An Analysis of Market Structures and their Pricing Strategies

Abstract

This paper describes oligopoly, perfect competition, monopolistic competition, and monopoly markets and explains pricing strategies. Notably, this influence emanates from the inherent features of each market type that firms must contemplate while formulating the ultimate goal. Firms in perfectly competitive and monopolistic markets have limited pricing choices because of the lack of control over market prices. Monopolistic competitive firms can influence these prices through differentiation strategies. On the other hand, firms operating in monopoly and oligopoly markets have greater power over market prices. A monopoly can increase product prices to a certain level without losing much profit. An oligopolistic firm may collude with other firms to set a price or impede entrants through predatory pricing. The paper also uses Amazon to illustrate a pricing strategy in the market.

Keywords: Cost-plus Pricing, Equilibrium Price, Predatory Pricing

In the business and economics world, buyers and sellers get connected through market structures. There are numerous market structures types, including monopoly, monopolistic competition, perfect competition, and oligopoly. Each has distinctive characteristics based on several factors, such as ease of entry and exit, production levels, pricing strategies, and forms of products and services offered. When a firm is starting a business or entering an established market, the prevalent conditions may determine what kind of market structure eventually ensues both in the short-run and long run. If an industry has several businesses selling the same undifferentiated product, this scenario is perfect competition. A monopoly exists when a firm has no close substitutes and enjoys massive market power. All these underlying forces of a market influence strategies business can use to achieve its objective and goals. This paper aims to describe the four different market structures and highlight their pricing strategies, using a real-world case example of a pricing strategy.

1           Perfect Competition

1.1         Description

By description, perfect competition refers to a situation in which a firm operates in a market with numerous sellers of an indistinguishable product. However, it is not reasonable to categorize a market type based on just one characteristic. There are several other conditions required for perfect competition to exist. For instance, the market must have many buyers available to purchase the product and many suppliers available to sell the product (OpenStax Economics, 2016). In such a situation, it becomes apparent that the firms are price takers implying that they will only sell the product at a price predetermined by the market forces of demand and supply. All sellers and buyers in such markets presumably possess the same relevant information to make rational decisions about the offered product. There is no restriction to enter or leave the market – meaning that the risk of entrants is high, and the existing firms can exit at will. A perfectly competitive firm takes the price at which the supply curve intersects the demand curve, called the equilibrium price. If the firm raises the price above the equilibrium point, much of its revenue gets lost as buyers prefer the cheaper substitutes. Such firms control a negligible percentage of the entire market, so increasing and decreasing prices change demand for their products instead of the whole market. In the long run, a perfectly competitive firm will choose to increase production if it earns profits and reduce production in response to losses. Consequently, the sustainability of these kinds of firms can get influenced by the pricing strategy they choose.

1.2         Pricing Strategies

As described in the earlier section, in perfect competition, the single firm takes its price from the industry and is thus considered a price taker. This industry consists of many firms selling the same product, and the market price is where the demand curve intersects the market supply curve (Sekar, 2016). Consequently, each firm must charge this price and cannot diverge from it without experiencing impacts on profits. The market curve in a perfectly competitive market comprises supply, demand, and prices. The supply curve is upward sloping, indicating the positive relationship between supply and market prices. The demand curve is downward sloping, demonstrating that consumers tend to decrease their demand when prices increase and vice versa. Notably, a price above this point drives buyers away from competitors or close substitutes. If set below the equilibrium price, the firm cannot make profits and may even fail to recover the total cost of production. For the overall market, increasing prices above this point may cause excess supply, and lowering it below the market price cause an excess demand. Because this market structure presumably is free to enter and exit by other firms, the pricing can attract entrants in the long run and increase competition. As more firms enter the market, supply gradually increases beyond the demand. This situation causes a decrease in product prices up to the point at which super-normal profits get exhausted, forcing some to leave the market while the remaining experience a return to ordinary profits as the supply curve shifts to the left.

Figure 1: Demand Curve for a Firm in a Perfectly Competitive Market

(Source: Lumen learning)

Figure 1 describes correlates the demand curve for an individual firm with the equilibrium price of the market. The market demand curve is downward-sloping.

From the concept of traditional economics, the ultimate goal of a firm is to maximize profits by maximizing the difference between the earnings/revenue and the spending/costs. To discover the point at which this difference is the largest, firms look at the marginal revenue – the total additional revenue accrued from the sale of an extra unit of output – and the marginal cost – the cost a firm incurs by producing one more unit of the good. If the marginal revenue is greater than the marginal cost incurred for that particular unit, the firm is making a profit. This concept leads to the marginal decision rule predominant in perfect competition markets. According to this rule, a firm should continue producing a product if marginal revenue exceeds the marginal cost. Thus, perfectly competitive firms’ pricing strategies rely much on the maximization strategy or solution that prioritizes a marginal revenue equal to marginal cost.

2           Monopolistic Competition

2.1         Description

Monopolistic competition is a market structure comprised of many producers that sell differentiated products but not perfect substitutes. In this condition, each firm takes the prices charged by the competitor as given and ignores the impact of its pricing on other firms. Unlike the perfect competition markets, firms that operate in this kind of market structure have some market power depending on the type of product differentiation they use. Characteristics of firms in this market structure include differentiated products, free entry, and exit, in the long run, independence in decision-making, and some degree of market power. But, this market is different from a monopoly specifically because firms do not enjoy any control over the market. Each firm operates independently without regard to the actions of its rivals. This market is associated with productive and allocative inefficiency because firms work with excess capacity. A large number of firms with a small market share implies that a single firm cannot influence the market price, and the possibility of price collusion is negligible. There is ample innovation and variety in this market as companies continuously improve their products’ quality and charge a high price. Examples of industries that exhibit this market structure include clothing and apparel, restaurants, and PC manufacturers. Because of the differences in differentiation strategies used by different firms in this market, they can set their prices. These new prices might also be different based on customer segments explained by the rampant price discrimination in monopolistic competition.

2.2         Pricing Strategies

Monopolistic competition pricing strategies rely on product differentiation that acts as the foundation of different forms of price discrimination. Plausibly, a firm may generate a relatively higher market share than rivals if it uses an efficient differentiation strategy and offers customers a unique value. “Different consumer types may have varying degrees of brand loyalty, switching costs, or sensitivity to product differentiation across firms. These differences may lead to varying degrees of competition to serve particular consumer types” (Katz, 1984, p. 1470). Take, for instance, an apparel brand that has a higher customer loyalty in the market. It is highly likely for the firm to increase the prices irrespective of what other brands charge in the same market and still get a considerable share. This kind of product differentiation gets enforced by the performance, durability, cost of operation, and maintenance of the product. Non-technical differentiation may take the form of brand names, packing, shape, and size, among others. All these features add a distinct appeal to a product prompting customers to consume more or be willing to pay a higher price. Other than the differentiation strategy, selling expenses can also impact the pricing strategy for a firm. For instance, if a firm engages in advertising and promotion, it will try to shift the demand curve of the advertised product to the right so that buyers can pay more for the same quantity or be willing to purchase more products at the same price. Differentiation offers these firms some market power, allowing them to sell uniquely propositioned products at a higher price and earn higher profit margins.

3           Oligopoly

3.1         Description

An oligopoly market is associated with a few but large companies that control the largest share of the market. Examples of such firms include CBS Corporation, Walt Disney, and NBC Universal. These firms possess control over a significant percentage of mass media market share. In most cases, oligopoly exists because of collaboration. Firms experience more benefits when they collaborate on a specific price than trying to compete in pricing. There are many forms of oligopoly. For instance, a market might have several firms but only one holding the largest share of the market. There might be two or three firms that have a substantial market share. All these are classified as market leaders because their pricing could impact the entire market. The ability of a firm to control prices strengthens the entry barriers and protects the incumbents from potential entrants into the market. It is crucial because if entrants possess some financial or technological power, they could jeopardize the profitability of other firms and eventually impact their pricing strategies. Even though some industries and economies have devised ways to prevent violation of antitrust laws, such as price collusion, oligopolistic firms can still use it without getting detected by the regulators.

3.2         Pricing Strategies

3.2.1        Predatory Pricing

Price is usually the control concept in marketing and economics within oligopoly and other market structures. Predatory pricing is a common pricing strategy in oligopolistic markets. It refers to the “pricing below an appropriate measure of cost for the purpose of eliminating competitors in the short run and reducing competition in the long run” (Dixit et al., 2006, p. 172). A firm engaging in this practice chooses to incur severe short-term losses to disadvantage the rivals. But, there are limitations or drawbacks to this strategy. For instance, even if the firm manages to outcompete others in the long run, it will need to recover the losses by raising prices to supra-competitive levels. At such levels, the price would still attract new firms into the market, reducing the ability to recoup its losses.

3.2.2        Limit Pricing Strategy

Oligopolistic firms can choose between short-run profit maximization pricing or limit pricing. With short-run profit maximization, the high prices may encourage other firms to enter the market, expand the output, and cause prices to fall toward competitive levels. On the other hand, established firms in the market might decide to charge the limit price – less than the short-run maximization price – that corresponds to the highest possible revenue they can earn without attracting a single entrant (Phillips & Stern, 1977). Therefore in choosing a pricing strategy, most firms in oligopoly choose the limit price because it guarantees persistent profits.

For example, a firm may use limit pricing to deter entry or expansion of a fringe firm by setting prices just below the profit-maximizing price but above the competitive level. In this case, the rival or an entrant will analyze this price and realize it is way below the estimated average cost, hence cannot be profitable. The incumbent is willing to sacrifice profits during this period to prevent entry. The rival firm or entrant may decide that the market is not viable because the risks are too high – with a significant loss and possibly lack of resources to sustain these losses before they become competitive. This pricing model could cause the entire market to become concentrated on one firm or a small number of dominant firms.

3.2.3        Cost-plus Pricing

The cost-plus pricing model seeks to ensure that costs are covered while providing a minimum acceptable profit rate for the firm. Firms calculate cost-plus pricing by adding a fixed margin to the average cost of production. If one firm, perhaps the market leader, uses this pricing method, others may have to follow suit. To apply the cost-plus pricing method, a firm must follow three steps. Firstly, it has to determine the total cost of the product or service by getting the sum of fixed and variable costs. Secondly, the firm divides the total cost by the units to determine the extra unit’s average expenses. Finally, the firm would need to multiply the unit cost by a markup percentage to obtain the selling value and the profit margin.

4           Monopoly

4.1         Description

A monopoly is quite different from other market structures identified in this paper. For instance, a monopoly is regarded as a profit maximizer because it experiences minimal to no competition. As a result, it can charge a set price above what a perfectly competitive firm would charge. Doing so increases the firm’s revenue. Notably, a monopoly is a price maker because, contrary to perfect competition and monopolistic competition markets, these markets involve a substantial market power whereby the firm determines what price to charge. It is a market characterized by the most extreme entry barriers. Monopoly may result from laws and regulations, such as those that specify the firm to operate in the industry. For example, John D. Rockefeller’s Standard Oil Company in the U.S. Similarly, a monopoly may impede the entry of new firms by taking complete ownership of the resources or raw materials used in the production. Monopoly power can also result from the superiority of a firm in finances and resources that may be hard for an entrant to replicate or try to compete. Examples of these include technological capabilities, capital requirements, and economies of scale. There is also price discrimination in this market. A monopolistic firm may change its price and quantity of the product depending on the suitability of the prices or market elasticity.

4.2         Pricing Strategies

Even though the marginal cost curve faced by monopolies is similar to those faced by perfectly competitive firms, the marginal cost curve is quite different in both. In these markets, marginal revenue curves do not represent the product price, as in perfect competition. To maximize profits, therefore, a monopoly sets a marginal cost equal to marginal revenue. As discussed earlier in this paper, these firms possess more power than competitive firms. Nevertheless, they are also limited in by how much they can raise the prices. Significantly higher prices result in lower sales. For this reason, monopolies can either decide to choose their price or choose their quantity to produce and allow the market demand to determine the price.

In a real-world scenario, a monopolist often lacks sufficient data to evaluate the total revenues or costs. The firm does not know what would happen by changing the production even with a small margin. However, it often has better reliable information on production’s effect on marginal revenues and marginal costs because of past experiences and the fact that it is possible to extrapolate small changes using current data. This information is crucial in guiding the firm to seek out a profit-maximizing combination of price and quantity. It can determine the best price to charge to maximize profit. If the marginal revenue increases above the marginal cost, the firm can produce an extra unit.

5           Case Study

Amazon and the use of Predatory Pricing Methods

Market Structure

Amazon operates in an oligopoly market because, together with eBay, they control the most e-commerce sales. The market has its barriers, and the dominance of Amazon and a few other firms gives them the power to dictate prices for several product types. Amazon streaming media, with the likes of Netflix, control massive numbers of customers globally. As a result, these firms can easily lock out their rivals from the market. On the internet market, AWS is rising in popularity day by day. Its powerful cloud system has made many companies rely on the service provider. Smaller companies cannot invest as massive as Amazon to develop such structural and technological superiority, leaving the market dominated by a few powerful brands.

Predatory Pricing

In 2017, Lina Khan, a law student at Yale, published an article, “Amazon’s Antitrust Paradox,” and used some supporting evidence to pin down the incidences of predatory pricing by Amazon (Khan, 2017). Khan explained why Amazon chose a price below-cost but yet expanded widely instead of incurring losses. In her view, the company either relied on revenue from AWS to subsidize the losses in the retail division or used investors’ money to cover short-term losses. She states, “With the exception of a few quarters in 2014, Amazon’s shareholders have poured money in despite the company’s penchant for losses. On a regular basis, Amazon would report losses, and its share price would soar” (p. 748). 

Whether Khan’s claims were sufficiently substantiated or not, these platforms enjoy massive economics that influences their ability to control the market through means such as predatory pricing. Firms such as Amazon can raise prices through personalized pricing or price discrimination in ways not easily detectable, use their power to negotiate better terms with producers and suppliers, or raise prices of unrelated goods. The consequence of this scenario is that consumers – people like us who demand quality products from such brands – get low-quality products and less variety.

6           Conclusion

Market structure influences pricing strategies. A monopoly is likely to choose the price that corresponds to the market demand. In perfectly competitive firm has its price fixed by the forces of demand and supply. In an oligopolistic market, firms can collude to set a discriminatory price that eliminates others or impedes possible entrants, or even use other common strategies such as limit pricing and predatory pricing. The firm sacrifices the profitability goal to keep rivals out of the market and raise prices in the long run to recover the losses. For a monopolistic competitive firm, the goal is to use product differentiation to gain a larger market share by building customer loyalty and brand equity. While some firms have less power over market prices depending on the market structure, some decide to engage in illegal pricing strategies to prevent fair and healthy competition. Despite the lack of sufficient evidence to substantiate the accusations, the company has continually been the target of backlash for years from smaller companies and competitors. Most of these firms are victims of unfair practices by giant companies like Amazon and eBay that use pricing strategies to reduce potential competition. The world of economics is evolving towards more significant violations of antitrust laws. Shockingly, these laws are increasingly becoming less effective in identifying and punishing global firms that engage in unfair market practices. Nevertheless, market structures remain crucial for all types of firms because they influence pricing and competition strategies.

References

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Katz, M. L. (1984). Price discrimination and monopolistic competition. Econometrica52(6), 1453. https://doi.org/10.2307/1913515

Khan, L. (2017). Amazon’s antitrust paradox. Yale Law Journal126, 710–805.

Lumen Learning. (n.d.). Boundless Economicshttps://courses.lumenlearning.com/boundless-economics/

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Sekar, P. (2016). An analysis of the validity of kinked demand curve on granite industries at Chennai.