MARKET STRUCTURE AND PRICING PRACTICES

Meaning and classification of Market

An arrangement whereby buyers and sellers come in close contact with each other directly or indirectly to sell and buy goods is described as market

Classification of market Local marketsRegional marketsNational marketsWorld markets

Perfect CompetitionA market structure in which a large number of firms all produce the same product and no single seller controls supply or prices.

Perfect Competition is a market structure where there is a perfect degree of competition and single price prevails. A perfectly competitive market is a hypothetical market where competition is at its greatest possible level. It is also called as pure competition.

Features of Perfect CompetitionMany SellersMany BuyersHomogenous ProductsZero Advertisement CostFree entry and ExitPerfect KnowledgeNo Government InterventionNo Transport CostPerfect Mobility of factors

Determination of Price under perfect competition

In prefect competition, price is determined by the market forces of demand and supply. All buyers and sellers are price takers and not price makers. Buyer represents demand side in the market. Every rational buyer aims at maximising his satisfaction by purchasing more at lower price and lower at higher price. This is called demand behaviour of buyer i.e. Law of Demand.Seller represents supply side in the market. Every rational seller aims at maximizing his profits by selling more at higher price and lesser at lower price. This is called supply behaviour of seller i.e. Law of supply.

But at a common price, buyer is ready to demand a particular quantity of goods and seller is also ready to supply exactly the same quantity of goods to buyer, such common price is called 'Equilibrium Price' and such quantity is called 'Equilibrium Quantity'.

It is the price at which total demand is exactly equal to total supply.

MonopolyThe term monopoly is derived from Greek words 'mono' which means single and 'poly' which means seller. So, monopoly is a market structure, where there only a single seller producing a product having no close substitute. This single seller may be in the form of an individual owner or a single partnership or a Joint Stock Company.

Such a single firm in market is called monopolist. Monopolist is price maker and has a control over the market supply of goods. But it does not mean that he can set both price and output level. A monopolist can do either of the two things i.e. price or output. It means he can fix either price or output but not both at a time.

In monopoly, the firm has control over the price of output. Therefore, it will choose the level of price and output that maximises profits.

Features of Monopoly

A single seller has complete control over the supply of the commodity.There are no close substitutes for the product.There is no free entry and exit because of some restrictions.There is a complete negation of competition.Monopolist is a price maker.Since there is a single firm, the firm and industry are one and same i.e. firm coincides the industry.Monopoly firm faces downward sloping demand curve. It means he can sell more at lower price and vice versa. Therefore, elasticity of demand factor is very important for him.

Types of Monopoly Perfect Monopoly Imperfect Monopoly ( Telecom)Private Monopoly ( Reliance)Public Monopoly ( Railways, Defence)Simple Monopoly Discriminating MonopolyLegal Monopoly ( Music Industry)Natural Monopoly ( Gulf Countries)Technological Monopoly ( Windows OS)Joint Monopoly ( Pizza and Burger Joint)

Pricing under MonopolyBe careful of saying that "monopolies can charge any price they like" - this is wrong. It is true that a firm with monopoly has price-setting power and will look to earn high levels of profit. However the firm is constrained by the position of its demand curve. Ultimately a monopoly cannot charge a price that the consumers in the market will not bear.

A pure monopolist is the sole supplier in an industry and, as a result, the monopolist can take the market demand curve as its own demand curve. A monopolist therefore faces a downward sloping AR curve with a MR curve with twice the gradient of AR. The firm is a price maker and has some power over the setting of price or output. It cannot, however, charge a price that the consumers in the market will not bear. In this sense, the position and the elasticity of the demand curve acts as a constraint on the pricing behaviour of the monopolist. Assuming that the firm aims to maximise profits (where MR=MC) we establish a short run equilibrium as shown in the diagram below.

Assuming that the firm aims to maximise profits (where MR=MC) we establish a short run equilibrium as shown in the diagram below.

The profit-maximising output can be sold at price P1 above the average cost AC at output Q1. The firm is making abnormal "monopoly" profits (or economic profits) shown by the yellow shaded area. The area beneath ATC1 shows the total cost of producing output Qm. Total costs equals average total cost multiplied by the output.

A change in demand will cause a change in price, output and profits.

In the example below, there is an increase in the market demand for the monopoly supplier. The demand curve shifts out from AR1 to AR2 causing a parallel outward shift in the monopolist's marginal revenue curve (MR1 shifts to MR2). We assume that the firm continues to operate with the same cost curves. At the new profit maximising equilibrium the firm increases production and raises price.Total monopoly profits have increased. The gain in profits compared to the original price and output is shown by the light blue shaded area.

Price DiscriminationPrice discrimination occurs when a firm charges different prices to different customers for reasons other than differences in costs

Price-discriminating monopoly does not discriminate based on prejudice, stereotypes, or ill-will toward any person or group– Rather, it divides its customers into different categories based on their

willingness to pay for good

Forms of Price DiscriminationPersonal Discrimination ( Doctor)Age Discrimination ( Bus Fares)Sex Discrimination ( Concession for ladies)Location or Territorial Discrimination (petrol in Goa)Size Discrimination (Economy size Toothpaste)Quality variation discrimination ( Book Prices)Special service or comforts ( Restaurants)Use discrimination ( Electricity)Time discrimination ( Telephone charges)Nature of commodity discrimination ( Freight charges in railways & Bus)

Second Degree Price Discrimination

Third Degree of Price Discrimination

When is price discrimination profitable?

Price discrimination is possible when there are different separate markets. But, the profitability aspect of price discrimination basically depends upon the nature of the elasticity of the demand in these markets.The basic condition of profitable price discrimination are –

Elasticity of demand differs for different marketsThe cost differential of supplying output in different markets should not be large in relation to the price-differential based on elasticity differential

Monopolistic CompetitionMonopolistic competition is a market structure characterized by a large number of relatively small firms. While the goods produced by the firms in the industry are similar, slight differences often exist. As such, firms operating in monopolistic competition are extremely competitive but each has a small degree of market control.

Monopolistic Competition is a market structure in which many firms sell products that are similar but not identical.

In effect, monopolistic competition is something of a hybrid between perfect competition and monopoly. The real world is widely populated by monopolistic competition.

Features of a Monopolistic Competition

Large number of small firmsProduct differentiationRelative resource mobilityExtensive knowledge

Pricing under Monopolistic Competition

Short run EquilibriumOver the short-run, firms can usually gain some abnormal profit, it is a time period in which at least one factor of production is fixed. The firm will produce quantity Q at price P. The firm produces where marginal cost (MC) and marginal revenue (MR) curves meet, because MC is the cost of producing an one more of the good and MR is the revenue of selling one more good and their meeting point is the most efficient production. This means that the shaded area between Ps, b (average cost of producing one good at this quantity) and the AR curve (average revenue curve) is the abnormal profit the firm makes. AR is equivalent to the demand curve and is the average revenue the firm makes per item sold. Producing at this point ensures the highest amount of profit. Thus, equilibrium is created in the short run.

Short run equilibrium

Long run EquilibriumIn the long run, there are no abnormal profits because of the features of Monopolistic competition. There are a few large firms, but many small firms that will compete for profit and thus drive the price down. Also, low entry barriers mean new firms will enter the market and further add competition. Finally, the goods are similar enough to ensure that competition will always remain high.

In this diagram, the firm produces where the LRMC, or long run marginal cost curve, and the marginal revenue curve meets. The LRMC describes the cost of producing one more of the good when no factors of production are fixed over the long run. That point is, in the long run, equivalent to the LRAC, or long run average cost curve, which shows them average cost of producing one good at this quantity over the long run. Because the LRAC curve is above the AR curve, there is no abnormal profit, as the average cost of the good equals the average revenue of the good. Thus, in the long run, equilibrium is acquired.

Essentially, the difference between short and long run equilibrium is that in short run equilibrium, the firm can gain abnormal profits. Over the long run, that is impossible.

Long run Equilibrium

Product DifferentiationThe goods produced by firms operating in a monopolistically competitive market are subject to product differentiation. The goods are essentially the same, but they have slight differences.

Product differentiation is usually achieved in one of three waysPhysical DifferentiationPerceived DifferentiationSupport Services

Product differentiation is the primary reason that each firm operating in a monopolistically competitive market is able to create a little monopoly all to itself.

Oligopoly

A market structure characterized by competition among a small number of large firms that have market power, but that must take their rivals’ actions into consideration when developing their competitive strategies.

Oligopoly is a market structure in which the number of sellers is small. It requires strategic thinking, unlike perfect competition, monopoly, and monopolistic competition. Under oligopoly, a seller is big enough to affect the market. You must respond to your rivals’ choices, but your rivals are responding to your choices.

In oligopoly markets, there is a tension between cooperation and self-interest. If all the firms limit their output, the price is high, but then firms have an incentive to expand output.

Features of Oligopoly large number of potential buyers but only a few sellershomogenous or differentiated productbuyers are small relative to the market but sellers are large Firms have market power derived from barriers to entryEach firm doesn’t have to consider the actions of other the actions of other firms, thus, behavior is interdependent. However, a small number of firms compete with each other. Imperfect dissemination of information AdvertisingConstant struggle

Kinked Demand CurveThe kinked demand curve or the average revenue curve is made of Relatively elastic demand curveRelatively inelastic demand curve

At given price P, there is a kink at point K on the demand curve DD. DK is the elastic segment and KD is the inelastic segment of the curve. Here, the kink implies an abrupt change in the slope of the demand curve. Before the kink the demand curve is flatter, after the kink it becomes steeper.

The kink leads to indeterminateness of the course of demand for the product of the seller. Raising the price would contract sales as demand tends to be elastic at this stage. Lowering the price would imply an immediate retaliation from the rivals on account of close interdependence of price output movement in oligopolistic market.

Kinked Demand Curve

It is observed that quite often in oligopolistic markets, once a general price level is reached whether by collusion or by price leadership or through some formal agreement, it tends to remain unchanged over a period of time. This price rigidity is on account of conditions of price interdependence .Discontinuity of the oligopoly firm’s marginal revenue curve at the point of equilibrium price, the price combination at the kink tends to remain unchanged even though marginal cost may change.

In the figure, it can be seen that the firm's marginal cost curve can fluctuate between MC1,MC2 and MC3 within the range of the gap in the MR curve, without disturbing the equilibrium price and output position of the firm. Hence, the price remains at P and output at Q, despite change in marginal costs.

Price LeadershipAnother type of oligopolistic behaviour is price leadership. This is when one firm has a clear dominant position in the market and the firms with lower market shares follow the pricing changes prompted by the dominant firm.

As the name implies, the price leadership consists of a leader and a bunch of followers. The leader, however, is always mindful of the demand and will set prices low enough that a satisfactory demand remains after all the followers have made production decisions.

This implies that the dominant firm is better off with larger amounts of the market share and less competition. As a result, the price leader may choose prices to minimize the participation of smaller firms. This pricing strategy is called predatory pricing.

The price leadership of a firm depends on number of factors as

Dominance in the market InitiativeAggressive pricing Reputation

cartel It is often observed that when a market is dominated by a few large firms, there is always the potential for businesses to seek to reduce market uncertainty and engage in some form of collusive behaviour. When this happens the existing firms decide to engage in price fixing agreements or cartels. The aim of this is to maximise joint profits and act as if the market was a pure monopoly. It is considered illegal under anti-trust laws, such as competition act 2002, India.

Collusion is often explained by a desire to achieve joint-profit maximisation within a market or prevent price and revenue instability in an industry. Price fixing represents an attempt by suppliers to control supply and fix price at a level close to the level we would expect from a monopoly.