Market Structures and Pricing Strategies Explained

Introduction to Market Structures

Market structure refers to the number of competitors operating in a particular industry and the level or intensity of competition among them. Market structure is more of an economic concept than a marketing concept, as it directly deals with the pricing strategies that companies operating in the same industry formulate to compete with each other, the major costs that influence these pricing strategies, the number of buyers and sellers that play an important role in making competition more intensive, the patterns of entry and exit of competitors, and the availability of substitute products (Boyes & Melvin, 2012). Modern economists define market structure as a set of characteristics that collectively shape the competitive environment within an industry. Market structure not only takes into account the local businesses operating in an industry, but also the international corporations that are either trying to penetrate its markets or have established their presence and become equal participants in the industry (Gitman & McDaniel, 2009).

Although the level of competition is mainly characterized by the businesses which hold the greatest market share in an industry, the significance of a large number of small competitors cannot be ignored when the market structure of that industry is discussed. Other main features of market structures include barriers to entry for new businesses, economic efficiency which makes competition easier or stiffer for participants, profit maximization strategies, the impacts of competition in the short run and the long run, and the use of product differentiation strategies by competitors (Mankiw, 2011).

Types of Market Structures

There are four major types of market structure: perfect competition, monopolistic competition, oligopoly, and monopoly. Each of these market structures has its own features, characteristics, intensity of competition, and pricing strategies used by competitors to operate according to the specific type of competition present in the market (McConnell, Brue, & Flynn, 2009). These market structures are described comprehensively in the following sections.

1. Perfect Competition

Perfect competition (also called pure competition or perfect market) is an ideal market structure in which there are a large number of small and large-scale competitors offering identical or homogeneous products at the same prices. Competitors operate in the presence of stiff competition from top market leaders as well as from new entrants. However, none of the competitors holds a large market share due to the extremely large number of participants. Markets are quite open to new businesses due to the absence of barriers to entry and strict country penetration mechanisms. Government policies and regulations are also very relaxed with respect to licensing and registration for businesses in a perfect competition. The prices of products and services offered by local and international businesses are purely determined by supply and demand forces (McEachern, 2008).

Due to open market competition, substitutes are found for almost every product. In a perfect competition, sellers and buyers have full knowledge of prices, technology, and processes. All competitors in an industry use the same production techniques and technological processes, which keeps their costs of production at the same level. Therefore, no firm can manufacture its products faster or cheaper than its rivals. Due to extremely identical product and service offerings, competitors do not generally need to advertise on expensive media in order to attract potential customers. However, they do use advertisements to create awareness of new offers (Taylor & Weerapana, 2009).

2. Monopolistic Competition

In contrast to perfect competition, there are three different market structures under imperfect competition: monopolistic competition, monopoly, and oligopoly. Monopolistic competition shares many characteristics with perfect competition but differs due to the heterogeneity of products—that is, the products offered by competitors are not identical to each other. The market in a monopolistic competition is composed of a large number of small-scale competitors with no single major holder of market share. Competitors make variations in the features and quality of their products in order to make them appear different from other products in the market. Sometimes, the products offered in a monopolistic competition are referred to as close substitutes, as they fulfill the same consumer needs but vary in the level of satisfaction they provide. Competitors manufacture their products using the same technological processes, but variations in features and quality are made possible through innovative procedures, quality management techniques, and operational excellence. Therefore, a highly competitive business environment exists for participants in monopolistic competition (Tucker, 2010).

Monopolistic competition offers very limited or no barriers to entry and exit for new and existing firms, respectively. Penetration into the industry may not be as easy as in perfect competition, but firms do not generally face strict governmental policies or regulations due to the open nature of competition. Buyers in a monopolistic competition market have complete knowledge of the technologies and pricing strategies used by manufacturers, which facilitates better purchase decisions based on a variety of parameters.

3. Monopoly

In a monopoly market structure, there is only one producer or supplier of a particular product or service in the entire industry. Monopoly may be created by a single firm or a group of firms that collectively dominate the market and drive supply and demand forces according to their own policies and strategies. Monopoly exists due to high business setup costs or significant risks and uncertainties that restrict new businesses from emerging as competitors. Due to the monopoly power and full control over industry patterns, the monopoly firm or group may charge high prices or reduce the quality of its products at will. Monopoly market structures are often discouraged by governments and international regulatory authorities, because a monopoly does not promote open competition, which strongly discourages new investment (Hall & Lieberman, 2010).

Sometimes, a government itself creates a monopoly in a sector of the economy when it determines that a particular sector should not compete with private corporations. A well-known example is electricity generation, which in many countries is entirely controlled by the government. A similar monopoly is created when a government intends to control the natural resources extracted from a country's lands. The oil and gas sector of Saudi Arabia is a prime example of such a monopoly, where full control of the industry rests in the hands of the government.

4. Oligopoly

Oligopoly is the fourth major type of market structure, classified between monopolistic competition and monopoly. Oligopoly refers to the level of competition among a few large competitors in an industry. While there are also a large number of small competitors, they do not play a major role in driving demand and supply forces. The market in an oligopolistic competition is said to be highly concentrated. Barriers to entry in this type of market structure are higher than in monopolistic competition. However, new firms can enter the industry if they employ effective market penetration and promotion strategies. The entry of new firms facilitates open competition between the few market leaders and numerous smaller competitors from local and international markets. Demand and supply factors are driven by market leaders, who hold the majority of market share and exert great influence over pricing strategies and product quality (Mankiw, 2011).

The level of competition among these few large firms is very high, requiring each to remain on the most competitive edge in order to operate profitably. Oligopoly is the most common type of market structure found in most industries in a developing economy. This market structure is also influenced by important external environmental factors, including political, governmental, social and demographic, economic, and technological forces. Due to extremely stiff competition, the top industry rivals must use expensive advertising and marketing campaigns to attract customers. Competition also requires them to expend a large portion of their budgets on research and development, which helps them manufacture innovative products that meet customer requirements (McConnell, Brue, & Flynn, 2009).

Pricing Strategies in Different Market Structures

Competitors in each type of market structure use different pricing strategies, which are either determined by supply and demand forces or by their own control over the pricing mechanism. Pricing strategies are among the major factors that distinguish these market structures from one another.

a. Perfect Competition

In a perfect competition, customers are fully aware of the prices prevailing in the industry. Competitors must keep the prices of their products in line with those charged across the market. If a competitor increases the price of its products in an attempt to improve profit margins, customers reject this increase and immediately switch to other competitors' products. This dynamic makes it impossible for any competitor to generate high revenues by charging elevated prices. Competitors are simply price takers—they cannot set prices of their own choosing and must accept what is established by market forces. Transportation costs are also minimal, as all sellers operate in a single market and obtain raw materials from the same locations, which further promotes equal pricing across competitors. Generally, competitors in a perfect market promote their products through brand image, which helps well-established firms attract potential customers and challenge new entrants (McEachern, 2008).

b. Monopolistic Competition

Unlike perfect competition, competitors in a monopolistic competition charge different prices based on the features and quality of their products—they are not price takers. The pricing strategy used by one competitor may affect its top rivals, but it does not significantly alter the overall market structure. Because buyers have full knowledge of the pricing strategies of different competitors, they choose the brand that best meets their requirements within their available budget. To attract customers, sellers expend substantial amounts on marketing and promotional efforts (Taylor & Weerapana, 2009), which places a heavy burden on profit margins that must be managed by selling products at higher rates.

Sometimes, competitors in a monopolistically competitive market act like monopolies, charging the highest price in the market. This short-term monopoly prevails when a competitor introduces an exceptional feature that becomes its core competency—until a rival copies it and ends that advantage. In the long run, no competitor can sustain a high price due to the competitive pressure from a large number of rivals (Boyes & Melvin, 2012).

c. Monopoly

Being the only producer or supplier in the entire industry, a monopoly has full control over the pricing mechanism and the quality of its products or services. It is the sole price setter. Prices in a monopoly market structure are typically very high due to the absence of competition and limited government oversight. Therefore, the pricing strategies of a monopoly firm or group are entirely shaped by its own revenue objectives. The customer base for a monopoly firm is also strong and stable due to the non-existence of competition (Hall & Lieberman, 2010).

d. Oligopoly

Since competitors in an oligopolistic market produce both identical and differentiated products, prices vary according to features and quality. Generally, the pricing strategies of the few large competitors in an oligopoly market are based on their competitiveness. For example, if a competitor offers the best product in the market with respect to technology, features, or design, it can charge the highest price. However, the price range of products is set with consideration of the social and economic forces in the country, which are directly linked to consumer consumption patterns and preferences. Buyers in an oligopoly market have full knowledge of products—including quality, technology, and prices charged by different competitors—and therefore make purchase decisions after evaluating all available alternatives and substitutes (Gitman & McDaniel, 2009).

Conclusion

The level of competition in an industry defines the type of its market structure. The four major types of market structures vary with respect to the number of buyers in the industry, demand and supply forces, barriers to entry, governmental policies, and pricing strategies used by competitors. Perfect competition prevails when there are a large number of small and large-scale competitors offering identical products. The pricing strategies in this type of market structure are based on demand and supply factors. The second type, monopolistic competition, exists when the products offered by a large number of competitors act as substitutes for each other. Pricing strategies are designed according to the level of differentiation used to distinguish the products from their substitutes. Monopoly is a rare form of market structure in which only one firm or group holds full control of the market, and pricing, supply, and product quality are determined entirely by that firm. The fourth form of market structure, oligopoly, constitutes a few large competitors that make up the entire competitive environment in the industry. They set prices for their products according to the level of consumer acceptability and the expenses incurred to produce and market those products.

References

Boyes, W. J., & Melvin, M. (2012). Economics (9th ed.). Mason, OH: South-Western Cengage Learning.

Gitman, L. J., & McDaniel, C. D. (2009). The future of business: The essentials (4th ed.). Mason, OH: South-Western Cengage Learning.

Hall, R. E., & Lieberman, M. (2010). Microeconomics: Principles and applications (5th ed.). Mason, OH: South-Western Cengage Learning.

Mankiw, N. G. (2011). Principles of economics (6th ed.). Mason, OH: Thomson South-Western.

McConnell, C. R., Brue, S. L., & Flynn, S. M. (2009). Economics: Principles, problems, and policies (18th ed.). Boston: McGraw-Hill Irwin.

McEachern, W. A. (2008). Economics: A contemporary introduction (8th ed.). Mason, OH: Cengage Learning.

Taylor, J. B., & Weerapana, A. (2009). Economics (6th ed.). Boston, MA: Houghton Mifflin.

Tucker, I. B. (2010). Microeconomics for today (6th ed.). Mason, OH: South-Western Cengage Learning.