Module 4

Market structure and pricing practices

1) A large number of buyers and sellers

There exist a large number of buyers and sellers in a perfectly competitive

market. The number of sellers is so large that no individual firm owns the
control over the market price of a commodity.

Due to the large number of sellers in the market, there exists a perfect and free
competition. A firm acts as a price taker while the price is determined by the
‘invisible hands of market’, i.e. by ‘demand for’ and ‘supply of’ goods. Thus,
we can conclude that under perfectly competitive market, an individual firm is
a price taker and not a price maker.

2) Homogenous products

All the firms in a perfectly competitive market produce homogeneous

products. This implies that the output of each firm is perfect substitute to
others’ output in terms of quantity, quality, colour, size, features, etc. This
indicates that the buyers are indifferent to the output of different firms. Due to
the homogenous nature of products, existence of uniform price is guaranteed.
3) Free exit and entry of firms

There is free entry and exit of firms. This ensures that all the firms in the long-
run earn normal profit or zero economic profit that measures the opportunity
cost of the firms either to continue production or to shut down. If there are
abnormal profits, new firms will enter the market and if there are abnormal
losses, a few existing firms will exit the market.

4) Perfect knowledge among buyers and sellers

Both buyers and sellers are fully aware of the market conditions, such as price
of a product at different places. The sellers are also aware of the prices at which
the buyers are willing to buy the product. The implication of this feature is that
if any individual firm is charging higher (or lower) price for a homogeneous
product, the buyers will shift their purchase to other firms (or shift their
purchase from the firm to other firms selling at lower price).
5) No transportation costs

In the perfectly competitive market, the costs for transporting goods,

services or factors of production from one place to another is either
zero or constant for all sellers.

6)Absence of Artificial Restrictions – There is no interference from the

government or any other regulatory body to hinder the smooth
functioning of the perfect competition. There are no controls or
restrictions over the supply or pricing and the price can change solely
based on the demand and supply conditions.
How is the price determined in a perfectly competitive
market with a fixed number of firms/ in the short run?

When the number of firms in a perfectly competitive

market is fixed, the firms are operating in the short-run.
The equilibrium price is determined by the intersection
of market demand curve and supply curve. It is the price
at which the market demand equals market supply.
In the given figure, if at any price above Pe, let us say Rs 12,
there will be an excess supply, which will increase the
competition among the sellers and they will reduce the price in
order to sell more output. This causes a fall in the price, finally
to Rs 8 (Pe), where the demand equals supply.

If at any price lower than Pe , let us say Rs 2, there will be an

excess demand that will raise the competition among the buyers
or consumers and they will be ready to pay higher price for the
given output. This will increase the price to Rs 8 (equilibrium
price), where the market will reach the equilibrium.

Thus, the invisible hands of market operate automatically

whenever there exist excess demand and excess supply; ensuring
equilibrium in the market.
 Long run equilibrium in a perfectly
competitive market

In order to attain long run equilibrium in a perfectly competitive marketYou need to make
sure that the marginal revenue is equal to the marginal cost (MR = MC).

If MR> MC, the Company has an incentive to expand production and sell additional units.

If MR<MC, the Company needs to reduce production because additional units generate
more costs than revenue.

Only when MR = MC does the Company achieve maximum profit.

 AR=MR in Perfect Competition
consider a firm which is selling an agricultural product
in a perfectly competitive market (such as wheat) at a
price of Rs. 3 per tonne. Since price remains fixed, TR
rises by Rs. 3 for every tonne sold. Since every unit
brings in Rs. 3, the AR per unit sold is surely Rs. 3.
Moreover; since each additional unit sold brings in Rs.
3, the MR of an extra unit sold is also Rs. 3.
i.e, AR=MR
Example for monopolistic competition are:-
Bakery shops
Laundry detergents
Tooth pastes
Tooth brushes
Soaps
Shampoos
i. Large number of buyers and sellers - There are a large number
of buyers and sellers in a monopolistic market.
ii. Differentiated product - Products of a firm are slightly different
from those of other firms, but they are close substitutes. Product
differentiation is achieved through brand name, trade mark and
advertisements.
iii. Selling cost - The need of the selling cost arises due to the sole
aim of differentiating products. It is through the help of
advertisements that a monopolistic firm tries to convince the
consumers by distinguishing its product from its substitutes on
qualitative basis.
iv. Free entry and exit of firms - The firms in the monopolistic
market enjoy the freedom of free entry and exit from the market.
However, at times, because of legal barriers and patent rights, a
new firm cannot enter the market.
v. Elastic demand curve- The demand curve faced by the firms
is highly elastic and slopes downwards. This is because of the
availability of close substitute products.
 PRICE DETERMINATION AND DEMAND CURVE
UNDER MONOPOLISTIC COMPETITION

Under monopolistic competition, large number of firms selling closely related but
differentiated products make the demand curve downward sloping. It implies that a
firm can sell more output only by reducing the price of its product.

In this kind of market, every company is responsible for determining the pricing of
their own items.As a result, it has a downward sloping demand curve.
Monopoly
The monopolist can either fix the price or fix supply, he cannot determine
the both". Explain this statement and show how a monopolist fixes the
price of his product. (From previous QP)

In theory a monopolist could pick the price and the amount to supply
(quantity); however, the point of this question is to say “in equilibrium”
they can only choose one. The key to this statement is that being a
monopolist does not make you immune to the Law of Demand.

When a monopolist picks a price, consumers then determine (based on

demand) the amount that they are willing to purchase at that price. If
the monopolist sets too high of a price for amount of product brought
to market, then a surplus of product will exist. Producing too much
product is an unnecessary cost if you can’t sell it, so the monopolist
would restrict their quantity supplied to however much product they
can sell at the price point chosen. Hence, they don’t “pick” how much
to supply of the product, but quantity demanded decides for them.
Relationship between AR and MR in monopoly (
FromUnder
previous QP)
monopoly, AR and MR curves slope downwards, and
MR curve lies below AR curve.
This is because, in a monopoly market, the monopolist can
only sell more output by lowering the price. AR curve
remains above MR curve only when price falls with rise in
output. If price remains same, then both AR and MR curves
coincide in a horizontal straight line parallel to the X-axis.
Thus, the MR curve lies below the AR curve and is twice as
steep.
Oligopoly examples
News Media
Smartphones
Funeral Services
Air Transportation
Cellular Networks
Social Media
A kinked demand curve is a demand curve that is not a
straight line but has a different elasticity for higher and
lower prices.
Firm A wants to make more revenue, so they increase their price from P to P1. In
this oligopoly market, other firms will not follow it. They keep their prices at P. This
means that Firm A will lose. Why? Because other firms have not increased their
price, and Firm A will lose customers to the other firms. Therefore, their demand
curve is elastic because there are substitutes within the market offering a better
price. Firm A loses too many customers and makes less revenue than before.

Firm A then decides to decrease its price so it can attract more customers and
increase its market share. However, the other firms will not let Firm A get away with
this so easily. They will also decrease their prices to P2. So what does Firm A
actually get in return? Not much - only a few more customers because some of the
other customers went to the other firms. This is why the demand curve is inelastic.
This out come has just led to a price war. So, Firm A has decreased its price, only to
get a very small return. It will end up losing revenue again.

This leads to Firm A ultimately deciding to remain at point A because the other
options it has in terms of pricing strategy, lead to lower revenue.

The kinked demand explains why so many oligopoly firms compete on a non-price
basis (non-price competition).
This explains the interdependence of firms within an
oligopoly market, because firms' decisions are made taking
into account the potential decisions of other firms.

The firms in an oligopoly market are like players in a game.

Take for instance a chess game. When one player makes a
move, he/she has to take into account the potential moves of
the other player before they even make their own.
Examples of Cartel;-
OPEC (Organization of the Petroleum Exporting
Countries)
Drug cartels
International sugar producers
International Coffee growers
 Types of price leadership
1. Barometric price leadership:
In this type of price leadership, a leading firm sets the price
based on its market knowledge and expertise.
The firm closely monitors market conditions, demand-
supply dynamics, and competitor behavior to determine the
optimal price level.
Other firms in the industry then follow it, considering the
leading firm's pricing decisions as a barometer for market
trends.
E.g: Unilever, Kellogg’s, Coca-Cola
2. Collusive Price Leadership:

Collusive price leadership occurs when firms in an

industry collaborate to set prices collectively. This type
of price leadership often involves formal or informal
agreements among competitors to coordinate their
pricing strategies.
By working together, these firms can stabilize prices,
avoid price wars, and maintain profitability.
3. Dominant Firm Price Leadership:

In industries with a clear market leader, the dominant firm can

exert its influence by setting the price levels.

The dominant firm's pricing decisions are typically followed

by other firms, either due to market dynamics or the
perception of the dominant firm's expertise.

This type of price leadership is often seen in industries with

high barriers to entry or where economies of scale play a
significant role.
E.g: Airline Industry
 Barometric Vs Dominant Price leadership

Barometric price leadership is when one company is seen as a

'barometer' for the market and sets prices based on its market
predictions, while dominant price leadership occurs when the
company with the largest market share or control dictates prices that
others in the industry follow.
4. Cost-Based Price Leadership: Cost-based price
leadership involves setting prices based on cost
considerations.
The leading firm in the industry determines the cost
structure and sets prices that cover its costs while
maintaining a competitive edge.
Other firms then align their pricing strategies based on
the cost-based price leadership, ensuring they remain
competitive in the market.
E.g: IKEA, McDonald’s
 Different types of games
1. Cooperative and Non-Cooperative Games:
Cooperative games are the one in which players are convinced to adopt
a particular strategy through negotiations and agreements between
players.
A popular example of this concept is the prisoner’s dilemma.

A classic example of the prisoner's dilemma in the real world is

encountered when two competitors are battling it out in the marketplace.

The Prisoner's Dilemma is a classic game theory scenario that illustrates

the conflict between individual and collective interests. In oligopoly
markets, it represents the strategic decision-making process firms face
when choosing between cooperation and competition.

The prisoner’s dilemma refers to a paradox in the decision-making and

modern game theory that exemplifies how two rational individuals
trapped in the same situation are likely to respond to it without knowing
other’s take on the same. They either act in their self-interests or refuse
to cooperate, leading to a sub-optimal or non-optimal outcome.
Suppose the police arrested two individuals, Jimmy and Ben,
for a crime. The prosecutors did not have enough evidence to
convict them. Hence, the officials decided to question them
in separate chambers to get a confession. They presented
these four deals to the arrested individuals.
 zero sum vs non zero sum game
In a Non-Zero-Sum Game, all parties could gain, or all parties could
lose. This is in direct contrast to a Zero-Sum Game where one party's
win necessitates another party's loss, such as in competitive games
like basketball, where if one team wins, the other automatically loses.
A static game is one static
in whichgame
a single decision is made by
each player, and each player has no knowledge of the
decision made by the other players before making their
own decision. Decisions are made simultaneously.

Schooling is generally a static game. Just because someone

else got an A on a test, does not make it any more or less
likely that you will get an A.
 Dynamic Games
In dynamic games:
• players move either sequentially or repeatedly
• players have complete information about payoff
functions
• at each move, players have perfect information about
previous moves of all players
Dynamic games are analyzed in their extensive form,
which specifies
• the n players
• the sequence of their moves
• the actions they can take at each move
• the information each player has about players’
previous moves
• the payoff function over all possible strategies
An example of dynamic games is an entry game. Consider
two firms, an incumbent and a potential entrant.
The potential entrant plays first and decide whether to
enter (E) the market or to stay out of it (O). If the entrant
decided to enter, the incumbent can choose either to fight
them or to accommodate .
 Nash
A Nash equilibrium is aequilibrium
situation where no player could
gain by changing their own strategy (holding all other
players' strategies fixed).
Suppose every player in a non-cooperative game reveal
their strategy to one another. If no player changes their
strategy after knowing this information, then a Nash
equilibrium exists.
Imagine a game between Tom and Sam. In this simple
game, both players can choose strategy A, to receive
$1, or strategy B, to lose $1. Logically, both players
choose strategy A and receive a payoff of $1.
Pricing approaches
Suppose it costs a furniture manufacturer $200 to
make a chair, factoring in both direct and indirect costs.
If the company wants a profit margin of 25%, it would
add a markup of $50 (25% of $200) to the cost. The
selling price for the chair would thus be set at $250.
 Product line pricing
A pricing strategy where a company offers a range of products or
services at different price points, with each product having a distinct
set of features and benefits.
Pricing Strategies
Pricing Strategies
 Loss Leader Pricing Strategy
Loss leader strategy is the process of selling the company’s
product/service at a price lower than its cost, without profit. Loss
leader pricing strategy serves two purposes; first is to attract new
customers, and the second is to finish the inventory or additional
products.
Businesses want to gain the maximum market share; in the
beginning, that’s why they penetrate the market with a loss leader
pricing strategy. It’s for the big companies because they can afford
no profit at a new product line. On the other hand, it’s a risky
pricing strategy for small businesses.
Microsoft’s Xbox, video gaming product initially sold its product at
a very low price because the management had the confidence in
its product that it would create the customers’ market, and it
would attract more customers and more profit ultimately.
 Peak load pricing
Peak load pricing is a pricing strategy in which businesses charge
higher prices during periods of high demand.