mono comp eption, oligopoly, pricing

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Market Structure:

Monopolistic Competition

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Imperfect competition

A market structure between the extremes of perfect competition and monopoly

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Today’s discussionWhat is the competitive strategy in M.C?How the equilibrium price and quantity are determined in M.C? -in the short run and -in the long run

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• Many small sellers

• Differentiated product

• Easy entry

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Product differentiation

The process of creating real or apparent differences between goods and services

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Many small sellersEach firm is so small relative to the total market

Each firm’s pricing decisions have a negligible effect on the market price

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Examples

• Most common in retail sector • Toothpaste• Clothing• Restaurants• Detergents etc

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Easy entry in monopolistic competition?

Not as easy as in perfect competition (Why?)

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Because of product differentiation

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Nonprice competition

• Competition in ways other than pricing policies

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Non-price competition

A firm competes using advertising, packaging, product development, better service, rather than lower prices

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Price taker or price maker?

Product differentiation gives the firm some control over its price. Hence price maker.

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Some monopoly power due to

• Better service

• Greater range of product verities

• Slightly lower price

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Competitive and Monopolistic elements

• Many sellers of the differentiated product (competitive element)

• The product sold by each seller is somewhat different from the product sold by other seller (monopoly element)

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Demand curve for monopolistic competition

It is less elastic (steeper) than for a perfectly competitive firm and more elastic (flatter) than for a monopolist (Why?)

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Because of the availability of many close substitutes, the demand curve faced by a monopolistically competitive firm is highly elastic

-What is the implication?

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Product variation and Selling expenses

• Product Variation: Changes in some of the characteristics of the product

• Selling expenses: All those expenses that the firm incurs to advertise the product, increase its sales force, provide better servicing for its product etc

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Effectiveness and Effect of

Advertising

`Somewhat effective in the short-run but less effective in the long-run

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Effect of advertising on Average cost of

production

It raises the long-run average cost (LAC)

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2.001.501.00

.50

2 4 6 8

2.503.003.504.00

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The effect of Advertising on Costs

LAC2

Co

st p

er u

nit With advertising

Without advertisingLAC1

P

Q

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What price to charge and how many units

to produce?

MR = MC

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AC

MCMR=MC

DMR

ProfitAVC

P

Q

Profit in the short-run (P>MC)

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Can Monopolistically competitor make more than

normal profit in the long run?

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Why only normal profit in the long-run?

Leftward shift in the firm’s demand curve (why?)

&The upward shift in the LAC curve (why?)

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LAC

MC

DMR

In Long-run, only normal profit due to more selling expenses/advertisements (P=LAC)

AVC

P

Q

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Efficiency of monopolistic competition

Less resources are used and a higher price is charged than would be the case under perfect competition

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LAC

MC

DMR


AVC

Minimum LAC

P

Q

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LACMC

MRP

rice

& C

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per

un

itMinimum

LAC

Perfect CompetitionP

Q

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Summary

• Product differentiation

• Some monopoly power over price• More selling price

• More efficient than monopoly

• In the short run, above-normal profit

• In the long run, only normal profit due to competition

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Market Structure: Oligopoly

• Few sellers

• Either homogeneous or a differentiated product

• Difficult market entry

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Few sellers

• Few firms are so large relative to the total

market

• They can affect the market price

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Sources of oligopoly (barriers to entry)

Economies of scale

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Example

• Aluminum Industry in India• Bharat Aluminum Company

Limited and Hindalco accounting for 88 % of production

• Hindalco –one of the most cost-efficient producers globally

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Entry barrier…

• Huge capital investments and specialised inputs (automobiles, aluminum and steel etc)

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Entry barrier…

• A few firms may own a patent for the exclusive right to produce a commodity (eg: pharma firms, for instance)

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Entry barrier…

• Loyal customer base for established firms

• A few firms may own or control the entire supply of a raw material required in the production of the product

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Entry barrier…

• Limit pricingExisting firms charge a price low enough to discourage entry into the industry.

By doing so, they voluntarily sacrifice short-run profits in order to maximize long run profits

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Price Wars &Nonprice competition

Price competition- mostly price cut to compete

Competition in ways other than pricing policies (eg: more advertising)

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Nonprice competition

• Oligopolists usually prefer to compete on the basis of product differentiation, advertising, and services

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Example

• Pepsi vs Coca-Cola huge advertising campaign

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Distinguishing feature of oligopoly

Mutual interdependence or

Rivalry among a few firms in the industry

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Mutual interdependence

An action by one firm may cause a reaction on the part of other firms

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Example

• In Airlines Industry

• Telephone

• Soft drinks

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Pricing Behaviour

The way firm behave depends on how they think rival firms will respond to pricing strategy

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Pricing strategy models

Difficulty in predicting pricing behaviour

-Nonprice competition model -A kinked demand curve

model-Price leadership model-Cartel model

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Kinked demand curve model

Rival’s reactions

Rival firms will match a firm’s price decrease, but ignore a price increase

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Oligopolist’s Kinked Demand Curve

Rivals ignore price increase

Rivals match price cut

P

Q

Initial price & demand

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Pricing Strategy-Price Leadership-

They play the game “follow the leader” -- price leadership

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Price leadership

A pricing strategy in which a dominant firm sets the price for an industry and the other firms follow

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Price leadership

When a dominant firm in an industry raises or lowers price, other firms follow suit.

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CartelA group of firms formally agreeing to control the price and output of a product.

Cartel may behave like a monopoly

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Cartel

• Maximisation of joint profits• Sharing of the market by

agreement on quotas • Firms compete on non-price

basis• But, price wars starts when

any firm cheats

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Examples

• Organization of Petroleum Exporting Countries (OPEC)

• International Telephone Cartel (CCITT)

• International Airline Cartel (IATA)

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The major weakness of a cartel

Member firms cheating

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Summary

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Imperfect competition is the market structure between the extremes of perfect competition and monopoly Monopolistic competition and oligopoly belong to the imperfect competition category.

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Monopolistic competition is a market structure characterized by (1) many small sellers, (2) a differentiated product, and (3) easy market entry and exit. Given these characteristics, firms in monopolistic competition have a negligible effect on the market price.

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Product differentiation is a key characteristic of monopolistic competition. It is the process of creating real or apparent differences between products.

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Nonprice competition includes advertising, packaging, product development, better quality, and better service. Under imperfect competition, firms may compete using nonprice competition, rather than price competition.

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Short-run equilibrium for a monopolistic competitor can yield economic losses, zero economic profits, or economic profits. In the long run, monopolistic competitors make zero economic profits.

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Comparing monopolistic competition with perfect competition, we find that the monopolistic competitive firm does not achieve allocative efficiency,charges a higher price, restricts output, and does not produce where average costs are at a minimum.

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Oligopoly is a market structure characterized by (1) few sellers, (2) a homogeneous or differentiated product, and (3) difficult market entry. Oligopolies are mutually interdependent because an action by one firm may cause a reaction on the part of other firms.

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The nonprice competition model is a theory that might explain oligopolistic behavior. Under this theory, firms use advertising and product differentiation, rather than price reductions, to compete.

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The kinked demand curve is a model that explains why prices may be rigid in an oligopoly. The kink is established because an oligopolist assumes that rivals will match a price decrease, but ignore a price increase.

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Price leadership is another theory of pricing behavior under oligopoly. When a dominant firm in an industry raises or lowers price, other firms follow suit.

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A cartel is a formal agreement among firms to set prices and output quotas. The goal is to maximize profits, but firms have an incentive to cheat, which is a constant threat to a cartel.

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Comparing oligopoly with perfect competition, we find that the oligopolist allocates resources inefficiently, charges a higher price, and restricts output so that price may exceed average cost.

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PRICING PRACTICES

• Introduction

• Marginal Cost Pricing Rule

• Uniform Pricing vs Price Discrimination

• Multiple-Unit Pricing Strategies

Two-Part Pricing

Bundling

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PRICING PRACTICES…

• Markup- Pricing/ Cost plus Pricing

• Pricing of Multiple ProductsJoint product pricingTransfer pricing

• Summary

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Introduction

A pricing strategy aims to enlarge the customer base that the firm can sell to, and capture as much consumer surplus as possible.

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Introduction

Pricing without market power (perfect competition) is determined by market supply and demand.

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Introduction

• Perfectly competitive market

• MR=MC rule

• Price is set at marginal cost of production (P = MC)

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Introduction

• Firms with market power have the potential to earn large profits (Why?)

• But realizing that potential may depend critically on the firm’s pricing strategy.

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Introduction

• Pricing with market power (imperfect competition) requires the individual producer to know much more about the characteristics of demand.

• Characteristics of demand??

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Introduction

• The simplest way to set price is through uniform pricing.

• That is a seller charges the same price for every unit of the product.

• It is least profitable way to set a price

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Introduction

• The most profitable pricing policy is complete price discrimination (First degree PD)

• Every buyer is charged the maximum he/she is willing for pay for each unit

• Second degree & Third degree PD

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Multiple-Unit Pricing

• When products have different values for different customers, profits can be enhanced by using multiple unit pricing

• Multiple unit pricing can result in some combination of “per unit” and “lump sum”

Example: Two part pricing

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The Two-Part Pricing

The purchase of some products and services can be separated into two decisions, and therefore, two prices.

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Examples

1) Amusement Park

• Pay to enter

• Pay for rides and food within the park

2) Tennis Club

• Pay to join

• Pay to play

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• Charge all customers a fixed “membership” fee per month or per year, plus a per unit usage charge

• Choosing the trade-off between

Free-entry and high use prices or

High-entry fee and low user fee.

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Bundling Price

Practice of selling two or more products together for a single price.

Examples?

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Bundling

• Computer companies

• Car manufacturers (vehicle with AC, cassette decks etc)

• Hospitality sector (Room plus rent a car)

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Bundling

• Bundling is more common (why?)

• It requires less information about tastes and preferences of consumers (compared to price discrimination)

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Bundling

• Condition necessary for bundling

–Preferences of the consumers should be negatively related

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How bundling can increase profits? An Example

Two consumers A & B (Tourists) and their willingness to pay

Consumer Room Rent a Car

Type A Rs 800 Rs 400

Type B Rs 1200 Rs 200

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Example…

• If room charge is > Rs 800, consumer A will not stay in hotel

• If rent a car charge is > Rs 200, consumer B will not rent a car

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Example…

• So maximum separate price the company can charge is

Rs.800 for room

Rs.200 for rent a car

Then Total revenue from separate pricing

2 (800 + 200) = Rs. 2000

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Example• Suppose company follows

bundling room and car in a package deal

• Combination of room and car (Rs.800 + Rs 400 = Rs.1200)

• Combination of room and car (Rs.1200 + Rs 200 = Rs.1400)

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Example…

• Both consumers will opt both room & rent a car if company charge Rs. 1200

• Then Total Revenue = 2(Rs.1200) = Rs 2400

• By bundling, company earns an additional Rs.400.

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Peak-Load Pricing

Practice of charging a higher price for consumers who require service during period of peak demand and a lower price for those who consume during off-peak periods.

Example?

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Peak-Load PricingExamples…

• Pricing of long-distance telephone calls

• Higher price for peak-period calls

• Off-peak customers have to pay lower rates

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Electricity rates• Higher price per kilowatt-hour for peak

hours than for off-peak hours• Older and less efficient plants and

equipments have to be brought into operation to meet peak hour demand.

• The peak load pricing is different from third degree price discrimination (Why?)

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Because higher peak hour electricity rates are based on higher costs of generating electricity at peak hours.

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Conditions for peak-load pricing

• Demand characteristics vary from period to period

• The product or service is not storable

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Markup pricing or Cost plus pricing

• Most commonly used pricing method

• Prices are set to cover all direct costs plus a percentage markup for profit contribution

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Markup pricing

• This method requires less precise data than MR=MC rule

• Cost-plus pricing provide a clear justification for price increase when costs rise

• Simple and easy to use

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Markup pricing

Markup on cost

• Difference between price and cost, measured relative to cost, expressed as a percentage

• Markup on cost = Price - Cost/Cost

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Markup pricing

Firms usually apply higher markups to products facing inelastic demand than to products with elastic demand (Examples?)

Grocery business (price elasticity is very high). So markup on cost will be lower

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Criticisms

• Cost plus pricing is based on the average cost of production rather than MC

• Does not take demand conditions into account

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Pricing of Multiple ProductsJoint products

• More complex than pricing for single product

• There are two demand curves

• Demand curve could be different

• Demand for one good may be more elastic than other

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Pricing of joint products

• In single product case, price is set by following MR=MC

• If two goods are assumed to be jointly produced in fixed proportions, then calculate the marginal revenue from good A and marginal revenue from good B. Sum the marginal revenues and equate it with joint cost of production, MC.

• Profit maximising rule is MR1 + MR2 = MC• Then we can estimate the the optimal

quantity which maximises profit

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Transfer pricing (TP)

• Pricing of intermediate goods by vertically integrated firms

• Many large firms sell their products to another division

• Intermediate goods: materials that will be needed as inputs at a later stage of the firm’s operations

• TP is about pricing of goods and services within a multi-divisional organisation

• For example: Selling of goods from production division to marketing division

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Transfer pricing

• Parent company to foreign subsidiary division

• Each division of the firm has its own function and its own management

• Choice of price depends on tax level in the country

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Transfer pricing

• Firms use transfer pricing to shift profits from division to division to minimize tax liability

• Usually companies show that most of the profit is made in a country with low taxes

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Transfer pricing

• Pricing and profit maximization decision when there is

-External MarketThe division making the intermediate goods can

sell it buyers outside the firm. If there exists perfect competition, then apply P = MC rule

-No external marketThe intermediate good can be bought and sold

only between the divisions of the firm. In this case there is no market determined price for the product

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Transfer pricing

• If the divisions are not allowed to trade with other firms, a conflict may arise regarding the proper price to be charged

• If a higher price is set by the division which sells intermediate good, that division may benefit more.

• For buying division, it is input for final product and they benefit from a lower price.

• So price is a determining factor

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Transfer pricing

• The goal of the top management is to determine the price for the product that results in maximum profit for the combined firm

• There will be two types of costs:• Marginal cost incurred by division that

produced intermediate good and • marginal cost incurred by the division that

produced final product using intermediate good

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Transfer pricing

• Thus for the combined firm, the profit maximising choice is to produce where MR from final product is equal to combined MC. That is MC of producing both intermediate good and marginal cost of transforming the intermediate good into final good.

• MR (final product) = MC(Inter) + MC (trans)

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Summary

• Pricing is important in management decision making

• Some goods are jointly produced in fixed proportions. Profit maximisation requires that the two goods be considered as a product package.

• Price discrimination occurs when variation in price for a product sold in different markets does not correspond to differences in cost

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Summary

• Product bundling is a pricing strategy that allows firms to capture part of the consumer surplus.

• Pure bundling involves the selling of two or more products only as a package.

• Cost-plus or markup pricing is widely used by firms.

• This practice involves setting price at average cost (AC) plus a markup designed to provide a target rate of return.

mono comp eption, oligopoly, pricing

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