Price and Output decisions - I

Meaning of Perfect Competition:

A Perfect Competition market is that type of market in which the number of buyers and
sellers is very large, all are engaged in buying and selling a homogeneous product without any
artificial restrictions and possessing perfect knowledge of the market at a time.

Features of of Perfect Competition:

1. Large Number of Buyers and Sellers:
2. Homogeneity of the Product:
3. Free Entry and Exit of Firms:
4. Perfect Knowledge of the Market:
5. Perfect Mobility of the Factors of Production and Goods:
6. Absence of Price Control:
7. Perfect Competition among Buyers and Sellers:
8. Absence of Transport Cost:
9. One Price of the Commodity:
10. Independent Relationship between Buyers and Sellers:

Price and Output Determination

Meaning of Monopoly
Market situation where one producer controls supply of a good or service, and where
the entry of new producers is prevented or highly restricted. Monopolist firms (in their attempt to
maximize profits) keep the price high and restrict the output, and show little or no responsiveness to
the needs of their customers
Types

Oligopoly: Is a situation in which sales of a product are dominated by a small number of a relatively
large seller who is able to collectively exert control over its supply and prices.

Cartel: Is a type of oligopoly in which a centralized institution exists for the purpose of coordinating
the action of several independent suppliers of a product. The best example today is the Organization
of Petroleum Exporting Countries (OPEC)

Trust: Popular way to form monopolies in USA. This was an arrangement by which stockholders in
several companies transferred their shared to a single set of trustees. In exchange, the stockholders
received a certificate entitling them to a specified share of the consolidated earning of the jointly
managed companies. The trust came to dominate a number of major industries (tobacco, sugar, etc.)

Monopsony: Is the opposite of a conventional monopoly in the sense that there is only a single
buyer or only one dominant buyer for a product for which there are multiple sellers. Some
companies are both monopolies and monopsonies. By being also a monopsonist, a monopoly can
increase its profits even further by putting pressure on the companies that supply inputs for its
products to reduce their prices.

Causes for Monopoly

1. Natural: A monopoly may arise on account of some natural causes. Some minerals are available
only in certain regions. For example, South Africa has the monopoly of diamonds; nickel in the
world is mostly available in Canada and oil in Middle East. This is natural monopoly.
2. Technical: Monopoly power may be enjoyed due to technical reasons. A firm may have control
over raw materials, technical knowledge, special know-how, scientific secrets and formula that
enable a monopolist to produce a commodity. e.g., Coco Cola.
3. Legal: Monopoly power is achieved through patent rights, copyright and trade marks by the
producers. This is called legal monopoly.
4. Large Amount of Capital: The manufacture of some goods requires a large amount of capital or
lumpiness of capital. All firms cannot enter the field because they cannot afford to invest such a
large amount of capital. This may give rise to monopoly. For example, iron and steel industry,
railways, etc.
5. State: Government will have the sole right of producing and selling some goods. They are State
monopolies. For example, we have public utilities like electricity and railways. These public
utilities are undertaken by the State.

Price Discrimination

Price discrimination is a pricing strategy that charges customers different prices for the same
product or service. In pure price discrimination, the seller charges each customer the maximum
price that he is willing to pay. In more common forms of price discrimination, the seller places
customers in groups based on certain attributes and charges each group a different price.]

Objectives of Price Discrimination:

1. To earn maximum profit

2. To dispose of surplus stock
3. To enjoy the economies of scale
4. To capture foreign markets
5. To secure equity through pricing.

Degrees of Price discrimination

1st Degree Price Discrimination

This type of discrimination, also known as perfect price discrimination, essentially states the
company charges the consumer the maximum price that individual is willing to pay for that product.
This extracts all the consumer surplus and earns the firms the highest possible profits. This method
of discrimination is also one of the most difficult to adopt because it requires the company knows
each of its customers perfectly at each level of consumption.
 2nd Degree Price Discrimination

In this type of discrimination the companies are actually not able to differentiate between the
different types of consumers. This practice creates a schedule of declining prices for different
quantities. Using this strategy the company can extract some of the consumer surplus without
knowing much about the individual consumer. The consumer chooses the amount of product they
wish to consume with the posted prices, and this allows consumers to differentiate themselves
according to preference.

3rd Degree Price Discrimination

This type of price discrimination, is based around the idea that the firm sets prices that will
accomodate the consumer. The firms know broad demographics about the particular types of
consumers they will supply, and charge prices such that everyone will be able to consume the
product. In order for this form of discrimination to work the firm must be able to predict the
elasticity of demand in various consumers.

Conditions necessary for price discrimination

1. Firm a price maker. The firm must operate in imperfect competition; it must be a price maker with a
downwardly sloping demand curve.

2. Separate markets. The firm must be able to separate markets and prevent resale. E.g. stopping an
adults using a child’s ticket. Prevent business travellers buying discount tickets.

3. Different elasticities of demand. Different consumer groups must have elasticities of demand. E.g.
students with low income will be more price elastic and sensitive to price. Business travellers will
have more inelastic demand.

4. Low admin costs. It must be relatively cheap to separate markets and implement price
discrimination.
 Price Output Decisions – II
Monopolistic Competition

Monopolistic Competition refers to competition among a large number of sellers producing

close but not perfect substitutes for each other. In other words Monopolistic Competition (or
imperfect competition) is that condition of industrial market in which a particular commodity of one
seller creates an idea of difference from that of the other sellers in the minds of the consumers.

Features of Monopolistic Competition:

1. Less Number of Buyers and Sellers
2. Difference in the Quality and Shape of the Goods
3. Lack of Knowledge on the Part of Consumers
4. High Transportation Cost
5. Advertisement
6. Ignorance of the Buyers
7. Differences in the Establishment of Industry
Product differentiation

Product differentiation is a marketing process that has the objective of making customers perceive
the product of a specific firm as unique or superior to any other product belonging to the same
group,

There are three types of product differentiation:

 Simple: the products are differentiated based on a variety of characteristics;

 Horizontal: the products are differentiated based on a single characteristic, but consumers are
not clear on which product is of higher quality; and

Vertical: the products are differentiated based on a single characteristic and consumers are clear on
which product is of higher quality.

Differentiation occurs because buyers perceive a difference. Drivers of differentiation include

functional aspects of the product or service, how it is distributed and marketed, and who buys it. The
major sources of product differentiation are as follows:

 Differences in quality, which are usually accompanied by differences in price;

 Differences in functional features or design;
 Ignorance of buyers regarding the essential characteristics and qualities of goods they are
purchasing;
 Sales promotion activities of sellers, particularly advertising; and
 Differences in availability (e.g. timing and location).
 Oligopoly

Oligopoly is a market structure with a small number of firms, none of which can keep the others
from having significant influence. The concentration ratio measures the market share of the largest
firms.]

Forms of Oligopoly

i. Collusive Oligopoly: In such oligopoly few firms unite together through a formal or informal
agreement. The example for formal agreement is cartels and the example for informal agreement is
price leadership model.

ii. Non-Collusive Oligopoly: If the firm takes its decision of price setting and output level
independently without any mutual understanding or without collaboration with any other firm then
such oligopolistic firm is non-collusive.

Types of Oligopoly:
1. Pure or Perfect Oligopoly:
2. Imperfect or Differentiated Oligopoly:
Collusive Oligopoly
4. Non-collusive Oligopoly

Features of Oligopoly:
1. Few firms
2. Interdependence
3. Non-Price Competition
4. Barriers to Entry of Firms
5. Role of Selling Costs
6. Group Behaviour
7. Nature of the Product

Kinked Demand Curve

The kinked demand curve model assumes that a business might face a dual demand
curve for its product based on the likely reactions of other firms to a change in its price or another
variable

Non-price competition

Market situation in which competitors would not lower prices for fear of a price war. Instead
they focus on extensive promotions to highlight the distinctive benefits or features of their products.
Non price competition is an anomaly in a free market systems based on price-quantity relationship.
 Price Leadership
Price leadership is when a leading firm in its sector determines the price of goods or services. This
can leave the leader's rivals with little choice but to follow its lead and match the prices if they are to
hold onto their market share. Alternatively, competitors may also choose to lower their prices in the
hope of gaining market share.

Advantages of Price Leadership

1. Interdependence between the firm’s own behaviour and the behaviour of its rivals.
2. This process facilitates development of new products and improvement in quality.
3. High profit margin
4. Eliminates the possibility of a price-war
5. Mutual understanding between the oligopoly firms
6. Most convenient strategy for oligopoly firms to stay and grow together.
 III – Pricing Policies
Pricing Policy
Pricing policy refers to how a company sets the prices of its products and services based on
costs, value, demand, and competition.

Objectives of Pricing policy

(i) Price-Profit Satisfaction
(ii) Sales Maximisation and Growth
(iii) Making Money
(iv) Preventing Competition
(v) Market Share
(vi) Survival
(vii) Market Penetration
(viii) Marketing Skimming
(ix) Early Cash Recovery
(x) Satisfactory Rate of Return

Methods of pricing (Cost & Competition)

Pricing over the Life-Cycle of a product

Many products generally have a characteristic known as ‘perishable distinctiveness'. This means
that a product which is distinct when new, degenerates over the years into a common commodity.
The process by which the distinctiveness gradually disappears as the product merges with other
competitive products. The cycle begins with the invention of a new product, and is often followed by
patent protection, and further development to make it saleable. This is usually followed by a rapid
expansion in its sales as the product gains market acceptance. Then competitors enter the field with
imitation and rival products and the distinctiveness of the new product starts diminishing. The speed
of degeneration differs from product to product. The innovation of a new product and its
degeneration into a common product is termed as the life-cycle of a product.

Life-cycle of a Product

1 Introduction: Research or engineering skill leads to product development. The product is put on the
market; awareness and acceptance are minimal. There are high promotional costs. Volume of sales is
low and there may be heavy losses.

2 Growth: The product begins to make rapid sales gains because of the cumulative effects of
introductory promotion, distribution, and word-of-mouth influence. High and sharply rising profits
may be witnessed. But, to sustain growth, consumer satisfaction must be ensured at this stage.

3 Maturity: Sales growth continues, but at a diminishing rate, because of the declining number of
potential customers who remain unaware of the product or who have taken no action. There is no
improvement in the product but changes in selling effort are common. Profit margins slip despite rising
sales.

4 Saturation: Sales reach and remain on a plateau marked by the level of replacement demand. There
is little additional demand to be stimulated.

5 Decline: Sales begin to diminish absolutely as the customers begin to tire of the product and the
product is gradually edged out by better products or substitutes.
 Pricing a new product
The basic question is whether to charge a high skimming (initial) price or a low penetration price.

If a skimming price is adopted, the initial price is very high. The policy may be held for varying periods
of time, indefinitely if the product enjoys valid and defensible patent protection. But usually, it is not
longer than the time necessary for competitors to study the product's usefulness, to decide what to
do about it, and to prepare for making it, a period ranging from a few weeks to as much as two years.
After this period, the price is apt to drop precipitately and over a period of a few years to approach
the usual or customary margin above cost that is common in the industry.

In case of penetration pricing, the initial price of the new product is apt to be somewhere near what
may be expected to be the usual or customary level once competitors enter the field, generally only
slightly above the level. If the initial price is properly fixed, only minor adjustment would have to be
made if and when competition develops.

A) A high initial price (skimming price), together with heavy promotional expenditure, may be used
to launch a new product if conditions are appropriate.

B) A low penetration price: In certain conditions, it can be successful in expanding the market rapidly
thereby obtaining larger sales volume and lower unit costs. It is appropriate where:

i) Sales respond quickly and strongly to low prices;

ii) There are substantial cost savings from volume production;
iii) The product is acceptable to the mass of consumers;
iv) There is no strong patent protection; and
v) There is a threat of potential competition so that a big share of the market must be captured
quickly.

The objective of low penetration price is to raise barriers against the entry of prospective competitors.

Pricing Concepts
I. Cost based pricing

a) cost plus pricing

b) Marginal cost pricing

c) Target return pricing

II. Pricing based on firm's objectives

a) Profit maximization

b) Sales maximization

III. Competition based pricing

a) Penetration pricing
 b) Skimming Price Pricing
c) Bundle Pricing
d) Premium Pricing
e) Product Line Pricing
f) Optional Pricing

Dual pricing
Dual pricing is a situation in which the same product or service is sold at different prices in
different markets. There are a number of reasons why dual pricing may be employed, including the
following: An aggressive competitor may use dual pricing to drastically lower its price in a new
market.

Administered price
Administered prices are prices of goods set by the internal pricing structures of firms that
take into account cost rather than through the market forces of supply and demand and predicted
by classical economics.

Transfer pricing
Transfer pricing is the setting of the price for goods and services sold between controlled (or
related) legal entities within an enterprise. For example, if a subsidiary company sells goods to a
parent company, the cost of those goods paid by the parent to the subsidiary is the transfer price.

Resale price maintenance

Resale price maintenance is a practice in which a manufacturer fixes the price for the resale
of a brand product and the retailer is not allowed to sell it at a lower price.
 IV - Profit Management
Profit
Profit is a financial benefit that is realized when the amount of revenue gained from a business
activity exceeds the expenses, costs and taxes needed to sustain the activity. Any profit that is gained
goes to the business's owners, who may or may not decide to spend it on the business.

Profit Management
Managing the profits gained by the company over a financial year in a efficient way that the
gained profit may not be misutilised.

Theories of profit
1. Walker’s theory.
2. Clark’s Dynamic theory.
3. Hawley’s Risk theory.
4. Schumpeter’s Innovation theory.
5. Knight’s theory.

Profit earning and profiteering

Example: If I sell bottled water in my store for two dollars a bottle, I'll make a profit from it.

If I sell bottled water to a person who's literally dying of thirst and make him pay one hundred
dollars a bottle, I'm Profiteering.

Accounting profit vs economic profit

 Profit Policies
It is generally held that the main motive of a firm is to make profits. The volume of profit
made by it is regarded as a primary measure of its success. Economic theory advocates profit
maximisation as the chief policy of a firm. Modem business enterprises do not accept this view and
relegate the profit maximisation theory to the back ground. This does not mean that modem firms
do not aim at profits. They do aim at maximum profits but aim at other goals as well. All these
constitute the profit policy.

(i) Industry Leadership

(ii) Restricting the Entry
(iii) Political Impact
(iv) Consumer Goodwill
(v) Wage Consideration
(vi) Liquidity Preference
(vii) Avoid Risk

Profit maximization
Profit maximization is the short run or long run process by which a firm may determine the
price, input, and output levels that lead to the greatest profit.

Profit maximisation assumptions

1. The objective of the firm is to maximise its profits where profits are the difference between the
firm’s revenue and costs.

2. The entrepreneur is the sole owner of the firm.

3. Tastes and habits of consumers are given and constant.

4. Techniques of production are given.

5. The firm produces a single, perfectly divisible and standardised commodity.

6. The firm has complete knowledge about the amount of output which can be sold at each price.

7. The firm’s own demand and costs are known with certainty.

8. New firms can enter the industry only in the long run. Entry of firms in the short run is not
possible.

9. The firm maximises its profits over some time-horizon.

10. Profits are maximised both in the short run and the long run.
 Profit maximisation objections

1. Exploitation
2. Social Inequalities
3. Corrupt Practices
4. Lowers Human Values

Alternative Profit Policies

 V - Business Cycles
The business cycle describes the rise and fall in production output of goods and services in
an economy. Business cycles are generally measured using rise and fall in real – inflation-adjusted
– gross domestic product (GDP), which includes output from the household and nonprofit sector and
the government sector, as well as business output.

Phases

1. Economic growth – when real output increases.

2. Economic boom – fast economic growth which tends to be inflationary and unsustainable.
3. Economic downturn – when the growth rate falls and the economy heads towards recession
4. Recession – when there is a period of negative economic growth, and real output falls.

Tools used in (effective control) minimising effects of business cycles

1. Monetary Policy

2. Fiscal Policy

3. State Control of Private Investment

4. International Measures to Control of Business Cycle Fluctuation

5. Reorganization of Economic System