Price Discrimination, and Externalities

Yes, I believe that price discrimination in the form of a senior citizen discount or child discount is a fair pricing policy.  Even setting aside the firm's concerns with capturing consumer surplus by charging different prices based on ability/willingness to pay (a child's demand curve for most things a child would buy is quite elastic), it seems a truism that it is right to price things differently for these two groups.

However, I sense a few potential problems here.  For instance, do the seniors in your area, or the majority of the senior citizens you serve, have very elastic demand curves (owing, for instance, to low disposable income)? That is to say, are you giving a discount to people who "deserve" it (meaning they have a hard time paying the usual asking price), or are most of your seniors actually well-off, country club goers whose demand elasticities are lower and therefore can and will pay a higher price?  Are you maximizing revenue by offering the discount, or not?

In the children's case, we should consider the product in question.  There stereotypical ones that come to mind are ice cream cones, candy, admission to parks/buses, and travel tickets.  In some cases, you may be maximizing revenue by admitting kids at a reduced or $0 rate because, without doing so, you may have lost the revenue for the kid's whole family.  In other cases, like candy and ice cream cones, are you damaging the current and future health of the child by putting fatty and sugary indulgences within their grasp?  

In this case, are you contributing to a negative externality in the form of obesity/diabetes/cardiovascular disease?  Does that matter, to you or in general?  Should a firm, or a manager, include ethical considerations in these pricing decisions?  I am not sure.

Price discrimination leads to increased profit by capturing more consumer surplus than would be achieved with a uniform pricing strategy.  In general, a firm sets P on demand curve D where MR intersects MC; this is the profit-maximizing uniform price for single product firm.  However, this price is the maximum price that the last consumer is willing to pay for the last unit produced; all other consumers have paid the same price but would have been willing to pay a slightly price.  This lost revenue, the difference between what each customer would have been willing to pay and the price they actually paid, is consumer surplus.

The basic premise of price discrimination is that we charge people a price that corresponds perfectly to their individual demand curves for the product; we charge them the maximum price they are willing to pay.  If we can do this for every consumer (essentially impossible), we are practicing perfect price discrimination and we will capture all consumer surplus.

A more practical approach comes with second- and third-degree price discrimination.  The first approach, second-degree discrimination, operates on the principle that buyers who need to buy more of a product have a smaller marginal benefit from each product and are therefore more price elastic than consumers who buy few units of a product.  Consumers self-select the prices they'll pay from a pre-determined schedule.  Declining block pricing and two-part pricing are approaches to second-degree discrimination.

Third-degree discrimination attempts to separate a market into two or more sub-markets and charge a different price in each sub-market.  It requires market research to segment markets based on needs and ability to pay, and with this information a firm can charge different prices to different sub-markets.  Third-degree discrimination cannot capture all consumer surplus, but does extract more profit than uniform pricing.

Negative externalities (and positive ones) are unintended or unwanted spillovers of the economic process whose costs are not internalized in the costs of production.  Pollution emitted from a factory is externalized because it is rationally ignored by the firm's decision makers because they are only concerned with the private costs of production.  Cleaning up the pollution is someone else's problem, especially because other firms in a competitive industry will make the profit-maximizing decision and ignore the pollution.

Emission taxes are a common regulation designed to reduce pollution optimal levels.  The first task is to decide what the "optimal level" of pollution might be, a problematic proposition in any case.  Also, the marginal damage caused by the pollution must be estimated, another problematic step.  The goal is to find a level at which the total cost of pollution, including pollution abatement, is minimized.  The optimal emissions tax is at the intersection of marginal damage and marginal abatement cost, MD and MAC.  A firm abates pollution so long as doing so costs less than paying the emissions tax; it abates no more than that.

Internalization is the act of paying for a cost that you could otherwise avoid.  Examples include pollution and waste, as well as their consequences, such as damaged wetlands and poisoned people (Bhopal, anyone?).  Internalization can happen voluntarily, from an ethical stance or to avoid costly litigation in the future; it can also be imposed by government.

Commonly imposed internalizations include recycling in municipalities where businesses and consumers are required to recycle (usually the minimum plastic, aluminium, and paper) and pollution control.  For any externality, the fact is that the externalizing firm is not paying the full costs of production.  For instance, a hazardous chemical company probably pays many of its workers a premium wage because of the hazards inherent in the work, and may even pay more for extra dangerous work, like being the guy who has to swim in the nuclear reactor pool.  In that case, the firm is internalizing some of the costs of production.

However, how do they dispose of their waste?  They probably used to pour it in the Cuyahoga River until they were forced to do something else.  But do they dispose of it themselves, properly?  In expensive, sealed chemical ponds; do they just burn it, making it "go away" but releasing toxic ash and dioxins, etc.; do they sell it to some company overseas who just dumps it in the ocean or in the local river?  

Personally, I am fairly cynical when it comes to our environmental effectiveness.  Businesses, acting rationally, externalize everything they can.  Those things they do internalize they do for marketing or regulatory reasons; the costs of internalization are themselves often re-externalized, as in the example of shipping waste overseas.  

Frankly, you will not get firms to effectively internalize by adopting the frame, the language, of business and managerial economics.  Decades of research into the business case for environmentalism, and decades of consultations, round-tables, task forces, and green marketing has consistently failed to achieve much of anything because managerial economics is the frame of business.

By adopting the opposing side's frame, we've lost.  That frame is defined by atomization and individualization; by external motivators like status and money; and, in the case of environmentalism, by appeals to future benefits lost.  This frame doesn't drive people to think of others, to value things intrinsically, or to think about future generations; it drives people into burrows where the natural instinct is to fend for yourself, for today, and tomorrow be damned because it sounds pretty bad.  

Profit Maximization in Different Market Structures

Profit-maximizing strategies differ among firms depending on the competitive nature of their industries.  Our text divides them into the following:

• Perfect Competition: In a perfectly competitive market (which is only approximated in the real world in some industries), a firm has zero market power, meaning that it has no ability to set its own price.  There are many relatively small firms producing a homogeneous, undifferentiated product. This means that the demand curve facing a perfect competitor is horizontal, the firm can sell as many units as it can produce at the market-determined price (which is also the marginal revenue curve), and it cannot raise its price without losing all of its sales.  Profit-maximizing scale is achieved, as always, at the point at which marginal cost equals marginal revenue, whether for the short run or the long.  In the long-run, this scale is achieved where the demand curve is tangent to LAC, which (since demand is horizontal) occurs at LACmin.  The firm produces as long as price exceeds AVC; otherwise, the firm shuts down to minimize its loss to its fixed (sunk) costs.
• Monopoly and monopolistic competition: These firms differ from perfect competitors because they have a degree (though limited) of market power and have some discretion over the prices they charge.  The monopolist is the only firm in the market, usually by virtue of legislation, whereas the monopolistic competitor is one among many, only slightly differentiated, producers.  The assumption is that the pricing and output decisions of monopolistic competitors has little or no effect on other firms in the industry and therefore operates independently.  Their demand curves are downward sloping and thus a price increase will reduce the output they can sell, and vice-versa.  Again, profit-maximizing scale is achieved where marginal revenue intersects marginal cost in both the short and the long run.  In the long-run, optimal scale also occurs where demand is tangent to LAC; though in this case, it cannot occur at LACmin (because demand is downward sloping).
• Oligopolies: An oligopoly is characterized by few, relatively powerful firms in the market whose pricing, output, and other business decisions affect the other firms in the oligopoly; this is called interdependence.  Each firm has a healthy degree of market power and can set its own price.  This is different from the monopolist or the monopolistic competitor setting their prices because in an oligopoly, the decisions of one firm engender reactions from the other firms.  Optimal scale is still achieved when MR = MC, but these curves depend on the firms demand curve which depends on the demand curves of the other firms in the industry.     Dealing with this uncertainty entails listing the help of game theory, a framework used to help predict the decisions of other firms.  The industry-profit maximizing result would tend to happen when the firms in an oligopoly cooperate; however, cooperation is unstable because any firm could unilaterally change its price and earn higher profits.  Therefore, even under explicit cooperation agreements, oligopolies tend to move toward the Nash equilibrium, which is the optimal decision assuming that all other players also make the optimal decision for their own best interest.  The Nash equilibrium is not the industry- or firm-profit maximizing position.  Successful strategic use of game theory requires detailed understanding of the industry and the cost, revenue, and demand curves facing competing firms.  Since cooperation tends to result in higher firm and industry profits, but since outright collusion is illegal, managers can attempt to identify their firms as strict tit-for-tat players or use techniques such as price matching, sale-price guarantees, public pricing, and price leadership.  These are all strategies to discourage cheating and avoid costly tactics such as price-wars, which lower profits for all firms.  

The best example I can think of for a monopoly is that of Microsoft with its Windows and Office software, or Apple with OSX and related software.  No one else can sell this software without express license from the owner.  Furthermore, both Apple and Microsoft can choose a price for their new OS or for an upgrade.  These monopolies are supported with strong consumer-lock-in because of high switching costs (buying a new computer, learning the new OS) and network effects, such that the more people that use the OS (say, iOS) the more useful it becomes for those who already use it.  Furthermore, any firm attempting to enter the market (say, Ubuntu Touch or Intel Tizen OS) faces sizable barriers to entry, in addition to those above, because to compete with either of these giants would require a massive entrance of advertising and other marketing efforts.

If I ran a small business, I think I would prefer a monopolistically competitive industry.  I think this because operating in an oligopoly sounds mighty difficult and the perfect competitor is subject to the whims of the market and has only to produce optimally.  The monopolistic competitor has things easier because it doesn't need to pay nearly as much attention to other firms as the oligopolist does, yet still has an opportunity to choose its price and output and compete on other points such as service and quality.  Then again, the oligopoly sounds like the most interesting, if the most stressful, arrangement.

These market structures are the crux of the course, and they incorporate everything we've learned so far.  The procedures for choosing optimal scale are applicable to almost any business endeavor, and the strategic framework outlined in chapter 13 is also incredibly useful.  They can be applied to decision-making on points besides price and help guide us, even in non-competitive instances, to the best decision given the decisions of others.  It also helps explain the sometimes odd behavior of industries, such as the example in the text of movie-star salaries, and gives insight into the moves of the companies that affect us the most, such as car, computer, and clothing companies.  

Production and Cost Theory

I've learned a great deal about production and cost decisions, but most of the principles I have already been exposed to.  For instance, the relationships between marginal and average cost and marginal and average product have been a part of most of my economics classes, as well as the dictum to ignore fixed costs for short-term decisions.  In general, while I did learn some things and the review was useful, Chapter 8 on the short-run was old hat for me.

Chapter 9, the long-run, was newer to me.  I had seen isoquants before but had not had the benefit of the in-depth treatment in this chapter.  More illuminating is the description of expansion paths between short- and long-term, and the strategic considerations that such an analysis allows.  The many elegant graphs throughout these chapters (and the text) aid my understanding.

Finally, the discussion of economies of scale and scope were a helpful review, and the "economy of experience" I had not come across before.  To be sure, I need to review both of these chapters to help me understand everything better.

The difference between the short- and long-runs is simple: in the short-run, only variable costs have a bearing on decision making, while in the long-run every cost is "variable".  The long-run is the planning horizon: "...the collection of all possible short-run situations."  In the long-run everything is possible: move production overseas, buy new capital, enter a new market, close down business.  In the short-run, we can make decisions only with those resources that are immediately disposable and have a direct bearing on production, such as hiring/firing workers; that is, the short-run variable costs.

Many companies take advantage of economies of scale and scope.  In fact, we might say that all companies take advantage of these concepts, because they are the long-run applications of short-term decision making theory (deciding on the margin).  Where I work, for instance, we try to take advantage of an economy of scope when we both deliver/pick-up the furniture as well as selling it, since we can provide the service of delivery for less in-house than it would cost to outsource it to another company.

The LRAC diminishes over time as output increases for industries with a high up-front investment, such as water treatment, steel refinement, or oil production.  That is, it takes an enormous amount of resources to create an infrastructure capable of doing steel refinement, and that massive up-front cost is averaged over each ingot produced.

Similarly, new drugs can really only be developed by companies with massive resources because of the huge expense of research, testing, and the high risk associated with the industry.

An economy of scale is also present in shipping: if you can ship more items / freight carrier, average cost per item goes down.

Supermarkets often band together in trade associations and other loose forms of cooperation in order to buy in bulk, lowering the average cost for all firms.

Elasticity of Demand and Indifference Curves

• Using what you have just learned about indifference curves and budget lines, explain how this might change your thinking about an every day task.

Economic thinking is very useful.  We would do well to remember the lessons we learn here in our everyday lives.  Indifference curves and budget lines, for instance, provide a conceptual way of thinking about the trade-offs we all make between various bundles of goods.  When I shop, for instance, I certainly try to maximize my total utility for the money I spend.  I have to make a decision about how much of one or some goods I am willing to sacrifice to buy, for instance, a case of soda, a high-dollar snack, or a big tub of ice cream.  

Perhaps a better example might be features on a new car.  I want all the bells and whistles, but can't afford them.  So I make an ad-hoc indifference curve in my mind between something like heated seats and an upgraded sound system.  If there are unheated fabric seats, heated fabrics, unheated leather, and heated leather; and if there are basic sound, upgraded sound, and premium sound, and an increase in one necessarily decreases the other, I might settle on upgraded sound and heated fabric seats.

However, sense my budget line doesn't actually touch all that many indifference curves, my marginal rates of substitution tend to apply to things like "with my budget, if I buy this energy drink at the store, is it worth it to sacrifice buying a beer after work?"  

You could apply indifference curves and budget lines to other decisions involving limited resources.  If my budget line represents the time I have for two different tasks, and I can perform one task better only at the expense of quality in the other task, I will try to set the marginal increases in quality in each task equal to the ratio of their respective time intensities; MQualX/Time = MQualY/Time.

• What are some factors that effect the price elasticity of demand?

There are three important factors:

• Availability of Substitutes
• Two goods are substitutes in consumption if an increase in price in one good increases the quantity demanded of the other good.  A good with many reasonable substitutes is price elastic because consumers will quickly buy the substitute after (even a ) small increase in price.  This is the most important determiner.
• Percentage of Consumer budget
• If a good takes up a relatively small amount of a consumer's budget, it will be more likely to be price inelastic because even a large change in the price is small relative to total money available.  A large purchase, like a computer, is more price elastic than the purchase of a jump drive
• Time period of adjustment
• Over time, for most goods, price elasticity of demand will tend to "normalize' over longer periods of time.  For instance, a good that is price-inelastic in the short term may find that its quantity demanded slowly falls after a price increase, even though the increase had little effect on quantity demanded initially.  Also, perhaps the opposite is true: a price elastic good that may have seen its quantity demanded rise/fall after a price decrease/increase might see quantity demanded move back to its original level over time as consumers (and the market) adjust to the new price.

• What type of price elasticity of demand does a Rolls-Royce exhibit.  How might having a knowledge of the concept of price elasticity of demand help your business as a high end auto manufacturer?

I would guess that a luxury good like a RR is relatively price-inelastic around the normal asking price for a RR.  But it depends on the model to an extent: the ultra-high-end, $500,000 model might be sold for $550K or $600K will only small changes in quantity demanded (but you couldn't just charge $1000K).  Moving down in price, however, would move toward greater dominance of the quantity effect as more consumers were able to afford the car.  

A more important determiner in this case is the availability of substitutes.  A wealthy playboy might choose a different car (a new Bentley) over the RR if it was a good amount cheaper.  Or, since wealthy people are sometimes crazy, he might by the RR simply because it's more expensive!  

As a manufacturer, I might try to construct indifference curves for various target-market incomes that made trade-offs between features I thought were important to my market: hugely powerful engine and performance vs overall comfortability of the experience (lots of amenities, noise insulation, more comfortable suspension, all of which add weight).  I would try to balance those qualities where the budget line of my target buyer is the tangent line to that indifference curve.

Reflections

Phillip Miller, ECO post one

• What did you learn in this module's readings that surprised you?
• The most interesting things I read concerned optimization and marginal analysis.  Also, I enjoyed the treatment of economic vs accounting profit.  I've taking courses that mentioned it before, but this text had a great explanation.
• Explain the difference between price taking and price setting firms.  Give an example of your experience with each.  Discuss the characteristics of the four market structures discussed in your text. 
• A price-taking firm is one that has no market power, operates in a competitive environment, and has the price of its good determined by market forces.  Such markets exist where consumers view competing products as identical and have no reason to pay more.  A price-setting firm is one with a degree of market power who can change its prices without losing all of its customers.  
• We all interact with these firms: to an extent, entry-level products from toe-nail clippers to value-menu burgers have their prices determined by the market.  And firms like Apple and Google operate in oligopolies, and they have some leverage, and strategic incentive, to manipulate their prices relative to their competitors.
• A monopoly is relatively rare these days but occurs when there are large barriers to entry, there are no real competitors, there are no close substitutes to the product, and the firm can charge almost whatever it wants.  Monopolistic competition occurs when there are many, relatively small firms competing who produce differentiated products but are not protected by substantial barriers to entry.  Monopolistic competitors are price-setters because product differentiation bestows a degree of market power.  Pure competition is similar to monopolistic competition except that perfect competitors don't have the market power necessary to set their own price: they are price-takers.  An oligopoly exists when there are only a few large firms supplying a market.  Their business decisions affect each other greatly, and is therefore the most complicated structure to analyze. 
• Discuss how you, or a business, "thinks at the margin" or uses marginal analysis to operate on a daily basis.  ie. give examples of what it means to optimize and how optimization problems are prevalent in your life. 
• I learned "thinking at the margin" a long time ago from a science teacher in high school.  He showed me exactly what our text has explained: that sunk, fixed, and average costs are irrelevant to the decision to do something "one more time."  He emphasized that whatever I had already invested - time, money - the only that that mattered was if "producing" another unit would raise my benefits over my total costs.  This applies, for example, to an essay: sure, I could write another section, go over it one more time, or find someone to proof-read it, but that extra effort might not pay off in an improved grade.
• Concerning optimization, I use calculus-based optimization language in my daily job.  My job is always constrained by time, resources, and physical capability.  I must decide, with the time and effort I have, how much a given piece of furniture needs to be protected, the amount of preparation - like putting blankets, moving objects - required to move the piece, etc.  If I am late to the next appointment, I've failed, just as I've failed if I damaged the piece but arrived on time.  Some pieces, like pine, are lightweight and require little in the way of protection.  Others demand a third person be present for the move.