Market Structure and Pricing theory

8/20/2019 Market Structure and Pricing theory

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Market Structure &Pricing Theor

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Manageria! Econo"ic#

Managerial Economics Overview

A close interrelationship between management and economics had led tothe development of managerial economics. Economic analysis is requiredfor various concepts such as demand, profit, cost, and competition. In thisway, managerial economics is considered as economics applied to!problems of choice"" or alternatives and allocation of scarce resources by

the firms.Managerial economics is a discipline that combines economic theory withmanagerial practice. It helps in covering the gap between the problems of logic and the problems of policy. The subject offers powerful tools andtechniques for managerial policy maing.

Managerial Economics $ DefinitionTo quote Mansfield, !Managerial economics is concerned with the

application of economic concepts and economic analysis to the problemsof formulating rational managerial decisions.

!pencer and !iegelman have defined the subject as !the integration of

economic theory with business practice for the purpose of facilitatingdecision maing and forward planning by management.#

Micro, Macro, and Managerial Economics RelationshipMicroeconomics studies the actions of individual consumers and firms"managerial economics is an applied specialty of this branch.Macroeconomics deals with the performance, structure, and behavior ofan economy as a whole. Managerial economics applies microeconomic

theories and techniques to management decisions. It is more limited inscope as compared to microeconomics. Macroeconomists study aggregateindicators such as #$%, unemployment rates to understand the functionsof the whole economy.

Microeconomics and managerial economics both encourage the use ofquantitative methods to analy&e economic data. 'usinesses have finitehuman and financial resources" managerial economic principles can aidmanagement decisions in allocating these resources efficiently.Macroeconomics models and their estimates are used by the government

to assist in the development of economic policy.Nature and Scope of Managerial Economics

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The most important function in managerial economics is decision(maing.It involves the complete course of selecting the most suitable action from

two or more alternatives. The primary function is to mae the mostprofitable use of resources which are limited such as labor, capital, landetc. A manager is very careful while taing decisions as the future isuncertain" he ensures that the best possible plans are made in the mosteffective manner to achieve the desired objective which is profitma)imi&ation.

*+ Economic theory and economic analysis are used to solve theproblems of managerial economics.

+

Economics basically comprises of two main divisions namely Microeconomics and Macro economics.

-+Managerial economics covers both macroeconomics as well asmicroeconomics, as both are equally important for decision maing andbusiness analysis.

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+ Macroeconomics deals with the study of entire economy. It considersall the factors such as government policies, business cycles, national

income, etc.

/+ Microeconomics includes the analysis of small individual units ofeconomy such as individual firms, individual industry, or a singleindividual consumer.

All the economic theories, tools, and concepts are covered under thescope of managerial economics to analy&e the business environment. Thescope of managerial economics is a continual process, as it is adeveloping science. $emand analysis and forecasting, profit management,

and capital management are also considered under the scope ofmanagerial economics.

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Demand Analysis and Forecasting$emand analysis and forecasting involves huge amount of decision(maing0 $emand estimation is an integral part of decision maing, anassessment of future sales helps in strengthening the maret position andma)imising profit. In managerial economics, demand analysis andforecasting holds a very important place.

rofit Management!uccess of a firm depends on its primary measure and that is profit. 1irmsare operated to earn long term profit which is generally the reward for

ris taing. Appropriate planning and measuring profit is the mostimportant and challenging area of managerial economics.

!apital Management2apital management involves planning and controlling of e)penses. Thereare many problems related to capital investments which involveconsiderable amount of time and labor. 2ost of capital and rate of returnare important factors of capital management.

Demand for Managerial EconomicsThe demand for this subject has increased post liberali&ation andglobali&ation period primarily because of increasing use of economic logic,concepts, tools and theories in the decision maing process of largemultinationals.

Also, this can be attributed to increasing demand for professionallytrained management personnel, who can leverage limited resourcesavailable to them and ma)imi&e returns with efficiency and effectiveness.

Role in Managerial Decision Ma"ingManagerial economics leverages economic concepts and decision sciencetechniques to solve managerial problems. It provides optimal solutions tomanagerial decision maing issues.

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Market Structure%rice determination is one of the most crucial aspects in economics.'usiness managers are e)pected to mae perfect decisions based on theirnowledge and judgment. !ince every economic activity in the maret ismeasured as per price, it is important to now the concepts and theoriesrelated to pricing. %ricing discusses the rationale and assumptions behindpricing decisions. It analy&es unique maret needs and discusses howbusiness managers reach upon final pricing decisions.

It e)plains the equilibrium of a firm and is the interaction of the demandfaced by the firm and its supply curve. The equilibrium condition differsunder perfect competition, monopoly, monopolistic competition, andoligopoly. Time element is of great relevance in the theory of pricing sinceone of the two determinants of price, namely supply depends on the timeallowed to it for adjustment.

Mar"et StructureA maret is the area where buyers and sellers contact each other and

e)change goods and services. Maret structure is said to be thecharacteristics of the maret. Maret structures are basically the numberof firms in the maret that produce identical goods and services. Maretstructure influences the behavior of firms to a great e)tent. The maretstructure affects the supply of different commodities in the maret.

3hen the competition is high there is a high supply of commodity asdifferent companies try to dominate the marets and it also createsbarriers to entry for the companies that intend to join that maret.

erfect !ompetition%erfect competition is a situation prevailing in a maret in which buyersand sellers are so numerous and well informed that all elements ofmonopoly are absent and the maret price of a commodity is beyond thecontrol of individual buyers and sellers

3ith many firms and a homogeneous product under perfect competitionno individual firm is in a position to influence the price of the product thatmeans price elasticity of demand for a single firm will be infinite.

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Pricing %eci#ion#

Determinants of rice #nder erfect !ompetitionMaret price is determined by the equilibrium between demand andsupply in a maret period or very short run. The maret period is a periodin which the ma)imum that can be supplied is limited by the e)istingstoc. The maret period is so short that more cannot be produced inresponse to increased demand. The firms can sell only what they havealready produced. This maret period may be an hour, a day or a few

days or even a few wees depending upon the nature of the product.

Mar"et rice of a erisha$le !ommodityIn the case of perishable commodity lie fish, the supply is limited by theavailable quantity on that day. It cannot be stored for the ne)t maretperiod and therefore the whole of it must be sold away on the same daywhatever the price may be.

Mar"et rice of Non%erisha$le and Reproduci$le &oodsIn case of non(perishable but reproducible goods, some of the goods canbe preserved or ept bac from the maret and carried over to the ne)tmaret period. There will then be two critical price levels.

The first, if price is very high the seller will be prepared to sell the wholestoc. The second level is set by a low price at which the seller would notsell any amount in the present maret period, but will hold bac the wholestoc for some better time. The price below which the seller will refuse to

sell is called the 4eserve %rice.

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Monopolistic !ompetition

Monopolistic competition is a form of maret structure in which a largenumber of independent firms are supplying products that are slightlydifferentiated from the point of view of buyers. Thus, the products of thecompeting firms are close but not perfect substitutes because buyers donot regard them as identical. This situation arises when the samecommodity is being sold under different brand names, each brand beingslightly different from the others.

1or e)ample ( 5u), 5iril, $ove, etc.

Each firm is therefore the sole producer of a particular brand or !product#.It is monopolist as far as a particular brand is concerned. 6owever, sincethe various brands are close substitutes, a large number of !monopoly#

producers of these brands are involved in a een competition with oneanother. This type of maret structure, where there is competition amonga large number of !monopolists# is called monopolistic competition.

In addition to product differentiation, the other three basic characteristicsof monopolistic competition are (

There are large number of independent sellers and buyers in the maret.

The relative maret shares of all sellers are insignificant and more or lessequal. That is, seller(concentration in the maret is almost non(e)istent.

There are neither any legal nor any economic barriers against the entry of new firms into the maret. 7ew firms are free to enter the maret ande)isting firms are free to leave the maret.

In other words, product differentiation is the only characteristic that

distinguishes monopolistic competition from perfect competition.

Monopoly

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Monopoly is said to e)ist when one firm is the sole producer or seller of aproduct which has no close substitutes. According to this definition, there

must be a single producer or seller of a product. If there are manyproducers producing a product, either perfect competition or monopolisticcompetition will prevail depending upon whether the product ishomogeneous or differentiated.

8n the other hand, when there are few producers, oligopoly is said toe)ist. A second condition which is essential for a firm to be calledmonopolist is that no close substitutes for the product of that firm shouldbe available.

1rom above it follows that for the monopoly to e)ist, following things areessential (

8ne and only one firm produces and sells a particular commodity or aservice.

There are no rivals or direct competitors of the firm.

7o other seller can enter the maret for whatever reasons legal,technical, or economic.

Monopolist is a price maer. 6e tries to tae the best of whatever demandand cost conditions e)ist without the fear of new firms entering tocompete away his profits.

The concept of maret power applies to an individual enterprise or to agroup of enterprises acting collectively. 1or the individual firm, ite)presses the e)tent to which the firm has discretion over the price that itcharges. The baseline of &ero maret power is set by the individual firmthat produces and sells a homogeneous product alongside many othersimilar firms that all sell the same product.

!ince all of the firms sell the identical product, the individual sellers arenot distinctive. 'uyers care solely about finding the seller with the lowestprice.

In this conte)t of !perfect competition#, all firms sell at an identical price

that is equal to their marginal costs and no individual firm possess anymaret power. If any firm were to raise its price slightly above themaret(determined price, it would lose all of its customers and if a firmwere to reduce its price slightly below the maret price, it would be

swamped with customers who switch from the other firms.

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Accordingly, the standard definition for maret power is to define it as thedivergence between price and marginal cost, e)pressed relative to price.

In Mathematical terms we may define it as (

5 9 :% ( M2+

%

OligopolyIn an oligopolistic maret there are small number of firms so that sellersare conscious of their interdependence. The competition is not perfect, yet

the rivalry among firms is high. #iven that there are large number ofpossible reactions of competitors, the behavior of firms may assumevarious forms. Thus there are various models of oligopolistic behavior,each based on different reactions patterns of rivals.

8ligopoly is a situation in which only a few firms are competing in themaret for a particular commodity. The distinguishing characteristics ofoligopoly are such that neither the theory of monopolistic competition northe theory of monopoly can e)plain the behavior of an oligopolistic firm.

Two of the main characteristics of 8ligopoly are briefly e)plained below (

;nder oligopoly the number of competing firms being small, each firmcontrols an important proportion of the total supply. 2onsequently, theeffect of a change in the price or output of one firm upon the sales of itsrival firms is noticeable and not insignificant. 3hen any firm taes anaction its rivals will in all probability react to it. The behavior ofoligopolistic firms is interdependent and not independent or atomistic as isthe case under perfect or monopolistic competition.

;nder oligopoly new entry is difficult. It is neither free nor barred. 6encethe condition of entry becomes an important factor determining the priceor output decisions of oligopolistic firms and preventing or limiting entryof an important objective.

1or E)ample ( Aircraft manufacturing, in some countries< wireless

communication, media, and baning.

Pricing Strategie#

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%ricing is the process of determining what a company will receive ine)change for its product or service. A business can use a variety of pricingstrategies when selling a product or service. The price can be set toma)imi&e profitability for each unit sold or from the maret overall. It canbe used to defend an e)isting maret from new entrants, to increasemaret share within a maret or to enter a new maret.

There is a need to follow certain guidelines in pricing of the new product.1ollowing are the common pricing strategies (

ricing a New roductMost companies do not consider pricing strategies in a major way, on aday(today basis. The mareting of a new product poses a problembecause new products have no past information.

1i)ing the first price of the product is a major decision. The future of thecompany depends on the soundness of the initial pricing decision of theproduct. In large multidivisional companies, top management needs toestablish specific criteria for acceptance of new product ideas.

The price fi)ed for the new product must have completed the advancedresearch and development, satisfy public criteria such as consumer safetyand earn good profits. In pricing a new product, below mentioned twotypes of pricing can be selected (

S"imming rice!imming price is nown as short period device for pricing. 6ere,companies tend to charge higher price in initial stages. Initial high helpsto !!im the 2ream# of the maret as the demand for new product is

liely to be less price elastic in the early stages.

enetration rice%enetration price is also referred as stay out price policy since it preventscompetition to a great e)tent. In penetration pricing lowest price for thenew product is charged. This helps in prompt sales and eeping thecompetitors away from the maret. It is a long term pricing strategy andshould be adopted with great caution.

Multiple roductsAs the name indicates multiple products signifies production of more thanone product. The traditional theory of price determination assumes that a

firm produces a single homogenous product. 'ut firms in reality usuallyproduce more than one product and then there e)ists interrelationships

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between those products. !uch products are joint products or multi)

products. In joint products the inputs are common in the production

process and in multi(products the inputs are independent but havecommon overhead e)penses. 1ollowing are the pricing methods followed(

Full !ost ricing Method1ull cost plus pricing is a price(setting method under which you addtogether the direct material cost, direct labor cost, selling andadministrative cost, and overhead costs for a product and add to it amarup percentage in order to derive the price of the product. The pricingformula is (

%ricing formula 9 Total production costs ( !elling and administration

costs ( Marup

7umber of units e)pected to sell

This method is most commonly used in situations where products andservices are provided based on the specific requirements of the customer.Thus, there is reduced competitive pressure and no standardi&ed productbeing provided. The method may also be used to set long(term prices thatare sufficiently high to ensure a profit after all costs have been incurred.

Marginal !ost ricing MethodThe practice of setting the price of a product to equal the e)tra cost ofproducing an e)tra unit of output is called marginal pricing in economics.'y this policy, a producer charges for each product unit sold, only theaddition to total cost resulting from materials and direct labor. 'usinessesoften set prices close to marginal cost during periods of poor sales.

1or e)ample, an item has a marginal cost of =.>> and a normal sellingprice is =-.>>, the firm selling the item might wish to lower the price to

=.*> if demand has waned. The business would choose this approachbecause the incremental profit of *> cents from the transaction is betterthan no sale at all.

'ransfer ricingTransfer %ricing relates to international transactions performed betweenrelated parties and covers all sorts of transactions.

The most common being distributorship, 4?$, mareting, manufacturing,

loans, management fees, and I% licensing.

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All inter(company transactions must be regulated in accordance withapplicable law and comply with the @arms length@ principle which requires

holding an updated transfer pricing study and an inter(companyagreement based upon the study.

!ome corporations perform their inter(company transactions based uponpreviously issued studies or an ill advice they have received, to wor at a!cost plus BC#. This is not sufficient, such a decision has to be supported

in terms of methodology and the amount of overhead by a proper transferpricing study and it has to be updated each financial year.

Dual ricing

In simple words, different prices offered for the same product in differentmarets is dual pricing. $ifferent prices for same product are basicallynown as dual pricing. The objective of dual pricing is to enter differentmarets or a new maret with one product offering lower prices in foreigncounty.

There are industry specific laws or norms which are needed to be followedfor dual pricing. $ual pricing strategy does not involve arbitrage. It isquite commonly followed in developing countries where local citi&ens areoffered the same products at a lower price for which foreigners are paid

more.

Airline Industry could be considered as a prime e)ample of $ual %ricing.2ompanies offer lower prices if ticets are booed well in advance. Thedemand of this category of customers is elastic and varies inversely withprice.

As the time passes the flight fares start increasing to get high prices fromthe customers whose demands are inelastic. This is how companiescharge different fare for the same flight ticets. The differentiating factorhere is the time of booing and not nationality.

rice Effect%rice effect is the change in demand in accordance to the change in price,other things remaining constant. 8ther things include ( Taste and

preference of the consumer, income of the consumer, price of other goodswhich are assumed to be constant. 1ollowing is the formula for priceeffect (

%rice Effect 9 %roportionate change in quantity demanded of B

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These somewhat abstract concerns tend to determine some but not all

details of a specific concrete maret system where buyers and sellersactually meet and commit to trade. In other words, competition can alignthe seller"s interests with the buyer"s interests and can cause the seller to

reveal his true costs and other private information. In the absence ofperfect competition, three basic approaches can be adopted to deal withproblems related to the control of maret power and an asymmetrybetween the government and the operator with respect to objectives andinformation< :a+ subjecting the operator to competitive pressures, :b+gathering information on the operator and the maret, and :c+ applyingincentive regulation.D*

Mar"et Structure SellerEntry)arriers

SellerNum$er

)uyerEntry)arriers

)uyerNum$er

%erfect

2ompetition

NO MAN' NO MAN'

Monopolistic competition NO MAN' NO MAN'

8ligopsony NO MAN' 'ES FE(

Monopoly 'ES ONE NO MAN'

The main criteria by which one can distinguish between different maretstructures are< the number and si&e of producers and consumers in themaret, the type of goods and services being traded, and the degree to

which information can flow freely.

Conc!u#ion

3e may thus conclude that if demand increases, price will immediately

rise but ultimately it will rise, fall or remain constant, according as theindustry is subject to the law of diminishing returns, increasing returns or

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constant returns, respectively. In case of decrease in demand, the effecton normal price will be the opposite. This is how the laws of returns

influence price. 3e repeat that they cannot influence maret price, i.e.,price at any given moment. They can only affect normal price, i.e., pricein the long run.

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Market Structure and Pricing theory