JWI 515: Managerial Economics Week 6 Lecture Notes Competition and Pricing Practices What It Means In this lecture, you will learn about the methods that company leaders use to increase the competitiveness of their products and services. Competitive advantage is dependent upon the economic environment in which you are operating and the market structure of your industry. Therefore, the lecture will cover the key Market Structures and explore the major types of competition found in developed economies. You will learn about the concept of perfect competition and explore several imperfect models of competition, such as monopoly, monopsony, and oligopoly. Products and services may be sold at different prices to different groups of buyers, depending upon factors such as key features preferred, needs and wants of the customer, speed of delivery required, and many other factors. This key sales technique is called Price Discrimination, an umbrella term which includes multiple types of price differentiation for specific target customer segments. A business leader must understand the various price strategies used to maximize this or her company’s revenue, in order to make well informed and strategic business decisions. Why It Matters • Competitive advantage is related to the market structure in which your company operates • Price discrimination is an important methodology for maximizing sales and revenue • Leaders who understand competition and pricing make more strategic business decisions “No market is perfectly competitive, but some get closer to the ideal than others.” Frakt & Piper © Strayer University. All Rights Reserved. This document contains Strayer University confidential and proprietary information and may not be copied, further distributed, or otherwise disclosed, in whole or in part, without the expressed written permission of Strayer University. JWI 515 – Week 6 Lecture Notes (1202) Page 1 of 6 JWI 515: Managerial Economics Week 6 Lecture Notes TYPES OF MARKET STRUCTURE A market represents any mechanism that brings together buyers and sellers. A market can be anything from an online shopping site to a grocery store. In turn, a market structure defines the environment in which an exchange of goods and services takes place. In this lecture, we will explore several different market structures, each of which represents a different type of competition taking place in a developed economy. Pure Competition Pure or perfect competition is a concept central to microeconomics. Markets are perfectly competitive when they feature a large number of buyers or sellers, with multiple competitors selling a given product. None of the sellers has total control of the market. The market has free entry and exit, which means that there are no regulations that prevent certain companies from entering an industry. Also, everyone in the industry has access to cost information, so that they can compare their costs of production with the costs of their competitors. Finally, companies have the ability to earn a normal and reasonable profit over the long run. As you can readily see, this is an idealized market. Real-world markets are not perfectly competitive because one or more of the conditions described above is not in place. The model of perfect competition, however, serves as a point of comparison to other market structures. Monopoly A monopoly exists when a single business entity dominates an individual market. Classic examples of monopolies are public utilities, which manage the needs of a large population for energy, water, and other basic necessities. A monopoly is often called a price maker because its decisions effectively set market prices. Market entry is blocked for other providers, due to economies of scale, legal barriers like patents and licenses, and limited information sharing with outsiders. Clearly, a monopoly has the potential to earn a large, disproportionate economic profit. When compared to the ideal of a perfectly competitive market, a monopoly causes a loss in social welfare, also known as a deadweight loss. A monopoly may restrict output in an attempt to increase prices and earn more profits. Then shortages occur because the company is putting its goals ahead of society’s needs. It may not use cost-effective production methods and it may be slow to research and develop better systems. This approach is detrimental to consumers but the monopoly can get away with its antisocial behavior, due to the lack of market competition. © Strayer University. All Rights Reserved. This document contains Strayer University confidential and proprietary information and may not be copied, further distributed, or otherwise disclosed, in whole or in part, without the expressed written permission of Strayer University. JWI 515 – Week 6 Lecture Notes (1202) Page 2 of 6 JWI 515: Managerial Economics Week 6 Lecture Notes To prevent monopolies abusing their power in this way, governments use price and profit controls in the form of regulations. Regulatory commissions determine the price a monopoly is allowed to charge for their product or service, based on a fair return on investment and given the inherent risk involved. They then establish a price ceiling. Thus, regulators allow the company to achieve only a limited profit, so as to protect consumers. Monopolies are not always socially harmful. A variant of the model called a natural monopoly can benefit society. This happens when an organization dominates the market as a result of superior technology or economies of scale. Regulated utilities are often considered natural monopolies. In exchange for exclusive operating licenses, they accept price regulation by government agencies. Utilities build and maintain the costly infrastructures needed to deliver power or water supplies, or to remove sewage. Due to economies of scale, one company can offer lower prices than several companies competing for the business with separate but similar infrastructures. Monopsony A monopsony is the opposite of a monopoly structure. A monopsony is the sole buyer of an input to the production process. Like the monopoly, operating as the only player allows the monopsony to set market prices for the items that they purchase. Thus, the monopsony can pay a lower price than would be demanded in a competitive environment. For example, if a factory is the only major employer in town, it can pay a lower wage to workers than if two factories operated there. The work of its employees is a necessary input for production but, with no competition for labor, the management can reduce the level of wages. As a result, the factory makes a higher level of profit when it sells its goods. Factory workers have no leverage to demand higher pay because they lack an alternative local employment option. Oligopoly Oligopoly is a market structure in which a small number of business entities dominate the market and compete with each other on a limited basis. Industries that might at first appear competitive may operate as an oligopoly through informal or formal cooperation. For example, groups of airlines sometimes work out agreements where, if one company raises the price for airline tickets on a certain route, the other companies in the group will quickly match the new sales price. A popular type of oligopoly is known as a cartel. This is a group of competitors who work together under a formal agreement that fixes prices and levels of output. An example is the Organization © Strayer University. All Rights Reserved. This document contains Strayer University confidential and proprietary information and may not be copied, further distributed, or otherwise disclosed, in whole or in part, without the expressed written permission of Strayer University. JWI 515 – Week 6 Lecture Notes (1202) Page 3 of 6 JWI 515: Managerial Economics Week 6 Lecture Notes of Petroleum Exporting Countries (OPEC), a large international cartel which seeks to control the market for oil. OPEC operates openly and legally as a mechanism that limits competition in the oil market, which benefits all the members of the cartel, but is decidedly less beneficial to the consumers buying oil and oil-based goods. Oligopolies may also arise in a more informal or unplanned manner, due to the constraints of a market. For example, a small town can support only so many grocery stores, banks, and movie theaters. Thus, in smaller areas, a few companies naturally dominate each business sector. These companies effectively become oligopolies, even though they may have no formal agreement. As a result, their decisions have a major impact on prices in that community. PRICE DISCRIMINATION Price discrimination is the act of selling the same product at different prices to different buyers, in order to maximize profits. In a perfectly competitive market, each firm controls a small percentage of the total industry, which means no one firm can control the overall price of the product. Information is widely available to all companies in a state of perfect competition, so setting the appropriate market price for products or services is fairly straightforward. In the imperfectly competitive markets of the real world, it is harder to determine the ideal combination of price and output for different target markets that will maximize a company’s revenue. This is where understanding the effects of price discrimination becomes relevant. Setting Prices There are two basic methodologies used by companies to set prices for a good or service. These two approaches are fundamentally different from each other. It is important for business leaders to understand the difference. The two approaches are markup pricing and margin pricing. Markup Pricing Markup pricing is a common way to maximize profits. The markup is fundamentally the extra amount of money charged beyond what it costs the company to produce the item. In practice, markups can be calculated in two different ways: either (1) based on a percentage of the cost to produce or purchase the product; or (2) based on a profit margin percentage of the product’s price. The terms markup and margin are often used interchangeably by non-economists, but they are © Strayer University. All Rights Reserved. This document contains Strayer University confidential and proprietary information and may not be copied, further distributed, or otherwise disclosed, in whole or in part, without the expressed written permission of Strayer University. JWI 515 – Week 6 Lecture Notes (1202) Page 4 of 6 JWI 515: Managerial Economics Week 6 Lecture Notes not actually the same thing. The markup is the difference between the actual cost and the selling price. The margin is the difference between the selling price and the profit made. Clearly, they are related concepts, but there can be situations where they are different. One such situation is when a company decides to sell an item at a loss for a period, so as to introduce it into the market. Both markup and margin are typically expressed as percentages. The difference between markup and margin is important because a given percent markup over cost does not necessarily equal the same percent gross profit margin. A company may use either or both the markup or margin methods for setting its prices. While the markup method is simpler for the accounting department to calculate, savvy leaders tend to use the margin method, since this generally provides a truer picture of the profits being generated. First, Second, and Third Degree Price Discrimination The objective of price discrimination is to maximize revenue across the market by taking advantage of the differences between groups of consumers in your target market, especially the different prices they are willing to pay. This means the seller must divide the market for its goods into groups or segments and ascertain what price will work for each group. Economists say that each market segment has a different price elasticity. Markups are assigned to each group based on their elasticity of demand. When price elasticity of demand is low, the variation in price between target groups in the market is small and the overall achievable markup is small. When price elasticity of demand is high, the variation in price between target groups is large and the overall achievable markup is larger. There are three significant types of price discrimination that sellers use to increase sales of their goods and services. The proper term for these in economics is degrees of price discrimination. • First-degree price discrimination This occurs when the seller charges the highest price consumers are willing and able to pay. It is quite rare, but can happen where sellers have significant market power, such as with durable goods like automobiles.
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