6 Market structure and pricing

1. 6 Market structure and pricing

3. 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

4. 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.

5. 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.

6. 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) Perfect competition: Which is a typical firm’s demand curve? a b P c e D

7. 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?

8. 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

9. 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.

10. Answer = e A trade off between price and demand not = c (perfectly elastic) Not b (supply curve) Not a (perfectly inelastic) Monopoly: Which is a firm’s demand curve? a b P c e D

11. 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

12. 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

13. 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).

14. Price discriminating monopolist

15. 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).

16. 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.

17. 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

18. 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

19. 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.

20. 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.

21. Kinked Demand Curve a price rise will cause consumers to purchase from competitors: demand elastic P l k demand curve kinked at this point m a price fall will be matched by competitors: demand inelastic a b c D

22. 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

23. 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

24. 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

25. Market types

26. 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

27. 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.

28. What is the market type for each of these? • Coca-cola stall in the desert! • Monopoly • Qantas • Monopolistic competition

29. … 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

30. 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.

31. 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.

32. 6 Market structure and pricing: The End