All industries can be divided into four market structures: pure competition, monopoly, monopolistic competition, and oligopoly (McConnell, Brue, & Flynn, 2012). These market models substantially differ in several important respects: a number of firms operating in the industry, type of products they produce, control over prices, and conditions of entry in the industry (McConnell et al., 2012). The aim of this paper is to examine four market structures and explore different pricing strategies in the framework of each of these structures. It will analyze pricing strategy of Sirius Satellite Radio and identify its market structure.
Perfectly competitive markets are characterized by the availability of demand and supply information as well as a lack of substantial entry barriers. Perfect competition exists when a large number of sellers and buyers of the same product vigorously compete with each other. Perfectly competitive markets require fragmentation of the industry: numerous buyers imperceptibly affect market price by small purchases (Besanko & Braeutigam, 2014). Many sellers operating in such market make small input purchases that also influence input prices. Perfect competition is possible when products that are being sold on the market are essentially undifferentiated.
In other words, consumers should not perceive any difference between products from different producers. Flowers and sugar are examples of undifferentiated products. Perfectly competitive markets provide consumers with perfect information about prices (Besanko & Braeutigam, 2014). Taking into consideration that consumers see no difference between products under perfect competition, they are only interested in prices charged by sellers in the market (Besanko & Braeutigam, 2014). Another characteristic of perfectly competitive markets is equal access to resources for both businesses already operating in the industry and prospective entrants (Besanko & Braeutigam, 2014).
The above-mentioned characteristics of perfectly competitive markets allow “sellers and buyers act as price takers” (Besanko & Braeutigam, 2014, p. 334). It means that market price is being accepted as a given during purchase decisions or output decisions. Furthermore, all sales are made at the lowest price that is available in the market during transactions. The final implication of perfect competition is that equal access to resources allows new firms easily enter the industry if it is profitable for them to do so.
Monopolistically competitive markets are characterized by large numbers of buyers and sellers. Therefore, just like perfectly competitive markets, they are fragmented. Monopolistic competition allows free entry and exit: any business willing to operate in the market is free to hire necessary inputs such as labor and can release them at any moment. The most important characteristic distinguishing monopolistically competitive markets from perfectly competitive markets is horizontal differentiation of products (Besanko & Braeutigam, 2014). It means that buyers perceive products produced by different firms as “imperfect substitutes for each other” (Besanko & Braeutigam, 2014, p. 562).
Oligopoly is characterized by markets controlled by a small number of firms (Stone, 2011). It should be noted that there is no rigid definition of what constitutes ‘a small number’ of producers. Firms operating in oligopoly markets can sell products that “may or may not be differentiated” (Pindyck & Rubinfeld, 2013, p. 456). Under oligopoly model, industries can consist either of a dominant firm and a couple of small rivals or a couple of firms having similar market shares. Even though there are many oligopoly models, all of them share similar characteristics (Pindyck & Rubinfeld, 2013) Oligopolistic industries have only a few firms that dominate the whole market. Each firm has to take actions of their competitors into its strategic considerations. Oligopolistic markets are also associated with significant barriers to entry (Pindyck & Rubinfeld, 2013).
Monopoly is a market structure that is characterized by the presence of a single producer who caters to the need of many consumers. Therefore, a monopolistic firm can neglect the behavior of other firms because they do not offer products that could be considered close substitutes. A classic example of such firm is an electric company that is not being influenced by actions of candle producers. The demand curve of such firm equals to the market demand curve (Pindyck & Rubinfeld, 2013).
The conditions of monopoly market create a situation allowing a monopolist to have a direct control of prices, which leads to the lower quantity of products at a higher price. Monopoly power imposes significant costs on society because fewer people can afford to buy products sold at a price determined by a monopolist not restricted by competition (Pindyck & Rubinfeld, 2013).
The firms operating under conditions of perfect competition are price-taking firms. Therefore, in order to maximize their profits, they have to produce “an output level at which the market price equals marginal cost” (Besanko & Braeutigam, 201, p. 341). Pricing strategies under conditions of perfect competition can be divided into three groups: price determination in a very short market period, price determination in the short run, and price determination in the long run (Besanko & Braeutigam, 2014).
A very short period is characterized by fixed supply of products as well as fixed inputs in supply. Therefore, demand for products creates pricing variations in a very short market period. It should be mentioned that markets for perishable goods cannot easily adjust to the demand. Therefore, market price shifts if supply remains fixed and the demand suddenly rises (Besanko & Braeutigam, 2014). Firms in the markets for durable goods, on the other hand, can easily adjust their supply to demand by accumulating their products.
The short run market period is characterized by the fixed number of firms in the industry. During the short run period, one or more of the inputs such as land or capital of each firm are also fixed. It means that supply can change only as a result of the alteration of variable factors but not the change in a plant capacity. Therefore, pricing in the short run is “determined by the interaction of short period supply and demand curve” (Besanko & Braeutigam, 201, p. 352). A decline in demand decreases both the quantity and price of a product to the equilibrium point, while an increase in demand does the opposite.
In the long run period, firms can adjust their supply according to the changes in demand. It means that the shift in demand over a long period translates into significant adjustments in supply and smaller adjustments in prices (Besanko & Braeutigam, 2014).
The demand curve of a monopolistic competitor is elastic to a high degree. It has to do with a fact that unlike a monopolist, a monopolistically competitive firm has rivals producing goods that could be easily substituted by other similar products (McConnell et al., 2012). However, a monopolistic competitor has fewer competitors than a pure competitor and produces differentiated products that could not be perfect substitutes. Therefore, monopolistic competitors maximize their profit by utilizing monopolistic and pure competition strategies in the short run: production of “the level of output at which marginal revenue equals marginal costs” (McConnell et al., 2012, p. 219).
In the long run, new firms will become attracted by short-run profits and enter the industry. As this happens, the demand curve of firms already operating in the industry will fall reducing their profits. It occurs because new firms will have a small share of demand for close-substitute products (McConnell et al., 2012). Taking into consideration that there are no significant restrictions on entry to the industry, rival firms will continue to emerge until “total revenue costs equals total costs” (McConnell et al., 2012, p. 219).
Oligopoly models are associated with the following pricing strategies: the kinked-demand curve, collusive pricing, and price leadership. Unlike perfect competition and monopolistic competition, the behavior of oligopolistic firms cannot be explained by a single market model. It has to do with the fact that oligopolistic firms can act in collusion with each other and independently. Moreover, there are also significant variations in barriers to entry and differentiation of products. Furthermore, oligopolistic firms are mutually interdependent; therefore, they cannot correctly predict actions of their rivals. It means that they “cannot determine their profit-maximizing price and output” (McConnell et al., 2012, p. 228).
Under kinked-demand theory, firms not engaging in collusive price practices will react to price changes introduced by their competitors by either matching price changes or ignoring them (McConnell et al., 2012). If oligopolistic firms decide to cut their prices in response to the similar move by a rival, they will prevent it from gaining competitive advantage. However, if oligopolistic firms ignore price changes, they will lose some sales to the rival willing to lower its price (McConnell et al., 2012). Non-collusive industries are characterized by generally stable prices because producers are rarely willing to engage in a price war. However, during recession periods, some firms tend to reduce prices, just like inflationary periods are often associated with price increases.
The most popular form of collusive pricing strategy is a cartel. It is often, a secret collusion that is maintained with the help of a written agreement “specifying how much each member will produce and charge” (McConnell et al., 2012, p. 231). Oligopolies forming a cartel can eliminate uncertainties associated with non-collusive pricing strategies, increase profits, and create substantial entry barriers for new rivals. A classic example of oligopolistic collusion is the Organization of Petroleum Exporting Countries (OPEC) (McConnell et al., 2012).
Price leadership is another market model explaining the behavior of oligopolies. Price leadership is a practice in those industries that have a dominant firm that could initiate price changes followed by competitors without having to engage in collusion with them (McConnell et al., 2012). Firms using price leadership strategy usually explore the tactic of infrequent price changes as a response to industry-wide events such as an increase in price of energy, wages or excise taxes among others (McConnell et al., 2012). Price adjustments are often communicated to other firms “through speeches by major executives, trade publication interviews, or press releases” (McConnell et al., 2012, p. 233). Price leaders are interested in holding barriers to entry; therefore, they sometimes forego prices maximizing their short-run profits in order to discourage new competitors from entering the industry.
Unlike a firm in a perfectly competitive market, a monopolist has the advantage of setting the market price for commodities it sells (Besanko & Braeutigam, 2014). Moreover, monopolists produce products that are not easily substituted by others. Therefore, monopolists can choose a pricing strategy that maximizes their profits. It means that producers in monopoly market settings have to take into account volume-margin trade-off (Besanko & Braeutigam, 2014). That is the higher price a monopolist sets for its product, the fewer units it will sell. Therefore, the market demand curve for a monopolist is downward slopping (Besanko & Braeutigam, 2014).
Sirius Satellite Radio
Sirius Satellite Radio and XM merged in 2008 creating SiriusXM (Trefis Team, 2015, par. 1). The firm offers satellite radio services in the United States. It has a dominant share of more than 70 percent of the new car market (Trefis Team, 2015, par. 2). The company earns a large share of its revenues from the monthly, semi-annual and annual subscription fees. It could be argued that SirusXM is a natural monopoly because it does not have any direct competitors in its market share. Therefore, the company is free to set the prices for its services. A recent article suggests that SiriusXM has been keeping its “subscription prices constant” (Trefis Team, 2015, par. 4) for the last few years. The company faces stiff competition of HD radio, advanced in-dash infotainment systems, traditional AM/FM radio, direct broadcast satellite and cable audio, internet radio, and internet-enabled smartphones among others (SiriusXM, n.d.). Therefore, it could be argued that despite its dominant market share SiriusXM cannot simply choose a pricing strategy maximizing its profits but has to take into account behavior of its competitors.
All industries can be divided into four market structures: pure competition, monopoly, monopolistic competition, and oligopoly. The pricing guidelines substantially differ across these structures. Perfectly competitive markets are associated with the availability of demand and supply information as well as a lack of substantial entry barriers. The firms operating under conditions of perfect competition are price-taking firms; therefore, they have to set their prices at the marginal cost of commodities they produce. Monopolistic competitors maximize their profit by utilizing monopolistic and pure competition strategies in the short run.
Oligopoly models are associated with the following pricing strategies: the kinked-demand curve, collusive pricing, and price leadership. Pricing strategy in monopoly is pretty straightforward: a monopolist is guided by volume-margin trade-off while setting its prices. SiriusXM is a monopoly; therefore, the company is free to set the prices for its services.
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Pindyck, R., & Rubinfeld, D. (2013). Microeconomics (8th ed.). New York, NY: Pearson.
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Trefis Team. (2015). Sirius XM: why a rise in revenue share and royalties will be slow. Forbes. Web.