essential economics: pricing power
Topic: The Pricing Power of Businesses
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Students should understand the factors which affect the ability of a firm to fix the price of its product
This topic focuses on the pricing decisions of individual firms in different markets. The factors that determine the pricing decisions open to a business nearly always come back to two main driving forces:
• The market structure in which a business operates
• The objectives that a business may be pursuing at a given time (e.g. profit max and revenue max)
In reality, most businesses are multi-product firms servicing a variety of different markets. This is particularly so given the increasingly integrated nature of the global economy. Indeed markets can become highly segmented – each with different characteristics – so the factors will vary from industry to industry
Market Structure
Perfect competition
Price–taking firms each with no influence over the ruling market price
Free entry and exist of businesses in the long run – long run normal profit equilibrium
Each supplier produces homogeneous products – each a perfect substitute – hence the perfectly elastic demand curve for the individual supplier
Pure monopoly
Market dominance – the monopolist has price setting power and the ability to earn supernormal profits in both the short and long run
Their market position may be protected through the use of entry barriers
There is the potential for price discrimination to extract consumer surplus and increase profits
Oligopoly
Competition among the few. Each firm has market power, branded products, entry barriers exist
Key factor is the interdependent nature of pricing decisions between rival firms. Each firm must consider strategic behaviour of other “players” in the market
Objective might be protecting market share or increasing market share
Game theory can help to model different types of behaviour
Contestable markets
Markets where the entry and exit costs are low
Potential for hit and run entry to cream off profits if incumbent firms are being inefficient
Always the threat of new entry from new suppliers or new products – this affects the current behaviour of existing firms (may force them to price more competitively)
There are barriers to contestability in most markets – but the higher the barriers, the greater the pricing power in the hands of the incumbent firms
Price and Cross-price Elasticity of Demand
Price elasticity of demand remains a fundamental factor affecting a firm’s pricing power.
When demand is price inelastic, the business can raise price without losing a disproportionate level of demand / sales (see left hand diagram on next page). When demand is price elastic, the potential to raise price and extract consumer surplus, turning it into higher producer surplus / profit is much reduced – see the right hand diagram on the next page
Cross price elasticity of demand is linked to this – i.e. the percentage change in demand for good X resulting from a given percentage change in the price of a related product (in particular the relative price of a substitute)
When the cross-elasticity of demand is low, the “substitution-effect” arising from changes in relative prices is weak consumers are less likely to switch their demand, giving the firm greater price power.
Product differentiation – moving away from homogeneous products
Product life-cycles
Some consumers pay premium prices for new products (known as “early-adopters”)
Products towards the end of their life-cycle – more elastic demand, lower prices as businesses are trying to keep sales high – they may accept a lower profit margin
The Regulatory System
o The regulatory agencies covering privatised utilities such as gas, electricity, telecommunications and the rail industry – most of these regulators have at times enforced price-capping formulae limiting the extent to which the utilities can increase prices. Some of the regulators have now lifted price controls because they believe that there is now sufficient competition in the market (a good example is the gas industry)
The competition authorities – one of the main features of competition policy both in the UK and the European Union is to come down hard on anti-competitive behaviour such as price-fixing (cartel behaviour) – the strength of competition policy enforcement affects the “environment” in which a firm sets prices and engages in other forms of competition
The International Environment
Most businesses face competition either from domestic rivals or from international competitors. Increasingly the pricing decisions of one business are influenced by the strength of competition from overseas suppliers. The process of globalisation has made this a key factor in many industries
The Economic Cycle
When demand is strong and rising (e.g. during the upturn phase of the economic cycle), a business will have more “pricing power” than when demand is much weaker and falling (e.g. during a recession). Often a market may be affected by a demand-side “shock” which takes away the pricing power of suppliers.
Other A2 Economics Essential Revision Notes:
| Business Objectives |
| Causes of Unemployment |
| Current Account Deficits |
| Economies of Scale & Scope |
| Globilisation & the UK |
| Manufacturing Industry in the UK |
| Phillips Curve |
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