How will a firm’s pricing strategy depend on the structure of the market?
A pricing strategy is important to any firm in realising its corporate objectives, whether that be its sales revenue, market share or indeed profit, and thus there is much preoccupation within a business about its pricing strategy. Ultimately, this will be guided by many factors; not least the market power it has to set the price of its products and the nature of the demand curve it faces. This essay will attempt to outline how a firm’s pricing strategy is influenced by the characteristics of the market in which it operates, looking at various market structures, including perfect competition, monopoly and oligopoly.
One particular market structure worthy of consideration in addressing the question is perfect competition. According to Besanko and Braeutigam (2005) firms in this market structure act as price takers. Due to the industry being fragmented, each firm’s output is a significantly small proportion of the industry supply and demand, which determines the market price. In addition, it is assumed that firms operating in this industry produce products that are homogeneous and consumers possess perfect knowledge about the prices and availability of products. Consequently, the consumer will purchase the good at the lowest available price. Varian (1999) asserts that firms operating in this market structure will face a horizontal demand curve at market price. If the firm sets its price above market price, then it will sell nothing. If the firm sets its price below the market price, then it will capture the entire market demand but will not cover its costs in the long run. Thus, the only sensible pricing strategy available to the firm is to take the market price, where it can sell all it can produce.
By contrast, a monopolist is able to set the market price for the product that it sells. Besanko and Braeutigam (2005: 404) define a monopolistic market as one which “consists of a single seller facing many buyers”. Therefore, the firm’s demand curve is also the industry demand curve. However, since the monopolist’s demand curve is downward sloping, it cannot set an infinitely high price. In order to increase its sales, the firm must lower its price; thus marginal revenue will be less than average revenue represented by the demand curve. If the monopolist wishes to maximise its profits then it will set its output where marginal cost equates to marginal revenue. At this point, the price exceeds the marginal cost of production and assuming that average costs are also below the demand curve, the firm is able to earn economic profit (A+B), illustrated in Figure 1 (Lecture Notes, 2007) below.
The optimal mark-up of price above marginal cost for the monopolist is going to depend on the shape of the demand curve, or its elasticity. As Figure 2 (Lecture Notes, 2007) shows, the gap between the profit-maximising price and marginal cost is greater when the demand curve becomes more inelastic and thus the greater the opportunity there is for the firm to raise its price above marginal cost. Firms are often faced with consumers having different demand curves and use the concept of elasticity to form a pricing strategy, known as third-degree price discrimination, in order to capture more surplus than could have been achieved by setting a uniform price. Price discrimination itself is, according to Besanko and Braeutigam (2005: 448), “the practice of charging consumers different prices...
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