MARKET STRUCTURE AND PRICING DECISIONS

The determination of prices and output levels is very much affected by the competitive structure
of the market. Here “Competitive Structure” is a phrase which refers to the nature and extent of
the monopolistic elements that are present in any particular market situation.

MARKET STRUCTURE

PERFECT IMPERFECT

MONOPOLISTIC COMPETITION OLIGOPOLY DUOPOLY MONOPOLY

PERFECT COMPETITION

An industry is said to be operating under perfect competition when the following conditions are
satisfied.

i. Large number of firms: There must be a large number of firms in the industry. Each
firm controls only a very insignificant share of total output, so that any action ( addition
to/removal from the market) on its own part will have little or no effect on the price and
the output of the whole industry. The same holds good in the case of customers.
ii. Homogeneous Product: Each firm in the industry must be making a product which is
accepted by buyers as being identical or homogeneous, with that made by all the other
producers in the industry. This ensures that no producer can put his price up above the
general level.
iii. Freedom of Entry and Exit: Any individual or company with the funds and inclination
must be able to enter the industry without artificial hindrances being erected against him,
and any owner of a firm in the industry, who wants to leave the field, is free to do so.
iv. Independent Decision Making: Firms can take independent decisions. There should not
be any collusion or agreement between firms in decision making.
 v. Perfect Knowledge about the Market: There is perfect knowledge on the part of all
producers, consumers and resource owners regarding the conditions prevailing in the
market.
vi. Perfect Mobility of Factors: There is perfect mobility of factors of production among
different firms in the industry and among different industries in response to peculiarly
signals and transport costs are ignored.
vii. No Government Intervention: in a perfectly competitive market, there are any
Government interventions with the working of the market system. There is no licensing
system regulating the entry of the firms to the industry, no regulation of market prices.

Perfect competition is an uncommon phenomenon in the real business world. Perfect competition
model has been the most popular model used in economic theories due to its analytical value as it
provides a starting point and analytical frame work for pricing theory.

Price Determination under Perfect Competition:

Market Price in a perfectly competitive market is determined by the market forces – Market
Demand and Market Supply.

Market Demand: It refers to the demand for the industry as a whole. It is the sum of the
quantity demanded by individuals and consumers at different prices.

Market Supply: It is the sum of the quantity supplied by the individual firms in the industry.

In a perfectly competitive market the main problem for a profit maximizing firm is not to
determine the price of its product but to adjust its output to the market price so that profit is
maximum.

Price determination depends on the time taken by the supply position to adjust itself to the
changing demand conditions.

Pricing in Market Run: Price determination under perfect competition is analyzed under three
different time periods:

1. Market Period (Very Short Run)

2. Short Run
3. Long Run
1. Pricing in Market Period:

In a market Period, the total output of a product is fixed. Since the stock is fixed, the supply
curve is perfectly inelastic. That is the price is determined solely by the demand condition.
Supply remains an inactive agent.

In case of supply determined price, supply curve shifts leftward causing rise in price of the Short
supply goods. This phenomenon is illustrated in figure 1.
Figure1

Given the demand curve DD’ and supply curve S2, the price is determined at OP. Demand curve
remains the same, the fall in supply makes the supply curve shift leftward to S1. As a result price
increases from OP1 to OP2.

The other examples of very short run markets may be daily fish market, stock market, and coffin
markets during a period of natural calamities etc.

2. Pricing in the Short Run:

A short run is, a period in which firms can neither change their size nor quit, nor can new
firms enter the industry. In very short run the supply is fixed but it is possible in short run
to increase /decrease the supply by increasing/decreasing the variable inputs. That is in
short run the supply curve is elastic.
 The determination of market price in the short run is illustrated in the above
figure 1, and adjustment of output by the firm to the market price and firms
equilibrium are shown in figure2.

The figure1 shows the price determination for the industry by the demand
curve DD and supply curve SS, at the price OP1 or PQ. The price is fixed for all the
firms in the industry.

Given the price PQ (=OP1) an individual firm can produce and sell any
quantity at this price. But any quantity will not yield maximum profit. Given their
cost curves the firms are required to adjust their output to the price PQ so that they
maximize their profit.

The process of firm’s output determination and its equilibrium are shown
in figure 2. We know that the profit is maximum at the level of output where
MR=MC. Since price is fixed at PQ, firm’s AR=PQ. If AR is given MR=AR. The firms
MR is shown by AR=MR line. Firm’s upward sloping MC curve intersects AR=MR at
point E. At point E, MR=Mc. Point E is firm’s equilibrium point. An ordinate EM
drawn from point E to the horizontal axis determines the profit maximizing output at
OM. At this output firm’s MR=MC. This satisfies the necessary condition of
maximum profit. The total maximum profit has been shown by the area P1TNE. The
total profit may be calculated as PROFIT= (AR-AC)Q.

In figure 2 AR=EM, AC=NM, Q=OM; substitute these values into the

profit equation, we get, PROFIT= (EM-NM) OM=P1TNE. Since EM-NM,
PROFIT=EN*OM=P1TNE. This is the maximum super normal profit, gives the price
and cost curves, in the short run.

3. Pricing in the long run:

In contrast to the short run, in the long run, the firms can adjust their size
or quit the industry and new firms can enter the industry. If market price is such
that AR>AC, then the firms make economic or super-normal profit. As a result, new
firms get attracted towards the industry causing a rightward shift in the supply
curve. Similarly if AR>AC, then the firms make losses. Therefore, marginal firms
quit the industry causing a leftward shift in the supply curve. The rightward shift in
the supply curve pulls down the price and its leftward shift pushes it up. This
process continues until price is so determined that AR=AC, and firms earn only
normal profit.
The price determination in the long run and output or size adjustment by
an individual firm are presented in the figure given below.
 Let us suppose that the long run demand curve is DD’, the short run
supply is SS1 and price is determined at OP1. At this price the firms adjust their output to
point M, the equilibrium point, where OP1=AR’=MR’=LMC. Firms make an economic
profit of MS per unit. The super normal profit attracts other firms into the industry.
Consequently the industry’s supply curve shifts rightward to SS2 causing a fall in price to
op2. At this price firms are making losses because AR<LAC. Firms incurring losses cannot
survive in the long run. Such firms quit the industry. As a result, the total production in the
industry decreases causing a leftward shift in the supply curve say to the position of SS.
Price is determined at OP0. The existing firms adjust their output to the new market price,
at OQ; At the output OQ, firms are in a position to make only normal profit, Since at this
output, OP0=AR=MR=LMC=LAC(=EQ). No firm is in a position to make economic profit,
nor does any firm make loss. Therefore, there is no tendency of new firms entering the
industry or the existing ones going out. At this price and output, individual firms and the
industry are both in long run equilibrium.