WEEK 4 RESEARCH PROJECT
Complete your Research Project 1 in a Word document, APA formatted, and then submit it in the Assignment section of the classroom by midnight, EST, Day 7.
The instructions concerning this assignment as well as the grading rubric are reproduced below.
Pricing strategy varies significantly across different market structures. The pricing guidelines in a monopoly market are relatively straightforward. Since the company is the only producer offering the product, it can mark-up the price as far as the customer can bear. The pricing strategies for a producer operating in a perfect competition structure are also fairly intuitive. They are price takers, and hence price is set at the marginal cost of the product. This is due to the fact that there are many firms offering nearly identical products. However, there is optimal pricing for the market structures offering differentiated products with many competitors (oligopoly) or a few producers (monopolistic competition). These are much more complex and involved. It has been stated that differentiation in products that creates differences in customer valuation is the most prevalent type of competition. In such markets pricing strategies may include the three C’s of cost, competition, and customer.
Develop a paper detailing an analysis of market structures and relating pricing strategies that are suitable for each of these structures. Furthermore, include a real world example of pricing strategy for a specific company by identifying its market structure.
Your paper should be around 10 double spaced pages, in APA Format and structured as follows:
Cover page with a running head
Abstract
1. Perfect Competition
1.1. Description
1.2. Pricing Strategies
2. Monopolistic competition
2.1. Description
2.2. Pricing Strategies
3. Oligopoly
3.1. Description
3.2. Pricing Strategies
4. Monopoly
4.1. Description
4.2. Pricing Strategies
5. Case Study
6. Conclusion
References
Your paper needs to include at least three scholarly sources, i.e. peer reviewed articles.
LO1: Identify the purpose of managerial economics
LO2: Identify and discuss the six-step model of decision making
LO3: Identify how the firm’s profit-maximizing level of output is determined including the optimal condition in terms of the basic components, marginal revenue and marginal cost
LO4: Define a multi-variable demand function and identify its purposes
LO5: Explain the relationship between price elasticity of demand and revenue
LO6: Discuss how a firm can maximize its profit by using optimal markup pricing and price discrimination
LO7: Explain how empirical analysis is both “art and science”
LO8: Explain the statistics that are generated by regression analysis
The Example of Perfect Competition
To provide an example, let me discuss more at length the special case of perfect competition, a structure where pricing strategies of firms are straightforward. I will not steal your thunder since you will be discussing pricing strategies in your midterm paper, but I would like to discuss the assumptions underlying perfect competition, since they are strict and quite restrictive. Let me summarize them here.
Simply put, perfect competition describes a situation where there is a large number of firms that produce and sell identical products. This is fairly rare in real life, as most products have a degree of differentiation. It is an important assumption, though, because it determines the behavior of buyers: since they see no difference between the products offered, they will only purchase from the seller with the lowest price.
Oligopolies and monopolistic competition
BARRIERS TO ENTRY
Not only do products have to be identical or homogenous, but firms need to be able to enter the market with little investment if they find it attractive. In the same way, firms that are currently in the market need to be able to leave the market if they find the market unattractive. In other words, perfect competition assumes that the market has no barriers to entry or exit. This condition is important for these markets to converge toward long-run equilibrium.
To provide a definition, a barrier to entry is any factor or characteristic of the industry that creates an advantage for firms present on a market over any other wishing to enter the market. There are many factors that can prevent or limit the entry of new firms. The main ones are:
- legal rights such as patents, state or federal license,
- economies of scale: existing large firms benefit from lower average costs that would not be attainable by a smaller firm entering the market,
- investment requirements. The initial investment to enter some industries is very high. Think about starting an aviation company, for instance. A large initial capital requirement makes an entry in the industry very risky, and thus protects existing firms.
It would take too long to list all the potential barriers to entry. Let me mention two more. First, consumers may be loyal to established products with strong brand recognition, making entries of new firms very challenging. Second, some technological products have a value that depends on the existing number of customers. This network effect provides a strong protection to a market where established companies have already captured a large customer base.
References
Samuelson W.F. & Marks S.G. (2015). Managerial Economics. Hoboken, NJ: Wiley & Sons Inc.
Smith, Vernon L. (1994). Economics in the Laboratory, Journal of Economic Perspectives 8 (1), p 113-131.
Pricing strategy varies significantly across different market structures of perfect competition, monopolistic competition, oligopoly and monopoly which are complex. As discussed in detail in your textbook, the assessment of market structure is conducted on the basis of
- intensity of competition, depending on the number of firms in the industry,
- homogeneity of products, evaluated by the extent of substitutability of a firm product by the products of its rivals,
- barriers to entry, estimated by the complexities and obstacles confronting potential firms from entering the industry,
- information asymmetry, assessed by the degree of availability of knowledge of price to buyers.
Perfect information
The last characteristic of perfect competition I want to discuss is the condition that buyers and sellers are assumed to have perfect information on the market.
This means, for instance, that all buyers and sellers are supposed to know the prices offered by all sellers, and that sellers have immediate access to any resource used by another seller. This is clearly a tall order, even though the development of online shopping is a step in that direction. By the way, you will find a discussion of the pros and cons of using the internet as an example of perfect competition in your textbook (Samuelson & Marks, 2015, p. 232).
Why Study Perfect Competition?
As we briefly discussed, many of the assumptions underlying perfect competition are so restrictive that it is pretty much impossible to have truly perfectly competitive markets in real life. The question naturally arises: why bother? What can be gained from a study of perfectly competitive markets, if these markets do not exist practically? It is argued in most textbooks that perfect competition is the ideal situation that allows comparison of other structures to a standard, but I believe there is more to the story.
In fact, some recent experiments have shown that the study of perfect competition can provide results that are applicable to many real-life situations.
A new discipline has emerged about 50 years ago, often called for lack of a better term ‘experimental economics’. It is based on the idea to replicate what scientists do in fields like physics and chemistry, where it is possible to design experiments performed in labs to test hypotheses, and validate (or invalidate) them.
Economists have used the same principle and conducted a number of experiments to test the validity of key elements of economic theory.
One of the main contributors to this experimental approach to economics has been Vernon Smith, who won the 2002 Nobel Prize in Economics for this work in experimental economics.
In one of his early experiments, published in the Journal of Economic Perspective (Smith, 1994), Smith brought individuals into a confined setting and randomly separated them into two groups: buyers and sellers of a commodity we can call C for convenience. In real life, each potential buyer had in mind a maximum price he or she would be willing to pay for a unit of C. To replicate this situation, each buyer was confidentially given his or her maximum price. If the buyers had been able to communicate and plot their numbers on a graph, they would have seen the demand curve for this commodity. To provide an incentive that would replicate a real life situation, each buyer was told he would receive a cash payment equal to the difference between the price at which he/she was able to purchase the commodity, and the maximum price he/she was willing to pay. Clearly, each buyer gained financially by purchasing at lower prices – just as you and I do in real life when we purchase any good.
The sellers had the opposite strategy. They were assigned a minimum value representing their cost, and if they were able to sell the commodity for more than this minimum, they would receive a cash payment for the difference.
Buyers and sellers were free to negotiate individually with each other until they agree on a price.
Clearly, since Vernon Smith knew the prices given to every participant, he was able to draw a demand and supply curve and to determine the equilibrium price for the commodity he created. He was also able to calculate the total cash amount that both buyers and sellers would receive as a group if all transactions occurred at the equilibrium price. This information was provided to all participants in a sealed envelope that would be opened at the end of the experiment.
Once the experiment was over, participants described it as chaotic – which is easy to believe since every buyer was trying to negotiate with as many sellers as possible – and vice-versa. We can imagine their surprise when they opened the sealed envelope they had received early on: they saw that their seemingly disorganized actions had achieved close to the maximum possible income for their group and that most transactions had occurred close to the equilibrium price.
These and similar experiments indicate that the outcome approximating those of perfect competition emerge even when the restrictive assumption of the model is not exactly met. This is the case, for instance, in situations where the number of sellers is relatively small, in the 10 to 15 range.
Conclusion
In this lesson, we discussed how markets are classified according to four main guiding principles: number and size of the firm, the degree of product differentiation, the amount and cost of information about product price and quality, and the ease of entry in the market. Next, we covered information on the perfect competition by providing an example.
Various types of limitations were discussed as barriers to entry for firms. Lastly, perfect information and its importance were introduced to the course. It is important to remember that, although practically non-existent, perfect competition is an ideal situation which can be used as a standard by firms.
I hope you enjoyed this introduction to market structures. As you work on your first research paper this week, make sure to refer to the description of the project as well as to the grading rubric. I look forward to reading your work!
References
Dou, W. W., Ji, Y., & Wu, W. (2022). Oligopoly Lucas Tree. Review of Financial Studies, 35(8), 3867–3921. https://doi.org/10.1093/rfs/hhab120
Hoof, S. (2021). Dynamic Monopolistic Competition: A Steady-State Analysis. Journal of Optimization Theory & Applications, 189(2), 560–577. https://doi.org/10.1007/s10957-021-01843-w
Hovenkamp, H. (2021). Antitrust and Platform Monopoly. Yale Law Journal, 130(8), 1952–2050.