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Market structures

The objective
Learn

about market formation

How

decisions of price and output


are taken in the markets

Pricing

strategies

The Coverage
Price and output determination in

various market structures perfect


competition, monopoly, monopolistic
competition, oligopoly
Pricing strategies for firm with market
power- price discrimination
A comparison of market structures for
efficient production and equitable
distribution

Four basic components of


market
1. Consumers
3. Commodity

2. Sellers
4. Price

Market classification
By the area
By the nature of transaction
By the volume of business
By the nature of competition

Competition in the market


Depends on
Number and size distribution of sellers
Number and size distribution of buyers
Product differentiation
Conditions of entry and exit
Structure
Conduct
Performance

A classification of market forms


Form of Market
Structure

Number of
Firms

Nature of Product

Price
elasticity of
demand for

Degree of
control

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

Perfect competition
Infinite buyers

and sellers
Perfect
knowledge and
information
Identical
products
No barriers on
entry or exit

Maximum profits
or minimum
losses
No transportation
cost
All are price
takers

Types of firms
Efficient (least cost) and profit
making firms
Efficient but breaking even firms
Inefficient but operating firms
Inefficient and closing down firms

Perfect competition and


the public interest
P = MC
Competition as spur to efficiency
Development of new technology
Economical use of national
resources
Least cost Q in long run (LR)

Monopoly
One seller
Barriers on entry
No substitutes

Market power
Through elasticity of demand
Learner (Abba) index = P MC/P or
MR = P(1+1/E)
Learner index = -1/E
Cross price elasticity of demand

Acquiring market power


Economies of scale
Product differentiation and brand loyalty
Ownership of, or control over, key factor
and/or wholesale or retail outlets
Consumer lock in- high search, switching and
initiation cost
Legal protection
Network externalities products value rises
as more consumers use it.
Mergers and takeovers
Aggressive tactics

Monopoly and the public


interest
Disadvantages Higher price and

lower output, possibility of higher


cost due to lack of competition,
unequal distribution of income
Advantages Economies of scale,
lower
cost,
competition
for
corporate control, innovation and
new products

Deadweight loss a measure of the


aggregate loss in well-being of the
participants in a market resulting from
an inefficient output level.

Monopolistic competition
Many alternative suppliers
Differentiated product
Easy entry
(e.g.
cosmetics,
medicines, grocers,
restaurants)

detergents,
barbershops,

Oligopoly
Few interdependent sellers
Standardized
or
differentiated
oligopoly
Restricted entry
(e.g.
steel,
aluminum,
fertilizes, petrol and cars).

cement,

Oligopoly in different
forms
Kinked demand curve
Collusive oligopoly
Price leadership
Joint profit maximizing cartel
Market sharing cartel

Kinked demand curve


model

Factors favoring collusion


Few firms well known to each other
They are not secretive
Similar production methods and AC and
want to change price at the same time
Similar products
Significant barriers to entry
Stable market
No government measure to curb collusion

Dominant firm

Price leadership
Joint profit maximizing cartel
Market sharing cartel

Case - OPEC: the rise and fall of a


cartel
OPEC set up in 1960 by Saudi Arabia,
Iran, Iraq, Kuwait and Venezuela.
Objectives
The co-ordination and unification of
the petroleum policies of member
countries
The organization to ensure the
stabilization of prices, elimination of
harmful and unnecessary fluctuation
in the price and quantity

OPEC
OPEC is a joint profit maximizing
cartel
Saudi Arabia is a dominant
producer and price leader within
the cartel

OPEC
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.
1973 thirteen members transfer of
powers, OPEC makes decisions on oil
production and thereby determining oil
revenues.
1970s setting market price for Saudi
Arabian crude and OPEC members to set
their prices in line dominant firm price
leadership

OPEC
As long as demand is price inelastic this

policy allowed large P


TR
1973-74 Arab-Israeli war, OPEC raised
price $3 per barrel to over $12 until 1979
and sales did not fall.
After 1979 price $15 to $40 per barrel
demand did fall
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

OPEC

Cartel was beginning to break down due


to
- world recession
- growing output from non-OPEC members
- cheating by some OPEC members who
exceeded their quota limit
The trend of lower oil prices was
reversed in the late 1980s due to boom
1990 Iraq invaded Kuwait Gulf war
supply of oil fell
P
End of war and recession of 1990s the
price fell again - $ 16

Other cartels
During mid-1970s International Bauxite
Association (IBA) quadrupled bauxite
prices
A secretive international uranium cartel
pushed up uranium prices
From 1928-1970s Mercurio Europe kept
the prices of mercury close to monopoly
levels
A cartel monopolized the iodine market
from 1878-1939
Tin, coffee, tea and cocoa cartels failed

Pricing Strategies for Firm


With Market Power

Pricing decisions
How do we set prices relative to costs?
How do we change them?
To what extent should we try to
protect our market?
Strategy to lead to the highest profit
rate.
Lowering prices in response to
potential competition.

Strategies that yield even


greater profits
Extracting
Surplus
consumers
Price discrimination
Two part pricing
Block pricing
Commodity bundling

from

Price discrimination
Meaning
Changing different prices for the same

product
Charging same price for different
products when costs differ.
Possibility of differences in
financial status
educational status
age of the customer
time of purchase

First degree price discrimination


(unit wise)
Meaning
Charging each consumer one maximum
price, he or she is willing to pay for each
unit. Extracting all consumer surplus and
earning maximum profit.
Requirement
- full information
regarding consumers
Application - service related business
mechanics,
doctors,
lawyers,
professionals etc.

Second degree price


discrimination (Lot wise)
A

practice

of

posting

schedule

of

declining

different

ranges

of

discrete

prices

for

quantities.

Extracting part of the surplus, lower


profit.

Third degree discrimination


(Market wise)
Charging different groups of consumers
different prices for the same product.
Essential conditions

Different elasticity of demand - students


discount, senior citizen discount

Information

regarding

demand

Separate markets

elasticity

of

Price discrimination
Essential conditions
Separate markets

Different elasticity of demands


MC
9

7
5

DX

MRX

MRX

DX

MRT

3000 Q
0
2000
1000
Q 0
Q
a) Market X
b) Market Y
c) Total (market X+Y)
Profit-maximizing output under third-degree price discrimination

Two part pricing


Initially a fixed fee for the right to
purchase its goods, plus a per unit
charge for each unit purchased.
Examples - athletic clubs, golf
courses, health clubs
Initiation (fixed) fee plus monthly
or per visit charges.

Block pricing
All or none decision
Block pricing provides a means by
which the firm can get one consumer
to pay the full value of the blocked
units.
Consumers decision - buying all
units (blocked) or buying nothing.
(hiring a bus, a pack of three soaps)

Commodity Bundling
Bundling two or more different products and selling
them at a single bundle price.
Example - travel companies package deal,
computer, monitor, software deal

Consumer Valuation of
computer
1
20,000/-

Valuation of
monitor
2,000/-

Total
22,000/-

15,000/-

3,000/-

18,000/-

Total

35,000/-

5,000/-

40,000/-

Pricing strategies for special cost


and demand structures
Peak load pricing
Cross subsidies

Peak load pricing


Markets having high demand and low
demand periods.
Example - road, train, air, electricity,
telephone. No problem of resale.
Commodity must be consumed as it is
purchased.

Peak-load pricing
Objective- to reduce costs and increase
profits if
the same facilities are used to provide a
product or service at different periods
of time.
the product or service is not storable.
demand characteristics vary from
period to period.
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.

Case - Central Electricity


Generating Board, UK (CEGB)
High demand - morning & evening
Moderate - throughout rest of the day
Very little - night
Extra power stations for peak load capacity cost. Stations idle rest of the
day and therefore high MC.
Charge different prices.
Group,
capacity
limitation,
price
discrimination

Peak load pricing(cont)


CEGB combining peak load pricing and two part

tariff
CEGB uses less efficient power stations during
peak load hours MC
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
1986-87 - Complex structure of energy charges
1.4 pence/KWh at night during weekends
3.8 pence/KWh at breakfast time on week days
Further surcharge of 2.5 pence/KWh (hourly)
during heaviest demand.

Case - Computer time and peak


load pricing
Three criteria
1. Usually a computer has only a single
CPU but is in constant use. Same facility
to provide the service at different
periods of time.
2. CPU time not used is lost forever i.e.
service is not storable.
3. Center may provide same service at
different times, late -night service is not
desirable.

Prices at university computer facility


DAY
Mon. - Fri
Mon. - Fri
Mon. - Fri
Mon. - Fri
Sat. - Sun.
Sat. - Sun.

TIME
PERIOD
8 AM - 1 PM
1 PM - 5 PM
5 PM - 1 AM
1 AM - 8 AM
8 AM - 5 PM
5 PM - 8 AM

COST PER
MIN.(Rs.)
3
6
1
0.2
1
0.2

Case
Peak load pricing of Computer time

CPU
Usage
After pricing

Before pricing
Time of Day
Midnight

6 AM

Noon

6 PM

Midnight

Cross subsidies
A strategy which uses profits made with one
product to subsidize sales of another
product
Relevant in situations where a firm has cost
complementarities and demand for a
product independence
Economies of scope - saving in producing
jointly or using excess capacity to produce
another products
Example - computer & software

Advantage
It permits the firm to sell multiple
products.
If the two products have
independent demands, the firm
can induce consumers to buy
more of each product than they
would otherwise.

Pricing strategies in markets with


intense price competition

1.
2.
3.
4.
5.

Limit pricing
Pricing joint products
Price matching
Inducing brand loyalty
Randomized pricing

Limit pricing
Reduce price to discourage the
entry of new firms- initially enjoy
profit and face competition.
Increasing
returns
to
scale
provides cost advantages for large
firms.

Limit pricing
Used when
To influence expectations of entrants
To protect margins
Entrants have limited information of
market.
Present V/s future prices.
Convince new firms of low cost and
charge less.
Give misleading information

Pricing Joint Products


When goods are produced jointly
and in fixed proportion, they
should be thought of as a product
packages

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.

Inducing Brand Loyalty


Brand loyal customers will continue to
buy a firms product even if another firm
offers a slightly better price.
To induce brand Loyalty
engage in advertising compaign
give incentives

Randomized pricing
A firm varies its prices frequently hour to hour or day to day

Case - Randomized pricing in the


airline industry
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 Deltas
more than 70,000 fares. New fares filed
the prior day with Air Traffic Publishing Co.
are tracks by Delta computer.

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.
Why do airlines take such drastic
measures to learn the prices set by their
rivals?
Why do airfares change so frequently?
Source - Marius Schwartz, the nature and
scope of contestable theory Oxford

Thank you and all the best

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