Economics Study Set 18

Business

Quiz 23 :

Price-Searcher Markets With Low Entry Barriers

Quiz 23 :

Price-Searcher Markets With Low Entry Barriers

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Is price discrimination harmful to the economy? How does price discrimination affect the total amount of gains from exchange? Explain. Why do colleges often charge students different prices based on their family income?
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Price discrimination is strategy where a firm makes discrimination among the customers. They charge different price to different customer.
Brief idea on price searcher market:
Competition is the basis of market classification in micro economics. Price searchers market is very common form of competitive market. It has the following properties.
1. Many firms
2. Products are not homogeneous but close substitutes and
3. Entry and exit are easy.
Due to above features, firm has control over price. It can decide the price it will charge for the product.
Although it can control price yet it cannot control price and quantity simultaneously. All firms will consider a down ward sloping highly elastic demand curve. If firm wants to charge high price then it has to reduce quantity based on the demand curve.
Main objective of a firm is to maximize profit. A price searcher adopts different strategies to win the heart of the customers. They innovate different ideas, try to implement them. It includes introduction of varieties, size, quality, services etc. In this manner firm always continues searching the price which can maximize revenue.
Price discrimination basic idea:
Sometimes a firm adopts the strategy of price discrimination to improve its profit further. It distinguishes customers into different groups. Different prices are charged to different customers on the basis of their ability. In this manner total revenue is increased. Profit can be optimized.
Example: In airlines business higher price is charged to business class and low fare to economy class. Railways also discriminate fare among different class although difference in facilities does not vary much.
Harmful effect of discrimination:
Many people consider price discrimination is harmful for the society. They say that here all people are not looked upon equally. A rich has to pay more since he is rich. On the other hand a poor will pay less since he is poor. A rich may have achieved his position by dint of his efficiency while a person is poor since he is inefficient. Thus discrimination is punishing an efficient one due to his efficiency. It is not justifiable.
Although, the argument apparently seems to have a strong basis, but considering it from the point of view of overall economy then it will not look like harmful. An economy has many people. Basic objective of the society is to maximize total satisfaction of the people of the economy. It is possible if they can consume to the maximum possible extent.
Through price discrimination more people can get the opportunity to consume. So, overall satisfaction level of the people of the economy will improve. When low price is charged to poor people, many persons who are not able to buy the commodities earlier will now get them within their reach. Hence they will consume. Their satisfaction level will increase. On the other hand rich has higher ability to pay. They will not mind to pay a little more for the product. Their satisfaction level will not decrease much due to such discrimination. Thus society as a whole will be benefitted from price discrimination. Welfare will be maximized.
Explanation of gain from price discrimination:
Let one group consist of customers coming from high income group. Another group customer is coming from average and low income group.
Rich customers demand is less affected by price increase. So firm will charge comparatively high price to them. Due to down ward sloping curve, sales volume will decrease, but percentage decrease in the sales volume of rich people will be less than the percentage increase in the sales price. Thus total revenue from sale to rich customers will go up after price increase.
Now consider second group of customers. They are more sensitive to price change. Firm will sell same product to them at lower price. It will induce them to buy more units. It will be observed that due to decreasing price sales quantity will increase more than the percentage decrease in selling price. In consequence total revenue after price cut will be more than the total revenue before price cut.
Thus combined effect of price discrimination will be substantial increase in total revenue and profit. The concept discussed above can be explained by a numerical example to show how a discriminating firm is gaining from such exchange.
Example: Suppose a firm is currently selling 100 units of a product at uniform price of $10 per unit. Now it has observed that, a section of customer is from rich income group and others from poor income group. So the firm wants to discriminate by charging 20% higher price to rich customers and 20% less price to poor customer. At present out of total sales 50% is sold to rich and balance to poor.
After discrimination it was observed that demand of rich customer has dropped to 45 units, while sales to poor has moved up to 65 units.
Thus revenue before and after discrimination will be as follows-
img Note that due to 20% increase in price, sales volume of rich customer has decreased by
img . Thus decrease in volume is less than increase in price. As a result total revenue has increased after discrimination by
img .
For poor people a 20% cut in price has increased sales volume by
img . Thus percentage increase in volume is greater than percentage decrease in price. Result is an increase in total revenue after discrimination by
img . Amount of gain in total revenue from such discriminatory exchange is shown in the diagram below.
img img In diagram 1, total revenue is shown before discrimination when 100 units were sold at $10 per unit. Violet area indicates total revenue. Demand curve or AR curve of the total market is orange color downward sloping line.
In diagram 2, total revenue from rich customer is shown by the pink colored area and total revenue from poor customer is shown by the green area. Note that AR curve of rich is steeper than the AR curve of poor. So demand curve of poor is more price sensitive than the curve of rich. It has caused benefit to firm from such discrimination.
Variation in college fees:
College often charges students different prices based on their family income. It is the application of price discrimination strategy based on income.
It is possible when high income students have a comparatively inelastic demand curve than the same of poor students. Elasticity is the degree of responsiveness of demand due to a percentage change in price. In case of inelastic demand curve, demand will fall due to higher fees. But decrease in demand in percentage will be much less than the increase in fees. So college will be able to collect more revenues from them.
Logic of charging high fees to rich students is their high level of consumer surplus. Consumer surplus is the excess of total satisfaction over total payment. Total satisfaction depends upon how much money the consumer is ready to pay for the commodity. A rich person can spend more. So he will be ready to pay more than a poor person to get the product. Hence consumer surplus of a rich will be higher than the poor. College is extracting a portion of higher consumer surplus enjoyed by rich student by changing high fees to them.
On the other hand there may be many students who are meritorious but cannot take the admission because current fees are not affordable. If fees are lowered then they can take admission. Thus due to elastic nature of their demand curve, percentage of new admission be lower income group students will go up. It will be more than the decrease in fees. Result will be more fees collected from poor section of students by the college.

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Rod N. Reel owns a dealership that sells fishing boats in an open, price-searcher market. To develop his pricing strategy, Rod hired an economist to estimate his demand curve. Columns (1) and (2) of the chart on the next page provide the data for the expected weekly quantity demanded for Rod's fishing boats at alternative prices. Rod's marginal (and average) cost of supplying each boat is constant at $5,000 per boat no matter how many boats he sells per week in this range. This cost includes all opportunity costs and represents the economic cost per boat. a. Find Rod's economic profits at each alternative price by calculating the difference between total revenue and total cost. b. Find Rod's marginal revenue and marginal cost from the sale of each additional boat. c. If Rod wants to maximize his profits, what price should he charge per boat? d. How many boats will Rod sell per week at the profitmaximizing price? e. What will Rod's profits be per week at this price and sales volume? f. At the price and sales level where profits are maximized, has Rod sold all boats that have higher marginal revenue than marginal cost? g. If Rod's profits are typical of all firms in the boat sales business, what might be expected to happen in the future? Will more boat dealers open in the area, or will some of the existing ones go out of business? What will happen to the profitability of the boat dealers in the future once the entry/exit has occurred? h. Challenge Question: Recall the relationship between elasticity of demand, price changes, and their impact on total revenues. As Rod lowers his price from $9,000 to $5,000, his total revenues keep increasing. Is demand in this price range elastic, inelastic, or unit elastic? When Rod lowers his price from $5,000 to $4,000, his total revenues stay the same. Is demand in this price range elastic, inelastic, or unit elastic? Can you guess what might happen at prices below $4,000? Explain. img
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Table showing cost, revenue and profit figures of Rod N. Reel
img Figures of first two columns are available in the problem. Remaining columns are filled up. Figure within bracket indicates negative value. Details are explained below:
1. Total Revenue (TR)
It is total sales value of fishing boats. The formula is-
img Figures are available in column (1) and column (2). They are multiplied to get figures of column (3).
img 2. Total cost per week (TC)
Average cost of boat per week is $5,000. It is multiplied by the quantity to get total cost. Calculations are shown below:
img 3. Economic profit:
It is the excess of total revenue over total cost. Total revenue and total cost calculations are shown in workings 1 and 2 above.
img 4. Marginal Revenue(MR):
It is the extra revenue generated from one extra unit of fishing boat sold. In other words, it is the sale proceeds of last boat.
The calculations are shown below.
img 5. Marginal cost (MC):
It is the extra cost of manufacturing one extra unit. In the problem cost per unit is constant at $5,000. So marginal cost of last unit produced will be always $5,000. No detailed calculations are needed.
Answers of different questions of the problem are explained below:
(a) Rod's economic profit for each alternative price is shown in column (5) of above filled up table.
(b) Marginal revenue and marginal costs are shown in column (6) and column (7) of the filled up column.
(c) Maximum economic profit is $4,000 as per column (5) of the above table. It is achieved, if Rod charges a price of $7,000 per boat.
(d) At profit maximizing point, Rod will sale 2 boats per week.
(e) Profit maximizing economic profit per week is $4,000 and total revenue is $14,000 per week.
(f) Yes at profit maximizing price and sales level, Rod has sold all the boats that have higher marginal revenue than marginal cost. It has sold only two boats in a week. Marginal revenue of first boat was $8,000. It is greater than its marginal cost of $5,000. Also it has sold second boat having marginal revenue of $6,000. It also has a marginal cost of $5,000.
(g) Since at equilibrium output Rod is earning economic profit, it will attract many new dealers to enter the business in the long run. Thus supply of boat will go up and economic profit will be eliminated.
(h) Elasticity is the degree of responsiveness of demand due to a percentage change in price. Since a firm has downward sloping demand curve, number of fishing boats demanded will increase with the decrease in price and vice versa.
However intensity of the change will differ. It may be of three types as stated below:
i. Elastic: When change in demand is more than the change in price the demand is elastic. In this case when price is increased, total revenue will decrease. Here decrease in total revenue due to drop in demand will be more than the increase in total revenue due to increase in price. Resultant effect will be a fall in total revenue. Thus for elastic demand an inverse relation exists between price and total revenue.
ii. Inelastic: Now consider the opposite situation when change in demand is less than the absolute change in price. It is known as inelastic demand. If price is raised in inelastic demand situation, total revenue will decrease. Here fall in total revenue due to fall in demand is less than the rise in total revenue due to rise in price. So resultant effect will be an increase in total revenue.
iii. Unit elastic: Finally consider a situation when response of demand due to a percentage change in price is same. If price is increased by one percent, then demand will decrease by one percent only. Thus whatever increase in total revenue is found from the increase in price will be offset by the decrease in total revenue due to decrease in demand. Result is no change in total revenue.
On the basis of above analysis the nature of elasticity at different ranges of price change are shown below:
1. When price is lowered from $9,000 to $5,000, total demand is going up from zero boat to 4 boats. Here price is curtailed by
img .But demand has increased more than the change in price. So demand is elastic. Note that total revenue ay $9,000 price was nil. After price cut it is $20,000. Since TR after price cut is going up, the demand is elastic.
2. Now consider second situation, when price is lowered from $5,000 to $4,000. Here cut in price is
img . Before this price cut Rod was selling 4 boats. After price cut it can sell 5 boats. Thus demand is going up by
img . So in this price range degree of responsiveness of demand and the percentage change in price. Are same. Hence the demand is unit elastic. Also note that total revenue before price cut was $20,000. After price cut also it is $20,000. Since total revenue is not changing, it is an indication of unit elasticity.
3. Now consider a situation when price is cut below $4,000. In that case firm will not be able to recover marginal cost which is $5,000 per Boat. So firm will not continue its business. It will be closed.

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a. What determines whether corporations, individual proprietorships, employee-owned firms, consumer cooperatives, or some other form of business structure will dominate in a market? b. What determines whether small firms, medium-size firms, or large firms will dominate in a market?
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Firms can be of different types. They can be classified on the basis ownership and on the basis of size.
(a) Ownership wise dominancy:
On the basis of ownership a firm may take following different forms-
1. Proprietorship: It is owned by one person known as proprietor. All activities are carried out by the proprietor. He contributes capital, undertakes all risk and enjoys the entire surplus.
2. Partnership business : It is run by a few persons known as partner. They collectively contribute capital, undertake risk and share the surplus. All these are guided by an agreement undertaken by them.
3. Employee owned Firm: Employees are owner of this concern. They contribute capital by contributing proportionately according to their capacity. Whatever surplus is earned is distributed among employees on the basis of their capital holding.
4. Corporations: It is owned by public. They contribute to the capital by purchasing shares according to their capacity. Liability of each shareholder is limited by the value of share purchased. Profit is distributed proportionately among them as dividend.
Market does not have any restriction about the type of concern. It can absorb any specific form. Only condition required is that the firm has to remain competitive. What type of firm will dominate the market will depend upon many factors according the nature of business. They are as follows-
1. Capital requirement: If the production requires large amount of capital, then corporate form of business will dominate the market. In other form number of persons who can contribute the capital is very few. They have limited capacity for such contribution. But in this form unlimited number of persons can own the share so any required amount can be collected from them.
2. Risk: Another important point is the degree of risk is associated with the production. If the risk is low any form of ownership can dominate. But in a very high risk market, corporate form with limited liability will be the dominant one.
3. Cost: Most important factor is how a consumer will value the product. If consumers are concerned with the low cost per unit, then corporate form will be better. In corporate form due to high volume of capital and limited risk, large production capacity plant can be introduced. It will lower per unit cost, by distributing fixed cost on large quantity base. Also variable cost per unit will be low due to the benefit of large quantity production. Such benefits include quantity discount on material procured, introduction of specialization through division of labor, employing professionals in different areas of activities etc.
4. Personal skill and care: In some product customer pay more attention on personal care and relation. Corporate form is not suitable for such business. Rather proprietorship or partnership will be most effective there. These forms will carry more value for consumer.
5. Consumer's preference: Sometimes consumers have special preference towards a specific form. For instance, consumers are ready to encourage small firm since close personal relation can be established between owner and consumer. For such personal relation, they are ready to buy the product from small firm at higher price even though they knew that the same product is available in big concern at lower cost. Proprietorship firm will dominate in such market.
Thus dominancy of a type of firm will depend upon the factor which the consumer value most.
(b) Size wise dominancy:
Size is another important aspect of classifying firm. On the basis of capacity firm can be-
1. Large size firm
2. Medium size firm and
3. Small size firm.
Small size firms have lowest possible production capacity. Large size firm operates with highest production capacity. Medium size plants are coming in between these two extreme forms.
Here also survival of a particular size will depend upon the factors which consumer value high. Most of such factors are common with the ownership as described above.
1. Cost: If consumers are cost conscious and put maximum value on low per unit cost, then large size firm will dominate the market. By manufacturing product in large quantity, allocated fixed cost per unit can be minimized. Also advantages of large production will lower the variable cost. Thus consumer will get the product almost at lowest possible long run average cost.
2. Varieties: If consumer is interested in varieties then standardized bulk production will not carry high value. So large size firm will not survive there. Large size firm cannot be cost effective unless standardized product is manufactured in bulk. Hence small and medium size plant will dominate.
3. Individual skill: Some products are sophisticated and require individual skill. Ornaments are products requiring special skill. Beauty of designing is very crucial and highly valued by consumer. Large scale production is totally unsuitable here. Only small sized plant will dominate here.
4. Service: If consumer value personalized service then only small or medium sized plant will dominate. Quality of service is crucial here. It will depend upon personalized relation among consumer and seller. Big firms cannot dominate in these cases.
5. Consumer awareness: When product is not well known to the consumer, proper awareness about the product should receive prior importance. It will require huge spending on advertisement and publicity. Small and medium size firm may be incapable to withstand such expenses. Large size plant will dominate in such market
Thus survival of a particular size of concern also depends upon the variables which consumer valued highly for satisfaction.

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Because price searchers can set their prices, does this mean that their prices are unaffected by market conditions? In price-searcher markets with low barriers to entry, will the firms be able to make economic profit in the long run? Why or why not?
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"When competition is intense, only the big firms survive. The little guy has no chance." True or false? Explain.
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The accompanying graph shows the short-run demand and cost situation for a price searcher in a market with low barriers to entry. a. What level of output will maximize the firm's profit level? b. What price will the firm charge? c. How much revenue will the firm receive in this situation? How much is total cost? Total profit? d. How will the situation change over time? img
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"The superiority of the competitive market is the positive stimuli it provides for constantly improving efficiency, innovating, and offering consumers diversity of choice." This quotation is from Alfred Kahn, the architect of transportation deregulation during the 1970s. Evaluate the statement. Is it true? Discuss.
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What determines the variety of styles, designs, and sizes of different products? Why do you think there are only a few different varieties of toothpicks but lots of different types of napkins on the market?
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Is quality and style competition as important as price competition? Would you like to live in a country where government regulation restricted the use of quality and style competition? Why or why not? Do you think you would get more or less for your consumer dollar under restrictions like these? Discuss.
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What is the primary requirement for a market to be competitive? Is competition necessary for markets to work well? Why or why not? How does competition influence the following: (a) the cost efficiency of producers, (b) the quality of products, and (c) the discovery and development of new products? Explain your answers.
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Suppose that a group of investors wants to start a business operated out of a popular Utah ski area. The group is considering either building a new hotel complex or starting a new local airline serving that market. Each new business would require about the same amount of capital and personnel hiring. The group believes each endeavor has the same profit potential. Which is the safer (less likely to result in a substantial capital loss) investment? Why? Is there an offsetting advantage to the other investment?
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What must an entrepreneur do in order to introduce a new innovative product? What determines whether the new product will be a success or failure?
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Suppose that a price searcher is currently charging a price that maximizes the firm's total revenue. Will this price also maximize the firm's profit? Why or why not? Explain.
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Price searchers can set the prices of their products. Does this mean that they will charge the highest possible price for their products? Why or why not?
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What keeps McDonald's, Walmart, General Motors, or any other business firm from raising prices, selling shoddy products, and providing lousy service?
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Would our standard of living be higher if the government "bailed out" troubled businesses? If a firm goes out of business, what happens to the firm's assets, workers, and customers? Are business failures bad for the economy? Why or why not?
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What do competitive price searchers have to do to make economic profit?
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