Microeconomics Revision Essay (2): Pricing Power and Discrimination (a) (b) Explain the factors that affect the pricing power of producers within a particular market or industry To what extent does price discrimination by suppliers in many industries lead to an improvement in economic efficiency and welfare? 20 marks 30 marks Part (a) Factors that affect the pricing power of producers within a market or industry Define your terms what do we mean by pricing power? The ability to set price above average total cost? The ability to charge different prices to different groups of consumers (price discrimination)? The discretion to set prices independently of other suppliers in the market? Many factors can influence pricing power in part (a) the examiners are looking for clear explanations of a range of these factors (you do not have to include them all) Some link back to market structure is needed as if are references to the importance of price elasticity of demand and a distinction between short run and long run changes in the market. The examiners will also reward some reference to the limits on pricing power imposed by regulatory authorities (i.e. using examples drawn from the UK utilities sector) Pricing power and market structure Firms operating in perfectly competitive markets are assumed to be price-takers i.e. they take the ruling market price. Reasons: suppliers in perfectly competitive markets are assumed to be producing homogeneous products that are perfect substitutes for each other and no one firm has sufficient market share to be able to influence the market price through its own supply decisions. In the long run, prices are determined by changes in market demand and supply in the short run, firms can be making any level of profit (normal, subnormal, supernormal) but in the long run, the market will adjust towards equilibrium where firms make normal profit. Page 1
Industry Individual firm Ms MC AR=MR P1 AC Md Industry Output Q1 Firm s Output Under conditions of oligopoly, individual firms do have some discretionary power over pricing but the nature of an oligopoly is that firms must take into account the likely reactions of other suppliers to changes in their prices i.e. there is interdependent decision-making within an oligopoly. Some firms may have price-leadership power. leadership: The setting of the price of a product by a dominant firm in an industry in the knowledge that competitors will follow this lead in order to avoid the high cost of a price war. As the price leader is as anxious as the other members of the industry to achieve a stable market, it is in their interest to set the price at a sensible level; a price leader who fails to do so will soon be replaced as leader by another member of the group Clearly, under conditions of pure or working monopoly, individual businesses have a greater degree of pricing power. In a pure monopoly, the firm is the industry and in theory, the only constraint on a monopolist s pricing power is the level of and price elasticity of demand for the products they are selling. In other words, the consumers willingness and ability to pay for a good or service acts as the main limitation on short and long run pricing power. Much depends on the contestability of the market. It is perfectly possible for a supplier to have monopoly power in the market, but for the market to be contestable (i.e. there is a genuine threat of new competition because the entry and exit costs are relatively low should the existing firm become inefficient or exploit/abuse their monopoly position) The Importance of Elasticity of Demand This needs to be stressed in your answer. The nature of the demand for the good or service determines its elasticity for example, the degree of necessity or luxury, the availability of close substitutes in the market-place, the percentage of consumer income allocated to the product, and the cost of substitution between alternative products. Page 2
When demand is price elastic, consumers respond more than proportionately to a change in price and this limits the ability of the supplier to charge high prices. Conversely when demand is inelastic, the producer may be able to exploit this by raising price, extracting some of the consumer surplus from buyers and increasing his total revenue / profit. The Importance of Regulation In many industries, some form of regulatory scrutiny takes places. And, in the United Kingdom, the regulatory agencies have often imposed some form of price-capping system designed to limit the monopoly pricing power of suppliers. Good examples can be drawn from telecommunications and electricity and gas generation. In order to improve profitability when average prices must fall in real terms each year, these industries have had to achieve significant improvements in productivity leading to lower average costs. The Importance of International Competition Many suppliers are constrained in their pricing behaviour by intense competition from overseas suppliers particularly when the exchange rate is strong leading to a surge in demand for relatively cheaper products from abroad. The response of domestic firms is often to cut prices and profit margins in order to maintain market share. So, although a domestic firm may enjoy a dominant market position viz other home suppliers, the presence of international competition acts as a major check and balance on their pricing power. (b) To what extent does price discrimination by suppliers in many industries lead to an improvement in economic efficiency and welfare? 30 marks discrimination occurs when a firm charges a different price to different groups of consumers for an identical good or service, for reasons not associated with the costs. Allocative efficiency occurs when the value consumers place on a good (reflected in the price people are willing and able to pay) equals the cost of the resources used up in production. The condition required is that price = marginal cost. Productive efficiency refers to a firm's costs of production and can be applied both to the short and long run. It is achieved when the output is produced at minimum average total cost (AC). There are several conditions required for price discrimination to work There must be a different price elasticity of demand from each group of consumers. The firm will then charge a higher price to the group with a more inelastic demand and a lower price to the group with a more elastic demand. The firm must be able to prevent market seepage - where consumers who purchase a good or service at a lower price resell it to those consumers who would have paid the higher price. The costs of separating a market and then selling to different consumers are not prohibitive. The monopolist must have control over the sale of the product with some price setting power. There are different types of price discrimination these should be mentioned briefly before developing the analysis and evaluation (e.g. 1 st, 2 nd and 3 rd degree discrimination) with relevant examples drawn from real-world markets. 3 rd degree discrimination is shown below. Stress the Page 3
importance of price elasticity of demand this affects the amount of consumer surplus that can be extracted by discriminatory pricing. Market A Market B Profit from selling to market A relatively elastic demand lower price Pb Profit from selling to market B relatively inelastic demand higher market price Pa MC=AC ARa MRa MRb ARb Evaluation The case for and against price discrimination must be considered to gain high marks for evaluation: (1) Consumer surplus is reduced in most cases - representing a loss of consumer welfare. For the majority of consumers, the price charged is significantly above the marginal cost of supply examples to draw on might include the extremely high prices for airline travel charged to business class users (well in excess of the extra costs of production) However some consumers who can buy the product at a lower price may benefit. Previously they may have been excluded from consuming it. Low-income consumers may be priced into the market if the supplier is willing and able to charge them a lower price. (2) Producer profits: discrimination is clearly in the interests of firms who achieve higher profits. A discriminating monopoly is extracting consumer surplus and turning it into extra super normal profit The profits made in one market may allow firms to cross-subsidise loss-making activities/services that have social benefits (positive externalities). For example profits made on commuter rail or bus services may allow transport companies to support loss making rural or night-time services. Without the ability to price discriminate these services may have to be with drawn because they cannot generate a sufficiently high rate of return. The premium prices paid by business purchases of software licences might allow a software company to offer educational users a lower-price for similar or identical products Page 4
Pmon AC = MC MR AR= market demand Qm Qe Normal profit maximising price and output is P1 and Q1 (where marginal revenue meets marginal cost) With perfect price discrimination, output may rise to Qe where marginal cost meets the demand curve Overall, price discrimination reinforces the market power of producers and can lead to a loss of allocative efficiency. But there are potential gains in welfare for some groups of consumers who might not otherwise have consumed a good or service. With perfect price discrimination, the final output by a monopolist may rise to Qe (the equilibrium output we would expect under competitive market conditions) Page 5