Reminder: Next week you have 1 Monday Tuesday Wednesday - - PDF document

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets Session 8 • Pricing with Market Power Page 1

1

Reminder: Next week you have …

Monday Tuesday Wednesday Thursday Friday Session 9 Review Quiz – Session 10

Roxy case

2

Market power and imperfect competition

(Sessions 1–6)

Firms are price-takers (Perfect competition)

(Sessions 7–15)

Firms have market power (Imperfect competition)

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets Session 8 • Pricing with Market Power Page 2

3

Pricing with market power

(Sessions 1–6)

Firms are price-takers (Perfect competition) Firms have market power (Imperfect competition)

(Sessions 7–11)

Individual decisions

(Sessions 12–15)

Equilibrium

4

From the individual firm’s viewpoint

Price taker: No trade-off

1 2 3 4 5 1 2 3 4 5 6 7

Qi P Pi

“Demand curve” for i ’s output

Market power: volume–price trade-off

1 2 3 4 5 1 2 3 4 5 6 7

Qi Pi

Demand curve for i ’s output

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets Session 8 • Pricing with Market Power Page 3

5

Where are the other firms?

Price taker: perfect competition

1 2 3 4 5 1 2 3 4 5 6 7

Qi P Pi

“Demand curve” for i ’s output

Market power: imperfect competition

1 2 3 4 5 1 2 3 4 5 6 7

Qi Pi

Demand curve for i ’s output

6

Quantity choice? It’s about MR vs MC

Price taker:

1 2 3 4 5 1 2 3 4 5 6 7

Demand

Q P Market power:

1 2 3 4 5 1 2 3 4 5 6 7

Q

Demand

P

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets Session 8 • Pricing with Market Power Page 4

7

Marginal revenue versus price

(Data are from Exercise 7.3) What is your marginal revenue for unit 8?

Demand Q € (1000s)

3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 1 2 3 4 5 6 7 8 9 10 11 12 13

8

Marginal revenue for linear demand

Demand: d(P) Q = 16 − (2/3)P Inverse demand: p(Q) Revenue: r(Q) = p(Q) × Q Marginal revenue: MR = r′(Q)

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets Session 8 • Pricing with Market Power Page 5

9

Graph of the demand and MR curves for linear demand

2 4 6 8 10 12 14 16 18 20 22 24 −2 −4 −6 2 4 6 8 10 12 14 16

€ Q p(Q) d(Q) = 16 − (2/3)P p(Q) = 24 − (3/2)Q mr(Q) = 24 − 3Q

10

Linear demand and constant MC

2 4 6 8 10 12 14 16 18 20 22 24 −2 −4 −6 2 4 6 8 10 12 14 16

€ Q mr(Q) p(Q) mc(Q)

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets Session 8 • Pricing with Market Power Page 6

11

The markup over MC

5 10 15 20 25 20 40 60 80 100 120 140 160

Q $ d(P) MC MR

12

Markup is the gap between P and MR

Demand Q € (1000s)

3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 1 2 3 4 5 6 7 8 9 10 11 12 13

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets Session 8 • Pricing with Market Power Page 7

13

Session 8: Pricing with Market Power

1. ✓ The quantity choice. 2. ➥ Entry and exit.

• 3. Business-plan example

(P&M meets FMV & UDJ & Man. Acc.)

14

Exit/Entry: Effect of a LR fixed cost

FC affects shut-down option, not whether you produce 10 or 12 units

(or whether you charge 20 or 24).

Recipe: 1 Calculate profit-maximizing price/quantity ignoring the fixed cost. 2 Calculate profit ignoring the fixed cost (“variable profit”). 3 Check whether it is higher than the fixed cost. If so, go ahead and produce; otherwise shut down or don’t start up.

Cash flow

Time R&D Testing & approval Product launch Patent protection Entry of similar patented molecules Patent expires, competition with generics

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets Session 8 • Pricing with Market Power Page 8

15

Graphically

5 10 15 20 25 30 1 2 3 4 5 6 7 8

€ Q (millions) Variable cost Variable profit Consumer surplus Deadweight loss Qπ Inverse demand p(Q) Marginal cost mc(Q) MC ¯ P Pe

16

Socially efficient benchmark

5 10 15 20 25 30 1 2 3 4 5 6 7 8

€ Q (millions) Variable cost Gains from trade (variable surplus) Qe Marginal valuation mv(Q) (i.e., inverse demand p(Q) ) Marginal cost mc(Q) MC ¯ P

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets Session 8 • Pricing with Market Power Page 9

17

Session 8: Pricing with Market Power

1. ✓ The quantity choice. 2. ✓ Entry and exit. 3. ➥ Business-plan example (P&M meets FMV & UDJ & Man. Acc.)

18

Monday: How pricing depends on demand

Finally see elasticity in action! …and we get some nice qualitative (low data) conclusions:

• 1. Volume effect: higher volume ⇒ higher price.
• 2. Price-sensitivity effect: less elastic ⇒ higher price.

FPM reading. Chapter 9. Article. “Airlines Hold Back”.

• Deliverables. Exercise 9.3.

(The demand exercise that I sent by email—also on course website under “Extras”— is good preparation.)