economics - pricing under different market structure

UNIT IV - PRICING
(16 MARKS)

1.EXPLAIN MONOPOLY MARKET WITH PRICING STRUCTURE

MONOPOLY

Monopoly is the least competitive market structure of all. A pure monopoly is a market with only one producer who produces 100% of the output. Consumers have the least choice in a monopoly market – buy from the monopolist or don’t buy. A monopoly market will have the highest price and the lowest total production of any market structure.

The assumptions of monopoly are:

One seller: The classic monopoly has only one seller by definition. In actuality, we also use the market structure to analyze industries that have essentially one producer controlling almost all the output.

Unique product: Since there is only one producer, or effectively one producer, the product they make cannot be compared to alternatives. It is unique. This is important in understanding why a company like Pepsi is not a monopoly even though it is the only company that can produce its version. The product is not unique.

Good or poor information is largely irrelevant: Whether the information is good or bad is essentially irrelevant since there is no other product to compare this one to.

Barriers to Entry: As in oligopoly, firms are not able to move resources in, and out of this market relatively easily with little expense. The barriers to entry are higher in monopoly and also include the same two types.

Artificial barriers: artificial barriers to entry keep new firms from entering even if they wish to. These are generally structural features that make entry difficult or impossible. Artificial barriers to entry include patents, government licenses, control of a raw material, network advantage and high start-up costs. A monopoly that mainly exists because of artificial barriers is called a non-natural monopoly. Since there are no or few cost advantages to this company, it will result in higher prices and lower output for the consumer.
Natural barrier: there is one natural barrier – large economies of scale – that discourages new producers from even trying to enter. There is such a cost advantage to being big that the industry has ended up with only one producer. A new producer is reluctant to enter because they can’t produce for as low a cost. A monopoly that mainly exists because of economies of scale is called a natural monopoly.

A perfectly competitive industry automatically sets price equal to marginal cost – this is called marginal cost pricing. Since the marginal cost is relatively easy to calculate, the government could use this strategy to set the price for a monopoly. The problem is that the usual reason we are regulating this industry instead of breaking it up involves large economies of scale. If there are still economies of scale in the industry, then by definition the average cost of production is falling. If the average cost is falling, then marginal cost must be below it.

If the average cost of production is falling each time we get bigger and produce more units, then the cost of the next unit must be smaller than the current average. (If your GPA were falling then your new or marginal grades must be lower than the previous average.) The marginal cost curve must be below the average cost curve. Remember that any average cost curve falls until it intersects the marginal cost curve.

If we set price by the MC curve while the cost of production is off the LRAC curve, then this firm will be making a negative economic profit.

In addition, if the industry is one where the input prices regularly fluctuate – as electricity is given the volatility of oil prices – then even if the original approved rate were perfect, it would not long remain so. The firm lacks the flexibility to raise price when production costs rise and the incentive to lower price when production costs fall.

The regulatory body could try to limit the power of a noncompetitive industry while avoiding these issues by regulating the profit rate. This would allow the firm to set price at a level consistent with good service, maintenance and investment and force them to adjust price as costs change to prevent excessive profit. Unfortunately, this eliminates the incentive for the firm to keep costs down once the maximum profit allowed has been achieved. The management of the firm may inflate costs beyond what they would pay if the money were coming out of their own pockets. Extra money is likely to be spent on fancy offices, expensive business trips, higher wages than those paid by the unregulated private sector, etc. Decision makers are maximizing a combination of profit and personal benefit rather than profit alone – this is known as satisficing.

2.EXPLAIN MONOPOLISTIC MARKET WITH PRICING STRUCTURE

MONOPOLISTIC COMPETITION
The first of the non-perfectly competitive markets is known as monopolistic competition – this is a market structure marked by a high degree of competition – it’s just not perfectly competitive. Each individual company has its own version of a product, so in one respect it is the only seller of this version. However, this version is very similar to the other goods in the market so there is a large amount of competition. Numerically, this is by far the most common market structure in the US as most proprietorships are in monopolistic competition, and proprietorships are the most common form of business organization in the US. These firms, however, do not have strong individual power.
The assumptions of monopolistic competition are:

Many buyers and sellers: There are so many buyers and sellers in monopolistic competition that no one of them has any significant influence on the market. The number of consumers and producers is not as great as in perfect competition but is still sufficient to be very competitive.

Similar or heterogeneous product: Every producer in the market makes a similar, but not identical product – consumers are able to distinguish between the output of one firm and the output of another. There can be labels, brands or any other distinguishing features used to make a product look distinct – a process known as product differentiation. This is the biggest difference between perfect and monopolistic competition.

Relatively good information: Both buyers and sellers in this market have information about the product, but not as good as in perfect competition. Because the products are somewhat different, each one has to be investigated separately and consumers do not usually have the time or inclination to do those completely. Instead, we rely on word of mouth, trial and error and advertising in order to find goods we are satisfied with. We do not generally proceed to the point that we know we have the BEST product for the money.

Relatively free entry and exit: Firms are able to move resources in and out of this market relatively easily with little expense. This makes firms especially quick to respond to changing consumer demand.

This can be a highly competitive market and consumers usually fare well under monopolistic competition. There are many producers of a similar product – not only is there good competition, but there is great variety in the nature of the product. This gives consumers a lot of choices.
Product differentiation involves a number of business activities. We may vary the physical properties of the product – adding scents, flavors, textures and colors, changing the shape of the product or the materials it’s made of.
We can vary the service offered, either as an independent service or in combination with a good. We can have a 24-hour store, or free delivery or an extended warranty. Out tech support people can come to your house and move all your old programs onto your new computer. We can accept returns, no questions asked, or special order material. Stores can be located on major streets with drive through windows.
Finally, we can vary the marketing. The product and service itself might not have any substantive differences but we could change the package and labeling. Advertising might be used to give our product a certain image that other versions of this product lack. Prestige and status, attractiveness and sex appeal, safety and reliability, economy and thriftiness are all common themes stressed in the image of certain products. Generally, major investments in this kind of marketing are most seen in the next market structure, but to a lesser extent it can be found in monopolistic competition.
Product differentiation gives consumers a range of choices in the product and service. It is likely, however, to also raise the cost of production. All other things equal, the cost per unit of producing goods with special features or extra service will be greater than the cost of making all the goods exactly alike with the minimum features necessary. All other things equal, the money spent on advertising, packaging and labeling will raise the cost per unit of the good. All other things equal, the entire ATC curve is higher with product differentiation.
Advertising may allow the firm to increase its size and enjoy economies of scale. In this case the advertising might result in a more efficient company rather than a less. Since monopolistic competition is generally marked by smaller companies that operate in a highly competitive industry, it seems likely that the economies of scale are limited. Large economies of scale tend to result in very large producers and that seems more relevant to the next two market structures.

Short-run equilibrium in Monopolistic Competition

In monopolistic competition the production decision will look like this. Q* is set at the intersection of the marginal cost and marginal revenue, while P is set by the demand curve at Q*. If we add an average total cost curve to the graph, we can calculate the cost per unit of Q*.
The firm makes a profit on each unit equal to the price minus the unit cost. This is the vertical distance between the demand and ATC curve at the Q* quantity. The firm’s total profit is the profit per unit times the number of units – Q*. Since Q* is the horizontal distance from the vertical axis out to the Q* quantity, total profit is the area of the rectangle as shown to the left. The height is profit per unit, the width is the number of units and the product (the area) is the total profit.

Long-run equilibrium in Monopolistic Competition

The same process works in monopolistic competition that we see in perfect competition. Relatively free entry and exit will push the industry to a breakeven point. The breakeven point is not located in the same place, however.
In the long run, monopolistic competitive firms will not continue to produce at a negative economic profit. If they could make more money elsewhere and it is relatively easy to exit the market, that is exactly what some of them would do. As those firms leave the industry, the price will rise for the remaining firms – this process will continue until all negative economic profits have been eliminated.
In the long run, monopolistic competitive firms will not continue to produce at a positive economic profit. If they are making more money than elsewhere and it is relatively easy to exit and enter the markets, that is exactly what some of the firms will do in the other industries. As those firms exit their market and enter this market, the price will fall for the original firms – this process will continue until all positive economic profits have been eliminated.

The monopolistically competitive firm on the left is at a breakeven point. The firm sets production at Q* - the point where MR = MC. The demand curve establishes P, but since the ATC curve is tangent to the demand curve at that point, the P = ATC. We are breaking even.
Notice that the firm, although breaking even, is not operating at peak efficiency. There is room to lower the ATC by expanding production; however, in order to sell the good the price would have to fall even more. Expansion is therefore not profitable and does not occur.

This is the trade-off in monopolistic competition – consumers gain variety at the expense of some efficiency. If the product differentiation raised the ATC curve, then consumers lose even more efficiency. 3.EXPLAIN OLIGOPOLY MARKET WITH PRICING STRUCTURE

OLIGOPOLY
Characteristics of Oligopoly
Oligopoly is the first of the market structures that is marked by a limited degree of competition. Oligopoly covers a multitude of markets from those that are fairly competitive to some that have very little competition at all. Consumers will face more limited choices in oligopoly and it is within this market structure that the balance of power shifts against the consumer.
This is the market structure containing the industries that drive the US economy. The major corporations are in this market structure, and although they are not as numerous as monopolistic competitive firms, they are far larger, more powerful and account for more production. These companies often hold significant political influence in addition to their economic influence. The assumptions of oligopoly are:

Relatively few sellers: There are few enough sellers in oligopoly that they can individually have influence on the market. Producers in oligopoly are interdependent – a firm’s success can be as influenced by the actions of a competitor as its own. The cut-off for oligopoly is arbitrarily chosen to be a concentration ratio of .4 or over. In other words, if the top four firms in the industry have 40% of sales or more, then it is considered to have relatively few sellers. When firms are this large and control this much market share, then the actions of one significantly affects its competitors.

Identical or Similar product: In some oligopolies, such as the steel industry, the product can be identical from producer to producer. In other oligopolies, such as the auto industry, the product is only similar from company to company. AOTE, the more similar the goods the more competitively the market will behave. This is because it is easier for consumers to switch from one good to another reducing the firm’s power over price.

Good or poor information: Both buyers and sellers in this market could have good information about the product or not. Good information is more likely to occur when the products are identical or very similar. The more differences between versions of a good the more data the consumer has to gather to have good information for comparison. AOTE, the better the information the more competitively the market will behave. Firms will be pressured to keep quality and price in line with other producers – if they fail to do so, consumers have the knowledge to go buy the better value.

Barriers to Entry: Firms are not able to move resources in and out of this market relatively easily with little expense. The barriers to entry are of two types.

Artificial barriers: artificial barriers to entry keep new firms from entering even if they wish to. These are generally structural features that make entry difficult or impossible. Artificial barriers to entry include patents, government licenses, control of a raw material, network advantage (where the size of a system of associated services is part of the attractiveness of the good) and high start-up costs.
Natural barrier: there is one natural barrier – large economies of scale – that discourages new producers from even trying to enter. There is such a cost advantage to being big that a few huge firms control this market. A new producer is reluctant to enter because they can’t produce for as low a cost.

Oligopolies vary in the degree of competition – some are competitive enough that they are only slightly different than the least competitive firms in monopolistic competition. Some are uncompetitive enough that they are almost a monopoly. While there is disagreement among economists on any rule of thumb to categorize oligopolies, we will use the following generalizations.

o Concentration ratio of .4 to .6 Weak Oligopoly, not strongly concentrated o Concentration ratio of .6 to .8 Standard Oligopoly neither weak nor strong o Concentration ratio of .8 or over Strong Oligopoly, strongly concentrated
Competitive Oligopolies
If an oligopoly market has at least a moderate number of producers that are truly competing with one another – i.e. no cooperation and no basis for anticipating the decisions of the other firms - they may exhibit an unusual shaped demand curve. Suppose you are running a firm in such a market, and you are considering changing your price as you search for the profit maximizing point of production. You have to consider how your competitors will react when you change price, because that reaction will change the profitability of any decision you could make.
You are currently selling 600 units a week at a price of $6. You are not sure that this is the profit maximizing point of production and are considering change price to find out. You could lower price and hope to make up on volume what you lose on profit per unit; you could raise price and hope that the higher profit margin makes up for a drop in sales. The effect you see will depend on whether the other firms in the industry ignore your price change, keeping theirs about where it was before or match it.
In this case the competition decided to ignore your price change. If you raise price you will be the only firm to do so and you will see a large drop in sales. Some of your consumers are going to go buy the product from someone else. If you lower price you will also be the only firm to do so and you will see a large rise in sales. The demand curve is relatively elastic.

If this were the situation in the market, it would suggest that you either leave prices alone or cut them. A price increase is very unlikely to raise profits; on the contrary, it will probably lower them.

In this case the competition decided to match your price change. If you raise price, so too do the other firms and there will be a small drop in sales. Consumers have nowhere to go but out of the market. If you lower price, the other firms will match you and you will all gain very few sales, only receive less profit per unit. The demand curve is relatively inelastic.

If this were the situation in the market, it would suggest that you either leave prices alone or raise them. A price decrease is very unlikely to raise profits; only the consumers win a price war.

Since these two possibilities suggest two contradictory price policies, the question becomes which is true? The answer might be both of them, depending on the nature of the price change. Oligopoly firms which are truly competing may match a price decrease but ignore a price increase.
The Kinked Demand Curve

If firms ignore a price increase then the demand curve will be fairly flat or elastic at prices higher than the current one.

If firms match a price decrease then the demand curve will be fairly steep or inelastic at prices lower than the current one.

This gives us a demand curve that is bent or kinked. The bend occurs at the existing price in the market.

In this situation, the firm is best leaving the price where it is. Prices in such a market will be very stable unless underlying costs change or the whole demand curve shifts significantly.
Price Leadership

It’s understandable how the corner or kinked price persists, but how did the industry establish the corner price to begin with? In some industries there is an acknowledged leader – a firm which is looked to by the other firms when it is time to set a new industry price structure or technology. This may be because of its size, or technological dominance, or history. In times of turmoil, when external forces such as a changing technological base or significantly changing consumer demand render the old equilibrium obsolete, firms will look to this leader to establish the new stable order in the industry.

But, we may have now relaxed one of the assumptions under the competitive oligopoly model – that there is no basis for anticipating the decisions of the other firms. The industry leader has a past precedent that other firms follow its lead – it may decide to risk raising price when there are no external forces at work. Kellogg’s is the leader in the cereal industry. If Kellogg’s knows that every time corn prices change, General Mills and General Foods follow Kellogg’s lead in setting the new price and the timing of the price change, then Kellogg’s knows there is a good possibility that they will follow its lead if it raises cereal prices when costs aren’t rising.

The likelihood of this happening is related to the number of major firms in the industry. If there are only 3 or 4 dominant firms, then if one changes price the other three only have to worry about what 2 other firms are going to do. The probability of a firm taking the risk to follow a price increase by one competitor is much higher if the number of businesses in the industry is small. Traditionally, in the cereal industry there were only 3 producers making about 85% of the output.

This can lead to the industry leader essentially setting price for the entire industry – a phenomenon known as price leadership. Price leadership can be used as a way of establishing a near monopoly price as long as the other firms do not use the opportunity to gain short run sales at the expense of long run profit. Provided the firms do not actually coordinate their strategy, it is unclear if this behavior is illegal.

4.EXPLAIN PERFECT COMPETITION MARKET WITH PRICING STRUCTURE

Perfect competition
A perfectly competitive market is a hypothetical market where competition is at its greatest possible level. Neo-classical economists argued that perfect competition would produce the best possible outcomes for consumers, and society. Key characteristics
Perfectly competitive markets exhibit the following characteristics:
1. There is perfect knowledge, with no information failure or time lags. Knowledge is freely available to all participants, which means that risk-taking is minimal and the role of the entrepreneur is limited.
2. There are no barriers to entry into or exit out of the market.
3. Firms produce homogeneous, identical, units of output that are not branded.
4. Each unit of input, such as units of labour, are also homogeneous.
5. No single firm can influence the market price, or market conditions. The single firm is said to be a price taker, taking its price from the whole industry.
6. There are a very large numbers of firms in the market.
7. There is no need for government regulation, except to make markets more competitive.
8. There are assumed to be no externalities, that is no external costs or benefits.
9. Firms can only make normal profits in the long run, but they can make abnormal profits in the short run.
The firm as price taker
The single firm takes its price from the industry, and is, consequently, referred to as a price taker. The industry is composed of all firms in the industry and the market price is where market demand is equal to market supply. Each single firm must charge this price and cannot diverge from it. Equilibrium in perfect competition
In the short run
Under perfect competition, firms can make super-normal profits or losse
In the long run
However, in the long run firms are attracted into the industry if the incumbent firms are making supernormal profits. This is because there are no barriers to entry and because there is perfect knowledge. The effect of this entry into the industry is to shift the industry supply curve to the right, which drives down price until the point where all super-normal profits are exhausted. If firms are making losses, they will leave the market as there are no exit barriers, and this will shift the industry supply to the left, which raises price and enables those left in the market to derive normal profits. The super-normal profit derived by the firm in the short run acts as an incentive for new firms to enter the market, which increases industry supply and market price falls for all firms until only normal profit is made.
Evaluation
The benefits
It can be argued that perfect competition will yield the following benefits:
1. Because there is perfect knowledge, there is no information failure and knowledge is shared evenly between all participants.
2. There are no barriers to entry, so existing firms cannot derive any monopoly power.
3. Only normal profits made, so producers just cover their opportunity cost.
4. There is no need to spend money on advertising, because there is perfect knowledge and firms can sell all they can produce. In addition, selling unbranded goods makes it hard to construct an effective advertising campaign.
5. There is maximum possible: o Consumer surplus o Economic welfare
6. There is maximum allocative and productive efficiency: o Equilibrium will occur where P = MC, hence allocative efficiency. o In the long run equilibrium will occur at output where MC = ATC, which is productive efficiency.
7. There is also maximum choice for consumers.