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Unit III
Unit III
Market
Defined as the institutional relationship between buyers and sellers.
Market refers to the interaction between buyers and sellers of a
good (or service) at a mutually agreed upon price.
◦ Such interaction may be at a particular place, or maybe over the telephone,
or even through the Internet!
Sellers and buyers may meet each other personally, or may not ever
see each other, as in E-commerce.
Thus, the market may be defined as a place, a function, and a
process. 2
Typology of markets
Number of buyers
A few oligopoly
Monopolistic/
Many monopsony
Perfect
Competition
MARKET STRUCTURES AND PRICING
4
Market Morphology
Markets may be characterized on the basis of:
Number, size and distribution of sellers in any market
Whether the product is homogeneous or differentiated
Number and size of buyers:
large number of buyers but small size of individual buyer, the market will be evenly balanced between buyers and sellers.
small number of buyers but their size is large, the market is driven by buyers’ preferences.
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Types of
Monopoly
Legal Monopoly
Created by the laws of a country in the greater public interest.
Economic Monopoly
Created due to superior efficiency of a particular player.
Natural Monopoly
Formed when the size of the market is so small that it can
accommodate only one player.
Regional Monopoly
Geographical or territorial aspects also help in creation of monopolies.
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Price and Output Decisions in Short Run
Price, AR>AC
Revenue, MC
In order to maximize profit a monopoly Cost
B AC
firm follows the rule of MR=MC when P E
MC is rising.
A
A monopoly firm may earn supernormal E AR
profit or normal profit or even MR
subnormal profit in the short run. O Q
E Quantity
In the short run, the firm would reap
the benefits of supplying a product
which unique. Firm maximizes profit where
(i) MR=MC (ii) MC cuts MR from below, at
point E.
Supernormal profit= AEBPE,
since price (AR) > AC 10
Price and Output Decisions in Short Run
Price,
Revenue, AR=AC Price, AR<AC
Cost Revenue,
MC Cost MC AC
AC
A B
PE B PE C
E
E AR
AR MR
MR
O QE O QE Quantity
Quantity
Discrimination among buyers on the basis of the price charged for the
same good (or service).
Preconditions of Price Discrimination
Market control
Market imperfection and control are necessary
Division of market
when the whole market can be divided into various segments, and
transfer of goods between the markets is not possible, i.e., paying
capacity, demography.
Different price elasticities of demand in different markets
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13
Bases of Price Discrimination
Personal
On basis of the paying capacity and/or the intensity of needs.
Geographical
People living in different areas are required to pay different prices for
the same product.
Time
The same person may be required to pay different prices for the same
product, e.g. off season discounts.
Purpose of use
Customers are segregated on basis of their purpose of use.
E.g. electricity rates are lower for domestic purpose and higher for industrial purpose.
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14
Degrees of Price Discrimination
Pigou has identified three degrees of price discrimination.
First Degree
Seller is able to charge different prices for different units of the same product from the
same consumer.
Joan Robinson referred to it as perfect discrimination.
Second Degree
Divides consumers in groups on the basis of their paying capacities; a person with lower
paying capacity is charged a lower price and vice versa
Third Degree
Segregates consumers such that each group of consumers is a separate market, and
charges the price on basis of price elasticity of different groups.
Different rates of ticket for different seats in theatre.
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15
Features of Monopolistic Competition
Chamberlin:
“Monopolistic competition is a challenge to the traditional viewpoint of economics
that competition and monopoly are alternatives…By contrast it is held that most
economic situations are composites of both competition and monopoly.”
Features:
Large number of buyers and sellers:..
◦ Heterogeneous products.
◦ A differentiated product enjoys some degree of uniqueness in the mindset of customers, be it
real, or imaginary.
◦ Selling costs exist.
◦ Independent decision making. •Imperfect knowledge.
•Unrestricted entry and exit.
Price and Output Decisions in Short Run
Price,
Revenue,
Cost M
C A Total revenue = OPEBQE
C
PE B Total cost =OAEQE
A E Supernormal profit =APEBE
AR since price OPE > OA
MR (AR>AC)
O
QE Quantity
Price & Output Decisions in Short Run
Firm maximizes profit where (i) MR=MC; (ii) MC cuts MR
when MC is rising.
Profit maximising output OQE and Price OPE
Price,
Revenue,
Cost M
C Total revenue = OPEBQE
A
A E
C Total cost =OAEQE
PE B
Loss =APEBE
AR since price OPE < OA
MR
(AR<AC)
O
QE Quantity
Price & Output Decisions in Long Run
Firm maximizes profit where (i) MR=MC; (ii) MC cuts MR
when MC is rising.
Profit maximising output OQE and Price OPE
Price,
Revenu
e, Cost M
C Total revenue = OPEBQE
A
C Total cost =OAEQE
PE B
Normal profit = No loss
no gain
AR since AR=AC
MR
O
QE Quanti
ty
Price & Output Decisions in Long Run
•Just like perfect competition, in monopolistic competition
too all the firms would earn normal profits in the long run.
•In the long run supernormal profit would attract new
firms to the industry till all the firms earn only normal
profits.
•Losses, will force firms to exit the industry till
remaining firms in the market earn only normal profits.
•If all the firms earning only normal profit there will be no
tendency to enter or exit the market.
Features of Oligopoly
Number of firms in the industry: Lower the number of firms in the industry, the
easier to monitor the behaviour of other members.
Nature of product: Formed in markets with homogenous goods rather than
differentiated goods, to arrive at common price. But if goods are homogeneous,
an individual firm may gain larger market share by cheating, i.e. by lowering the
price.
Cost structure: Similar cost structures make it easier to coordinate.
Characteristics of sales: Low frequency of sales coupled with huge amounts of
output in each of these sales make cartels less sustainable, because in such cases
firms would like to undercut the price in order to gain greater market share.
◦ with large number of firms and small size of the market some firms may
deviate from the cartel price and thus cheat other members.
Price Leadership
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Loss Leader
Loss Leader
Goods/services deliberately sold below cost to encourage
sales elsewhere
◦ Typical in supermarkets, e.g. at Christmas, selling bottles of gin
at `300 in the hope that people will be attracted to the store
and buy other things
Purchases of other items more than covers ‘loss’ on item
sold
Psychological Pricing
Psychological Pricing
Used to play on consumer perceptions
Classic example - `499!
Links with value pricing – high value goods priced
according to what consumers THINK should be the price
Going Rate (Price Leadership)
Going Rate (Price Leadership)
In case of price leader, rivals have difficulty in competing on price
– too high and they lose market share, too low and the price
leader would match price and force smaller rival out of market
May follow pricing leads of rivals especially where those rivals
have a clear dominance of market share
Where competition is limited, ‘going rate’ pricing may be
applicable – banks, petrol, supermarkets, electrical goods – find
very similar prices in all outlets
Tender Pricing
Tender Pricing
Many contracts awarded on a tender basis
Firm (or firms) submit their price for carrying out
the work
Purchaser then chooses which represents best
value
Mostly done in secret
Price Discrimination
Price Discrimination Charging a different price for
the same good/service in
different markets
Requires each market to be
impenetrable
Requires different price
elasticity of demand in each
market
Prices for rail travel differ for the same journey
at different times of the day
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Destroyer Pricing/Predatory Pricing
Destroyer/Predatory Pricing
Deliberate price cutting or offer of ‘free gifts/products’
to force rivals (normally smaller and weaker) out of
business or prevent new entrants
Anti-competitive and illegal if it can be proved
Absorption/Full Cost Pricing
Absorption/Full Cost Pricing
Full Cost Pricing – attempting to set price to
cover both fixed and variable costs
Absorption Cost Pricing – Price set to ‘absorb’
some of the fixed costs of production
Marginal Cost Pricing
Marginal Cost Pricing
Marginal cost – the cost of producing ONE extra or ONE fewer
item of production
MC pricing – allows flexibility
Particularly relevant in transport where fixed costs may be
relatively high
Allows variable pricing structure – e.g. on a flight from London to
New York – providing the cost of the extra passenger is covered,
the price could be varied a good deal to attract customers and fill
the aircraft
Marginal Cost Pricing
Example:
Aircraft flying from Delhi to Mumbai– Total Cost
(including normal profit) = `1,50,000 of which `1,30,000 is
ly
on
fixed cost*
s
ate
Number of seats = 160, average price = `937.5
tim
es
re
MC of each passenger = 20,000/160 = `125.0
a
es
ur
If flight not full, better to offer passengers chance of flying
fi g
ll
at `125.0 and fill the seat than not fill it at all!
*A
Contribution Pricing
Contribution Pricing
Contribution = Selling Price – Variable (direct costs)
Prices set to ensure coverage of variable costs and a
‘contribution’ to the fixed costs
Similar in principle to marginal cost pricing
Break-even analysis might be useful in such
circumstances
Target Pricing
Target Pricing
Setting price to ‘target’ a specified profit level
Estimates of the cost and potential revenue at
different prices, and thus the break-even have to be
made, to determine the mark-up
Mark-up = Profit/Cost x 100
Cost-Plus Pricing
Cost-Plus Pricing
Price Elastic:
% change in quantity demanded > % change in price
e.g. A 4% rise in price would lead to sales falling by something
more than 4%
Revenue would fall
A 9% fall in price would lead to a rise in sales of something more
than 9%
Revenue would rise
Multi Product Pricing/ Product Line Pricing
Demand Interdependence: A firm may produce goods which can
either be substitutes or complementary in demand.
In case of substitutes, Seller has two options:
◦ Charge the same price for the two goods or
◦ Differentiate the products from each other and take advantage of perceived
value pricing.
In case of complements, suitable strategy would be either
◦ Product bundling or
◦ Loss leader, depending upon company’s objective and market conditions.
Multi Product Pricing/ Product Line Pricing
Supply (or Production) Interdependence: Some goods are jointly
produced as an outcome of production process.
The firm has to first decide whether to sell only the primary
product or both the products.
For the primary product it can adopt any of the pricing strategies
depending upon the market structure or life cycle stages of the
product.
Alternatively it may adopt full costing for the primary product and
marginal costing for the joint product.