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PRICE STRATEGY
AND
MONOPOLISTIC COMPETITION
Afonso Sebastião
Feliciano Grosso
Joana Fernandes
Ricardo Costa
Susana Serôdio
Lisbon, February 2006
PRICE STRATEGY
THE IMPORTANCE OF PRICE
Price means one thing to the consumer and something else to the seller.
CONSUMER
The cost of something
SELLER
Price is revenue, the primary source
of profits
WHAT IS PRICE?
• Price is that which is given up in an exchange to acquire a good or service.
• Price is typically the money exchanged for the good or service.
• Prices are the key to revenues, which in turn are the key to profits for an
organization.
PRICE STRATEGY
REVENUE
Revenue is the price charged to customers multiplied by the number of
units sold. It’s what pays for every activity of the company: production,
finance, sales, distribution, and so on.
PROFIT
What’s left over is profit. Managers usually strive to charge a price that will earn a
fair profit.
To earn profit, a managers must choose a price that is not too high or too low, a
price that equals the perceived value to customers. If a price is set to high in
consumers’ minds, the perceived value will be less than the cost, and sales
opportunity will be lost.
PRICING OBJECTIVES
To survive in today’s highly competitive marketplace, companies need pricing
objectives that are specific, attainable, and measurable. Realistic pricing goals then
require periodic monitoring to determine the effectiveness of company’s strategy.
LONG-TERM PRICING
Long-term pricing framework for a good or service should be a
logical extension of the pricing objectives. It is necessary to
choose a price strategy that defines the initial price and gives
direction for price movements over the lifecycle.
Lifecycle of the product:
• Introductory stage – management usually sets prices high during the
introductory stage. But, if the target market is highly sensitive, management often
finds it better to price the product at the market level or lower.
• Growth stage – Prices generally begin to stabilize as the product enters the
growth stage.
• Maturity stage – Maturity usually brings further price decreases as
competition increases and inefficient, high-cost firms are eliminated.
• Decline stage – The final stage of the lifecycle may see further price
decreases as the few remaining competitors try to salvage the last vestiges of
demand
LONG-TERM PRICING
Price Skimming
Selling at a high price, sacrificing high sales to gain a high profit, therefore
“skimming” the market.
This strategy is often used to target “early adopters” of a product/service.
These early adopters are relatively less price sensitive because either their
need for the product is more than others or they understand the value of the
product better than others.
This strategy is employed only for limited duration to recover
most of the investment made to build the product.
LONG-TERM PRICING
Price Skimming
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LONG-TERM PRICING
Penetration price
Is the pricing technique of setting a relatively low initial entry price,
a price that is often lower than the eventual market price. The
expectation is that the initial low price will secure market
acceptance by breaking down existing brand loyalties.
The advantages of penetration pricing to the firm:
• It can result in fast diffusion and adoption;
• It can create goodwill among the all-important early adopter segment;
• It creates cost control and cost reduction pressures from the start,
leading to greater efficiency;
• It discourages the entry of competitors;
• It can be based on marginal cost pricing;
LONG-TERM PRICING
Penetration price
The main disadvantages with penetration pricing is that:
• It establishes long term price expectations for the product;
• Image preconceptions for the brand and company;
• It’s difficult to eventually raise prices.
Penetration pricing attracts only the switchers (bargain hunters)
It is most appropriate when:
• Product demand is highly price elastic;
• Substantial economics of scale area available;
• The product is suitable for a mass market – sufficient demand;
• The product will face stiff competition soon after introduction.
LONG-TERM PRICING
Penetration price
This strategy is particularly adequate to introduction of products of regular
buying, because the difference between them and the existent products is not
obvious.
For example, in the 80’s CP announced the intercity service. As a promotion,
the second class tickets suffered a substantial discount relatively to the usual
price. This way CP could attract potential clients that didn't use the train
regularly.
NON-LINEAR PRICES (NLP)
With a fixed price structure the company leaves a potential surplus
of the market to appropriate
Distinct prices to different clients
We will now study other ways of appropriating the surplus,
from more complex price structures
NLP - QUANTITY DISCOUNT
Companies
P=f(Q)
throw offers of quantity discount
One of the reason is the existence of scale economies
on processing the goods
Discount for segment the demand
Another reason of quantities discounts passes throw the possibility of
discriminating prices between different groups
If the company identifies which consumers belong to which group, they
can establish different prices
NLP - QUANTITY DISCOUNT
Discount for segment the demand
Sometimes the companies can make their clients reveal to which
group they belong
P1
P
D1
P1
P2
(to who buys at least Q2)
It's obvious that clients of type 2 will use the
discount
B
and
P2
E
D2
Clients of type 1 will prefer not use the
discount because
CMg
Q1
Q2
Q
B + little triangle < E
NLP - QUANTITY DISCOUNT
Rappel discount
The discount depends on the total volume of goods bought, and not
from the expense of one time.
Discount for homogeneous clients
Only one consumer with demand D
P
P1 , Q1
P1
P2
Maximizes the revenue of the company
Company can improve his situation by
offering a quantity discount offering P2
to who buys at least Q2
B
E
A
C
CMg
Q1
Q2
Consumer
B + little triangle > E
Company
A+C+E>A+B
Q
NLP - PREÇOS POR BLOCOS
REVENUE
Pm
Qm
A+B
P2
Q2
A+B+C
Qm
Q2
P
Unity above Qm
D
Pm
Consumer
A
Surplus
E
P2
Company can do
better then
C
B
CMg
Qm
Q2
Q
P2 and PM
in E
NLP - PREÇOS POR BLOCOS
P2 only when Q > Q1
P
E>F
The consumer will prefer
buying Q2, then Qx
D
It's possible to
P1
Revenue of the company by:
F
Initial price (P1) > PM
Q in which the price becomes
P2 > QM
E
P2
CMg
Qx
Q1
Q2
Q
In both cases the P2 must go
down for the consumer to buy
NLP - TWO PART TARIFF
Price equal to a fixed price plus a variable part (proportional to quantity
bought )
- Fixed net signature
Revenue of the company by making
the consumer to consume more than
he would do with a constant price
- Some sport clubs
- Internet
- Cellular phones price plans
Example of Portugal Telecom
P
Initially:
D
P1, Q1
Rate of activation
With this tariff it's cheaper to talk after Q1
P1
P2
A and P2 for each more minute
The client will keep talking until he reaches Q2
minutes of conversation
A
B
C
CMg
Q
Q1
Q2
Revenue of company
NLP - TWO PART TARIFF
Heterogeneous clients
Two groups with identical number and distinct demand
P
- A fixed price higher than A + B tends to the exclusion of consumers 1
D2
D1
Company offer a package of Q1 at a global price of A + B, which extracts
the surplus of clients 1. They will not buy any additional goods
Nevertheless, consumers 2 still demand more quantity, that
will be offered at P2
A
Revenue of company =
P2
C
CMg
B
Q1
Q2
Q
2xA+C
NLP - TWO PART TARIFF
Heterogeneous clients
Other ways of rising the profit
Instead of offering additional units at P2, the company could offer an
additional package of P + E price
P
D2
D1
A
1st package at
A+B
of Q1 units
2st package at
A+B+P+E
of Q2 units
If F > A then by ignoring consumers 1, the
company would increase their profit by selling
only one package of Q2 units at a price of:
F
P2
P
CMg
B
E
Q1
Q2
Q
A+B+P+E+F
NLP - QUANTITY AND BLOCK DISCOUNT
Different elasticity's of the demand, the company decides to offer the
product at different prices
P
D1
- Package with Q1 units at global price of:
A+B+C
- Company would like to sell Q2 units at:
(to extract all surplus)
B+C+D+E+F+G
A
At this price consumer 2 would buy package 1.
For him package 1 would cost:
A+B+C
B
D
D2
And his utility would be:
E
B+C+D
CMg
C
F
Q1
G
Since D > A
Q2
Q
surplus
NLP - QUANTITY AND BLOCK DISCOUNT
The company needs to sell package Q2 for less than
A+B+C+E+F+G
For the company this price means a revenue bigger in E
to the revenue of consumer 2 buying package 1
P
D1
Revenue of company:
A
B
D
- Consumer buying package 1
A+B
- Consumer buying package 2
A+B+E
D2
E
CMg
C
F
Q1
G
Q2
Q
PRICE DISCRIMINATION
Price discrimination exists when sales of identical goods or
services are transacted at different prices from the same provider.
lower prices for some consumers
Price discrimination
higher prices for others.
Price discrimination conditions:
Monopoly power
Firms must have some price setting power, monopolies or oligopolies
Elasticity of demand
There must be a different price elasticity of demand for the product from
each group of consumers.
Separation of the market
The firm must be able to split the market into different sub-groups of
consumers and then prevent discount customers from becoming resellers, and
so competitors.
PRICE DISCRIMINATION
The purpose of price discrimination is to capture the market's
consumer surplus and turn it into producer surplus.
The aims of price discrimination:
To increase the total revenue and/or
profits of the supplier!
Some consumers do benefit from this
type of pricing - they are "priced into the
market" when with one price they might
not have been able to afford a product.
For most consumers however the price they pay reflects pretty closely
what they are willing to pay.
PRICE DISCRIMINATION
A single price (P) is available to all customers.
The revenue is represented by area P,A,Q,O.
Consumer surplus: area above line segment P,A.
P1 is charged to the low elasticity segment, and
P2 is charged to the high elasticity segment.
The total revenue from the first segment is equal
to the area P1,B,Q1,O.
The total revenue from the second segment is
equal to the area E,C,Q2,Q1.
The sum of these areas is greater than the area without discrimination.
The more prices that are introduced, the greater the sum of the revenue
areas, and the more of the consumer surplus is captured by the producer.
PRICE DISCRIMINATION
Types of price discrimination
First-degree price discrimination
The monopolist sells different units of output for different prices and these
prices may differ from person to person.
Second-degree price discrimination
The monopolist sells different units of output for different prices, but every
individual who buys the same amount of the good pays the same price.
Thus prices differ across the units of the good, but not across people.
Third-degree price discrimination
The monopolist sells output to different people for different prices, but every
unit of output sold to a given person sells for the same price.
PRICE DISCRIMINATION
First-degree price discrimination
Under first-degree price discrimination, each unit of the good is sold to the
individual who values it most highly. The value of goods is subjective.
A customer with low price elasticity is less deterred by a higher price than a
customer with high price elasticity of demand.
As long as the price elasticity for a customer is less than one, it is very
advantageous to increase the price: the seller gets more money for less goods.
With an increase of the price elasticity tends to rise above one.
It is assumed that the consumer passively reacts to the price set by the seller, and
that the seller knows the demand curve of the customer.
In practice there is a bargaining situation: the customer may try to influence the
price, such as by pretending to like the product less than he or she really does, and
by "threatening" not to buy it.
PRICE DISCRIMINATION
First-degree price discrimination
willingness
to pay
willingness
to pay
MC
MC
quantity
quantity
Here are two consumers’ demand curves for a good along with the constant
marginal cost curve. The producer sells each unit of the good at the
maximum price it will command, which yields it the maximum possible profit.
PRICE DISCRIMINATION
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First-degree price discrimination
The producer’s goal is to maximize its profits subject to the constrain that
the consumers are just willing to purchase the good.
The outcome will be the Pareto efficiency!!
The producer’s profit can’t be increased, since it’s already the maximal
possible profit, and the consumer’s surplus can’t be increased without
reducing the profit of the producer.
PRICE DISCRIMINATION
First-degree price discrimination
Examples:
Bargaining for carpets in Turkey
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Flower markets in Amsterdam.
In a Dutch auction the price starts very high and
gradually falls until the first bidder bids and
takes the good or service. This means that the
price paid is going to be very close to the
maximum price the consumer is willing to pay,
thereby allowing the producer to extract as much
consumer surplus as it possibly can.
image58.webshots.com
A doctor in a small town who charges his
patients different prices, based on their
ability to pay.
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PRICE DISCRIMINATION
Second-degree price discrimination
In the First Degree it’s Hard to discriminate…

In perfect price discrimination (First Degree Discrimination):


To set the right prices the monopolist has to know the demand
curves of the consumers.
Not enough:
 Consumers of one type may pretend to be consumers of
another type;
 No effective way to tell them apart
Alternative Method:

Construct price-quantity packages that will induce the consumer
to choose the package meant for him:

Self-selection.
PRICE DISCRIMINATION
Second-degree price discrimination

Price per unit is not constant but depends on how much is
bought;
 Non-linear pricing;

Commonly used by public utilities;


Price per unit of electricity;
Sometimes available in other industries;

Bulk discounts for great quantities.
PRICE DISCRIMINATION
Second-degree price discrimination
“Self-selection problem”
High end
customer would
choose to buy x01
at price A with a
surplus of B
instead of x02 with
no surplus.
willingness
to pay
Customer - 2
High-end
Customer - 1
Low-end
B
Quantity: x02
Price: A+B+C
Quantity:
Price: A
x01
One solution:
Offer x02 at price
A+C
A
C
x01
x02
quantity
PRICE DISCRIMINATION
Second-degree price discrimination
“Reduction of output for consumer 1”
willingness
to pay
Profits increase:
Customer - 2
High-end
Customer - 1
Low-end
The decrease of
A is smaller than
the increase of
C.
B
A
Decreasing x01:
A decreases;
C increases
C
x02
x01
x03
quantity
PRICE DISCRIMINATION
Second-degree price discrimination
“Profit maximization solution”
Low-demand costumer:
willingness
to pay
• Quantity: x0m
Customer - 2
High-end
• Price: A
• Surplus: 0
B
High-demand costumer:
Customer - 1
Low-end
• Quantity: x02
• Price: A+C+D
Point where
marginal benefits
and costs of
quantity
reduction
balance
C
• Surplus: B
A
D
quantity
x0m
x02
PRICE DISCRIMINATION
Second-degree price discrimination
“In practice”

Self-selection encouraged by adjusting the quality of the good instead
of its quantity.

Example:

Airline companies:
 Business tickets:


Other tickets:




No restrictions;
Stay over Saturday night, buy 14 days in advance, etc;
Business travelers are willing to pay for business tickets;
Tourists consider the restrictions acceptable;
Company profits more than by selling tickets at a flat price.
PRICE DISCRIMINATION
Third-degree price discrimination



Different prices for different people
Same price for a given group
 student’s discounts; senior citizen’s discounts,...;
Profit maximization:
max[p1(y1)y1 + p2 (y 2 )y 2 - c(y1 + y 2 )]
y1 ,y 2
MR1 (y1 ) = MC(y1 + y 2 )
MR2 (y 2 ) = MC(y1 + y 2 )
The marginal cost of
producing one extra unit of
output must be equal to the
marginal revenue in each
market
PRICE DISCRIMINATION
Third-degree price discrimination

The market with the higher prices must have the lower elasticity
p1 y1 1 -
1
1
= p2 y 2 1 e(y1 )
e(y 2 )
IF (p1 > p2 )
 1-
1 < - 1
1
e1 (y1 )
e2 (y 2 )
 e1 (y1 ) < e2 (y 2 )
Standard elasticity
formula for marginal
revenue
PRICE DISCRIMINATION
Third-degree price discrimination

Example – movie tickets
PRICE
D1 - Ordinary
citizen
D2 - Students,
Senior citizens
If the monopolist
can charge only one
price, he will charge
p1* , but he sells
only to Market 1
D1
P1*
With price
discrimination, it will
also sell at p2* to
Market 2
P2*
D2
q1*
Output
PRICE DISCRIMINATION
Bundling

Packages of related goods offered for sale together
 cost savings
 Complementarities
 Dissiminate products (software – the many people use it, the better)
 Consumers with different preferences
good 1
good 2
price = 100
bundle
type A
200
100
2 x 100
1 x 300
type B
100
200
2 x 100
1 x 300
400
600
MONOPOLISTIC COMPETITION
Definition
 a market structure in which many firms sell products that are
similar but not identical.
Characteristics of Monopolistic Competition
•
Many Sellers - Firms Compete
• Product Differentiation - Each firm faces downward-sloping demand
curve.
• Free Entry - Economic Profits are zero
Examples of monopolistic competition:
• Books, CDs, movies, computer software, restaurants, sodas
MONOPOLISTIC COMPETITION
Demand directed to the firm
• A firm has its own product portfolio and its own market demand.
• Each firm tries to differentiate its product.
• The position and the elasticity of the search directed to each product
are influenced by the portfolio of existing products in the market.
• Demand of each product faces downward-sloping demand curve.
• When a new product get into the market, the demand of each initial
product it’s modified.
P
P’
D’
P’’
D’’
y’’
y’
y
MONOPOLISTIC COMPETITION
Managing in a Monopolistic Competition Market
• The market power allows the company to practice prices above
the marginal costs (MC), and act like a monopolistic firm.
• Product quantity that a firm sells depends on the price they
established to the product, like a monopolistic firm.
• The presence of other substitute products in the market, make
demand more elastic than in the monopolistic market.
• The firm has a limited market power.
MONOPOLISTIC COMPETITION
The Short-Run Equilibrium
• Each firm in monopolistically competitive market follows the
monopolist's rule for maximizing profit
• It chooses the output level where marginal revenue (MR) is equal to the
marginal cost (MC)
• It sets the price using the demand curve (D) to ensure that consumers
will buy the amount produced:
P
D
MC
y’ – Firm product amount
P’ – Firm Price
D – Market Demand
MR – Marginal Revenue
MC – Marginal Costs
ATC – Average Total Costs
ATC
P’
ATC
D’
y’ MR
y
MONOPOLISTIC COMPETITION
The Short-Run Equilibrium
• We can determine whether or not the monopolistically competitive
firm is earning a profit or loss by comparing price and average total
cost (ATC)
• If P > ATC, the firm is earning a profit
• If P < ATC, the firm is earning a loss
• If P = ATC, the firm is earning zero economic profit
P
D
MC
y’ – Firm product amount
P’ – Firm Price
D – Market Demand
MR – Marginal Revenue
MC – Marginal Costs
ATC – Average Total Costs
ATC
P’
Profit
ATC
Losses
D’
y’ MR
y
MONOPOLISTIC COMPETITION
The Long-Run Equilibrium
• When firms in monopolistic competition are making profit, new firms have
an incentive to enter the market
• This increases the number of products from which consumers can choose.
• Thus, the demand curve faced by each firm shifts to the left .
• When
firms monopolistic competition are incurring losses, firms in the
market will have an incentive to exit
• Consumers will have fewer products for each to choose.
• Thus, the demand curve for each firm shifts to the right.
P
MC
y’ – Firm product amount
P’ – Firm Price
D – Market Demand
d – Firm Demand
MR – Marginal Revenue
MC – Marginal Costs
ATC – Average Total Costs
ATC
D
P’
d
y’
MR
y
MONOPOLISTIC COMPETITION
The Long-Run Equilibrium
• The process of exit and continues until firms are earning zero
profits.
• This means that the demand curve and the average total cost curve are
tangent to each other
• At this point, price is equal to average total cost (ATC) and the firm is
earning zero economic profit.
P
MC
y’ – Firm product amount
P’ – Firm Price
D – Market Demand
d – Firm Demand
MR – Marginal Revenue
MC – Marginal Costs
ATC – Average Total Costs
ATC
D
P’
d
y’
MR
y
MONOPOLISTIC COMPETITION
Strategies to prevent (or to postpone) the result of Null Profits
• Product Differentiation:
• Publicity
• Introduction of new products
• Costumer loyalty
• Innovate to prevent the appearing of long-term
• Entry barriers
• Keep “business secret” and “strategic plans”, in a way to delay the
necessary time to competition copy our product
MONOPOLISTIC COMPETITION
Example
- The MEGT Company has estimated the following demand equation to its product:
QD = 12000 - 4000P
- The firm Total Costs are 4000€ when noting is produced. This costs increases by
0,5€ for each unit produced.
TC = 4000 + 0,5Q
1 – We are facing a short-run or a long-run scenario?
2 – Specify the marginal cost function
Short-Run
MC =0,50
3 – Write an equation for total revenue in terms of output
TR = P * QD = (3 - QD / 4000) * QD = 3QD - QD / 4000
2
4 – Specify the marginal revenue function
MR = 3 - 2Q / 2000
MONOPOLISTIC COMPETITION
Example (cont.)
- The MEGT Company has estimated the following demand equation to its product:
QD = 12000 - 4000P
- The firm Total Costs are 4000€ when noting is produced. This costs increases by
0,5€ for each unit produced.
TC = 4000 + 0,5Q
5 – At what level of output will profits be maximized? MC = MR <=> 0.5 = 3 - 2Q / 2000 <=>
Q = 5000
6 - What price will be charged?
P = 3 - 5000 / 4000 = 1.75
7 – What will total profits or losses be?
Pr ofits = P * Q - TC =
= (1,75 * 5000) - (4000 + 0,5 * 5000) =
= 2250
BIBLIOGRAPHY
Mata, J. (2001), Economia da empresa, 2th ed., Fundação Calouste de
Gulbenkian, pp. 261-346
Varian, H. (2003), Intermediate Microeconomics: A Modern Approach,
6th ed., W. W. Norton & Co
Images
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http://en.wikipedia.org
http://faculty.inverhiks.edu/rmitche/marketing/chap17and18i.htm