Managerial Economics/Pricing

Monopoly

A monopoly is a firm that solely produces a product with no close substitute in the market. In an unregulated monopoly, a firm has influence and market power over the prices of goods which prevents new entrants in the market. The business (or a person) running a monopoly is called a monopolist.

Sometimes people might have a lot of options, but after they have made a number of choices, they might be stuck in a situation where some firms hold monopoly power over a number of individuals in certain segments in the market. This relates to the holdup problem mentioned before: customers get into an engagement with a particular firm and after some time the firm might act as a monopolist towards those customers because customers have already spent lots of time and energy on that firm and the switching costs might be high, so they can either take it or leave it.

Examples of Monopolies can be seen in utility companies such as Energex (Australia) or to a certain degree, Youtube.

Natural monopolies can come to exist when a large firm in the market gains advantages from network externalities or economies of scale. Network externalities, when a product or service becomes more valuable as the number of users increases. This can create a monopoly as individual consumers are unwilling to switch to a new product unless the new product has a larger consumer base. An example of this is Facebook. Economies of scale, when as a firm produces more the average total cost of production gets smaller. This occurs as inputs become cheaper in 'bulk', the firm uses more efficient processes or has access to more advanced technologies.

Monopoly barriers to entry

There are different barriers to entry which greatly prevent potential competitors from entering the market because of the strong market power. Barriers to entry include:

1. Limited access to resources As the supply of some natural resources like oil and diamond is limited and this give the owner of the monopoly power of the supply. For example the diamond market is dominated by De Beers, which control a large amount of diamond reserves. This has resulted in a high price.

2. High set-up costs Some industries require high capital expenditure when entering the market, such as high levels of research and development costs, which hinders new entrants. Examples of such industries include gold production and pharmaceuticals.

3. Economies of Scale Monopolies exhibit decreasing marginal costs given an increase in output. With large start-up costs and continuous decreasing in marginal cost, it makes the large firm become cost effective and stand out among other competitors. It is hard for new entrants to immediately reach economies of scale, which puts them at a competitive disadvantage. Hence, the existence of economies of scale can act as a barrier to entry

4. Network Effects Because of the use of products by a large population, it will increase the product's original value. There are examples like Microsoft Excel and word processing software. This is because when the software is used by a large amount of people, they can be less exposed to problem like compatibility when they are doing group work or other activities. The value of the product increases when others use it and this will hamper new corporations in developing and selling software. For example Facebook has a large market share and are over-performed with others competitors like twitter and Google+. The company has seen successful because of one of the main factor, network effect,s that other will be hard to establish a huge network of users to compete with.

5. Legal Barriers There are different legal rights which will offer opportunities for companies right to exclude other competitors in competing. Government provide patents and copyright to give a particular user exclusive right over the production and selling of the goods. Others like permits and professional licenses also will be in favor of certain firms. Government requirement of standard will also make new entrant hard to meet.

Monopoly pricing

A monopoly pricing is a well-defined market with one single supplier known as the monopolist. A monopolist sets out the price of goods and the quantity of consumer demand and while doing so, it also incurs cost.

Monopolist maximises their profits by multiplying the price of goods to the quantity of consumer demand and the cost incurred by the monopolist is subtracted. Hence:

• Profit (𝜋) = Price (P) x quantity of consumer demand (D(p)) - cost incurred by the monopolist (C(q)): $\pi =p\times D(p)-C(q)$
• Or equivalently: $\pi =q\times P(q)-C(q)$

All firms (including monopolies and competitive firms) set their marginal revenue (MR) equal to the marginal cost (MC) to maximise their profits and thereby, producing a profit function of:

• ${\frac {d\pi }{dq}}=MR=MC$ where q is the quantity demanded
• $\Rightarrow ({\frac {dp}{dq}}q+p)-{\frac {dC(q)}{dq}}=0$

A monopolist is able to general abnormal profits due to some barriers of entry of new competition.

Elasticity rule

Based on the elasticity rule, the profit maximising condition for the monopoly is:

• $p(1-{\frac {1}{\epsilon }})=MC$ (price-cost margin)
• Re-organising it would equal to: ${\frac {p-MC}{p}}={\frac {1}{\epsilon }}$
  • where ε is the elasticity of demand ($\epsilon =-({\frac {dq}{dp}})({\frac {p}{q}})$) and
  • $p(1-{\frac {1}{\epsilon }})$ is derived from $MR=({\frac {dp}{dq}}q+p)=p(1+{\frac {dp}{dq}}{\frac {q}{p}})$

As shown, the higher the elasticity of demand, the closer is the monopoly price to competitive price would be. In the equation ${\frac {p-MC}{p}}={\frac {1}{\epsilon }}$, where the denominator on the right hand side of the equation is the elasticity of demand and the left hand side is the price-cost margin and they are inversely related. Therefore, when elasticity of demand is high, the price-cost margin is low and the monopoly price approaches the level of competitive price. The price-cost margin implies market power of the firm, the higher their price-cost margin the more market power they have. Therefore, when demand elasticity is high, leading to a low price-cost margin, signifying low levels of market power which means the firm may not be able to sell at a price that is substantially above cost.

There are a few factors pertaining to the creation and maintenance of a Monopoly. Firstly, through mergers and acquisitions, a firm can maintain market power through the process of vertical or horizontal acquisitions or mergers. However, these mergers and acquisitions are subjected to external constraints of the ACCC's regulations. Secondly, plan strategic actions to prevent entry such as engaging in price war as an incumbent to punish entrants and act as barrier to entry. Incumbents can also intendedly act aggressively towards the first entrant, which will act as a barrier to future entrants. Lastly, innovation can lead to first-mover advantage, in which the first to apply for patents or copyrights can increase the cost of entry for others.

Monopoly Power

Monopoly power is the ability to sell a product (or good) at a price that is substantially above the required cost. It is also important to note that the degree of market power (or monopoly power) is inversely proportional to the elasticity of demand faced by the firm.

To create and maintain a monopoly, the following can be used:

1. Mergers and Acquisition:
   • Defined as the consolidation of two companies. A monopoly may buy out a smaller rival and merge it into their preexisting company.
   • Economies of scale (which can be defined as a proportionate saving in costs gained by an increased level of production) create economic efficiencies that allow companies to drive prices down to the level where other competitors cannot survive.
     • An example of mergers is the newspaper market
     • An example of acquisitions is when start-ups start portraying signs of success and competitiveness, larger and more established firms will buy them out or purchase most or all of their stocks to gain control over that company. One such example in 2017 would be amazon acquiring whole food.
2. Strategic actions to prevent entry:
   • Through limit pricing, which limits market share and in that process, lowers the price so much that it is deemed unprofitable so as to discourage others from entering the market.
   • This can be the use of pricing, such as predatory pricing or limit pricing
     • Limit pricing: the incumbent firm sets a low price, and a high output level so that entrants cannot make a profit at that price (illegal in some countries)
     • Predatory pricing: a firm may deliberately lower price to try to force rivals out of the market
3. Innovation:
   • Progressive development where improvements and enhancements deliver value added properties to the product or services provided, generating differentiations between close or substitute products. Causing inconvenience for market follower to trace the footsteps of research and development. For example, curing a desease with a special medicine, patenting a logarithm. Even though the patent expires the company still hold some market power. This means they leave a strong presence on the market, such as "Paracetamol" and "Ibuprofen", people keep choosing them even though there are more options in the market.
   • Regulation
     • An example of this would be the use of patents in the pharmaceutical industry, where the firm holding the legal rights to the patent has free will in applying upward or downward pressure on the price of the medications or drugs under its lawful rights. Resulting in monopoly on the drugs, putting lives at risk in the name of profits.
     • Even with the expiry of the patent, market share that was held by the firm with patents under normal circumstances do not dissolve (e.g. Panadol) due to the firm holding the trump card of a first mover in the industry. (the first ones that enter into market are well-known by most people) which demonstrated its prowess even long after the legal patent designation date has concluded.

Therefore, it means when the firm has more monopoly power, it made the smaller degree of competition within the market.

Psychology of Pricing

Pricing of goods is about influencing a consumer's price perception for goods, reducing the pain of paying and taking advantage of switching costs consumers will incur if they change firms. When pricing goods organizations must keep in mind context as some price strategies will work in specific market settings and some strategies only work in the short run. For instance, brands that are deemed a luxury and gain their reputation for their expensive pricing (creates a perception of higher quality) would not implement these strategies as it could affect the consumer's demand for the good or service. The assumption behind pricing is that consumers make rational decisions to maximize their utility. Therefore, consumers will buy products that give more happiness to them. Consumer's behaviour is complex because not always consumers buy more at the cheapest price. In the handbook of hospitality marketing management, the 3 consumer patterns that are not common in the traditional framework of supply and demand are:

1)Snob Effect: Consumers buy expensive products because they want to distinguish themselves from others.
2)Bandwagon Effect: Consumers want to be with a lot of people around them and buy everything that everyone else is buying.
3)Veblen Effect: Consumers buy products that cath their attention and those products look really expensive.

There are three prominent methods in which organisations can alter the consumers' perception of pricing:

1. Influencing the Consumers Price Perception

Prime a Smaller Number: It refers to the enterprise's psychology of seeking honesty for consumer and intends to set a price that is different from the integer when pricing commodities. This is a kind of psychological pricing strategy with strong stimulating effect. Consider two prices: $20 and $19.99. By reducing the initial cost by $0.01, it can create a perception of a cheaper good. Western consumers read prices from left to right and thus will anchor the '2' from the $20 and the '1' from the $19.99. Even if the good is identical, the $0.01 difference can alter the overall perception of the price. The small differences in piece tails can significantly affect consumers' buying behaviour. the tail pricing method can give consumers a psychological feeling of the lowest price, which is calculated accurately. Sometimes it can also give consumers a feeling that the original price is discounted and the goods are cheap.

Separate Price of Good and Shipping/Handling Cost: Another way of manipulating consumer's perception is to separate the price of the good and the shipping or handling cost. Indeed, customers are sensitive to what they see. Adding shipping cost separately to the price forces consumers to provide a cognitive effort to calculate the whole price, which they are not always apt to furnish. For instance, people are more prone to buy a good that costs $9.99 (plus $9.99 for shipping) than the same good offered at $19.98 (free shipping), as it appears less expensive. Moreover, shipping cost appears as the counterpart of receiving the goods to our door. This is why showing shipping cost apart can be a good solution to give the impression of a cheaper price.

Anchoring a High Reference Price: Expose consumers to higher incidental prices - if you have a product that you want to sell, placing a similar product with a higher price next to it can create a perception that the price of the original good is "bargain". Another way of achieving this is by sorting prices from high to low, usually in a menu, or offering a decoy option to sway consumers into picking the option that you want to be sold. An example of this is when the Economist was offering different subscriptions: an online subscription, a print subscription, and an online + print subscription. They made the online subscription price the same as the price of the online + print subscription so that people were more inclined to just buy the one with both options, as it felt more useless to buy the other one.

Anchoring Bias

Firms can manipulate consumers' perceptions by using anchors around an item they want to sell and setting a high reference point to consumers. For example, by placing a television near a similar television that has a much higher price, the seller is attempting to manipulate the consumer’s perception into believing that the cheaper television is a great deal.

The prices of different sized popcorn at the cinemas is another example of offering a decoy option to consumers to exploit their anchoring bias. When popcorn is sold in small, medium and large sizes, the medium size is often used as a decoy item. For instance, if the cinema sold the small for $3, the medium for $6.50 and the large for $7 consumers would place a higher value on the large popcorn. The small difference in price between the medium and large (only $0.50) gives the perception that the large is greater value for money inducing the consumer to purchase the large instead of the small or medium. If the decoy option was left out of the equation then consumers may perceive the $7 large heavily overpriced compared to the $3 small and be induced to purchase the cheaper option.

Psychology of Pricing

The context of the psychology of pricing is very important. While sellers want to sell their products for a high amount, some don’t want the perception of their products to be expensive. Other sellers, however, don’t want their products to be perceived as cheap but rather high quality (e.g. luxury cars) and thus they are able to sell their products at a higher price.

Consumers can catch onto pricing strategies and strategies, therefore, may need to be revised and changed over the course of time by firms.

Consumers often develop reference prices against which they compare the current prices of products. When there are huge deviations from the reference price, then customers doubt about what products to buy. Definitely consumers decisions would be different and it will depend on some factors such as culture, prior experience, purchase environment, level of income, demographics of the consumers and other aspects. For example, Thaler (1985) studied a group of beer drinkers and they needed to state the maximum price they would be willing to pay for a bottle of beer in the next scenerario .

When people are on the beach on a hot day and all they have is ice water. The last hour, they were thinking about what if they would have a bottle of 
their favourite beer. One of their friends needs to make a call and he offers to bring a bottle of beer from the only nearby place, which is a fancy 
hotel. How much are people willing to pay for the bottle of beer? This friend says that if the beer costs as much, or less than the price people said, 
he will buy it. If it costs more than the price people say, he will not buy it. How much would people tell their friend?

The result of this study was that people gave a median price of $2.65 (1984 prices). Another group was given another version of the scenario and instead of the fancy resort, there were a small run-down store. In this version, participants gave a median price of $1.50. According to this study, the median price reflects the different views and perspectives from the participants. Moreover, the environment influences their decisions .

2. Reducing the Pain of Paying

Timing of Payment: Depending on when the consumer pays for the good or service, it can affect their perception of the good. Take a restaurant as an example. If the bill is paid prior to consumption, it gives the consumer a sense of anticipation and excitement whilst waiting for their service. If the bill is paid after the meal, the consumer may be unaware of the amount consumed (food and beverages) and thus feel a sense of shock when paying the bill.

Salience of Paying: The salience of paying also plays reduces the pain of paying. Usually, this is in the form of digital payments or artificial payment mediums (tokens, credits, chips). Digital payments, such as using the app Uber, make the consumer feel as though they're not spending a lot of money. This is because there's no physical action of paying and it induces cognitive ease, so the consumer is left feeling satisfied even if the payment was expensive.

3. Exploiting Switching Costs

Organisations that feature cancellation costs or switching costs can take advantage of the fact that consumers tend to overlook these characteristics. For instance, when signing the contract to a new phone plan, there is a cancellation cost if you choose to leave early. However, most consumers forget about this feature when signing up. A further example can be seen in Add-on Pricing. This occurs when the cost of an initial good or service is relatively cheap (i.e. a printer), but the add-ons for this good are expensive (i.e ink and paper).

Switching costs are the costs that a consumer incurs as a result of changing supplier, brands or products. Typically, the company attempts to employ strategies that incur high switching cost to the consumers.

1. Switching costs (or cancellation) are delayed and not salient so many individual underestimate the switching costs.
2. Honeymoon pricing
   • low initial price (or free trial)with auto-renewal
   • e.g streaming service subscription distribute first month free trial and charge automatically monthly later until you cancel before the next renewal date.
3. Add-on pricing for shrouded attributes
   • charge low price for the item and high price for the replacement
   • e.g printer and razor, razor and blades

Pricing Standardization

Pricing standardization is setting giving a flat price that can be applied worldwide. This flat price is then applied in all the different countries, taking into account certain factors such as exchange rates. A common example of a strategy of pricing standardization is a company such as Paypal, charging a flat transaction fee (e.g. 1%, 2%) worldwide. This methodology of pricing can sometimes actually be extremely profitable as all consumers feel the rate is fair, no matter the size of the company.

Price Discrimination

A selling strategy whereby some customers are charged different prices for the same product or service than others. In pure price discrimination, the seller charges each customer the maximum price he or she will pay.

Price discrimination can add revenue to the firm if:

• The markets for the product are separable, and
• The price elasticity of demand is different in different markets.

The separability of markets is essential if low price customers are not to resell to high price ones. The basic profitability requirement for price discrimination is a difference is demand price elasticities. The firm facing different markets for the same product will maximise its print by setting marginal revenue equal to marginal cost in each. This implies that price will be lower in the more elastic market.

Why would firms price discriminate?

The purpose of price discrimination is to capture the market's consumer surplus. Price discrimination allows the seller to generate the most revenue possible for a product or service.

1. It captures all of the consumer surplus from customers that are willing to pay more than the uniform price (customer’s maximum amount they are willing to pay is higher than uniform price)
   • For example, Luxury goods merchants seize the psychology of consumers and use limited sales to attract consumers who have a special liking for luxury goods. The sold out of goods attract more consumers to book to pay higher prices, thus then gain the consumer surplus
2. It sells to some people who were not willing to pay as much as the uniform price. Thus, it focus on attracting people who are driven by lower prices.

Price discrimination can be used to achieve other objectives as well as increasing revenues. For example, an off-peak low pricing strategy for electricity may reduce demand fluctuations during the day, and hence reduce production costs. It may also accomplish social objectives; for example, improving the mobility of pensioners through the use of discount qualifying bus passes.

Conditions to Price Discriminate

1. A firm must have market power. (which mean the firms must have the downward demand curve, otherwise, there will just be Bertrand competition resulting in a price war).
2. Groups of consumers must have demand curves that differ. The firm must be able to identify how its customers’ demand curves differ. This means that consumers will have differences in their willingness to pay
3. A firm must be able to prevent or limit resale. ( The ability of the firm to prevent resale or arbitrage between customers makes the necessary conditions). This can be achieved through warranty restrictions, transaction costs, and legal restrictions.
   • Resale is difficult for most services when transaction costs are high.
   • Some firms act to raise transaction cost (Example: Voiding a product warranty)
   • Government aids price discrimination by banning resale.

Not all price differences are price discrimination

• Price differences should reflect cost differences, otherwise, it is still price discrimination.
  • For example, an electronic device with high memory might not necessarily be more expensive, in terms of the costs, than the one with low memory, but it's actually sold at a higher price attracting those who have high willingness to pay. So such price differences are not reflecting cost differences.

Empirical evidence shows that there is some discontinuity in the pricing theory and practice for a number of reasons:

• It it nearly impossible to infer what firms are doing about price from what they say or appear to be doing.
• Different market situations or levels of management experience and ability may give rise to entirely different pricing procedures.
• Price is a single element in a competitive strategy and may not be particularly important when compared to product development.
• The price of a product may be ambiguous, subject to discount or service qualifications, or even to negotiation for large buyers.
• Factors determining the price level and those that determine price adjustments may be different.
• Pricing in a world of uncertainty, with time lags, stocks and order backlogs, booms and recessions may be different from pricing in a world of certainty and perfect information.
• Pricing objectives may very, from survival, through maintaining or increasing market share to growth or profit maximisation. Profit for short term survival, where the intention it to keep production flowing and cover variable costs, will differ substantially from pricing to maximise long run profit.

Types of Price Discrimination:

Perfect price discrimination (first-degree price discrimination)

Where a firm explores/judges what customers are willing to pay for an item, it is able to charge each customer based on their maximum willingness to pay. Therefore, a given customer may pay more for some units than for others. This only works if the firm has market power and knows exactly how much each customer’s reservation price (reservation price = the maximum amount a person is willing to pay for a unit of output.)

The best example of perfect price discrimination is lawyers. When a client sees a lawyer, they disclose a vast amount of personal and financial information. This means that the lawyer can adjust their rate depending on the client's willingness to pay. If a client feels the price is unfair, they may switch lawyers but it is more likely that they will stay and pay, after divulging so much personal information.

The welfare effect of the first-degree price discrimination

• Consumer surplus=0
• The producer surplus is maximised and absorbs the consumer surplus
• It conforms to Pareto efficiency optimization principle

Nonlinear price discrimination (second-degree price discrimination)

Nonlinear price discrimination involves charging a different price for varying levels of volume. This is typically seen in the example of 'bulk billing' When a consumer purchases more of the product, the unit price is discounted, incentivising larger purchases. Consumers are willing to pay more for the first unit than successive units due to the demand curve being downward sloping. Block-pricing schedules are an example of this, where the discount varies with particular volume ranges or 'blocks' of product. However, block pricing such as giving quantity discounts do not necessarily increase revenues based on empirical studies done in class. A scenario of a gaming company giving quantity discounts on their online "currency" was given in class and revenue for each medium-value player decreased when a radical discount of 73% was given. Revenue for each high-value player also decreased when given radical discounts of 73%. The 'value' players received from this game decreased as game "currency" is inflated as it has become so cheap that everyone can afford and no need to "work" for it.

Two-part pricing

A form of price discrimination, whereby consumers are charged for a product or service on both an entry fee (fixed price) and a usage fee (per-unit price).

• Service enterprises often charge a fixed fee, in the case of variable fee, the fixed fee can be set at a lower price to promote services sales, the profit can be obtained from the see. For example: a phone contract that charges a fixed monthly charge and per-minute charge for use of the phone. Another example is Golf Clubs. Golf clubs usually charge an initiation fee and then usage fees based on the meals eaten and golf rounds played.

The key to two-part pricing is to determine the relative ratio of fixed and variable costs

General principles for firm to set up a two-part pricing system

1. Low fixed cost pricing strategy to attract customers to use this service
2. Also, pricing the variable cost high, in order to guarantee the firm sufficient profit.
   • E.g. Console game industry

Two-Part Pricing with Identical Consumers:

• A monopoly that knows its customers’ demand curve can set a two-part price that has the same two properties as the perfect Price Discrimination equilibrium
• The efficient quantity is sold because the price of the last unit equals marginal cost
• All consumer surplus is transferred from consumers to the firm

The application

• Park admission is a fixed fee, and customers are often only able to visit the park's common attractions after buying the ticket, while some of the better attractions have to pay for additional tickets.
• A fixed monthly fee is charged for landline calls, which are then charged according to the circumstances of the call.

Group price discrimination (third-degree price discrimination)

• Where a firm charges each group of customers a different price according to their unique observable or perceptible visual demographic differences, but it does not charge different prices within the group.
• A firm divides potential amount of consumer surplus into two or more groups and setting different prices for each group so as to maximise the collection of the consumer surplus. (For example: in theme parks where there are different ticket pricing for students, senior citizen, veteran or even kids that are younger than a certain age)
• Implications of group price discriminations include ethical and social concerns, as it is deemed unethical to discriminate groups according to their race, ethnicity or gender

Identifying Groups

Two approaches to divide customers into groups:

1. Divide buyers into groups based on observable characteristics of consumers.

Example: Cinemas charge children, adults, and seniors differently.

1. Identify and divide consumers on the basis of their actions or perceptive actions and characteristics.

Example: Data may identify a group of consumers as discount shoppers if they use coupons when making purchases.

• Firms use numerous diverse approaches to induce consumers to stipulate whether they have relatively high or low elasticity of demand. Price-sensitive consumers are able to differentiate themselves from others. As the probability of them taking the long road and search for a chance at lowering with a coupon or bargaining the price is higher.
• E.g. Coupons, holiday discounts, Groupon, Buying in advance (like Airline Tickets) and Rebates. Such as having a discount only if the consumer can produce a newspaper cutout of the advertisement. This activity increases the transaction cost and when consumers do adhere to the instructions to obtain the newspaper ads for the discount, it implies that these are consumers who are more price sensitive.

Welfare Effects of Group Price Discrimination

• Group price discrimination results in inefficient production and consumption.
• Welfare under group price discrimination is lower than that under competition or perfect price discrimination.
• However, welfare may be lower or higher with group price discrimination than with a single-price monopoly.
• Rule of thumb: economists have determined that if output increases as a result of price discrimination then welfare is likely to benefit, however if the output is reduced as a result, welfare will have decreased.
  • Some people (with low willingness to pay) might benefit more from group price discrimination because they're getting a discount so they are now able to buy the products. But it's possible that some of the consumers are now paying more because they're being identified by the sellers as having high willingness to pay, which results in their being charged a higher price than the uniform price. Those highly charged consumers are losing some of their consumer surplus while the additional new consumers are getting some of the additional surplus from the overcharged consumers. So depending on the size of both situations, it might have different impacts.

In some cases the welfare of certain groups does improve as a result of price discrimination. For instance, if a pharmaceutical company sells medication to different markets, charging different amounts in each market eg. its UK market pays $15, while it charges Ugandans $0.50, then from a welfare perspective those in Uganda are comparatively better off as a result of the discrimination. If it had to charge only one price and couldn't discriminate, then it would choose to abandon the African market and continue charging $15. Those living in the United Kingdom will be no better off as they are still paying a high price for their medications and those living in Uganda become worse off as they now will have to pay a much higher price for medication.

Predatory Pricing

A "Predator" is a firm which takes strategic actions to reduce current or future profitability of its competitors, being the "prey". Directed at entrants who have already entered the industry, the motivation behind predatory pricing is gaining market power in the long-run and is done by the predator deviating from the current short-run optimal strategy. Typically, the predatory firm lowers its prices to below the cost of production, which the smaller firm cannot match, and is driven out of business. Once the prey has left the industry the predator enjoys the luxuries of higher profits through the maintained market power. It is considered anti competitive and several countries have legislation prohibiting it, but it is difficult to prove prices dropped because the firm was practicing predatory pricing, and not as part of a legitimate strategy.

War of Attrition

The OECD Organisation for Economic Co-operation Development (2007), define Predatory Pricing as a financial War of Attrition. In a War of Attrition, the Predator must be able to sustain losses itself in order to force a loss on their competitors (Elzinga and Mills, 2014). Firms considering to engage or react to a price war must be cautious as either party of the price war could turn the odds in their favour. Additionally, a War of Attrition is costly as Heil and Helson (2001) noted that parties involved may incur substantial damages. This suggests that the winner of the war might be significantly better off without having a price war at all.

Predation and Imperfect Capital Markets

In imperfect capital markets it is not uncommon for firms with more financial resources than other firms to wage wars with weaker rivals to drive them out of the markets. Firms cannot make negative profits in the long-run, so weak firms are forced to exit the market. The Chicago School of Economics presented an idea that if two firms are in a perfect capital market and the weaker firm is at least as efficient as the incumbent, then there is no reason for the weaker firm to exit the market as it is possible to make positive economic profits.

Deep Pocket Predation

When there are two firms in two periods (being the incumbent and entrant) in the first period the incumbent can fight the entrant or accommodate. The entrant can then decide to exit or stay in the market. Within the second period if the entrant stayed then there is accommodation for the entrant, however, if the entrant exited in the first period then the incumbent is now a monopoly in the second period. This is an example of a sequential game, where one party can observe the actions of its rival.

Evidence of Predatory Pricing

Predation has two necessary conditions, being the predating firm sacrificing profits in the short-run and the expected ability to increase profits in the long-run. The Areeda-Turner test was designed in 1974 to try and clearly identify firms that are taking part in predatory pricing. The test states that a price below the short run marginal cost is unlawful and if the marginal cost is hard to estimate then the short-run marginal cost can be estimated by the average variable cost. This test, however, is not completely accurate and may be outdated as there are numerous instances when the price can be below the marginal cost. These instances can include:

1. Increasing Returns to Scale 2. Being a producer of complementary products 3. Consumer switching costs 4. Network externalities 5. Imperfect Information

Bertrand Competition

Bertrand competition which named after Joseph Louis Francois Bertrand, is a competition model used in economics. It describes the interaction between the company (seller) who sets the price and the customer (buyer) who chooses the quantity at the set price.

The Bertrand Model views firms as competing through a factor of price, assuming that the other firm/s will keep prices unchanged. Each firm is incentivised to reduce prices, to undercut rival firms, leading to a price war.

Assumptions of the model

1. Two firms in the market
2. Goods produced are homogenous (products are perfect substitutes)
3. Both firms know the market demand curve
4. Firm set prices simultaneously
   • A key concept within this assumption is that both firms will assume their rival will keep their prices unchanged. Consequently, both firms have an incentive to cut prices. If both firms engage in reducing their prices, it can instigate a price war, in which (because the products are perfect substitutes) the price will be driven down to marginal cost. Although P = MC is an allocatively efficient equilibrium, some firms may not be able to cover their fixed costs, which is an unsustainable equilibrium.
5. Each firm has the same constant marginal cost

Bertrand Demand

• Whichever firm sets the lowest price gets the entire demand.
• Occurs when $p_{i}=p_{j}=MC$(Marginal Cost) - None of the firm will be willing to deviate when price equals marginal cost.

• Demand for firm $i$:
  • $D(p)$ $if$ $p_{i}<p_{j}$
  • $0$ $if$ $p_{i}>p_{j}$
  • $D(p)/2$ $if$ $p_{i}=p_{j}$
  • Consider two firms. Simultaneously,each firm $i$ sets a price $p-i$. The firm $i$ with the lower prices $p_{i}<p_{j}$ sells $D(p)$ units and the other firm cannot sell any. If the firms set the same price, the demand is divided between them equally.
• What is firm i's best response function?
  • Pi*(Pj): firm i's optimal price for each price by firm j
  • The equilibrium is where the reaction curve's intersect: at this point none of the firms have an incentive to change its price.

For example there is an example given the demand curve of firm A and firm B as following: Firm A: qa= 400-4Pa+2Pb Firm B: qb= 240-3Pb+1.5Pa It is given that that firm A and B will have 0 marginal cost. Profit maximization requires each firm set the price in order to maximize their profit. Firm A’s total revenue is equal to the total revenue times the total quantity TRa= Pa*Qa = Pa(400-4Pa+2Pb) = 400Pa-4Pa^2 By taking the derivative of firm A’s total revenue with the changes of price dTRa/dPa = 400-8Pa+2Pb By setting the above equation to 0 and solve it for Pa will generate firm’s A reaction function Pa= 50+0.25Pb By repeating the step for firm B will result in Pb= 40+0.25Pa Substitute firm A reaction function into firm B Pa= 64 and Pb= 56

Under price competition with homogenous product and a constant symmetric marginal cost (Bertrand Competition), firms price at the level of marginal cost. The equilibrium prices are unaffected by the number of firms. This results in a "Bertrand Paradox" since it suggests that we need only two firms to achieve perfect competition, which we don't observe in reality.

Explanation for the Bertrand Paradox

Bertrand paradox can be defined as under static price competition with homogenous products and constant, symmetric marginal cost, firms price at the level of marginal cost and make no economic profits. The Bertrand model relies on relatively extreme assumptions which do not necessarily hold true in reality, thereby classifying the Bertrand Paradox as a fallacy. The assumptions which undermine the Bertrand Paradox are as follows:

1. Product differentiation: In reality, most firms produce products that consumers perceive as different from a rival's. When products are differentiated, either real or otherwise, a competitors choice to undercut the other will not necessarily raise profits substantially. Consequently, price competition does not have the power to drive prices down to marginal cost.
2. Dynamic competition: The Bertrand model assumes that the pricing game is a one shot game whereas in reality the lifespan of a firm typically lasts for longer than one period. In multi period simultaneous game agents could achieve mutually beneficial outcomes that would otherwise not have been possible. Extending the idea, when we consider the pricing competition game over a finitely large number of periods, and that the game is repeated in each, it is possible for the firms to achieve an equilibrium where prices are greater than marginal cost.
3. Capacity rationality: The implicit assumption is that the firm in deviating and undercutting its competitor obtains the entire market, it is able to meet the full demand of the market. However, this need not be true all the time. The firm has an endogenous constraint in the sense that it is not possible for it to meet all the demand of the market should it undercut its competition.
4. Bounded rationality: Rationality is limited when individuals make decisions but within the limits of the information available to us and our mental capabilities.
5. Asymmetric costs: An assumption of the Bertrand model is that all firms face the same marginal and average cost functions. This, however, is not necessarily exhibited in reality and thus will change the pricing strategy a firm executes. That is if firm A has a marginal cost of 10, and firm B has a marginal cost of 5, it is irrational to assume that firm A will price their product at P = 5 as this is not a sustainable equilibrium.

Cournot Competition

The Cournot Model views firms as competing through a factor of quantity produced rather than price, with the strategic variable being output quantity. Each firm decides the amount of a good/service to produce, with the market demand curve and cost structures of the other firm known. Firms then adjust output relative to their belief of the other firms' output behaviours.

Assumptions of the model

The basic Cournot assumption is that each firm chooses its quantity, taking as given the quantity of its rivals. The resulting equilibrium is a Nash equilibrium in quantities, called a Cournot (Nash) equilibrium. The cost structures of the firms are public information - that is, each firm knows the cost structures of their rivals. Market price is given by total demand equals total quantity produced

To find the equilibrium prices are quantities

• Derive each firm's reaction curve
• Find the equilibrium actions at the intersection of reaction curves
• For each pair of output choices $(q_{i},q_{j})$ the market price equals
  • $P(q_{i}+q_{j})=p_{i}=p_{j}$
• Firm i's profit is given by:
  • $\pi _{i}=q_{i}\times P(q_{i}+q_{j})-C(q)$
• FOC =>${\frac {d\pi _{i}}{dq_{i}}}=0\Rightarrow MR=MC$

• Equilibrium price and quantity in Cournot is between monopoly and perfect competition outcomes
• Equilibrium prices in Cournot falls with the number of the firms in a market

Cournot and Bertrand Comparison

When choosing to apply either the Bertrand or the Cournot Model, the following should be considered:

• If capacity and output can be easily adjusted -------Bertrand model applied
• If capacity and output are difficult to adjust-------Cournot model (better approximation of the industry competition)

Bertrand and Cournot can also be differentiated by evaluating the time frames in which the competition takes place in. The Cournot model can be applied to games of long-run capacity competition. In this, competitors choose capacity and then compete as capacity-constrained price setters. Comparatively, Bertrand competitors are not constrained by their capacity choice, arising either from a reduction in demand or a rival's miscalculation of capacity. As such, the Bertrand model can be applied to games of short-run price competition.

Furthermore, the models have different assumptions about rival behaviour in response to their competitive strategies. In the Cournot model, firms are required to make capacity decisions in advance, and therefore must be committed to maintaining sales to planned production volumes. As such, they are less likely to respond to fluctuations in their rivals output. Firms under Cournot competition are not able to lower prices to gain market share and demand, and therefore will not price as aggressively. In comparison, the Bertrand model suggests that capacity is flexible enough to allow firms to meet market demand that is correlated to the prices they announce. If firms are able to adjust their output easily, then aggressive pricing and Bertrand-type competition will emerge.

Critique of Bertrand Model

1. The Bertrand model assumes that demand within the market will be distributed entirely based on price. In reality, however, there are other variables which influence an individual's purchasing decision. Such influences include: non-price competition, product differentiation, transport and search costs.
2. The Bertrand model ignores capacity constraints - not all firms are able to produce sufficient capacity to satisfy the full demand of the market.

Critique of Cournot Model

1. The assumption that both firms set their capacity independently is impractical. When there are only two firms within the market, it is likely they will be highly responsive to any competitive or production strategies rather than operating with ignorance to rival behaviour.
2. There is some question surrounding how often oligopolies actually compete on quantity as opposed to price.
3. The Cournot model assumes that the market has homogeneous products.

Over production in Cournot Model

When a firm increases the quantity produced, the individual firm does not recognise the consequences (negative effects) of this increase in quantity on rivals and the market. This is known as a firm exerting negative externalities onto other firms by overproducing. This is the reasoning behind Oligopoly market having a higher industry production than Monopolies.

Correct Oligopoly Model for different industries

In Oligopoly theory, it is important to recognise that Capacity + Prices = Cournot. Either Bertrand or Cournot should be used in the industry depending on how important capacity constraints are in that particular industry. For example, industries without capacity constraints such as insurance and banking the Bertrand model is most appropriate whereas industries with capacity constraints such as airlines or rental cars (where capacity is adjustable in the short run) the Cournot model is more appropriate.

Collusion

Collusion is an attempt to suppress competition where there is a non-competitive agreement between rivals that attempts to disrupt the market's equilibrium.

Inefficiencies arise from collusion because the price is greater than marginal cost, and thus there is deadweight loss.

• P > MC --> DWL
• Cartels can be worse than monopolies because they usually don't achieve the economies of scale that monopolies do

The incentive for collusion is increased profits. Under the Bertrand duopoly p₁ = p₂ = c --> π = 0. For a monopolist, profits are positive: π_m > 0. Colluding firms can charge monopoly prices and share the profits:

• π_i = π_m/2.

Repeated Prisoners Dilemma

The prisoner's dilemma is a paradox in decision analysis in which two individuals acting in their own self-interests do not produce the optimal outcome.

For infinite horizon repeated Price Discrimination, ‘Grim Trigger’ strategy can facilitate collusion:

• Cooperate as long as another player cooperates, but once he defects, defect forever,
• His defection triggers the punishment,
• Grim because punishment lasts forever.

To check if there is asymmetric equilibrium with trigger strategies:

• Make sure that cooperating is better than defecting if another player has cooperated,
• Make sure that ‘punishment’ is a credible threat, that you will actually go through with it.

Factors that affect the success of collusion

The stability of collusion between firms are dependent on a few factors, without which the collusion agreement would invariably fall apart.

• Ability to get “monopoly profits” in collusive phase

The higher the collusion profits the more firms will collude. The collusion profits depend on several factors such as elasticity of demand and entry barriers.

• Ability to reach a collusive agreement

It is difficult for firms to agree on a collusive agreement as sometimes it does not benefit all firms equally. Therefore, it is much easier to collude between a fewer number of firms as effective communication can be simplified; it reduces the risk of a participant from deviating from the agreement; and most importantly, the profits are shared among fewer firms, so each firm receives a larger share. It is also helpful if the participating firms are similar in size and market power.

• Amount of interaction between firms

Frequent, regular communication between participants allows for more adaptive pricing strategies to fully optimize their collusion to reap maximum monopoly profits. The shorter the periods the higher the discount rate. If firms meet daily, it is easier for them to organise their collusion strategy and thereby the probability of continuation also increases if their interactions are more frequent.

• Ability to detect cheating

The success of collusion will be affected if one firm cheats while another cooperates. A collusive outcome rests on a credible punishment strategy in case of cheating. For example, one firm gets caught giving discounts to buyers.

Proving Collusion

Collusion can be defined as the instance where firms will coordinate to raise prices and affect quantities in order to raise profits. In turn, this suppresses competition.  

It is often difficult to prove collusion as there exists implicit or tacit collusion (where collusion can occur without direct communication), which is legal. Often what occurs in tacit collusion is conscious parallel price raising (or "concious parallelism"), where firms will raise prices aware (but not in explicit agreement) that rival firms will do the same – which may lead to collusive outcomes (such as monopolistic pricing).

Illegal collusion is explicit collusion, where firms are directly coordinating collusive actions.

It's difficult to prove collusion without a "smoking gun". Conclusive evidence is needed as proof and often hard to come by.

• Price-fixing agreement (on paper/tape)
• Agreement to divide territory (on paper/tape)
• Firms will act contrary to self-interest

Identical prices are predicted in most non-collusive models.

• Unilateral, independent identical prices is known as "conscious parallelism" and is legal
• To prove collusion, need evidence that firms were acting contrary to self-interest, if not for collusive agreement

Competition Policy: Leniency Schemes

Under the leniency policy, the ACCC offers:

• Automatic immunity from the ACCC initiated proceedings, where the leniency applicant is the first to disclose the existence of a cartel of which they were previously unaware, or
• Automatic immunity from pecuniary penalty, where the leniency applicant is the first to make an application for leniency in relation to a cartel of which the ACC was aware, but for which we had insufficient evidence to commence court proceedings.

The leniency policy comes with conditions. It is only available if those seeking leniency:

• Give full and frank disclosure, cooperating fully, expeditiously and continuously with the ACCC;
• Cease involvement in the cartel;
• Were not the instigators of the cartel, nor have coerced others into participating in it; and importantly,
• Were first through the door.

Theory behind leniency programs

Leniency programs are an important tool in detecting cartel activity. The Antitrust Authority and the implementation of leniency programs is motivated by social welfare and minimizing collusion among firms. If corporations and individuals can meet the requirements of the leniency programs through revealing their cartel activity and cooperating with authorities they can avoid criminal convictions and fines.

In this environment, firms play an infinitely repeated game where they first have to decided on whether to collude or deviate from a cartel and then decide whether to confess the details of the cartel to the Authority or not. However, differing from the basic prisoner’s dilemma model, just choosing to confess is not enough. In order for the firm to maximize its gains from confessing, they need to be the first to do so before any other firm. This is due to the leniency program rewarding amnesty (the Authority’s highest form of reward) to the first confessor.

Therefore, there are three games of play for firms or individuals in a cartel: to confess first, confess second or not to confess at all. Since confessing first is preferred over confessing second, in order to maximize the individual’s gains, then if either player in the cartel believes that the action of mutual non-confession will not occur, it would be in the best interest of both to confess first. This demonstrates that leniency programs have a deterrent effect on cartel formation because it creates distrust and suspicion among cartel members.

Examples:

Recent leniency schemes in real life:

1. 8th March 2017 – Six car air conditioning and engine cooling suppliers were fined 155 million Euros for operating four cartels around Europe. For assisting the Commission in charging other participating suppliers, Denso received full immunity from three cartels and Panasonic received full immunity from one of the cartels. Suppliers Behr, Calsonic, Valeo and Sanden received leniency reductions ranging from 15-45% of fines.
2. 17th July 2016 – Volvo/Renault, Daimler, Iveco, MAN and DAF were found to be operating a cartel for 14 years and were collectively fined 2.93 billion Euros. MAN applied for immunity and received 100% leniency. Additionally, Volvo/Renault, Daimler and Iveco received 40%, 30% and 10% fine reductions respectively for their assistance and cooperation with the Commission.

Collusion and Game Theory

Game theory is a useful tool in understanding how individual stakeholders in a collective action may interact within different scenarios. For example, game theory explores how stakeholders become more cooperative by acting in their best interest of the collective. Games may be examined over an infinite horizon where a grim trigger strategy may foster an environment of collusion . Therefore, cooperation occurs until one player deviates from a cooperative strategy. Once a player deviates from equilibrium, the other players will deviate for the rest of the game. To prevent collusion, policymakers and regulators need to ensure that cooperating is more beneficial than colluding, and that deviation is a viable option with higher benefits for the player .

Applied Research and Game Theory

Examining pricing and incentive strategies within the United States healthcare market provides an example of game theories uses in applied research . Researchers used game theory to evaluate healthcare price inflation by comparing traditional fee-for-service pricing framework with a modified doctor, hospital and insurer. Applying game theory predictions the researches determined from the experiments that “the alternative pricing framework benefits all parties by producing substantially lower administrative costs along with higher profit margins for the providers and the insurer”. The above is just one example of game theory within applied and academic research.

Ethical Considerations of Pricing Strategies

Firms may use all this knowledge about pricing strategies to gain a competitive advantage in their industry, which brings about some ethical considerations. As discussed above, firms may be able to influence consumers (customers) to purchase a larger quantity or spend more money than what the consumer (customer) originally intended. This may be done by exploiting the known psychology of human beings. Looking at the cinema industry as an example, it is evident that they can exploit high reference prices and anchoring. Using these strategies, customers may, for example, purchase more popcorn (for more money) than what they originally desired, due to lower cost per popcorn in higher quantities/sizes. Consequently, popcorn may go wasted. The fact that the firm sells larger quantities, makes more revenue and probably more profit, is good for the firm. However, all the wasted popcorn is an externality that the firm is not considering in their profit calculations. The firm may have been able to increase their economic profits by unloading costs onto society. These costs that society wears may include environmental pollution through transporting wasted popcorn kernels or even higher medical costs from a less healthy population (overconsumption of popcorn may contribute to obesity). Firms should consider the ethical implications of the pricing strategies they choose to employ.

The question that firms and regulators need to consider is how does pricing strategies influence consumers (customers), and further, how does this behaviour improve or detract towards the goal of improving society. It wouldn’t be entirely incorrect to subscribe to the theory that individuals should be responsible for the consequences of their actions; meaning firms are absolved of their responsibility to be a good corporate citizen since their customers ultimately cause the negative effects (not consuming all the products purchased and not being active enough that they may eat a larger quantity of popcorn). However, corporate citizens and regulators play a large role in shaping society. This may be seen in the way that UK regulators banned unhealthy fast food advertising to children in 2007. This ban ultimately led to a small decrease in consumption of fast food. Children that grew up post-advertising ban likely developed a smaller appetite for greasy foods. Further, when they have children in the future, they will likely encourage their children to maintain a healthier diet than the group that grew up pre-advertising ban. This creates a positive feedback loop that will have tangible (but likely unquantifiable) effect on society in the future.

Thus, firms carry an ethical responsibility. They are responsible for the consequences arising directly or indirectly as a result of their actions, especially when it comes to making decisions around pricing strategies. Firms should consider how they are directly and indirectly contributing towards a better society and regulators should not be asleep at the wheel.

Summary

The below section aims to briefly summarise the key points from the topic:

Monopoly: A monopoly can be defined as a firm having complete control over a market or industry by being the sole supplier or seller of certain commodities or services. With no competition in the market structure, monopolists can shift and adjust prices without restraints to maximise their revenue and profit and simultaneously dissuade any chance of entrance into the market.

Elasticity Rule:
The elasticity equation shows that the monopoly price becomes closer to the perfect competition price the higher the elasticity of demand is.

Monopoly Power: Monopoly power is defined as monopolists holding the authoritative power to position the price of the product or services higher than or lower than the acceptable market price. A monopolist can adopt three different methods to increase its monopoly power, these being mergers, acquisitions and strategic actions with intention to prevent entry and innovation.

Psychology of Pricing: Psychology of pricing can be defined as the strategy that the price can affect consumers' perception, reduce the pain of paying and emphasis switching cost to the goods or service. A firm uses pricing strategies to influence consumers feelings or perceptions of goods and services, in an attempt to affect the consumers purchasing decision.

Price Discrimination: Price Discrimination is a price strategy employed by producers in order to extract as much consumer surplus for themselves as possible. This is achieved by the firm charging different prices to different types of consumers.

• First-degree Price Discrimination: Firms can fully evaluate their consumer’s demand curves and their resulting willingness to pay (WTP) for a good or service. The firms then charge each consumer their individual maximum WTP, thereby capturing all consumer surplus for themselves. Though the most effective degree of price discrimination, this is the hardest to implement due to the limited knowledge that firms have of consumers true WTP.

• Second-degree Price Discrimination: Firms charge a different price for the product based on the amount purchased. E.g. If the consumer buys a large quantity, the firm is willing to sell to the consumer at a discounted price.

• Third-degree Price Discrimination: Firms divide consumers into groups based upon various characteristics and charge different prices to the different groups. Common characteristics include age, time of use, sex and geographical differences.
  

Bertrand Competition:
In Bertrand Competition, firms compete on price, not output. Both firms assume the other will keep the same price, so each firm has an incentive to cut prices. This can lead to a price war.

Cournot Competition:
In Cournot Competition, firms choose a quantity to produce independently and simultaneously.

Collusion Is an attempt to suppress competition. Often hard to prove and inefficiencies may arise resulting in dead weight loss to the firm.