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6 Market structure and pricing

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Learning outcomes

• By studying this section students will be able to:– understand how and why firms come to be

price takers, price makers or price shapers– analyse the pricing strategies that result from

different market situations

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Pricing in the private sector

• Private sector organizations which seek to maximize profits will attempt to minimize their costs and maximize their revenue.

• Revenue is composed of price multiplied by quantity sold

• The price that an organization can charge for its product depends largely on the type of market within which it is operating.

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Price takers: Perfect competition• Market conditions

– many buyers, many sellers– identical products– freedom of entry and exit in the market– perfect knowledge about prices and products in the

market.• Firms which operate in this type of market have

to accept the market price. – This is because any attempt to increase their own

price over and above market price will lead to consumers purchasing identical goods or services from competitor firms.

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Perfect competition: Which is a typical firm’s demand curve?

• Answer = c– (perfectly elastic: if the firm

increases its price customers will buy from competitors)

• Not b– (Supply curve)

• Not a – (perfectly inelastic)

• Not e– (Some customers remain

even after price rise)

P

D

a b

c

e

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A Paradox

• In the UK a major supermarket (Tesco) sells top 50 CDs for £9.99. Regular retailers (e.g. HMV) charge £13.99 for an identical product. These stores are opposite each other but HMV still manages healthy sales of its more expensive CDs. Why?– consumer ignorance (i.e. lack

of perfect knowledge)?– Non-identical shopping

experience?

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Price takers: Perfect competition• Whilst free market prices and normal profits are

good for consumers, profit-maximizing producers will aim to increase profits.

• Thus there are few examples in the real world of price takers. If firms are not in the fortunate position of being price makers they will generally take steps to become price shapers.

• How could they do this?– by introducing imperfections into the market

• What is the effect of the Internet on competition?– increases knowledge and introduces more sellers

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Price makers: Monopoly • literally defined as one seller• monopoly power is maintained by ensuring

that barriers to entry into the industry are maintained.

• the firm’s demand curve is the same as the industry demand curve. Why?– the firm is the industry

• because of this, the monopolist is in a position to be a price maker.

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Monopoly: Which is a firm’s demand curve?

• Answer = e– A trade off between price

and demand

• not = c– (perfectly elastic)

• Not b– (supply curve)

• Not a – (perfectly inelastic)

P

D

a b

c

e

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Price makers: Monopoly

• a monopoly producer faces a trade-off– it can raise prices but as it does so demand

falls (but does not disappear as would be the case under perfect competition).

• so what is the best price to charge? – that price that will maximise total revenue

• where demand is inelastic will it pay to increase or decrease price?– increase

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Which of the following is a monopoly?

• BA – Airline, or• BA – London Eye

– Ans = London Eye

• Why?– No close substitute

• What does this mean for pricing strategy?– Where demand is

inelastic it pays to raise prices

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Price discriminating monopolist/yield management

• The conditions for price discrimination to take place are:– The product cannot be resold. If this were not the

case, customers buying at the low price would sell to customers at the high price and the system would break down. Services therefore provide good conditions for price discrimination.

– There must be market imperfections (otherwise firms would all compete to the lowest price).

– The seller must be able to identify different market segments with different demand elasticities (for example, age groups, different times of use).

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Price discriminating

monopolist

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Is this price discrimination?• British Airways return fares from London

to New York (summer 1999) are: – £5446 (first class), – £3213 (club class), – £828 (standard economy), – £417 (APEX), – £82.80 (staff 10 per cent standby) and – £0 (staff yearly free standby/holders of

airmiles or frequent flyer miles).

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Not strictly because• In fact BA is not a monopolist …• but most fares are subject to International Air Transport

Association (IATA) regulation and thus many firms are able to act as monopolists.

• The fare differential for club and first-class passengers is not strictly price discrimination since these represent different services with different costs.

• But since all economy-class passengers receive an identical service, why should BA charge different prices and why do passengers accept different prices? – The answer is that by price discrimination companies can

increase their profits by charging different prices according to how much different market segments are prepared to pay.

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Yield management

• Computer technology is able to identify patterns of demand for a particular product and compare it with its supply.

• A request for a hotel reservation or an airline ticket will result in the system suggesting a price that will maximize the yield for a particular flight or day’s reservations

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Price shapers

• Firms operating in markets between these two extremes can exert some influence on price. Such firms are called price shapers

• The two main market types which will be examined are:– oligopoly– monopolistic competition

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Oligopoly

• An oligopoly is a market dominated by a few large firms.

• An example of this is the cross-channel (UK to France) travel market.

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Oligopoly• Oligopoly makes pricing policy more difficult to

analyse since firms are interdependent, but not to the extent as in the perfectly competitive model.

• The actions of firm A may cause reaction by firms B and C, leading firm A to reassess its pricing policy and thus perpetuating a chain of action and reaction.

• For these reasons firms operating in oligopolistic markets often face a kinked demand curve.

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Kinked Demand Curve

P

D

k

l

m

a price rise will cause consumers to purchase from competitors: demand elastic

a price fall will be matched by competitors: demand inelastic

a b c

demand curve kinked at this point

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Kinked demand curve• With a kinked demand curve it is clearly not in the

interests of individual firms to cut prices, and these markets tend to be characterized by price rigidities.

• Marketing and competition under oligopoly conditions are often based around:– advertising– free gifts and offers– quality of service or value added– follow-the-leader pricing – pricing is based on the decisions of

the largest firm– informal price agreements– price wars occasionally break out if one firm thinks it can

effectively undercut the opposition

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Monopolistic competition• This is a common type of

market structure, exhibiting some features of perfect competition and some features of monopoly. – The competitive features

are freedom of entry and exit and the existence of a large number of firms.

– However products are not identical

– E.g. hotels

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Monopolistic competition

• The more inelastic a firm is able to make its demand curve, the more influence it will have on price, and thus firms will attempt to minimize competition by:– product differentiation– acquisitions and mergers– cost and price leadership

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Market types

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Pricing in the public sector

• Prices of public sector goods and services will depend upon the market situation which prevails in a particular industry as well as the objectives set for a particular organization. These might be:– profit maximization– break-even pricing– social cost/benefit pricing

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Pricing and the macroeconomy

• The condition of the economy at large also has an influence on firms’ pricing policy. – If the demand in the economy is growing quickly,

there may be temporary shortages of supply in the economy and firms will take advantage of boom conditions to increase prices and profits.

– Similarly, during a recession there may well be over-capacity in the economy and demand may be static or falling. These conditions will force firms to have much more competitive pricing policies to attract consumers.

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What is the market type for each of these?

• Coca-cola stall in the desert!– Monopoly

• Qantas– Monopolistic

competition

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… and these?• Arsenal Football Club

– Monopoly– One seller– Demand elasticity?

• Inelastic

– Possibility for high profits

• Fast Food in China– Perfect competition– Many buyers and sellers– Demand elasticity?

• elastic

– Normal profits

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Review of key terms• Price taker =

– a firm in a perfectly competitive market which cannot directly influence price.

• Price maker = – a firm in a monopoly market which sets its desired

price.• Price shaper =

– a firm in an oligopoly or imperfectly competitive market which may seek to influence price.

• Perfect competition = – many buyers and sellers, homogeneous products,

freedom of entry and exit to market.

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Review of key terms• Monopoly =

– one seller, barriers to entry.

• Oligopoly = – a small number of powerful sellers.

• Monopolistic competition = – many buyers and sellers, freedom of entry and exit, products

differentiated.

• Product differentiation = – real or notional differences between products of competing firms.

• Price discrimination = – selling the same product at different prices to different market

segments.

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6 Market structure and pricing:

The End