Page 1 of 15 Name : Course Name: Date: Module Number Olusegun Adeleke Odunuga 540 Managerial Economics August 26,

, 2011 Module 2:

1. If the demand for a product is inelastic, what will happen to total revenue if price is increased? The law of demand provides insightful and useful information with respect to what an organization will charge in selling a product. The higher a price of a product charge by a seller, the less demand or purchasing of less of the product. Zimmerman et al (2009) explained the importance of product price in demand analysis, be it in quantity demanded by a consumer and the setting of product price by a producer. Simply explained, in any economic system, scarce resources have to be allocated among competing uses. Market economies harness the forces of supply and demand to serve that end. Supply and demand together determine the prices of the economys many different goods and services; prices in turn are the signals that guide the allocation of resources. In any competitive market, such as the market for wheat, the upward-sloping supply curve represents the behaviour of sellers, and the downward-sloping demand curve represents the behaviour of buyers. The price of the good adjusts to bring the quantity supplied and quantity demanded of the good into balance. Furthermore, it is noted that buyers usually demand more of a good when its price is lower, when their incomes are higher, when the prices of substitutes for the good are higher, or when the prices of complements of the good are lower. This discussion of demand was more of qualitative and not of quantitative. To measure how much demand responds to changes in its determinants, economists use the concept of elasticity.

Page 2 of 15 The price elasticity of demand measures how much the quantity demanded responds to a change in price. Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in the price. Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the price. In other words, this is the percentage change in the quantity demanded of a given product that results because of a given percentage change in the price of that product. It measures how much buyers respond to a percentage change in the price. Elasticity, a measure of how much buyers and sellers respond to changes in market conditions, allows us to analyze supply and demand with greater precision. Economists classify demand curves according to their elasticity. Demand is elastic when the elasticity is greater than 1, so that quantity moves proportionately more than the price. Demand is inelastic when the elasticity is less than 1, so that quantity moves proportionately less than the price. Mankiw (2008) noted that if a demand is relatively inelastic, the buyers reduce their buying, with very little, as the price of the product rises. If the demand is relatively elastic, the buyers not only reduce their buying, but they reduce it considerably, as the price rises. However, if the demand is unit elastic, unit" means one, and then demand is perfectly inelastic. This means that buyers do not change their quantity demanded at all if the price rises. Perfectly inelastic demand would be a violation of the law of demand, It means that the market is infinitely large; the seller can sell as much as he or she wants at the price that exists in the market. Consequently, it is right to say that if the demand for a product is inelastic, then an increase in the price of the product would increase total revenue. Simply explained, when a demand is inelastic (a price elasticity less than 1), a price increase raises total revenue, and a price decrease reduces total revenue.

Page 3 of 15 Madonik (2009) buttressed the above in his article that many of the most disruptive events for the worlds economies over the past several decades have originated in the world market for oil. In the 1970s members of the Organization of Petroleum Exporting Countries (OPEC) decided to raise the world price of oil in order to increase their incomes. These countries accomplished this goal. From 1973 to 1974, the price of oil (adjusted for overall inflation) rose more than 50 percent. Then, a few years later, OPEC did the same thing again. The price of oil rose 14 percent in 1979, followed by 34 percent in 1980, and another 34 percent in 1981. Demand for oil is inelastic because buying habits do not respond immediately to changes in price. Many drivers with old gasguzzling cars, for instance, will just pay the higher price, thus bringing huge revenue to oil companies.

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2. Define and explain the differences between economies of scale and economies of scope. Define learning effects and explain the differences between economies of scale and learning effects? Defining economies of scale and economies of scope Arnold (2008) defined economies of scale as and economies that exist when inputs are increased by some percentage and output increases by a greater percentage, causing unit costs to fall. As defined, economies of scale results from lower direct and indirect production costs, lower marketing and distribution costs resulting from higher scales of production rather than lower scales of production. A firm experiences economies of scale if costs per unit of output fall as the scale of production increases. Sloman (2006) went on to explain that , if a firm is getting increasing returns to scale from its factors of production, then as it produces more it will be using smaller and smaller amounts of factors per unit of output. Other things being equal, this means that it will be producing at a lower unit cost. Economies of scope occurs, as defined, when increasing the range of products produced by a firm reduces the cost of producing each one. It arises from flexibility to produce different types of products, depending on changes in demand, from the same economies without much investment in alteration as well as diversification of risk through catering to different markets. Economies of scope exist when the cost of joint production is less than the cost of producing multiple outputs separately. A firm will produce products that are complementary in the sense that producing them together costs less than producing them individually.

Explaining the differences between economies of scale and economies of scope

Page 5 of 15 Conceptually, economies of scope are economies of scale are similar, as noted above in the definition. However, there are differences between economies of scale and economies of scope as noted below:

i. Economies of scale refers primarily to efficiencies associated with supply-side changes, such as increasing or decreasing the scale of production, of a single product type, while economies of scope refer to efficiencies primarily associated with demand-side changes, such as increasing or decreasing the scope of marketing and distribution, of different types of products. ii. Economies of scope apply to certain industries, while economies of scale apply to any size firm expanding its scale of operation. iii. Economies of scope permit a firm to translate superior skill in a given product line into unique advantages in the production of complementary products. Effective competitive strategy often emphasizes the development or extension of product lines related to a firms current stars, or areas of recognized strength. While economies of scale labour productivity can be higher in large firms, where individuals are hired to perform specific tasks. iv. Economies of scope offer a useful means for evaluating the potential of current and prospective lines of business. It naturally leads to definition of those areas in which the firm has a comparative advantage and its greatest profit potential. When economies of scale are substantial, larger firms are able to achieve lower costs of production or distribution than their smaller rivals. These cost advantages translate into higher and more stable profits and a permanent competitive advantage for larger firms in some industries

Page 6 of 15 Explaining the differences between learning effects versus Economies of scale For many manufacturing processes, average costs decline substantially as cumulative total output increases. Improvements in the use of production equipment and procedures are important in this process, as are reduced waste from defects and decreased labour requirements as workers become more proficient in their jobs. Wilkinson (2005) then explained that when knowledge gained from manufacturing experience is used to improve production methods, the resulting decline in average costs is said to reflect the effects of the firms learning curve otherwise known as learning effects. The learning effects phenomenon affects average costs in a way similar to that for any technical advance that improves productive efficiency. Both involve a downward shift in the longrun average cost curve at all levels of output. Learning through production experience permits the firm to produce output more efficiently at each and every output level. It should be noted that learning effects arises from factors due to changes over time. The most important of these changes is the effect of economies of scale. However, there are distinct differences between the learning effects and economies of scale. As noted above, economies of scale relate to cost differences associated with different output levels due to changes in along average cost. While learning effects relate cost differences to total cumulative output measured as a result of shift in average cost overtime. These shifts result from improved production efficiencies stemming from knowledge gained through production experience Furthermore, learning effects is differentiated from economies of scale because of the competitive strategy possibilities provided by learning effects. It is possible for an organization to achieve competitive strategy of achieving and maintaining a dominant position in a given market. By virtue of their large relative volume the organization acquired through greater opportunity for

Page 7 of 15 learning than do smaller, non-leading firms. In some instances, the market share leader is able to drive down its average cost curve faster than its competitors, underpriced them, and permanently maintains a leadership position. Non-leading firms face an important and perhaps insurmountable barrier to relative improvement in performance. Where the learning effects advantages of leading firms are important, it may be prudent to relinquish non-leading positions and redeploy assets to markets in which a dominant position can be achieved or maintained.

Page 8 of 15 3. What four basic conditions characterize a competitive market Economists generally believe that market consists of all firms and individuals willing and able to buy or sell a particular product. This includes firms and individuals currently engaged in buying and selling a particular product, as well as potential entrants. Market structure describes the competitive environment in the market for any good or service.

Market structure is typically characterized on the basis of four important industry characteristics. Zimmerman et al (2009) named these characteristics as follows: i. The number and size distribution of active buyers and sellers and potential entrants: Perfect competition is a market structure characterized by a large number of buyers and sellers of essentially the same product. Each market participant is too small to influence market prices. Individual buyers and sellers are price takers. Firms take market prices as given and devise their production strategies accordingly.

ii. The degree of product differentiation: The output of each firm is essentially the same as the output of any other firm in the industry.

iii. The amount and cost of accurate information about product price and quality: Cost, price, and product quality information is known by all buyers and all sellers. The availability and cost of information about prices and output quality is a similarly important determinant of market structure. Competition is always most vigorous when buyers and sellers have ready access to detailed price/performance information. Free and complete demand and supply information is available in a perfectly competitive

Page 9 of 15 market, and there are no meaningful barriers to entry and exit. As a result, vigorous price competition prevails.

iv. Conditions of free entry and exit in the market. Firms are not restricted from entering or leaving the industry market structure is broadly determined by entry and exit conditions. Low regulatory barriers, modest capital requirements, and nominal standards for skilled labor and other inputs all increase the likelihood that competition will be vigorous.

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4. Explain why perfect personalization pricing is typically more profitable than menu pricing. Why then do companies use menu pricing?

Economists asserted that with multiple markets or customer groups, the potential exists to enhance profits by charging different prices and mark-ups to each relevant market segment. Market segmentation is an important fact of life for firms in the software, personal consumer products, entertainment, hotel, professional services industries. Firms that offer goods or services also often segment their market into different strata in order to maximise profits. Price discrimination occurs whenever different classes of customers are charged different mark-ups for the same product. Price discrimination occurs when different customers are charged the same price despite underlying cost differences, and when price differentials fail to reflect cost discrepancies. For price discrimination to be profitable, different price elasticity of demand must exist in the various submarkets. Unless price elasticity differs among submarkets, there is no point in segmenting the market. With identical price elasticity and identical marginal costs, profit maximizing pricing policy calls for the same price and mark-up to be charged in all market segments. A market segment is a division or fragment of the overall market with unique demand or cost characteristics. Wilkinson (2005) explained that the extent to which a firm can engage in price discrimination is classified into two major categories. Under personalised pricing, also known as, first-degree price discrimination, here the firm extracts the maximum amount each customer is willing to pay for its products. Each unit is priced separately at the price indicated along each product demand curve. Although first-degree price discrimination is uncommon, it has the potential to emerge in any market where discounts from posted prices are standard and effective

Page 11 of 15 prices are individually negotiated between buyers and sellers. When sellers possess a significant amount of market power, consumer purchases of big-ticket items such as appliances, automobiles, homes, and professional services all have the potential to involve first-degree price discrimination. The second category is menu pricing or second-degree price discrimination. It is a more frequently employed type of price discrimination, involves setting prices on the basis of the quantity purchased. Bulk rates are typically set with high prices and mark-ups charged for the first unit or block of units purchased, but progressively greater discounts are offered for greater quantities. Quantity discounts that lead to lower mark-ups for large versus small customers are a common means of discriminating in price between retail and wholesale customers. . However, it should be noted that perfect personalized price menu is more profitable than

menu pricing because personalized pricing extracts the maximum profit from each consumer. The usual examples of perfect price discrimination relate to the supply of personal services, for example lawyers, where the supplier is able to charge each customer according to his willingness or ability to pay. Other examples relate to the use of auctions. Of recent, a group of technology lead by Apple and Blackberry maker, RIM, out bid Google by billions of dollars to purchase patents held by Nortel. On the other hand, menu pricing or second-degree price discrimination typically provides some of the consumers obtain surplus. The consumer benefits from larger output and retains some consumer surplus. However, many producers or sellers tries to extract the maximum surplus from each customer by using pricing menu options in a particular way, some of the consumers, of the producers or sellers products or services, are likely to be able to select different options to obtain surplus. This ability to self-select from the menu typically makes it impossible to extract all consumer surpluses.

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5. Case Study Consider three firms: a shoe store at the mall, an automobile dealership, a house painting firm.

a. Which firm would you expect to engage in the most price discrimination? Why? Answering the question require a better background understanding of the principle and definition of Price discrimination. Economists believe that price discrimination is fundamental to demand and supply of goods and services. Price discrimination has been defined in a number of different ways. The simplest definition relates to the situation where a firm sells the same product at different prices to different customers. However, the most useful definition involves a firm selling the same or similar products at different prices in different markets, where such price differentials are not based on differences in marginal cost. The main objective of price discrimination is the objective of maximising profit by the seller. It is an extremely common type of pricing strategy operated by virtually every business with some discretionary pricing power. In perfect price discrimination the seller charging whatever the market will bear, the firm separates the whole market into each individual consumer and charges them the price they are willing and able to pay. If successful, the firm can extract all consumer surplus that lies beneath the demand curve and turn it into extra revenue. It is a classic part of price competition between firms seeking a market advantage or to protect an established market position. However, there are two fundamental conditions for price discrimination to happen. Namely, (a) There must be different market segments with different demand elasticity.

Page 13 of 15 (b) The market segments must be separated so that there is no possibility of resale from one segment to another.

In order to illustrate the importance and application of these conditions to a shoe store at the mall, an racing boats manufacturer, a house painting firm is use to explain who among these firms is expected to engage in the most price discriminating. A shoe store or racing boats manufacturer may choose not to advertising their prices and may wait until the customers comes into the shop and charge prices according to an assessment of the individual customers ability and willingness to pay. They are able to judge the willingness to pay before negotiating the final deal. However, boats and shoes are becoming more of a commodity and it is becoming easier to comparison store and boat manufacturers showroom. The typical shoe store quotes a price to all customers and while it can engage in menu pricing, personalized pricing is more difficult. Boats and shoes also can be resold among consumers. Such a strategy may be successful in the case of customers who are ignorant of the prices being charged to other customers; however, once they become aware of this situation, and assuming that other shoe store or boat manufacturer are following the same practice, high-paying consumers will find ways to avoid paying higher prices by buying their shoes or boats from other sources, including customers that have bought from the same store Thus in this instance a shoe store or racing boats manufacturer cannot successfully practise price discrimination. On the other hand, house painting firm is in a position to practise price discrimination. House owners cannot ask other house owners customers to have their house painted for them. The painter has an opportunity to observe the prospective buyer and make an assessment about the willingness to pay before quoting a price. It can be expensive for the buyer to

Page 14 of 15 obtain additional quotes (in terms of time).Thus price discrimination is generally easier in the markets for services, especially personal and professional services.

b. How has the internet changed the pricing policies of these businesses? Many businesses both small and large are spending large amounts of intellectual and financial capital to get ahead in this competitive new medium of communication. Internet or ecommerce has greatly benefit business organization by expanding their geographical reach , expanded customer base, increase visibility through search engine marketing, provide customers valuable information about business. Furthermore, internet makes buying and selling of goods available 24/7/365, it never closes.

The internet is unlikely to have a large impact on the ability of house painters to price discriminate because internet doesnt offer physical opportunity for a seller to assess individual customers ability and willingness to pay in other hand, it does provide opportunity for the consumer to identify potential painters to make competitive quotes. The internet makes it relatively easy to obtain detailed comparable selling prices on different boats from different manufacturers and incentives offered . These factors have made price discrimination more difficult for boat manufactures. An internet store specializing in shoes has the technology to make certain price options available to consumers based on purchase histories, etc. This might increase the ability to price discriminate. On the other hand it can make it easier to comparison shoping, thus limiting market power.

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REFERENCES 1. Brickley/Smith/Zimmerman (2010), Managerial Economics and Organizational Architecture 5th Edition, by McGraw Hill Irwin. 2. Gregory Mankiw (2008) , Principles of Economics, 6th Edition, South-Western, Cengage Learning 3. John Sloman(2006) , Economics, sixth edition, Pearson Education Limited 4. Roger A. Arnold (2008) Economics 9th edition, South-Western Cengage Learning