Market structures influence a firm’s behavior and profit opportunity and are therefore critical to understanding how a market functions. The conditions that distinguish each market structure define the level of competition observed within the market which in turn determines the profit level that can be made. Because pricing strategies are intended to maximize a firm’s profit, understanding market competition is necessary when deciding an appropriate pricing strategy approach.
The third section of this paper gives the pricing strategy for a real-world firm for each market structure. An Analysis of Market Structures and Their Related Pricing Strategies An average or typical market does not exist. However, models of market structures give a general representation of a type of real market. There are extremes seen in market structure models that are not likely to happen in the real world, but they allow us to compare and contrast real world and model information.
The information gathered can be used as a benchmark. Firms may function under four primary market structures; perfect competition, monopolistic competition, oligopoly, and monopoly. These market structures affect a market’s outcomes based on its influence over a firm’s behavior and profit opportunity. The first section of this paper will provide a detailed analysis of the four market structures which can be distinguished based on various conditions.
These conditions or characteristics may include the number of firms within the market, the concentration or market power of firms as measured by their market shares, the purchasing behavior of buyers, the product type including differentiation or degree of homogeneity, the substitutability of the product, the elasticity of demand, the entry and exit barriers, the control over market price or output, and the level of profit maximization to name just a few.
These conditions determine the level of competition that is present within the market. When competition between firms is not present, the market is considered concentrated as seen in monopolies. Conversely, when competition between firms is at its strongest, the market is considered less concentrated as seen in perfect competition. The second section will describe the pricing strategies that are appropriate for each market structure and how these strategies have the ability to maximize a firm’s profit.
The conditions that distinguish the four market structures determine the level of competition that is present and because pricing strategies are intended to maximize profit it is necessary to understand how competition works in determining the appropriate pricing strategy approach. Lastly, a case study of a real world business for each of the market structures will be given. Each firm’s pricing strategy will be identified and analyzed. Market Structure Market structures are critical to understanding how a market functions.
One way the structure of the market may be defined is according to the conditions that are present within the market such as the number and size of the firms within the market, entry and exit barriers, characteristics of the products, and information availability such as perfect or imperfect knowledge. These conditions affect the level of competition observed between firms within a market. The level of competition present within the market determines the classification of the market structure. Market structures that are absent of competition are classified as concentrated markets.
Pure monopolies fall into this classification. Conversely, market structures with the greatest amount of competition are classified as less concentrated. Perfectly competitive markets are in this classification. Monopolistically competitive markets and oligopolies are found in the middle of this range with monopolistically competitive markets located closer to the more competitive/less concentrated end and oligopolies closer to the less competitive/more concentrated end. This section will provide a detailed analysis of the four market structures.
Each analysis will describe the characteristics that are found within a market structure and describe how these characteristics influence a firm’s behavior and profit opportunity. Perfect Competition A perfectly competitive market is one where competition between firms is intense; the market is considered concentrated. The characteristics of a perfectly competitive market include having a large number of firms in the market, homogeneous products, no entry or exit barriers, no non-price competition or external costs or benefits, perfect knowledge, and zero control over the market price or conditions.
These characteristics create a condition in which the firms in a market act as price takers; in other words, no single firm has any role in setting the market price and therefore must take their prices from the industry. Price taking is the primary condition of a perfectly competitive market. The two main characteristics necessary for price taking include: having a large enough number of buyers and sellers in the market so that each is only able to contribute a negligible amount to the total market supply and, secondly, that firms produce homogenous products that are perfect substitutes for each other.
In order for a product to be considered a perfect substitute for another, each product must be standardized and undifferentiated and consumers must have perfect knowledge regarding all the competing products’ cost, price, and quality so they are indifferent as to which product they purchase. Because all products are homogenous, it can be established that the “law of one price” is in effect. The “law of one price” states that “[a]ll market transactions take place at a single price” (Samuelson & Marks, 2012, p. 290).
Therefore, the horizontal demand curve that is provided by the current market price will be the same for all firms within the market. Another primary condition that must be fulfilled in order for a market to be perfectly competitive is that there cannot be any entry or exit barriers. Entry barriers may include legal restrictions such as patents, existing advantages by current firms such as brand loyalty, substantial economies of scale, capital requirements, and strategic barriers from existing firms such as threatened retaliatory pricing.
Exit barriers prevent a firm from leaving the market and may include such things as sunk costs. The lack of entry and exit barriers is significant in the attraction of new competitors to a perfectly competitive market when there are temporary positive economic profits to be made. Firms are influenced to enter the market freely when there are positive economic profits to be made or freely exit when it has become unprofitable to remain in the market.
The lack of entry and exit barriers results in average competitive firms having a zero economic profit. Monopolistic Competition Monopolistic competition operates under the concept of imperfect competition; it does not have all of the conditions for perfect competition even though it is a competitive market structure. This market structure is located between perfectly competitive and monopolies with regards to concentration and competition and therefore shares some key characteristics with both of these market structures.
One characteristic that is shared with perfect competition is that there are relatively no entry or exit barriers which, in the long run drive, economic profits to zero. Another characteristic involves having a large enough number of small, independently acting firms within the market that each firm’s actions has an insignificant effect on the market’s average price and total output. The primary difference between perfect competition and monopolistic competition is that output is lower and price is higher with monopolistic competition than with perfect competition.
Product differentiation; limited control over prices so firms may be considered price makers, which indicates that demand is relatively elastic; and limited knowledge between market participants are characteristics that monopolistically competitive markets share with monopolies. An important difference between monopolies and monopolistic competition involves long run positive economic profit; there is no chance in monopolistic completion for long run positive economic profits because there are no significant barriers to entry.
Other characteristics that monopolistically competitive markets display include the use of advertising to inform consumers about a product’s differences, firms are assumed to maximize profit, and collusion between firms is unlikely. The primary feature of competition is that of product differentiation. Product differentiation indicates that there are small differences that occur between two or more very similar products. Differentiated products have very close substitutes but there are no substitutes that are completely identical to it.
These differences are intended to give a firm a competitive advantage and allow it to attain some market control. If a firm is able to attain some market control they then possess the power to increase their costs to some extent. There are four principal ways in which products maybe differentiated and these can be either physical or qualitative. The first involves the differentiation of the actual physical product which includes size and shape, design, color, performance, and special features.
Distinctive packaging and promotional methods are ways in which firms try to differentiate their products by using the second type of differentiation, marketing differentiation. The third way for firms to create differentiation is by utilizing human capital differentiation which includes employee skills, the level of training employees receive, and unique uniforms. The last way for firms to distinguish their products from others through differentiation is by promoting distribution differentiation such as using mail or internet ordering.
Oligopoly An oligopoly is a market structure that has an extreme range of industry models. The number of firms that make up an oligopoly market is unknown; however, the number is small enough that the actions of one firm significantly impact the actions of other firms. Because firms are interrelated, they are considered mutually interdependent; in other words, a firm must consider the effects its actions has on other firms within the market and any corresponding reaction the other firm may take.
The strategic interdependence within the market is the primary characteristic of oligopolies because it expects that the few firms that influence the market control a larger market share. The strategic interdependence begins to lessen when the combined market share starts to decline. Other key characteristics of oligopolies include producing standardized or differentiated products, high barriers to entry including non-price competition, the potential for collusion, and a kinked demand curve which indicates that price may be relatively stable across the industry due to the anticipated reactions of competitors to price changes.
The concentration ratio is one way to measure the number of firms within an oligopoly market. Here the percentage of sales is based on the number of top firms within the market. For instance, an eight-firm concentration ratio is the percentage of sales acquired by the top eight firms in a market. Concentration ratios are easy to compute and understand; the higher the concentration ratio the greater the scale of market power by a small number of firms. There is specific nomenclature to help distinguish market structures by their degree of concentration.
An effective monopoly occurs when a single firm’s concentration ratio is greater than 90 percent. A concentration ratio of less than 40 percent indicates an effectively competitive market where each top firm holds an average of less than 10 percent each of market shares while numerous smaller firms control even smaller market shares. Monopolistic competition usually is included in the loose oligopoly concentration ratio range of greater than 40 percent but less than 60 percent. A tight oligopoly has a concentration ratio of greater than 60 percent.
Concentration ratios have serious limitations the primary one being that it is unable to identify relevant markets. Concentration ratios intend to condense the distribution of size for firms within a market, however, it fails to take into account the geographic range of the market, the importing of products by firms, the product’s substitutability range, or that firms may produce multiple products. The Herfindahl-Hirschman Index (HHI) has advantages over concentration ratios because of its three properties.
These are: (a) the HHI includes the market shares of all firms within the market, not just the top few; (b) because market shares are squared, the HHI will be weighted for firms with larger market shares; and (c) the more firms within the market, the lower the HHI as long as everything else is equal. The basic idea behind the HHI is that it calculates a firm’s competitiveness in an industry by comparing the degree of market share concentration among the firms within the industry (Samuelson & Marks, 2012).
In order to maintain controlling power within a market, firms may erect barriers to keep potential competitors out. These barriers may be natural barriers, strategic barriers that are produced by a firm, or legal barriers. Natural barriers may include the exploitation of economies of scale due to technology and market share by firms already entrenched within the market. Control or ownership of scarce resources such as choice location, possession or control of a unique product or manufacturing process, or scientific talent also constitutes entry barriers. High set-up costs can act as an ntry barrier because they raise the output level needed in order for a firm to break-even and thus postpose profit making. Set-up costs may also include sunk costs that are not recoverable when a firm leaves the market. Sunk costs may include marketing and advertising costs and other fixed costs. Lastly, high research and development costs may indicate to a potential competitor that the present firm has large financial backing. This conveys to the potential competitor that it must be able to match or go beyond this expense level in order to compete (Economics Online, n. . ). Strategic barriers that may be erected by firms include (a) predatory pricing in which firms significantly lower prices so as to force competitors out; (b) limit-pricing where a firm lowers the price and increases the output of a product so that competitors are unable to make a profit; (c) the predatory acquisition of a competitor in which a firm may buy just enough of a competitor’s shares in order to gain a controlling interest or the firm may just buy-out the competitor entirely; and (d) creating customer loyalty through the use of loyalty schemes.
Strategic barriers to entry may also involve the use of advertising which is another sunk cost that a potential competitor must consider before entering the market. The previous strategic barriers to entry are also included in a firm’s pricing strategy. Vertical integration, however, is not included in pricing strategies. This form of barrier may create havoc by tying up the supply chain thus discouraging entry into the market. This occurs when a firm controls both the production and distribution portion of an industry (Economics Online, n. . ). Lastly, legal barriers such as patents and licenses make entry into a market difficult. Exclusive contracts between suppliers and retailers usually exclude competitors from entering the market is another form of legal barrier. In order to maintain their market position, oligopolies may lobby government officials. This may create government barriers that either regulate or prevent the entry of competitive entrants, whether foreign or domestic, into a market.
Monopoly Monopolies maybe defined in a couple of different ways. A pure monopoly, in which a single firm has control over the entire market, is very rare. Because of the rarity of pure monopolies, monopolies are usually understood as a single firm controls 90 percent or more of the market. Near monopolies, on the other hand, include markets in which a very few firms possess the majority of the market. There are many explanations as to how and why monopolies are created.
These may include the exclusive ownership of a scarce resource, granting monopoly status to a firm by the government, securement of patents or copyrights, or following the merger of two or more firms. The last case regarding the merging of firms is closely regulated by the government and may not be allowed if the two firms will ultimately control at least 25 percent of the market share. Another way in which monopolies are formed involves natural monopolies and cartels. Natural monopolies occur when “the average cost of production declines throughout the relevant range of product demand” (Samuelson & Marks, 2012).
In these cases increasing competition would be expensive and inefficient since one firm has the ability to produce a specified quantity of output at a lower average cost than multiple firms could and also because the market is only able to support one firm. Cartels are created when a collusive agreement is made by a group of producers. The collusive agreement attempts to limit output and raise prices in a market in order to capture monopoly profits for those involved. Monopolies can be considered the opposite of perfectly competitive markets.
The primary characteristics of a monopoly include a single seller for many buyers, heterogeneous products with no close substitutes, substantial barriers to entry and exit, and full control over price and output enabling firms to be price makers. Even as price makers, monopolists are not immune to market demand and therefore cannot raise their prices continuously; the optimal output and price are still dependent upon market demand. In other words, monopolists are allowed to earn excess profits but the magnitude of those profits is determined by comparing cost and demand.
Competition is another way that differentiates perfectly competitive markets from monopolies. In a perfectly competitive market, the industry economic profit is zero because the long run price is pushed to the lowest maintainable level by competition from other firms. Competition creates an environment where output is produced at a minimal price and there are no economic profits to be made. Conversely, the monopolist has the ability to utilize its market power to the fullest; it is able to increase prices above those seen at the competitive level.
Monopolies, therefore, produce maximum economic profits by limiting its output and increasing its prices. Monopolies obtain their market power through the use of barriers to entry also called barriers to competition. These may include the following: * Economies of scale: This occurs when, through an increase in its output production and usage of inputs, the firms’ long run average cost decreases. In order for a new firm to enter the market and be competitive at this point, it must enter with a large market share.
This type of barrier can be seen in natural monopolies such as in utility markets where an expensive infrastructure is required for product delivery. * Capital requirements: When production costs or the cost of investing in research and development are very large then entry into the market is risky since a firm may not be able to recover the sunk costs. * Pure quality and cost advantages: When one firm holds pure quality or cost advantages over potential competitors it efficiently blocks entry into the market. Cost advantages may include specialized knowledge or equipment or more efficient management. Product differentiation: Brand appeal due to advertising or marketing campaigns significantly reduces a competitor’s entry into the market. Switching costs for information-intensive goods or services can be a barrier since customers have time invested in learning a particular type of technology and are less likely to switch to a competitor. * Control of resources: There are times when the current firm retains exclusive control over a scarce resource necessary for entry into a market. These resources may include mineral or oil deposits or employee talent. Patents, copyrights, and other legal barriers: Patents and copyrights impose considerable entry barriers into various markets. Occasionally the government will grant legal monopolies to some firms such as construction companies on highway or national park jobs. * Strategic barriers: Firms may take actions to directly impede entry of competing firms into markets. These may include securing legal protection in the form of patents or copyrights, practicing of limit pricing in order to keep prices below monopoly levels, threatened retaliatory pricing, bombardment of the market with widespread advertising in order to increase awareness of the ncumbent’s brand, or intimidation of potential competitors by flooding the market with an increase in production so as to warn them that output can be expanded if the new firm tries to enter the market (Samuelson & Marks, 2012). It has been argued that monopolies have the ability to benefit the progress of technology for various reasons. Innovation is more likely to occur in a large firm because the high profits seen by monopolies tend to increase research and development investments.
A firm must maintain a strong lead over other firms in order to allow them to have the monetary means of protecting their intellectual property through patents and copyrights therefore allowing them to withstand the risks that comes with innovation, such as coping by firms that do not invest in research and development. Further, the technological progress that is made by large firms can later be used by smaller firms in competitive markets which will lead to lower costs (Economics Online, n. d. ).
It has also been argued that monopolies have a negative effect on consumers. Monopolies are accused of limiting consumer choices for products thus reducing their freedom of choice. Monopolies are also accused of directing the global market towards a less competitive economy and towards lower employment. Other arguments are based on monopoly pricing strategies. These include the habit of limiting product output into the market in order to charge a higher price then would be seen in competitive markets (Economics Online, n. d. ).
Monopoly pricing strategies will be examined more closely in the following section. Pricing Strategies The conditions that distinguish the four market structures determine the level of competition that is present within the market. The level of competition within each market structure is important when determining pricing strategies. The greater the levels of competition in a market the more likely we have lower prices and zero economic profit. Conversely, the lesser the amount of competition the more likely higher prices and profits will be observed.
Because pricing strategies are intended to maximize profit for a firm it is necessary to understand how competition works in determining the appropriate pricing strategy approach. The pricing strategy for perfectly competitive markets is determined by market demand which makes the firms within the market price takers because their price is set at the marginal cost of the product. There is no need for non-price competition, external costs, or benefits in this market structure because firms produce homogenous products that are perfect substitutes for each other.
Monopolistic competitors are price makers and have the ability to raise their prices a small amount without fear of losing their market share to competitors. In order to achieve the highest possible level of profit, monopolistic competitors must balance the product price, differentiation of the product, and advertising costs. Pricing strategies for this market structure include new product development, non-price competition in the form of customer service, product guarantees, free delivery, better packaging, or price segmentation which segments the market according to how much a consumer is willing or not willing to pay.
Advertising is the primary pricing strategy that monopolistic competitors utilize because it allows them to inform or persuade the consumer to purchase a product because of the different qualities found between their product and a competitors. Strategic interdependence is the primary characteristic of an oligopoly. It states that a firm must consider the effects its actions has on other firms within the market and any corresponding reaction the other firm may take.
There are three basic oligopoly models that are used the majority of the time when explaining oligopolistic pricing and output strategy: the kinked-demand model, collusion and cartel agreements, and the price leadership model. Advertising is also a price strategy that is used in this market structure. Having the ability to influence output and raise prices without worrying about losing sales to lower price competitors is a result of monopolies being price makers. Monopolists are not able to raise prices indefinitely; the optimal price and output of a firm is still dependent upon market demand.
Optimal output is determined by setting the marginal revenue equal to the marginal cost of production; MR = MC. Monopolies are best able to maximize their profits when they use their market power to limit output levels to those below competitive levels and then raising prices. The extent of the profit that can be made is determined by the size and elasticity of the market demand and on the monopolist’s average cost. Price discrimination, of which there are three types, is a pricing strategy that is utilized by monopolies in order to maximize profits.
Another pricing strategy includes setting up a two-part tariff approach towards payment in which a consumer pays a flat or fixed fee so they may purchase as many units of a product as they want at some given price. Perfect Competition Price taking means that no single firm has any role in setting the market price for its products and must therefore take the market price as given. The only decision a firm has to make is related to the output it wants to produce and sell. The firm uses information gained from the buyer/seller interaction that defines market price and quantity in order to decide its optimal production amount.
Price taking creates a demand curve that is perfectly, or infinitely, elastic. In all market structures profit is maximized by setting the output level so that marginal revenue equals the marginal cost; MR = MC. In a perfectly competitive market, because the demand curve is perfectly elastic, the marginal revenue that a firm earns from selling an additional unit is the price it receives for the unit; MR = P. This information allows a firm to determine that the optimal output level to maximize profit is found by setting the market price equal to the marginal cost; P = MC (Samuelson & Marks, 2012).
Since firms may enter the market freely they are able to take advantage of any positive economic profit that may be made. However, positive economic profit is temporary. Positive economic profits attract new competitors to the market which increases output. This, in turn, reduces the current market price to a point where all economic profits are zero. The long run equilibrium observed helps explain the paradox of profit-maximizing competition which states, “[t]he simultaneous pursuit of maximum profit by competitive firms results in zero economic profits and minimum-cost production for all” (Samuelson & Marks, 2012).
In other words, the average firm will only earn a normal rate of return when it produces at the point of minimum long run average cost (LAC) since price equals the long run average cost; P = LAC (Samuelson, 2012). When the industry demand is equal to the industry supply, the market is considered to be in equilibrium; firms generate zero economic profits and have no reason to change their output or to enter or exit the industry. In order to maintain market equilibrium in the event of a ermanent increase in market demand, the market price will temporarily increase with the increase in industry output. When this occurs, positive economic profits are realized and attract new competitors into the industry. The increase in competitors decreases the market price until all economic profits are zero again, however, the increased industry output will stay at the new amount. While there is no long run change to the market price or the industry’s unit cost, the demand increase has prompted a matching increase in the number of firms in the industry.
There are two cases in which the market supply may be affected in the long run. The first case is that of a constant-cost industry where the long run supply curve is horizontal and at a level that is equal to the minimum long run average cost of production. An increase in demand allows for an increase in economic profits which will then attract new firms to the industry. Since the key inputs are being supplied by a large, well-developed market, the new firms will pay the same cost for key inputs and will have the same production costs as the firms already in the industry.
In other words, the increase in economic profits will increase the number of firms in the industry while the average costs of production stays the same in the long run. The second case is that of an increasing-cost industry that has an upward-sloped (or positively-sloped) long run supply curve. Here the price of key inputs, which are limited in supply, will increase as the industry output expands due to the entry of new firms into the industry.
The higher cost of the key inputs will raise the minimum average costs of production for firms in the industry in the long run. The positive economic profits observed from the demand increase will attract new firms to the industry which will reduce any economic profit until it is zero, however the minimum average cost will stay at the new higher amount due to the higher input costs. Because products within a perfectly competitive market are homogeneous, there is no need for non-price competition or external costs or benefits.
As mentioned earlier, homogenous products are those that are standardized, undifferentiated, and are perfect substitutes for each other. Since homogenous products are identical to each other consumers are indifferent as to which seller the product comes from because all the products have the same features. Without some distinguishing feature, such as quality, there is no need for advertising or sales promotions. Monopolistic Competition Monopolistic competition has a relatively elastic, or downward sloping, demand curve because of product differentiation.
This reveals that price surpasses the minimum average cost which gives firms some control over the price they charge allowing them to be price makers. Price makers have the ability to raise their prices a small amount without losing the entire market to competitors; demand quantity will decrease but not completely to zero. Lowering prices will generate additional, but not unrestricted, sales. Being a price maker also allows a firm to use price segmentation in order to segment the market according to how much a consumer is willing to pay or not pay.
Similar to the perfectly competitive market, monopolistically competitive markets see short run positive economic profits when demand increases and then return to earning zero economic profits in the long run due to the lack of entry and exit barriers. In order to analyze short run equilibrium, profit maximization is established when firms set their marginal revenue equal to their marginal cost, MR = MC. Positive economic profits are observed because the price is greater than the average cost (Samuelson & Marks, 2012). Free entry and exit from the market ensures that any positive economic profits are not enjoyed by firms for long.
The profits attract new firms that enter the market and the demand curve then shifts towards the left as the demand for the product is reduced. The profit maximizing firm will earn zero economic profit again when its price equals its average cost at its optimal output. Because firms want to continue making a profit, even if short term, they must be in a continuous state of innovation and product differentiation. While new product development enables a firm to gain a competitive advantage, this advantage is only short lived before competitors are able to reproduce any modification or new product.
Non-price competition can be used as a means to increase the demand for a product in ways other than by cutting prices. This may include offering better service to consumers, product guarantees, free delivery, or even better packaging. Regardless of any increase in demand that a firm may see due to non-price competition, the firm will still earn zero economic profit in the long run. Additionally, non-price competition may be one of the reasons that firms earn zero economic profit. Non-price competition can be expensive; advertising, staff training, and roduct guarantees have a price tag. These additional costs are included in the firm’s average cost curve which shifts the curve up (Hall, J. & Hall, P. , 2005b). In order to achieve the highest possible level of profit, monopolistic competitors must balance the product price, differentiation of the product, and advertising costs. Advertising is the primary pricing strategy that monopolistic competitors utilize. Advertising allows firms to inform or persuade the consumer to purchase a particular product because of the different qualities that the product has versus another product.
Monopolistically competitive firms also use advertising as a way to increase the quantity demanded by shifting the demand curve towards the right and to decrease the elasticity of demand for its product. By decreasing the elasticity of demand, firms are able to increase price and may also experience a smaller loss in demand quantity. Advertising will continue to be the primary pricing strategy of monopolistic competition as long as the marginal benefits of advertising, in terms of profit, equals the marginal cost of advertising (Samuelson & Marks, 2012). There are two potential pricing outcomes that may occur due to advertising.
The first is the price of the product is raised in the long run because of the additional costs associated with advertising; advertising increases average total costs. In this instance the advertising costs increases the fixed costs which shifts the average cost curve up and right which increases short term economic profits by allowing the firm to take advantage of economies of scale. The second potential outcome is an increase in sales due to advertising which, in turn, allows firms to produce at levels closer to optimal capacity output thus lowering the costs per unit.
In other words, advertising has the possibility of increasing the market size and therefore increases the number of units purchased. In the long run, free entry will force firms to pass cost savings back to the consumer and will move firms back to earning zero economic profit. Oligopoly An oligopoly is a market structure that has an extreme range of industry models. Because of the diversity found within oligopolies and the degree of complication regarding mutual interdependence among firms that makes any prediction regarding pricing and output quantity unpredictable, there cannot e one model to describe an oligopoly. The primary characteristic of an oligopoly, strategic interdependence, is the one thing that holds true for all oligopoly models: that a firm must consider the effects its actions has on other firms within the market and any corresponding reaction the other firm may take. There are three basic oligopoly models that are used the majority of the time when explaining oligopolistic pricing and output strategy: the kinked-demand model, collusion and cartel agreements, and the price leadership model.
In the kinked-demand model, there are no collusive agreements. A kinked demand curve is used to explain the price stability seen within oligopolies. As mentioned earlier, a firm must take into consideration the potential reactions of a competitor to any action that it may take. This is especially true with regards to price changes. When a firm decreases its price in a market where price competition among firms is strong, the firm will only see a small rise in sales before competitors also decrease their prices.
This indicates relatively inelastic demand with regards to price decreases. Conversely, when a firm raises its prices this allows its competitors to increase their market share by taking sales away from the price raiser. This indicates that when price increases demand is elastic. Another way of putting it is that when a single firm raises its price the competitive firms will not follow suit. The kink in the demand curve causes the firm’s marginal revenue curve to have a gap at the profit maximizing quantity.
The firm’s profit maximizing price and quantity will remain optimal as long as the marginal curve stays within the gap. This permits the industry’s price to remain stable even during changes in market conditions (Samuelson & Marks, 2012). Collusion and cartel agreements are the second type of oligopoly model. This type of cooperation usually occurs when a few firms that produce similar products with similar production methods and average costs want to change price at the same time (Satapathy, 2011).
Collusions and cartels determine the optimal price and output by setting marginal costs equal to marginal revenue; MC = MR. Collusions are formed in order to decrease uncertainty within the market, increase profits, and to deter new competition from entering the market. Cartels decrease the likelihood of price wars since its members have the opportunity to communicate and make agreements regarding how high their prices should be set. There are three types of collusions: tacit collusion, covert collusion, and overt or explicit collusion the extreme form of which are cartels.
There are various difficulties that must be overcome before competitors can form collusions which include demand and cost differences, the number of firms to be involved, incentives for cheating, recessions and declining demand which increases the firm’s average total cost, potential entry of another competitor that is not willing to join the collusion, and antitrust laws (Chapter 11, n. d. ). Tacit agreements are also known as “gentlemen’s agreements” and are usually made informally and without communication between smaller, equally matched firms.
Competitors often use the tit for tat game strategy of adopting the same cheating or non-cheating action that their competitor performed in the previous period in order to remind them of their informal agreement (Hall & Hall, 2005b). Covert collusion, such as seen in trade associations, is a formal collusive agreement that firms try to hide from regulators. In some cases the law will authorize trade and professional groups to prepare and authorize industry wide practices; however, price collusion is still illegal (Samuelson & Marks, 2012). Overt or explicit collusion may be the simplest form of cooperation between competitors.
In this case management from a small number of dominating firms decide together how to set prices and output levels. The most extreme type of explicit collusion is the creation of a cartel where a group of firms attempts to limit output and raise prices in the market in order to capture monopoly profits for those involved. The last type of cooperative relationship is that of the price leader which involves a single dominant firm that controls the price of a product and whose maximized profit is constrained by market demand and by the behavior of the smaller firms.
The smaller competitive firms within the industry follow the dominant firms pricing policy and are allowed to sell as much of the product as they want at the price set by the dominant firm. This relationship divides the quantity demanded between the dominant firm and the smaller competitive firms; however, the size of the output division is defined by how much market power the dominant firm holds. There are a couple of drawbacks to the price-leadership model. First, it gives the dominant firm motivation to drive the smaller competition out of the industry and to launch a monopoly.
Secondly, when price leadership relationships collapse, firms may initiate price wars. The last pricing strategy discussed for oligopolies involves advertising. Some firms pursue advertising as a pricing strategy because it acquaints consumers with products and prices. Advertising campaigns may have a better long term impact than lowering prices; advertising campaigns are harder to fight and match compared to lowering prices which are easily and quickly copied (Chapter 11, n. d. ; Chapter 12, n. d. ). Advertising may affect price and competition in various ways.
These may include a decrease in consumer search time and costs; a decrease in monopoly power, and thus an increase in economic efficiency, because consumers have more information about competing goods; and technological progress may also be increased since firms have the ability to more quickly introduce new products into the mainstream. Another more direct way that advertising may affect price and completion is that in the event that demand is successfully increased, then the larger resulting output will decrease the long run average total cost.
This results in firms a chance to benefit from economies of scale (Chapter 12, n. d. ). Monopoly Monopolies are price makers; they have the ability to influence output and raise prices without the worry of losing sales to the lower prices of a competitor. Monopolies are able to pursue profit-maximization without the fear of competitors, even though excessive profits may encourage the entry of competitors, because of intense barriers to market entry and the pricing strategies allow them to ward off or restrict competition.
Monopolies also have the luxury of having a low elasticity of demand which indicates that there is a very limited number or no substitutes available to the consumer. This lack of alternatives and the low elasticity of demand ensures that the consumer will purchase the product regardless of any price increases. Before pricing strategies can be examined, a monopolist’s price and output decisions in relation to maximization of profits must be examined. The defining characteristics of a monopoly allow the monopolist to be the ndustry; thus the demand curve is the same as the industry curve which is downward sloping. And although monopolists have the ability to use market power to raise prices above competitive levels, it does not mean that prices can be raised indefinitely; the optimal price and output of a firm is still dependent upon market demand. Optimal output is determined by setting the marginal revenue equal to the marginal cost of production; MR = MC. Monopolies are best able to maximize their profits when they use their market power to limit output levels to those below competitive levels and then raising prices.
The extent of the profit that can be made is determined by the size and elasticity of the market demand and on the monopolist’s average cost. Price discrimination is a pricing strategy that is utilized by monopolies in order to maximize profits. The practice of price discrimination involves selling the same product or service to different people or groups of people at different prices. In order to utilize price discrimination effectively, the firm must be able to identify the various customer groups available, their differing price elasticity’s, and must be able to maintain a separation of the groups in order to prevent resale between them.
There are three types of price discrimination available to the monopolist: first degree, second degree, and third degree discrimination. First degree discrimination, also known as perfect price discrimination, happens when a firm has the ability to charge individual consumers the maximum possible price they are willing to pay for every unit sold. This ensures that the firm is able to secure all available revenue to be made by not losing the potential extra revenue from consumers who are willing to pay more. Second degree discrimination involves quantity discounts; larger quantities are priced lower than smaller quantities.
Charging different consumer groups different prices is third degree discrimination. In this case the firm segments the market based on some difference such as commuter and casual travelers, peak and off peak usage, or even based on age such as senior, adult, and children prices. Another pricing strategy that monopolies may utilize includes setting up a two-part tariff approach towards payment. In this case a consumer first pays a flat or fixed fee so they are entitled to purchase as many units of a product or products as they want at some given price.
The flat or fixed fee may have various names such as a membership fee, a hookup fee, or an entry fee. This type of pricing strategy may be seen at fairs where an entry fee is charged or at some discount stores such as Sam’s Club or Costco where a membership fee is charged. Monopolies have the ability to increase profit in a couple of ways with this strategy. First, profits may be increased when the products purchased surpass the average cost of the product. Secondly, the fixed fee revenue by itself may enable firms to increase profits when the available consumer surplus is large (Haworth, n. d. ). Case Study
This section details case studies of real world businesses for each of the market structures discussed. The firm’s pricing strategy will be identified and analyzed. Perfect Competition The agricultural industry gives the best model for a perfectly competitive industry because it is one of a very few industries that contain all the characteristics of a perfectly competitive market. First, farmers and ranchers are price takers; each farm or ranch can only supply a small portion to the total market supply and is therefore unable to have any effect on the market price and must take their prices from the industry.
The agricultural industry also produces homogeneous products with no distinguishing features, therefore no farmer or rancher has a quality edge over another and there is no need for non-price competition in the form of advertising or sales promotions. Advertising by individual farms would be a waste of time and money because consumers have perfect knowledge regarding a farmer’s or rancher’s products. They know that there are not any distinguishing features that will allow them to tell one farm’s product apart from another farm’s.
Lastly, it is fairly easy to enter and exit the agricultural industry. There are not any major barriers, either legal or technological, to prevent a competitor from starting up and selling their produce in the market. Perfect competition prevents those in the agricultural industry from earning any long term positive economic profits. Any positive economic profits observed will attract new farmers or ranchers to the industry which will reduce the economic profit until it is zero. This can especially be seen in case of long run market supply.
Unlike the agricultural industry, the firms that farmers and ranchers buy machinery, fuel, fertilizer, seeds, etc. from have some influence over their prices; they do not have to keep their prices the same if the demand for any type of agricultural product increases (NASDA, 1993). When agricultural demand increases, the long run market supply curve will be upward-sloped and we will have a case of an increasing-cost industry. In this case however, the key inputs are not necessarily limited in supply but rather its price is able to be regulated by the firms that produce them in order to generate positive economic profits.
Of course the profits observed from the demand increase will attract new farmers and ranchers to the market and the industry output will expand. The higher cost of the key inputs will raise the minimum average costs of production for the farmers and ranchers in the long run and the positive economic profits observed from the demand increase will be reduced until it is zero. The minimum average cost for the farmers and ranchers, however, will stay at the new higher amount due to the higher cost of the key inputs. Monopolistic Competition
Abercrombie & Fitch Company is a monopolistic competitor in the clothing/shoe/accessory market with rivals including Aeropostale, Inc. , American Eagle Outfitters, Inc. (AEO), ANN Inc. , Buckle, Inc. , Cache, Inc. , Christopher & Banks Corporation, and Coldwater Creek, Inc. to name just a few. The company is setting itself apart from its competitors by utilizing differentiation including e-commerce, an increased international presence, advertising campaigns that include scantily clad models, and other non-price competition in the form of image conscious branding.
During the beginning of the US recession, Abercrombie’s CEO, Michael Jeffries, tried, and for the most part succeeded, in keeping the same pricing strategy it has used for a number of years. The pricing strategy involved, and still involves, a mixture of international growth and pricing policies and domestic pricing issues. During the US recession, Jefferies resisted the use of price promotions in order to generate short-term sales and continued using the domestic pricing strategy of high prices in order to keep their premium brand position. However in 2009, Abercrombie found it had lost its relevance in the teen market.
This means that not only did they lose a year’s worth of consumers, they also potentially lost those for the following year who use the group ahead of them as their fashion guides (Smith, 2011). In 2010, Jeffries made limited price promotions a part of Abercrombie’s new, revised pricing strategy. However, the new pricing strategy still does not look for short-term gains; it still utilizes high prices in order to keep their premium brand position. Abercrombie is using price promotions as a form of price segmentation; to separate the market between consumers who will pay full price from those consumers that will not.
In addition, they are practicing a divergent price differential promotional policy similar to the one Volkswagen uses (Smith, 2011). The divergent price differential promotional policy calls for the firm to discount the product with the lowest value more than its premium brand. Abercrombie is using very limited price promotions at its Abercrombie & Fitch and their abercrombie for kid’s stores, its premium namesake brands, and is utilizing price promotions more widely in its lower priced brands such as Hollister.
There four primary consumer behavior rationales that make this policy work. The first is that premium brands are more likely to target consumers that have a greater willingness-to-pay, or the more utility sensitive consumers who are relatively price insensitive. The second rationale is that the more price sensitive consumer, with a lower willingness-to-pay, is more likely to be targeted by lower priced brands because they react more to price promotions. These individuals are just as easily swayed by discounting lower valued brands as they are when premium brands are discounted.
Three, the cross over between premium and lower valued brands is unequal because utility sensitive consumers are not likely to change to lower valued brands even if the brands are discounted, whereas price sensitive consumers are just as likely purchase the discounted premium brand as they are the discounted lower valued brand. Lastly, premium brands that are discounted tend to lose their brand’s premium status and any future pricing power the brand had is ruined (Smith, 2011).
Today, Abercrombie’s pricing strategy still involves a mixture of international growth and pricing policies and domestic pricing concerns. The company has successfully been able to identify that its international consumers are more willing to pay full, sometimes even double, price for its premium brands. This knowledge is key to the company’s international growth strategy which involves selling its premium brand clothing as a luxury American brand. The international aspect of Abercrombie’s strategy must be kept in mind when looking at its new divergent price differential promotional pricing strategy.
If there is a large difference between US prices and international prices, such as what would happen if price promotions were used in the US, and then there would be greater parallel importing. Parallel importing involves international customers purchasing directly from US stores or from online US websites and then exporting the products back home. If Abercrombie did utilize price promotions in the US, its international pricing power would be eliminated since its international consumers would be more likely to purchase from the US stores as opposed to the international stores. Oligopoly
Strategic interdependence is the primary characteristic of an oligopoly. This means that a firm must consider the effects its actions has on other firms within the market and any corresponding reaction the other firm may take. The pricing strategies that firms in oligopoly markets use may include price leadership, collusion agreements, predatory pricing, price fixing, price discrimination, and manipulated demand in the form of advertising (Zaheer, n. d. ). PepsiCo is no different. When its Tropicana brand lost market shares to Coca-Cola’s Minute Maid and Simply Orange brands, the firm changed its pricing strategy for the product.
They are using product innovation as well as increasing its Tropicana brand by adding new juices and teas. PepsiCo is also changing its formula for its orange juice; the Tropicana brand is producing products with less juice by adding water instead of mimicking Coca-Cola’s 100 percent juice formula. PepsiCo’s primary Tropicana product is the Trop50 which was introduced to the market in 2009. Sales have been increasing for the Trop50 product which only contains 42 percent orange juice and has fewer calories because it uses a stevia-based sweetener (Stanford, 2012).
Since Coca-Cola and PepsiCo have an interdependent relationship they must consider the other firm’s reaction to any action they may take. In this case, Coca-Cola was able to regain market shares between 2008 and 2010 by using price segmentation in order to sway those consumers that willing to pay higher prices toward their premium brand Simply Orange and to sway to the more price conscious consumers towards their value brand Minute Maid. The firm has since introduced a mid-range Minute Maid product, Minute Maid Squeezed that will utilize the same price strategy in order to win market shares away from Tropicana Pure Premium (Stanford, 2012).
PepsiCo’s reply to Coca-Cola’s pricing strategy of eliminating Tropicana’s Pure Premium customer base was that they were not going to get into the 100 percent orange juice war and fight for its mid-price market share since all 100 percent orange juices “are all essentially the same” (Stanford, 2012). The view from PepsiCo’s CEO, Massimo D’Amore, is that the true cost comes from the actual juice and not the process of producing the product, and as for adding water to some of their products D’Amore states about the customer; “They themselves add water before drinking OJ. . . So why not add the water ourselves and charge for it? ’ (as cited in Stanford, 2012). D’Amore was very clear regarding the reason PepsiCo is in business, to make money. The firm would rather build the Tropicana name on blends with less juice and more innovative, higher margin products like Trop50. In addition, PepsiCo is beginning to market less than 100 percent juice blends to the US Hispanic population through its Dole brand (Stanford, 2012).
Lastly, PepsiCo has also begun to model their packaging and marketing strategies off of some of Coca-Cola’s past products and marketing schemes (Stanford, 2012). Monopoly De Beers was founded in the 1880s and from its inception has pursued a strategy that involved supply control. The company has been able to control about 90 percent of the world’s diamonds just by mining their own diamonds and by buying from other mines. Their near monopoly over the diamond industry allowed the company to keep the price of diamonds high and relatively stable even though diamonds are not that rare or useful.
De Beers was able to destroy competitor pricing power by flooding the market with diamonds similar to those a rival tried to sell outside the de Beers monopoly and also used some very effective advertising campaigns. The cartel that was reputed for being extremely forceful in its cooperative dealings and in its refusal to lower list prices has had to make some changes with the political and economic shifts of the 1990s. Anti-trust disputes needed to be settled and stories regarding blood diamonds began to emerge (Dishman, 2012).
In addition, American and European regulators began to demand more competition in the industry just as new deposits of diamonds were found. De Beers began seeing their market share decrease with the rise of a competitive market that was not under their control. This increased supplier bargaining power and therefore increased the cost of goods and sales for de Beers. De Beers continued to try to compete with an increase in production but market demand began to declined and de Beers saw an increase in stored inventory and thus invested capital (O’Connell, 2009).
The de Beers situation illustrates the instability a cartel faces. Today de Beers does not control as much diamond production and trade as it did in its cartel days but they still control about a third of the world’s rough diamond production and is considered the most significant competitor in the diamond industry (Dishman, 2012). De Beers and their strategy of keeping the supply of diamonds in the market low and keeping prices high has changed to that of driving demand and to increasing its brand name by offering de Beers branded jewelry to consumers directly (O’Connell, 2009).
De Beers is now utilizing vertical integration into its strategy so they are no longer just supplying rough diamonds, but are polishing and marketing them as well. Ironically, Leviev, who is currently challenging de Beers in the diamond market, is imitating the de Beers’ original way of undercutting the competition and making deals with diamond-producing countries (The Cartel isn’t for ever, 2004). Will his be the next cartel? Conclusion Market structure models give us a general representation of a real world market and allow us to compare and contrast the two situations for use in benchmarking.
The four primary market structures discussed in this paper include perfect completion, monopolistic competition, oligopoly, and monopoly. The conditions that distinguish the market structures determine the level of competition that is present. The competition level is important when determining pricing strategies which are intended to maximize profit for a firm. This paper began by providing a detailed analysis of the four market structures which may be distinguished based on various conditions. These different set of conditions present within market structures help define the level of competition present.
A pure monopoly is defined as being absent of competition and are concentrated markets. On the other end, perfectly competitive markets are those with the greatest level of competition and are therefore less concentrated. The grey area here includes monopolistically competitive markets and oligopolies. Monopolistically competitive markets are not as competitive as and more concentrated than perfectly competitive markets. Oligopolies are more competitive and less concentrated than monopolies. The conditions that distinguish the market structures also determine the level of competition present.
The greater the level of competition within a market, the more likely for us to observe lower prices and zero economic profit while the lesser amount of competition means higher prices and profits. Because pricing strategies are intended to maximize profit for a firm it is necessary to understand how competition works in determining the appropriate pricing strategy approach. The second section of this paper showed that each market structure had price strategies that were based on the level of competition within the market and therefore on the conditions that distinguish the market structures.
Firms that compete within perfectly competitive markets are price takers based on the defining characteristics of this market structure. Monopolistic competitors are price makers and have the ability to raise prices without fear of losing their market share to competitors. In an oligopoly all firms within a market are strategically interdependent which means a firm must consider the effects its actions has on other firms within the market and any corresponding reaction the other firm may take. This primary characteristic is true in all oligopoly models and helps determine the appropriate pricing and output strategy a firm should take.
Lastly, monopolies are price makers and have the ability to determine the output of a product and raise prices without losing sales; however, they are not able to raise prices indefinitely because the optimal price and output of a firm is still dependent upon market demand. The last section of this paper gave a case study for each of the four market structures: the agricultural industry which is an example of a perfectly competitive market; Abercrombie and Fitch which practices divergent price differential promotional pricing strategy which is a form of market egmentation found in an monopolistically competitive market; PepsiCo and its Tropicana brand of juices is an example of a monopolistically competitive market: where the competitor is using price segmentation to try and begin a price war; and lastly the de Beers monopoly who made formal agreements with various governments, diamond mines, and polishers in order to keep diamond prices high and relatively stable while destroying any competitor pricing power by flooding the market with stones when competitors tried to enter and sell their product.
References
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