Market structures
The objective
Learn about market formation
How decisions of price and output are taken in the markets
Pricing strategies
The Coverage
Price and output determination in various market structures – perfect competition, monopoly, monopolistic competition, oligopoly
Pricing strategies for firm with market power- price discrimination
A comparison of market structures for efficient production and equitable distribution
Four basic components of market
1. Consumers 2. Sellers3. Commodity 4. Price
Market classification By the area By the nature of transaction By the volume of business By the nature of competition
Competition in the marketDepends onNumber and size distribution of sellersNumber and size distribution of buyersProduct differentiationConditions of entry and exit
Structure Conduct Performance
A classification of market formsForm of Market Structure
Number of Firms
Nature of Product Price elasticity of demand for
Degree of control
1 2 3 4 5
a) Perfect
competition
A large no. of firms
Homogeneous Product Infinite None
b) Imperfect
competition
A large no. of firms
Differentiated products (but) they are close substitutes of each other
Large Some
i) Monopolistic
competition
A large no. of firms
Product differentiation by each firm
Large Some
ii) Pure oligopoly
Few firms Homogeneous Product Small Some
iii) Differentiated
oligopoly
Few firms Differentiated products Small Some
c) Monopoly One Unique product without close substitutes
Very Small Considerable
Perfect competitionInfinite buyers
and sellersPerfect
knowledge and information
Identical products
No barriers on entry or exit
Maximum profits or minimum losses
No transportation cost
All are price takers
Types of firms
Efficient (least cost) and profit making firms
Efficient but breaking even firmsInefficient but operating firmsInefficient and closing down firms
Perfect competition and the public interest
P = MCCompetition as spur to efficiencyDevelopment of new technologyEconomical use of national
resourcesLeast cost Q in long run (LR)
Monopoly
One sellerBarriers on entryNo substitutes
Market power
Through elasticity of demandLearner (Abba) index = P – MC/P or
MR = P(1+1/E) Learner index = -1/E Cross price elasticity of demand
Acquiring market power Economies of scale Product differentiation and brand loyalty Ownership of, or control over, key factor
and/or wholesale or retail outlets Consumer lock in- high search, switching
and initiation cost Legal protection Network externalities – product’s value rises
as more consumers use it. Mergers and takeovers Aggressive tactics
Monopoly and the public interest
Disadvantages – Higher price and lower output, possibility of higher cost due to lack of competition, unequal distribution of income
Advantages – Economies of scale, lower cost, competition for corporate control, innovation and new products
w
Deadweight loss – a measure of the aggregate loss in well-being of the participants in a market resulting from an inefficient output level.
Monopolistic competition
Many alternative suppliersDifferentiated productEasy entry(e.g. cosmetics, detergents,
medicines, grocers, barbershops, restaurants)
Oligopoly
Few interdependent sellersStandardized or differentiated
oligopolyRestricted entry(e.g. steel, aluminum, cement,
fertilizes, petrol and cars).
Oligopoly in different forms
Kinked demand curveCollusive oligopolyPrice leadershipJoint profit maximizing cartelMarket sharing cartel
Kinked demand curve model
Factors favoring collusion
Few firms well known to each otherThey are not secretiveSimilar production methods and AC and
want to change price at the same timeSimilar productsSignificant barriers to entryStable marketNo government measure to curb collusion
Dominant firm
Price leadershipJoint profit maximizing cartelMarket sharing cartel
Case - OPEC: the rise and fall of a cartel
OPEC set up in 1960 by Saudi Arabia, Iran, Iraq, Kuwait and Venezuela.
ObjectivesThe co-ordination and unification of
the petroleum policies of member countries
The organization to ensure the stabilization of prices, elimination of harmful and unnecessary fluctuation in the price and quantity
OPEC
OPEC is a joint profit maximizing cartelSaudi Arabia is a dominant producer and price leader within the cartel
OPEC Initially OPEC was increasingly in conflict
with international oil companies - as under ‘Concessionary Agreement’ they were given right to extract oil in return for royalties.
1973 – thirteen members – transfer of powers, OPEC makes decisions on oil production and thereby determining oil revenues.
1970s – setting market price for Saudi Arabian crude and OPEC members to set their prices in line – dominant firm price leadership
OPECAs long as demand is price inelastic – this
policy allowed large P TR1973-74 – Arab-Israeli war, OPEC raised
price $3 per barrel to over $12 until 1979 and sales did not fall.
After 1979 – price $15 to $40 per barrel demand did fall
1982 – OPEC agreed to limit output and allocate production quotas to keep the price up. A production ceiling of 16 million barrel per day in 1984
OPECCartel was beginning to break down
due to - world recession - growing output from non-OPEC
members - ‘cheating’ by some OPEC members
who exceeded their quota limitThe trend of lower oil prices was
reversed in the late 1980s due to boom 1990 – Iraq invaded Kuwait Gulf war
supply of oil fell PEnd of war and recession of 1990s the
price fell again - $ 16
Other cartels
During mid-1970s International Bauxite Association (IBA) quadrupled bauxite pricesA secretive international uranium cartel pushed up uranium pricesFrom 1928-1970s Mercurio Europe kept the prices of mercury close to monopoly levelsA cartel monopolized the iodine market from 1878-1939Tin, coffee, tea and cocoa cartels failed
Pricing Strategies for Firm With Market Power
Pricing decisions
How do we set prices relative to costs?How do we change them?To what extent should we try to
protect our market?Strategy to lead to the highest profit
rate.Lowering prices in response to
potential competition.
Strategies that yield even greater profits
Extracting Surplus from consumers
Price discriminationTwo part pricingBlock pricingCommodity bundling
Price discrimination
MeaningChanging different prices for the
same productCharging same price for different
products when costs differ.Possibility of differences infinancial statuseducational statusage of the customertime of purchase
First degree price discrimination (unit wise)
MeaningCharging each consumer one maximum price, he or she is willing to pay for each unit. Extracting all consumer surplus and earning maximum profit. Requirement - full information regarding consumers Application - service related business - mechanics, doctors, lawyers, professionals etc.
Second degree price discrimination (Lot wise)
A practice of posting a discrete
schedule of declining prices for
different ranges of quantities.
Extracting part of the surplus, lower
profit.
Third degree discrimination (Market wise)
Charging different groups of consumers
different prices for the same product.
Essential conditions
Different elasticity of demand - students’
discount, senior citizen discount
Information regarding elasticity of
demand
Separate markets
Price discriminationEssential conditions Separate marketsDifferent elasticity of demands
Profit-maximizing output under third-degree price discriminationa) Market X b) Market Y c) Total (market X+Y)
Q0 1000MRX
DX
0 2000MRX
DX
0 3000
MRT
5
9 7
5
Q Q
MC
5
Two part pricing
Initially a fixed fee for the right to purchase its goods, plus a per unit charge for each unit purchased.Examples - athletic clubs, golf courses, health clubsInitiation (fixed) fee plus monthly or per visit charges.
Block pricing
All or none decisionBlock pricing provides a means by which the firm can get one consumer to pay the full value of the blocked units.Consumer’s decision - buying all units (blocked) or buying nothing.(hiring a bus, a pack of three soaps)
Commodity Bundling
Bundling two or more different products and selling them at a single ‘bundle price’.Example - travel companies package deal, computer, monitor, software deal
Consumer Valuation ofcomputer
Valuation ofmonitor
Total
1 20,000/- 2,000/- 22,000/-
2 15,000/- 3,000/- 18,000/-
Total 35,000/- 5,000/- 40,000/-
Pricing strategies for special cost and demand structures
Peak load pricingCross subsidies
Peak load pricing
Markets having high demand and low demand periods.
Example - road, train, air, electricity, telephone. No problem of resale. Commodity must be consumed as it is purchased.
Peak-load pricingObjective- to reduce costs and increase
profits if the same facilities are used to provide
a product or service at different periods of time.
the product or service is not storable. demand characteristics vary from
period to period. The theory of peak-load pricing suggests
that peak-period users should pay most capacity costs while off-peak user may be required to pay only variable costs.
Case - Central Electricity Generating Board, UK (CEGB)
High demand - morning & evening Moderate - throughout rest of the dayVery little - nightExtra power stations for peak load -
capacity cost. Stations idle rest of the day and therefore high MC.
Charge different prices.Group, capacity limitation, price
discrimination
Peak load pricing(cont)
CEGB combining peak load pricing and two part tariff
CEGB uses less efficient power stations during peak load hours MC
Capacity Charges to directly recoup costs of building plants and electricity charges on the basis of KWh used. In addition energy charges to cover short run MC of extra plants
1986-87 - Complex structure of energy charges1.4 pence/KWh at night during weekends3.8 pence/KWh at breakfast time on week daysFurther surcharge of 2.5 pence/KWh (hourly)
during heaviest demand.
Case - Computer time and peak load pricing
Three criteria1. Usually a computer has only a single
CPU but is in constant use. Same facility to provide the service at different periods of time.
2. CPU time not used is lost forever i.e. service is not storable.
3. Center may provide same service at different times, late -night service is not desirable.
Prices at university computer facility
DAY TIMEPERIOD
COST PERMIN.(Rs.)
Mon. - Fri 8 AM - 1 PM 3Mon. - Fri 1 PM - 5 PM 6Mon. - Fri 5 PM - 1 AM 1Mon. - Fri 1 AM - 8 AM 0.2Sat. - Sun. 8 AM - 5 PM 1Sat. - Sun. 5 PM - 8 AM 0.2
Case Peak load pricing of Computer time
6 AM Noon 6 PM MidnightMidnight
CPUUsage
After pricing
Before pricing
Time of Day
Cross subsidies
A strategy which uses profits made with one product to subsidize sales of another product
Relevant in situations where a firm has cost complementarities and demand for a product independence
Economies of scope - saving in producing jointly or using excess capacity to produce another products
Example - computer & software
Advantage It permits the firm to sell multiple
products. If the two products have
independent demands, the firm can induce consumers to buy more of each product than they would otherwise.
Pricing strategies in markets with intense price competition
1. Limit pricing2. Pricing joint products 3. Price matching4. Inducing brand loyalty5. Randomized pricing
Limit pricingReduce price to discourage the
entry of new firms- initially enjoy profit and face competition.
Increasing returns to scale provides cost advantages for large firms.
Limit pricing
Used whenTo influence expectations of entrantsTo protect margins Entrants have limited information of
market.Present V/s future prices.Convince new firms of low cost and
charge less.Give misleading information
Pricing Joint Products
When goods are produced jointly and in fixed proportion, they should be thought of as a ‘product packages’
Price matchingA strategy in which a firm advertises a price and promises to ‘match’ any lower price offered by a competitor.Advertisement“Our price is P. If you find a better price in the market, we will match that price. We will not be undersold.”
Inducing Brand LoyaltyBrand loyal customers will continue to buy a firm’s product even if another firm offers a slightly better price.To induce brand Loyalty engage in advertising compaign give incentives
Randomized pricing
A firm varies its prices frequently - hour to hour or day to day
Case - Randomized pricing in the airline industry
There are over 215,396 changes in the airfares each day. This translates into 150 changes per minute. Domestic airlines spend considerable sums of money in an attempt to monitor the prices of another firms. As noted by Marius Schwartz:“Delta airlines assigns 147 employees to track rivals’ prices and select quick responses - on a typical day, comparing over 5,000 industry pricing changes against Delta’s more than 70,000 fares. New fares filed the prior day with Air Traffic Publishing Co. are tracks by Delta computer.
“Secret” price changes that are deliberately withheld from the Air Traffic Publishing System for several days are tracked through local newspapers or call to other airlines’ reservation offices. Once Delta learns of a competitors pricing more, it can put a matching fare into its reservation system within two hours.
Why do airlines take such drastic measures to learn the prices set by their rivals?
Why do airfares change so frequently?Source - Marius Schwartz, “the nature and scope of contestable theory” Oxford Economic Papers, 1986, pp. 46-49.
Thank you and all the best