ME

Unit-V

MARKET STRUCTURE AND PRICING PRACTICES

MARKET:

 Market is a place where commodities are bought and sold.

 In a market there will be two types of transactions namely sale and purchase.
 The market is located in a particular locality or building.
 In a market there will be sellers, buyers, products or services and exchange transactions.

DEFINITION OF MARKET:

Marketing as a societal process by which individuals and groups obtain what they need and
want through creating, offering and freely exchanging products and services of value with others.

- Philip Kotler.

Marketing is the process of determining consumer demand for a product or service,

motivating its sales & distributing it into ultimate consumption at a profit.

-E.F.L.Brech

 Marketing is the process of identifying the customers requirements and satisfying them
efficiently and effectively.
MARKET STRUCTURE

Market structure refers to the characteristics of a market that influence the behaviour &
performance of firms that sell in that market.

The structure of market is based on the following features:

a) The number of buyers and sellers.

b) The nature & substitutability of the product.
c) Existence of barriers to entry.
a) Based on the number of sellers & buyers:-

Based on number of sellers:- Based on number of sellers the market is classified as:

1) Perfect market:- under perfect market there are a large number of firms producing fairly
insignificant quantity of the product in the market. A individual firm is a price taker but not a

1
ME

price maker. Price for the product is determined by the forces of total demand & total supply
in the market.
2) Monopoly:- if there is only one seller, monopoly market is said to exist.
 Here a single seller controls the entire industry.
 In monopoly, there is very little difference between the firm and industry.
Ex: maruti-suzuki enjoyed all the govt. protection for a long time when it enjoyed monopoly
in respect of small cars.
3) Monopolistic competition:- when large number of sellers produces differentiated products,
monopolistic competition is said to exist.
 A product is said to be differentiated when its important features vary.
 In monopolistic (competition) market, due to heterogeneity firm can independently determine
the price.
Ex: cameras, mobile phones.
4) Duopoly:- Duopoly is a market where there are only two sellers each one having significant
control over the supply of the market & also the price.
Ex: Pepsi & coke.
5) Oligopoly:- if there is competition among a few sellers, oligopoly is said to exist.

In oligopoly firms produce either homogenous or heterogeneous products.

Ex: car manufacturing companies such as Maruthi, Suzuki, Toyota and soon.

Newspapers such as Hindu, Indian express, times of India, Eenadu & so on.

 In oligopoly, each individual seller or firm can affect the market price.

Based on number of buyers:- Markets are also classified based on the number of buyers.

1)Monopoly:- it is a market where there is a single buyer of the entire products.

2)Duopsony:- it is a market where there are only two buyers of the product.

3)Oligopsony:- it is a market where there are few buyers of the product & with some degree of
control over the price.

b) Nature Product substitutability & Interdependence:-

The market structures can also be classified based on the product substitutability & product
interdependence.

2
ME

1) Substitutability:- the degree of control that a firm can exercise on price is influenced more by the
substitutability of the products.

2) Interdependence:- product interdependence can be used to measure the reaction of the

competitors.

It is used to understand the impact on the price of one firm due to increase in the output of other firm.

c) Entry Barriers:-

Some of the major barriers to entry are:

1) Legal restrictions: Due to strategic needs & security threats the government prohibits the entry
of new firms. Most of the monopoly public sector enterprises come under this category.

2) High initial investment: Some industries require large amount of investment and are capital
lumpy in nature.

3) Gestation period: If the gestation period of conceiving & completing a project is long, firms may
not try to enter in to those product lines.

4) Patent rights: Some products are controlled by patents as a result entry into those product lines
become very difficult.

5) Switching costs: Firms even fear to incur more costs on training the labour & maintenance of new
technology/machines.

6) Price and Profits: Higher profits induce new firms to enter into the industry & lower profit
margins prevents the entry.

TYPES OF COMPETITION

Based on degree of competition, the markets can be divided into:

3
ME

Types of
competition

Perfect Imperfect
competition competition

Monopolistic
Monopoly oligopoly

PERFECT COMPETITION:

A market there are large number of buyers & sellers of an homogenous product having no
transportation cost & the price of the product is determined by the free working of market force i.e.,
demand & supply.

Features of perfect competition:

1. Large number of buyers & sellers.

2. Homogenous product.
3. Free entry & free exit.
4. Perfect knowledge about the market.
5. Absence of transport cost.
6. Absence of advertisement
7. Perfect mobility of factors of production.

1. Large number of buyers and sellers:

 Under perfect competition the number buyers and sellers is large, a single firm produces an
insignificant portion of the total supply in the market.
 A firm is only a price taker but not a price maker.
 At the market given price a firm can sell any number of units.

2. Homogenous product:

 Under perfect competition all the products produced by all the firms are identically the same or
homogenous.

4
ME

 The products manufactured by all the firms are perfect substitutes for one another.
 Hence no seller can change a higher price or sells at a lesser price.

3. Free entry and exit:

 There are no barriers to the entry & exit of the firm.

 Firms enter or leave the industry based on the profits/losses they get.
 When the existing firms are getting more profits in short run new firms are induced to enter into
the industry.
 When the entry of new firms increases the supply and price falls.
 When the existing firm is getting losses, some firms leaves the industry in the long run by
reducing the market supply.

4. Perfect knowledge:

Under perfect competition it is assumed that both the buyers and sellers have perfect
knowledge about the market. Hence the same price rules throughout the market.

5. Absence of advertisement: Since the products are homogenous and the consumers have perfect
knowledge about the product there is no need for advertisement.

6. Absence of transport costs: The golden rule of perfect competition is that the same price has to
prevail in the entire market. If the price is to remain the same then there should not be any cost of
transportation.

7. Perfect mobility of factors of production: under perfect competition all the firms should charge
the same price. If the price is to remain the same costs should be equal. In order to eliminate cost
variations it is assumed that factors of production are perfectly mobile.

PRICE DETERMINATION UNDER PERFECT COMPETITION:

 The price of the product is determined by the industry depending upon the market demand &
market supply of the product.
 In perfect competition, price is determined by market demand & market supply.
 The market demand curve slopes downwards from left to right.
 The market supply curve slopes upwards from left right.
 The equilibrium price will be determined at the point where the demand and the supply curve
intersect each other.

5
ME

Where
DD- the market demand curve
SS- the market supply curve
OP- the equilibrium price

 The market demand curve DD is intersecting the market supply curve SS at point E.
 The firms under perfect market should accept this equilibrium price & sell their product.
 An individual firm or an individual buyer cannot change the given market price but a change in
the market supply or the market demand curves can affect the equilibrium price.

Benefits of perfect competition:

The advantages of perfect competition are:

1. No expectation: under perfect competition the customer gets the product at the lowest price,
because the firm has no ability to fix the price.

2. Economic efficiency: In the perfect competition all the firms operates at the optimum level in the
long run that gives economic efficiency.

3. No Advertisement cost: Under perfect competition customers have perfect knowledge about the
markets, so there is no need for advertisement.

4. Smooth adjustments: Perfect competition due to free entry & exit ensure the smooth adjustments
between demand and supply.

5. Uniform price: In perfect competition the firms are price takers than price makers. Therefore the
prices of the products are same throughout the market.

IMPERFECT COMPETITION

A competition is said to be imperfect when it is not perfect. Based on number of buyers & sellers,
the imperfect markets are classified as explained below:

1. MONOPOLY:

Monopoly is a market where there is a single seller dominating the entire market. Monopoly
is one of the forms of imperfect market. In the word monopoly ‘mono’ means single and ‘poly’
means seller.

6
ME

Ex: Reserve Bank of India is the sole supplier of currency notes in India.

Features of Monopoly:

1. Single seller and large number of buyers.

2. Homogenous products.
3. Absence of close substitutes.
4. Restrictions to the entry of new firms.

1.Single seller: In monopoly there is a single seller. There is no difference between the firm and
industry.

 The entire market supply of the product is under the control of the monopolist.
 The monopolistic is a price maker or price dictator. He can increase or decrease the supply of the
product in the market at his own discretion.
 Thus monopoly firm has control over the price as well as supply.

Large number of Buyers:

Under monopoly the number of buyers is many. Therefore no single buyer has control over the
market demand or the price of the product.

2.Homogenous Product:

Since a single firm controls the entire market, all the products produced by it are identically the
same.

3. Absence of close substitutes:

 There is no close substitute for the monopoly product.

 If there is no substitute at all, then that monopoly is called pure monopoly.
 In case there is a substitute but not a close substitute then it is called simple monopoly.

4.Restrictions to the entry of new firm:

Under monopoly there are restrictions to the entry of new firms into the industry.

1. Legal restrictions: these restrictions are imposed legally by the statutory authority prohibiting
competition in certain lines of activity.

7
ME

2. Cut throat competition: when a new competitor enters the market the monopoly slashes down
the price to such low levels that no new competitor can survive in the market.
3. Exclusive control over raw materials.
4. Unfair practices.

PRICE-OUTPUT EQUILIBRIUM UNDER MONOPOLY:

Under monopoly the firm itself contributes the industry, hence price-output equilibrium determined
simultaneously.

The conditions of equilibrium are:

1. MC must be equal to MR.

2. MC should cut MR from below(or left)
 Under monopoly in the short run a firm may get either profits or suffer losses.
 In the long run it can get abnormal profits.

Short run equilibrium:

 In short run the average and marginal curves under monopoly slope downwards from left to
right.
 A firm finds it equilibrium at the point where MC equals MR and MC cuts MR as shown in the
figure.

 In figure point E is the firm’s equilibrium where MC=MR and MC is cutting MR from below.
 Here both the conditions are satisfied, the equilibrium output is OM and the price is OP.

 A monopolist in the short run may even suffer losses.

8
ME

 From figure, AR is less than AC the firm is suffering losses.

Long run Equilibrium:

Under monopoly the firm will get abnormal profits in the long run.

From figure the equilibrium output is OM as the

two conditions of firms equilibrium are satisfied.

2. MONOPOLISTIC COMPETITION:

Monopolistic competition is exists when there are many firms & each one produces such
goods & services that are similar but not identical.

Features of Monopolistic Competition:

1. Number of buyers and sellers.

2. Heterogeneous products.
3. Free entry and exit.
4. Close substitutes.
5. Selling costs.

1.Number of buyers and sellers: There are large number of buyers and sellers in the market. Hence
no individual firm can influence the supply. Often the presence or absence of a firm goes unnoticed
by the market.

2.Heterogeneous Products: In monopolistic competition each firm produces differentiated products.

9
ME

 Differences in the products can be classified as real and imaginary.

 The quantitative differences in the form weight , length, size etc.,
 Qualitative differences in the quality of the product.
 Imaginary differences are created by the producers in the mind of the customers through
advertisements.
3. Free Entry and Exit:
 Under monopolistic market also firms have the freedom to enter or exit the industry.
 When existing firms are making abnormal profits, new competitors are induced to enter the
industry and if the existing firms are suffering losses some of them may leave the industry.

4.Close Substitutes: In monopolistic markets firms produce goods that are close substitutes to each
other’s products.

5.Selling Costs: Monopolistic firms incur huge amount of selling costs. These costs include
advertisement expenditure, free gifts, dealer discounts etc.,

FIRMS PRICE EQUILIBRIUM UNDER MONOPOLISTIC COMPETITION:

In monopolistic competition firms may get abnormal profits or losses in the short run and normal
profits in the long run. The conditions of equilibrium are:

1. MC should be equal to MR and

2. MC should cut MR from below.

Short run equilibrium:-

From figure at equilibrium output OM the firms ‘AR’ is ‘AM’ and ‘AC’ is BM, the firms average
profit is ‘AB’ and the total profit is equal to the area ‘pp1AB’.

10
ME

From figure at equilibrium output ‘OM’ the firm is getting losses equal to the area ‘pp1AB’.

Long run equilibrium:-

The long run equilibrium conditions are:

1. MC=MR
2. MC should cut MR from below
3. AR=AC

In long run firms get only normal profits due to free entry & exit of the firms.

From figure, at equilibrium output ‘OM’ the firm ‘AR’= ‘AC’.

3. OLIGOPOLY:

 The term oligopoly is derived from two Greek words ‘oligor’ means ‘ a few’ and ‘pollein’ means
‘to sell’.
 It is a situation where there are only a few sellers producing homogenous or heterogeneous
products.
 It is a competition among the few sellers & they have a sizable control over the market supply.

Features of oligopoly:

1. Few firms.
2. Homogenous & heterogeneous products.
3. Interdependence.
4. Advertising & selling costs.

11
ME

5. Price rigidity & price war.

1. Few firms: there are a few firms selling their product means a competition among the few and
have a considerable effect on the market conditions. Any decision taken by one firm influences
the actions of another firm in the industry.
2. Homogenous & heterogeneous products: In oligopoly firms can produce both homogenous and
heterogeneous products. Oligopoly with homogenous products may be called “pure oligopoly”.
Oligopoly with heterogeneous products is called differentiated oligopoly.
3. Interdependence: As the number of firms are very few the price & out decisions of the firm will
be naturally effect the other firms. When price of a product of a firm reduces, the other firms also
reduce their prices.
4. Advertising & selling costs: aggressive advertising is highly required in oligopoly market. In
order to continue the present market share & to increase it more expenditure on advertising and
sales promotion techniques is needed.
5. Price rigidity & price war: in the oligopoly market price rigidity and price war are the common
features. If one firm increases price other firms will remain silent there by allotting that firm to
lose its customers. So, no firm is ready to change the existing price.

PRICE DETERMINATION UNDER OLIGOPOLY:

1. Independent pricing: when there is product differentiation each firm can fix an independent
price, aiming at maximum profits. In this situation the price fixed by each firm may be more or
less.
2. Collusive pricing: To avoid competition the firms under oligopoly may form a curtel to regulate
prices & output of all firms. The control board will determine the output & the price to be
charged by each firm.
3. Price leadership: In price leadership a dominant firm takes the leadership and fixes the prize of
product for the entire industry. The price leadership industries are like petroleum, flour, cement,
milk, steel, cigarettes etc.,

Different types of price leaderships are:

1. Barometric price – leadership: The wisest firm announces the prize on the basis of demand and
cost conditions & the other firms follow it.
2. Dominant price – leadership: A large and the biggest firm in the industry announced, the prize
the remaining firms accepts it.

12
ME

3. Aggressive price - leadership: the dominating firm done the profit maximisation price which is
known as aggressive price leadership. It forces the other firms to accept or leave the industry.
4. Effective price- leadership: Where few firms are in industry which has same cost conditions &
less elastic demand a price may be agreed upon by all the firms to avoid competition among
them.
____________________________________________________________________________

PRICING METHODS

There are a number of pricing methods that are adopted by business enterprises. They can be
grouped into three categories:

1) Cost oriented pricing

 Cost plus pricing
 Incremental cost pricing or marginal cost pricing
 Target pricing
2) Competition oriented pricing
 Going rate pricing
 Loss leader pricing
 Trade association pricing
 Customary pricing
 Price leadership
 Sealed bid pricing
3) Other methods.
 Price lining
 Skimming pricing
 Penetration pricing
 Peal load pricing
 Psychological pricing
 Limit pricing
1. Cost oriented pricing methods:

13
ME

a) Cost plus pricing: Cost plus pricing is also known as full cost pricing or standard pricing.
The top level manager determined a certain markup on the costs of production based on the
business objectives of the firm.
 This markup is the net profit margin for the firm over the costs.
Assuming:
AFC=40, AVC=60
 AC=AFC+AVC= 40+60=100
 Markup=20%,
 => 20/100*100= 20

.'. the price =120

b) Incremental cost pricing (or) Marginal cost pricing:

 Incremental pricing is a method where the prices are determined based on the incremental costs
by ignoring the fixed or indirect cost.
 This concept is very much useful in short-run decision making particularly when firm has un
utilized plant capacity.

c) Target pricing:
 It is a method of pricing where the producer tries to receive a certain pre- targeted return on the
capital invested.
 In this method costs & profits are based on the standard sales volume.
 It tries to fix the price to get targeted profits on investment.

Price = AVC+ AFC + rk

Where,

AVC = average variable cost, AFC = average fixed cost, rk is average return on capital employed.

2) Competition Oriented pricing:

a) Going rate pricing:

 Some firms adopt a price ruling in the market rather than independently determining the price on
their own. This is called “Going rate pricing.”
 The advantage of this pricing is it saves the firm from the risk of uncertainty it may face in the
event it determine its own price.

14
ME

b) Loss leader pricing:

 This is a method adopted by firms producing joint products.
 For example super markets fix relatively low prices on food grains and pulses and recover what
ever the low margins they get by pricing other products at a higher (price) level.
 So, the price of loss leader is lesser, the buyer buys the product to feel the advantage of buying
the product.

c) Trade association pricing:

 Trade associations generally determine prices in order to avoid a price war among the members.
 All the manufacturers generally charge the same price.
 These prices are generally determined through explicit collusion.
 Explicit collusions are declared illegal under the anti- trust laws all over the world and in India
also.

d) Customary pricing:
 It is a method of pricing goods continuously at a particular level and affecting any change in their
prices even if the costs escalate.
 In this method the firms try to adjust size, quality or quantity of the product but never change the
price.
e) Price leadership:
 The price leader determines the price and others simply follow the price fixed by the price leader.
The price leadership is classified as:
1) Dominant price leadership
2) Barometric price leadership
3) Aggressive price leadership
f) Sealed bid pricing:

In this method where the sealed tenders are called from the prospective buyers or sellers inviting
them to quote a price at which they are willing to buy or sell their products.

Ex: government contracts of construction or repair works etc.,

3. Other methods of pricing:

a) Price lining:

15
ME

 It is a method where the price of a product in its product line is fixed based on size, quantity or
quality.
 If ONIDA fixes the price of its 29 –inch TV and based on that it determines the prices of other
sizes of TV’s in manufactures. Any change in price of 29- inch TV, also changes the prices of
other TV’s.

b) Skimming pricing:

 Price skimming is method where the price of a commodity is fixed at very high levels initially.
 The objective is to take away what all the customer is willing and able to pay and not leave any
customer surplus.
 Once the creamy layer is exhausted the company reduces the prices slowly.

C) Penetration pricing:

 Under penetration pricing the company fixes low initial prices and tries to penetrate into the
market and get market domination.
 Due to low initial prices it can reduces the entry of new competitors.

d) Peak load pricing:

This is a method adopted by service organisation like telephone department, electricity boards etc.,
whose products or services cannot be stored and the demand fluctuates fat different points of time.

For example, during the day time the demand for telephone services are very high compared to night
time.

e) Psychological pricing:

A price creates a psychological impact that the firm is charging a low price. The best example is
BATA company fixes the price of 199.99 paisa or 99/- . It creates an impression that the price is
around rupees hundred.

f) Limit pricing:
 Limit pricing is a mechanism to eliminate the threat of entry of new firms into the industry.
 In this method a monopoly firm or oligopoly firms determines prices by collusion in such a way
that they do not allow the entry of new competitors.

16
ME

INTERNET PRICING MODELS

The Internet Pricing Models are
1. Flat rate pricing
2. Non-flat rate pricing
3. Precedence model
4. Smart market mechanism model

1. Flat rate pricing:

 To start with more number of internet service providers adopted flat rate pricing strategy.
 A plat fee for a certain period of time.
 The user does not pay for any additional amount for usage of any new applications.
 It worked well in the beginning but it became very difficult to continue with this strategy
when internet usage increases.

2. Non flat- rate pricing:

a) Usage – sensitive pricing:- In this model the fee paid by the user is divided into two
portions. The first portion of fee is for the connection and the second portion of fee is for the
usage of each bit sent or received.
b) Transaction based pricing:- Like usage sensitive pricing in this model also first portion of
fee is for connection and the second portion of fee is charged on the characteristics of
transaction not by the volume of bits send/ received.
c) Priority pricing:- in this method the user choose the quality of services that they want and
pay a fee for the same.

3. Precedence Model:
 In this model a process is set to prioritise the different applications in the precedence field of
the different data packets.
 Precedence model logically decides which packet should be hold up (or) not to send.

4. Smart market mechanism model:

 Depending on the level of network congestion, the price of sending a packet varies from
minute to minute.
 Users indicate their maximum willingness to pay for processing each packet.

17
ME

 Higher bided packets processed earlier than the lower bided packets in the event of
congestion.

_________________________________________________________________________
THEORIES OF THE FIRMS
Marris and Williamsons’ models:

1) MARRIS GROWTH MAXIMIZATION THEORY:

Prof. Marris has developed growth maximisation model in recent years. Profit maximisation is
the main objective of a firm. Marris assumes that the ownership and control of the firm is in the
hands of two groups of people, ie., owner and manager. Both of them have two distinctive goals.

 Managers have a utility function in which the amount of salary, status, position, power,
prestige and security of the job etc., are the most important variables.
 Where as in case of owners are more concerned about the size of output, volume of
profits, market share & sales maximisation.

Utility function of the manager & that of the owner are expressed in the following manner.

U0= f (size of output, market share, volume of profit, capital, public esteem etc.,)

Um=f (salaries, power, status, prestige, job security etc)

Where,

U0 is utility function of owner.

Um is utility function of manager.

In view of Marris the realization of these two functions would depend on the size of the firm.

2. WILLIAMSON THEORY:
Oliver E. Williamson state that profit maximisation would not be the objective of the
manager of a joint stock organization. Like other managerial theories of the firm, this theory
assumes that utility maximisation is manager’s sole objective.
The managers can use their discretion to frame and execute policies which would maximize
their own utilities.

18
ME

The managerial utility function includes variables such as salary, job security, power status,
prestige & professional excellence of managers.
Utility function or expense preference of a manager can be given by

U = U(S, M, ID)

Where:
U denotes the utility function, S denotes the monetary expenditure on the staff, M stands for
Management slack and ID stands for amount of ‘Discretionary investment’.
___________________________________________________________________________

Bain’s Limit Pricing Theory:

Bain formulated his ‘limit-price’ theory in an article published in 1949, several years before his
major work Barriers to New Competition which was published in 1956.

His aim in his early article was to explain why firms over a long period of time were keeping their
price at a level of demand where the elasticity was below unity, that is, they did not charge the price
which would maximize their revenue.

His conclusion was that the traditional theory was unable to explain this empirical fact due to the
omission from the pricing decision of an important factor, namely the threat of potential entry.
Traditional theory was concerned only with actual entry, which resulted in the long-run equilibrium
of the firm and the industry (where P = LAC).

However, the price, Bain argued, did not fall to the level of LAC in the long run because of the
existence of barriers to entry, while at the same time price was not set at the level compatible with
profit maximization because of the threat of potential entry. Actually he maintained that price was set
at a level above the LAC (= pure competition price) and below the monopoly price (the price where
MC = MR and short-run profits are maximized).

This behaviour can be explained by assuming that there are barriers to entry, and that the existing
firms do not set the monopoly price but the ‘limit price’, that is, the highest price which the
established firms believe they can charge without inducing entry. Bain, in his 1949 article, develops
two models of price setting in oligopolistic markets.

19
ME

Assumptions:
1. There is a determinate long-run demand curve for industry output, which is unaffected by price
adjustments of sellers or by entry. Hence the market marginal revenue curve is determinate. The
long-run industry-demand curve shows the expected sales at different prices maintained over long
periods.

2. There is effective collusion among the established oligopolists.

3. The established firms can compute a limit price, below which entry will not occur.

The level at which the limit price will be set depends:

(a) On the estimation of costs of the potential entrant,

(b) On the market elasticity of demand

(c) On the shape and level of the LAC,

(d) On the size of the market,

(e) On the number of firms in the industry.

4. Above the limit price, entry is attracted and there is considerable uncertainty concerning the sales
of the established firms (post entry).

5. The established firms seek the maximization of their own long-run profit.

Model A: there is no collusion with the new entrant:

Assume that the market demand is DABD’ and the corresponding marginal revenue is Dabm (figure
13.1).

20
ME

Assume further that the limit price (PL) is correctly calculated (and known both to the existing firms
and to the potential entrants). Given PL, only the part AD’ of the demand curve and the section am of
the MR are certain for the firms. The part to the left of A, that is, DA is uncertain, because the
behaviour of the entrant is not known.
Whether the firms will charge the PL or not depends on the profitability of alternatives open to them,
given their costs.
Assume the LAC (which is uniquely determined by the addition of the LMC = LAC of the collusive
oligopolists) is LAC1. In this case two alternatives are possible.
Either to charge the PL (and realise the profit PLAdPc1 with certainty).
Or to charge the monopoly price, that is, the price that corresponds to the intersection of LAC 1 =
MC1 with the MR. This price will be higher than PL (given LAC1), but its precise level is uncertain
post-entry. Thus the profits in the second alternative are uncertain and must be risk-discounted. The
firm will compare the certain profits from charging P L with the heavily risk-discounted profits from
the second ‘gamble’ alternative, and will choose the price (P L or PM) that yields the greatest total
profits.
Assume that the LAC is LAC2 = MC2. In this case the price that maximises profit is
PM2(corresponding to the intersection MC2 and MR over the certain range of the latter). The PM2 is
lower than PL. The firm will clearly charge PM2 which maximises the profits. In this case the ceiling
set by the price PL is not operative.
The observed fact of setting the price at a level where e < 1 is justified by a situation where the limit
price is low, cutting the demand curve at a point at which the MR is negative (figure 13.2). Clearly if

21
ME

the limit price is PL* the MR is b* which is negative and hence the elasticity of demand at price P L is
less than unity.

In summary: given that an entry-preventing price PL is defined, the alternatives open to the
established firms are three:
1. To charge a price equal to PL and prevent entry.
2. To charge a price below PL and prevent entry (this will be adopted if PM < PL).
3. To charge a price above PL and take the risks associated with the ensuing entry and the
indeterminate situation that arises in the post-entry period. (This course of action will be in any case
adopted if PL < LAC).
The firm will choose the alternative which maximises profit.

Model B: collusion takes place with the new entrant:

With collusion assumed to take place between the established firms and the entrant the conclusions
are as before. The model is easier, however. With collusion the whole D curve shifts to the left by the
share which is allocated to the new entrant at each price. The new DD” curve is known with certainty
at all its points, as a consequence of the collusion, and so is the corresponding m” (figure 13.3).

22
ME

Again the alternatives open to the firm are three:

1. Either charge PL and exploit AD’ without entry.
2. Or charge a price above PL and attract entry. The firm will eventually move to a point on the
share-of-the-market curve DD”, via collusive agreement with the new entrant.
3. Or charge the profit-maximizing price PM, if PM < PL.
Among these alternatives the firm will choose the one that yields maximum profits.

The basic and crucial assumptions of the above analysis are firstly, that the entrants react on the basis
of the current price they expect the price charged by the established firms to continue in the post-
entry period; secondly, that the established firms are aware of the threat of potential entry; thirdly,
that the established firms can estimate correctly the limit price.

Then three major possibilities exist:

The policy of pricing to maximize industry profit with no entry resulting is adopted when P L > PM,
i.e. the limit price is not operative because by charging the lower PMprice (monopoly price
corresponding to MC = MR) profits (certain in this case) are maximized.
Pricing to forestall entry with industry profits not maximized, but the profit of established sellers
maximized, is adopted when PL < PM and the certain profit accruing by charging P L is greater than
the heavily risk-discounted profit which would accrue if the higher PM were charged and an uncertain
quantity sold.
Pricing to maximize industry profit but with resulting entry. This implies PM > PL. This action would
be chosen if it is more profitable as compared with charging PL and necessarily, if PL < LAC.
The first two situations lead to long-run equilibrium of the industry without entry or exit. The third
case implies an unstable equilibrium since entry would be taking place.

23
ME

In all the above cases one should add to the profits of established sellers any transitional profit which
the established sellers might gain while raising the price above PLand before entry became effective.
The new element of Bain’s model is the redrawing of the market demand so as to account for the
threat of entry. Once the demand is redefined, the model accepts collusion and profit maximisation
as valid hypotheses, capable of explaining the policy of setting a price below the monopoly level,
that is, below the level that maximises profit. Bain’s model is not incompatible with profit
maximisation.

The limit price will be chosen in favour of monopoly price if the former yields maximum long-run
profits. The rationale of adopting an entry-prevention policy is profit maximisation. Whenever such a
limit price is adopted it is implied that the firm has done all the relevant calculations of profits of
alternative policies and has adopted the limit price because this yields maximum profits.

24