Market structure and pricing practices


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Market structure and pricing practices

  2. 2. Meaning and classification of MarketAn arrangement whereby buyers and sellers come in close contact witheach other directly or indirectly to sell and buy goods is described asmarketClassification of marketLocal marketsRegional marketsNational marketsWorld markets
  3. 3. Perfect CompetitionA market structure in which a large number of firms all produce the sameproduct and no single seller controls supply or prices.Perfect Competition is a market structure where there is a perfect degreeof competition and single price prevails. A perfectly competitive market isa hypothetical market where competition is at its greatest possible level. Itis also called as pure competition.
  4. 4. Features of Perfect CompetitionMany SellersMany BuyersHomogenous ProductsZero Advertisement CostFree entry and ExitPerfect KnowledgeNo Government InterventionNo Transport CostPerfect Mobility of factors
  5. 5. Determination of Price under perfect competitionIn prefect competition, price is determined by the market forces ofdemand and supply. All buyers and sellers are price takers and not pricemakers. Buyer represents demand side in the market. Every rational buyeraims at maximising his satisfaction by purchasing more at lower price andlower at higher price. This is called demand behaviour of buyer i.e. Law ofDemand.Seller represents supply side in the market. Every rational seller aims atmaximizing his profits by selling more at higher price and lesser at lowerprice. This is called supply behaviour of seller i.e. Law of supply.But at a common price, buyer is ready to demand a particular quantity ofgoods and seller is also ready to supply exactly the same quantity of goodsto buyer, such common price is called Equilibrium Price and such quantityis called Equilibrium Quantity.
  6. 6. It is the price at which total demand is exactly equal to total supply.
  7. 7. MonopolyThe term monopoly is derived from Greek words mono which meanssingle and poly which means seller. So, monopoly is a market structure,where there only a single seller producing a product having no closesubstitute. This single seller may be in the form of an individual owner or asingle partnership or a Joint Stock Company.Such a single firm in market is called monopolist. Monopolist is pricemaker and has a control over the market supply of goods. But it does notmean that he can set both price and output level. A monopolist can doeither of the two things i.e. price or output. It means he can fix eitherprice or output but not both at a time.In monopoly, the firm has control over the price of output. Therefore, itwill choose the level of price and output that maximises profits.
  8. 8. Features of MonopolyA single seller has complete control over the supply of the commodity.There are no close substitutes for the product.There is no free entry and exit because of some restrictions.There is a complete negation of competition.Monopolist is a price maker.Since there is a single firm, the firm and industry are one and same i.e.firm coincides the industry.Monopoly firm faces downward sloping demand curve. It means he cansell more at lower price and vice versa. Therefore, elasticity of demandfactor is very important for him.
  9. 9. Types of Monopoly Perfect MonopolyImperfect Monopoly ( Telecom)Private Monopoly ( Reliance)Public Monopoly ( Railways, Defence)Simple Monopoly Discriminating MonopolyLegal Monopoly ( Music Industry)Natural Monopoly ( Gulf Countries)Technological Monopoly ( Windows OS)Joint Monopoly ( Pizza and Burger Joint)
  10. 10. Pricing under MonopolyBe careful of saying that "monopolies can charge any price they like" - thisis wrong. It is true that a firm with monopoly has price-setting power andwill look to earn high levels of profit. However the firm is constrained bythe position of its demand curve. Ultimately a monopoly cannot charge aprice that the consumers in the market will not bear.A pure monopolist is the sole supplier in an industry and, as a result, themonopolist can take the market demand curve as its own demand curve.A monopolist therefore faces a downward sloping AR curve with a MRcurve with twice the gradient of AR. The firm is a price maker and hassome power over the setting of price or output. It cannot, however, chargea price that the consumers in the market will not bear. In this sense, theposition and the elasticity of the demand curve acts as a constraint on thepricing behaviour of the monopolist. Assuming that the firm aims tomaximise profits (where MR=MC) we establish a short run equilibrium asshown in the diagram below.
  11. 11. Assuming that the firm aims to maximise profits (where MR=MC) weestablish a short run equilibrium as shown in the diagram below.
  12. 12. The profit-maximising output can be sold at price P1 above the averagecost AC at output Q1. The firm is making abnormal "monopoly" profits (oreconomic profits) shown by the yellow shaded area. The area beneathATC1 shows the total cost of producing output Qm. Total costs equalsaverage total cost multiplied by the output.A change in demand will cause a change in price, output and profits.In the example below, there is an increase in the market demand for themonopoly supplier. The demand curve shifts out from AR1 to AR2 causinga parallel outward shift in the monopolists marginal revenue curve (MR1shifts to MR2). We assume that the firm continues to operate with thesame cost curves. At the new profit maximising equilibrium the firmincreases production and raises price.Total monopoly profits have increased. The gain in profits compared to theoriginal price and output is shown by the light blue shaded area.
  13. 13. Price DiscriminationPrice discrimination occurs when a firm charges differentprices to different customers for reasons other thandifferences in costsPrice-discriminating monopoly does not discriminate basedon prejudice, stereotypes, or ill-will toward any person orgroup– Rather, it divides its customers into different categories based on their willingness to pay for good
  14. 14. Forms of Price DiscriminationPersonal Discrimination ( Doctor)Age Discrimination ( Bus Fares)Sex Discrimination ( Concession for ladies)Location or Territorial Discrimination (petrol in Goa)Size Discrimination (Economy size Toothpaste)Quality variation discrimination ( Book Prices)Special service or comforts ( Restaurants)Use discrimination ( Electricity)Time discrimination ( Telephone charges)Nature of commodity discrimination ( Freight charges in railways & Bus)
  15. 15. Second Degree Price Discrimination
  16. 16. Third Degree of Price Discrimination
  17. 17. When is price discrimination profitable?Price discrimination is possible when there are different separate markets.But, the profitability aspect of price discrimination basically depends uponthe nature of the elasticity of the demand in these markets.The basic condition of profitable price discrimination are – Elasticity of demand differs for different marketsThe cost differential of supplying output in different markets should not belarge in relation to the price-differential based on elasticity differential
  18. 18. Monopolistic CompetitionMonopolistic competition is a market structure characterized by a largenumber of relatively small firms. While the goods produced by the firms inthe industry are similar, slight differences often exist. As such, firmsoperating in monopolistic competition are extremely competitive but eachhas a small degree of market control.Monopolistic Competition is a market structure in which many firms sellproducts that are similar but not identical.In effect, monopolistic competition is something of a hybrid betweenperfect competition and monopoly. The real world is widely populated bymonopolistic competition.
  19. 19. Features of a Monopolistic CompetitionLarge number of small firmsProduct differentiationRelative resource mobilityExtensive knowledge
  20. 20. Pricing under Monopolistic CompetitionShort run EquilibriumOver the short-run, firms can usually gain some abnormal profit, it is atime period in which at least one factor of production is fixed. The firm willproduce quantity Q at price P. The firm produces where marginal cost(MC) and marginal revenue (MR) curves meet, because MC is the cost ofproducing an one more of the good and MR is the revenue of selling onemore good and their meeting point is the most efficient production. Thismeans that the shaded area between Ps, b (average cost of producing onegood at this quantity) and the AR curve (average revenue curve) is theabnormal profit the firm makes. AR is equivalent to the demand curve andis the average revenue the firm makes per item sold. Producing at thispoint ensures the highest amount of profit. Thus, equilibrium is created inthe short run.
  21. 21. Short run equilibrium
  22. 22. Long run EquilibriumIn the long run, there are no abnormal profits because of the features ofMonopolistic competition. There are a few large firms, but many small firmsthat will compete for profit and thus drive the price down. Also, low entrybarriers mean new firms will enter the market and further add competition.Finally, the goods are similar enough to ensure that competition will alwaysremain high.In this diagram, the firm produces where the LRMC, or long run marginal costcurve, and the marginal revenue curve meets. The LRMC describes the cost ofproducing one more of the good when no factors of production are fixed overthe long run. That point is, in the long run, equivalent to the LRAC, or long runaverage cost curve, which shows them average cost of producing one good atthis quantity over the long run. Because the LRAC curve is above the AR curve,there is no abnormal profit, as the average cost of the good equals the averagerevenue of the good. Thus, in the long run, equilibrium is acquired.Essentially, the difference between short and long run equilibrium is that inshort run equilibrium, the firm can gain abnormal profits. Over the long run,that is impossible.
  23. 23. Long run Equilibrium
  24. 24. Product DifferentiationThe goods produced by firms operating in a monopolistically competitivemarket are subject to product differentiation. The goods are essentiallythe same, but they have slight differences.Product differentiation is usually achieved in one of three waysPhysical DifferentiationPerceived DifferentiationSupport ServicesProduct differentiation is the primary reason that each firm operating in amonopolistically competitive market is able to create a little monopoly allto itself.
  25. 25. OligopolyA market structure characterized by competition among a small number oflarge firms that have market power, but that must take their rivals’ actionsinto consideration when developing their competitive strategies.Oligopoly is a market structure in which the number of sellers is small. Itrequires strategic thinking, unlike perfect competition, monopoly, andmonopolistic competition. Under oligopoly, a seller is big enough to affectthe market. You must respond to your rivals’ choices, but your rivals areresponding to your choices.In oligopoly markets, there is a tension between cooperation and self-interest. If all the firms limit their output, the price is high, but then firmshave an incentive to expand output.
  26. 26. Features of Oligopolylarge number of potential buyers but only a few sellershomogenous or differentiated productbuyers are small relative to the market but sellers are largeFirms have market power derived from barriers to entryEach firm doesn’t have to consider the actions of other the actions ofother firms, thus, behavior is interdependent.However, a small number of firms compete with each other.Imperfect dissemination of informationAdvertisingConstant struggle
  27. 27. Kinked Demand CurveThe kinked demand curve or the average revenue curve is made ofRelatively elastic demand curveRelatively inelastic demand curveAt given price P, there is a kink at point K on the demand curve DD. DK isthe elastic segment and KD is the inelastic segment of the curve. Here, thekink implies an abrupt change in the slope of the demand curve. Beforethe kink the demand curve is flatter, after the kink it becomes steeper.The kink leads to indeterminateness of the course of demand for theproduct of the seller. Raising the price would contract sales as demandtends to be elastic at this stage. Lowering the price would imply animmediate retaliation from the rivals on account of close interdependenceof price output movement in oligopolistic market.
  28. 28. Kinked Demand Curve
  29. 29. It is observed that quite often in oligopolistic markets, once a general pricelevel is reached whether by collusion or by price leadership or throughsome formal agreement, it tends to remain unchanged over a period oftime. This price rigidity is on account of conditions of priceinterdependence .Discontinuity of the oligopoly firm’s marginal revenuecurve at the point of equilibrium price, the price combination at the kinktends to remain unchanged even though marginal cost may change.In the figure, it can be seen that the firms marginal cost curve canfluctuate between MC1,MC2 and MC3 within the range of the gap in theMR curve, without disturbing the equilibrium price and output position ofthe firm. Hence, the price remains at P and output at Q, despite change inmarginal costs.
  30. 30. Price LeadershipAnother type of oligopolistic behaviour is price leadership. This is whenone firm has a clear dominant position in the market and the firms withlower market shares follow the pricing changes prompted by thedominant firm.As the name implies, the price leadership consists of a leader and a bunchof followers. The leader, however, is always mindful of the demand andwill set prices low enough that a satisfactory demand remains after all thefollowers have made production decisions.This implies that the dominant firm is better off with larger amounts ofthe market share and less competition. As a result, the price leader maychoose prices to minimize the participation of smaller firms. This pricingstrategy is called predatory pricing.
  31. 31. The price leadership of a firm depends on number of factors asDominance in the marketInitiativeAggressive pricingReputation
  32. 32. Cartels It is often observed that when a market is dominated by a few large firms,there is always the potential for businesses to seek to reduce marketuncertainty and engage in some form of collusive behaviour. When thishappens the existing firms decide to engage in price fixing agreements orcartels. The aim of this is to maximise joint profits and act as if the marketwas a pure monopoly. It is considered illegal under anti-trust laws, such ascompetition act 2002, India.Collusion is often explained by a desire to achieve joint-profitmaximisation within a market or prevent price and revenue instability inan industry. Price fixing represents an attempt by suppliers to controlsupply and fix price at a level close to the level we would expect from amonopoly.
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