Business Economics 09 Market Structures & Pricing Strategy


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Business Economics 09 Market Structures & Pricing Strategy

  1. 1. Market structures
  2. 2. The objective <ul><li>Learn about market formation </li></ul><ul><li>How decisions of price and output are taken in the markets </li></ul><ul><li>Pricing strategies </li></ul>
  3. 3. The Coverage <ul><li>Price and output determination in various market structures – perfect competition, monopoly, monopolistic competition, oligopoly </li></ul><ul><li>Pricing strategies for firm with market power- price discrimination </li></ul><ul><li>A comparison of market structures for efficient production and equitable distribution </li></ul>
  4. 4. Four basic components of market <ul><li>1. Consumers 2. Sellers </li></ul><ul><li>3. Commodity 4. Price </li></ul><ul><li>Market classification </li></ul><ul><li>By the area </li></ul><ul><li>By the nature of transaction </li></ul><ul><li>By the volume of business </li></ul><ul><li>By the nature of competition </li></ul>
  5. 5. Competition in the market <ul><li>Depends on </li></ul><ul><li>Number and size distribution of sellers </li></ul><ul><li>Number and size distribution of buyers </li></ul><ul><li>Product differentiation </li></ul><ul><li>Conditions of entry and exit </li></ul><ul><li>Structure Conduct Performance </li></ul>
  6. 6. A classification of market forms Form of Market Structure Number of Firms Nature of Product Price elasticity of demand for Degree of control 1 2 3 4 5 a) Perfect competition A large no. of firms Homogeneous Product Infinite None b) Imperfect competition A large no. of firms Differentiated products (but) they are close substitutes of each other Large Some i) Monopolistic competition A large no. of firms Product differentiation by each firm Large Some ii) Pure oligopoly Few firms Homogeneous Product Small Some iii) Differentiated oligopoly Few firms Differentiated products Small Some c) Monopoly One Unique product without close substitutes Very Small Considerable
  7. 7. Perfect competition <ul><li>Infinite buyers and sellers </li></ul><ul><li>Perfect knowledge and information </li></ul><ul><li>Identical products </li></ul><ul><li>No barriers on entry or exit </li></ul><ul><li>Maximum profits or minimum losses </li></ul><ul><li>No transportation cost </li></ul><ul><li>All are price takers </li></ul>
  8. 8. Types of firms <ul><li>Efficient (least cost) and profit making firms </li></ul><ul><li>Efficient but breaking even firms </li></ul><ul><li>Inefficient but operating firms </li></ul><ul><li>Inefficient and closing down firms </li></ul>
  9. 9. Perfect competition and the public interest <ul><li>P = MC </li></ul><ul><li>Competition as spur to efficiency </li></ul><ul><li>Development of new technology </li></ul><ul><li>Economical use of national resources </li></ul><ul><li>Least cost Q in long run (LR) </li></ul>
  10. 14. Monopoly <ul><li>One seller </li></ul><ul><li>Barriers on entry </li></ul><ul><li>No substitutes </li></ul>
  11. 15. Market power <ul><li>Through elasticity of demand </li></ul><ul><li>Learner (Abba) index = P – MC/P or </li></ul><ul><li>MR = P(1+1/E) </li></ul><ul><li>Learner index = -1/E </li></ul><ul><li>Cross price elasticity of demand </li></ul>
  12. 16. Acquiring market power <ul><li>Economies of scale </li></ul><ul><li>Product differentiation and brand loyalty </li></ul><ul><li>Ownership of, or control over, key factor and/or wholesale or retail outlets </li></ul><ul><li>Consumer lock in- high search, switching and initiation cost </li></ul><ul><li>Legal protection </li></ul><ul><li>Network externalities – product’s value rises as more consumers use it. </li></ul><ul><li>Mergers and takeovers </li></ul><ul><li>Aggressive tactics </li></ul>
  13. 17. Monopoly and the public interest <ul><li>Disadvantages – Higher price and lower output, possibility of higher cost due to lack of competition, unequal distribution of income </li></ul><ul><li>Advantages – Economies of scale, lower cost, competition for corporate control, innovation and new products </li></ul>
  14. 19. w
  15. 21. Deadweight loss – a measure of the aggregate loss in well-being of the participants in a market resulting from an inefficient output level.
  16. 22. Monopolistic competition <ul><li>Many alternative suppliers </li></ul><ul><li>Differentiated product </li></ul><ul><li>Easy entry </li></ul><ul><li>(e.g. cosmetics, detergents, medicines, grocers, barbershops, restaurants) </li></ul>
  17. 27. Oligopoly <ul><li>Few interdependent sellers </li></ul><ul><li>Standardized or differentiated oligopoly </li></ul><ul><li>Restricted entry </li></ul><ul><li>(e.g. steel, aluminum, cement, fertilizes, petrol and cars). </li></ul>
  18. 28. Oligopoly in different forms <ul><li>Kinked demand curve </li></ul><ul><li>Collusive oligopoly </li></ul><ul><li>Price leadership </li></ul><ul><li>Joint profit maximizing cartel </li></ul><ul><li>Market sharing cartel </li></ul>
  19. 29. Kinked demand curve model
  20. 31. Factors favoring collusion <ul><li>Few firms well known to each other </li></ul><ul><li>They are not secretive </li></ul><ul><li>Similar production methods and AC and want to change price at the same time </li></ul><ul><li>Similar products </li></ul><ul><li>Significant barriers to entry </li></ul><ul><li>Stable market </li></ul><ul><li>No government measure to curb collusion </li></ul>
  21. 32. Dominant firm
  22. 33. <ul><li>Price leadership </li></ul><ul><li>Joint profit maximizing cartel </li></ul><ul><li>Market sharing cartel </li></ul>
  23. 34. Case - OPEC: the rise and fall of a cartel <ul><li>OPEC set up in 1960 by Saudi Arabia, Iran, Iraq, Kuwait and Venezuela. </li></ul><ul><li>Objectives </li></ul><ul><li>The co-ordination and unification of the petroleum policies of member countries </li></ul><ul><li>The organization to ensure the stabilization of prices, elimination of harmful and unnecessary fluctuation in the price and quantity </li></ul>
  24. 35. OPEC <ul><li>OPEC is a joint profit maximizing cartel </li></ul><ul><li>Saudi Arabia is a dominant producer and price leader within the cartel </li></ul>
  25. 36. OPEC <ul><li>Initially OPEC was increasingly in conflict with international oil companies - as under ‘Concessionary Agreement’ they were given right to extract oil in return for royalties. </li></ul><ul><li>1973 – thirteen members – transfer of powers, OPEC makes decisions on oil production and thereby determining oil revenues. </li></ul><ul><li>1970s – setting market price for Saudi Arabian crude and OPEC members to set their prices in line – dominant firm price leadership </li></ul>
  26. 37. OPEC <ul><li>As long as demand is price inelastic – this policy allowed large P TR </li></ul><ul><li>1973-74 – Arab-Israeli war, OPEC raised price $3 per barrel to over $12 until 1979 and sales did not fall. </li></ul><ul><li>After 1979 – price $15 to $40 per barrel demand did fall </li></ul><ul><li>1982 – OPEC agreed to limit output and allocate production quotas to keep the price up. A production ceiling of 16 million barrel per day in 1984 </li></ul>
  27. 38. OPEC <ul><li>Cartel was beginning to break down due to </li></ul><ul><li>- world recession </li></ul><ul><li>- growing output from non-OPEC members </li></ul><ul><li>- ‘cheating’ by some OPEC members who exceeded their quota limit </li></ul><ul><li>The trend of lower oil prices was reversed in the late 1980s due to boom </li></ul><ul><li>1990 – Iraq invaded Kuwait Gulf war supply of oil fell P </li></ul><ul><li>End of war and recession of 1990s the price fell again - $ 16 </li></ul>
  28. 39. Other cartels <ul><li>During mid-1970s International Bauxite Association (IBA) quadrupled bauxite prices </li></ul><ul><li>A secretive international uranium cartel pushed up uranium prices </li></ul><ul><li>From 1928-1970s Mercurio Europe kept the prices of mercury close to monopoly levels </li></ul><ul><li>A cartel monopolized the iodine market from 1878-1939 </li></ul><ul><li>Tin, coffee, tea and cocoa cartels failed </li></ul>
  29. 40. Pricing Strategies for Firm With Market Power
  30. 41. Pricing decisions <ul><li>How do we set prices relative to costs? </li></ul><ul><li>How do we change them? </li></ul><ul><li>To what extent should we try to protect our market? </li></ul><ul><li>Strategy to lead to the highest profit rate. </li></ul><ul><li>Lowering prices in response to potential competition. </li></ul>
  31. 42. Strategies that yield even greater profits <ul><li>Extracting Surplus from consumers </li></ul><ul><li>Price discrimination </li></ul><ul><li>Two part pricing </li></ul><ul><li>Block pricing </li></ul><ul><li>Commodity bundling </li></ul>
  32. 43. Price discrimination <ul><li>Meaning </li></ul><ul><li>Changing different prices for the same product </li></ul><ul><li>Charging same price for different products when costs differ. </li></ul><ul><li>Possibility of differences in </li></ul><ul><li>financial status </li></ul><ul><li>educational status </li></ul><ul><li>age of the customer </li></ul><ul><li>time of purchase </li></ul>
  33. 44. First degree price discrimination (unit wise) <ul><li>Meaning </li></ul><ul><li>Charging each consumer one maximum price, he or she is willing to pay for each unit. Extracting all consumer surplus and earning maximum profit. </li></ul><ul><li>Requirement - full information regarding consumers </li></ul><ul><li>Application - service related business - mechanics, doctors, lawyers, professionals etc. </li></ul>
  34. 45. Second degree price discrimination (Lot wise) <ul><li>A practice of posting a discrete schedule of declining prices for different ranges of quantities. Extracting part of the surplus, lower profit. </li></ul>
  35. 46. Third degree discrimination (Market wise) <ul><li>Charging different groups of consumers different prices for the same product. </li></ul><ul><li>Essential conditions </li></ul><ul><li>Different elasticity of demand - students’ discount, senior citizen discount </li></ul><ul><li>Information regarding elasticity of demand </li></ul><ul><li>Separate markets </li></ul>
  36. 47. Price discrimination <ul><li>Essential conditions </li></ul><ul><li>Separate markets </li></ul><ul><li>Different elasticity of demands </li></ul>Profit-maximizing output under third-degree price discrimination a) Market X b) Market Y c) Total (market X+Y) Q 0 1000 MR X D X 0 2000 MR X D X 0 3000 MR T 5 9 7 5 Q Q MC 5
  37. 48. Two part pricing <ul><li>Initially a fixed fee for the right to purchase its goods, plus a per unit charge for each unit purchased. </li></ul><ul><li>Examples - athletic clubs, golf courses, health clubs </li></ul><ul><li>Initiation (fixed) fee plus monthly or per visit charges. </li></ul>
  38. 49. Block pricing <ul><li>All or none decision </li></ul><ul><li>Block pricing provides a means by which the firm can get one consumer to pay the full value of the blocked units. </li></ul><ul><li>Consumer’s decision - buying all units (blocked) or buying nothing . </li></ul><ul><li>( hiring a bus, a pack of three soaps ) </li></ul>
  39. 50. Commodity Bundling <ul><li>Bundling two or more different products and selling them at a single ‘bundle price’. </li></ul><ul><li>Example - travel companies package deal, computer, monitor, software deal </li></ul>
  40. 51. Pricing strategies for special cost and demand structures <ul><li>Peak load pricing </li></ul><ul><li>Cross subsidies </li></ul>
  41. 52. Peak load pricing <ul><li>Markets having high demand and low demand periods. </li></ul><ul><li>Example - road, train, air, electricity, telephone. No problem of resale. Commodity must be consumed as it is purchased. </li></ul>
  42. 53. Peak-load pricing <ul><li>Objective- to reduce costs and increase profits if </li></ul><ul><li>the same facilities are used to provide a product or service at different periods of time. </li></ul><ul><li>the product or service is not storable. </li></ul><ul><li>demand characteristics vary from period to period. </li></ul><ul><li>The theory of peak-load pricing suggests that peak-period users should pay most capacity costs while off-peak user may be required to pay only variable costs. </li></ul>
  43. 54. Case - Central Electricity Generating Board, UK (CEGB) <ul><li>High demand - morning & evening </li></ul><ul><li>Moderate - throughout rest of the day </li></ul><ul><li>Very little - night </li></ul><ul><li>Extra power stations for peak load - capacity cost. Stations idle rest of the day and therefore high MC. </li></ul><ul><li>Charge different prices. </li></ul><ul><li>Group, capacity limitation, price discrimination </li></ul>
  44. 55. Peak load pricing(cont) <ul><li>CEGB combining peak load pricing and two part tariff </li></ul><ul><li>CEGB uses less efficient power stations during peak load hours  MC  </li></ul><ul><li>Capacity Charges to directly recoup costs of building plants and electricity charges on the basis of KWh used. In addition energy charges to cover short run MC of extra plants </li></ul><ul><li>1986-87 - Complex structure of energy charges </li></ul><ul><li>1.4 pence/KWh at night during weekends </li></ul><ul><li>3.8 pence/KWh at breakfast time on week days </li></ul><ul><li>Further surcharge of 2.5 pence/KWh (hourly) during heaviest demand. </li></ul>
  45. 56. Case - Computer time and peak load pricing <ul><li>Three criteria </li></ul><ul><li>Usually a computer has only a single CPU but is in constant use. Same facility to provide the service at different periods of time. </li></ul><ul><li>CPU time not used is lost forever i.e. service is not storable. </li></ul><ul><li>Center may provide same service at different times, late -night service is not desirable. </li></ul>
  46. 57. Prices at university computer facility
  47. 58. <ul><li>Case </li></ul><ul><li>Peak load pricing of Computer time </li></ul>6 AM Noon 6 PM Midnight Midnight CPU Usage After pricing Before pricing Time of Day
  48. 59. Cross subsidies <ul><li>A strategy which uses profits made with one product to subsidize sales of another product </li></ul><ul><li>Relevant in situations where a firm has cost complementarities and demand for a product independence </li></ul><ul><li>Economies of scope - saving in producing jointly or using excess capacity to produce another products </li></ul><ul><li>Example - computer & software </li></ul>
  49. 60. <ul><li>Advantage </li></ul><ul><li>It permits the firm to sell multiple products. </li></ul><ul><li>If the two products have independent demands, the firm can induce consumers to buy more of each product than they would otherwise. </li></ul>
  50. 61. Pricing strategies in markets with intense price competition <ul><li>Limit pricing </li></ul><ul><li>Pricing joint products </li></ul><ul><li>Price matching </li></ul><ul><li>Inducing brand loyalty </li></ul><ul><li>Randomized pricing </li></ul>
  51. 62. Limit pricing <ul><li>Reduce price to discourage the entry of new firms- initially enjoy profit and face competition. </li></ul><ul><li>Increasing returns to scale provides cost advantages for large firms . </li></ul>
  52. 63. Limit pricing <ul><li>Used when </li></ul><ul><li>To influence expectations of entrants </li></ul><ul><li>To protect margins </li></ul><ul><li>Entrants have limited information of market. </li></ul><ul><li>Present V/s future prices. </li></ul><ul><li>Convince new firms of low cost and charge less. </li></ul><ul><li>Give misleading information </li></ul>
  53. 64. Pricing Joint Products <ul><li>When goods are produced jointly and in fixed proportion, they should be thought of as a ‘product packages’ </li></ul>
  54. 65. Price matching A strategy in which a firm advertises a price and promises to ‘match’ any lower price offered by a competitor. Advertisement “ Our price is P. If you find a better price in the market, we will match that price. We will not be undersold.”
  55. 66. Inducing Brand Loyalty <ul><li>Brand loyal customers will continue to buy a firm’s product even if another firm offers a slightly better price. </li></ul><ul><li>To induce brand Loyalty </li></ul><ul><li>engage in advertising compaign </li></ul><ul><li>give incentives </li></ul>
  56. 67. Randomized pricing <ul><li>A firm varies its prices frequently - hour to hour or day to day </li></ul>
  57. 68. Case - Randomized pricing in the airline industry <ul><li>There are over 215,396 changes in the airfares each day. This translates into 150 changes per minute. Domestic airlines spend considerable sums of money in an attempt to monitor the prices of another firms. As noted by Marius Schwartz:“Delta airlines assigns 147 employees to track rivals’ prices and select quick responses - on a typical day, comparing over 5,000 industry pricing changes against Delta’s more than 70,000 fares. New fares filed the prior day with Air Traffic Publishing Co. are tracks by Delta computer. </li></ul>
  58. 69. <ul><li>“ Secret” price changes that are deliberately withheld from the Air Traffic Publishing System for several days are tracked through local newspapers or call to other airlines’ reservation offices. Once Delta learns of a competitors pricing more, it can put a matching fare into its reservation system within two hours. </li></ul><ul><li>Why do airlines take such drastic measures to learn the prices set by their rivals? </li></ul><ul><li>Why do airfares change so frequently? </li></ul><ul><li>Source - Marius Schwartz, “the nature and scope of contestable theory” Oxford Economic Papers, 1986, pp. 46-49. </li></ul>
  59. 73. Thank you and all the best