Demand and Supply Analysis

1
Road Map for Prices and Markets

• Demand and Supply Analysis
• Demand and Revenue
• Elasticity of demand
• Costs
• Marginal costs fixed costs variable costs
• Competitive Markets
• Pricing under competition (P MR MC)
• Short run and long run decisions
• Strategies to survive in a competitive market
• Forecasting in the context of entry decisions
• Pricing with market power
• Pricing by a monopolist (MR MC)
• The trade off between high price and low
  quantity (MR lt P)
• Some pricing fallacies

TOOLS
2
Understanding Cost (session 3)
Revenue Understanding Demand (session 2)
Profit Revenue Cost
Pricing
Monopoly Trade off b/w high P and low Q
(session 6)
Perfect Competition Supply and entry decisions
(session 4 5)
What if we can price discriminate? (i.e.,
different consumers pay different
prices) (session 9 10)
How pricing depends on demand through the
elasticities (session 7)
Strategic Competition Solving for the NE
price and quantity competition (session 12)
How timing matters Stackelberg (session 14)
Exotic topics Strategic Demand Network
externalities and Auctions. (session 15)
Tools Games Theory (session 11)
Externalities and Strategic interaction
Collusion (session 13)
3
Today Pricing with Market Power

• Monopoly Pricing
• The rule of profit maximization MC MR.
• The relationship between marginal revenue and
  price.
• Graphical and algebraic solutions to the
  monopoly pricing problem.
• Some pricing fallacies
• The midpoint pricing rule
• Not all gains from trade realized or extracted
• How pricing depends on the demand curve
• How elasticity relates to revenue
• How elasticity relates to pricing
• Implications of the mark up elasticity formula

Next Sessions
Price Discrimination (Explicit and Implicit
market segmentation)
4
Role of Fixed Costs
Fixed costs did not appear in our discussion of
pricing. Why?


AC
AC AFC AVC
P
P
AC
AC
MC AVC
MC AVC
Q
MR
Q
MR
Positive Net Profit
Net loss
Fixed cost determines whether the business is
profitable or not, but not how the pricing
decision should be made
5
Sunk Cost Fallacy Revisited
Business looks unprofitable. Temptation (1)
close it (2) raise prices to bring in more
revenues. But From the perspective of
relevant (forward looking) costs and
revenues, it is profitable!! And, there is no
way to improve things by charging higher
(or lower) prices.

P
AC SC/Q
AC
MC AVC
Q
MR

• Positive profits
• Sunk cost not recovered

6
Fallacies

• Monopoly power fallacy
• monopolist can charge any price she likes -
  Microsoft
• Imitation fallacy
• price to match competitors - Eurotunnel
• Fixed cost fallacy
• pass on fixed cost increases to consumers -
  Seagram
• price to recover fixed costs
• Sunk cost fallacy
• take into account costs that decisions cannot
  possibly impact

7
Lesson so Far

• All questions about pricing have the same
  answer (although it may not
• always be a helpful one) MR MC.
• The equality of MR and MC gives us a systematic
  way to understand
• what determines optimal pricing
• For a monopolist MR lt P.
• Cost is a dynamic concept. Make sure you avoid
  cost fallacies
• The monopolist prices charges a higher price
  (lower output) than
• that which maximizes revenue.

8
Shortcuts Monopoly optimal pricing Price Choke
and midpoint pricing rule
2

• Q(P) a bP
• P(Q) (a/b) (1/b)Q (inverse demand)
• ? P(Q) Pchoke (1/b)Q (inverse demand)

P
Pchoke
The choke price (i.e, Pchoke) is the price for Q
0
Example Q(P) 12 2P P(Q) 6 (1/2)Q
Pchoke
Q
9
Shortcuts Monopoly optimal pricing Price Choke
and midpoint pricing rule (cont.)
R P(Q)Q (Pchoke (1/b)Q)Q (revenue) R
PchokeQ (1/b)Q (revenue) MR
Pchoke (2/b)Q (marginal revenue)
2

• Profit maximizing quantity (MC is constant)?
• MR MC ? Pchoke (2/b)Q MC ? (2/b)Q P MC
  ? Q (Pchoke MC)b/2
• Profit maximizing price (MC is constant)?
• Plug back for Q in inverse demand
• P Pchoke (1/b)Q ? P Pchoke (1/b)
  (Pchoke MC)b/2
• P Pchoke (Pchoke MC) /2 ? P (Pchoke
  MC) /2

Shortcut for linear demand curves and constant
MC Midpoint pricing rule P (Pchoke MC)/2
10
Summary Solving the monopolists pricing problem

• Option I
• Obtain the inverse demand and the MR curves
• Equate MC MR ? obtain Q
• Plug in Q into the inverse demand to obtain P
• Option II (linear demand, constant MC)
• Use theMidpoint pricing rule
• P (Pchoke MC)/2
• Plug in P into the demand to obtain Q

11
Assume FC 0
Consumer surplus
Deadweight loss
gain
loss
12
Perfect Price Discrimination
If every consumer could be made to pay their
maximum willingness to pay, the monopolist can
extract all the potential profits. Q What is the
deadweight loss?
Price
mc (Q)
Potential Profit
d (P) mv(Q)
Quantity
Q
13
Wrap Up session 6

• A profit maximizing firm produces up to the
  point where MC MR.
• The equality of MR and MC gives us a systematic
  way to understand
• what determines optimal pricing
• For a monopolist MR lt P.
• Cost is a dynamic concept. Make sure you avoid
  cost fallacies
• Be able to solve the monopolists pricing
  problem numerically and
• graphically.
• Be able to use the Midpoint pricing rule P
  (Pchoke MC)/2
• Monopoly pricing implies substantial consumer
  surplus and a deadweight
• loss ? Antitrust Law

14
How pricing depends on the demand curve

• How elasticity relates to revenue
• How elasticity relates to pricing
• Implications of the mark up elasticity formula
• Rule of thumb for monopoly pricing
• How to price in different markets
• Effect of an exogenous demand shift

15
Evaluate

• After a advertising campaign, the cost of the
  advertising is sunk. Hence, the advertising
  campaign should have no effect on the firms
  pricing.
• What happened to airline prices just after
  September 11, 2001?

16
Recall Elasticity

• The elasticity of demand measures demand
  responsiveness
• Or

17
Elasticity and Revenue

• If P decreases (i.e., Q increases), what is the
  effect on Revenue?

18
Marginal revenue and elasticity

• What is the effect on revenue from selling one
  more unit of output?
• Effect 1 You sell one more unit of output for P
• Effect 2 You have to decrease your price by dP/
  dQ for all Q units you could have sold at higher
  price (the adjustment term)
• Net Effect MR P (dP/dQ)Q

E ? MR ?
19
Elasticity and Revenue (cont.)
E 1
Revenue
E lt 1
E gt1
A
Revenue
Quantity
Q
MRgt0
MRlt0
MR0
20
Elasticity and Revenue (cont.)
Punch-line Elasticity allows you to maximize
revenue even when you do not know all of your
demand, but you have only local information.
E 1
Revenue
E lt 1
E gt1
A
Revenue
Quantity
Q
MRgt0
MRlt0
MR0
21
Price and elasticity
At the profit maximizing quantity MR MC
E ? P ?
22
Lesson so Far

• For profit maximization we need

• The Mark-up elasticity formula

• How may I use this?

23
A monopolist operates on the elastic portion of
the demand.
Implication of the mark up elasticity formula
(I) Rule of thumb for monopoly pricing
Price
E gt 1
E 1
E lt 1
Demand
quantity
MR
24
 
From a 2001 study on telecom privatization in Peru
   Price Elasticities of the Use Demand 1990s data
City Services
Elasticity
    Lima 1/ Local
-0.494 Domestic Long Distance
-0.478 International Long Distance
-1.095 Province 2/
Local
-0.689 Domestic Long Distance
-0.548 International Long Distance
-1.585  
  1/ Lima Metropolitana 2/ Cusco, Arequipa,
Trujillo and Chiclayo
25
Elasticity and Linear Demand
Price (1000s)
30
25
20
15
10
5
d(P)
0
0
2
4
6
8
10
12
14
16
18
Demand for Minivans (100,000s)
For a given Price the demand curve with the lower
Pchoke is the more elastic
26
Implication of the mark up elasticity formula
(II) How to price in different markets

• Assume that a firm sells in US and Canada. Where
  should you charge a higher price?

Price
Demand US
Demand Canada
Quantity
The higher the elasticity, the lower the price.
27
Implication of the mark up elasticity formula
(II) How to price in different markets (cont)

Price
Demand B
Demand A
Quantity
28

Implication of the mark up elasticity formula
(II) An exogenous demand shift
Price
MC
Demand before 09/11
Demand after
quantity
29

Implication of the mark up elasticity formula
(II) An exogenous demand shift
P
P
MC
MC
P1
P
D2
D1
P2
D1
D2
MR2
MR2
MR1
MR1
Q
Q
Q
Q1
Q2

• The effect of exogenous demand shifts on price is
  ambiguous.

30
Determinants of elasticity

• The more close substitutes a good has, the _____
  elastic is demand.
• Demand for a particular brand (Hitachi) or (17
  flat panel) is _____ elastic than demand for the
  entire category (computer displays).
• The more differentiated the brand, the ____
  elastic is demand.
• Advertising usually both increases demand and
  makes it _____ elastic.
• Demand is _____ elastic in the long run (after
  consumers have time to adjust).
• Demand is typically ____ elastic for people with
  lower income.

31
Implications of the mark up elasticity formula

• A monopolist operates in the elastic part of his
  demand.
• The higher the elasticity the lower the price.
• The effect of exogenous demand shifts on price is
  ambiguous.

32
Wrap up Session 7

• Elasticity and marginal cost determine the price
  not supply and demand.
• The profit maximizing price satisfies
• Be able to interpret the mark-up elasticity
  formula and its implications.
• The more elastic the demand is, the lower the
  price is.
• The effect of a demand shift on price is ambiguous