Firms compete in the market to increase their customer base, sales, market share and profits.
Price competition involves competing to offer consumers the lowest or best possible prices of a product. Non-price competition is competing on all other features of the product (quality, after-sales care, warranty etc.) other than price.
Informative advertising means providing information about the product to consumers. Examples include advertising of phones, computers, home appliances etc. which include specific information about their technical features.
Persuasive advertising is designed to create a consumer want and persuade them to buy the product in order to boost sales. Examples include advertisements of perfumes, clothes, chocolates etc.
What can influence the price that producers fix on a product?
- Level and strength of consumer demand.
- The amount of competition from rival producers in the market.
- The cost of production and the level of profit targeted.
Price skimming: When a new and unique product enters the market, its producers charge a very high price for it initially as consumers will be willing to pay more for the new product. As more competitors begin to launch similar products, producers may lower prices. Apple’s iPhones are good examples – they are very expensive at launch and get cheaper overtime.
Penetration pricing: when producers set a very low price which encourages consumers to try the product, helping expand sales and increase loyalty. This way, the product is able to penetrate a market, especially useful when there are a lot of existing rival products. Netflix, when it first started out as a DVD rental service, used penetration pricing ($1 monthly subscription!) to encourage customers to try their service which helped it create a large customer base.
Destruction pricing (predatory pricing): prices are kept very low (lower than the cost of production per unit) in order to ‘destroy’ the sales of existing products, as consumers will turn to the lowest priced products. Once the product is successful, it can raise prices and cover costs. India’s Reliance Jio, a telecom company, was accused of predatory pricing during its initial launch years. Predatory pricing is illegal in many countries as it creates a non-competitive business environment and encourages monopoly practices.
Price wars happen when competing firms continually trying to undercut each other’s prices.
Cost-plus-pricing: this involves calculating the average cost of producing each unit of output and then adding a mark-up value for profit.
Price = (Total Cost/Total Output) + Mark-up
This ensures that the cost of production is covered and that each unit produces a profit.
In a perfectly competitive market, there will be many sellers and many buyers – a lot of different firms compete to supply an identical product.
As there is fierce competition, neither producers nor consumers can influence market price – they are all price takers. If any firm did try to sell at a high price, it would lose customers to competitors. If the price is too low, they may incur a loss. There will also be a huge amount of output in the market.
- High consumer sovereignty: consumers will have a wide variety of goods and services to choose from, as many producers sell similar products. Products are also likely to be of high quality, in order to attract consumers.
- Low prices: as competition is fierce, producers will try and keep prices low to attract customers and increase sales.
- Efficiency: to keep profits high and lower costs, firms will be very efficient. If they aren’t efficient, they would become less profitable. This will cause them to raise prices which would discourage consumers from buying their product. Inefficiency could also lead to poor quality products.
- Wasteful competition: in order to keep up with other firms, producers will duplicate items; this is considered a waste of resources.
- Mislead customers: to gain more customers and sales, firms might give false and exaggerated claims about their product, which would disadvantage both customers and competitors.
Dominant firms who have market power to restrict competition in the market are called monopolies. In a pure monopoly, there is only a single seller who supplies a good or service. Example: Indian Railways. Since customers have no other firms to buy from, monopolies can raise prices – that is they are able to influence prices as it will not affect their profitability. These high prices result in monopolies generating excessive or abnormal profits.
Monopolies don’t face competition because the market faces high barriers to entry – obstacles preventing new firms from entering the market. That is, there might be high start-up costs (sunk costs), expensive paperwork, regulations etc. If the monopoly has a very high brand loyalty or pricing structures that other firm couldn’t possibly compete with, those also act as barriers to entry.
- There is less consumer sovereignty: as there are no (or very little) other firms selling the product, output is low and thus there is little consumer choice.
- Monopolies may not respond quickly to customer demands.
- Higher prices.
- Lower quality: as there is little or no competition, monopolies have no incentive to raise quality, as consumers will have to buy from them anyway. (But since they make a lot of profit, they may invest a lot in research and development and increase quality).
- Inefficiency: With high prices, they may create high enough profits that, costs due to inefficiency won’t create a significant problem in their profitability and so they can continue being inefficient.
Why monopolies are not always bad?
- As only a single producer exists, it will produce more output than what individual firms in a competition do, and thus benefit from economies of scale.
- They can still face competition from overseas firms.
- They could sell products at lower price and high quality if they fear new firms may enter the market in the future.
Notes submitted by Lintha
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