'Although corporate pricing decisions are influenced by many different factors, fundamentally prices will reflect cost and market conditions.Explain and discuss.

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 For my essay I have chosen the second option available to me, which is:

‘Although corporate pricing decisions are influenced by many different factors, fundamentally prices will reflect cost and market conditions.

Explain and discuss.

Firms have to know not only about costs, but also about revenues when they make pricing and output decisions. In order to understand the relationship between output, revenues and price, a firm has to know the structure of the market or industry in which it is selling its product. There are various market structures, all dependant upon the extend to which buyers and sellers can assume that their own buying and selling decisions do not affect market price. At one extreme, when buyers and sellers correctly assume that they cannot affect market price, the market structure is one of perfect competition. Whenever buyers and sellers must take into account how their individual actions affect market price, we are not in a market structure of perfect competition and have entered an imperfectly competitive market. Such a market is examined later in the essay relating to the extreme on the other side of the line  -monopoly.

The characteristics of perfect competition

The following section will cover how a firm acting within a perfectly competitive market structure makes decision about how much to produce. Before I go ahead with this analysis, I want to give the characteristics of the market structure called perfect competition. These characteristics are as follows:

  1. The product that is sold by the firms in the industry is homogeneous. This means that the product sold by each firm in the industry is a perfect substitute for the product sold by every other firm. In other words, buyers are able to choose from a large number of sellers of a product that the buyers believe to be the same. The product is thus not in any sense differentiated as a result of whoever is the source of supply.
  2. Any firm can enter or exit the industry without serious impediments. Resources must be able to move in and out of the industry without, for example, government legislation that prevents such resource mobility.
  3. There must be a large numbers of buyers and sellers. When this is the case, no one buyer or one seller has any influence on price, and also when there are large numbers for buyers and seller they would be acting independently.
  4. There must be complete information.  Both buyers and sellers must clearly know about market about market prices, product quality and cost condition.

Now that I have defined the characteristics of a perfectly competitive market structure, I can consider the position of and individual constituent unit. A perfectly competitive firm is a small part of the total industry in which it operates that it cannot significantly affect the price of the product in question.

Since the perfectly competitive firm is a small part of the industry, that firm has no control over the price of the product. This means that each firm in the industry is a price-taker – the firm takes price as given as something that is determined outside the individual firm.

The price that is being given to the firm is determined by the forces of market supply and market demand. That is, when all individual customers’ demands are added together into a market demand curve, and all the supply schedules of individual firms are added together into a market supply curve, the intersection of those two curves will give the market price, which the purely competitive or price-taking firm must accept.

This definition of a competitive firm is obviously idealised, for in one sense the individual firm has to set prices. But here we have a situation where firms regard prices as set by forces outside their control. This is because, even though every firm, by definition, sets its own prices, a firm in a perfectly competitive situation will find that it will eventually have no customers at all if it sets its price above the competitive price.

Below I have displayed (figure 1.0) what the demand curve of an individual firm in a competitive industry looks like graphically.

The figure above shows the demand curve for an individual pocket calculator producer is such a small part of the total market that he or she cannot influence the price. The firm accepts the price as given. At the going market price it faces a horizontal demand curve, dd. If it raises its price by even 1p, it will sell no calculators. The firm would be foolish to lower its price below £5 because it can sell all that it can produce at a price of £5. The firm’s demand curve is completely, or perfectly elastic.

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Cost structure of the firm

A firm’s cost are divided into fixed costs and variable costs. Fixed costs consist of pre-committed outgoings, which are payable regardless of the level of output. Variable costs represent outgoings, such as materials, energy and distribution costs, which rise and fall in accordance with the volume of output. Fixed costs can be subdivided into sunk costs and other fixed costs. Some costs refer to past expenditure on fixed assets, which have no alternative use and the cost of which can be amortised or recouped only by trading. Examples of sunk costs include the ...

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