Market Structures and Pricing Strategies - Essay Example

? Market Structures and Pricing Strategies The four basic market structures are analysed in the following paper- Perfect Competition, Monopoly, Oligopoly and Monopolistic Competition. A Perfect Competition is a market with large numbers of participants (buyers and sellers) and identical products. The other extreme is a monopoly where only one firm sells the concerned product. Most of the economists think of these two structures as theoretical. Yet, we have a few examples of these market structures. A market of bathing soaps is a perfect competition whereas Government regulated Indian Railways is a monopoly. Most of the realistic markets, however, lie between the two extremes. In a monopolistic Competition, there are many participants but the sellers have differentiated products. In an oligopoly, there are only a few players because the barriers to entry are high. In a perfect competition the market determines the price. In a monopoly the price is set by the firm. But customers also play a role in determining the price because the price has to be lower than what customers can bear. However, in an oligopoly and in monopolistic competition, the prices also depend on the prices of the competitor. The example of Sony Aibo illustrates the pricing strategy followed by monopolies. Sony is a monopoly in the robotic dog market because of the patent it has earned for its robot Aibo. The price charged by Sony maximizes the profit of firm. It produces a quantity and charges a price at which marginal cost is equal to marginal revenue. However, this price is much above the competitive price and results in deadweight loss. Introduction to Market Structures: The four basic structures are perfect competition, monopoly, monopolistic competition and oligopoly. Perfect Competition and Monopoly are the extreme forms and most of the markets in existence lie between the two extremes. It has been observed by economists that perfect competition and monopoly are theoretical. During 1930s Edward Chamberlin of Harvard University and Joan Robinson of Cambridge University tried to make the study of market structures more realistic. The structure they analyzed is called monopolistic competition. 1. Perfect Competition­­­­­ “The concept of perfect competition was first introduced by Adam Smith in his book "Wealth of Nations". Later on, it was improved by Edgeworth. However, it received its complete formation in Frank Kight's book "Risk, Uncertainty and Profit" (1921).” As stated on : http://economicsconcepts.com/perfect_competition.htm Perfect competition is the market structure where you have large number of buyers and sellers. The sellers sell identical products. An example of Perfect Competition is the market of bathing soaps. Features of Perfect Competition: Key characteristics of Perfect Competition are 1. Knowledge is freely available 2. No barriers to entry 3. Firms produce identical products 4. No single firm can influence the price. The firm is the price taker and the price is determined by the industry demand and supply. 5. There are large number of firms in the market 6. The motive of the firms is profit maximisation 2. Monopolistic Competition Monopolistic competition and Oligopoly lie between the two extreme market structures of Perfect Competition and Perfect Monopoly. What is Monopolistic Competition? In this market structure, there are many buyers and sellers, like in a perfect competition. However, the products are more differentiated. An example could be Restaurants, where every restaurant may specialize in a different cuisine. As Karen Collins puts it in the book Exploring Business, “Products can be differentiated in a number of ways, including quality, style, and convenience, location, and brand name.” Features of Monopolistic Competition: The Key features of Monopolistic Competition as mentioned in the book “Economics: Principles and Policy” by William j. Baumol and Alan S. Blinder are: 1 Large number of buyers and sellers 2 Freedom of entry and exit 3 Perfect Competition 4 Heterogeneous Products It, thus, differs from perfect competition only in terms of differentiation. 3. Oligopoly What is oligopoly? In words of P.C.Dooley, “Oligopoly is a market structure of only a few sellers, offering either differentiated or homogenous products. There are so few sellers that they recognise their mutual dependence.” Companies in an oligopoly are few. There are major barriers to entry, where the barrier could be technological, monetary, legal (regulatory) or something else like patents and licenses. The companies in an oligopoly are affected by the decisions of the rival companies. Steel industry is an example of oligopoly. Features of Oligopoly: As stated in Business Economics by T.R.Jain and O.P.Khanna, following are the features of oligopoly: 1. Few Sellers and many buyers 2. Products could be homogenous or differentiated 3. Mutual Interdependence: Companies are significantly affected by each others’ price and output decisions. The products are close substitutes. 4. Advertisement: Products of rival companies are close substitutes. Hence, the cross elasticity of products is high. Companies, therefore, incur heavy expenditure on advertisements. 5. Price Rigidity: A firm in an oligopoly may not like to lower its price because the rival firms will retaliate by lowering their prices. However, if it increases its price, the rival firms will not increase their prices. 6. Barriers to entry 7. Existence of Non-Profit motive: A firm under oligopoly may have other motives besides profit maximisation like sales maximisation, risk minimisation, output maximisation, security maximisation etc. 4. Monopoly What is monopoly? As per the concise encyclopaedia of economics “A monopoly is an enterprise that is the only seller of a good or service. In the absence of government intervention, a monopoly is free to set any price it chooses and will usually set the price that yields the largest possible profit.” Example of Monopoly is the distribution of Electric Power. If only one firm exists, the power lines need not be duplicated. But for multiple firms, the power lines have to be distributed. Because of the economies of scale, distribution of power, thus, becomes a natural monopoly. Pricing Strategies: 1. Perfect Competition Figure.1. Source: economicsonline.co.uk D=Demand S=Supply MC=Marginal Cost MR=Marginal Revenue AR=Average Revenue ATC=Average Total Cost Since there is no differentiation amongst products in a perfect competition, the demand curve and the supply curve have linear relationship with prices. The market price is the price at which demand is equal to supply. The firms in a perfect competition are price takers. For the given price, they will produce a quantity at which marginal cost is equal to marginal revenue, for profit maximisation. 2. Monopolistic Competition: In monopolistic competition, an important factor is the entry of new firms. The entry of new firms leads to a shift in demand curve, resulting in a change of equilibrium price and output. Equilibrium before the entry of a new firm: Figure.2. Source: http://train-srv.manipalu.com/wpress/?p=115297 In the short run, a firm acts as a monopolist in a monopolistic competition because of its differentiated product. Equilibrium in the long run (after the entry of a new firm): Figure.3. Source: http://train-srv.manipalu.com/wpress/?p=115297 In the long run, the differentiating characteristic will be copied by a competing firm. This will lead to a leftward shift in the demand curve. The price will drop down and the firm will earn zero economic profit. 3. Oligopoly: The determination of price in an oligopolist industry may be based on any of the four common oligopolistic models are: A. The Collusion Model- Sometimes the firms in an oligopoly get together to decide the output and the price. These firms together are called a cartel. The scenario then becomes similar to a monopoly. A common example is OPEC (Organization of Oil Producing Countries). B. The kinked curve model- This model assumes that the firms follow price cuts but not price increases. As shown in the figure, demand is relatively elastic about the price P1. Therefore, if the price is increased above P1, the firm will lose its customers to the competition. This will lead to the loss of market share. If the firm reduces its price below P1, the rival firm also reduces its price. Therefore, below P1the demand curve is relatively inelastic. Reducing the price below P1 may result in the loss of revenue. Source: http://tutor2u.net/economics/content/topics/monopoly/kinked_demand.htm C. The Cournot model- A cournot model is based on the following assumptions- a. It is a duopoly b. Each firm takes the output of the other as given and c. Each firm tries to maximize profit. There are two firms, an existing firm and a new firm. To begin with the existing firm operates like a monopoly selling a product at some level of output and price. The new firm assumes that the existing firm will continue to produce at the same level. So it subtracts the level of output of existing firm from the market demand to determine its own output level. The older firm now finds that its demand is reduced because the new firm has been producing the same product. It, therefore, assumes that the level of output of new firm will remain constant and determines its new level of output subtracting the level of output of new firm from market demand. This continues. The old firm reduces its output in small steps and the new firm increases its output in small steps. This happens until both split the market and charge the same price. D. The price leadership Model- There is one big firm in the industry that dominates the other firms. The other firms follow the leader’s pricing policy. Thus, in an oligopoly, what determines the price is the following: 1.Whether the industry is made up of a cartel that determines the price (In which case it will act like monopoly) 2. Whether there is a leader in the industry. 4. Monopoly: In a monopoly, the manufacturer is the only player in its market segment. Hence, the price is set by the manufacturer. However, if the price set is too high, the number of customers buying the product may decline. Source: http://train-srv.manipalu.com/wpress/?p=115297 The monopoly will set the price where marginal revenue is equal to marginal cost. This price is above the competitive price. It is advisable for a monopolist to increase the price as long as the price elasticity for most of the customers is less than one. As the price rises further, the price elasticity rises causing a shift in the demand curve. As rightly mentioned on the site, http://train-srv.manipalu.com/wpress/?p=115297 , “The economy as a whole suffers when monopoly power is used in this way because the extra profit earned by the monopoly will be smaller than the loss in consumer surplus. This difference is known as a deadweight loss.” Case Study Case study of Sony Aibo: Sony started selling Aibo in 1999. Aibo is a robotic dog. Sony has a patent to manufacture Aibo. This makes Sony a monopoly in the robotic dog market. When Sony launched Aibo, it announced that it would sell 3000 robotic dogs in Japan at a price of $2000 and 2000 robotic dogs in United States of America at a price of $2500. An analysis of the price and quantity determined is as follows (Given on wps.aw.com) Source: http://wps.aw.com/aw_perloff_microcalc_1/76/19538/5001729.cw/content/index.html In both the markets, the United States of America and Japan, we can clearly see that the price charged by Sony is much above the competitive price of $500 that it can charge. This is because Sony manufactures a quantity where marginal revenue is equal to marginal cost. We, thus, see Sony exercising its monopoly by charging $2000 in Japan and $2500 in United States of America. When Sony charges a price above the competitive price, it results in deadweight loss. We can also see that there is difference in the price of Aibo in Japan and in United States of America. The reason for this difference is that the demand curve is more elastic in Japan and less elastic in United States of America. Sony maximized its profits by maximizing the profits separately for each group. Conclusion: The four structures analysed in the paper differ in terms of number of sellers and buyers, differentiation of products and barriers to entry. In a perfect competition, the factors that affect the price are demand and supply of product in the market. In a monopoly, the price is determined by the monopolist. The price is higher than the competitive price. However, this results in a deadweight loss to the economy. This is because the extra profit earned by the monopolist is smaller than the consumer surplus. In monopolistic competition, the firm operates as monopolist in the short term. When another firm with a similar product enters the market, there is a leftward shift in the demand curve of the older firm, which causes a reduction in the price. Thus, in a monopolistic competition, the price is affected when there is another firm that sells identical product. In an oligopoly, there are four different ways in which the prices are determined. The firms in an oligopoly may form a cartel. If that happens, the price is set by the cartel and the cartel acts as a monopolist. Or there may be one large firm in an oligopoly. The prices are set by this large firm while other firms follow the prices. If none of the above cases is observed, the firms follow price cuts by the rivals but not an increase in price. This is depicted by the kinked curve model. There is one more form of oligopoly that has only two players. The two players increase or decrease their prices and quantities until both the players sell at the same price. Thus, in a perfect competition the price is determined only by the market forces. In a monopoly the price is determined by the firm and is more than the competitive price. In an oligopoly and monopolistic competition, the prices are affected by the prices of the rival firms. References: William J. Baumol, Alan S. Blinder, Economics Principles and Policy, 12th Edition, Page 236 http://economicsconcepts.com/perfect_competition.htm http://wps.aw.com/aw_perloff_microcalc_1/76/19538/5001729.cw/content/index.html http://train-srv.manipalu.com/wpress/?p=115297 http://tutor2u.net/economics/content/topics/monopoly/kinked_demand.htm Case Karl E., Principles of Economics, Pearson education, 8th Edition, Pages 301-326 http://www.econlib.org/library/Enc/Monopoly.html T.R.Jain, O.P.Khanna, Business Economics, V.K.Publications, Page 111 http://catalog.flatworldknowledge.com/bookhub/reader/7?e=collins-ch01_s06 John Duffy, Economics, Wiley Publishing, Page 129 http://economicsonline.co.uk/Business_economics/Perfect_competition.html khanacademy.org William A McEachern, Economics a contemporary introduction, 9th Edition Paul A Samuelson, William D Nordhaus, Economics, 19th Edition Roger A. Arnold, Economics, 9th Edition http://www.youtube.com/watch?v=7UWgKZsKZOc http://www.youtube.com/watch?v=T3F1Vt3IyNc&feature=relmfu http://www.youtube.com/watch?v=2wSpC3OmKHU&feature=related Walter J. Wessels, Barron’s Economics, 4th Edition Read More