Module 3
Module 3
In the realm of economics, the dynamics of markets are both fascinating and pivotal in shaping the
world we live in. Markets are the bedrock of economic activity, where goods and services change
hands, prices are determined, and resources are allocated. However, the markets are not always
flawless; they can be marked by imperfections and pitfalls that lead to suboptimal outcomes for
society.
Market structures are like the blueprints or plans for how this marketplace works. They decide who
can sell what, how prices are set, and how businesses and people behave. Picture it as the shape of
the playing field in a game.
Now, contrast this with Infosys which is a leading IT services company that primarily focuses on
delivering technology solutions to clients globally. Its management typically adheres to profit
maximization and shareholder wealth maximization theories, aiming to generate consistent profits
and increase shareholder value. They prioritize operational efficiency and cost control to maintain
healthy profit margins. The company regularly returns cash to shareholders through dividends and
share buybacks, aligning with its commitment to maximizing shareholder wealth. This aligns with
Profit Maximization and Shareholder Wealth Maximization Theory.
In managerial economics, various theories and models are used to explain the behavior and decision-
making of firms. Managers may follow different theories of firms or approaches to management
because the choice of theory depends on various factors, including the organization's goals, the
industry it operates in, market conditions, and the personal beliefs and values of the managers. In this
session, we are going to discuss four prominent theories 1) Profit Maximization, 2) Revenue
Maximization 3) Sales Maximization 4) Profit Satisficing
If MR is greater than MC (MR > MC), producing one more unit adds more to revenue than it
does to cost. In this case, the firm should increase production to maximize profit.
If MC is greater than MR (MC > MR), producing one more unit adds more to cost than it does
to revenue. In this case, the firm should reduce production to maximize profit.
Profit is maximized at the quantity (Q) where MR equals MC. At this point, the firm is
operating efficiently because the last unit produced adds exactly as much to revenue as it does
to cost. This is also the point at which the gap between TR and TC will be the highest.
The idea of profit maximization represents a simplified economic concept that is often used as a
theoretical framework for understanding business decisions. However, in the real business world, the
pursuit of profit maximization is more nuanced, and firms often consider various factors and
constraints beyond just maximizing short-term profits.
For instance, businesses are subject to various regulations and legal requirements that may limit their
ability to maximize profits without consideration for social or ethical factors. Pharmaceutical
companies must comply with strict regulations related to drug safety and pricing, which may limit
their ability to set prices solely for profit maximization.
Example: Reliance Jio, a subsidiary of Reliance Industries Limited, is a prime example of a company
that has pursued a revenue maximization strategy in the Indian telecommunications industry. When
Reliance Jio entered the Indian telecom market in September 2016, it disrupted the industry by
offering extremely competitive pricing and free data services for an extended period. Jio's primary
objective at the time was not immediate profit but rather to maximize its revenue potential by gaining
a substantial market share and customer base. Jio initially offered free voice calls and data services,
followed by low-cost data plans that significantly undercut competitors' prices. This strategy attracted
millions of new subscribers. The company rapidly gained a massive subscriber base and disrupted
the Indian telecommunications industry. While initially reporting losses due to heavy investments,
Jio's approach eventually paid off. It transformed into one of the largest telecom operators in India
and achieved profitability by leveraging its large customer base for data consumption and by offering
a variety of value-added services.
This example illustrates how a company, in this case, Reliance Jio, can pursue a revenue
maximization strategy by prioritizing market share and total revenue over short-term profitability. By
offering competitive pricing and innovative services, Jio was able to attract a significant customer
base and establish itself as a major player in the Indian telecom market.
Total Revenue is calculated by multiplying the number of units sold (Q) by the price per unit (P) and
as studied before Marginal revenue is the additional revenue earned by selling one more unit of a
product. It measures the change in total revenue resulting from a one-unit increase in output.
TR = Q x P
MR = ΔTR / ΔQ
To maximize TR, a firm often employs pricing strategies aimed at stimulating higher demand and
sales. This can involve setting prices at levels that attract more customers, even if it means accepting
lower profit margins per unit. Marginal revenue (MR) plays a vital role in revenue maximization. A
firm continually assesses how changes in output affect its TR.
When MR is positive (MR > 0), the firm continues to increase output because producing
one more unit adds more to TR than it costs to produce.
This continues until MR equals zero (MR = 0), indicating the output level where TR is
maximized.
Beyond that point, MR becomes negative (MR < 0), suggesting that producing additional units
reduces TR.
The output level where MR equals zero (MR = 0) corresponds to the point where TR reaches its
maximum value. This is the quantity of output that the firm aims to produce to maximize its revenue.
Sales maximization for a firm, when prices are equal to the average total cost (ATC), represents a
unique scenario in which the firm is operating at a break-even point. In this situation, the firm is not
making a profit, but it is also not incurring losses. By setting prices at the level of ATC, the firm
ensures that it covers all its production costs, both variable and fixed. This allows the firm to continue
operating in the long term without incurring losses that could threaten its survival. Operating at ATC-
level prices can help the firm capture a larger market share. When prices are competitive and
customers perceive good value for the price, they are more likely to choose the firm's products over
those of competitors. This increased market share can lead to economies of scale, reduced production
costs, and a stronger competitive position in the industry.
It is also the point when the firms earn zero economic profit. Note that economic profit and accounting
profits are different. While economic profit is zero, accounting profit can be positive but it is the
minimum acceptable accounting profit at which the firm would want to operate.
Economic profit adjusts for both explicit as well as implicit or opportunity cost whereas accounting
profits only account for explicit costs.
Achieving zero economic profit does not necessarily mean the firm is failing; rather, it suggests that
the firm can sustain its operations over the long term without deteriorating its financial position. It
covers all of its costs and can continue to serve its customers.
One example of a company that has demonstrated elements of sales maximization is Tata Motors
Limited, an Indian multinational automotive manufacturing company. Tata Motors operates in the
global automotive industry, which is characterized by oligopoly. In India, it is one of the largest
players, competing with companies like Maruti Suzuki, Mahindra & Mahindra, and Hyundai. Tata
Motors has historically engaged in non-price competition strategies to maximize its sales. For
instance, they have focused on product differentiation by offering a diverse range of vehicles,
including budget-friendly cars, luxury cars (through their Jaguar Land Rover acquisition), and
commercial vehicles. While profit is certainly important to them, they have also demonstrated a
strong commitment to market leadership and growth. For instance, Tata Motors acquired Jaguar Land
Rover in 2008, expanding its global presence and product portfolio significantly. This strategic move
was not solely based on profit maximization but aimed at increasing their sales and global market
share. It's important to note that companies like Tata Motors do not exclusively pursue sales
maximization but incorporate elements of this theory in their overall strategy. They seek to strike a
balance between increasing sales and generating profits to remain competitive in their industry.
Another reason why managers may opt for sales maximisation over profit maximisation can be
understood in the context of the principal-agent problem through an example.
Wells Fargo is a prominent American multinational financial services company that provides
banking, investment, mortgage, and other financial services. The company faced a significant
principal-agent problem that became public in a scandal that emerged in the mid-2010s.
1. The Principals or Shareholders: In this case, the principals are the shareholders of Wells
Fargo, who own the company and expect it to generate profits and maximize shareholder
value. Shareholders typically entrust the company's management (the agents) with running
the business in a way that achieves these objectives.
2. The Agents (Managers/Employees): The agents, in this scenario, are the managers and
employees of Wells Fargo, including branch managers and salespeople. They were
responsible for selling financial products and services to customers.
The principal-agent problem at Wells Fargo revolved around the aggressive sales practices of its
employees, which were driven by a flawed incentive system. The company set unrealistic sales targets
and provided significant financial incentives to employees who could meet or exceed these targets.
These incentives included bonuses, promotions, and job security.
The misalignment of interest between the principal and agent led to the following:
1. To meet their sales targets and earn bonuses, some employees engaged in unethical practices,
such as opening unauthorized bank and credit card accounts in customers' names without their
consent. These actions were driven by a desire to maximize sales and, consequently, their
compensation.
2. While these practices may have temporarily boosted sales figures, they damaged the
company's reputation and exposed it to legal and regulatory risks. Shareholders, who aimed
for long-term sustainability and value creation, suffered as a result of the scandal.
3. The misalignment of interests between employees and shareholders led to a situation where
Wells Fargo's financial performance, as measured by sales figures, did not accurately reflect
the underlying health and ethical conduct of the company.
The Wells Fargo scandal resulted in significant financial and reputational damage to the company.
The CEO and other top executives faced public scrutiny, regulatory penalties, and lawsuits.
Ultimately, the scandal highlighted the importance of aligning the interests of agents (employees)
with those of the principals (shareholders) to prevent unethical behavior and prioritize long-term
corporate sustainability over short-term sales maximization.
This example underscores the challenges companies can face when trying to strike a balance between
achieving sales targets and maintaining ethical behavior and the trust of shareholders. The principal-
agent problem is a recurring issue in corporate governance that requires careful oversight and
alignment of incentives to ensure the interests of both parties are harmonized.
Segment 4 - Profit Satisficing
The theory of profit satisficing is an economic concept that suggests some firms may not strive to
maximize profits, as traditional economic theory posits. Instead, these firms aim to achieve a level of
profit that satisfies their specific objectives while minimizing the effort and risk associated with profit
maximization. Traditional economic theory assumes that firms aim to maximize profits, which
involves producing the quantity of goods or services that generates the highest possible profit. In
contrast, profit satisficing suggests that some firms are content with achieving a satisfactory level of
profit rather than pushing for maximum profits.
For example, consider the case of Amul which is a cooperative of dairy farmers in Gujarat, India. It's
known for its "Operation Flood" initiative, which aimed to help rural dairy farmers and improve milk
production. Amul prioritizes the welfare of its farmer members, offering them fair prices for their
milk and supporting rural development. This practice ensures that farmers receive a reasonable
income, even during market fluctuations. This commitment to fair pricing goes beyond pure profit
maximization. Amul's cooperative structure fosters a sense of community among its farmer members.
This approach emphasizes collective decision-making and shared benefits, which is distinct from the
profit-maximizing behavior of many private enterprises.
In essence, Amul seeks to achieve a level of profit that ensures the sustainability and well-being of
its farmer members and the communities it serves. The cooperative's focus on equitable profit
distribution, rural development, and sustainable practices demonstrates a commitment to values
beyond mere profit maximization, aligning with the theory of profit satisficing. While profitability is
essential, Amul's cooperative model prioritizes the interests of its stakeholders and the broader goals
of social and economic development.
To illustrate this concept, let's consider four distinct market structures with real-world examples:
1. Perfect Competition: Imagine a farmers' market where numerous small-scale farmers sell
identical products like tomatoes. No single farmer can influence the price, and consumers can choose
from any vendor they prefer. In this structure, there is a high degree of competition, and prices are
determined by supply and demand.
2. Monopolistic Competition: Think of the fast-food industry, where there are many burger joints,
but each offers a slightly different menu and brand experience. While they compete, they also have
some control over their pricing and can differentiate themselves to attract customers.
3. Oligopoly: Consider the mobile phone industry, where a handful of major companies dominate the
market. These companies closely watch each other's moves and engage in strategic decisions, such
as pricing wars or technological advancements, to gain an edge. Competition is intense, but a few
players dominate the field.
4. Monopoly: Picture a local utility company that provides electricity. They are the sole provider in
the area, giving them a significant amount of control over prices and quality of service. Consumers
have no alternative but to purchase from this single provider.
A quick review of this table demonstrates the key differences between each of these market forms.
Let’s discuss each of these market forms in detail.
Insert table 14 and figure 13
1. A large number of buyers and sellers: Perfectly competitive markets have a large number
of buyers and sellers. No single buyer or seller has enough market power to influence prices.
2. Homogenous or Identical Products: In a perfect competition market, all firms produce
identical or nearly identical products. Consumers perceive these products as perfect
substitutes, meaning there is no differentiation based on branding or quality.
3. Perfect Information: Both buyers and sellers have access to complete and perfect
information about the market. This means consumers are aware of all available prices, and
producers are aware of the demand for their products and the prices at which they can be sold.
4. Ease of entry and exit: New firms can enter the market easily, and existing firms can exit the
market without significant barriers. This ensures that there is no monopoly power or long-
term abnormal profits in the long run.
5. Price Taker Behaviour: Individual firms in a perfectly competitive market are price takers.
This means they accept the market price as given and adjust their output accordingly. They
have no control over the market price. If one firm were to charge a slightly higher price than
its competitors, all its customers would switch to other firms since the products are perfect
substitutes, and due to perfect information, they know this. Moreover, since there are no
transaction costs, there are no transportation or search costs involved in switching to other
sellers.
6. No Government Intervention: Perfect competition assumes no government intervention in
terms of price controls, regulations, or subsidies.
Perfect competition serves as a theoretical benchmark for analyzing other market structures, and it is
relatively rare in the real world. However, it provides a useful framework for understanding how
competitive markets function and the economic forces that shape them.
The demand curve faced by a single perfectly competitive firm and the market demand curve are
distinct concepts in the context of perfect competition. Here's how they differ:
Insert figure 14
In perfect competition, allocative and productive efficiency are two important concepts that describe
the optimal allocation of resources and the minimization of waste in the production of goods and
services.
Allocative Efficiency:
Allocative efficiency occurs when the allocation of resources in the market results in the
production of the quantity of goods and services that maximizes consumer satisfaction,
represented by the intersection of the demand (price) and supply (marginal cost) curves.
In perfect competition, allocative efficiency is achieved because firms are price takers.
At the point where MC = P (and MR), the quantity supplied meets the quantity demanded in
the market. This ensures that resources are used to produce goods that consumers value the
most, maximizing societal welfare.
Any deviation from this equilibrium, where MC does not equal P, would result in either
underproduction (MC < P) or overproduction (MC > P), leading to a reduction in overall
welfare.
Productive Efficiency
Productive efficiency refers to the production of goods and services at the lowest possible
cost. In other words, it occurs when firms produce output at the minimum average total cost
(ATC) possible.
Competition among firms in perfect competition drives them to operate at the lowest point on
their ATC curve, ensuring that resources are used efficiently.
This efficiency ensures that society gets the maximum possible quantity of goods and services
for a given amount of resources, further enhancing overall welfare.
Segment 4 -Monopoly
A monopoly is a market structure characterized by a single seller or producer that has significant
control and influence over the market. In a monopoly, there is no close substitute for the product or
service being offered, and the monopolist can set the price and quantity of output.
To explain a monopoly market, let's use the example of the Microsoft Corporation in the 1990s. In
the 1990s, Microsoft Corporation held a dominant position in the market for computer operating
systems, particularly with its Windows operating system. This situation exhibited several key
characteristics of a monopoly. Microsoft was the sole provider of its Windows operating system for
personal computers. There was no direct competition offering an identical product. Windows had a
unique position in the market. It was the standard operating system for PCs, and it was not easily
substitutable by other operating systems due to compatibility issues with software and hardware.
Microsoft had substantial control over the price of Windows. It could set the price at a level it deemed
most profitable, and consumers had no alternative but to accept that price if they wanted to use
Windows. Microsoft's dominance created significant barriers to entry for potential competitors. The
cost and complexity of developing a new operating system that could compete with Windows were
extremely high. Consumers did not have perfect information about alternative operating systems, and
the high switching costs (in terms of software compatibility and user familiarity) discouraged many
from exploring other options.
It's important to note that monopolies can raise concerns about consumer welfare and market
competition. In this case, Microsoft faced legal challenges related to antitrust issues, as its monopoly
position was seen as potentially harmful to competition in the software industry. Monopolies often
require government regulation to prevent abuse of market power and ensure that consumers are not
subjected to excessive prices or reduced choices. In some cases, governments may break up
monopolies or impose regulations to promote competition and protect consumers' interests.
A natural monopoly is a specific type of monopoly that arises when a single firm can produce a good
or service more efficiently and at a lower cost than multiple competing firms. In other words, it is a
market structure in which economies of scale are so significant that it is most efficient to have only
one firm provide the product or service. Natural monopolies often occur in industries with high fixed
costs and low marginal cost
A classic example of a natural monopoly is the provision of water supply in a city or region. Here's
how it works:
1. High Fixed Cost: Establishing a water supply system, including building reservoirs, pipelines,
treatment plants, and distribution networks, involves substantial upfront fixed costs. These costs are
required to build the infrastructure necessary to provide water to households and businesses.
2. Low Marginal Costs: Once the water supply infrastructure is in place, the cost of providing water
to additional customers (marginal cost) is relatively low. It primarily involves the cost of treating and
pumping a bit more water, which is typically a fraction of the initial fixed costs.
3. Economies of Scale: Natural monopolies benefit from significant economies of scale. As the scale
of operations increases, the average cost of production per unit of output decreases. This means that
the larger the water supply system, the lower the cost of supplying water to each customer.
4. Efficiency: Because of the high fixed costs and low marginal costs, it is most efficient to have a
single entity (usually a government agency or a regulated private company) provide water supply
services. If multiple competing firms were to build their separate water supply systems, it would lead
to duplication of infrastructure, higher costs, and inefficiencies.
5. Regulation: Recognizing the natural monopoly characteristics of water supply, governments often
regulate these services to ensure fair pricing, quality standards, and universal access. Regulatory
bodies oversee the pricing and operations of the monopoly provider to prevent abuse of market power
and ensure that consumers are not subjected to excessive prices.
Marginal revenue (MR) is the additional revenue a firm earns when it sells one more unit of
its product. In a monopoly, MR is not equal to the market price (P) as it is in perfect
competition.
MR is determined by the change in total revenue when one more unit is sold. Mathematically,
MR is the derivative of the total revenue function for quantity (MR = dTR/dQ).
3. Profit Maximisation:
To maximize profit, the monopolist selects the level of output where MR equals marginal cost
(MC). This is the point where the additional revenue from selling one more unit equals the
additional cost of producing that unit.
The monopolist then reads off the price (P) at this output level on the demand curve.
Once MR equals MC, the monopolist can determine both the price and the quantity it will
produce and sell.
The price will be higher than the monopolist's marginal cost (P > MC), which is the source of
its monopoly profit.
The quantity produced (Q) is the level where MR equals MC. This is the monopolist's profit-
maximizing level of output.
In some cases, a monopoly may produce at a level where MR is below MC (MR < MC). This
can result in a loss for the monopolist.
Even though a monopoly can set prices above marginal cost, it must be cautious not to produce
excessively, as this can lead to a loss.
The monopolist sets the price based on the demand curve and the profit-maximizing quantity.
The price is typically higher than the competitive market price (which is determined by supply
and demand in a competitive market).
7. Profit or Losses
The monopolist's profit is calculated as the difference between total revenue (P * Q) and total
cost (TC).
If the monopolist's total revenue exceeds the total cost, it earns a profit. If total cost exceeds
total revenue, it incurs a loss
Monopolistic competition is a market structure characterized by a large number of firms that produce
differentiated products and have some degree of control over the price they charge. This market
structure combines elements of both monopoly (product differentiation) and perfect competition
(many firms). Here are the key features of monopolistic competition
Numerous firms are competing in the market, making it resemble perfect competition in terms
of the number of participants.
Each firm produces a product that is slightly different from its competitors. These differences
can be real or perceived and may include variations in branding, quality, design, or features.
Firms in monopolistic competition have some control over the price of their products due to
product differentiation. However, this control is not absolute, as consumers can choose from
similar products offered by other firms.
Each firm makes independent decisions regarding pricing, production, and marketing
strategies. There is no collusion or coordination among firms, as in an oligopoly.
Barriers to entry and exit are relatively low compared to a monopoly or oligopoly. New firms
can enter the market or existing firms can exit without significant obstacles.
Firms often engage in non-price competition to differentiate their products. This can involve
advertising, branding, customer service, product design, and other marketing strategies.
The demand curve for a firm in monopolistic competition slopes downward because
consumers are willing to pay different prices for products with varying degrees of
differentiation.
For example, Nike operates in the global sportswear and athletic footwear industry, which includes
numerous competitors like Adidas, Puma, Under Armour, Reebok, and many other smaller brands.
Nike offers a wide range of athletic footwear, apparel, and accessories. The company is known for its
distinctive product designs, innovative technologies (such as Nike Air cushioning), and endorsements
by athletes like Michael Jordan and LeBron James.
While Nike can set its prices for its products, it faces competition from other sportswear and footwear
brands. It must consider the pricing strategies of its competitors, especially when launching new
product lines or entering new markets.
The sportswear and footwear industry allows for relatively easy entry and exit for new competitors.
Emerging brands can enter the market with unique designs and marketing strategies, and some may
exit if they cannot establish a competitive foothold.
Nike invests heavily in non-price competition through branding, marketing, and product innovation.
The company's iconic "swoosh" logo, athlete endorsements, advertising campaigns, and limited-
edition releases contribute to its brand recognition and customer loyalty.
Nike's position in the sportswear and athletic footwear industry exemplifies monopolistic
competition. It offers a wide range of differentiated products and competes with many other brands
in the same market. While Nike can set its prices, it must remain competitive to attract consumers
who have various alternatives in terms of sportswear and athletic footwear brands. Nike's focus on
innovative product design, branding, and marketing is central to its strategy in this market structure.
In the short run, a monopolistic firm may earn economic profit, incur economic losses, or break even.
This depends on the relationship between its total revenue (TR) and its total cost (TC). To maximize
profit in the short run, the monopolistic firm will produce the quantity of goods where marginal
revenue (MR) equals marginal cost (MC). This is the same profit-maximizing principle as for firms
in perfect competition. After deciding on the output level, the firm sets the price based on the demand
curve for its differentiated product. The price will be higher than the marginal cost (P > MC), which
is the source of its abnormal profit. In the short run, consumers may pay higher prices, and the
monopolistic firm captures a portion of consumer surplus as economic profit. Some consumer surplus
is transferred to the firm as producer surplus. If the firm sets its price too high or produces at an
inefficient level, it may incur economic losses. However, in the short run, the firm can continue to
operate, as it can cover its variable costs and part of its fixed costs.
In the long run, due to the freedom of entry and exit in monopolistic competition, other firms may
enter the market if they see that the monopolistic firm is making an economic profit. This new entry
increases competition. As new firms enter, the demand for the monopolistic firm's product may
decrease as consumers have more options and substitutes. This shifts the firm's demand curve to the
left. With more competition, the monopolistic firm's market share may decline, and its ability to set
prices above marginal cost diminishes. To remain competitive and avoid further economic losses, the
monopolistic firm reduces its price and output. It may produce a quantity where MR equals MC, but
at this point, the price is less than the average total cost (ATC). In the long run, the monopolistic firm
achieves zero economic profit (normal profit) as it operates at the point where P = MC = ATC. It
produces a quantity that is less than the short-run level, which allows it to cover all its costs without
earning economic profit.
Economic Efficiency
Monopolistic firms, by their nature, have the ability to set prices above marginal cost. In pursuit of
profit, they often charge prices that exceed the marginal cost of production. This results in a gap
between the price consumers are willing to pay (as reflected by their demand) and the actual cost of
producing an additional unit of the product. Because monopolistic firms set prices higher than
marginal cost, they tend to produce less than the socially optimal level of output. In other words, they
produce fewer units than what consumers are willing to buy at the price they are willing to pay. This
leads to an under allocation of resources and a deadweight loss to society. Due to the higher prices
charged by monopolistic firms, consumers experience a reduction in consumer surplus.
Consumer surplus represents the difference between what consumers are willing to pay for a good
and what they actually pay. Monopolistic pricing reduces this surplus, indicating that some consumers
are willing to pay more than they do. Allocative efficiency implies that resources should be allocated
to produce goods and services until marginal cost equals marginal benefit (as reflected in the demand
curve). Monopolistic firms, with their pricing strategies, miss the opportunity to capture this welfare
gain for society.
It's important to note that monopolistic firms are generally less economically efficient than perfectly
competitive firms. However, they can still play a role in the economy by providing innovation,
product differentiation, and variety. Additionally, some industries, such as utilities and natural
monopolies, may require government regulation to balance market power and ensure that consumers
are not exploited. In such cases, regulation is aimed at achieving a balance between efficiency and
other social goals, like equity and access.
Segment 8 - Oligopoly
An oligopoly is a market structure characterized by a small number of large firms dominating the
industry, leading to a situation where each firm's actions can significantly impact the market. One
such example is the automobile industry, where a handful of major companies control a significant
portion of the market. Some features of the oligopoly market are:
Few Large Firms: In an oligopoly, there are a limited number of dominant firms that account
for the majority of the market share. In the automobile industry, companies like Toyota,
General Motors, Ford, Volkswagen, and Honda are prime examples.
High Barriers to Entry: Entering the automobile industry requires substantial financial
investment in research and development, manufacturing facilities, distribution networks, and
brand development. This creates significant barriers to entry for new competitors.
Interdependence: Oligopolistic firms closely monitor and react to each other's actions,
particularly in terms of pricing, product launches, and marketing strategies. The actions of
one firm can trigger responses from others, leading to a complex interdependent relationship.
Product Differentiation: Firms often engage in product differentiation to distinguish their
vehicles from competitors. This may involve branding, design, features, and technological
innovations.
Price Rigidity: Oligopolistic firms tend to avoid frequent price changes. They often engage in
tacit collusion, where they maintain stable prices to avoid price wars that could harm profits
for all firms.
Non-Price Competition: Oligopolistic firms compete vigorously through non-price factors,
such as advertising, quality, safety, fuel efficiency, and warranties. These factors play a crucial
role in attracting customers.
Strategic Behaviour: Oligopolistic firms engage in strategic decision-making to maximize
their market power and profitability. This includes setting prices, engaging in research and
development, expanding into global markets, and forming strategic alliances.
Mutual Interests and Conflicts: Oligopolistic firms may have mutual interests, such as
stabilizing prices and maintaining industry profitability. However, they also have conflicting
interests in gaining a larger market share and outperforming competitors.
Government Regulation: Governments often regulate the automobile industry to address
safety, environmental, and fuel-efficiency concerns. Regulations can have a significant impact
on the strategies and operations of oligopolistic firms.
The kinked demand curve model assumes that if a firm increases its price above the prevailing market
price, its competitors will not follow suit. However, if the firm lowers its price below the market
price, competitors are likely to match the price cut to avoid losing customers. The demand curve
facing an oligopolistic firm has two distinct segments meeting at a kinked point. The upper portion is
relatively elastic, meaning that consumers are responsive to price changes. The lower portion is
relatively inelastic, indicating that consumers are less responsive to price changes. At the kink of the
demand curve, there is typically a gap or discontinuity in the marginal revenue (MR) curve. This
means that a small change in quantity sold does not lead to a corresponding change in MR. The gap
represents a situation where multiple price-output combinations can yield the same profit.
Consider two scenarios:
If the firm raises its price above the prevailing market price, consumers are likely to switch to
competitors offering a lower price. As a result, the firm's quantity sold will decrease
significantly, and its total revenue will decline.
If the firm lowers its price below the prevailing market price, competitors are expected to
match the price reduction to retain their market share. This means the firm's quantity sold may
not increase significantly, and its total revenue may not change much.
The kinked demand curve reflects this behavior. It implies that a firm is content with the status quo,
represented by the kink, as deviating from it could lead to reduced profitability. Firms find it more
attractive to maintain stable prices and avoid the uncertainty associated with price changes and
potential retaliatory actions by competitors.
Maruti Suzuki, India's largest car manufacturer, often sets the benchmark for pricing in the Indian
automobile industry. Its pricing decisions for popular models, such as the Maruti Suzuki Swift or
Alto, influence pricing strategies adopted by other car manufacturers in India. Competitors adjust
their pricing to remain competitive in the market.
There can be some challenges in this model. The dominant firm can potentially exploit its position
by setting prices at higher levels than what would occur in a more competitive market. The focus on
price coordination may divert attention away from product innovation and other competitive
strategies. In some cases, regulators may closely scrutinize price leadership arrangements to ensure
they do not result in anticompetitive behavior or harm consumers.
It's important to note that not all industries or markets operate under the price leadership model, and
its effectiveness can vary depending on the specific circumstances of the oligopoly. In some cases,
formal collusion or competition authorities may intervene if they suspect anti-competitive behavior.
Collusion
Collusion in an oligopoly occurs when two or more firms within the industry coordinate their actions
to collectively maximize their joint profits, often by setting prices, production levels, or market
shares. Collusion is typically illegal and considered anticompetitive because it harms consumers by
reducing competition and potentially leading to higher prices.
Collusion requires that firms reach an agreement and stick to it. This is easier in markets where there
are few firms, when the firms in the market face similar average costs, and the market is not
contestable. A market is contestable when there are weak barriers to entry and it is possible for new
firms to enter the market to compete. The greater the entry barriers, the less contestable the market
is. Oligopoly markets tend to be less contestable due to barriers to entry, and they also have fewer
firms. For these reasons, collusion is more likely to occur in an oligopoly market than in
monopolistically competitive markets where there are many firms each acting independently.
Consider the example of OPEC i.e. Organisation of the Petroleum Exporting Countries. OPEC is an
international organization consisting of multiple oil-producing countries, including Saudi Arabia,
Iran, Iraq, Kuwait, Venezuela, and others. While it's not a traditional corporation, it operates similarly
to a cartel. It is perhaps one of the most well-known examples of successful collusion in the world. It
was founded in 1960 to coordinate the production and pricing of oil among its member countries.
OPEC's actions have a significant impact on global oil prices and supply. OPEC members agree on
production quotas for each member country. These quotas specify how much oil each country is
allowed to produce and export. It sets target oil prices for its crude oil. Member countries work
collectively to influence global oil prices by adjusting their production levels to meet these targets.
OPEC's coordinated efforts have, at times, led to significant control over oil prices and supply. For
example, during the 1970s, OPEC's oil embargo and production cuts led to a sharp increase in oil
prices worldwide. Their actions have also helped stabilize oil prices during periods of oversupply or
falling demand. While successful in influencing oil prices, OPEC's actions have been subject to
criticism for their impact on global energy markets and consumer costs.
It's important to note that OPEC's actions have had both positive and negative consequences. While
it demonstrates the potential for successful collusion in an oligopolistic industry, it has also faced
challenges in maintaining cohesion among its member countries, as their interests sometimes conflict.
Firms in the real world often face a mix of these market structures, and pricing strategies can vary
within industries. Firms also consider factors like production costs, demand elasticity, consumer
preferences, regulatory constraints, and market conditions when setting prices. Dynamic factors such
as changes in technology, competition, and consumer behavior can lead to adjustments in pricing
strategies over time. In this session, we will learn about different price strategies that firms might
adopt.
The learning objectives of this session are:
1. Analyze various pricing strategies such as limit pricing, predatory pricing, cost plus pricing,
price leadership, etc.
2. Differentiate between different forms of price discrimination: first-degree, second-degree, and
third-degree price discrimination
Imagine a simplified scenario in the airline industry, where there are three major airlines: Airline A,
Airline B, and Airline C. One day, there is a significant increase in the price of jet fuel, a crucial cost
factor for airlines. Airline A is quick to recognize this change and realizes that they will need to
increase ticket prices to maintain profitability. In response to the increased fuel costs, Airline A
decides to raise its ticket prices by 10%. They do this with the expectation that the other two major
airlines, B and C, will also face the same increased costs and will likely follow suit by raising their
prices. As expected, Airlines B and C observe Airline A's price increase and recognize the same cost
pressures. To remain competitive and profitable, they also raise their ticket prices by a similar
percentage, say 10%. With all three major airlines raising their prices, ticket prices across the industry
increase uniformly. This price adjustment reflects the barometric price leadership exercised by Airline
A. The prices are now higher to cover the increased fuel costs, and all three airlines have maintained
their relative price positions.
In the early 20th century, major copper mining companies, including Anaconda Copper, formed a
cartel known as the "Copper Trust" to control the supply and price of copper. It was eventually
dissolved under antitrust laws.
OPEC is perhaps one of the most famous cartels globally. It comprises several oil-producing
countries, including Saudi Arabia, Iran, and Venezuela, which collectively control a significant
portion of the world's oil production. OPEC seeks to influence global oil prices by coordinating
production quotas among its member countries.
Several major airlines, including British Airways, Korean Air, and Qantas, were involved in a cartel
that fixed cargo fuel surcharges and rates for international airfreight services. This cartel was exposed
in the mid-2000s, resulting in hefty fines for the companies involved.
Another case is that several LCD panel manufacturers, including LG Display, Sharp, and Chunghwa
Picture Tubes, were found guilty of forming a cartel to fix prices of liquid crystal display (LCD)
panels used in electronic devices. This cartel operated in the mid-2000s and led to significant fines
and penalties.
Cartel formation is often possible in an oligopoly form of market. If there are significant barriers to
entry for new firms, existing companies may have more control over the market and may be more
willing to collude. Barriers to entry can include high startup costs, government regulations, and
economies of scale.
In the 1980s, American Airlines held a dominant position at Dallas/Fort Worth International Airport
(DFW), which was one of its major hubs. To deter potential competitors, American Airlines engaged
in a limit pricing strategy by offering exceptionally low fares on routes where it faced competition
from other carriers. The airline strategically lowered prices on routes to and from DFW, making it
financially challenging for other airlines to compete effectively. This limit pricing tactic aimed to
discourage other airlines from establishing a significant presence at DFW and allowed American
Airlines to maintain its dominance at the airport.
Walmart, a major retail giant, has faced accusations of predatory pricing when entering new markets.
When Walmart opens a store in a new location, it often offers extremely low prices on a wide range
of products to attract customers. These low prices can make it difficult for smaller, local retailers to
compete, potentially leading to some of them going out of business. Once local competition is
weakened or eliminated, Walmart may raise prices to more profitable levels.
Predatory pricing will also be less effective and costly if the new firm has the financial strength to
engage in penetration pricing for an extended period. Penetration pricing occurs when a firm charges
a low price to establish itself in an industry and obtain a desired market share.
Another opposing strategy is Prestige pricing, also known as premium pricing or image pricing, in
which a company sets higher prices for its products or services to create a perception of high quality,
luxury, or exclusivity. This strategy is often associated with premium or luxury brands and relies on
the psychology of consumers who associate higher prices with superior quality or status.
For example, Louis Vuitton, a French fashion house, is synonymous with prestige pricing in the
luxury fashion industry. Their handbags, luggage, and accessories are known for their iconic
monogram and craftsmanship. Louis Vuitton products are priced at a premium, targeting customers
seeking high-end fashion and exclusivity.
Another example is Tiffany & Co., a luxury jewelry brand, which is renowned for its prestige pricing
strategy. The brand's iconic blue box and timeless designs contribute to its image of luxury and
exclusivity. Tiffany's jewelry is priced at a premium to reflect its craftsmanship and brand status.
These examples demonstrate how prestige pricing is commonly used by luxury and premium brands
to create a perception of quality, status, and exclusivity, allowing them to charge higher prices and
attract a specific target audience willing to pay for the prestige associated with the brand.
2. Second-Degree Price Discrimination: This involves charging different prices based on the
quantity or volume of a product or service purchased. Companies offer discounts or tiered pricing to
incentivize customers to buy more.
Software companies often use second-degree price discrimination by offering different pricing tiers
based on the number of licenses or seats required. For example:
Microsoft offers Office 365 Business plans with tiered pricing based on the number of users
or devices. Customers pay more for additional licenses.
Adobe Creative Cloud offers pricing options for individuals, teams, or enterprises, each with
different features and pricing based on the number of users.
These tiered pricing models encourage customers to purchase higher-priced plans when they need
more licenses, maximizing revenue for the software companies.
For firms to practice price discrimination, certain conditions and characteristics in the market must
exist. The key conditions required for price discrimination include:
Market Power: Price discrimination is most effective when a firm has substantial market
power, meaning it can influence the market price and quantity of goods or services it offers.
A monopolistic or oligopolistic market structure is often conducive to price discrimination
because firms have greater control over prices.
Identifiable Customer Segments: Firms must be able to identify distinct customer segments
based on factors such as willingness to pay, demographics, location, or purchase history.
These segments should have varying levels of price sensitivity or preferences.
Inelastic Demand in One Segment: Price discrimination is more profitable when there is a
segment of customers with relatively inelastic demand. Inelastic demand means that price
changes have a relatively small impact on the quantity demanded. Firms can charge higher
prices to these customers without losing too much business.
Segment Isolation: To practice price discrimination, firms must be able to prevent or limit
arbitrage, which occurs when customers from one segment buy at the lower price intended for
another segment and then resell the product. Effective isolation of segments is crucial.
Firms use a variety of pricing strategies which involve charging different prices for the same service
or product. However, if costs differ, the price differences will not be only due to price discrimination.
For example, Peak-load pricing is a pricing strategy used by companies, particularly in industries
where demand fluctuates significantly throughout the day or year. This strategy involves charging
higher prices during periods of high demand (peak times) and lower prices during periods of lower
demand (off-peak times). The goal is to maximize revenue while efficiently allocating resources and
managing capacity. For instance, Surge pricing is a dynamic pricing strategy employed by Uber
during high-demand periods to balance supply and demand for rides. During peak hours or in
situations where demand for rides suddenly surges, there may not be enough available drivers to meet
all the ride requests. This demand-supply imbalance can lead to longer wait times for riders.
Price skimming is a pricing strategy where a company initially sets a high price for a new product or
service for which there are no close substitutes and demand is relatively price inelastic. This strategy
is often used for innovative or technologically advanced products to maximize profit and recover
development and marketing costs quickly.
For example, Dyson, known for its innovative vacuum cleaners, uses price skimming for its product
launches. When Dyson introduces a new vacuum cleaner with advanced features and technology, it
sets an initial high price. As the product matures in the market and production costs decrease, Dyson
reduces the price to appeal to a broader range of consumers.
Intertemporal pricing, also known as time-based pricing or dynamic pricing, is a strategy where a
company adjusts the prices of its products or services based on the time of purchase, demand
fluctuations, or other temporal factors. This approach allows companies to optimize revenue by
aligning prices with changing market conditions and customer preferences over time. For example,
Subscription-based streaming platforms like Netflix and Disney+ adjust their subscription prices over
time, often increasing them as they add more content and features. They may also offer promotional
pricing for new subscribers to encourage sign-ups during specific periods.
Another strategy is a two-part tariff where a company charges customers both a fixed fee (a lump-
sum fee) and a per-unit fee for the consumption of a product or service. This pricing structure is often
used to capture a portion of consumer surplus while ensuring a stable stream of revenue for the
company. For example, many gyms and fitness clubs implement a two-part tariff pricing structure for
their members. Gyms charge their customers a monthly or annual membership fee to access their
facilities and services. This fee grants members the right to use the gym's equipment, attend fitness
classes, and access other amenities. In addition to the membership fee, gyms may charge a per-visit
fee for certain services, such as personal training sessions, spa treatments, or specialty classes. These
fees are paid on a per-unit basis, meaning customers are charged each time they use or attend these
services.
Multi-product Pricing
Multiproduct pricing is a strategy in which a company offers multiple products or services as a bundle
or package, to influence consumer behavior, increase sales, and maximize revenue. This approach
often involves pricing products together at a discounted rate compared to purchasing each item
individually. Companies use multiproduct pricing to encourage customers to buy more, enhance
perceived value, and boost overall profitability.
For example, McDonald's, the global fast-food chain, is a prime example of a company that uses
multiproduct pricing through its "Value Meals" or "Combos." These meal deals bundle several food
items together at a lower price than if customers were to buy each item separately. For example, a
"Big Mac Meal" may include a Big Mac burger, medium fries, and a medium soft drink. The price of
the value meal is set at a lower rate than if a customer were to order each item individually. This
discount is a key incentive for customers to opt for the bundled meal. Multiproduct pricing encourages
customers to purchase more items, boosting sales and revenue. This approach not only increases sales
for the company but also provides convenience and perceived value for customers, making it a win-
win strategy for both the company and its consumers.
Another example could be that companies like Microsoft offer software suites like Microsoft Office
365, which include various applications such as Word, Excel, and PowerPoint. These suites are priced
at a lower rate compared to purchasing each software application individually.
Transfer Pricing
Transfer pricing is a practice used by multinational corporations to determine the prices at which
goods, services, or intellectual property are bought and sold between their subsidiary companies
located in different countries. The primary goal of transfer pricing is to allocate profits and expenses
among subsidiaries in a manner that complies with tax regulations, maximizes efficiency, and
minimizes tax liabilities.
Starbucks Corporation, the global coffeehouse chain, provides an interesting example of transfer
pricing due to its extensive international presence. Starbucks operates thousands of stores in various
countries and engages in the sale of coffee beans, branded merchandise, and intellectual property
rights like its brand and recipes.
How does Starbucks use Transfer Pricing?
Starbucks sources coffee beans from coffee-producing countries, such as Ethiopia or
Colombia, and roasts them in its manufacturing centers. These roasted beans are then sold to
Starbucks retail stores around the world.
Starbucks licenses its brand, recipes, and operational know-how to its international
subsidiaries, allowing them to operate Starbucks stores and sell Starbucks-branded products.
Starbucks employs various pricing methods to set transfer prices. For instance, for coffee bean
purchases, it may use the Comparable Uncontrolled Price (CUP) method, comparing prices to those
paid by other coffee companies for similar beans.
Like many multinational corporations, Starbucks uses transfer pricing to optimize its global tax
situation. By allocating profits efficiently, it can minimize tax liabilities in high-tax jurisdictions.
While transfer pricing is a legitimate practice when conducted by tax regulations and the arm's length
principle, it can become a subject of controversy and legal scrutiny when authorities or the public
perceive it as aggressive tax avoidance.