managerial economics can be defined as amalgamation of economic theory with business practices so as...

7/31/2019 Managerial Economics Can Be Defined as Amalgamation of Economic Theory With Business Practices So as to Eas

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Managerial Economics can be defined as amalgamation of economic theory with business

practices so as to ease decision-making and future planning by management. ManagerialEconomics assists the managers of a firm in a rational solution of obstacles faced in the firmsactivities. It makes use of economic theory and concepts. It helps in formulating logicalmanagerial decisions. The key of Managerial Economics is the micro-economic theory of the

firm. It lessens the gap between economics in theory and economics in practice. ManagerialEconomics is a science dealing with effective use of scarce resources. It guides the managers intaking decisions relating to the firms customers, competitors, suppliers as well as relating to the

internal functioning of a firm. It makes use of statistical and analytical tools to assess economictheories in solving practical business problems.

Study of Managerial Economics helps in enhancement of analytical skills, assists in rationalconfiguration as well as solution of problems. While microeconomics is the study of decisionsmade regarding the allocation of resources and prices of goods and services, macroeconomics isthe field of economics that studies the behavior of the economy as a whole (i.e. entire industriesand economies). Managerial Economics applies micro-economic tools to make business

decisions. It deals with a firm.

The use of Managerial Economics is not limited to profit-making firms and organizations. But itcan also be used to help in decision-making process of non-profit organizations (hospitals,educational institutions, etc). It enables optimum utilization of scarce resources in suchorganizations as well as helps in achieving the goals in most efficient manner. ManagerialEconomics is of great help in price analysis, production analysis, capital budgeting, risk analysisand determination of demand.

Managerial economics uses both Economic theory as well as Econometrics for rationalmanagerial decision making. Econometrics is defined as use of statistical tools for assessing

economic theories by empirically measuring relationship between economic variables. It usesfactual data for solution of economic problems. Managerial Economics is associated with theeconomic theory which constitutes Theory of Firm. Theory of firm states that the primary aimof the firm is to maximize wealth. Decision making in managerial economics generally involvesestablishment of firms objectives, identification of problems involved in achievement of those

objectives, development of various alternative solutions, selection of best alternative and finallyimplementation of the decision.


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Business Strategy is closely related with the concept of Strategic Management which is defined as a

process of specifying an organization's objectives, developing plans and policies to achieve these

objectives and effectively allocating resources to implement the required plans and policies.Business Strategy can be defined as a constant process of strategizing and prioritizing the goals of a

business such as to conform to its long term objectives of growth and expansion and a motive to

capture a larger market share. It is a continuous and ongoing situation where the business assesses

the industry trend in which the company is involved, the nature of its existing and potentialcompetitors, new technologies and a constantly changing social, political and financial environment.Business strategies or strategic planning is undertaken by the top managerial authority of a

business and is subject to dynamic changes. A business strategy would usually constitute a strategy

formulation (evaluation of the present situation) and a strategy implementation (allocation of

resources and assigning specific tasks to particular individuals). Business Strategies when

formulated have the most important feature of assessing the strengths and weaknesses of the

company, the opportunities that the future holds and reviewing the threats posed by competing

business rivals. A business strategy can integrate all the aspects of a business' activities and can

serve as a systematic and management tool for problem solving and product development strategies

and the issues of market planning.

Business Strategy and Managerial Economics is an interdisciplinary field of study of economics thatencompasses the fields of both managerial economics and business strategy. The branch builds a bridgebetween the two closely interrelated fields of study in undertaking the most prudent business decisions ina competitive setting with a large number of firms where each of them act to maximize their revenue andprofits. Business strategy and managerial economics as a branch of social science vis--vis economics issimilar to theory of games which is extensively used to determine business decisions in a world ofimperfect competition. The optimal solution in a situation of games occurs when each of the acting agents(business firms in this case) optimize their own strategies insuring against the best strategies of theirrivals.

Managerial economics or business economics is a division of economics that involves heavy applicationof microeconomic analysis in case of business decisions. It is drawn heavily from quantitative techniques

such as regression and correlation and methods of Lagrangian calculus. One of the essential features ofmanagerial economics as a true bridge between economic theory and economics in practice is the attemptto optimize business decisions subject to the business' objectives and the constraints imposed upon it bythe scarcity of resources. This is where we find unison between business strategy and managerialeconomics. It is widely approached as an integration subject. Business strategy concentrates itself on thestrategic planning techniques and business planning strategies to maximize its long term objectives. Thelong term objectives usually constitute growth objectives, maximization of sales and revenue in the longterm and the constant effort to diversify its services. Business strategy is an ongoing and continuousprocess which undergoes continuous adaptations with changing objectives and plans and policies toachieve those objectives. The adaptations are made in view of the changing business environment withthe with entry and exit of business firms and an assessment or review of its strategies annually orquarterly to face the competition meted out by the existing and potential competitors. Business strategy

constitutes of strategy formulation and strategy implementation. While strategy formulation entails doinga situation analysis and competitor analysis and setting goals in accordance with this assessment, strategyimplementation requires allocation of sufficient resources and establishing a chain of command oradhering by an alternative structure. Strategy implementation involves managing the process, monitoringthe results and analyzing the efficiency and efficacy of the process and accommodating the necessaryadjustments.


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Development of its product and its effective marketing is one of the pillars of the business strategies for abusiness organization. Microeconomic considerations such as maximization of one's own returns can belooked at both from the point of view of business economics as well as studies of business strategies ofdifferent firms or companies. Business strategy and managerial economics works with great efficacy inthe following aspects of economics :

It is especially useful in analyzing the risk of a business decision and various uncertainty models,decision rules and risk quantification techniques comes under its ambit.

Production efficiency, optimum factor allocation, costs and economies of scale can be analyzed usingmicroeconomic techniques that come under its fold.

Microeconomic methods coming under the ambit of business strategy and managerial economics can beused to evaluate pricing decisions such as transfer pricing, joint product pricing, price discriminationpractices and the accounting for differences of price elasticity.

Investment theory which can be formulated by business strategy and managerial economics can behelpful to deal with capital budgeting used to examine the capital purchasing and investment decisions ofa business.

Technically, Managerial Economics and Business Strategy encompasses the issues of the number of firmsin the market, the extent of diffusion of technology and the extent of research and developmentundertaken by businesses to gain technological advantage, the demand conditions in the market and thebehavior of consumers towards a particular brand, production efficiency in terms of economies of scalethus capturing market power, measures of industry concentration, profits of the business and whetherproduction takes place at the socially optimum level. Business strategy and managerial economics alsodelves deep into the topics of integration and merger activity (horizontal or vertical integration orconglomerate mergers), antitrust policies, analysis of market failure in the presence of externalities andincomplete information.


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Production function

Inmicroeconomicsandmacroeconomics, a production function is afunctionthat specifies theoutput of a firm, an industry, or an entire economy for all combinations ofinputs. This functionis an assumed technological relationship, based on the current state ofengineeringknowledge; it

does not represent the result of economic choices, but rather is an externally given entity thatinfluences economic decision-making. Almost all economic theories presuppose a productionfunction, either on the firm level or the aggregate level. In this sense, the production function isone of the key concepts ofmainstreamneoclassicaltheories. Some non-mainstream economists,however, reject the very concept of an aggregate production function.[1][2]

Concept of production functions

Inmicro-economics, a production function is afunctionthat specifies the output of a firm forall combinations of inputs. A meta-production function (sometimes metaproduction function)compares the practice of the existing entities converting inputs into output to determine the mostefficient practice production function of the existing entities, whether the most efficient feasiblepractice production or the most efficient actual practice production.[3]clarification needed In either case,the maximum output of a technologically-determined production process is a mathematicalfunction of one or more inputs. Put another way, given the set of all technically feasiblecombinations of output and inputs, only the combinations encompassing a maximum output for aspecified set of inputs would constitute the production function. Alternatively, a productionfunction can be defined as the specification of the minimum input requirements needed to

produce designated quantities of output, given available technology. It is usually presumed thatunique production functions can be constructed for every production technology.

By assuming that the maximum output technologically possible from a given set of inputs isachieved, economists using a production function in analysis are abstracting from theengineering and managerial problems inherently associated with a particular production process.The engineering and managerial problems of technical efficiencyare assumed to be solved, sothat analysis can focus on the problems of allocative efficiency. The firm is assumed to bemaking allocative choices concerning how much of each input factor to use and how muchoutput to produce, given the cost (purchase price) of each factor, the selling price of the output,and the technological determinants represented by the production function. A decision frame in

which one or more inputs are held constant may be used; for example, (physical)capitalmay beassumed to be fixed (constant) in theshort run, and labour and possibly other inputs such as rawmaterials variable, while in thelong run, the quantities of both capital and the other factors thatmay be chosen by the firm are variable. In the long run, the firm may even have a choice oftechnologies, represented by various possible production functions.

The relationship of output to inputs is non-monetary; that is, a production function relatesphysical inputs to physical outputs, and prices and costs are not reflected in the function. But the
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production function is not a full model of the production process: it deliberately abstracts frominherent aspects of physical production processes that some would argue are essential, includingerror, entropy or waste. Moreover, production functions do not ordinarily model the businessprocesses, either, ignoring the role of management. (For a primer on the fundamental elements ofmicroeconomic production theory, seeproduction theory basics).

The primary purpose of the production function is to address allocative efficiency in the use offactor inputs in production and the resulting distribution of income to those factors. Undercertain assumptions, the production function can be used to derive a marginal productfor eachfactor, which implies an ideal division of the income generated from output into an income dueto each input factor of production.

Specifying the production function

A production function can be expressed in a functional form as the right side of

where:

quantity of output

quantities of factor inputs (such as capital, labour, land or raw

materials).

IfQ is not amatrix(i.e. a scalar, avector, or even a diagonal matrix), then this form does notencompass joint production, which is a production process that has multiple co-products. On theother hand, iff maps from Rn to Rk then it is a joint production function expressing thedetermination ofkdifferent types of output based on the joint usage of the specified quantities ofthe n inputs.

One formulation, unlikely to be relevant in practice, is as a linear function:

where and are parameters that are determined empirically.

Another is as aCobb-Douglasproduction function:

The Leontief production function applies to situations in which inputs must be used in fixedproportions; starting from those proportions, if usage of one input is increased without anotherbeing increased, output will not change. This production function is given by
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Other forms include theconstant elasticity of substitutionproduction function (CES), which is ageneralized form of the Cobb-Douglas function, and the quadratic production function. The best

form of the equation to use and the values of the parameters ( ) vary from company to

company and industry to industry. In a short run production function at least one of the 's(inputs) is fixed. In the long run all factor inputs are variable at the discretion of management.

Production function as a graph

Quadratic Production Function

Any of these equations can be plotted on a graph. A typical (quadratic) production function isshown in the following diagram under the assumption of a single variable input (or fixed ratiosof inputs so the can be treated as a single variable). All points above the production function areunobtainable with current technology, all points below are technically feasible, and all points onthe function show the maximum quantity of output obtainable at the specified level of usage of
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the input. From the origin, through points A, B, and C, the production function is rising,indicating that as additional units of inputs are used, the quantity of output also increases.Beyond point C, the employment of additional units of inputs produces no additional output (infact, total output starts to decline); the variable input is being used too intensively. With toomuch variable input use relative to the available fixed inputs, the company is experiencing

negative marginal returns to variable inputs, and diminishing total returns. In the diagram this isillustrated by the negative marginal physical product curve (MPP) beyond point Z, and thedeclining production function beyond point C.

From the origin to point A, the firm is experiencing increasing returns to variable inputs: Asadditional inputs are employed, output increases at an increasing rate. Both marginal physicalproduct(MPP, the derivative of the production function) and average physical product (APP, theratio of output to the variable input) are rising. The inflection point A defines the point beyondwhich there are diminishing marginal returns, as can be seen from the declining MPP curvebeyond point X. From point A to point C, the firm is experiencing positive but decreasingmarginal returns to the variable input. As additional units of the input are employed, output

increases but at a decreasing rate. Point B is the point beyond which there are diminishingaverage returns, as shown by the declining slope of the average physical product curve (APP)beyond point Y. Point B is just tangent to the steepest ray from the origin hence the averagephysical product is at a maximum. Beyond point B, mathematical necessity requires that themarginal curve must be below the average curve (See production theory basics for furtherexplanation.).

Stages of production

To simplify the interpretation of a production function, it is common to divide its range into 3stages. In Stage 1 (from the origin to point B) the variable input is being used with increasing

output per unit, the latter reaching a maximum at point B (since the average physical product isat its maximum at that point). Because the output per unit of the variable input is improvingthroughout stage 1, a price-taking firm will always operate beyond this stage.

In Stage 2, output increases at a decreasing rate, and the average and marginal physical productare declining. However, the average product of fixed inputs (not shown) is still rising, becauseoutput is rising while fixed input usage is constant. In this stage, the employment of additionalvariable inputs increases the output per unit of fixed input but decreases the output per unit of thevariable input. The optimum input/output combination for the price-taking firm will be in stage2, although a firm facing a downward-sloped demand curve might find it most profitable tooperate in Stage 1. In Stage 3, too much variable input is being used relative to the available

fixed inputs: variable inputs are over-utilized in the sense that their presence on the marginobstructs the production process rather than enhancing it. The output per unit of both the fixedand the variable input declines throughout this stage. At the boundary between stage 2 and stage3, the highest possible output is being obtained from the fixed input.
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Shifting a production function

By definition, in the long run the firm can change its scale of operations by adjusting the level ofinputs that are fixed in the short run, thereby shifting the production function upward as plottedagainst the variable input. If fixed inputs are lumpy, adjustments to the scale of operations may

be more significant than what is required to merely balance production capacity with demand.For example, you may only need to increase production by a million units per year to keep upwith demand, but the production equipment upgrades that are available may involve increasingproductive capacity by 2 million units per year.

Shifting a Production Function

If a firm is operating at a profit-maximizing level in stage one, it might, in the long run, chooseto reduce its scale of operations (by selling capital equipment). By reducing the amount of fixedcapital inputs, the production function will shift down. The beginning of stage 2 shifts from B1to B2. The (unchanged) profit-maximizing output level will now be in stage 2.

Homogeneous and homothetic production functions

There are two special classes of production functions that are often analyzed. The production

function is said to be homogeneous of degree n, if given any positive

constant , . If , the function exhibits increasingreturns to scale, and it exhibits decreasing returns to scale if . If it is homogeneous ofdegree 1, it exhibits constant returns to scale. The presence of increasing returnsmeans that aone percent increase in the usage levels of all inputs would result in a greater than one percentincrease in output; the presence of decreasing returns means that it would result in a less than one
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percent increase in output. Constant returns to scale is the in-between case. In the Cobb-Douglas

production function referred to above, returns to scale are increasing if ,

decreasing if , and constant if .

If a production function is homogeneous of degree one, it is sometimes called "linearly

homogeneous". A linearly homogeneous production function with inputs capital and labour hasthe properties that the marginal and average physical products of both capital and labour can beexpressed as functions of the capital-labour ratio alone. Moreover, in this case if each input ispaid at a rate equal to its marginal product, the firm's revenues will be exactly exhausted andthere will be no excess economic profit.[4]:pp.412-414

Homothetic functions are functions whose marginal technical rate of substitution (the slope ofthe isoquant, a curve drawn through the set of points in say labour-capital space at which thesame quantity of output is produced for varying combinations of the inputs) is homogeneous ofdegree zero. Due to this, along rays coming from the origin, the slopes of the isoquants will be

the same. Homothetic functions are of the form where is a

monotonically increasing function (the derivative of is positive ( )), and the

function is a homogeneous function of any degree.

Aggregate production functions

In macroeconomics, aggregate production functions for whole nations are sometimesconstructed. In theory they are the summation of all the production functions of individualproducers; however there are methodological problems associated with aggregate productionfunctions, and economists have debated extensively whether the concept is valid.[2]

Criticisms of production functions

There are two major criticisms of the standard form of the production function. On the history ofproduction functions, see Mishra (2007).[5]

On the concept of capital

During the 1950s, '60s, and '70s there was a lively debate about the theoretical soundness ofproduction functions. (See the Capital controversy.) Although the criticism was directedprimarily at aggregate production functions, microeconomic production functions were also put

under scrutiny. The debate began in 1953 whenJoan Robinsoncriticized the way the factor inputcapitalwas measured and how the notion of factor proportions had distracted economists.

According to the argument, it is impossible to conceive of capital in such a way that its quantityis independent of the rates of interest and wages. The problem is that this independence is aprecondition of constructing an isoquant. Further, the slope of the isoquant helps determinerelative factor prices, but the curve cannot be constructed (and its slope measured) unless theprices are known beforehand.
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On the empirical relevance

As a result of the criticism on their weak theoretical grounds, it has been claimed that empiricalresults firmly support the use of neoclassical well behaved aggregate production functions.Nevertheless,Anwar Shaikh[6]has demonstrated that they also have no empirical relevance, as

long as alleged good fit outcomes from an accounting identity, not from any underlying laws ofproduction/distribution.
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Returns to scaleFrom Wikipedia, the free encyclopedia

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In economics, returns to scale and economies of scale are related terms that describe whathappens as the scale of production increases in the long run, when all input levels includingphysicalcapitalusage are variable (chosen by the firm). They are different terms and should notbe used interchangeably. The term returns to scale arises in the context of a firm'sproductionfunction. It refers to changes in output resulting from a proportional change in all inputs (whereall inputs increase by a constant factor). If output increases by that same proportional changethen there are constant returns to scale (CRS). If output increases by less than that proportionalchange, there are decreasing returns to scale (DRS). If output increases by more than thatproportional change, there are increasing returns to scale (IRS). Thus the returns to scale facedby a firm are purely technologically imposed and are not influenced by economic decisions or bymarket conditions.[citation needed]

A firm's production function could exhibit different types of returns to scale in different rangesof output. Typically, there could be increasing returns at relatively low output levels, decreasingreturns at relatively high output levels, and constant returns at one output level between thoseranges.[citation needed]

Example

When all inputs increase by a factor of 2, new values for output will be:

Twice the previous output if there are constant returns to scale (CRS) Less than twice the previous output if there are decreasing returns to scale (DRS) More than twice the previous output if there are increasing returns to scale (IRS)

Assuming that the factor costs are constant (that is, that the firm is a perfect competitor in allinput markets), a firm experiencing constant returns will have constantlong-run average costs, a

firm experiencing decreasing returns will have increasing long-run average costs, and a firmexperiencing increasing returns will have decreasing long-run average costs.[1][2][3]However, thisrelationship breaks down if the firm is not a perfect competitor in the input markets. Forexample, if there are increasing returns to scale in some range of output levels, but the firm is sobig in one or more input markets that increasing its purchases of an input drives up the input'sper-unit cost, then the firm could have diseconomies of scale in that range of output levels.Conversely, if the firm is able to get bulk discounts of an input, then it could have economies of
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scale in some range of output levels even if it has decreasing returns in production in that outputrange.

Network effect

Network externalities resemble economies of scale, but they are not considered such becausethey are a function of the number of users of a good or service in an industry, not of theproduction efficiency within a business. Economies of scale external to the firm (or industrywide scale economies) are only considered examples of network externalities if they are drivenby demand side economies.

Formal definitions

Formally, a production function is defined to have:

constant returns to scale if (for any constant a greater than 0) increasing returns to scale if (for any constant a greater than 1) decreasing returns to scale if (for any constant a greater than 1)

where K and L are factors of production, capital and labor, res
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Production Optimization

To maximize the performance and bottom-line contribution of operational assets, organizationsneed to move beyond traditional operating approaches and embrace new methods andtechnologies that enable the highest possible production yield at the lowest possible cost, while

operating in a safe and environmentally conscious manner.

Invensys Operations Management provides a wide range of solutions aimed at addressing thischallenge, combining our extensive global expertise and experience with state of the artmodeling and simulation software. The results are immediate and significant, includingimproved yield, reduced energy consumption, reduced emissions and higher availability. Oursolutions include integration with your business systems to provide real-time businessintelligence, allowing you to optimize profitability in real time.

Our consulting and services team work with you throughout the process identifyingopportunities for improvement, designing and implementing the required solutions and then

continuing with you to ensure that the expected returns are met and exceeded.

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China Ministry of Railways

Starting with a 100-mile line for the 2008 Beijing Olympics, the China Ministry of Railways haschosen Wonderware software to expand the countrys national railway system.
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Break-even (economics)The Break-Even Point'

Ineconomics&business, specificallycost accounting, the break-even point (BEP) is the pointat which cost or expenses and revenue are equal: there is no net loss or gain, and one has "broken

even". A profit or a loss has not been made, althoughopportunity costshave been "paid", andcapital has received the risk-adjusted, expected return.[1]

For example, if a business sells fewer than 200 tables each month, it will make a loss, if it sellsmore, it will be a profit. With this information, the business managers will then need to see ifthey expect to be able to make and sell 200 tables per month.

If they think they cannot sell that many, to ensure viability they could:

1. Try to reduce the fixed costs (by renegotiating rent for example, or keeping better control oftelephone bills or other costs)

2. Try to reduce variable costs (the price it pays for the tables by finding a new supplier)3. Increase the selling price of their tables.

Any of these would reduce the break even point. In other words, the business would not need tosell so many tables to make sure it could pay its fixed costs.

Computation

In the linearCost-Volume-Profit Analysismodel,[2]the break-even point (in terms of Unit Sales(X)) can be directly computed in terms of Total Revenue (TR) and Total Costs (TC) as:

where:

TFC is TotalFixed Costs, P is Unit Sale Price, and V is Unit Variable Cost.
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The Break-Even Point can alternatively be computed as the point whereContributionequalsFixed Costs.

The quantity is of interest in its own right, and is called theUnit Contribution Margin(C): it is the marginal profit per unit, or alternatively the portion of each sale that contributes toFixed Costs. Thus the break-even point can be more simply computed as the point where TotalContribution = Total Fixed Cost:

In currency units (sales proceeds) to reach break-even, one can use the above calculation andmultiply by Price, or equivalently use the Contribution Margin Ratio (Unit Contribution Margin

over Price) to compute it as:

R=C, Where R is revenue generated, C is cost incurred i.e. Fixed costs + Variable Costs or Q *P(Price per unit) = TFC + Q * VC(Price per unit), Q * P - Q * VC = TFC, Q * (P - VC) = TFC,or, Break Even Analysis Q = TFC/c/s ratio=Break Even

Margin of SafetyMargin of safety represents the strength of the business. It enables a business to know what is theexact amount it has gained or lost and whether they are over or below the break even point.[3]

margin of safety = (current output - breakeven output)

margin of safety% = (current output - breakeven output)/current output x 100

When dealing with budgets you would instead replace "Current output" with "Budgeted output".

If P/V ratio is given then profit/ PV ratio

Break Even Analysis

By inserting different prices into the formula, you will obtain a number of break even points, onefor each possible price charged. If the firm changes the selling price for its product, from $2 to$2.30, in the example above, then it would have to sell only (1000/(2.3 - 0.6))= 589 units tobreak even, rather than 715.
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To make the results clearer, they can be graphed. To do this, you draw the total cost curve (TC inthe diagram) which shows the total cost associated with each possible level of output, the fixedcost curve (FC) which shows the costs that do not vary with output level, and finally the various

total revenue lines (R1, R2, and R3) which show the total amount of revenue received at eachoutput level, given the price you will be charging.

The break even points (A,B,C) are the points of intersection between the total cost curve (TC)and a total revenue curve (R1, R2, or R3). The break even quantity at each selling price can beread off the horizontal axis and the break even price at each selling price can be read off thevertical axis. The total cost, total revenue, and fixed cost curves can each be constructed withsimple formulae. For example, the total revenue curve is simply the product of selling pricetimes quantity for each output quantity. The data used in these formulae come either fromaccounting records or from various estimation techniques such asregression analysis.

Application

The break-even point is one of the simplest yet least used analytical tools in management. Ithelps to provide a dynamic view of the relationships between sales, costs and profits. A betterunderstanding of break-even, for example, is expressing break-even sales as a percentage ofactual salescan give managers a chance to understand when to expect to break even (bylinking the percent to when in the week/month this percent of sales might occur).

The break-even point is a special case ofTarget Income Sales, where Target Income is 0(breaking even). This is very important for financial analysis.

Limitations

Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you nothing aboutwhat sales are actually likely to be for the product at these various prices.

It assumes that fixed costs (FC) are constant. Although this is true in the short run, an increase inthe scale of production is likely to cause fixed costs to rise.

It assumes average variable costs are constant per unit of output, at least in the range of likelyquantities of sales. (i.e. linearity)

It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., thereis no change in the quantity of goods held in inventory at the beginning of the period and the

quantity of goods held in inventory at the end of the period).

In multi-product companies, it assumes that the relative proportions of each product sold andproduced are constant (i.e., the sales mix is constant).
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Price discriminationFrom Wikipedia, the free encyclopedia

Jump to:navigation,search

Price discrimination or price differentiation[1]exists when sales of identical goods or servicesare transacted at differentpricesfrom the same provider.[2]In a theoretical market withperfectinformation,perfect substitutes, and notransaction costsor prohibition on secondary exchange(or re-selling) to preventarbitrage, price discrimination can only be a feature ofmonopolisticandoligopolisticmarkets,[3]wheremarket powercan be exercised. Otherwise, the moment the sellertries to sell the same good at different prices, the buyer at the lower price can arbitrage by sellingto the consumer buying at the higher price but with a tiny discount. However, productheterogeneity,market frictionsor high fixed costs (which make marginal-cost pricingunsustainable in the long run) can allow for some degree of differential pricing to differentconsumers, even in fully competitive retail or industrial markets. Price discrimination also occurswhen the same price is charged to customers which have different supply costs.

The effects of price discrimination onsocial efficiencyare unclear; typically such behavior leadsto lower prices for some consumers and higher prices for others. Output can be expanded whenprice discrimination is very efficient, but output can also decline when discrimination is moreeffective at extracting surplus from high-valued users than expanding sales to low valued users.Even if output remains constant, price discrimination can reduce efficiency by misallocatingoutput among consumers.

Price discrimination requiresmarket segmentationand some means to discourage discountcustomers from becoming resellers and, by extension, competitors. This usually entails using oneor more means of preventing any resale, keeping the different price groups separate, making

price comparisons difficult, or restricting pricing information. The boundary set up by themarketer to keep segments separate are referred to as a rate fence. Price discrimination is thusvery common in services where resale is not possible; an example is student discounts atmuseums. Price discrimination inintellectual propertyis also enforced by law and bytechnology. In the market for DVDs, DVD players are designed - by law - with chips to preventan inexpensive copy of the DVD (for example legally purchased in India) from being used in ahigher price market (like the US). TheDigital Millennium Copyright Acthas provisions tooutlaw circumventing of such devices to protect the enhanced monopoly profits that copyrightholders can obtain from price discrimination against higher price market segments.

Price discrimination can also be seen where the requirement that goods be identical is relaxed.

For example, so-called "premium products" (including relatively simple products, such ascappuccino compared to regular coffee) have a price differential that is not explained by the costof production. Some economists have argued that this is a form of price discrimination exercisedby providing a means for consumers to reveal their willingness to pay.
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Types of price discrimination

First degree price discrimination

This type of price discrimination is primarily theoretical because it requires the seller of a good

or service to know the absolute maximum price (orreservation price) that every consumer iswilling to pay. By knowing the reservation price, the seller is able to absorb the entire marketsurplus, thus taking all of theconsumer's surplusfrom the consumer and transforming it intorevenues. From a social welfare perspective though, first degree price discrimination is notnecessarily undesirable. That is, the market is entirely efficient and there is nodeadweight losstosociety. In a market with first degree price discrimination, the seller(s) simply captures allsurplus. This type of market does not exist much in reality, hence it is primarily theoretical.Examples of where this might be observed are in markets where consumers bid for tenders,though still, in this case, the practice ofcollusive tenderingundermines efficiency.

Second degree price discrimination

In second degree price discrimination, price varies according to quantity sold. Largerquantities are available at a lower unit price. This is particularly widespread in sales to industrialcustomers, where bulk buyers enjoy higher discounts.

Additionally to second degree price discrimination, sellers are not able to differentiate betweendifferent types of consumers. Thus, the suppliers will provide incentives for the consumers todifferentiate themselves according to preference. As above, quantity "discounts", or non-linearpricing, is a means by which suppliers use consumer preference to distinguish classes ofconsumers. This allows the supplier to set different prices to the different groups and capture alarger portion of the total market surplus.

In reality, different pricing may apply to differences in product quality as well as quantity. Forexample, airlines often offer multiple classes of seats on flights, such as first class and economyclass. This is a way to differentiate consumers based on preference, and therefore allows theairline to capture more consumer's surplus.

Third degree price discrimination

In third degree price discrimination, price varies by attributes such as location or by customersegment, or in the most extreme case, by the individual customer's identity; where the attribute inquestion is used as a proxy for ability/willingness to pay.

Additionally to third degree price discrimination, the supplier(s) of a market where this type ofdiscrimination is exhibited are capable of differentiating between consumer classes. Examples ofthis differentiation are student or senior discounts. For example, a student or a senior consumerwill have a different willingness to pay than an average consumer, where the reservation price ispresumably lower because of budget constraints. Thus, the supplier sets a lower price for thatconsumer because the student or senior has a more elastic price elasticity of demand (see thediscussion of price elasticity of demand as it applies to revenues from the first degree price
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discrimination, above). The supplier is once again capable of capturing more market surplus thanwould be possible without price discrimination.

Note that it is not always advantageous to the company to price discriminate even if it ispossible, especially for second and third degree discrimination. In some circumstances, the

demands of different classes of consumers will encourage suppliers to ignore one or more classesand target entirely to the rest. Whether it is profitable to price discriminate is determined by thespecifics of a particular market.

Fourth degree price discrimination

In fourth degree price discrimination, prices are the same for different customers, howevercosts to the organization may vary. For example, one may buy a plane ticket, but call ahead toorder a vegetarian meal, possibly costing the company more to provide, but your ticket has nogreater cost to you. This is also known as reverse price discrimination, as the effects are reflectedon the producer.

Modern taxonomy

The first/second/third degree taxonomy of price discrimination is due to Pigou (Economics ofWelfare, 4th edition, 1932). See, e.g.,modern taxonomy of price discrimination. However, thesecategories are not mutually exclusive or exhaustive. Ivan Png (Managerial Economics, 2ndedition, 2002) suggests an alternative taxonomy:

Complete discrimination -- where each user purchases up to the point where the user'smarginal benefit equals the marginal cost of the item;

Direct segmentation -- where the seller can condition price on some attribute (like age orgender) that directlysegments the buyers;

Indirect segmentation -- where the seller relies on some proxy (e.g., package size, usagequantity, coupon) to structure a choice that indirectlysegments the buyers.

The hierarchycomplete/direct/indirectis in decreasing order of

profitability and information requirement.

Complete price discrimination is most profitable, and requires the seller to have the mostinformation about buyers. Indirect segmentation is least profitable, and requires the seller to have

the least information about buyers.
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Two part tariff

the two part tariff is another form of price discrimination where the producer charges an initialfee then a secondary fee for the use of the product, an example of this is razors, you pay an initialcost for the Gillet razor and then pay for the replacement blades, this pricing strategy works

because it shifts the demand curve to the right since you have already paid for the initial bladeholder you will buy the blades which are now cheaper than buying a disposable razor, theformulea for profit from a two part tariff is =PQ+nT-C1(Q)-C2(n) where is profit P is price Qis quantity n is number of customers (who pay tariff) C is cost

so re written it is = (price x quantity + number of people x tariff) - the cost of producing thatquantity - the cost of producing the tariff (blade holders)

Sales revenue without and with Price Discrimination

The purpose of price discrimination is generally to capture the market'sconsumer surplus. Thissurplus arises because, in a market with a single clearing price, some customers (the very lowprice elasticity segment) would have been prepared to pay more than the single market price.Price discrimination transfers some of this surplus from the consumer to the producer/marketer.Strictly, a consumer surplus need not exist, for example where some below-cost selling isbeneficial due to fixed costs or economies of scale. An example is a high-speed internetconnection shared by two consumers in a single building; if one is willing to pay less than halfthe cost, and the other willing to make up the rest but not to pay the entire cost, then pricediscrimination is necessary for the purchase to take place.

It can be proved mathematically that a firm facing a downward sloping demand curve that isconvex to the origin will always obtain higher revenues under price discrimination than under asingle price strategy. This can also be shown diagrammatically.

In the top diagram, a single price (P) is available to all customers. The amount of revenue isrepresented by area P, A, Q, O. The consumer surplus is the area above line segment P, A butbelow the demand curve (D).

With price discrimination, (the bottom diagram), the demand curve is divided into two segments(D1 and D2). A higher price (P1) is charged to the low elasticity segment, and a lower price (P2)is charged to the high elasticity segment. The total revenue from the first segment is equal to the

area P1,B, Q1,O. The total revenue from the second segment is equal to the area E, C,Q2,Q1.The sum of these areas will always be greater than the area without discrimination assuming thedemand curve resembles a rectangular hyperbola with unitary elasticity. The more prices that areintroduced, the greater the sum of the revenue areas, and the more of the consumer surplus iscaptured by the producer.
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Note that the above requires both first and second degree price discrimination: the right segmentcorresponds partly to different people than the left segment, partly to the same people, willing tobuy more if the product is cheaper.

It is very useful for the price discriminator to determine the optimum prices in each market

segment. This is done in the next diagram where each segment is considered as a separate marketwith its own demand curve. As usual, the profit maximizing output (Qt) is determined by theintersection of the marginal cost curve (MC) with the marginal revenue curve for the total market(MRt).

Multiple Market Price Determination

The firm decides what amount of the total output to sell in each market by looking at theintersection of marginal cost with marginal revenue (profit maximization). This output is then

divided between the two markets, at the equilibrium marginal revenue level. Therefore, theoptimum outputs are Qa and Qb. From the demand curve in each market we can determine theprofit maximizing prices of Pa and Pb.

It is also important to note that the marginal revenue in both markets at the optimal output levelsmust be equal, otherwise the firm could profit from transferring output over to whichever marketis offering higher marginal revenue.
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Examples of price discrimination

Retail price discrimination

In certain circumstances, it is a violation of theRobinson-Patman Act, (a 1936 Federal U.S.

antitrust statute) for manufacturers of goods to sell their products to similarly situated retailers atdifferent prices based solely on the volume of products purchased.

Travel industry

Airlinesand other travel companies use differentiated pricing regularly, as they sell travelproducts and services simultaneously to different market segments. This is often done byassigning capacity to various booking classes, which sell for different prices and which may belinked to fare restrictions. The restrictions or "fences" help ensure that market segments buy inthe booking class range that has been established for them. For example, schedule-sensitivebusiness passengers who are willing to pay $300 for a seat from city A to city B cannot purchase

a $150 ticket because the $150 booking class contains a requirement for a Saturday night stay, ora 15-day advance purchase, or another fare rule that discourages, minimizes, or effectivelyprevents a sale to business passengers.

Notice however that in this example "the seat" is not really always the same product. That is, thebusiness person who purchases the $300 ticket may be willing to do so in return for a seat on ahigh-demand morning flight, for full refundability if the ticket is not used, and for the ability toupgrade to first class if space is available for a nominal fee. On the same flight are price-sensitivepassengers who are not willing to pay $300, but who are willing to fly on a lower-demand flight(say one leaving an hour earlier), or via a connection city (not a non-stop flight), and who arewilling to forgo refundability.

On the other hand, an airline may also apply differential pricing to "the same seat" over time, e.g.by discounting the price for an early or late booking (without changing any other fare condition).This could present an arbitrage opportunity in the absence of any restriction on reselling.However, passenger name changes are typically prevented or financially penalized by contract.

Since airlines often fly multi-leg flights, and since no-show rates vary by segment, competitionfor the seat has to take in the spatial dynamics of the product. Someone trying to fly A-B iscompeting with people trying to fly A-C through city B on the same aircraft. This is one reasonairlines useyield managementtechnology to determine how many seats to allot for A-Bpassengers, B-C passengers, and A-B-C passengers, at their varying fares and with varying

demands and no-show rates.

With the rise of the Internet and the growth of low fare airlines, airfare pricing transparency hasbecome far more pronounced. Passengers discovered it is quite easy to compare fares acrossdifferent flights or different airlines. This helped put pressure on airlines to lower fares.Meanwhile, in the recession following the September 11, 2001, attacks on the U.S., businesstravelers and corporate buyers made it clear to airlines that they were not going to be buying airtravel at rates high enough to subsidize lower fares for non-business travelers. This prediction
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has come true, as vast numbers of business travelers are buying airfares only in economy classfor business travel.

There are sometimes group discounts on rail tickets and passes. This may be in view of thealternative of going by car together.

Coupons

The use of coupons in retail is an attempt to distinguish customers by their reserve price. Theassumption is that people who go through the trouble of collecting coupons have greater pricesensitivity than those who do not. Thus, making coupons available enables, for instance,breakfast cereal makers to charge higher prices to price-insensitive customers, while still makingsome profit off customers who are more price-sensitive.

Premium pricing

For certain products, premium products are priced at a level (compared to "regular" or"economy" products) that is well beyond theirmarginal costof production. For example, a coffeechain may price regular coffee at $1, but "premium" coffee at $2.50 (where the respective costsof production may be $0.90 and $1.25). Economists such asTim Harfordin theUndercoverEconomisthave argued that this is a form of price discrimination: by providing a choice betweena regular and premium product, consumers are being asked to reveal their degree of pricesensitivity (or willingness to pay) for comparable products. Similar techniques are used inpricing business class airline tickets and premium alcoholic drinks, for example.

This effect can lead to (seemingly)perverse incentivesfor the producer. If, for example,potential business class customers will pay a large price differential only if economy class seats

are uncomfortable while economy class customers are more sensitive to price than comfort,airlines may have substantial incentives to purposely make economy seating uncomfortable. Inthe example of coffee, a restaurant may gain more economic profit by making poor qualityregular coffeemore profit is gained from up-selling to premium customers than is lost fromcustomers who refuse to purchase inexpensive but poor quality coffee. In such cases, the netsocial utility should also account for the "lost" utility to consumers of the regular product,although determining the magnitude of this foregone utility may not be feasible.

Segmentation by age group and student status

Manymovie theaters,amusement parks,tourist attractions, and other places have different

admission prices per market segment: typical groupings are Youth, Student, Adult, and Senior.Each of these groups typically have a much different demand curve. Children, people living onstudent wages, and people living on retirement generally have much lessdisposable income.

Discounts for members of certain occupations

Many businesses, especially in theSouthern United States, offer reduced prices to activemilitarymembers. In addition to increased sales to the target group, businesses benefit from the resulting
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positive publicity, leading to increased sales to the general public. Less publicized are discountsto other service workers such aspolice; off-duty police customers in high-crime areas are said toconstitute free security.[citation needed]

Employee discounts

Most people feel that discounts businesses give to their own employees are an employee benefit(and is often listed as such in the employee handbook). However, some might construe this as aform of price discrimination.

Retail incentives

A variety of incentive techniques may be used to increase market share or revenues at the retaillevel. These include discount coupons, rebates, bulk and quantity pricing, seasonal discounts,and frequent buyer discounts.

Incentives for industrial buyers

Many methods exist to incentivize wholesale or industrial buyers. These may be quite targeted,as they are designed to generate specific activity, such as buying more frequently, buying moreregularly, buying in bigger quantities, buying new products with established ones, and so on.Thus, there are bulk discounts, special pricing for long-term commitments, non-peak discounts,discounts on high-demand goods to incentivize buying lower-demand goods, rebates, and manyothers. This can help the relations between the firms involved.

Sex-based examples

Many sex-based price differences are held to be illegal but still occur often in countries such astheUnited Statesand theUnited Kingdom.

"Ladies' night"

Many North American and Europeannightclubsfeature a "ladies' night" in which women areoffered discount or free drinks, or are absolved from payment ofcover charges. This differs fromconventional price discrimination in that the primary motive is not, usually, to increase revenueat the expense of consumer surplus, but to increase the club's attractiveness to the market sidemore willing to pay (men), for the benefit of the other (women). (See alsotwo-sided market)

Dry cleaning

Dry cleaners typically charge higher prices for the laundering of women's clothes than for men's.Some US communities have reacted by outlawing the practice. Dry cleaners justify the pricedifferences because women's clothes typically require far more time to press than men's clothesdue to more pleating. This qualifies an example of price discrimination if at least part of thereason for the higher pricing is really the dry cleaner's belief that women will be willing to paymore than men.
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Haircutting

Women's haircuts are often more expensive than men's haircuts because women generally havelonger, more complex hairstyles whereas men generally have shorter hairstyles. Some salonshave modified their pricing to reflect "long hair" versus "short hair" or style instead of sex. This

situation has been common practice in barber shops for decades.

Automobile Insurance

Males have traditionally been charged higher rates than women for automobile insurance,andmuch higher rates for under-30s. This disparity is especially prevalent for males under the age of25.

Financial aid in education

Financial aidas offered by U.S.collegesanduniversitiesis a form of price discrimination that is

widely accepted, and completely legal.

Haggling

Many cultures involvehagglingin market transactionsinflated prices are posted, but thecustomer can negotiate with the vendor. In theUnited States, haggling is rare to non-existent inretail, but common whenautomobilesand homes are sold. Negotiation often requires knowledge,confidence, and the ability to manage confrontational personalities, and vendors know that manycustomers will pay higher prices in order to avoid negotiating.

International price discrimination

Pharmaceutical companies may charge customers living in wealthier countries (such as theUnited States) a much higher price than for identical drugs in poorer nations, as is the case withthe sale of anti-retroviral drugs in Africa. Since the purchasing power of African consumers ismuch lower, sales would be extremely limited without price discrimination. The ability ofpharmaceutical companies to maintain price differences between countries is often eitherreinforced or hindered by national drugs laws and regulations, or the lack thereof.

Although not common in modern times, governments have traditionally raised revenues fromtariffs. When these are not flat tariffs, the government effectively sets the prices of goods that arenot produced locally and are only imported.

Even online sales for non material goods, which do not have to be shipped, may changeaccording to the geographic location of the buyer. A song in Apple's iTunes costs 79 pence (1.49USD) for Britons but only 99 cents for Americans. (~50% more for the same song) Thesedifferences may arise because of changes inexchange ratesthat occur much more frequentlythan changes in prices, or they may arise because the license-holders (in this case, recordcompanies) are enforcing their existing pricing policy on new licensees or intermediaries.
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Academic pricing

Main article:Academic software pricing

Companies will often offer discountedsoftwareto students and faculty at K-12 anduniversitylevels. These may be labeled as academic versions, but perform the same as the full priceretail

software. Academic versions of the most expensive software suites may be priced as little as onefifth or less of retail price. Some academic software may have differing licenses than retailversions, usually disallowing their use in activities for profit or expiring the license after a givennumber of months. This also has the characteristics of an "initial offer" - that is, the profits froman academic customer may come partly in the form of future non-academic sales due tovendorlock-in. For example, an accounting student buys academically pricedMicrosoft Excel, and as aresult of getting used to it, continues to use it throughout a future career, the future editions ofwhich he buys at full price, instead of moving to the fully compatibleOpenOffice.orgequival

managerial economics can be defined as amalgamation of economic theory with business practices so as...

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