Variations in Price Strategies across Market Structures

Variations in Price Strategies across Market Structures
Jason Ruby
ECON600
American Military University









Abstract
Companies that operate in one of the four market structures must adapt their pricing strategies to meet their primary objective, which is to maximize profits. Markets structures that operate in perfect competition, monopolistic competition, or are monopolies or oligopolies are all influenced by various factors that are defined by environments. These factors include price whether the products are unique, if there are exact substitutes, if there are close substitutes, and what barriers exists for firms to enter or exit the market. When companies operate in perfect competition or monopolies, the demand curve plays a critical role in price strategy. When companies operate in monopolistic competition or oligopolies, competing firms attempt to differentiate themselves from competitors in the market through advertising, branding, and gaining customer loyalty. Some companies may even for alliances, like OPEC, that control price and output of a product and thereby increase profits for all parties.






Optimal pricing is a key consideration for private and commercial organizations, whose primary object is always to maximize profit. In different market structures, like monopolies with no competition, oligopies with much competition, and monopolistic competition markets with few producers, the strategic approchaes to optimal prices will mecissarily vary. In these very different types of market environments, product differentiation play a critical roles in the valuation of products by customers, as does cost, competition, and the customers themselves. With this in mind, the different forces at work in these varied market structures create challenges for executives and strategic planners, requiring different strategies for optimal pricing.
If a market may be said to be in perfect competition, also referred to as pure competition, four or five specific factors must be present, depending on the source of reference. The five common criteria are that all companies must sell the same, standardized product or service, must all be price takers, must have a small non-majority share of the market, must convey their prices to the buyer, and the market itself must have free entry and exit to these companies. The term price taker refers to a condition in which a “firm that can alter its rate of production and sales without significantly affecting the market price of its product” (Investopedia, 2001). It is a rare occurrence for a market to meet these criteria to be considered in perfect completion, but more often a benchmark used for comparison with other market types.
There are many companies, however, that partially meet all the criteria to be considered in perfect competition or come close enough to be based their pricing strategies on this type of market structure. While real-world examples of perfect or pure competition are difficult to find, many academic sources cite agricultural markets as being close, like wheat, soy, etc. The reason for this is that agricultural products are produced by many companies, and the products they produce are essentially identical. In addition, there are generally no barriers to entry or exit into these markets, and both the producers and consumers are price takers because their actions have effect in the price of the product. This is not a perfect example, however, because the products themselves may be differentiated by quality, and some barriers to entry may exist like startup costs.
In contrast to markets that may be considered to have pure or perfect competition with companies that each produce the same, standardized product, markets that are monopolies are characterized by companies that each produce a unique product or service. In markets that are considered to have monopolistic competition, companies produce products that are similar yet have differentiating aspects. The three primary criteria for a monopolistic competition market are that all companies must produce similar but differentiated products, there must be many companies in the market, and that there are no barriers to entry. As such, products within this market types are said to be close substitutes of one another, which usually results in efforts to establish product differentiation in terms of price, quality, and branding.
Markets that are considered in monopolistic completion differ from those in pure or perfect competition in other significant ways besides product differentiation. Probably the biggest consideration for executives and strategic planners is demand elasticity, or the affect of price on demand. As previously mentioned, markets in perfect competition have perfect elasticity, which means that changes demand for products is extremely sensitive to changes in price. In contrast, markets that are considered to be in monopolistic competition operate in an environment with relatively elastic demand, meaning that “the firm has some discretion in raising price without losing its entire market to competition” (Samuelson, W. & Marks, S., 2010, pg. 314). The automobile industry would be an example of companies operating in a market with monopolistic competition, as products are similar but differentiated, and companies have some control over price.
Another type of market type structure that is relative to both perfect competition and monopolistic competition is an oligopoly. An oligopoly has significantly different characteristics than those of markets with perfect and monopolistic competition, and is defined by three characteristics. There are three generally accepted criteria for a market to be considered an oligopoly, which are that companies are “characterized by a small number of large firms that dominate the market, selling either identical or differentiated products, with significant barriers to entry into the industry” (Amosweb.com, 2011). Oligopolies are also characterized by significant barriers to entry, as these are generally large, international companies, and the market is very sensitive to the effects of substitutes.
Market structures that are considered oligopolies, as previously stated, are those that generally consist of a small number of very larger, international companies. Because of this, these companies usually have significant, but not total, control over the price of the good or service being sold. Oligopolies do share some of the characteristics of both perfect and monopolistic markets, in that companies that are part of an oligopoly may produce identical products, differentiated products, or both. Some examples of markets that operate in an oligopoly would be the oil industry, with companies like British Petroleum and Shell, and the market for wireless phones, with major service providers like Verizon and AT&T.
The fourth type of basic market structure is a monopoly, which is the most familiar to people and is generally understood to be an environment where one company sells a specific product, and where no substitutes are available. Pure monopolies have only one seller, and like markets with pure or perfect competition are extremely rare. More common are near monopolies, in which one company sells 90 percents of all products or services in the market. Other than the common characteristic of a monopoly having one seller, the other criteria of this market type is a very high barrier or barriers to entry and that substitutes are not easily obtainable. High barriers to entry are commonly due to patents, copyrights, licenses, and other legal obstructions.
Some examples of pure monopolies would be pharmaceutical companies where there is no generic alternative to the drug, or a software vendor which develops a new application where nothing similar exists. Some examples of near monopolies would be companies that harvest natural resources like diamonds and lumber in one country, and public utilities like that provide water, electric, and Internet service to specific geographic regions. Because of the market control that is demonstrated in a monopoly, the selling company is larger enough “to influence its own price, such that it is the price setter rather than taker, unlike a perfectly competitive market where each firm faces a perfectly elastic demand curve (BasicEconomics.info, 2011).
Companies that operate in markets with perfect or near perfect competition, like agricultural products, have little or no influence on price and as a result are highly sensitive to demand and the supply curve. The demand curve in perfect or near perfect competition “shows the total quantities that consumers are willing and able to purchase at various prices,” and the supply curve “shows the total quantities that producers are willing and able to supply at various prices, other factors held constant (Samuelson, W. & Marks, S., 2010, pg. 314). The pricing strategy for companies in a perfectly competitive market would be to determine the equilibrium price, which is where the supply and demand curves intersect, or where Price = Marginal Cost.
Pure or perfect competition is used as a benchmark when evaluating effective price strategies because it’s Price = Marginal Cost model is inherently efficient. This equation determines the company’s optimal output, which is profitable if marginal costs remain constant. Because there are no barriers to entry, however, “the existence of positive economic profit will attract new suppliers into the industry, and as new firms enter and produce output, the current market price will be bid down (Samuelson, W. & Marks, S., 2010, pg. 272). When this occurs, over the long term, market equilibrium results in no economic profits for companies within the market. Companies no longer have reason to increase or decrease production, nor reason to enter or exit the market.
Compared to markets that have characteristics of an oligopoly or of monopolistic competition, the pricing strategies of a monopoly are defined solely defined by the demand curve. With no alternatives to the product being produced by a single company, monopolies are not affected by production from new entrants to the market. Monopolies maximize their profits by setting both the price and the level of output. Optimal pricing is determined by the marginal revenue equally marginal cost, MR = MC, based on the demand curve. Companies that hold the position of a monopoly in a market generally earn more profit than would be made if there were other sellers, but there may be close alternatives that reduce the demand, and as a result, the overall profit.
The influence of a monopoly on price and output is demonstrated in very clearly in the sale of name brand drugs from pharmaceutical companies. When new drugs are released, and where no generic alternative exists, the price is usually very high because consumers will pay the high costs out of necessity. It is common for a pharmaceutical company to hold a monopoly on one type of drug for a period of time and see large profits. Price will be as high as demand allows and if the product is a cancer or other life-saving or life-extending drug, demand will be nearly limitless. However, when generic alternatives begin arriving on the market as close alternatives, demand drops and as a result profits are greatly reduced.
Markets that may be considered to be in monopolistic competition are similar to both monopolies and those in perfect competition, in both characteristics and in pricing strategy. Companies that meet the criteria of monopolistic competition each produce a unique product, but there are many companies and each is a close alternative to the others. The result of these market influences is that companies but differentiate their products from the others based generally on cost, competition, and customer preference and need. Firms invest considerably in the efforts, commonly in “advertising and marketing, aimed at creating product or brand-name allegiance” (Samuelson, W. & Marks, S., 2010, pg. 314). These factors create a more complicated approach to pricing strategy.
Other similarities between firms operating in a monopolistic competition market in perfect competition is that both have easy entry and exit into the market, which contributes to long term profits declining until profit no longer exists. As in perfect competition, new firms enter the market and drive down long-term profits for all companies which are competing. Some companies operating in monopolistic competition may continue to see long term profits, however, due to increased advertising, branding, and a loyal customer base. Use of advertising must be planned and used efficiently, as “too much spending will result in higher cost, and lower profit. Price, product attributes, and advertisement are three main factors that producers have to consider” (FullColl.edu, 2010). Because of these factors, average cost is high than in perfect competition or monopolies.
The fourth type of market structure, the oligopoly, is very similar to the monopoly in many respects. A monopoly is characterized by one seller and high or no barriers to entry, while the oligopoly is characterized by a small number of companies that produce standardized, differentiated products. A monopoly that does manage to gain additional sellers of a product becomes an oligopoly. Also like monopolies, oligopolies tend to be very large companies, requiring a very large investment to enter the market. Companies like BP, Exxon, and Shell generate more wealth than annual gross domestic product of many of the nations of the world. As a result, relatively large amounts of capital are available for differentiation strategies like research and development, advertising, branding, and even political lobbying.
Because there are very few sellers, each company in oligopoly is very sensitive to changes made by the other companies, including those of price, advertising, and production output. Because of this, some companies in oligopolies form alliances or cartels in which price strategies are agreed upon for the benefit for all the firms involved. For example, “The Organization of Petroleum Exporting Countries (OPEC) is a cartel. The eleven countries agreed on the output amount and working together to control the world’s crude oil supply” (FullColl.edu, 2010). When all firms that have formed a cartel within an oligopoly market raise their prices, all members benefit.
This strategy of cartels in an oligopoly market, to raise prices so that all members profit, is an example of a optimal pricing strategy of any of the members. OPEC, rather than being controlled by commercial companies, is actually an intra-government organization founded in 1960 and consists of the largest oil-producing countries in the world including, Kuwait, Iraq, Iran, Saudi Arabia, Qatar, and Venezuela. OPECs goal is is to coordinate the petroleum pricing and policies of member nations, and thereby control the price of oil worldwide. There is a minimum set of criteria for entry into the OPEC cartel, one being a minimum required production of oil each year.
Because OPEC controls the price and production levels of oil, the most important natural resources for national economies, it may be the most powerful non-governmental organization in the world. OPEC is able to raise prices as high as demand will permit, but has made mistakes. In 1979, OPEC double the price of petroleum, “but the price elasticities of demand and non-OPEC supply were much higher than anticipated, so that OPEC did very poorly--not only in absolute terms, but also relative to what it could have achieved if it had set its price more cautiously” (Highbeam.com, 2011). Within a few years OPEC was forced to cut this price by more than half, and today the OPEC lets the market dictate price to some degree, but rather controls output more closely.
The four common types of market structures – perfect competition, monopolistic competition, monopolies, and oligopolies, - each have specific criteria that differential each one from the other three, so companies in each market type have their own approach to optimal pricing strategy. Companies that operate in a market with pure or perfect competition are very rare, and this market structure is more commonly used as a benchmark with which to analyze other companies. Pricing strategies for the other three types of market structures are more complex, however, and factors such as cost, competition, and customer preference and loyalty all play importance parts.

References
Samuelson, W. & Marks, S. (2010). Managerial Economics. Wiley & Sons, Inc. New Jersey USA: Wiley.
Investopedia. (2001). Perfect Competition. Retrieved Sep 1, 2011 from: http://www.investopedia.com/terms/p/perfectcompetition.asp#axzz1X6Nj2dBw
Amosweb.com. (2011). Oligopoly. Retrieved Sep 3, 2011 from: http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=oligopoly
BasicEconomics.info. (2011). Monopoly Companies. Retrieved Sep 5, 2011 from:
http://www.basiceconomics.info/monopoly-companies.php
FullColl.edu. (2010). Strategies for OPEC's pricing and output decisions. Retrieved Sep 5, 2011 from:
http://staffwww.fullcoll.edu/fchan/Micro/4oligopoly.htm