Research Project 1 Terry Smith (3)

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Pricing Strategy Across Different Market Structures Terry J. Smith American Public University ECON600: Managerial Economics Dr. Fassil Fanta 31 March 2024

2 Pricing S trategy A cross D ifferent M arket S tructures Introduction The paper comprehensively explores the existing market structures and their critical role in pricing strategies. There is an intricate dance between the market forces and pricing decisions, which are essential in defining the competitive landscape. It is also said to influence the consumer experience, and the paper would aim to dissect the nuance of the different market structures, each of which has unique characteristics and strategic implications when it comes to pricing. The paper will make use of theoretical literature and real-world examples to highlight the complexities of pricing strategies within these frameworks that will end with a case study focusing on one of the companies that would help highlight how the market structures and pricing have influenced the said company that would help bridge theory with tangible market realities. Perfect Competition The first of the market is perfect competition, representing the idealized market structure that often acts as a benchmark in economic analysis. This type of market is characterized by a highly competitive nature where many small firms would compete against each other, and within this utopian market scenario, all the firms would be selling homogenous or identical products that would ensure that no one company would be able to exert influence on the market price (Hayes, 2022; Triani, 2023). This would mean that the market is only influenced by the market forces. Another characteristic is the perfect information availability, as information about the ecosystem and competition is often said to provide a significant advantage. In some of the

3 research-intensive industries, like pharmaceuticals, information about patients and research initiatives could help companies develop competitive strategies and build a moat around their products. The availability of perfect information is also free and ensures that each firm can produce its products or services at the same rate and using the same techniques (Hayes, 2022). In this type of market, the government plays a critical role in forming the market by ensuring regulations and price controls. They would be able to control the entry and exit of firms into the market by creating rules to function in the market. For example, in the pharmaceutical industry, there is a set of rules governed by the FDA that need to be met. Real-world competition would differ significantly from the deal due to the differentiation in production, sales, and marketing. An example would be that a small organic shop product could advertise extensively about grain fed to the cows that made the manure that fertilized the non-GMO crop, which would help them differentiate their product from the competitors. This is called differentiation and is a critical aspect of marketing (Islami et al., 2020). The expectation of homogenous products and price takes is unrealistic, making the theoretical model less capable but still helpful in explaining the different behaviors. It is mentioned that in perfect competition, the profit margins would be low, and also, due to this, the innovation could be higher as the prospect of a more significant market share or setting themselves apart from the competition is not an incentive for the companies. Pricing Strategy The pricing strategy can be explained well using the demand and supply chart provided in Figure 1.

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4 Figure 1 Perfect Competition (Pettinger, 2019) In this graph, P represents the price, Q represents the quantity, MC represents the marginal cost, and AC represents the average cost curve. The intersection between AC and MC at its lowest point indicates productive efficiency. The demand curve for firm D1 is found to be perfectly elastic, shown by the horizontal line at price level P1, which implies that the firms could sell any quantity at the market price but not above that. Supernormal profits are a short- term situation where the firm could profit above the average profit level. These supernormal profits would attract new entrants caused by increased demand for D2. However, the entry would push the price down, and this dynamic would continue until the price reaches a point where it would just cover the average cost, which means there would be only a minimum level of profit. This also shows that the aggregate supply and demand determine the market price, and individual firms must accept this price. If a firm attempts to set a higher price, then the buyers will turn to other sellers who offer the same product at the market price. The focus here is on ensuring that the marginal cost of production equals the market price and marginal revenue. Marginal cost refers to the cost of production of additional units of goods or services, and in

5 perfect competition, the optimal output level for a firm is where the price is the same as the MC of production. Monopolistic competition A monopoly is said to exist in a market when one supplier provides a good or service to many consumers. In such markets, the monopoly is known to exert control over the price and supply in the market. These markets often have just one seller that controls the production and distribution of the goods and services, and there are also high levels of barriers to entry that prevent other companies from entering these markets. Since there are no alternatives as the entry is difficult, there are no alternatives, and it could be mentioned that a monopoly would have absolute product differentiation because no other goods are comparable (Bertoletti & Etro, 2022; Parenti et al., 2017). Monopolistic competition would exist between monopoly and perfect competition and includes companies that have similar but not identical product offerings. Restaurants and clothing are examples of monopolistic competition where the demand is highly elastic for the competing companies, and pricing is often a key strategy. One company could opt to lower prices, which would reduce its profit margins but gain more market share, while another could increase the price and use that in marketing to portray itself as better. Unlike in monopoly, in monopolistic competition, the barriers to entry are low, and often, companies do not consider how their decision would influence the competitors, so they operate without any fear of the challenges posed by it. This is also one of the main advantages as there are various choices for consumers and consistent quality of products is available. That said, many competitors would mean limited economies of scale and inefficient

6 company spending on marketing. There are too many choices in place for consumers, and this would mean extra research is needed. Pricing strategy Unlike perfect competition, the supply and demand forces do not dictate pricing as the firms are selling similar but distinct products. Apple and Samsung sell smartphones, but each has uniqueness and product differentiation, attracting different customer groups. In this type, the pricing strategies are more nuanced and dynamic. Pricing is often a balancing act that weighs the cost of production, the perceived value for product enhancement, and the competitive landscape. An example of pricing is the short-run decision on output and price, and Figure 2 provides an illustration of this. Profits are at their peak in the market when the marginal revenue (MR) is equivalent to the minimum cost (MC), and the point of meeting determines the equilibrium output. At the point where the imaginary line from the equilibrium output passes through the intersection and meets the average revenue curve, which is also the demand curve, the price is determined.

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7 Figure 2 Monopolistic competition (CFI, 2023) Various pricing strategies are adopted, and each company can choose or adopt several strategies. They can use penetration pricing, which involves setting a low price that attracts customers and helps establish a market presence. They could also use premium pricing, where the quality and other features that differentiate the product are highlighted, and a higher price is justified, similar to that seen in Apple and Samsung. The goal often is maximizing profits while ensuring the products are different. Over time, as new entrants mimic successful product features and saturate the market with alternatives, firms see their demand curve become more elastic, which reduces prices. However, continuous innovation and brand reinforcement strategies help provide unique product offerings and use premium pricing strategies. Oligopoly An oligopoly is a market structure with a small number of firms, each collectively having a significant market share. Moreover, these firms would produce either homogenous or differentiated products. Their markets are characterized by high barriers to entry, which could be

8 due to the economic scale, control of resources, legal patents, or technology (Aziz et al., 2023; Pellegrino, 2023). These types of market structures are considered stable, and one of the reasons for this is that most of the participating firms would need to see the benefits of collaboration over the economic competition and then agree to cooperate. The firms often use this as a tool to find creative ways of price-fixing, setting prices rather than letting the market determine them. The barriers to entry are also the conditions that allow for oligopolies to exist, and globalization has changed the conditions over the years. Over the years, Game theorists have developed models for oligopolies which is based on a prisoner’s dilemma where the cost and benefits would be balanced so that no firm would want to take a break from the group, and this is considered to be the Nash equilibrium, which is a state that can be achieved by market conditions, strategic relationship or legal restriction between the various stakeholders within the oligopoly that would punish the cheaters (Holt & Roth, 2004). Maintaining the market structure and coordinating actions of buying and selling in general on the market is said to involve often shaping the payouts to different dilemmas and related coordination games that would keep repeating over time. The main advantage of this market structure is the limited competition, as there are few players, which allows for higher profits. The increased customer demand is often considered to be high and is because there would be better products and services. The lack of competition does stall innovativeness, which means no diversity in offerings.

9 Pricing strategies The pricing strategies are more varied and often complex due to the interdependencies of the firms. One theory, the Kinked Demand Curve, proposes that the firms could face a demand curve, which is more elastic for a price increase than for a decrease as a result of the asymmetric response observed from the competitors (Wang, 2009; Zhou & Zhou, 2019). It mentions that if one firm reduces its price, others are known to follow or avoid losing market share, but if one firm increases its price, the other may not follow, which would lead to a loss of customers for their competitor. Some strategies include price leadership, where the dominant firm sets the price, and others would follow. Another strategy used is collusive pricing, where firms collude to set the prices collectively, and this reduces competition and leads to higher prices, which are seen to be similar to those in monopolies, as observed in OPEC. In some instances, the oligopolistic firms would engage in aggressive pricing, which focuses on increasing market share. However, this is rare, and the focus is always on co-existing and cooperating. Monopoly A monopoly is the least competitive market structure as it just has one seller or producer, and there are no substitutes available for the product it provides. The monopoly is said to limit the available alternatives for its products, which would create barriers for the competitors to enter the marketplace. The journey to being a monopoly starts with controlling the entire supply chain from production and sales, achieved through vertical integration or by purchasing competing companies through horizontal integration and thus being the sole producer (Wooten, 2021).

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10 There are different forms of monopolies, and one type is a pure monopoly, where only a single seller is present and has high barriers to entry, like a high capital requirement for entry, which means there is no other substitute available. One example would be Microsoft, which had held a pure monopoly position, but later, others entered the market, holding 72% of the market share (Statscounter, 2024). Monopolistic competition is also a part of monopoly, and another one is a natural monopoly, which is developed due to reliance on unique raw materials, technology, or specialization. There are also monopolies in the public sector, like the utility industry, which the government heavily regulates. Without any competition, the monopolies are free to set prices, which could mean consistent customer pricing. These companies enjoy economies of scale and can produce mass quantities at lower prices. The same advantages could also be harmful when the company tries to create artificial scarcities, fix the prices, or provide low-quality products. Pricing strategies These market structures use multiple strategies to maximize their profits. The first is price discrimination, where the company charges different prices based on the customers' willingness to pay. This is common in airlines, where price discrimination is relatively high, especially on specific routes. Another strategy is bundling, where the monopolies could bundle products and charge for the bundle, like Microsoft, where Office is a bundle of different applications sold together instead of separately. Limit pricing is where the monopolies could set a meager price, discouraging any entry into the market.

11 Case Study Tesla, Inc. is one of the leading companies operating in the vehicle industry. However, it focuses on electric vehicles alone and is expanding its services to other renewable energy products that are not linked to the automotive industry. That said, its primary revenue is from electric vehicles (Tesla, 2020). The market for EVs is said to be an oligopoly as there are very few players in the market, and all try to exert significant influence over market trends, technology standards, and pricing. The company and its position are helped by the advanced technology it has developed over the years, along with being one of the first companies that focus on EVs while all other cars delay the transition. Due to this, the company was able to position itself as a suitable alternative to current vehicles that cause pollution, and this led to the creation of brand recognition where EVs were equated with Tesla and created a loyal customer base. The capital required to enter the market is substantial, and there is also a need for technological expertise, all of which makes the entry challenging, and even established auto manufacturers have found it difficult to compete with Tesla (Carlier, 2023). All of this points to an oligopolistic market. Over the years, the company has used different strategies for the different models it has developed. For the Roadster and Model S, which are priced at a premium, the focus was on targeting affluent customers, and this led to establishing the company as a leader in the field and also provided the revenue required to further its research. Tesla also used price skimming with new models by setting high prices at the launch, which targeted early adopters willing to pay the premium, and then the prices were gradually lowered over time. The company has also shown a willingness to adjust the price in response to changes in market conditions and has lowered

12 prices as a way to qualify for government incentives or to compete in specific markets (Trudell, 2023). The company also has not colluded openly, but they have an open innovative or patent strategy that allows sharing patents and encouraging other manufacturers to develop their vehicles, thus expanding the market instead of restricting and dividing it. The competition is non- price competition, and each firm, with their expertise and investment in research, could contribute to the industry's growth and hence is considered to be collaborating. It is difficult for new entrants to have the capital to create production facilities and technology to aid their growth. Conclusion The paper helps show the different market structures and how each has pricing strategies based on the differences in customer requirements and the availability of alternatives. It reveals a complex landscape where companies must navigate competition to ensure advantage and profitability. From strategies like price-taking in perfect competition to price-making in monopolies, understanding the strategies and their dynamics is critical for strategic decision- making. Examining the case study further helps understand the practical application and provides valuable insights into the economic principles.

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13 References Aziz, A., Hidayat, A., Herlina, E., & Ernawati, W. (2023). Oligopoly Market and Monopolistic Competition in the Digital Era: Shariah Economic Perspective. Quality - Access to Success , Retrieved from 24 (193). https://doi.org/10.47750/QAS/24.193.07 Bertoletti, P., & Etro, F. (2022). Monopolistic competition, as you like it. Economic Inquiry , Retrieved from 60 (1). https://doi.org/10.1111/ecin.13030 Carlier, M. (2023, August 30). Tesla’s revenue from FY 2008 to FY 2022 . Statista. Retrieved from https://www.statista.com/statistics/272120/revenue-of-tesla/ CFI. (2023). Monopolistic Competition . CFI. Retrieved from https://corporatefinanceinstitute.com/resources/economics/monopolistic-competition-2/ Hayes, A. (2022). Perfect Competition: Examples and How It Works. Investopedia . Holt, C. A., & Roth, A. E. (2004). The Nash equilibrium: A perspective. In Proceedings of the National Academy of Sciences of the United States of America . Retrieved from https://doi.org/10.1073/pnas.0308738101 Islami, X., Topuzovska Latkovikj, M., Drakulevski, L., & Borota Popovska, M. (2020). Does differentiation strategy model matter? Designation of organizational performance using differentiation strategy instruments – an empirical analysis. Business: Theory and Practice , Retrieved from 21 (1). https://doi.org/10.3846/btp.2020.11648

14 Parenti, M., Ushchev, P., & Thisse, J. F. (2017). Toward a theory of monopolistic competition. Journal of Economic Theory , p. 167 . Retrieved from https://doi.org/10.1016/j.jet.2016.10.005 Pellegrino, B. (2023). Product Differentiation and Oligopoly: A Network Approach. SSRN Electronic Journal . Retrieved from https://doi.org/10.2139/ssrn.4344416 Pettinger, T. (2019, January 14). Diagram of Perfect Competition . Economics Help. Retrieved from https://www.economicshelp.org/blog/198/economics/diagrams-of-perfect-competition/ Statscounter. (2024). Desktop Operating System Market Share Worldwide . Statscounter. Retrieved from https://gs.statcounter.com/os-market-share/desktop/worldwide/ Tesla. (2020). About Tesla . Tesla.Com. Triani, N. V. (2023). Perfect Competition Market. SSRN Electronic Journal . Retrieved from https://doi.org/10.2139/ssrn.4338530 Trudell, C. (2023, September 1). Tesla drops Model X price to qualify for federal incentives that Elon Musk once opposed: ‘I’m literally saying, get rid of all subsidies.’ Fortune. Retrieved from https://fortune.com/2023/09/01/tesla-drops-model-x-price-to-qualify-for-incentives-elon-musk- opposed/ Wang, Z. (2009). (Mixed) strategy in oligopoly pricin: Evidence from gasoline price cycles before and under a timing regulation. Journal of Political Economy , 117 (6). Retrieved from https://doi.org/10.1086/649801

15 Wooten, J. (2021). Market structures. In Parks and Recreation and Economics (pp. 42–53). Retrieved from Routledge. https://doi.org/10.4324/9781003094906-7 Zhou, H., & Zhou, S. (2019). Pricing strategy of multi-oligopoly airlines based on service quality. PLoS ONE , 14 (6). Retrieved from https://doi.org/10.1371/journal.pone.0216651

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