Unit 7 The firm and its customers
7.8 Price setting, competition, and the market
Our analysis of pricing decisions applies to any firm that produces and sells a product, which is in some way different from that of any other firm. In the nineteenth century, the French economist Augustin Cournot carried out a similar analysis using the example of bottled water from ‘a mineral spring which has just been found to possess salutary properties possessed by no other’. He showed, as we have done, that the firm would set a price greater than the marginal production cost.1
Great economists Augustin Cournot
Augustin Cournot (1801–1877) was a French economist, now most famous for his model of oligopoly (a market with a small number of firms). Cournot’s 1838 book, Recherches sur les Principes Mathématiques de la Théorie des Richesses (Research on the Mathematical Principles of the Theory of Wealth), introduced a new mathematical approach to economics, although he feared it would ‘draw on me … the condemnation of theorists of repute’. Cournot’s work influenced other nineteenth-century economists, such as Marshall and Walras, and established the basic principles we still use to understand the behaviour of firms. Although we use diagrams rather than algebra, our analysis of demand and profit maximization is very similar to his.
Markets with differentiated products reflect differences in the preferences of consumers. Consumers of mineral water may be attracted by combinations of characteristics including taste, mineral content, and bottle design, or they may be concerned about environmental impact. Figure 7.21 shows prices for mineral water in Singapore in 2019, according to a price comparison website.
| Price ($) | |
|---|---|
| Acqua Panna | 3.20 |
| Badoit | 3.17 |
| Evian | 2.24 |
| San Pellegrino | 3.10 |
| Volvic | 1.76 |
Figure 7.21 Prices of a litre of mineral water in Singapore, 2019.
The website finewaters.com compares brands of mineral water on a range of properties including mineral composition, acidity, carbonation, hardness, and vintage.
Each brand has unique characteristics. Acqua Panna is more expensive than the others, and Volvic much cheaper, but each one is able to attract consumers.
Likewise, cars combine a range of characteristics. A consumer’s willingness to pay for a particular model depends on its own characteristics and price, but also on those of other models on sale. When many similar models are available, consumers will be more responsive to price differences. The demand for each one is likely to be quite elastic. If the price of a VW Polo rose, demand would fall because some people would choose to buy one of several comparable small cars. Only those with high brand loyalty, or a strong preference for a feature other models do not possess, will fail to respond. And if the price fell, demand would increase because consumers would be attracted away from other cars.
- substitutes
- Two goods (or services) are described as substitutes when consumers would readily replace one with the other if the prices were similar. If the price of one of the goods increased, consumers would be more likely to choose the other (so demand for it would increase).
- market power
- A firm has market power if it can sell its product at a range of feasible prices, so that it can benefit by acting as a price-setter (rather than a price-taker).
A firm will be in a strong position if few firms produce close substitutes for its own brand. It faces less competition, and its demand elasticity will be lower. We say that such a firm has market power—that is, sufficient bargaining power to set a high price without losing its customers to competitors.
Remember from Section 7.6 that the producer of a differentiated product sets its price so that the markup of price above marginal cost equals the inverse of the price elasticity of demand:
\[\frac{(P-c)}{P}=\frac{1}{\varepsilon}\]So we would expect higher markups for products with fewer close substitutes.
Figure 7.22 shows estimates of elasticities and corresponding markups from a 1995 study of the US automobile industry, which confirmed that markups were lowest in the most crowded segments of the market. The Mazda and Nissan, with many similar competitors, had demand elasticities of 6.3 and 6.4, giving markups of just under 16%. The BMW and Lexus models, with higher specifications and fewer substitutes, had much higher markups: the profit margin was around a third of the price.
| Price ($) | Profit margin, P – MC ($) |
Markup, (P – MC)/P | Elasticity | |
|---|---|---|---|---|
| Mazda 323 | 5,049 | 801 | 16% | 6.3 |
| Nissan Sentra | 5,661 | 880 | 16% | 6.4 |
| Lexus LS400 | 27,544 | 9,030 | 33% | 3.1 |
| BMW 735i | 37,490 | 10,975 | 29% | 3.4 |
Figure 7.22
Estimates of profit margin, markup, and demand elasticities
(prices in 1983 USD).
In some markets it is more difficult to measure market power. For example, digital platforms like Amazon connect two sides of a market. Multiple retailers, including Amazon itself, use it to sell their goods, and the same platform provides a place for end users to shop. Amazon may have different degrees of market power in relation to retailers and end users. Facebook also operates in a two-sided market, with end users active on the social media site and advertisers buying both advertising space and customer data enabling them to provide tailored ads.
Just one or two firms may provide a platform service because of the need for scale to achieve network benefits. This suggests they face little competition and therefore have market power. But it is hard to assess the implications for the prices of products sold on the platform. Membership and usage of Facebook is free, so it seems to earn no markup on costs on the end user side of the market. However, Meta (Facebook’s owner) has annual profits of $9bn in 2021: on the advertising side of the market, where the product is the ‘right to advertise’, it earns a margin on the data sold to advertisers. In fact, it receives revenue from end users’ data, but doesn’t pay them for it. Perhaps if it faced more competition, it would do so.
Monopoly and market power
- monopoly
- A firm that is the only seller of a product without close substitutes. Also refers to a market with only one seller. See also: natural monopoly.
Cournot described the mineral water with unique salutary properties as a case of monopoly: literally, a single seller. Economists use this word to cover a variety of situations in which a good or service is to some extent unique. In extreme cases, a monopolist faces no competition, and no threat of a new rival entering the market: we can think of hypothetical examples, such as a remote island with only one shop, or a mineral found only on land owned by one person. Colonial powers gave monopoly control of trade to individual companies: the Dutch and British East India Companies were granted exclusive trading rights; the Danish king had monopoly control of trade with the Faroe Islands for two hundred years, with a single shop on the islands for much of that time.
In practice, most companies face some competition—there were other traders in the East Indies. Even in cases where a company is the only seller of a particular type of product (a monopoly in a niche market), there are rivals selling similar products. But some, like the famous example of De Beers in South Africa, can nevertheless dominate the market. De Beers controlled 80% of diamond distribution for more than a century. A modern example of a dominant firm is Amazon’s position in bookselling. There are many other booksellers, but (for example) it accounted for 64% of print books sold in Germany in 2021.
Parker Brothers first marketed a property-trading board game called Monopoly in 1935. In a series of court cases in the 1970s, they attempted to prevent Ralph Anspach, an economics professor, from selling a game called Anti-Monopoly. Anspach claimed that Parker Brothers did not have exclusive rights to sell Monopoly, since the company had not originally invented it.
The court ruled in favour of Anspach, and many competing versions of Monopoly appeared on the market. Following a change in the law, Parker Brothers established the right to the Monopoly trademark in 1984, so Monopoly is now a monopoly again.
- market share
- A firm’s proportion of the market in which its product is sold. It may be measured as its share of the total revenue in the market, or of the total quantity sold in the market.
Producers of differentiated products enjoy market power, but how much depends on how we define the market in which they are operating. Measuring market power by market share (the firm’s share of total market quantity or revenue), we might say that the owner of a mineral spring controlled 100% of the market for its particular mineral water, making it a monopoly in that market, but only 20% of the market for mineral waters with high bicarbonate, and successively smaller percentages of the markets for all mineral water, bottled water, all bottled drinks, and so on. The elasticity of its demand curve gives us an overall measure of the extent of competition from firms in all of these markets, and determines its power to set its own price above marginal cost.
If a firm has invented or created a new product, it may be able to prevent competition altogether by claiming exclusive rights to produce it, using patent or copyright laws. In the 1970s a company called Parker Brothers spent years fighting in court to protect a monopoly that they had on a profitable board game—called Monopoly.
Great economists Joan Robinson
A letter to a female student in 1970, from Paul Samuelson, perhaps the most influential economist of the twentieth century, concluded: ‘P.S. Do study economics. Perhaps the best economist in the world happens also to be a woman (Joan Robinson).’
Robinson (1903–1983) earned respect and recognition in 1933 with her first major work, The Economics of Imperfect Competition. She challenged the conventional wisdom by developing an analysis of what we now call monopolistic competition. Facing a downward-sloping demand curve, firms act as price-setters, not price-takers.2
She was a member of the small circle at the University of Cambridge that John Maynard Keynes drew upon to comment on and refine his General Theory, published in 1936. In 1937 she published Introduction to the Theory of Employment, which made Keynes’ work accessible to students.
That Robinson’s much-lauded intellectual achievements were not crowned with a Nobel prize has drawn much speculation. Was it because of her relentless critique of what she called ‘mainstream’ economics including, very pointedly, Samuelson’s ideas?
Her advice to teachers of economics was to ‘start from the beginning to discuss various types of economic system. Every society (except Robinson Crusoe) has to have some rules of the game for organizing production and the distribution of the product.’ She also urged economists to ‘displace the theory of the relative prices of commodities from the centre of the picture.’3
Question 7.13 Choose the correct answers
Which of the following factor(s) would increase the market power of a firm?
- The number of substitutes in the market would decrease, so the firm’s market power would increase.
- If consumers mainly care about price rather than other product characteristics, the firm would have less bargaining power in their relationship with consumers.
- The firm would then be the sole producer of that specific product, so its market power would increase.
- With stronger brand loyalty, the firm can set a high price without losing a large number of customers to its competitors.
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Augustin Cournot and Irving Fischer. 1971. Researches into the Mathematical Principles of the Theory of Wealth. New York: A. M. Kelley. ↩
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Joan Robinson. 1933. The Economics of Imperfect Competition. London: MacMillan & Co. ↩
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George R. Feiwel (ed.). 1989. Joan Robinson and Modern Economic Theory. New York: New York University Press: p. 4. ↩
