One of the most important decisions made by managers is setting the price of the firm’s product. If the price set is too high, the firm will be unable to compete with other suppliers in the market. On the other hand, if the price is too low, the firm may not be able to earn a normal rate of profit. Pricing is thus a crucial decision area, which needs much of managerial attention.
Traditional economic theory explains this in term of demand and supply functions. According to traditional analysis, firms aim towards maximisation of profits. The interplay of demand and supply in the market determines the price, which is often referred to as equilibrium price. There are, however, many other factors that influence the pricing decision of a firm. These are – the number of firms in the industry, the nature of product, and the possibility of new firms entering the market and so on. In this post you should gain valuable insights into the operations of firms under different market structures, which are more typical of the existing real world situations.
CLASSIFICATION OF MARKET STRUCTURES
The structure of a market depicts the existence of firms in a particular market and to what extent the firms constituting a specified market are functionally interrelated to each other. The term ‘market structure’ refers to the degree of competition prevailing in that particular market. The power of an individual firm to control the market price by changing its own output determines the degree of competition and this power varies inversely with the degree of competition. The higher the degree of competition, the less market power the firm has and vice-versa. Market power is generally thought to be the ability of the firm to influence price.
A firm behaves according to its policies and practices regarding price, output decisions etc. The firm’s performance is an indicator of its outcome or results of its conduct. The whole concept explains the Structure-Conduct-Performance (S-C-P) hypothesis. Hence in microeconomics theory, this hypothesis states that the performance of a firm is determined by its conduct, which in turn is determined by the structure of the market in which it is operating. The performance and the conduct of a firm vary from market to market. If the market is highly competitive then the performance and conduct of the firm is different as compared to that of the market with little or no competition. For example, pricing behaviour of firms in the fast moving consumer goods (FMCG) sector where there are a large number of rivals is very different from the pricing in the Airline industry where there are fewer firms.
Pricing decisions are affected by the economic environment in which the firm operates. Managers must, therefore, make their decisions to the specific market environment in which their firms operate. The central phenomenon in the functioning of any market is competition. Competitive behaviour is moulded by the market structure of the product under consideration. Since the decision-making environment depends on the structure of the market, it is necessary to have a thorough understanding of this concept.
The structure of a particular market plays an important role in defining the determinants that affect these market structures. Determinants like price, product differentiation etc. are affected by the competitive structure of the market. The classification of markets in terms of their basic characteristics helps identify a limited number of market structures that can be used to analyse decision-making. The four characteristics used to classify market structures are:
i) Number and size distribution of sellers,
ii) Number and size distribution of buyers,
iii) Product differentiation and
iv) Conditions of entry and exit.
i) Number and size distribution of sellers
The firm’s ability to affect the price and the quantity of a product supplied to the market is related to the number of firms offering the same product. If there are a large number of sellers, the influence of any one firm is likely to be less. Consider the number of firms selling fruits and vegetables in your locality. It is unlikely that any one of them will exercise a great influence over price. On the contrary, if there are only few sellers in the market, an individual firm can exercise greater control over price and total supply of the product. Considering this fact the number of firms can be classified into large, few, two and one.
ii) Number and size distribution of buyers
Markets can also be characterized by the number and size distribution of buyers, where there are many small buyers of a product and all are likely to pay about the same price. Consider a big firm in a city. For example, TISCO in Jamshedpur is a large and perhaps the only firm in the area. TISCO will thus be able to exercise considerable influence on the price at which it buys inputs from suppliers in the area. Similarly, Maruti Udyog Limited (MUL) in Gurgaon is one of the large automobile manufacturers and has considerable influence over the price at which it buys inputs such as glass, radiator caps and accessories from other suppliers located in the region. Both MUL and TISCO are firms that are said to have ‘monopsony’ power in their buying decisions. However, if there are a large number of buyers they will be unable to demand lower prices from sellers. One reason why large firms are able to negotiate lower prices is because of large volume purchases.
iii) Product Differentiation
If the products competing in the market are not identical or homogeneous, they are said to be differentiated and hence ‘product differentiation’ exists in the market. Product differentiation is a fact of life and there is some amount of differentiation for almost all products that we buy in markets. For example, ingredients in different soaps could be different as can be the packaging, advertising etc. Even seemingly homogeneous goods such as apples and bananas are at present differentiated on the basis of the orchards where they have been grown and the way these are marketed. Wheat is a good example of a product that can be considered undifferentiated. The degree of substitutability or product differentiation is measured by cross-elasticity of demand between two competing products. Products can be classified into perfect substitutes or homogeneous products, close substitutes like soaps of different brands, remote substitutes like radio and television and no substitutes like cereals and soaps. Further, perfect substitutes for one consumer may not be so for another. For example, Rahul may feel that Coke and Pepsi are perfect substitutes while Sachin may have a strong brand preference for Pepsi. Product differentiation is a basis for a lot of advertising that is seen in the media where the focus is to create a strong brand preference for the product being advertised.
iv) Conditions of Entry and Exit
Entry or exit of firms to an industry refers to the difficulty or ease with which a new firm can enter or exit a market. In short run, where the capital of firms is fixed, entry and exit does not make much difference. Ease of entry and exit is however a crucial determinant of the nature of a market in the long run. When it is difficult for firms to enter the market, existing firms will have much greater freedom in pricing and output decisions than if they had to worry about new entrants. Consider a firm such as Ranbaxy that has a patent on a particular drug. A patent is an exclusive right to market the product for a given period of time, say 12 years. If there are no close substitutes to that drug, the firm will be free from competition for the duration of the patent. Thus the barriers to entry in the market for this drug are high. Similarly, since Indian Railways, is a public monopoly no new entrant can enter the market. Microsoft too has been able to create substantial entry barriers in the market making it difficult for new firms to enter in the market. On the other hand, retail outlets and the restaurant business witness several new firms entering the market periodically, implying that entry barriers are relatively low.
Based on the above characteristics markets are traditionally classified into four basic types. These are Perfect Competition, Monopoly, Oligopoly and Monopolistic Competition.
Perfect competition is characterised by a large number of buyers and sellers of an essentially identical product. Each member of the market, whether buyer or seller, is so small in relation to the total industry volume that he is unable to influence the price of the product. Individual buyers and sellers are essentially price takers. At the ruling price a firm can sell any quantity. Since there is free entry and exit, no firm can earn excessive profits in the long run.
Monopoly is a market situation in which there is just one producer of a product. The firm has substantial control over the price. Further, if product is differentiated and if there are no threats of new firms entering the same business, a monopoly firm can manage to earn excessive profits over a long period.
Monopolistic competition a term coined by E. M. Chamberlin implies a market structure with a large number of firms selling differentiated products. The differentiation may be real or is perceived so by the customers. Two brands of soaps may just be identical but perceived by the customers as different on some fancy dimension like freshness. Firms in such a market structure have some control over price. By and large they are unable to earn excessive profits in the long run. Since the whole structure operates on perceived product differentiation, entry of new firms cannot be prevented. Hence, above normal profits can be earned only in the short run.
Oligopoly is a market structure in which a small number of firms account for the whole industry’s output. The product may or may not be differentiated. For example, only 8 or 10 firms in India constitute 100% of the integrated steel industry’s output. All of them make almost identical products. On the other hand, passenger car industry with only three firms is characterised by market differentiation in products. The nature of products is such that very often one finds entry of new firms difficult. Oligopoly is characterised by vigorous competition where firms manipulate both prices and volumes in an attempt to outsmart their rivals. No generalisation can be made about profitability scenarios.
It must also be noted that these market structures can be classified in only two fundamental forms – Perfect Competition and Imperfect Competition. Under this classification, Monopoly, Oligopoly and Monopolistic Competition are treated as special cases of markets, which are less than perfect. Thus these forms illustrate the degree of imperfection in a market by using the number of firms and product differentiation as basic criteria. Table-1 provides a ready reference for different types of markets based on their characteristics.
FACTORS DETERMINING THE NATURE OF COMPETITION
We have already seen that the number of firms and product differentiation are extremely crucial in determining the nature of competition in a market. It has been tacitly assumed that there are a large number of buyers. What would happen if there are several firms producing standardised product but only one buyer? Obviously, the buyer would control the price, he will dictate how much to buy from whom. The entire price-volume decision takes on a different qualitative dimension. Similarly, product features and characteristics, the nature of production systems, the possibility of new entrants in a market have profound impact on the competitive behaviour of firms in a market. The ‘entry’ of new firms has special relevance in business behaviour which we discuss in the next section and deal with other issues in the present one.
Effect of Buyers
We have already referred to the case where there is only one buyer. Such a situation has been referred to as monopsony. For example, there are just six firms in India manufacturing railway wagons all of which supply to just one buyer, the Railways. Such a situation can also exist in a local labour market where a single large firm is the only provider of jobs for the people in the vicinity. More frequently encountered in the Indian markets is a case of a few large buyers, defined as oligopsony. The explosive industry which makes detonators and commercial explosives, has three major customers: Coal India Ltd. (CIL), Department of Irrigation and various governmental agencies working on road building activities. Of these, just one customer, CIL takes nearly 60% of the industry’s output. There are about 10 firms in the industry, which negotiate prices and quantities with CIL to finalise their short-term plans.
Most industries manufacturing heavy equipment in India are typically dominated by a few manufacturers and few buyers with the Government being the major buyer. Price and volume determination in such products often takes the form of ‘negotiation across the table’ rather than the operation of any market forces. Since the members in the whole market inclusive of buyers and sellers are not many, very often they know each other. In other situations, like the consumer goods, firms have no direct contact with their customers.
Minimum Efficient Scale (MES) of production in relation to the overall industry output and market requirement sometimes plays a major role in shaping the market structure. MES is the minimum scale of output that is necessary for a firm to produce in order to take advantages of economies of scale. For example, the minimum efficient scale for an automobile firm is very high. This is intuitively appealing because if only 100 cars are produced in a capital intensive automobile plant, the average costs will be high, while a larger volume of cars will allow the fixed costs to be spread over a number of cars, thus reducing average costs and increasing the minimum efficient scale. MES for a service firm such as a travel agent will accordingly be relatively small.
The reason why there are no more than say, 5 or 10 integrated steel plants even in an advanced country like the U. S. A. can be partly explained by economies of scale and thus MES. Since the minimum economic size of such a steel plant is a few million tonnes, the entire world steel industry can be about 100 efficient and profitable firms. Thus every country has only a handful of steel plants. On the other hand, when one comes to rolling mills which take the steel billets or bars as input, the minimum efficient size comes down considerably, and given the existing demand, several firms can be seen to operate.
Further, the minimum size does not remain constant but changes drastically with technological advancements. When technical changes push up the economic size of a plant, one notices that the number of firms decline over time. This can be noticed in some process industries like synthetic fibre. Conversely, technological innovations may make it possible for smaller sized plants to economically viable. In such a case a lot of new entrants come and soon the market becomes highly competitive as has happened in the personal computer industry in India.
Apart from minimum plant size, factors like the availability of the required raw material, skilled labour etc. can also mould market structures. Presently, only one Indian source (IPCL) provides all the raw materials for plastic products. Likewise, enough skilled people are not available to work on the sophisticated machines. These factors sometimes restrict output and push up prices even though adequate market potential for expansion exists.
We have already stated that product differentiation is an important market characteristic because it indicates a firm’s ability to affect price. If a firms product is perceived as having unique features, it can command a premium price and the firm is said to possess market power. For example, the Rolls Royce has come to be regarded as the ultimate in automobile luxury and therefore commands a high price. Consumers are willing to pay that premium for the product. The degree of competition faced by Rolls Royce or Mercedes Benz is thus very low. One could also consider the market for Cable TV service. Most households in India are serviced by a local cable TV monopoly and are thus dependent upon their local cable provider for service. Thus the market for provision of cable TV service is not competitive in the sense that only one operator provides the facility till the emergence of new technology of Satelite TV(Direct to Home through Disc). On the other hand, for a product like soap or detergents, there are many firms producing a large variety of substitutable products. Therefore, one notices more violent competition, in the detergent market. The physical characteristics of a product can also influence the competitive structure of its market. If the distribution cost is a major element in the cost of a product, competition would tend to get localised. Why do you see so many Fiat taxis in Mumbai, while Kolkata is dominated by the ageless Ambassador? Similarly, for perishable products, the competition is invariably local.
Conflict between physical characteristics and minimum economic size
An interesting question arises in the case of a product like cement. For reasons of minimising the transport costs on raw materials, most cement plants in the country are located near mine sites. A large efficient plant near a mine site can manufacture cement at the optimum cost, but the local demand is never large enough. If such a plant has to sell in far away markets (from Gujarat to Kerala, for example) the transport costs can be quite high. Customers located in such areas will always buy cement at a much higher price. The government partly offsets this by using the mechanism of levy price which is the same throughout the country.