Dr.

Karim Kobeissi

Chapter 7: Pricing Decision

The Four Models of Market Structure

1) Perfect or Pure Competition

Many sellers of an identical product (e.g., sugar,

salt), price takers.

2) Pure Monopoly

One firm -sole seller of a specific product (e.g., electricity),

the price is usually regulated by the government.

3) Oligopoly

Few sellers (e.g., cars producers), differentiated products,

must take prices of others into account when determining
its own price and strategies.

4) Monopolistic Competition

Many sellers (e.g., clothes producers), who trade over a

range of prices.

Sellers can differentiate their offers to buyers .

The market structure distinction is extremely

important for sellers because if price transparency
eventually results in a completely efficient market,
sellers will have no control over prices (they
become price takers)the result will be pure
competition.

Efficient Markets Mean Loss of Pricing Control

How Price is
Determined in
Each of These
Four Market
Structure?

I - Perfectly Competitive
Market

Factors That Make a Market Perfectly

Competitive
1) Very large number of sellers:

examples include

milk, yogurt, sugar, salt.

2) Standardized product: A homogeneous product.
3) Price Takers: Individual firms exert no significant

control

over

price.

The

price

is

the

same

everywhere; and buyers will be indifferent about

which seller they buy the product from.
4) Free entry and exit: no obstacles to entry--legal,

technological, financial etc.

A Competitive
Firm

Demand Curve of a Competitive Firm

A competitive firm has a perfect demand curve:
For any price increase Demand will drop to zero,
because customers will buy from somewhere else at
the equilibrium price The firm cannot obtain a
higher price by restricting its output; nor does it
have to lower price (although it may) to increase its
sales volume.

Although, the demand for the INDIVIDUAL

firm in a purely competitive industry is
PERFECTLY ELASTIC.
However, this does NOT mean that the
MARKET demand is perfectly elastic. In fact,
TOTAL-DEMAND curves for most agricultural

Short Run Profit Maximization (Accounting Perspective)

A firms profit function:

Profit (q)= (q) = Total revenue(q) - Total cost(q)
Or, a function is maximum when its derivative is
equal to zero / q = 0
The firm maximizes its profit by producing q*
where:
[Total revenue(q)]-[Total cost(q)]=0
Marginal Revenue Marginal Cost =0
Marginal Revenue=Marginal Cost
MR = MC
Or MR = Price
MR = MC = Price

Economic Vs Accounting
Profit

Economic

profitis

thedifference

betweentotal monetary revenue and

total costs, but total costs include both
explicit and implicit costs. Economic
profitincludes
associated

the

with

opportunity

production

costs

and

is

 IF WE HAVE AN ACCOUNTING LOSS (implicit costs are not

taken into consideration) WE HAVE AN ECONOMIC
LOSS (implicit costs are taken into consideration) .
IF WE HAVE AN ECONOMIC LOSS WE HAVE AN
ACCOUNTING LOSS
IF WE HAVE AN ECONOMIC PROFIT (implicit cost are
taken into consideration)

WE HAVE AN ACCOUNTING

PROFIT (implicit costs are not taken into consideration).

IF WE HAVE AN ACCOUNTING PROFIT (implicit costs are
not taken into consideration)

WE HAVE AN ECONOMIC

PROFIT (implicit costs are taken into consideration).

Economic Profit
The

competitive

firm

will

make

an

economic profit (AT PROFIT MAXIMIZING

QUANTITY) whenever:
Price = MR > ATC

IN THE LONG TERM

E. Profit () = (P ATC)
Q
OR P = ATC

Economic Loss
The competitive firm will have an economic
loss

(AT

PROFIT

QUANTITY)whenever:
Price = MR < ATC

MAXIMIZING

Loss Minimization & Shut-Down Rule

Suppose that P < ATC. Since the firm is experiencing
an economic loss (

accounting loss), should it shut

down?
Let us compare the profits of producing and selling (Q)
to the profits when the firm shuts down:
When the firm shut down: (0) = - Fixed Cost
When the firm produce and sell Q: (Q) = [(PQ) (FC +
VC)]
Therefore, (Q) > (0) when PQ > VC.
Divide both sides by (Q): P > AVC.

If P > AVC, then producing and selling (Q) is better

than shutting down Stay in business .
If P < AVC then it is impossible to do better than
shutting down.

Loss Minimization & Shut-Down Rule

- A firm should continue producing in

the short-run as long as its total
revenue is greater than its variable
costs.
- A firm should shut down if its total
revenue is less than its variable
costs.

II- Monopoly

Factors That Make a Market a

Monopoly
1) Single seller
2) No close substitutes
3) Price maker (..not price taker)
4) Blocked entry
5) No price competition
In a MONOPOLY, the firm and the industry are
the same.

MR <
P

MC <
P

Q*

MR = MC < P

IN THE SHORT TERM

E. Profit () = (P ATC)
Q
E. Profit () > 0 if P >

IN THE SHORT TERM

E. Profit () = (P ATC)
Q
E. Profit () > 0 if P >

IN THE SHORT TERM

E. Profit () = (P ATC)
Q
E. Profit () > 0 if P >

IN THE SHORT TERM

E. Profit () = (P ATC)
Q
E. Profit () > 0 if P >

IN THE LONG TERM

E. Profit () = (P ATC)
Q
OR P = ATC
E. Profit () = 0

So far, we have been assuming

that the monopoly firm charges
the same price to all consumers.
In many cases, however,
monopolist will use PRICE
DISCRIMINATION, or sell the same
good to different customers for
different prices.
This practice is not possible in
competitive markets where there are
many firms selling the same product
at competitive prices.

How Does the Monopolist Decide Why and

How to Price Discriminate?
Suppose you are President of Books-R-Us.

The

newest publication can be sold at differing prices

to 2 types of readers:
1)100,000 die-hard fans who will pay $30 /book,
and
2)400,000 less enthusiastic readers who will pay
$5/book

There are 2 Options to Consider:

Option 1

Option 2

100,000

500,000

$30

$5

$ 3 million

(revenue)

$ 2.5 million

- 2 million

(cost)

- 2 million

$1 million

(profit)

$500,000

(revenue)

(cost)

(profit)

Books R-Us will choose option 2 since it yields more

Examples of Price Discrimination

include:
1) Movie tickets
2) Airline tickets on particular
destinations
3) Discount coupons
4) Financial aid
5) Quantity discounts

III- Oligopoly

Factors That Make a Market an

Oligopoly
1. Relatively few sellers,
2. Relatively differentiated products,
3. Price interdependence
4. Relatively difficult entry into and exit from the
industry

Price Interdependency

The distinguishing feature of oligopolistic market structures it is

the degree to which the output, pricing and other decisions of
one firm affect, and are affected by, the similar decision
made by other firms in the industry.

What is important is the interdependence of the managerial

decisions among the various firms in the industry. The analysis
oligopolistic behavior may be modeled as a non-cooperative game
in which the actions of one firm to increase market share will,
unless countered, result in a reduction of the market share of
other firms in the industry. Thus, action will be followed by
reaction. This interdependence is the essence of an analysis of
oligopolistic market structures.

Game Theory
Game theory is perhaps the most important
tool in the economists analytical kit for
analyzing the strategic behavior. Strategic
behavior is concerned with how individuals
make decisions when they recognize that
their actions affect, and are affected by, the
actions of other individuals or groups.

Game Theory

can also be illustrated by what is called

THE

PRISONERS DILEMMA.
The police have enough evidence to convict Bonnie and Clyde of
possession of an illegal firearm so that each would spend 1 year
in jail. But they suspect that the two have pulled off some bank
robberies but they have no evidence. They put Bonnie and Clyde
in separate rooms and offer a deal.

Right now, we can lock you up for one

year. But if you testify against your
partner, we will set you free and your
partner will get 20 years in prison. If you
both confess to the crime, we can avoid
the cost of a trial and you both get 8
years.

THE PRISONERS DILEMMA GAME AND THE REAL WORLD

The Prisoners Dilemma is an example of a twoperson,

non-cooperative,
simultaneous-move,
one-shot game in which both players have a
strictly dominant strategy.
A player has a strictly-dominant strategy if it
results in the largest payoff regardless of the
strategy adopted by other players.
A Nash equilibrium occurs in a non-cooperative
game when each player adopts a strategy that is
the best response to what is believed to be the
strategy adopted by the other players.
When a game is in Nash equilibrium, neither
player can improve their payoff by unilaterally
changing strategies.

THE PRISONERS DILEMMA GAME AND THE REAL WORLD

(con)
The key insight of the prisoners dilemma game is the tension between
the equilibrium outcome (in which both players best strategy is to
confess because they cant trust each other) and the fact that both
players could make themselves better off if only they would cooperate.
This tension helps explain complex events in the real world.
The Organization of Petroleum Exporting Countries (OPEC) provides a
classic example of this tension. OPEC is a cartel that controls a large
fraction of the worlds oil. Looking at OPEC as a whole, restricting the
supply of petroleum and keeping the price of petroleum high is in OPECs
interest. Keeping the price of petroleum high, perhaps near $40 a barrel,
which was the price about 20 years ago, would maximize the total
revenues and profits of the OPEC nations. But when the price is this high,
the individual interest of each nation lies in pumping more oil than the
amount allocated to it under the OPEC agreement. Each nation figures
that if it and it alone cheats on the output restriction imposed by the
cartel agreement, the effect on the world price of oil would be small but
the positive impact on its profit from selling more oil would be large. So
each nation is tempted to cheat on the cartel.

Non-cooperative Oligopoly/Duopoly

Four popular models of firm behavior in oligopolistic

industries are:
1) The Cournot Model is an economic model used
to describe an industry structure in which the two
companies compete on the quantities of output
they will produce (to maximize profits), which
they decide on independently of each other and
simultaneously.
2) The Stackelberg Model is an economic model
used to describe an industry structure in which
the two companies compete on the quantities of
output they will produce (to maximize profits),
which they decide on independently of each
other and consecutively (Leader firm and
Follower firm).

Non-cooperative Oligopoly/Duopoly (con)

3) The Sweezy Model is an economic model used

to describe an industry structure in which the two
companies compete on the price they will set to
maximize profits. Each firm will follow a price
decrease by other firms in the industry, but will
not follow a price increase.
4) The Bertrand Model is an economic model used
to describe an industry structure in which each
firm sets the price of its product to maximize
profits and ignores the price charged by its rival.

C o u r n o t M o d e l Fo r a
Duopoly

Five Assumptions:
1) The two firms produce a homogeneous product,
i.e. there is no product differentiation (e.g., water).
2) The two firms do not cooperate.
3) The two firms have market power, i.e. each firm's
output decision affects the product's price.
4) The firms are economically rational and act
strategically, usually seeking to maximize profit
given their competitors' decisions.
5) The two firms compete on quantities, and choose
quantities simultaneously (each firm take the
output quantity of the other as a given
constant).

Cournot Model of an Airlines Market

Example: American Airlines and
United
Airlines
compete
for
customers
on
flights
between
Chicago and Los Angeles.
Cournot
equilibrium
(NashCournot equilibrium) - a set of
quantities sold by firms such that,
holding the quantities of all other
firms constant, no firm can obtain a
higher profit by choosing a different

Cournot Model of an Airlines Market

(cont).
Residual Demand Curve
The market demand that is not met by
other sellers at any given price.

Cournot Model of an Airlines Market

(cont).
Market demand function is
Q = 339 p
p - dollar cost of a one-way flight
Q total quantity of the two airlines (thousands
of passengers flying one way per quarter).

Each airline has a constant marginal cost,

MC, and average cost, AC, of $147 per
passenger per flight.

Cournot Model of an Airlines Market

(cont).

Residual demand American Airlines faces is:

qA = Q(p) qU = (339 p) qU.

rewriting

p = 339 qA qU

The marginal revenue function is:

MRr = 339 2qA qU

Cournot Model of an Airlines Market

(cont).

American Airlines best response is the

output that equates its marginal
revenue, and its marginal cost:
MRr = 339 2qA qU = 147 = MC
and rearranging

qA = 961/2 qU

Cournot Model of an Airlines Market

(cont).

United Airlines best-response

function is
qU = 961/2 qA
This statement is equivalent to saying
that the Nash-Cournot equilibrium is a
point at which the best response
curves cross.

Cournot Model of an Airlines Market

(cont).

To solve the model:

qA = 961/2 (961/2 qA)
and solve for qA.

Doing so, we find that

qA = 64; qU = 64
Q = qA + qU = 128.
Nash - Cournot equilibrium price is
$211.

IV- Monopolistic
Competition

Factors That Make a Market a Monopolistic

competition

1- There are a large number of firms

(Many Sellers).
2- The products produced by the
different firms are differentiated (e.g.,
video games).
3- Entry and exit occur easily (There are
few barriers to entry or exit).

1- Many Sellers
When there are many sellers, they do not
take into account rivals reactions.
The existence of many sellers makes
collusion difficult The many sellers
characteristic

gives

monopolistic

competition its competitive aspect.

2 - P r o d u c t D i ff e r e n t i a t i o n
Product

differentiation

implies

that

the

products are different enough (e.g. by branding

or

quality)

Product

differentiation

gives

monopolistic competition its monopolistic aspect.

The

firms

compete

more

on

product

differentiation than on price.

Entering firms produce close substitutes, not an
identical or standardized product Firms have a
degree of control over price.

Differentiated Products
Differentiation

exists

so

long

as

advertising convinces buyers that it

exists.
Firms will continue to advertise as
long as the marginal benefits of
advertising
costs.

exceed

its

marginal

Multiple Dimensions of Competition

One dimension of competition is product
differentiation.
Another is competing on perceived quality.
Competitive advertising is another.
Others include service and distribution outlets .

3- Easy Entry of New Firms in the Long

Run
There are no significant barriers to
entry.
Ease of entry limits long-run profit.

Characteristics of a Monopolistic Competitor

Like a Monopoly,
* The monopolistic competitive firm has some monopoly power so
the firm faces a downward sloping demand curve.
* Marginal revenue is below price : MR< P
*

At profit maximizing output, marginal cost will be equal to

marginal revenu and less than price MR = MC < P

Like a Perfect Competitor,

* zero economic profits exist in the long run.

Comparing Monopolistic Competition with

Monopoly In The Long Run
It is possible for the monopolist to make
economic profit in the long-run (AS LONG
AS PATENT EXIST).
No long-run economic profit is possible in
monopolistic competition.