MANAGERIAL ECONOMICS - Material No.

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Topic: Market Structure and Pricing Strategies
References:
https://www.tutorialspoint.com/managerial_economics/pricing_strategies.htm
https://www.tutorialspoint.com/managerial_economics/market_structure_pricing_decisions.
htm

MARKET STRUCTURE AND PRICING DECISIONS

Introduction

Price determination is one of the most crucial aspects in economics. Business

managers are expected to make perfect decisions based on their knowledge and
judgment. Since every economic activity in the market is measured as per price, it is
important to know the concepts and theories related to pricing. Pricing discusses the
rationale and assumptions behind pricing decisions. It analyzes unique market needs
and discusses how business managers reach upon final pricing decisions.

It explains the equilibrium of a firm and is the interaction of the demand faced by the
firm and its supply curve. The equilibrium condition differs under perfect competition,
monopoly, monopolistic competition, and oligopoly. Time element is of great relevance
in the theory of pricing since one of the two determinants of price, namely supply
depends on the time allowed to it for adjustment.

What is Pricing?

Pricing is a process to determine what manufactures receive in exchange of the

product. Pricing depends on various factors like manufacturing cost, raw material cost,
profit margin etc.

What are Pricing Decisions?

Pricing decisions are the choices businesses make when setting prices for their
products. The pricing decision has been the major focus of economic theory in the
analysis of resource allocation, but its position in managerial economics is more
limited.

In the analysis of business decision making, pricing is just one element in a

comprehensive competitive strategy.

When it comes to setting the price of the product, then it involves two parties: the
marketing team and the production staff. However, the marketing team comprises of
company’s management, top executives, and marketing staffs. They consider how the

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product would play out in the market.

Senior management is responsible for setting the overall pricing strategy for the
company. They are responsible for determining the pricing objectives, such as
maximizing profits, gaining market share, or increase revenue. Senior management
also oversees the pricing team and guides pricing decisions.

How is Price Determined?

Pricing decisions for products and services should first be based on how much it costs
the company to make or how much time it cost to do the service. After that, consider
what the competitors are doing with their pricing and the customers willingness to pay
the product’s price (affordability).

Objectives of Pricing

The main objectives of pricing can be learnt from the following points −

• Maximization of profit in short run

• Optimization of profit in the long run
• Maximum return on investment
• Decreasing sales turnover
• Fulfill sales target value
• Obtain target market share
• Penetration in market
• Introduction in new markets
• Obtain profit in whole product line irrespective of individual product profit
targets
• Tackle competition
• Recover investments faster
• Stable product price
• Affordable pricing to target larger consumer group
• Pricing product or services that simulate economic development

Pricing objective is to price the product such that maximum profit can be extracted
from it.

Factors Influencing Pricing

Pricing of a product is influenced by various factors as price involves many variables.

Factors can be categorized into two, depending on the variables influencing the price.

• Internal Factors: The following are the factors that influence the increase and
decrease in the price of a product internally −

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 • Marketing objectives of company
• Consumer’s expectation from company by past pricing
• Product features
• Position of product in product cycle
• Rate of product using pattern of demand
• Production and advertisement cost
• Uniqueness of the product
• Production line composition of the company
• Price elasticity as per sales of product

Internal factors that influence pricing depend on the cost of manufacturing of the
product, which includes fixed cost like labor charges, rent price, etc., and
variable costs like overhead, electric charges, etc.

• External Factors: The following are the external factors that have an impact on
the increase and decrease in the price of a product −

• Open or closed market

• Consumer behavior for given product
• Major customer negotiation
• Variation in the price of supplies
• Market opponent product pricing
• Consideration of social condition
• Price restricted as per any governing authority

External factors that influence price depend on elements like competition in

market, consumer flexibility to purchase, government rules and regulation, etc.

Pricing Methods

Pricing methods are ways of calculating the price of goods and services by taking into
account all factors that can influence pricing strategy. Factors can include the product
or service, its life cycle, market competition, and target audience.

Here are various pricing methods:

• Cost plus Pricing. Cost plus pricing can be defined as the cost of production per
unit of product plus profit margin decided by the management. Cost-plus pricing
is also known as markup pricing. It’s a pricing method where a fixed percentage
is added on top of the cost it takes to produce one unit of a product. The
resulting number is the selling price of the product. This pricing method looks
solely at the unit cost and ignores the prices set by competitors. For this
reason, it’s not always the best fir for many businesses because it doesn’t take

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 external factors, like competitors, into account. The formula is: Formula of
I cost plus pricing
Selling Price = Total Cost (1 + Markup Percentage)

Markup is the percentage difference between the unit cost and the selling price
of the product.

Break-even analysis is a financial calculation that weighs the cost of a new

business, service or product against the unit sell price to determine the point at
which the business firm will break even. It is a point when the investment and
revenue of an enterprise is equal; after this point an enterprise gains profit.

• Prices based on Marginal Analysis. In this method, additional cost of that activity
is compared to additional profit and the price is calculated according to margin
cost. Thus, the cost and the price are evaluated and as per unit result, the price
is decided as to maximize the profit.

Market Structure

A market is the area where buyers and sellers contact each other and exchange goods
and services. Market structure is said to be the characteristics of the market. Market
structures are basically the number of firms in the market that produce identical
goods and services. Market structure influences the behavior of firms to a great
extent. The market structure affects the supply of different commodities in the market.

When the competition is high there is a high supply of commodity as different

companies try to dominate the markets and it also creates barriers to entry for the
companies that intend to join that market. A monopoly market has the biggest level of
barriers to entry while the perfectly competitive market has zero percent level of
barriers to entry. Firms are more efficient in a competitive market than in a monopoly
structure.
All the
Perfect Competition same
products
Perfect competition is a situation prevailing in a market in which buyers and sellers
are so numerous and well informed that all elements of monopoly are absent and the
market price of a commodity is beyond the control of individual buyers and sellers

With many firms and a homogeneous product under perfect competition no individual
firm is in a position to influence the price of the product that means price elasticity of
demand for a single firm will be infinite.

Pricing Decisions: Determinants of Price Under Perfect Competition

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Market price is determined by the equilibrium between demand and supply in a market
period or very short run. The market period is a period in which the maximum that can
be supplied is limited by the existing stock. The market period is so short that more
cannot be produced in response to increased demand. The firms can sell only what
they have already produced. This market period may be an hour, a day or a few days or
even a few weeks depending upon the nature of the product.

• Market Price of a Perishable Commodity. In the case of perishable commodity

like fish, the supply is limited by the available quantity on that day. It cannot be
stored for the next market period and therefore the whole of it must be sold
away on the same day whatever the price may be.

• Market Price of Non-Perishable and Reproducible Goods. In case of non-

perishable but reproducible goods, some of the goods can be preserved or kept
back from the market and carried over to the next market period. There will
then be two critical price levels.

The first, if price is very high the seller will be prepared to sell the whole stock.
The second level is set by a low price at which the seller would not sell any
amount in the present market period, but will hold back the whole stock for
some better time. The price below which the seller will refuse to sell is called
the Reserve Price.
Close but
Monopolistic Competition not perfect
substitutes

Monopolistic competition is a form of market structure in which a large number of

independent firms are supplying products that are slightly differentiated from the point
of view of buyers. Thus, the products of the competing firms are close but not perfect
substitutes because buyers do not regard them as identical. This situation arises when
the same commodity is being sold under different brand names, each brand being
slightly different from the others.

For example: Lux, Dove, etc.

Each firm is therefore the sole producer of a particular brand or “product”. It is

monopolist as far as a particular brand is concerned. However, since the various
brands are close substitutes, a large number of “monopoly” producers of these brands
are involved in a keen competition with one another. This type of market structure,
where there is competition among a large number of “monopolists” is called
monopolistic competition.

In addition to product differentiation, the other three basic characteristics of

monopolistic competition are −

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 • There are large number of independent sellers and buyers in the market.
• The relative market shares of all sellers are insignificant and more or less
equal. That is, seller-concentration in the market is almost non-existent.
• There are neither any legal nor any economic barriers against the entry of new
firms into the market. New firms are free to enter the market and existing firms
are free to leave the market.
• In other words, product differentiation is the only characteristic that
distinguishes monopolistic competition from perfect competition.

Monopoly Single
Producer

Monopoly is said to exist when one firm is the sole producer or seller of a product
which has no close substitutes. According to this definition, there must be a single
producer or seller of a product. If there are many producers producing a product,
either perfect competition or monopolistic competition will prevail depending upon
whether the product is homogeneous or differentiated.

On the other hand, when there are few producers, oligopoly is said to exist. A second
condition which is essential for a firm to be called monopolist is that no close
substitutes for the product of that firm should be available.

From above it follows that for the monopoly to exist, following things are essential −

• One and only one firm produces and sells a particular commodity or a service.
• There are no rivals or direct competitors of the firm.
• No other seller can enter the market for whatever reasons legal, technical, or
economic.
• Monopolist is a price maker. He tries to take the best of whatever demand and
cost conditions exist without the fear of new firms entering to compete away his
profits.

The concept of market power applies to an individual enterprise or to a group of

enterprises acting collectively. For the individual firm, it expresses the extent to which
the firm has discretion over the price that it charges. The baseline of zero market
power is set by the individual firm that produces and sells a homogeneous product
alongside many other similar firms that all sell the same product.

Since all of the firms sell the identical product, the individual sellers are not distinctive.
Buyers care solely about finding the seller with the lowest price.

In this context of “perfect competition”, all firms sell at an identical price that is equal
to their marginal costs and no individual firm possess any market power. If any firm
were to raise its price slightly above the market-determined price, it would lose all of
its customers and if a firm were to reduce its price slightly below the market price, it
would be swamped with customers who switch from the other firms.

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Accordingly, the standard definition for market power is to define it as the divergence
between price and marginal cost, expressed relative to price. In Mathematical terms
we may define it as −
L = (P − MC) / P

Oligopoly

In an oligopolistic market there are small number of firms so that sellers are
conscious of their interdependence. The competition is not perfect, yet the rivalry
among firms is high. Given that there are large number of possible reactions of
competitors, the behavior of firms may assume various forms. Thus, there are various
models of oligopolistic behavior, each based on different reactions patterns of rivals.

Oligopoly is a situation in which only a few firms are competing in the market for a
particular commodity. The distinguishing characteristics of oligopoly are such that
neither the theory of monopolistic competition nor the theory of monopoly can explain
the behavior of an oligopolistic firm.

Two of the main characteristics of Oligopoly are briefly explained below −

• Under oligopoly the number of competing firms being small, each firm controls
an important proportion of the total supply. Consequently, the effect of a change
in the price or output of one firm upon the sales of its rival firms is noticeable
and not insignificant. When any firm takes an action its rivals will in all
probability react to it. The behavior of oligopolistic firms is interdependent and
not independent or atomistic as is the case under perfect or monopolistic
competition.
• Under oligopoly new entry is difficult. It is neither free nor barred. Hence the
condition of entry becomes an important factor determining the price or output
decisions of oligopolistic firms and preventing or limiting entry of an important
objective.

For Example: Aircraft manufacturing, in some countries: wireless communication,

media, and banking.

PRICING STRATEGIES

Pricing is the process of determining what a company will receive in exchange for its
product or service. A business can use a variety of pricing strategies when selling a
product or service. The price can be set to maximize profitability for each unit sold or
from the market overall. It can be used to defend an existing market from new
entrants, to increase market share within a market or to enter a new market.

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Pricing strategies are the methods and procedures firms employ to determine the
rates they charge for their goods and services. In terms of the marketing mix some
would say that pricing is the least attractive element. Marketing companies should
really focus on generating as high a margin as possible. Let us now understand the
various pricing strategies:

• Penetration pricing. This is a pricing strategy that is used to quickly gain market
share by setting an initially low price to entice customers to purchase. This
pricing strategy used by new entrants into a market. An extreme form of
penetration pricing is called predatory pricing.

The price charged for products and services is set artificially low in order to
gain market share. Once this is achieved, the price is increased. This approach
was used by France Telecom and Sky TV. These companies need to land grab
large numbers of consumers to make it worth their while, so they offer free
telephones or satellite dishes at discounted rates in order to get people to sign
up for their services. Once there is a large number of subscribers prices
gradually creep up. Taking Sky TV for example, or any cable or satellite
company, when there is a premium movie or sporting event prices are at their
highest – so they move from a penetration approach to more of a
skimming/premium pricing approach.

• Economy pricing. This is a pricing strategy where products have lower prices
due to low production costs. Economy pricing allows businesses to price
products according to their production value because they don’t acquire the
extra costs of advertising or marketing. The costs of marketing and promoting a
product are kept to a minimum.

Supermarkets often have economy brands for soups, spaghetti, etc. Budget
airlines are famous for keeping their overheads as low as possible and then
giving the consumer a relatively lower price to fill an aircraft. The first few seats
are sold at a very cheap price (almost a promotional price) and the middle
majority are economy seats, with the highest price being paid for the last few
seats on a flight (which would be a premium pricing strategy). During times of
recession economy pricing sees more sales.

• Price skimming. A price skimming is a strategy that sets a new product prices
high and substantially lowers as competitors enter the market. Skim pricing is
the opposite of penetration pricing.

Price skimming sees a company charge a higher price because it has a

substantial competitive advantage. However, the advantage tends not to be
sustainable. The high price attracts new competitors into the market, and the
price inevitably falls due to increased supply.

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• Psychological pricing. This is a way business set prices to influence how
customers perceive the value of a product or service. Companies do this by
using tactics like pricing just below round numbers or choosing prices that
sound appealing to make products seem more affordable or attractive.

This approach is used when the marketer wants the consumer to respond on an
emotional, rather than rational basis. For example: Price Point Perspective
(PPP) Php 99 not Php 100. It’s strange how consumers use price as an indicator
of all sorts of factors, especially when they are in unfamiliar markets.

• Product line pricing. This is a pricing strategy where a company offers a range
of products or services at different price points, with each product having a
distinct set of features and benefits. Product line pricing seldom reflects the
cost of making the product since it delivers a range of prices that a consumer
perceives as being fair incrementally – over the range. Profit is made on the
range rather than single items.
• Optional product pricing. A pricing strategy whereby the core component of a
product is sold for a basic price, and a menu of complementary services are
offered for a separate fee. Companies will attempt to increase the amount
customers spend once they start to buy. Optional ‘extras’ increase the overall
price of the product or service. For example, airlines will charge for optional
extras such as guaranteeing a window seat or reserving a row of seats next to
each other.

• Captive product pricing. This is a pricing strategy devised to attract a large

volume of customers to a one-time purchase of a lower-priced core (main)
product that requires accessory (or captive) products for the main product to
function. For example, a printer manufacturer will sell you an inkjet printer at a
low price. In this instance, the inkjet company knows once you run out of the
consumable ink you will need more, and this tends to be relatively expensive.
Again, the cartridges are not interchangeable and you have no choice.

• Product bundle pricing. Also known as price bundling, is a pricing strategy that
combines two or more products to sell them at a lower price than if the same
products were sold separately. This also serves to move old stocks. It’s a good
way of moving slow selling products, and in a way is another form of
promotional pricing. The bundle pricing technique is popular in retail and e-
Commerce as it offers more value for the price.

• Promotional pricing. This is a strategy where the price of a product is kept

reduced for a short period to build customer loyalty and swell sales volumes,
then increased later on. Another popular price promotion in the market is by
way of the famous and effective ‘Buy 1 Get 1 Free’ offer.

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• Geographical pricing. This is the practice of adjusting an item’s sale price based
on the location of the buyer. Geographic pricing sees variations in price in
different parts of the world. Sometimes the difference in the sale price is based
on the cost to ship the item to that location, legislation which limits how many
products might be imported again, or tax imposition.

• Value pricing. Known as value-based pricing is a strategy that involves basing

prices on how the customer perceives the value of the product or service.
Rather than looking at competitors or the market or the cost of the product,
companies go directly to the source, the customer, and choose a price based on
what they’re willing to pay.

• Premium pricing. Premium pricing is a strategy that involves tactically pricing

the product higher than the immediate competitors. The purpose of this pricing
tactic is to put a premium price on the product to cultivate a sense of the
company’s product’s market being just that bit higher in quality than the rest.
Often clever branding, marketing and, messaging that appeals to the product’s
customer base. The strategy is mostly used when a company has a solid and
strong brand.

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