The Stackelberg Leader Follower Model

The Stackelberg Leader –Follower Model

In this model of oligopoly, firms set output, and one firm acts before the others. The leader firm picks its output level and then the other firms are free to choose their optimal quantities given their knowledge of the leader’s output. In some industries, historical, institutional, or legal factors determine which firm is the first mover. For example, the firm that discovers and develops a new product has a natural first mover advantage. ( See also the modified behavioural models)

In terms of equilibrium, the Stackelberg leader produces more output and the follower less output than would a Cournot firm. (The Stackelberg equilibrium because the leader acts first and the follower knows for certain its rivals output. That is, the leader’s claim that it will produce a large quantity is credible because it has already done so. Total Stackelberg output is greater than the Cournot output but less than the social optimum (competitive equilibrium) output. The Stackelberg price is higher than the competitive price, but lower than the Cournot price. As a result, consumer surplus is higher with a Stackelberg duopoly, than with a Cournot duopoly, but lower than the social optimum. Total industry profits under Stackelberg are less than combined profits in the Cournot or collusive equilibria.

Comparison of the major oligopoly models

The three major non-cooperative models make different assumptions about whether firms choose output or price and whether the firms choose simultaneously or sequentially. As a result, they predict very different firm and industry outputs, prices, profits and consumer surpluses in equilibrium. If there is only one firm, all three models predict monopoly behaviour. The more firms, n, in the industry the closer the Cournot and Stackelberg equilibria to the social optimum or competitive equilibrium. The Bertrand equilibrium with homogeneous goods , however is unaffected by the number of firms in the industry, as long as it includes at least two firms with unlimited capacity. The Bertrand oligopoly equilibrium is the same as the social optimum. With heterogeneous goods, the Bertrand equilibrium differs from the competitive equilibrium and the number of firms in the industry affects prices.

The Cournot, Bertrand and Stackelberg models can be interpreted as conjectural variations models rather than as game theory models. In each model, firms control only quantity or price. (firms form expectations about the reactions (or variations) of other firms and this is called conjectural variations. In the Cournot model, each firm’s conjecture is that other firms are satisfied to continue producing (selling) their current quantity of output.

In the Stackelberg follower firms make the Cournot conjecture. The Stackelberg leader takes those conjectures into account in making its decisions. In the Bertrand model, each firm makes the conjecture that its rivals will not change their price in response to a change in its own price.

1 Cartel arrangements The cartel is an explicit agreement between the oligopoly firms. Cartel agreements represent the most complete form of collusion among the oligopolists. Cartel type collusions are formed with a view to (1) eliminating uncertainty surrounding the market and (2) restraining competition and thereby ensuring monopoly gains to the cartel group. The board of control first calculates the MC and MR for the industry; MC for industry is the summation of MCs of individual firms. On the basis of industry’s MR and MC, the total output for the industry is determined. The total output is then allocated between the member firms on the basis of their own MC.(see diagram below). The total profit may be different , but there will be no motivation to change in price –quantity combination, since their individual profits are maximum. There are two types of cartel: the centralized cartel and the market sharing cartel. As the name implies, the market sharing cartel gives each member the exclusive right to operate in a particular geographical area. The most well known type of cartel is the centralized cartel. This is a formal agreement among the oligopolistic producers of a product to set the monopoly price, allocate output among its members, and determine how profits are to be shared.

Firm 1 Firm 2 Industry (cartel)

MC1 MC2

8 ATC1

ATC2 ∑MC

E1 E 2 E

2 0 20 Q 1 0 30 Q 2 0 50 Q

In the oligopoly models described previously there is no collusion. Collusion can be overt or explicit as in centralised and market sharing cartels, or tacit or implicit as in price leadership models. IATA is an example of a cartel as is OPEC.

Cartel Types

Two types:

(a) Market sharing – each member is given the exclusive right to operate in a particular geographical area. and

(b) Centralized cartel- this is the most well-known type. It is a formal agreement among the oligopolistic producers of a product to set the monopoly price, allocate output among its members and determine how profits are to be shared. From the diagram above ∑MC is the MC curve for the entire cartel and is obtained by summing horizontally the MC curves of the two firms. The centralised cartel will sell at P=$8 and sell Q=50 units given at point E at which MC intersects MR curve of the cartel. To minimise production costs, the centralised authority will have to allocate 20 units of output to firm 1 and 30 units of output to firm 2

given respectively by point E1 at which MC1 =MR and by point E2 at which MC2 = MR. If

MC1>MC2 at the point of production, the total costs of the cartel as a whole can be reduced

by shifting production from firm 1 to firm 2 until MC 1 = MC2. The result would be the same for a multiplant monopolist operating plants 1 and 2. Firm 1 however may demand a more equitable share of profits under the threat of withdrawing from the carte, and herein lies an important weakness of most cartels and the reason for their failure. Cartel members also have a strong incentive to cheat by selling more than their quota.

One way of making necessary adjustments in oligopolistic markets without fear of starting a price war and without overt collusion is by price leadership. With price leadership, the firm that is recognized as the price leader initiates a price change and then the other firms in the industry quickly follow.

The market- sharing cartel

Suppose that the market demand function for a 2-firm equal –market-sharing cartel is Q=120-10P and that the total cost function of duopolist 1 is TC’=0.1Q2

The half –share market faced by each duopolist is then Q’=60-5P or P’=12-0.2Q so that TR’=P’Q’=(12-0.2Q’)Q’=12Q’-0.2Q’2 and MR’=

The marginal and average total cost of each duopolist is and

3 Setting MC’ equal to MR’, we get 0.2Q’=12-0.4Q’ and P’=12-0.2(20)=$8

Therefore TR’=12(20)-0.2(20)2 =240-80=$160 and

The centralized Cartel model Suppose that a two firm cartel faces the following demand function: Q=120-10P or P=12-0.1Q and the total cost function of each member firm is respectively, and

We can calculate MR, MC1, and MC2 as follows:

In order to add MC1 and MC2 horizontally to find , we solve for Q1 and Q2 and get

Q1=-20+5MC1 and Q2=-10+5MC2 so that Solving for , we have (Strictly speaking this is the average function ). Setting =MR, we get so that Then At Q=30;

Setting MC1 and MC2 equal to MR, we have 4+0.2Q1=6 so that Q1=10 and 2+0.2Q2=6 so thatQ2=20 and Q=Q1+Q2=10+20=30 Therefore and

Instability of cartels

The more the membership , the greater the difficulty of keeping a stable cartel. A firm that secretly cheats (‘chiseling’) can increase its profits as long as other firms do not do the same thing and as long as the cartel does not punish it in some way. If all firms do this the cartel breaks down. Price concessions made secretly by a few chiselers cut into the sales of the cooperative members, thus breaking down the cartel completely.

MODIFIED BEHAVIOURAL PRICING MODELS These are models which incorporate one or more of the appropriate behavioral assumptions (profit maximizing) It looks at several more complex models of pricing behaviour in imperfectly competitive markets. They include: (a) Price Leadership models- these are mostly under oligopoly where there is upward adjustment of prices. One firm leads the way and will be followed within a relatively short period by all or most of the other firms adjusting their prices to a similar degree. The leader is a firm willing to take the risk of being the first to adjust price, and usually has good reason to expect that other firms will follow suit. The risk here is if the firm raises price and is not followed by other firms, it will experience an elastic demand response and lose profits. Price leadership is possible under both product homogeneity and product differentiation; where there is a small number of firms; restricted entry; inelastic demand for industry and firms have almost similar cost curves. (1) Barometric Price Leader- the leader possesses an ability to accurately predict when climate is right for a price change e.g. following a generalized increase in labour or materials costs, or a period of increased demand, the barometric firm judges that all firms are ready for a price change and takes the risk of sales losses by being the first

4 to adjust its price. If the other firms trust the firm’s judgement they adjust prices to the extent or if they do not they may adjust to a lesser degree, the leader reviewing the price to that level. It does not have to be the same firm functioning as leader always. (2) Low Cost Price Leadership- is a firm that has a significant cost advantage over its rivals and inherits the role of price leader largely due to the other firms’ reluctance to incur the wrath of the lower cost firm. In the event of a price war, the other firms would incur greater losses and be more prone to the risk of bankruptcy than would be the lower cost firm. (3) Dominant Firm Price Leadership- the dominant firm is large relative to its rivals and its market. It is large and has several smaller firms competing with it in the industry. Large firm may have achieved its position by being the first seller in the industry, because it has lower costs resulting from scale economies, or by virtue of superior management skill. If the small firms in an industry look to the dominant firm to establish price, they can be viewed as price takers. As such their behaviour is similar to firms in perfect competition. If they can sell all they produce at the market price, they maximise profit by producing until P=MC. Total output supplied by all the small firms is the sum of their marginal cost curves in the diagram The smaller firms accept the firm’s price leadership perhaps simply because they are unwilling to risk being the first to change prices or perhaps out of fear that the dominant firm could drive them out of business, by forcing raw materials suppliers to boycott a particular small firm on pain of losing the order of the larger firm for example. In such a situation the smaller firms accept the dominant firm’s choice of the price level and simply adjust output to maximize their profits. They are more like pure competitors. Knowing how much the smaller firms will supply at each price level, the dominant firm can subtract this from the market demand to find how much demand is left over at each price level. The dominant firm will choose the price level in order to maximize its own profits from this assured or residual demand.

If the dominant firm is content to set a price and let its small rivals supply as much as they want, the large firms can be thought of as supplying the residual demand.

Price DT Cost

per unit DL

5 O Q L Q T Quantity per period

If the dominant firm is content to set a price and let its small rivals supply as much as they want, the large firm can be thought of as supplying the residual demand. The leader’s

demand curve is DLDL. Total demand is DTDT. MCL is dominant firm’s MC while MRL is

dominant firm’s MR. If price is set at Po, the small firms will meet total market demand and the dominant firm will have no sales because there is no residual demand. So prices will be

set below Po. The demand curve faced the industry leader can easily be determined for any

price level (it is the horizontal distance between DTDT and ) Output for the price leader is QL.

Output of small firms is QT-QL.

6 PRICING STRATEGIES: PRICING MODELS

Predatory, skimming and sealed Bid Pricing, Modified behavioural models.

PRICING ANALYSIS AND DECISIONS Price is the amount of money paid for a unit or quantity of the good or service under consideration. A “package” of other services goes with the physical commodity and include time and place of delivery, time payment is expected by the seller, cash and quantity discounts, guarantees that go with the product, or any rights of return of goods.

The setting of prices involves three areas of information- costs, competition and consumer demand. Costs information is derived from internal sources whereas information on competition and consumer demand involves the external environment. In any business a great deal of information is potentially available about its external environment from the operations of its own staff.

PRICING STRATEGIES This is the task of defining the initial price range and planned price movement through time that the company will use to achieve its marketing objectives in the target market. 1. COST ORIENTED PRICING STRATEGIES

(a) Mark up pricing or cost plus pricing- also called Average Cost pricing or full cost pricing. It is the most common method of pricing a product by manufacturing firms. The term cost plus is often used to describe the pricing of jobs that are non-routine and difficult to “cost” in advance, such as construction and military weapon development. Under the cost plus pricing, the firm calculates or estimates its AVC , and then sets its price by adding on a percentage mark-up that includes a contribution towards the firm’s fixed costs, and a profit margin. The general practice under the mark-up pricing method is to add a fair percentage of profit margin to the AVC. The price is set as:

P= AVC+ x% (of AVC) where x is the mark-up percentage chosen. Or

P=AVC + AVC x (m) = (1+m)AVC or (1+m)C where m is the mark-up percentage fixed so as to cover AFC and net profit margin. The size of mark up depends on the willingness of consumers to pay the maximizing and this level varies inversely with the value of price elasticity. Products with higher price elasticities of demand should be expected to have relatively lower percentage mark ups in order to make the maximum total contribution to overheads and profits. Firms find their “best” mark up by trial and error or by adopting the same mark up that is applied by other firms or by the price leader in the industry.

Firms usually apply higher mark-ups to products facing less elastic demand than to products with more elastic demand. It can also be shown that cost-plus pricing leads to approximately the profit – maximising price. If we take where Ep is the price elasticity of demand. Solving for P we get .Since profits are maximised where MR=MC, we can substitute MC for MR in the above equation and get . If the firm’s MC is constant and equal to C we can get . We can then set P =(1+m)C or 1+m. Thus we get . From this if Ep=-1.5, m=2, or 200%; if Ep=-2, m=1 or 100%. It can then be concluded that the

7 optimal mark-up is lower the greater is the price elasticity of demand of the product. Firms in practice have been found to apply a higher mark-up to products with inelastic demand than to products with elastic demand, and when increased competition has increased the price elasticity of demand, they have been found to reduce their mark-up. It can thus be concluded that cost-plus pricing does lead to approximately profit-maximizing prices. In a world of inadequate and imprecise data on demand and costs, firms may simply utilize cost-plus pricing as the rule-of-thumb method for determining the profit-maximising prices.

The advantages of mark-up pricing are:

(i) by pinning the price to unit costs, sellers simplify their own pricing task considerably and they do not have to make frequent adjustments as demand conditions change. (ii) There is also generally less uncertainty about costs than about demand. (iii) It requires less information and less precise data than in MC=MR case. (iv) It results in stable prices when costs do not vary much. (v) It provides a justification for price increases when costs rise. (vi) It is easy and simple to use (may be misleading since difficulty of projecting TVCs and overheads allocation).

Limitations (i) Assumes firm’s resources are optimally allocated and the standard cost of production is comparable with the average for the industry. (ii) Uses historical cost rather than current cost data- this may lead to underpricing under increasing cost conditions and to overpricing under decreasing cost conditions. (iii) If VC fluctuates frequently and significantly, cost plus pricing may not be an appropriate method of pricing. (iv) It is “alleged” that cost plus pricing ignores the demand side of the market and is solely based on supply conditions (“alleged” because firms determine the markup on the basis of what the market can bear.).

(b) Marginalist Pricing .There are three main ways of practicing marginalist pricing under uncertainty:

(i) Given estimated demand and MC curves. MR has the same intercept value and twice the slope value as compared with the demand curve and thus we can quickly derive an estimate of MR. Setting the expression for MR equal to that of MC, we can solve for the quantity level that preserves the equality. This method of price determination involves inserting the result back into the demand curve to give us the price that will maximize contribution and hence profit.

(ii) Given estimated price elasticity and MC- involves using the elasticity value and the current price and output levels to find an expression for the demand curve and then proceed to equate estimated marginal revenue and marginal cost.

(iii) Given estimates of incremental costs and revenues- is a marginalist approach since it is concerned with changes in both total revenues and total costs. Where demand contains indivisibilities or discontinuities we cannot construct the marginal revenue function, since the total revenue curve is not continuous and therefore is

8 not differentiable. Instead we must compare the incremental costs and incremental revenue at each price level and choose the price that allows the maximum contribution to be made.

(c) Target Pricing- also cost oriented pricing approach in which the firm, tries to determine the price that would give it a specified target rate of return on its total costs at an estimated standard volume e.g. pricing of good X so as to achieve an average rate of return of 15 to 20% on a firm’s investment. The breakeven chart can be used to illustrate target pricing. The total cost curve (TC) and total revenue (TR) curve have to be worked out. Target pricing has a major conceptual flaw- the company uses an estimate of sales volume to derive the price but price is a factor that influences the sales volume.

2. DEMAND ORIENTED PRICING STRATEGIES This calls for setting a price based on consumer perceptions and demand intensity rather than on cost. (a) Perceived value pricing or prestige pricing-deliberately setting high prices to attract prestige-oriented consumers (goods have a snob appeal. An increasing number of companies are basing their price on the product’s perceived value. They see the buyers’ perception of value as the key to pricing. Price is set to capture the perceived value. A company develops a product for a particular target market with a particular market positioning in mind with respect to price, quality and service. Market research has to be carried out to establish the market’s perceptions. (b) Demand Differential pricing- is another of demand oriented pricing. It is also called price discrimination. It takes many forms (i) Customer basis- different customers pay different amounts for same product/service. (ii) Product form basis- different versions of the product are priced differently but not proportionately to their respective marginal costs. (iii) Place basis- different locations are priced differently although there is no difference in MC. (iv) Time basis- different prices charged seasonally by the day, by the hour, etc. For effectiveness the market must be segmentable and have different demand elasticities, no resale to segment paying the higher price. The cost of segmenting and policing the market should not exceed the extra revenue derived from price discrimination the practice should not breed customer resentment and turning away.

Price discrimination types There are three types First degree Discrimination – involves charging the maximum possible price for each unit of output. It involves making the price per unit of output depend on the identity of the purchaser and on the number of units purchased. Thus the consumer who attaches the greatest value to the product is identified and charged a price of P1 (this being individual 1’s reservation price) Similarly, the consumers willing to pay P2 for the second unit (this being individual 2’s reservation price) and P3 for the third are identified and required to pay P2 and P3 respectively. each customer is being charged different prices. Each unit of product is charged separately. All consumer surplus is extracted.

9 First degree Second Degree

P1---- P1

P2 ------P2

P3------

Pc MC=AC P3

Q1 Q2 Q3 QD O Q1 Q2 Q3

With first degree price discrimination , the profit maximising output rate is where the MC and Demand curves intersect. Any sale in excess of QD would reduce profits because price would have been less than MC. First degree Price discrimination is uncommon because it requires that the seller have complete knowledge of the market demand curve and also of willingness of individuals to pay for the product, In addition the market must be segmentable and also that resale is not possible.

Second degree price discrimination- this involves pricing based on the quantities of output purchased by individual consumers.. That is it involves making the price per unit of output depend on the number of units purchased. The monopolist designs a menu of prices and quantities (or use rates of quantities purchased) such that each consumer chooses a price –quantity combination that allows the monopolist to discriminate profitably between consumers. The price does not depend on the identity of the purchaser. It involves charging uniform prices per unit for a specific quantity or block of the product sold to each customer, a lower price per unit for an additional batch or block of the product and so on.. This is easy where there are meters as in electricity and water. Another version is discriminating among groups of buyers on a time or urgency basis. This probably applies to new products. For example first 10 units at 15cents, next 20 units at 10 cents and all additional at 5cents each. In other words blocks are charged at different prices. Examples include the charging of electricity, whereby there is a two-part tariff, requiring the payment of a fixed fee if the consumer wishes to make any purchases at all, plus an additional uniform price per unit purchased. It also involves charging different prices in two or more different markets at the same point in time (until MR of the last unit of product sold in each market equals the MC of producing the product). This implies that MR1=MR2=MC. The market is segmentable e.g. student versus nonstudent.

Third Degree price discrimination - most common. The price per unit depends on the identity of the purchaser. The price does not depend on the number of units purchased. Involves separating consumers or markets in terms of their price elasticity of demand. The monopolist charges a relatively high price to consumers whose demand is price inelastic, and a relatively low price to consumers whose demand is price elastic. Segmentation can be based on several factors e.g. geographical location (selling of books outside US at lower prices), telephone users may be residential or commercial (nature of use), usage of electricity ( industrial or residential) or during certain times), can be according to age (personal characteristics).

Forms of price discrimination used in practice These include:

10  Intertemporal price discrimination, whereby the supplier segments the market by the point in time at which the product is purchased.  Branding, whereby different prices are charged for similar or identical goods differentiated solely by a brand label.  Loyalty discounts for regular customers.  Coupons that provide price discounts discriminate between consumers on the basis of willingness to make the effort to claim the discount.  Stock clearance sales involving successive price reductions are a form of intertermporal price discrimination.  Free-on-board pricing involving the producer or distributor absorbing transport costs, and representing a form of price discrimination favouring buyers in locations where transport costs are higher.

3. COMPETITION ORIENTED PRICING This is when a company sets its price chiefly on the basis of what its competitors are charging. It is not necessary to charge the same price as the competition. The firm may seek to keep its prices lower or higher than the competition by a certain percentage. The distinguishing characteristic is that it does not seek to maintain a rigid relation between its price and its own costs or demand. Conversely the same firm will change its price when competitors change theirs, even if its costs or demand have remained constant. Going rate pricing- the firm tries to keep its price at the average level charged by the industry. The pricing primarily characterizes pricing practice in homogeneous product markets, although the market structure itself may vary from pure competition to pure oligopoly.

Bidding Sealed Bid pricing- also called competitive tendering or competitive bidding. In this there is only one buyer in the market whose requirements are individual to himself. In other words a number of sellers compete for the business of a single buyer. Confronting him is a number of suppliers each of whom is capable of doing the work e.g. building a ship, an office block, or building a nuclear power station. The buyer, wishing to secure the benefits of competition, puts his contract up for tender. It may be open to all comers or may be restricted to a select group which the buyer judges to have the competence and resources to undertake the work successfully. Normally the contract will go to the bidder quoting the lowest price but, with a view to protecting his own interest, the buyer will usually reserve the right to accept any tender – or none. Competitive bids may also occur where Services of a product may not be identical hence combination of price and quality also matter. Examples are in the service sector. all bidders have to submit their bid in a sealed envelope at the same time. The most striking difference with open auction is that you do not learn about the private information of the other bidders during the auction process. In sealed bid auctions, the private valuations of all players remain unobservable. In situations of uncertainty regarding the true value of the auctioned object, all private valuations must be based on estimates.

Normally buyer has budgeted expenditure whilst bidders do not know of it. Too low a price leads to loss or loss of tender. Too high a price may be rejected If you are the winner, there may be good news and bad news in the outcome. The good news is that you have got the deal. The bad news may be that you have based your calculations on the most optimistic calculations of all competitors. This is called the winner’s curse in game theory. A firm can thus win a tender but may incur losses due to rising costs- and end up with the ‘winner’s curse’.

11 Types of sealed Bids There are three types of bids (1) Fixed price bids. (2) Cost plus fee bids. (3) Incentive bids.

Fixed Price Bids This is when suppliers tender for a price bid regardless of variation of costs. Supplier tenders a bid price or price quote and undertakes to complete the job for that price regardless of any variation of costs from expected levels. where is the bid price; is target profit and is supplier’s target cost. The actual profit=+ () where is actual cost. (NB. If Ct > Ca falls)

Cost Plus Fee Bids In these the entire risk is borne by the buyer who agrees to meet the actual cost plus what supplier stated was their profit. where is the bid price. (NB. is the fee)The buyer expects to audit the costs. The contract is unfair to the buyer because of the problems of conducting the audit. Incentive Bids- These are also called risk sharing bids. The buyer and seller (supplier) agree before hand on a bid price but agree to share any deviation from expected costs level in a given way. More formally mathematically if = supplier’s share of cost variation where 0<<1 then For the buyer is the bid price , is supplier’s target cost, is target profit. For the Seller =+ (). If =1 then and this becomes fixed price bids. All risk goes to the seller. =+ . On the other hand if =0, . In this case the buyer is bearing the burden. =. This is the cost plus fee bid. All risk goes to the buyer.

Auctions There are four basic auction formats. 1. English Auction- also called the ascending bid auction and involves the price being set initially at a very low level which many bidders would be prepared to pay, and then raised successively until a level is reached which only one bidder is willing to pay. The last remaining bidder secures the item at the final price and the auction stops.

2. The Dutch auction- also known as the descending bid auction, is the exact opposite of the English. Price is set initially at a very high level which no bidder would be prepared to pay, and is then lowered successively until a level is reached which one bidder is prepared to pay. The first bidder who is prepared to match the current price secures the item at that price, and the auction stops.. normally used to sell agricultural produce.

3. First price sealed bid auction- each bidder independently submits a single bid, without seeing the bids submitted by other bidders. The highest bidder secures the item, and pays a price equal to his or her winning bid. This has been used by governments to sell drilling rights for gas and oil, and the rights to extract minerals from state owned land.

12 4. The second price sealed bid auction- sometimes known as a Vickrey auction after the seminal paper on auction theory by Vickrey in 1961. The bidding process works in the same manner as a first price sealed bid auction: Each bidder independently and privately submits a single bid. Again the highest bidder secures the item, but pays a price equal to the second-highest submitted bid. Has been used occasionally in practice.

There is a Sealed bid auction and an open auction Open Bid- the bids of all parties are observable. In an ‘increasing bid’ competition the optimal strategy for the individual bidder is to remain in the bidding competition until the price rises to his own valuation of the item. If all bidders are rational and execute this strategy, the item, the item will be transferred to the buyer with the highest private valuation of the item. As the bidding process unfolds one is able to observe the private valuations by noticing who remains in the competition and who drops out. The bidding process forces the players to reveal their preferences. In the ‘Dutch auction’ instead of an increasing bid competition, the auctioneer starts off from a very high price. The auctioneer cries out loudly prices which slowly decrease.

4 PRICING WITHOUT COMPETITION Cases exist where there may be only one source of supply in the market, for example, in the provision of defence equipment. If there is only one source of supply but an exact specification can be laid down- as where the same equipment has been supplied before- the supplier can be asked to quote a firm price on the basis of which the order can be placed. The fairness of the price quoted can be judged in the light of previous experience. Thus contracts under such circumstances are stated “price to be agreed”. Such prices are to be agreed contracts based on costs. They may be based on estimates of costs made either before or during production. Alternatively they may be founded on actual costs which are ascertained after production has finished.

PRICING A NEW PRODUCT – SKIMMING AND PENETRATION

The term new product has many meanings. It may refer to a product of distinctive novelty- the first TV set or the first ball point pen. On the other hand it may be a product new to the market in the sense of a new brand of detergent or beer where guidelines to price already exist in the form of established brands.

The producer of a pioneering product is faced is faced with a dynamic competitive situation – at first he enjoys a degree of freedom because he is alone in the market- he may have protection of a patent, and if rewards look high enough, ways can usually be found to evade the patent without infringing his legal rights. At the outset he has a choice between a skimming price and a penetration price.

Price Skimming- It involves setting a relatively high initial price for a new product when it is first introduced, to capture customers with high purchasing power, with the intent of getting as much profit from the product as possible. This is a short term intent. This may be similar to first degree price discrimination and can somewhat be compared to prestige pricing. Here the product pioneer takes advantage of any price insensitivity which exists at the early stages of marketing and charges a high “monopoly” price. In this way he secures a relatively high cash flow at an early stage which helps to minimize his losses if, in the end, the product fails to “take off”. If however demand builds

13 up according to his hopes and expectations then he will be seen to be earning high returns. The conditions to encourage competitors to try to enter the market are strongly established. As competition builds up, he reduces his price in an attempt to check their (competitors) inroads on his market. He may get credit for pioneering price reductions. The firm may also lower its price to draw in the more price elastic elements of the market.

Rationale for price skimming

(1) it is difficult to know the demand curve when entering a market, which market is unknown. Demand elasticity is unknown. (2) Production of the new product is at small scale. Low plant size will limit output. Maximize revenue through higher prices which will generate high initial cashflows. (3) High R and D to be recouped as quickly as possible. (4) Skimming may also enable firm to identify different market segments for the product, each prepared to pay progressively lower prices. If there is product differentiation it may be possible to continue to sell at higher prices to some market segments. (5) There is presently a sufficient number of buyers having high current demand. (6) The high price creates an impression of a superior product. (7) The high initial price will not attract more competitors. Skimming can also be maintained by : (1) barriers. (2) Quality of product. Demand is expected to be maintained.

Penetration Pricing This is the opposite strategy to price skimming strategy and has the aim of discouraging competition. This type of policy is likely to be followed when the producer is likely to be followed when the producer is of the opinion that the period of exclusive occupation of the market is likely to be of short duration. Competition will arise quickly and his aim is to try to make this as unattractive as possible by setting a low price and a fine margin of profit. The motive for so doing will be strengthened if the market is one which is not easily segmented and where it is considered that the sales volume of the product will be very sensitive to price even when it is first introduced. An added inducement in support of such a policy is to be found in those cases where an increased volume of output is subject to marked economies of scale. The policy requires faith in the speedy realization of a high volume of sales and will almost certainly need to be associated with a considerable sales promotion effort. Circumstances favouring this strategy

(1) wish to discourage rivals from entering. (2) Firm wishes to shorten initial period of PLC in order to enter growth and maturity stages quickly. (3) Significant economies of scale to be realized from large output may build larger capacity and then reduce prices further.

Other Pricing Practices These include: Price lining-this refers to the setting of a price target by a firm and then developing a product that would allow the firm to maximise total profits at that price. Thus instead of deciding first on the type

14 of product to produce and then on the price to charge so as to maximise the firm’s total profits (as usual), the order is reversed with price lining. (Cart before horse strategy). Value Pricing- refers to the selling of quality goods at much lower prices than previously. The manufacturers are also redesigning the product to keep or enhance quality while lowering costs so as to still earn a profit.

Ramsey Pricing No product should be supplied by a firm unless its incremental revenues are expected to exceed its incremental cost. If there are common costs managers must decide which products will be priced above incremental cost and how much above. According to the Ramsey pricing, for an enterprise to cover its total cost at least one of its two goods must be priced above its marginal cost. In its simplest form, Ramsey pricing requires that price deviations from marginal costs be inversely related to the elasticity of demand. That is, for goods with very elastic demand, the price should be set close to marginal cost. Conversely for goods with relatively inelastic demand, the price should deviate more from marginal cost. The rationale for Ramsey rule is that if demand is elastic, increasing the price causes a substantial reduction in quantity demanded. . But if demand is highly inelastic , large changes in price will result in little change in the quantity demanded. In the extreme, if demand were totally inelastic (a vertical demand curve), there would be no change in quantity demanded as price increased. Hence , if deviations from marginal cost pricing are greatest for those goods with inelastic demand, the resource misallocation will be minimized.

Ramsey pricing

Px MCx Py MCy

Q’x Qx Q’y Qy Good X Good Y

Prices charged for X and Y are respectively P’x and P’y.

PRODUCT LIFE CYCLE (PLC) The product life cycle concept draws an analogy between biological life cycles and the pattern of sales growth exhibited by successful products. In doing so it distinguishes four basic stages in the life of a product- introduction, growth, maturity and decline. The concept in other words derives from a biological metaphor namely that all “living things” go through a cycle of birth, growth, maturity and

15 inevitable decline and death. Product forms, product classes and brands are likened to living things in this context.

Product Life Cycle

Product

Sales Growth or Expansion Maturity Decline Introduction

Stage 1 Stage 2 Stage 3 Stage 4

Stage 1 Introduction Stage or introductory stage- this is the most hazardous stage of all, when the product has to prove its value and find a market. Preproduction costs are also high at this stage. Pursuing the life cycle analogy, infant mortality is very high and most products do not survive this stage. The initial price will be relatively high compared with later stages in the life cycle. The aim is to recover development costs as quickly as possible. Some consumer goods may be sold at an introductory price offer which is withdrawn when the selling momentum picks up.

Stage 2 Expansion, growth, or breakthrough period. The product receives general acceptability, rapid growth as more cautious buyers enter the market. Other firms are joining in. Production costs are likely to fall. Prices are also likely to fall.

Stage 3 Maturity stage- the product is now well established, existing in a variety of forms to suit different needs and different markets. The uniqueness of the product (characteristic of stage 1) has gone and the rapid period growth of stage 2 has disappeared. The original firm may be on the point of withdrawing. Costs including advertising and promotional costs are likely to fall as the momentum of sales gathers strength.

Stage 4 Decline- this marks the old age and virtual death of the product in its original form. There are many causes of decline but two main ones are (1) Change in fashion. (2) a technical breakthrough may render the original product obsolete.

PRICE POSITIONING Price setting is a very challenging task because reaction of consumers and competitors is very difficult to ascertain. Apart from cost considerations other factors, particularly in the consumer fields ought to be considered as they play an important role.

16 (i) Possible existence of a traditional price range for the product. Unless the product embodies something entirely new most consumers and producers know instinctively what a “reasonable” price ought to be and a decision to move outside this band involves not merely finding a new market segment but possibly also a new marketing strategy. (ii) Prevailing attitude of mind of the customers towards switching. If there is a strong brand loyalty, the situation is particularly difficult for the newcomer. In this situation a dramatic break with the existing price structure, either a substantially cheaper product or improved mark ups for the distributors, may be required. In established product markets, firms can be classified as price makers or price takers, that is, they are either price leaders of followers. Price leaders normally choose the price that they feel best fulfils their objectives, perhaps subject to the constraint that the chosen price must lie within a range that is acceptable to the price followers.

In established product markets, the general price level may be regarded as being historically determined, in the sense that it has gravitated to a specific level (in real terms) over a prolonged period of time , and to the general satisfaction or acquiescence of the firms involved. The firm must therefore position its price correctly in relation to its competitors.

Product Line Price Strategy Almost all firms have more than one product in their line of production. These multiple models or sizes of a product produced by the same company may be considered as different products or perfect substitutes for each other. Each has different AR and MR curves. The pricing under these conditions is known as multiproduct pricing or product line pricing. A frequent procedure is to apply a common mark up percentage to the per unit variable costs of each item in the product line. This is not optimal pricing since some products have relatively smaller price elasticities while others have relatively higher price elasticities. Higher price elasticities result from a product’s having a variety of substitutes and / or being relatively expensive. There are 3 basic decisions to be made in product line pricing:

(1) Choose the price of the basic or bottom of the line item. The “loss leader” considerations must be weighed against connotations of lower quality that may be attached to lower prices, in order to achieve maximum contribution from the entire production line.

(2) Choose the price of the top of the line item with an eye to the impact of that price on sales of the whole line. A high mark up prestige item at the top of the line may confer status and quality connotations on all other items in the line. Alternatively a price too high could give the impression that other items are overpriced as well and could cause total sales and contribution to be reduced.

(3) Choose the price intervals for the remaining items in the line. These price differentials should reflect the presence, absence, or degree of perceived attributes and should be chosen after observation of rival firms’ chosen differentials.