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Finance 30210: Managerial Economics

Finance 30210: Managerial Economics. Strategic Pricing Techniques. Recall that there is an entire spectrum of market structures. Market Structures. Perfect Competition Many firms, each with zero market share P = MC Profits = 0 (Firm’s earn a reasonable rate of return on invested capital)

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Finance 30210: Managerial Economics

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  1. Finance 30210: Managerial Economics Strategic Pricing Techniques

  2. Recall that there is an entire spectrum of market structures Market Structures • Perfect Competition • Many firms, each with zero market share • P = MC • Profits = 0 (Firm’s earn a reasonable rate of return on invested capital) • NO STRATEGIC INTERACTION! • Monopoly • One firm, with 100% market share • P > MC • Profits > 0 (Firm’s earn excessive rates of return on invested capital) • NO STRATEGIC INTERACTION!

  3. Most industries, however, don’t fit the assumptions of either perfect competition or monopoly. We call these industries oligopolies • Oligopoly • Relatively few firms, each with positive market share • STRATEGIES MATTER!!! Mobile Phones (2011) Nokia: 22.8% Samsung: 16.3% LG: 5.7% Apple: 4.6% ZTE:3.0% Others: 47.6% US Beer (2010) Anheuser-Busch: 49% Miller/Coors: 29% Crown Imports: 5% Heineken USA: 4% Pabst: 3% Music Recording (2005) Universal/Polygram: 31% Sony: 26% Warner: 25% Independent Labels: 18%

  4. The key difference in oligopoly markets is that price/sales decisions can’t be made independently of your competitor’s decisions Your Price (-) Monopoly Oligopoly Your N Competitors Prices (+) Oligopoly markets rely crucially on the interactions between firms which is why we need game theory to analyze them!

  5. Market shares are not constant over time in these industries! Airlines (1992) Airlines (2002) American American United United Delta Delta Northwest Northwest Continental Continental US Air SWest While the absolute ordering didn’t change, all the airlines lost market share to Southwest.

  6. Another trend is consolidation Retail Gasoline (1992) Retail Gasoline (2001) Shell Exxon/Mobil Chevron Shell Texaco BP/Amoco/Arco Exxon Amoco Chev/Texaco Mobil Total/Fina/Elf BP Conoco/Phillips Citgo Marathon Sun Phillips

  7. Recall the prisoners dilemma game… Clyde Jake The prisoner’s dilemma game is used to describe circumstances where competition forces sub-optimal outcomes

  8. Price Fixing and Collusion Prior to 1993, the record fine in the United States for price fixing was $2M. Recently, that record has been shattered! In other words…Cartels happen!

  9. Suppose that we have two firms in the market. They face the following demand curve… Each has a marginal cost of $80. Firm 1’s output Firm 2’s output If these firms formed a cartel, they would operate jointly as a monopolist. Each firm agrees to sell 20 units at $240 each. Each firm makes $3200 in profits

  10. However, given that firm 2 is producing 20 units, what should firm 1 do? Firm 1’s output Firm 2’s output Firm 1 cheats and earns more profits!

  11. But if they both cheat and produce 30 units…

  12. Cartels - The Prisoner’s Dilemma The problem facing the cartel members is a perfect example of the prisoner’s dilemma ! Clyde Jake Cheating is a dominant strategy!

  13. Cartel Formation • While it is clearly in each firm’s best interest to join the cartel, there are a couple problems: • With the high monopoly markup, each firm has the incentive to cheat and overproduce. If every firm cheats, the price falls and the cartel breaks down • Cartels are generally illegal which makes enforcement difficult! Note that as the number of cartel members increases the benefits increase, but more members makes enforcement even more difficult!

  14. Perhaps cartels can be maintained because the members are interacting over time – this brings is a possible punishment for cheating. Clyde Jake Jake “I plan on cooperating…if you cooperate today, I will cooperate tomorrow, but if you cheat today, I will cheat forever!” 0 1 2 3 4 5 Time Make Strategic Decision Make Strategic Decision Make Strategic Decision Make Strategic Decision Make Strategic Decision Make Strategic Decision

  15. “I plan on cooperating…if you cooperate today, I will cooperate tomorrow, but if you cheat today, I will cheat forever!” Jake Cooperate: $3200 $3200 $3200 $3200 $3200 $3200 Clyde 0 1 2 3 4 5 Time Make Strategic Decision Make Strategic Decision Make Strategic Decision Make Strategic Decision Make Strategic Decision Make Strategic Decision Cheat: $3600 $2400 $2400 $2400 $2400 $2400 Cooperate: $19,200 Cheat: $15,600 Clyde should cooperate, right?

  16. We need to use backward induction to solve this. Jake Clyde 0 1 2 3 4 5 Time Make Strategic Decision Make Strategic Decision Make Strategic Decision Make Strategic Decision Make Strategic Decision Make Strategic Decision Regardless of what took place the first four time periods, what will happen in period 5? What should Clyde do here?

  17. We need to use backward induction to solve this. Jake Clyde 0 1 2 3 4 5 Time Make Strategic Decision Make Strategic Decision Make Strategic Decision Make Strategic Decision Make Strategic Decision Make Strategic Decision Cheat Given what happens in period 5, what should happen in period 4? What should Clyde do here?

  18. We need to use backward induction to solve this. Jake Clyde 0 1 2 3 4 5 Time Make Strategic Decision Make Strategic Decision Make Strategic Decision Make Strategic Decision Make Strategic Decision Make Strategic Decision Cheat Cheat Cheat Cheat Cheat Knowing the future prevents credible promises/threats!

  19. Where is collusion most likely to occur? High profit potential • Inelastic Demand (Few close substitutes, Necessities) • Cartel members control most of the market • Entry Restrictions (Natural or Artificial) Low cooperation/monitoring costs • Small Number of Firms with a high degree of market concentration • Similar production costs • Little product differentiation

  20. Price Matching: A form of collusion? Price Matching Removes the off-diagonal possibilities. This allows (High Price, High Price) to be an equilibrium!!

  21. The Stag Hunt - Airline Price Wars Suppose that American and Delta face the given demand for flights to NYC and that the unit cost for the trip is $200. If they charge the same fare, they split the market $500 $220 American 60 180 What will the equilibrium be? Delta

  22. The Airline Price Wars If American follows a strategy of charging $500 all the time, Delta’s best response is to also charge $500 all the time If American follows a strategy of charging $220 all the time, Delta’s best response is to also charge $220 all the time American This game has multiple equilibria and the result depends critically on each company’s beliefs about the other company’s strategy Delta

  23. The Airline Price Wars: Mixed Strategy Equilibria Suppose American charges $500 with probability Charges $220 with probability Charge $500: American Charge $220: Delta (6%) (19%) (19%) (56%) (75%) (25%)

  24. Continuous Choice Games • Consider the following example. We have two competing firms in the marketplace. • These two firms are selling identical products. • Each firm has constant marginal costs of production. What are these firms using as their strategic choice variable? Price or quantity? Are these firms making their decisions simultaneously or is there a sequence to the decisions?

  25. Cournot Competition: Quantity is the strategic choice variable There are two firms in an industry – both facing an aggregate (inverse) demand curve given by D Total Industry Production Both firms have constant marginal costs equal to $20

  26. Consider the following scenario…We call this Cournot competition Two manufacturers choose a production target Two manufacturers earn profits based off the market price P S Q1 P* Profit = P*Q1 - TC D Q Q1 + Q2 A centralized market determines the market price based on available supply and current demand Q2 Profit = P*Q2 - TC

  27. For example…suppose both firms have a constant marginal cost of $20 Two manufacturers choose a production target Two manufacturers earn profits based off the market price P S Q1 = 1 $60 Profit = 60*1 – 20 = $40 D Q 3 A centralized market determines the market price based on available supply and current demand Q2 = 2 Profit = 60*2 – 40 = $80

  28. From firm one’s perspective, the demand curve is given by Treated as a constant by Firm One Solving Firm One’s Profit Maximization…

  29. In Game Theory Lingo, this is Firm One’s Best Response Function To Firm 2 If firm 2 drops out, firm one is a monopolist! 0

  30. What could firm 2 do to make firm 1 drop out?

  31. Firm 2 chooses a production target of 3 3 1 Firm 1 responds with a production target of 1

  32. The game is symmetric with respect to Firm two… Firm 2 responds with a production target of 2 Firm 1 chooses a production target of 1

  33. Eventually, these two firms converge on production levels such that neither firm has an incentive to change Firm 1 We would call this the Nash equilibrium for this model Firm 2

  34. Recall we started with the demand curve and marginal costs

  35. The markup formula works for each firm

  36. Had this market been serviced instead by a monopoly…

  37. Had this market been instead perfectly competitive,

  38. Monopoly 2 Firms Perfect Competition

  39. Recall, we had an aggregate demand and a constant marginal cost of production. CS = (.5)(120 – 70)(2.5) = $62.5 Monopoly $120 $62.5 $70 D What would it be worth to consumers to add another firm to the industry? 2.5

  40. Recall, we had an aggregate demand and a constant marginal cost of production. CS = (.5)(120 – 53)(3.33) = $112 Two Firms $112 $53 D 3.33

  41. Suppose we increase the number of firms…say, to 3 Demand facing firm 1 is given by (MC = 20) The strategies look very similar!

  42. With three firms in the market… CS = (.5)(120 – 45)(3.75) = $140 Three Firms $140 $45 D 3.75

  43. Expanding the number of firms in an oligopoly – Cournot Competition N = Number of firms • Note that as the number of firms increases: • Output approaches the perfectly competitive level of production • Price approaches marginal cost.

  44. Increasing Competition

  45. Increasing Competition

  46. The previous analysis was with identical firms. Suppose Firm 2’s marginal costs increase to $30 Firm 1 50% Firm 2 50%

  47. Suppose Firm 2’s marginal costs increase to $30 If Firm one’s production is unchanged Firm 2

  48. Firm 1 Firm 2 42% Firm 2’s market share drops Firm 1’s Market Share increases 58%

  49. Market Concentration and Profitability Industry Demand The Lerner index for Firm i is related to Firm i’s market share and the elasticity of industry demand The Average Lerner index for the industry is related to the HHI and the elasticity of industry demand

  50. (58%) (42%) Industry Firm 1 Firm 2

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