Question

Discuss the concept of elasticity of demand and its role in making economic decisions.

Discuss about the Price strategy of the company in context of imperfect competition.

Competitive Microeconomic strategies of large enterprises in the context of the “new economy”

Answer 1

Role of Price Elasticity of Demand in Decision-Making

The concept of elasticity of demand plays a crucial role in the pricing decisions of the business firms and the Government when it regulates prices. The concept of price elasticity is also important in judging the effect of devaluation or depreciation of a currency on its export earnings.

It has also a great use in fiscal policy because the Finance Minister has to keep in view the price elasticity of demand when it considers to impose taxes on various commodities. We shall explain below the various uses, applications and importance of the elasticity of demand.

Pricing Decisions by Business Firms:

The business firms take into account the price elasticity of demand when they take decisions regarding pricing of the goods. This is because change in the price of a product will bring about a change in the quantity demanded depending upon the coeffi­cient of price elasticity.

This change in quantity demanded as a result of, say a rise in price by a firm, will affect the total consumer’s expenditure and will therefore, affect the revenue of the firm. If the demand for a product of the firm happens to be elastic, then any attempt on the part of the firm to raise the price of its product will bring about a fall in its total revenue.

Thus, instead of gaining from the increase in price, it will lose if the demand for its product happens to be elastic. On the other hand, if the demand for the product of a firm happens to be inelastic, then the increase in price by it will raise its total revenue. Therefore, for fixing a profit-maximising price, the firm cannot ignore the price elasticity of demand for its product.

Price elasticity of demand can be used to answer the following types of questions:

1. What will be the effect on sales if a firm decides to raise the price of its product, say by 5 per cent.

2. How large a reduction in price of a product is required to increase sales, say by 25 percent.

Big corpo­rate business firms have established their research departments which estimate the coefficient of price elasticity from the data concerning past prices and quantities demanded. Further, they are also using statistical techniques to isolate the price effect on the quantity demanded from the effects of other factors.

Example - Uses in Economic Policy Regarding Price Regulation and Crop Restriction of Farm Products:

Governments of many countries, especially the United States of America provide subsidies per unit of the products produced to the farmers to give them incentives to produce more as due to inelastic nature of demand for farm products more production causes such a steep fall in the prices of farm products that leads to the decrease in incomes of farmers.

Pricing Strategies : Imperfect Competition :

Monopolistic Competitive Market Pricing Strategy

In a monopolistic competitive market, companies set prices for their products. Since every company sells a product that might be the same as that of another company, each company can successfully set its prices. However, these prices will be dependent on the quantity they desire to produce. Since there are still many producers, this will not affect the market as a whole.

A company will use branding, advertising, and packaging to sell seemingly different products. Consequently, there exist many prices in the market due to differentiated products.

Also, since there are many competitors, a firm won’t be affected by another firm’s strategy. As a result, companies will have control over their own prices.

Oligopolistic Competition Market Pricing Strategy

Here, prices are determined by competitors. Firms in this market structure are highly dependent on each other for setting prices. With only a few sellers in an oligopoly, a company can affect the market prices but cannot control the whole market. As a result, competition is based on product differentiation and services, but not on price wars.

Generally, an optimal pricing strategy, in the long run, incorporates the reactions of rival firms to changes in prices by competitors.

Monopoly Market Structure

The pricing strategy here is relatively simple. A monopoly can comfortably set prices due to the absence of competitors. However, monopolists are careful not to set their prices too high not to attract competitors or have consumers change their consumption habits in favor of substitutes. Raising prices may also lead to a fall in sales since prices depend on demand.

Competitive Microeconomic strategies of large enterprises in the context of the “new economy”:

Competition policy in the information economy In general, vertical or horizontal integration tends to be pro-competitive as long as the decisions of firms are strategic complements in markets with imperfect competition. Further, mergers or strategic alliances can be expected to promote innovation activities which make use of complementary system components to create new products or new value-creating combinations of existing system components. In this respect increased concentration tends to enhance the innovation performance of industries. On the other hand, increased concentration enables firms to exploit bundling strategies in order to extract the increased willingness of consumers to pay for more integrated bundles of products or services. In particular, the presence of network externalities or switching costs makes it possible for a firm to achieve a dominant market position, in the sense of antitrust legislation, at a lower market share than what would be the case in a “traditional” industry. Similarly, a firm possessing a dominant market position and operating in a network industry has access to a larger number as well as more efficient strategic instruments in order to abuse its dominant market position relative to a firm operating in a “traditional” industry. For that reason structural microeconomic policies in the form of competition policy and antitrust legislation can be regarded to potentially have a higher social rate of return when applied within the innovationintensive core industries in the information economy than within “traditional” industries. As a consequence thereof, the potential gains from these microeconomic policies can be expected to increase relative to those associated with macroeconomic policies. However, as an antitrust evaluation of switching costs in oligopolistic industries the analysis of the previous paragraph is restricted to a short-run perspective, where firms compete in the market. In the long run oligopoly firms strategically compete for markets by introductory offers or by commitments to discounts or loyalty programs. Thus, in order to assess the welfare consequences of switching costs we face a tradeoff between short-run competition in markets at the stage when customer relationships are already formed and long-run competition for markets at the stage prior to the formation of customer relationships. The existing literature offers model-specific, and thereby mixed, evaluations of this tradeoff. Klemperer (1987, 1995) focuses on models in which individual firms and industries generally profit from switching costs and his policy recommendation seems to be in favor of policies designed to prevent the strategic creation of switching costs. However, in Klemperer’s models firms are not able to engage in intertemporal price discrimination. Contrary to this approach Gehrig and Stenbacka (2002a) focus on an environment where firms can engage in intertemporal price discrimination and they demonstrate that competition for market shares will be so intense at the stage prior to the formation of customer relationships that the subsequent stage of relaxed competition sheltered from switching cost barriers cannot compensate. Thus, Gehrig and Stenbacka (2002a) offer a formalized argument for the policy conclusion that the strategic use of introductory offers should be promoted, not banned, if firms are able to discriminate across different vintages of customers. Switching costs may also affect the welfare implications of information exchange between oligopolists. Gehrig and Stenbacka (2002b) show that information sharing between lenders enhances the profits in loan markets by relaxing price competition among banks at the stage when customer relationships are formed within the framework of a banking model where oligopoly rents are generated by switching costs. In other words, if banks have market power due to switching costs, information sharing in lending markets will magnify the industry rents associated with this market power. The implementation of competition policy might in general be more difficult in the core industries of the information economy than in “traditional” industries. In the new economy the competition policy concepts and instruments always need to be modified so as to fit not only traditional and static views of competition, but also the dynamic features of competition in the high-tech network industries.

Competition policy: challenges ahead Monopoly tends to be good for the owners, but bad for consumers. Common wisdom among economists further suggests that the negative impact on consumers tends to dominate relative to the positive profit effects associated with monopolization. This divergence explains, in a nutshell, why governments employ antitrust policies. However, technological progress, network externalities and international competition all represent disturbances relative to the common wisdom outlined above. With the innovationintense competition typical for the information economy, innovation is increasingly driven by firms that win temporary monopoly power, but enjoy it only for a moment before being replaced by a company with a better product that itself gains a short-lived monopoly position. This suggests that the information economy may feature more monopolies than the traditional sectors of the economy, but that these monopolies may harm consumers only for a limited period of time. Indeed, if these market dynamics encourage innovation, consumers might actually benefit from the dynamic efficiency generated by high market concentration. Analogously, the presence of network externalities offers additional strategic instruments whereby incumbent firms might be able to abuse dominant market positions. Finally, the presence of export revenues in imperfectly competitive international markets, in its turn, means a shift in the tradeoff between consumer and producer interests. Future research on competition policy should attach particular priority to general characterizations of optimal national competition policy as well as its implementation in the presence of endogenous technological progress, network effects and international competition. The existing literature has typically addressed compe-tition policy issues in the absence of network externalities or international trade. Access pricing is a good example of a policy which promotes competition among firms in industries exhibiting network effects (e.g., telecommunication services). In fact, a large majority of the antitrust cases, which during the past few years have reached, for example, the Competition Council in Finland, focus on firms operating in network industries. There are strong reasons for why future policy-related research in this field should pay particular attention to the implementation issues. How should access pricing be designed and what should be the relationship between regulatory authorities and competition authorities when it comes to network industries? What is generally the optimal design of the competitionpromoting agency, i.e. what objectives given to the competition authorities represent an optimal form of strategic delegation? How can the competition authorities overcome barriers created by asymmetric information in relationship to the firms? How can, for example, leniency programs be exploited to induuce self-reporting on behalf of cartel members? The importance of precisely identifying the objective(s) which competition policy is supposed to achieve is emphasized by the characteristics of the information economy. Namely, the information economy is likely to magnify the conflict between consumer welfare, on the one hand, and plausible alternative objectives such as fairness relative to competitors or the promotion of small and medium sized enterprises, on the other hand. Namely, the combination of economies of scale on the supply side and network effects on the demand side tends to make concentrated markets consistent with efficiency and mechanical attempts to keep the market artificially fragmented are likely to damage not only the industry, but also the consumers. In spite of the tendency for single firms to dominate high-tech industries, these firms are unable to persistently sustain monopoly positions, either by raising prices or by failing to innovate. For lurking behind every corner are potential threats to dominance. In fact, the recent history of high-tech industries offers many examples of once-dominant firms that have failed to run hard enough to defend their dominance – McDonnell-Douglas, Polaroid and Silicon Graphics to name a few examples.