Pricing Theory: Pricing Under Different Market Conditions (Perfect Competition, Imperfect Competition and Monopoly)8th February 2020
The theory of price is an economic theory whereby the price for any specific good or service is based on the relationship between supply and demand. The theory of price posits that the point at which the benefit gained from those who demand the entity meets the seller’s marginal costs is the most optimal market price for the good or service.
The theory of price, or price theory, is a microeconomic principle that uses the concept of supply and demand to determine the appropriate price point for a good or service. The goal is to achieve the equilibrium where the quantity of the goods or services provided match the demand of the corresponding market and its ability to acquire the good or service. The concept allows for price adjustments as market conditions change.
For example, suppose that market forces determine that a widget costs $5. A widget buyer is, therefore, willing to forgo the utility in $5 to possess the widget, and the widget seller perceives that $5 is a fair price for the widget. This simple theory of determining prices is one of the core principles underlying economic theory.
Pricing under different market conditions
- Perfect Competition
A perfectly competitive market is one in which the number of buyers and sellers is very large, all engaged in buying and selling a homogeneous product without any artificial restrictions and possessing perfect knowledge of market at a time. In the words of A. Koutsoyiannis, “Perfect competition is a market structure characterised by a complete absence of rivalry among the individual firms.” According to R.G. Lipsey, “Perfect competition is a market structure in which all firms in an industry are price- takers and in which there is freedom of entry into, and exit from, industry.”
Characteristics of Perfect Competition
The following are the conditions for the existence of perfect competition:
(a) Large Number of Buyers and Sellers
The first condition is that the number of buyers and sellers must be so large that none of them individually is in a position to influence the price and output of the industry as a whole. The demand of individual buyer relative to the total demand is so small that he cannot influence the price of the product by his individual action.
Similarly, the supply of an individual seller is so small a fraction of the total output that he cannot influence the price of the product by his action alone. In other words, the individual seller is unable to influence the price of the product by increasing or decreasing its supply.
Rather, he adjusts his supply to the price of the product. He is “output adjuster”. Thus no buyer or seller can alter the price by his individual action. He has to accept the price for the product as fixed for the whole industry. He is a “price taker”.
(b) Freedom of Entry or Exit of Firms
The next condition is that the firms should be free to enter or leave the industry. It implies that whenever the industry is earning excess profits, attracted by these profits some new firms enter the industry. In case of loss being sustained by the industry, some firms leave it.
(c) Homogeneous Product
Each firm produces and sells a homogeneous product so that no buyer has any preference for the product of any individual seller over others. This is only possible if units of the same product produced by different sellers are perfect substitutes. In other words, the cross elasticity of the products of sellers is infinite.
No seller has an independent price policy. Commodities like salt, wheat, cotton and coal are homogeneous in nature. He cannot raise the price of his product. If he does so, his customers would leave him and buy the product from other sellers at the ruling lower price.
The above two conditions between themselves make the average revenue curve of the individual seller or firm perfectly elastic, horizontal to the X-axis. It means that a firm can sell more or less at the ruling market price but cannot influence the price as the product is homogeneous and the number of sellers very large.
(d) Absence of Artificial Restrictions
The next condition is that there is complete openness in buying and selling of goods. Sellers are free to sell their goods to any buyers and the buyers are free to buy from any sellers. In other words, there is no discrimination on the part of buyers or sellers.
Moreover, prices are liable to change freely in response to demand-supply conditions. There are no efforts on the part of the producers, the government and other agencies to control the supply, demand or price of the products. The movement of prices is unfettered.
(e) Profit Maximization Goal
Every firm has only one goal of maximizing its profits.
(f) Perfect Mobility of Goods and Factors
Another requirement of perfect competition is the perfect mobility of goods and factors between industries. Goods are free to move to those places where they can fetch the highest price. Factors can also move from a low-paid to a high-paid industry.
(g) Perfect Knowledge of Market Conditions
This condition implies a close contact between buyers and sellers. Buyers and sellers possess complete knowledge about the prices at which goods are being bought and sold, and of the prices at which others are prepared to buy and sell. They have also perfect knowledge of the place where the transactions are being carried on. Such perfect knowledge of market conditions forces the sellers to sell their product at the prevailing market price and the buyers to buy at that price.
(h) Absence of Transport Costs
Another condition is that there are no transport costs in carrying of product from one place to another. This condition is essential for the existence of perfect competition which requires that a commodity must have the same price everywhere at any time. If transport costs are added to the price of the product, even a homogeneous commodity will have different prices depending upon transport costs from the place of supply.
(i) Absence of Selling Costs
Under perfect competition, the costs of advertising, sales-promotion, etc. do not arise because all firms produce a homogeneous product.
Perfect Competition vs Pure Competition
Perfect competition is often distinguished from pure competition, but they differ only in degree. The first five conditions relate to pure competition while the remaining four conditions are also required for the existence of perfect competition. According to Chamberlin, pure competition means, competition unalloyed with monopoly elements,” whereas perfect competition involves perfection in many other respects than in the absence of monopoly.” The practical importance of perfect competition is not much in the present times for few markets are perfectly competitive except those for staple food products and raw materials. That is why, Chamberlin says that perfect competition is a rare phenomenon.”
Though the real world does not fulfill the conditions of perfect competition, yet perfect competition is studied for the simple reason that it helps us in understanding the working of an economy, where competitive behaviour leads to the best allocation of resources and the most efficient organization of production. A hypothetical model of a perfectly competitive industry provides the basis for appraising the actual working of economic institutions and organizations in any economy.
- Imperfect Competition
Imperfect competition exists whenever a market, hypothetical or real, violates the abstract tenets of neoclassical pure or perfect competition. The contemporary theory of imperfect versus perfect competition stems from the Cambridge tradition of post-classical economic thought.
Characteristics of Imperfect competition
(i) Large number of Sellers and Buyers
There are large numbers of sellers in the market. All these firms are small sized. It means that each firm produces or sells such an insignificant portion of the total output or sale that it cannot influence the market price by its individual action. No firm can affect the sales of any other firm either by increasing or reducing its output; so there is no reaction from other firms. Every firm acts independently without bothering about the reactions of its rivals. There are a large number of buyers and none of them can affect price by his individual action.
(ii) Product Differentiation
Another important characteristic is product differentiation. The product of each seller may be similar to, but not identical with the product of other sellers in the industry. For example, a packet of Verka butter may be similar in kind to another packet of Vita butter, but because of the idea that there are differences, real or imaginary, in the quality of these two products, each buyer may have a definite preference for the one rather than for the other. As a result, each firm will have a group of buyers who prefer, for one reason or another, the product of that particular firm.
(iii) Selling Costs
Another important characteristic of the monopolistic competition is existence of selling costs. Since there is product differentiation and products are close substitutes, selling costs are important to persuade buyers to change their preferences, so as to raise their demand for a given article. Under monopolistic competition, advertisement is not only persuasive but also informatory because a large number of firms are operating in the market and buyer’s knowledge about the market is not perfect.
(iv) Free Entry and exit of Firms
Firms under monopolistic competition are free to join and leave the industry at any time they like to. The implication of this characteristic is that by entering freely into the market, the firms can produce close substitutes and increase the supply of commodity in the market. Similarly, the firm commands such a meager amount of resources that in the event of losses, they may easily quit the market.
(v) Price makers
In the monopolistic competitive market, each firm is a price-maker as it can determine the price of its own brand of the product.
(vi) Blend of Competition and Monopoly
In this market, each firm has a monopoly power over its product as it would not lose all customers if it raises the price as its product is not perfect substitute of other brands. At the same time, there is an element of competition because the consumers treat the different firms’ products as close substitutes. Hence, if a firm raises the price of its brand, it would lose some customers to other brands.
- Monopoly Market
Monopoly is a market situation in which there is only one seller of a product with barriers to entry of others. The product has no close substitutes. The cross elasticity of demand with every other product is very low. This means that no other firms produce a similar product. According to D. Salvatore, “Monopoly is the form of market organization in which there is a single firm selling a commodity for which there are no close substitutes.” Thus the monopoly firm is itself an industry and the monopolist faces the industry demand curve.
The demand curve for his product is, therefore, relatively stable and slopes downward to the right, given the tastes, and incomes of his customers. It means that more of the product can be sold at a lower price than at a higher price. He is a price-maker who can set the price to his maximum advantage.
However, it does not mean that he can set both price and output. He can do either of the two things. His price is determined by his demand curve, once he selects his output level. Or, once he sets the price for his product, his output is determined by what consumers will take at that price. In any situation, the ultimate aim of the monopolist is to have maximum profits.
Characteristics of Monopoly
The main features of monopoly are as follows:
- Under monopoly, there is one producer or seller of a particular product and there is no difference between a firm and an industry. Under monopoly a firm itself is an industry.
- A monopoly may be individual proprietorship or partnership or joint stock company or a cooperative society or a government company.
- A monopolist has full control on the supply of a product. Hence, the elasticity of demand for a monopolist’s product is zero.
- There is no close substitute of a monopolist’s product in the market. Hence, under monopoly, the cross elasticity of demand for a monopoly product with some other good is very low.
- There are restrictions on the entry of other firms in the area of monopoly product.
- A monopolist can influence the price of a product. He is a price-maker, not a price-taker.
- Pure monopoly is not found in the real world.
- Monopolist cannot determine both the price and quantity of a product simultaneously.
- Monopolist’s demand curve slopes downwards to the right. That is why, a monopolist can increase his sales only by decreasing the price of his product and thereby maximize his profit. The marginal revenue curve of a monopolist is below the average revenue curve and it falls faster than the average revenue curve. This is because a monopolist has to cut down the price of his product to sell an additional unit.