Ebook Business economics: Part 2

(BQ) Part 2 book Business economics has contents: Corporate strategy and pricing policy, market structures, other types of imperfect competition, labour markets, financial markets, the macroeconomic environment, macroeconomics – inflation and price stability, the global economy,...and other contents.

11 CORPORATE STRATEGY

AND PRICING POLICY

LEARNING OBJECTIVES

In this chapter you will:

• Look at the meaning of strategy

• Be shown the key stages in developing andimplementing strategy

• Cover a variety of pricing strategies that firms can use

After reading this chapter you should be able to:

• Give a clear definition of strategy

• Outline at least two frameworks for strategic analysis

• Outline some benefits and limitations of strategicplanning

• Outline the main features of the resource-based model

• Explain the idea of emergent strategy

• Outline the idea of logical incrementalism

• Explain the main features of market-based strategiesincluding value chain analysis, cost leadership,differentiation and niche marketing

• Analyze the processes and challenges of implementingstrategy

• Explain the concept of the margin

• Discuss the issues facing firms in making pricingdecisions covering a range of pricing strategies

255

www.downloadslide.com

In this chapter we will be looking at aspects of corporate strategy and pricing policy.Strategy is a controversial subject with many different points of view but we will pres-ent an outline of the key issues We are going to start by looking at the idea of corpo-rate strategy and then at some of the principal pricing strategies that firms inimperfectly competitive markets can adopt Pricing strategies are not relevant inperfect competition because firms are price takers and have no control over the pricethey charge

BUSINESS STRATEGY

As noted above, the concept of strategy is a controversial one There are many bookswritten on the subject and intense debates between academics, between businessleaders and between academics and business leaders about exactly what it means.What follows is an outline of the main schools of thought Whenever you read aboutstrategy, the important thing to consider is that if anyone really knew what strategywas about they would be making many millions The very fact that there is no onemagic formula would suggest that it is highly complex and differs from organization

to organization

What is Strategy?

To take a broad definition, strategy can be seen as a series of actions, decisions and gations which lead to the firm gaining a competitive advantage and exploiting the firm’score competencies This definition implies the future and as such we can shorten thisdefinition to note that strategy is about where the business wants to be at some point

obli-in the future and what steps it needs to take to get there It is, therefore, about settobli-ingthe overall direction of the business but in times of change much of this direction will becarried out in an environment of uncertainty In Chapter 8 we noted how firms set mis-sion and value statements to try and capture the essence of what they are about In manycases, these mission and value statements can be seen as being an attempt to summarizethe firm’s strategy

The Strategic HierarchyTypically we might expect the strategic direction of the firm to be formulated at thehighest levels of the business and this strategy then informs decisions and behaviourlower down the organization This may be the case in many firms but we must also

be aware that organizations now recognize that the senior team do not always haveall the answers and increasingly strategy is formulated at lower levels of the organi-zation Such strategic formulation and management is likely to be carried out in thecontext of the firm’s overall strategy but that overall strategy may be formulatedaround a series of strategic intents rather than being anything specific Strategicintent was picked up by Max Boisot in 1995 following the development of theidea by Gary Hamel and C.K Prahalad in an article in the Harvard Business Review

in 1989

strategic intent a framework for establishing and sharing a vision of where a business wants to be at some point in the future and encouraging all those involved in the business to understand and work towards achieving this vision

256 Part 4 Microeconomics – The Economics of Firms in Markets

www.downloadslide.com

It refers to establishing and sharing a vision of where a business wants to be at some point

in the future and encouraging all those involved in the business to understand and worktowards achieving this vision Strategic intent can be thought of as a framework for decisionmaking in an uncertain environment where detailed plans can be very quickly blown offcourse Whenever key decisions need to be made, the decision maker/s need to refer back tothe strategic intent and ask themselves the question: what decision would help to allow thefirm to operate at a higher level in line with the vision?

Strategic Planning

If a firm is able to articulate where it wants to be in the future then it needs to put thing in place to help it achieve that goal and this might be a plan of some description

some-Strategic planning aims to put in place a system for decision making which is designed

to help the business achieve its long-term goals Such a plan may include four elements;

establishing the purpose, the objectives, strategies and tactics, commonly referred to bythe acronym POST

In order to develop the plan some understanding needs to be developed aboutthe organization and where it stands in relation to its external environment Such anawareness-building exercise might start with an analysis of the firm and its market, itsplace within that market and to understand the market

This might be carried out by various means such as a SWOT analysis (an analysis ofthe firm’s strengths, weaknesses, opportunities and threats) or analyzing its product port-folio using the Boston Consulting Group’s matrix This matrix classifies the firm’s pro-ducts in four ways: as cash cows, rising stars, problem children or dogs Each of theseclassifications relates to the extent to which the product is part of a growing marketand the proportion of market share the product has

A cash cow, for example, will be a product that is in a mature market– the market isnot growing but the product has a high market share and as such does not require signifi-cant expenditure to maintain sales A problem child will be a product which has a lowmarket share in a growing market There might be something that is preventing the prod-uct from capturing more of the market and the firm may have to invest more money if theproduct is to go anywhere in the market The firm may have to make a decision aboutwhether to continue to support the product or whether it might be better to withdraw itfrom the market – something which would be sensible if the cost of supporting it wasmuch higher than the revenues it was going to bring in A rising star is a product which

is part of a growing market whose market share is also rising This type of product may be

a future cash cow A dog is a product in a market which is declining and it may also have alow market share This is a product which is a candidate for withdrawal from the market

C.K Prahalad and Gary Hamel, pioneers of the idea of core competencies.

SWOT analysis an analysis of the firm’s strengths, weaknesses, opportunities and threats

Many larger firms have large product portfolios so using the Boston Matrix may be away in which it can analyze this portfolio and enable it to make decisions about support-ing products, on whether new product development needs to be carried out on cashflows and its overall market presence It is a framework, therefore, for making decisionsabout the future and reflects the firm’s obligations and where it wants to be in the future.Similarly, a firm might use a framework referred to as Porter’s Five Forces This wasdeveloped by Michael Porter in the 1980s and is cited extensively in the literature TheFive Forces framework allows a firm to analyze its own competitive strength set in thecontext of external factors The firm can analyze the existing competitive rivalry betweensuppliers in the market, the potential threat posed by new entrants into the market, howmuch bargaining power buyers and suppliers in the market have and what threat is pro-vided by substitute products.

The Five Forces model has been, and remains, extremely influential in business egy It is not, however, without its limitations In particular, the movement of businesses

strat-to build collaboration through things such as joint ventures, supplier agreements, buyeragreements, research and development collaboration, and cost sharing all mean thatbuyer and supplier power might be moderated and not simply be seen as a threat It isalso important that a business recognizes the importance and role of its internal cultureand the quality of its human resources in influencing its competitive strategy

Regardless of the model used, the firm needs to have a clear understanding of its tion in the market and that of its competitors to be able to formulate actions that willenable it to be where it wants to be in the future Some element of planning, therefore,will be essential but the dynamic nature of business means that plans have to be flexibleand subject to constant amendment if they are to be of any longer term benefit Fewfirms would create a plan and then stick rigidly to it The strategic plan may be a way inwhich the firm outlines its strategy but how does it choose this strategy in the first place?There are a number of different approaches which have been suggested The followingprovides a brief outline of each

posi-Resource-Based ModelEvery firm uses resources It could be argued that each firm has a unique set of resourcesand it can use this uniqueness as the basis for choosing its strategy Resources could be

FIGURE 11.1

The Boston Consulting Group Matrix

The Boston Consulting Group matrix classifies products in relation to market share (horizontal axis) and the extent to which it is a part of a growing market (vertical axis) The matrix then groups products into four classifications: Stars, Dogs, Cash Cows and Problem Children

Stars

Cash Cows

258 Part 4 Microeconomics – The Economics of Firms in Markets

www.downloadslide.com

unique because the firm owns a particular set of assets which few other firms have, oremploys a particularly brilliant team of production designers; it could be the location ofthe business that is unique or the way in which the firm has designed and organized itsproduction operations These resources can be analyzed to find, identify and isolate corecompetencies Core competencies are the things a business does which are the source ofcompetitive advantage over its rivals Firms can be in the same industry and have access

to similar resources but for some reason one firm might better utilize these resources toachieve returns that are above others in the industry The firm’s strategy can be devel-oped once these unique features have been identified and exploited and it is this whichhelps provide the competitive advantage

Remember that competitive advantage refers to the advantages a firm has over its als which are both distinctive and defensible What this tells us is if a firm is able toidentify its core competencies it can exploit these in order to achieve greater returnsand its rivals will not be able to quickly or cheaply find a way to emulate what the firmdoes in order to erode the advantage/s the firm has

riv-If a firm develops a strategy that starts to move away from its core competencies thenthere is a potential for failure unless it can develop core competencies in this new area

For example, a firm like 3M has core competencies in substrates (the base material ontowhich something will be printed or laminated or protected), coatings and adhesives Itmight use its expertise in these areas to formulate a strategy which seeks to exploitthese competencies but if it decides that it will branch out to another area, for example,into cleaning products to complement its Scotchguard protection brand, then it mightfind the expertise needed in that area is not something it possesses and as such mayend up making below average returns

There are plenty of examples of firms that have tried to branch out into new areasoutside their expertise and have failed Harley Davidson, for example, attempted tomove into the perfume market, Bic, the ball point pen manufacturer, into ladies under-wear and the women’s magazine, Cosmopolitan, attempted to launch a range of yoghurts

In each case the moves were unsuccessful, partly because consumers failed to understandthe association between what were established brands and a new departure, but alsobecause the new ideas did not represent the core competencies of each firm

Is the brand association of a firm like Harley Davidson so ingrained that moving into

an unrelated market becomes difficult?

core competencies the things a business does which are the source of competitive advantage over its rivals

Emergent StrategyThe dynamic and often chaotic nature of the business environment means that whateverplans a business has are likely to be outdated almost as soon as they are written, or over-taken by events which occur and which are outside the control of the business Themodel of emergent strategy recognizes this reality.

A firm might start off with an intended (sometimes referred to as deliberate) strategywhich is planned, deliberate and focused on achieving stated long-term goals However,

it is highly likely that some part of this intended strategy will not be realized and assituations and circumstances change the firm will have to make decisions These deci-sions are made with the overall intended strategy in mind but adjusted to take account

of the changed circumstances

Over time this decision making forms a pattern which becomes emergent strategy.This implies that firms may adopt broad policies of intent rather than detailed plans sothat they can respond to changed circumstances and also that they can learn as they goalong

Logical IncrementalismThe term logical incrementalism was used by James Brian Quinn, a professor of manage-ment at Amos Tuck School, Dartmouth, Colorado Quinn suggests that managers might

be seen to be making various incremental decisions in response to events which may notseem to have any coherent structure However, these responses may have some rationalbasis whereby the firm has an overall strategy but local managers respond to local situa-tions The overall strategy can be realized but incrementally Such incremental decisionsmay be affected by resource constraints at a local level which mean that trade-offs andcompromises have to be made in order to adjust to these local conditions

Market-Based StrategyMarket-based strategy turns the focus onto the business environment in which the firmoperates and strategy is chosen based on an understanding of the competitive environ-ment that the firm operates Analysis of the competitive environment is focused on twokey areas– the firm’s cost structure and how it differentiates itself from its rivals

It is often assumed that a firm can adopt pricing strategies regardless of other factors

in an attempt to win market share or expand sales, but as will be noted later in thischapter, flexibility on the choice of pricing strategy is partly dependent on whether afirm can afford to adopt a pricing strategy For example, it is only possible to adoptprices that are lower in comparison to rivals if the firm’s cost base allows it to do so

look at its value chain and examine every aspect to determine where inefficiencies mayexist and where cost benefits can be gained The term value chain refers to all the activi-ties and operations which a firm carries out and how value is added at each of thesestages If the value created is greater than the cost of making the good or service available

to the consumer then the firm will generate profit It makes sense, therefore, to focus onthese value stages and extract maximum value at minimum cost as the basis of creatingsustainable competitive advantage

Crucially, value chain analysis can focus on aspects of the business which may havebeen seen as being unimportant but necessary For example, publishers have warehouseswhere stock is processed prior to delivery to customers, whoever those customers may be– book shops, university campuses, online retailers and so on Time spent looking at

value chain the activities and operations which a firm carries out and how value is added at each of these stages

260 Part 4 Microeconomics – The Economics of Firms in Markets

www.downloadslide.com

ways in which orders can be processed and shipped in the minimum time possible and

at minimum cost could help create competitive advantage Not only is the operation cient but the reputation the publisher gets through having a highly efficient processingand distribution system can be worth additional sales in the market when competition

effi-is strong Two business economics textbooks may be as good as each other but if onepublisher can guarantee order-shipment-delivery times weeks ahead of the other, andwith 99.99 per cent reliability, then this may be the reason why a customer chooses onebook over another

Porter outlined a number of key value chain activities

• Inbound logistics includes goods inwards, warehousing and stock control; operationsrelates to the processes that transform inputs into outputs; outbound logistics focus

on fulfilling orders, shipping and distribution, marketing and sales which deals withmaking consumers aware of the product and ensuring that products get to consumers

at the right time and at the right place, the right price and in sufficient quantities; andfinally, service which is associated with the functions that help build product valueand reputation and which include customer relations, customer service and mainte-nance and repair (or lack of it)

By exploiting value chain analysis a firm can identify ways of reducing its costs belowthat of its competitors and thus gain competitive advantage, which, remember, must bedistinctive and defensible This is the essence of cost leadership A firm might be able toidentify particular efficiencies as described above or exploit possible economies of scale

to gain the advantage over its rivals As the firm progresses through these processes itcan also benefit from the learning curve (sometimes also referred to as the experiencecurve) This states that as tasks and processes are repeated, the firm will become moreefficient and effective at carrying out those tasks and in a cumulative way, build in fur-ther improvements and efficiencies as time progresses

Cost leadership may be beneficial in markets where price competition is fierce, wherethere is a limit to the degree of differentiation of the product possible, where the needs ofconsumers are similar and where consumers can relatively easily substitute one rivalproduct for another– in other words, they incur low switching costs

Quick Quiz Why might a firm want to reduce maintenance and repair to

a bare minimum as a means of increasing value?

A detailed analysis of every aspect of the firm’s value chain can reveal small but sibly important activities where efficiencies can be improved to generate added value andreduce cost Ensuring that the various functions and activities are coordinated and canalso help generate competitive advantage

pos-Travelling around many countries these days, you might notice extremely large bution centres located near to major arterial roadways, airports, ports or railways Thedevelopment of these massive distribution centres has come through value chain analy-sis A number of retail chain stores have such a system where the distribution centre acts

distri-as a hub receiving supplies and distributing them along ‘spokes’ Such systems havehelped give firms cost advantages as well as improving reputation for efficient deliveryand order processing Hub-and-spoke systems are also used by airlines to help simplifyroutes and keep costs under control as well as get passengers to their destinations as effi-ciently as possible

If a firm is able to generate cost advantages through value chain analysis it can gain aposition of being a cost leader and as such has greater flexibility in being able to setprices which help maximize revenues or profit

cost leadership a strategy to gain competitive advantage through reducing costs below competitors

An interior view of part of the baby and children ’s retailer, Mothercare, which also links in with the Early Learning Centre ’s, distribution centre in Daventry

in Northamptonshire, UK Daventry is a town located within a few miles of major arterial motorways connecting to all parts of the UK including the M1, M40 and M6 motorways and close to London and Birmingham, the first and second cities in the UK respectively.

Differentiation The second focus of market-based strategies is on differentiation.

Differentiationis the way in which a firm seeks to portray or present itself as being different

or unique in some way This can be physical in the form of the actual product itself or tal and emotional through the way in which the business is able to develop its brands, adver-tise and promote itself and create emotional attachments to its products Firms attempting todifferentiate themselves do need to be aware of the importance of taking into account chang-ing tastes and fashions What differentiates a firm one year might become a burden the nextand the perception of the business becomes difficult to change as time moves on

men-Apple has been very successful at differentiating itself from its rivals both in terms ofthe functionality of its products but also in its design and the way in which it creates aloyal following of customers who are keen to snap up its products whenever they arereleased Similarly, firms like Bose and Bang & Olufsen have created a reputation forhigh-quality sound systems and enviable design which set them apart from their rivals.Food manufacturers like Heinz increasingly place an emphasis on quality, on the use ofnatural ingredients and low fat and sodium as a means of differentiating themselves.Hotel chains such as Holiday Inn place an emphasis on consistency so that wherever aguest stays, in whatever country it may be, there are certain features that are familiar andcomforting so that guests do not experience any shocks

mar-ket with specific wants and needs which are not currently being met by the marmar-ket.Focusing on a niche might allow a business to identify some very specific customerrequirements which it can meet profitably Imagine a firm which develops flip-flopswhich have a built in supportive arch It is unlikely that‘everyone’ will buy this productbut for those people who suffer from foot problems, such as fallen arches or flat feet, theproduct might be extremely useful – so much so that they are prepared to pay a pre-mium price for the comfort they bring The niche market in this case is a small section

of the overall market for summer footwear who have podiatry problems (a podiatrist is aspecialist in the treatment of foot problems)

Niche strategies are often beneficial to small firms which have developed specializedproducts but are certainly not unique to these types of business Small businesses, inaddition, may not have the resources to compete in terms of cost and in producing amass market product have problems in differentiating themselves from their bigger riv-als In such cases, niche marketing may be an appropriate strategy to follow

Larger firms may also target niche markets by creating trademarks, brands or securingpatents In such cases, firms may be able to not only target a wider market but also spe-cific niches within it In our flip-flop example, a large firm such as SSL, the owner of the

Dr Scholl footwear brand, might patent the design of foot support flip-flops and securethe niche market as a result

Quick Quiz What are the key features of a market niche? Give threeexamples of niche products with which you are familiar

Strategic ImplementationHaving analyzed the firm and the market and then decided on some strategy, the nextphase is to implement this strategy This is invariably the most challenging part of strategicmanagement Implementation involves the way in which the plans and direction are actu-ally put into practice and decisions that a firm takes to translate words into action.Those who have created the strategy – often the senior leaders and managers in abusiness– have to communicate the vision and strategy to a range of stakeholders (notjust the employees) and then make sure that the structures, design, people and opera-tions are in place to deliver the strategy In addition, the senior team will have to put

differentiation the way in which a firm seeks to portray or present itself as being different or unique in some way

market niche a small segment of an existing market with specific wants and needs which are not currently being met

by the market

262 Part 4 Microeconomics – The Economics of Firms in Markets

www.downloadslide.com

in place systems to monitor progress of the strategy This is not to suggest that the wholeprocess is simply a top-down approach; as noted earlier, an increasing number of firmsrecognize that strategy has to be a focus at all levels of the business and that individualsand groups lower down the hierarchy have to have the flexibility and freedom to makechoices and decisions The caveat is seeking to ensure that these choices and decisionsare made with the overall strategy in mind.

One framework which has been suggested for managing strategic implementation is theFAIR framework This stands for Focus, Alignment, Integration and Review In the focusphase, senior managers identify shorter-term objectives in conjunction with departmental

or functional heads and in line with the overall strategic goals These shorter-term tives then have to be aligned throughout the functional and departmental areas of theorganization, with resourcing and practical implications considered and worked through

objec-These plans are then integrated into the day-to-day operational processes and workflowsbut management of these processes has to be reviewed periodically to see the extent towhich the strategy is being implemented and what the results are

SummaryThis brief overview of a very complex topic has outlined some of the issues and thinking

on strategy There are many excellent books and articles on strategy and strategic agement, many of which go into much greater detail about the debates and differing per-spectives that characterize the field of strategy Ultimately, however, a firm has to havesome understanding of itself and its market, identify and articulate a clear vision aboutwhere it wants to be in the future and find ways of implementing the strategic choices ithas made

man-PRICING STRATEGIES

One of the key decisions any firm has to make is on the price to charge for its products

There are a number of pricing strategies (some argue they should properly be called tics) The purpose of pricing strategies is to influence sales in some way or to reflectsomething about the product that the firm wishes to communicate to its customers andpotential customers At its simplest, there are only a few things a firm can do– either setprice lower than its rivals, set price higher in order to reflect a standard or some sugges-tion of quality, or seek to set price at a similar level to that of its rivals

tac-Of course, the ability of the firm to use price as a means of influencing sales depends

to a large extent on its costs The difference between the cost of production and price can

be looked at as a margin– the amount of profit a firm makes on each sale Of course,this definition does depend on how‘cost of production’ is calculated and what costs areincluded However, for our purposes, looking at margins as the profit a firm makes fromeach sale is sufficient for our analysis A firm operating at a higher cost base than itsrivals will struggle in the long term to match the low prices its rivals may be able tocharge because they have a lower average cost

Cost-plus pricingThis is perhaps the simplest form of pricing The firm calculates the cost of productionper unit and then sets price above this cost The price can therefore reflect the margin ormark-up that the firm desires For this reason cost plus pricing is also referred to asmark-up pricing or full-cost pricing Let us take an example Assume that a hairdressercalculates the average cost of a styling to include the cost of the stylist’s time, the chemi-cals used during the styling as well as working out how the fixed costs could be

margin the amount of profit a firm makes on each sale

attributed to each customer (for example, the cost of heating and lighting, rent on thepremises, rates, insurance, drinks and magazines given to customers, performing rightsfees for music played in the salon and so on) at€30 If the salon owner desired a profitmargin of 10 per cent then they should charge a price of€33 but if a mark-up of 50 percent was required then the customer will be charged €45 The formula for calculatingprice given a desired mark-up percentage is:

Selling price¼ Total cost per unit  ð1 þ percentage mark-up expressed as a proportionÞ

If our salon owner calculated the total cost per customer of a simple wash, cut andblow-dry at€12 and the desired mark-up was 25 per cent then the price charged would

However, one of the problems is that basing price simply on a desired mark-up doesnot take into account market demand and the competition In reality many firms willtake these factors into consideration and adjust the size of the mark-up accordingly.Assume that our salon owner knows that there is another salon in town which charges

€14 for a wash, cut and blow-dry and that the owner wants to undercut the rival Theyset the price at€13 What is the mark-up now?

To calculate the mark-up in this case we use the formula:

Mark-upðper centÞ ¼ ðSelling price – Total cost per unit=Total costÞ  100The mark-up percentage, therefore, will be ((13 12)/12)  100 ¼ 8.3 per cent.The mark-up is not the same as the margin In the example above the margin is thedifference between the selling price and total cost per unit which as €1 This margin

is then expressed as a percentage of the selling price and so would be (1/13)  100 ¼7.69 per cent

It is possible that the salon owner might have a desired margin level (let’s say it is

20 per cent) in which case this can be used to determine the selling price using theformula:

Selling price ¼ Total cost per unit =ð1  MarginÞ

In our example the selling price will now be 12/(1 0.20) ¼ 12/0.8 ¼ €15

Quick Quiz Using examples, explain the difference between mark-upand margin

Contribution or Absorption Cost PricingThis is related to cost-plus pricing and is based on the same principles but instead ofattempting to calculate the total cost per unit, the firm will estimate the variable costonly and then add some mark-up to determine the selling price The difference betweenthe variable cost per unit and the selling price is called the contribution This sum repre-sents a contribution to the fixed costs which must also be paid Recall the analysis of thebreak-even point in Chapter 8 As the firm sells more and more units the contributioneventually covers the fixed costs and, for all subsequent sales, the contribution will add toprofit

264 Part 4 Microeconomics – The Economics of Firms in Markets

www.downloadslide.com

Contribution pricing may be useful if it is difficult for the firm to ascribe fixed costs

to output easily, which may be the case in some service industries

Psychological PricingThe basis of psychological pricing is that humans respond to different prices in differentways and for some reason may, as a result, behave differently or have a different emotionalresponse The classic example of psychological pricing is that of a firm charging€5.99 for aproduct rather than €6.00 This is partly due to the way we view things – many peoplemay look at the first figure in a price and pay little attention to the last two digits (calledthe left-digit effect) If the firm believes that customers would see the number‘5’ as being

‘reasonable’ but ‘6’ as being too expensive then setting the price at €5.99 might encourageconsumers to purchase believing they are getting some sort of discount

Psychological pricing is based on a fundamental assumption that consumers do notbehave rationally If they did then why would they be willing to buy something at

€15.49 but not at €15.50? It could also be argued that psychological pricing treats mers as if they are not very bright and cannot see through the tactic One can only con-clude that the prevalence of use of this tactic would suggest that it does work

consu-Penetration Pricing

As the name suggests, penetration pricing is a tactic that is used to gain some tion in a market The firm sets its price at the lowest possible level in order to capturesales and market share This is a tactic that may be used when a firm launches a newproduct onto the market and wants to capture market share Once that market sharehas been captured and some element of brand loyalty built up, the firm may start topush up the price If this is the longer-term aim then there could be a problem with con-sumers getting used to low prices and being put off when prices begin to rise At thispoint, the price elasticity of demand is crucial to the longer-term success of the product

penetra-If consumers are sensitive about price then increases might lead to a switch to substitutes

or the consumer leaving the market altogether

Penetration pricing assumes that firms will operate at low margins whilst pursuingsuch a tactic, but if successful and sales volumes are high, then total profit could still berelatively high Penetration pricing implies that a firm needs to have considerable controlover its costs to enable it to operate at low margins

Quick Quiz Why does penetration pricing tend to be a tactic that isassociated with high-volume products?

Market SkimmingMarket or price skimming is a tactic that can be used to exploit some advantage a firmhas which allows it to sell its products at a high price The term‘skimming’ refers to thefact that the firm is trying to ‘skim’ profits while market conditions prevail by settingprice as high as demand will allow

Such a situation can arise when a firm launches a new product onto the market whichhas been anticipated for some time Companies like Apple are very good at building suchanticipation (some would call it hype) so that when the product does finally launch themarket price can be relatively high It may be that some months later the price of theproduct starts to fall, partly because of the need to persuade consumers who are marginal

Some products may be priced at a low level but sell in very large volumes and so make high profits as

buyers, i.e those that are not devoted to the product and would only consider buying atlower prices, or because the competition has reacted and launched substitutes.

The high initial prices imply that the firm is able to generate relatively high margins inthe early stages of the product which may be used to help offset the development costs,which in the case of technology products like smartphones, tablets and gaming consoles(where market skimming is not unusual as a pricing tactic) can be relatively high

Destroyer or Predatory PricingThis is a tactic designed to drive out competition A firm uses its dominance in the mar-ket and its cost advantages to set price below a level its competitors are able to match.The intention is that some rivals will be forced from the market and so competition isreduced Ultimately the firm which instigated the strategy is able to operate with greatermonopoly power This tactic is illegal in many countries and comes under anti-competitive laws; however it is often difficult to prove

Loss-LeaderThe use of loss-leaders is a tactic that is often seen in larger businesses and especially insupermarkets A loss-leader is a product deliberately sold below cost and therefore at aloss in an attempt to encourage sales of other products At holiday times, for example,many supermarkets will sell drinks at prices below cost and advertise this in the hopeand expectation that consumers will come into the store, buy the drinks which are onoffer but also buy other things as well The other items that are bought generate a profitand this profit offsets the losses made on the loss-leader

The type of product chosen to be the loss-leader can be important Often a firm willchoose something that it thinks consumers will have a good understanding of in terms ofvalue and original price By doing this it hopes that the‘incredible’ offer it is making will

be noticed more obviously by the consumer and thus encourage the consumer to takeadvantage

Products which are complements may also be the target of such a tactic For example,selling a blu-ray DVD player at a loss may encourage consumers to buy blu-ray DVDs;

or a firm sells wet shavers at low prices but consumers find that replacement blades tend

to be sold at relatively high prices (and often packaged in large quantities so that not justone new blade can be purchased) Potential drawbacks could occur if the consumer ishighly disciplined and only buys the goods on offer, but evidence suggests this is rela-tively unusual

Quick Quiz How might a firm calculate whether a loss-leader has been asuccessful tactic?

Premium or Value PricingThe type of market a firm operates in can be a determinant of the pricing strategy itadopts On the one hand, fast selling consumer goods might generate large volumesales for firms but at a price which is competitive and yields low margins (such aschocolate bars, newspapers and ball point pens) but at the other end of the scale, afirm might deliberately set its price high to reflect the quality or exclusivity of the prod-uct It knows that sales volumes will be low but that the margins are high and as a resultprofits can still be high on low sales

Loss-leaders are designed to

cre-ate interest in the business in the

hope of generating wider sales on

products which have higher profit

Premium pricing may be a feature of certain types of technology-based products, ury yachts, some motor cars, jewellery, designer fashion items, hotels, perfumes and firstclass travel In each of these cases the firm may deliberately set prices high or output isrestricted so that price rises relative to demand.

lux-Competition PricingCompetition pricing occurs where a firm will note the prices charged by its rivals andeither set its own price at the same level or below in order to capture sales One of theproblems facing firms who use this strategy is that firms have to have an understanding

of their competitors For example, if a rival firm was charging a particular price for a uct because it benefited from economies of scale and had lower average costs, then a newfirm coming into the market and looking to compete on price might find that it cannot do

prod-so because it does not have the cost advantages It could alprod-so be the case that a rival has setprice based on established brand loyalty and as such simply setting a price at or below this

in an attempt to capture sales may not work because the price difference is insufficient tobreak the loyalty that consumers have for the branded product

In markets where competition is limited,‘going rate’ pricing may be applicable andeach firm charges similar prices to that of its rivals and in each case price may be wellabove marginal cost Such a situation might be applicable to the banking sector, petroland fuel, supermarkets and some electrical goods where prices tend to be very similaracross different sellers

Price Leadership

In some markets, a firm may be dominant and is able to act as a price leader In suchcases, rivals have difficulty in competing on price; if they charge too high a price theyrisk losing market share and forcing prices lower could result in the price leader match-ing price and forcing smaller rivals out of the market The other option, therefore, is toact as a follower and follow the pricing leads of rivals especially where those rivals have aclear dominance of market share

? what if …a firm which is seen as a price leader increases prices by 10 per

cent but its rivals who are classed as followers decide not to raise price in thiscase?

Marginal-Cost PricingThis typically occurs when a firm faces a situation where the marginal cost of producing

an extra unit is very low and where the bulk of the costs are fixed costs In such a tion the cost of selling an additional unit is either very low or non-existent and as aresult the firm is able to be flexible about the prices it can charge

situa-An example occurs in the transport industry on airlines and trains If an airline ates a scheduled flight with 300 seats available from Amsterdam to Riyadh, then the bulk

oper-of the costs will be incurred regardless oper-of how many seats are sold Let us assume thatfive days prior to departure only half of the seats have been sold and it does not look as

if demand is going to rise in the time leading up to the flight departing If the firm culates that the cost of taking an extra passenger is€5 (the additional cost of fuel, foodand processing) then it makes sense for the firm to accept any price above€5 in the timeleading up to departure

www.downloadslide.com

If the standard ticket was priced at€300 but demand is weak then it is clear that theairline ought to reduce price It could conceivably keep reducing prices down to€5 inorder to fill all the seats because every additional€1 above this amount would contribute

to the fixed costs and thus make it worthwhile for the airline

Pitfall Prevention We have covered a range of pricing strategies in this section.However, it is important to remember that firms do not make pricing decisions in isola-tion– i.e if a firm decides to adopt a price skimming strategy it will not do this withouttaking into account many other factors including what its competitors are charging,what type of product they are selling and so on, all of which may be factors that arecharacteristic of decision making in other pricing strategies

C A S E S T U D Y

J.C Penney ’s Pricing StrategyJ.C Penney is a US retailer It runs around 1100 department stores in the US andPuerto Rico with annual sales of around $17.5 billion In January 2012, the companyannounced a new pricing strategy The company noted that over a period of a year ithad numerous sales and customers had clearly got wise to this and tended to waitfor sales periods to come round Like many such stores, J.C Penney found that ithad very busy periods during sales times but very quiet periods in non-sales times.Its new pricing strategy is designed to reduce this guessing game where custo-mers wait for sales periods and instead the company announced that it would cutthe price of all its merchandise by 40 per cent from the previous year’s prices andthus offer customers a much simpler pricing structure It called this strategy‘Everyday pricing’

The new strategy was introduced by Ron Johnson, the chief executive officer ofJ.C Penney Johnson came to the position from Apple where he was Vice Presi-dent for retail and had been partly responsible for the success of the Apple storeconcept Johnson believes that pricing is a simple thing and that customers aresavvy and will not pay more than how much they value the product at– which isnot an unreasonable statement If a customer is willing to buy an item then theymust place at least a value on that product that they are willing to pay– if they donot buy it then presumably they do not believe the price being asked is sufficient tocompensate them for the value they expect to get from the good

So Johnson is introducing a strategy which means that customers will face agreat deal more predictability in pricing Sale prices become the norm rather thanthe exception – hence the use of the term ‘every day pricing’ The firm will stillhave sales but they will not be as frequent as in previous year’s and will tend to

be more targeted For example, gift items for Easter might go on sale for themonth prior to the holidays (called ‘Month-Long Value’) and clearance itemsoffered at particular times to coincide with when workers get paid– typically thefirst and third Friday of each month To distinguish these prices from the rest theywill be referred to as‘Best Prices’ The simple pricing principle will be further rein-forced with goods being given specific price tags to alert customers to the threedifferent pricing structures and in addition, prices will always be expressed inround numbers– no psychological pricing here

The main costs of an airline flight are

fixed The cost of filling an extra seat

is minimal which gives airlines

flex-ibility in pricing.

New pricing tactics at J.C Penney –

but will they work?

The new pricing strategy was launched with an advertising campaign, new logo,

a catalogue mailed to customers, a new spokesperson and other promotions Itmay sound like a bold strategy and analysts are complementing Johnson on hisvision but at the same time urging caution The strategy is being launched at atime when the USA has been struggling with slow economic growth and for someyears the US consumer has been used to retailers offering excellent discountsthrough regular sales How consumers respond to the idea of cutting back onsales when they are used to bargain hunting and to a different approach to pricingwhich requires them to change habits will be the key to whether Johnson can helpimprove the fortunes of J.C Penney

IN THE NEWS

Strategy and Pricing in the Digital Imaging Market

You might think that a firm which invents a product which revolutionizes the market might be in

a position to exploit the market and achieve long-term success Not so– the case of EastmanKodak is a good example of how strategic choices rely ultimately on human judgement whichcan often be found to be wanting as time marches on

Strategy and Pricing in theDigital Imaging MarketEastman Kodak was founded over 130years ago It has become synonymouswith photography and imaging and onemight assume that it is in these areaswhere its core competencies lie Back

in 1995, Bloomberg Businessweek ran

an article on George M.C Fisher whotook over as CEO for Kodak in 1993 Thearticle noted that Fisher had inherited‘apowerhouse brand name… trapped inthe slow-growth photography industry,hobbled by huge debts, a dysfunctionalmanagement culture, and a dispiritedworkforce.’1 At that time Kodak wasoperating in a market which had alarge number of competitors (the Busi-nessweek article reported some 599global competitors) which meantincreased supply and lower prices Tomaintain profit levels in a market in

which sales growth was slow, Kodakwould have to cut manufacturingcosts, as well as investing in new pro-ducts in what was then the infant digitalimaging market Fisher had sold offother businesses such as health careand household products which Kodakhad sought to expand into and insteaddecided to focus more on the firm’score competencies One of theseareas was digital imaging Digital imag-ing is not a new idea – it has beenaround since the 1970s and Kodakhad been at the forefront of researchand development into the area sincethat time One of the problems thatKodak faced was that the development

of digital imaging products such asscanners and cameras had the poten-tial to cannibalize its photographic filmand handheld camera market Some ofthe most profitable parts of the busi-ness were centred on the sale of film(for cameras and in the entertainmentindustry), chemicals and photographicpaper In 1976, for example, Kodak

had a 90 per cent market share in filmand 85 per cent market share in cam-eras in the USA The arrival of digitalimaging threatened these revenueearning parts of the business

Kodak is credited with being one ofthe inventors of the digital camera AKodak engineer, Steve Sasson, spentaround a year working on the develop-ment of the product as far back as 1975

In terms of the amount of funds itinvested in digital imaging, it could beargued that Kodak had first moveradvantage in the market Over thenext 35 years, however, Kodak couldnot seem to square the inevitabletrade-off between digital and film-based photography and as technologychanged rapidly key competitors such

as Canon, Fujitsu, Hewlett Packard,Nikon and Sony embraced digital imag-ery far quicker than Kodak

The result has been that in January

2012, Kodak filed for Chapter 11 ruptcy in the USA to protect itself whilst

bank-it restructured The company also

1

http://www.businessweek.com/archives/1995/

b340974.arc.htm accessed 11 February 2012.

www.downloadslide.com

announced that it would withdraw fromthe digital camera, pocket video cam-era and digital picture frames busi-nesses It decided to exit thesebusinesses because it could not com-pete with rivals on both price and oper-ational efficiency Instead the companysaid that its strategy would focus on itsinks and printer business, wouldlicence its brand name to other imagecapturing based firms and on its onlineand retail photo printing.

Kodak said that these businessareas were where it had seen somesuccess in terms of market growthand the opportunity to increase mar-gins Its decision to reduce the focus

of its business and its product portfoliowas based on an‘analysis of the indus-try trends’ according to Kodak’s chief

marketing officer, Pradeep Jotwani

The new strategy does not come out a cost, however The company has

with-a number of mwith-anufwith-acturing contrwith-actswith other firms and ending these con-tracts will incur some costs It also hassponsorship deals with organizationssuch as the Oscars but it was notable to escape early from some ofthese contracts and so will have toincur costs in this respect also Esti-mates suggest that the cost of exitwill be around $30 million but that theoverall benefits to the business will be

up to $100 million

Questions

1 Use the Boston Consulting GroupMatrix to analyze the position ofKodak’s digital cameras, handheld

film cameras, and camera andmovie film Explain your reasoning

2 One of the reasons why Kodak saidthat it was exiting some marketswas because it could not compete

on price and efficiency with its als What factors might have con-tributed to this situation?

riv-3 Explain why exiting the marketcosts so much money

4 Evaluate the decision of the currentKodak senior team to refocus itsstrategy in the way outlined in thearticle

5 Discuss the factors which may haveconvinced the senior managers ofKodak to not exploit its first moveradvantage in digital imaging

S U M M A R Y

• Strategy looks at where a firm wants to be in the future

• Strategy involves an analysis of the firm and its market, ing strategic choices and then implementing those choices

mak-• Firms have to consider a wide range of factors prior toadopting any strategy, not least the sort of market structure

it operates in; what rivals might do in response; how mers value the product; what its cost structures are and howthese compare to rivals; the extent to which brand loyaltyaffects demand; and the price elasticity of demand

consu-• There is considerable debate over strategy – ultimately wemight conclude that if it was easy then everyone would do itwell and be successful!

• There are a range of pricing strategies (or tactics)

• Price is only one aspect of positioning a product– i.e wherethe product sits in relation to the market

• Any decision on price will be one part of the overall strategy

of the firm

KEY CONCEPTS

strategic intent, p 256SWOT analysis, p 257core competencies, p 259

value chain, p 260cost leadership, p 261differentiation, p 262

market niche, p 262margin, p 263

Q U E S T I O N S F O R R E V I E W

1 Give a definition of the term‘strategy’

2 Explain how the idea of‘strategic intent’ helps a firm provide

a framework for strategic decision making

3 Outline two frameworks which a business might use instrategic analysis

4 Give a bullet point list to outline the main features of the:

5 How can value chain analysis help a firm establish anappropriate pricing policy?

6 Why might niche market strategies be beneficial to smalland medium-sized firms?

7 Outline three challenges facing a business in implementingstrategy

8 Explain the relevance of the concept of the margin in pricingdecisions

9 Outline two advantages and two disadvantages to a firm ofusing cost-based pricing policies

10 Explain the difference between market skimming and pricepenetration strategies

P R O B L E M S A N D A P P L I C A T I O N S

1 A chemical firm believes it has a core competency inidentifying and exploiting particular chemical processes inintermediate products (i.e chemical products which will beused to help make other chemical products/drugs etc.) Howmight this core competency lead to competitive advantage?

2 ‘The thicker the strategic plan the less relevant it will be’

(Quote adapted from Davies, B and Ellison, L 1999 StrategicDirection and Development of the School London:

Routledge.) To what extent to you agree with this view?

Explain your reasoning

3 Consider the models of emergent strategy and logicalincrementalism To what extent would you agree with theview that they are effectively describing the same thing–the reality of decision making in an uncertain environment

4 Using an appropriate example, explain how value chainanalysis can be a source of cost leadership and competitiveadvantage

5 Choose a product with which you are familiar Explain howthe firm producing that product tries to differentiate it fromrivals

6 A firm producing fancy dress costumes estimates the fixedcosts per costume at€20 and the variable costs at €5

a Using this information, calculate the price if:

i The desired profit margin is 75 per cent

ii The desired mark-up is 45 per cent

b The firm knows that its rivals charge€50 per costumeand it wants to undercut its rivals by 10 per cent

i Calculate the price, the profit margin and themark-up

7 Two firms operate in different markets and introduce a newproduct into their respective markets One uses a pricepenetration strategy and the other a market skimming strat-egy At the end of the first year they both make the sameamount of profit Explain how this situation could arise

8 Explain why predatory pricing is illegal in many countries Doyou agree that it should be illegal or is this pricing strategyjust an inevitable consequence of competition? Explain yourreasoning

9 The tactic of using loss leaders is sometimes referred to

as the‘razor strategy’ because firms who sell razors do sobelow cost but then charge high prices for replacementblades What sort of razors do you think this sort of tacticwould work with (Hint: think of the difference between aproduct such as the Gillette Fusion and disposable razorssuch as those produced by Bic.) How does a firm preventconsumers treating the razors used as loss-leaders frombeing treated as disposable?

10 What other factors does a firm have to have in place inorder to adopt a premium pricing strategy?

www.downloadslide.com

LEARNING OBJECTIVES

In this chapter you will:

• See how imperfect competition differs from perfectcompetition

• Learn why some markets have only one seller

• Analyze how a monopoly determines the quantity toproduce and the price to charge

• See how the monopoly’s decisions affect economicwell-being

• Consider the various public policies aimed at solving theproblem of monopoly

• See why monopolies try to charge different prices todifferent customers

After reading this chapter you should be able to:

• List three reasons why a monopoly can remain the soleseller of a product in a market

• Use a monopolist’s cost curves and the demand curve itfaces to show the profit earned by a monopolist

• Show the deadweight loss from a monopolist’sproduction decision

• Show why forcing a natural monopoly to set its sellingprice equal to its marginal cost of production createslosses for the monopolist

• Demonstrate the surprising result that pricediscrimination by a monopolist can raise economicwelfare above that generated by standard monopolypricing

www.downloadslide.com

If you own a personal computer, it probably uses some version of Windows, the ing system sold by the US company, Microsoft Corporation When Microsoft firstdesigned Windows many years ago, it applied for and received a copyright, first fromthe US government and then from many of the governments of the world The copyrightgives Microsoft the exclusive right to make and sell copies of the Windows operatingsystem So if a person wants to buy a copy of Windows, he or she has little choice but

operat-to give Microsoft the price that the firm has decided operat-to charge for its product Windows

is the operating system used by around 85 per cent of the PCs in the world Microsoft issaid to have a monopoly in the market for Windows

If you use a PC or laptop, there is a very high chance that when you use a searchengine it will be Google which dominates the search engine market with a market share

of around 64 per cent

In most countries, the option for consumers to purchase utilities like gas, water andelectricity is limited to a very small number of firms and in some cases there might only

In the breakfast cereal aisle, for example, there is a very wide range of choice availablebut most are produced by four very large firms, Nestlé, Kellogg, General Mills andQuaker Equally, toothpaste, detergents, soaps, washing up liquid and so on are likely to

be made by Procter & Gamble, Colgate-Palmolive, Kimberley-Clarke and Unilever

There is a choice in the purchase of mobile phones and mobile phone service providersbut again the market is dominated by a small number of very large firms Apple, Nokia,Samsung, LG, Research in Motion (the makers of the BlackBerry brand), Motorola, HTCand Sony Ericsson are the main suppliers of handsets, Orange, O2, Vodafone, Verizon,T-Mobile, AT&T, Etisalat and Orascom being very large firms across Europe and theMiddle East which dominate mobile phone service provision

If you are a business and want to employ a firm of accountants to check your books andprovide financial advice, it is very likely that you might turn to one of the so-called‘Big-Four’

accounting firms, KPMG, Deloitte, PwC (PriceWaterhouseCoopers) and Ernst & Young

You might think there is lots of choice if you want to buy some takeaway food or go

to a restaurant or bar How often, in reality, do you go back to the same place on a ular basis? If you analyze your behaviour it is likely that you will tend to have a degree ofloyalty to particular brands for a variety of reasons

reg-What these examples highlight is that our everyday lives are influenced to a very largeextent by interaction with a relatively small number of very large firms Many markets arenot characterized by a large number of relatively small firms who are price takers andhave no influence of price selling products that are very similar (homogenous) Even if we

do have to buy an homogenous product like petrol or diesel, for example, we will tend tobuy from a small number of very big suppliers such as BP, Shell, Texaco and Esso

IMPERFECT COMPETITION

The business decisions of many of these firms we have used as examples are not welldescribed by the model of a competitive market we have been assuming in the previouschapters The reality is that firms can be price makers rather than having to be pricetakers and do not sell homogenous products In some way or another, either because ofsome physical difference or because our psychology tells us, products are not

A variety of well-known products which all have something in common; they are all brands owned by the multinational firm Procter & Gamble, which has 4.4 billion customers around the world.

www.downloadslide.com

homogenous and the degree to which one product is a substitute for another can beinfluenced by firms If firms can influence price or control the amount they supply or

in some way present their product as being something very different, then they havesome element of market power A firm such as Microsoft has few close competitorsand such a dominant market share that it can influence the market price of its product.When a firm has some element of market power its behaviour is different to that underthe assumptions which characterized a highly competitive market

Pitfall Prevention Care is needed when using the word‘competitive’ in economicanalysis In everyday usage, we use competitive to describe the degree of rivalrybetween groups or individuals In economics, a firm in a competitive market is onewhich operates under the assumptions of a competitive market structure Once we relaxthose assumptions we are interested in how a firm’s behaviour changes Competitionbetween firms in market structures where there is considerable market power is cer-tainly intense but the options available to firms and their behaviours are different tothose firms operating under more perfectly competitive conditions

In this chapter we examine the idea of imperfect competition and in particular theextreme form of imperfect competition, monopoly In the next chapter we will look atother forms of imperfect competition

An imperfectly competitive market is one where the assumptions of perfect tion do not hold Just as the very extreme of the perfectly competitive model assumeshomogeneity of product, perfect information, perfect substitutability of goods, a largenumber of small firms with no influence on market price able to sell all they produce

competi-at the going market price, the extreme of imperfect competition is monopoly

A monopoly, in the extreme case, is a single supplier of a good with no competitors.Just as the extreme model of perfect competition does not exist in its purest form, thereare few examples of a perfect monopoly However, what we can identify are certain char-acteristics in particular markets where firms behave as if they are a monopoly supplier Afirm with an 85 per cent market share such as Microsoft in the Windows operating sys-tem market is not a pure monopoly– there are other operating systems such as Apple’siOS, Java, Linux, Android and Symbian, for example, but the market power that Micro-soft can wield is considerable

Where firms have some element of market power it can alter the relationship between

a firm’s costs and the price at which it sells its product to the market A competitive firmtakes the price of its output as given by the market and then chooses the quantity it willsupply so that price equals marginal cost By contrast, the price charged by firms withmarket power exceeds marginal cost This result is clearly true in the case of Microsoft’sWindows The marginal cost of Windows– the extra cost that Microsoft would incur byprinting one more copy of the program onto a CD– is only a few euros The marketprice of Windows is many times marginal cost

It is perhaps not surprising that firms with considerable market power can charge atively high prices for their products Customers of monopolies might seem to have littlechoice but to pay whatever the monopoly charges But, if so, why is a copy of Windowspriced at about€50 and not €500? Or €5000? The reason, of course, is that if Microsoftset the price that high, fewer people would buy the product People would buy fewercomputers, switch to other operating systems or make illegal copies Monopolies cannotachieve any level of profit they want because high prices reduce the amount that theircustomers buy Although monopolies can control the prices of their goods, their profitsare not unlimited In other words, under conditions of imperfect competition firms donot face a horizontal demand curve which suggests they can sell any amount they offer

rel-at the going market price Instead, firms face a downward sloping demand curve whichmeans that if they want to sell more products they have to accept lower prices If this is

274 Part 4 Microeconomics – The Economics of Firms in Markets

www.downloadslide.com

the case then price does not equal average revenue and marginal revenue is lower This ispartly what leads to changed behaviour.

We are going to start our analysis of behaviour of firms under imperfect competition bylooking at monopolies A monopoly is a firm which is the sole supplier of a product in amarket In reality we describe firms as monopolies even though there are other suppliers, as

we have seen in the case of operating systems Because there are concerns about the effect

of market power on consumers and suppliers, most national competition policy definesmonopolies in a much stricter way A firm might be able to exercise some monopolypower if it has 25 per cent or more of the market However, for the purposes of our analysislet us assume that there is only one supplier in the market Remember that features of ouranalysis will apply fairly closely to situations where a firm dominates the market eventhough there are other suppliers When we looked at firms under highly competitive condi-tions we saw that the profit maximizing output would occur where MC = MR We also sawthat if market conditions change any abnormal or subnormal profit would disappear in thelong run as new firms enter and leave the industry In a competitive market firms are pricetakers and P = AR = MR A firm operating as a monopoly does not face these same con-ditions and so production and pricing decisions are different

As we examine the production and pricing decisions of monopolies, we also considerthe implications of monopoly for society as a whole We base our analysis of monopolyfirms, like competitive firms, on the assumption that they aim to maximize profit Butthis goal has very different ramifications for competitive and monopoly firms In a com-petitive market, price is equal to marginal cost and in the long run the firm operates atthe lowest point on the average cost curve This implies that firms are operating effi-ciently and consumers not only have choice but pay low prices Because monopolyfirms face different market conditions, the outcome in a market with a monopoly isoften different and not always in the best interest of society It is these market imperfec-tions that are so interesting and form the basis for so much government policy

One of the Ten Principles of Economics in Chapter 1 is that governments can sometimesimprove market outcomes The analysis in this chapter will shed more light on this princi-ple As we examine the problems that monopolies raise for society, we will also discuss thevarious ways in which government policy makers might respond to these problems TheCompetition Commission in Europe, for example, has been keeping a close eye on Micro-soft for some years Microsoft was accused of preventing fair competition because it bun-dled its web browser, Internet Explorer (IE), with its Windows operating system (this isknown as‘tying’) Companies have complained about the way in which Microsoft allegedlymakes it more difficult for other browsers to be interoperable– that is, work within a range

of other platforms The Commission imposed a fine of $1.4 billion in 2008 on Microsoft forbreaching EU competition rules As part of that investigation, the EU insisted that Micro-soft made more of its code available to other software manufacturers to ensure greaterinteroperability Microsoft had argued that such a move would compromise its securityand that the code constituted sensitive commercial information

monopoly a firm that is the sole seller of a product without close substitutes

The battle between Microsoft and the European Commission over tying has been going on for many years with accusa- tions that Microsoft ’s inclusion

of IE with its Windows ing system constitutes anti- competive behaviour.

island have working wells, the competitive model we have previously described is likely

to hold In such a situation the price of a litre of water is driven to equal the marginalcost of pumping an extra litre But if there is only one well in town and it is impossible

to get water from anywhere else, then the owner of the well has a monopoly on water.Not surprisingly, the monopolist has much greater market power than any single firm in

a competitive market In the case of a necessity like water, the monopolist could mand quite a high price, even if the marginal cost is low

com-Although exclusive ownership of a key resource is a potential cause of monopoly, inpractice monopolies rarely arise for this reason Actual economies are large, andresources are owned by many people Indeed, because many goods are traded interna-tionally, the natural scope of their markets is often worldwide There are, therefore, fewexamples of firms that own a resource for which there are no close substitutes

Government-Created Monopolies

In many cases, monopolies arise because the government has given one person or firmthe exclusive right to sell some good or service European kings, for example, oncegranted exclusive business licences to their friends and allies in order to raise money–

a highly prized monopoly being the exclusive right to sell and distribute salt in a ular region of Europe Even today, governments sometimes grant a monopoly (perhapseven to itself) because doing so is viewed to be in the public interest In Sweden, theretailing of alcoholic beverages is carried out under a state-owned monopoly known asthe Systembolaget, because the Swedish government deems it to be in the interests ofpublic health to be able to control directly the sale of alcohol

partic-As a member of the EU, questions have been raised about this policy but Swedenseems keen to maintain its control of alcohol sales In a recent study commissioned bythe Swedish National Institute for Public Health, researchers concluded that if retail alco-hol sales were privatized, the net effects on the country would be negative with anincrease in alcohol-related illness and deaths, fatal accidents, suicides and homicidesand a large increase in the number of working days lost to sickness.1

The patent and copyright laws are two important examples of how the governmentcreates a monopoly to serve the public interest When a pharmaceutical company dis-covers a new drug, it can apply to the government for a patent If the governmentdeems the drug to be truly original, it approves the patent, which gives the companythe exclusive right to manufacture and sell the drug for a fixed number of years –often 20 years Similarly, when a novelist finishes a book, they can copyright it Thecopyright is a government guarantee that no one can print and sell the work withoutthe author’s permission The copyright makes the novelist a monopolist in the sale oftheir novel

The effects of patent and copyright laws are easy to see Because these laws give oneproducer a monopoly, they lead to higher prices than would occur under competition.But by allowing these monopoly producers to charge higher prices and earn higherprofits, the laws also encourage some desirable behaviour Drug companies are allowed

to be monopolists in the drugs they discover in order to encourage research Authors areallowed to be monopolists in the sale of their books to encourage them to write moreand better books

Thus, the laws governing patents and copyrights have benefits and costs The benefits

of the patent and copyright laws are the increased incentive for creative activity Thesebenefits are offset, to some extent, by the costs of monopoly pricing, which we examinefully later in this chapter

Natural Monopolies

An industry is a natural monopoly when a single firm can supply a good or service to anentire market at a lower cost than could two or more firms A natural monopoly ariseswhen there are economies of scale over the relevant range of output Figure 12.1 showsthe average total costs of a firm with economies of scale In this case, a single firm canproduce any amount of output at least cost That is, for any given amount of output, alarger number of firms leads to less output per firm and higher average total cost

An example of a natural monopoly is the distribution of water To provide water toresidents of a town, a firm must build a network of pipes throughout the town If two ormore firms were to compete in the provision of this service, each firm would have to paythe fixed cost of building a network Thus, the average total cost of water is lowest if asingle firm serves the entire market

When a firm is a natural monopoly, it is less concerned about new entrants eroding itsmonopoly power Normally, a firm has trouble maintaining a monopoly position withoutownership of a key resource or protection from the government The monopolist’s profitattracts entrants into the market, and these entrants make the market more competitive

By contrast, entering a market in which another firm has a natural monopoly is tive Would-be entrants know that they cannot achieve the same low costs that the monop-olist enjoys because, after entry, each firm would have a smaller piece of the market

unattrac-External GrowthMany of the largest firms in the world have grown partly through acquisition, merger ortakeover of other firms As they do so, the industry becomes more concentrated; thereare fewer firms in the industry Earlier we mentioned the Big Four accounting firms

This is an example where smaller accounting firms have merged or been taken overand has resulted in a number of large firms dominating the industry One effect of thistype of growth is that a firm might be able to develop monopoly power over its rivalsand erect barriers to entry to make it harder for new firms to enter It is for this reasonthat governments monitor such acquisitions to see if there are implications for competi-tion In the UK, for example, any merger that gives a firm 25 per cent or more of themarket may be investigated to see if the acquisition is in the public interest

FIGURE 12.1

Economies of Scale as a Cause of Monopoly

When a firm ’s average total cost curve continually declines, the firm has what is called a natural monopoly In this case, when production

is divided among more firms, each firm produces less, and average total cost rises As a result, a single firm can produce any given amount at the smallest cost.

Cost

Average total cost

natural monopoly a monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms

www.downloadslide.com

Quick Quiz What are the four reasons that a market might have amonopoly?• Give three examples of monopolies, and explain the reasonfor each.

HOW MONOPOLIES MAKE PRODUCTION AND PRICING DECISIONS

Now that we know how monopolies arise, we can consider how a monopoly firm decideshow much of its product to make and what price to charge for it The analysis ofmonopoly behaviour in this section is the starting point for evaluating whether monopo-lies are desirable and what policies the government might pursue in monopoly markets.Monopoly versus Competition

The key difference between a competitive firm and a monopoly is the monopoly’s ability

to influence the price of its output A competitive firm is small relative to the market inwhich it operates and, therefore, takes the price of its output as given by market condi-tions and is assumed to be able to sell all its output By contrast, because a monopoly isthe sole producer in its market, it can alter the price of its good by adjusting the quantity

it supplies to the market

Because a monopoly is the sole producer in its market, its demand curve is the marketdemand curve Thus, the monopolist’s demand curve slopes downward for all the usualreasons, as in panel (b) of Figure 12.2 If the monopolist raises the price of its good, con-sumers buy less of it Looked at another way, if the monopolist reduces the quantity ofoutput it sells, the price of its output increases

FIGURE 12.2

Demand Curves for Competitive and Monopoly Firms

Because competitive firms are price takers, they in effect face horizontal demand curves, as in panel (a) Because a monopoly firm is the sole producer in its market, it faces the downward sloping market demand curve, as in panel (b) As a result, the monopoly has to accept

a lower price if it wants to sell more output.

278 Part 4 Microeconomics – The Economics of Firms in Markets

www.downloadslide.com

Pitfall Prevention Because a monopolist faces a downward sloping demandcurve it can either set price and accept the level of demand to determine its sales or itcan fix output at a certain level and allow the market to determine the price it cancharge– it cannot do both, i.e., it cannot fix price and output together.

The market demand curve provides a constraint on a monopoly’s ability to profitfrom its market power A monopolist would prefer, if it were possible, to charge a highprice and sell a large quantity at that high price The market demand curve makes thatoutcome impossible In particular, the market demand curve describes the combinations

of price and quantity that are available to a monopoly firm By adjusting the quantityproduced (or, equivalently, the price charged), the monopolist can choose any point onthe demand curve, but it cannot choose a point off the demand curve

What point on the demand curve will the monopolist choose? As with competitivefirms, we assume that the monopolist’s goal is to maximize profit Because the firm’sprofit is total revenue minus total costs, our next task in explaining monopoly behaviour

is to examine a monopolist’s revenue

A Monopoly ’s RevenueConsider a town with a single producer of water Table 12.1 shows how the monopoly’srevenue might depend on the amount of water produced

The first two columns show the monopolist’s demand schedule If the monopolistproduces just 1 litre of water, it can sell that litre for €1 If it produces 2 litres, it mustlower the price to€0.90 in order to sell both litres And if it produces 3 litres, it mustlower the price to€0.80, and so on If you graphed these two columns of numbers, youwould get a typical downward sloping demand curve

The third column of the table presents the monopolist’s total revenue It equals thequantity sold (from the first column) times the price (from the second column) Thefourth column computes the firm’s average revenue, the amount of revenue the firmreceives per unit sold We compute average revenue by taking the number for total reve-nue in the third column and dividing it by the quantity of output in the first column As

we discussed in the previous chapter, average revenue always equals the price of thegood This is true for monopolists as well as for competitive firms

The last column of Table 12.1 computes the firm’s marginal revenue, the amount ofrevenue that the firm receives for each additional unit of output We compute marginalrevenue by taking the change in total revenue when output increases by 1 unit For

TABLE 12.1

A Monopoly’s Total, Average and Marginal Revenue

example, when the firm is producing 3 litres of water it receives total revenue of€2.40.Raising production to 4 litres increases total revenue to€2.80 Thus, marginal revenue is

€2.80 minus €2.40, or €0.40

Table 12.1 shows a result that is important for understanding monopoly behaviour: amonopolist’s marginal revenue is always less than the price of its good For example, if thefirm raises production of water from 3 to 4 litres, it will increase total revenue by only€0.40,even though it will be able to sell each litre for€0.70 For a monopoly, marginal revenue islower than price because a monopoly faces a downward sloping demand curve To increasethe amount sold, a monopoly firm must lower the price of its good Hence, to sell the fourthlitre of water, the monopolist must get less revenue for each of the first three litres.Marginal revenue for monopolies is very different from marginal revenue for compet-itive firms When a monopoly increases the amount it sells, it has two effects on totalrevenue (P × Q):

• The output effect More output is sold, so Q is higher, which tends to increase totalrevenue

• The price effect The price falls, so P is lower, which tends to decrease total revenue.Because a competitive firm can sell all it wants at the market price, there is no priceeffect When it increases production by 1 unit, it receives the market price for that unit,and it does not receive any less for the units it was already selling That is, because thecompetitive firm is a price taker, its marginal revenue equals the price of its good Bycontrast, when a monopoly increases production by 1 unit, it must reduce the price itcharges for every unit it sells, and this cut in price reduces revenue on the units it wasalready selling As a result, a monopoly’s marginal revenue is less than its price

Figure 12.3 graphs the demand curve and the marginal revenue curve for a monopolyfirm (Because the firm’s price equals its average revenue, the demand curve is also theaverage revenue curve.) These two curves always start at the same point on the verticalaxis because the marginal revenue of the first unit sold equals the price of the good Butthereafter, for the reason we just discussed, the monopolist’s marginal revenue is lessthan the price of the good Thus, a monopoly’s marginal revenue curve lies below itsdemand curve (We analyzed the maths of this in Chapter 8, Figure 8.5)

FIGURE 12.3

Demand and Marginal Revenue Curves for a Monopoly

The demand curve shows how the quantity affects the price of the good The marginal revenue curve shows how the firm ’s revenue changes when the quantity increases by 1 unit Because the price on all units sold must fall if the monopoly increases production, marginal revenue is always less than the price.

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

€1.1 Price

0.0

20.4 20.3 20.2

(litres)

Demand (average revenue)

Marginal revenue

280 Part 4 Microeconomics – The Economics of Firms in Markets

www.downloadslide.com

You can see in Figure 12.3 (as well as in Table 12.1) that marginal revenue can evenbecome negative Marginal revenue is negative when the price effect on revenue isgreater than the output effect In this case, when the firm produces an extra unit of out-put, the price falls by enough to cause the firm’s total revenue to decline, even thoughthe firm is selling more units.

Profit MaximizationNow that we have considered the revenue of a monopoly firm, we are ready to examinehow such a firm maximizes profit We apply the logic of marginal analysis to the mono-polist’s decision about how much to produce

Figure 12.4 graphs the demand curve, the marginal revenue curve and the cost curvesfor a monopoly firm All these curves should seem familiar: the demand and marginalrevenue curves are like those in Figure 12.3, and the cost curves are like those weencountered in earlier chapters These curves contain all the information we need todetermine the level of output that a profit-maximizing monopolist will choose

Suppose, first, that the firm is producing at a low level of output, such as Q1 In thiscase, marginal cost is less than marginal revenue If the firm increased production by

1 unit, the additional revenue would exceed the additional costs, and profit would rise

Thus, when marginal cost is less than marginal revenue, the firm can increase profit byproducing more units

A similar argument applies at high levels of output, such as Q2 In this case, marginalcost is greater than marginal revenue If the firm reduced production by 1 unit, the costssaved would exceed the revenue lost Thus, if marginal cost is greater than marginal rev-enue, the firm can raise profit by reducing production

In the end, the firm adjusts its level of production until the quantity reaches QMAX, atwhich marginal revenue equals marginal cost Thus, the monopolist’s profit-maximizingquantity of output is determined by the intersection of the marginal revenue curve andthe marginal cost curve In Figure 12.4, this intersection occurs at point A

FIGURE 12.4

Profit Maximization for a Monopoly

A monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost (point A) It then uses the demand curve to find the price that will induce consumers to buy that quantity (point B).

Demand

Costs and revenue

Average total cost

Marginal revenue

Marginal cost

A

B Monopoly

price

1 The intersection of the marginal revenue curve and the marginal cost curve determines the profit-maximizing quantity…

2 … and then the demand curve shows the price consistent with this quantity.

www.downloadslide.com

Remember that competitive firms choose to produce at the quantity of output atwhich marginal revenue equals marginal cost In following this rule for profit maximi-zation, competitive firms and monopolies are alike But there is also an importantdifference between these types of firm: the marginal revenue of a competitive firmequals its price, whereas the marginal revenue of a monopoly is less than its price.That is:

For a competitive firm: P¼ MR ¼ MCFor a monopoly firm: P > MR¼ MC

Assuming profit maximization, the decision to produce at a point where marginalrevenue and marginal cost are equal is the same for both types of firm What differs isthe relationship of the price to marginal revenue and marginal cost

How does the monopoly find the profit-maximizing price for its product? Thedemand curve answers this question because the demand curve relates the amount thatcustomers are willing to pay to the quantity sold Thus, after the monopoly firm choosesthe quantity of output that equates marginal revenue and marginal cost, it uses thedemand curve to find the price consistent with that quantity In Figure 12.4, the profit-maximizing price is found at point B

We can now see a key difference between markets with competitive firms and marketswith a monopoly firm: in competitive markets, price equals marginal cost In monopo-lized markets, price exceeds marginal cost As we will see in a moment, this finding iscrucial to understanding the social cost of monopoly

FYI

Why a Monopoly Does Not Have a Supply Curve

You may have noticed that we haveanalyzed the price in a monopoly mar-ket using the market demand curve andthe firm’s cost curves We have notmade any mention of the market supplycurve By contrast, when we analyzedprices in competitive markets beginning

in Chapter 4, the two most importantwords were always supply anddemand

What happened to the supply curve?

Although monopoly firms make sions about what quantity to supply (in

deci-the way described in this chapter), amonopoly does not have a supplycurve A supply curve tells us the quan-tity that firms choose to supply at anygiven price This concept makes sensewhen we are analyzing competitivefirms, which are price takers But amonopoly firm is a price maker, not aprice taker It is not meaningful to askwhat such a firm would produce at anyprice because the firm sets the price atthe same time it chooses the quantity tosupply

Indeed, the monopolist’s decisionabout how much to supply is impossible

to separate from the demand curve itfaces The shape of the demand curvedetermines the shape of the marginalrevenue curve, which in turn deter-mines the monopolist’s profit-maximizing quantity In a competitivemarket, supply decisions can be ana-lyzed without knowing the demandcurve, but that is not true in a monopolymarket Therefore, we never talk about

a monopoly’s supply curve

282 Part 4 Microeconomics – The Economics of Firms in Markets

www.downloadslide.com

A Monopoly ’s ProfitHow much profit does the monopoly make? To see the monopoly’s profit, recall thatprofit equals total revenue (TR) minus total costs (TC):

Profit¼ TR  TC

We can rewrite this as:

Profit¼ (TR/Q  TC/Q)  QTR/Q is average revenue, which equals the price P, and TC/Q is average total cost ATC

Therefore:

Profit¼ (P  ATC)  QThis equation for profit (which is the same as the profit equation for competitive firms)allows us to measure the monopolist’s profit in our graph

Consider the shaded box in Figure 12.5 The height of the box (the segment BC) isprice minus average total cost, P  ATC, which is the profit on the typical unit sold

The width of the box (the segment DC) is the quantity sold QMAX Therefore, the area

of this box is the monopoly firm’s total profit

Quick Quiz Explain how a monopolist chooses the quantity of output toproduce and the price to charge

FIGURE 12.5

The Monopolist’s Profit

The area of the box BCDE equals the profit of the monopoly firm The height of the box (BC) is price minus average total cost, which equals profit per unit sold The width of the box (DC) is the number of units sold.

Costs and revenue

Monopoly price

Average total cost D

E

C B

www.downloadslide.com

C A S E S T U D Y

Monopoly Drugs versus Generic DrugsAccording to our analysis, prices are determined quite differently in monopolizedmarkets from the way they are in competitive markets A natural place to test thistheory is the market for pharmaceutical drugs, because this market takes on bothmarket structures When a firm discovers a new drug, patent laws give the firm amonopoly on the sale of that drug But eventually the firm’s patent runs out, andany company can make and sell the drug At that time, the market switches frombeing monopolistic to being competitive

What should happen to the price of a drug when the patent runs out?Figure 12.6 shows the market for a typical drug In this figure, the marginal cost

of producing the drug is constant (This is approximately true for many drugs.)During the life of the patent, the monopoly firm maximizes profit by producingthe quantity at which marginal revenue equals marginal cost and charging a pricewell above marginal cost But when the patent runs out, the profit from makingthe drug should encourage new firms to enter the market As the market becomesmore competitive, the price should fall to equal marginal cost

Experience is, in fact, consistent with our theory When the patent on a drugexpires, other companies quickly enter and begin selling so-called generic productsthat are chemically identical to the former monopolist’s brand-name product Andjust as our analysis predicts, the price of the competitively produced generic drug iswell below the price that the monopolist was charging

The expiration of a patent, however, does not cause the monopolist to lose allits market power Some consumers remain loyal to the brand-name drug, perhapsout of fear that the new generic drugs are not actually the same as the drug theyhave been using for years As a result, the former monopolist can continue tocharge a price somewhat above the price charged by its new competitors

FIGURE 12.6

The Market for Drugs

When a patent gives a firm a monopoly over the sale of a drug, the firm charges the monopoly price, which is well above the marginal cost of making the drug When the patent on a drug runs out, new firms enter the market, making it more competitive As a result, the price falls from the monopoly price to marginal cost.

0

Price after patent expires

Price during patent life

Quantity Competitive

quantity

Monopoly quantity

Costs and revenue

Marginal revenue

Marginal cost Demand

284 Part 4 Microeconomics – The Economics of Firms in Markets

www.downloadslide.com

THE WELFARE COST OF MONOPOLY

Is monopoly a good way to organize a market? We have seen that a monopoly, in trast to a competitive firm, charges a price above marginal cost From the standpoint ofconsumers, this high price makes monopoly undesirable At the same time, however, themonopoly is earning profit from charging this high price From the standpoint of theowners of the firm, the high price makes monopoly very desirable Is it possible thatthe benefits to the firm’s owners exceed the costs imposed on consumers, makingmonopoly desirable from the standpoint of society as a whole?

con-We can answer this question using the concepts of consumer and producer surplus as ourmeasure of economic well-being Total surplus is the sum of consumer surplus and producersurplus Consumer surplus is consumers’ willingness to pay for a good minus the amountthey actually pay for it Producer surplus is the amount producers receive for a good minustheir costs of producing it In this case, there is a single producer– the monopolist

The Deadweight Loss

We begin by considering what the monopoly firm would do if it were run by a lent social planner The social planner cares not only about the profit earned by thefirm’s owners but also about the benefits received by the firm’s consumers The plannertries to maximize total surplus, which equals producer surplus (profit) plus consumersurplus Keep in mind that total surplus equals the value of the good to consumersminus the costs of making the good incurred by the monopoly producer

benevo-Figure 12.7 analyzes what level of output a benevolent social planner would choose Thedemand curve reflects the value of the good to consumers, as measured by their willingness topay for it The marginal cost curve reflects the costs of the monopolist Thus, the socially effi-cient quantity is found where the demand curve and the marginal cost curve intersect Belowthis quantity, the value to consumers exceeds the marginal cost of providing the good, so

FIGURE 12.7

The Efficient Level of Output

A benevolent social planner who wanted to maximize total surplus in the market would choose the level of output where the demand curve and marginal cost curve intersect Below this level, the value of the good to the marginal buyer (as reflected in the demand curve) exceeds the marginal cost of making the good Above this level, the value to the marginal buyer is less than marginal cost.

Price

Value to buyers

is greater than cost to seller.

Value to buyers

is less than cost to seller.

Efficient quantity

Value to buyers

Value to buyers

Demand (value to buyers)

Marginal cost

Cost to monopolist

Cost to monopolist

www.downloadslide.com

increasing output would raise total surplus Above this quantity, the marginal cost exceeds thevalue to consumers, so decreasing output would raise total surplus.

If the social planner were running the monopoly, the firm could achieve this efficientoutcome by charging the price found at the intersection of the demand and marginalcost curves Thus, like a competitive firm and unlike a profit maximizing monopoly, asocial planner would charge a price equal to marginal cost Because this price wouldgive consumers an accurate signal about the cost of producing the good, consumerswould buy the efficient quantity

We can evaluate the welfare effects of monopoly by comparing the level of output thatthe monopolist chooses to the level of output that a social planner would choose As wehave seen, the monopolist chooses to produce and sell the quantity of output at which themarginal revenue and marginal cost curves intersect; the social planner would choose thequantity at which the demand and marginal cost curves intersect Figure 12.8 shows thecomparison The monopolist produces less than the socially efficient quantity of output

We can also view the inefficiency of monopoly in terms of the monopolist’s price Becausethe market demand curve describes a negative relationship between the price and quantity ofthe good, a quantity that is inefficiently low is equivalent to a price that is inefficiently high.When a monopolist charges a price above marginal cost, some potential consumers value thegood at more than its marginal cost but less than the monopolist’s price These consumers donot end up buying the good Because the value these consumers place on the good is greaterthan the cost of providing it to them, this result is inefficient Thus, monopoly pricing pre-vents some mutually beneficial trades from taking place

The inefficiency of monopoly can be measured in Figure 12.8 which shows the weight loss Recall that the demand curve reflects the value to consumers and the mar-ginal cost curve reflects the costs to the monopoly producer Thus, the area of thedeadweight loss triangle between the demand curve and the marginal cost curve equalsthe total surplus lost because of monopoly pricing

dead-The deadweight loss is caused because a monopoly exerts its market power by ing a price above marginal cost, creating a wedge The wedge causes the quantity sold tofall short of the social optimum In this situation a private firm gets the monopoly profit

charg-FIGURE 12.8

The Inefficiency of Monopoly

Because a monopoly charges a price above marginal cost, not all consumers who value the good at more than its cost buy it Thus, the quantity produced and sold by a monopoly is below the socially efficient level The deadweight loss is represented by the area of the triangle between the demand curve (which reflects the value of the good to consumers) and the marginal cost curve (which reflects the costs of the monopoly producer).

Price

Monopoly price

Quantity Efficient

quantity

Monopoly quantity 0

Marginal cost

Marginal

Deadweight loss

286 Part 4 Microeconomics – The Economics of Firms in Markets

www.downloadslide.com

JEOPARDY PROBLEM

How might a situation arise through which a government granting monopolyrights to a TV company to provide national TV broadcasting leads to an overallincrease in welfare in society?

The Monopoly ’s Profit: A Social Cost?

It is tempting to decry monopolies for‘profiteering’ at the expense of the public And,indeed, a monopoly firm does earn a higher profit by virtue of its market power Accord-ing to the economic analysis of monopoly, however, the firm’s profit is not in itself nec-essarily a problem for society

Welfare in a monopolized market, like all markets, includes the welfare of bothconsumers and producers Whenever a consumer pays an extra euro to a producerbecause of a monopoly price, the consumer is worse off by a euro, and the producer

is better off by the same amount This transfer from the consumers of the good to theowners of the monopoly does not affect the market’s total surplus – the sum of con-sumer and producer surplus In other words, the monopoly profit itself does not rep-resent a shrinkage in the size of the economic pie; it merely represents a bigger slicefor producers and a smaller slice for consumers Unless consumers are for some rea-son more deserving than producers– a judgement that goes beyond the realm of eco-nomic efficiency– the monopoly profit is not a social problem

The problem in a monopolized market arises because the firm produces and sells aquantity of output below the level that maximizes total surplus The deadweight lossmeasures how much the economic pie shrinks as a result This inefficiency is connected

to the monopoly’s high price: consumers buy fewer units when the firm raises its priceabove marginal cost But keep in mind that the profit earned on the units that continue

to be sold is not the problem The problem stems from the inefficiently low quantity ofoutput Put differently, if the high monopoly price did not discourage some consumersfrom buying the good, it would raise producer surplus by exactly the amount it reducedconsumer surplus, leaving total surplus the same as could be achieved by a benevolentsocial planner

There is, however, a possible exception to this conclusion Suppose that a monopolyfirm has to incur additional costs to maintain its monopoly position For example, a firmwith a government-created monopoly might need to hire lobbyists to convince law-makers to continue its monopoly In this case, the monopoly may use up some of itsmonopoly profits paying for these additional costs If so, the social loss from monopolyincludes both these costs and the deadweight loss resulting from a price above marginalcost

Quick Quiz How does a monopolist’s quantity of output compare to thequantity of output that maximizes total surplus?

? what if …a monopolist did not have a primary goal of maximizing profit Wouldthe welfare losses still be as high?

www.downloadslide.com

PRICE DISCRIMINATION

So far we have been assuming that the monopoly firm charges the same price to all tomers Yet in many cases firms try to sell the same good to different customers for dif-ferent prices, even though the costs of producing for the two customers are the same.This practice is called price discrimination

cus-Before discussing the behaviour of a price-discriminating monopolist, we should notethat price discrimination is not possible when a good is sold in a competitive market In

a competitive market, there are many firms selling the same good at the market price

No firm is willing to charge a lower price to any customer because the firm can sell all

it wants at the market price And if any firm tried to charge a higher price to a customer,that customer would buy from another firm For a firm to price discriminate, it musthave some market power

A Parable About Pricing

To understand why a monopolist would want to price discriminate, let’s consider a simpleexample Imagine that you are the chief executive officer of Readalot Publishing Company.Readalot’s best-selling author has just written her latest novel To keep things simple, let’simagine that you pay the author a flat €2 million for the exclusive rights to publish thebook Let’s also assume – for simplicity – that the cost of printing the book is zero Read-alot’s profit, therefore, is the revenue it gets from selling the book minus the €2 million ithas paid to the author Given these assumptions, how would you, as Readalot’s CEO,decide what price to charge for the book?

Your first step in setting the price is to estimate what the demand for the book islikely to be Readalot’s marketing department tells you that the book will attract twotypes of readers The book will appeal to the author’s 100 000 diehard fans These fanswill be willing to pay as much as€30 for the book In addition, the book will appeal toabout 400 000 less enthusiastic readers who will be willing to pay up to€5 for the book.What price maximizes Readalot’s profit? There are two natural prices to consider: €30

is the highest price Readalot can charge and still get the 100 000 diehard fans, and€5 isthe highest price it can charge and still get the entire market of 500 000 potential readers

It is a matter of simple arithmetic to solve Readalot’s problem At a price of €30, alot sells 100 000 copies, has revenue of€3 million, and makes profit of €1 million At aprice of €5, it sells 500 000 copies, has revenue of €2.5 million, and makes profit of

Read-€500 000 Thus, Readalot maximizes profit by charging €30 and forgoing the opportunity

to sell to the 400 000 less enthusiastic readers

Notice that Readalot’s decision causes a deadweight loss There are 400 000 readerswilling to pay €5 for the book, and the marginal cost of providing it to them is zero.Thus, €2 million of total surplus is lost when Readalot charges the higher price Thisdeadweight loss is the usual inefficiency that arises whenever a monopolist charges aprice above marginal cost

Now suppose that Readalot’s marketing department makes an important discovery:these two groups of readers are in separate markets All the diehard fans live in Switzer-land and all the other readers live in Turkey Moreover, it is difficult for readers in onecountry to buy books in the other How does this discovery affect Readalot’s marketingstrategy?

In this case, the company can make even more profit To the 100 000 Swiss readers, itcan charge €30 for the book To the 400 000 Turkish readers, it can charge €5 for thebook (or the Turkish lira equivalent) In this case, revenue is €3 million in Switzerlandand €2 million in Turkey, for a total of €5 million Profit is then €3 million, which issubstantially greater than the €1 million the company could earn charging the same

€30 price to all customers Not surprisingly, Readalot chooses to follow this strategy ofprice discrimination

price discrimination the business practice of selling the same good at different prices to different customers

288 Part 4 Microeconomics – The Economics of Firms in Markets

www.downloadslide.com

Although the story of Readalot Publishing is hypothetical, it describes accurately thebusiness practice of many publishing companies Textbooks, for example, are often sold

at a different price in Europe from in the United States, the Middle East and Africa

Even more important is the price differential between hardcover books and paperbacks

New novels are often initially released as an expensive hardcover edition and laterreleased in a cheaper paperback edition The difference in price between these two edi-tions far exceeds the difference in printing costs The publisher’s goal is just as in ourexample By selling the hardcover to diehard fans (and libraries) who must have thebook as soon as it is published and the paperback to less enthusiastic readers who don’tmind waiting, the publisher price discriminates and raises its profit

? what if …the price elasticity of demand is not that different in differentmarkets– would a monopolist still be able to practise price discrimination?

The Moral of the StoryLike any parable, the story of Readalot Publishing is stylized Yet, also like any parable, itteaches some important and general lessons In this case, there are three lessons to belearned about price discrimination

The first and most obvious lesson is that price discrimination is a rational strategy for

a profit-maximizing monopolist In other words, by charging different prices to differentcustomers, a monopolist can increase its profit In essence, a price-discriminatingmonopolist charges each customer a price closer to his or her willingness to pay than ispossible with a single price

The second lesson is that price discrimination requires the ability to separate mers according to their willingness to pay In our example, customers were separatedgeographically But sometimes monopolists choose other differences, such as age orincome, to distinguish among customers Energy companies are able to discriminatethrough setting different prices at different times of the day with off-peak usage pricedlower than peak time Similarly, rail companies charge different prices to passengers atcertain times of the day with peak travel attracting a much higher price than off-peaktravel Where there is a difference in the price elasticity of demand the monopolist canexploit this and practise price discrimination Between the hours of 6.00am and 9.30am

custo-on weekday mornings, for example, the price elasticity of demand for rail travel is tively low, whereas between 9.30am and 4.00pm it tends to be relatively high A higherprice can be charged at the peak time but during the off-peak period, the firm may ben-efit from charging a lower price and encouraging more passengers to travel; the cost ofrunning the train is largely fixed and the marginal cost of carrying an additional passen-ger is almost zero Lowering the price, therefore, is a way of utilizing the capacity on thetrain and adding to profit

rela-A corollary to this second lesson is that certain market forces can prevent firms fromprice discriminating In particular, one such force is arbitrage, the process of buying agood in one market at a low price and selling it in another market at a higher price inorder to profit from the price difference In our example, suppose that Swiss bookshopscould buy the book in Turkey for€5 and resell it to Swiss readers at a price well below

€30 This arbitrage would prevent Readalot from price discriminating because no Swissresident would buy the book at the higher price In fact, the increased use of the Internetfor buying books and other goods through companies like Amazon and eBay is likely toaffect the ability of companies to price discriminate internationally Where firms canenforce the division of the market, as in the case of rail fares, it can practise price dis-crimination A passenger buying a ticket at off-peak rates is not allowed to travel on atrain running during peak periods, and hence arbitrage is circumvented

www.downloadslide.com

The third lesson from our parable is perhaps the most surprising: price discriminationcan raise economic welfare Recall that a deadweight loss arises when Readalot charges asingle €30 price, because the 400 000 less enthusiastic readers do not end up with thebook, even though they value it at more than its marginal cost of production By con-trast, when Readalot price discriminates, all readers end up with the book, and the out-come is efficient Thus, price discrimination can eliminate the inefficiency inherent inmonopoly pricing.

Note that the increase in welfare from price discrimination shows up as higher ducer surplus rather than higher consumer surplus In our example, consumers are nobetter off for having bought the book: the price they pay exactly equals the value theyplace on the book, so they receive no consumer surplus The entire increase in totalsurplus from price discrimination accrues to Readalot Publishing in the form ofhigher profit

pro-The Analytics of Price DiscriminationLet us consider a little more formally how price discrimination affects economic welfare

We begin by assuming that the monopolist can price discriminate perfectly Perfect pricediscrimination describes a situation in which the monopolist knows exactly the willing-ness to pay of each customer and can charge each customer a different price In this case,the monopolist charges each customer exactly his willingness to pay, and the monopolistgets the entire surplus in every transaction

Figure 12.9 shows producer and consumer surplus with and without price tion Without price discrimination, the firm charges a single price above marginal cost,

discrimina-FIGURE 12.9

Welfare With and Without Price Discrimination

Panel (a) shows a monopolist that charges the same price to all customers Total surplus in this market equals the sum of profit (producer surplus) and consumer surplus Panel (b) shows a monopolist that can perfectly price discriminate Because consumer surplus equals zero, total surplus now equals the firm ’s profit Comparing these two panels, you can see that perfect price discrimination raises profit, raises total surplus and lowers consumer surplus.

Price

Monopoly price

Deadweight loss

Price

Profit Profit

Quantity 0

Demand Demand

Marginal cost Marginal cost

Marginal revenue

290 Part 4 Microeconomics – The Economics of Firms in Markets

www.downloadslide.com

as shown in panel (a) Because some potential customers who value the good at morethan marginal cost do not buy it at this high price, the monopoly causes a deadweightloss Yet when a firm can perfectly price discriminate, as shown in panel (b), each cus-tomer who values the good at more than marginal cost buys the good and is charged hiswillingness to pay All mutually beneficial trades take place, there is no deadweight loss,and the entire surplus derived from the market goes to the monopoly producer in theform of profit.

In reality, of course, price discrimination is not perfect Customers do not walk intoshops with signs displaying their willingness to pay Instead, firms price discriminate bydividing customers into groups: young versus old, weekday versus weekend shoppers,Germans versus British, and so on Unlike those in our parable of Readalot Publishing,customers within each group differ in their willingness to pay for the product, makingperfect price discrimination impossible

How does this imperfect price discrimination affect welfare? The analysis of these ing schemes is quite complicated, and it turns out that there is no general answer to thisquestion Compared to the monopoly outcome with a single price, imperfect price discrim-ination can raise, lower or leave unchanged total surplus in a market The only certainconclusion is that price discrimination raises the monopoly’s profit – otherwise the firmwould choose to charge all customers the same price

pric-Examples of Price DiscriminationFirms use various business strategies aimed at charging different prices to different cus-tomers Now that we understand the economics of price discrimination, let’s considersome examples

citi-zens than for other patrons This fact is hard to explain in a competitive market In acompetitive market, price equals marginal cost, and the marginal cost of providing aseat for a child or senior citizen is the same as the marginal cost of providing a seat foranyone else Yet this fact is easily explained if cinemas have some local monopoly powerand if children and senior citizens have a lower willingness to pay for a ticket In thiscase, cinemas raise their profit by price discriminating

charge a lower price for a round-trip ticket between two cities if the traveller stays over

a Saturday night At first this seems odd Why should it matter to the airline whether apassenger stays over a Saturday night? The reason is that this rule provides a way to sep-arate business travellers and personal travellers A passenger on a business trip has ahigh willingness to pay and, most likely, does not want to stay over a Saturday night

By contrast, a passenger travelling for personal reasons has a lower willingness to payand is more likely to be willing to stay over a Saturday night Thus, the airlines can suc-cessfully price discriminate by charging a lower price for passengers who stay over a Sat-urday night

newspapers and magazines A buyer simply has to cut out the coupon in order to get

€0.50 off his next purchase Why do companies offer these coupons? Why don’t theyjust cut the price of the product by€0.50?

The answer is that coupons allow companies to price discriminate Companies knowthat not all customers are willing to spend the time to cut out coupons Moreover, thewillingness to clip coupons is related to the customer’s willingness to pay for the good Arich and busy executive is unlikely to spend her time cutting discount coupons out of thenewspaper, and she is probably willing to pay a higher price for many goods A person

www.downloadslide.com

who is unemployed is more likely to clip coupons and has a lower willingness to pay.Thus, by charging a lower price only to those customers who cut out coupons, firmscan successfully price discriminate.

charges different prices to different customers Sometimes, however, monopolists pricediscriminate by charging different prices to the same customer for different units thatthe customer buys Traditionally, English bakers would give you an extra cake for noth-ing if you bought 12 While the quaint custom of the‘baker’s dozen’ (i.e 13 for the price

of 12) is largely a thing of the past, many firms offer lower prices to customers who buylarge quantities This is a form of price discrimination because the customer effectivelypays a higher price for the first unit bought than for last Quantity discounts are often asuccessful way of price discriminating because a customer’s willingness to pay for anadditional unit declines as the customer buys more units

Quick Quiz Give two examples of price discrimination.• How does fect price discrimination affect consumer surplus, producer surplus andtotal surplus?

per-PUBLIC POLICY TOWARDS MONOPOLIES

We have seen that monopolies, in contrast to competitive markets, fail to allocateresources efficiently Monopolies produce less than the socially desirable quantity of out-put and, as a result, charge prices above marginal cost Policy makers in the governmentcan respond to the problem of monopoly in one of four ways, by:

• trying to make monopolized industries more competitive

• regulating the behaviour of the monopolies

• turning some private monopolies into public enterprises

• doing nothing at all

All industrialized countries have some sort of process for legally prohibiting mergersthat are against the public interest

The earliest moves towards using legal remedies to monopoly power were taken inthe US in the late 19th and early 20th centuries, forming the basis of legislation thathas become known in the USA as the anti-trust laws (in the UK and the rest of Eur-ope, anti-trust law and anti-trust policy are more commonly referred to as competi-tion law and competition policy, although usage of both terms is becomingwidespread) These laws cover proposed mergers between two companies whichalready have substantial market share and are closely examined by the authorities,who might well decide that the merger would make the industry in question substan-tially less competitive and, as a result, would reduce the economic well-being of thecountry or region as a whole

In Europe, each country has a competition authority In the UK it is the CompetitionCommission; in Germany it is the Federal Cartel Office (Bundeskartellamt); in 2009 theFrench Competition Authority began discharging its regulatory powers following reform

of competition regulation; and in Italy the Anti-trust Authority (Autorità garante dellaconcorrenza e del mercato) oversees competition issues National competition authoritiessuch as these cooperate with each other and with the EU Competition Commissionthrough the European Competition Network (ECN) The aim of the network is to coor-dinate activities and share information to help enforce EU competition law in member

292 Part 4 Microeconomics – The Economics of Firms in Markets

www.downloadslide.com

states where the opportunities for cross-border business have increased as the EU hasdeveloped and expanded.

Whilst each national country can enforce its own competition legislation, these lawshave to be in line with overall EU competition legislation In the UK, for example, theCompetition Act 1998 and the Enterprise Act 2002 both deal with competition issueswithin the UK but cross-border competition cases would be dealt with under EU law

There are well-defined criteria for deciding whether a proposed merger of companiesbelonging to more than one European Union country is subject to reference exclusively

to the European Commission rather than to national authorities, such as the size of theworldwide or European turnover of the companies in question

Competition legislation covers three main areas:

• Acting against cartels and cases where businesses engage in restrictive business tices which prevent free trade

prac-• Banning pricing strategies which are anti-competitive such as price fixing, predatorypricing, price gouging and so on, and through behaviour which might lead to arestriction in competition such as the sharing of information or carving up marketsbetween different firms, rigging bids in tender processes or deliberately restrictingproduction to reduce competition

• Monitoring and supervising acquisitions and joint ventures

The legislation allows competition authorities the right to fine firms who are foundguilty of restricting competition, ordering firms to change behaviour and banningproposed acquisitions The investigation will consider whether the acquisition,regardless of what size company it produces, is in the public interest This is in rec-ognition of the fact that companies sometimes merge not to reduce competition but

to lower costs through more efficient joint production These benefits from mergersare often called synergies

Clearly, the government must be able to determine which mergers are desirable andwhich are not That is, it must be able to measure and compare the social benefit fromsynergies to the social costs of reduced competition

RegulationAnother way in which the government deals with the problem of monopoly is by regu-lating the behaviour of monopolists This solution is common in the case of naturalmonopolies, for instance utility companies like water, gas and electricity companies

These companies are not allowed to charge any price they want Instead, governmentagencies regulate their prices

What price should the government set for a natural monopoly? This question is not aseasy as it might at first appear One might conclude that the price should equal themonopolist’s marginal cost If price equals marginal cost, customers will buy the quantity ofthe monopolist’s output that maximizes total surplus, and the allocation of resources will beefficient.

There are, however, two practical problems with marginal-cost pricing as a tory system The first is illustrated in Figure 12.10 Natural monopolies, by definition,have declining average total cost When average total cost is declining, marginal cost

regula-is less than average total cost If regulators are to set price equal to marginalcost, that price will be less than the firm’s average total cost, and the firm will losemoney Instead of charging such a low price, the monopoly firm would just exit theindustry

Regulators can respond to this problem in various ways, none of which is perfect Oneway is to subsidize the monopolist In essence, the government picks up the losses inher-ent in marginal-cost pricing Yet to pay for the subsidy, the government needs to raisemoney through taxation, which involves its own deadweight losses Alternatively, theregulators can allow the monopolist to charge a price higher than marginal cost If theregulated price equals average total cost, the monopolist earns exactly zero economicprofit Yet average-cost pricing leads to deadweight losses, because the monopolist’sprice no longer reflects the marginal cost of producing the good In essence, average-cost pricing is like a tax on the good the monopolist is selling

The second problem with marginal-cost pricing as a regulatory system (and withaverage-cost pricing as well) is that it gives the monopolist no incentive to reduce costs.Each firm in a competitive market tries to reduce its costs because lower costs meanhigher profits But if a regulated monopolist knows that regulators will reduce priceswhenever costs fall, the monopolist will not benefit from lower costs In practice, regula-tors deal with this problem by allowing monopolists to keep some of the benefits fromlower costs in the form of higher profit, a practice that requires some departure frommarginal-cost pricing

FIGURE 12.10

Marginal Cost Pricing For a Natural Monopoly

Because a natural monopoly has declining average total cost, marginal cost is less than average total cost Therefore, if regulators require

a natural monopoly to charge a price equal to marginal cost, price will be below average total cost, and the monopoly will lose money.

Price

Average total cost Regulated price

Quantity 0