In the product market, market structures affect how an entrepreneur prices their products and the amount (output quantity) of product to deliver in the market. The goal of every entrepreneur is to make profits, and profit maximization is the objective of all producers of goods or services. The exploration represented herein is a review of theories and techniques of pricing under different market structure conditions. It also shows how an entrepreneur can use demand analysis (price elasticity of demand) and costing (marginal cost) to make sound production and pricing decisions. Lastly, the exploration will present different concepts and techniques of pricing to optimize profit decisions.
Pricing Decisions under Different Market Structure Conditions
Price Decision in a Perfectly Competitive Market
Many sellers and many buyers exist in a perfectly competitive market. When this scenario occurs, complete information exists between the buyers and the sellers (Greenlaw and Shapiro 182). The market, in this case, floods with homogenous products. A perfectly competitive market also has very few barriers to entry. Combining all these factors implies that no single seller can influence the product’s price. Because the price elasticity of demand for the individual seller is infinite, sellers in a perfectly competitive market are compelled to be price takers (Mankiw 290). No single buyer or seller enjoys or exercises market power over rivals.
The equilibrium between supply and demand in the short-run or within a market period determines the market price of a product in a perfectly competitive market. To maximize profits, therefore, a seller in the perfectly competitive market produces at that quantity at which the price (P), the marginal costs (MC), and the marginal revenues (MR) are all exactly equal (Mankiw 294; Greenlaw and Shapiro 195). This statement holds that for the seller to realize an economic profit, the price should be higher than the average total costs (ATC) (Greenlaw and Shapiro 196). If the price equals the ATC then though the seller will earn accounting profits, economic profits will be nil. If the price falls below the ATC, then the seller accrues a loss.
Keeping in mind that a perfectly competitive market has limited barriers to entry, it follows that if the market has economic profits, new entrants enter the market. This tendency shifts the supply curve right, implying that more products will be sold at a lower price. Given that incumbent sellers can expand production quickly, or new entrants join the industry without impediment, then economic profits cannot last long. In the long run, sellers in a competitive market only enjoy normal profits.
Price decision in a Monopolistic Competition
In a monopolistic competitive market, there are many sellers and equally many buyers, but the products are differentiated rather than standardized. Though not perfect substitutes, the products sold in this market are close substitutes; they are not identical but serve the same purpose (Mankiw 346; Greenlaw and Shapiro 281). In this case, the price decision for sellers is similar to a seller in a perfectly competitive market.
The only difference is, if a seller has conduct very rigorous advertising and enjoys some brand loyalty amongst the buyers, they may not take price like in perfect competition. Brand loyalty is the only leverage that a seller in monopolistic competition has against price-taking. For instance, if Adidas has got a strong brand loyalty for sweatsuits compared to Mike, Zara, H&M, and other garment producers, Adidas will not be constrained to take the market price because its customers are willing to buy it at a different rate. Barriers to entry in monopolistic competition are few, and market profits incentive newcomers to enter (Mankiw 347).
The only difference there is between sellers in this market is that their products are not identical. Therefore, the seller will sell at the price where the price meets the ATC curve and the demand curve, and there is a markup between price, p, and the MC which equals the MR (Mankiw 352) in the long run. In the short run, the seller will act as one in perfect competition. A seller will deviate from this norm if and only if the buyers exercise some loyalty to their brand.
Price Decision in an Oligopoly
In an oligopoly, the sellers are very few; they could be three or four, and what they sell can either be differentiated or identical. There is competition among the firms, but it is not perfect. There is no ideal information between the buyers and the sellers or between the sellers themselves. However, one seller’s price decision is easily noticeable by rival sellers because each seller controls a given market share of the total market output (Mankiw 366).
If one seller decides to alter the price, the future performance of their firm depends on the action the rival sellers take. Thus sellers in an oligopoly are interdependent, and they will never make independent price and output decisions. The payoff matrix is what a seller uses to determine the payoff to a pricing decision depending on the rivals’ response (Mankiw 378). If rivals match price cuts but not price hikes the demand curve for the oligopoly becomes kinked. To compute the expected payoff, a seller multiplies the probability of competitors matching and the loss from a price cut and then add this product to the product of the likelihood of rivals not matching and the gain from the price cut.
However, sellers in an oligopoly limit price competition amongst them for the reward of profits and the fear of mutual destruction. Price discounting thwarts the gains in an oligopoly. The sellers coordinate a lot to ensure that profits remain at the maximum level by averting price wars. The desired combination of price and output that maximizes profits for the oligopoly is the point where the MC intersects the MR for the industry.
To ensure that sellers coordinate, they must first agree to be content with their current market shares and thus keep the output and price at a profit-maximizing level. It is within an oligopoly that firms engage in antitrust behaviors like price-fixing and price leadership to avoid price wars (Mankiw 378). To keep away newcomers, incumbent firms engage in predatory pricing to kick new entrants out of business (Mankiw 381).
Price Decision in a Monopoly
A monopoly is the most undesired market structure of all product-market structures. In a monopoly, there is only one seller, and all the buyers depend on him to get the commodity the seller offers. A firm, in this case, is equivalent to the entire industry and enjoys all the market power it desires. As a result, the monopolist’s demand curve is sloping downwards for its output (Greenlaw and Shapiro 225). The seller here singlehandedly produces the entire market supply of the commodity. The seller, in this case, can alter prices at their own will. It may sound simple for an entrepreneur to set the price of a product in a monopoly, but the arithmetic of maximizing profits is a bit complicated.
The rule of the thumb for profit maximization in monopoly is to produce at that rate where the MC = MR for all prices above MR (Greenlaw and Shapiro, 225). Monopolists enjoy significant economies of scale, and they institutionalize many barriers to entry to ensure that whether the market is contestable or not, newcomers do not enter. When they successfully bar new entrants, monopolists continue to enjoy insane profits alone.
Using Demand Analysis and Costing to Make Production and Pricing Decisions
In the commodity market, the quantity demanded, and that supplied are rather slow in response to the price in the short run but will react considerably fast in the long run. Demand and supply are, therefore, relatively inelastic in the short-run but more elastic in the long run (Greenlaw and Shapiro 128). If demand for a product is elastic, then, a larger percentage fall in quantity offsets dramatically any given change in price so that the total revenue falls (Greenlaw and Shapiro 117). If the demand has unitary elasticity, any given percentage change in price has an equal percentage change in quantity, and thus, the revenues remain intact (Greenlaw and Shapiro 117).
If the demand is inelastic, any given percentage change in price results in a much smaller percentage change in quantity, and therefore, the revenues rise (Greenlaw and Shapiro 117). Elasticity also shows if the firm can pass on higher production costs to the consumers. Such costs may include higher taxes levied on the firms by the government. However, the regulation provides that producers share the tax burden with the consumers instead of passing the entire burden onto them through the tax incidence.
Tax incidence also depends on the relative price elasticity of demand and supply. If supply is more elastic than demand is, the consumers bear a more significant part of the burden, and conversely, if demand is more elastic than supply, the sellers will shoulder much of the tax burden (Greenlaw and Shapiro 128). The larger the tax revenue is, the more inelastic the demand and supply are.
Different Concepts and Techniques of Pricing to Optimize Profit Decisions
For a firm to be profitable and cost-effective, it must consider a pricing strategy that envisions the firm’s internal capacity, competence, skills, and corporate advantages over its rivals (De Toni et al. 131). De Toni and others also contend that to be cost-effective and to maximize profits firms also need to consider their buyers’ needs and the quantity they are willing to buy and the price as well (131).
Setting lower prices could compromise profits because a large volume of sales may fail to compensate for low margins of profit. Similarly, higher rates could sabotage profits because large price margins per unit may fail to compensate for the low volume sold. A customer value-based pricing strategy that designates high prices, rationally within the market context reaps more profits compared to firms that implement a competition-based pricing technique. The latter relies on price discrimination but may not guarantee enough volume of sales to earn large profits.
Conclusion: Is the Project Feasible?
Table 1: Demand schedule for the project.
According to the information on the table above, there is a general rise in quantity demanded as price falls, and a converse truth. However, the plot of this is not linear, as seen in Figure 2 below.
After selecting the type of market the firm is to operate in, the proprietor should then use the profit maximization function for a particular market type to arrive at a profit-maximizing price and output level. Then the proprietors should factor in the tax incidence as well as the price elasticity of demand and supply. Then on selecting the pricing strategy, the proprietors should adopt a customer value-based pricing strategy that designates high prices, rationally within the market context to reap more profits. The project is not feasible for any prices lower than 20.
De Toni, Deonir et al. “Pricing Strategies and Levels and Their Impact on Corporate Profitability.” Revista De Administração, vol 52, no. 2, 2017, pp. 120-133. Web.
Greenlaw, Steven A., and David Shapiro. Principles of Microeconomics 2E. 2nd ed., Openstax, Rice University, 2018. Web.
Mankiw, N. Gregory. Principles of Microeconomics. 5th ed., South-Western Cengage Learning, 2014.