Price Setting and Price Taking
Price Setting and Price Taking
The determination of prices in different markets is usually characterized by two opposing strategies: price taking and price setting.
PRICE-TAKING STRATEGY
In this theoretical situation, which characterizes the limiting case of “pure competition,” market price is determined by the confrontation of a supply curve and a demand curve. With the usual assumption that the supply curve is increasing and the demand price is decreasing, there exists generally one intersection point. Other assumptions are that this intersection point is unique and stable, stability being warranted by adjustment processes, tâtonnement, which will lead to convergence on the equilibrium position. Here, the equilibrium point is unambiguously associated with the position where supply equals demand at price p *.
The equilibrium price is determined at the intersection of the supply curve and the demand curve (see Figure 1 left); this price is “given” to the firm (see Figure 1 right), which appears as the price taker. The firm’s production level will be determined at the intersection of this given price and its own marginal cost curve: the firm’s profit is maximized at the intersection, since the marginal cost equals the marginal revenue. Producing more would be inefficient, since the marginal cost will exceed the price; producing less would mean that the marginal cost is less than the price, and profit may be increased by increasing
the production level. The individual firm makes a profit, since the price is superior to the average cost, and the total profit is obtained by multiplying the unit profit by the quantity produced.
In the conventional narrative, under long adjustment, new firms will appear in this market. The presence of positive profits induces new firms to enter. Hence, adjustment will be characterized by an increase in supply and a decrease in the market price, which will eliminate profit-making firms. Eventually, the market price level will coincide with the minimum average cost curve of the firm.
This price system plays an essential role in the information and regulation of general activity for producers and consumers. Equilibrium prices are scarcity indicators. Utility maximization implies that the market price represents the marginal value of the last dollar spent by consumers on the considered commodity. But the market equilibrium price also will represent production conditions, since the supply curve is derived from aggregation of the individual firm’s marginal cost curves.
PRICE-SETTING STRATEGIES
Producers are generally able to fix, or set, their output price by taking into account quantities demanded by consumers.
Monopoly A monopolistic firm provides the whole product for the relevant market. The firm’s demand and the market’s demand are the same; hence, product demand, for which the firm is the only supplier, is a decreasing function of price. A monopoly will then maximize profit when it sets its level of output such that marginal cost is equal to marginal revenue. Given the profit-maximizing level of output, the monopolist then uses the demand curve to find the highest price that consumers are willing and able to pay for the profit-maximizing level of output. Consequently, in this case, quantity and price are determined simultaneously.
With the assumption of linearity of average and marginal receipt, representation is simple, as indicated in Figure 2.
More complicated strategies can be taken into account. In some cases, a monopoly may try, for instance, to maximize its turnover, which will be realized when marginal revenue equals zero, determining quantity and
price. In another case, a monopoly will try to get balanced accounts—that is, zero profit—which will be realized when average cost equals average revenue. Such strategies obviously lead to more production, and can appear when a monopolist tries to avoid the “entry” of competitors.
Lastly, a monopolist may engage in marginal cost pricing, a strategy frequently used by publicly owned enterprises that guarantees optimal use of economic resources. The relevant level of production corresponds to equality of marginal cost and marginal revenue. Such a strategy, which appears as “optimal,” may imply deficits; consequently, economists have come to “second-best” solutions. Discrimination between different types of consumers or markets also can occur. Elasticity of demand is to be taken into account in price-setting strategies.
Monopsony In the symmetrical situation of a monopsony, a large number of suppliers of a homogeneous product or service face a unique buyer. The monopsony average unit curve is represented by the supplier’s curve. The monopsony’s marginal cost increases with quantity, and is situated above the average cost curve. With the simplified assumption that the monopsony sells its product at a fixed price, maximization of profits will be realized when the firm buys a quantity of raw materials (or labor services), qM, such that the value of its marginal product is equal to its marginal cost.
The purchase price paid to sellers, pp, will correspond to this quantity on the supply curve of the product. The monopsony will set the selling price on the product market, ps, at the point of the monopsony’s average receipt corresponding to the quantity sold (in this simplified case, no transformation of the product is taken into account); the profit unit is the difference between the “purchase price,” pp, and the “selling price,” Ps
Monopolistic Competition Monopolistic competition is a market structure characterized by a mixture of perfect competition and monopoly. There are a multiplicity of sellers, but each firm produces a unique product, although it is a product that is similar to those of other firms within the industrial group. So-called fast-food franchises, for example, are usually considered monopolistically competitive firms. As such, McDonald’s Big Mac hamburger is considered different from, but substitutable for, Burger King’s Whopper or Wendy’s Single. Or, more broadly, these different burgers are also competitive substitutes for KFC’s original fried chicken or Long John Silver’s fish and chips. Each producer then faces a downward-sloping demand curve that is affected by the decisions of both its competitors and its consumers. An increase in the number of sellers or a decrease in attractiveness of its products mean a reduction in demand for a monopolistically competitive firm. It will sell less at all available prices. An increase in its own price means a reduction in the quantity demanded.
Similar to a monopoly, in the short run, a monopolistically competitive firm will maximize profit at the level of production such that marginal cost equals marginal revenue and the output price is consistent with consumer demand. However, if economic profits exist, this is an unstable situation; new competitors will progressively appear, which will decrease the firm’s receipts. The firm’s demand curve will progressively shift to the left until it is tangent to the average cost curve, a situation where the price will be set with zero profit. Further decrease in demand will lead to a new shift of the demand curve to the left, and the firm will disappear, since there is no further production level that will allow profitability.
Duopoly and Oligopoly In a duopoly or oligopoly, price setting by one competitor generally leads to price wars with fatal outcomes. Of course, it is always possible that firm A draws customers from firm B by a price decrease. But since it is also possible for B to do the same, the only outcome, if a price war breaks out, is perfect competition equilibrium with price being equal to marginal cost, leading to ruin for one of the competitors. So price setting is generally not the solution, except when agreements between firms lead to a situation close to a monopoly. Such situations are common, and have developed among such firms as Boeing and Airbus, Pepsi and Coca-Cola, and Ford, General Motors, and Toyota.
The only strategy left, if one excludes agreements, collusion, and various nonmarket arrangements, is a determination of quantity produced by one or more competitors, the same price being settled by all. Such a situation will be stable or unstable, according to the behavior of competitors (i.e., their aggressiveness).
It must be recognized that in many industries, firms sell very similar, nonidentical products. In such markets, it is equally easy to represent firms as price choosers or quantity choosers.
BIBLIOGRAPHY
Chamberlin, Edward H. 1962. The Theory of Monopolistic Competition: A Re-orientation of the Theory of Value. 8th ed. Cambridge, MA: Harvard University Press.
Cournot, A. A. [1838] 1929. Researches into the Mathematical Principles of the Theory of Wealth. Trans. Nathaniel T. Bacon. New York: Macmillan.
Henderson, James M., and Richard E. Quandt. 1971. Microeconomic Theory: A Mathematical Approach. 2nd ed. New York: McGraw-Hill.
Robinson, Joan. 1933. The Economics of Imperfect Competition. London: Macmillan.
Samuelson, Paul A., and William D. Nordhaus. 1998. Economics. 16th ed. Boston: McGraw-Hill.
Gilbert Abraham-Frois