Chapter 10 Special Pricing Policies

Chapter Ten

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Cartel arrangements

A cartel is an arrangement where firms in an industry cooperate and act together as if they were a monopoly

cartel arrangements may be tacit or formal illegal in the US: Sherman Antitrust Act, 1890 examples: OPEC, IATA
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Cartel arrangements

Conditions that influence the formation of cartels small number of large firms in the industry geographical proximity of the firms homogeneous products that do not allow differentiation stage of the business cycle difficult entry into industry uniform cost conditions, usually defined by product homogeneity
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Chapter Ten

Cartel arrangements

In order to maximize profits, the cartel as a whole should behave as a monopolist the cartel determines the output which equates MR = MC of the cartel as a whole the MC of the cartel as a whole is the horizontal summation of the members marginal cost curves price is set in the normal monopoly way, by determining quantity demanded where MC=MR and deriving P from the demand curve at that Q
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Chapter Ten

Cartel arrangements

MCT is the horizontal sum of MCI and MCII QT is found at the intersection of MRT and MCT price is found from the demand curve at QT this is the price that maximizes total industry profits
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Cartel arrangements

to determine how much each firm should produce, draw a horizontal line back from the MRT/MCT intersection where this line intersects each individual firms MC determines that firms output, QI and QII. Note that the firms may produce different outputs Key point: the MC of the last unit produced is equated across both firms
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Cartel arrangements

Profits for each firm are shown as rectangles in blue

Firms may earn different levels of profit, though combined profits are maximized
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Cartel arrangements

Problem: incentive for firms to cheat on agreement, thus cartels are unstable

Additional costs facing the cartel formation costs monitoring costs enforcement costs cost of punishment by authorities weigh the benefits against these costs

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Cartel arrangements

Examples: price fixing by cartels GE, Westinghouse Archer Daniels Midland Company Sothebys, Christies Roche Holding AG, BASF AG

Chapter Ten

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Price leadership

Barometric price leadership one firm in an industry will initiate a price change in response to economic conditions the other firms may or may not follow this leader leader may vary

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Price leadership

Dominant price leadership one firm is the industry leader dominant firm sets price with the realization that the smaller firms will follow and charge the same price can force competitors out of business or buy them out under favorable terms could result in investigation under Sherman Anti-Trust Act

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Price leadership
DT = demand curve for entire industry MCD = marginal cost of the dominant firm MCR = summation of MC of follower firms in setting price, dominant firm must consider the amount supplied by all firms
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Price leadership
Demand curve facing the dominant firm is found by subtracting MCR from DT dominant firm equates its MC with MR from its residual demand curve DD the dominant firm sells A units and the rest of the demand (QT A) is supplied by the follower firms
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Revenue maximization

Baumol model: firms maximize revenue (not profit) subject to maintaining a specific level of profits Rationale a firm will become more competitive when it achieves a large size management remuneration may be related to revenue not profits Implication: unlike the profit maximization case, a change in fixed costs will alter price and output (by raising the cost curve and lowering the profit line)
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Chapter Ten

Price discrimination

Price discrimination: products with identical costs are sold in different markets at different prices the ratio of price to marginal cost differs for similar products Conditions for price discrimination the markets in which the products are sold must by separated (no resale between markets) the demand curves in the market must have different elasticities

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Price discrimination

First degree price discrimination seller can identify where each consumer lies on the demand curve and charges each consumer the highest price the consumer is willing to pay allows the seller to extract the greatest amount of profits requires a considerable amount of information

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Price discrimination

Second degree price discrimination differential prices charged by blocks of services requires metering of services consumed by buyers

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Price discrimination

Third degree price discrimination customers are segregated into different markets and charged different prices in each segmentation can be based on any characteristic such as age, location, gender, income, etc

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Price discrimination

Third degree discrimination: assume the firm operates in two markets, A and B the demand in market A is less elastic than the demand in market B the entire market faced by the firm is described by the horizontal sum of the demand and marginal revenue curves

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Price discrimination

the firm finds the total amount to produce by equating the marginal revenue and marginal cost in the market as a whole: QT if the firm were forced to charge a uniform price, it would find the price by examining the aggregate demand DT at the output level QT the firm can increase its profits by charging a different price in each market
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Chapter Ten

Price discrimination

in order to find the optimum price to charge in each market, draw a horizontal line back from the MRT/MCT intersection where this line intersects each submarkets MR curve determines the amount that should be sold in each market: QA and QB these quantities are then used to determine the price in each market using the demand curves DA and DB
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Chapter Ten

Price discrimination

Examples of price discrimination

doctors telephone calls theaters hotel industry
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Chapter Ten

Price discrimination

Tying arrangement: a buyer of one product is obligated to also by a related product from the same supplier illegal in some cases one explanation: a device to meter demand for tied product other explanations of tying quality control efficiencies in distribution evasion of price controls

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Nonmarginal pricing

Cost-plus pricing: price is set by first calculating the variable cost, adding an allocation for fixed costs, and then adding a profit percentage or markup Problems with cost-plus pricing calculation of average variable cost allocation of fixed cost size of the markup

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Nonmarginal pricing

Incremental pricing (and costing) analysis: deals with changes in total revenue and total cost resulting from a decision to change prices or product Features: incremental, similar to marginal analysis only revenues and costs that will change due to the decision are considered examples of product change: new product, discontinue old product, improve a product, capital equipment
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Chapter Ten

Multiproduct pricing

When the firm produces two or more products

Case 1: products are complements in terms of demand an increase in the quantity sold of one will bring about an increase in the quantity sold of the other Case 2: products are substitutes in terms of demand an increase in the quantity sold of one will bring about a decrease in the quantity sold of the other
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Multiproduct pricing

When the firm produces two or more products

Case 3: products are joined in production products produced from one set of inputs Case 4: products compete for resources using resources to produce one product takes those resources away from producing other products
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Transfer pricing

Internal pricing: as the product moves through these divisions on the way to the consumer it is sold or transferred from one division to another at a transfer price

Rationale: firm subdivided into divisions, each may be charged with a profit objective without any coordination, the final price of the product to consumers may not maximize profits for the firm as a whole
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Transfer pricing

Design of the optimal transfer pricing mechanism is complicated by the fact that
each division may be able to sell its product in external markets as well as internally each division may be able to procure inputs from external markets as well as internally

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Transfer pricing

Case A: no external markets no division can buy from or sell to an external market the selling division will produce exactly the number of components that will be used by the purchasing division one demand curve and two MC curves MC curves are summed vertically set production where MR = Total MC
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Chapter Ten

Transfer pricing

Case B: external markets divisions have the opportunity to buy or sell in outside competitive markets if selling division prices above the external market price, the buying division will buy from outside if selling division cannot produce enough to satisfy buying division demand, the buying division will buy additional units from the external market
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Chapter Ten

Other pricing practices

Price skimming the first firm to introduce a product may have a temporary monopoly and may be able to charge high prices and obtain high profits until competition enters Penetration pricing selling at a low price in order to obtain market share
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Chapter Ten

Other pricing practices

Prestige pricing

demand for a product may be higher at a higher price because of the prestige that ownership bestows on the owner

Psychological pricing

demand for a product may be quite inelastic over a certain range but will become rather elastic at one specific higher or lower price

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Global application

Example: decline of European cartels

carton-board vitamin copper pipe elevator operators

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