Introdcution
With Taziclor as the only available product in the market, Aveta was able to enjoy a monopolistic position. There could be no close substitute to the product, as Aveta was holding the patent for Taziclor. Since Aveta was the sole supplier in the market the demand curve specific for the firm and the market are the same. Aveta used the inverse elasticity-pricing rule and set the price at $ 12. With the entry of the competitor Gakk, no change in the market demand curve is expected as the same number of people will seek the remedy, irrespective of the maker. Since the market share of Aveta lab will go down from 100%, the demand curve for Aveta will shift inward.
Entry of Gakk into the market will significantly affect the pricing strategy of Aveta and in order to maintain its market share, Aveta has to consider the strategy of Gakk before revising its prices for Taziclor. Marginal cost is one element that needs to be considered by Aveta in the pricing decision. The relationship between market share, pricing can be spelt in the expression (P-c)/P = S/e where “s” stands the market share of the firm.
Discussion
The above payoff matrix presents the relative positions of both the firms and the possible outcomes when Aveta wants to follow the particular pricing strategy of “limit pricing”. Irrespective of the actions of Gakk, the profits of Aveta are bound to be higher if Aveta follows a no limit pricing. In case Gakk decides NOT to acquire the patent, Aveta is sure to earn three times the limit pricing profits by adopting a no limit pricing policy. In case Gakk acquires the patent also, the profits of Aveta would be in the region of twice the profits of limit pricing if the firm adopts a no limit pricing strategy.
However, there is a distinct possibility that Gakk will view the limit pricing strategy as an empty threat. It will not be advantageous to Aveta to give up the potential profits from the oligopolistic situation for a long period. The firm may adopt the policy just as a barrier to prevent new firms entering the market. Nevertheless, this move to limit the price cannot be considered as prudent from the point of view of Aveta as there would be no new product developed at least for the next five years and the firm would be able to enjoy its market position.
From the following annual profit payoff matrix, it can be observed that both the firms do not possess a dominated strategy.
Annual profit Levels for Aveta and Gakk (in US $ millions):
Irrespective of the actions of the competitor Gakk, Aveta would be able to increase its prices to more than $ 4 and would still earn an increased profit. With Aveta not choosing to charge $ 4 (because the firm is in a position to charge more) Gakk cannot decide to charge a price of $ 4 or $ 7 since it would not be a wise move. This is because the profits for Gakk are optimized at the price levels of $ 5 to $ 6 irrespective of any price choice of Aveta. Similarly, for Aveta the price level of $ 5 seems to be the profit maximize considering all the remaining combinations, with disregard to the pricing of Gakk. For Gakk also charging $ 5 would be the best strategy. The Nash equilibrium for this matrix is at the point where both the firms adopt the price of $ 5 for their products.
Aveta can think of two possible methods to arrive at a win-win situation. Since Taziclor is a product aimed to meet the demands of larger drug stores Aveta can possibly build a favored customer class and this class of buyers would receive the product at the lowest price Aveta offers for the product. This strategy would prevent Gakk from undercutting the price because of the higher cost involved. As an alternative, Aveta may decide to meet the competition from Gakk by matching any price charged by the competitor. This would deter Gakk from entering into any price war in the product. This strategy will also ensure Aveta gets the market information on the price reduction by Gakk, as there would be a number of market watchers to advise Aveta of any price reduction by Gakk. A rebate program is yet another alternative. However since Aveta is already enjoying significant brand recognition this may not be a suitable move.
On a situation where Gakk buys, the patent and both the firms decide to charge a price of $ 5 the profit for Aveta would be in the region of $ 190 million for a period of next five years with a total profit of $ 950 million. If the company maintains the monopoly price of $12, the company would net a profit of $ 42,697 per year totaling to $ 213,485 leaving a difference of $ 212,535. For the same period, the profit for Gakk would be $ 850 million reduced by the amount they pay for the patent. Therefore, an offer of $ 850 million by Aveta to the Palant Research Center for the patent would ensure that Gakk does not buy the patent and would enable Aveta to earn a profit of$ 212,653 over the next five years.
Conclusion
The price-cost margin (Lerner Index) is calculated by the markup of price over marginal cost. This is expressed as a percentage of price, i.e., (P-MC)/P. This also gives the measure of market power of the firm. With the entry of Gakk, Aveta’s price-cost margin is (5-2)/5=.6. Price-cost margin of Gakk would be (5-3)/5=.4. With a monopoly, Aveta would have a price-cost margin of (12-2)/12=.83 whereas Gakk would be having zero.