Micro eco notes.docx

8/18/2019 Micro eco notes.docx

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MODULE II

Market structure

Introduction

Traditionally a market was regarded as a place where buyers and sellers meet. Buttoday this concept has undergone a lot of changes. Sitting in the comfort of one’s home, one

can engage in buying and selling with persons anywhere in the world. Now it is not necessary

for the buyer to meet the seller to get the product he wants. There are also many ways by

which payments for goods and services can be effected without the actual direct meeting of

buyers and sellers. ence the concept of market and the definition of market has also changed

to incorporate this modernity. ence, market is defined as “a set of conditions in which

buyers and sellers come in contact for the purpose of exchange.

Structure of market

!arket can be classified of the basis of area, time and degree of competition. "n the

basis of area the market for a product can be divided into local market, national market and

international market. "n the basis of time, the market can be identified as market period,

short period and long period. But, with the development of technology these two

classifications have become outdated. The phenomenal progress made in the fields of

transport and preservation has made international market possible for those commodities

which had only local markets. !oreover, these market structures have had little impact on

pricing decisions.

Based on the degree of competition, a market can be broadly classified into sellers’

market and buyer’s market. #conomist have developed market forms from the buyer’s anglelike monopsony and duopsony. But, it is the market structure from the seller’s point of view

which is of real importance.

The nature of competition among the sellers is viewed on the basis of two ma$or

aspects%

i. The number of firms in the market.

ii. The characteristics of products, such as whether the products are homogenous

or differentiated.

Individual sellers control over the market supply and his hold on price determination

basically depend upon these factors.

"n the selling side or supply side of the market, the following types of market

structures are commonly distinguished%

i. &erfect competition

ii. !onopoly

iii. "ligopoly

iv. !onopolistic competition and certain minor forms like duopoly and bilateral

monopoly.


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&erfect competition and oligopoly are two e'tremes of market situations. "ther forms

of market such as oligopoly and monopolistic competition fall in between these two

e'tremes.

Perfect Competition

The classical and neo(classical economists believed that a state of perfect competition

always prevailed in the market. )ll pricing were perfect competition oriented for a long

period. #veryone believed that this market system had found a realistic solution to all pricing

problems. Till the *+th century, perfect competition was the sole market structure that was

prevailing.

efinition of perfect competition%

&erfect competition can be defined as a market situation in which there are large

number of buyers and sellers with perfect knowledge and in close contact, dealing in identicalcommodity without price discrimination.

-onditions /eatures -haracteristics of perfect competition

The following conditions must e'ist for a market to be perfectly competitive. These

are also distinct features of perfect competition.

&erfect competition and pure competition

Before we proceed to make a study of the main features of this market system, it is

necessary to study the concept of 0pure competition’. &ure competition is a type of perfect

competition, but it has only three features. They are%

1. 2arge number of buyers and sellers.

*. omogenous product

3. /ree entry and e'it of firms.

But in a perfectly competitive market, there are more characteristics in addition to the

three features given above. Therefore the characteristics of the perfect competition are

analysed under the clear assumption that pure competition is a part of perfect competition.

1. 2arge number of buyers and sellers% &erfect competition is characterised by the

presence of actual and potential buyers and sellers. Since the number of these participants are very large, no single seller or buyer would be able to influence the

prevailing price. Similarly, this large number prevents either the buyers or the

sellers from a collusion and influence the price.

*. omogenous or identical product% The industry is defined as a group of firms

producing a homogenous product. The technical characteristics of the product as

well as the services associated with its sale and delivering are identical. There is

no way in which a buyer could differentiate among the products of different firms.

Since each firm produces an identical product, these products can be readily

substituted for each other.

3. &rice taker% In a perfectly competitive market, a single market price prevails for the commodity, which is determined by the forces of total demand and total


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supply in the market. In other words, under perfect competition, the industry fi'es

the price and the firm accepts it. No firm is in a position to influence the price.

Because each individual firm supplies only a small part of the total 4uantity

offered in the market.

5. /reedom of entry or e'it of firms% There is no barrier of entry or e'it from the

industry. )ttracted by e'cess profit new firms enter into the industry. /irms are

also firm to leave the industry at any time, especially, when they fail in the

struggle for e'istence 6due to sustained loss7.

8. &rofit ma'imisation% The goal of all firms is profit ma'imisation. No other goals

are pursued.

9. &erfect mobility of goods and factors% :oods are free to move to those place

where they can get the highest price. /actors can also move from a low paid to a

high paid industry.

;. &erfect knowledge of market conditions% &erfect competition re4uires that all the

buyers and sellers must possess perfect knowledge about the e'isting market

conditions, particularly present and future prices and costs. Nobody behavesirrationally.


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In the figure, point 0#’is the e4uilibrium point, at which the S!- curve intersects theS!? curve from below. -onse4uently, "@ is the e4uilibrium level of output. Since areas

under the respective average revenue and cost curves measure total revenue and total cost, the

difference between the two show profits. The shaded area )B represents the minimised

profits. The condition for e4uilibrium is%

!?A!-

To summarise the analysis%

1. The firm in the short(run has temporary e4uilibrium.*. The firm is at e4uilibrium in the short run, when the short run marginal cost is

e4ual to the short run marginal revenue at the given short run e4uilibrium price.

i.e.6S!-AS!?7.

3. The firm gets ma'imum normal profits when the price is e4ual to the firm’s

average total cost. i.e.6&A)-7.

5. The firm yields ma'imum e'cess profits when the market price is higher than the

firms average total cost. i.e. 6&)-7.

8. ) ma'imum loss is incurred by the firm when the price is $ust e4ual to the average

variable cost 6&A)C-7. The loss is e4ual to the total fi'ed cost. The loss is

minimised when the price is less than the average total cost but above the averagevariable cost.

9. If the price is very low, being less than the average variable costs, the firm stops

production altogether.

!hort period e#uilibrium of the industry

)n industry is in e4uilibrium in the short run when there is no tendency for its total

output to e'pand or contract, i.e., the output of the industry is steady. Dhen the following

three conditions are satisfied, an industry will be in e4uilibrium in the short run%

1. )ll the e'isting firms must be producing in an e4uilibrium level of output 6at

which !?A!-7.*. It is not necessary that each firm in the industry should be earning normal profits

in the short. Some may be earning normal profits, some super normal profits or

even some may be incurring losses depending on their cost functions. This means,

firms making super normal profits and ma'imum losses can co(e'ist along with

the short run e4uilibrium of the industry.

3. The short period market price and its determining factors vi>, Short run demand

and short period supply, are in e4uilibrium. Dhen the total 4uantity demanded is

e4ual to the total 4uantity supplied at the e4uilibrium short run market price, the

market is clearedE so there is no reason for the market price to change in the short

run. Thus, the market and all the firms in the industry attains short run e4uilibriumat this price.


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In figure 6a7, SS curve represents short run industry supply and represents short

run industry demand. Both the curves intersect at point # determining "& as the short run

e4uilibrium price, at which "@ is the 4uantity demanded e4ual to the 4uantity supplied in themarket. )t this price, industry is in e4uilibrium. The firms are also in e4uilibrium by e4uating

!? with !-. But they may be making profits or losses as in figure 6b7 and 6c7.

Long run e#uilibrium of the firm

In the long run, firms are in e4uilibrium when they have ad$usted their plants so as to

produce at minimum points of their long run )- curve, which is tangent to the demand curve

defined by the market price. In the long run, firms will be earning $ust normal profits, which

are included in the 2)-. If they are making e'cess profits, new firms will be attracted in the

industry. This will lead to a fall in price and an upward shift of the cost curves due to the

increase of the prices of factors as the industry e'pands. These changes will continue until the2)- is tangent to the demand curve defined by the market price. If the firms make losses in

the long run, they will leave the industry, price will rise and the cost may fall as the industry

contracts, until the remaining firms in the industry cover their total costs inclusive of the

normal rate of profit.

The following figure e'plains long run e4uilibrium of the firm under perfect

competition.


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In the above figure, we show how firms ad$usts to their long run e4uilibrium position.

If the price is "&, the firm is making e'cess profits working with the plant whose cost is

denoted by S)-. It will therefore, have an incentive to increase production. )t the same time

the new firms will be entering the industry attracted by e'cess profits. )s a result the 4uantitysupplied in the market increases and the supply curve in the market will shift to the right and

the price will fall until it reaches the level of "&, at which the firms and the industry are in

long run e4uilibrium. 6The 2)- is the final cost curve including any increase in the prices of

factors that may have taken place as the industry e'panded7.

-ondition of a long run e4uilibrium of a competitive firm%

1. 2!-A2!? i.e. profit is ma'imised.

*. &rice 6)?7 A2)-, therefore normal profit.

3. 2!-A2)- i.e. the firm is operating at a minimum average cost.

The last condition indicates that under perfect competition, all firms in the long period

must operate at their most efficient level of output so that )- is at the minimum of this is so,

the resources are utilised in an optimum way.

5. The e'istence of long run e4uilibrium conditions of a firm means that short run

e4uilibrium firm also e'ists simultaneously, because the long run is composed of a

series of short run phases.

Thus, when a firm is in a long run e4uilibrium%

&riceA 2!- A 2!? A 2)2 A S)2 A S!-

#4uilibrium &rice% "&1

#4uilibrium output% "@1

E#uilibrium of industry in the long run

The e4uilibrium of the industry in the perfectly competitive market is established

under the following conditions.

1. Industry being a collection of firms, for an industry to be in long run

e4uilibrium, apparently all the e'isting firms in the industry must be producingan e4uilibrium level of output by e4uating the long run marginal cost with the

long run marginal revenue 62!-A2!?7. )ggregate of their output constitutes

the total supply of the industry.

*. The number of firms in the industry must be stable. There must be no entry of

a new firm or an e'it of firm in the industry. This re4uires that all the e'isting

firms in the industry must be earning normal profits. This happens when all

the firms have price or 2)?A2)-.

Fnless all the firms are earning $ust the normal profits, industry will not attain

a stable e4uilibrium in the long run. Because, if some firms are earning e'cess

profits, it would encourage new entry in the industry will lead to changes inthe industry supply and market prices in the long run.


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3. The long run e4uilibrium price is established so that the total 4uantities

demanded and supplied in the long run are e4ual and the market is cleared off.

The long run e4uilibrium of the industry is shown in the following figure.

In the following figure, the long run e4uilibrium price "& is determined by the

intersection of the long run supply curve SS and the demand curve at the

point /. )t this price, the firm’s e4uilibrium is determined by e4uating

2!?A2!-. Thus, "! is the e4uilibrium output of the firm in the long run.

Thus industry is in long run e4uilibrium when%

&riceA 2)? A2!? A2)- A 2!-

)s such, the firm en$oys $ust normal profits.

Merits of $erfect %ompetition

1. Increased production% Since every commodity is produced by large number of

producers, consumers do not feel any scarcity for essential goods.


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*. 2owest price% &erfect competition enables the consumers to purchase things at the

lowest possible price without any bargain.

3. #fficient production% Fnder perfect competition, the general efficiency of production

is very high because inefficient producers who fail to compete with others leave the

industry.

5. Best rewards for factors% The mobility of the factors of the production enables them toget the best rewards.

8. )bsence of waste% Fnder perfect competition, advertisement is unnecessary. It is

assumed that each producer can sell any 4uantity at the ruling price.

9. )bsence of price discrimination% The absence of price discrimination under perfect

market makes the consumers happy and contended.

;. Technological progress% -ompetition provides conducive atmosphere for scientific

invention and technological progress. Inventions and innovations lead to economic

development.

efects of perfect competition%

1. #conomic ills% The e'istence of large number of producers in each industry

generally leads to over production, glut, economic depression and un employment.

Fnder perfect competition the e4uality between demand and supply is brought

about only in the long run period.

*. eception% Fnder perfect competition, the producers are compelled to sell their

goods at the lowest rate. Dhen this cannot be honestly done, they resort to

adulteration and other forms of deception. #.g.% rice mi'ed with stones.

3. Fnrealistic assumption% !any of the assumptions on the perfect competition like

perfect knowledge on the part of the consumers, perfect mobility of factors of

production etc. are 4uite unreal. In real life manufacturers attract consumers

through advertisement, publicity. Similarly, the imperfect knowledge of the

labourers may not enable them to get the best rewards.

5. igher cost% Fnder perfect competition, many independent firms are engaged in

production in each industry. Therefore, the average cost of production is likely to

be higher. It becomes very low if all the firms merge into a single large scale

production unit.

8. #'ploitation of workers% #very producer under perfect competition is compelled

to lower the cost of production per unit of output. This may lead into the

e'ploitation of ignorant and illiterate workers by giving them hard work and low

wages.

9. -heck the progress of the society% If a producer invents a better techni4ue of

production, he keeps it as a business secret. So that, his competitors may not

imitate. But it checks the progress of the society.

;. Bad business atmosphere% The keen competition among the competitors may

make them enemies. The strong enmity that develops in the minds of some

producers may tempt to undersell their goods $ust to see the ruin of others.

Deri&ation of supply cur&e under perfect competition

!hort run supply cur&e of the competiti&e firm


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) supply for a firm shows how much output it will produce at every possible price. The

competitive firms will increase the output to a point at which the price is e4ual to marginal

cost 6&A!-7, but will shut down if price is below average variable cost. The supply curve of

the firm is shown in the following figure.

In the following figure, the minimum output the firm will produce is G where price & is e4ual

to the minimum point on the )C- curve. /or any price below &+ is e4ual, the firm’s revenues

do not even cover variable costs. So the firm will not supply any 4uantity 6will close down7.

)s price rises above &+, the 4uantity supplied increases 6G1 and G*7. ence, the short run

supply curve of the firm is the cross hatched portion of the marginal cost curve.

Short run supply curve for the competitive firms slope upward for the same reason

that marginal cost increases( the presence of diminishing returns to one or more factors of

production. )s a result an increase in the market price will induce those firms already in the

market to increase the 4uantities they purchase.

!hort run supply cur&e of the competiti&e industry or short run market supply cur&e

The short run market supply curve shows the amount of output that the industry will

produce in the short run for every possible price. The industries output is the sum of the

4uantities supplied by all the individual firms, Therefore, the market supply curve can be

obtained by adding their supply curve. In other words, the supply curve of the industry isobtained by the hori>ontal summation of short run supply curve of all the individual firms in

the industry.

The following figure shows how this is done when there are only three firms, all of

which have different short run production costs. #ach firm’s !- curve is drawn only for the

portion that lies above its average variable cost curve.


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In the figure, at any price below &1, the technology will not produce no output because&1 is

the minimum average variable cost of the lowest cost firm. Between &1 and &*, only firm 3

will produce. The industry supply curve, would be therefore identical to that of firm 3’s

marginal cost curve !-3. )t price &*, the industry supply will be the sum of the 4uantity

supplied by all three firms. /irm 1 supplies 5 units, firm* supplies ; units and firm 3 supplies

1+ unitsE the industry supplies *1 units. Note that the industry supply curve is upward sloping

but has a kink at price &*, the lowest price at which all three firms produce. Dith many firms

in the market, however, the kink becomes unimportant. Thus, we usually draw industry

supply as a smooth, upward sloping curve.

!hut down period

In the short, the cost of production of a firm is the sum of the fi'ed costs and variable

costs at the fi'ed level of output. The total revenue of the firm must cover both these costs.

"therwise, it will incur losses. But a firm may carry on production in the short run if its

variable costs are covered. This is with the hope that in the long run the conditions will

improve and total revenue will become greater them total costs.

The point at which the firm covers its variable cost is called the Hshutdown point6&A)C-7. The firm will close down if price falls below the average variable cost

6&J)C-7 since by discontinuing its operations the firm is better off% it minimises its losses. If

the firm stops production in the short run, losses will be e4ual to the fi'ed cost. 2osses will be

less than the fi'ed cost if a firm while operating earns revenue which covers variable costs

fully as well as a part of the fi'ed costs. 6See figure% Short run supply curve of the

competitive firm7.

In the long run, total revenue does not cover the total cost, the firm is to be closed

down 6&A)T-7.

MO'O$OL(

!onopoly is a well(defined market structure where there is only one seller who

controls the entire market supply, as there are no other close substitutes for his product and


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there are barriers to the entry of rival producers. The word monopoly comes from the :reek

word 0monos polein’, which mean ’single seller’. This single seller is called a monopolist.

By definition, monopoly is a market situation in which there is only one producer or

seller of a particular commodity which has no close substitutes and he has sufficient control

over the supply of the commodity so as to influence the price. The monopolist is thus a pricemaker and not a price taker. Thus, the monopoly market model is the opposite e'treme of

perfect competition.

)eatures or characteristics of monopoly

The main features of a monopoly market are e'plained below%

1. Single producer or seller% Fnder monopoly, there is only one producer or seller of a

commodity. Thus, firm and industry are identical.

*. No close substitute% There is no substitute for the commodity produced by the

monopolist. So the buyers have no choice. Therefore, the cross elasticity of demand

for the product of the monopolist is >ero.

3. Barriers to entry% ) monopolist has no immediate rivals due to the e'istence of strong

barriers to the entry of firms. The barriers which prevent the firms to enter the

industry maybe legal, technological, economic or natural obstacles.

5. ownward sloping demand curve% The demand curve of the monopolist slopes

downward. This means he cannot sell more output unless the price is lowered.

8. &rice maker% In monopoly, the producer or seller has complete control over the supply

of the commodity. Therefore, the monopolist can fi' any price for his commodity that

suit him best.

9. iscriminate price policy% The monopolist may follow a discriminative price policy

for his product. e may charge different prices for his product from different buyers.

!ources or reasons of monopoly power

There are ma$or reasons or sources of monopoly. It is because of these reasons that

these monopolists en$oy a high degree of monopoly power. These sources relate to the factors

which prevent the entry of new firms into an industry. They are%

1. &atent or -opyright% /irst important source of a monopoly is that a firm may possess a

patent or a copyright which prevents others to produce the same product or use a

particular product process. These rights are obtained from the government. These

patent rights are granted for a certain period of time to encourage inventions.*. -ontrol over key raw materials% Some firms gain monopoly power from their

overtime control over certain scarce and key raw materials that are essential for the

production of certain other goods. #.g.% "- 6"rganisation of &etroleum #'porting

-ountries7 e'ercises monopoly power in the world over the supply of petroleum

products as it has control over the supply of crude oil of these countries.

3. #conomies of scale% Natural monopoly% The si>e of the market maybe such as not to

support more than one plant of optimal si>e. The technology maybe such that to show

substantial economies of scale, which re4uire only a single plant if they are only to be

reaped. /or e.g.E in transport, electricity, communications, there are substantial

economies which can be realised only at a large scale of output. The si>e of themarket may not allow the e'istence of more than a single large plant. In those


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conditions, it is said that the market creates a natural monopoly and it is usually the

case that the government undertakes the production of the commodity or of the

services to avoid e'ploitation of the consumers. This is the case of public utilities.

5. !arket /ranchises% The government gives e'clusive right to the firm to sell a certain

good or service in a certain area. Fsually, this is done with television cable

companies, ta'i companies and so on. These franchises create monopoly to profits for

the holders of the franchises.

$rice and Output determination or monopoly e#uilibrium

The ob$ective of the monopoly firm is to gain ma'imum profit from the sale of its

product. The firm can achieve its ends in two alternative ways. The firm can either fi' the

price of its product or it can fi' the 4uantity to be sold to the customers. :iven the downward

sloping demand curve, the monopolist cannot fi' the price and output simultaneously. e has

to select one of these two alternatives. #ither he can fi' the price and leave the output to be

determined by the demand of customers or he can fi' the output to be produced and leave the price to be determined by the consumer demand for his product.

The monopolist fi'es the price in such a way as to get the ma'imum profits. The

ma'imum price he can fi' for a commodity depends on the nature of the commodity and its

elasticity of demand. If the commodity is having inelastic demand, the monopolist fi'es a

higher price in order to earn ma'imum profit. "n the other hand, if the commodity is having

elastic demand, he can sell more only by reducing the price of the commodity.

!hort run E#uilibrium

The monopolist ma'imises his short run profits if the following two conditions are

fulfilled%

1. The !- is e4ual to the !?.

*. The slope of !- is greater than the slope of !? at the point of intersection.

The short run e4uilibrium of a monopoly firm is graphically e'plained below%

In the figure, the e4uilibrium of the monopolist is defined by point #, at which the

!- intersects the curve from below. Thus both conditions for e4uilibrium are fulfilled. The

e4uilibrium price is "& and the e4uilibrium output is "!. The monopolists realises the


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e'cess profit e4ual to the shaded area &)B-. Note that the price is higher than the !?

6&!?7.

Long run e#uilibrium

In the long run the monopolist has the time to e'pand his plant, or to use his e'isting

plant at any level which will ma'imise his profit. e will not stay in the business if he makes

losses in the long run. e will most probably continue to earn super normal profit, even in the

long run, given the entry of new firms blocked. owever, the si>e of his plant and the degree

of utilisation of any plant si>e depend entirely on the market demand. The monopolist may

reach the optimum scale 6minimum point of 2)-7 or remain at the sub optimal scale 6falling

part of his 2)-7 depending on the market conditions.

The most profitable level of output is the case each plant is at the point where the

2!- curve intersects the !? curve from the below and the S!- curve passes through this

point. /urther the S)- curve must be tangent to the 2)- curve at this level of output. De

discuss below monopoly e4uilibrium in smaller than the optimum si>e plant.

Suppose, in the long run, the monopolist installs a plant represented by the curve S)-1 and

S!-1. "n this plant, the long run profits are the ma'imum at the output "! where

2!-A2!? at point ). Since at this level, the short run average cost curve, S)-1, is tangent

to the 2)- at point #, the S!- curve is also e4ual to the 2!- curve and to the !? curve,

i.e. 6S!-1A2!-A!?7 at the e4uilibrium point ). Thus, when the monopoly firm is in long

run e4uilibrium, it is in short run e4uilibrium. The monopolist charges the price "B 6A!&7,

sells the output "! and earns B- monopoly profit. owever, this plant is less than the

optimum si>e since the monopoly firm is not producing at the lowest point 02’ of the 2)-

curve. It has some e'cess capacity. It is not in a position to take full advantage of theeconomies of scale due to the small si>e of the market for its product.


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Discriminating monopoly"price discrimination

) monopoly firm which adopts the price of firm discrimination is referred to as a

discriminating monopoly. &rice discrimination involves the act of selling the same product at

different prices in different markets or to different buyers. In the words of !rs. Koan

?obinson, the act of selling the same product produced under a single control, at different

prices to different buyers is known as price discrimination. /or e.g. If the manufacturer of a

television of a given variety sells it at rs.8+++( to one buyer and at rs.88++( to another buyer

6)ll conditions of sale and delivery are the same in the two cases7, then he is practising price

discrimination.

/orms or types of price discrimination

&rice discrimination may take many forms. The common forms of price

discrimination maybe stated below%

1. &ersonal discrimination% &rice discrimination is personal when the buyer charge

different prices from different persons. /or e'ample, a surgeon may charge a high

operation fee from a rich patient and a lower fee from a poor one.

*. )ge discrimination% &rice discrimination on the basis of age of the buyers is known as

age discrimination. Fsually buyers are grouped into children and adults. #.g.% )

barber may charge higher rate for adults than that he charges for children, in railways

and bus transport services, children between 3 and 1* years are charged only half the

adult rates.

3. Se' discrimination% In selling certain goods, producers may discriminate between

male and female buyers by charging low prices from females. #.g.% ) tour organi>ingfirm may provide seats to ladies at a concessional rates.

5. 2ocational or place discrimination% Dhen a monopolist charge different prices in

different markets located at different places, it is called locational or geographical

discrimination. #.g.% ) producer may sell a commodity at one price at home and at

another price abroad.

8. Fse discrimination% Sometimes, depending on the kind of use of product, different

prices may be charged. #.g.% #lectricity is usually sold at a cheaper rate for domestic

uses than for commercial purposes.

9. Time discrimination% "n the basis of the time of service, different prices may be

charged. #.g.% The telephone companies charges half rates for trunk calls at night.

Necessary conditions for price discrimination%

The necessary conditions which must be fulfilled for the implementation of price

discrimination are the following%

1. &rice elasticity is different at different markets% The market must be divided into

submarkets with different price elasticities. It is the difference in price elasticities that

provides opportunity for price discrimination. If price elasticites of demand in

different markets are the same, price discrimination would not be gainful.


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*. !arkets are so separated that resale is not profitable% There must be effective

separation of submarkets, so that buyers of low(price market do not find it profitable

to resell the commodity in the high priced market because of

• :eographical distance involving high cost of transportation.

• #'clusive use of commodity. #.g.% octor services etc.

• 2ack of distribution channels. #.g.% transfer of electricity and gas.

3. There must be imperfect competition in the market% The seller must possess some

monopoly power over the supply of the product to be able to distinguish between

different classes of consumers, and to charge different prices.

egrees of price discrimination%

The degree of price discrimination refers to the e'tent to which a seller can divide the

market and take the advantage of market division in e'tracting the consumer surplus.

)ccording to ).-.&igou, There are three degrees of price discrimination practiced by the

monopolists%

1. /irst degree price discrimination.

*. Second degree price discrimination.

3. Third degree price discrimination.

1. /irst degree price discrimination or 6perfect price discrimination7% The

discriminatory price that attempts to take away the entire consumer surplus is

called first degree price discrimination. It is said to occur when the seller charges a

different price for each unit of output. This involves charging different prices to

different consumers as well as charging different prices for different units sold tothe same consumer. The ma'imum price that someone is willing to pay for a unit

output is called the reservation price. The perfectly discriminating monopolistic

charges the reservation price for each unit of output. Thus, the !? curve for the

monopolist becomes demand curve. In this case, the e4uilibrium level of output,

which is given by intersection of the demand curve and the !- curve, is the same

as the output under the perfect competition. This is shown in the following figure%

The monopolist’s output is "- and revenues are given by the area ")B-. Since

the monopolist charges a different price for each unit. Subtracting from this, the

cost 6which are "- multiplied by the average cost "-#7, we get themonopolist’s profit which is the shaded area )B#.


16/35

*. Second degree price discrimination% This occurs when the monopolist is able to

charge different prices for the different 4uantities of purchase. The second degree

price discrimination is also called block pricing system. ) different price is

charged from different category of consumers. ) monopolist adopting the seconddegree price discrimination intends to siphon off only the ma$or part of the

consumer surplus, rather than the entire of it. The second degree price

discrimination is feasible where%

• The number of consumers are large and the price rationing can be

effective, as in case of utilities like telephone, natural gas and

electricity.

• emand curves of all the consumers are identical.

• ) single rate is applicable for a large number of buyers.

The second degree price discrimination is e'plained through the followingdiagram%

In the figure, a monopolist sets the price first at "&1 and sells "@1. )fter selling

"@1, he sets a lower price "&*, and sells @1@* units. )fter the sale of @1@*additional units, he sets still a lower price "&3 for the ne't additional sale of @1@*

units. Thus by adopting a block pricing system, the monopolist ma'imises his total

revenue 6T?7 as

T? A 6"@1L)@17 M 6@1@*LB@*7 M 6@*@3L-@37

If a monopolist is restrained from price discrimination, and is forced to choose any

one of the three prices, "&1, "&* or "&3, his total revenue will be much less.

3. Third degree price discrimination% This occurs when monopolists sets different

price at different markets having demand curves with different elasticities. ere,


17/35

the monopolist is trying to e'ploit the different price elasticities of demand for

different markets. The monopolists are therefore re4uired to allocate total output

between different markets so that profit can be ma'imised in each market. The

profit in each market would be ma'imum only when the !?A!- in each market.

E#uilibrium price and output under discriminating monopoly

Fnder single monopoly, a single price is charged for the whole output. But under

price discrimination, the monopolist will charge different prices in different submarkets. /irst

of all, therefore the monopolist has to divide his total market into various submarkets on the

basis of differences in price elasticity demand in them.

The reason for a monopolist to apply price discrimination is to obtain an increase in t

total revenue and his profit. In order to reach the e4uilibrium position, the discriminating

monopolists has to take three decisions%

1. The total output to be produced.*. The distribution of supply of outputs in different markets. i.e how much to sell

in each market with a view to ma'imise profit.

3. The prices of product in different markets.

The e4uilibrium conditions in this regard are%

1. To determine total output, the monopolist should e4uate marginal cost 6!-7

with combined marginal revenue 6)!?7 of different markets. I.e. !-A)!?.

*. To ma'imise the profits, the total output in different markets will be

distributed in such a way that marginal revenue in each market is the same.

3. &rices in different markets will be decided in relation to the 4uantity of outputallocated for the sale and position of the demand curve.

)s a rule, higher prices will be charged in the market with inelastic demand and lower

price in the market with elastic demand. "bviously, lesser 4uantity will be supplied to the

inelastic market and larger amount to the elastic demand market. Indeed, once allocation of

output is decided, price determination in each market automatically follows directly from the

demand curve.

*he model

To e'plain the e4uilibrium conditions of the price discriminating monopolist, we may

assume a simple model for graphical analysis as follows%

1. The monopolist is facing separate markets ) and B.

*. The demand for the product in the market B is relatively inelastic.

3. The demand for the product in the market B is relatively elastic.

5. The firm’s cost conditions are known.

8. The rationale of price discrimination is ma'imisation of total profits.

Fnder these assumptions, comparing per unit cost and revenue conditions, the

e4uilibrium level of output can be reached by the monopolist when the !- is e4ual to

the combined !? 6!-A!?7, as shown in the following figure 6panel -7.


18/35

In the above figure, &anel 6a7 represents the conditions of market ). a represents its

demand curve, which is relatively inelastic. &anel 6b7 represents market B. Its demand curve

is b which is relatively elastic. &anel 6c7 represents the condition of aggregate market of themonopoly firm. )!? represents the combined marginal curve, )!?A!?a M !?b. The

firms marginal cost is shown by !- curve which represents )!? at point #, so at this point,

!-A)!?. It is the profit ma'imising e4uilibrium condition. Thus, "@ is the e4uilibrium

output. The monopolists now allocate the "@ output between the two markets in such a way

that the necessary conditions for profit ma'imisations is satisfied in both the markets 6i.e

!-A!?7. Therefore, he will allocate "@ output between the two submarkets in such

proportions that !?aA!?b. The profit ma'imising output for each market can be obtained

by drawing a line from point #, parallel to '(a'is, through !?a6#17 and !?b6#*7 determine

the optimum level of output for each market. ence, the monopolist ma'imises profit in

market ) by selling "@a units at price &1@a, and by selling "@b units in market B at price&*@b.

The firm’s total e4uilibrium output is "@A"@aM"@b. Since at "@a, !?aA!- in

market ), and at "@b, !?aA!- in market B.

!-A)!?A!?aA!rb

The total profit of the monopolist is shown by the areas between the )!? curve and

the !- curve. Thus, shaded area B#- measures total profit.

Thus, for the discriminating monopolist to be in e4uilibrium, the following conditions

must be fulfilled%

1. )!?A!-

*. !?aA!?bA!-.

Dumping

The act of selling a commodity produced under a single control, at a higher price in

the home market and at a lower price in the world market is known as dumping.


19/35

"b$ectives

1. ) monopolist may resort to dumping to drive out the rivals from the foreign

markets. In order to achieve this ob$ective, he may even sell his product in the

foreign market at a price which is lower than cost of production. "nce the market

is con4uered he can raise price and earn ma'imum profits.

*. umping may happen because of an error in the demand estimates. The producer

may produce more output than what is necessary for the domestic market. If he

tries to sell the e'cess output in the home market he will have to lower the price

not only for the e'cess output but for the entire output. ence, it will be more

profitable if he disposes of the e'cess output in a foreign market at a lower price.

3. )nother ob$ective of dumping is to reap the advantages of increasing returns.

Together with the home market, if the foreign market is also available, the

monopolist may be able to organise production on a large scale. This will help him

to reap the advantages of increasing returns, therefore, he resorts to dumping.

5. The monopolist may resort to dumping if the demand for his product at home is

inelastic whereas in foreign markets, it is elastic. So dumping will help him to take

full advantage of the elastic demand in the foreign market.

Monopsony

!onopsony refers to a market in which there is a single buyer of a commodity or a

service. It was !rs. Koan ?obinson who coined the term 0monopsony’. !onopsony allows a

buyer to purchase a good less than the price that would e'ist in a competitive market. Fnder

this situation, the buyer has the upper hand in fi'ation of the price of the product. !onopsonyis also very rare in real life.

Sources of monopsony power%

It is possible to draw analogies with monopoly and monopsony power. The monopoly power

depends on three things. The elasticity of market demand, the number of sellers in the market

and the ways those sellers interact.

The monopsony power depends on three similar things%

1. #lasticity of market supply% ) monopsonist faces it because it faces an upward

sloping supply curve, so that marginal e'penditure e'ceeds average e'penditure.The less elastic the supply curve, the greater difference is between the marginal

curve and the average e'penditure and the monopsony power the buyer en$oys. If

supply is highly elastic monopsony power is small and there is little gain in being

the only buyer.

Marginal Expenditure% The additional cost of buying one more unit of a good.

+&erage Expenditure% &rice is paid per unit of a good. The market supply curve

is monopsonits average e'penditure curve.

Marginal ,alue% The additional benefit from purchasing one more unit of a

good. It is a function of the 4uantity purchased. Therefore value schedule is the

demand curve for the good.


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*. Number of buyers% The number of buyers is an important determinant in the

monopsony power. Dhen the number of buyers is very large, no single buyer can

have much influence over price. Thus each buyer faces an e'tremely elastic

supply curve, so that the market is almost completely competitive. The potentialfor monopsony power arises when the number of buyers is limited.

3. Interaction among buyers% Suppose three or four buyers are in the market. If those

buyers compete aggressively. They will bid up price close to the marginal value of

the product and will thus have a little monopsony power. "n the other hand, if

those buyers compete aggressively, or even collude, prices will not be bid up very

much, and the buyer’s degree of monopsony will be nearly as high as if there were

only one buyer.

-ilateral monopoly

Bilateral monopoly is a market situation where there is only one seller 6monopolist7

and only one buyer 6monpsonist7. Both the buyer and the seller have monopoly power in their

respective fields( The monopsonist in the buying field and the monopolist in the selling field.

!onopsony power and the monopoly power tend to counteract each other. In other words, the

monopsony power of buyers will reduce the effective monopoly power of sellers and vice

versa.

Both parties want to ma'imise gains from the transactions. The seller wants to get a

high price for his product from the buyer, the buyer wants a lower price from the seller.

Fnder this situation determination of e4uilibrium price and output is difficult and can only be

determined by the traditional tools of demand and supply. ence, price and output

determination under bilateral monopoly is done by on(economic factors such as bargaining

power, skill and other strategies of the participating firm. Bilateral monopoly is rare. !arkets

in which a few producers have some monopoly power and sell to a few buyers who have

some monopsony power are more common.

Monopolistic %ompetition

&roduct pricing under perfect competition and monopoly are e'treme cases which are

seldom found in practice. In fact, there are market situations which fall in between these two

e'tremes. It was prof. #.. -hamberlein who in his Htheory of monopolistic competition and

!rs. Koan ?obinson in her #conomics of Himperfect competition brought out a synthesis of

perfect competition and pure monopoly independently of each other. ) market with blending

of monopoly and competition is known as monopolistic competition.

efinition of monopolistic competition

) monopolistic competition is defined as a market situation in which there are a large

number of buyers and sellers dealing in differential products with different prices.

/eatures or characteristics


21/35

1. 2arge number of sellers% In a monopolistic competition, the number of sellers is

large which leads to competition. )n individual firm’s supply is $ust a small part

of the total supply so that it has a very limited degree of control over the market

price. )nd each firm adopts an independent price and production policy.

*. &roduct differentiation% It is the most distinguishing feature of monopolistic

competition. The products supplied by various sellers are not identical. They are

differentiated products. They are close substitutes of one another. Through product

differentiation, each seller ac4uires a limited degree of monopoly power.

3. 2arge number of buyers% There are large number of buyers in this type of market.

owever, each buyer has a preference for a specific brand of the product. Fnlike

perfect competition, buying is by choice and not by chance.

5. /reedom of entry and e'it of firms% There are no entry barriers under perfect

competition. New firms can enter and old firms can leave the industry.

8. Selling costs% Since products are differentiated and vary from time to time,

advertising and other forms of sale promotions become an important part in

marketing the goods. #'penditure incurred on this account are selling costs.Selling costs are thus costs which are meant for sales promotion.

9. Two dimensional competition% !onopolistic competition has two facesE &rice

competition and non(price competition. Non price competition is in terms of

product variation and selling costs incurred by each sellers to capture his share in

the market.

;. The group% -hamberlein introduced the concept of group to replace the traditional

concept of industry. !onopolistic competition is characterised by product

differentiation. -hamberlein therefore introduced the concept of group. ) group is

a cluster of firms producing very closely related but differentiated products.

&roduct differentiation

&roduct differentiation is intended to distinguish one producer from that of other

producers in the industry. It can be real when the inherent characteristics of the products are

different. )nd the basis of differentiation maybe imaginary, when the products are basically

the same yet the consumer is persuaded via advertising or other selling activities that the

products are different.

?eal differentiation e'ists when there are differences in the specification of the

products or differences in the factor inputs or the location of the firm or the services offered

by the producer.

/ancied differentiation is established by advertising differences in packaging,

differences in design and simply the brand name. Dhatever the case, the aim of the product

differentiation is to make the product uni4ue in the mind of the consumer.

The effect of product differentiation is that the producer has some discretion in the

determination of the price. e is not a price taker, but has some degree of monopoly power

which he can e'ploit. owever he faces the competition of the close substitutes offered by

firms. ence the discretion of the price is limited.


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.b/ Long run e#uilibrium or group e#uilibrium under monopolistic competition0

-hamberlain called the long run e4uilibrium of the industry under monopolistic

competition as e4uilibrium of the group 6group of firms7 because product differentiationcreates difficulties in analytical treatment of the industry. eterogeneous products cannot be

added to form the market demand and supply schedules as in the form of homogenous

products. The concept of industry needs redefinition. -hamberlain uses the concept of

0product group’ which includes products which are closely related or close substitutes.

The ma$or difficulties associated with the group e4uilibrium are the vast diversity of

conditions which e'ist in many matters between different firms forming a group or industry.

These difficulties consist of product differentiation, different kinds of consumer preferences

and also variations in cost curves as well as in demand curves and difference in efficiency of

each firm.

In order to simplify the analysis of group e4uilibrium, -hamberlain suggests four

basic assumptions to be laid down%

1. )ll firms in the group are producing more or less identical products.

*. The share of each firm in the market is almost e4ual. The implication of this

assumption is that all firms face similar demand curve.

3. The efficiency of each firm is similar. This implies that all firms have an e4ual

cost curves.

5. The analysis of firms in the group is sufficiently large so that one firms actions

regarding price and output will have negligible effect upon numerous competitors.

:iven these assumptions, it is possible to e'plain group e4uilibrium in the long run. In

a monopolistic competition, the full long period e4uilibrium position is possible only when

both firms and the industry are in e4uilibrium whereas for each firm, the condition for

e4uilibrium 6!?A!-7 will apply whatever the output for the industry, we must allow for

entry of new firms. #'istence of supernormal profits in the long run and the anticipation of

the same in the future will attract new firms to enter the industry and also induce e'isting

firms to e'pand. "n the other hand, e'istence of losses in the short run and the anticipation of

the same in the long run will induce the e'isting firms to leave the industry.

If the new firms are set up or the e'isting firms e'pand, there will be a tendency for

the prices to decline and e4ual average cost. )t the same time, there is a possibility for prices

to decline and e4ual average cost. There is a possibility that the long run average cost curve

for every firm rises because of rising demand for the factors of production. These two

tendencies operate simultaneously.( prices to decline and average cost to rise.( will remove

supernormal profits. &rofits are normal only when )-A)?. Thus the long run e4uilibrium

output is where

!-A!? and )-A)?


23/35

In the long run, under the monopolistic competitive conditions, every firm will reap

normal profits.

Diagrammatic representation

In the figure, long run e4uilibrium output is "! where !-A!? and )-A)?.

#4uilibrium price is "& or !@. #ach firms earns normal profits only.

)s regards under the price and output determination under monopolistic competition,

the following conclusion maybe drawn

1. There is no uniformity of price.

*. The price is not as high as the monopoly price and not as low as the

competitive price.

3. The e4uilibrium output is less than that under perfect competition and is

greater than under the monopoly.

5. &rice is greater than !?( a result of falling demand curve.

8. #ach firm incurs advertisement e'penditure in addition to production

costs.

9. The optimum output of each firm is that the output at which !-A!?.

emerits or wastes of the monopolistic competition

1. #'cess capacity% Since the demand curve )? of a monopolistic competitive firm

is downward sloping, its tangency point with 2)- curve will always occur to the

left of its minimum point. Thus, when the firm is in a long term e4uilibrium, it

underutilises its optimum scale plant. This is a wastage of resources.

*. Inefficient /irms% In a monopolistic competition, an inefficient firm can survive

under the shade of product differentiation and advertisement.

3. -ross Transport% #ach producer tries to sell his product in far off markets rather

than in the markets near to its place of manufacture. This involves hugetransportation cost.


24/35

5. Too many varieties% ) large number of brands, styles, designs etc. confuses the

consumer. It reduces the chances of large scale production. Then these firms fail to

en$oy the economies of large scale production.

8. -ompetitive advertising% /alse advertising designed for false propaganda and

unsubstantiated claims of superiority of the product in order to create a partial

monopoly is regarded as wasteful. The consumers have to pay high prices due to

the cost of advertising.

9. Fnemployment% Fnder monopolistic competition, the productive capacity of the

economy is not used to the fullest e'tend and this will result in the unemployment

of resources in the economy.

'on price competition and selling costs

Non price competition is a market strategy in which one firm tries to distinguish its

product or service from competing products on the basis of attributes like design and

workmanship. The firm can also distinguish its product offering 4uality of service, e'tensivedistribution, customer focus or any other sustainable competitive advantage other than price.

Non(price competition typically involves promotional e'penditures 6such as advertising,

selling staff, the locations, sales promotions, coupons etc.7, marketing research, new product

development and brand management cost.

/irms will engage in non(price competition, in spite of additional costs involved,

because it is usually more profitable than selling for a lower price, and avoid the risk of a

price war. Non(price competition is the most common among oligopolies and monopolistic

competition.

Fnder monopolistic competition, the firms are reluctant to use price as a competitive

weapon to promote sales. They uses non(price weapons like advertisement, product

modification, introduction of special services etc. The necessary results are selling costs.

Selling costs may be defined as those costs which are incurred by a firm to persuade

the customers to buy its product in preference to those of others. &rof. -hamberlain defines

selling cost as Hcosts incurred in order to alter the position or shape of the demand curve for a

product. By chamberlain’s definition, selling costs include%

1. -ost of advertisement.

*. #'penditure on sales promotion schemes 6including gifts and discount to buyers73. Salary and commission paid to sales personnel.

5. )llowance to retailers for displays and

8. -ost of after sales service.

)ccording to chamberlain, the selling costs perform the following functions%

1. Informing potential buyers about the availability of the product.

*. Increasing demand for the product by attracting customers of the rival

products and

3. To make the demand curve shift upwards.


25/35

Thus, under monopolistic competition, firms use non(price weapons heavily to

promote thir sales which involves huge rise in selling costs.

Ideal output and excess capacity under monopolistic competition

The e'cess capacity of a firm is defined as the difference between the 0ideal output’

and the ’actual output’ attained in the long run. Ideal output can be defined as the output that

can be produced at minimum long run average cost 62)-7. This ideal output is linked to

socially optimum output. #'cess capacity is also called as Hidle capacity and Hunused

capacity.

Theories of chamberlain monopolistic competition and Koan ?obinson’s imperfect

competition has revealed that a firm under monopolistic competition or imperfect

competition in the long run e4uilibrium produces an output is less than socially optimum or

ideal output. This means that firms operate at the point on the following portion of long run

average cost curve, i.e. they do not produce the level of output at which 2)- is minimum.

The e'istence e'cess capacity under monopolistic competition is e'plained with the

help of the following figure%

) firm under monopolistic competition is in e4uilibrium at output "! at which its

!? curve is e4ual to !- 6!?A!-7 and average revenue is e4ual to average cost 6)?A)-7.

It will be noticed that at output "!, the long run average cost is still falling and goes on

falling up to output "N. This means that the firm can e'pand production up to "N and reduce

its 2)- to the minimum. Ideal output is the output at which the 2)- is minimum, i.e. "N.

Therefore the firm is producing !N less than the ideal output. Thus !N output represents the

e'cess capacity which emerges under the monopolistic competition.

-auses of the e'cess capacity%


26/35

1. The most important reason is the downward sloping demand curve 6)? curve7 of

the firm. The downward sloping )? curve can be tangent to the u shaped )-

curve at the latter’s minimum point. /rom this, it also follows that greater the

elasticity of )? curve confronting a monopolistically competitive firm, the less

the e'cess capacity and vice versa.

*. The second reason for the emergence of e'cess capacity, as has been emphasised

by -hamberlain is the entry of a very large number of firms in the industry in the

long run. 2ured by e'cess profits in the short run, new firms enter the industry in

the long run. This results in sharing of the market demand among many firms so

that each firm produces a smaller output than its full or optimum capacity.

Oligopoly

"ligopoly is an important form of imperfect competition. "ligopoly is a market

structure in which there are a few sellers selling homogenous or differentiated products. In

other words, oligopoly is said to e'ist when there are a few sellers or firms in the market producing or selling a product.

If oligopoly firm sells a homogenous product, it is called pure or homogenous

oligopoly. #.g.% Industries producing bread, cement, steel, cooking gas, chemicals, aluminium

and sugar are industries characterised by homogenous oligopoly. )nd if firms of an oligopoly

industry sell differentiated products, it is called heterogeneous or differentiated oligopoly.

)utomobiles, televisions, soap and detergents, etc. are some e'amples of industries

characterised by differentiated oligopoly.

Nature of "ligopoly or features of "ligopoly%

In oligopoly, certain characteristics are found which are not present in other market

structures. These features throw some light on the basic nature of oligopoly%

1. Small number of sellers% There are small number of sellers under

oligopoly. ow small is not given precisely. It depends largely on the si>e

of the markets. Since the number of sellers are so small, the market share

of each firm is so large that a single firm can influence the market price

and business strategy of its rival firms,

*. Interdependence% The most striking feature of oligopoly is the

interdependence among the sellers or firms. This is because when thenumber of competitors is few, any change in product, price, etc. by a firm

will have a direct effect on the fortune of its rivals, which will then

retaliate in changing their own prices, outputs or the products as the case

maybe. The competition between the firms take the form of action,

reaction and counter action in the absence of collusion between the firms.

The business strategy of each firm in respect to pricing, advertising and

product modification is closely watched by the rival firms and it evokes

imitation and retaliation. Dhat is e4ually important in the strategic

business decisions is that the firms initiating a new business strategy

anticipate and take into account the counter action by the rival firms.


27/35

3. &rice stickiness or price rigidity% The price under the oligopoly market is

likely to be sticky or rigid. If any firm tries to reduce its price, the rival

firms retaliate by a higher reduction in their prices. This will lead to a

situation of price war, which benefit none. "n the other hand if any firm

increases their price, then other firms will not follow the same. ence no

firm like to reduce price or increase the price. 6refer swee>y model7

5. &resence of monopoly power% If firms under oligopoly industry produce

differentiated products 6close substitutes7, each firm becomes petty

monopolist. The degree of monopoly en$oyed by each firm depends upon

the attachment of the customers to its product.

8. 2ack of uniformity% )nother feature of the oligopoly market is the lack of

uniformity in the si>e of firms. /irms differ considerable in si>e. Some

may be small, others very large.

9. -ollusions and conflicts% ?ealising the disadvantages of mutual

competition, at times they desire to combine in order to ma'imise their

$oint profits. )t the same time, the selfish desire of each firm to amassma'imum profits give chance for conflicts and antagonism. Thus, two

opposite forces are at a work under oligopoly.

;. Barriers to entry% Barriers to entry under oligopoly market arise due to %

• uge investment re4uirement to match the production capacity

of the e'isting firms.

• The economies of scale and absolute cost advantage en$oyed by

e'isting firms based on 4uality and service.

• ?esistance by the established firm by price cutting. owever,

the new entrants that can cross the barriers can and do enter the

industry.y has introduced the kinked demand curve for

oligopoly market situation. It is a downward sloping curve with a bend

6see swee>y model7.

%ollusi&e Oligopoly

In order to avoid uncertainty arising out of interdependence and to avoid price wars

and cut throat competition, firms working under oligopolistic conditions often enter into

collusive agreement. The agreement maybe either formal 6open7 or tacit 6secret7. But since

formal or open agreement to form monopolies are illegal in most countries, agreements

reached between oligopolists are generally tacit or secret. Dhen the firm the firm enters such

collusive agreements formally or secretly regarding a uniform price output policy to be

pursued by them, collusive oligopoly e'ists.


28/35

Types of collusion

There are two types of collusion(cartels and price leadership.

-artels

"riginally, the term cartel was used for the agreement in which there e'isted a

common sales agency which alone undertook the selling operations of all the firms that were

party to the agreement. But, nowadays, all types of formal or informal or tacit agreements

reached among the oligopolistic firms of an industry are known as cartels. In such a cartel

type of oligopoly, firms $ointly fi' a price and output policy towards agreement. There are

two typical forms of cartel% 6a7 -artels aiming at $oint profit ma'imisation, and 6b7 cartels

aiming at sharing of the market.

a7 -artels aiming at $oint profit ma'imisation% -artels imply direct 6although secret7

agreements the competing oligopolists with the aim of reducing the uncertainty

arising out from their mutual interdependence. In this particular case, the aim of the

cartel is ma'imisation of the industry 6$oint7 profit.

)n e'treme form of collusion is formed when the member firms agree to

surrender completely their rights of price and output determination to a central agency

so as to secure ma'imum $oint profit for them. /ormation of such a $oint collusion is

generally known as perfect cartel. Fnder perfect cartel, the price and outputdetermination for the whole industry as well as of each member firm is determined by

the central agency so as to achieve a ma'imum $oint profits for the member firms. The

central agency decides the allocation of production among the members of the cartel

and the distribution of the ma'imum $oint profit among the participating members.

The output 4uota to be produced by each firm is decided by the central agency in such

a way that the total costs of the total output produced is minimum. Total cost will be

minimised when the various firms in the cartel produce such separate outputs so that

their marginal costs are e4ual. The central agency acting as the multi(plant

monopolist, will set the price and industry’s output defined by the intersection of the

industry !? and !- curves. The $oint profit made by the cartel will be ma'imum atthese price and output levels.

b7 !arket sharing -artels% This form of collusion is more common in practice because it

is more popular. The firms agree to share the market, but keep a considerable degree

of freedom concerning the style of their output, their selling activities and other

decisions.

There are two basic methods for sharing the market%

i. Non price competition.

ii. etermination of 4uotas.

i. !arket sharing by non(price competition% In this form of loose cartel,

the firms agree on a common price at which each of them can sell atany of the 4uantity demanded. The price is set by bargaining, with the


29/35

low cost firms processing for a lower price and the high cost firms for

a high price. The agreed price must be such as to allow some profits to

all the members. The cartel agrees not to sell at a price below the cartel

price. But they are free to vary the si>e of their product and the

advertising e'penditure and to promote sales in other ways. In other

words, the firms compete on a non(price basis.

This form of the cartel is indeed loose in the sense that it is more

unstable than the complete cartel aiming at $oint profit ma'imisation

because the low cost firm will have strong incentives to break away

from the cartel openly and charge a lower price, or to cheat other

members by secret price concessions to the buyers. owever, as the

other members gradually lose their customers, the cheating by the low

cost firm will be ultimately discovered and conse4uently open price

war may start and cartel breaks down.

ii. !arket sharing by output 4uota% The second type of market sharing

cartel is the agreement reached between the members regarding the

4uota of output to be produced and sold by each of them at the agreed

price. If all the firms have identical costs, the monopoly solution will

emerge, with the market being shared e4ually by member firms.

owever, if the costs are different, the 4uota and market share will

differ. The 4uotas and market shares in the case of cost difference are

decided by bargaining. The final 4uota of each firms depend on the

level of its cost as well as on its bargaining skills. uring the

bargaining process, the two main criteria are most often adopted%4uotas are decided on the basis of past level of sales and for on the

basis of past level capacity. Fltimately, the 4uotas fi'ed for various

firms depend upon their bargaining power and skills.

The second common basis for the 4uota system and market sharing is

the definition of the region in which the firm is allowed to sell. In this

case of geographical sharing of the market, the price as well as the

style of the product may differ.

$rice leadership

&rice leadership is an important form of collusive oligopoly. Fnder price leadership,

one firm assumes the role of a price leader and fi'es the price of the product for the entire

industry and the other firms in the industry accept it and ad$ust their output to this price. &rice

leadership may emerge spontaneously due to technical reasons or out of tacit or e'plicit

agreements between the firms to assign leadership role to one of them. The spontaneous price

leadership maybe the result of such technical reasons as the si>e of the firm, efficiency of the

firm, ability of the firm to forecast future developments, reputation and goodwill of the firm

etc. This type of pricing is found in industries like coal, cement, petroleum, etc. in FS).

&rice leadership is more wide(spread than cartels, because it allows the members

complete freedom regarding their product and selling activities and this is more acceptable to


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the followers than a complete cartel, which re4uires the surrounding of all freedom of action

to the central agency.

Types of price leadership%

1. &rice leadership by low cost firms.*. &rice leadership by a large firm.

3. Barometric price leadership.

These are the form of price leadership e'amined by the traditional theory of leadership

developed by feller and others. The characteristics of the traditional price leader is that he sets

his price on margionalistic rules, that is, at the level defined by the intersection of !- and

!? curves. /or the leader the behavioural rule is !-A!?. The other firms are price takers

who will not normally ma'imi>e their profit by adopting the price of their leaders.

1. The low cost price leadership model% In this model, an oligopolistic firm having

lower cost than the other firms sets price Onormally at which its !-A!?P which

the other firms have to follow. The low cost firm thus becomes the price leader.

Since the high cost firms will not be able to sell their product at the higher price,

they are forced to agree to a lower price set by the lower cost firm. "f course, the

low cost price leader must ensure that the price that he sets must yield some

profits to the high cost firms.

*. &rice leadership by a dominant firm% &rice leadership by a dominant firm is more

common than a low cost firm. In this firm it is assumed that there is a huge

dominant firm which have considerable share of the total market. The smaller

firms, each of them having a small market share. The dominant firm fi'es the

price and the other firms accept it and ad$ust their output accordingly. The

dominant firm chooses that price and output that ma'imi>es their profit. It fi'es

the price and output at that point which is !-A!?. If the smaller firms raise the

price, they will lose customers. ence, the small firms behave passively as price

takers like a firm in a perfectly competitive market, i.e. smaller firms accept the

price set by the dominant firm. #ach small firm will have to ad$ust its output to the

point at which !-Aprice.

If the dominant firm is very large in si>e, the price leadership is also called

partial monopoly.

3. The barometric price leadership% The barometric price leadership is that in which

one firm in the oligopolistic firms which is supposed to have good knowledge

about the prevailing market conditions and has an ability to predict it better than

the others, announces a price change which is accepted by other firms in the

industry. In short, the firm chosen as the leader is considered as a barometer,

which reflects the changes in the conditions and environment of the industry. The

barometric firm may be neither low cost nor a large firm. Fsually it is a firm

which from past behaviour has established the reputation of a good forecaster of

economic changes. The price changes announced by the barometric firm serve as a

barometer of changes in demand and supply conditions in the market. ) firm

belonging to another industry may be chosen as the barometric leader.


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Barometric price leadership may be established for various reasons%

a7 The rivalry between several large firms in the industry may make it impossible to accept

one among them as the leader.

b7 !ost firms in the industry may have neither the capacity nor the desire to make

continuous calculations of cost, demand and supply conditions. Therefore, they find itadvantageous to accept the price changes made by a firm which has the proven ability to

make remarkably good forecasts.

c7 )s a reaction to earlier e'perience of violent price changes and cut(throat competition

among oligopolistic firms, they accept one firm as the leader.

!wee1y2s model of oligopoly0 3inked"demand cur&e model

The origin of the kinked demand curve can be traced into -hamberlain’s theory of

monopolistic competition. 2ater all and itch used kinked(demand curve to e'plain rigidity

of prices in their respective theories. It was &aul !. Swee>y who used the kinked demandcurve in his model of price rigidity in oligopolistic market.

)ccordingly to the kinked demand curve hypothesis, the demand curve facing an

oligopolist has a 0kink 0at the level of the prevailing price. The kink is formed at the

prevailing price because the segment of the demand curve above the prevailing price level is

highly elastic and the segment of the demand curve below the prevailing price level is

inelastic. This difference in elasticities is due to the particular competitive reaction pattern

assumed by the kinked demand curve hypothesis.

The competitive reaction pattern assumed by the kinked demand curve theory of

oligopoly is as follows%

#ach oligopolist believes that if he lowers the price below the prevailing level, his

competitors will follow him and will accordingly lower their price in order to avoid losing

their customers. Thus the firm lowering the price will not be able to increase its demand

much. So this portion of the demand curve below the prevailing market price is relatively

inelastic. "n the other hand, if the oligopolistic firm rises the price above the prevailing price

level, its rivals will not follow it and increase their prices. Thus, the 4uantity demanded of

this firm will fall considerably. Therefore, the portion of the demand curve above the

prevailing market price is relatively elastic.

Thus, the demand curve of an oligopolistic firm has a kink at the prevailing market

price which e'plains price rigidity. )n oligopolist facing a kinked demand curve will have no

incentive to rise its price or to lower it. Since the oligopolist will not gain a large share of the

market by reducing his price below the prevailing level and will have substantial increase in

sales by increasing his price above the prevailing level, so, he will not change the prevailing

market price. Thus, price rigidity is e'plained in this way by the kinked demand curve theory.

It is e'plained in the following figure%


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In the figure, the segment of the demand curve, which lies below the prevailing

price "& is inelastic showing that very little increase in sales can be obtained by a reduction

in price by an oligopolist. The segment of the demand curve which lies above the current

price level "& is elastic showing a large fall in sales if a producer raises his price. The

demand curve of the oligopolist has a kink 6at point 7 at the prevailing market price "&.

Price and output determination under Oligopoly

The oligopolist confronting a kinked demand curve will be

maximizing his prot at the current price level. For nding the prot

maximising price –output combination, Marginal revenue M!" curve

corresponding to the kinked demand curve #$ has been drawn. %t is worth

mentioning that the marginal revenue curve associated with a kinked

demand curve is discontinuous, or in other words, it has a broken vertical

portion. The length of the discontinuit& depends upon the relative

elasticities of the two segments d# and #$ of the demand curve at point

#. The greater the di'erence in the two elasticities, the greater the length

of the discontinuit&. The M! has two segments( segment d) correspond to

upper part of the demand curve, while the segment from point *

corresponds to the lower part of the kinked demand curve. M! curve has adiscontinuous gap or portion )*.

+uppose that the marginal cost curve is given as M which

intersects M! at point -, then point - satises the necessar& conditions for

prot maximization M!M". Therefore, oligopol& rms are in e/uilibrium

output 0M and price 01 and the& are making maximum prot. )s long as

the M curve cuts the M! curve an&where in the gap between ) and *,

there will not be an& change in the price or /uantit&. Thus, both price and

output are stable. 0ligopol& rms would think of charging their price and

output onl& if M rises be&ond point ) or a decrease in below point *.

Duopoly

)n extreme case of oligopol& is duopol&, where there are onl& two

rms producing homogenous or di'erentiated products. $uopol& is the

market in which two rms compete with each other.

There are three principal duopol& models2 ournot duopol& model,

*ertrand3s duopol& model and +tackelberg3s duopol& model.

%n ournot model, each rm acts on the assumption that its rival willnot change its output and decides its own output so as to maximise prot.


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The *ertrand model assumes that each rms expects that the rival

will keep its price constant, irrespective of its own decision of pricing.

Thus, each rm sets the price of its product to maximize prot on the

assumption that the price of the rival will remain constant.

Finall&, The +tackelberg model assumes that one rm will behave asin the ournot model b& taking the output of rival as constant, but that

the rival incorporate this behaviour into its production decisions.

Market with Asymmetric information

0ne of the basic conditions for the market to work e4cientl& is

5perfect knowledge6. For e4cient allocation of resources, consumer

re/uire complete information about market price of the products and their

/ualit&. 1roducers need to have full information about the market size,

demand for the product, availabilit& of inputs, their prices andproductivit&, their cost conditions and so on.

7owever, in the real world, consumers and producers do not have

full information about the price, /ualit& and availabilit& of the products. %n

fact, the& have onl& imperfect information about opportunit& set available

to them. ) leading example of imperfect information is as&mmetric

information about the /ualit& of used goods. 8e.g.2 used cars in the

market9. *& as&mmetric information, we mean one part& in the market for

used cars the bu&er" does not know about the /ualit& of the product

being sold. %n case of the used cars, while the sellers know about the true/ualit& of their products, the bu&ers do not know about the /ualit& of the

used cars which ma& turn out to be :lemons3i.e. a defective product".

+imilarl& as&mmetric information occurs in the labour market, where, the

workers who sell their labour services know their abilit& and e4cienc&, the

rms who hire them are not well informed about it.

Thus, as&mmetric information means the market situation when the

bu&ers and seller have a di'erent information while making a transaction.

*ecause of as&mmetric information, low /ualit& goods drive high /ualit&

goods out of the market. This phenomenon is referred to as lemonsproblem. The problem about the as&mmetric information is that it leads to

market failure, i.e. failure to achieve market e4cienc&.

The implications of the as&mmetric information about product

/ualit& were rst anal&sed b& ;eorge )kerlof.


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