Relevance of Price Elasticity of Demand in Different Market Structures

Market structures define the behavior of individual firms for industry conditions. Various structures defined by economists help firms understand among other variables, their output and pricing decisions in a rational manner. Even though the structures are theoretical models their implications in practical life are undeniable as they help firms realize the effects of management decisions on profitability and viability of the firm. Where all countries have different regulations, there unmistakably exist unique market structures that are defined on the basis of various features as: Monopoly, oligopoly, perfect competition, duopoly and monopolistic competition.

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According to Bized.co.uk, market structures are distinguished on the basis 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’ behavior – pricing strategies, non-price competition, output levels, the extent of barriers to entry and the impact on efficiency.

In order to study the relevance of price elasticity in different market structures, it is imperative that the behavior of firms in each structure be known and discussed in detail before the rationale is sought out.

With regards to a monopoly, which is a market structure where only one firm is the supplier and there are not substitutes for the product while the barriers to entry too are high, the firm determines the price, profit level and the output level. However in case the monopoly is state-run, the government decides the output and price levels. In either, case the price elasticity of the firm is a relevant consideration in the firms’ pricing decisions. Price Elasticity of demand is defined by Mike Moffat as:

The Price Elasticity of Demand (commonly known as just price elasticity) measures the rate of response of quantity demanded due to a price change. Moffat, Mike (2009)

In the case of a monopoly, the demand curve is downward sloping which indicates that the firm can push up prices by restricting output and increasing demand relative to supply.

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The relationship between price elasticity and the revenue earned by the monopoly is such that at high prices and smaller quantities, demand is relatively elastic as small changes in price change quantity by a larger percentage.

In the case of larger quantity demanded and lower prices, demand is relatively inelastic as demand doesn’t change as much relative to price.

Consequently in terms of marginal and total revenue, where the demand curve is elastic, and the marginal revenue (revenue earned from each additional unit sold,) is positive the total revenue increases while in case of the demand curve being inelastic, the marginal revenue is negative and total revenue falls.

Thus a monopoly’s pricing decisions are based on the substitutability of their products. In case a product is highly substitutable, the price elasticity is high, greater than -1and in case of few alternates, price elasticity is lower than one.

An example of a highly substitutable monopoly includes that of Laptops when first launched. They were easily substitutable by desktops and personal computers. However a product with low substitutability would be railways which are generally state-run but is the only service of their kind.

Monopolies like to aim for a good which has no close substitutes, but in such a case demand is relatively inelastic so the firm does not achieve higher total revenues. Thus a firm does not produce in its inelastic range as it would result in negative marginal revenues.

In case of an Oligopolistic market structure, a majority of the market share is held by a few dominant firms. In this case, as the market is dominated by a few firms which are in competition with each other, the pricing decisions depend mainly on the decisions taken by other firms. To illustrate, take the case of the colas. There are only a few dominant firms with products that are nearly substitutable, i.e. Coke and Pepsi.

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Therefore in Oligopolies firms face a kinked demand curve. The kinked demand curve indicates different price elasticities at both the intervals- before and after the kink. This is caused because each firm faces a downward-sloping demand curve but if the firm decides to raise prices, other firms may not follow suit and the firm will lose out with the competition due to the high substitutability of goods provided by the rival firms, consumers can easily switch to goods provided by other firms.

Moreover, in case a firm decides to decrease prices to get more sales, the rival firm might reduce prices to a larger extent and the firm will lose out.

The kink therefore indicates that at higher levels of prices and lower output, demand is elastic and a change in price will lead to a larger change in quantity and therefore total revenue will fall.

At lower prices the firm’s demand is inelastic but that also means that other firms will match the price cuts and total revenue might fall. This is the reason why in many real-world cases, firms collude to decide upon a certain price level. Although this is illegal according to competition laws, firms have been caught and penalized in trying to fix prices.

Moreover in such markets where there are a few dominant firms, even if businesses do not collude they engage in non-price competition and focus on increasing brand loyalty so that price consideration effects are minimized.

Coming to perfect competition, the firm faces a horizontal demand curve where the price remains constant at all levels of demand. This case ensues when consumers have perfect information, there are no barriers to entry for supplying firms, and there is a high substitutability of goods and consumers can switch easily to other goods. Especially so when, in case of perfect information, consumers know which supplier will give them the lowest prices and switch to that firm.

Such a market structure is possible as there are many small firms and many individual buyers, which means that no individual firm has control over oversupply and no individual buyer can control prices.

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This implies that although firms can charge at market rates, they can also sell at lower prices to increase quantity demanded. An illustration is the wheat market where consumers know the price of wheat and while wheat from one firm is perfectly substitutable by wheat from another and there are no barriers to entry, the market is perfectly competitive.

With regards to the marginal revenue and average revenue curves, the marginal revenue curve equals the average revenue or demand curve of the industry as each additional unit of sales costs the same.

This indicates that the price elasticity of the good that the firm is providing is infinitely elastic and that the prices are constant at all levels of demand. In such a case, the market demand and supply determine the prices and although the market demand curve is downward sloping, the individual firm faces a horizontal average revenue curve.

With regards to a duopoly a structure similar to an oligopoly exists where only two firms dominate the market and are in rivalry with each other. In case of high elasticity, the firm can decrease prices to increase sales turnover but revenue might fall for both firms if the other response with a price cut.

While in case of demand inelasticity the firm cannot afford to increase prices if the rival firm maintains its prices as again this leads to a fall in demand for the firm.

A monopolistic competition situation is also referred to as imperfect competition. In such a structure, there are many firms but they are able to differentiate their offerings in some or the other way and are therefore offering close but not perfect substitutes as firms in case of a perfect competition are offering.

Moreover the market faces imperfect information and on the basis of this, firms are able to exercise control over prices. This is similar to many real-life structures as perfect competition is more of an ideal situation than an existing one.

Examples of such a structure include toothpaste suppliers, mobile phone companies, jewelers, shoemakers, booksellers among the like.

In any case, a firm in monopolistic competition faces a downward-sloping demand curve but what differentiates it is the fact that its marginal cost curve is not its supply curve as is the case in perfect competition but charges a higher price.

Further a firm in such a structure maximizes profits by producing at a quantity and price that is determined by equating marginal revenue and marginal cost. This is because it has some control over price and quantity and that it has to respond to market conditions and sensitivity of consumers to prices to set a price for its goods.

In such a structure, firms earn abnormal profits which are over and above the normal profits earned by firms which are price takers under perfect competition.

According to AmosWEB

As a price maker with some degree of market control, a monopolistically competitive firm reacts to demand conditions, especially the price elasticity of demand, when setting the price and corresponding quantity produced. While a monopolistically competitive firm, especially one with limited market control, is likely to sell a larger quantity at a higher price, it is also conceivable that it might offer a smaller quantity at a higher price or a larger quantity at a lower price. AmosWEB Encyclonomic Webpedia (2009)

In conclusion, price sensitivity or price elasticity of demand is an important aspect in any market structure and is extremely relevant in firms’ profit-maximizing decisions as it is an important variable that indicates how consumers will respond to price changes.

Although in many cases, one might feel that the features that distinguish between various structures are ideal and exist in theory; in real life, these models help us understand the implications in real-world hybrid markets that are a mix of these models.

Thus the elasticity of demand is an important variable in many firms’ pricing decisions and even though it might be difficult to determine its exact value practically it is imperative for firms to consider even in broad terms if it wants to survive profitably in its environment.

References

Biz/ed, (2006). Market Structure. Web.

Moffatt, M. (2009). Price Elasticity of Demand. Web.

Rile, G. (2006). Market Structures – Summary. Web.

Scribd, (2008). Different Types of Market Structure & Comparison. Web.

Webpedia, E. (2009). Monopolistic Competition, Short-Run Supply Curve. Web.

Webpedia, E. (2009). Perfect Competition, Demand. Web.

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