Block 4

PRICING DECISIONS
Unit 10: Market Structure and Barriers to Entry 221
Unit 11: Pricing Under Perfect Competition and 245
Pure Monopoly
Unit 12: Pricing Under Monopolistic and Oligopolistic 263
Competition
Unit 13: Pricing Strategies 280
BLOCK 4 PRICING DECISIONS
Block 4 introduces the different market structures and their implication for pricing
behavior of firms.
Unit 10 discusses the market structure and the significant concept of entry barriers.
It examines the reasons why certain entry barriers are ‘natural’ i.e. determined
by the nature of the industry and why certain entry barriers are created by managers
themselves in order to maximize current or even long-term profitability.
Unit 11 dwells on the extreme types of markets structures i.e. perfect competition
and monopoly and rationalizes them as benchmarks. The outcomes achieved
under these markets are used to compare outcomes achieved in other markets
that lie in between these two market structures. Although both these structures
are difficult to find in practice,, they are useful from the public policy point of
view.
Unit 12 examines monopolistic competitions and oligopoly and briefly introduces
the tools of game theory. This is done in an extremely elementary manner, so as
not to detract from the main focus of the unit. The concept of market concentration
and its measurement is also discussed.
Unit 13 explores the various methods of pricing followed in different kinds of
markets introduced in the previous units. It explains the concepts of price
discrimination and its nuances and argues that to engage in price discrimination,
the firm must have some control over price. Other interesting pricing techniques
viz. bundling, peak load pricing, two part and multipart pricing along with a
number of examples are developed.
 Market Structure and
UNIT 10 MARKET STRUCTURE AND Barriers to Entry

BARRIERS TO ENTRY
Structure
10.0 Objectives
10.1 Introduction
10.2 Classification of Market Structures
10.3 Factors Determining the Nature of Competition
10.4 Barriers to Entry
10.5 Strategic Entry Barriers–A Further Discussion
10.6 Pricing Analysis of Markets
10.7 Let Us Sum Up
10.8 Key Words
10.9 Terminal Questions

10.0 OBJECTIVES

After going through this unit, you should be able to:

 understand the concept of market structure and the impact it has on the
competitive behaviour of the firms;
 classify different types of market structures;
 analyze the factors that influence the pricing decisions of a firm; and
 identify the barriers to entry of firms in the market.

10.1 INTRODUCTION
One of the most important decisions made by managers is setting the price of
the firm’s product. If the price set is too high, the firm will be unable to
compete with other suppliers in the market. On the other hand, if the price is
too low, the firm may not be able to earn a normal rate of profit. Pricing is
thus a crucial decision area, which needs much of managerial attention.

In this unit we will examine the factors that govern this key decision area.
Traditional economic theory explains this in term of demand and supply
functions. According to traditional analysis, firms aim towards maximization
of profits. The interplay of demand and supply in the market determines the
price, which is often referred to as equilibrium price.

There are, however, many other factors that influence the pricing decision of
a firm. These are – the number of firms in the industry, the nature of product,
and the possibility of new firms entering the market and so on. In this unit you 221
Pricing Decisions will understand more about some of the crucial factors that operate in the
market place. In the process, you should gain valuable insights into the
operations of firms under different market structures, which are more typical
of the existing real world situations.

10.2 CLASSIFICATION OF MARKET

STRUCTURES
The structure of a market depicts the existence of firms in a particular market
and to what extent the firms constituting a specified market are functionally
interrelated to each other. The term ‘market structure’ refers to the degree of
competition prevailing in that particular market. The power of an individual
firm to control the market price by changing its own output determines the
degree of competition and this power varies inversely with the degree of
competition. The higher the degree of competition, the less market power the
firm has and vice-versa. Market power is generally thought to be the ability
of the firm to influence price.

A firm behaves according to its policies and practices regarding price, output
decisions etc. The firm’s performance is an indicator of its outcome or results
of its conduct. The whole concept explains the Structure-Conduct-
Performance (S-C-P) hypothesis. Hence in microeconomics theory, this
hypothesis states that the performance of a firm is determined by its conduct,
which in turn is determined by the structure of the market in which it is
operating. The performance and the conduct of a firm vary from market to
market. If the market is highly competitive then the performance and conduct
of the firm is different as compared to that of the market with little or no
competition. For example, pricing behaviour of firms in the fast moving
consumer goods (FMCG) sector where there are a large number of rivals is
very different from the pricing in the Airline industry where there are fewer
firms.

Pricing decisions are affected by the economic environment in which the firm
operates. Managers must, therefore, make their decisions to the specific
market environment in which their firms operate. The central phenomenon in
the functioning of any market is competition. Competitive behaviour is
moulded by the market structure of the product under consideration. Since the
decision-making environment depends on the structure of the market, it is
necessary to have a thorough understanding of this concept.

The structure of a particular market plays an important role in defining the

determinants that affect these market structures. Determinants like price,
product differentiation etc. are affected by the competitive structure of the
market. The classification of markets in terms of their basic characteristics
helps identify a limited number of market structures that can be used to
analyze decision-making. The four characteristics used to classify market
structures are: i) Number and size distribution of sellers, ii) Number and size
222
distribution of buyers, iii) Product differentiation and iv) Conditions of entry Market Structure and
Barriers to Entry
and exit.

i) Number and size distribution of sellers

The firm’s ability to affect the price and the quantity of a product
supplied to the market is related to the number of firms offering the same
product. If there are a large number of sellers, the influence of any one
firm is likely to be less. Consider the number of firms selling fruits and
vegetables in your locality. It is unlikely that any one of them will
exercise a great influence over price. On the contrary, if there are only
few sellers in the market, an individual firm can exercise greater control
over price and total supply of the product. Considering this fact the
number of firms can be classified into large, few, two and one.

ii) Number and size distribution of buyers

Markets can also be characterized by the number and size distribution of

buyers, where there are many small buyers of a product and all are likely
to pay about the same price. Consider a big firm in a city. For example,
A Steel manufacturing Company in Jamshedpur is a large and perhaps
the only firm in the area. The Steel manufacturing Company will thus be
able to exercise considerable influence on the price at which it buys
inputs from suppliers in the area. Similarly, An Automobile Company in
Gurgaon is one of the large automobile manufacturers and has
considerable influence over the price at which it buys inputs such as
glass, radiator caps and accessories from other suppliers located in the
region. Both the Automobile and Steel manufacturing Companies are
firms that are said to have ‘monopsony’ power in their buying decisions.
However, if there are a large number of buyers they will be unable to
demand lower prices from sellers. One reason why large firms are able to
negotiate lower prices is because of large volume purchases.

iii) Product Differentiation

If the products competing in the market are not identical or

homogeneous, they are said to be differentiated and hence ‘product
differentiation’ exists in the market. Product differentiation is a fact of
life and there is some amount of differentiation for almost all products
that we buy in markets. For example, ingredients in different soaps could
be different as can be the packaging, advertising etc. Even seemingly
homogeneous goods such as apples and bananas are at present
differentiated on the basis of the orchards where they have been grown
and the way these are marketed. Wheat is a good example of a product
that can be considered undifferentiated. The degree of substitutability or
product differentiation is measured by cross-elasticity of demand
between two competing products. This feature was explained in unit 5.
Products can be classified into perfect substitutes or homogeneous
products, close substitutes like soaps of different brands, remote 223
Pricing Decisions substitutes like radio and television and no substitutes like cereals and
soaps. Further, perfect substitutes for one consumer may not be so for
another. For example, Rahul may feel that products C and P are perfect
substitutes while Sachin may have a strong brand preference for product P.
Product differentiation is a basis for a lot of advertising that is seen in the
media where the focus is to create a strong brand preference for the
product being advertised.

iv) Conditions of Entry and Exit

Entry or exit of firms to an industry refers to the difficulty or ease with

which a new firm can enter or exit a market. In short run, where the
capital of firms is fixed, entry and exit does not make much difference.
Ease of entry and exit is however a crucial determinant of the nature of a
market in the long run. When it is difficult for firms to enter the market,
existing firms will have much greater freedom in pricing and output
decisions than if they had to worry about new entrants. Consider a
pharmaceutical firm that has a patent on a particular drug. A patent is an
exclusive right to market the product for a given period of time, say 12
years. If there are no close substitutes to that drug, the firm will be free
from competition for the duration of the patent. Thus the barriers to entry
in the market for this drug are high. Similarly, since Indian Railways, is a
public monopoly no new entrant can enter the market. An American
multinational technology corporation which produces computer software
and related services too has been able to create substantial entry barriers
in the market making it difficult for new firms to enter in the market. On
the other hand, retail outlets and the restaurant business witness several
new firms entering the market periodically, implying that entry barriers
are relatively low.

Based on the above characteristics markets are traditionally classified into

four basic types. These are Perfect Competition, Monopoly, Oligopoly and
Monopolistic Competition.

Perfect competition is characterized by a large number of buyers and sellers

of an essentially identical product. Each member of the market, whether
buyer or seller, is so small in relation to the total industry volume that he is
unable to influence the price of the product. Individual buyers and sellers are
essentially price takers. At the ruling price a firm can sell any quantity. Since
there is free entry and exit, no firm can earn excessive profits in the long run.

Monopoly is a market situation in which there is just one producer of a

product. The firm has substantial control over the price. Further, if product is
differentiated and if there are no threats of new firms entering the same
business, a monopoly firm can manage to earn excessive profits over a long
period.

Perfect Competition and Monopoly are discussed in more detail in unit 11.
224
Monopolistic competition a term coined by E. M. Chamberlin implies a Market Structure and
market structure with a large number of firms selling differentiated products. Barriers to Entry

The differentiation may be real or is perceived so by the customers. Two

brands of soaps may just be identical but perceived by the customers as
different on some fancy dimension like freshness. Firms in such a market
structure have some control over price. By and large they are unable to earn
excessive profits in the long run.

Since the whole structure operates on perceived product differentiation, entry

of new firms cannot be prevented. Hence, above normal profits can be earned
only in the short run.

Oligopoly is a market structure in which a small number of firms account for

the whole industry’s output. The product may or may not be differentiated.
For example, only 5 or 6 firms in India constitute 100% of the integrated steel
industry’s output. All of them make almost identical products. On the other
hand, passenger car industry with only three firms is characterized by market
differentiation in products. The nature of products is such that very often one
finds entry of new firms difficult. Oligopoly is characterized by vigorous
competition where firms manipulate both prices and volumes in an attempt to
outsmart their rivals. No generalization can be made about profitability
scenarios.

We willdiscuss Monopolistic Competition and Oligopoly in detail in unit 12.

It must also be noted that these market structures can be classified in only
two fundamental forms – Perfect Competition and Imperfect Competition.
Under this classification, Monopoly, Oligopoly and Monopolistic Competition
are treated as special cases of markets, which are less than perfect. Thus, these
forms illustrate the degree of imperfection in a market by using the number of
firms and product differentiation as basic criteria. Table 10.1 provides a ready
reference for different types of markets based on their characteristics.

Table 10.1 Classification of markets based on their characteristics

Type of market Basis of Distinction

structure
Number of Seller Product Condition of
independent sellers concentration differentiation entry
Perfect or Pure Large Non-existent Homogeneous Free or easy
competition product
Monopolistic Large Non-existent Products are Free or easy
competition or low close substitutes
Oligopoly Few Medium or high Products may be Difficult
homogeneous or
close substitutes
Duopoly Two High Products may be Very difficult
homogeneous or or impossible
close substitutes
Monopoly One Very high Remote Barred or
substitutes impossible 225
Pricing Decisions Activity 1

1. Suppose you are working in a company dealing with fast moving

consumer goods. Classify the products of your company and its
competitions under the type of competition it operates in and why?

10.3 FACTORS DETERMINING THE NATURE

OF COMPETITION
We have already seen that the number of firms and product differentiation are
extremely crucial in determining the nature of competition in a market. It has
been tacitly assumed that there are a large number of buyers. What would
happen if there are several firms producing standardized product but only one
buyer?

Obviously, the buyer would control the price, he will dictate how much to
buy from whom. The entire price-volume decision takes on a different
qualitative dimension. Similarly, product features and characteristics, the
natures of production systems and the possibility of new entrants in a market
have profound impact on the competitive behaviour of firms in a market. The
‘entry’ of new firms has special relevance in business behaviour which we
discuss in the next section and deal with other issues in the present one.

Effect of Buyers

We have already referred to the case where there is only one buyer. Such a
situation has been referred to as monopsony. For example, there are just six
firms in India manufacturing railway wagons all of which supply to just one
buyer, the Railways. Such a situation can also exist in a local labour market
where a single large firm is the only provider of jobs for the people in the
vicinity. More frequently encountered in the Indian markets is a case of a few
large buyers, defined as oligopsony. The explosive industry which makes
detonators and commercial explosives has three major customers: Coal India
Ltd. (CIL), Department of Irrigation and various governmental agencies
working on road building activities. Of these, just one customer, CIL takes
nearly 60% of the industry’s output. There are about 10 firms in the industry,
which negotiate prices and quantities with CIL to finalize their short-term
plans.

Most industries manufacturing heavy equipment in India are typically

dominated by a few manufacturers and few buyers with the Government
being the major buyer. Price and volume determination in such products often
takes the form of ‘negotiation across the table’ rather than the operation of
any market forces. Since the members in the whole market inclusive of
buyers and sellers are not many, very often they know each other. In other
situations, like the consumer goods, firms have no direct contact with their
226 customers.
Production Characteristics Market Structure and
Barriers to Entry
Minimum efficient scale (MES) of production in relation to the overall
industry output and market requirement sometimes plays a major role in
shaping the market structure. MES is the minimum scale of output that is
necessary for a firm to produce in order to take advantages of economies of
scale. For example, the minimum efficient scale for an automobile firm is
very high. This is intuitively appealing because if only 100 cars are produced
in a capital intensive automobile plant, the average costs will be high, while a
larger volume of cars will allow the fixed costs to be spread over a number of
cars, thus reducing average costs and increasing the minimum efficient scale.
MES for a service firm such as a travel agent will accordingly be relatively
small.

The reason why there are no more than say, around 10 integrated steel plants
even in an advanced country like the U. S. A. can be partly explained by
economies of scale and thus MES. Since the minimum economic size of such
a steel plant is a few million tonnes, the entire world steel industry can have
no more than 100 efficient and profitable firms. Thus every country has only a
handful of steel plants. On the other hand, when one comes to rolling mills
which take the steel billets or bars as input, the minimum efficient size comes
down considerably, and given the existing demand, several firms can be seen
to operate.

Further, the minimum size does not remain constant but changes drastically
with technological advancements. When technical changes push up the
economic size of a plant, one notices that the number of firms decline over
time. This can be noticed in some process industries like synthetic fibre.
Conversely, technological innovations may make it possible for smaller sized
plants to economically viable. In such a case a lot of new entrants come and
soon the market becomes highly competitive as has happened in the personal
computer industry in India.

Apart from minimum plant size, factors like the availability of the required
raw material, skilled labour etc. can also mould market structures. Likewise,
enough skilled people are not available to work on the sophisticated
machines. These factors sometimes restrict output and push up prices even
though adequate market potential for expansion exists.

Product Characteristics

We have already stated that product differentiation is an important market

characteristic because it indicates a firm’s ability to affect price. If a firms
product is perceived as having unique features, it can command a premium
price and the firm is said to possess market power. For example, the Luxury
Cars have come to be regarded as the ultimate in automobile luxury and
therefore commands a high price. Consumers are willing to pay that premium
for the product. The degree of competition faced by Luxury Cars is thus very 227
Pricing Decisions low. One could also consider the example of railway services in India. Indian
Railway Catering and Tourism Corporation (IRCTC) have monopoly in
railways so people are just dependent on IRCTC for railway ticket bookings.
Thus, the market for railway services is not competitive in the sense that only
one corporation provides the service. Although this monopoly is due to
government restrictions in India which is going to change in the coming
years. On the other hand, for a product like soap or detergents, there are many
firms producing a large variety of substitutable products. Therefore, one
notices more competition, in the detergent market. The physical
characteristics of a product can also influence the competitive structure of its
market. If the distribution cost is a major element in the cost of a product,
competition would tend to get localized. Similarly, for perishable products,
the competition is invariably local.

Conflict between physical characteristics and minimum economic size

An interesting question arises in the case of a product like cement. For

reasons of minimizing the transport costs on raw materials, most cement
plants in the country are located near mine sites. A large efficient plant near
a mine site can manufacture cement at the optimum cost, but the local
demand is never large enough. If such a plant has to sell in far away markets
(from Gujarat to Kerala, for example) the transport costs can be quite high.
Customers located in such areas will always buy cement at a much higher
price. The government partly offsets this by using the mechanism of levy
price which is the same throughout the country.

228
 Market Structure and
10.4 BARRIERS TO ENTRY Barriers to Entry

Market selection: Entry and Exit

Market selection process includes firm’s entry, then its survival and finally
the exit process. The selection and expansion depends how efficient the firm
is. The efficient firms enter and the inefficient ones exit.

Conditions of Entry: The entry of a new firm in an industry or a market

depends on the ease with which it can enter. If we see the long-term
perspective, the number of firms and the degree of seller concentration
depends on the conditions of entry. In case of free entry, the number of sellers
is large in number and in case of restricted entry, the number of sellers tend to
reduce. In the long run the degree of competition depends on the condition of
entry. A new entrant could bring with it the following advantages:

 Provides new goods and services,

 Changes the balance between different sectors,
 Comes with new technological and managerial techniques,
 Increases opportunities.

Factors determining conditions of entry

The following are some of the factors that determine the structure of any
market. This list is not meant to be exhaustive, but is likely to cover a large
part of real world situations.

 Legal barriers
 Initial capital cost
 Vertical integration
 Optimum scale of production
 Product differentiation

Legal barriers: Almost all countries have their set of rules and regulations.
Patent law is one such regulation, which promotes and protects the interests
of inventors and innovators. Under this law, no firm other than the patent
holder or the licensed firm is allowed to make use of the process. India has its
own legal barriers and it had certain laws like Industrial Licensing Regulation
and Reservation of products, which restrict entry and thus protect the
incumbent firm from competition.

Initial capital cost: For industries producing basic inputs like coal, steel,
power etc., the initial capital cost is quite high. Therefore, it becomes difficult
for new entrepreneurs to enter. In industries where the capital requirement is
high, the market is dominated by a few firms, whereas for industries such as
non-durable consumer goods, the initial capital cost is less and therefore the
number of firms in the market can be quite large.

Vertical integration: A vertically integrated firm is one that produces raw

material i.e. an intermediate product as well as the final product. Examples of
vertically integrated firms in India are integrated steel plants such as SAIL 229
Pricing Decisions and TISCO and DMart a supermarket chain. Entry in this case is restricted to
limited producers as here the existing producer produces raw material or an
intermediate product along with the final product. New entrants will find that
their capital requirements are high and hence it will not be easy for them to
enter the market.

Optimization: Optimum scale of production means the scale of output at

which the long run average cost of production is minimum. As defined earlier
this is the minimum efficient scale of production for the firm. If the optimum
scale of output for any product is quite large and if the total market can be
efficiently served by a few firms, the new entrants will find it difficult to
enter such markets. Examples of such markets are electricity generation and
aircraft production.

Product differentiation: New entrants face difficulty to enter the market

where the products are highly differentiated. Consider an example of a
popular ready to eat breakfast cereal company. It is the market leader and
produces more than 40 different kinds of cereal ranging from the ordinary
corn flakes to granola flakes and muesli. With such a wide variety, new
entrants find it difficult to compete with it for shelf space in retail outlets
which is crowded with its products. By implementing such widespread
product differentiation, it has managed to increase the cost of entry for
potential entrants in the market.

Related to entry conditions is the concept of entry barriers. Any manager is

concerned about his firms market share and thus threat to its competitive
position. By establishing an entry barrier a firm not only preserves its market
share but could also increase it. This is perhaps the most interesting aspect of
market structure and its analysis. Such attempts are made everyday by
managers and are widely visible in the environment around us. An example
of an entry barrier is advertising expenditure by firms. Think about the
enormous advertising spend of soft drink firms such as C and P and examine
whether it is possible for a new entrant to try and compete with such large
existing brands even if it come up with an equally good soft drink. We will
study this feature of markets in detail now.

Barrier to entry A barrier to entry exists when new firms cannot enter a
market. There are many types of barriers, which become sources of market
power for firms. Entry barriers can be broadly classified as: Natural barriers,
Legal Barriers and Strategic Barriers.

Natural barriers: Economies of scale create a natural barrier to the entry of

new firms and it occurs when the long run average cost curve of a firm
decreases over a large range of output, in relation to the demand for the
product. Due to the existence of substantial economies of scale, the average
cost at smaller rates is so high that the entry is not profitable for small-scale
firms. This results in existence of natural monopoly. Power generation,
Aircraft manufacturers, Railways, etc. are examples of natural monopolies.
You should keep in mind that technological progress often undermines the
natural monopoly character of certain industries. This has happened in
230
telecommunications, which not very long ago used to be considered a natural Market Structure and
monopoly. Barriers to Entry

Legal barriers: Patents, as discussed above, are an example of a legal entry

barrier. Industrial licensing that used to be common in India in the 1970s and
80s is another example of such a barrier. By giving a license to a firm the
government provided exclusive rights to that firm or a few firms to produce.
This restricted the number of players in the market through industrial
licensing, thus creating a legal entry barrier.

Figure 10.1: Entry Limit Pricing

231
Pricing Decisions Strategic barriers: Such barriers exist exclusively due to the strategic
behaviour of existing firms. Managers undertake investments to deter entry
by raising the rival’s entry costs. To bar or restrict the entry of a new entrant,
an established firm may change price lower than the short-run profit-
maximizing price. This strategy is known as entry limit pricing. The entry
limit pricing depends on established firm taking a cost advantage over
potential entrants. The established firm must have a long run average cost
curve below that of the other firm in order to lower its price and continue to
make an economic profit.

For example, established firm lowers its price below profit-maximizing level.
Figure 10.1 shows demand and marginal revenue curves for an established
firm and also the firm’s long run average cost (LRAC) and marginal cost
(MC) curves as LRACE and LRMCE.

To maximize profit, the firm produces 50,000 units of output when MR=MC
and fix a price of Rs. 100 from the demand curve. Therefore the firm’s profit
becomes:

P = (Rs. 100– Rs. 80) * Rs. 50,000 = Rs. 10,00,000

Suppose the established firm sets the prices at Rs. 90 for say 70,000 units of
output, the new entrant would not be able to cover the average cost as it
would be making loss. The economic profit of the established firm now
would be:

EP = (Rs. 90 – Rs. 80) * Rs. 70,000 = Rs. 7, 00,000

Though this profit is less than the original profit but if we look at the practical
point, it is found that even if the established firm incurs a loss, the sales of the
firm can be increased in the future regarding the difficulties posed for the new
entrant. The lower profit would be higher had the new firm entered the
market and would have taken away some share of the sales from the
established firm. This example shows that entry-limit pricing is not feasible
without the cost advantage.

Building Excess Capacity: Another way to restrict the entry is to build and
maintain excess capacity over and above the required amount. This poses a
threat to the new entrant deliberating the fact that the established firm is
prepared to increase the output and lower the price if and when entry occurs.
The excess capacity can be built up easily as it takes a longer time for the
new entrant to build a factory of such capacity. This type of barrier is also
known as capacity barrier to entry.

Producing Multiple Products: Economies of scope arise when cost of

producing two or more goods together is less costly than producing the two
goods separately. The process goes on and becomes cost effective as more
232 goods are produced. This acts as entry deterrent for new firms.
New Product Development: Producing substitutes for its own product in the Market Structure and
Barriers to Entry
market can discourage the entry for the new firms. For example a consumer
good company producing different types of soaps targeted to different
customer base. The more the number of substitutes, the lower and more
elastic is the demand for any given product in the market. This makes the
entry of new firm more difficult.

Take the case of Microsoft. Why does every other personal computer
(PC)/laptop that one comes across is Microsoft windows compatible. The PC
cannot work without windows. By developing industry level standards,
Microsoft has created ‘high switching costs’ in an attempt to create entry
barriers.

Activity 2

Given below is the list of some industries. Indicate in column 3 whether the
entry barriers are high or low. Give reasons in column 4.

S.No. Name of the Industry Entry Barriers Reasons

1. Software
2. Hardware
3. Oil-field chemicals
4. CNC machine tools
5. Breakfast cereals
6. Aluminium
7. Ball-point pens
8. Television Sets
9. Cement
10. Chocolates

10.5 STRATEGIC ENTRY BARRIERS — A

FURTHER DISCUSSION
No one likes competition and companies with a leading position in a market
will go to considerable lengths to keep out likely new opponents. Although
all companies strive to develop one form of competitive advantage or
another, relatively few are persistently successful over long periods.
Innovative activity is almost always followed by waves of imitation and
relatively few first movers are able to maintain their initial market position.

One of the Indian instant messaging apps founded in 2016 was so popular for
its funny and cool stickers that every month million users got on it. It was one
of the youngest startup which became unicorn in short span of time with a
valuation of over $ 1 billion. But the business could not sustain competition
from foreign instant messaging apps. It had to shut down its operations 233
Pricing Decisions in early 2021. despite being one of the major innovations of Indian
communication industry. The simple truth is that most large-scale
expenditures designed to create competitive advantage are unlikely to realize
a return unless that advantage can be sustained.

Economists think about this problem as one of creating, or strategically

exploiting, barriers to entry or mobility barriers. Entry barriers, as defined
above are structural features of a market that enable incumbent companies to
raise prices persistently above costs without attracting new entrants (and,
therefore, losing market share). Entry barriers protect companies inside a
market from imitators in other industries. Entry barriers give rise to persistent
differences in profits between industries.

Although different commentators produce different lists, almost all sources of

entry barriers fall into one of the three following categories: product
differentiation advantages, absolute cost advantages, and scale-related
advantages. Product differentiation arises when buyers distinguish the
product of one company from that of another and are willing to pay a price
premium to get the variant of their choice. Such differences become entry
barriers whenever imitators, whether they be new entrants or companies
operating in other niches of the same market, cannot realize the same prices
for an otherwise identical product as the incumbent. On the face of it, it is
hard to understand how this might come about since consumers will (surely)
always prefer the lower-priced variant of two otherwise identical products.

However, if it is costly for consumers to change from purchasing one product

to purchasing another, then prices for otherwise identical products can differ
for long periods of time.

Economists call costs of this type switching costs and business managers
always try to create switching costs by locking consumers into their product.
Habit formation is an obvious source of switching costs and many marketing
campaigns are designed to reinforce the purchasing patterns of existing
customers and raise their resistance to change. Further, many consumers sink
costs into gathering information about new products and, once they have
made a choice that satisfied them, they are likely to resist making further
investments

Both sources of switching costs are often reinforced by the use of brand
names to help consumers quickly find familiar products. The value of these
labels depends, of course, on the size of the switching costs that they help to
sustain. Finally, switching costs also arise when consumption involves the
purchase of highly specific complementary products that lock consumers into
existing purchasing patterns. Buyers of a foreign company's mainframes
234 often found that the large costs of rewriting software and recording data
dwarfed price or performance differences that might otherwise have induced Market Structure and
Barriers to Entry
them to switch to one of its foreign rivals.

Absolute cost advantages arise whenever the costs of incumbent companies

are below those of new rivals and they enable incumbents to under-cut the
prices of rivals (by an amount equal to the cost disadvantage) without
sacrificing profits. There are many sources of absolute cost advantages.
Investments in R&D and learning-by-doing in production can be important in
many sectors and they can occasionally be protected by patents. Similarly,
privileged access to scarce resources (such as deposits of high-quality crude
oil, much sought after airport landing slots or the odd scientific genius) can
open up substantial differences in costs between companies producing
identical products. Many companies vertically integrate upstream to assure
control over limited natural resources or downstream to assure access to the
most valuable distribution channels, actions that can make entry anywhere in
the value chain difficult.

Scale-related advantages create the most subtle form of entry barriers. They
arise whenever a company’s costs per unit fall as the volume of production
and sales increases. Economies of scale in production (created by set up
costs, an extensive division of labour, and advantages in bulk buying and so
on) are the most familiar source of scale advantages but economies can also
arise in distribution. One way or the other, the important implication of scale
advantages is that they impede small-scale entry. If costs halve as production
doubles, then a small entrant will have costs per unit twice as high as an
incumbent twice its size. Since it is unlikely that such an entrant will be able
to differentiate its product enough to justify a price difference of this size, it
must either enter at a scale similar to that of the incumbent or not enter at all.
Needless to say, this compounds its problems, since raising the finance to
support a large-scale (and therefore much riskier) assault on a privileged
market can be much more difficult than raising funds for a much more modest
endeavor.

As stated above, few markets naturally develop entry barriers and, even when
they do, very few incumbent companies rely on structural features of market
alone to protect them. Whether it is creating or exploiting entry barriers,
companies with profitable market positions to protect usually need to act
strategically to deter entry. Although there are as many different examples of
strategic entry deterrence, there are at least three types of generic strategies
that companies typically employ: sunk costs, squeezing entrants and raising
rival’s costs.

Sunk costs: Displacing incumbents is possibly the most attractive strategy for
an entrant to follow since, if successful, it enables the entrant both to enter a
market and monopolies it. Somewhat more modestly, if an entrant can at least
partially displace an incumbent, it will make more profit after entry than if it
235
Pricing Decisions has to share the market on a less equal basis. To deter entrants from following
this strategy, an incumbent needs to lock itself into the market in a way that
raises the cost to the entrant of displacing it. This usually requires the
incumbent to make investments whose capital value is hard to recover in the
event of exit. Sunk costs raise the costs of exit (and so make it that much
harder for the entrant to force the incumbent out). Some incumbents do this
by investing in highly dedicated, large-scale plant and equipment since this
also enables them to reap economies of scale in production. These activities
also have the additional benefit of creating product differentiation or absolute
cost advantages.

Squeezing entrants: It is usually all but impossible to deter very small-scale

entry and frequently it is not worth the cost. However, capable entrants
interested in establishing a major position in a market are a much more
serious threat and many entry-deterring strategies work by forcing entrants to
enter at large scale while at the same time making this too expensive.
Squeeze strategies usually build on scale economies that prevent small-scale
entry by forcing entrants to incur even more fixed costs (say through
escalating the costs of launching a new product by extensively advertising),
which increases their minimum scale of entry. Further, if these fixed costs are
also sunk then these activities also increase the risks associated with entry.
The squeeze comes through actions that limit their access to customers,
making the larger scale of entry much more difficult and expensive to realize
than a more modest market penetration strategy might have been. This is
often done by filling the market with more and more variants of the generic
product, developing fighting brands closely targeted on the entrant’s product
or limiting access to retail outlets.

A simple glance at the shelves of most super markets will reveal many
instances where the multiple brands of a single company (or a small group of
leading companies) completely fill all the available space, leaving little or no
room for an entrant (examples might include laundry detergents of India's
largest fast-moving consumer goods company and ready to eat breakfast
cereals of an American multinational food manufacturing company).

Raising rival’s costs: Even when an incumbent is sure that it cannot be

displaced by an entrant and it has managed to squeeze the entrant into a tiny
niche of an existing market, entry can sometimes be profitable when the
market is growing.

Indeed, market growth is an important stimulus to entry since it automatically

creates room for the entrant without reducing the incumbent’s revenues.
However, most entrants have only modest financial support and any strategy
that raises costs in the short run and slows the growth of their revenues may
make it difficult for them to survive long enough to penetrate the market and
turn a profit. One rather obvious strategy of this type is to escalate advertising
236 and, indeed, this is a very frequent response to entry by incumbents.
Advertising is a fixed cost (which, therefore, disadvantages small-scale Market Structure and
Barriers to Entry
entrants) and it is often the case that what matters is the relative amount of
advertising a company does rather than the absolute amount. An advertising
war initiated by an incumbent that raised total market advertising but keeps
the advertising shares of companies relatively constant will, therefore, raise
the entrant’s costs without raising its revenues. The interesting feature of this
strategy is that an advertising war will also raise the incumbent’s costs.
Besides, investments in advertising are often sunk, meaning that they are
likely to raise the exit costs of the incumbent. Entrants are more adversely
affected by an advertising war than the incumbent is. That is, some
investments that incumbents make seem irrational because they raise costs
without generating much, if any, additional revenues. When successful,
however, they are justified by the fact that they protect existing revenue
streams from entrants. This point is one of the most characteristic features of
investments in entry deterrence: they do not generate net revenue so much as
they prevent it from being displaced.

A company that successfully deters entry will have lower profits than a
company that did not face an entry threat but that is not an interesting
observation. What matters is that a company that successfully deters entry
will preserve its profits while a company that has not been able to deter entry
will see its market position, and the profits that it generates, gradually
disappear.

10.6 PRICING ANALYSIS OF MARKETS

Pricing is an important function of all firms. Every firm is engaged in the
production of some goods and/or services, incurring some expenditure to sell
them in the market. It must, therefore, set a price for its product. It is only in
extreme cases that the firm has no say in pricing its product because there
prevails perfect competition in the market or the good has so much public
significance that its price is decided by the government. Otherwise, in large
number of cases, the individual producer plays the role in pricing her/his
product.

The quantity supplied depends upon a number of factors. The law of supply
takes into account its main determinant i.e price of the commodity. The law
of supply states that supply of a commodity refers to the various quantities of
the commodity which a seller is willing and able to sell at different prices in a
market, at a point of time, ceteris paribus, other things remaining the same.
Supply is related to scarce goods and not freely available goods. In this
regard the role of demand and supply in determination of price is very
important.
237
Pricing Decisions Table 10.2 Demand-Supply Schedule

Price Demand Supply

5 100 200
4 120 180
3 150 150
2 200 110
1 300 50

Setting the right price for its product is crucial for any firm in the market.
This is because the price is such a parameter that it exerts a direct influence
on the demand for and supply of the product and thereby on its sales and
profit – the important yardsticks for the success or failure of the firm. If the
price is set too high, the seller may not find enough customers to buy his/her
product.

Figure 10.2: Demand-Supply curve

Quantity

On the other hand, if the price is set too low, the seller may not be able to
recover her/his costs. Further, demand and supply conditions vary over time
and the managers must therefore review and reformulate their pricing
decisions from time to time.

It is clear that the price of a product is determined by the demand for and
supply of that product. Table10.2 illustrates the demand and supply schedules
238 of a product.
 Figure 10.3: Effect of a change in demand on price and quantity Market Structure and
Barriers to Entry

Let us assume that in the above example the market price, P = 3 and no other
price prevails in the market (Figure 10.2). Because if P = 5, supply exceeds
demand and the producers may not be able to find enough customers for their
product. This would result into competition among the producers forcing
them to bring down the price to 3. On the other hand, if P = 1, the demand
exceeds supply which would give rise to competition among the buyers of the
product, pushing the price up to 3. Therefore, at P = 3, demand equals supply,
which is called equilibrium price. The equilibrium price is thus determined
by the interaction of demand and supply. 239
Pricing Decisions We have seen in Block 2 that the demand for a good depends on a number of
factors as does supply of a good. Therefore, the factors which affect either
demand or supply are also determinants of price. A change in demand and/or
supply would bring in a change in price. For instance, if the supply of a good
is fixed, as shown in figure 10.3, the level of demand appears to determine
the equilibrium price. In this case, the price is determined by the ‘other
factors’ influencing the level of demand curve. An increase in demand from
D1 to D2, leads to an increase in equilibrium price from P1 to P2 and an
increase in quantity from Q1 to Q2 [see figure10.3 (a)]. Quite the opposite
holds true in the event of a decrease in demand which is shown in figure
10.3(b).

If the demand for a commodity is fixed, as shown in figure 10.4 the level of
the supply curve determines the equilibrium price of the commodity. The
equilibrium price would, therefore depend on the ‘other factors’ underlying
the supply curve of the commodity. Figure 10.4 (a) shows that an increase in
supply from S1 to S2 causes price to fall from P1 to P2 and the quantity to
increase from Q1 to Q2. Figure 10.4 (b) shows exactly the reverse case.

So far we have discussed the general equilibrium price which is determined

by the interaction of demand and supply. However, the actual shapes of the
demand and supply schedules depend on the structure of the product, market
and the objectives of the firm. Thus market structure and firms’ objectives
also have a bearing on price.

Figure 10.4: Effects of a change in supply on price and quantity

Price

Quantity

(a) Increase in Supply

240
 Market Structure and
Barriers to Entry

Price

Quantity

(b) Decrease in Supply

Since market structure influences price and different product groups fall
under different market structures, pricing decisions depend upon market
structure. For instance, automobile prices are set quite differently from prices
of soap because the two products are produced by firms in different market
structures.

Accordingly, in the subsequent units we shall discuss price determination

under perfect competition and pure monopoly, and monopolistic competition
and oligopoly (Units 12 and 13 respectively).

A large firm may produce a number of products, which are sold in variety of
markets catering to the needs of different sections of the society. Let us take
the example of FMCG, which produces products ranging from cosmetics to
food products. Here comes the real task to be performed. At times it happens
that price set for one of such products may affect the demand for the other
product sold by the same firm. For example, the introduction of product R
from an automobile company had an effect on the price of product 2 sold in
the market.

Pricing of multiple products /a number of products produced by the

same firm

It is difficult to set a price of multiple products but once it is set, the products
make their own place in the market. Take the example of Fast Moving
Consumer Goods Companies which are India’s largest Packed Mass
241
Pricing Decisions Consumption Goods (PMCG). The vision of the company is to meet
the everyday needs of the people everywhere. Over the past years
these Company's have introduced somewhere around 100 brands, most of
which have become household names in the country. The products vary from
personal care products to beverages. A list of such products of FMCG
Company is provided in Table 10.3. This example also gives an idea of
product differentiation. In this case the price of each product is different
because it caters to different segments of the market.

Table 10.3: List of Products by FMCG Companies

Beauty & Examples Soaps and Examples Food, Examples

Personal Care Detergents Beverages,
Products Ice-cream,
and Soups
ORAL Tooth Paste PERSONAL Soaps FOOD Flour, Salt,
CARE Tooth Powder CARE Body
Wash
SKIN CARE Face Cream Green Tea
Tea granules
Body FABRIC Washing Energy
. Lotions WASH Powder & BEVERAGE Drinks
Detergents

HAIR CARE Shampoos Ice cream cone

Hair Gel HOUSEHOLD Utensil Cleaning SOUPS &
Ice cream cup
CARE Powder and liquid and soups
ICE- CREAM

BODY CARE Deodorant

Perfumes

COLOUR Lipstick
COSMETICS Nail
Polish

Many Companies produce similar products under different brand names.

Activity 3

1) List five examples where the price of one product affects the demand
for the other and vice-versa.

2) List (any five) the name and product of the companies producing
multiple products.
242
 Market Structure and
10.7 LET US SUM UP Barriers to Entry

In this unit, we have made an attempt to understand the concept of market

structure and the impact it has on the competitive behaviour of firms. Various
competitive market situations were defined and broadly discussed. The
number of firms and product differentiation are crucial determinants of the
nature of competition in the market. The level of competition also gets
influenced by number of sellers and buyers, buyers’ behaviour, characteristics
of product and production.

The pricing analysis of markets helps to understand how the equilibrium

price is determined by the interaction of demand and supply. This forms the
basis for analyzing the price-output decisions of firms under different
competitive situations.

10.8 KEY WORDS

Barriers to entry refer to the obstacles that impede the entry of new firms in
an industry.

Competition is the collective outcome of the forces generated within a given

market structure (for a product or service) in combination with product
characteristics, number of buyers, potential entrants and government policy.
Market structure refers to the number and size distribution of buyers and
sellers in the market for goods or service.
Monopolistic competition is characterized by many sellers of a
differentiated product.
Monopoly situation is characterized by just one producer of a product or
service
Oligopoly situations have fewer sellers with or without the existence of
product differentiation.
Perfect competition is a market structure where a large number of buyers
and sellers deal in nearly identical products. Each is individually so small in
relation to the total output that all members are ‘price takers’.
Product differentiation refers more to the differences in products as
perceived by the customers than in real or technical difference in
specifications.

10.9 TERMINAL QUESTIONS

1) Classify the market structures based on certain factors and support your
answer with the help of examples.
2) Discuss the different structural variables. Illustrate your answer with the
help of examples.
243
Pricing Decisions 3) Discuss the important technical barriers to entry.
4) Take the example of a hypothetical firm. Apply the strategic barriers to
the firm and discuss.
5) The paperback books and the hardcover books are sold at different
prices. Explain.
6) What are switching costs? Cite one example of a switching cost and
examine how a firm can advantage from the existence of switching
costs?

FURTHER READINGS
Mote, V. L., Paul, S., & Gupta, G. S. (2016). Managerial Economics:
Concepts and Cases, Tata McGraw-Hill, New Delhi.

Maurice, S. C., Smithson, C. W., & Thomas, C. R. (2001). Managerial

Economics: Applied Microeconomics for Decision Making. McGraw-Hill
Publishing.

Dholakia, R., & Oza, A. N. (1996). Microeconomics for Management

Students. Oxford University Press, Delhi.

244
 Pricing Under Perfect
UNIT 11 PRICING UNDER PERFECT Competition and Pure
Monopoly
COMPETITION AND PURE
MONOPOLY
Structure
11.0 Objectives
11.1 Introduction
11.2 Characteristics of Perfect Competition
11.3 Profit Maximizing Output in the Short Run
11.4 Profit Maximizing Output in the Long Run
11.5 Characteristics of Monopoly
11.6 Profit Maximizing Output of a Monopoly Firm
11.7 Welfare: Perfect Competition vs Monopoly
11.8 Implications of Perfect Competition and Monopoly for Managerial
Decision Making
11.9 Let Us Sum Up
11.10 Key Words
11.11 Terminal Questions

11.0 OBJECTIVES
After going through this unit, you should be able to:
 describe the characteristics of pure/perfect competition and pure
monopoly;
 identify the equilibrium conditions for a firm and the industry in a
perfectly competitive situation;
 examine price-output decisions under pure monopoly; and
 analyze the relevance of pure/perfect competition and pure monopoly.

11.1 INTRODUCTION
In the preceding unit, you have been introduced to the concept of market
structure and the impact it has on the competitive behaviour of firms. You
must have noted that the number and size of the firms is an important
determinant of the structure of the industry and/or market.

In this unit, we shall analyze the behaviour of a firm under two different
market structures, namely, pure/perfect competition and monopoly. The
crucial parameter is the size of the constituent firms in relation to the total 245
Pricing Decisions industry’s output. Throughout this unit, we go by the assumption that the
firms are guided by profit maximization.

11.2 CHARACTERISTICS OF PERFECT

COMPETITION
Perfect competition is a form of market in which there are a large number of
buyers and sellers competing with each other in the purchase and sale of
goods, respectively and no individual buyer or seller has any influence over
the price. Thus perfect competition is an ideal form of market structure in
which there is the greatest degree of competition.

A perfectly competitive market has the following characteristics:

1. There are a large number of independent, relatively small sellers and

buyers as compared to the market as a whole. That is why none of them
is capable of influencing the market price. Further, buyers/sellers should
not have any kind of association or union to arrive at an understanding
with regard to market demand/price or sales.

2. The products sold by different sellers are homogenous and identical.

There should not be any differentiation of products by sellers by way of
quality, variety, colour, design, packaging or other selling conditions of
the product. That is, from the point of view of buyers, the products of
competing sellers are completely substitutable.

3. There is absolutely no restriction on entry of new firms into the industry

and the existing firms are free to leave the industry. This ensures that
even in the long run the number of firms would continue to remain large
and the relative share of each firm would continue to remain insignificant.

4. Both buyers and sellers in the market have perfect knowledge about the
conditions in which they are operating. Buyers know the prices being
charged by different competing sellers and sellers know the prices that
different buyers are offering.

5. The distance between the locations of competing sellers is not significant

and therefore the price of the product is not affected by the cost of
transportation of goods. Buyers do not have to incur noticeable
transportation costs if they want to switch over from one seller to
another.
246
The characteristics of perfect competition are summarized in Table 11.1 Pricing Under Perfect
Competition and Pure
Number and size of distribution of Many small sellers. No individual Monopoly

sellers. seller is able to exercise a significant

influence over price.
Number and size distribution of Many small buyer
buyers No buyer is able to exert a significant
influence over price.
Product differentiation. No product differentiation.
Decisions to buy are made on the
basis of price.
Conditions of entry and exit. Easy entry and exit.
Resources are easily transferable
among industries.

As mentioned in the previous unit, it is difficult to find a market that satisfies

all the text book conditions of perfect competition. There are markets that
come close to fulfilling these stringent conditions, but none that completely is
in synchronization with all of them. You might well ask the rationale for
studying this market structure if it does not exist in the real world. The answer
is that perfect competition is the ideal market, and serves as a benchmark. We
can use the outcomes of other markets to compare with outcomes that would
have been achieved under perfect competition. For instance, if the market is
competitive, prices would be lower and closer to costs, while if the market is
monopolized then prices are likely to be higher. Another useful comparison
relates to the concept of consumer’s surplus.

Intuitively, consumer’s surplus can be thought of as the difference between

the maximum amount the consumer is willing to pay for a product and the
amount he actually pays. Think about your purchase of a big ticket item such
as a camera. You have a price in mind that is the maximum you are willing to
pay. The difference between this and the price actually paid is the consumer’s
surplus1.

In perfectly competitive markets, consumer’s surplus is the maximum, while

in monopoly markets it is low. In fact, it is the endeavour of monopolies to
capture as much of the consumer’s surplus as possible. When a perfectly
competitive industry gets monopolized there is a transfer of surplus from the
consumer to the producer. Or stated differently, the producer is able to
increase his surplus (or profit) at the expense of the consumer. On the other
hand, when a monopolized industry becomes competitive, there is transfer

1
Note that you will never pay more than maximum amount. 247
Pricing Decisions from producers to the consumers; i.e. consumers become better off when
there is increased competition. An illustration of this can be gauged from the
conduct of the automobile industry in India since it was deregulated in 1991.
The consumers have benefited from competition in the sector and one can
definitely assert that producer margins (or surplus) have declined to the
benefit of the consumers.

Activity 1

Grocery stores in a large city appear to have a perfectly competitive market

structure as there are many sellers and each seller is relatively small who is
selling similar products.

a) Do you think that grocery stores can be an example of perfect

competition? Discuss.

b) What in your opinion is the market structure of grocery stores and why?

11.3 PROFIT-MAXIMISING OUTPUT IN THE

SHORT RUN
Having examined the rationale for studying perfectly competitive markets, let
us analyze the profit-maximizing output of a profitable competitive firm in
the short run. As you already know, the short run is defined as a period of
time in which at least one input is fixed. Often the firm’s capital stock is
viewed as the fixed input. Accordingly, this analysis assumes that the number
of production facilities in the industry and the size of each facility do not
change because the period being considered is too short to allow firms to
enter or leave the industry or to make any changes in their operations.

Under perfect competition, since an individual firm cannot influence the

market price by raising or lowering its output, the firm faces a horizontal
demand curve, that is, the demand curve of any single firm is perfectly elastic
– its elasticity is equal to infinity at all levels of output. If a firm charges a
price slightly higher than the prevailing market price, demand for that firm
will fall to zero because there are many other sellers selling exactly the same
product. On the other hand, if a firm reduces its price slightly, its demand will
increase to infinity and thus other firms will match the low price.

A firm under perfect competition is a price-taker and not a price-maker.

Because an individual firm’s demand or Average Revenue (AR) curve is
horizontal under perfect competition, the Marginal Revenue (MR) curve of
the firm is also horizontal coincides with the AR curve. In other words, AR
248
and MR are constant and equal at all levels of output. You should satisfy Pricing Under Perfect
Competition and Pure
yourself that if price (i.e. average revenue) is constant, marginal revenue will Monopoly
be equal to price2.

The price-output determination and equilibrium of the firm under perfect

competition may be explained through a numerical example. Suppose the
demand and supply conditions of a product are represented by the following
equations:

Aggregate Demand: Q = 25 – 0.5 P

Aggregate Supply: Q = 10 + 1.0 P

The equilibrium price would be at a point where aggregate demand equals

aggregate supply

25 – 0.5 P = 10 + 1.0 P

or P = 10

Industry output at P = 10 is obtained by substituting this price into either the

demand or supply function:

Q = 10 + 1.0 (10)

= 20

Therefore equilibrium price, P = 10 and equilibrium output, Q = 20.

Figure 11.1 shows that when the market price is at P1, demand and marginal
revenue facing the firm are D1 and MR1. The optimal output for the firm to
produce is at point A, where Marginal Cost (MC) = P1, and the firm will
produce Q1 units of output. At Q1 level of output, the Average Total Cost
(ATC) is less than the price and the firm makes an economic profit.

Suppose the market price falls to P2, price equals MC at point C. Because at
this level of output (Q2) average total cost is greater than price, total cost is
greater than total revenue, and the firm suffers losses. The amount of loss is
the loss per unit (CR) times the number of units produced (Q2).

2
If p=10 and q=1, TR =10; if p = 10 and q=2, TR = 20; MR is thus 10 and so on. MR will always = 10
and therefore will be the same as price as long as price is constant. 249
Pricing Decisions Figure 11.1: Profit Maximizing Equilibrium in the Short Run

At price level P2, demand is D2 = MR2, there is no way that the firm can earn
a profit. This is because at every output level average total cost exceeds price
(ATC > P). The firm will continue to produce only if it loses less by producing
than by closing its operations entirely. When the firm produced zero output,
total revenue would also be zero and the total cost would be the total fixed
cost. The loss would thus be equal to total fixed cost. If the firm produces at
MC = MR2 (point C), total revenue is greater than total variable cost, because
P2 > AVC at Q2 units of output. The firm will be in a position to cover all its
variable costs and still has CD times (as in graph 11.1) the number of units
produced (Q2) left over to pay part of its fixed cost. This way the firm suffers
a smaller loss when it continues production than it shut down its operations.

At market price P3, demand is given by D3 = MR3. The equilibrium output Q3

would be at T where MC = P3. At this output level, since the average variable
cost of production exceeds price, the firm not only loses all its fixed costs but
would also lose Rs. ST per unit on its variable costs as well. The firm could
improve its earnings situation by producing zero output and losing only fixed
costs. In other words, when price is below average variable cost at every level
of output, the short-run loss-minimizing output is zero.

To reiterate, the profit maximizing output for a perfectly competitive firm in

the short run is to set P = MC. Since P = MR, this is equivalent to setting MR
= MC. In the short run, as the above discussion shows, it is possible for the
firm to make above normal or economic profit. On the other hand, it is also
possible for the firm to make losses, as long as those losses are less than its
250
total fixed costs. In other words, the firm will continue to produce as long as Pricing Under Perfect
Competition and Pure
P>AVC in the short run, because this is a better strategy than shutting down.
Monopoly
The firm will shut down only if P< AVC.

11.4 PROFIT-MAXIMISING OUTPUT IN THE

LONG RUN
Now let us analyze the profit maximizing output decision by perfectly
competitive firms in the long run when all inputs and therefore costs are
variable. In the long run, a manager can choose to employ any plant size
required to produce the efficient level of output that will maximize profit.
The plant size or scale of operation is fixed in the short run but in the long
run it can be altered to suit the economic conditions.

In the long run, the firm attempts to maximize profits in the same manner as
in the short run, except that there are no fixed costs. All costs are variable in
the long run. Here again the firm takes the market price as given and this
market price is the firm’s marginal revenue. The firm would increase output
as long as the marginal revenue from each additional unit is greater than the
marginal cost of that unit. It would decrease output when marginal cost
exceeds marginal revenue. This way the firm maximizes profit by equating
marginal cost and marginal revenue (MR = MC; as discussed above).

Figure 11.2: Profit Maximizing Equilibrium in the Long Run

The firm’s long run average cost (LAC) and marginal cost (LMC) curves are
shown in Figure 11.2. The firm faces a perfectly elastic demand indicating
the equilibrium price (Rs. 17) which is the same as marginal revenue (i.e., D
251
Pricing Decisions = MR = P). You may observe that as long as price is greater than LAC, the
firm can make a profit. Therefore, any output ranging from 20 – 290 units
yields some economic profit to the firm. In figure 11.2, B and B1 are the
breakeven points, at which price equals LAC, economic profit is zero, and the
firm can earn only a normal profit.

The firm, however, earns the maximum profit at output level 240 units (point
S). At this point marginal revenue equals LMC and the firm would ideally
select the plant size to produce 240 units of output. Note that in this situation
the firm would not produce 140 units of output at point M, which is the
minimum point of LAC. At this point marginal revenue exceeds marginal
cost, so the firm can gain by producing more output. As shown in figure 11.2,
at point S total revenue (price times quantity) at 240 units of output is equal
to Rs. 4080 (= Rs. 17 * 240), which is the area of the rectangle OTSV. The
total cost (average cost times quantity) is equal to Rs. 2,880 (= Rs. 12 * 240)
which is the area of the rectangle OURV. The total profit is Rs. 1,200 = (Rs.
17 – Rs. 12) * 240, which is the area of the rectangle UTSR.

Thus, the firm would operate at a scale such that long run marginal cost
equals price. This would be the most profitable situation for an individual firm
(illustrated in figure 11.2). Therefore, if the price is Rs. 17.00 per unit, the
firm will produce 240 units of output, generating a profit of Rs. 1,200.00.
This profit is variously known as above normal, super normal or economic
profit. The crucial question that one needs to ask is whether this is a
sustainable situation in a perfectly competitive market i.e. whether a firm in a
perfectly competitive industry can continue to make positive economic profits
even in the long run? The answer is unambiguously no.

This result derives from the assumption that in a perfectly competitive market
there are no barriers to entry. Recall that in a market economy, profit is a
signal that guides investment and therefore resource allocation decisions. In
this case, the situation will change with other prospective entrants in the
industry. The economic force that attracts new firms to enter into or drives
out of an industry is the existence of economic profits or economic losses
respectively. Economic profits attract new firms into the industry whose entry
increases industry supply. As a result, the prices would fall and the firms in the
industry adjust their output levels in order to remain at profit maximization
level. This process continues until all economic profits are eliminated. There
is no longer any attraction for new firms to enter since they can only earn
normal profits. By observing figure 11.2 you should try to work out the price
that will prevail in this market in the long run when all firms are earning
normal profit.

252
Analogous to economic profit which serves as a signal to attract investment, Pricing Under Perfect
Competition and Pure
economic losses drive some existing firms out of the industry. The industry Monopoly
supply declines due to exit of these firms which pushes the market prices up.
As the prices have risen, all the firms in the industry adjust their output levels
in order to remain at a profit maximization level. Firms continue to exit until
economic losses are eliminated and economic profit becomes zero, that is,
firms earn only a normal rate of profit.

Activity 2

Assume that all the assumptions of perfect competition hold true.

a) What would be the effect of technological change in the long-run under

perfect competition?

b) What conditions, in your opinion, would encourage research and

development activities in the industry operating under perfect
competition?

11.5 CHARACTERISTICS OF MONOPOLY

Monopoly can be described as a market situation where a single firm
controls the entire supply of a product which has no close substitutes. The
market structure characteristics of monopoly are listed below:

 Number and size of distribution of sellers Single seller

 Number and size of distribution of buyers Unspecified
 Product differentiation No close substitutes
 Conditions of entry and exit Prohibited or difficult
entry

Though perfect competition and monopoly are the two extreme cases of market
structure, they both have one thing in common – they do not have to compete
with other individual participants in the market. Sellers in perfect competition
are so small that they can ignore each other. At the other extreme, the
monopolist is the only seller in the market and has no competitors. The market
or industry demand curve and that of the individual firm are the same under
monopoly since the industry consists of only one firm.

Managers of firms in a perfectly competitive market facing a horizontal

demand curve would have no control over the price and they simply choose
the profit maximizing output. However, the monopoly firm, facing a
downward-sloping demand curve (see Figure 11.3) has power to control the
price of its product. If the demand for the product remains unchanged, the
monopoly firm can raise the price as much as it wishes by reducing its output.
On the other hand, if the monopoly firm wishes to sell a larger quantity of its
product it must lower the price because total supply in the market will 253
Pricing Decisions increase to the extent that its output increases. While an individual firm under
perfect competition is a price-taker, a monopolist firm is a price-maker. It
may, however, be noted that to have price setting power a monopoly must not
only be the sole seller of the product but also sell a product which does not
have close substitutes.

11.6 PROFIT MAXIMISING OUTPUT OF A

MONOPOLY FIRM
Often students are tempted into thinking that since a monopolist is the only
producer in the market, he will be able to charge any price for the product.
While a monopolist will certainly charge a high price, it must also ensure that it
is maximizing profit. Our earlier discussion proves that a profit maximizing
monopoly firm determines its output at that level where its marginal cost (MC)
curve intersects its downward sloping marginal revenue (MR) from below.
Since the MR curve of the monopoly firm is below its average revenue or
demand curve at all levels of output, and at the equilibrium output level
marginal revenue is equal to marginal cost, the profit maximizing monopoly
price is greater than marginal cost. You may recall, the profit maximizing price
under perfect competition is equal to marginal cost. Since the demand curve of
the monopoly firm is above the firm’s average cost curve, the price at
equilibrium output is also greater than average cost. Therefore, super-normal
profits are a distinguishing feature of equilibrium under monopoly.

Figure 11.3: Equilibrium output and price under monopoly

The firm would enjoy such super normal profits even in the long run because it
254 is very difficult for new firms to enter in a monopolized market.
The determination of profit maximizing equilibrium output and price under Pricing Under Perfect
Competition and Pure
monopoly is shown in figure 11.3. DD and MR are the downward sloping
Monopoly
demand (or average revenue curve) and marginal revenue curves respectively
of the monopoly firm. AC and MC are its average cost and marginal cost
curves. At point E, MC intersects MR from below. Corresponding to E, the
profit maximizing equilibrium output is OQ. At OQ output, the price is OP =
QR; and average cost is OC = QK. The monopoly profits are equal to price
minus average cost multiplied by output i.e., (OP – OC) * OQ = PC *CK =
PCKR. The rectangle area PCKR represents the super normal profits of the
monopoly firm.

Monopoly Power

The above analysis shows that whereas under perfect competition, price is
equal to marginal cost and profits are normal in the long run; under
monopoly, price is greater than marginal cost and profits are above normal
even in the long run.

Therefore, the monopolist has power to charge a price which is higher than
marginal cost and earn super normal profits. The extent of monopoly power
of a firm can be calculated in terms of how much price is greater than
marginal cost. Recall that a perfectly competitive firm sets P = MC. Thus the
greater the difference, the greater is the monopoly power. Economist A.P.
Lerner devised such an index to measure the degree of monopoly power and
which has come to be known as the Lerner index. According to this index,
the monopoly power of a firm is —

µ = (P – MC)/P

Where
P = Price of the firm’s product
MC = Firm’s marginal cost

We know that at equilibrium output MC = MR and MR = P (1 – 1/e) where e

is the price elasticity of demand.

µ = (P – MC)/P
µ = (P – MR)/P = 1 – (MR/P)
But (MR/P) = (1-1/e)
µ = 1 – (1 – 1/e)
µ = 1/e

The monopoly power of a firm is inversely related to elasticity of demand for

its product. The less elastic the demand for its product, the greater would be
its monopoly power, and vice versa. As we have discussed in Block 2,
elasticity of demand depends on the number and closeness of the substitutes
available for a product. In the real world we find some essential goods and 255
Pricing Decisions services like life saving medicines, petroleum, cooking gas, railways etc.
which enjoy a high degree of monopoly power because the demand for these
products is highly inelastic. Left to itself the monopoly could price such
inelastic products at rates that do not meet the social objectives of the
government and policy makers. Thus we often witness government
intervention in monopolies. For example, Railway ticket prices are fixed by
the government and electricity tariffs are set by a regulatory authority. The
reason why monopolies need to be regulated is discussed in the next section.

11.7 WELFARE: PERFECT COMPETITON VS

MONOPOLY
Our discussion reveals that in a pure monopoly price will generally be greater
than marginal cost and that the firm is able to generate super normal profits at
the expense of welfare of consumers and society even in the long run. Recall
that key conditions that give rise to monopolies are economies of scale and
barriers to entry. On the other hand, production processes like food
processing, textiles, garments, wood and furniture, it is relatively easy to
enter the market as a supplier – for example, capital requirements are low and
sunk costs are also low. Many service industries like travel agencies fall into
this category. In such industries, competition ensures that prices are set
‘right’ and moreover the threat of entry ensures that prices never exceed long-
run average cost (for example, marginal companies in the industry cannot
persistently earn above average profits). Moreover, competition also ensures
that price equals long-run marginal cost. Hence the price of a good accurately
reflects the opportunity cost of manufacturing it.

Problems arise from leaving everything to the market, however when a

situation of monopoly occurs. In economists’ jargon, there are economies of
scale to be exploited when one company meets market demand. There are
typically also major barriers to entry in such industries. Most public utilities –
electricity generation, water supply, gas supply and perhaps national
telecommunications systems – have technologies of this sort. There are
several special problems for these industries.

First, their size and capital intensity often puts particular strain on private
capital markets in satisfying their investment needs. In India, in the 1990s
strain was felt instead on the public coffers, and this was a major factor
behind the move towards disinvestment and privatization. Hence, while for
example automobile or chemicals manufacture are also characterized by huge
scale economies, governments have rarely seen it as their role to regulate
companies in these industries. The question for policy makers is what to do
about natural monopolies like power and water supply. Left to themselves,
they will charge monopoly prices and restrict output. The absence of any
competitive threat will also probably leave such organizations wasteful,
inefficient and sluggish. Since all costs can be passed on to the consumers,
256
there will be little incentive for managers to keep them under control. Pricing Under Perfect
Competition and Pure
Experience from, for example, the railways suggests that it will not be long
Monopoly
before the absence of competitive pressures may damage the motives for
innovation and change, so crucial in such capital-intensive sectors. Thus in
some cases a regulator is appointed who must fix the natural monopolist’s
price. In India, privatization of power and telecommunications has been
accompanied by the creation of a regulator, while there is no such institution for
cement, automobile or chemical industry.

The above discussion can also be illustrated with the help of Figure 11.4.
Assume a perfectly competitive industry. We know that price would be Pc
and quantity supplied Qc.

Figure 11.4: Evaluation of Monopoly

The consumer’s surplus will be the area Pc AD. Now consider output and
price of the profit maximizing monopolist. As indicated in the figure, price
would be Pm and quantity would be Qm. Notice that the monopolist will
charge a higher price and produce a lower quantity as expected. The
consumer surplus is reduced to PmAB. The rectangle Pc Pm BC that was
part of consumer surplus under competition is now economic profit for the
monopolist. This economic profit represents income redistribution from
consumers to producers. Further, there is also a deadweight loss to society
represented by the area BCD that represents loss of consumer surplus that
accrued under competition, but is lost to society because of lower production
levels under monopoly.

If we now consider the reverse case i.e. a monopoly being broken to foster
competition, the result will be transfer of income from producers to
consumers and elimination of deadweight loss. Herein lies the economic 257
Pricing Decisions basis for regulation of monopoly firms. It is to generate the outcomes of
competitive markets and pass these benefits to consumers in the form of
lower prices. If competition exists in markets then arguably, that is the best
regulation. If it does not, and the industry is envisaged to play a social role,
regulation of monopoly becomes an important policy objective.

Activity 3

1. Give few examples of market situation where monopoly exists and

explain.

11.8 IMPLICATIONS OF PERFECT

COMPETITION AND MONOPOLY FOR
MANAGERIAL DECISION MAKING
The assumptions underlying perfect competition market are very restrictive.
Few markets are found with characteristics of many small sellers, easy entry
and exit, and an undifferentiated product. Normally, a majority of modern
industries operate under conditions of oligopoly or monopolistic competition.
You will study these two market structures in detail in Unit 13.

Perfect competition and monopoly are the two extreme market conditions
which we rarely come across in the real world of business. Then the question
arises as to why study them? It is useful to think of perfect competition and
pure monopoly as extremes with other market structures placed in between.
There are many industries that have most of the characteristics of perfect
competition or monopoly. The two extreme models therefore serve as
benchmarks and provide guidance in making decisions.

Consider the following case. A multinational soft drink company P was in

bankruptcy for the second time. The President of the Company tried to sell it
to soft drink Company C, but the C Company wanted no part of the deal. In
order to reduce costs the President purchased a large supply of recycled 12-
ounce beer bottles. At that time, soft drink P and C were sold in six ounce
bottles. Initially Company P priced the bottles at 10 cents, twice the amount
of the original six ounce bottles, but with little success. Then the President of
the Company had the brilliant idea of selling the 12 ounce bottles of softdrink
P at the same price as the six ounce bottles of softdrink C. Then scale took off
and shortly softdrink P was out of bankruptcy and soon making a very nice
profit.

Softdrink P pricing decision was clearly crucial to the life of the firm. The
primary background necessary for understanding the pricing decision is a
good understanding of the law of demand – i.e. as price goes up, demand
goes down – and some understanding of the amount by which a price
increase effects a quantity decrease – i.e. the price elasticity of demand. We
258
will start by examining the polar cases of pricing under perfect competition Pricing Under Perfect
Competition and Pure
and pricing under monopoly, and then move on to examining Softdrink P and
Monopoly
C company's situation.

Alfred Marshall, a famous 19th Century economist, used a fish market as an

example of perfect competition. For the sake of argument, consider a fish
seller selling cod. How would s/he price his product? First, s/he would look
around and find out at what price her/his numerous competitors were selling
cod. s/he certainly could not price above the competitors; since cod is pretty
much identical and consumers should not care from whom they purchase.
Furthermore, in fish markets, it is quite easy for consumers to compare
prices. So, if s/he priced above her/his competitors, s/he would not sell any
fish. Suppose s/he decided to price below her/his competitors. All of the
customers would certainly purchase from him. However, if s/he were still
making a profit, the other competitors would also be making a profit at the
lower price and would match the price cut in order to retain their customers.
They may even consider lowering price more, if they could still make a profit
and capture further customers.

This reasoning, along with the ease of entry for new fish seller, if there is a
profit to be made (which prevents collusion among fish seller already in the
market), ensures that the price being charged is equal to the cost of supplying
an additional fish, or the marginal cost. A fish seller will be a price-taker,
setting her/his price identically to her/his competitors’ prices. A firm is a
monopoly if it has exclusive control over the supply of a product or service.
Therefore, a monopolist, in her/his pricing decisions, cannot consider the
pricing decision of rival firms. So, what does s/he consider?

The smart monopolist considers the incremental effect of his decision, i.e.
what is the revenue to be received from selling one additional unit of a
product and what are the costs of selling one additional unit of a product.
Certainly, if the costs of selling one additional unit of a product exceed the
revenues, the monopolist would certainly not want to sell that additional
product. The law of demand says that s/he could raise the price of her/his
product and thus sell less. Alternatively, if the revenues of selling an
additional unit of a product exceed the costs of selling that unit, the
monopolist should want to sell more units. The law of demand says that s/he
could sell more by lowering his price.

Thus, by setting the price correctly, the monopolist can sell the exact number
of units such that the costs of selling one additional unit exactly equals the
revenues of selling the additional unit, which, by the above reasoning, is the
only optimal price. However, there is an additional complication: the costs of
selling one additional unit do not include any part of the salary of the CEO or
the rental costs of the plant, both must be paid whether or not the additional
unit is sold. Thus, in the long run, if a monopolist cannot cover his overhead
by pricing in the optimal manner, he should shut down.
259
Pricing Decisions The situation involving soft drink P and soft drink C clearly differs from
either of the above scenarios, but what can we learn from both the cases?
First, P clearly saw that C was pricing the six-ounce bottles at 5 cents. By
pricing the 12- ounce bottles at 5 cent also, P made the bet that C would not
cut its price. C did not see the need to cut price because its product was
different from P and it did not fear losing many of its customers. Whether the
gain in revenues resulting from increased demand would offset the loss in
revenue from the lower price depends on the price elasticity of demand. The
price elasticity of demand faced by soft drink P company depends on soft
drink C response to the price cut and the consumer’s responses. As we saw
above, P made the assumption that C would not cut price. P counted on a
highly elastic consumer response, that is the percentage change in quantity
purchased by the consumer due to the lower price, and therefore profits
would accrue to P.

What other concerns you think played a part in the soft drink P company's
decision?

11.9 LET US SUM UP

In this unit, you have studied the market forces operating in perfect
competition and pure monopoly; and the pricing and output decisions in these
two market structures. The perfect competition model assumes a large
number of small sellers and buyers, identical products, and an easy entry and
exit conditions. In perfect competition, firms face a horizontal demand curve
at equilibrium price. Price is determined by the interaction of the market
supply and demand curves. Since no single firm has control over price, the
objective of managers is to determine the level of output that maximizes
profit.

The perfectly competitive firm maximizes profit at a point where price equals
marginal cost. The firm can make an economic profit or loss in the short run,
depending on market price. If the price drops below average variable cost, the
firm should shut down. Or even if the firm is making a profit in the short run,
it may wish to change its plant size or capacity in the long run in order to earn
more profit.

The monopolist is a single seller of a differentiated product. Entry into the

market is difficult or prohibited. Being the single seller, the monopolist has
power over price. For maximizing profits, the firm produces until marginal
revenue equals marginal cost. This way the monopolist earns economic
profits in both the short run and long run as well because entry is restricted
for new firms.

In the real world, few market structures meet the restrictive assumptions for
perfect competition or monopoly. Still, these two models are useful because
many industries have the characteristics of perfect competition or monopoly.
260
Moreover, the perfectly competitive model serves as a benchmark for Pricing Under Perfect
Competition and Pure
evaluating the performance of actual markets and provides guidance for
Monopoly
public policy.

11.10 KEY WORDS

Differentiated Products: Products which are similar in nature but differ in

terms of packing, look etc.

Economic Costs include normal profits.

Economic Profit represents an above-normal profit situation.

Equilibrium of a Firm (MR = MC) represents profit maximizing price-

output combination. In a situation where maximum profits mean a loss, the
equation gives loss.

Equilibrium of an Industry is stated in terms of the condition of normal

profit AR = AC such that the size and structure of the industry are strictly
defined in terms of number of firms.

Profit Maximization: It is the condition where marginal revenue and

marginal cost are in equilibrium.

11.11 TERMINAL QUESTIONS

1. Vegetable market is an example, closest to the pure competition. Discuss.

2. Suppose a firm A has

Q = 20 – 0.3 P
And
Aggregate supply as
Q = 10+0.2 P
What would be the equilibrium price and the equilibrium output of the
firm A?

3. Suppose a small locality has a single grocery store selling multiple products.
a. Is it a monopoly?

b. If yes, then give arguments in support of your answer.

4. Discuss the relevance of perfect competition and monopoly in the present

context.

261
Pricing Decisions
FURTHER READINGS
Mote, V. L., Paul, S., & Gupta, G. S. (2016). Managerial Economics:
Concepts and Cases, Tata McGraw-Hill, New Delhi.

Maurice, S. C., Smithson, C. W., & Thomas, C. R. (2001). Managerial

Economics: Applied Microeconomics for Decision Making. McGraw-Hill
Publishing.

Dholakia, R., & Oza, A. N. (1996). Microeconomics for Management

Students. Oxford University Press, Delhi.

262
 Pricing under
UNIT 12 PRICING UNDER Monopolistic and
Oligopolistic Competition
MONOPOLISTIC AND
OLIGOPOLISTIC COMPETITION
Structure
12.0 Objectives
12.1 Introduction
12.2 Monopolistic Competition
12.3 Price and Output Determination in Short run
12.4 Price and Output Determination in Long run
12.5 Oligopolistic Competition
12.6 Let Us Sum Up
12.7 Key Words
12.8 Terminal Questions

12.0 OBJECTIVES
After going through this unit, you should be able to:

 describe the concept of the pricing decisions under monopolistic

competition in short run as well as long run;
 explain the concept of product differentiation with special reference to
monopolistic competition;
 differentiate between monopolistic competition and oligopoly; and
 apply models of oligopoly behavior to real world situations.

12.1 INTRODUCTION
Pricing decisions tend to be the most important decisions made by any firm in
any kind of market structure. The concept of pricing has already been
discussed in unit 11. The price is affected by the competitive structure of a
market because the firm is an integral part of the market in which it operates.
We have examined the two extreme markets viz. monopoly and perfect
competition in the previous unit. In this unit the focus is on monopolistic
competition and oligopoly, which lie in between the two extremes and are
therefore more applicable to real world situations.

Monopolistic competition normally exists when the market has many sellers
selling differentiated products, for example, retail trade, whereas oligopoly is
said to be a stable form of a market where a few sellers operate in the market
263
Pricing Decisions and each firm has a certain amount of share of the market and the firms
recognize their dependence on each other. The features of monopolistic and
oligopoly are discussed in detail in this unit.

12.2 MONOPOLISTIC COMPETITON

Edward Chamberlin, who developed the model of monopolistic competition,
observed that in a market with large number of sellers, the product of
individual firms are not at all homogeneous, for example, soaps used for
personal care. Each brand has a specific characteristic, be it packaging,
fragrance, look etc., though the composition remains the same. This is the
reason that each brand is sold individually in the market. This shows that each
brand is highly differentiated in the minds of the consumers. The
effectiveness of the particular brand may be attributed to continuous usage
and heavy advertising.

As defined by Joe S. Bain ‘Monopolistic competition is found in the industry

where there are a large number of sellers, selling differentiated but close
substitute products’. Take the example of soaps L and C. Both are soaps for
personal care but the brands are different. Under monopolistic competition,
the firm has some freedom to fix the price i.e. because of differentiation a
firm will not lose all customers when it increases its price.

Monopolistic competition is said to be the combination of perfect

competition as well as monopoly because it has the features of both perfect
competition and monopoly. It is closer in spirit to a perfectly competitive
market, but because of product differentiation, firms have some control over
price. The characteristic features of monopolistic competition are as follows:

 A large number of sellers: Monopolistic market has a large number

of sellers of a product but each seller acts independently and has no
influence on others.

 A large number of buyers: Just like the sellers, the market has a large
number of buyers of a product and each buyer acts independently.

 Sufficient Knowledge: The buyers have sufficient knowledge about

the product to be purchased and have a number of options available to
choose from. For example, we have a number of petrol pumps in the
city. Now it depends on the buyer and the ease with which s/he will get
the petrol decides the location of the petrol pump. Here accessibility is
likely to be an important factor. Therefore, the buyer will go to the
petrol pump where s/he feels comfortable and gets the petrol filled in
the vehicle easily.

 Differentiated Products: The monopolistic market categorically

offers differentiated products, though the difference in products is
marginal, for example, toothpaste.
264
  Free Entry and Exit: In monopolistic competition, entry and exit are Pricing under
Monopolistic and
quite easy and the buyers and sellers are free to enter and exit the
Oligopolistic Competition
market at their own will.

Nature of the Demand Curve

The demand curve of the monopolistic competition has the following

characteristics:

 Less than perfectly elastic: In monopolistic competition, no single

firm dominates the industry and due to marginal product
differentiation, the product of each firm seems to be a close substitute,
though not a perfect substitute for the products of the competitors.
Due to this, the firm in question has high elasticity of demand.

 Demand curve slopes downward: In monopolistic competition, the

demand curve facing the firm slopes downward due to the varied
tastes and preferences of consumers attached to the products of
specific sellers. This implies that the demand curve is not perfectly
elastic.

12.3 PRICE AND OUTPUT DETERMINATION IN

SHORT RUN
In monopolistic competition, every firm has a certain degree of monopoly
power i.e. every firm can take initiative to set a price. Here, the products are
similar but not identical, therefore there can never be a unique price but the
prices will be in a group reflecting the consumers’ tastes and preferences for
differentiated products.

In this case the price of the product of the firm is determined by its cost
function, demand, its objective and certain government regulations, if there
are any. As the price of a particular product of a firm reduces, it attracts
customers from its rival groups (as defined by Chamberlin). Say for example,
if ‘S company’ TV reduces its price by a substantial amount or offers
discount, then the customers from the rival group who have loyalty for, say
‘L TV company’, tend to move to buy ‘S company's’ TV sets.

As discussed earlier, the demand curve is highly elastic but not perfectly
elastic and slopes downwards. The market has many firms selling similar
products, therefore the firm’s output is quite small as compared to the total
quantity sold in the market and so its price and output decisions go unnoticed.
Therefore, every firm acts independently and for a given demand curve,
265
Pricing Decisions marginal revenue curve and cost curves, the firm maximizes profit or
minimizes loss when marginal revenue is equal to marginal cost. Producing
an output of Q selling at price P maximizes the profits of the firm.

Figure 12.1: Short run equilibrium under monopolistic competition

In the short run, a firm may or may not earn profits. Figure 12.1 shows the
firm, which is earning economic profits. The equilibrium point for the firm is
at price P and quantity Q and is denoted by point A. Here, the economic
profit is given as area PAQR. The difference between this and the monopoly
case is that here the barriers to entry are low or weak and therefore new firms
will be attracted to enter. Fresh entry will continue to enter as long as there
are profits. As soon as the super normal profit is competed away by new
firms, equilibrium will be attained in the market and no new firms will be
attracted in the market. This is the situation corresponding to the long run and
is discussed in the next section.

12.4 PRICE AND OUTPUT DETERMINATION IN

LONG RUN
We have discussed the price and output determination in the short run. We
now discuss price and output determination in the long run. You will notice
that the long run equilibrium decision is similar to perfect competition. The
core of the discussion under this head is that economic profits are eliminated
in the long run, which is the only equilibrium consistent with the assumption
of low barriers to entry. This occurs at an output where price is equal to the
long run average cost. The difference between monopolistic competition and
perfect competition is that in monopolistic competition the point of tangency
266
is downward sloping and does not occur at minimum of the average cost Pricing under
curve and this is because the demand curve is downward sloping1. Monopolistic and
Oligopolistic Competition

Figure12.2: Long run equilibrium under monopolistic competition

Price & Cost

LRMC
(Rs.)

P
ATC (LRAC)

AR

MR

0 Q Quantity

Looking at figure 12.2, under monopolistic competition in the long run we

see that LRAC is the long run average cost curve and LRMC the long run
marginal curve. Let us take a hypothetical example of a firm in a typical
monopolistic situation where it is making substantial amount of economic
profits. Here it is assumed that the other firms in the market are also making
profits. This situation would then attract new firms in the market. The new
firms may not sell the same products but will sell similar products. As a
result, there will be an increase in the number of close substitutes available in
the market and hence the demand curve would shift downwards since each
existing firm would lose market share. The entry of new firms would
continue as long as there are economic profits. The demand curve will
continue to shift downwards till it becomes tangent to LRAC at a given price
P and output at Q as shown in the figure. At this point of equilibrium, an
increase or decrease in price would lead to losses. In this case the entry of
new firms would stop, as there will not be any economic profits. Due to free
entry, many firms can enter the market and there may be a condition where
the demand falls below LRAC and ultimately suffers losses resulting in the
exit of the firms. Therefore under the monopolistic competition free entry and
exit must lead to a situation where demand becomes tangent to LRAC, the

1
. You should appreciate that P=AC is the only compatible long run equilibrium under both perfect
competition and monopolistic competition. The reason is that there are no entry barriers. However,
because the demand curve is downward sloping in monopolistic competition the point at which P= AC
occurs to the left of the minimum point of the average cost curve, rather than at the minimum point, as
in perfect competition
267
Pricing Decisions price becomes equal to average cost and no economic profit is earned. It can
thus be said that in the long run the profits peter out completely.

One of the interesting features of the monopolistically competitive market is

the variety available due to product differentiation. Although firms in the
long run do not produce at the minimum point of their average cost curve,
and thus there is excess capacity available with each firm, economists have
rationalized this by attributing the higher price to the variety available.
Further, consumers are willing to pay the higher price for the increased
variety available in the market.

Activity 1

1. It is a usual practice for the customers to go to the market and purchase

household goods like toothpastes, soaps, detergents etc. List (any five)
such branded items along with their competitors having a substantial
share in the market.

2. ‘In a monopolistic competition, the profits in the long run evade off
completely’. Briefly discuss the statement taking into account the
present trends.

12.5 OLIGOPOLISTIC COMPETITION

We define oligopoly as the form of market organization in which there are
few sellers of a homogeneous or differentiated product. If there are only two
sellers, we have a duopoly. If the product is homogeneous, we have a pure
oligopoly. If the product is differentiated, we have a differentiated oligopoly.
While entry into an oligopolistic industry is possible, it is not easy (as
evidenced by the fact that there are only a few firms in the industry).

Oligopoly is the most prevalent form of market organization in the

manufacturing sector of most nations, including India. Some oligopolistic
industries in India are automobiles, primary aluminum, steel, electrical
equipment, glass, breakfast cereals, cigarettes, and many others. Some of
these products (such as steel and aluminum) are homogeneous, while others
(such as automobiles, cigarettes, breakfast cereals, and soaps and detergents)
are differentiated. Oligopoly exists also when transportation costs limit the
market area. For example, even though there are many cement producers in
India, competition is limited to the few local producers in a particular area.

Since there are only a few firms selling a homogeneous or differentiated

product in oligopolistic markets, the action of each firm affects the other
firms in the industry and vice versa. For example, when automobile company
GM introduced price rebates in the sale of its automobiles, automobile
company F and M immediately followed with price rebates of their own.
Furthermore, since price competition can lead to ruinous price wars,
268 oligopolists usually prefer to compete on the basis of product differentiation,
advertising, and service. These are referred to as non price competition. Yet, Pricing under
Monopolistic and
even here, if GM mounts a major advertising campaign, F and M are likely to
Oligopolistic Competition
soon respond in kind. When softdrink company P mounted a major
advertising campaign in the early 1980s softdrink company C responded with
a large advertising campaign of its own in the United States.

From what has been said, it is clear that the distinguishing characteristic of
Oligopoly is the interdependence or rivalry among firms in the industry. This
is the natural result of fewness. Since an oligopolist knows that its own
actions will have a significant impact on the other oligopolists in the industry,
each oligopolist must consider the possible reaction of competitors in
deciding its pricing policies, the degree of product differentiation to
introduce, the level of advertising to be undertaken, the amount of service to
provide, etc. Since competitors can react in many different ways (depending
on the nature of the industry, the type of product, etc.) We do not have a
single oligopoly model but many-each based on the particular behavioural
response of competitors to the actions of the first. Because of this
interdependence, managerial decision making is much more complex under
oligopoly than under other forms of market structure. In what follows we
present some of the most important oligopoly models. We must keep in mind,
however, that each model is at best in complete.

The sources of oligopoly are generally the same as for monopoly. That is, (1)
economies of scale may operate over a sufficiently large range of outputs as
to leave only a few firms supplying the entire market; (2)huge capital
investments and specialized inputs are usually required to enter an
oligopolistic industry (say, automobiles, aluminum, steel, and similar
industries), and this acts as an important natural barrier to entry; (3) a few
firms may own a patent for the exclusive right to produce a commodity or to
use a particular production process; (4) established firms may have a loyal
following of customers based on product quality and service that new firms
would find very difficult to match; (5) a few firms may own or control the
entire supply of a raw material required in the production of the product; and
(6) the government may give a franchise to only a few firms to operate in the
market. The above are not only the sources of oligopoly but also represent the
barriers to other firms entering the market in the long run. If entry were not
so restricted, the industry could not remain oligopolistic in the long run. A
further barrier to entry is provided by limit pricing, whereby, existing firms
charge a price low enough to discourage entry into the industry. By doing so,
they voluntarily sacrifice short-run profits in order to maximize long-run
profits.

As discussed earlier oligopolies can be classified on the basis of type of

product produced. They can be homogeneous or differentiated. Steel,
Aluminium etc. come under homogeneous oligopoly and television,
automobiles etc. come under heterogeneous oligopoly. The type of product
produced may affect the strategic behaviour of oligopolists. According to
economists, two contrasting behaviour of oligopolists arise that is the 269
Pricing Decisions cooperative oligopolists where an oligopolist follows the pattern followed by
rival firms and the non-cooperative oligopolists where the firm does not
follow the pattern followed by rival firms. For example, a firm raises price of
its product, the other firms may keep their prices low so as to attract the sales
away from the firm, which has raised its price. But as stated above, price is
not the only factor of competition. As a matter of fact other factors on the
basis of which the firms compete include advertising, product quality and
other marketing strategies. Therefore, we normally have four general
oligopolistic market structures, two each under cooperative as well as non-
cooperative structures. We have firms producing homogeneous and
differentiated products under each of the two basic structures. All these
differences exist in the oligopolistic market. This shows that each firm tries to
make an impact in the existing market structure and have an effect on the
rival firms. This tends to be a distinguishing characteristic of an oligopolistic
market.

Activity 2

1. List five products along with the names of the companies following
homogeneous oligopolistic competition.

2. List five products along with the names of the companies following
heterogeneous oligopolistic competition.

Price Rigidity: Kinked Demand Curve

Our study of pricing and market structure has so far suggested that a firm
maximizes profit by setting MR=MC. While this is also true for oligopoly
firms, it needs to be supplemented by other behavioural features of firm
rivalry. This becomes necessary because the distinguishing feature of
oligopolistic markets is interdependence. Because there are a few firms in the
market, they also need to worry about rival firm’s behaviour. One model
explaining why oligopolists tend not to compete with each other on price, is
the kinked demand curve model of Paul Sweezy. In order to explain this
characteristic of price rigidity i.e. prices remaining stable to a great extent,
Sweezy suggested the kinked demand curve model for the oligopolists. The
kink in the demand curve a rises from the a symmetric behaviour of the firms.
The proponents of the hypothesis believe that competitors normally follow
price decreases i.e. they show the cooperative behaviour if a firm reduces the
price of its products whereas they show the non-cooperative behaviour if a
firm increases the price of its products.

Let us start from P1 in Figure 12.3. If one firm reduces its price and the other
firms in the market do not respond, the price cutter may substantially increase
its sales. This result is depicted by the relative elastic demand curve, dd. For
example, a price decrease from P1 to P2 will result in a movement along dd
and increase sales from Q1 to Q2 as customers take advantage of the lower
270
price and abandon other suppliers. If the price cut is matched by other firms, Pricing under
Monopolistic and
the increase in sales will be less (Q ).
Oligopolistic Competition

Figure 12.3: Demand curve for an Oligopolist

Since other firms are selling at the same price, any additional sales must
result from increased demand for the product. Thus the effect of price
reduction is a movement down the relatively inelastic demand curve, DD,
then the price reduction will be from P1 to P2 which only increases sales to
.

Here we assume that P1 is the initial price of the firm operating in a non-
cooperative oligopolistic market structure producing Q1 units of output. P is
also the point of kink in the demand curve and is the initial price and DD is
the relatively elastic demand curve above the existing price P1. When the firm
is operating in the non-cooperative oligopolistic market it results in decline in
sales if it changes its price to P1. Now if the firm reduces its price below P1
say P2, the other firms operating in the market show a cooperative behaviour
and follow the firm. This is shown in the figure as the curve below the
existing price P1. The true demand curve for the oligopolistic market is dD
and has the kink at the existing price P1.The demand curve has two linear
curves, which are joined at price P.

Associated with the kinked demand curve is a marginal revenue function.

This is shown in Figure 12.4. Marginal Revenue for prices above the kink is
given by MR1 and below the kink as MR2. At the kink, marginal revenue has
a discontinuity at AB and this depends on the elasticity of the different parts
of the demand curve.
271
Pricing Decisions Therefore, in the presence of a kinked demand curve, firm has no motive to
change its price. If the firm is a profit maximizing firm where MR=MC, it
would not change its price even if the cost changes. This situation occurs as
long as changes in MC fall within the discontinuous range i.e. AB portion.
The firm following kinked model has a U-shaped marginal cost curve MC.
The new MC curve will be MC1 or MC2 and will remain in the discontinued
area and the equilibrium price remains the same at P.

Figure 12.4 Kinked demand curve

/AR

Price Competition: Cartels and Collusion

Cartel Profit Maximization

We already know now that in an oligopolistic competition, the firms can

compete in many ways. Some of the ways include price, advertising, product
quality, etc. Many firms may not like competition because it could be
mutually disadvantageous. For example, advertising. In this case many
oligopolies end up selling the products at low prices or doing high advertising
resulting in high costs and making lower profits than expected. Therefore, it
is possible for the firms to come to a consensus and raise the price together,
increasing the output without much reduction in sales. In some countries this
kind of collusive agreement is illegal e.g. USA but in some it is legal. The
most extreme form of the collusive agreement is known as a cartel.

A cartel is a market sharing and price fixing arrangement between groups of

firms where the objective of the firm is to limit competitive forces within the
272
market. The forms of cartels may differ. It can be an explicit collusive Pricing under
Monopolistic and
agreement where the member firms come together and may reach a
Oligopolistic Competition
consensus regarding the price and market sharing or implicit cartel where
the collusion is secretive in nature.

Throughout the 1970s, the Organization of Petroleum Exporting Countries

(OPEC) colluded to raise the price of crude oil from under $3 per barrel in
1973 to over $30 per barrel in 1980. The world awaited the meeting of each
OPEC price-setting meeting with anxiety. By the end of 1970s, some energy
experts were predicting that the price of oil would rise to over $100 per barrel
by the end of the century. Then suddenly the cartel seemed to collapse. Prices
moved down, briefly touching $10 per barrel in early 1986 before recovering
to $18 per barrel in 1987. OPEC is the standard example used in textbooks
when explaining cartel behaviour. The cartel profit maximizing theory can be
explained using figure 12.5.

Figure 12.5: Cartel profit maximization

/AR

The market demand for all members of the cartel is given by DD and
marginal revenue (represented by dotted line) as MR. The cartels marginal
cost curve given by MCc is the horizontal sum of the marginal cost curves of
the member firms. In this the basic problem is to determine the price, which
maximizes cartel profit. This is done by considering the individual members
of the cartel as one firm i.e. a monopoly. In the figure this is at the point
where MR= MCc, setting price = P. The problem is regarding the allocation
of output within the member firms. Normally a quota system is quite popular,
whereby each firm produces a quantity such that its MC = MCc. One serious
problem that arises from this analysis is that while the joint profits of the
cartel as a whole are maximized, each individual member of the cartel has an
incentive to cheat on its quota. This is because the price for the product is
greater than the members marginal cost of production. This implies that an 273
Pricing Decisions individual member can increase its profit by increasing production. What
would happen if all members did the same? The market sharing arrangement
will breakdown and the cartel would collapse. Here lies the inherent
instability of cartel type arrangement and can be summarized as follows.

There is an incentive for the cartel as a whole to restrict output and raise
price, there by achieving the joint profit maximizing result, but there is an
incentive on the part of the members to increase individual profit. If this kind
of situation occurs, it leads to break-up of the cartel. The difficulty with
sustaining collusion is often demonstrated by a classic strategic game known
as the prisoner’s dilemma.

Game theory (Prisoner’s dilemma)

The story is something like this. Two KGB officers spotted an orchestra
conductor examining the score of Tchaikovsky’s Violin Concerto. Thinking
the notation was a secret code, the officers arrested the conductor as a spy. On
the second day of interrogation, a KGB officer walked in and smugly
proclaimed, “OK, you can start talking. We have caught Tchaikovsky”.

More seriously, suppose the KGB has actually arrested someone named
Tchaikovsky and the conductor separately. If either the conductor or
Tchaikovsky falsely confesses while the other does not, the confessor earns
the gratitude of the KGB and only one year in prison, but the other receives
25 years in prison. If both confess each will be sentenced to 10 years in
prison; and if neither confesses each receives 3 years in prison. Now consider
the outcome.

The conductor knows that if Tchaikovsky confesses, he gets either 25 years

by holding out or 10 years by confessing. If Tchaikovsky holds out, the
conductor gets either 3 years by holding out or only one year confessing.
Either way, it is better for the conductor to confess. Tchaikovsky, in a separate
cell, engages in the same sort of thinking and also decides to confess. The
conductor and Tchaikovsky would have had three-years rather than 10-year
jail sentences if they had not falsely confessed, but the scenario was such
that, individually, false confession was rational. Pursuit of their own self
interests made each worse off.

CONDUCTOR
Cooperate Confess
3.3 25.1
Cooperate
TCHIKOVSKY 1.25 10,10
Confess

This situation is the standard prisoner’s dilemma and is represented in the

above matrix. This first payoff in each cell refers to Tchaikovsky’s, and the
second is the conductors. Examination of the payoffs shows that the joint
274
profit maximizing strategy for both is (Cooperate-Cooperate). 2 The Pricing under
Monopolistic and
assumption in this game is that both the parties decided their strategies
Oligopolistic Competition
independently. Let us assume both parties are allowed to consult each other
before the interrogation. Do you think cooperation will be achieved? It is
unlikely since each of them will individually be concerned about the worst
outcome that is 25 years in jail. Cooperation in this prisoner’s dilemma
becomes even more difficult, because it is a one shot game.

This scenario is easily transferred to the pricing decision of a company.

Consider two companies setting prices. If both companies would only keep
prices high, they will jointly maximize profits. If one company lowers price,
it gains customers and it is thus in its interests to do so. Once one company
has cheated and lowered price, the other company must follow suit. Both
companies have lowered their profits by lowering price. Clearly, companies
repeatedly interact with one another, unlike Tchaikovsky and the conductor.
With repeated interaction, collusion can be sustained.

Robert Axelrod, a well-known political scientist, claims a “tit-for-tat”

strategy is the best way to achieve co-operation. A tit-for-tat strategy always
co-operates in the first period and then mimics the strategy of its rival in each
subsequent period.

Axelrod likes the tit-for-tat strategy because it is nice, retaliatory, forgiving

and clear. It is nice, because it starts by co-operating, retaliatory because it
promptly punishes a defection, forgiving because once the rival returns to co-
operation it is willing to restore co-operation, and finally its rules are very
clear: precisely, an eye for an eye.

A fascinating example of tit-for-tat in action occurred during the trench

warfare of the First World War. Front-line soldiers in the trenches often
refrained from shooting to kill, provided the opposing soldiers did likewise.
This restraint was often indirect violation of high command orders.

Price Leadership

Price leadership is an alternative cooperative method used to avoid tough

competition. Under this method, usually one firm sets a price and the other
firms follow. It is quite popular in industries like cigarette industry. Here any
firm in the oligopolistic market can act as a price leader. The firm, which is
highly efficient, and having low cost can be a price leader or the firm, which
is dominant in the market acts as a leader. Whatever the case may be, the
firm, which sets the price, is the price leader. We have two forms of price
leadership-Dominant price leadership and Barometric price leadership.

In dominant price leadership, the largest firm in the industry sets the price. If
the small firms do not conform to the large firm, then the price war may take
place due to which the small firms may not be able to survive in the market.

2
Remember the payoffs in the matrix are years in jail, thus the lesser the better. 275
Pricing Decisions It is more or less like a monopoly market structure. This can be seen in the
airlines industry in India where the dominant Airlines Firms sets prices and
the others Subordinate Airlines Firms follow the price changes of dominant
Airlines Firms.

Barometric price leadership is said to be the simpler of the two. This

normally occurs in the market where there is no dominant firm. The firm
having a good reputation in the market usually sets the price. This firm acts
as a barometer and sets the price to maximize the profits. Here it is important
to note that the firm in question does not have any power to force the other
firms to follow its lead. The other firms will follow only as long as they feel
that the firm in action is acting fairly. Thought his method is quite ambiguous
regarding price leadership, it is legally accepted. These two forms are an
integral part of different types of cooperative oligopoly. Barometric price
leadership has been seen in the automobile sector.

ILLUSTRATION

Reestablishing Price Discipline in the Steel industry

A US steel company S was the leader in setting prices in the steel industry.
However, in 1962, a price increase announced by S company provoked so
much criticism from customers and elected officials, that the firm became
less willing to act as the price leader. As a result, the industry evolved from
dominant firm to barometric price leadership. This new form involved one
firm testing the waters by announcing a price change and then S. Steel
company either confirming or rejecting the change by its reaction.

Later S company found that its market share was declining. The company
responded by secretly cutting prices to large customers. This action was soon
detected by Steel company B which cut its posted price of steel from $113.50
to $88.50 per ton. Within three weeks, all of the other major producers, S
Steel included, matched Steel company B's new price.

The lower industry price was not profitable for the industry members.
Consequently, U.S. Steel signaled desire to end the price war by posting a
higher price. Steel company B waited nine days and responded with a slightly
lower price than that of S. Steel. S. Steel was once again willing to play by
industry rules.

Steel company B announced a price increase to $125 per ton. All of the other
major producers quickly followed suit, and industry discipline was restored.
Note that the price of $125 patron was higher than the original price of
$113.50.

Source: Peterson and Lewis, 2002. Managerial Economics. Pearson

Education Asia.
276
Activity 3 Pricing under
Monopolistic and
1. Suppose a firm is operating in a non-cooperative oligopolistic market Oligopolistic Competition

structure. It produces 400 units of output per period and sells them at
Rs. 5 each. At this stage its total revenue is Rs. 2,000. The firm now
thinks of changing its price and increases it from Rs. 5 to Rs. 6. The
rivals do not change the price and the sales dip from 400 units to 200
units.

Now the firm decides to decrease the price of the product from Rs. 5 to
Rs. 4 and expects the rivals to match the price decrease so as not to lose
sales. Now the sales increase marginally from 400 units to 450 units.

a) Find the total revenue of the firm when its price increases from Rs. 5 to
Rs.6.

b) Find the total revenue of the firm when the price decreases from Rs.5 to
Rs.4.

c) Plot the changes along with the initial price and quantity sold according
to the concept to price rigidity under oligopoly.

12.6 LET US SUM UP

In this unit we have tried to explain the concept of pricing with special
reference to monopolistic and oligopolistic competition. The effort has also
been made to include the application part of the concept of product
differentiation in monopolistic competition and the oligopolistic competition.
Talking about monopolistic competition, we have seen that in monopolistic
competition, the firm's economic profit is evaded off completely in the long
run. In the short run monopolistic competition is quite similar to monopoly.
We have discussed the oligopolistic competition in brief. The main
characteristic of oligopolistic competition seems to be mutual
interdependence and this factor decides the nature of oligopolistic
competition.

We can summarize the whole unit by saying that the basis of differentiation
between different types of competitions comprises of the number of sellers,
the number of buyers, product differentiation, and barriers to entry. These
factors decide the nature of competition in a particular market structure.

12.7 KEY WORDS

Economic profit is also known as the pure profit and is the residual left after
all contractual costs have been met.

Marginal cost is the cost arising due to the production of one additional unit
of output.
277
Pricing Decisions Marginal Revenue is the revenue obtained from the production and sale of
one additional unit of output.

Non-price competition is a form of competition used in Oligopolistic

competition where price change by firms is not involved.

Price leadership a firm setting up the price at profit maximizing level and
other firms following it.

12.8 TERMINAL QUESTIONS

1. Distinguish between perfect competition and imperfect competition,
giving examples.
2. Which of the following markets could be considered monopolistically
competitive? Explain.
Cable Television
Ball pens (low priced)
Food joints
Automobiles
3. Take the case of a monopolistically competitive firm and describe the
steps involved in attaining long- run equilibrium for the firm.
4. Explain whether the firms producing differentiated products are more
likely to face price competition than the oligopolists producing
homogeneous products.

5. Write short notes on:

Dominant price leadership
Barometric price leadership

6. Which of the following markets could be considered oligopolistically

competitive? Explain.
Theaters
Automobiles
Aircrafts
Restaurants
Oil producing companies
Yarns
Newspapers
Garments
Cereals
Branded products like Photo film
7. Suppose production decisions of two members of OPEC, say Iran and
Iraq are as follows. Each has just two production levels, either 2 or 4
million barrels of crude oil a day. Depending on their decisions, the total
output on the world market will be 4, 6, or 8 million barrels. Suppose the
price will be $25, $15, and $10 per barrel, respectively. Extraction costs
278 are $2 per barrel in Iran and $4 per barrel in Iraq.
 a. Represent the game in the form of a Prisoner’s Dilemma. Pricing under
Monopolistic and
b. If Iran were to cheat successfully, what would be the daily increase in Oligopolistic Competition
Iran’s profits?
c. If Iraq were to cheat successfully, what would be the daily increase in
Iraq’s profits?
d. For which of the countries is the cost of cheating higher. Why?
e. If it takes Iraq a month to detect Iran’s cheating and respond, how
many days will it take for the extra profits of Iran to be wiped out?
f. What are some of the mechanisms you can think of that will entice
co- operation from the two countries?

FURTHER READINGS
Mote, V. L., Paul, S., & Gupta, G. S. (2016). Managerial Economics:
Concepts and Cases, Tata McGraw-Hill, New Delhi.

Maurice, S. C., Smithson, C. W., & Thomas, C. R. (2001). Managerial

Economics: Applied Microeconomics for Decision Making. McGraw-Hill
Publishing.

Dholakia, R., & Oza, A. N. (1996). Microeconomics for Management

Students. Oxford University Press, Delhi.

Lewis, W. C., Jain, S. K., & Petersen, H. C. (2005). Managerial Economics

(4th ed.). Pearson.

279
Pricing Decisions
UNIT 13 PRICING STRATEGIES
Structure

13.0 Objectives
13.1 Introduction
13.2 Concentration Ratios, Herfindahl Index & Contestable Market
13.3 Price Discrimination
13.4 Peak Load Pricing
13.5 Bundling
13.6 Two-Part Tariffs
13.7 Pricing of Joint Products
13.8 Transfer Pricing
13.9 Other Pricing Practices
13.10 Let Us Sum Up
13.11 Key Words
13.12 Terminal Questions

13.0 OBJECTIVES
After going through this unit, you should be able to:

 understand different pricing strategies adopted by firms;

 identify the relevance of these pricing strategies under different
conditions; and
 apply pricing decision.

13.1 INTRODUCTION
Not every customer is willing to pay the same price for the same product. So
how is a seller to set prices to maximize business? The answer is the world of
price discrimination. A good example of price discrimination is different
prices charged for movie, concert tickets from students and adults. U Cab
company is an American company which offers cab services across the
world, even in India. Price discrimination is one of the major strategies they
have been following for a while now. Pricing for a same distance journey is
different for different customers depending on their geographical location.
The question “How should a product be priced?” is of enormous importance
to businesses, and most companies allocate substantial budgets to market
research, both before launching a new product and, once launched, through
the different stages of the product’s life cycle. Economists argue that the level
of demand for a product at any price is the sum of what all individual
280
consumers in the market would be willing to purchase. This demand or Pricing Strategies
willingness to pay, for any product is affected by three key factors:

 Individual consumers’ preferences for the different characteristics of

the product.
 The price of close substitutes to the product and the price of goods
that must be used in conjunction with it.
 The level of each individual consumer’s income.

This will apply to any product, be it cans of softdriks, automobiles or laptops.

This unit will examine the common pricing strategies adopted by firms
including price discrimination.

13.2 CONCENTRATION RATIOS, HERFINDAHL

INDEX AND CONTESTABLE MARKETS
The degree by which an industry is dominated by a few large firms is
measured by Concentration ratios. These give the percentage of total
industry sales of 4, 8, or 12 largest firms in the industry. An industry in which
the four-firm concentration ratio is close to 100 is clearly oligopolistic, and
industries where this ratio is higher than 50 or 60 percent are also likely to be
oligopolistic. The four-firm concentration ratio for most manufacturing
industries in the United States is between 20 and 80 percent.

Another method of estimating the degree of concentration in an industry is

the Herfindahl index (H). This is given by the sum of the squared values of
the market shares of all the firms in the industry. The higher the Herfindahl
index, the greater is the degree of concentration in the industry. For example,
if there is only one firm in the industry so that its market share is 100%,
H=1002=10,000. If there are two firms in an industry, one with a 90 percent
share of the market and the other with a 10 percent share, H = 902 + 102
=8,200. If each firm had a 50 percent share of the market, H = 502 + 502 =
5,000. With four equal-sized firms in the industry, H = 2,500. With 100
equal-sized firms in the (perfectly competitive) industry, H = 100. This point
to the advantage of the Herfindahl index over the concentration ratios
discussed above. Specifically the Herfindahl index uses information on all the
firms in the industry- not just the share of the market held by the largest 4, 8,
12 firms in the market. Furthermore, by squaring the market share of each
firm, the Herfindahl index appropriately gives a much large weight to larger
than to smaller firms in the industry. The Herfindahl index has become of
great practical importance since 1982 when the Justice Department in the US
announced new guidelines for evaluating proposed mergers based on this
index.

In fact, according to the theory of Contestable markets developed during the

1980s, even if an industry has a single firm (monopoly) or only a few firms
(oligopoly), it would still operate as if it were perfectly competitive if entry is 281
Pricing Decisions “absolutely free” (i.e. if other firms can enter the industry and face exactly
the same costs as existing firms) and if exit is “entirely costless” (i.e., if there
are no sunk costs so that the firm can exit the industry without facing any loss
of capital). An example of this might be an airline that establishes a service
between two cities already served by other airlines if the new entrant faces
the same costs as existing airlines and could subsequently leave the market
by simply reassigning its planes to other routes without incurring any loss of
capital. When entry is absolutely free and exit is entirely costless, the market
is contestable. Firms will then operate as if they were perfectly competitive
and sell at a price which only covers their average costs (so that they earn
zero economic profit) even if there is only one firm or a few of them in the
market.

13.3 PRICE DISCRIMINATION

In economic jargon, price discrimination is usually termed monopoly price
discrimination. This label is appropriate because price discrimination cannot
happen in a perfectly competitive industry in equilibrium. Monopoly power
must be present in a market for price discrimination to exist. This seems a
trivial point, when you understand, the definition of price discrimination; the
practice of charging different prices to various consumers for a given
product. In a competitive market, consumers would simply buy from the
cheapest seller, and producers would sell to the highest bidders, and that
would be that.

With monopoly power, however, the opportunity may exist for the firm to
offer different terms (of which price is only one component) to different
purchasers, thus dividing the market–a practice known as market
segmentation. Price discrimination refers to the situation where a monopoly
firm charges different prices for exactly the same product. The monopoly
firm (a single seller in the market) can discriminate between different buyers
by charging them different prices because it has the power to control price by
changing its output. The buyers of its product have no choice but to buy from
it as the product has no close substitutes.

There are three types of price discrimination – First Degree price

discrimination, Second Degree price discrimination, and Third Degree price
discrimination. First degree price discrimination refers to a situation where
the monopolist charges a different price for different units of output
according to the willingness to pay of the consumer. For example, a doctor
who is the only super specialist in the town may charge different fee for
conducting surgery from different patients based on their ability to pay.
Second degree price discrimination refers to a situation where the
monopolist charges different prices for different set of units of the same
product. For example, the electricity charges per unit of the first 100 Kwh of
power consumption may be different from the rate charged for the additional
100 Kwhs. Another example is railway passenger fares; the per kilometer
282
fare is higher for the first few kilometers, which declines as the distance Pricing Strategies
increases. Thus the discrimination is based on volume of purchases. When
the monopolist firm divides the market (for its product) into two or more
markets (groups of buyers or segments) and charges different price in each
market, it is known as third degree price discrimination. Airline tickets are
a common example of this form of price discrimination. For example, lower
rates are applicable to senior citizens than business travelers, electricity rates
applicable to residential users are lower than those applied to commercial
establishments and so on.

a) First Degree Price Discrimination

Monopolists engage in price discrimination when they can increase their

profits by doing so. Even if sellers know the maximum amount that different
customers are willing to pay, developing a pricing scheme that makes each
customer pay that amount, a practice known as first degree price
discrimination, can be difficult. Under first degree price discrimination, the
full benefit from the trade between buyer and seller accrues to the seller. One
strategy to achieve first degree price discrimination is to sell to the highest
bidders through sealed bid auctions. The auction approach is best suited for
situations where the volume of sales are low (usually due to scarcity of the
product), where there are many potential buyers who are unable to co-operate
among themselves and where all buyers have access to the same information
about the product’s characteristics. The auction approach would enable to
seller to identify those buyers with the highest willingness to pay and would
yield the highest possible revenues for the same production costs. This is a
common strategy for the sale of very special types of products such as art
objects, antique furniture or the rights to the mining and exploration of plots
of land. It is not suitable for most bulk-produced products such as cans of soft
drinks or computers. Perfect or first-degree price discrimination can occur
when a firm knows the maximum price the individual is willing to pay for
each successive unit. The firm could then charge that highest price for each
successive unit and capture the entire consumer surplus. Remember that all
forms of price discrimination involve some monopoly power, but perfect
price discrimination involves a degree of monopoly power rarely found in the
real world.

b) Second Degree Price Discrimination

Where the auction approach is not feasible, the company must do its best to
approximate the first degree outcome using its pricing structure. This is based
on the notion that an individual consumer derives diminishing satisfaction
from each successive unit of any product consumed.

This form of price discrimination, which is based on the volume of consumer

purchases, is very common and is known as second degree price
discrimination. Other forms of second degree price discrimination include
two-tier tariffs, i.e. prices where the consumer must pay a flat fee for access
283
Pricing Decisions and then a separate fee (which may be zero) for usage. This is typical of
many clubs, amusement parks and transport facilities offering monthly or
annual passes.

The idea in the case of travel pass, for example, is that the traveller who
travels infrequently pays on average, a higher price per trip because the fixed
access cost is spread over fewer trips. On the other hand, the high volume
user spreads this fixed cost over so many trips that he or she may actually sit
next to the infrequent traveller, consume the exact same services (meals, fuel
and so on), but end up paying a lower average price for any given trip.

Second-degree price discrimination is also referred to as multipart pricing.

It is a block, or step, type of pricing, in which the first set of units is sold at
one price, a second set at a lower price, a third set at a still lower price, and so
on. Note that this is different from a quantity discount in which the lower
(discounted) price applies to all units purchased. In second-degree price
discrimination, the lower price applies only to units purchased in that block.
The buyer must have already paid the higher price for the earlier units. Some
familiar examples should make this clear:

1. Many retailers adopt second degree price discrimination for

encouraging customers to buy in bulk. E.g., when a customer buys 1
shirt s/he will be charged full MRP for that, say rupees 2000. But if
s/he buys one more shirt then s/he will be given discount of rupees
1000 on that. So, the first shirt will be sold at rupees 2000 and second
shirt will be sold at rupees 1000.

2. Take example of pricing of an American fast food company which

sells burger or fries. When you buy individual burger or fries, you are
charged more as compared to when you buy burger fries and soft
drink together as a meal.

Now, let’s look at second-degree price discrimination in a more formal

graphic model. In figure 13.1, the seller faces the demand curve (D) of one
typical consumer. Although the cost function is not shown in the figure,
assume that marginal revenue and marginal cost intersect and lead to an
optimal price of P*. The consumer would choose to buy the quantity Q* at
this price. The shaded area of the figure represents the consumer’s surplus. It
may be, however, that the firm uses multi part pricing to capture a portion of
this surplus. Suppose that the firm sets a price of P1 for the first Q1 units
purchased and that additional units sell for P2 (a two-stage pricing scheme).
The consumer buys Q1 units at price P1 and Q2 units at price P2. That portion
of the consumer surplus labeled P1BCP2 is now captured by the firm rather
than by the consumer. This still leaves a rather large portion of the consumer
surplus still in the consumer’s hands. The firm’s management would prefer to
capture it all, and could do so by using more parts in a multipart pricing
strategy. However, to do so, management needs to know a great deal about
the consumer’s demand.
284
 Figure 13.1: Second-Degree Price Discrimination Pricing Strategies

Quantity

In this example of second-degree price discrimination, or multi part pricing,

the first block of units (Q1 units) is sold at the price P1, and the second block
(Q2 units) is sold at the price P2. This allows the seller to capture that part of
the consumer’s surplus represented by the area P1BCP2.

c) Third Degree Price Discrimination

Pricing based on what type of consumer is doing the purchasing rather than
the volume of purchase is an approach known as third degree price
discrimination. This is very common in the sales of air and rail travel, movie
tickets and other products where consumers can be segmented into different
groups, who are likely to differ greatly in their willingness to pay based on
certain easily identifiable attributes.

Thus, third-degree price discrimination, or market segmentation, requires that

the seller be able to (1) segment, or separate, the market so that goods sold in
one market cannot be resold by the buyers in another; and (2) identify distinct
demand curves with different price elasticities for each market segment.

Students are one of the main beneficiaries of third degree price

discriminations schemes, since their demand is more sensitive than the
population at large. Other often identified groups include senior citizens and
the young, both of whom also tend to be more price sensitive, and business
purchasers, who are often less price sensitive and may be willing to pay a lot
for small quality improvements. Suppose, for example, there are only two
types of travellers; students and business men.

Students pay for their travel out of their own pockets, while businessmen
charge their travel to their employers who in turn deduct these expenses from
their taxable income. Since a typical student is likely to be willing to pay less
for a travel ticket, all else being equal, than a typical businessmen, it makes
285
Pricing Decisions sense for the company selling travel services to price higher to the
businessman and lower to the tourist to get the largest possible volume of
business out of each customer group.

Pricing schemes can be quite complex and may combine elements of second-
and third-degree price discrimination: for example, discounted travel passes
for students and pensioners. In any case, the main danger to the seller is that
customers have an incentive to get together and trade among themselves to
benefit from existing price differentials.

Thus, a student may try to purchase a ticket s/he does not plan to use for the
express purpose of selling it to a business traveler and sharing the difference
between the prices. Or, a holder of a travel pass may offer the pass to a friend
to use, enabling the friend to benefit from the high volume of the holder’s
travel. If this were allowed to happen, the seller would lose the business of
the high-price paying customer and would be better off offering a single
profit-maximizing price.

The seller engaging in price discrimination must therefore take measures

such as passport checks at the departure gate and photos on rail passes to
make sure consumers are not able to engage in arbitrage, i.e. profit from their
access to a lower price by selling to someone to whom such access is
precluded.

The other danger the price discriminating seller faces is that a rival firm may
enter with a single price that undercuts the incumbent’s higher price. Then
the rival will draw away the most profitable market segments and the original
company will only be left with the low-margin discount buyers.

That is why price discrimination is only possible in imperfectly competitive

markets, where direct competition by rivals is made difficult by entry barriers
such as established brand names (laptops), differentiated products
(magazines), scale economies in production (air and rail travel), technology
patents (pharmaceuticals) where access to a key input is limited (fine art).

Activity 1

1. Necessary conditions for price discrimination include all, but the

following.
a) The firm must have some control over price.
b) The firm’s markets must be separable.
c) The firm must have declining long run average costs.
d) The elasticity of demand must vary among markets.

2. The train fare charged by Delhi Metro from Dwarka to Saket is Rs. 45
during the morning rush hour from 9:00 am to 11:00 am, but drops to
Rs. 40 after 11:00 am. This is because the demand for train rides from
Dwarka to Saket is:
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 a) Elastic in the rush hour, but inelastic later in the day. Pricing Strategies

b) Unit elastic at all times of the day.

c) Inelastic in the rush hour, but elastic later in the day.
d) Unit elastic in the rush hour, but inelastic later in the day.

3. Price discrimination is possible between markets. Discuss, with help of

an example

13.4 PEAK LOAD PRICING

Peak load pricing is a type of third-degree price discrimination in which the
discrimination base is temporal. We single out this particular form of price
discrimination in part because of its widespread use. But remember that all
forms of third-degree price discrimination, including peak load pricing,
involve a seller attempting to capitalize on the fact that buyers’ demand
elasticities vary. In the case of peak load pricing, customer demand
elasticities vary with time.

Very few, if any, business economic activities are characterized by an

absolutely constant demand during all seasons of the year and at all times of
day. For many, the variations, or fluctuations, are not large enough to be of
concern; but for some activities, fluctuations in demand are significant. These
variations are sometimes relatively stable and predictable. Hotel booking
prices for vacation spots (say hill stations in India) are good example of peak
load pricing. During peak season (summers), hotels booking charges are
highest and reduced during off season. Travelers are encouraged to visit hill
station during slack period (off season) and those who visit during peak
season pay relatively higher prices. Whenever price discrimination is based
on time differentials, the object of the selling firm is to charge a higher price
for the product during the more inelastic period and a lower price during the
more elastic interval.

Activity 2

1. Calculus can be used to accomplish price discrimination provided that

the firm knows its TC functions and the demand functions for the
markets it is selling to. Consider two markets X and Y. The total revenue
functions are TRx and TRy = PxQx and PyQy respectively. The demand
curves for the two markets are :

Px = 2 – Qx

Py = 3 –2Qy

While the producers marginal cost is given by

TC= 100 +1.5Q

Where Q= Qx+ QY 287

Pricing Decisions Calculate the profit maximizing output and price with and without price
discrimination.

Show that profit is larger when the firm practices price discrimination.

2 Peak load pricing is a type of third-degree price discrimination. Recall

that all forms of third-degree price discrimination, including peak load
pricing, involve a seller attempting to capitalize on the fact that buyers’
demand elasticities vary. In the case of peak load pricing, customer
demand elasticities vary;

a) Across categories of consumers.

b) With time.
c) Across different regions or countries.

13.5 BUNDLING
You must have come across campaigns of the following kind: “Buy one, get
the second at half-price”. A camera is sold in a box with a free tripod; a hotel
room often comes with complimentary breakfast. These are examples of
Bundling.

Bundling is the practice of selling two or more separate products together for
a single price i.e. bundling takes place when goods or services which could
be sold separately are sold as a package. A codification of bundling practices
and definitions of selling strategies is:

Pure bundling: products are sold only as bundles;

Mixed-bundling: products are sold both separately and as a bundle; and

Tying: The purchase of the main product (tying product) requires the
purchase of another product (tied product) which is generally an additional
complementary product.

This is not an exhaustive list but covers the most frequently encountered
cases. Pure bundling involves selling two products only as a package and not
separately.

Fig 13.2 (a): PURE BUNDLING

Bundled Product

Price Product

Product

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For example, Microsoft Office 365 is available as bundle of different Pricing Strategies
applications such as word, excel, access, PowerPoint, outlook, OneNote etc.
You cannot buy these applications separately, you have to buy this in bundle
only. Microsoft has followed this practice because some applications are
more in demand as compared to others.

Mixed Bundling involves selling products separately as well as a bundle.

An American fast food company's are examples of Mixed Bundling. The

Times of India and The Economic Times can be purchased together for
weekdays for a price much less than if purchased separately. This is also an
example of mixed bundling. In most cases mixed bundling provides price
savings for consumers.

Fig 13.2 (b): MIXED BUNDLING

Separate
Bundled
Product Price

Product Price
Price

Product Price

Product Price

Tying involves purchases of the main product (tying product) along with
purchase of another product (tied product) which is generally an additional
complementary product.

Fig 13.2 (c): TYING

Lead Product Tie – in Product

A well known example of it was used by IBM in 1930s where in if you

purchased IBM tabulating machines you agreed to purchase IBM punch
cards. As a result, IBM was trying to extend its monopoly from one market to
another. But it had to abandon this practice of it in 1936 due to antitrust
cases. In 1950’s customers who leased a photo Copying Machine had to buy
Photo copy Paper. Another case of tying was that by Kodak in which Kodak
held a monopoly in the market for Kodak Copier Parts. Kodak engaged in
tying when it refused to sell its parts to consumers or independent service
providers except in connection with a Kodak Service Contract. Today when
you buy a Mach3 razor, you must buy the tied product i.e. the cartridge that
fits into the Mach3 razor.
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Pricing Decisions Financial bundling has become widespread. “Manufacturing is becoming the
loss-leader of the profit chain for many companies.” In other words, give
away the product; make money on the lending that is bundled with it. In India
too, a number of automobile companies are providing finance and bundling
the automobile with financing.

Bundling can be good for consumers. It can reduce “search costs” (the
bundled goods are in the same place), as well as the producer’s distribution
costs. There are lower “transaction costs” (because a single purchase is
cheaper to carry out than multiple ones). And the producer may be a more
efficient bundler than the customer: few of us choose, after all, to buy the
individual parts of a computer to assemble them ourselves.

In perfectly competitive markets, bundling should happen only if it is more

efficient than selling the products separately. Where there is less than perfect
competition-that is, most markets-economic models suggest that bundling
sometimes benefits consumers and sometimes producers. When firms have a
measure of market power, they can engage in price discrimination, charging
different prices to different customers. Bundling can play a part in price
discrimination, as different bundles of goods and prices may appeal to
different customers.

In a celebrated case that caught much media attention is of, Microsoft who
was accused of anti-competitive conduct in ‘bundling’ Internet Explorer and
Windows as a pure bundle. Microsoft claimed they are not a bundle at all,
rather a single product incapable of being broken into parts. It is of course
difficult to settle such arguments. But the interesting aspect is that the
company does not consider its product (Windows and Internet Explorer) as
being capable of being broken into parts.

Activity 3

1) What is bundling? Give examples. Do you think this is anti-consumer?

2) Give examples of tying from the Indian market.

13.6 TWO-PART TARIFFS

The techniques requires buyers to pay a fee for the right to purchase the
product and then to pay a regular price per unit of the product. For example,
mobile telecom operators A, V etc. used to charge a monthly fixed charge
and then additional charges based on usage for their post-paid plans.
The fee for privilege of service plus prices for services consumed is called a
two- part tariff. Theme parks such as D W usually employ such a pricing
scheme to increase their profits. To see how the scheme works, suppose you
290 operate a theme park and have a local monopoly. Figure 13.3 shows the
demand for rides at your theme park by any given tourist, along with the Pricing Strategies
marginal revenue and marginal cost of the rides. If you charge a single
monopoly price, your rides will be priced at $6 each and each tourist will
consume four rides per visit, spending $24.
Now let’s see if a bit more can be extracted from each tourist. Given the
demand curve drawn, each tourist would be willing to pay more than $24 to
enter your theme park and take four rides. If you know the demand curve for
rides, you know that the typical tourist is enjoying a consumer surplus of $8,
corresponding to the area of triangle ABC in the graph (area ABC=1/2*4*4).
Therefore, if you charge an entry fee of $8 in addition to $6 per ride, you can
add $8 per tourist to your profit.
Given the demand curve of a typical tourist, you can add still more to your
revenue from each tourist if you simply eliminate the price per ride and just
charge an admission fee equal to consumer surplus at zero price per ride. For
example, if the price per ride were zero, a tourist would go on 10 rides per
visit and you would get revenue of $50 per tourist –0.5 ($10)(10)—instead of
the $32 you would get from the two-part pricing scheme. But be careful.
With more rides your marginal costs will increase, and thus your profit might
not increase. Also, if you extract the entire consumer surplus with a single
entry fee, you increase the tourists’ cost per visit, so the total number of
admissions will fall.

Figure 13.3: Demand for rides

/AR

A two-part tariff is often a good way to increase profit by extracting some,

but not all, of the consumer surplus from a monopolist’s clients. Monopolists
usually experiment with various two-part tariff pricing schemes before hitting
on the one that gives them maximum profit.

When theme Parks Amusement rides opened, it was the first amusement park
of its kind in Mumbai and so had no precedent to go by. As the objective was 291
Pricing Decisions to sell the concept to as many people as possible, it avoided charging a
composite fee, for a stiff entrance fee would keep families away. Instead, it
selected what seemed the most sensible approach: pay-as-you-go. It charged
an entrance fee of ` 5 for children and ` 10 for adults. And the individual
rides were priced between ` 2 and ` 15. Later, however, theme Parks
Amusement rides jettisoned the split pricing strategy and switched over to
composite pricing. Under the new tariff structure children were charged a fee
of ` 80, while adults had to pay ` 100. There were no charges levied on the
rides. What prompted the switch? According to their vice-president they
found difficult to implement the pay-as-you-go strategy because of logistical
problems.

13.7 PRICING OF JOINT PRODUCTS

Products can be related in production as well as demand. One type of
production inter dependency exists when goods are jointly produced in fixed
proportions. The process of producing leather shoes and handbags in a leather
factory is a good example of fixed proportions in production. Each unit
provides a certain amount of leather shoes and handbags. There is little that
the leather factory can do to alter the proportions of the two products.

When goods are produced in fixed proportions, they should be thought of as a

“product package.” Because there is no way to produce one part of this
package without also producing the other part, there is no conceptual basis
for allocating total production costs between the two goods. These costs have
meaning only in terms of the product package.

Calculating the Profit-Maximizing Prices for Joint Products

Assume a retailer sells leather shoes and handbags. The two goods are
assumed to be jointly produced in fixed proportions. The marginal cost
equation for the product package is given by:

MC = 30 +5Q

The demand and marginal revenue equations for the two products are

Shoes Handbags
P = 60 – 1Q P = 80 –2Q
MR = 60 – 2Q MR = 80 –4Q

What prices should be charged for shoes and handbags? How many units for
the product package should be produced? Summing the two marginal revenue
(MRT) equations gives:

MRT = 140 – 6Q
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The optimal quantity is determined by equating MRT and MC and solving for Pricing Strategies

Q. Thus:

140-6Q = 30 +5Q

and, hence, Q = 10

Substituting Q =10 into the demand curves yields a price of $50 for shoes and
$60 for handbags. However, before concluding that these prices maximize
profits, the marginal revenue at this output rate should be computed for each
product to assure that neither is negative. Substituting Q=10 into the two
marginal revenue equations gives 40 for each good. Because both marginal
revenues are positive, the prices just given maximize profits. If marginal
revenue for either product is negative, the quantity sold of that product should
be reduced to the point where marginal revenue equals zero.

13.8 Transfer Pricing

In today’s world, a lot of companies have divided their operations into
several divisions. Transfer pricing is setting the price for goods that are
sold between these related legal entities (branches, subsidiary etc.). It
means the price of goods, which is paid by one unit of an organization to
another unit. E.g., Branch A of a company sells goods to Branch B, the price
paid by B is the transfer price. Transactions covered under transfer pricing
are Sale of finished goods, Purchase of raw material, IT Enabled services,
Purchase of fixed assets, Sale or purchase of machinery, Sale or purchase of
Intangibles, Reimbursement of expenses paid/received, Support services,
Software Development services, Technical Service fees, Management fees,
Royalty fees, Corporate Guarantee fees, Loan received or paid etc.

Purpose of transfer pricing

 Profits of different units can be ascertained separately and this helps in

separate performance evaluation of each unit of an organization.

 Transfer pricing also impact resource allocation among different units of

an organization.

Organization for Economic Cooperation and Development (OECD) is

responsible for governing transfer pricing for multinational companies.
Through transfer pricing, multinationals try to take tax advantage and that is
the reason OECD has set some guidelines. It has specified a particular
principle named Arm’s Length Principle (ALP) for these type of dealings
between related parties. ALP states that prices should be set by assuming
each party as independent, not dependent or related parties. In simple words,
it means transactions should be executed at fair market price. In addition to
this principle, guidelines also specify different methods of transfer pricing.
293
Pricing Decisions These methods are divided into two main heads: Traditional Transaction
Methods and Transactional Profit Methods.

Traditional Transaction Methods

 Comparable Uncontrolled Price (CUP) method

Under these methods, comparison is done between the terms and
conditions of uncontrolled transactions (with unrelated parties) and
controlled transactions (related parties). This requires high standard
comparable data to ensure that transaction has been done on the basis of
ALP.

 Resale price method

In this method, selling price of a product is used which is known as resale
price. Margin amount and different costs (determined by comparing to
unrelated transactions) are deducted to determine resale price.

 Cost Plus method

Under this, a markup (profit) amount is added in the total costs incurred
by the supplier unit of the organization.

Transactional Profit Methods

 The Comparable Profits Method

Under this method, basis of the transfer price is net profit of controlled
transaction.

 The Profit Split Method

This pricing method is used where companies are engaged in
interconnected transactions and profits are separated by examining how
unrelated parties would split profits in similar transactions.

13.9 Other Pricing Practices

Prestige Pricing
Prestige pricing is a type of pricing strategy, where a product is placed at a
higher price, because consumers associate higher price with higher quality
and a prestige is attached to the ownership of the product. This is also known
as Image Pricing. NIKE is one of the best examples of prestige pricing.

Price Skimming
It is a strategy where a company charges high prices from consumers at first
and earn substantial profits, later reduces the prices gradually to attract other
customers who are price sensitive. APPLE is the best example of this type of
pricing strategy.

Penetration Pricing
Companies charge relatively lower prices for their product to attract
customers and increase market share. This pricing strategy is to lure
294 customers away from competitor’s products.
Psychological Pricing Pricing Strategies
Psychological pricing involves pricing that has impact on the psychology of
the consumers. E.g., Companies set prices such as ` 499 etc. which
consumers perceive as lower prices than they actually are.

13.10 LET US SUM UP

For a firm to be able and willing to engage in price discrimination, the
buyers of the firm’s product must fall into classes with considerable
differences among classes in the price elasticity of demand for the product,
and it must be possible to identify and segregate these classes at moderate
cost. Also, buyers must be unable to transfer the product easily from one
class to another, since otherwise persons could make money by buying the
product from the low-price classes and selling it to the high- price classes,
thus making it difficult to maintain the price differentials among classes. The
differences among classes of buyers in the price elasticity of demand may be
due to differences among classes in income, level, tastes, or the availability of
substitutes.

13.11 KEYWORDS
Bundling is the practice of selling two or more separate products together for
a single price i.e. bundling takes place when goods or services which could
be sold separately are sold as a package.

First degree price discrimination refers to a situation where the monopolist

charges a different price for different units of output according to the
willingness to pay of the consumer.

Peak load pricing is a type of third-degree price discrimination in which the

discrimination base is temporal.

Second degree price discrimination refers to a situation where the

monopolist charges different prices for different set of units of the same
product.

Third degree price discrimination is when the monopolist firm divides the
market (for its product) into two or more markets (groups of buyers or
segments) and charges different price in each market.

13.12 TERMINAL QUESTIONS

1. Assume a company produces a product that currently sells for ` 160.
The unit costs for producing the product are—

Materials ` 51
Direct labour ` 32
Overhead ` 40
Sales expense ` 21
` 144
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Pricing Decisions These unit costs are based on sales of 100,000 units per year. Capacity
is generally accepted to be 150,000 units per year. A foreign retail chain
has contacted the company with an offer to purchase 60,000 units on a
short-term basis during the next year at a price of 130 each. Sales of
these units in the foreign market would not have any effect on the
company’s domestic market. Should the offer be accepted? Explain
why or why not. Identify any assumptions you make in answering the
question.

2. Which are the various methods of price discrimination identified in this

unit? Explain with examples.

3. Why are auctions not used to extract consumer’s surplus for most
products sold? Under what conditions and for which goods are auctions
useful to price the product being sold? Substantiate with a real world
example.

4. Choose any product or service for which price discrimination exists in

India. Identify the different categories of consumers and tabulate the
corresponding prices for the chosen product or service. Comment on
this pricing policy.

5. How many options does an amusement park have when it comes to the
pricing decision?

6. Basically, there are four options open to the manager:

i) Keep the entrance free, but charge the visitor for every ride
separately.

ii) Charge a lump sum entrance fee and allow the visitor unlimited fee
rides.

iii) Same as the second option but limit the visitor to just one ride.

iv) Charge an entrance fee and also get the consumer to pay a
cumulative fee for the rides, the number of rides to be availed of
being decided by the visitor.

The second, third and fourth options are based on the principle of a two-part
tariff- the consumer is charged for entry and then for the rides (note that tariff
for rides may be zero) . Traditional economic theory is able to conclusively
prove that a two-part tariff is the best way to maximise revenue and hence the
profits of the park owner, if two conditions simultaneously hold. First, if the
seller is a monopolist. Second, the benefit of enjoying the good cannot be
transferred. In case of an amusement park both these conditions hold. The
rationale for a two-part tariff stems from the concept of consumer surplus.
Consider a person who places the value for visiting the park and enjoying the
rides at ` 100. Now if the rides are priced such that it costs him ` 90, then his
296
(consumer) surplus is ` 10. He will opt for the product if the price is less than Pricing Strategies
or equal to his perceived value.

a) For the park owner, the trick is to extract a portion of this surplus.
How?
b) What are the variables you consider as important in the pricing
decision?

FURTHER READINGS
Mote, V. L., Paul, S., & Gupta, G. S. (2016). Managerial Economics:
Concepts and Cases, Tata McGraw-Hill, New Delhi.

Maurice, S. C., Smithson, C. W., & Thomas, C. R. (2001). Managerial

Economics: Applied Microeconomics for Decision Making. McGraw-Hill
Publishing.

Lewis, W. C., Jain, S. K., & Petersen, H. C. (2005). Managerial Economics

(4th ed.). Pearson.

Keat, P. J., Young, P. KY., & Banerjee, S. (2009). Managerial Economics:

Economic Tool for Today’s Decision Makers (5th ed.). Pearson.

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