Slides - Amine Ouazad

Road Map for Prices and Markets:
Pricing under Different Market Structures
Monopoly Pricing
•  Pricing by a monopolist (e.g., Microsoft)
•  Some pricing fallacies
•  Not all gains from trade realized or extracted
Price Discrimination
•  More exotic pricing strategies
•  Explicit market segmentation
•  Implicit market segmentation
Competitive Markets (“Commodity Markets”)
What we did so far:
Pricing with Market Power
What we’re starting today:
The polar opposite
•  Pricing under competition (commodity markets)
•  Short run and long run decisions
•  Strategies to survive in a competitive market
This Session
Implicit Price Discrimination (continued)
1.  Implicit Price Discrimination
2.  Airline pricing
3.  Bundling
Next Session
Perfect Competition
Bundling
•  Selling several goods in one bundle
! Hardware and software
! Software suites
! Sports/Concert tickets
! Auto accessories
Exercise 6.6: Screening via Bundling
Pricing of the polo shirt and the dinner party at the Lebanese week.
Highly segmented, with only three types of customers:
Valuation
Type of Customer
Polo Shirt
Dinner
A
$50
$5
B
$40
$40
C
$5
$50
A customer may buy either the polo shirt or the dinner.
– Benchmark: Perfect Price Discrimination –
– No Bundling –
– Pure Bundling –
– Mixed Bundling –
The Genius of Dell??
What is this? Buy One Get One Free (BOGO)
"  Shoppers don't understand why retailers offer this kind of promotion when it's
no better for customers and no more profitable for stores than a half-price
sale….
-  Washington Post consumer columnist Margaret Webb Pressler
Hmmm…it is more profitable than a half-price sale!!
Pizza: Valuation for 1st: $15.01; Valuation for 2nd: $5.01; MC = $2
BOGO at $20
Profit = 20 – 4 = 16
2 Pizzas for $10 each
Profit = 10 – 2 = 8
This Session
Implicit Price Discrimination
1.  Implicit Price Discrimination
2.  Airline pricing
3.  Bundling
Next Session
Perfect Competition
Bottom Line
Marketing guru says:
the right product for the right customer at the right price,
Economist sage says:
segment, differentiate, then segment some more!!
1. Find products where you can effectively prevent high-end consumers
from buying the low-end product
2. If you can t, implicitly segment the market – design a product line through
bundling, differentiation, versioning, inter-temporal pricing, damaging that
achieves price discrimination
Do not ignore the composition of your market!
Prices and Markets
Session 9
Perfect Competition
Prof. Amine Ouazad
Alusaf s $2 billion question
1994: Alusaf wants to build a primary aluminum smelter
"  Capacity: 466 ktpy
"  Located at Richard s bay, on the east coast of South Africa
"  Major bet: Capital expenditure close to 60% of Gencor s net worth!!
Feasibility study for this Hillside smelter was performed two years earlier
"  But aluminum prices plummeted to around $1,110 per ton
….as a result of the flow of Russian and other former eastern block countries
Given that aluminum prices are at historic lows would you recommend
dropping the Alusaf project?
This Session:
Competitive Supply and Market Price
1.  Alusaf’s $2 billion question
2.  Perfect Competition
3.  Primary Aluminum Market’s Supply
4.  Demand Shocks
Next Session
Short-Run Costs and Prices
Perfect Competition
•  Homogeneous product that is traded in a well-functioning transparent marketplace bringing
together lots of buyers and sellers easily
⇒
product sold at common “market price” determined by market-clearing condition:
quantity supplied = quantity demanded
•  Large number of small firms — no single producer can materially affect market price (at least
when industry was on flat portion of supply curve) ⇒ firms act as price takers
•  Fragmented demand — no single buyer has significant “bargaining power” to affect the price
•  Industries with these characteristics are close to the conditions of Perfect Competition.
Examples include:
•  mining, such as copper
•  primary metal fabrication, such as aluminum
•  agricultural commodities
•  certain types of commodity semi-conductors
Modeling Supply Decisions in Competitive Markets
$
Firm
$
Industry
s (P)
mc (q)
P = MR
d (P)
q
q*
Marginal conditions for optimal output (MR = MC): mc (q) = P
→ Supply curve s (P) is simply (inverse of) the marginal cost curve.
Q
An Exercise
•  There are 10 firms on a perfectly competitive market. Firms have
the same cost structure.
•  c(Q) = 100 + 10Q + Q2
•  mc(Q) =
•  ac(Q) =
•  Construct the supply curve of each firm, and the supply curve of
the market.
•  A firm’s supply curve
•  The market’s supply curve
si(P) =
s(P) =
•  Shut down production if P <
80
70
60
50
mc(Q)
40
ac(Q)
avc(Q)
30
20
10
0
0
5
10
15
20
25
30
35
The Aggregate Supply Curve
$
15
14
s
13
A
(P)
s
12
B
(P)
s(P) = s
11
A
(P)+ s
B
(P)
10
9
8
P*
7
6
5
4
3
d (P)
2
1
0
0
2
4
6
8
10
12
Q*
14
16
18
Output Q
Elasticity of Market Supply
– Measuring responsiveness of supply to changes in price –
% change in Q s
Es =
% change in P
Point Elasticity
Es =
dQ P
dP Q
20
This Session:
Competitive Supply and Market Price
1.  Alusaf’s $2 billion question
2.  Perfect Competition
3.  Primary Aluminum Market’s Supply
4.  Demand Shocks
Next Session
Short-Run Costs and Prices
Alusaf’s Hillside Project Seems like a simple
business…
"  Competitive Market – identical product; no tech. differences; pricetakers
"  No room for fancy marketing strategies; nimble operational
improvements
"  Profitability boils down to a simple equation
price – average cost
That cannot be that hard?
"  Need to understand:
•  What determines prices?
•  Which costs are relevant to Alusaf s decision?
•  What drives industry dynamics?
"  For this, we need an economic model of what drives supply decisions
and prices
Back to Alusaf: Cost (per ton) Analysis
Smelter
Country
Company
Capacity (tpy)
Sorocaba A
Brazil
Other
122
Grand Baie
Canada
Alcan
180
Zaporozhye
Ukraine
CIS
100
Electricity usage (kWh/t)
Electricity price ($/kWh)
Total electricity cost:
15769
0.005
85.61
14215
0.005
67.48
17454
0.008
136.45
Alumina usage (t/t Al)
Alumina price ($/t Alumina)
Total alumina cost:
1.94
111.83
216.51
1.94
179.39
347.30
1.94
146.58
283.78
Other raw materials
156.19
95.66
58.28
Plant power and fuel
Consumables
Maintenance
Labor
Freight
6.51
79.28
30.13
150.40
43.43
10.00
42.16
52.93
149.85
39.09
4.04
67.31
32.57
17.27
48.86
57.66
66.27
72.16
General and administrative
Which costs are variable and which are fixed?
Group 6, Section 6
Supply of an Incumbent Firm: Constant MC
$
Assuming variable cost includes
all but labor, maintenance, plant
power, and G&A
Min. AC
LR shutdown
Min. AVC
SR shutdown
AC
AVC = MC
MC is vertical once capacity is reached
Group 9, Section 7
Max. capacity
Short-run: P > MC = AVC then produce at capacity
shut down in the short run if P<AVC
Long-run: P > MC = AC then produce at capacity
shut down in the long run if P<AC
The World’s Supply Curve of Primary Aluminum
•  Arrange firms by marginal cost in an ascending manner
•  Table below shows the lowest 4 firms.
Firm
Capacity
Cumulative
volume
MC/
AVC
Sorocaba
122
122
581
Grand Baie
180
302
591
Zaporozhye
100
402
594
Arvida 2
147
549
607
12
93 2
8
18 .5
00
31 .5
25
40 .5
82
53 .2
44
65 .2
37
71 .5
12
86 .5
46
95 .5
4
10 7.5
23
11 3.5
20
12 2.8
06
12 5.8
95
13 1.8
62
5.
14 3
22
15 2
37
16 5
16 206
83
0.
17 5
47
18 3
06
18 9
42
19 8
12
19 9
70
20 6
0
20 27
29
20 6.7
88
4.
7
Price (per ton)
Section 7, Group 9
Primary Aluminum Short Run Supply Curve
2500.00
Market
Demand Curve
2000.00
1500.00
1000.00
500.00
0.00
Output ('000 tons)
How does the model measure up to the data?
In 1993, at a price of $1,110
"  Actual production = 19,781
"  Supply model predicts = 19,412 (cumulative capacity of plants
whose P = 1,110 > MC)
"  Wow!!
Anything else??
"  Idle capacity of 950 thousand tpy in some European plants; low cost and
should be operating at $1,110
"  Subtract 950 from 19,412 to get
Adjusted Supply = 18,462
Demand = 18,500
Irrational Capacity: Incentives don t matter!
Is this the whole story?
It can t be: Case says that inventories are accumulating fast,
→ supply > demand
Explanation: Irrational Capacity which stays up and running regardless
of pricing
"  State-owned capacity that would not have operated under normal
market incentives, but operates because decisions are driven by non-profit
considerations
"  Add all state-owned capacity with average variable cost exceeding $1,110
How does the model measure up to the data?
Actual demand
18,500
At a price of $1,110 the model predicts
19,412
Very close to actual production
19,781
Deduct 950 to adjust for idled European capacity
18,462
Add back 1,120 irrational capacity
(difference builds up as inventories)
19,582
Question:
Given that Aluminum prices are at historical lows, should Alusaf drop the project?
Answer depends on a more fundamental question:
What is the relationship between current prices and long-run prices?
This Session:
Competitive Supply and Market Price
1.  Perfect Competition
2.  Alusaf’s $2 billion question
3.  Primary Aluminum Market’s Supply
4.  Demand Shocks and Price Effects
Are we missing something?
Next Session
Short-Run Costs and Prices
Aluminum in 1992: Introduction of new capacity can lead to
catastrophic collapse in prices
2500.00
Price (per ton)
2000.00
1500.00
1000.00
Short Run
Demand Curve
(inelastic)
500.00
New Capacity
0.00
0
5000
10000
15000
20000
25000
Output ('000 tons)
Collapse when: a) Demand highly inelastic; b) Initial equilibrium on steep segment of supply curve
It All Depends on Relative Demand and Supply
But if supply intersects demand on the flat segment of the supply curve then…
Demand and supply can vary by a significant amount without big prices changes
2500.00
Price (per ton)
2000.00
1500.00
1000.00
500.00
0.00
0
5000
10000
15000
Output ('000 tons)
20000
25000
Elasticity of Market Supply
– Measuring responsiveness of supply to changes in price –
% change in Q s
Es =
% change in P
Point Elasticity
Es =
dQ P
dP Q
Lessons for a smart investor??
“We think gold and platinum are an outright
buy at present levels as both metals have very
low supply elasticity and are key beneficiaries
of loose monetary policy” UBS Gold Outlook
2013
"In view of the expected high
demand, pressure on real estate
prices may continue.
Such developments can easily
generate bubbles in the real
estate market because of
problems in the elasticity of
supply.”
-- Rakesh Mohan, Deputy
Governor, Bank of India, Dec.
2007
This Session:
Competitive Supply and Market Price
1.  Perfect Competition
2.  Alusaf’s $2 billion question
3.  Primary Aluminum Market’s Supply
4.  Demand Shocks
Next Session
Short-Run Costs and Prices
Take Away Point from Alusaf
So what is the relationship between current prices and long-run
profitability?
"  Quick answer: NONE!!
"  Firms make mistakes and can lose profits if they misinterpret short-run
fluctuations and trends
" 
KEY IMPLICATIONS:
#  It is very dangerous to be either overly optimistic or overly pessimistic
about a commodity market opportunity based on just observing shortrun trends
#  You need to forecast long run prices (next session)
Wrap up
•  A perfectly competitive market has:
•  A large number of small players, i.e. fragmented supply and demand.
•  A homogeneous product.
•  In a perfectly competitive market, firms are price-takers, and MR=p. Firms produce
quantity Q such that p = MC. The firm’s supply curve is the inverse of the marginal
cost curve.
•  Construct the market’s supply curve by adding the firms’ supply curves horizontally.
Use the market’s supply curve to forecast the effect of demand shocks on the
market’s price.
•  The effect of demand shocks on the market price are larger when supply is inelastic.
•  At this point, is our analysis complete???
•  The decision of Alusaf depends on the forecast of the price of aluminum and the
average cost of production.
Next session : Short Run Costs and Prices
•  Answer this: Should Alusaf invest $2b in the Hillside Plant?
•  Reading:
•  Course Guide Chapter 11.
•  Read “Reading the Course Guide” !!
•  Chipmakers signal second dip, Financial Times, October 7,
2010.