Pricing MethodsPrice Discrimination

Prepared By:Zegeye Demissie

Nabil AbdurrahmanJune 20, 2012

Price methods and Price Discrimination

Market Structure and Pricing Perfect competitionMonopolistic competitionOligopolyThe oligopoly Models- Sweezy Kinked demand curve model,- Price leadership Models- Collusive model, the cartel arrangement- Game theory-Monopoly Price discrimination- 6.1.1 Necessary condition for Price Discrimination-Price Discrimination by Degrees (1st , 2nd, 3rd degree) Summary

Out Line

Market Structure and PricingA market can be defined as a group of

economic agents, usually firms and individuals, who interact with each other in a buyer–seller relationship. This is fine as a general definition but it lacks practical applicability in defining a specific market.

Economists usually classify market structures into four main types: perfect competition, monopoly, monopolistic competition and oligopoly.

The following Table show the Behavior of markets

Market Structure and PricingMarket

structure

No.of

sellers

Type of

product

Barrier

to entry

affect

Power

to price

Non-price of

competition

Perfect

Competition

Many Standardized None None None

Monopolistic

Competition

Many Differentiated Low Low Advertising and

product

Differentiation

Oligopoly Few Standardized or product Differentiated

High Medium Heavy

advertising and

Differentiated

Monopoly

One Single

product

Very

high

High High Advertising

Perfect competition There are five main conditions for perfect competition to exist:1 Many buyers and sellers. Each of these must buy or

sell such a small proportion of the total market output that none is able to have any influence over the market price.

2 Homogeneous product. Each firm must be producing an identical product, for example premium unleaded petrol or skimmed milk.

3 Free entry and exit from the market. This means that there are no barriers to entry or exit that give incumbent firms an advantage over potential competitors who are considering entering the industry. These barriers, which can represent either demand or cost advantages, are explained in more detail in the next section.

Perfect competition….

4 Perfect knowledge. Both firms and consumers must possess all relevant market information regarding production and prices.

5 Zero transportation costs. This means that it does not cost anything for firms to bring products to the market or for consumers to go to the market.

Monopolistic competitionThere are five main conditions for

monopolistic competition to exist:There are many buyers and sellers in the

industry.2. Each firm produces a slightly differentiated

product.3. There are minimal barriers to entry or exit.4. All firms have identical cost and demand

functions.5. Firms do not take into account competitors’

behavior in determining price and output.

Oligopoly Market

The main conditions for oligopoly to exist are therefore as follows:

A relatively small number of firms account for the majority of the market.

There are significant barriers to entry and exit.

There is interdependence in decision-making. Unregulated, comparable products are markedly cheaper.

Sweezy Kinked demand curve model,This model was originally developed by Sweezy and has

been commonly used to explain price rigidities in oligopolistic markets. Price rigidity refers to a situation where firms tend to maintain their prices at the same level in spite Market structure and pricing of changes in demand or cost conditions.

The model assumes that if an oligopolistic cuts its prices, competitors will quickly react to this by cutting their own prices in order to prevent losing market share. On the other hand, if one firm raises its price, it is assumed that competitors do not match the price rise, in order to gain market share at the expense of the first firm. In this case the demand curve facing a firm would be much more elastic for price increases than for price reductions. This results in the kinked demand curve.

Price leadership Models:A commonly observed pattern of behavior in

oligopolistic industries is the situation where one firm sets a price or initiates price changes, and other firms follow the leader with a short time lag, usually just a few days. There are various ways in which such behavior can occur, depending on two main factors.

1. Product differentiation. For homogeneous products the followers normally adjust their prices to the same level as the leader. In the more common case of differentiated products the price followers generally conform to some structure of recognized price differentials in relation to the leader. E.g. Ford may adjust the prices of various models so that they are given percentages lower or higher than some benchmark GM model.

:Price leadership Models

Type of leadership. There are two main possibilities here. Dominant price leadership refers to the situation where the price leader is usually the largest firm in the industry. In this case the leader is fairly certain of how other firms will react to its price changes, in terms of their conforming to some general price structure,

The other main type of price leadership is called barometric. This time the price leader is not necessarily the largest firm, and leaders may frequently change. There is more uncertainty in this case regarding competitive reactions, but the leader is normally reacting to changes in market demand ,cost conditions.

Collusive model, the cartel arrangementCollusion is the term frequently used

to refer to co-operative behavior between firms in an oligopolistic market. This is an agreement among firms, of a formal or informal nature, to determine prices, total industry output, market shares or the distribution of profits.

E.G On an international basis the best-known cartel is OPEC, the Organization of Petroleum Exporting Countries,

Factors affecting success of a cartel Number of sellers Firms are more likely to have disagreements

regarding price and output strategies Product differentiation There are different grades according to

country of origin, and sellers can also vary payment terms as a form of competition.

Cost structures. As with differences in product, differences in

cost structures can make co-operation more difficult.

Transparency

11.6 Oligopoly Behavior: Game Theory Overview

Game Theory is a study of how people behave in strategic situations. This applies to oligopolies because there are only a few major firms. Their profit will depend on the strategy each firm chooses and the strategy its rival chooses.

See the next Figure (4 possible strategies & 2 firms are involved)

Oligopoly Behavior: Game Theory OverviewOligopolies are encouraged to collude or

cooperate with their rivalsRevisit the Game Theory model of decision-

makingOligopolies are also encouraged to “cheat”

MonopolyAfter an analysis of perfect competition it is usual to consider monopoly next. Again, this is not because this is a frequently found type of market structure, but because as an extreme form it provides a benchmark for comparison. As we shall see, it can also be claimed that many firms are in effect limited monopolies.

Economists have defined monopoly in many different ways. Literally, it means a single seller in an industry. However, it is preferable to define a monopoly as being a firm that has the power to earn supernormal profit in the long run. This ability depends on two conditions:

1 There must be a lack of substitutes for the product. This means that any existing products are not very close in terms of their perceived functions and characteristics. Electricity is a good example.

2 There must be barriers to entry or exit. These are important in the long run in order to prevent firms entering the industry and competing away the supernormal profit. We now need to examine them in detail.

MonopolyThere must be a lack of substitutes for the

product. This means that any existing products are not very close in terms of their perceived functions and characteristics. Electricity is a good example.

2 There must be barriers to entry or exit. These are important in the long run in order to prevent firms entering the industry and competing away the supernormal profit. We now need to examine them in detail.

By Nabil Abdurrahman

PRICE DISCRIMINATION

Selling the same good to different people at different prices

A tool that firms use to extract additional surplus from consumers

Price Discrimination

Example

Price Discrimination

Conditions necessary: Imperfect competition in the market.

(Monopoly) Identifiable customer groups with differing

price elasticities Maintain separation of groups--prevent

resale.

where firms would like to charge the maximum amount that the consumer would be willing to pay

 For firms this is basically the best situation they can reach, gives them the best opportunity to extract surplus from the consumer.

1st Degree Price Discrimination

It requires that the firms know exactly how much each consumer is willing to pay

 extremely difficult to implement because the firm must have perfect information which is very difficult to have

1st Degree Price Discrimination

 Even though it is difficult to implement there are still businesses that can implement this style.

1st Degree Price Discrimination

Identify and charge each customer what they are willing to pay. Limit: D = MR, no consumer surplus.

Same MarketDifferent PeopleDifferent Price

1st Degree Price Discrimination

Quantity discounts. Volume purchases are given lower prices. Need to measure goods and services bought by consumers.

setting a discrete schedule of declining prices for a different range of quantities

2nd Degree Price Discrimination

 allows the firm to charge higher prices to different groups of individuals even though it doesn’t know the maximum amount that each consumer is willing to pay

the firms let consumers sort themselves into the groups and price that they are willing to pay

2nd Degree Price Discrimination

Different CustomersDifferent PriceSame Market

2nd Degree Price Discrimination

Example

EEPCO where it charges higher rates for

the first set amount of electric usage and then lower the price depending on the schedule.

Ethio telecom where it charges lower rates for

Happy Hours(09PM-07AM)

2nd Degree Price Discrimination

The graph shows where the firm sells it product at one price P1 and at quantity Qa that is point X. With a second degree price discrimination they will also charge a second price on a discrete schedule they had set up. To gain more profits they will charge a price P2 and Qa at Point Y. So they can sell more quantity of their product at a cost that the consumer’s who were not willing to pay at the higher price are now willing to pay at the lower price

2nd Degree Price Discrimination

Is when firms recognize that the demand for their product is different for each group of consumers.

This pricing strategy can only exist when firms have some price setting power

3rd Degree Price Discrimination

The firm must be able to differentiate between consumer segments and be able to put them in groups based upon income or geography.

The firm must be able to differentiate between elasticity of demand for consumers.

3rd Degree Price Discrimination

when firms recognize that the demand for their product is different for each group of consumers.

 Firms know that charge different prices to different groups for the same product

The pricing strategy can only exist when firms have some price setting power.

3rd Degree Price Discrimination

 The firm must be able to differentiate between consumer segments and be able to put them in groups based upon income or geography

The firm must be able to differentiate between elasticity of demand for consumers.

3rd Degree Price Discrimination

Treat each segment as a separate market– then do MR=MC in each

The firms Segment markets in some way. Charge all in the segment the same prices.

3rd Degree Price Discrimination

Different Price in Different PlacesSame People

3rd Degree Price Discrimination

Example

Price of a T-Shirt in Merkato and Bole