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PRICING ANALYSIS

MARKET CLASSIFICATION
MARKET  A market is any area over which buyers and sellers are in such close touch, either directly or through dealers, that the prices obtainable in one part of the market affect the prices paid in other parts.


Four Basic Component of MarketMarketConsumer  Seller  Commodity and  Price




Classification By Area
Local markets  Regional Markets  National Markets  International Markets


ClassificationClassification- By nature of Transaction


Spot Market  Future Market


ClassificationClassification- By the volume of Business


Wholesale market and  Retail market


ClassificationClassification- on the basis of Time


Very short period  Short period  Long period


ClassificationClassification- by status of Sellers


Primary market  Secondary market  Terminal market


Classification by nature of Competition


Substitutability factor  Interdependence factor  Ease of entry factor


FORMS OF MARKET STRUCTURE

Market Structure

Market Structure


Market structure identifies how a market is made up in terms of:


       

The number of firms in the industry The nature of the product produced The degree of monopoly power each firm has The degree to which the firm can influence price Profit levels Firms behaviour pricing strategies, non-price competition, output levels The extent of barriers to entry The impact on efficiency

Market Structure
Perfect Competition Pure Monopoly

More competitive (fewer imperfections)

Market Structure
Perfect Competition Pure Monopoly

Less competitive (greater degree of imperfection)

Market Structure
Perfect Competition Pure Monopoly

Monopolistic Competition

Oligopoly

Duopoly Monopoly

The further right on the scale, the greater the degree of monopoly power exercised by the firm.

Market Structure
Importance:  Degree of competition affects the consumer will it benefit the consumer or not?  Impacts on the performance and behaviour of the company/companies involved


Market Structure


Models a word of warning!


   

Market structure deals with a number of economic models These models are a representation of reality to help us to understand what may be happening in real life There are extremes to the model that are unlikely to occur in reality They still have value as they enable us to draw comparisons and contrasts with what is observed in reality Models help therefore in analysing and evaluating they offer a benchmark

Market Structure


Characteristics of each model:


   

Number and size of firms that make up the industry Control over price or output Freedom of entry and exit from the industry Nature of the product degree of homogeneity (similarity) of the products in the industry (extent to which products can be regarded as substitutes for each other) Diagrammatic representation the shape of the demand curve, etc.

Market Structure
Characteristics: Look at these everyday products what type of market structure are the producers of these products operating in?
Electric Guitar Jazz Body Vodka
Remember to think about the nature of the product, entry and exit, behaviour of the firms, number and size of the firms in the industry. You might even have to ask what the industry is??

Mercedes CLK Coupe

Canon SLR Camera Bananas

Perfect Competition
 

One extreme of the market structure spectrum Characteristics:


     

Large number of firms Products are homogenous (identical) consumer has no reason to express a preference for any firm Freedom of entry and exit into and out of the industry Firms are price takers have no control over the price they charge for their product Each producer supplies a very small proportion of total industry output Consumers and producers have perfect knowledge about the market

Perfect Competition
Diagrammatic representation
Cost/Revenue

MC AC

Givenaverage the cost ofis the Thethis industry price firm The MC is cost curve is the output the At The assumption of profit maximisation, shapedproduces standard U additional curve. producing theby the demand determined firm is(marginal) AC of MC industry making units of output. It at an cuts supply curve =profit. MC output where the atMR and the normal its This point long to thethe falls a output The of (Q1). asis first (due run alaw of lowest at whole. levelfirm is a This a because is diminishing relationship fraction of small supplier within mathematicaltotal industry rises very the position. equilibriumreturns) then asthe output rises. supply. industry and has no between marginal and average values. control over price. They will sell each extra unit for the same price. Price therefore = MR and AR

P = MR = AR

Q1

Output/Sales

Perfect Competition
Diagrammatic representation
Cost/Revenue

MC MC1 AC AC1

Because the model assumes perfect knowledge, makes Average and and MC firm The assume a firm thewould Nowlower ACMarginal costs gains that advantage nowlower could form of firm to be imply be the modification to some theexpected is for only a short timein the short run, form but price, or gains some its product before others copy earning abnormal profit the idea the same. remains or are attracted the (AR>AC) represented a new of cost advantage (saybyto the industry by grey area. method). What production the existence of abnormal profit. would happen? If new firms enter the industry, supply will increase, price will fall and the firm will be left making normal profit once again.

AC1

Abnormal profit

P = MR = AR P1 = MR1 = AR1

Q1

Q2

Output/Sales

Monopolistic or Imperfect Competition




Where the conditions of perfect competition do not hold, imperfect competition will exist Varying degrees of imperfection give rise to varying market structures Monopolistic competition is one of these not to be confused with monopoly!

Monopolistic or Imperfect Competition




Characteristics:
 

 

Large number of firms in the industry May have some element of control over price due to the fact that they are able to differentiate their product in some way from their rivals products are therefore close, but not perfect, substitutes Entry and exit from the industry is relatively easy few barriers to entry and exit Consumer and producer knowledge imperfect

Monopolistic or Imperfect Competition


Implications for the diagram:
Cost/Revenue

MC AC

1.00

Abnormal Profit
0.60

We assume that theQ1 and Marginal Cost equilibrium This is demandrunandfacing IfThe firm produces firm Since the additional the a short curve produces where willabeMC Average Cost in position forreceived1.00the sells firm willfirmdownward the each a be MR = on revenue unit for from (profit maximising output). same shape. falls, the the monopolistic market (on average with represents sloping and the cost each unit sold However, At because the products this output average) lies under the AR earned each unit being MR curve level, AR>AC structure. for from sales. and the firm makes in 40p x are differentiated 60p, curve. will make AR the firm abnormal profit (the grey some way, the firm Q1 in abnormal profit.will shadedbe able to sell extra only area). output by lowering price.

MR
Q1

D (AR)
Output / Sales

Monopolistic or Imperfect Competition


Implications for the diagram:
Cost/Revenue

MC AC

Because there is relative freedom of entry and exit into the market, new firms will enter encouraged by the existence of abnormal profits. New entrants will increase supply causing price to fall. As price falls, the AR and MR curves shift inwards as revenue from each sale is now less.

MR1
Q1

MR

AR1

D (AR)
Output / Sales

Monopolistic or Imperfect Competition


Implications for the diagram:
Cost/Revenue

MC AC

AR = AC

Notice that the existence of more substitutes makes the new AR (D) curve more price elastic. The firm reduces output to a point where MC = MR (Q2). At this output AR = AC and the firm will make normal profit.

MR1
Q2 Q1

MR

AR1

D (AR)
Output / Sales

Monopolistic or Imperfect Competition


Implications for the diagram:
Cost/Revenue

MC AC

This is the long run equilibrium position of a firm in monopolistic competition.

AR = AC

MR1
Q2

AR1
Output / Sales

Monopolistic or Imperfect Competition monopolistic Some important points about


competition:  May reflect a wide range of markets  Not just one point on a scale reflects many degrees of imperfection  Examples?

          

Monopolistic or Imperfect Restaurants Competition


Plumbers/electricians/local builders Solicitors Private schools Plant hire firms Insurance brokers Health clubs Hairdressers Funeral directors Estate agents Damp proofing control firms

   

Monopolistic or Imperfect Competition In each case there are many firms


in the industry Each can try to differentiate its product in some way Entry and exit to the industry is relatively free Consumers and producers do not have perfect knowledge of the market the market may indeed be relatively localised. Can you imagine trying to search out the details, prices, reliability, quality of service, etc for every plumber in the UK in the event of an emergency??

Oligopoly


Competition between the few




May be a large number of firms in the industry but the industry is dominated by a small number of very large producers

Concentration Ratio the proportion of total market sales (share) held by the top 3,4,5, etc firms:


A 4 firm concentration ratio of 75% means the top 4 firms account for 75% of all the sales in the industry

Oligopoly
Example:  Music sales

The music industry has a 5-firm concentration ratio of 75%. Independents make up 25% of the market but there could be many thousands of firms that make up this independents group. An oligopolistic market structure therefore may have many firms in the industry but it is dominated by a few large sellers.

Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html

Oligopoly


Features of an oligopolistic market structure:


        

Price may be relatively stable across the industry kinked demand curve? Potential for collusion Behaviour of firms affected by what they believe their rivals might do interdependence of firms Goods could be homogenous or highly differentiated Branding and brand loyalty may be a potent source of competitive advantage Non-price competition may be prevalent Game theory can be used to explain some behaviour AC curve may be saucer shaped minimum efficient scale could occur over large range of output High barriers to entry

Oligopoly
Price
The kinked demand curve - an explanation for price stability? The firm therefore, charging demand IfThe principle of is effectively faces Assume the firm to lower its price to of the firm seeks the kinked a price a kinked demand on the principle rivals 5 andcompetitivean output of its to gain a curve rests curve forcing it producing advantage, 100. maintain asuit. Any gains pricing will will follow stable or rigid it makes that: If it chose to raise price above 5, its structure. Oligopolistic firms may in quickly be lost and the % change rivals would not follow suit andits firm a. If a firm raises its price, the overcome this by engaging in nondemand will be smaller than the % effectively facesnot follow suit rivals will an elastic demand price competition. total revenue reduction in price curve for its product (consumers would would If a firm lowers its price, its again fall as the firm now faces b. buy from the cheaper rivals). The % a relatively inelastic demand curve. rivals will all do the same change in demand would be greater than the % change in price and TR would fall.

Total Revenue B

Total Revenue A Total Revenue B


100

Kinked D Curve D = Inelastic

D = elastic

Quantity

Duopoly


Market structure where the industry is dominated by two large producers


 

  

Collusion may be a possible feature Price leadership by the larger of the two firms may exist the smaller firm follows the price lead of the larger one Highly interdependent High barriers to entry Cournot Model French economist analysed duopoly suggested long run equilibrium would see equal market share and normal profit made In reality, local duopolies may exist

Monopoly
   

Pure monopoly where only one producer exists in the industry In reality, rarely exists always some form of substitute available! Monopoly exists, therefore, where one firm dominates the market Firms may be investigated for examples of monopoly power when market share exceeds 25% Use term monopoly power with care!

Monopoly


Monopoly power refers to cases where firms influence the market in some way through their behaviour determined by the degree of concentration in the industry
     

Influencing prices Influencing output Erecting barriers to entry Pricing strategies to prevent or stifle competition May not pursue profit maximisation encourages unwanted entrants to the market Sometimes seen as a case of market failure

Monopoly


Origins of monopoly:
Through growth of the firm  Through amalgamation, merger or takeover  Through acquiring patent or license  Through legal means Royal charter, nationalisation, wholly owned plc


Monopoly


Summary of characteristics of firms exercising monopoly power:




Price could be deemed too high, may be set to destroy competition (destroyer or predatory pricing), price discrimination possible. Efficiency could be inefficient due to lack of competition (X- inefficiency) or


could be higher due to availability of high profits

Monopoly


Innovation - could be high because of the promise of high profits, Possibly encourages high investment in research and development (R&D) Collusion possible to maintain monopoly power of key firms in industry High levels of branding, advertising and non-price competition

Monopoly


Problems with models a reminder:




   

Often difficult to distinguish between a monopoly and an oligopoly both may exhibit behaviour that reflects monopoly power Monopolies and oligopolies do not necessarily aim for traditional assumption of profit maximisation Degree of contestability of the market may influence behaviour Monopolies not always bad may be desirable in some cases but may need strong regulation Monopolies do not have to be big could exist locally

Monopoly
Costs / Revenue

MC
7.00

AC

Monopoly Profit
3.00

This is curve for a monopolist Given both the short run and AR (D)the barriers to entry, likelyrunbe relativelyposition the monopolist will be able to long to equilibrium price inelastic. Output assumed the exploit abnormal profits in to for a monopoly be at profit entry to the long run as maximising output (note caution here market is restricted. not all monopolists may aim for profit maximisation!)

MR
Q1

AR
Output / Sales

Monopoly
Costs / Revenue

Welfare implications of monopolies


A look back a the diagram for The higher in at competitive be The price priceprice lower monopoly and would perfectunit with output levels output means that 3will reveal 7 per competition with market would be consumer that in equilibrium, price will be surplusat Q2. at Q1. output is reduced, indicated by lower levels equal to the MC of production. the grey shaded area. On the face of it, consumers We higher prices and less facecan look therefore at a comparison of the differences choice in monopoly conditions between price and competitive compared to more output in a competitive situation compared environments. to a monopoly.

MC
7

AC Loss of consumer surplus


3

MR
Q2 Q1

AR
Output / Sales

Monopoly
Costs / Revenue

Welfare implications of monopolies


The monopolist will be benefit from additional producer affected by a loss of producer surplus shownto the grey equal by the grey shaded but.. triangle rectangle.

MC
7

AC Gain in producer surplus


3

MR
Q2 Q1

AR
Output / Sales

Monopoly
Costs / Revenue

Welfare implications of monopolies


The value of the grey shaded triangle represents the total welfare loss to society sometimes referred to as the deadweight welfare loss.

MC
7

AC

MR
Q2 Q1

AR
Output / Sales

Contestable Markets
Theory developed by William J. Baumol, John Panzar and Robert Willig (1982) Helped to fill important gaps in market structure theory Perfectly contestable market the pure form not common in reality but a benchmark to explain firms behaviours

Contestable Markets
Key characteristics:
Firms behaviour influenced by the threat of new entrants to the industry No barriers to entry or exit No sunk costs Firms may deliberately limit profits made to discourage new entrants entry limit pricing Firms may attempt to erect artificial barriers to entry e.g

Contestable Markets
Over capacity provides the opportunity to flood the market and drive down price in the event of a threat of entry Aggressive marketing and branding strategies to tighten up the market Potential for predatory or destroyer pricing Find ways of reducing costs and increasing efficiency to gain competitive advantage

Contestable Markets
Hit and Run tactics enter the industry, take the profit and get out quickly (possible because of the freedom of entry and exit) Cream-skimming identifying parts of the market that are high in value added and exploiting those markets

Contestable Markets
Examples of markets exhibiting contestability characteristics:
Financial services Airlines especially flights on domestic routes Computer industry ISPs, software, web development Energy supplies The postal service?


 

Final reminders:

Market Structures

 

Models can be used as a comparison they are not necessarily meant to BE reality! When looking at real world examples, focus on the behaviour of the firm in relation to what the model predicts would happen that gives the basis for analysis and evaluation of the real world situation. Regulation or the threat of regulation may well affect the way a firm behaves. Remember that these models are based on certain assumptions in the real world some of these assumptions may not be valid, this allows us to draw comparisons and contrasts. The way that governments deal with firms may be based on a general assumption that more competition is better than less!

The Necessary Conditions for Perfect Competition




There are no barriers to entry.


Barriers to entry are social, political, or economic impediments that prevent other firms from entering the market.  Barriers sometimes take the form of patents granted to produce a certain good.


The Necessary Conditions for Perfect Competition




There are no barriers to entry.




Technology may prevent some firms from entering the market. Social forces such as bankers only lending to certain people may create barriers.

The Necessary Conditions for Perfect Competition




The firms' products are identical.




This requirement means that each firm's output is indistinguishable from any competitor's product.

The Necessary Conditions for Perfect Competition




There is complete information.


Firms and consumers know all there is to know about the market prices, products, and available technology.  Any technological breakthrough would be instantly known to all in the market.


Demand Curves for the Firm and the Industry


The demand curves facing the firm is different from the industry demand curve.  A perfectly competitive firms demand schedule is perfectly elastic even though the demand curve for the market is downward sloping.


Perfect Competitors Demand Curve




The result is that the individual firm perceives the demand curve for its product as being perfectly horizontal.

Market Demand Versus Individual Firm Demand Curve


Market Market supply Firm Price $10 8 6 Market demand 1,000 3,000 Quantity 4 2 0 10 20 30 Quantity Individual firm demand

Price $10 8 6 4 2 0

Market Supply and Demand and Single-Firm Demand Single-

The Definition of Supply and Perfect Competition


These strong six conditions are seldom met simultaneously, but are necessary for a perfectly competitive market to exist Supply is a schedule of quantities of goods that will be offered to the market at various prices


When a firm operates in a perfectly competitive market, its supply curve is its short-run marginal cost curve above average variable cost

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Perfect Competition Long Run


Chapter 10-2

The Long Run




The short run is a timeframe in which at least one of the resources used in production cannot be changed. Exit and entry are long-run phenomena. In the long run, all quantities of resources can be changed.

An Increase in Demand


An increase in demand leads to higher prices and higher profits.


Existing firms increase output.  New firms enter the market, increasing output still more.  Price falls until all profit is competed away.


An Increase in Demand


If input prices remain constant, the new equilibrium will be at the original price but with a higher output.

An Increase in Demand


The original firms return to their original output but since there are more firms in the market, the total market output increases.

An Increase in Demand


In the short run, the price does more of the adjusting.

In the long run, more of the adjustment is done by quantity.

Market Response to an Increase in Demand


Price Market S0SR B $9 7 A D1 D0 0
McGraw-Hill/Irwin

Price S1SR

Firm

MC AC

C SLR

$9 Profit 7

B A

700

8401,200 Quantity

1012 Quantity

2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Normal Profit in the Long Run




Entry and exit occur whenever firms are earning more or less than normal profit (zero economic profit).


If firms are earning more than normal profit, other firms will have an incentive to enter the market. If firms are earning less than normal profit, firms in the industry will have an incentive to exit the market.

Economic Profit in the Long Run

The Predictions of the Model of Perfect Competition




A zero economic profit is a normal accounting profit, or just normal profit. Firms produce where marginal cost equals price. No one could be made better off without making someone else worse off. Economists refer to this result as economic efficiency.

Who is Better Off?




Lower labor costs mean Chinese firms can charge 30% to 50% less than their U.S. competitors for the same product. Makers of apparel, electric appliances, and plastics have been shutting U.S. factories for decades, resulting in the loss of 2.7 million manufacturing jobs since 2000. Meanwhile, America's deficit with China is likely to pass $150 billion this year.

LongLong-Run Competitive Equilibrium


At long run equilibrium, economic profits are zero 

Profits create incentives for new firms to enter, market supply will increase, and the price will fall until zero profits are made

The existence of losses will cause firms to leave the industry, market supply will decrease, and the price will increase until losses are zero
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LongLong-Run Competitive Equilibrium


Zero profit does not mean that the entrepreneur does not get anything for his efforts Normal profit is the amount the owners would have received in their next best alternative Economic profits are profits above normal profits

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LongLong-Run Competitive Equilibrium Graph


P

At long-run equilibrium, economic profits are zero

MC LRAT C SRATC

P = D = MR

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Market Response to an Increase in Demand Graph


P

Market
S0(SR)

Firm
MC

P1 P0
1

2 2

S1(SR)

ATC

S(LR) 1 D1 1 2 D0

P1 P0

SR Profits

1 1 2

Q0 Q1 Q2

Q0,2 Q1

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LongLong-Run Market Supply


If the long-run industry supply curve is perfectly elastic, the market is a constant-cost industry 

If the long-run industry supply curve is upward sloping, the market is an increasing-cost industry If the long-run industry supply curve is downward
sloping, the market is a decreasing-cost industry

In the short run, the price does more of the adjusting, and in the long run, more of the adjustment is done by quantity

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Application: Kmart
Although Kmart was making losses, Kmart decided to keep 300 stores open because P>AVC 

After 2 years of losses, Kmart realized that the decrease in demand was permanent

They moved from the short run to the long run and closed the stores because prices had fallen below their long-run average costs

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