Running Head: MARKET STRUCTURES AND PRICING STRATEGIES 1

Market Structures and Pricing Strategies

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MARKET STRUCTURES AND PRICING STRATEGIES 2

ABSTRACT

There are different market structures in the business world. Each market structure has

its own pricing strategies and characteristics. A monopoly market consists of only one

producer who offers products. As such, the single producer has the power to mark-up the

prices of commodities as high as the consumers can stand. In a perfect competition market,

the producers are price takers and do not have the power to mark-up their prices. The

marginal cost dictates the prices set. In monopolistic competition and oligopoly markets,

optimal pricing is common since these markets have a few producers or several competitors.

The cost, customers, and the level of competition dictate the prices set for products in such

market structures, especially because of the differentiation in products. This differentiation

results in differences in customer valuation. This paper explains the characteristics of the

different market structures, detailing the number of producers, and explains the pricing

strategies for each market structure.

INTRODUCTION

A market refers to an institution or arrangement in which buyers and sellers, or

customers and producers, interact with each other indirectly or directly to sell/produce and

buy products. Markets may be grouped according to their sizes and the number of players. A

market may either be local, national, regional, or international. The market structure explains

the characteristics of a market in terms of the number of producers or sellers, the nature of the

products, and the level of competition. Different market structures exist in the many

industries that are there in the business world. It is important to identify and understand the

market structure for an organization or business since the market structure influences the way

an organization carries out business and the pricing strategy. By understanding the market

structure, an organization is able to make the right decisions on the pricing strategy and other

strategies such as marketing and business strategies. A pricing strategy that is effective is key

to the maximization of profits for a business organization.

1. PERFECT COMPETITION

1.1 Description

A perfect competition or pure competition market is a market structure characterized

by a large number of companies or producers who deal in a similar product, and many buyers

or customers (Makowski & Ostroy, 2001). All the organizations in a perfect competition

market produce or sell an identical product or service i.e. a perfect competition is

characterized by the homogeneity of a product. As such, the competition is at its highest level

in this market structure. In a perfect competition market structure, there are no advertisement

costs and the government intervention is absent. There is a perfect mobility of factors such as

labor and capital. The buyers or customers in a perfect competition market have complete

information about the service or product being offered by the producers and the prices
MARKET STRUCTURES AND PRICING STRATEGIES 4

charged by each producer. New companies may enter or exit a perfectly competitive market

without costs since there are no barriers to entry or exit (there are free entry and exit).

In a market that is perfectly competitive, the products or services provided by the

sellers are free to move to places where they are able to fetch the most lucrative prices. There

are no price controls in the market since the government does not interfere with the business

operations (Makowski & Ostroy, 2001). In order for a market to be classified as a perfect

competition, the market must have no transport costs, or the transport costs must be

negligible. This ensures that there is a uniformity in the prices set by different companies. In

the real world, however, competition is different mostly because of differentiation in the

production and marketing strategies. These differentiation strategies help companies create

brand value and gain pricing power. The conditions of homogenous product and companies

being price takers are not realistic. Conditions of factor mobility and perfect information are

made possible by resource and information flexibility brought about by technology and trade

transformation (De Bandt & Davis, 2000). Even though the theoretical model is far from

reality, it helps in the understanding and explanation of real-life observations in the market.

1.2 Pricing Strategies

As earlier stated, a perfect competition has a large number of sellers and buyers. The

sellers in this market structure deal in a common or homogenous product. As such, the

companies in a perfect competition are price takers. This means that the companies are not

able to influence the market prices of the product. The market share of each company has no

influence on market prices. This is because the buyers have accurate information on the

product and its past and present prices. The price is determined by the market demand and the

supply. The demand is determined by the total quantity of product that buyers are willing and

able to purchase, whereas supply is the quantity of the product that the suppliers are able and

willing to supply at a particular price. The companies in a perfect competition can only
MARKET STRUCTURES AND PRICING STRATEGIES 5

provide the product quantity that the buyers can consume at a particular price. The demand

and supply curves provide a perfect pricing strategy at equilibrium. The price is determined

by the market forces. This strategy explains the statement that the companies in a perfect

competition market structure are price takers.

No single company has the power to mar-up its product price in a perfect competition.

So long as the total costs of production remain below the revenues, the business organizations

in a perfectly competitive market continue to conduct business operations, supplying goods to

the buyers, and the prices are a reflection of the supply and demand. The producers in the

market earn a profit that is just enough for them to remain in business. Suppose some

companies started making an extra profit in the market, more companies would enter the

‘lucrative' market in pursuit of the excess profits (De Bandt & Davis, 2000). This would

result in the profits being driven down, maintaining the status of a market forces determined

price.

2. MONOPOLISTIC COMPETITION

2.1 Description

A monopolistic competition refers to a market structure where there are many firms

offering services or products that are similar but with some differentiating aspects. The

products offered in such a market are not perfect substitutes of each other. The companies in

a monopolistic competition are many, though not as many as those in a perfect competition.

In a monopolistic competition, there are low barriers to entry and exit of companies. Every

company in the market has the ability to control its price and output policy to some extent

(Zhelobodko et al., 2012). New firms enter the market at any point when the existing

companies are making extra or excess profits, while some of the marginal companies in the

market will exit when the companies in the monopolistic competition market are making
MARKET STRUCTURES AND PRICING STRATEGIES 6

losses. The decisions of one company have no direct effect on the other companies in the

market.

A key characteristic of the monopolistic competition market structure is product

differentiation (Zhelobodko et al., 2012). Product differentiation makes products different

from each other. The customers or buyers are able to differentiate the product offered by the

different companies in the market since they are slightly different. This differentiation may

either be imaginary (perceived differences due to advertising or differences in trademarks) or

real (differences in product design, skill in service provision, or materials used for

production). Product differentiation provides every company in the market with a monopoly

of its own product or service, although the companies still face competition. In a

monopolistic competition, each company promotes its product or service through various

forms of expenditure since the main goal of each company is to make maximum possible

profits. The companies adjust their expenditure to include promotion activities. Product

advertising is the most commonly used method of product promotion and is a constituent of

the selling cost of the product. The selling cost will have an effect on the demand and cost of

the product.

In a monopolistic competition, the sellers, or producers, and the buyers do not have a

perfect knowledge or perfect information of the market, products, and price. The market is

characterized by many products that are very close substitutes of each other, and the buyers

do not know about all the available products, their prices, and qualities. As such, most of the

buyers in the market buy the product that is closest to them or their homes out of the offered

varieties. In some instances, a customer has information on one of the product varieties

offered and the place where they can get it at a low price. However, because of being lazy or

lack of time to go and get it, they just select a similar product at a conveniently positioned

store. The companies in the market are also not aware of customer preferences. They,
MARKET STRUCTURES AND PRICING STRATEGIES 7

therefore, cannot take advantage of the market situation. The factors of production and the

services and goods offered are not perfectly mobile in a monopolistic competition.

2.2 Pricing Strategies

In a monopolistic competition, there are several companies. Each company has some

level of control on the price and output of its product, especially in the short run. The

companies follow an independent pricing policy since the decisions of a company do not

affect the other companies. Each company sets the prices of its products or services. The

prices set will depend on the quantity that the company wishes to produce, and will have no

effect on the market (Zhelobodko et al., 2012). Every company uses different activities for

product promotion, such as attractive packaging, advertising, and product branding. The

product differentiation enables the companies in the market to set different prices for

products (every company has control over its product’s price). A company will continue

producing and selling its products at the point where marginal cost meets marginal revenue,

making abnormal profits for a short while. The companies in the monopolistic competition

are price makers and not price takers.

In the long run, however, the companies in a monopolistic competition cannot make

abnormal profits from setting high prices for their products (Carlton & Perloff, 2015). When

the existing companies in the market start making excess profits, smaller or new firms enter

the market in pursuit of the high profits. Entry by new firms in a market results in an increase

in the supply, resulting in a decrease in the current price. This eventually normalizes the

market prices and the profits realized by all the companies in the market. In a situation where

the producers or sellers in a monopolistic competition are making losses for a sustained

period of time, a number of marginal companies will choose to leave the market. When some

firms exit the market, the supply of products will reduce. With low product supply, the prices
MARKET STRUCTURES AND PRICING STRATEGIES 8

of the few available products will rise over time, reinstating the profit-making of the

remaining companies.

3. OLIGOPOLY

3.1 Description

An oligopoly is a market structure that has a small number of producers. Each of the

companies in this market structure cannot prevent the others from having an influence that is

significant. While a monopoly market only has one company and a duopoly has two

companies, an oligopoly refers to a market with two or more companies, with no upper limit.

However, the total number of companies in the market has to be low enough to ensure that

the actions or policies of one firm affect the other companies. Common oligopolies occur in

the steel manufacture industry, oil production industry, tire manufacturing, and wireless

carriers (Carlton & Perloff, 2015). Because an oligopoly is composed of a small number of

companies, each of the companies holds a large market share and controls the output and

price in it. There is a clement of monopoly power in an oligopoly for this reason. This

monopoly power results in economic and legal concerns since the oligopoly may block new

companies from joining the industry. The companies in the market may slow innovation and

even hike prices.

In an oligopoly, the few companies in the market produce a product that is

homogeneous or one that is slightly differentiated from each other. There exists an

interdependence of companies in this market. None of the companies in this market can

ignore the policies or actions of the other companies since the companies are rivals. While

making decisions on price, each firm considers the prices of the other companies and how

they will react to the price decision (Fudenberg & Tirole, 2013). The companies realize the

demerits of competition and are willing to work together to increase their gains or profits. For
MARKET STRUCTURES AND PRICING STRATEGIES 9

this reason, the companies tend to form a collusion or secret agreement to collude and set a

certain price for products to acquire profits that are higher than the market average. However,

each of the companies is greedy or wishes to increase its own gains. This results in an

antagonism and conflict regarding the allocation of markets and profits from the collusion.

An oligopoly is also characterized by barriers to entry. The companies have some

monopolistic power since they are large firms with large market shares and economies of

scale. It is difficult for small firms to enter an oligopoly. There are many buyers in the

market, and the demand curve for an oligopoly is usually indeterminate as any action by one

company may have an effect on the curve. If the product offered is homogenous, the market

structure is a pure oligopoly. If the companies offer products that are differentiated, the

market structure is an impure oligopoly.

3.2 Pricing Strategies

Oligopolies have a hard time determining the optimal output for profit maximization

because of the interdependence between the firms and the diversity between them, especially

with regard to concentration ratios. In some industries, the concentration ratio is high, which

allows companies to act as a monopoly. In others, the concentration ratio is low, making it

difficult to make a decision on the pricing strategy. There are three major ways to explain the

pricing in an oligopoly (Fudenberg & Tirole, 2013):

i. Kinked-demand theory – when a company in the oligopoly increases its price, the

other companies are not likely to increase their prices since the move by the company

will enable them to acquire the market of the company that changed its price. The

demand curve becomes more elastic since the customers of the company that

increased its price will start buying from its rivals. If one firm in the market lowers its

price, the other companies will have to lower their prices to ensure that they do not
MARKET STRUCTURES AND PRICING STRATEGIES 10

lose their market share. The demand curve becomes more inelastic. This creates a

kinked demand curve, which explains why companies in the market are resistant to

price changes. The marginal curve is dependent on market prices. As such, it will also

be a kinked curve.

ii. Cartel theory – the companies in an oligopoly may create a cartel by agreeing to set a

fixed price on the products or to divide the available market amongst themselves. This

involves collusion, and the aim is to earn monopoly profits. If the companies are able

to collude successfully, they earn maximum profits by operating at an output where

marginal cost is equal to marginal revenue. However, if one company is dishonest and

lowers its price, a price war occurs, which results in a drop in the prices. In some

countries, collusion is illegal and is usually done secretly by firms.

iii. Price leadership – in many oligopolies, there is usually one dominant company. The

other companies in the industry usually follow the price changes of the dominant

company, a form of implicit price collusion. The dominant company becomes the

price leader. The companies in such a market do not change prices often. Prices are

changed if the changes in cost are substantial. The price leader communicates a need

to increase prices through means such as press releases and publications. The price

leader will also discourage the entry of new firms by limiting the price. This is

because high prices usually allow the entry of new firms that have the ability to

survive on a small market share.

4. MONOPOLY

4.1 Description

A monopoly is a market structure in which only one company or producer dominates

the entire market or the largest share of the market. A monopoly develops when an industry

has free-market capitalism or the absence of market restrictions. A company grows large
MARKET STRUCTURES AND PRICING STRATEGIES 11

enough to own almost the entire market for a product or service. Most economies have

restrictions and laws put up in place to prevent the formation of monopolies (Carlton &

Perloff, 2015). A number of instances may result in the formation of a monopoly. First, a

company may have exclusive ownership of a resource that is scarce. If this is the case, the

company will have monopoly power over the resource. The government of a country may

also grant one company a monopoly status, setting up a restriction for other companies to

enter the industry. A company may acquire a patent over its product design or a copyright

over its business idea. This patent or copyright will give the company an exclusive right to

deal with the product or service.

Two or more firms in an industry may enter a merger to form a monopoly. A

company in an industry may also acquire other companies to become a monopoly by

eliminating competition. In a monopoly, the single company makes decisions on the level of

output and the price of the product, and there are no product substitutes (Aguirre et al., 2010).

There are entry barriers and the demand curve is downward sloping.

4.2 Pricing Strategies

A monopoly market has a simple pricing strategy. The monopoly company is able to

set the price of products or services as a result of the absence of rivals. However, the

monopoly company cannot raise the price too high since a high price results in a decrease in

the sales and may attract competitors. The price that the monopoly company sets are

dependent on the market demand. The demand for a product will determine the price that the

company can sell the product at. The company maintains profits that are abnormally high in

the long run since there are no price wars. The company is able to conduct business at an

output level that meets the ‘Marginal cost is equal to Marginal revenue' condition for profit

maximization. The company is able to acquire huge profits since the profit level is dependent
MARKET STRUCTURES AND PRICING STRATEGIES 12

on the level of competition, which in the case of a monopoly market, is zero. The company

will continue charging the price and producing the quantity that is determined by the point

where the marginal cost and marginal revenue curves meet.

The position and the elasticity level of the market demand curve are the constraints

for the price set and quantity produced by the monopoly company. A change in the market

demand of the product or service offered by the company will result in a change in the level

of output produced and the price set. If the demand for the product or service increases, the

monopoly company will increase its output to meet the new demand, resulting in a shift in the

marginal revenue curve. As such, the company will increase the price of the product or

service to the new point where the marginal cost meets the marginal revenue. If the demand

decreases, the company reduces its output and price to meet the new lesser demand and avoid

making losses. The company may also impose a price discrimination strategy, where different

prices are set for different customers. The discrimination is based on the willingness of

customers to pay for the product. It may be on the basis of the difference in incomes, gender,

quality variation, or location.

5. CASE STUDY

As discussed above, a monopoly ensues when the barriers to market entry are present

in an industry mostly because one company in the industry is able to operate at a marginal

cost that is lower than that of its competitors (Aguirre et al., 2010). The barriers to entry may

be created legally or through government regulations, geographic, or economic. Due to the

lack of competition, the monopoly company has the power to increase market prices and

determine the level of output to control demand. Monopoly markets or industries exist as a

result of exclusive licensure, tariff protection and/or anti-competitive subsidization. Microsoft

is an American giant technology company. The company owns the Windows operating
MARKET STRUCTURES AND PRICING STRATEGIES 13

system that is used worldwide for computers and handheld devices. The company has the

exclusive ownership of the operating system, and is, therefore, the only company that can

produce it.

If a company has an exclusive right to a resource or commodity, it acquires monopoly

power over the resource or commodity. Microsoft is, therefore, a monopoly and has the

power to control the price of its Windows operating system. Even though some people may

not consider the market as a monopoly, arguing that Microsoft is in an oligopoly with

companies such as Yahoo and Google, the company’s Windows operating system is the

dominant operating system in the world, having a market share of more than 90 percent of the

total market.

6. CONCLUSION

The different characteristics of each market structure determine the appropriate

pricing strategies used by the companies or producers in the market. Selecting the appropriate

and effective pricing strategies is important in the realization of profits, which is the main

reason why companies enter a business. It is important to under the characteristics of a

market (such as the number of companies, the size of the market, the number of buyers, the

demand, and the supply) in order to make appropriate decisions on the pricing strategy to

implement.
MARKET STRUCTURES AND PRICING STRATEGIES 14

References

Aguirre, I., Cowan, S., & Vickers, J. (2010). Monopoly price discrimination and demand

curvature. American Economic Review, 100(4), 1601-15.

Carlton, D. W., & Perloff, J. M. (2015). Modern industrial organization. Pearson Higher Ed.

De Bandt, O., & Davis, E. P. (2000). Competition, contestability and market structure in

European banking sectors on the eve of EMU. Journal of Banking & Finance, 24(6),

1045-1066.

Fudenberg, D., & Tirole, J. (2013). Dynamic models of oligopoly. Routledge.

Makowski, L., & Ostroy, J. M. (2001). Perfect Competition and the Creativity of the Market.

Journal of Economic Literature, 39(2), 479-535.

Zhelobodko, E., Kokovin, S., Parenti, M., & Thisse, J. F. (2012). Monopolistic competition:

Beyond the constant elasticity of substitution. Econometrica, 80(6), 2765-2784.