3/9/17

1

ECON7012Wk3: Markets

Dr. Cameron Murrayckmurray@gmail.com

@rumplestatskinfresheconomicthinking.com

Week 3: Core concepts• Elasticity

• Competition: monopoly, duopoly, oligopoly, monopolistic competition, perfect competition etc.

• Consumer and producer surplus (Deadweight loss)

• Economic efficiency

• Choosing your product and price (price discrimination and other pricing strategies)

Price ($/unit)

Quantity (units)Demand

Supply

10,000

Economic surplus Elasticity

• How high can I raise my price?

• Sensitivity of quantity demanded to price

• What’s with all the straight lines?

ed

3/9/17

2

Elasticities• How is a calculated elasticity measure interpreted?

ed = 0

perfectly inelastic(slope = infinite)

ed

perfectly elastic= infinite (slope = 0)

Price ($/unit)

Quantity (units)

Rule of thumb

• If ed > 1 (elastic demand), an increase in price will

• If ed < 1 (inelastic demand), an increase in price will

•decrease revenue

•increase revenue

Determinants of elasticity• AKA: how sensitive are buyers to prices?

• Availability of close substitutes.

• Time: short term and long term effects can be different.

• Essentials verses luxuries.

• Share of a consumer’s budget spent on the product.

3/9/17

3

Cross-price elasticity

• How do you now how closely competitive other product are?

• You can see how sensitive the demand for your product is based on the price of their product.

• % change in (∆) quantity demanded of good A% change in (∆) price of good B

Example• You have a new organic cheese product, which is

now in crowded supermarket cheese fridges.

• The supermarket reduces the price of their own-brand cheese by 20%. You sales decline 5%.

• The store later starts selling discounted organic crackers and freshly backed breads, which boost your sales again.

• Summarise this scenario in economic terms.

Elasticity in strategy• Pick two goods that you suspect have a high and

low elasticity. Explain to your neighbour why.

• How would you now apply your understanding of elasticity of demand as a manager in your own firm?

• Can you really always define a product as either elastic or inelastic?

Models of competition• Monopoly / Duopoly / Oligopoly

• Monopsony

• Monopolistic competition

• Perfect competition (standard benchmark)

• MC = MR is profit-maximising rule for all

(Models reflect different external competitive environment)

3/9/17

4

Monopoly

• Single firm supplies the whole “market”

• There are no close substitutes (but there are always some substitutes)

• No price competition, or other competition

MonopolyPrice ($/unit)

Quantity (units)

Demand

Supply

MR

Consumer surplus

Producer surplus

Deadweight loss

Qm

Perfect competition• Many small firms supply “market” for a homogenous good.

• Many perfect substitutes (same good from another company)

• Because of this, each firm’s demand curve is flat.

• Pure price competition, no other competition (like product differentiation, etc)

• Maximises joint surplus (producer and consumer) This is economic efficiency defined!

Perfect competitionPrice ($/unit)

Quantity (units)

Demand

Supply

Consumer surplus

Producer surplus

Qc

Price ($/unit)

Quantity (units)

SupplyFirm

DemandFirm

Each firm’s view

Producer surplus

Qc

ATC

Duopoly / Oligopoly

• A market with two sellers

• A market with few sellers (3+)

• In standard theory they “share” the demand curve, with each firm “seeing” one with half the slope.

3/9/17

5

Other -opoliesPrice ($/unit)

Quantity (units)

Demand

Supply

MR

Consumer surplus

Producer surplus

Deadweight loss

Qm

P ≥ ATC Market Firm Assumptions

PerfectCompetition

• Huge number of small firms acting as price-takers

• Homogeneous product• Competition makes firm

demand curve flat

Duopoly / Oligopoly

• Few large firms with price-setting power

• Homogeneous product• More firms flattens each firm

demand curve (1/n)

Monopoly

• One large firm satisfies the whole market

• No substitutes• No competition

MonopolisticCompetition

• Each firm has a differentiated product (a unique market)

• Some substitutes• Competition pushes firm

demand curve downwards

none

Profits ≠ Social welfare

• Higher mark-ups and profit available due to lower competition may be good for the firms involved, but is not good in terms of social welfare (meaning joint surplus, due to deadweight losses)

• There are indexes of market power that show the gains of surplus to consumers from increases in output.

Competition• Two main ideas in economics:

Cournot (1838) and Bertrand (1883)

• Cournot: The more firms, the more elastic the demand curve of each

• Betrand: As soon as two firms compete purely on price, each faces perfectly elastic demand.

• Surprisingly little advance in 132 years on dynamics of competition in core of economics

3/9/17

6

Application• In the late 1990s several websites began enabling

customers to compare prices for life insurance policies across different companies.

Insurance companies had two main types of products. Term life insurance policies that were almost identical, and specialist policies that had unique combinations of inclusions and conditions.

• What happened to prices and which economic concepts are relevant?

Market concentration

• Rothschild index: R = ET / EF

- Market elasticity of demand divided by firm level elasticity of demand

• Lerner index: L = (P - MC) / P- a measure of mark-up over marginal cost- measures price setting power of a firm

Question Price discrimination

• Recall that prices are rules

• So far we have considered only cases where all buyers pay the same price for a single good

• But, this is not usually the best way to price if you want to maximise profits!

Price discrimination

• If identifiable groups exist within your market, and you can identify them and prevent resale, you can ‘partition’ the market and offer different prices to each group that maximise profits for each market segment.

General ideas• First degree: Prices are flexible. Each customer is

charged their willingness to pay

• Second degree: Prices are charged differently depending on the quantity bought by a customer (aka block pricing)

• Third degree: Different prices are charged to different customers based on identifiable characteristics

3/9/17

7

First degree

• Rule is treat individual customer demand curve as your market, and price for each where their elasticity = 1

• What can you think of where every customer is assessed on their willingness to pay?

Second degree

• This is more common - bulk discounts.

Third degree

• Here different groups get to pay different prices

• Child prices on airlines, student prices, etc.

• What else?

Third degree• Chapter 8 appendix

• If identifiable groups exist in your market, and you can identify them and prevent resale, you can ‘partition’ the market and charge different prices to different groups to maximise profits for each.

• Charge the more price sensitive group a___________ price

• Charge the less price sensitive group a ___________ price

• lower

•higher

25

20

10

Q (units)

$/unit

DF

MRF

ATC = MCF

Profit = 25 * (20-10) = 250

DF(student)DF (adult) MRF (student)MRF (adult)

25185

20 = P(student)

27 = P(adult)

Profit = 18 * (20-10) + 5 * (27-10)

+ = 265

ATC = MCF

3/9/17

8

Two-part pricing

• A price is charged first for the right to buy a good,then on a per unit basis to those who have purchased the right to buy

• Typically used for club goods and goods with large fixed costs and low marginal costs.

• E.g. utilities (electricity and gas)

Price matching

• Price matching is pricing rule where prices are set, but when a customer finds a lower price elsewhere for the same product the company will sell at their competitor’s price.

• Often leads to higher prices because customers assume that the promise implies that the firm has already set their prices lower than the competitors

Bundling

• Offering a number of products together at a single price (that is lower than total individual prices)

• Examples are mobile phones bundled with internet, home phone, etc.

http://www.wiglafjournal.com/pricing/2008/01/price-bundling-to-profit/

Surge / on-demand / time• Charge different prices at different points in time

• Examples include electricity (off-peak pricing), hotels, car parks, Uber, airlines.

• Difference between ‘traditional’ time-based pricing and surge price (where prices update instantly), is that time-based pricing is known in advance

• In theory the same as price discrimination

3/9/17

9

Decoy / “goldilocks” Confusopoly• “The art of baffling your customers on price”

• In competitive markets, making prices seem attractive while also being difficult to compare is valuable

• Examples in insurance, mortgages, financial services, telecommunications.

• Combinations of other types of prices (bundling, discrimination, decoys, time-based discounts, penalty fees, rewards schemes, etc)

Why?Customer Valuation

computerValuation of

monitor

1 2,000 200

2 1,500 300

• Maximise revenue for computers:2 x 1,500 = 3,0001 x 2,000 = 1,000

• Maximise revenue for monitors:2 x 200 = 4001 x 300 = 300

Is $3,400 the best outcome?

Why?Customer Valuation

computerValuation of

monitorValuation of

bundle

1 2,000 200 2,200

2 1,500 300 1,800

• Maximise revenue for bundle:2 x 1,800 = 3,6001 x 2,200 = 2,200

$3,600 is a better outcome!

Warning!• Price gouging / profiteering - laws evolve to respond to

consumer dissatisfaction at some types of price discrimination

Break

• Then tutorial activity