Pricing Strategies Across Market Structures | CFA Level I Economics
Welcome back! In this lesson, we’ll summarize the pricing strategies of the four types of market structures we’ve learned about: perfectly competitive markets, monopolistically competitive markets, oligopolies, and monopolies. By comparing these market structures side-by-side, you’ll better comprehend and remember their differences. So, let’s dive in!
Golden Rule for Profit Maximization
Before we discuss the pricing strategies for each market structure, remember this golden rule: a firm’s profits are maximized when it produces at the point where the firm’s marginal revenue equals marginal cost (MR = MC).
Pricing Strategies for Different Market Structures
- Perfect Competition: Firms in perfectly competitive markets are price takers, meaning their demand curve is horizontal. In this case, the market price is the marginal revenue and also the average revenue. Firms will produce at the profit-maximizing output where MR = MC.
- Monopolistic Competition: In this market structure, firms differentiate their products, resulting in a downward-sloping demand curve for each firm. The marginal revenue curve is also downward-sloping, but with a steeper gradient. Firms will produce at the profit-maximizing output where MR = MC, earning economic profit in the short run. However, in the long run, new entrants attracted by economic profit will increase competition, lowering the firm’s demand curve, reducing output, and eliminating economic profit.
- Monopoly: A monopolist’s demand curve is the same as the market’s demand curve, which is downward-sloping. Monopolists also produce at the profit-maximizing output where MR = MC. Due to high entry barriers, monopolists can maintain economic profit in the long run.
Oligopoly Pricing Strategies
Oligopoly markets are unique due to the interdependence of firms’ pricing and output decisions. The optimal pricing strategy depends on our assumptions about the market:
- Perfect Collusion: If firms perfectly collude, the entire market acts like one big monopoly. Firms collude to produce at the level where market MR = market MC and charge a high price to maximize and sustain long-run profit.
- Perfect Competition: If firms act as perfect competitors, market behavior is like a perfectly competitive market. In the long run, price converges to the level of the minimum average cost of production, and no economic profit can be made.
However, these are extreme theoretical models. In practice, as demonstrated by the Nash equilibrium model, firms tend to cheat on collusive agreements, making the long-run outcome indeterminate. Prices will likely fall between monopoly and perfect competition prices.
Other oligopoly models include the kinked demand model and the dominant firm model:
- Kinked Demand Model: Assumes competitors will match a price decrease but not a price increase. Firms maximize profit where MR = MC, but there is a gap in the marginal revenue curve, resulting in the same optimal quantity for many cost structures. Firms have little incentive to deviate from the prevailing price.
- Dominant Firm Model: Assumes one firm has the lowest cost structure and a large market share. The dominant firm maximizes profits by producing the quantity for which its marginal cost equals its marginal revenue and charges the price on its firm demand curve for that quantity. Other firms in the market essentially take that price as given and produce the quantity for which their marginal cost equals that price.
In summary, we’ve discussed the pricing strategies for firms under various market structures:
- Perfectly competitive firms are price takers and produce where MR = MC.
- Monopolistically competitive firms have downward-sloping demand curves and also produce where MR = MC.
- Monopolists have downward-sloping market demand curves and produce where MR = MC, maintaining economic profit in the long run.
- Oligopolists have various pricing strategies depending on market assumptions, such as perfect collusion, perfect competition, the kinked demand model, and the dominant firm model.
Now that we’ve covered the pricing strategies for different market structures, we’ll conclude this topic with a discussion on market concentration and how to measure it. Stay tuned!