Pricing Behavior of Firms

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.

1) Price Leadership

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.

* Tacit Collusion occurs where firms undergo actions that are likely to minimize a response from another firm, e.g. avoiding the opportunity to price cut an opposition. Put another way, two firms agree to play a certain strategy without explicitly saying so.

** 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.

2) Price Wars

Price wars occur when firms break out of the price leadership model and begin undercutting one another’s prices. Although it sounds bad, price wars are often advantageous to consumersbecause of the competitive prices created in the process.

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.

Product Differentiation

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.

[Optional] Price and Output Determination under Oligopoly
Pricing in Monopolies

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
• geography
• government protection

Price Increases

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.

[Optional] 10 Companies You Probably Never Realized Had Monopolies
Price Discrimination

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.

Example of Price Discrimination in Airline Tickets:

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.

[Optional] Examples of Price Discrimination
Collusive Pricing
One of the benefits of competition is that it leads to lower prices for consumers. For the producer, however, low prices often mean low profits. Given a choice between competition and cooperation, profit-maximizing firms would more often than not prefer cooperation.  

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.

How Collusion Works

Even though it violates the law, businesses from time to time will collude in order to set prices.

Colluding firms can divide up the market in a way that is beneficial for them. The firms avoid competition, set higher prices, and reduce their operating costs.

Because collusion is illegal and punishable by fine and prison, executives at firms are reluctant to engage in the practice.

Forming Cartels

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.

Example of a Cartel:

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.

[Optional] 5 Brazen Examples of Price Fixing
Jim Rohn Sứ mệnh khởi nghiệp