Pricing Theories

Various Models
 Limit Pricing
(Entry Preventing Pricing)
Potential Entrants - Attraction

Existing
Competition
Potential Entrants - Repulsion

Entry
Price
Barrier

Existing
Competition
 Entry Conditions and Pricing

• Entry may be ‘blockaded’, or ‘effectively

impeded’ by appropriate pricing
strategies

• Entry barriers are advantageous to

incumbent firms, since it prevents the
clutter in the industry

• The ‘limit price’ is the highest price that

can be charged without inducing new
entry
Oligopoly firms do not charge monopoly
price – because it attracts newer firms
to the industry – this can potentially be
a threat to existing firms 
Different kinds of Entry Barriers

– Absolute cost advantages

• Control over supply of raw materials
• Labour economies of scale
• Capacity raise specialised capital
• Vertical integration
– Initial capital requirements barrier
• Capital and Technology
– Economies of scale
• Production economies, labour economies,
technology, IPR
– Product differentiation
• Huge spend on advertising and branding
Different kinds of Entry Barriers

– Absolute cost advantages

• Control over supply of raw materials

Max Valu
Different kinds of Entry Barriers

– Absolute cost advantages

• Labour economies of scale
 Different kinds of Entry Barriers

– Absolute cost advantages

• Capacity raise specialised capital

Iridium - Motorola
Different kinds of Entry Barriers

– Absolute cost advantages

• Vertical integration
Different kinds of Entry Barriers

- Initial capital requirements barrier

• Capital and Technology
Different kinds of Entry Barriers

– Economies of scale
• Production economies, Technology, IPR
Different kinds of Entry Barriers

- Huge spend on advertising and branding

Pricing Theories – Various Models

• Bain’s Models
• Sylos – Labini’s Model
• Franco Modigliani’s Model
• Bhagawati’s Model
• Pashigian’s Model
 • Barriers to New Competition: their character and
consequences in manufacturing industries, 1956.
• Industrial Organization, 1959.
• "Chamberlin's Impact on Microeconomic Theory",
in Kuenne, editor, Monopolistic Competition Theory
• International Differences in Industrial Structure,
1966
• Northern California's Water Industry, with R.E.
Caves and J. Margolis, 1966.
• Essays on Economic Development, 1970.
• Essays on Price Theory and Industrial
Organization, 1972.
Joe S Bain • Environmental Decay: Economic causes and
remedies, 1973.
• "Sturcture versus Conduct as Indicators of Market
Performance", 1986, Antitrust Law and Econ Rev
• Industrial Organization: a treatise, with T.D.
Qualls, 1987.
 Bain’s Theory of Limit Pricing

• Assumptions
– Threat of potential entry is real
– Established firms are in collusion
– Established firms can determine the limit price
which prevents new entrant to market
• Estimated costs to potential entrants
• Level of Long run Average Cost and its shape
• Size of the market
• Market elasticity of demand
• Number of firms in the industry
– If the price is set above limit – price, it will attract
new entrant and results in considerable uncertainty
about the sales of existing firms
Bain’s Theory of Limit Pricing (Revised Version)

• Assumptions
– Each industry has a minimum size of plant
and the economies of scale fully realised
and this is called as the minimum optimal
scale of plant.
– All the firms and entrants are at the same
technology and hence LAC is same for all.
– Both the established firms and the new
entrants know the market demand curve,
– All firms produce very similar products and
have equal market shares
 Bain’s Models

Model – 1
– Constant Price at the pre-entry level
• Model – 2
– Constant output at the pre-entry level
• Model – 3
– Price and output change at post-entry
Constant Price @ Pre - entry Level

• Potential entrant assume

– Firms will maintain prices @ pre-entry level
– This will allow the entrant to gain market
share

• Existing firms will set a limit price to

prevent the entry,
PL = PC (1 + E)
– PL = Limit Price
– PC = Competitive Price
– E = Premium amount
 Constant Price @ Pre - entry Level

PL = PC (1 + E)

The premium amount E, depends on,

• The initial share of the entrant relative to
the minimum optimal scale
• The number of already existing firms
• Steepness of LAC
• Elasticity of the industry demand curve
Constant Quantity @ Pre-entry Level

• In this model, the entrant assumes that

existing firms will not change their level
of output when entry occurs. However,
due to entry of the new firms industry
output increases and price falls.

The existing firms expect the new entry will not take place when
the price falls below the minimum long run average cost and
entry occurs only at the minimum optimal plant size. Generally,
in these circumstances, entry is not possible because of scale
barrier.
Price and Output Change @ Post-Entry

• New entrant expects that the existing

firms will accept it partially by reducing
their output and price will also decrease
eventually.

• This is more realistic

 Sylos – Labini’s Model
Major works of Paolo Sylos-Labini

– "Monopoli ristagno economico e politica

keynesiana", 1954, Econ Internaz
– "Il prolema dello sviluppo economico in Marx ed in
Schumpeter", 1954, in Papi, editor, Teoria e
political dello sviluppo economico
– Oligopoly and Technical Progress, 1956.
– L'imndustria petrolifera negli Stati Unit, nel
Canada, e nel Messico, with G. Guarino, 1956.
– "Relative Prices and Development Programmes",
1957, BNLQR
– "Lo sviluppo economico in Marx e Schumpeter",
1960, in Economie capitalitische ed economie
Paolo Sylos-Labini pianificate
– "Prices Distribution and Investment in Italy, 1951-
Professor of Economics, 1966", 1967, BNLQR
University of Rome. – "Prices and Wages: A theoretical and statistical
interpretation of Italian experience", 1967, J
Industrial Econ
– "Produttivita, salari e prezzi", 1967, in Produttivita
e prezzi.
 Sylos – Labini’s Model

• The price is determined by the leader

which is the largest and most efficient
firm. The price fixed is called
‘equilibrium price’ and it fulfils two
conditions
– It is acceptable to all the firms in the
industry
– It prevents the new entrant to the industry
 Franco Modigliani’s Model

Important Works
– Adventures of an
Economist
– Foundations of
Financial Markets
and Institutions
Franco Modigliani
– Capital Markets:
Institutions and
Nobel Laureate in Economics – 1985
for his pioneering analyses of saving and of
Instruments
financial markets.
 Franco Modigliani’s Model

- The limit price has a positive relationship

with the minimum optimal plants size and
the competitive price which equals to LAC.
It is negatively related with the size of the
market and the price elasticity of demand.

• According to Modigliani, the scale barriers are

responsible for a higher limit price than the
competitive price. The difference between the
two is called ‘entry gap’ or ‘premium’ . It
measures the amount by which the price can
exceed LAC without attracting entry into the
industry.
 Bhagwati’s Model
Jagdish Bhagwati

Professor at Columbia University and André Meyer Senior Fellow in

International Economics at the Council on Foreign Relations.

An external adviser to the Director General of the World Trade

Organization, he has been Economic Policy Adviser to the Director
General, GATT, and Special Adviser to the United Nations on
Globalization.

He is the author of several volumes and he has been honored with three
festschrifts. He has received several honorary degrees and awards,
including the Bernhard Harms Prize, the Freedom Prize, and the
Seidman Distinguished Award in Political Economy.

Major Works:
•International Trade Theory and Policy
•The Uruguay Round and the Developing Countries
•Trade and the Environment in General Equilibrium: Evidence from Developing
Economies
•Market Integration, Regionalism and the Global Economy
 Bhagwati’s Model

• Extension of Modigliani’s model

• Bhagwati considers two more
determinants
– Number of firms in the industry
– Switch over of customers to new entrant,
because of dissatisfaction with the existing
firms

• In the dynamic market, firms must try to

maximise their demand and look for
other factors to discourage the entry of
new player
 Pashigian’s Model

• Pashigian adopted mixed strategy in his

theory

• During a particular time period, the

existing firm may abandon the monopoly
price and may start charging the limit
price or competitive price, which is more
profitable among these two.

• Pashigian justifies the limit price on the

grounds of maximum profitability
• What are the other ways of keeping
the new entrant away from the
industry?
Managerial Theories of Firm
 Important Theories

• Baumol’s Theory of Sales Revenue

Maximisation

• Manis Model of Managerial Enterprises

• William’s Model of Management Discretion

• The Behavioural Model of Cyert and March

Baumol’s Theory of Sales Maximisation
• "A Country's Maximal Gains from Trade and
Conflicting National Interests,"

• "Protected Frictional Unemployment as a

Heavy Cost of Technical Progress,"

• "Speed of Technical Progress and Length of

the Average Inter job Period,"

• "Privatization, Competitive Entry and Rational

Rules for Residual Regulation,"

• "Pareto Optimal Sizes of Innovation

Spillovers,"
Prof. W.J. Baumol
• "Competitive Neutrality Via Differential
Dept of Economics Access Pricing: Preservation of Desired Cross
Subsidies Under Competitive Entry,"
Princeton University
• "Parity Pricing and Its Critics: Necessary
Condition for Efficiency in Provision of
Bottleneck Services to Competitors"
Baumol’s Theory of Sales Maximisation

• Evolving Corporate Firms – Changing ownership

patterns

• Owners – Profit
• Managers – Sales

• Emperical study shows

– Salaries of CEO’s are closely related to sales
– Banks look into sales figures
– Sales enhances the prestige of Managers (Dividends are
distributed )
– Spectacular profits are difficult to maintain - Steady profits
are preferred
– Large sales strengthens the competitive power of the firm
Baumol’s Theory of Sales Maximisation

• Static Model
– With Advertising
– Without Advertising

• Dynamic Model
– Multi-product enterprise
Baumol’s Theory of Sales Maximisation

• Important assumptions

– Firm’s decision making is limited to

single period. i.e., it does not consider
the implications of decisions for the
subsequent periods

– Total sales revenue maximisation is

subject to minimum profit constraint
(which is exogenously determined by
shareholders, Banks,…)
Baumol’s Theory of Sales Maximisation

• Model without advertising

– Firm produces at the level at which its sales
revenue is maximised, subject to profit
constraint

• Model with advertising

– It ‘always pay the sales maximiser to
increase his advertising outlay until he is
stopped by the profit constraint – until
profits have been reduced to the minimum
acceptable level’
• Multi – Product Firms
 Multi-Product Firms

Total Profits

Profit
Constraint
Total Profit

PM
D TP1
R
Overhead TP2
Costs C
Decrease in
Total Profits
O Qp Q’c Qc
Quantity
 Marris’s Theory
This model incorporates financial policies into
the decision making process of a corporate.
He argues growth and profit are competing
goals. A firm cannot achieve both maximum
profit and maximum growth.

Owners of corporate firm seem to prefer

maximisation of growth rather than
maximisation of profits.

This theory suggests that although the

managers and the owners have different goals,
it is possible to find a solution which
maximises utility of both.