Market Structures, Firm

Behavior and Pricing

Group 9
 Management & Market
Structures
• Manager must determine how much to
produce and at what price.
• According to the market he decides to
operate in, he either becomes a price
taker or price maker.
– Price Taker: small player in highly
competitive market whose price is
determined by demand for and supply
of product.
– Price Maker: Sole provider of product
with control over price

 Types of Market Structures
• Monopoly: Only single Seller, No
Product Differentiation, market
position is protected, no entry for
other sellers,
• Monopolist advertises only for public
awareness,
• Management is focused on
maximizing profit
• Monopoly is fleeting/short lived due
to development of new
• Oligopoly: Few firms selling similar
product or service, collusion of firms
to generate monopoly type profits,
price fixing through observation,
• Product differentiation is dependant on
nature of industry being either
homogenous or differentiated based
on prices or enhanced product
characteristics.
• Entering Oligopoly is hard but not
impossible. Economies of scale
determine the firms capacity to enter
• Monopolistic Competition: Many buyers and
sellers, each firm sells only a small part of
industry output,
• Key component is product differentiation,
capitalizing on some monopoly power of its
unique product offering.
• Prices are determined by demand and supply of
firm’s as well as substitute goods
• Entry into this market is relatively easy, with
costs not being as high as they are in
oligopoly
• Marketing is the key to success for firms,
promoting and developing unique products
tailored to customers needs and preferences.
Firms rely heavily on advertising
• Managers focus on creating product distinction,
• Perfect Competition: Many sellers
offering identical products, firms are
price takers depending on supply &
demand for the product
• Only firms producing at lowest costs
survive, consumers enjoy low prices
and society benefits from proper
allocation of resources
• No individual advertising because
benefits are spread among sellers
since there is no product distinction.
Industry-wise advertising is carried
out
 Monopoly Pricing and Profit
Maximization
• Monopolist is price maker, with
management deciding what price
to set for product.
• Aim is to maximize profit where
Profit(P)=Revenue(R)-Cost(C)
• Relationship between price and
quantity sold follows law of demand
i.e. higher the price of good, lower
the units demanded

Monopolist Demand Curve
• Monopolist is
constrained by
law of demand
• Law of demand
states that
everything else
equal, higher the
price lower will
be the demand
for the good
• Understanding consumer response
through demand curve helps in
estimating revenue
• Firms estimating demand function
accurately, selects price to gain
greatest potential profit
• For now it is assumed the firm is
perfectly informed about its demand
function
• Demand Function: Q=20-0.5P
where Q is quantity demanded and
P is price set by firm
• With this the firm will be able to predict
 Revenue Analysis
Quantity (Q) Price (P) Revenue (R) Marginal
0 $40 $0 Revenue (MR)
1 38 38 $38
2 36 72 34
3 34 102 30
4 32 128 26
5 30 150 22
6 28 168 18
7 26 182 14
8 24 192 10
9 22 198 6
10 20 200 2
11 18 198 -2
12 16 192 -6
 Cost Function
• Firms Objective is to maximize profit
not revenue
• To select price and production quantity
to maximize profit, firm considers
Demand Function as well as Cost
Function
• Cost is comprised of Fixed as well as
Variable cost
• Cost Function: Cost (C)= 26+12Q
Where C is firms total cost & Q is no. of

units produced (taking into

consideration previous example firm
whose demand function was analyzed)
 Profit Analysis
Quantit Price Revenu Margin Total Margina Profit Margina
y0 (Q) (P)
$40 e$0(R) al Cost
$26 l Cost -$26 l Profit
1 38 38 Revenu
$38 (C)
38 $12 0 $26
2 36 72 e34(MR) 50 12 22 22
3 34 102 30 62 12 40 18
4 32 128 26 74 12 54 14
5 30 150 22 86 12 64 10
6 28 168 18 98 12 70 6
7 26 182 14 110 12 72 2
8 24 192 10 122 12 70 -2
9 22 198 6 134 12 64 -6
10 20 200 2 146 12 54 -10
11 18 198 -2 158 12 40 -14
12 16 192 -6 170 12 22 -18
Revenue Sharing Contracts vs.
Profit Sharing Contracts
• Profit objective of a monopoly firm
depends on type of contract they
enter into
• When two firms enter into a joint selling
contract, the problem they face of
either sharing profits or revenue, is
known as the author-publisher
problem
• E.g.: A textbook monopoly firm and a
publisher who incurs entire cost of
printing and publishing book. Authors
 Author-Publisher Revenue
Sharing
• Demand Function for Textbook:
 Q=1000-20P ( where Q is quantity
demanded and produced, and P is price)
• Cost Function for Textbook:
 C= 1500+5Q ( where Q is quantity
demanded and C is total cost)
• Let us assume a 50-50 revenue sharing
contract
• Publisher sets the price and gives 50% of
total revenue to the author
• Publisher seeks to maximize not total profit,
But profit he actually receives i.e. (=1/2R-
C)
 Analysis of Example
• Publisher sets price of $30 and sells 400
units
• Revenue received is $6000 out of which
$3500 is paid as cost and $2500 is earned
as profit
• Author receives his share, $6000, entirely as
profit
• Therefore total profit earned by both parties
is $8500
• One problem one may face here is a
disagreement on the price of the product
• Second problem maybe that profit sharing
contracts may be more profitable but
 Profit Sharing Contract
• Let us now consider a profit sharing contract between
the author and publisher
• Publisher sets a price of $27.50 to maximize profit and
sells 450units
• Profit of $8625 is split between the publisher and
author, which is a higher profit than in the case of
revenue sharing.
• Even if the two share the profit 70% to author and
30% to publisher, they earn more than in the
previous case
• The revenue sharing option is taken because its easier
to multiply sales with price rather than verify and
calculate cost
• Crooked firms pad costs in a PS agreements to make
their profits seem lower than they really are
• This makes Revenue Sharing contracts more
favorable despite profit sharing contracts being
 Demand Estimation
• Demand doesn’t only depend on
price but on other factors that
affect a business climate
• Demand Function with Many
Variables:
• Qx =2+0.0005Y+0.1Ps-0.5Px
• Qx is quantity demanded of product
X
• Y is average level of income of
consumers
• Ps is price of substitute
• Consider a situation where average income
of consumer is $35,000 and price of
substitute is $15. This reduces X’s
demand function to
• Qx= 2+(0.0005x35000)+(0.1x15)-0.5Px
• = 20-0.5Px
• Now if the price of substitute changes to
$25 it will cause a change in the demand
function to
• Qx= 2+(0.0005x35000)+(0.1x25)-0.5Px
• = 22-0.5Px
• With increase in demand , monopolist will
have more quantity demanded and can
now raise the price
• Manager estimates the demand
function through instinct, past
experience, consumer surveys and
data analysis
• To determine profit maximizing price,
manager has to generate an
algebraic relation between quantity
demanded and price through a
method of estimation.
• If he has previous data he may use
regression analysis to estimate a
 Example for estimation
Through Regression Analysis
Region Quantity Price Average Price of
1 1152 $45 Income
$35000 Substitute
$25
2 1148 53 45000 37
3 1185 28 30000 35
4 849 72 28000 60
5 1188 51 55000 26
6 1316 17 29500 45
7 906 82 45500 28
8 943 68 34000 57
9 1536 35 37500 56
10 960 58 40000 35
11 752 78 38800 28
12 1405 26 24000 35
13 1142 37 35000 28
 Results
• Using Excel we generate Demand Function
• Q=1129.39+0.01Y+4.93Ps-10.96P
• Q is quantity demanded, Y is Avg. Income,
Ps is price of substitute, P is price of good
• A new region with Avg. Income of $45000
and substitute price of $25 would have a
demand function
• Q=1129.39+(0.01x45000)+(4.93x25)-
10.96P
• = 1702.64-10.96P
• Assuming fixed costs equal $2000 and
variable cost is $5 per unit, manager
maximizes profit at Price of $80 and
production of 826 units
 Natural Monopoly and Govt.
Regulation
• These are monopolies that arise out of generation of
infrastructure that is too expensive for other firms to
duplicate.
• Economies of scale are so high they become a one firm
industry naturally
• Monopolies are checked by governments with regard to
prices, operation efficiencies, and duration of market
leadership. Market leadership is limited with a system of
patents through which the firm is rewarded for their
innovation and costly research.
• Government regulates natural monopolies by setting
favorable prices to both firm and consumer
• Using our recurring example, the monopolist has a cost
function of
• C=26+12Q and demand function of Q=20-0.5P
• Average cost is defined as cost of production at any unit
divided by number of units produced
• AC=(26/Q)+12
Quantit Price Revenu Margin Total Margin Profit Averag
y0 (Q) (P)
$40 e$0(R) al Cost
$26 al Cost -$26 e
1 38 38 Revenu
$38 (C)
38 $12 0 Cost
2 36 72 e34(MR) 50 12 22 25.00
3 34 102 30 62 12 40 20.67
4 32 128 26 74 12 54 18.50
5 30 150 22 86 12 64 17.20
6 28 168 18 98 12 70 16.33
7 26 182 14 110 12 72 15.71
8 24 192 10 122 12 70 15.25
9 22 198 6 134 12 64 14.89
10 20 200 2 146 12 54 14.60
11 18 198 -2 158 12 40 14.36
12 16 192 -6 170 12 22 14.17
Natural Monopoly Cost &
Revenue
• Diagram shows the
cost and revenue
structure of a
Natural monopoly
and the average
cost which the
government forces
it to charge.
• This results in not
only a lower price
for consumers but
a fair Accounting
profit for the firm
despite having an
 Oligopoly
• Few firms selling a similar product or service.
• They have high fixed cost and low marginal cost
of production
• It is difficult but not impossible for new firms to
enter.
• Intense competition exists between the firms
and all actions are closely observed by
competitors
• Firms are interdependent with each firm being
affected by actions of other. The success or
failure of other firms determines the
individual firms market power.
• Firms share profits and unless collusive
agreements are reached, the firms are
expected to follow personal incentives of
price cutting. This results in sub-optimal
 Game Theory
• In order to facilitate decision making
among oligopolistic firms, they
adopt the Game Theory introduced
by economists John Von Neumann
and Morgenstern
• They showed a minimax technique is
used to identify an equilibrium.
• It suggests a firm examine its options
and select the best of worst
possibilities.
 Price Cutting Game
Firm B -> Set $26 Set $20 • The matrix shows
Price Price each firms
Firm A V possible choices
i.e. Set $26 or $20
Set $26 36,36 15,51 price
Price • Each cell shows the
payoff for firm A
and Firm B
Set $20 51,15 27,27 respectively
Price • If A selects a Price of
$20 its worst
payoff is $27
• Since the game is
symmetric, firm
B’s minimax
selection is also
Game Theory and Oligopoly
• The government stifles overt price collusion,
while firms understand the need to set higher
prices to generate close to monopoly profits.
• Monopoly profits are typically unattainable due
to having to keep prices lower to increase
market share, but oligopolists rarely reduce
prices to equal their marginal costs.
• Unspoken agreements ensure maintenance of
profitability
• Research coordination among firms is also
difficult, with firms not wanting to give away
secrets too early. Products are then
manufactured to standard levels and then
negotiations and adjustments are made.
 Nash Equilibrium
• A form of game theory strategy introduced by John
Forbes Nash Jr. that expects players to adopt the
best response to what other firms are doing rather
than response/outcome dependent on dominant
strategy
• No player has incentive to change the choice given
what everyone else selected.
• In the following example Kirk and Sandra have to
coordinate a Friday night date at either the Opera or
the Basketball Game. Both forget where they finally
decided to meet so both have to pick an eventy and
hope the other picks the same. Both receive payoffs
of zero if they pick different events.
• Kirk is an opera fan so recieves a higher payoff if he
meets Sandra there and the same applies for
Sandra and the Basketball game
 Battle of The Sexes
Sandra Opera Game • In this case both
Kirk{game,game} and
Kirk Sandra {opera,opera}
are in Nash Equilibrium
Opera 3,1 0,0 • Unless an agreement is
made to choose either
option, neither of them
has an incentive to
Game 0,0 1,3 change their choice
• Nash was the first to
characterisegames with
multiple equilibriums.
• Nash equilibrium shows
possible equilibriums
but does not help
determine possible
outcomes
 Monopolistic Competition
• There are many sellers trying to differentiate
products from its competition.
• Easy entry and Exit is possible from this market.
• One firm develops a profitable venture and
other firms copy it soon.
• Managers focus on product differentiation
through effective advertising to develop an
almost monopoly power
• Firm achieving such a position faces a
downward sloping demand curve similar to a
monopolists
• Without product distinction, firm becomes a
price taker, accepting price determined by
competitive market and its demand curve is
flat.
 Distinctive Features
• Monopolistic competitors have close
substitutes unlike a monopoly
• Demand curve is not commanded by
firm but is affected by new firms
entering the market on seeing a profit
generating opportunity.
• The demand curve then becomes
shared
• While the firm holds monopoly position
with distinctive product, it maximises
profit by setting a price such that
marginal revenue equals marginal
Cost & Revenue Structure
Short Run
• Graph shows that Marginal
costs are increasing in
monopolistic
competition
• It shows many firms
become inefficient
operating on a large
scale
• Firm is making profit with
price being higher than
average cost
• With entry of new firms,
demand curves shifts
left and flattens out
showing the new firms
capture demand and
original firm has less
control over price
• In the long run firms make
zero economic profit due
Cost & Revenue Structure
Long Run
• Prices are higher in
the long run
• Firms produce at
excess capacity
• Firm in the long run
does not produce
at minimum of
avg.tot.cost and
society is better
off allocating
resources more
efficiently
 Advertising and Barriers to
Entry
• Advertising is the most important tool in
Monopolistic Competition as a form of
product differentiation
• Many debate that it adds to the cost of the
product as well as creates perceived
needs that are not truly necessary
• Managers must determine whether benefits
of advertising outweigh the costs
• Barriers to entry are a tool used by
monopolistic competitors to maintain their
monopoly. They do this by creating
patents. Being first mover can be vital to
claiming buyer loyalty ,maintaining
market share and enjoying economic
profit for longer.
 Perfect Competition
• Manager has no control over price
the market sets on the product
• Many sellers offering identical
products
• Firms are price takers and their
demand curves are flat lines
• Market price is also their marginal
revenue.
• Marginal Revenue curve is the same
as the demand curve
Perfect Competition in the
Short Run
• Firm sets its output
such that
marginal cost
does not exceed
marginal revenue
• Firms follow
MR=MC rule to
maximise profit
• Graph shows a firm
making economic
profit in the short
run as market
price is greater
Perfect Competition in the
Long Run
• Firms do not make
economic profit in the
long run
• Additional firms enter
and market supply
curve shiftsto the
right with increased
sellers
• Price continues to drop
till firm is no longer
making a profit
• In the long run, firm
produces where
MR=MC and P=AC
• Firm makes no economic
profit but does make
an accounting profit
 Distinctive Features
• Firms produce at lowest point on average
cost curve
• No excess capacity and resources are
allocated efficiently
• Best situation for society as well as firms
• Managers focus on managing business as
cost effectively as possible
• Only firms that produce at lowest possible
cost survive.
• More efficient firms outside the market
enter and drive inefficient firms out
• Perfect Competition is an ideal market and
does not exist in real world situations