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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

One A few Many

Number suppliers

One Bilateral Monopoly

Monopoly

A few oligopoly
Monopolistic/
Many monopsony
Perfect
Competition
MARKET STRUCTURES AND PRICING

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 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.

 Absence or presence of financial, legal and technological constraints

 Thus we have:
 Perfect Competition  Monopolistic competition
 Monopoly  Oligopoly 5
 Market Morphology
Type of market Number Nature of Number Freedom of Examples
of firms product of entry and
buyers exit
Perfect Very Homogeneous Very Unrestricted Agricultural
competition Large (undifferentiated) Large commodities,
unskilled labour
Monopolistic Many Differentiated Many Unrestricted Retail stores,
competition FMCG
Oligopoly Few Undifferentiated Many Restricted Automobiles,
or differentiated computers,
universities
Monopoly Single Unique Many Restricted Indian Railways,
Microsoft, Intel

Monopsony Many Undifferentiated Single Not Arms

or differentiated applicable manufacturers
and Defense
industry 6
Features of Perfect Competition

Perfect competition may be defined as that market where infinite number

of sellers sell homogeneous good to infinite number of buyers while buyers
and sellers have perfect knowledge of market conditions
Features
 Presence of large number of buyers and sellers
 Homogeneous product
 Freedom of entry and exit
 Perfect knowledge
 Perfectly elastic demand curve
 No governmental intervention
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 Price determined by market and firm is a price taker.
 Features of Monopoly
Single seller
 The entire market is under control of a single firm.
Single product
 A monopoly exists when a single seller sells a product which has no substitute or, at least, no
close substitute in the market.
No difference between firm and industry
 There is a single firm in the industry
Independent decision making
 Firm is regarded as a price maker
Restricted entry
 Existence of barriers leads to the emergence and/or survival of a monopoly

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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

Firm makes normal profit. Firm makes loss.

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 Price and Output Decisions in Long Run

 A monopolist is in full control of the market price

 It would not continue to incur loss in the long run.
 It would try to reduce cost of production
 Otherwise it would close down in the long run.
 Monopolist would try to earn at least normal profit in the long run and may
earn supernormal profit due to entry restrictions in the market.
 If in the long run a monopoly firm earns supernormal profit
 This would attract competition and high price would make it possible for a new entrant to
survive.
 To retain its monopoly power, the firm may have to resort to a low price and
earn only normal profit even in the long run to create an economic barrier to
new entrants.
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 Price Discrimination

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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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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 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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 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

Joan Robinson said: Each firm has a monopoly over its

product.
Firms have limited discretion over price, due to the existence
of consumer loyalty for specific brands.
The reason for supernormal profit in short run, is supplying a
product which is differentiated, or at least perceived to be
different by the consumer.
 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 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

Derived from Greek word: “oligo” (few) “polo” (to sell)

Few Sellers: small number of large firms compete
Product: Some industries may consist of firms selling
identical products, while in some other industries firms may
be selling differentiated products.
Entry Barriers: No legal barriers; only economic in nature
◦ Huge investment requirements
◦ Strong consumer loyalty for existing brands
 Duopoly
Duopoly is that type of oligopoly in which only two players operate
(or dominate) in the market.
◦ Used by many economists like Cournot, Stackelberg, Sweezy, to explain the
equilibrium of oligopoly firm, as it simplifies the analysis.
Price and Output Decisions
No single model can explain the determination of equilibrium price
and output
◦ Difficult to determine the demand curve and hence the revenue curve of the
firm
 Kinked Demand Curve
Paul Sweezy (1939) introduced concept of kinked demand curve to explain ‘price stickiness’.
Assumptions
◦ If a firm decreases price, others will also do the same. So, the firm initially faces a highly elastic
demand curve.
◦ A price reduction will give some gains to the firm initially, but due to similar reaction by rivals,
this increase in demand will not be sustained.
◦ If a firm increases its price, others will not follow. Firm will lose large number of its customers
to rivals due to substitution effect.
◦ Thus an oligopoly firm faces a highly elastic demand in case of price fall and highly inelastic
demand in case of price rise.
A firm has no option but to stick to its current price.
At current price a kink is developed in the demand curve
The demand curve is more elastic above the kink and less elastic below the kink.
 Kinked Demand Curve
(price and output determination) •
Discontinuity in AR (D1KD2) creates
Price, discontinuity in the MR curve.
Revenue, D1
Cost • At the kink (K), MR is constant
MC1
P K
between point A and B.
MC2
A • Producer will produce OQ, whether
S
it is operating on MC1 or MC2, since
T B D2 the profit maximizing conditions are
being fulfilled at points S as well as
O Q Quantity T.
MR
• If MC fluctuates between A and B,
• D1K = highly elastic portion of the
the firm will neither change its
demand curve (AR) when rival firms do
not react to price rise output nor its price.
• KD2 = less elastic portion, when rival • It will change its output and price
firms react with a price reduction. only if MC moves above A or below
• Kink is at point K. B.
 • Assuming the case of a cartel with
two firms facing same MR and AR
Centralized Cartels • MCA = Firm A’s marginal cost
• MCB = Firm B’s marginal cost
Price, • ∑MC = industry marginal cost
Cost, MCB ∑MC
Revenue MCA • OQ = profit maximizing output
because (MR=∑MC).
• OQA = A’ output
P
• OQB = B’s output
• OQ=OQA + OQB; OQA > OQ B
MR
AR=D • OP = price at which both firms can
sell their output. Price will be
O
QB QA Q
determined by summation of all
Quantity
firms’ costs and demand.
• In a cartel an individual firm is just a
price taker.
 Market Sharing Cartels • Firms decide to divide the
market share among them and
fix the price independently.
• All firms have the same cost
Price,
Cost, functions because they are
Revenue producing a homogenous
MC AC
product but have different
PA demand functions.
PB • Due to different demand
functions, at equilibrium total
ARA output = OQA+ OQB, where
MRA
ARB OQA> OQB.
MRB
• The quantity of output produced
O
QB Q A Quantity and sold would depend upon the
terms of agreement among the
firms in the cartel.
 Factors Influencing Cartels

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

Dominant Firm: a leader in terms of market share, or presence in all

segments, or just the pioneer in the particular product category.
◦ Either a benevolent/ kind firm or an exploitative firm.
Benevolent leader
◦ Allows other firms to exist by fixing a price at which small firms may also
sell.
◦ so that it does not have to face allegations of monopoly creation;
◦ Earns sufficient margin at this price and still retains market leadership
 Price Leadership
Exploitative leader: fixes a price at which small inefficient players
may not survive and thus it gains large share of the market.
Barometric Firm: has better industry intelligence and can preempt
(being pioneer) and interpret its external environment in a more
effective manner than others.
◦ No single player is too large to emerge as a leader, but there may
be a firm which has a better understanding of the markets.
◦ Acts like a barometer for the market.
| Pricing |
Price denotes two aspects:
•It is revenue to the seller and
•It is the perceived value of the good
(or service) to the buyer.

Market structure also affects pricing decisions.

Change in government policy regarding taxation, subsidies and

administered prices would also lead to change in existing
price.
Pricing Strategies
Penetration Pricing
 Penetration Pricing
Price set to ‘penetrate the market’
‘Low’ price to secure high volumes
Typical in mass market products – chocolate bars, food stuffs,
household goods, etc.
Suitable for products with long anticipated life cycles
May be useful if launching into a new market
Market Skimming
 High price, Low volumes

Market Skimming Skim the profit from the market

Suitable for products that have
short life cycles or which will face
competition at some point in the
future (e.g. after a patent runs out)
Examples include: Playstation,
jewellery, digital technology, new
DVDs, etc.

Many are predicting a firesale in

laptops as supply exceeds demand.
Copyright: iStock.com
Value Pricing
Price set in accordance with
Value Pricing
customer perceptions about
the value of the
product/service
Examples include status
products/exclusive products

Companies may be able to set prices

according to perceived value.

Copyright: iStock.com
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

Copyright: iStock.com
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

Calculation of the average cost (AC) plus a

mark up
AC = Total Cost/Output
Influence of Elasticity
Influence of Elasticity
Any pricing decision must be mindful of the impact
of price elasticity
The degree of price elasticity impacts on the level of
sales and hence revenue
Elasticity focuses on proportionate (percentage)
changes
% Change in Quantity demanded
PED = -----------------------------------------------
% Change in Price
Influence of Elasticity
Price Inelastic:
% change in Q < % change in P
e.g. a 5% increase in price would be met by a fall in sales of something
less than 5%
Revenue would rise
A 7% reduction in price would lead to a rise in sales of something less
than 7%
Revenue would fall
Influence of Elasticity

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.