Market Structure Internal rivalry

Market structure and pricing decisions are closely related. But how to define the market? The degree to which the firm gets to choose price is determined in large part by market structure. There are two extreme cases: perfect competition and monopoly.

Perfect Competition
Conditions necessary: Large numbers of buyers and sellers Homogeneous product Free entry and exit Perfect information Demand curve for any given firm is horizontal. Price is set by market at P e Demand curve for any given firm is horizontal. Price is set by market at P e

Firm can sell as much or as little as desired at market price, but nothing if they raise P.

Monopoly
Conditions necessary Single seller of product No close substitutes Significant barriers to entry There are few examples of perfect competition and pure monopoly. Most firms have a differentiated product, and there are substitutes.

Pricing in Perfect Competition

Do not choose price. Choose output quantity. TC includes opportunity cost of capital invested. What will be our profit (loss) from our output decision? Should we produce now? (SR) Should we stay in the industry? (LR)

Pricing in a Monopoly
Profit maximization will be achieved by setting price so that MC=MR. It is not reached by setting price as high as possible. Like any firm, the monopolist is constrained by their demand curve. One cannot choose both P and Q.

The Shut-Down Rule

At what point should the firm cease production of a certain item? When might it pay to produce at a loss? In SR, many costs are fixed. Just because a firm is making losses, it does not necessarily mean it should shut down (short run), or even go out of business (long-run). Profit = TR TC; TR=P*Q, TC = VC + FC (TR - VC) - FC = [(P - AVC)Q] FC Separate out fixed costs, focus on variable elements As long as P>AVC, there is a positive contribution to fixed costs. If firm shuts down (Q = 0), then Profit = - FC If shut down: Firm has a loss of fixed costs. In SR, firm may minimize losses by continuing to produce. If losses are expected permanently, get out. Case of multiple products: C = FC + VC1 + VC2 The Shut-Down Rule cont. 1. P = (TR1 - TVC1) + (TR2 - TVC2) - FC 2. P = (P1*Q1 - AVC1*Q1) + (P2*Q2 - AVC2*Q2) - FC 3. P = [(P1 - AVC1)*Q1]+ [(P2 - AVC2)*Q2] - FC Results: 1. SR - each product should be produced if P i>AVCi 2. In LR, the firm should continue operating only if expected P>=0 (Profits are non-negative)

Oligopoly and Monopolistic Competition

Oligopoly Few sellers - usually large ones Recognized interdependence in pricing and output decisions Need to consider response of rivals in pricing decisions Typically significant barriers to entry n Oligopoly and Monopolistic Competition Monopolistic Competition Large number of interdependent sellers Differentiated product Good substitutes Easy entry and exit n Oligopoly and Monopolistic Competition Most U.S. industries are one or the other Oligopoly: many heavy manufacturing Autos, steel, chemicals, pharmaceuticals Monopolistic Competition Service companies, retail stores, large corporations (McDonalds, Wendys) The important point is that demand is downward sloping

cartel
A cartel is a collection of businesses or countries that act together as a single producer and agree to influence prices for certain goods and services by controlling production and

marketing. A cartel has less command over an industry than a monopoly - a situation where a single group or company owns all or nearly all of a given product or service's market. In the United States, cartels are illegal; however, the Organization of Petroleum Exporting Countries (OPEC) - the world's largest cartel - is protected by U.S. foreign trade laws.

Four basic components of market 1. Consumers 2. Sellers 3. 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 market Depends on Number and size distribution of sellers Number and size distribution of buyers Product differentiation Conditions of entry and exit Structure Conduct Performance A classification of market forms

Perfect competition Infinite buyers and sellers Perfect 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 firms Inefficient but operating firms Inefficient and closing down firms Perfect competition and the public interest P = MC Competition as spur to efficiency Development of new technology Economical use of national resources Least cost Q in long run (LR)

Monopoly One seller Barriers on entry No substitutes 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 Monopolistic competition Many alternative suppliers Differentiated product Easy entry (e.g. cosmetics, detergents, medicines, grocers, barbershops, restaurants) Oligopoly Few interdependent sellers Standardized or differentiated oligopoly Restricted entry (e.g. steel, aluminum, cement, fertilizes, petrol and cars).

Price Discrimination
Selling the same good to different people at different prices

 Conditions necessary: Identifiable customer groups with differing price elasticities Maintain separation of groups--prevent resale.

Types of Price Discrimination

First degree Identify and charge each customer what they are willing to pay. Limit: D = MR, no consumer surplus. Second degree Quantity discounts. Volume purchases are given lower prices. Need to measure goods and services bought by consumers. Third degree Segment markets in some way. Charge all in the segment the same prices. Treat each segment as a separate market then do MR=MC in each Are coupons as a price discrimination mechanism? Oligopoly Strategies Common theme - Rivalrous behavior Pricing - limit pricing - set prices low as signal to possible entrants or other competitors your willingness and ability to defend your market share. Must have credibility. Trading SR profit for more profits later Use the legal / regulatory systems File patent application Challenge business charter application File regulatory challenge Pre-emptive entry - Wal-Mart Capacity and production Announce capacity expansion Revise/modify products - more difficult to copy Advertising Raise cost of entry for others 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 clubs Initiation (fixed) fee plus monthly or per visit charges. Block pricing All or none decision Block pricing provides a means by which the firm can get one consumer to pay the full value of the blocked units. Consumers 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 of Valuation of computer monitor 1 20,000/2,000/2 Total 15,000/35,000/3,000/5,000/-

Total 22,000/18,000/40,000/-

Pricing strategies for special cost and demand structures Peak load pricing Cross 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 pricing Objective- 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. 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 pricing Objective- 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. 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. 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 pricing Objective- 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. 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. 1. 2. 3. 4. 5. Pricing strategies in markets with intense price competition Limit pricing Pricing joint products Price matching Inducing brand loyalty Randomized pricing

 Limit pricing Reduce 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 when To influence expectations of entrants To 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 matching A 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 Loyalty Brand loyal customers will continue to buy a firms 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