Professional Documents
Culture Documents
Lecture Notes
on
Intertemporal Production and Pricing
(Revise d: August
2007)
Often firms must deci de not simply what price to set or what
quantity to produce, but how the price of a pr odu ct and the firm’s
output shou ld change over time. In these not es, our main concern
will be with how intertemporal production constraints affec t patt erns of pricing
and production. By “intertemporal production constra ints,” I am
referring to wa ys in wh ich curr ent production can affect future
costs. We will focus on two kinds of intertemporal constra ints:
(i) the learning curve (as cumulative production increases,
production cost falls); and (ii) resource depletion (as an oil reserve is
depleted, production cost rises). Before turning to these cost-
related issues, however, we will begin with a brief review of how
demand constraints affect pricing patterns .
Pr ic
e
Current 1975
Mo del Dollars Dollars
1963-1966 Model 100 $164 .95 $290
1964-1967 Model 10 1 134 .95 234
1965-1967 Model 10 4 59.95 103
1969-1972 Co lor Pack II 29.95 44
1971-197 3 Bi g Shot Portra it 19 .95 26
1975-1977 Super Shooter 25.00 25
1
The data are from The First Thirty Years, 1948-78: A Chronology of Polaroid Photographic
Products (Cambridge, Mass: Polaroid Coproration, 1979) reproduced in T. Nagle and R. Holden, The
Strategy and Tactics of Pricing, Prentice Hall.
Penetration Pr icing. In some situa tions, the opt imal strat egy is
just the opposite of “cream skimmi ng.” Instead , it is best to
practice penetration pricing —i.e., to laun ch a new product at a low price
and then raise the price over time. As you saw (briefly) in 15 .010 ,
and as you will see in more detail in this course, this could be
optimal when there are significant positive network externalities.
Obvious examples are computer operating systems (Windows) and
app lications software (Mic ros oft Office), where the positive
network ex terna lities are ex tremel y stro ng. Anoth er ex ample is
when a company wants to estab lish its pr oduct or system as the
“standa rd,” as with the Beta/VHS batt le in vi deocassette
recorders, and the curr ent batt le over the next generat ion of DVD
players and disks (Toshiba ’s HD- DVD vs. Sony’s Blu-r ay).
Penetra tion pricing can also be opt imal for a monopolist facing
no thr eat of entry. Sup- pose dem and follows a dyna mi c saturat ion
process in which the rate of growth of the number of buyers is
positivel y related to the current number of buyers. In this case, a
penetration strategy can be particularly effec tive because it will
acceler ate the rate of saturation, and thus the growth of sales.
In the remainder of these lec ture notes, we will ex ami ne dynami c
pr oduction and pr icing in more detail, from the point of view of a
firm, and also in the contex t of market equili brium. La ter in 15 .01 3
we will revi sit the issue of dynami c prici ng, with an emphasis on
gaming and competitive strategy. For ex ample, we will ex ami ne
wh at h appens when there is a saturation process, but there are two
or three competing companies that are all trying to satura te the
market simultaneously.
The firm in Figure 2 cle arly has market power; it has downward-
sloping average and marginal revenue cur ves. But is the firm’s
market power in any wa y aff ec ted by the presence of a learning
curve? Compared to a hypothetical situat ion in which there is no
learning- by-doing, does the learning curve result in more or less
market power?
As Figure 2 ill ustrates, the learning curve increases the firm’s
degree of market power. In the figure, MP denotes the firms
increme ntal monopoly power, me asur ed as the difference between
the price it charges and its full marginal cost. Suppose that there
was no learning, so that marginal cost is ex pec ted to remain at MC0
. In that case the profit- maximizi ng (and value-maximizi ng) price
and output would be P0 and Q0 , and the monopoly profit would be
MP0 . With the learning curve, the fi r m’s value-maximizi ng price is
lower (P ∗ < P0 ), but full
marginal cost is much lower (MC* < MC0 ), so that the monopoly
profit is larger ( MP* > MP0 ). Intuitively, the learning curve works
like a reduction in marginal cost, which ex pands output. As output
ex pands, the ga p betwee n averag e revenue (i.e. , price) and
marginal revenue widens, thereby increasing the firm’s
increme ntal profit.
4 Exhaustible Resource s
We turn now to what is effec tivel y the opposite of the learning
curve. In the case of an exhaustible resource ; prici ng and production
are dynami c (i.e. , intertemporal) in nature bec ause a un it of the
resource produced and sold today will not be available to be
produced and sold in the future. Thus, produ cing the unit
involves not only the usual marginal production cost, but also a
positive opportun ity cost associated with the foregone future
production. In many textbooks, incl ud ing P&R, that opportun ity
cost is referred to as a user cost of production, so I will some time s
refer to it that wa y here.
The nature of this user cost is easiest to understand in the
contex t of a simple example. Suppose you own a quantity of in-
ground reserves R of an ex haust ible resource like oil. To keep
things simple, suppose you can produce the resource either this year
or nex t year. Th en how much should you produce in each year?
We will solve this problem in two wa ys. First, for those of you
who enj oy mathematics, we will use the method of Lag range
multipliers. Th ose of you who are not famili ar with this technique
can skip this mathematical appro ach, bec ause we then solve the
problem intuitivel y.
p2 C (q2)
ma P DV = p1 (q2 )q2 − C (q1) (1
x (1 )
q1 ,q2 (q1 )q1 + (1 −
+ r)
+ r)
subject
to
q1 + q2 = R (2)
1
∂L
= − −λ=0 (4)
MR MC1
∂q1
so
λ = MR1 − MC1 (5)
∂L
= MR2 − MC2 − λ = 0 (6)
∂q2 (1 (1
so + r) + r)
(MR2 −
λ = MC ) (7)
2
(1 +
r)
Combining (5) and (7) we get the following funda me ntal result:
or, in
general:
MRt+1 − MCt+1 = (1 + r)(MRt − MCt ) (9)
Assume that demand is fixe d and isoelas tic, and marginal cost MC
= 0. In this speci al case, it can be shown that the competitive
and monopoly output paths are identical. To see this,
wr ite the d em and
curve as:
P = AR = Q−η (10)
=
dQ/dt
= = r
−η
(12)
Q
For a competitive industr y, P − MC must rise at the rate of
interest. Since MC = 0,
Hence the monopoly price and competitive price are the same,
and there is no monopoly power.
If the interest rate is pos itive but small (e.g., r = 1%), P and
MR both grow very slowly,
and start from very high levels, not much below P . Now in Figure
the monopoly price (P 5)
is above the competitive price (P ), but the difference is small.
Hence there is only very little
monopoly
power.
is the payoff from producing and selli ng a barrel of oil as a fun ction
of the price of oil. At a price of $50, the payoff is zero; at a price of
$60 the payoff is $10 ; and at a p rice of $80 the payoff is $30.
There is no limi t to the payoff on the ups ide — but the downs ide is
cle arly limite d to zero. If the price falls to $40 you simply won’t
produce any oil. Likewise if the price falls to $30, or $20, or
anything else below your production cost of $50. This means that
un certa inty over the future price of oil increases the value of the
reserve. Your oil reserve is equivalent to a call option on a dividend paying stock.
The curved line in Figure 6 indicates the value of each barrel of
oil as a fun ction of the price of oil. Note that at the current price
of $60, the value of each barrel is greater than $60 − $50 = $10 .
This is a resu lt of the asymme tric payoff function combined with
un certa inty over price cha nges. If you took a basic finance course
you shou ld imme diatel y recognize Figure 6 as the value of a call
opt ion on a divi dend payi ng stock. And bec ause it
is a divi dend payi ng stock, there is an optimal exercise point ($80
in the figur e); at prices above that point, the option value is eq ual
to the net payoff . In the case of an oil reserve, the “divi dend” is
the money you receive from producing and selli ng the oil.
Thus valuing oil reserves and deci ding when to produce the oil
boils down to valuing a call opt ion and determining the opt imal
exercise price. In pra ctice, “exercising” an oil reserve option
me ans developing the reserve. An oil reserve that has been
discovered and d eli neated is calle d an und evel oped reserve; a
great deal of money must be spent to develop the reserve by
sinking pr oduction wells, building pipelines, etc. Valuing the
und eveloped r eserve and deci ding how high the price of oil shou ld
be before the reserve is developed is the funda me ntal option
valuation problem faced by oil compa nies. Table 1 lays out in
more detail the analogy betwee n an und evel oped oil reserve and a
finan cial call opt ion.
Dividend Ne t production
revenue less
depletion
5 Related Pro blems of Intert em poral Pricing and Pro-
duc tion
The pr oduction and pricing of an ex haust ible resource or a good for
which there is a learning cure are just speci al cases of the general
problem of intertemporal pricing and production . In other words, prici ng and
production deci sions today are interrelated with prici ng and
production deci sions in the futur e. In the case of an ex haust ible
resource, the intertemporal aspec t of the problem comes about
because of depletion, i.e., the “using up” of in-ground reserves.
You have seen many other wa ys in which pricing and production
deci sions have intertemporal aspec ts. For example, the demand
for most products is inherently dynami c (rec all the saturation
curve model for the demand for computers, or the dynami c
demand characteristics in the case of automobiles or gaso line).
Bas ically, the solution of intertemporal pricing and production
problems usu ally boils down to maximizi ng the present discounted
value of a net cash flow over time. Th is is ill us trated once aga in
in the ex ample that follows.
1. How many cases should you buy, how long should you wait to
sell them, and how much money will you receive at the time of
thei r sale?
3. Now suppose that the inflat ion rate is g = 0.05. How many
cases should you b uy, and how long should you ho ld them?
?
Solution.
1. Buyi ng wine is a good investment if the net present value is
positive. If we buy a case and sel l it afte r t years, we pay $10 0
now and receive $10 0t1/2 at the end. The NPV of this investme nt is
NPV = −10 0 +
e−rt 10 0t1/2
= −10 0 +
e−0.1t10 0t1/2
Theref ore, we should buy the wine and ho ld it for 5 years. Since
each case is a good investment, we should buy all 100.
Another approach is to compare holding wine to putting your
$10 0 in the bank. The
bank pays you 10 percent interest, while the wine increases in
value at the rate
d(value)/dt 50t−1/2
1
=
=
val 10 0t1/2 2t
ue
As long as t < 5, the return on wine is greater than 10 percent, the
rate of interest; after
t = 5, the return on wine drops below the rate of interest.
Th eref ore, t = 5 is the time to sw itch your wealth from wine to the
bank. As for whether to buy the wine at all, if we put
$10 0 in the bank, we will have 100 (ert ) = 100 (e0.5 ) = $164.87
after 5 years, whereas if we spend the $10 0 on wine, we will have
100 t1/2 = 100 (51/2 ) = $22 3.61.
2. You just bought the wine and are offered $13 0 for resale.
You should acce pt if the NPV of the deal is positive. You get $13 0
now, but lose the $100 (51/2 ) you would get if you hold the wine and
sel l it in 5 years. The NPV is
Theref ore, you should not sell. Another wa y to see this is to note
that the $13 0 could be put in the bank and would grow to $214 .33
($13 0e0.5 ) in 5 years. This is still less than $223 .61 ($100 (51/2 )), the
value of the wine in 5 years.
3. Assu me that wine prices keep up with infla tion, i.e., the real
price of wine is ($100 )t1/2 .
If the nomi nal interest rate is r, the real interest rate is r − g. Thus, if r =
0.1 and g = 0.05, the NPV of wine sold at t is
NPV = −10 0 +
e−0.05t10 0t1/2
dNPV
= e−0.05t(50t−1/2 )
0.05e−0.05t 10 0t1/2
= 0
dt
50t−1/2 − (0.05)100 t1/2 = 0
50 − (0.05)100 t = 0
t =
10
Infl ation reduces the real interest rate (for a fi xe d nomi nal rate)
and so it pays to hold onto wine longer before selli ng it and pu tting
the money in the bank. (In reality, inflation may cause investors
to look for real assets like wine with prices that kee p up with
infla tion.) You should aga in buy all the cases. (Notice that if the
nomi nal interest rate r rises when inflat ion g increases, so that r − g
is consta nt, inflat ion does not change the results of part 1.)