marketing structure and pricing practices

1. LECTURE FOUR
MARKET STRUCTURE AND
PRICING PRACTICES

2. PRICING AND OUTPUT FOR
PROFIT MAXIMISATION
• To recap; firms aim at profit maximization.
• In order therefore to determine the output and
price which maximizes profits firms will produce
up to the point where the marginal revenue is
equal to the marginal cost. At this point, output
produced and price charged maximizes profits.
• This condition is also referred to as the golden
rule or marginalist principle. Therefore price and
output which maximize profit are attained when:
MR = MC.

3. MARKET STRUCTURE
• Market defined
• A market is an interpersonal institution, which brings
together buyers and sellers of commodities or services.
• Markets are categorized into perfect and imperfect
markets based on the following criterion: -
- Number and size of the buyers and sellers of a product.
- The type of product bought and sold whether
homogeneous or differentiated.
- The degree of mobility of resources meaning the extent
to which firms can enter and exit the market.
- The extent to which information on prices, costs demand
and supply conditions are available.

4. PERFECT COMPETITION
• The perfect competitive market structure is the unique competitive
market described by the following characteristics: -
• - There are many buyers and sellers of a product, each too small
to affect the price of the product.
• - The product being traded is standard or homogeneous. Each
seller’s product is identical to its competitor’s.
• - There is freedom of entry and exit in the market. Thus there
are no significant obstacles preventing firms from entering or leaving
the industry.
• - Economic agents (i.e. firms and consumers) have perfect
knowledge of market conditions.
• - Individual firms must accept the market price. They are price
takers and can exert no influence on price.

5. PERFECT COMPETITION
• The above characteristics are difficult to meet in practice although
many international markets in commodities and financial markets
come very close;
• however, the model is still useful because perfect competition is a
benchmark of economic efficiency.
• Price and output determination
• In a perfectly competitive market, the market price of a product is
determined at the intersection of the market demand curve and
market supply curve of the product. The perfectly competitive firm is
then a price taker and therefore can sell any quantity of that
commodity at that price.
• The best level of output of a firm in the short run is given at the point
at which price (P) or marginal revenue (MR) equals marginal cost
(MC). This is true as long as P exceeds the average variable cost
(AVC) of the firm

6. PERFECT COMPETITION
• Short run equilibrium:
• In the short run, one input used in the production process is fixed.
Therefore depending on the relationship between the price of the
commodity and average cost, in the short run a firm can earn
economic profits (P>ATC), incur losses (P<ATC) or just break even
(P=ATC).
• Long run equilibrium
• In the long run, the firm will build the optimal scale of plant to
produce the best level of output. This is possible because all factors
used in the production process are adjustable (variable). The
existence of profits will attract more firms into the industry, while
losses will cause some firms to leave it. This proceeds until the long
run equilibrium is reached, at which all firms produce at the price
that equals the lowest point on the long run average cost (LAC)
curve, and all firms break even. (P=LMC=LMR=LATC).

7. LONG RUN EQUILIBRIUM OF
PERFECT COMPETITION

8. EFFICIENCY IMPLICATIONS OF
PERFECT COMPETITION
• The perfect competitive market is considered efficient as
it allocates economic resources efficiently through the
price mechanism.
• Attains allocative and productive efficiency. Productive
efficiency is attained when P=min LATC. Allocative
efficiency is attained when P = LMC.
• Output produced is optimal.One reason for this is that at
the point of long- run equilibrium firms only earn “normal
profit”.
• Normal profit is the minimum level of profit, or return on
capital employed, necessary to keep a firm in production
in the long-run. Normal profit is a cost and is included in
the average cost curve.
•

9. EXAMPLES OF PERFECT
COMPETITION
• Examples of perfect competition:
• Although it is difficult to meet the characteristics of
perfect competition in full, we do have few examples in
financial markets, which reflect perfect competition.
• The functioning of the stock exchange and foreign
exchange market demonstrates very good examples of
the functioning of perfect competition.
• Both markets are composed of many buyers and
sellers. Money or stock/shares are homogeneous in a
sense. The flow of information in these two markets is
swift and readily available to players in the market
because of developments in information technology.

10. MONOPLOY
• A pure monopoly market structure is defined as a single firm
producing a product for which there is no close substitute.
• The basic characteristics that explain pure monopoly are as follows:
• - There is a single seller so the firm and the industry are
synonymous.
• - There are no close substitutes for the firm’s product.
• - The firm is a “price maker” that is, the firm has considerable
control over the price because it can control the quantity supplied.
• - Entry into the industry by other firms is blocked.
• - A monopolist may or may not advertise, depending on the
nature of its products. Advertising may be done to increase
demand.
• Dominant examples of pure monopoly in practice include public
utilities like electricity and water. Local examples include Tanesco
for electricity and Dawasa for water.

11. MONOPLOY
• Sources of monopoly
• Why should monopolies exist in practice? This question can be
answered by examining the barriers to entry, which limit
competition in the market structure. These barriers are explained
as follows:
– Existence of economies of scale. In the long run, average cost
may fall over a sufficiently large range of outputs as to leave
only one firm supplying the entire market. Existence of
economic of scale implies that it is only efficient to have only
one big firm to supply the entire market rather than having
many small firms operating at high costs.
– Legal barriers in terms of patents and licenses.
• Patents grant the investor the exclusive to produce or license a
product for a good number of years. This exclusive right earns
profit for future research, which in turn results into more patents
and monopoly profits. Government licenses are another form of
entry barrier.

12. MONOPOLY
– Ownership of essential resources.
• A firm may control the entire supply of raw materials required to
produce a product. This situation directly creates a monopoly.
Examples include the ownership of land that has diamond reserves;
hence Mwadui Diamond Company Ltd. controls almost all Tanzania
diamond supplies.
– Government Legislation
• Government through legislation can also create monopolies. The
government may decide to allow one producer in certain services or
sectors for example when Tanzania adopted the Arusha Declaration
in 1967, all private commercial banks were nationalized and the
government established the National Bank of Commerce (NBC) as
the only commercial bank.

13. Price and output
determination(Monopoly)
• Price and output determination
• As in the perfect competitive market, a monopolist is guided by
the golden rule of MR = MC in determining its profit maximizing
output and price. In addition, a monopolist faces a downward
sloping market demand curve and the usual U-shaped marginal
and average cost curves.
• Short run equilibrium:
• In the short run a monopolist can either earn economic profits (P>
ATC), economic losses (P<ATC) or just break even (P=ATC)
depending on the relationship between the average cost and the
price of the commodity.

14. Price and output determination(Monopoly
• Long run equilibrium:
• However, in the long run, all inputs and costs of production are
variable and hence the monopolist can select the optimal scale or
plant to produce the best level of output.
• If a monopolist earns short run economic profits, in the long run
economic profits will tend to persist as there are barriers to entry and
no competition.
• Likewise, if a monopolist experiences short run economic losses it
will be forced to look for other profitable uses of its resources or else
it will leave the industry in the long run.
• Hence it can be concluded that the long run equilibrium of a firm
under monopoly market structure is characterized by the existence
of economic profits. The price charged is greater than the long run
average costs incurred in producing equilibrium output (P>LATC).
• A monopolist in the long run will enjoy economic profits Note well,
however, that a firm in a monopoly position will only make a profit if
there is sufficient demand for its output compared with its costs. The
existence of a monopoly right does not guarantee a profit unless the
good or service in question is demanded.

15. LONG RUN EQUILIBRIUM IN
MONOPOLY

16. Regulation of monopoly
• Regulation of monopoly
We have observed that in practice the existence of
monopoly is unavoidable because of economies
of scale (natural monopolies). Therefore to
correct for monopoly inefficiency government
regulates monopoly.
One way of regulating activities of a monopolist to
tax his excess profits so that he can earn only
normal profit.
On the other hand, the monopolist may be
regulated by forcing it to charge a price equal to
its long average cost.

17. WELFARE EFFECTS OF
MONOPOLY
• Comparing perfect competition and monopoly market structures.
• Monopoly charges a higher price and produces a lower output level.
Perfect competition charges a lower price and produces a higher
output level.
• High consumer surplus in perfect competition. Consumer surplus
reduced in monopoly market structure.
• Consumer surplus is the difference between what a consumer was
willing to pay and what he/she actually pays in the market.
• Consumer deadweight loss represents the reduction in consumer
surplus that is not captured as an income transfer to a monopolist
• Producer deadweight arises when society’s resources are
inefficiently employed because the monopolist does not produce at
the minimum per unit cost.

18. MONOPOLISTIC COMPETITION
– Description of Monopolistic competition
• Monopolistic competition refers to a market structure with a
relatively large number of sellers offering similar but not identical
products. This market structure is a hybrid of perfect competition
and monopoly in the sense that it borrows characteristics from
both.
– Characteristics of Monopolistic Competition
• Products sold are differentiated. Differentiated products are
those, which are similar but not identical and satisfy the same
basic need.
• The number of sellers is large enough for each to act
independently of each other.
• There is free entry and exit.
• There is limited influence on price charged because of customer
loyalty caused by product differentiation.

19. MONOPOLISTIC COMPETITION
• Product differentiation distinguishes this market structure from pure
competition. Economic rivalry is dominated by non-price
competition. Product differentiation can either be physical or
qualitative.
• Ways or methods used to practice product differentiation may
include: -
-Services and conditions accompanying the sale of the product.
-Location of the firm.
-Promotion activities.
-Packaging.
-Advertisement.
• Monopolistic competition is most common in the retail and service
sectors. Examples include retail shops, petrol stations, restaurants,
fast food outlets etc.

20. Price and output
determination(Monopolistic
Competition)
• The monopolistic competitive firm faces a demand curve, which is
highly, but not perfect elastic. The demand curve is more elastic
than the monopoly’s demand curve because the seller has many
close substitutes.
• In addition it is elastic than pure competition because of product
differentiation which brings about limited control over price charged
by monopolistic competitive firms. Firms set price and output
maximizing profits at the point where MR = MC.
• Short run equilibrium:
• In the short run, depending on the relationship between the price
and average cost curves, a monopolistic competitive firm can earn
economic profits(P>ATC), economic losses (P<ATC) or just break
even (P=ATC).

21. EQUILIBRIUM IN MONOPOLISTIC
COMPETITION
• Long run equilibrium:
• Since there is free entry and exit, any economic profits earned
will attract more firms up to a point where existing firms just earn
normal profits.
• Hence the long run equilibrium of monopolistic competitive firms
is attained when firms just receive normal profits (zero economic
profits) i.e. (P=LATC).
• However, it is important to note that firms in monopolistic
competition do not produce at the minimum average cost i.e. (P is
not equal to Min LATC). This is because firms incur extra cost in
differentiating their products.
• Hence firms charge a higher price and produce a lower output as
compared to perfect competition. This market is also characterized
by firms operating to the left of the minimum point on their LATC
curve. This phenomenon is described as existence of “excess
capacity”.

22. EFFICIENCY IMPLICATIONS OF
MONOPOLISTIC COMPETITION
• The market is not considered efficient because:
(i) does not produce at the minimum cost. P is
not equal to min LATC.
• It is important to note that although production is
less efficient, the consumer is rewarded with
product variety.
• This market enhances consumer sovereignty.

23. OLIGOPOLY
• Oligopoly
• Description of Oligopoly
• An oligopoly market structure is dominated by few large
firms producing a homogeneous or differentiated
product. If there are only two sellers than the market is
termed as duopoly.
• The distinguishing feature of oligopolistic or duopolistic
market structures, especially compared with perfect
competition or monopoly, is not simply a matter of the
number of the firms in the industry. Rather, it is the
degree to which output, pricing, and other decisions of
one firm affect, and are affected by, similar decisions
made by other firms in the industry.
• What is important is the interdependence of the
managerial decisions among the various firms in the
industry.

24. OLIGOPOLY
• Characteristics of Oligopoly
• The oligopoly market structure is defined by the following
characteristics:
• - Market is dominated by few big firms who either
produce standardized or differentiated products.
• - Because of fewness, firms are mutually
interdependent, that is each firm must consider its rivals
reactions in response to its decisions abut price and
output.
• There are restrictions or obstacles in entering the
market.
• - Non price competition in form of advertising, product
differentiation and sales promotion is dominant.
• - The sources of oligopoly are similar to that of
monopoly and include existence off economies of scale,
control of raw materials, patents, substantial advertising

25. OLIGOPOLY
• Very distinctive feature of Oligopoly is the interdependence of firms
in pricing and output decisions. Since firms are few, each firm
controls a certain percentage of the market share. So any action by
one firm will affect the market share of another.
• For example if Coca-Cola Company limited decreases its price for
coca-cola, the market share for Pepsi Company Limited will be
affected it does not respond by reducing its price.
• Hence other firms closely watch any action taken by a rival firm and
they respond to defend their market share. Oligopoly is most
dominant in the manufacturing industry.
• Examples of Oligopoly in the Tanzania context include the following:
• Brewing industry (Tanzania Breweries Limited and Associated
Brewery).
• Cement industry (Wazo Hill Cement, Tanga Cement and Mbeya
Cement).
• Soft drinks industry (Coca-Cola and Pepsi Cola). Mobile phone
providers(Tigo, Vodacom, Zain, Zantel, TTCL)
• Other examples include manufacturing in the computer, automobile,
steel and aluminum industry.

26. Short and long run equilibrium in
Oligopoly:
• As indicated earlier, the distinctive characteristic of oligopolies and
duopolies is the interdependence of firms. Where collusion is
prohibited by law, oligopolistic behaviuor may be presented as a non
cooperative game in which the actions of one firm to increase
market share will, unless countered, result in a reduction of the
market share of other firms in the industry.
• Thus action will be followed by reaction. It is therefore difficult to
determine the short and long run equilibrium of oligopoly and
duopoly because of the many ways in which firms deal with this
interdependence.
• Thus there is no general theory to explain this interdependence.

27. Selected Oligopoly theories
• Kinked demand curve model.
Tries to explain the price rigidities in the oligopoly market.
-Because of interdependence a price increase will result into a firm
losing market share as rival will not respond.
-A price reduction will result into a price war as rival firms will respond.
• Hence firms will tend to maintain the same price
• Collusion model
Oligopolies recognise their mutual interdependence, they might agree
to coordinate their output decisions to maximise the output of the
entire industry.
• Collusion represents a formal agreement among firms in an
oligopolistic industry to restrict competition in order to increase
industry profits.
• Collusion may take the form of explicit price fixing agreements or
output fixing agreements like OPEC.
• Most well known manifestation of of collusive behavior is the cartel.
• A cartel is an explicit agreement among firms in an oligopolistic
industry to allocate market share and or industry profits.

28. PRICING PRACTICES
• We had earlier assumed that a firm has precise knowledge about
the firm’s production , revenue and cost functions.
• For a profit maximising firm, price was assumed to be determined
at the point where MR=MC. The problem is that in practice it is
difficult to measure revenue and cost functions.
• Price discrimination
• Price discrimination refers to the practice of charging different
prices for different quantities of a product to different customers or
groups in different markets, although the price differences are not
justified by cost differences.
• In other words, price discrimination occurs when a given firm’s
prices in different markets are not related to differentials in
production and distribution costs. The motivating factor in
practicing price discrimination is the potential for increasing total
revenue and profits for a given level of sales and total costs.

29. TYPES OF PRICE
DISCRIMINATION
• First degree price discrimination
Occurs when firms charge each individual a different price for each
unit purchased. The price charged for each unit purchased is based
on the seller’s knowledge of each individual’s demand curve.
• Because it is virtually impossible to satisfy this informational
requirement, first degree price discrimination is extremely rare.
• Second degree price discrimination
• Also referred to as volume discounting
• Setting prices according to the amount purchased. Sellers attempt to
maximize profits by selling product in blocks or bundles rather than
one unit at a time.

30. TYPES OF PRICE
DISCRIMINATION
• Third degree price discrimination
Occurs when firms segment the market for a particular good or service
into easily identifiable groups, then charge each group a different
price.
• In order to practice third degree price discrimination successfully,
three conditions must be met.
• - First the firm must be able to segment the market for a product.
The firm must identify sub markets and prevent transfers among
customers in different sub markets. Segmentation of market allows
the firm to charge different prices to different groups of customers
without the possibility of inter-market leakages.
• - Price elasticities in the different sub markets must be different
in order to be able to charge different prices for the same product.
Having different price elasticities the firm would tend to charge
higher prices for inelastic market and lower price for elastic market.
• - Finally, monopoly power is needed with the ability to control
output and prices.

31. TYPES OF PRICE
DISCRIMINATION
• Price discrimination can only be practiced by firms in
markets where there is imperfect competition. Price
discrimination is common practice to firms in monopoly,
monopolistic competition and Oligopoly.
• - Examples of price discrimination include:
- different fares for first, second and third class in aero
planes, trains, ships etc.
-Different charges for telephone calls depending on time
made.
-The practice of utility companies charging lower prices to
commercial users and higher prices to residential users
etc.
-Offering different interest rates charged to big and small
borrowers.

32. OTHER PRICE PRACTICES
• Cost- Plus Pricing(mark up or full-cost pricing).
This is the practice of adding a predetermined mark up to a firm’s
estimated per unit cost of production at the time of setting the selling
price.
P = ATC(1+m),
where m is the percentage mark up over the fully allocated per unit
cost of production.
• This method is simple and easy to use.
• Peak load Pricing-Charging a higher price for a service when
demand is high and capacity is fully utilized and a lower price when
demand is low and capacity is underutilised.
• In many markets the demand for a service is higher at certain times
than at others. During such peak periods it becomes difficult to
satisfy demand of all customers. Thus a higher price is charged
during peak periods and a lower price is charged during off peak
periods.

33. OTHER PRICE PRACTICES
• Price skimming
This is an attempt by a firm that introduces a new product to extract
consumer surplus through differential pricing before competitors
develop their version of the new product.
• Charging initially the highest price possible and then reduce the
price gradually.
• Penetration pricing
• Occurs when a firm entering a new market charges a price that is
below the prevailing market price to gain a foothold in the industry.
• Prestige Pricing
• Practice of charging a higher price for a product to exploit the belief
by some consumers that a higher price means better quality, which
in turn confers on the owner greater prestige.
• This method capitalizes on snob appeal. Firms exploit this
perception by charging higher prices because of the increased
prestige that they believe ownership of their product confers.