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Chapter 10
SPECIAL PRICING PRACTICES

Capital Arrangements
Competition is a very tough taskmaster. To survive in competition, in the long run, a company
must operate at its most efficient (minimum) cost point, and it will earn no more than a normal return.
Thus, there is always an incentive for a company to try to become more powerful than its competitors—
in the extreme, to become a monopolist. In an oligopolistic type of industry, where there are several
powerful firms, it would probably be impossible for one firm to eliminate all the others. So, to reap the
benefits of a monopoly (i.e., higher profits and the general creation of a more certain and less competitive
environment), it may be possible for companies in the industry to act together as if they were a monopoly.
In other words, they all agree to cooperate with one another; they form a cartel. Cartel arrangements may
be tacit, but in most cases, some sort of formal agreement is reached. The motives for cartelization have
been recognized for many years. Indeed, early recognition can be found in a passage in Adam Smith's
famous book written in 1776: “People of the same trade seldom meet together, even for merriment and
diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise
prices.

Cases of Price Fixing by Cartels

A classic case of price-fixing and market sharing ended in February 1961 in a Philadelphia court,
when seven executives of General Electric, Westinghouse, and other companies were sent to jail and fined;
twenty-three others were given suspended sentences and fined, and twenty-nine companies were fined
a total of about $2 million. Starting shortly after World War II, this conspiracy is involved a number of
heavy electrical equipment products, such as switching gears, circuit breakers, transformers, and turbine
engines. The companies involved pleaded guilty and no contest to the federal indications.

Price Leadership
When collusive arrangements are not easily accomplished, another type of pricing practice may
occur under oligopolistic market conditions. This is the practice of price leadership, in which there is no
formal or tacit agreement amongst the oligopolists to keep prices at the same level or change them by
the same amount. However, when a price movement is initiated by one of the companies, others will
follow. Examples of such practices are bound. You may have observed that at two or more petrol stations
at the same intersection, prices for each grade of gasoline are either identical or almost the same most of
the time. Another example is automobile companies, which in recent years have come up with rebate
programs. Surely you have seen ads offering “$1,000 cash or 3.9 percent financing.” One company is
typically the first to announce such a program; the others follow in short orders.
We just described two major variations of the price leadership phenomenon: barometric and
dominant price leadership.

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1. Barometric Price Leadership. There may not be a firm that dominates all the others and sets
the price every time. One firm in the industry—and it does not necessarily have to be the
same one—will initiate a price change in response to economic conditions, and the other
firms may or may not follow the leader.
2. Dominant Price Leadership. When an industry contains one company distinguished by its size
and economic power relative to other firms, the dominant price leadership model arises. The
dominant company may well be the most efficient (i.e., lowest-cost) company.

Revenue Maximization
Another model of oligopolistic behavior was developed a few years ago by the American
economist William Baumol. Ignoring interdependence, the Baumol model suggests that a firm's primary
objective, rather than profit maximization, may be the maximization of revenue, subject to satisfying a
specific level of profits. He gives several reasons for this objective, amongst them (1) a firm will be more
competitive when it achieves large size (in terms of revenue), and (2) management remuneration may be
more closely related to revenue than to profits.

Price Discrimination
Up to this point, we assume a company will sell identical products at the same price in all markets.
(When the terms identical is used in this context, it implies that the costs of producing and delivering the
product are the same.) But such is not always the case. When a company sells identical products in two
or more markets, it might charge different prices in the markets. Such a practice is typically referred to as
price discrimination. the word discrimination here is not used in a normative sense There is no judgment
being made about whether this practice is good or bad. (The term differential pricing could have been
used instead, but the former term has become part of the everyday language of the economist.)
Price discrimination means one of the following:
1. Products with identical costs are sold in different markets at different prices.
2. The ratio of price to marginal cost differs for similar products.

Non-Marginal Pricing
Throughout this text, we appear to have assumed all businesspeople calculate demand and cost
schedules, obtain marginal revenue and marginal cost curves, equal marginal revenue with marginal cost,
and thereby determine their profit-maximizing selling price and production quantity.

Multi-Product Pricing
In economics, much of the analysis makes use of simplifying assumptions. For example, we know
that very few products in our economy are produced under conditions of perfect competition.
Nevertheless, a large portion of our text—and all other economics texts—is dedicated to its discussion.
There are good reasons for this practice. First, perfect competition is the simplest of the economic models
and is thus a good starting point for the discussion of more complex systems. Second, many markets,
although

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not perfectly competitive (i.e., firms are faced by downward-sloping demand curves), can be
analyzed as such because their behavior resembles perfect competition closely enough. Any predictions
based on this analysis will be extremely accurate to obviate the need for more complex models.

Transfer Pricing
The management of each division is charged with a profit goal. Thus, each stage of production
must measure its costs and then establish a price at which it will “transfer” its product to the next phase.
However, if each intermediate profit center were to set its price to maximize its own profit, the price of
the final product might not maximize the profit of the company as a whole, which is the appropriate
objective. The price set by the division moving the intermediate product becomes the cost of the division
receiving this product. If that price is set too high, this may start a chain reaction resulting in the final
product price being higher than the price which would maximize company's profit. The transfer pricing
mechanism should be geared toward maximizing total company profit; Hence, the final pricing policy may
be dictated centrally from the top of the corporation.

Other Pricing Practices

1. Price Skimming, occurs when a firm is the first to introduce a product. It may have a virtual
monopoly, and often will be able to charge high prices and obtain substantial profits before
competition enters.
2. Penetration pricing, a company sets a relatively low price in order to get market share.
3. Limit Pricing, exists when a monopoly sets a price below the monopoly price (where MR 5
MC) to discourage potential competitors from entering the market and competing. At the
lower price, the monopolist’s profit will be below its maximum. Of course, limited pricing may
be based on the monopolist's expectation that its cost will decrease because of the existence
of a learning curve so that in the end the limit price will become the profit-maximizing price.
4. Predatory Pricing, where a company prices below its marginal cost to cause competitors to
exit the market. After the competitors have left the market, the company will raise its prices.
However, this practice is not seen very often in the United States because it is illegal under
the Sherman Antitrust Act. Also, it may create considerable losses to the monopolist and may
not be worthwhile in the long run. Further, after the monopolist raises prices, a new
competitive threat may appear. So, the company may have to lower prices again and incur
new losses.
5. Prestige Pricing, demand for a product may be higher at a higher price because of the prestige
that ownership bestows on the buyer.
6. Psychological Pricing, takes advantage of the fact that the demand for a particular product
may be quite inelastic over a certain range but will become rather elastic at one specific higher
or lower price. Such a request curve has the appearance of a step function.

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Chapter 11
GAME THEORY AND ASYMMETRIC INFORMATION

Game Theory: Modelling The Strategy of Conflict

Economists have expanded and refined the analysis of oligopoly markets using game theory to
examine strategic interaction. A game is distinguished by the number of players in the game and the
number of options or strategies available to every player. A game involving players making strategic
decisions from an available set of options. Players are the decision-making units that play the game Each
player selects among various strategies or options. A strategy is an option available for a player.
In the present context, a player is just a firm, and the options available to that player (firm) are
the policy alternatives under the control of the player. For example, there might be two nightclubs in town
and each can decide whether to have a deejay or a live band play on a Saturday evening. The players are
the two nightclubs (or more accurately the managers of the two nightclubs), and the options are either to
have a live band or a deejay. This is a 2 3 2 game (two players with each player having two choices). Each
of the four possible alternatives (two players with two strategies each) will have payoffs linked with that
alternative for both players. Payoffs are the results associated with a set of strategies. Every player will
have a payoff for each set of alternatives.
Oligopolistic interactions can be modeled using game theory. Games are most easily examined if
we limit our analysis to two players. Each player has a set of possible strategies that they can follow The
outcome, or payout, to each player depends not only on which strategy she or he decides to pursue but
also which strategy her or her rival decides to pursue. A payoff matrix describing the set of strategies and
payouts available in the game.

The Prisoners’ Dilemma

Many oligopolistic interactions have the structure of a prisoner's dilemma. The prisoners'
dilemma is a game in which the option of "confessing" dominates "not confessing" for both players, but
confessing leads to a worse outcome for both than if both could decide not to confess. In the context of
oligopolistic price and volume setting, for example, the cartel solution has a higher price and lower output
than the individual profit-maximizing solution; Hence, there is an incentive for each party to cheat on the
cartel solution.
Suppose that two individuals, White and Gray, are suspected of jointly committing a crime, and
there is weak evidence to support this suspicion. For example, both have been caught trying to fence (sell)
items that were stolen in an armed robbery. The prosecutors would like to convict the suspect on the
more serious charge, but the evidence linking the individuals to that charge is weak The suspects were
picked up and put in separate interrogation rooms, where prosecutors provide each suspect with the
following options:
• If neither suspect confesses, both will be convicted of the stolen property and receive a 1-
year sentence.

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• If only one suspect confesses and is willing to testify at the trial of the other, the one who
confesses will get probation on the stolen property charge and receive no prison time. The
other will accept a 15-year sentence.
• If both suspects admit, both will be put away for 10 years.
The dilemma is that recognition is a dominant strategy for both parties. Confession dominates not
confessing for White regardless of what Gray does, and confession dominates not confessing for Gray
despite what White does. Put in terms of the discussion in this chapter, the set of strategies (confess,
confess) representing a dominant strategy equilibrium. Of course, both parties would be better off if they
could communicate with one another and agree not to confess. And that is the reason that the
prosecutors try to "sweat" each suspect separately. But even if they can communicate and reach an
agreement, there is an incentive to cheat on the bargain.

The Basics of Bargaining

Bargaining is negotiating over the terms of an agreement. When two individuals’ bargain over the
terms of the sale of a house they engage in explicit bargaining Such games as these are called cooperative
games. A cooperative game is a game in which the players can negotiate explicit binding contracts over
different states of nature. The negotiation over the sale of a house involves explicit bargaining over what
happens under different states of nature, which makes it an example of a cooperative game. Price is the
most obvious negotiation point in the sale of a house, and a higher price for the seller means less
consumer surplus for the buyer, so you might be surprised to learn that this is a cooperative game. The
fact that $1 more for one player means $1 less for the other player means that this is zero sum game. Zero
sum game is a game where the sum of payouts is constant Whether the constant is zero or another
number does not change how such games are analyzed therefore, they are often called constant sum
games. Most games we examined are, by contrast, variable. A variable sum game is a game where the
sum of payouts for each set of strategies varies. These games are also called non-zero-sum games or non-
constant-sum games.

Asymmetric Information
A different problem arises when buyers and sellers have different information about the product.
It is known as asymmetric information. A market is subject to an informational asymmetry if one party or
the other tends to be at a systematic informational advantage relatively to the other party in the market
interaction. Consider three possible markets interactions involving asymmetric information:
• Who knows more about the quality of a used car, the buyer or the seller?
• Who knows more about the probable future productivity of a worker, the person who is trying
to get hired, or the person who is doing the hiring?
• Who knows more about how risky a driver is, the person who is purchasing auto insurance or
the person selling auto insurance?

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In the first two markets, the seller knows more than the buyers. In the third, the buyers know
more than the seller. Each of these markets is a classic example that highlights how asymmetric
information affects markets for a product

The Lemon Model

The lemons model developed by George Akerlof includes sellers with more information than
buyers. In this setting, an adverse selection problem occurs as the market for used cars becomes skewed
toward low-quality cars (lemons) because buyers are not able to differentiate a good used car from a
lemon. As a result, used cars sell for a discount based purely on the informational asymmetry that exists
in this market.
The lemons problem can lead to markets in which only low-quality cars will be sold, or it may
simply lead to a market in which the proportion of low-quality cars are higher than would be sold if buyers
and sellers had the same information. A secondary implication of the lemons model is that demand may
be backward bending because buyers will recognize that the average quality declines as price declines. If
used car prices declined, consumers will demand more due to the law of downward sloping demand But
this decline in used car price increases the odds of getting a lemon.

Moral Hazard and Principal-Agent Problems

The moral hazard problem is a specific example of the principle-agent problem. The principal-
agent problem occurs because the principal (the person who has hired an agent to perform a task) cannot
(fully) monitor the actions of the agent. This permits the agent to pursue objectives that may be at odds
with those of the principal. The classic example of the agency issue is the problem faced by shareholders
in monitoring the actions of managers of a firm. The separation of ownership (principal) from control
(manager) leads to the ability of managers to pursue their own objectives. Managers do not have
complete latitude in this regard—if they are stray too far from the owner's wishes, they may find
themselves without a job either because they are fired or because their firm is acquired by corporate
raiders.
The principal-agent problem may be reduced by the appropriate choice of a managerial
compensation package. If the goals of the owner are instilled in the manager via the incentive structure
built into the compensation package, then the manager’s interests will coincide more closely with the
owners. Profit-sharing plans and stock options are two common mechanisms for achieving this objective.

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Chapter 12
CAPITAL BUDGETING AND RISK

The Capital Budgeting Decision

Capital budgeting describes decisions where expenses and receipts for a particular undertaking
will continue over a period of time. These decisions usually involve outflows of funds (expenditures) in
the early periods, and the inflows (revenues) start rather later and continue for a significant number of
periods.
Capital budgeting involves the evaluation of projects in which initial expenditures provide streams
of cash inflows over a significant period of time. The process of evaluating capital proposals includes the
following:
1. Estimating all incremental cash flows resulting from the project
2. Discounting all flows to the present
3. Determining whether a proposal should be accepted

Types of Capital Budgeting Decision

Now that we have described the general characteristics of a capital budgeting decision, we can
list types of projects that fit this category:
1. Expansion of facilities. Growing demand for a company's products leads to the consideration
of a new or additional plant, sales offices, or warehouses.
2. New or improved products. Additional investment may be required to bring a new or changed
product to the market.
3. Replacement. Replacement decisions can be of at least two types: (1) replacement of worn-
out plant and equipment or (2) replacement with more efficient machinery of equipment that
is still operating but is obsolete.
4. Lease or buy. A company may need to decide whether to make a sizable investment in buying
a piece of equipment or to pay rental for a sufficient time period.
5. Make or buy. A company may be faced with deciding whether to make a significant
investment to produce components or to forgo such investment and contract for the
components with a vendor. Outsourcing, which has become extremely important during the
past decade or so, is discussed in Chapter 2 and elsewhere.
6. Other. A capital budgeting problem exists whenever initial cash outflows and subsequent cash
inflows are involved. For instance, an advertising campaign or an employee training program
would lend itself to the same method of analysis.
7. Safety or environmental protection equipment. Such investments may be mandated by law
and therefore are not necessarily governed by economic decision-making. However, if there
are alternate solutions, capital budgeting analysis may be helpful in identifying the most cost-
effective alternative.

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Time Value of Money

Because capital budgeting involves cash flows occurring at various times in the future, we have to
make them equivalent at a particular point in time. It involves the use of the time value of money. All this
term really means that a dollar today is worth more than a dollar tomorrow. As long as there is an
opportunity to earn a positive return on funds, a dollar today and a dollar a year from now are not equal.
(In the consumer's choice context, there is a time value of money even in the absence of being able to
earn a positive return. A dollar today provides extra options to the individual. she or he can either spend
it today or save it to spend tomorrow.

Methods of Capital Project Evaluation

Various methods are used to make capital budgeting decisions, that is, to evaluate the worth of
investment projects. Two methods that have been used for many years are mentioned only briefly. They
are the payback method and the accounting rate of return method. Although they are still often used in
the business world, they have generally been judged to be inadequate.
The payback method calculates the time period (years) necessary to recover the original
investment. The accounting rate of return is the percentage resulting from dividing average annual profits
by average investment. Among the many drawbacks of these methods is the fact that neither applies the
criterion of the time value of money in its computations. Readers who are not familiar with these two
measures and are interested in learning about them will find more lengthy descriptions in any basic
corporate finance textbook.
The two major methods that do discount cash flows to a present value are net present value (NPV)
and internal rate of return (IRR). Both techniques satisfy the two major criteria required for the correct
evaluation of capital projects: use of cash flows and use of the time value of money.
1. Net Present Value. The net present value of a project is calculated by discounting all flows to
the present and subtracting the present value of all outflows from the current value of all
inflows.
2. Internal Rate of Return. Rather than looking for an absolute amount of present-value dollars,
as in the NPV analysis, we solve for the interest rate that equals the present value of inflows
and outflows
3. The Profitability Index. There is a third method for evaluating projects, which supplement the
previous two methods. It is called the profitability index (PI).
Two methods are recommended for evaluating capital budgeting proposals — NPV and IRR. The
validity of these two criteria are compared. We found that, from a theoretical viewpoint, the NPV is the
more valid. However, there is much to recommend the use of IRR, and business, in fact, prefers this
technique. In most cases both methods lead to the same answer.

Cash Flows
When faced with a capital budgeting proposal, the analyst's most difficult task is to enter the best
estimates of cash flows into the analysis. Because all of the inflows and outflows are in the future, their
amounts and timing are uncertain. Some of them, such as the cost of the new machine, may be assessed

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with relative certainty. But as the analyst attempts to assess future annual benefits and costs, the amount
of uncertainty increases.
Cash flows come in many variations. Some of the most common and important types are covered
next.
1. Initial Cash Flows
2. Operating Cash Flows
3. Additional Working Capital
4. Salvage or Resale Values
5. Non-Cash Investment

Cost of Capital
To invest in capital projects, a company must get financing. Financing, of course, comes from
various sources. There is a debt, either short-term or long term. So there is equity. A company may retain
earnings, which then becomes part of its equity, or it can issue new shares. Each type of financing should
be paid for; each has its costs. It is these costs that established a company's cost of capital. When all the
costs have been identified, they are combined to arrive at an average cost of capital for a given debt /
equity mix.

Risk Versus Uncertainty

In economic or financial theory, the two terms risk and uncertainty have somewhat different
meanings, even though they are frequently used interchangeably. Although no future events are known
with certainty, some events can be assigned probability, and others cannot. Where future events can be
defined and the probability assigned, we have a case of risk. Thus, for example, a company's sales manager
estimates that next year's sales of diet cola have a 25 percent probability to be 5 million cases, a 50 percent
probability to be 6 million, and a 25 percent probability to be 7 million. If there is no way to assign any
probability to future random events, we are addressing pure uncertainty. Even though this distinction is
theoretically important, many writers’ omission it as a matter of convenience.

Sources of Business Risk

What are the sources of risk faced by a businessperson?
1. Economic conditions: Firms face the rising and falling phases of the business cycle. Although
forecasting can help prepare a business for changes, it cannot totally predict the timing and
volatility of economic activity.
2. Fluctuations in specific industries: Such fluctuations may not necessarily coincide with the
overall economy.
3. Competition and technological change: When competitors improve a product or new
technologies are introduced, sales of specific companies or industries are affected.
4. Changes in consumer preferences: Successful products for one year may become the
discarded, undesirable items of the next. The fashion industry is a great example of changing
styles.

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5. Costs and expenses: Labor and material costs are subject to change, sometimes unexpectedly.
Oil prices are an excellent example of such a certainty.

Two Other Method for Incorporating Risk

Two other techniques of accounting for risk are generally used. Both make the risk adjustment
within the present-value calculation (without the use of the standard deviation) so that the final result is
just one number: the net present value adjusted for risk. The two methods are:
1. The risk-adjusted discount rate (RADR), in which the risk adjustment is made in the
denominator of the present-value calculation.
2. The certainty equivalent, in which the numerator of the present-value calculation is adjusted
for risk.

Sensitivity and Scenario Analysis

The sensitivity analysis and scenario analysis are both pragmatic ways to estimate project risk.
1. The sensitivity analysis, involves the changing of a key variable to evaluate the impact that
the change will have on the results of the capital budgeting analysis.
2. The scenario analysis, similar to sensitivity analysis but corrects the latter’s shortcoming. It
takes into account the changes in several important variables simultaneously.
Sensitivity analysis and scenario analysis are frequently used in business. Their outcomes can be displayed
in a simple, unclear manner. These analyzes permit analysts (and their managers) to assess each important
variable and examine the trade-offs among them. They can easily use a spreadsheet program to produce
alternative results quickly.

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