Theory of Product Pricing

A reference note on Pricing Theory and Techniques Compiled by Bindu Raj Khanal, Apex College
Setting the price of the product produced by the firm is regarded as one of the major areas of managerial decision. If the price of the product is set too high, the firm cant compete with other firms. On the other hand, if the price is set too low, the firm may make economic losses. Setting appropriate price of the product requires the knowledge of economic environment in which the firm is operating. Therefore, the managers must consider the specific market structure in which their firms operate.

Market Structure
Various economists have suggested various criteria for the classification of markets. The basic criteria are the existence and closeness of substitutes, the extent to which firms in the industry take into account the reactions of competitors and the condition of entry. In the market where there is large number of firms producing homogeneous products, an individual firm has very little control over the price of its product. In contrast, the firm, whose product has no substitute, can set the price of its product at any level. Traditionally, the following market structures are distinguished.

Perfect Competition
Perfect competition is the market structure characterized by large number of buyers and sellers in the industry. In other words, there is large number of firms in the industry. Competition is perfect in that every firm can sell any amount of output at existing market price. An individual firm cant influence the market price because the share of the firm in the market is very small and the products are homogeneous. Therefore, the firm in the perfect competition is said to be a price taker. The products of the firm are perfect substitutes for one another so that the price elasticity of demand is infinite. There are no barriers for new firms to enter into the industry and for the existing firms to exit out from the industry.

Monopoly
Monopoly is the market structure where there is only one firm in the industry and there is no close substitute for the product produced by the firm. The demand curve for the monopolist coincides with the industry demand curve. Entry for new firm into the industry is blocked. Therefore the firm has full control over the price of the product.

Sources of monopoly
1. Legal Restriction: Some monopolies are created by the law in the public interested. Generally television, airlines, roadways, electricity etc are public monopolies that are created by pubic law. Sometimes it may create monopolies in private sector also by restricting entry of the firms by law. Such monopolies are generally to reduce cost of production by enlarging the size and investing in the technological innovations such monopolies are known as franchise monopolies. 2. Control over Raw Materials: Some firms acquire monopoly power because of there traditional control over certain scarce and key raw materials which are

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Theory of Product Pricing essential for the production .e.g.: bauxite, graphite, diamond etc such monopolies are known as raw materials monopolies. 3. Efficiency: A primary and technical reason for growth of monopolies is the economies of the scale. In same industries long run minimum cost of production or the most efficient scale of production almost coincides with the size of the market. Under this condition the large size firms finds it profitable in the long run to eliminate the competition by cutting dawn its price for a short period. Once monopoly established it becomes almost impossible for the new firms to enter and survive. This is known as natural monopolies. 4. Patent Right: Another source of monopoly is the patent right of the firms for a product or for a production process. Patent right are granted by the government to a firm to produce a commodity of specific quality and character or to use a specific technique of production. Such monopolies are called as patent monopolies. Pricing Under Monopoly Market Monopoly is said to exist when one firm is the sole producer or seller of a product, which has no close substitutes. The market structure characteristics of monopoly are as follows: 1. There is a single producer or seller of a product, but the number and size distribution of buyers is unspecified. 2. There are no close substitutes for the product produced by the monopolist. 3. Strong barriers to the entry into the industry exist, that is, there are some factors that prevent the entry of other firms. The factors may be of various natures such as; sole ownership of the factors of production, legal restrictions (patent rights or government licensing), huge amount of cost of production, etc. Since there is only one producer (or firm) in the industry, the firm itself is the industry and hence the demand curve or average revenue curve is downward sloping. If the monopolist tries to increase the price of the commodity, the quantity demanded for his product will decline. In the following figure, AR is the average revenue (or demand) curve, which slopes downward to the right. MR is the marginal revenue curve.

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Theory of Product Pricing AR, MR

AR O MR Price and Output Determination (in short-run) A rational producer (whether he is producing under perfect competition or monopoly always tries to maximize profit. Therefore, the monopolist will be in equilibrium when his profits are maximized. A monopolist maximizes his profits if and only if the following conditions are fulfilled: a. The marginal cost (MC) is equal to the marginal revenue (MR). b. The slope of marginal cost curve is greater than the slope of marginal revenue curve at he point of intersection. The following figure illustrates the short-run equilibrium for a monopolist. In the figure, AC and MC are the firms average cost and marginal cost curves respectively. Similarly, AR and MR are the average revenue and marginal revenue curves respectively. At point E, MC cuts MR from below and hence, both the conditions are fulfilled. Therefore, E is the equilibrium point. Corresponding to this equilibrium point E, Qo is the equilibrium quantity that the monopolist produces and sells in the market. When the monopolist produces Qo amount of output, the average cost is BQo or OM as represented by the average cost (AC). Similarly, the average revenue or price at the equilibrium level of output is AQo or OPo. Q

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Theory of Product Pricing

P, C MC AC Po M A B E AR

Qo

Q MR

At the equilibrium level of output Qo, Total Revenue (TR) = Average Revenue Quantity of Output = OPo OQo = Area APoOQo Total Cost (TC) = Average Cost Quantity of Output = OM OQo = Area BMOQo Profit () = TR TC = Area APoOQo Area BMOQo = Area ABMPo Generally, the monopolist makes profit as explained above. However, in the short-run, the firm may also lose. The following figure depicts the situation where the firm is P, C MC AC M Po B A

E AR

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Qo

Q MR 4

Theory of Product Pricing making loss. In the figure above, AC, MC, AR and MR are average cost, marginal cost, average revenue and marginal revenue curves respectively. E is the equilibrium point, where MC cuts MR from below. Corresponding to the equilibrium point E, OQo is the equilibrium amount of output and OPo is the equilibrium level of price. The amount of loss is represented by the area ABMPo. Price and Output Determination (in long-run) In the long run, the monopolist has the enough time to expand his plant, or to use his existing plant at any level, which will maximize his profit. With entry blocked, however, it is not necessary for the monopolist to reach an optimal scale (that is, to build up his plant until he reaches the minimum point of the LAC). In the long run, the monopolist generally makes profit. The monopolist will not stay in business if he makes losses in the long run. (In practice, some monopoly firms may make losses as there are other factors working behind the general principle.) The price and output determination under monopoly in the long run is depicted in the figure below. P, C LMC LAC Po M A B E AR

Qo

Q MR

LAC, LMC, AR and MR are long run average cost, marginal cost, average revenue and marginal revenue curves for the monopolist respectively. In monopoly, there are no market forces similar to those in perfect competition, which lead the firms to earn only normal profits in the long run. Therefore, in the long run, the monopolist may continue to earn super normal profit. The area ABMPo represents the profit of the monopolist in the long run. Total Revenue (TR) = Average Revenue Quantity of Output = OPo OQo = Area APoOQo Total Cost (TC) = Average Cost Quantity of Output Bindu Raj Khanal 5

Theory of Product Pricing = OM OQo = Area BMOQo = TR TC = Area APoOQo Area BMOQo = Area ABMPo

Profit ()

Monopolistic Competition
In a market of monopolistic competition, there is very large number of firms but their product is somewhat differentiated. Therefore, the demand curve of the individual firm has a negative slope, but its price elasticity is high due to the existence of close substitute produced by the other firms in the industry. Due to these reasons, the individual firm can have little control over price of the product. There is no restriction for entry and exit.

Oligopoly
Oligopoly is the market structure characterized by few sellers. The firms under oligopolistic market are conscious of their interdependence, and each firm takes into account the rivals, reaction. The products product by oligopolist may be homogeneous or differentiated. Entry is not completely blocked but the barrier is high.

Pricing Under Oligopoly

Pricing under oligopoly is quite different than pricing under other market structures. In the oligopoly, there are few firms in the industry and hence action of one firm affects the selling strategies of others. Pricing cutting by other firm will reduce the market share of other firms. Similarly, attractive advertisement may increase sales at the expense of other sellers. There are many models that try to explain the pricing under oligopoly. The kinkeddemand model, cartels and price leadership are some of them, which are explained below. The kinked-demand model explains the pricing under non collusive oligopoly where as the cartels and price leadership are pricing techniques under collusive oligopoly.

Non-collusive oligopoly; the Kinked-Demand Model

The model tries to explain pricing under non collusive oligopoly. The kinked-demand curve was first used by economist R.L. Hall and C.I. Hitch, in their article, price theory and business behavior(1939) to explain the price rigidity of a product. In the same year, P. Sweezy published an article Demand under Condition of Oligopoly in which he introduced the kinked-demand curve for the determination of the equilibrium in oligopolistic market. The demand curved faced by an oligopolist has a kink (at point E in the figure) as shown in the figure below

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Theory of Product Pricing

D d

I H E G F D d

P2 P P1

Q Q2 Q2 Q Q 1 Q1 Q1

Initially the price of the product is OP and the quantity demand for the firms product is OQ. Now, if the firm reduces the price of the product from OP to OP1 and the other firms in the market do not respond, then the quantity demanded for the firms product would be OQ1, a movement along the relatively elastic demand curve dd from point E to G. However, in the market of oligopolistic competition, a price cut is expected to be matched by other rival firms in an attempt to maintain their market shares and hence the actual quantity demanded for the firms product due to price cut is OQ1, a movement along the relatively inelastic demand curve DD. On the other hand, if the firm increases the price from Op to OP2 then it is expected that the competitors will not follow this increase in price, so that the firm will lose a considerable share of market. That is, the increase in the price of the product will lead the firm to move along the demand curve dd instead of DD. Therefore, the quantity demanded for the firms product will be OQ2 rather OQ2. Thus, once the price of the product is set, the price remains sticky because of the firms kinked-demand curve dED.

Firms Equilibrium
The upper section of the kinked-demand curve has higher price elasticity than the lower parts. For a linear demand curve, the absolute value of the slope of the corresponding marginal revenue is twice1. Due to the kink in the demand curve, the marginal revenue
Proof A linear demand curve can be written as P = a - bQ Slope of demand curve = -b The total revenue (TR) is given by
1

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Theory of Product Pricing (MR) curve is discontinuous at the level of output corresponding to the kink (at point E in the figure). The MR has two segments; segment dA corresponds to the upper part of the demand curve, while the segment from point B corresponds to the lower part of the kinked-demand curve.
P
MC1

d E P A

MC

B O

D
Q

Q
MR

The equilibrium of the firm is illustrated in the figure above. In the diagram, MC is the marginal cost curve for the firm. The firm is in equilibrium corresponding to the point of kink because at any point to the left of the kink, marginal cost MC is below marginal revenue (MR), while to the right of the kink the MC is larger than the MR. thus, in general, the firms profit is maximum at the equilibrium at the point of kink. The intersection of the marginal cost and marginal revenue requires abnormally high or abnormally low costs, which are rather rare practice. Therefore, even if the cost of the firm increases as represented by the marginal cost curve MC the equilibrium output and price remains same. This is why the price of some product remains sticky for a long time period.

Criticisms of kinked-demand Model

1. The kinked-demand model has been criticized on the ground that it does not define the level at which price will be set in order to maximize profits. 2. The kinked-demand curve can explain the stickiness of prices in a situation of changing costs and of high rivalry. However, it does not explain the level of the
TR = PQ TR = (a-bQ)Q TR = aQ bQ2 MR= a 2bQ Slope of MR = -2b =2(-b) Slope of MR = 2 (Slope of Demand Curve).

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Theory of Product Pricing price at which the kink will occur. For instant two kinked-demand curves D1 and D2 are depicted in the figure below. The kinked-demand model does not explain which of the two kinks will prevail. Therefore, some economists do not regard it as a theory of pricing, but rather a tool for explaining why the price, once determined will tend to remain sticky. P

P1

E1 E2

P2 D1 O D2 Q

3. The kinked-demand model has also been criticized for the reason that empirical research has not verified the predictions of the model. In a study of seven oligopoly markets, George Stigler found that firm in these industries were just as likely to follow the price increase by a competitor, as they were to follow a rivals cut in price.

Collusive Oligopoly
In oligopolistic industries, rivalry competition among firms forces their products prices downwards and reduces profits. As a result, the managers of these industries tend to avoid such price competition and enter into some kinds of agreements. It would benefit all the firms in an industry if they got together and set prices so as to maximize total industry profits. Consequently, there is a natural tendency for collusion to occur in the oligopolistic industries. The collusion may take the firm of cartels (formal agreements), price-leadership, or other practices that reduce competition between the firms in the market. (For e.g. syndicate in transport industry in Nepal)

Cartels
Cartels imply direct or formal (although secret) agreement among the firms with the aim of reducing the uncertainty arising from their mutual interdependence. In other words, cartels refer to those groups of firms that enter into the formal agreement to set the prices of their products. The aim of the cartel may differ from one industry to another. Some cartels aim at joint-profit maximization (maximizing industry profit) while others aim at sharing the market (price leadership).

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Theory of Product Pricing

Joint-Profit Maximizing Cartels

In this particular case, the aim of the cartel is to maximize the industry profit. It is assumed that the group of the firms appoints a central agency, which decides the price and output for each of the firm so that the joint profit is maximum. For simplicity, it is assumed that there are only two firms say A and B , in the industry whose costs curves are given MCa and MCb respectively as shown in the figure below. Price & Cost P A C B EA MCA

ACA P G I

MCB ACB P H EB E F

D M

QA Output (Q)

QB

In the figure above MCA and ACA represents the marginal and average costs of firm A. Similarly MCB and ACB are the marginal and average costs for the firm B. The marginal cost for the industry (MC) is obtained by the horizontal summation of the individual cost curves MCA and MCB . Given the industry demand curve D and the corresponding marginal revenue curve MR the industry profit will be maximum at the level of output given by the point E where MC cuts MR from below. Therefore, the equilibrium output is OQ i.e. the total output of the industry that will be sold in the market is OQ. The corresponding point F on the demand curve D gives the equilibrium price OP at which all the firms under the industry sell their products. Each individual firm under the industry produces and sells the amount of output given by the equality of marginal revenue MR and their corresponding marginal cost curves i.e. the firms equilibrium is given by the condition MR = MC A = MC B This implies that the firm A will produce OQA amount of output and the firm B will produce OQB amount of output. Therefore with the equilibrium price OP and the average cost curves ACA and ACB for the firm A and B, the shaded areas ABCP and GHIP represents the profits for the firms A and B respectively. For the cartels (with n number of firms) aiming at joint-profit maximization, the necessary condition for the firms equilibrium is MR = MC1 = MC 2 = MC3 = ............................. = MC n The sufficient condition is that the slope of marginal revenue curve is less than the slope of marginal cost curves for all the firms.

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Theory of Product Pricing

d ( MR) d ( MC1 ) dQ dQ

d ( MR) d ( MC 2 ) dQ dQ

. . . .
d ( MR) d ( MC n ) dQ dQ The theoretical discussion of joint-profit maximizing cartel suggests that it is easy to arrive at the solution that benefits all the firms under the industry. However, there are several difficulties for achieving maximum joint profits. Some of the obstacles are as follows;

1. Estimation of Revenue and Cost Curves:

Mistakes in the estimation of MR and MC curves lead to the mistakes in the estimation of joint-profit maximizing equilibrium price. In order to get more advantage, there is a strong tendency for the individual firms to present false cost figures.

2. Slow Process of Cartel Negotiations:

Cartel agreement takes a long time to negotiate due to the difference in size, cost and market of the individual firms. Due to the time consuming process of cartel negotiations, once the price is set, it tends to remain sticky even if the market conditions are changing.

3. Existence of High-cost Firm:

The firms with higher marginal cost than the equilibrium level should close down if the joint profits are to be maximized. But no firms would join the cartel if it has to close down.

4. Fear of New Firm to Enter:

Even if the cartels aim at maximizing profits, more often they dont charge the price because of the fear that too high profits would attract the new firms to enter into the industry.

Market Sharing Cartels

This form of collusion is more common in practice because it is more popular. The firms agree to share the market but keep a considerable degree of freedom concerning the style of their product, their selling activities and other decisions. There are two methods for sharing the market; non-price competition and determination of quotas.

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Theory of Product Pricing

Non-Price Competition
In this form of cartel, the member firms set a common price by bargaining, at which all the firms sell their products. Since the firms with low costs favor the lower price and the high costs firm forces to increase the price, the cartel price actually depends on the bargaining skill and power of the member firms. Nevertheless, the agreed price must be such as to allow some profits to all members. After the determination of the price of the product, all the firms agree not to sell their product at a price below the agreed price; however they are free to change the style of their product, advertisement strategies and other selling activities. Thus, the member firms of this form of cartel compete on nonprice entities. This form of cartel is said to be a loose cartel because it is unstable than the cartel aiming at joint profit maximization. If the costs of the member firms are identical, then it will be possible that the price is set at the monopoly level. However, in practice, it seldom happens that the costs of the firms are identical. With cost differences, there is a strong incentive for the low costs firms to break away from the cartel openly or to cheat the other members by secret price concessions to the customers. This is illustrated in the figure below. Price & Cost MCA ACA P0 PA PA MRA O QA Output (Q) The monopoly price (price corresponding to the joint profit maximization) is OP0. Firm A has lower cost than firm B, and hence firm A will have the tendency to reduce the price below the monopoly level in order to make the high cost firm B leave the industry. Even if the costs are of the same structure, these forms of cartels are intrinsically unstable because of the high probability of attracting the customers of other member firms by offering lower price. DA QB MRB DB E Q MR

MCB ACB

MC

P0

Determination of Quotas
Another method for sharing market is the agreement on quotas i.e. agreement on the quantity that each member may sell at agreed price. This form of cartels also results in a monopoly solution if all the firms have identical costs. In such a situation the market will be shared equally among the member firms. If there are only two firms in the industry with identical costs, the price will be set at the Bindu Raj Khanal 12

Theory of Product Pricing monopoly level and each of the firm will produce and sell exactly half of the total output of the industry. This is depicted in the figure below.
Price, Revenue & Cost

MC1

MC2

MC=MC1+MC

P0 D D1
O

D2 Q2 MR2
Firm B

MR Q
Industry

Q1

MR1

Firm A

Output However, if the costs are not identical, the market share will be different. Market shares for the firms in the case of cost differentials are decided by the bargaining, which is again unstable. Besides these two methods of sharing the market, the geographical sharing of the market is also popular. In such a case, particular region is defined for each of the firm in which each of the firms is allowed to sell their product.

Breakdown of Cartels
In an oligopoly industry, it is obvious that a successful cartel lead all the member firms profitable than in other circumstances. However, in practice, the cartels are usually short lived because of the benefits of cheating on the collusive agreements. There is a strong incentive for the firms to offer secret price concession in order to attract the other firms customers thereby increasing their profits significantly. This is illustrated in the figure below.

P
E P1 P2 A B
C

AC G

D2 F D1

O Bindu Raj Khanal

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Theory of Product Pricing

If all the members of the cartel reduce the price of their product simultaneously the individual firms demand curve will be steeper (inelastic) as represented by D1.However, on the other hand, if the individual firm is able to cheat and reduce the price while the other member firms remaining unnoticed, the demand curve for cheater will be relatively flatter (elastic) as denoted by D2. In the figure, AC is the average cost curve for the individual firm. If the cartel price is OP1, then the quantity sold by the firm is OQ1 and hence area ACEP1 indicates the profit for the firm. Now let the individual firm reduces the price of the product from OP1 to OP2 and this price cut is not detected by the other firms. In such circumstances, the firm will be able to sell OQ2 amount of its output (by moving down along the elastic demand curve D2) thereby enjoying the profits represented by the area BFGP2. it is clearly seen from the figure that the area BFGP2 is greater than the area ACEP1. From the above discussion, it is apparent that if the cheating is not detected, then the cheater may enjoy a considerable amount of profits by setting a slightly lower price. On the contrary, if the other member firms noticed the deception, they may punish the cheater or the cartel may breakdown. The breakdown of cartels also occurs if new firms can easily enter into the industry because it is not certain that a new firm will join the cartel. However, the existing firms may charge a low price or may even threaten a price war on the newcomer in order to make entry unattractive.

Price Leadership
Price leadership is a form of collusion in which on firm sets the price and the other firms follow it. It may be practiced either by explicit agreement or informally. The leadership may result form cost efficiency from the size and strength of the leader firm, or as a result of the recognized ability of the leader to forecast economic conditions accurately. Price leadership is more popular than cartels because of the freedom for the follower firms regarding the style of their product and other selling activities. There are various forms of price leadership. Three traditional forms are explained below.

Low cost Price Leader

In this particular form of price leadership, the firm with the lowest cost is regarded as the leader and the other firms in the industry will charge that price that is set by the leader. Consider an economy where there are only two firms A and B, the firm A having lower costs. The two firms may have equal market shares or unequal market shares as shown in the figure first and second respectively below.

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Theory of Product Pricing

Equal Market Share

Price & Cost MCB PB PA EB D=DA=DB EA O QB
QA=QB

ACB

MCA ACA

DA=DB Q Q0

MRA=MRB In the figure above, ACA and MCA are average and marginal cost curves for firm A and ACB and MCB are average and marginal costs curves for firm B. Since the two firms are assumed to share the market equally, the demand curves for the firms (DA and DB) and their corresponding marginal revenue (MRA and MRB) coincide. The leader firm A with low cost determines the price of the product, which is given by the intersection of MRA and MCA curves. Hence, price OPA is determined at which both the firms sell their products. Even though the price OPB maximizes the profits for firm B, it sell its product at a lower price OPA in order to avoid a price war. Hence, both the firms sell equal quantity (OQA=OQB) of output at price OPA.

Unequal Market Share

The price determination in case of unequal market shares is depicted in figure below; the principle is same.

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Theory of Product Pricing Price & Cost MCB PB P EB EA O QB

*

ACB

MCA ACA

DB

DA Q

QB QA

MRB

MRA

The low cost leader firm sets price at OPA according to the marginalist principle i.e. MR = MC and the firm B follows the same price even if the Price OPB maximizes the firm Bs profits.

Dominant-Firm Price Leader

This form of price leadership exist in the oligopoly industry where there is a large dominant firm having significant market share. All the remaining firms are assumed to have a small market share so that they cant influence the price of the product and hence they follow the price determined by the dominant firm. Because the smaller firms are the price-takers, the total supply by the smaller firms is obtained directly by the horizontal summation of their marginal cost curves.

P G P1 P0 P2 K L M N

S = MCs

Price & Cost

MCL P1 P0 A P2 D
B E F

ACL

DL Q2 MRL Q

Q0

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Theory of Product Pricing The supply curve for smaller firms is denoted by S (=MCs) in the figure. It is assumed that the dominant firm set the price and it allows all the competitors to sell as much as they can do at the given price. The dominant firm will supply only that amount that is demanded in the market and is not supplied by the smaller firms. Therefore, with the total market demand curve D, the demand for the dominant firm at each price is the difference between the total demand D and total supply by smaller firms S. The demand curve for the leader firm is represented by DL in the second panel of the diagram above, which is obtained by subtracting the total supply by smaller firms from the total market demand at each level of price. For e.g. at price P1 the total demand is P1G all of which is supplied by the smaller firms and hence the demand for the product of dominant firm is zero. At the price of the product OP2, the smaller firms supply P2K amount of the product and the total demand is P2L, thus the remaining amount of output KL(=OQ2) comprises the demand for the leader firm. In the second panel of the figure, MRL is the corresponding marginal revenue curve and MCL and ACL are the marginal and average cost curves for the leader firm. The leader firm decides the price of the product at OP0 corresponding to which MRL is equals to MCL and the smaller firms also sell their product at the same price. At the price OP0 the dominant firm will supply OQ0 (=MN) amount of output and the smaller firms will supply P0M. The shaded area ABCP0 represents the profit for the dominant firm.

Barometric Price Leadership

In this form of price leadership, one firm sets the price of the product and the other firms in the industry follow the leader. However, it is not necessary that the leader be a dominant firm or low cost firm. The leader is generally considered to be a good forecaster of the prevailing economic conditions. In other words, the leader firm is thought of as a barometer, which reflects the changing economic environment. Sometimes, a firm from another industry may be chosen as a leader firm. Barometric price leadership may be established for various reasons.

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