Oligopoly, Monopolistic Competition

1. Go Global !Go Global !
Managerial Economics :Managerial Economics :
Oligopoly & MonopolisticOligopoly & Monopolistic
CompetitionCompetition
By
Stephen OngStephen Ong
Visiting Fellow, Birmingham City UniversityVisiting Fellow, Birmingham City University
Visiting Professor, College of Management,Visiting Professor, College of Management,
Shenzhen UniversityShenzhen University
May 2013May 2013

2. AgendaAgenda
1.1. Market CharacteristicsMarket Characteristics
2.2. Monopolistic PricingMonopolistic Pricing
3.3. Non-price CompetitionNon-price Competition

3. Learning objectivesLearning objectives
contrast monopolisticcontrast monopolistic
competition and oligopolycompetition and oligopoly
describe the role that mutualdescribe the role that mutual
interdependence plays in settinginterdependence plays in setting
prices in oligopolistic marketsprices in oligopolistic markets
explain how non-price factorsexplain how non-price factors
help firms to differentiate theirhelp firms to differentiate their
products and servicesproducts and services

4. 11
Oligopoly & MonopolisticOligopoly & Monopolistic
CompetitionCompetition

5. OverviewOverview
Monopolistic competitionMonopolistic competition
OligopolyOligopoly
Pricing under oligopolyPricing under oligopoly
Competing in imperfectlyCompeting in imperfectly
competitive marketscompetitive markets
Strategy: the challenge forStrategy: the challenge for
firms in imperfect competitionfirms in imperfect competition

6. IntroductionIntroduction
Imperfect competition
some market power but not absolute
market power
firms have the ability to set prices
within the limits of certain
constraints
mutual interdependence: interaction
among competitors when making
decisions

7. IntroductionIntroduction
PerfectPerfect Monopoly Monopolistic OligopolyMonopoly Monopolistic Oligopoly
Competition CompetitionCompetition Competition
Market power?Market power? NoNo Yes* Yes YesYes* Yes Yes
Mutual interdependence No No No YesMutual interdependence No No No Yes
among competingamong competing
firms?firms?
Non-price competition? No Optional Yes YesNon-price competition? No Optional Yes Yes
Easy market entry Yes No Yes NoEasy market entry Yes No Yes No
or exit ?or exit ?
* subject to government regulation* subject to government regulation

8. Monopolistic CompetitionMonopolistic Competition
A market structureA market structure
characterized by acharacterized by a largelarge
number of small firmsnumber of small firms
that have some marketthat have some market
power from producingpower from producing
differentiated productsdifferentiated products..

9. Characteristics ofCharacteristics of
Monopolistic CompetitionMonopolistic Competition
Product differentiationProduct differentiation existsexists
among firmsamong firms
There are aThere are a large numberlarge number ofof
firms in the product groupfirms in the product group
No interdependenceNo interdependence existsexists
among firmsamong firms
Entry and exit by new firmsEntry and exit by new firms isis
relatively easyrelatively easy

10. Monopolistic competitionMonopolistic competition
Monopolistic competition:Monopolistic competition:
characteristicscharacteristics
many firmsmany firms
relatively easy entryrelatively easy entry
product differentiation: can setproduct differentiation: can set
price at a level higher than the priceprice at a level higher than the price
established by perfect competitionestablished by perfect competition
use MR = MC rule to maximize profituse MR = MC rule to maximize profit

11. Monopolistic competitionMonopolistic competition
 If earning above-normal profits,If earning above-normal profits,
newcomers will enter the marketnewcomers will enter the market
 market supply curve shiftsmarket supply curve shifts
out and to the rightout and to the right
 firm’s demand curve shiftsfirm’s demand curve shifts
down and to the leftdown and to the left
 ultimately, in the long run,ultimately, in the long run,
firms earn onlyfirms earn only normal profitnormal profit

12. Monopolistic Competition –Monopolistic Competition –
Short-RunShort-Run
At QAt Q11::
MR = MCMR = MC
P > ATCP > ATC
P > MCP > MC
ATCATC Not atNot at
Minimum PointMinimum Point
$$
QQ
MRMR
MCMC
DD
ATCATCPP11
QQ11

13. Monopolistic Competition –Monopolistic Competition –
Long-RunLong-Run
At QAt Q22 ::
MR = MCMR = MC
P = ATCP = ATC
P > MCP > MC
ATCATC Not atNot at
Minimum PointMinimum Point
MCMC ATCATC
DD
MRMR
PP22
QQ22

14. Examples of MonopolisticallyExamples of Monopolistically
Competitive BehaviourCompetitive Behaviour
DrugstoresDrugstores
HardwareHardware
StoresStores
BookstoresBookstores

15. OligopolyOligopoly
 Oligopoly is a market dominated by a relativelyOligopoly is a market dominated by a relatively
small number of large firmssmall number of large firms
 Herfindahl-Hirschman index (HH)Herfindahl-Hirschman index (HH)
measures market concentrationmeasures market concentration
(max HH = 10,000;(max HH = 10,000;
unconcentrated markets have HH < 1,000)unconcentrated markets have HH < 1,000)
n = number of firms in then = number of firms in the
industryindustry
SSii = firm’s market share= firm’s market share
∑=
=
n
i
iSHH
1
2

16. Examples of OligopolisticExamples of Oligopolistic
IndustriesIndustries
AirlinesAirlines
Soft DrinksSoft Drinks
DoughnutsDoughnuts
Parcel andParcel and
Express DeliveryExpress Delivery

17. Oligopoly ModelsOligopoly Models
NoncooperativeNoncooperative
oligopoly models areoligopoly models are
models of interdependentmodels of interdependent
oligopoly behaviour thatoligopoly behaviour that
assume that firms pursueassume that firms pursue
profit-maximizingprofit-maximizing
strategies based onstrategies based on
assumptions aboutassumptions about
rivals’ behaviourrivals’ behaviour andand
the impact of thisthe impact of this
behaviour on the givenbehaviour on the given
firm’s strategies.firm’s strategies.
CooperativeCooperative
oligopoly models areoligopoly models are
models ofmodels of
interdependentinterdependent
oligopoly behaviouroligopoly behaviour
that assume that firmsthat assume that firms
explicitly orexplicitly or
implicitly cooperateimplicitly cooperate
with each other towith each other to
achieve outcomes thatachieve outcomes that
benefit all the firms.benefit all the firms.

18. NoncooperativeNoncooperative
Oligopoly ModelsOligopoly Models
The Kinked Demand Curve ModelThe Kinked Demand Curve Model
Game Theory ModelsGame Theory Models
Strategic Entry DeterrenceStrategic Entry Deterrence
Predatory PricingPredatory Pricing

19. Kinked Demand CurveKinked Demand Curve
 The kinked demandThe kinked demand
curve model ofcurve model of
oligopoly incorporatesoligopoly incorporates
assumptions aboutassumptions about
interdependentinterdependent
behaviour andbehaviour and
illustrates whyillustrates why
oligopoly prices mayoligopoly prices may
not change in reactionnot change in reaction
to either demand orto either demand or
cost changes.cost changes.
MC
$
Q
D2: Rivals don’t
follow
D1: Rivals do followMR1
MR2
P1
Q1

20. Pricing in an oligopolisticPricing in an oligopolistic
marketmarket
Mutual interdependence:Mutual interdependence: relativelyrelatively
few sellers create a situation wherefew sellers create a situation where
each is carefully watching the otherseach is carefully watching the others
as it sets its priceas it sets its price
Implication:Implication: kinked demand curvekinked demand curve
modelmodel Basic assumption is thatBasic assumption is that
competitor willcompetitor will follow a pricefollow a price
decreasedecrease but will not make a changebut will not make a change
in reaction to a price increasein reaction to a price increase

21. Pricing in an oligopolisticPricing in an oligopolistic
marketmarket
If reduce price andIf reduce price and
competitors match thecompetitors match the
price cut then moveprice cut then move
along more inelasticalong more inelastic
demand segment Ddemand segment Dii
If increase price andIf increase price and
competitors do notcompetitors do not
follow then move alongfollow then move along
the more elasticthe more elastic
segment Dsegment Dff
 marginal revenuemarginal revenue
curve has kink (at A)curve has kink (at A)
Competitors do not
match price increases
Competitors
match
price cuts

22. Pricing in an oligopolisticPricing in an oligopolistic
marketmarket
Price leader:Price leader: one firm in theone firm in the
industry takes the lead in changingindustry takes the lead in changing
prices, and assumes that otherprices, and assumes that other
firms:firms:
• will follow a price increasewill follow a price increase
• but will not go even lower in orderbut will not go even lower in order
not to trigger a price warnot to trigger a price war
Non-price leader:Non-price leader: firm that leadsfirm that leads
thethe differentiationdifferentiation of products onof products on
other, non-price attributesother, non-price attributes

23. Game Theory ModelsGame Theory Models
A set of mathematical toolsA set of mathematical tools
for analyzing situations infor analyzing situations in
which players make variouswhich players make various
strategic moves and havestrategic moves and have
different outcomes ordifferent outcomes or
payoffs associated withpayoffs associated with
those moves.those moves.

24. Dominant Strategies andDominant Strategies and
the Prisoner’s Dilemmathe Prisoner’s Dilemma
This payoff matrixThis payoff matrix
shows the variousshows the various
prison terms forprison terms for
Bonnie and ClydeBonnie and Clyde
that would resultthat would result
from thefrom the
combination ofcombination of
strategies chosenstrategies chosen
when questionedwhen questioned
about a crimeabout a crime
spree.spree.

25. Prisoner’s Dilemma –Prisoner’s Dilemma –
Dominant StrategyDominant Strategy
A dominantA dominant
strategy is onestrategy is one
that results in thethat results in the
best outcome orbest outcome or
highest payoff tohighest payoff to
a given playera given player nono
matter whatmatter what
action or choiceaction or choice
the other playerthe other player
makes.makes.

26. Nash EquilibriumNash Equilibrium
Nash equilibrium isNash equilibrium is
a set of strategiesa set of strategies
from which allfrom which all
players areplayers are
choosing their bestchoosing their best
strategy,strategy, given thegiven the
actions of the otheractions of the other
players.players.

27. Strategic Entry DeterrenceStrategic Entry Deterrence
Limit pricingLimit pricing isis
a policy ofa policy of
charging acharging a
price lowerprice lower
than the profit-than the profit-
maximizingmaximizing
priceprice to keepto keep
other firmsother firms
from enteringfrom entering
the market.the market.
$
Q
D
MR
MC
ATCPπmax
Qπmax
PLP =
ATCEN
QLP

28. Predatory PricingPredatory Pricing
Predatory pricing:Predatory pricing:
Japanese share ofJapanese share of
market Qmarket QPP - Q- QUSUS ==
NM = RGNM = RG
Loss per unit toLoss per unit to
Japanese firmsJapanese firms
PPCC - P- PPP = NR= NR
Total loss toTotal loss to
Japanese firmsJapanese firms
NRGMNRGM
$
Q
PUS
PJ
PC
PP
QUS QcQJ QP
K
L
J G
M
N
E
R S
T

29. Cooperative Oligopoly ModelsCooperative Oligopoly Models
CartelsCartels
TacitTacit
CollusionCollusion

30. Cartels - ExamplesCartels - Examples
OPECOPEC
DiamondDiamond
CartelCartel

31. Cartel BehaviourCartel Behaviour
A cartel is an organizationA cartel is an organization
of firms thatof firms that agree toagree to
coordinate their behaviourcoordinate their behaviour
regarding pricing and outputregarding pricing and output
decisions in order todecisions in order to
maximize the joint profitsmaximize the joint profits
for the organization.for the organization.

32. Model of Joint Profit MaximizationModel of Joint Profit Maximization
MC2
D
MCMC11
$$ $$$$
QQ QQ QQ
MCMC22
MCMCcc
MCMCccMCMC11
PPCC
MRMR
QQCCQQ2*2*QQ1*1*
Firm 1Firm 1 Firm 2Firm 2 CartelCartel

33. Success in CartelsSuccess in Cartels
A cartel is likely to be the mostA cartel is likely to be the most
successful when:successful when:
It canIt can raise the market priceraise the market price withoutwithout
inducing significant competition frominducing significant competition from
noncartel members.noncartel members.
The expectedThe expected punishmentpunishment for forming thefor forming the
cartelcartel is lowis low relative to the expectedrelative to the expected
gains.gains.
TheThe costs of establishing and enforcingcosts of establishing and enforcing
the agreement are lowthe agreement are low relative to therelative to the
gains.gains.

34. Tacit CollusionTacit Collusion
Because cartels are illegal inBecause cartels are illegal in
the United States due to thethe United States due to the
antitrust laws, firms mayantitrust laws, firms may
engage in tacitengage in tacit collusioncollusion,,
coordinated behaviour thatcoordinated behaviour that
is achieved without a formalis achieved without a formal
agreement.agreement.

35. Practices that facilitatePractices that facilitate
tacit collusiontacit collusion
Uniform pricesUniform prices
A penalty for price discountsA penalty for price discounts
Advance notice of price changesAdvance notice of price changes
Information exchangesInformation exchanges
Swaps and exchangesSwaps and exchanges

36. Competing in imperfectlyCompeting in imperfectly
competitive marketscompetitive markets
Non-price competitionNon-price competition: any effort: any effort
made by firms in order to change themade by firms in order to change the
demand for their product (other thandemand for their product (other than
the price)the price)
Non-price determinants of demand:Non-price determinants of demand:
tastes and preferencestastes and preferences
incomeincome
prices of substitutes and complementsprices of substitutes and complements
number of buyersnumber of buyers
future expectations of buyersfuture expectations of buyers
financing termsfinancing terms

37. Competing in imperfectlyCompeting in imperfectly
competitive marketscompetitive markets
 ExamplesExamples: of efforts by managers to: of efforts by managers to
influence non-price demand influences:influence non-price demand influences:
advertising and promotionadvertising and promotion
location and distribution channelslocation and distribution channels
market segmentationmarket segmentation
loyalty programsloyalty programs
product extensions and new productsproduct extensions and new products
special customer servicesspecial customer services
product ‘lock-in’ or ‘tie-in’product ‘lock-in’ or ‘tie-in’
pre-emptive new productpre-emptive new product
announcementsannouncements

38. Competing in imperfectlyCompeting in imperfectly
competitive marketscompetitive markets
Equalizing at the margin: economicEqualizing at the margin: economic
concept which managers can use toconcept which managers can use to
help make an optimal decisionhelp make an optimal decision
egeg MR = MC is an example ofMR = MC is an example of
equalizing at the marginequalizing at the margin
can be used to decide the optimalcan be used to decide the optimal
expenditure level on a non-priceexpenditure level on a non-price
factorfactor
may occur over amay occur over a long period of timelong period of time
firm must adjustfirm must adjust MR, MC for the timeMR, MC for the time
value of moneyvalue of money

39. Competing in imperfectlyCompeting in imperfectly
competitive marketscompetitive markets
ExamplesExamples: the: the
reality of ‘imperfectreality of ‘imperfect
competition’competition’
auto industryauto industry
small retailerssmall retailers
global credit cardglobal credit card
issuersissuers

40. Strategy for firms inStrategy for firms in
imperfectimperfect
competitioncompetition
How doesHow does industry concentrationindustry concentration
affect the behaviour of firmsaffect the behaviour of firms
competing in the industry?competing in the industry?
Strategy: the means by which anStrategy: the means by which an
organization uses its scarceorganization uses its scarce
resources to relate to theresources to relate to the
competitive environment in acompetitive environment in a
manner that is expected to achievemanner that is expected to achieve
superior business performance oversuperior business performance over
the long runthe long run

41. Strategy for firms in
imperfect
competition
Strategy is important when firms areStrategy is important when firms are
price makersprice makers and are faced with priceand are faced with price
and non-price competition as well asand non-price competition as well as
threats from new entrants into thethreats from new entrants into the
marketmarket
More important for firms inMore important for firms in
imperfectly competitive markets thanimperfectly competitive markets than
those in perfectly competitive marketsthose in perfectly competitive markets
or monopoly marketsor monopoly markets

42. Strategy for firms inStrategy for firms in
imperfectimperfect
competitioncompetition
Managerial economics:Managerial economics: the use ofthe use of
economic analysis to make businesseconomic analysis to make business
decisions involving the best use of andecisions involving the best use of an
organization’s scarce resourcesorganization’s scarce resources
Industrial organization:Industrial organization: studies thestudies the
way that firms and markets areway that firms and markets are
organized and how this organizationorganized and how this organization
affects the economy from theaffects the economy from the
viewpoint of social welfareviewpoint of social welfare

43. Strategy for firms inStrategy for firms in
imperfect competitionimperfect competition
 Structure-Conduct-Performance (S-C-P)Structure-Conduct-Performance (S-C-P)
paradigm: says structure affects conductparadigm: says structure affects conduct
which affects performancewhich affects performance
structure: number of firms in industry,structure: number of firms in industry,
conditions of entry, productconditions of entry, product
differentiationdifferentiation
conduct: pricing strategies, advertising,conduct: pricing strategies, advertising,
product development, legal tactics,product development, legal tactics,
collusioncollusion
performance: maximization of society’sperformance: maximization of society’s
welfarewelfare
CriticismCriticism: weak empirical evidence of relationship: weak empirical evidence of relationship
between observed concentration and profit levelsbetween observed concentration and profit levels

44. Strategy for firms inStrategy for firms in
imperfect competitionimperfect competition
 ‘‘New’ Theory of Industrial Organization: saysNew’ Theory of Industrial Organization: says
there is no necessary connection betweenthere is no necessary connection between
observed industry structure and performanceobserved industry structure and performance
that uniquely leads to maximum socialthat uniquely leads to maximum social
welfarewelfare
 theory of contestabletheory of contestable
markets: performance bymarkets: performance by
firms is ultimately influencedfirms is ultimately influenced
not by actual competition,not by actual competition,
but by thebut by the threat of potentialthreat of potential
competitioncompetition

45. Strategy for firms in imperfectStrategy for firms in imperfect
competitioncompetition
Porter’s Five Forces model: illustratesPorter’s Five Forces model: illustrates
the various factors that affect thethe various factors that affect the
ability of any firm in the industry toability of any firm in the industry to
earn a profitearn a profit

46. Strategy for firms inStrategy for firms in
imperfect competitionimperfect competition
Porter’s generic strategies forPorter’s generic strategies for
earning above-average return onearning above-average return on
investmentinvestment
DifferentiationDifferentiation approachapproach: for a: for a
monopoly or monopolisticallymonopoly or monopolistically
competitive marketcompetitive market  following MRfollowing MR
= MC rule, firm sets a= MC rule, firm sets a price on theprice on the
demand line that is above ACdemand line that is above AC

47. Strategy for firms inStrategy for firms in
imperfect competitionimperfect competition
Porter’s generic strategies for earning
above-average return on investment
Cost leadership approach: for
perfect competition
 maintain cost structure low
enough so when P = MC, there is
a positive difference between P
and AC

48. Global applicationGlobal application
 ExampleExample: world beer: world beer
markemarke
 neither pureneither pure
monopoly nor puremonopoly nor pure
competitioncompetition
 US market leaderUS market leader
Anheuser BuschAnheuser Busch
controls 50% ofcontrols 50% of
marketmarket
 mature market, withmature market, with
merger activitymerger activity

49. 22
Monopolistic Pricing PoliciesMonopolistic Pricing Policies

50. OverviewOverview
Cartel arrangementsCartel arrangements
Price leadershipPrice leadership
Revenue maximizationRevenue maximization
Price discriminationPrice discrimination
Nonmarginal pricingNonmarginal pricing
Multiproduct pricingMultiproduct pricing
Transfer pricingTransfer pricing

51. Cartel arrangementsCartel arrangements
A cartel is an arrangement whereA cartel is an arrangement where
firms in an industry cooperate andfirms in an industry cooperate and
act together as if they were aact together as if they were a
monopolymonopoly
• cartel arrangements may be tacit orcartel arrangements may be tacit or
formalformal
• illegal in the US: Sherman Antitrustillegal in the US: Sherman Antitrust
Act, 1890Act, 1890
• examplesexamples: OPEC, IATA: OPEC, IATA

52. Cartel arrangementsCartel arrangements
Conditions that influence the formation
of cartels
small number of large firms in the
industry
geographical proximity of the firms
homogeneous products that do not
allow differentiation
stage of the business cycle
difficult entry into industry
uniform cost conditions, usually
defined by product homogeneity

53. Cartel arrangementsCartel arrangements
In order to maximize profits, the cartelIn order to maximize profits, the cartel
as a whole should behave as aas a whole should behave as a
‘monopolist’‘monopolist’
 the cartel determines thethe cartel determines the outputoutput
which equateswhich equates MR = MCMR = MC of the cartelof the cartel
as a wholeas a whole
 the MC of the cartel as a whole is thethe MC of the cartel as a whole is the
horizontal summation of the members’horizontal summation of the members’
marginal cost curvesmarginal cost curves
 price is set in the normal monopolyprice is set in the normal monopoly
way, by determining quantityway, by determining quantity
demanded wheredemanded where MC=MRMC=MR and derivingand deriving
P from the demand curve at that QP from the demand curve at that Q

54. Cartel arrangementsCartel arrangements
MCMCTT is the horizontal sum of MCis the horizontal sum of MCII and MCand MCIIII
QQTT is found at the intersection of MRis found at the intersection of MRTT and MCand MCTT
 price is found from the demand curve at Qprice is found from the demand curve at QTT ……
this is the price that maximizes total industrythis is the price that maximizes total industry
profitsprofits

55. Cartel arrangementsCartel arrangements
 to determine how much each firm should produce, draw ato determine how much each firm should produce, draw a
horizontal line back from the MRhorizontal line back from the MRTT/MC/MCTT intersectionintersection
 where this line intersects each individual firm’s MCwhere this line intersects each individual firm’s MC
determines that firm’s output, QI and QII. Note that thedetermines that firm’s output, QI and QII. Note that the
firms may produce different outputsfirms may produce different outputs
Key point: the MC of the last unit produced is equatedKey point: the MC of the last unit produced is equated
across both firmsacross both firms

56. Cartel arrangementsCartel arrangements
Profits for each firm are shown as rectanglesProfits for each firm are shown as rectangles
in bluein blue
Firms may earnFirms may earn different levels of profitdifferent levels of profit,,
though combined profits are maximizedthough combined profits are maximized

57. Cartel arrangementsCartel arrangements
 Problem: incentive for firms to cheat onProblem: incentive for firms to cheat on
agreement, thus cartels are unstableagreement, thus cartels are unstable
 Additional costs facing the cartelAdditional costs facing the cartel
formation costsformation costs
monitoring costsmonitoring costs
enforcement costsenforcement costs
cost of punishment by authoritiescost of punishment by authorities
 weigh the benefits against theseweigh the benefits against these
costscosts

58. Cartel arrangementsCartel arrangements
Examples: price
fixing by cartels
GE,
Westinghouse
Archer Daniels
Midland Company
Sotheby’s,
Christie’s
Roche Holding
AG, BASF AG

59. Price leadershipPrice leadership
Barometric price leadershipBarometric price leadership
one firm in an industry willone firm in an industry will
initiate ainitiate a price changeprice change inin
response to economic conditionsresponse to economic conditions
the other firms may or may notthe other firms may or may not
follow this leaderfollow this leader
leader may varyleader may vary

60. Price leadershipPrice leadership
Dominant price leadershipDominant price leadership
one firm is theone firm is the industry leaderindustry leader
dominant firm sets price with thedominant firm sets price with the
realization that the smaller firmsrealization that the smaller firms
will follow and charge thewill follow and charge the samesame
priceprice
can force competitors out ofcan force competitors out of
business orbusiness or buy them outbuy them out underunder
favourable termsfavourable terms
could result in investigation undercould result in investigation under
Sherman Anti-Trust ActSherman Anti-Trust Act

61. Price leadershipPrice leadership
DDTT = demand curve= demand curve
for entire industryfor entire industry
MCMCDD = marginal cost= marginal cost
of the dominant firmof the dominant firm
MCMCRR = summation of= summation of
MC of follower firmsMC of follower firms
 in setting price,in setting price,
dominant firm mustdominant firm must
consider the amountconsider the amount
supplied by all firmssupplied by all firms

62. Price leadershipPrice leadership
Demand curve facing theDemand curve facing the
dominant firm is founddominant firm is found
by subtracting MCby subtracting MCRR fromfrom
DDTT
 dominant firmdominant firm
equates its MC with MRequates its MC with MR
from its ‘residualfrom its ‘residual
demand curve’ Ddemand curve’ DDD
 the dominant firmthe dominant firm
sells A units and the restsells A units and the rest
of the demand (Qof the demand (QTT – A)– A)
is supplied by theis supplied by the
follower firmsfollower firms

63. Revenue maximizationRevenue maximization
 Baumol model:Baumol model: firms maximize revenuefirms maximize revenue (not(not
profit) subject to maintaining a specific level ofprofit) subject to maintaining a specific level of
profitsprofits
RationaleRationale
a firm will become more competitivea firm will become more competitive
when it achieves awhen it achieves a large sizelarge size
management remuneration may bemanagement remuneration may be
related to revenue not profitsrelated to revenue not profits
ImplicationImplication: unlike the profit maximization case,: unlike the profit maximization case,
aa change in fixed costs will alter price andchange in fixed costs will alter price and
outputoutput (by raising the cost curve and lowering(by raising the cost curve and lowering
the profit line)the profit line)

64. Price discriminationPrice discrimination
 Price discrimination: products with identicalPrice discrimination: products with identical
costs are sold in different markets at differentcosts are sold in different markets at different
pricesprices
 the ratio of price to marginal cost differs forthe ratio of price to marginal cost differs for
similar productssimilar products
Conditions for price discriminationConditions for price discrimination
the markets in which thethe markets in which the
products are sold must byproducts are sold must by
separated (separated (no resaleno resale betweenbetween
markets)markets)
the demand curves in thethe demand curves in the
market must havemarket must have differentdifferent
elasticitieselasticities

65. Price discriminationPrice discrimination
First degree price discriminationFirst degree price discrimination
seller can identify where eachseller can identify where each
consumer lies on the demand curveconsumer lies on the demand curve
and charges each consumer theand charges each consumer the
highest price the consumer is willinghighest price the consumer is willing
to payto pay
allows the seller to extract theallows the seller to extract the
greatest amount of profitsgreatest amount of profits
requires arequires a considerable amount ofconsiderable amount of
informationinformation

66. Price discriminationPrice discrimination
Second degree priceSecond degree price
discriminationdiscrimination
differential prices charged bydifferential prices charged by
blocks of servicesblocks of services
requiresrequires meteringmetering of servicesof services
consumed by buyersconsumed by buyers

67. Price discriminationPrice discrimination
Third degree price discriminationThird degree price discrimination
customers are segregated intocustomers are segregated into
different marketsdifferent markets and chargedand charged
different prices in eachdifferent prices in each
segmentationsegmentation can be based on anycan be based on any
characteristic such as age, location,characteristic such as age, location,
gender, income, etcgender, income, etc

68. Price discriminationPrice discrimination
Third degree discrimination:Third degree discrimination:
• assume the firm operates in two markets, A and Bassume the firm operates in two markets, A and B
• the demand in market A is less elastic than the demandthe demand in market A is less elastic than the demand
in market Bin market B
• the entire market faced by the firm is described by thethe entire market faced by the firm is described by the
horizontal sum of the demand and marginal revenuehorizontal sum of the demand and marginal revenue
curves …curves …

69. Price discriminationPrice discrimination
• the firm finds the total amount to produce by equatingthe firm finds the total amount to produce by equating
the marginal revenue and marginal cost in the market asthe marginal revenue and marginal cost in the market as
a whole: Qa whole: QTT
• if the firm were forced to charge a uniform price, it wouldif the firm were forced to charge a uniform price, it would
find the price by examining the aggregate demand Dfind the price by examining the aggregate demand DTT atat
the output level Qthe output level QTT
• the firm can increase its profits by charging a differentthe firm can increase its profits by charging a different
price in each market …price in each market …

70. Price discriminationPrice discrimination
• in order to find the optimum price to charge in each market, drawin order to find the optimum price to charge in each market, draw
a horizontal line back from the MRa horizontal line back from the MRTT/MC/MCTT intersectionintersection
• where this line intersects each submarket’s MR curve determineswhere this line intersects each submarket’s MR curve determines
the amount that should be sold in each market: Qthe amount that should be sold in each market: QAA and Qand QBB
• these quantities are then used to determine the price in eachthese quantities are then used to determine the price in each
market using the demand curves Dmarket using the demand curves DAA and Dand DBB

71. Price discriminationPrice discrimination
ExamplesExamples of priceof price
discriminationdiscrimination
• doctorsdoctors
• telephone callstelephone calls
• theaterstheaters
• hotel industryhotel industry

72. Price discriminationPrice discrimination
 Tying arrangement: a buyer of one productTying arrangement: a buyer of one product
isis obligatedobligated to also by a related productto also by a related product
from the same supplierfrom the same supplier
illegal in some casesillegal in some cases
one explanation: a device toone explanation: a device to
‘meter’ demand for tied product‘meter’ demand for tied product
other explanations of tyingother explanations of tying
quality controlquality control
efficiencies in distributionefficiencies in distribution
evasion of price controlsevasion of price controls

73. Nonmarginal pricingNonmarginal pricing
 Cost-plus pricing: price is set by firstCost-plus pricing: price is set by first
calculating the variable cost, adding ancalculating the variable cost, adding an
allocation for fixed costs, and thenallocation for fixed costs, and then
adding a profit percentage or markupadding a profit percentage or markup
Problems with cost-plus pricingProblems with cost-plus pricing
calculation of average variablecalculation of average variable
costcost
allocation of fixed costallocation of fixed cost
size of the markupsize of the markup

74. Nonmarginal pricingNonmarginal pricing
 Incremental pricing (and costing) analysis:Incremental pricing (and costing) analysis:
deals with changes in total revenue anddeals with changes in total revenue and
total cost resulting from a decision tototal cost resulting from a decision to
change prices or productchange prices or product
Features:Features:
incrementalincremental, similar to marginal, similar to marginal
analysisanalysis
only revenues and costs that willonly revenues and costs that will
change due to the decision arechange due to the decision are
consideredconsidered
examples of product change: newexamples of product change: new
product, discontinue old product,product, discontinue old product,
improve a product, capital equipmentimprove a product, capital equipment

75. Multiproduct pricingMultiproduct pricing
When the firm produces two or moreWhen the firm produces two or more
productsproducts
Case 1Case 1: products are: products are complementscomplements inin
terms of demandterms of demand  an increase inan increase in
the quantity sold of one will bringthe quantity sold of one will bring
about an increase in the quantityabout an increase in the quantity
sold of the othersold of the other
Case 2Case 2: products are: products are substitutessubstitutes inin
terms of demandterms of demand  an increase inan increase in
the quantity sold of one will bringthe quantity sold of one will bring
about a decrease in the quantity soldabout a decrease in the quantity sold
of the otherof the other

76. Multiproduct pricingMultiproduct pricing
When the firm produces two or moreWhen the firm produces two or more
productsproducts
Case 3Case 3: products are joined in production: products are joined in production
products producedproducts produced from one set offrom one set of
inputsinputs
Case 4Case 4: products: products compete for resourcescompete for resources
 using resources to produce oneusing resources to produce one
product takes those resources awayproduct takes those resources away
from producing other productsfrom producing other products

77. Transfer pricingTransfer pricing
 Internal pricingInternal pricing: as the product moves: as the product moves
through these divisions on the way to thethrough these divisions on the way to the
consumer it is ‘sold’ or transferred from oneconsumer it is ‘sold’ or transferred from one
division to another at a ‘transfer price’division to another at a ‘transfer price’
Rationale:Rationale:
• firm subdividedfirm subdivided into divisions, each may beinto divisions, each may be
charged with a profit objectivecharged with a profit objective
• without any coordination, the final price ofwithout any coordination, the final price of
the product to consumersthe product to consumers may not maximizemay not maximize
profitsprofits for the firm as a wholefor the firm as a whole

78. Transfer pricingTransfer pricing
Design of the optimal transferDesign of the optimal transfer
pricing mechanism is complicatedpricing mechanism is complicated
by the fact thatby the fact that
each division may be able to selleach division may be able to sell
its product inits product in external markets asexternal markets as
well as internallywell as internally
each division may be able toeach division may be able to
procure inputs from externalprocure inputs from external
marketsmarkets as well as internallyas well as internally

79. Transfer pricingTransfer pricing
Case ACase A: no external markets: no external markets
no division can buy from or sell to anno division can buy from or sell to an
external marketexternal market
the selling division will producethe selling division will produce
exactly the number of componentsexactly the number of components
that will be used by the purchasingthat will be used by the purchasing
divisiondivision
one demand curve and two MC curvesone demand curve and two MC curves
MC curves are summed verticallyMC curves are summed vertically
set production whereset production where MR = Total MCMR = Total MC

80. Transfer pricingTransfer pricing
Case BCase B: external markets: external markets
divisions have the opportunity to buydivisions have the opportunity to buy
or sell in outside competitiveor sell in outside competitive
marketsmarkets
if selling division prices above theif selling division prices above the
external market price, the buyingexternal market price, the buying
division will buy from outsidedivision will buy from outside
if selling division cannot produceif selling division cannot produce
enough to satisfy buying divisionenough to satisfy buying division
demand, the buying division will buydemand, the buying division will buy
additional units from the externaladditional units from the external
marketmarket

81. Other pricing practicesOther pricing practices
Price skimmingPrice skimming
the first firm to introduce a productthe first firm to introduce a product
may have amay have a temporary monopolytemporary monopoly
and may be able to charge highand may be able to charge high
prices and obtain high profits untilprices and obtain high profits until
competition enterscompetition enters
Penetration pricingPenetration pricing
selling at a low price in order toselling at a low price in order to
obtainobtain market sharemarket share

82. Other pricing practicesOther pricing practices
Prestige pricingPrestige pricing
demand for a product may be higherdemand for a product may be higher
at aat a higher price because of thehigher price because of the
prestige that ownershipprestige that ownership bestows onbestows on
the ownerthe owner
Psychological pricingPsychological pricing
demand for a product may bedemand for a product may be quitequite
inelasticinelastic over a certain range but willover a certain range but will
become rather elastic at one specificbecome rather elastic at one specific
higher or lower pricehigher or lower price

83. Global applicationGlobal application
Example: decline
of European
cartels
 carton-board
 vitamin
 copper pipe
 elevator
operators

84. 22
NonPrice CompetitionNonPrice Competition

85. BundlingBundling
Practice of selling two or more products as a package.Practice of selling two or more products as a package.
To see how a film company can use customer heterogeneityTo see how a film company can use customer heterogeneity
to its advantage, suppose that there are two movie theatersto its advantage, suppose that there are two movie theaters
and that their reservation prices for our two films are asand that their reservation prices for our two films are as
follows:follows:
If the films are rented separately, the maximum price thatIf the films are rented separately, the maximum price that
could be charged forcould be charged for WindWind is $10,000 because chargingis $10,000 because charging
more would exclude Theatermore would exclude Theater BB. Similarly, the maximum. Similarly, the maximum
price that could be charged forprice that could be charged for GertieGertie is $3000.is $3000.
But suppose the films areBut suppose the films are bundledbundled. Theater. Theater AA values thevalues the
pair of films at $15,000 ($12,000 + $3000), and Theaterpair of films at $15,000 ($12,000 + $3000), and Theater BB
values the pair at $14,000 ($10,000 + $4000).values the pair at $14,000 ($10,000 + $4000). Therefore,Therefore,
we can charge each theater $14,000 for the pair of filmswe can charge each theater $14,000 for the pair of films
and earn a total revenue of $28,000.and earn a total revenue of $28,000.
GONE WITH THE WIND
GETTING GERTIE’S
GARTER
TheaterTheater AA $12,000$12,000 $3000$3000
TheaterTheater BB $10,000$10,000 $4000$4000

86. Relative ValuationsRelative Valuations
Why is bundling more profitable than selling the filmsWhy is bundling more profitable than selling the films
separately? Because theseparately? Because the relative valuationsrelative valuations of the twoof the two
films are reversed.films are reversed.
The demands areThe demands are negatively correlatednegatively correlated—the—the customercustomer
willing to pay the most forwilling to pay the most for WindWind is willing to pay theis willing to pay the
least forleast for GertieGertie..
Suppose demands wereSuppose demands were positively correlatedpositively correlated——thatthat is,is,
TheaterTheater AA would pay more forwould pay more for bothboth films:films:
If we bundled the films, the maximum price that couldIf we bundled the films, the maximum price that could
be charged for the package is $13,000, yielding a totalbe charged for the package is $13,000, yielding a total
revenue of $26,000, the same as by renting the filmsrevenue of $26,000, the same as by renting the films
separately.separately.
GONE WITH THE WIND
GETTING GERTIE’S
GARTER
TheaterTheater AA $12,000$12,000 $4000$4000
TheaterTheater BB $10,000$10,000 $3000$3000

87. RESERVATION PRICESRESERVATION PRICES
ReservationReservation
pricesprices rr11 andand rr22
for two goods arefor two goods are
shown for threeshown for three
consumers,consumers,
labeledlabeled AA,, BB, and, and
CC..
ConsumerConsumer AA isis
willing to pay upwilling to pay up
to $3.25 for goodto $3.25 for good
1 and up to $6 for1 and up to $6 for
good 2.good 2.

88. CONSUMPTION DECISIONS WHENCONSUMPTION DECISIONS WHEN
PRODUCTS ARE SOLD SEPARATELYPRODUCTS ARE SOLD SEPARATELY
The reservationThe reservation
prices of consumersprices of consumers
inin region I exceed theregion I exceed the
pricesprices PP11 andand PP22 forfor
the two goods, sothe two goods, so
these consumers buythese consumers buy
both goods.both goods.
Consumers in regionsConsumers in regions
II and IV buy onlyII and IV buy only
one of the goods,one of the goods,
and consumers inand consumers in
region III buyregion III buy
neitherneither good.good.

89. CONSUMPTION DECISIONS WHENCONSUMPTION DECISIONS WHEN
PRODUCTS ARE BUNDLEDPRODUCTS ARE BUNDLED
ConsumersConsumers
compare the sumcompare the sum
of theirof their
reservation pricesreservation prices
rr11 + r+ r22, with the, with the
price of theprice of the
bundlebundle PPBB..
They buy theThey buy the
bundle only ifbundle only if rr11 ++
rr22 is at least asis at least as
large aslarge as PPBB..

90. RESERVATION PRICESRESERVATION PRICES
In (a), because demands are perfectly positivelyIn (a), because demands are perfectly positively
correlated, the firm does not gain by bundling: It wouldcorrelated, the firm does not gain by bundling: It would
earn the same profit by selling the goods separately.earn the same profit by selling the goods separately.
In (b), demands are perfectlyIn (b), demands are perfectly negatively correlated.negatively correlated.
Bundling is the ideal strategyBundling is the ideal strategy—all the consumer—all the consumer
surplus can be extracted.surplus can be extracted.

91. MOVIE EXAMPLEMOVIE EXAMPLE
ConsumersConsumers AA andand BB
are two movieare two movie
theaters. Thetheaters. The
diagram showsdiagram shows
their reservationtheir reservation
prices for the filmsprices for the films
Gone with the WindGone with the Wind
andand GettingGetting
Gertie’s Garter.Gertie’s Garter.
Because theBecause the
demands aredemands are
negativelynegatively
correlated,correlated,
bundling pays.bundling pays.

92. MIXED VERSUS PURE BUNDLINGMIXED VERSUS PURE BUNDLING
Mixed BundlingMixed Bundling
Selling two or more goods both as a package andSelling two or more goods both as a package and
individually.individually.
Pure bundlingPure bundling : Selling products only as a package.: Selling products only as a package.
With positive marginal costs,With positive marginal costs,
mixed bundling may be moremixed bundling may be more
profitable than pure bundling.profitable than pure bundling.
ConsumerConsumer AA has a reservationhas a reservation
price for good 1 that is belowprice for good 1 that is below
marginal costmarginal cost cc11, and consumer, and consumer
DD has a reservation price forhas a reservation price for
good 2 that is below marginalgood 2 that is below marginal
costcost cc22..
With mixed bundling, consumerWith mixed bundling, consumer
AA is induced to buy only good 2,is induced to buy only good 2,
and consumerand consumer DD is induced tois induced to
buy only good 1, thus reducingbuy only good 1, thus reducing
the firm’s cost.the firm’s cost.

93. Let’s compare three strategies:Let’s compare three strategies:
1. Selling the goods separately at prices1. Selling the goods separately at prices PP11 = $50 and= $50 and PP22 =$90.=$90.
2. Selling the goods only as a bundle at a price of $100.2. Selling the goods only as a bundle at a price of $100.
3. Mixed bundling, whereby the goods are offered separately3. Mixed bundling, whereby the goods are offered separately
at pricesat prices PP11 == PP22 = $89.95, or as a bundle at a price of $100.= $89.95, or as a bundle at a price of $100.
TABLE 4 BUNDLING EXAMPLE
PP11 PP22 PP33 PROFITPROFIT
SoldSold
separatelyseparately
$50$50 $90$90 —— $150$150
PurePure
bundlingbundling
—— —— $100$100 $200$200
MixedMixed
bundlingbundling
$89.95$89.95 $89.95$89.95 $100$100 $229.90$229.90
As we should expect,As we should expect, pure bundling is better than sellingpure bundling is better than selling
the goods separately because consumers’ demands arethe goods separately because consumers’ demands are
negatively correlatednegatively correlated. But what about mixed bundling?. But what about mixed bundling?

94. MIXED BUNDLING WITH ZERO MARGINALMIXED BUNDLING WITH ZERO MARGINAL
COSTSCOSTS
If marginal costs are zero, and ifIf marginal costs are zero, and if
consumers’ demandsconsumers’ demands are not perfectlyare not perfectly
negatively correlated, mixednegatively correlated, mixed
bundling is still more profitable thanbundling is still more profitable than
pure bundling.pure bundling.
In this example, consumersIn this example, consumers BB andand CC areare
willing to pay $20 more for the bundlewilling to pay $20 more for the bundle
than are consumersthan are consumers AA andand DD..
With pure bundling, the price of theWith pure bundling, the price of the
bundle is $100. With mixed bundling, thebundle is $100. With mixed bundling, the
price of the bundle can be increased toprice of the bundle can be increased to
$120 and consumers$120 and consumers AA andand DD can still becan still be
charged $90 for a single good.charged $90 for a single good.
TABLE 5 MIXED BUNDLING WITH ZERO MARGINAL COSTS
PP11 PP22 PP33 PROFITPROFIT
SoldSold
separatelyseparately
$80$80 $80$80 —— $320$320
PurePure
bundlingbundling
—— —— $100$100 $400$400
MixedMixed
bundlingbundling
$90$90 $90$90 $120$120 $420$420

95. MIXED BUNDLING INMIXED BUNDLING IN
PRACTICEPRACTICE
The dots in this figure areThe dots in this figure are
estimates of reservation pricesestimates of reservation prices
for a representative sample offor a representative sample of
consumers.consumers.
A company could first choose aA company could first choose a
price for the bundle,price for the bundle, PPBB, such, such
that a diagonal line connectingthat a diagonal line connecting
these prices passes roughlythese prices passes roughly
midway through the dots.midway through the dots.
The company could then tryThe company could then try
individual pricesindividual prices PP11 andand PP22..
GivenGiven PP11,, PP22, and, and PPBB, profits can, profits can
be calculated for this sample ofbe calculated for this sample of
consumers. Managers can thenconsumers. Managers can then
raise or lowerraise or lower PP11,, PP22, and, and PPBB andand
see whether the new pricingsee whether the new pricing
leads to higher profits. Thisleads to higher profits. This
procedure isprocedure is repeated until totalrepeated until total
profit is roughly maximized.profit is roughly maximized.
Bundling in PracticeBundling in Practice

96. THE COMPLETE DINNER VERSUS À LA CARTE:THE COMPLETE DINNER VERSUS À LA CARTE:
A RESTAURANT PRICING PROBLEMA RESTAURANT PRICING PROBLEM
For a restaurant, mixed bundling means offering bothFor a restaurant, mixed bundling means offering both
complete dinners (the appetizer, main course, andcomplete dinners (the appetizer, main course, and
dessert come as a package) and an à la carte menudessert come as a package) and an à la carte menu
(the customer buys the appetizer, main course, and(the customer buys the appetizer, main course, and
dessert separately).dessert separately).
This strategy allows the à la carte menu to be priced toThis strategy allows the à la carte menu to be priced to
capture consumer surplus from customers who valuecapture consumer surplus from customers who value
some dishessome dishes much more highlymuch more highly than others.than others.
At the same time, the complete dinner retains thoseAt the same time, the complete dinner retains those
customers who have lower variations in their reservationcustomers who have lower variations in their reservation
prices for different dishes (e.g., customers who attachprices for different dishes (e.g., customers who attach
moderate values to both appetizers and desserts).moderate values to both appetizers and desserts).

97. THE COMPLETE DINNER VERSUS À LA CARTE:THE COMPLETE DINNER VERSUS À LA CARTE:
A RESTAURANT PRICING PROBLEMA RESTAURANT PRICING PROBLEM
For a restaurant, mixed bundling means offering complete dinners and anFor a restaurant, mixed bundling means offering complete dinners and an àà la carte menu. Thisla carte menu. This
strategy allows the à la carte menu to be priced to capture consumer surplus from customersstrategy allows the à la carte menu to be priced to capture consumer surplus from customers
who value some dishes much more highly than others. Successful restaurateurs know theirwho value some dishes much more highly than others. Successful restaurateurs know their
customers’ demand characteristics and usecustomers’ demand characteristics and use thatthat knowledge to design a pricing strategy thatknowledge to design a pricing strategy that
extracts as much consumer surplus as possible.extracts as much consumer surplus as possible.
TABLE 6TABLE 6 MIXED BUNDLING AT MCDONALD’S (2011)MIXED BUNDLING AT MCDONALD’S (2011)
INDIVIDUAL ITEMINDIVIDUAL ITEM PRICEPRICE
MEAL (INCLUDESMEAL (INCLUDES
SODA AND FRIES)SODA AND FRIES)
UNBUNDLEDUNBUNDLED
PRICEPRICE
PRICE OFPRICE OF
BUNDLEBUNDLE SAVINGSSAVINGS
Chicken SandwichChicken Sandwich $5.49$5.49 Chicken SandwichChicken Sandwich $10.07$10.07 $7.89$7.89 $2.18$2.18
Filet-O-FishFilet-O-Fish $4.39$4.39 Filet-O-FishFilet-O-Fish $8.97$8.97 $6.79$6.79 $2.18$2.18
Big MacBig Mac $4.69$4.69 Big MacBig Mac $9.27$9.27 $6.99$6.99 $2.28$2.28
Quarter PounderQuarter Pounder $4.69$4.69 Quarter PounderQuarter Pounder $9.27$9.27 $7.19$7.19 $2.08$2.08
Double QuarterDouble Quarter
PounderPounder
$6.09$6.09
Double QuarterDouble Quarter
PounderPounder $10.67$10.67 $8.39$8.39 $2.28$2.28
10-piece Chicken10-piece Chicken
McNuggetsMcNuggets
$5.19$5.19
10-piece Chicken10-piece Chicken
McNuggetsMcNuggets $9.77$9.77 $7.59$7.59 $2.18$2.18
Large French FriesLarge French Fries $2.59$2.59
Large SodaLarge Soda $1.99$1.99

98. TyingTying
Practice of requiring a customer to purchase one goodPractice of requiring a customer to purchase one good
in order to purchase another.in order to purchase another.
Why might firms use this kind of pricingWhy might firms use this kind of pricing
practice?practice?
1.1.One of the main benefits of tying is that itOne of the main benefits of tying is that it
often allows a firm tooften allows a firm to meter demandmeter demand andand
thereby practice price discrimination morethereby practice price discrimination more
effectively.effectively.
2.2.Tying can also be used to extend a firm’sTying can also be used to extend a firm’s
market power.market power.
3.3.Tying can have other uses. An important oneTying can have other uses. An important one
is to protect customer goodwill connected withis to protect customer goodwill connected with
aa brand namebrand name. This is why. This is why franchisesfranchises are oftenare often
required to purchase inputs from therequired to purchase inputs from the
franchiser.franchiser.

99. EFFECTS OFEFFECTS OF
ADVERTISINGADVERTISING
AdvertisingAdvertising
AR and MR are average andAR and MR are average and
marginal revenue when themarginal revenue when the
firm doesn’t advertise,firm doesn’t advertise,
and AC and MC are averageand AC and MC are average
and marginal cost.and marginal cost.
The firm producesThe firm produces QQ00 andand
receives a pricereceives a price PP00..
Its total profitIts total profit ππ00 is given byis given by
the gray-shaded rectangle.the gray-shaded rectangle.
If the firm advertises, itsIf the firm advertises, its
average and marginal revenueaverage and marginal revenue
curves shift to the right.curves shift to the right.
Average cost rises (to AC′)Average cost rises (to AC′)
but marginal cost remains thebut marginal cost remains the
same.same.
The firm now producesThe firm now produces QQ11
(where MR′ = MC), and(where MR′ = MC), and
receives a pricereceives a price PP11..
Its total profit,Its total profit, ππ11, is now, is now
larger.larger.

100. The priceThe price PP and advertising expenditureand advertising expenditure AA toto
maximize profit, is given by:maximize profit, is given by:
The firm should advertise up to the point thatThe firm should advertise up to the point that
== fullfull marginal cost of advertisingmarginal cost of advertising
Advertising leads to increased output.Advertising leads to increased output.
But increased output in turn means increasedBut increased output in turn means increased
production costs, and this must be taken into accountproduction costs, and this must be taken into account
when comparing the costs and benefits of an extrawhen comparing the costs and benefits of an extra
dollar of advertising.dollar of advertising.

101. First, rewrite equation as follows:First, rewrite equation as follows:
Now multiply both sides of this equation byNow multiply both sides of this equation by
AA//PQPQ, the advertising-to-sales ratio., the advertising-to-sales ratio.
Advertising-to-sales ratioAdvertising-to-sales ratio
Ratio of a firm’s advertising expenditures to its sales.Ratio of a firm’s advertising expenditures to its sales.
Advertising elasticity of demandAdvertising elasticity of demand
Percentage change in quantity demanded resulting from a 1-percentPercentage change in quantity demanded resulting from a 1-percent
increase in advertising expenditures.increase in advertising expenditures.
A Rule of Thumb for AdvertisingA Rule of Thumb for Advertising

102. ADVERTISING IN PRACTICEADVERTISING IN PRACTICE
Convenience stores have lower price elasticities ofConvenience stores have lower price elasticities of
demand (around −5), but their advertising-to-salesdemand (around −5), but their advertising-to-sales
ratios are usually less than those for supermarketsratios are usually less than those for supermarkets
(and are often zero).(and are often zero). Why?Why?
Because convenience stores mostly serve customersBecause convenience stores mostly serve customers
who live nearby; they may need a few items late at nightwho live nearby; they may need a few items late at night
or may simply not want to drive to the supermarket.or may simply not want to drive to the supermarket.
Advertising is quite important for makers of designerAdvertising is quite important for makers of designer
jeans, who will havejeans, who will have advertising-to-sales ratios asadvertising-to-sales ratios as
high as 10 or 20 percent.high as 10 or 20 percent.
Laundry detergentsLaundry detergents have among the highest advertising-have among the highest advertising-
to-sales ratios of all products, sometimesto-sales ratios of all products, sometimes exceeding 30exceeding 30
percentpercent, even though demand for any one brand is at, even though demand for any one brand is at
least as price elastic as it is for designer jeans. Whatleast as price elastic as it is for designer jeans. What
justifies all the advertising? A very large advertisingjustifies all the advertising? A very large advertising
elasticity.elasticity.

103. ADVERTISING IN PRACTICEADVERTISING IN PRACTICE
TABLE 7TABLE 7 SALES AND ADVERTISINGSALES AND ADVERTISING
EXPENDITURES FOR LEADING BRANDSEXPENDITURES FOR LEADING BRANDS
OF OVER-THE-COUNTER DRUGS (INOF OVER-THE-COUNTER DRUGS (IN
MILLIONS OF DOLLARS)MILLIONS OF DOLLARS)
SALESSALES ADVERTISINGADVERTISING
RATIORATIO
(%)(%)
PainPain
MedicationsMedications
TylenolTylenol 855855 143.8143.8 1717
AdvilAdvil 360360 91.791.7 2626
BayerBayer 170170 43.843.8 2626
ExcedrinExcedrin 130130 26.726.7 2121
AntacidsAntacids
Alka-SeltzerAlka-Seltzer 160160 52.252.2 3333
MylantaMylanta 135135 32.832.8 2424
TumsTums 135135 27.627.6 2020

104. ADVERTISING IN PRACTICEADVERTISING IN PRACTICE
TABLE
11.4
SALES AND ADVERTISING
EXPENDITURES FOR LEADING BRANDS
OF OVER-THE-COUNTER DRUGS (IN
MILLIONS OF DOLLARS) (continued)
SALESSALES ADVERTISINGADVERTISING
RATIORATIO
(%)(%)
Cold Remedies (decongestants)Cold Remedies (decongestants)
BenadrylBenadryl 130130 30.930.9 2424
SudafedSudafed 115115 28.628.6 2525
CoughCough
MedicineMedicine
VicksVicks 350350 26.626.6 88
RobitussinRobitussin 205205 37.737.7 1919
HallsHalls 130130 17.417.4 1313
TABLE 7TABLE 7 SALES AND ADVERTISINGSALES AND ADVERTISING
EXPENDITURES FOR LEADING BRANDSEXPENDITURES FOR LEADING BRANDS
OF OVER-THE-COUNTER DRUGS (INOF OVER-THE-COUNTER DRUGS (IN
MILLIONS OF DOLLARS)MILLIONS OF DOLLARS) (continued)(continued)

105. ConclusionConclusion
““It is in rare moments that I seeIt is in rare moments that I see
my business clearly … why do Imy business clearly … why do I
still lie awake at night? I’mstill lie awake at night? I’m
trying to figure the damntrying to figure the damn
strategies of my competitors!”strategies of my competitors!”
A ManagerA Manager

106. Core ReadingCore Reading
• Keat, Paul G. and Young, Philip KY (2009)
Managerial Economics, 6th
edition, Pearson
• Samuelson, William F. and Marks, Stephen G.
(2010) Managerial Economics, 6th
edition, John
Wiley
• Pindyck, Robert S. and Rubinfeld, Daniel L.(2013)
Microeconomics, 8th
edition, Pearson
• Samuelson, P.A. and Nordhaus, W. D.Samuelson, P.A. and Nordhaus, W. D.
(2010)(2010)“Economics”“Economics” Irwin/McGraw-Hill, 19Irwin/McGraw-Hill, 19thth
EditionEdition
• Porter, Michael E. (2004)Porter, Michael E. (2004)“Competitive Strategy –“Competitive Strategy –
Techniques for Analyzing Industries and Competitors”Techniques for Analyzing Industries and Competitors”
Free PressFree Press

107. Questions?Questions?