UNIT 9 MARKET STRUCTURES AND NET WORK EXTERNALITIES

OBJECTIVES

After reading this unit, you should be able to:

• understand various market structures and their impact on competition;

• review the strategies related to various types of market structures;
• analyse the relevance of sustainable competitive advantage in these situations; and
• evaluate the influence of pricing on different market structures.

STRUCTURE

9.1 Introduction
9.2 Classification of Market Structures
9.3 Perfect Competition
9.4 Monopoly
9.5 Monopolistic Competition
9.6 Duopoly and Oligopoly
9.7 Market Structures and Competition
9.8 Market Structures and Sustainable Competitive Advantage
9.9 Market Structures and Pricing Strategies
9.10 Summary
9.11 Self Assessment Questions
9.12 Further Readings
9.1 INTRODUCTION
A firm operates in complex environment, which has social, political, cultural, legal and
economic facets. The decision making process of the firm is influenced by identifying
opportunities and threats from these factors. Further internal capability factors in terms of
strengths and weaknesses decide the extent of sustainable competitive advantage. The
externalities influence the pricing strategy and competition level. The entry and exit of
any firm is being decided on the basis of its external environment. Market forces tend to
follow competition and they determine firm’s potential buyers. Market competition tends
to be different for different firms. When a market has large number of buyers and sellers,
the competition level at that situation will be distinct. The external forces also affect the
firm in terms of its production, sales, pricing etc. In this unit, first the classification of
market structure is discussed. Subsequently, the description of each type of market
structure along with issues of competition, sustainable competitive advantage, entry/exit
policy etc. is dealt with. In the end, these issues are discussed at macro level so that
competitive position of various market structures and network externalities may be
related to each other for effective strategic decision.
9.2 CLASSIFICATION OF MARKET STRUCTURES
Market means a place where people gather to carry out transaction and exchange
something for value. Market is an essential part of any economy and provides the sellers
and buyers a meeting place to facilitate exchange. Different experts have defined market
as follows:

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According to Jevons, “The word market has been generalised so as to mean any body of
persons who are in intimate business relations and carry on extensive transactions in any
commodity.”
In the words of Benham” Market is an area over which buyers and sellers are in close
touch with one another, either directly or through dealers, that the price obtainable in one
part of the market affects the prices paid in other parts.” Market is also described as an
organisation whereby buyers and sellers of goods are kept in close touch with each other.
Market can be classified according to the following bases:
Area
Market can be classified as local, regional, national and international markets.
Volume of Business
Market is classified on the basis of volume of business as wholesale and retail markets. In
the wholesale market quantities exchanged are large and in bulk while in retail they are
exchanged in smaller lots.
Time
On the basis of time, markets are divided as very short period markets, short period
markets and long period markets. Very short period markets are for commodities which
are perishable and here, supply is fixed. In short period markets, supply can be increased
but to a limited extent and in long period markets supply can be increased to any extent.
Status
According to status of sellers, markets are classified as primary, secondary and terminal
markets. Manufacturers are part of primary markets, wholesalers constitute secondary
market and retailers form part of terminal market.
Nature of Transactions
One can classify the market on the basis of nature of transactions as spot market and
future market.
Regulation
When the government stipulates certain regulations on the transactions then such a
market is called regulated market and when transactions are left to the market forces then
such a market is called unregulated market.
Structure
According to market structure, markets are of the following types:
a) Pure or Perfect Competition
b) Monopoly
c) Monopolistic Competition
d) Duopoly, Oligopoly
9.3 PURE OR PERFECT COMPOSITION
In this section, we shall discuss perfect competition.
Characteristics
A perfectly competitive market has a very large number of relatively small buyers and
sellers.
– The product is homogeneous.
– There is free entry and exit in the industry.
– Every firm’s action is independent of the other firm.
– In this market there is perfect mobility of factors.
– The sellers operate in conditions of certainty having complete knowledge of costs,

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 demand, price and quantities.
Equilibrium of the firm is attained where Marginal revenue is equal to marginal cost, i.e.,
MR=MC (MC curve cuts the MR curve from below).
Competition Level
If a firm in a perfectly competitive market raises the price of its product above the going
price, then it will not be able to sell its products. Therefore, each firm is insignificant.
Also, the firm is not able to earn profit by cutting the price because it can sell any
quantity of goods at the going rate.
When faced with competition, all the firms sell their product at the same price. The
average and marginal revenues would be consistent and equal.
Strategy
The firm should adjust its output in relation to the prevailing price so that it could
maximize its profit. The entry or exit is not possible in the short run, so the firm may
either earn a profit or suffer a loss in the short run.
In the long run, the firms operating in the market are free to enter or exit. So, if there is a
situation of profit, new firms would enter the market and compete with existing firms.
Supply would increase and price would shift downwards, thus eliminating the excessive
profit. However, if there is loss, some firms would exit, there would be shortage and
supply would decline leading to an upward shift in the price, thus elimination in the
losses.
Price Determination
Price is determined at a point where the demand of a commodity equals its supply. The
determination is different in different time periods i.e. very short run, short run and long
run.
a) Price Determination In Very Short Run
• Supply of commodity is fixed.
• Input supply is fixed
• The demand varies and determines the price.
• For perishable goods, the entire supply has to be sold at the earliest and for durable
goods, this is not the case.
• For durable goods, supply can be adjusted with demand accordingly.

b) Price Determination In Short Run

• The firm can change its supply by changing the variable factors.
• The firm is not in a position to change the scale of its plant.
• Also supply can be changed to a limit as per the capacity of the firms.
• The number of firms can neither increase nor decrease in the short run.
• An increase in demand will lead to a rise in both quantity and price and vice versa.
c) Price Determination in the Long Run
• In the long run, it is possible to change the supply.
• Shift in demand takes place with greater adjustment in supply and smaller
adjustments in price.
• It is not necessary that the new price would go in the same direction as the demand.
• The new price may be equal to, less than or more than the initial price and this
depends on the industry cost conditions.

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Activity 1
1. State the impact of perfect competition.
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2. How are prices determined under perfect competition?
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9.4 MONOPOLY
There will be a single seller in monopoly. This is exactly opposite to perfect competition.
Characteristics
• There is only one firm selling the product.
• The firm has no rivals or direct competitors.
• Substitutes may exist. However, close substitutes are non existent.
• Difficult entry for other firms.
• The monopolist is the price maker and tries to take the best of whatever demand and
cost conditions exist without the fear of new firms entering to compete.
• Monopoly is not a permanent situation. Due to reasons like emergence of close
substitutes, entry of new firms, etc. a firm which is a monopoly now may not be a
monopoly in the future.
Price Determination under Monopoly
The price and output under monopoly are determined by taking into consideration
certain assumptions which include that the monopoly firm does not set discrimination
price. It aims at maximization of profits. The individual buyer is just a price taker and the
monopolist firm operates in the condition of no restrictions in terms of price.
• The monopolist firm controls both the price and the supply of the commodity but one
at a time.
• The firm’s demand curve is same as the demand curve of the industry.

a) Price Determination in the Short Run

The monopolist tries to maximize the profits by increasing the output to a level where
additional revenue exceeds additional cost. A monopolist could either earn profit or incur
losses in the short run.
Strategy
The firm can incur profit by keeping the price more than its cost and meeting the demand
by supplying specified units of the commodity.
However the firm can incur losses as well, due to its misjudgment in fixing the price or
determining demand. Also the danger of entry of competitors may lead to setting of
prices below the cost which may end up in a loss.
The monopolist in the short run can either fix the price or the quantity. He cannot fix both
at the same time. The firm has to develop a strategy which leads to maximisation of
profits or minimisation of losses. The firm has to be alert about the potential entry of its
competitors.

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b) Price Determination In The Long Run
The profits in the short run would definitely attract other firms to enter the market. With
the entry of new firms the market would change from a monopoly to a oligopoly or
perfect competition.
If the firm has control over the scarce resources, it can bar the entry of new firms and
enjoy its monopoly position. In the long run, it is not necessary for the firm to use its
existing plant at an optimum capacity due to lack of competition.
It is, however, necessary that the firm does not make losses in the long run. The size of
plant and the extent to which it can be utilized is dependent upon demand of the
commodity.
A monopoly firm is in a better position to exploit the market and it can limit the entry of
outside firms into the industry. There is concentration of economic power in the market
wherever monopoly exists.
9.5 MONOPOLISTIC COMPETITION
Monopolistic competition refers to a situation where the product to be sold is
differentiated and there are many sellers operating to sell it. The competition is not
perfect and is between firms making similar products (not substitutes).
Characteristics
• There are many sellers and no seller is big enough to influence the market price.
• Each seller has an independent price-output policy.
• Product is heterogeneous due to differentiation. Product of each firm is a close
substitute of the product of other firm.
• Patent rights, advertising, quality differentiation, etc. are used as the main
instruments of product differentiation.
• There are no restrictions on the entry and exit of firms.
• Each individual firm enjoys some monopoly power due to product differentiation
and hence, the demand curve is more elastic than that of the monopoly firm.
Price Determination in the Short Run
In the short run it is assumed that entry and exit is not possible for firms. The aim of
every firm is to maximize its profits.
Three conditions may be present in the short run, either the firm could earn super normal
profits or incur a loss or earn a normal profit.
Strategy
In the short run, it is not necessary that all the firms would earn super normal profits.
Some may incur losses or some may earn a normal profit.
Firms compete mostly on the basis of price they charge for their product. Each firm
charges different price and each firm produces different quantities. In case of losses, the
firm decreases its price so that it can at least cover its variable cost. It has to continue the
production till it starts recovering its fixed cost.
Though the products are not perfect substitutes, they are close substitutes and hence the
price changed by each firm is likely to be approximately equal to the others’ producing
similar products.
Price Determination in the Long Run
If industry seems to be profitable new firms would be attracted to enter it. But in lieu of
product differentiation they have to incur costs on R&D, advertising, promotion, etc. to
penetrate the market. Because of the entry of new competitors, the supply would increase

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and the market share of firms already existing would decline. This would shift the
demand curve and abnormal profits would be reduced. Due to the existence of profits,
there would be continuous entry of new firms till they bring the demand curve to a
position where the excess profits do not exist. As the profits touch normal level, the entry
would stop. The equilibrium would be stable and the firm tends to lose if it either raises
or lowers its price. Besides the competition based on price, monopolistic competition can
also be characterised by non price competition where the strategy of the firm would be
product differentiation, heavy advertising, quality, services, design guarantees, etc. A
monopolistic firm can use other distinct kinds of strategy to stay different from other
firms in the industry.
9.6 DUOPOLY AND OLIGOPOLY
In this section, duopoly and oligopoly are briefly discussed.
Duopoly
The duopoly market structure has the following characteristics.
Characteristics
• The number of sellers in this market structure is only two.
• The decision of the sellers is not independent of each other.
• The change in price and output by one seller affects the other seller who reacts to
the change.
• The product can be homogenous or differentiated.
• The decision variables include price, product differentiation, selling expenses, etc.
but the decisions depend upon the strategies of the competitor.
• Product differentiation is the entry barrier and also the firm dominating the market
can pose as an entry barrier.
The price is determined in the market by demand and supply forces. The competition is
between the two firms operating in the market. They respond to each others strategies.
Oligopoly
Oligopoly is a situation where a few large firms compete against one another and are
interdependent with respect to decision making.
Characteristics
• There are small number of large sellers.
• The product they sell can be differentiated or homogeneous.
• The policies of each seller have a noticeable impact due to the extent of influence
of each seller.
• The element of interdependence.
• Cross elasticity of demand is very high due to the close substitutes of the product.
• Existence of price rigidity.
• The firms may enjoy some monopoly power.
• Strategies available to an oligopolist include advertising, quality improvement,
etc. as the firms suffer from rigidity of prices.
• Oligopoly can be classified as perfect and imperfect oligopoly on the basis of
product differentiation, open or closed oligopoly on the basis of entry of firms,
partial or full depending upon presence or absence of market leader.
• When the firms follow a common price policy, it is known as collusive oligopoly.
Strategy

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Because of the element of interdependence, oligopolist market is characterised by price
wars. The oligopoly firms may decide to collude in order to avoid price wars. In a cartel,
firms collude in setting prices and output levels. The necessary conditions for collusion
include:
• Control of firms on supply in the market.
• Not a very price elastic product.
• Mechanism to detect and punish cheaters among the firms.
MRTP Laws do not allow collusion and collusion would result in higher price. Because
each firm has an incentive to secretly lower its prices and expand its market share, no
firm would like to change its price resulting in the rigidity of prices. Implicit collusion in
the form of price leadership may be done by the oligopolisitic firms.

Activity 2

1) State the strategy with respect to market structure of oligopoly.

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2) Explain competitive strategy with respect to monopolistic competition.

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9.7 MARKET STRUCTURES AND COMPETITION
As discussed in the preceding section, competition varies widely in different market
structures. Perfect competition and monopoly are the two extremes. At one end, we find
intense competition. While, no competition exists in case of monopoly. A monopolist
produces a product which is distinct and which cannot be produced by any competitor.
He himself will set the price at which he will sell his output. The demand curve of the
firm and the industry are the same. The monopolist firm controls both the price and
supply of the commodity. Depending upon the categories of customer, the monopolist
may decide different prices in discriminating monopoly.
In monopolistic competition, each seller has an independent price-output policy. Patent
rights, quality differentiation, packing, advertising, etc. are used to differentiate product.
Each individual firm enjoys some monopolistic power due to product differentiation. No
seller is big enough to influence the market price.
In duopoly, the two sellers in the market compete with each other. They respond to each
other’s strategies. This competition normally leads to strategic alliance as they start
feeling that their survival depends on cooperation and not on confrontation.
In oligopoly, the firms go for advertising, product differentiation, quality improvement,
etc. Competition amongst them bring the element of interdependence. There may be two
possible scenarios:
• One in which an oligopolist eliminates a few other competitors.
• Alternatively, there may be collusion amongst competing firms. MRTP laws regulate
collusions as this would result in higher price.
9.8 MARKET STRUCTURES AND SUSTAINABLE COMPETITIVE ADVANTAGE

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The different market structures have different view points with respect to competition. In
monopoly, competition is not fierce as the monopoly firm has an advantage over other
firms. This advantage may be in terms of product, process, technology, etc. In case of
monopolistic competition, all the firms try to achieve this advantage so that they could
be more successful than their competitors. Firm’s operations in oligopoly and duopoly
market structures also aim for sustainable competitive advantage to survive in the
market.
In the short run, a firm’s competitiveness derives from pricing or application attributes of
the products but in the long run, a firm’s competitiveness derives from its ability to
develop and grow at low cost and at a faster pace than its competitors. The most
important point about competitive advantage is that management must be able to
integrate corporate wide technologies and processes into competencies that provide a
solid ground to the individual business so that it could adopt quickly to the ever changing
opportunities. Core competence has been regarded as an effective way to help the
organisation in the task of restructuring its products, markets, management,
organisational setup and technology in the complex and dynamic environment.
According to Prahalad and Hemal, core competence is the collective learning in the
organisations, especially how to coordinate diverse production skills and integrate
multiple streams of technologies. When the organisation is faced with competition in the
market, it is the core competence which proves to be an asset and which can be enhanced
through application and sharing.
In all the market structures, price determination is an important strategy to win
competition but it is the core competence concept which focuses on the preservation of
firm’s existing superior skills. For instance, a monopolist would always like to remain a
monopolist by continuously improving and enhancing the product or service because of
which it has hold over the market. On the other hand, in monopolistic competitive
market every firm tries to compete through new ideas and strives to develop core
competencies. With respect to core competencies, Prahalad and Hemal provide the
following key issues:
• A core competence is one that provides access to various markets. For example, a
firm can operate as a monopolist in one business and can operate in a monopolistic
competitive market at the same time in other business.
• A core competence should make a significant contribution to the perceived customer
the benefits of the end product.
• A core competence should be difficult for competitors to initiate. For instance, a firm
entering a monopoly market may acquire some of the processes that comprise core
competency but it will not be easier to duplicate monopolist’s pattern of internal
coordination.
In any market, sustainable competitive advantage plays a major role and core
competencies are nurtured so as to meet the turbulent environment and improve and grow
by grabbing the right opportunity at the right time.
Apart from core competence, the possible strategic alternative to have sustainable
competitive advantage for different market structures are as follows:
Monopoly- Stability is the best strategic alternative. For strengthening the position,
vertical integration (either forward or backward) will be most effective. If any competitor
enters, mergers and acquisitions may be the appropriate option.

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Perfect Competition- The firm should not go for advertising or price differentiation.
Concentration strategy will improve the economics of scale and firm’s sustainable
competitive advantage will increase.
Monopolistic Competition- Advertising, quality control and branding are the
appropriate measures. Strategic alliances with respect to price may work. Differentiation
strategy may work. Diversification strategy may further enhance the competitive strength.
Duopoly and Oligopoly- Wide variety of options are available. They may go for
diversification, integration, mergers, etc. They may look into promotional strategies for
better competitive advantage.
9.9 MARKET STRUCTURES AND PRICING
The different market structures adopt different pricing strategies. A few pricing strategies
help deterring the entry of competitors. They may also enhance competitive strength and
force some of the competitors to go for exit promoting strategies. Various pricing
strategies used by the firms in different market structures have different implications. A
few pricing strategies are narrated below:

1) Price Lining Strategy

In this kind of pricing strategy, the firm fixes the price of one product in the total line of
its products. For example, a firm producing dresses fixes up the price of particular size
and price of rest of the sizes is then fixed on the basis of differences in sizes. This
strategy eliminates those competitors who can not compete on price.
2) Limit Pricing Strategy
For this strategy, some sort of collusion is necessary among existing firms. In this, the
firm may try to establish a price that reduces or eliminates the threat of entry of new
firms into the industry in which the firm operates. Normally, oligopolist and firms
operating in monopolistic competition go for this alternative.
3) Stay-out Pricing Strategy
When a firm is not able to ascertain the price of the product, it introduces the product at a
very high price. If it is not able to sell its product at this price, it would lower the price
and go on lowering it till it meets the targeted sales. With the help of this strategy, the
firm gets to know the maximum possible price it can charge from its customers.
Monopolists experiment this strategy to have maximum profits. They are also not having
any fear from competitors.
4) Psychological Pricing Strategy
Here, a firm fixes the price of its product in a manner which gives the impression of
being low. For example, if the price of the product is fixed at Rs.199.99 rather than Rs.
200, it has psychological impact on consumers that price is in 100s rather than in 200s.
This strategy may influence sales sometimes. In monopolistic competition, this
alternative may give better results.
5) Skimming Price
This strategy could be used in a market with sufficiently large segment whose demand is
relatively inelastic i.e. not sensitive to a high price. Another condition for this strategy is
that high price is unlikely to invite competition and unit costs are relatively unaffected by
small volume. The strategy implies skimming the cream by taking advantage of the target
markets willingness to pay a high price. This strategy is discriminatory. It enhances the

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quality image. In monopolistic competition and monopoly, this pricing strategy gives
results.
6) Penetration Price
This strategy requires a highly price sensitive market with high price elasticity. It is
characterised by low price which is likely to discourage competition. The policy is to
charge low price so as to stimulate demand and capture large share of the market.
There are various other strategies as well like sliding down the demand curve, premium
pricing, fraction below competition, price discrimination and put-out pricing. A firm can
use any of these strategies to compete in the market. Different strategies could be used at
different time periods by the same firm as per the conditions.
Activity 3
1) Discuss alternative strategies for sustainable competitive advantage in different
market structures.
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2) State alternative pricing strategies to be used in different market structures.
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9.10 SUMMARY
The markets in which the firms operate can be classified according to nature of
transaction, time, volume, status, regulation, area and structure. According to structure
markets are classified as perfectly competitive market, monopolistic competitive market,
monopoly, duopoly and oligopoly. The price determination is different in different
market structures. It also differs in the long run and in the short run. Economic theory
suggests that there lies a continuum of market structure that comprises of perfect
competition at one end and monopoly at the other. Between these two extremes lie
monopolistic competition, oligopoly and duopoly. There are large number of buyers and
sellers in a perfectly competitive market. The firms have to determine the quantity to be
produced because price is fixed at the market rates. In the short run the firm in a perfectly
competitive market can earn profit or loss. In a monopoly, there is a single seller whose
product has non close substitutes. There is no free entry in its case. In monopolistic
competition firms deal in differentiated products and take independent decisions. They
may earn supernormal profits or normal profits or incur losses as well. Duopoly is a
situation where in homogeneous or differentiated products are sold by only two firms.
Each firm has to see how its actions are likely to affect its rivals and how they are likely
to react. Oligopoly is a situation where there are small number of large sellers. The
element of interdependence exists in this market. To avoid price wars, the oligopoly
firms may decide to collude. For sustainable competitive advantage, various strategic
alternatives may be used. Several pricing strategies are used by the firms. These include
price lining strategy, limit pricing strategy, stay-out pricing strategy, psychological
pricing, skimming and penetration pricing strategies.
9.11 SELF ASSESSMENT QUESTIONS
1) Differentiate between the different market structures and their impact on competition.

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2) Discuss strategy for sustainable competitive advantage in the monopolistic
competitive market.
3) What are the various pricing strategies available to the firms? Discuss each one of
them with reference to different market structures.
4) What are the strategies for firms operating in an oligopoly? What can they do to
avoid price wars? Suggest appropriate pricing and competitive strategies.
5) Write an essay on different market structures and network externalities i.e.
competition, pricing, etc.
9.12 FURTHER READINGS
Baumol, W.J. (2002). Economic Theory and Operations Analysis, Englewood Cliffs,
N.J. Prentice Hall, 2002.
Haynes, W.W. (1962). Pricing Decisions In Small Business, Lexinaton: University of
Kentucky Press, 1996.
Mehta, P.L., (1996)..Managerial Economic: Sultan Chand Sons, New Delhi, 2003.
Ghosh, P.K., “ Business Policy Strategic planning and Management ”, Sultan Chand
& Sons, New Delhi.
Kazmi, Azhar (2002). “Business Policy and Strategic Management”, Tata Mcgraw
Hill Publishing Co, Ltd., New Delhi.
Miller, A. A. and G. G. Den, (1996). “ Strategic Management” Mcgraw hill, New
York.
Prashad, L.M., (2002). “Business Policy: Strategic Management”, Sultan Chand &
Sons, New Delhi.
Thompson, J.L. (1997). “Strategic Management: Awareness and Change”,
International Thompson Business Press, London.
Shrivastava, R.M., (1995). “ Corporate Strategic Management”, Pragati Prakashan,
Meerut.

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