Price Determination in Different Markets

Unit 4: Price Determination in Different Markets

Meaning and Types of Markets

  • Overview:
    • The theory of demand explains consumer behavior to determine commodity demand.
    • The theory of the firm explains firm goals and objectives.
    • Together, these theories ascertain commodity/service prices and output through demand and supply interplay.
    • The nature of the demand curve and price-output decisions depend on the market type.

Important Elements of a Market

  1. Nature of the Product:
    • Bought and sold at a mutually agreeable price.
    • Availability of substitutes increases market competition.
  2. Number of Firms (Sellers) or Size of the Industry:
    • More firms typically indicate a more competitive market.
  3. Existence of Competition:
    • Buyer competition raises prices.
    • Seller competition lowers prices.
  4. Free Communication:
    • Buyers and sellers communicate freely to ensure uniform prices.
  5. Location of Trade:
    • Can be a city, region, country, or the world.
  6. Government Policies:
    • Liberalization, price control, production location, technology choice, taxes, subsidies, foreign trade policies, etc.

Market Classification

  • (a) Basis of Area:
    • Local, national, and world markets.
  • (b) Basis of Time:
    • Market price (specific day/moment), short-period price, long-period price.
  • (c) Basis of Competition:
    • Perfect and imperfect markets.

Market Forms or Market Structures

  • Classification focuses on the basis of competition.
  • Crucial elements:
    • Number of firms producing a product.
    • Nature of the product (homogeneous or differentiated).

Classification of Market Forms

  • Perfect Competition
    • Many firms
    • Homogeneous products (e.g., wheat, sugar, vegetables)
    • No control over price.
  • Imperfect Competition
    • Monopolistic Competition
      • Many firms
      • Differentiated products (close substitutes)
      • Some control over price.
    • Oligopoly
      • Few firms
      • Homogeneous or differentiated products
      • Some control over price.
    • Monopoly
      • Single firm
      • Products without close substitutes
      • Very large control over price.

Examples of Markets

  • Perfect Competition:
    • Agriculture market (wheat, corn).
    • Numerous small, price-taking farmers with nearly identical products.
  • Monopoly:
    • Microsoft's Windows operating system (historically).
    • Dominated the PC operating system market.
  • Monopolistic Competition:
    • Fast-food industry (McDonald's, Burger King, KFC).
    • Similar but differentiated products through branding and menu variations.
  • Oligopoly:
    • Smartphone industry (Apple, Samsung, Huawei).
    • Small number of large companies with significant market power.

Perfect Competition

  1. Large Number of Buyers and Sellers:
    • No single entity can influence the market.
    • Firms are price takers, selling as much as they can at the prevailing price.
  2. Free Entry or Exit:
    • No legal, technological, or financial restrictions.
    • Firms make normal profits (covering opportunity cost).
    • Normal profit is the minimum amount necessary to attract/retain an entrepreneur.
  3. Homogeneous Product:
    • Uniform and standardized output.
    • Products are perfect substitutes.
    • Firms raising prices lose customers; lowering prices is unnecessary as they can sell any quantity at the prevailing price.
  4. Perfect Mobility of Factors of Production:
    • Labor and capital can move freely between firms.
    • Capital mobility from one firm to another, ensures no firm's monopoly over industrial inputs.
    • This Factor mobility helps reaching equilibrium prices.
  5. Perfect Knowledge of Market Conditions:
    • Buyers and sellers are fully aware of prices.
    • No seller can sell higher, and no buyer can buy lower than the prevailing price.
  6. Absence of Transport Cost:
    • Uniform prices require no transport costs or equal costs for all.
    • Transport cost differences would lead to price variations.
  7. Absence of Government Regulation:
    • No government intervention (tariffs, taxes, subsidies).

Definition by Prof. Boulding

  • A perfectly competitive market has many buyers and sellers trading identical commodities with free interaction.
  • Perfect competition is an ideal concept, approximated by markets for farm products like rice, cotton, wheat, etc.

Price and Output Determination under Perfect Competition

  • Shape of the Demand Curve:
    • Average Revenue (AR) is revenue per unit sold; AR equals price.
    • The consumer demand curve graphically shows the price-amount demanded relationship; it represents AR or price.
    • AR curve of the firm is the same as the demand curve of the consumer.

Marginal Revenue (MR)

  • In perfect competition, MR equals AR (price) because units are sold at the same price.
  • Sellers can sell any amount at the market price because no firm can influence it.
  • Products are identical from the consumer's viewpoint, leading to uniform prices.

Graphical Representation

  • The firm is a price taker; MR = AR.
  • The demand curve (AR curve) is perfectly elastic.
  • At price OP, the firm can sell its entire production.

Equilibrium of a Firm

  • A firm maximizes profits in equilibrium.
  • Profits increase by expanding output as long as MR exceeds Marginal Cost (MC).
  • MR and MC represent the additional revenue and cost from an extra unit of output, respectively.

Conditions for Equilibrium

  • Necessary Condition:
    • MC = MR
  • Sufficient Condition:
    • MC curve must cut MR curve from below.
    • Beyond equilibrium output, MC > MR
  • These conditions are valid in both the short run and long run.

Graphical Explanation

  • The demand curve is horizontal at price OP, representing AR and MR.
  • At point T, MC = MR, but MC cuts MR from above, so it's not equilibrium.
  • The Firm increases output beyond ON until OM, where MC cuts MR from below at point R.
  • Output beyond OM is unprofitable (MC > MR).
  • Point R satisfies both equilibrium conditions.

Short-Run Equilibrium

  • The short run allows output adjustment via variable factors, but fixed factors cannot be altered.
  • Plant size and type are unchangeable, and new firms cannot enter.
  • Firms operate under identical cost conditions (identical AC and MC curves).

Additional Equilibrium Explanation

  • Equilibrium conditions (MR=MC and other condition) maximize profits or minimize losses.
  • It doesn't dictate the absolute profit or loss of the firm.
  • Possible scenarios:
    • Supernormal profits (AR > AC, TR > TC)
    • Normal profits (AR = AC, TR = TC)
    • Losses, but the firm continues operation (AR < AC, TR < TC).

Super Normal Profits (SNP)

  • AR > AC, implying TR > TC

  • SNP occurs any profit above normal profit.

Profits and Costs Details

  • If price is OP, MC cuts MR at point E, resulting in output OQ.
  • AC curve is below AR curve, which means that the firm makes SNP per unit of EB (AR = EQ; AC = BQ, so EQ > BQ).
  • For OQ output, SNP equals area APEB.
  • [TR = AR × output = EQ × OQ = OPEQ; TC = AC × output = BQ × OQ = OABQ; TR > TC. Hence, SNP = APEB.]

Market Dynamics

  • With SNP, new firms enter to compete, but this is not feasible in the short run.
  • Existing firms continue to earn SNP at price OP in the short term.

Normal Profits

  • AR = AC, implying TR = TC
  • Sufficient earnings to stay in the industry.
  • Minimum profit for the entrepreneur to continue employing resources.
  • The least possible reward earned by the entrepreneur as a compensation for his organisational services and for bearing business risks.

Normal Profit Details

  • At price OP, the firm is in equilibrium at point E, with output OQ.
  • At point E, AR = AC, hence the firm earns normal profits.
  • [AR = EQ and AC = EQ. TR = EQ ×OQ = OPEQ; TC = EQ ×OQ = OPEQ; TR = TC. Hence, normal profit].

Losses

  • AR < AC, implying TR < TC

Losses Detail

  • Equilibrium is at point E with output OQ, but here AC curve is above AR curve. The firm incurs a loss of BE per unit.
  • [AR = EQ; AC = BQ. Since EQ < BQ, loss per unit equals BE].
  • For OQ output, the firm's loss totals area PABE.
  • [TR = EQ ×OQ = OPEQ. TC = BQ ×OQ = OABQ. TR < TC. Hence, loss = PABE]

Firm Behavior

  • Firms tend to exit when incurring losses, though not immediately in the short run.
  • A key question is why firms continue operating during losses.
  • Firms cannot alter fixed capital equipment in the short run and fixed costs must be borne regardless of shutdown.
  • Only variable costs can be avoided by stopping production.
  • Shutting down means losses equal fixed costs.

Operational Strategy

  • If revenue exceeds variable costs, continued operation is prudent.
  • Firms should aim to cover at least variable costs and some fixed costs.
  • Shutdown is advised if the price cannot cover variable costs to minimize losses.

Long Run Equilibrium of the Industry under Perfect Competition

  • In the long run, the industry achieves equilibrium when firms earn only normal profits.
  • Necessary conditions:
    • Long Run MR (LMR) of every firm is equal to its Long Run MC (LMC).
      LMR = LMC
    • Every firm's LMC curve cuts its LMR curve from below.
    • Long Run AR of every firm is equal to its Long Run AC.
      LAR = LAC

Equilibrium and Firm Dynamics

  • When LAR = LAC, the number of firms remains constant, ensuring industry equilibrium.
  • When LAR > LAC, firms enjoy supernormal profits (SNP), attracting new entrants, increasing supply, and reducing prices until LAR = LAC.
  • When LAR < LAC, firms experience losses, forcing exits, decreasing supply, and increasing prices until LAR = LAC.
  • The equilibrium price Pe occurs when LAR = LMR = LAC (at its minimum point) = LMC.
  • Under these conditions, the number of firms is stable, with only normal profits earned.

Monopoly

  • Derived from 'mono' (single) and 'poly' (selling), monopoly means single control over supply.
  • A market where a single producer controls the entire supply of a commodity with few or no substitutes.

Conditions for Monopoly

  1. Single Producer or Seller:
    • A sole entity (individual, company, or state) controls the supply.
    • The distinction between firm and industry disappears.
  2. No Close Substitutes:
    • The commodity has no close alternatives.
    • Ensures absence of rivalry, as similar products are not produced by other firms.

Examples and Price Setting

  • Electricity and water, essential societal needs, are often state-controlled to prevent consumer exploitation.
  • A monopolist can set either the price or the quantity, but not both simultaneously.

Features of Monopoly

  1. Single Producer/Seller:
    • Firm and industry are identical.
  2. No Close Substitutes:
    • Buyers have no choice but to buy the commodity or go without it.
  3. Price Maker:
    • Can vary the price, especially if a discriminating monopolist.
  4. Barriers to Entry:
    • Legal, technological, and financial circumstances keep rivals away.
  5. Downward Sloping Demand Curve:
    • More output sold only at a lower price.
  6. Negation of Competition:
    • Complete absence of competition.

Determination of Output Under Monopoly

  1. Elastic Segment of Demand Curve:
    • Monopolist operates where demand elasticity is greater than one.
  2. Monopoly Equilibrium Output:
    • the monopolist restricts output on the falling path of the Average Cost (AC) curve.

Monopoly Equilibrium Explained

  • The monopolist maximizes profit at the output level where the Marginal cost (MC) equals the Marginal Revenue (MR)

Elastic Demand

  • When demand is elastic (elasticity > 1), a slight price decrease significantly increases quantity demanded.
  • Total revenue (price × quantity) increases because the quantity increase outweighs the price decrease.

Revenue and Costs

  • If the monopolist decreases the price, the added revenue from higher sales more than covers the lower price.
  • Costs rise less sharply, increasing profits.

Inelastic Demand

  • If the monopolist lowers price in the inelastic region (elasticity < 1), total revenue won't increase much because demand doesn't rise significantly.
  • This leads to revenue loss and is less profitable.

Restricting Output

  • The monopolist restricts output before reaching the minimum AC level to maximize profit.

Profit Maximization

  • The monopolist is profit-focused, not cost-minimization focused.
  • Profit is maximized where MC = MR, regardless of production efficiency.

Supply Restriction

  • To maintain high prices, the monopolist supplies less than the efficient level.
  • This controlled scarcity raises prices, boosting profits.

Societal Impact

  • Restricted output results in goods being sold above the lowest possible cost (minimum AC).
  • Society can afford lower prices if it wasn't for the monopolistic market that restricts it.

Monopoly Equilibrium in the Short Run

  • Firm and industry analysis are the same under monopoly.
  • Equilibrium occurs when MR = rising MC.
  • Monopoly price can be greater than, equal to, or less than average cost.
  • Outcomes: supernormal profits, normal profits, or losses.

Super Normal Profits (SNP)

  • When AR > AC, a monopolist earns SNP.
  • Monopolists sustain SNP in the long run by creating entry barriers.

Graph Explanation

  • Equilibrium output is at level OQ where MR = rising MC.
  • Output is sold at price OP.
  • AC is lower than AR: monopolist earns SNP of BC per unit and DPBC for output OQ.
  • The equilibrium output is less than optimum, and happens when AC is falling.

Normal Profits

  • AR = AC, particularly for state-produced goods.
  • The output price equals cost, without additional charges, ensuring affordable basic goods.

Losses

  • Inefficient monopolists may incur short-run losses but don't sustain them in the long run.

Monopoly Equilibrium in the Long Run

  • Long run equilibrium occurs when LMR = LMC and LMC cuts LMR from below.
  • Outcomes: SNP or normal profits.
  • Super normal Profits - the monopolist creates barriers of entry.
  • If losses persist, the firm will shut down or adjust plant size.

Supernormal Profits in Long Run

  • (LAR > LAC) Monopolist earns BC per unit and DPBC for output OQ.
  • Entry barriers ensure sustained SNP.

Normal Profits in Long Run

  • (LAR = LAC) Monopolist earns normal profits as LAR = LAC at point B.
  • Output OQ is sold at price OP.

Monopolistic Competition

  • Both perfect competition and monopoly are theoretical extremes; reality lies in imperfect competition.
  • Monopolistic competition is a form of imperfect competition.
  • Coined by Prof. E.H. Chamberlin and developed by Joan Robinson.

Market Definition

  • Many sellers with some monopoly power, selling similar but differentiated (not identical) products that are close substitutes.
  • Blend of competition and monopoly, found in various sectors like soaps, cosmetics, and electrical appliances.

Examples of Monopolistic Competition

  • Clothing stores: many firms offering similar yet differentiated products.
  • Hotels: similar services with slight price and quality variations.
  • Fast food (McDonald's, Burger King): similar but not identical products where consumer preference is dependent on brand loyalty or difference in taste.

Features of Monopolistic Competition

  1. Large Number of Sellers:
    • Many firms selling closely related, yet non-identical products.
    • Limited control over the product price due to the limited firms.
    • Collusion to raise price is unlikely.
  2. No Mutual Interdependence:
    • Firms set price-output policies independently, disregarding rivals' reactions.
    • New entrants follow equilibrium prices but can adjust within that range.
    • Firms aren't price-takers and can adopt independent policies.
  3. Freedom of Entry and Exit:
    • No barriers to entry or exit in the long run.
  4. Product Differentiation:
    • Products are not uniform and homogeneous
    • Each product is branded, identified, and differentiated by packing, trademark, and salesmanship to induce brand loyalty.
  5. Selling Costs:
    • Advertising, publicity, and sales promotion are necessary given differentiated products.
    • Aims to shift the demand curve and expand the market share.
    • The demand curve is downward sloping, but relatively elastic due to many competitors.
  6. Concept of Group:
    • Sellers of similar products are grouped since products are not identical.
  7. Two Types of Competition:
    • Price competition: firms compete on price variation.
    • Non-price competition: firms compete through product variation and selling costs.

Short Run Equilibrium

  • Firms maximize profits when MR = MC.
    • Under monopolistic competition, demand curve is downward sloping and more elastic than a monopoly firm.

Factors Affecting AR Curve Elasticity:

  • i) Number of firms in the group
    • larger the number of firms (or more severe the competition), the greater the elasticity of demand. If the number of firms is small, demand tends to be relatively less elastic.
  • ii) Extent of product differentiation
    • If product differentiation is relatively weak, demand tends to be elastic. If product differentiation is prominently significant then demand tends to be less elastic.

Short Run Profitability

  • Monopolistically competitive firms may realize super normal profits (SNP), or suffer losses, or earn normal profits. Three possible cases are detailed as follows:
    • Case of Super Normal Profits (AR > SAC)
    • Case of Losses (AR SAC): In the long run, some firms will leave the industry so that the remaining firms will be earning normal profits.

Long Run Elasticity

  • Further in the long run equilibrium AR curve will be more elastic (i.e. flatter) since large number of substitutes will be available in the long run. Thus, there is equilibrium in the long run when MC = MR = AR = AC.

Oligopoly

  • Is a main form of competition
  • Small number of large firms that may or may not be differentiated

Market Definition for Oligopoly

  • “Oligopoly is defined as the market structure in which there are a few sellers of the homogeneous or differentiated products, who intensely compete against each other and recognise interdependence in their decision-making”
  • ‘Competition among the few’
  • Examples of industries are automobile, electrical appliances, tyres, computers air conditioners, aluminium etc.

Characteristics of Oligopoly

  1. Few Sellers:
    • A few sellers dominate each has influence in the market ( homogeneous or differentiated products).
    • Firms behave as strategic competitors, countering rivals' actions.
  2. Interdependence:
    • Firms consider the decisions of its rivals.
  3. Importance of Advertising and Selling Costs:
    • Oligopolists increase sales through non-price competition by advertising or improving quality.
    • Firms employ aggressive marketing strategies.
  4. Group Behavior:
    • Need to analyze firm behaviour as a group (cooperate or compete).
    • Group/ firm beheviour is unpredictable due to the potential differences in company goals.
    • Firms may collude formally/informally to avoid uncertainty and rivalry and maximize profit.
  5. Price Rigidity:
    • Firms are constantly afraid that one firms will start retaliating agaisnt one another hence they resort more to adds than price cuts.
    • Oligopolistic firms stick to its price
  6. Kinked Demand Curve:
    * Firms in an oligopolistic market face a kinked demand curve (or a kinked average revenue curve)
    * He sells depends on the prices charged by other producers, and unless these can be specified in advance he cannot know what demand for his product will be
    * The kinked demand curve provides a simple way of conceiving an average revenue curve for an oligopolist which in turn helps us to understand oligopoly pricing problems.
    * The kinked demand curve or the average revenue curve is made of two segments:
    * (i) The relatively elastic demand curve: DK, where the demand curve is flatter and
    * (ii) The relatively inelastic demand curve: KD', where the demand curve is steep
    * Corresponding to the given price OP, there is a kink at point K on the demand curve DD'. The kink implies an abrupt change in the slope of the demand curve.

Pricing Strategy - Demand Curve for a Product

*   The kink leads to indeterminateness of the course of demand for the product of the seller concerned. He thus, thinks it worthwhile to follow the prevailing price and not to make any change in it. This is because, if he raises the price, none of his competitors follow (because they feel that a higher price would give too low a level of sales)
*   Since the firms are producing very similar products, a small increase in the price of our seller’s product will therefore lead to a very large fall in its sales; demand is very elastic if one firm alone increases its price. Moreover, there is the fear of losing buyers to the rivals who do not raise their prices

Price Strategy (Cont.)

  • On the other hand, if he lowers the price, it would lead to an immediate retaliation from the rivals who will also cut their prices to the same extent. The rivals feel that while it may be unprofitable to cut prices, the danger that they will lose market share if they do not do so is too great for them to be able to allow our seller’s price cuts to go unmatched. The result is that our seller will not expect much rise in his sales with price reduction. The demand curve below the kink is less elastic if one firm reduces its price.

Example - India Airline Industry

*Indian airline (such as IndiGo, SpiceJet, Jet Airways, and Air India) used to operated in a market where a handful of major carriers dominated the industry. These airlines often adjusted their pricing strategies in response to each other’s pricing changes, which can be considered as an example of behavior resembling the kinked demand curve model.

  • For instance, when one airline in India announced fare reductions or sales, the others frequently matched these reductions to remain competitive and avoid losing market share. However, when any one of them decided to increase prices, the others might not necessarily follow suit, assuming customers might be more sensitive to price increases and could switch to other competitors if prices went up.
  • This behavior of matching price decreases and resisting price increases could align with the concept of the kinked demand curve in an oligopolistic market, where the demand for a company’s product or service becomes relatively inelastic above the prevailing price and relatively elastic below that level.