Business Economics 09 Market Structures & Pricing Strategy

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