit maximising under monopoly
£ MC
Total profit
AC

AR

AC

AR
MR
O Qm Q
 Monopoly
• The monopolist's demand curve
– downward sloping
• the greater the market power, the less elastic the
demand curve
– MR below AR
• Equilibrium price and output
– Equilibrium output, where MC = MR
– Equilibrium price, found from D curve
• Profit
– Measuring profit
– Supernormal profit can persist in long run
 Monopoly
• Monopoly versus perfect competition
– lower short-run output at a higher price
– supernormal profit not competed away
– costs under monopoly
• lack of competition to drive down costs
• BUT possibility of substantial economies of
scale
– innovation and new products
• less incentive to innovate
• BUT greater possibility of innovation through
investing ploughed-back profit
– competition for corporate control
Equilibrium of industry under perfect competition and
monopoly: with the same MC curve
£ MC

Monopoly
P1

AR = D

MR
O Q1 Q
Equilibrium of industry under perfect competition and
monopoly: with the same MC curve
£ MC ( = supply under
perfect competition)

Comparison with
P1 Perfect competition

P2

AR = D

MR
O Q1 Q2 Q
 Monopoly
• Monopoly versus perfect competition
– lower short-run output at a higher price
– supernormal profit not competed away
 Monopoly
• Monopoly versus perfect competition
– lower short-run output at a higher price
– supernormal profit not competed away
– costs under monopoly
• lack of competition to drive down costs
• BUT possibility of substantial economies of
scale
 Monopoly
• Monopoly versus perfect competition
– lower short-run output at a higher price
– supernormal profit not competed away
– costs under monopoly
• lack of competition to drive down costs
• BUT possibility of substantial economies of
scale
– innovation and new products
• less incentive to innovate
• BUT greater possibility of innovation through
investing ploughed-back profit
 Monopoly
• Monopoly versus perfect competition
– lower short-run output at a higher price
– supernormal profit not competed away
– costs under monopoly
• lack of competition to drive down costs
• BUT possibility of substantial economies of
scale
– innovation and new products
• less incentive to innovate
• BUT greater possibility of innovation through
investing ploughed-back profit
– competition for corporate control
 Oligopoly

• Key features of oligopoly

– barriers to entry
– interdependence of firms

• Competition versus collusion

• Collusive oligopoly
– cartels
• equilibrium of the industry
 Profit-maximising cartel
£

Industry D = AR

O Q
 Profit-maximising cartel
£

Industry MC

P1

Industry D = AR
Industry MR
O Q1 Q
 Oligopoly

• Key features of oligopoly

– barriers to entry
– interdependence of firms

• Competition versus collusion

• Collusive oligopoly
– cartels
• equilibrium of the industry
• allocating and enforcing quotas
 Oligopoly

• Collusive oligopoly (cont.)

– tacit collusion
• price leadership
• rules of thumb
– factors favouring collusion
• few firms which are open with each other
• similar cost structures
• similar products
• there is a dominant firm
• significant barriers to entry
• stable market conditions
• no government measures to curb collusion
 Oligopoly

• The breakdown of collusion

• Non-collusive oligopoly: game theory
– alternative strategies
• optimistic or cautious approach?
– simple dominant strategy games
Profits for firms A and B at different prices

X’s price
£2.00 £1.80

A B
£2.00 £10m each £5m for Y
£12m for X
Y’s price
C D
£1.80 £12m for Y £8m each
£5m for X
 Oligopoly

• The breakdown of collusion

• Non-collusive oligopoly: game theory
– alternative strategies
• optimistic or cautious approach?
– simple dominant strategy games
• Nash equilibrium
Profits for firms A and B at different prices

X’s price
£2.00 £1.80

A B
£2.00 £10m each £5m for Y
£12m for X
Y’s price
C D
£1.80 £12m for Y £8m each
£5m for X
 Oligopoly

• Non-collusive oligopoly: game theory

– alternative strategies
• optimistic or cautious approach?
– simple dominant strategy games
• Nash equilibrium
• the prisoners’ dilemma
 Oligopoly

• Non-collusive oligopoly: game theory

– alternative strategies
• optimistic or cautious approach?
– simple dominant strategy games
• Nash equilibrium
• the prisoners’ dilemma
– more complex non-dominant strategy games
 Oligopoly

• Non-collusive oligopoly: game theory

– alternative strategies
• optimistic or cautious approach?
– simple dominant strategy games
• Nash equilibrium
• the prisoners’ dilemma
– more complex non-dominant strategy games
– the importance of threats and promises
 Oligopoly

• Non-collusive oligopoly: game theory

– alternative strategies
• optimistic or cautious approach?
– simple dominant strategy games
• Nash equilibrium
• the prisoners’ dilemma
– more complex non-dominant strategy games
– the importance of threats and promises
• are threats seen by rivals as credible?
 Oligopoly

• Non-collusive oligopoly: game theory

– alternative strategies
• optimistic or cautious approach?
– simple dominant strategy games
• Nash equilibrium
• the prisoners’ dilemma
– more complex non-dominant strategy games
– the importance of threats and promises
• are threats seen by rivals as credible?
– the importance of timing
 Oligopoly

• Non-collusive oligopoly: game theory

– alternative strategies
• optimistic or cautious approach?
– simple dominant strategy games
• Nash equilibrium
• the prisoners’ dilemma
– more complex non-dominant strategy games
– the importance of threats and promises
• are threats seen by rivals as credible?
– the importance of timing
• decision trees
 A decision tree

r Boeing –£10m
(1)
ate Airbus –£10m
Airbus 00 se
5
decides
B1 400
sea
r ter Boeing +£30m (2)
a te
se

Airbus +£50m
0
50

Boeing
decides A 40
0s Boeing +£50m
ea ate
r (3)
te s e Airbus +£30m
r 5 0 0

B2 400
sea
Airbus ter
decides Boeing –£10m
Airbus –£10m
(4)
 Oligopoly
• Non-collusive oligopoly: the kinked
demand curve theory
– assumptions of the model
 Kinked demand for a firm under oligopoly
£

Current price
and quantity
give one point
on demand curve
P1

O Q1 Q
 Kinked demand for a firm under oligopoly
£

D
P1

D
O Q1 Q
 Oligopoly
• Non-collusive oligopoly: the kinked
demand curve theory
– assumptions of the model
– stable prices
Stable price under conditions of a kinked demand curve
£

MC2

P1 MC1

a
D = AR
b

O Q1 Q
MR
 Oligopoly
• Non-collusive oligopoly: the kinked
demand curve theory
– assumptions of the model
– stable prices
– limitations of the model
 Oligopoly
• Non-collusive oligopoly: the kinked
demand curve theory
– assumptions of the model
– stable prices
– limitations of the model
• Oligopoly and the consumer
 Oligopoly
• Non-collusive oligopoly: the kinked
demand curve theory
– assumptions of the model
– stable prices
– limitations of the model
• Oligopoly and the consumer
– advantages
 Oligopoly
• Non-collusive oligopoly: the kinked
demand curve theory
– assumptions of the model
– stable prices
– limitations of the model
• Oligopoly and the consumer
– advantages
– disadvantages
 Oligopoly
• Non-collusive oligopoly: the kinked
demand curve theory
– assumptions of the model
– stable prices
– limitations of the model
• Oligopoly and the consumer
– advantages
– disadvantages
– difficulties in drawing general conclusions
Alternative Aims to Profit Maximisation

• Alternative aims
– separation of ownership and control
– the principal–agent problem
– managerial utility maximisation
– profit satisficing
• Sales revenue maximisation (short run)
– equilibrium output and price
• comparisons with short-run profit maximising
• implications for advertising
 Sales revenue maximising price and output
£
MC

Profit-maximising
price and output
P1

AR

O Q1 Q
MR
 Sales revenue maximising price and output
£
MC

Sales revenue
maximising
P1 price and output

P2

AR

O Q1 Q2 Q
MR
Alternative Aims to Profit Maximisation

• Alternative aims
– separation of ownership and control
– the principal–agent problem
– managerial utility maximisation
– profit satisficing
• Sales revenue maximisation (short run)
– equilibrium output and price
• comparisons with short-run profit maximising
• implications for advertising
– implications for the consumer
Alternative Aims to Profit Maximisation

• Growth maximisation
– measuring ‘growth’
– equilibrium for growth maximising firm?
• Multiple aims
– satisficing and the setting of targets
• different stakeholders with different aims
• various possible targets
• potential conflicts between targets
– organisational slack
• a way of reconciling conflicting aims?
• cutting slack with 'just-in-time' methods
 Pricing in Practice

• Do firms know their costs and

revenues?
– difficulties in identifying the profit-
maximising price and output
– difficulties in predicting rivals’ behaviour
• Cost-based pricing
– the use of a profit mark-up on AC
• choosing the level of output
• choosing the mark-up
 Choosing the output and profit mark-up
£

P1
f

AC
P2 h
g
j

O Q1 Q2 Q
 Pricing in Practice

• Do firms know their costs and

revenues?
– difficulties in identifying the profit-
maximising price and output
– difficulties in predicting rivals’ behaviour
• Cost-based pricing
– the use of a profit mark-up on AC
• choosing the level of output
• choosing the mark-up
• equilibrium price and output?
 Pricing in Practice

• Do firms know their costs and

revenues?
– difficulties in identifying the profit-
maximising price and output
– difficulties in predicting rivals’ behaviour
• Cost-based pricing
– the use of a profit mark-up on AC
• choosing the level of output
• choosing the mark-up
• equilibrium price and output?
 Pricing in Practice

• Price discrimination
– meaning of price discrimination
• charging different prices to different consumers
for reasons unrelated to costs

• the prices depend on price elasticity of demand

 Price discrimination
P

P1

O 200 Q
 Price discrimination
P

P2

P1

O 150 200 Q
 Pricing in Practice

• Price discrimination (cont.)

– conditions for price discrimination
• firm must be able to set its price

• markets must be separate

• demand elasticity must differ between markets

– advantages to the firm

• higher profits

• possibility of cross-subsidisation
 Pricing in Practice

• Pricing and the product life cycle

– the four stages
• launch

• growth

• maturity

• decline

– competition and pricing in each stage

Sales per period The stages in a product’s life cycle

O Time
 The stages in a product’s life cycle

Product not
becoming
obsolete
Sales per period

Product
becoming
obsolete

O (1) (4) Time

(2) (3)
Launch Growth Maturity Decline