Market structures

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The objectiveLearn about market formationHow decisions of price and output are taken in the marketsPricing strategies

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The CoveragePrice and output determination in various market structures perfect competition, monopoly, monopolistic competition, oligopolyPricing strategies for firm with market power- price discriminationA comparison of market structures for efficient production and equitable distribution

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Four basic components of market1. Consumers 2. Sellers3. Commodity 4. Price

Market classificationBy the areaBy the nature of transactionBy the volume of businessBy the nature of competition

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Competition in the marketDepends onNumber and size distribution of sellersNumber and size distribution of buyersProduct differentiationConditions of entry and exitStructure Conduct Performance

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A classification of market forms

Form of Market StructureNumber of FirmsNature of ProductPrice elasticity of demand forDegree of control12345a) Perfect competitionA large no. of firmsHomogeneous ProductInfiniteNoneb) Imperfect competitionA large no. of firmsDifferentiated products (but) they are close substitutes of each otherLargeSomei) Monopolistic competitionA large no. of firmsProduct differentiation by each firmLargeSomeii) Pure oligopolyFew firmsHomogeneous ProductSmallSomeiii) Differentiated oligopolyFew firmsDifferentiated productsSmallSomec) MonopolyOne Unique product without close substitutes Very SmallConsiderable

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Perfect competitionInfinite buyers and sellersPerfect knowledge and informationIdentical productsNo barriers on entry or exitMaximum profits or minimum lossesNo transportation costAll are price takers

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Types of firmsEfficient (least cost) and profit making firmsEfficient but breaking even firmsInefficient but operating firmsInefficient and closing down firms

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Perfect competition and the public interestP = MCCompetition as spur to efficiencyDevelopment of new technologyEconomical use of national resourcesLeast cost Q in long run (LR)

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MonopolyOne sellerBarriers on entryNo substitutes

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Market powerThrough elasticity of demandLearner (Abba) index = P MC/P or

MR = P(1+1/E) Learner index = -1/ECross price elasticity of demand

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Acquiring market powerEconomies of scaleProduct differentiation and brand loyaltyOwnership of, or control over, key factor and/or wholesale or retail outletsConsumer lock in- high search, switching and initiation costLegal protectionNetwork externalities products value rises as more consumers use it.Mergers and takeoversAggressive tactics

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Monopoly and the public interestDisadvantages Higher price and lower output, possibility of higher cost due to lack of competition, unequal distribution of incomeAdvantages Economies of scale, lower cost, competition for corporate control, innovation and new products

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1.bin

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Deadweight loss a measure of the aggregate loss in well-being of the participants in a market resulting from an inefficient output level.

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Monopolistic competitionMany alternative suppliersDifferentiated productEasy entry(e.g. cosmetics, detergents, medicines, grocers, barbershops, restaurants)

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OligopolyFew interdependent sellersStandardized or differentiated oligopolyRestricted entry(e.g. steel, aluminum, cement, fertilizes, petrol and cars).

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Oligopoly in different formsKinked demand curveCollusive oligopolyPrice leadershipJoint profit maximizing cartelMarket sharing cartel

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Kinked demand curve model

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Factors favoring collusionFew 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

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Dominant firm

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Price leadershipJoint profit maximizing cartelMarket sharing cartel

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Case - OPEC: the rise and fall of a cartelOPEC set up in 1960 by Saudi Arabia, Iran, Iraq, Kuwait and Venezuela.ObjectivesThe co-ordination and unification of the petroleum policies of member countriesThe organization to ensure the stabilization of prices, elimination of harmful and unnecessary fluctuation in the price and quantity

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OPECOPEC is a joint profit maximizing cartelSaudi Arabia is a dominant producer and price leader within the cartel

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OPECInitially 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

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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 fall1982 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

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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

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Other cartelsDuring 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

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Pricing Strategies for Firm With Market Power

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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.

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Strategies that yield even greater profitsExtracting Surplus from consumersPrice discriminationTwo part pricingBlock pricingCommodity bundling

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Price discriminationMeaningChanging 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

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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.

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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.

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Third degree discrimination (Market wise)Charging different groups of consumers different prices for the same product.Essential conditionsDifferent elasticity of demand - students discount, senior citizen discountInformation regarding elasticity of demandSeparate markets

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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)Q

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Two part pricingInitially 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.

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Block pricingAll or none decisionBlock 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)

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Commodity BundlingBundling 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 computer

Valuation of monitor

Total

1

20,000/-

2,000/-

22,000/-

2

15,000/-

3,000/-

18,000/-

Total

35,000/-

5,000/-

40,000/-

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Pricing strategies for special cost and demand structuresPeak load pricingCross subsidies

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Peak load pricingMarkets 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.

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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.

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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

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Peak load pricing(cont)CEGB combining peak load pricing and two part tariffCEGB uses less efficient power stations during peak load hours MCCapacity 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 plants1986-87 - 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.

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Case - Computer time and peak load pricingThree criteriaUsually a computer has only a single CPU but is in constant use. Same facility to provide the service at different periods of time.CPU time not used is lost forever i.e. service is not storable.Center may provide same service at different times, late -night service is not desirable.

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Prices at university computer facility

DAY

TIME PERIOD

COST PER MIN.(Rs.)

Mon. - Fri

8 AM - 1 PM

3

Mon. - Fri

1 PM - 5 PM

6

Mon. - Fri

5 PM - 1 AM

1

Mon. - Fri

1 AM - 8 AM

0.2

Sat. - Sun.

8 AM - 5 PM

1

Sat. - Sun.

5 PM - 8 AM

0.2

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Case Peak load pricing of Computer time

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Cross subsidiesA strategy which uses profits made with one product to subsidize sales of another productRelevant in situations where a firm has cost complementarities and demand for a product independenceEconomies of scope - saving in producing jointly or using excess capacity to produce another productsExample - computer & software

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AdvantageIt 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.

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Pricing strategies in markets with intense price competition

Limit pricingPricing joint products Price matchingInducing brand loyaltyRandomized pricing

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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.

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Limit pricingUsed 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

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Pricing Joint ProductsWhen goods are produced jointly and in fixed proportion, they should be thought of as a product packages

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Price matchingA strategy in which a firm advertises a price and promises to match any lower price offered by a competitor.AdvertisementOur price is P. If you find a better price in the market, we will match that price. We will not be undersold.

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Inducing Brand LoyaltyBrand 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

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Randomized pricingA firm varies its prices frequently - hour to hour or day to day

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Case - Randomized pricing in the airline industryThere 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 Deltas more than 70,000 fares. New fares filed the prior day with Air Traffic Publishing Co. are tracks by Delta computer.

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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.

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Thank you and all the best

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