How do market structures determine the pricing decisions of businesses?

Quick answer:

Market structures influence how businesses set prices based on the type of structure in operation. In pure competition, price is set by supply and demand. In a monopolistic competition, prices may rise as a few businesses gain the upper hand in the market. In an oligopoly, prices rise as the market is controlled by only a few companies. In a monopoly, prices soar as one company controls the market with no competition.

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Economists identify four primary kinds of market structures: pure competition, monopolistic competition, oligopoly, and monopoly. The market structure in which a business (or set of businesses) operates helps determine the prices of the products that business makes and/or sells.

In pure competition, many small businesses operate on equal footing, sharing the market in a pretty much equal competition. Supply and demand work together to set price levels in this kind of market based on what consumers are willing to pay for a product and how much businesses are willing to produce and sell.

A monopolistic competition market also features many small businesses in competition, but in this case, a few stand out due to their brand name recognition, advertisement, or marketing strategies. These businesses lead the pack, so to speak, and they therefore have the ability to set prices a bit higher than they might otherwise have done in a pure competition market.

In an oligopoly, a few businesses dominate the market, and their competition with each other blocks other businesses from entering and also raises prices. Sometimes these businesses actually agree to charge more to consumers, but often their strict control over supply drives the prices up naturally. When there is less competition, consumers pay more for products.

Finally, in a monopoly, one business controls the whole market with no competition. This business, therefore, can set prices as it pleases, and it usually sets them quite high. In a monopoly, consumers have no choice about where to purchase the products or services they need or want. Instead, their decision is whether or not they can afford such products or services at the high cost of a monopoly.

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A monopoly market structure is characterized by the existence of a single seller. The concept of differentiation is inapplicable in such a market structure. The product or service offered is standardized for all buyers. The market does not provide any substitutes, and customers are restricted to one provider. The seller strongly controls the pricing decision in such a structure.  

An oligopoly market structure is characterized by the existence of few sellers. The sellers collude to reduce competition and entry into the industry. A price leader often determines prices for products or services in such a structure.

A monopolistic competition structure is characterized by a high number of sellers. The vendors provide goods and services that differ enough that no good or service is a perfect substitute for another good or service. In monopolistic competition, sellers are free to set their prices.

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Market structures are defined as the interconnections of the several elements binding buyers, sellers (agents) and products together. These elements are:

  • number of agents, buyers or sellers or both
  • buying/selling strength of agents and ability to influence prices
  • potential collusion among agents
  • levels of production
  • forms of competition
  • degree of product differentiation
  • ease of entry to or exit from the market

What your question is asking is how does this market structure, this interconnected structure of agents, strengths and products determine a business's decisions about pricing.

A business's pricing decisions are made under the determining influence of other agents in the market. For instance, if the market has strong competitors generating strong brand loyalty and the market is a difficult one to make entry into, a competing business will not decide to compete by setting higher prices on the presumption that a higher value good (giving greater rpoduct value to the customer, for example, shoes made of leather uppers and insoles) will generate a competitive clientele. The existing strong competitors will continue to pull customers based on brand loyalty and "competitive" pricing.

A business's pricing decisions are determined by taking into account all the influences and strengths of the all the market structure elements and adjusting their internal product pricing decisions accordingly.

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The type of market structure a firm faces has some impact on its pricing.  However, firms are never simply free to set their own prices if they want to make the maximum possible profit.

In perfect competition, firms have no choice but to charge the market price.  They are price takers in this market structure and must charge the same as everyone else.

In all other market structures, firms have some control over their pricing.  In oligopolies, they must pay attention to the pricing decisions of competitors, but they do not really need to do this in monopoly or monopolistic competition.  However, in all of these cases, firms must (to maximize profit or minimize loss) produce the quantity were their marginal revenues equal their marginal costs.  They must then charge a market clearing price--the price that will clear exactly that quantity of their product.

Market structure does affect firms' pricing decisions, but firms are never simply free to set their own prices if they want to maximize profits.

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