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Adm. Issues
• Mid-term exam will be held on 15th
December, 2005
• Topics in the mid-term exam include:
consumer demand, production costs, firm’s
supply, price determination, perfect
competitive markets And game theory
• Final exam will be held on 10th January
2006
Lecture 8
Monopoly
Topics covered
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The conditions for monopoly.
Price and output decisions in monopoly
markets.
Barriers to entry and exit.
Welfare costs of monopoly.
Possible dynamic gains from monopoly.
Assessing monopoly power.
Economic rent seeking behaviour.
Learning outcomes
This chapter will help you to:
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Identify the circumstances and conditions under
which a monopoly is said to exist.
Recognise the main features of monopoly markets
in terms of price and output decisions.
Appreciate why a monopolist can be described as
being a price-maker.
Understand the importance and various forms of
barriers to entry in monopoly markets as means of
sustaining a position of market dominance.
Grasp the significance of monopoly power and the
impact on economic welfare in terms of allocative
and productive efficiency.
Learning outcomes
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Assess the degree of monopoly power using
various methods of measuring market
dominance.
Appreciate the importance of potential
market entry in limiting monopoly power
(referred to as market contestability).
Understand the significance of rent seeking
behaviour.
Price and output decisions in monopoly markets
Figure 7.1 Price and output under monopoly
Barriers to entry and exit
Barriers to entry prevent competitors entering the market.
Important examples are the following:
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Patents and copyright
Government regulations, licences and state ownership
Tariffs and non-tariff barriers
The existence of natural monopolies.
Lower costs of production than competitors
Control of necessary factors of production and materials
Control of distribution channels
Even where there is no absolute barrier to entry,the monopolist may be
able to deter competitors by, for example:
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Predatory pricing or the threat of a price war and other action against
potential competitors.
Creating excess capacity ,which signals to potential suppliers that the
monopolist might react to competition by increasing output and thus
reducing the market price.
Creating brand loyalty ,including large-scale advertising expenditure.
High research and development expenditure ,as in the
pharmaceuticals industry.
A final barrier to entry is a barrier to exit .The main obvious barrier to
exit facing a firm occurs where there are appreciable sunk costs .
Sunk costs arise when there is a need for high capital investment by a
potential new entrant to match the production costs of the monopolist
and these are costs which cannot be recouped if the firm subsequently
decides to leave the industry.
The welfare losses associated with monopoly
fall into four main areas of concern.
These are:
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Higher prices, higher profits and lower
outputs.
Loss of consumer surplus.
Higher production costs.
Loss of consumer choice.
Higher prices, higher profits and lower
outputs than under perfect competition
Figure 7.2 The welfare costs of monopoly
Patents and monopoly power
Assessing monopoly power
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Profit rates, and
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Concentration ratios.
Profit rates
Lerner index =(P -MC)/P
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Simple concentration ratios
These ratios represent the extent of the market supplied by a given
number of firms. For example, a four-firm concentration ratio shows
the percentage of the market supplied by the four largest producers.
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Concentration ratios including market shares
One measure commonly used by government competition
authorities is the so-called Herfindahl 蓬Hirschman Index (HHI).This
index,when measuring the degree of competition in a market,takes
into account both the total number of firms in the market and their
relative size distribution. It is measured as follows:
n
Herfindahl-Hirschman Index (HHI) =
2
S
 i
i =1
Where Si represents the market shares of each of the i firms
in the market.
Key learning points
• A pure monopoly exists when a single firm supplies the
entire market for a good or service.
• Monopoly is associated with supernormal profits and with
high barriers to entry to the market that protect the
monopolist’s market dominance.
• The monopolist’s demand curve will be downward sloping,
implying that more can be sold at lower price.
• Monopolists are price-makers and profits are maximised
where marginal revenue(MR) equals marginal costs (MC).
• Barriers to entry prevent competitors entering the market,
examples being patents and copyright, government
regulations, licences and state ownership,tariffs and nontariff barriers,natural monopolies,lower costs of production
than competitors, control of necessary factors of production
and control over distribution channels.
Key learning points
• Sunk costs arise when there is a need for high capital
investment by a potential new entrant to match the production
costs of the monopolist and these are costs which cannot be
recouped if the firm subsequently decides to leave the industry.
• The welfare losses associated with monopoly,compared with a
competitive industry, fall into four main areas of concern,namely:
higher prices,higher profits and lower outputs;
loss of consumer surplus;
higher production costs;
loss of consumer choice.
• There are,however,possible dynamic gains from monopoly
involving:
economies of scale and scope;
increased product and process innovation through increased
investment in R&D.
• A contestable market occurs where there are no barriers to the
entry of firms into the market.
Key learning points
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The degree of monopoly power (dominance) in a
market can be assessed using:
朴profit rates;
- concentration ratios;
- the Herfindahl 蓬Hirschman Index.
Economic rent is earnings over and above those
necessary to maintain an input in its present use (or its
opportunity cost ).
Rent seeking behaviour exists when economic
agents attempt to earn economic rents.
Lecture 9
Pricing Strategy
Topics covered
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Price determination and managerial objectives.
Generic pricing strategies.
Pricing and the competitive environment.
The marketing mix and the product life cycle.
The economics of price discrimination.
Pricing in multi-plant and multi-product firms.
Peak-load pricing.
Two-part tariffs.
Pricing policy and the role of government.
Learning outcomes
This chapter will help you to:
• Understand that price serves three functions: (a) as the basis on
which firms generate revenue; (b) as a rationing device in
markets; and (c) as a signal to producers to alter supply.
• Identify how price is determined in a competitive market economy
through the interaction of demand and supply.
• Realise that pricing decisions are driven by particular managerial
objectives (such as profit maximisation, sales revenue
maximisation, etc.).
• Distinguish between different generic pricing strategies adopted
by firms, namely: marginal cost pricing, incremental pricing,
breakeven pricing and mark-up pricing.
• Appreciate the nature of various pricing strategies in markets with
differing degrees of competition.
• Recognise that pricing strategies require the integration of pricing
decisions into a wider marketing mix, taking into account nonprice as well as price factors that affect demand.
Learning outcomes
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Appreciate how pricing decisions may vary over the
life cycle of a product or service in the market.
Understand the economics of price discrimination.
Grasp the complexities introduced into pricing
decisions where multi-plant or multi-product
production occurs and the nature of transfer pricing.
Identify when peak-load pricing and two-part tariff
pricing may be appropriate.
Recognise the ways in which government affects
prices in market economies today.
Price determination and managerial objectives
Prices serve three broad functions.
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Prices raise revenue for the firm.
Prices act as a rationing device.
Prices indicate changes in the wants of consumers
and induce suppliers to alter product accordingly.
Figure 12.1 The market for Sony TVs
Generic pricing strategies
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Marginal cost pricing.
Incremental pricing.
Breakeven pricing.
Mark-up pricing.
Marginal cost pricing
Marginal cost pricing involves setting prices, and therefore
determining the amount produced, according to the marginal
costs of production, and is normally associated with a profitmaximising objective.
Incremental pricing
Incremental pricing deals with the relationship between larger
changes in revenues and costs associated with managerial
decisions.Proper use of incremental analysis requires a wideranging examination of the total effect of any decision rather
than simply the effect at the margin.
Breakeven pricing
Breakeven pricing requires that the price of the product is set so
that total revenue earned equals the total costs of production.
Figure 12.2 Pricing strategies compared
Mark-up pricing
Mark-up pricing is similar to breakeven pricing,
except that a desired rate of profit is built into the
price (hence this pricing is associated with terms
such as cost-plus pricing,full-cost pricing and targetprofit pricing).
M = (P - AC)/AC
where m is the mark-up, AC is the average total
cost, and P - AC is the profit margin.
The price, P, is then given by:
P = AC (1 + m)
Pricing and the competitive environment
The nature of the market in which the product is
sold will have a major influence on the pricing
policy adopted. As we saw earlier markets can be
conveniently divided into four broad kinds:
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Perfectly competitive markets.
Monopoly markets.
Monopolistically competitive markets.
Oligopoly markets.
Pricing in perfectly competitive markets
In perfectly competitive markets the firm is a pricetaker .
Pricing in monopoly markets
In a monopoly situation, the firm is a price-maker.
The marketing mix and the product life cycle
The marketing mix
In developing an effective marketing strategy,
marketing professionals draw attention to the
importance of the following ‘ four Ps’:
• Product.
• Place.
• Promotion.
• Price.
Together the four Ps determine what is called the ‘offer’
to the consumer.
Figure 12.3 Product positioning and customers’ perceptions
The product life cycle
(1) ‘Promotional’ or ‘penetration pricing’ occurs
when the price is set low to enter the market
against existing competitors, attract consumers
to the new product and gain market share.
(2)A ‘skimming policy ’arises when price is set
high initially to earn high profits before
competition arrives or to cover large unit costs in
the early stage of the product life.
Figure 12.4 Phases of the product life cycle
Definition of price discrimination
Price discrimination represents the practice of
charging different prices for various units of a
single product when the price differences are
not justified by differences in production/supply
costs.
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First-degree price discrimination.
Second-degree price discrimination.
Third-degree price discrimination.
Figure 12.5 First-degree price discrimination
Third-degree price discrimination
Most frequently found is third-degree price discrimination,
which simply involves charging different prices for the same
product in different segments of the market.
The markets may be separated in the following ways:
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By geography 紡as when an exporter charges a different price
overseas than at home.
By type of demand 紡as in the market for,say,butter where
demand by households differs from the bulk purchase demand
of large catering firms.
By time 殆with a lower price charged for off-peak periods (as
in the case of seasonal charges for hotel rooms).
By the nature of the product 紡as with private dental care with
differential pricing, where if one patient is treated he or she is
unable to resell that treatment to someone else.
Figure 12.6 Third-degree price discrimination
Pricing in multi-plant and multi-product firms
The multi-plant firm
Where a firm ’s output of the same product is
produced on more than one site, the profitmaximising output rule that marginal supply costs
must equal marginal revenue, is unchanged, but in
this case this marginal cost is the sum of the
separate plants ’marginal costs and production
must be allocated between the plants so that
the marginal supply cost at each plant is identical.
Figure 12.7 Pricing in a multi-plant firm
Pricing in multi-plant and multi-product firms
The multi-product firm
When producing and pricing a product, the multi-product
firm has to take into consideration not only the impact on
the demand for that product of a price change (its own
price elasticity of demand)but the impact on the demand
for the other products in the firm ’s product range (the
relevant cross-price elasticities).In other words,
pricing now involves obtaining maximum profits from the
full product range rather than from the individual products.
Figure 12.8 Peak-load pricing
Two-part tariffs
A two-part tariff is concerned with levying a charge according to the number of
volume of the units consumed, plus a fixed charge to cover fixed joint or
common costs, usually on a quarterly of annual basis.
Figure 12.9 Two-part tariffs
Pricing policy and the role of government
Taxes and subsidies
Direct price controls
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Rate-of-return regulation.
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Price-cap regulation.
Key learning points
• Equilibrium pricing is likely to be short-lived since the
conditions of demand and supply are likely to change regularly
if not continuously. In addition,producers may lack adequate
information about the market to predict the equilibrium price
precisely.
• Pricing ,in practice,is driven by managerial objectives relating
to factors such as profitability,corporate growth,sales revenue,
managerial satisfaction,etc.
• Generic pricing strategies may be based on marginal
cost,incremental cost,break-even or mark-up pricing.
• Marginal cost pricing involves setting prices,and therefore
determining the amount produced,according to the marginal
costs of production,and is normally associated with a profitmaximising objective.
• Incremental pricing deals with the relationship between larger
changes in revenues and costs associated with managerial
decisions.
Key learning points
• Breakeven pricing requires that the price of the product is set
so that total revenue earned equals the total costs of production.
• Mark-up pricing is similar to breakeven pricing,except that a
desired rate of profit is built into the price (therefore this pricing is
also sometimes referred to as cost-plus, full-cost or target-profit
pricing).
• In perfectly competitive markets, the supplier is a price-taker.
• In a monopoly situation,the firm is a price-maker.
• In developing an effective marketing strategy, marketing
professionals draw attention to the importance of the four Ps:
product, place, promotion and price.
• With respect to the product life cycle ,promotional or
penetration pricing sets the price low to enter the market
against existing competitors and in order to attract customers to
the new product and gain market share.
Key learning points
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A skimming policy arises when price is initially set high
perhaps to cover large unit costs (e.g.R&D costs)in the early
stage of the product life cycle or to make higher profits before
competitors can respond.
Price discrimination represents the practice of charging
different prices for various units of a single product when the
price differences are not justified by differences in
production/supply costs.Successful price discrimination
requires an absence of arbitrage opportunities and differing
elasticities of demand in the various markets.
First-degree price discrimination arises in the case of a
producer selling each unit of output separately,charging a
different price for each unit according to the consumer 痴
demand function.This results in the transfer of all consumer
surplus to the producer.
Second-degree price discrimination involves charging a
uniform price per unit for a specific quantity or block of output
sold to each consumer.
Key learning points
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Third-degree price discrimination involves charging different
prices for the same product in different segments of the
market.The market may be segmented by geography,by type of
demand,by time,or by the nature of the product itself.
In the case of a product produced by a multi-plant firm, the
profit-maximising output rule (MR =MC)is unchanged,but in this
case the marginal cost is the sum of the separate plants 知
marginal costs and production should be allocated between the
plants so that the marginal supply cost at each plant is identical.
The multi-product firm has to take into consideration not only
the impact of a price change on the demand for the product,but
also the impact on the demand for the other products in the
firm’s product range.Pricing policy, therefore, involves obtaining
the desired rate of return from the full product range rather than
from individual products.
Key learning points
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Decentralisation of large firms brings with it problems of internal
resource allocation, one aspect of which is the pricing of
products which are transferred between the firm’s divisions.This
gives rise to the need for an appropriate transfer pricing policy
and the problem of determining the transfer price so as to
maximise overall company profits.
Peak-load pricing involves differentiated pricing which reflects
differences in supply costs,given variations in demand for the
product over time.
A two-part tariff is concerned with levying a charge per unit
according to units consumed plus a charge to reflect fixed joint
or common costs.
The inverse price elasticity rule ,sometimes referred to as
Ramsey pricing,suggests that consumers with the more price
inelastic demands should bear a higher proportion of fixed
charges than consumers with a higher price elasticity of
demand.
Key learning points
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On the basis of a public interest or economic welfare
maximation rule, state enterprises should set prices in
order to reflect the marginal social benefits from the
additional output and the marginal social costs or
producing that output.
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Taxes and subsidies should be set so as to minimise
the damage to resource allocation in the economy. In
practice, state policies are determined by a mixture of
political, social and economic criteria so economic
welfare maximisation is far from guaranteed.
Lecture 10
Monopolistic Competition
Topics covered
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The conditions for monopolistic competition.
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Price and output decisions in the short run and
long run.
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The implications of monopolistic competition.
Learning outcomes
This chapter will help you to:
• Identify the circumstances and conditions under
which monopolistic competition is said to exist.
• Recognise the main features of monopolistically
competitive markets in terms of price and output
decisions.
• Appreciate the role of product differentiation in
competitive markets and the importance of
branding as a competitive strategy.
• Understand the economic welfare costs associated
with monopolistic competition.
• Differentiate between market equilibrium under
conditions of monopolistic competition in both the
short run and long run.
Conditions for monopolistic competition
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There is a large number of firms competing in the
market ensuring that each firm has an
insignificantly small share of the total market.
Each firm has the same,or very similar,costs of
production.
There is free entry to, and exit from ,the market
place.
The firms produce and sell goods or services
which are similar (and hence they are substitutes
for each other)but not identical to their rivals.
Firms,therefore,compete by trying to ensure
product differentiation for their goods or services.
Price and output decisions in monopolistic competition
Figure 8.1 Monopolastic competition: short run
Price and output decisions in monopolistic competition
Figure 8.2 Monopolastic competition: long run
Implications of monopolistic competition
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Competition will lower prices and profits as in a
perfectly competitive market. However,the price
will remain higher and the output lower than
under perfect competition .
Production occurs at less than optimum scale
and,as a result,there is excess capacity in the
market .
In practice,markets that approximate to the
monopolistically competitive model tend to be
associated with non-price competition including
branding and other efforts to differentiate the
product .
Figure 8.3 Long-run equilibrium: comparison of perfect and monopolistic
competition
Key learning points
• A monopolistically competitive market is one in which there
is a high degree of competition with a large number of firms
selling very similar,but not identical, products or services.
• Each firm faces a downward sloping demand curve
because the products or services are differentiated in some
way.This means that average revenue exceeds marginal
revenue (i.e.AR >MR).
• The short-run equilibrium in a monopolistically competitive
market occurs when profits are maximised. This,as always, is
the output associated with the condition that marginal revenue
equals marginal cost,i.e.MR =MC.
• In the short-run, supernormal profits can exist which act as
an incentive for new firms to enter the industry supplying close
substitute products or services.
• As new firms enter the market,the demand curve facing each
firm shifts to the left and becomes more price elastic because
of the larger number of suppliers and choice of products or
services available in the market.
Key learning points
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In the long-run equilibrium, all of the supernormal
profits are competed away and only normal profits now
exist,determined by the condition that AR =ATC (longrun).
Each firm in monopolistic competition produces an
output,in the long run,which is lower than that at which
ATC is minimised, i.e.production occurs at a suboptimal scale resulting in excess capacity in the
industry.
The price paid by consumers in monopolistically
competitive markets is higher than under perfect
competition (P >MC). Thus the higher price may be
interpreted as the cost to consumers of having the
choice of selecting from a range of differentiated
products.