Pricing Behavior of Firms
In this lesson, you’re expected to learn:
– the factors that affect price setting by firms
– pricing strategies in different market structures
– how pricing behavior influences competition and cooperation between firms
Businesses engage in many pricing (and non-price-related) competitions in order to increase their profits.
The pricing behaviors they choose are generally related to the type of market they are in.
Factors Affecting Change in Price
Having a pricing objective isn’t enough. A firm also has to look at a myriad of other factors before setting its prices.
Those factors include the offering’s costs, the demand, the customers whose needs it is designed to meet, and the external environment—such as the competition, the economy, and government regulations.
In addition, other aspects of the marketing mix, such as the nature of the offering, the current stage of its product life cycle, and its promotion or distribution also affect price setting.
How Do Firms Set Prices?
A standard result in imperfectly competitive models is that, under quite general conditions, firms choose to charge a price that represents a mark-up over marginal cost and have therefore some room for not adjusting it when facing a variation in costs.
On the contrary, in the case of perfect competition, all firms belonging to the same market set their prices at a unique market clearing level; there is no mark-up and prices always equal marginal costs.
Pricing in Oligopolies
Interdependence leads oligopolists to behave strategically. The strategic pricing behaviors that occur in oligopoly include price leadership and price wars.
In addition to these pricing behaviors, oligopolies also engage in non-price competition. The purpose of these price and non-price behaviors is the same, however, and that is to maximize oligopolistic firms’ profits.
Price leadership takes place when a dominant firm makes the pricing decision for the rest of the market. These decisions are often made public long before the new price goes into effect, and represent a form of tacit collusion.* Smaller firms in the industry will usually follow suit and match the price leader’s price.
Price leadership offers firms an opportunity to capture a price that is higher than would occur if the firms directly competed on price. Consumers usually fare better under price leadership than they would if the firms formed a cartel** but worse than if they were highly competitive.
** Cartel: A group of producers that agree to cooperate instead of compete with each other. Cartels seek higher profits for their members by collectively reducing production in order to increase prices.
Some firms have been accused of financing price wars by raising prices in one part of their market in order to cut their price in another part of their market. A price war continues until the firms once again reach tacit collusion and return to the price leadership model.
When operating under price leadership, firms compete on the basis of product differentiation as opposed to price.
By emphasizing their product’s differences and uniqueness, firms attempt to capture market share from one another. As in the monopolistically competitive market, oligopolists engaging in non-price competition will spend large sums on advertising.
For example, the major American beer brands do not compete on price, but instead rely on non-price competition in the form of advertising in order to gain market share from one another.
Monopolies are generally not allowed to exist, and efforts are made by government regulators in some countries to prevent their creation.
The reason for this prohibition is that monopolies create a serious problem for both consumers and likely competitors in the marketplace.
Despite the fact that monopolies are undesirable, there are several good reasons for some to exist. The following are the primary reasons for the existence of most monopolies:
• economies of scale
• government protection
Monopoly occurs when a competitive firm eliminates all competition. Through control of key resources, mergers, and even a little help from the government, once-competitive firms may find themselves in the enviable position of being a monopolist.
A typical pricing behavior for a monopoly is to increase prices as much as possible.
Because they lack competition, monopolies can engage in price discrimination to make it difficult for other firms to do business.
Price discrimination is the ability to charge different customers different prices for the same good or service.
Some forms of price discrimination still exist because they are seen as acceptable.
You might have benefited from price discrimination the last time you flew on an airplane.
Business travelers and vacationers often pay very different prices for tickets on the same flight (in the same class).
How do airlines get away with this?
It is defensible because vacationers and business travelers have different elasticities of demand for airline tickets. Vacationers have elastic demand for tickets because they are able to book travel months in advance and are often willing to purchase non-refundable fares.
Business travelers’ demand is much more inelastic, and thus they are willing to pay the higher price for the convenience of refundable fares and the privilege of booking tickets at short notice. By being allowed to charge different prices for basically the same ticket, the airline is able to better ration tickets between those who need a ticket and those who want a ticket.
What is Collusion?
Collusion means any type of illegal conspiracy. For economists, collusion also implies an intent to cheat or defraud consumers (and others) by artificially reducing competition.
Businesses that collude may form cartels.
What is a Cartel?
In economics, a cartel is an agreement between competing firms to control prices or exclude entry of a new competitor in a market. It is a formal organization of sellers or buyers that agree to fix selling prices, purchase prices, or reduce production using a variety of tactics.
It is a group of businesses that effectively function as a single producer or monopoly able to charge whatever price the market will bear.
A good example of a modern cartel is the Organization of the Petroleum Exporting Countries, also known OPEC.
OPEC is an organization made up of thirteen oil-exporting countries, that seeks to maintain high oil prices and profits for their members by restricting output. Each member of the cartel agrees to a production quota that will eventually reduce overall output and increase prices.
Fortunately for consumers, the individual members of a cartel have an incentive to cheat on their agreement. Cartels go through periods of cooperation and competition.
When prices and profits are low, the members of the cartel have an incentive to cooperate and limit production. If the cartel is successful, the market price of the commodity will rise.
Individual members driven by their own self-interest will have an incentive to slightly exceed their production quota and sell the excess at the now higher price. The problem is that all members have this incentive and the result is that eventually prices will fall as they collectively cheat on the production quota.