Evaluate some pricing approaches such as costs plus, market penetration, and skimming

Business Economics and Accounting

 Your learning objectives

After this lecture, you should be able to:

…Evaluate some pricing approaches such as costs plus, market penetration, and skimming

…Define demand elasticities by price and income

…Define and evaluate profit maximization strategy and other business motives

…Explain participation and incentive constraints in optimal contract

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Profit maximisation: simple calculus

• Π = Profit (q) = Revenue(q) – Costs(q), q – quantity produced

•To find the point of profit maximization, just differentiate by q and the maximum is achieved at the first order condition:

Second order condition: Profit’’(q)

= shows increase in revenue by

selling one additional unit of production, i.e. price of that unit

Marginal costs = shows costs of production of an

additional unit. Recall that marginal costs represent Supply curve.6

Finding maximum profit using total

revenue (TR) and total costs (TC) curves

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Finding the profit maximising

output using marginal curves

MC

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Exercise: explain the strange pricing

•A. Price of Gillette Mach 3 Razor is £6.63

•Gillette Mach3 Razor Blades - Pack of 8 - £14.49 or £1.81 per blade cartridge

•Gillette Mach3 Razor Blades - Pack of 12 - £20.37 or £1.70 per blade cartridge

•Why “30% off your first order”?

•B. Water Filter Jug price £8.45

•Water Filter, 6 pack filters - £21.99

•C. Why do you see prices like .99?

How to link demand with prices?

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percent change in demand

Demand elasticity ep = percent change in price

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Price elasticity by consumer income

•Consumer income is another important factor of price changes

•Income may shift due to macroeconomic changes (economic growth/recession) or regional shifts in unemployment or particular income sources

•Income elasticity of demand for some goods tend to be more stable than price elasticity

•If income elasticity >1 – such goods are defined as luxury goods such as jewellery, fashion cars, etc.

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A car plant dispute: an application

•A few years ago in a country U one car producer decided to fire several hundred workers due to falling demand (about 11%) right after the financial crisis of 2007-08

•Trade union was against this and offered instead to reduce wages by 20%. Wages accounted for 30% in the final car price

•Trade union argued that the proposed decrease in wages would reduce car price by 20%*0.3 = 6%. Given the Union estimated elasticity of demand for cars at 2.2, this should increase output by 6%*2.2 = 13.2% >11% and nobody needs to be fired

•Car plant owners argued that the elasticity of demand for cars was inelastic at 0.8, so that the Trade Union offer would increase revenue only by 6%*0.8 = 0.48%, at best

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Do firms maximise profit?

Difficulties in maximising profit

–Opportunity costs are not normally recorded in financial statements, which reflect nominal expenditures

–Difficulties in identifying demand

–Difficulties in deciding the time period for maximising profit, e.g. a start-up may have other development targets

–Bonuses (payroll costs) are usually issued in form of call options and other derivatives related to company stock prices and such prices are difficult to predict

–Is a firm market value affected only by company profits?!

–Prices also reflect ‘position’ to competitors’ products, i.e. should reflect strategic interaction with rivals

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Other market pricing strategies

•Penetration: set initial prices low to attract customers. This builds market share and discourages competition (left graph)

•Skimming: set initial prices very high and then lower them as product life cycle (fashion) declines. It helps to recoup product development and launch costs, but encourages competition

•Which of these pricing strategies are typical for pharmaceutical, mobile phone, textbook industries?

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Evidence on profit maximisation

motives from the UK company surveys

•Shipley (1981)

–Concluded that only 16% of his sample of 728 firms state profit maximisation as the main target

•Jobber and Hooley (1987)

–Found nearly 40% of their 1775 firms had profit maximisation as their primary objective

–But the objective pursued varied according to the product life cycle, which goes through emergence, growth, maturity and decline of demand for a product

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Evidence on profit maximisation in the UK

•Hornby (1994)

–Showed that 28.6% of 77 Scottish firms looked to profit maximisation as the overriding objective

–Most firms had multiple goals, perhaps with a minimum profit requirement

–There was no direct link between owner controlled firms and profit maximisation

•Stronger evidence for the goal of long termprofit maximisation

–E.g. Shipley (1981) and Hornby (1994)

–There is also intuitive appeal for this argument in high tech industries, e.g. computers, game consoles.

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Predicting the future (“Back to the future 2”)…

A modern view of the classical capitalist perspective

-The classical view of the firm has come under scrutiny for some time as the empirical foundations are mixing

-Practical view of Warren Buffet for investment: Look at business that (1) you can understand, (2) with excellent long- term prospects, (3) operated by competent people, (4) available at attractive share price

-However, this has also given rise to a critical revision of the classical perspective which envisages the firms as a ‘nexus of contracts’ employers-employees as well as suppliers and consumers

-A firm owners (Principals) must establish appropriate reward systems that maximise the effort level of other stakeholders (Agents), especially between owners and managers (CEOs)

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The Agency problem: conflicting objectives

•Agents might not perform for the Principals because they have conflicting objectives and different information

•Examples

–Managers may be interested in satisfying their own objectives such as expansion, “empire building”, using a company jet to play golf, or embarking on ‘pet projects’ to bolster own prestige

–Employees may be interested in minimum effort (shirking)

•The information asymmetry between the parties potentially gives rise to a ‘moral hazard’ problem, or post-contractopportunism if employees’ effort is not observable

•Principals can only observe outcomes and these might be the result of luck rather than great decisions of Agents

•For instance, in a “bull” market of 2005-07, majority of firms’ stock prices grew well on optimistic investors’ expectations despite arguably not the best decisions of some CEOs

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A solution for individual agents

•Thus, the principal must create contracts that induce the agent to engage in high levels of performance in order that their objectives are met

•This problem is considered in contract theory that sets optimal constraints and incentives for performance based payoffs

–Usually this is via payment systems with two elements:

>make the individual participate in the contract given the uncertain state of the environment: the participation constraint, i.e. pay an agent opportunity costs of taking a contract, e.g. a wage

>give the agent the incentive to engage in high levels of effort vs. low effort: the incentive compatibility constraint (as effort is a cost to an agent)

–Note, though, that money alone cannot always induce agents to act in the interests of the principal(s). You need corporate governance

–Empirically, there is a mixed evidence on the relationship between company performance and CEO compensation

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Moral Hazard: An Example with a shopping mall kiosk

•The kiosk is owned by Molly (the principal), who hires a single employee (Joe, the agent) to work in Molly’s kiosk

•If Joe works hard, the kiosk earns a weekly profit of £1000 with 80% probability, and £500 with 20% probability, depending on customers’ demand, with expected high profit of £900

•If Joe applies low effort (shirks), the probabilities are reversed – kiosk gets expected low profit of £600 = £500*0.8 + £1000*0.2

•Molly’s expected net profit is £900-£150 = £750 with high Joe’s effort and £600 - £150 = £450 with low Joe’s effort

•Joe does not like to work hard, he requires at least £150 per week compensation, and Molly cannot observe Joe’s effort

•Molly pays Joe a flat going market wage rate of £150 per week in hope he works hard

•As she cannot observe his effort, Joe mostly likely to shirk and

The Principal–Agent Problem as a Sequential Game

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The Principal–Agent Relationship as a Game

•This example (and most principal–agentrelationships) can be thought of as a sequential game

•In the first stage, the principal chooses between a set of

contracts

•In the second stage, the agent chooses a level of effort resulting in payoffs to the principal and agent

•The goal for the principal is to choose a contract structure that induces the agent to choose a high level of effort

•An introduction to game theory will follow in the next lectures. An interesting intuition is offered by Covey

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7 habits of highly effective people by

Stephen Covey

Covey’s “7 habits” through lens of the contract theory 1 “BE PROACTIVE” – design a contract

2 “BEGIN WITH THE END IN MIND” – plan outcomes

3 “PUT FIRST THINGS FIRST” – focus on key outcomes &payoffs

4 “SEEK TO UNDERSTAND, THEN BE UNDERSTOOD” – understand work incentives