UNIT 9 PERFECT COMPETITION:

FIRM AND INDUSTRY

EQUILIBRIUM
Structure
9.0 Objectives
9.1 Introduction
9.2 Perfect Competition: Characteristics of a Perfectly Competitive Market
9.3 The Firm as a Price Taker in Perfectly Competitive Market (PCM)
9.4 The Price-Taking Firm’s Cost Structure
9.5 The Perfectly Competitive Market: Firm in the Short Run and Long Run
9.5.1 Short Run Price and Output
9.5.2 Short Run Abnormal Profit – Market Entry
9.5.3 Short Run Loss
9.5.4 Long Run Price and Output of a PC Firm
9.5.5 Conclusions

9.6 Shut Down Point and Break-Even Output for PCM Firm
9.7 Supply Curve for a PC Firm and for PC Market
9.7.1 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries

9.8 Let Us Sum Up

9.9 References
9.10 Answers or Hints to Check Your Progress Exercises

9.0 OBJECTIVES
After reading this unit, you will be able to :
 identify the characteristics a perfectly competitive market and their
implications;

 explain the concept of firm as a Price Taker in Perfectly Competitive

Market (PCM);

 state the profit-maximisation condition for a perfectly competitive (PC)

firm;

 explain the Equilibrium of a perfectly competitive market or a industry;

 talk about the shut Down Point and Break-Even Output for a PC Firm;

 derive a perfectly competitive firm’s short-run supply curve from the

firm’s profit-maximisation problem;

Dr. S.P. Sharma, Associate Professor in Economics, Shyam Lal College (University of
Delhi), Delhi. 195
Market  construct the short-run market supply curve from the short-run supply
Structure curves of individual firms;

 perform comparative statics analysis of the short-run equilibrium in a

perfectly competitive market; and

 state the conditions for the long-run perfectly competitive equilibrium.

9.1 INTRODUCTION
Market structure refers to arrangements that bring buyers and sellers together.
The market for a product may also refers to the whole region where buyers and
sellers of that product are spread and there is such free competition that one
price for the product prevails in the entire region. Whether a firm can be
regarded as competitive depends on several factors such as the number of firms
in the industry, degree of rivalry, degree of homogeneity of the product,
economies of scale and easiness with which any firm can enter in the market
and exit from it. On the basis of these characteristics, especially in terms of
degree of competition, a market can be classified as a perfectly competitive
market, monopoly, duopoly, oligopoly and monopolistic competition. In this
unit, we aim to explore the features of a perfectly competitive market,
equilibrium of industry and firms under such a market.

9.2 PERFECT COMPETITION:

CHARACTERISTICS OF A PERFECTLY
COMPETITIVE MARKET
A perfectly competitive market exhibits the following characteristics:
1) The industry is fragmented. It consists of large number of buyers and
sellers. Each buyer’s purchases are so small that they have an
imperceptible effect on market price. Each seller’s output is so small in
comparison to the market demand that it does not affect the market price.
In addition, each seller’s input purchases are so small that they have an
negliable impact on input prices.
2) Firms produce homogeneous products. i.e., consumers perceive the
products to be identical or homogeneous no matter who produces them.
Product of Firm A will in no way be differentiated from those of Firm B.
This results in price competition.
3) There is perfect knowledge/information amongst both firms and
consumers: Firms will have total knowledge of any improvement in
technology and manufacturing processes, while consumers will be fully
aware of all firms’ prices.
4) The industry is characterised by equal access to resources. All firms –
those currently in the industry, as well as prospective entrants – have
access to the same technology and inputs. Firms can hire inputs, such as
labour, capital, and materials, as they need them, and they can release
them from their employment when they do not need them.
5) There are no barriers to entry: Nothing hinders firms from entering the
market in order to compete with existing producers. Such barriers could
196 be insurmountably high initial (start-up) costs, lack of access to key
 technology or raw materials, and legal barriers such as not having Perfect Competition:
necessary patent rights. Firm and Industry
Equilibrium
Sometimes, economists distinguish prefect competition from pure competition
and impose the following two more conditions for a market to be perfectly
competitive:
1) Perfect mobility of factors of production between the industries
2) No transport costs involved in a perfectly competitive market.
However, if one closely looks into the characteristics described earlier, one can
easily find that the additional conditions mentioned above are implicit and
therefore for the purpose of convenience and to avoid any confusion, pure and
perfect completions are used as synonyms to each other.
These characteristics have three implications for how perfectly competitive
markets work:
1) The first characteristic – the market is fragmented – implies that sellers
and buyers act as price takers. That is, a firm takes the market price of the
products given when making an output decision and a buyer takes the
market price as given when making purchase decisions. This
characteristic also implies that a firm takes input prices as fixed when
making decisions about input quantities.
2) The second and third characteristics – firms produce homogeneous
products and consumers have perfect information about prices – imply a
law of one price: Transactions between buyers and sellers occur at a
single market price. Because the products of all firms are perceived to be
identical and the prices of all sellers are known, a consumer will purchase
at the lowest price available in the market. No sales can be made at any
higher price. The lowest price demanded by one firm will become the
market price – every firm will have to sell at that price only.
3) The fourth and fifth characteristics imply that the industry is
characterised by free entry. That is, if it is profitable for new firms to
enter the industry, they will eventually do so. Free entry does not mean
that a new firm incurs no cost when it enters the industry, but rather that
it has access to the same technology and inputs that existing firms have.
In the real world it is hard to find examples of industries which fit all the
criteria of ‘perfect knowledge’ and ‘perfect information’. However, some
industries are close to perfectly competitive markets:
 Foreign exchange markets. As currency is all homogeneous and traders
will have access to many different buyers and sellers and buyers also
have choice from which trader to buy the currency. A good information
about relative prices is available to the buyers and thus easy to compare
prices while buying currency.

 Agricultural markets. Normally, there are several farmers selling

identical products in the market which has many buyers. At the market, it
is easy to compare prices. Therefore, agricultural markets often get close
to perfect competition.

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Market  Internet based markets: The internet has made many markets closer to
Structure perfect competition because the internet has made it very easy to compare
prices, quickly and efficiently (perfect information). Owing to the
relatively low cost of doing business through internet, it has become
easier to enter in the market. For example, selling a good on internet
through a service like Amazon or e-kart etc. is close to perfect
competition. Equal access to the market and availability of full
information about the prices of the products, enable the price of goods to
fall in line with the market price making the firms to earn only normal
profit in the long run.

Check Your Progress 1

1) Describe briefly the characteristics of a perfectly competitive market and
their implications?
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2) Can you imagine in real world the markets akin to a perfectly competitive
market, if yes list them with their similarities?
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9.3 THE FIRM AS A PRICE TAKER IN

PERFECTLY COMPETITIVE MARKET (PCM)
The aggregate demand and supply of industry determine the equilibrium price
of the homogeneous product. The firm cannot influence this on its own, and
thus simply accepts that it is facing a fixed price. The demand curve for the
price taker firm is infinitely elastic, since the market can absorb any amount
produced by any one supplier (Fig. 9.1).

Fig. 9.1 : Demand and Revenue for a Perfectly Competitive Market (PCM)
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In case for the perfectly competitive market firm, the price will be the same. Perfect Competition:
The horizontal demand curve, is also the average revenue (AR) and marginal Firm and Industry
revenue curve (MR), i.e. P = AR = MR. This can be verified as follows: Equilibrium

Total Revenue (TR) = Price × Quantity

TR = P. Q
.
AR = = = P - which is ‘given’
∆ ∆( . ) .∆
MR = = = = P (Price is given for a PCM firm)
∆ ∆ ∆

Supply curve for the firm. To know about the supply curve of the firm, it
would be necessary to look into the profit1 maximising behaviour of the price
taker firm.
Assuming that the firm produces and sells a quantity Q, its economic profit is
= TR(Q) – TC(Q), where TR(Q) is the total revenue derived from selling the
quantity Q and TC(Q) is the total economic cost of producing the quantity Q.
As the firm is a price taker, it perceives that its volume decision has a
negligible impact on market price and its goal is to choose a Q to maximise its
total profit. To illustrate the firm’s problem, suppose that a rose grower
anticipates that the market price for fresh-cut roses will be P = `1.00 per rose.
Table 9.1 shows total revenue, total cost, and profits for various output levels
and Fig. 9.2(a) graphs these numbers.
Table 9.1: Total Revenue, Cost and Profit for a Price Taking Rose
producer Firm

(Units in Thousands and value in `)

Q TR(Q)) TC(Q) Profit
0 0 0 0
60 60 95 35
120 120 140 20
180 180 155 25
240 240 170 70
300 300 210 90
360 360 300 60
420 420 460 40

Fig. 9.2(a) shows that profit is maximised at Q = 300 (i.e., 300,000 roses per
month). It also shows that the graph of total revenue is a straight line with a
slope of 1. Thus, as we increase Q, the firm’s total revenue goes up at a
constant rate equal to the market price, `1.00 which is also equal to MR.

1
A distinction is to be made between economic profit and accounting profit, i.e.
economic profit = sales revenue - economic costs
accounting profit = sales revenue - accounting costs
That is, economic profit is the difference between a firm’s sales revenue and the totality of its
economic costs, including all relevant opportunity costs, for example, reward or return of the
labour put in by the owner of the firm which is treated equivalent to the return expected in his
next best alternative use. Therefore, whenever we discuss profit maximisation, we are talking
about economic profit maximisation. 199
Market Marginal cost (MC), the rate at which cost changes with respect to a change in
Structure output, following usual return to scales, is exhibited as U-shaped curve.
Fig. 9.2 shows that for quantities between Q = 60 and the profit-maximising
quantity Q = 300, producing more roses increases profit. Increasing the
quantity in this range increases total revenue faster than total cost, i.e. MR >
MC or in our case P>MC.
When P > MC, each time the rose producer increases its output by one rose, its
profit goes up by P – MC, the difference between the marginal revenue and the
marginal cost of that extra rose.
Further, for quantities greater than Q = 300, producing fewer roses increases
profit. Decreasing quantity in this range decreases total cost faster than it
decreases total revenue – that is, marginal revenue is less than marginal cost, or
P < MC. When P < MC, each time the producer reduces its output by one rose,
its profit goes up by MC – P, the difference between the marginal cost and the
marginal revenue of that extra rose.
The producer can increase its profit when either P > MC or P < MC, quantities
at which these inequalities hold cannot maximise its profit. It must be the case,
then, that at the profit-maximising output, P = MC, i.e. a price-taking firm
maximises its profit when it produces a quantity Q* at which the marginal cost
equals the market price.

Fig. 9.2

Fig. 9.2 (b) however shows that there are two points (Q = 60, and Q = 300) at
which MR = MC. The difference between Q = 60 and Q = 300 is that at Q =
300, the marginal cost curve is rising, while at Q = 60 the marginal cost curve
is falling. The point at which Q = 60 represents the point at which profit is
200
minimised rather than maximised. This shows that there are two profit- Perfect Competition:
maximisation conditions for a price-taking firm: Firm and Industry
Equilibrium
a) P = MC.
b) MC must be increasing.
If either of these conditions does not hold, the firm cannot maximise its profit.
It would be able to increase profit by either increasing or decreasing its output.
Thus the rising part of the MC curve reflects the firm’s supply curve, and
horizontal summation of the entire firms’ supply curve will be the
market’s supply curve which is upward slopping. This concept would be
further elaborated in the later part of this Unit. Any change in market demand
will also shift the demand curve for the firm which would change the MC=MR
point along the MC curve. Fig. 9.3 shows that when market demand increases
from D0 to D1 and decreases to D2, the demand curve (which is also the MR
and AR curve) for the firm shifts upwards or downwards, along the upward-
sloping MC curve. Any change in MR will change the profit maximising
intersection of MC = MR, would accordingly change the supply of the firms,
whose horizontal summation would indicate the market supply curve.

Fig. 9.3: The PCM Firms’ Supply Curve

9.4 THE PRICE-TAKING FIRM’S COST

STRUCTURE
To understand the response of a price-taking firm in the short-run and also in
the long run, we need to explore the cost structure of a typical such firm in the
industry. The firm’s short-run total cost of producing a quantity of output Q is:
STC(Q) = SFC + NSFC + TVC(Q)
This equation identifies three categories of costs for this firm.
 TVC (Q) represents total variable costs. These are output-sensitive costs
— that is, they go up or down as the firm increases or decreases its
output. Total variable costs include materials costs and the costs of
certain kinds of labour (e.g., factory labour). Total variable costs are zero
if the firm produces zero output and thus are examples of non-sunk costs.
If a rose producer, in our example, decides to shut down its rose growing
201
Market operations, it would avoid the need to spend money on fertilizer and
Structure pesticide.

 SFC represents the firm’s sunk fixed costs. A sunk fixed cost is a fixed
cost that a firm cannot avoid if it temporarily suspends operations and
produces zero output. For this reason, sunk fixed costs are often also
called unavoidable costs. For example, suppose that a rose grower has
signed a long-term lease (e.g., for five years) to rent land on which to
grow roses and that the lease prevents it from subletting the land to
anyone else. The lease cost is fixed because it does not vary with the
quantity of roses that the firm produces. It is output insensitive. It is also
sunk because the firm cannot avoid the rental payments, even by
producing zero output.

 NSFC represents the firm’s non-sunk fixed costs. A non-sunk fixed cost
is a fixed cost that must be incurred if the firm is to produce any output,
but it does not have to be incurred if the firm produces no output. Non-
sunk fixed costs, as well as variable costs, are also often called avoidable
costs. For a rose grower, an example of a non-sunk fixed cost would be
the cost of heating the greenhouses. Because greenhouses must be
maintained at a constant temperature whether the firm grows 10 or
10,000 roses within the greenhouses, so the cost of heating the
greenhouses is fixed (i.e., it is insensitive to the number of rose stems
produced). But the heating costs are non-sunk because they can be
avoided if the grower chooses to produce no roses in the greenhouses.
The firm’s total fixed (or output-insensitive) cost, TFC, is thus given by TFC =
NSFC + SFC. If NSFC = 0, there are no fixed costs that are non-sunk. In that
case, TFC = SFC.
Check Your Progress 2
1) Why a firm is always a price taker in a perfectly competitive market?
Give adequate justification for your answer.
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2) Briefly explain the cost structure of a PC firm and its relevance in
determining the price and output of such a firm?
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9.5 THE PERFECTLY COMPETITIVE MARKET:

FIRM IN THE SHORT RUN AND LONG RUN
9.5.1 Short Run Price and Output
The perfectly competitive market firm (‘PCM firm’ henceforth) is basically left
with two decisions in the short run to maximise the profit; whether to produce
202 and how much to produce. It is pertinent to note that profit maximisation
output choice also implies cost-minimising input choices, or in short, profit Perfect Competition:
maximisation implies cost minimisation. Assuming that the firm has decided Firm and Industry
to produce, regarding the second decision, in line with our assumption of profit Equilibrium
maximisation, the PC firm will set output at the point where MC equals MR.
Being a price-taker, the price is set by market forces (supply and demand) and
the firm will have three possible outcomes in the short run, as shown in Fig.
9.4 below:

Fig. 9.4: Short run possibilities of a PCM firm

Given that profit is π = TR(Q) – TC(Q), which in the unit-cost picture

corresponds to AR – AC, Fig. 9.4 shows three possibilities:
 Normal profit: When the market price equals the AC of the PC firm, the
firm will be at break-even, i.e. it will enjoy normal profits. This is shown
in the first diagram of Fig 9.4 as the MR = MC point coincides with
average costs. As AR = AC there is a normal profit.

 Abnormal/supernormal profit: The middle diagram illustrates a situation

where the market price (and thus the MR, AR curve) is above the average
cost. The firm sets output at Qπ-max and earns an abnormal profit.

 Loss: Finally, when the price is below any point on the AC-curve, the
firm will operate at a loss, as profit maximising output (Qπ -max – which is
the same as the loss minimising level of output; Qloss-min in the diagram)
results in an AR below AC.
A firm in a perfectly competitive environment can only enjoy abnormal profits
in the short run. The same holds for losses, which makes intuitive sense as no
firm will be willing/able to uphold long term losses. The market mechanism
together with the assumptions will act to create long run equilibrium where the
PC firm will earn normal profits only.

9.5.2 Short Run Abnormal Profit – Market Entry

The firm depicted in the Fig. 9.5 on the left has an AC curve where the ACmin
point is below the market price, P0. The firm sets output at the profit
maximisation point of MC = MR and thus has an average revenue which is
above average cost. This is the abnormal profit per unit, shown by the double-
edged arrow, and these times the quantity shows the total abnormal profit for
the PC firm.
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Market
Structure

Fig. 9.5: Short run profit in a perfectly competitive market

What then happens, keeping in mind the assumptions of free market entry and
perfect knowledge/information, is that new firms will be attracted and of
course enter the market. This increases supply from S0 to S1 causing the price
to fall from P0 to P1. Falling market price will lower AR for the single PC firm,
creating a long run equilibrium where once again AR = AC. The firm’s short
run profit is thus eroded in the long run by market entry.

9.5.3 Short Run Loss

Assume that firms which have been attracted to the market in the situation of
abnormal profit, increased market output to the extent where the increase in
supply lowered the market price to a level where individual firms made losses.
This is the situation shown in Fig. 9.6 for a loss-making firm. At a market price
of P0, the firm’s AR is below AC. The firm will still produce at MC = MR
(‘loss-minimising’ point in this case) and will run at a loss, shown by the
double-sided arrow. Total loss is the rectangle. As firms begin to exit the
market over time – switching to more attractive producer substitutes – the
market supply curve will shift to the left.

Fig. 9.6: Short Run Loss in a PCM Firm

In the LR, some firms will exit the market and market supply will decrease –
shown by the shift from S0 to S1 in the market diagram on the right. As the
market price rises, the firm’s AR rises and when AR = AC once again, there is
LR equilibrium and every firms makes normal profits. What the firms can do
in the short run? As a PC firm is a price taker, not much can be done to
influence the AR side of the coin, so firms are focused on lowering costs. A
firm running at a loss will have to find ways to become more efficient (i.e.
lower MC) and/or decrease costs in general. One of the most common methods
204
Market a) The PC firm can make abnormal profits in the short run, but will make a
Structure normal profit in the long run as lack of entry barriers allows new firms to
enter the market and increase supply and lower the market price.
b) The firm cannot run at a loss in the long run either since some firms will
leave the market and supply will converge to a long run equilibrium
which allows the (surviving) firms a normal profit once again.
c) The LR equilibrium level of output is thus: P = ACmin = MC = AR = MR.
Check Your Progress 3
1) State whether following statements are true or false:
a) A competitive firm in the long run will produce output up to the
point where price equals average variable cost.
b) A firm’s shutdown point comes where price is less than minimum
average cost.
c) A firm’s supply curve depends only on its marginal cost. Any other
cost concept is irrelevant for supply decisions.
d) The P = MC rule for competitive industries holds for upward-
sloping, horizontal, and downward-sloping MC curves.
e) The competitive firm sets price equal to marginal cost.
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2) Interpret this dialogue:
A: “How can competitive profits be zero in the long run? Who will
work for nothing?”
B: “It is only excess profits that are wiped out by competition.
Managers get paid for their work; owners get a normal return on
capital in competitive long-run equilibrium – no more, no less.”
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3) A firm is operating at a loss. Explain why the firm might stay rather than
exit the market.
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4) Why can a PC firm only make a normal profit in the long run according
to our model?
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 Perfect Competition:
9.6 SHUT DOWN POINT AND BREAK-EVEN Firm and Industry
OUTPUT FOR PC FIRM Equilibrium

When a firm is earning normal profit, output is at the point where AR = AC,
this is the break-even point of output. The shut-down point, the point at which
firm is likely to leave the market, is the output level where it is equally costly
for the firm to continue producing as it is for the firm to leave the market. If the
firm can cover all of the variable costs and at least some of the fixed costs (i.e.
non-sunk fixed costs as defined above) then it has an incentive to remain on the
market. If the price falls below the AVC then the firm will not cover even the
variable costs – and leave the market. Hence, the point where the firm must
decide whether to remain on the market or leave is when AR = AVC. This is
the shut-down point.
It will be easier to understand these critical issues clearly in a figure using the
actual numbers rather than points A, B, and C etc. Fig. 9.8 attempts to explain
these points. Assume that the original demand on the market gives a market
price of `10, which are the PCM firm’s MR and AR. This is the long run
equilibrium and also the break-even point, as the firm covers all its costs –
even opportunity costs – earning it a normal profit. Assume that for some
reason (either increasing supply or decreasing demand) the market price starts
to fall and subsequently the firm’s AR, MR, D-curve falls to a price level of `6.
Being a profit maximiser, the firm sets output where MC = MR, which is now
at 80 units rather than 100. At this output level the firm cannot cover all its
costs; ATC at an output of 80 is `11. The firm loses `5 on each unit produced,
giving an overall loss of `400 (`5 × 80 units).

Fig. 9.8: Shut Down and Break-even Price for a PCM Firm

Why doesn’t the firm leave the market at a price level of `6? Consider the
choices facing the firm:
a) Stay in the business and make a loss of `400
b) Leave the business and make a loss of `560, which is the total fixed cost
(see TFC calculation in Fig. 9.7), i.e. TFC = (ATC – AVC) × Q. At an
output of 70, we get (`12 – `4) × 70 = `560.

207
Market This is not much of a choice, rather a lack of options. The firm will have a
Structure strong incentive to stay in the market during the short run, hoping perhaps that
either market price will increase or that increased efficiency and/or cost-cutting
can lower MC and AC to a normal profit level again.
If, however, the market price falls even further, to `4, then the options become:
a) Stay in the business and make a loss of `560
b) Leave the business and make a loss of `560
The firm’s TR (`4 × 70 = `280) will be identical to the TVC, which means that
there is no contribution towards covering the fixed costs. The firm is making a
loss of `560 by staying in the business and would make the same loss by
leaving it. The point where P (AR) = AVC is therefore the shut-down point for
the firm. The firm will not produce at a lower price level – just consider the
options at a price of `2. The firm’s TR would be `120 (`2 × 60) and TC would
be `720 (`12 × 60) leading to a loss of `600. The reason is that at a price (e.g.
AR) of `2 the firm would not even be covering all its variable costs so total
costs would be greater than total fixed costs alone. At any price below AVC
the firm will leave the market.
Therefore the important consideration for a PC firm will be: as long as the
firm has an AR above AVC, the firm covers variable costs and at least some of
the fixed costs (i.e. non-sunk fixed costs) – therefore there is an incentive to
stay in the business in the short run. The shut-down point is when P (AR) =
AVC

9.7 SUPPLY CURVE FOR A PC FIRM AND FOR

PC MARKET
The important decision points for a PC firm to stay in the business or leave the
market, as derived above, requires revisiting the concept of supply curve of
both a PC firm as well as of a perfectly competitive market. The significant
modifications to be noted for the supply curve of a PC firm in short and long
run are given below:
a) The PC firm’s supply curve in the short run is thus the portion of the
MC curve which is above the AVC curve.
b) The long run supply would be the portion of the MC curve above ATC
as no firm could withstand indefinite losses and would ultimately have to
leave the market if it did not cover all costs.
Building on the proposition that firms will supply at any possible level above
the average variable cost curve in the short run, the market supply can be
derived from this. Fig. 9.9 assumes a market of three firms (it could however
be any number), having different marginal and average costs. As the portion of
the MC-curve above AVC is relevant, summing the individual firms’ output at
various prices yields the short run industry/market supply curve; 5,000 units
per month at a price of `5 up to 25,000 units per month at a price of `12.

208
 Perfect Competition:
Firm and Industry
Equilibrium

Fig. 9.9: Supply Curve for PCM FIrms and Markets (∑MCPCM firm = Market Supply)

The concept of increasing marginal costs coupled to the profit maximisation

condition of MC = MR renders each individual firm’s supply curve, and their
horizontal aggregation is the market supply curve.

9.7.1 Constant-Cost, Increasing-Cost, and Decreasing-Cost

Industries
As the market supply curve is derived from PC firms supply curves, it implies
that when firms’ marginal costs are affected by technology, production
improvements, lower costs of labour and raw material etc., the total market
supply will also change accordingly.
Theoretically, we may have three situations:
First, when changes in industry output have no effect on input prices, we have
a constant-cost industry. In such a case, after all adjustment to a change in
demand have taken place, the market price must have returned to the lowest
point on the LRAC curve, which is exactly where it was before. So in this
case, the LR supply curve must be horizontal (instead of upward-sloping as in
the picture above). We call this a constant-cost industry. This is most likely to
be the case when the industry in question uses only a small portion of inputs,
available in the market and usable by all the industries.
Second, if the industry in question has a large impact on the markets for its
inputs, then the LR supply curve may slope upward or downward. If the effect
of entry into the industry is to bid up the price of inputs, so that a firm’s cost
curves rise as a result of the entry of new firms, then the market price after
adjustment will be higher than it was before. In this case, the LR supply curve
must be upward-sloping as in the picture above; this is called an increasing-
cost industry, which results from external diseconomies.
Third, on the other hand, if entry into the industry creates a greater demand for
inputs that allows those inputs to be produced through mass production
techniques (i.e., at lower average cost), then the industry can benefit from
lower costs of production. In this case, the LR supply curve is downward-
sloping. This is called a decreasing-cost industry, which results from external
economies.

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Market Check Your Progress 4
Structure
1) Explain why the sum of individual firms’ MC curves is the market
supply curve.
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2) What is the shutdown price when all fixed costs are sunk? What is the
shutdown price when all fixed costs are non-sunk?
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3) Would a perfectly competitive firm produce if price were less than the
minimum level of average variable cost?
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9.8 LET US SUM UP

We have studied in this unit how price-taking firms adjust their production
decisions in the light of the market price and how the market price is
determined. Since a PC firm is a price taker, in order to earn normal profit even
in the long run, they need to adopt the strategies concentrating on enhancing
their productivities so that they supply more output at given price with reduced
average and marginal costs. The salient features of a perfectly competitive
market are summarised below:
Supply Behaviour of the Competitive Firm
 A perfectly competitive firm sells a homogeneous product and is too
small to affect the market price. To maximise profits, the competitive
firm will choose that output level at which price equals the marginal
cost of production, that is, P = MC.
 Variable costs need to be taken into consideration in determining a firm’s
short-run shutdown point. Below the shutdown point, the firm loses more
than its fixed costs. It will therefore produce nothing when price falls
below the shutdown price.
 In the long run, PC firm will stay in business only if price is at least as
high as long-run average costs including some non-sunk fixed costs.
Supply Behaviour of Competitive Industries
 Each firm’s rising MC curve is its supply curve; the horizontal
summation of all firms in the industry will provide the supply curve of
the industry.

210
 Because firms can adjust production over time, we distinguish two Perfect Competition:
different time periods: (a) short-run equilibrium, when variable factors Firm and Industry
like labour can change but fixed factors like capital and the number of Equilibrium
firms cannot, and (b) long-run equilibrium, when the numbers of firms
and plants, and all other conditions, adjust completely to the new
demand conditions.
 In the long run, when firms are free to enter and leave the industry and no
one firm has any particular advantage of skill or location, competition
will eliminate any excess profits earned by existing firms in the industry.
So, just as free exit implies that price cannot fall below the zero-profit
point; free entry implies that price cannot exceed long-run average cost in
long-run equilibrium.
 When an industry can expand its production without pushing up the
prices of its factors of production, the resulting long-run supply curve
will be horizontal. When an industry uses factors specific and scarce
factors, its long-run supply curve will slope upward, e.g. important
special cases include relatively or completely inelastic supply which
produces economic rent shared between the firm and that factor of
production.
Disadvantages of Perfect Competition Generally Mentioned
 No scope for economies of Scale, this is because there are many small
firms producing relatively small amounts.
 Industries with high fixed costs would be particularly unsuitable to
perfect competition. This is one reason why existence of such a market is
highly unlikely in the real world.
 Undifferentiated products lead to a monotonous situation for the
consumers as little choice available to them. Differentiated products are
very important in industries in FMCGs.
 Lack of supernormal profit may make investment in R&D unlikely. This
would be important in an industry such as pharmaceuticals which require
significant investment.
 With perfect knowledge there is no incentive to develop new technology
because it would be shared with other companies.
Notwithstanding these facts, perfect competition is worth studying for two
reasons. First, a number of important real-world markets consist of many small
firms, each producing nearly identical products, each with approximately equal
access to the resources needed to participate in the industry. The theory of
perfect competition developed in this unit will help us to understand the
determination of prices and the dynamics of entry and exit in these markets.
Second, the theory of perfect competition forms an important foundation for
understanding theory of price determination as many of the key concepts such
as the vital roles of marginal revenue and marginal cost in output decisions will
apply when we study other market structures such as monopoly, duopoly,
monopolistic and oligopolistic competitive markets

211
Market
Structure
9.9 REFERENCES
1) Koutsoyiannis, A. (1979), Modern Micro Economics, London:
Macmillan, p. 67-103
2) Sanjay Rode, (2013), Modern Microeconomics, First Edition,
bookboon.com, First Edition, 2008, bookboon.com,
3) KristerAhlersten, (2008) Essentials of Microeconomics, First Edition,
bookboon.com, p. 76-87
4) David A. Besanko, Ronald R. Braeutigam and Michael J. Gibbs,
Microeconomics, 4th Edition, John Wiley and Sons, p. 327-376
5) Lipsey, RG (1979), An Introduction to Positive Economics, English
Language Book Society, p. 201-259

9.10 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Section 9.2 and answer
Check Your Progress 2
1) Read Section 9.3 and answer
2) Read Section 9.4 and answer
Check Your Progress 3
1) a) False b) False c) False d) False e) False
3) Read Section 9.5, sub-sections 9.5.1 to 9.5.5 and answer
4) Read Section 9.5.4 and answer
Check Your Progress 4
1) Read Section 9.7 and answer
2) Read Section 9.6 and answer
3) No

212
UNIT 10 MONOPOLY: PRICE AND
OUTPUT DECISIONS
Structure
10.0 Objectives
10.1 Introduction
10.1.1 Meaning of Monopoly
10.1.2 Some Definitions
10.1.3 Characteristics of Monopoly
10.1.4 Causes of Monopoly

10.2 Demand and Revenue Curves under Monopoly

10.2.1 Relationship between AR, MR, and Price Elasticity under Monopoly

10.3 Equilibrium of the Monopoly Firm: Price and Output Decision

10.3.1 Total Revenue and Total Cost Approach
10.3.2 Marginal Revenue and Marginal Cost Approach
10.3.3 Long Run Equilibrium under Monopoly

10.4 Comparison of Monopoly with Perfect Competition

10.5 Efficiency and Deadweight Loss under Monopoly
10.6 Price Discrimination under Monopoly: Types and Degrees
10.6.1 Types of Price Discrimination
10.6.2 Degrees of Price Discrimination

10.7 Pricing in Public Monopoly

10.7.1 Marginal Cost Pricing
10.7.2 Average Cost Pricing
10.7.3 Mark-up Pricing

10.8 Let Us Sum Up

10.9 References
10.10 Answers or Hints to Check Your Progress Exercises

10.0 OBJECTIVES
We have learned in Unit 9 that there are different forms of market. Broadly
speaking market can either be perfectly competitive or imperfectly
competitive. In Unit 9 we have already discussed price and output decisions of
a firm and industry under perfectly competitive market. There are various
forms of market under imperfect competition. These include monopoly,
oligopoly, and monopolistic competition. Some of them are extreme forms. In
this unit we will discuss an extreme form of market, that is monopoly, where,
there is only one seller.
After going through this unit, you will be able to:
 state the meaning, causes and characteristics of monopoly;
Ms. Shruti Jain, Assistant Professor in Economics, Mata Sundari College (University of
Delhi), Delhi. 213
Market  explain pricing and output decision under monopoly;
Structure
 discuss the concept of deadweight loss under monopoly;

 explain price discrimination under monopoly; and

 illustrate pricing in a public monopoly.

10.1 INTRODUCTION
10.1.1 Meaning of Monopoly
The word monopoly has been derived from the combination of two words i.e.,
‘Mono’ and ‘Poly’. Mono refers to a single entity and poly to control. In this
way, monopoly refers to a market situation in which there is only one seller of
a commodity.
There are no close substitutes for the commodity that monopoly firm produces
and there are barriers to entry. The single producer may be in the form of
individual owner or a simple partnership or a joint stock company. In other
words, under monopoly there is no difference between firm and industry.
Monopolist has full control over the supply of commodity. Having control over
the supply of the commodity, it exercises the market power to set the price.
Thus, as a single seller/producer monopolist may be a king without a crown. If
there is to be an effective monopoly, the cross elasticity of demand between the
product of the monopolist and the product of any other seller must be very
small.

10.1.2 Definitions
“Pure monopoly is represented by a market situation in which there is a single
seller of a product for which there are no substitutes; this single seller is
unaffected by and does not affect the prices and outputs of other products sold
in the economy.” -Bilas
“Monopoly is a market situation in which there is a single seller. There are no
close substitutes of the commodity it produces, and there are barriers to entry”.
-Koutsoyiannis
“Under pure monopoly there is a single seller in the market. The monopolist’s
demand is market demand. The monopolist is a price-maker. Pure monopoly
suggests no substitute situation”. -A. J. Braff
“A pure monopoly exists when there is only one producer in the market. There
are no dire competitors.” -Ferguson

10.1.3 Characteristics of Monopoly

1) Single Seller: There is only one seller; he can control supply of his
product. But he cannot control demand for the product, as there are
many buyers.
2) No close Substitutes: There are no close substitutes for the product.
Either they have to buy the product or go without it.
3) Control over price: The monopolist has control over the supply and
thereby on price. Sometimes he may adopt price discrimination. He may
214
 fix different prices for different sets of consumers. A monopolist can Monopoly: Price
either fix the price or quantity of output; but he cannot do both, at the and Output
same time. Decisions

4) No Entry: There is no freedom to other producers to enter the market as

the monopolist is enjoying monopoly power. Barriers for new firms to
enter are strong. There are legal, technological, economic and natural
obstacles, which may block the entry of new producers.
5) No difference between Firm and Industry: Under monopoly, there is
no difference between a firm and an industry. As there is only one firm,
that single firm constitutes the whole industry.
10.1.4 Causes of Monopoly
1) Natural: A monopoly may arise on account of some natural
causes. Some minerals are available only in certain regions. For example,
South Africa has the monopoly of diamonds; nickel in the world is
mostly available in Canada and oil in Middle East. This monopoly is
caused by natural availability of resources.
2) Technical: Monopoly power may be enjoyed due to technical reasons. A
firm may have control over raw materials, technical knowledge, special
know-how, scientific secrets and formula that enable a monopolist to
produce a commodity, e.g., Coco Cola.
3) Legal: Monopoly power is achieved through patent rights, copyrights and
trade marks by the producers. This is called legal monopoly.
4) Large Amount of Capital: The manufacture of some goods requires a
large amount of capital or lumpiness of capital. All firms cannot enter the
field because they cannot afford to invest such a large amount of capital.
This may give rise to monopoly. For example, iron and steel industry,
railways, etc.
5) State: Government will have the sole right of producing and selling some
goods. They are State monopolies. For example, in India we have public
utilities like electricity, railways, water supply. These public utilities are
generally run by the State.

10.2 DEMAND AND REVENUE CURVES UNDER

MONOPOLY
It is important to understand the nature of the demand curve facing a
monopolist. The demand curve facing an industrial firm under perfect
competition, is a horizontal straight line, but the demand curve facing the
whole industry under perfect competition is sloping downward.
This is so because the demand is made by all the consumers and the demand
curve of total consumers for a product usually slopes downward. The
downward-sloping demand curve of the consumers faces the whole
competitive industry. An individual firm under perfect competition does not
face a downward-sloping demand curve. But in the case of monopoly one firm
constitutes the whole industry. Therefore, the entire demand of the consumers
for a product faces the monopolist. Since the demand curve of the consumers
for a product slopes downward, the monopolist faces a downward sloping
demand curve.
215
Market A perfectly competitive firm merely adjusts the quantity of output it has to
Structure produce, price being a given and constant datum for him. But the monopolist
encounters a more complicated problem. He cannot merely adjust quantity at a
given price because each quantity change by him will bring about a change in
the price at which the product can be sold.
Consider Fig. 10.1. DD is the demand curve facing a monopolist. At price OP
the quantity demanded is OM, therefore he would be able to sell OM quantity
at price OP. If he wants to sell a greater quantity ON, then he has to price it
OL. If he restricts his quantity to OG, the price will rise to OH.
Thus, every quantity change by him entails a change in price at which the
product can be sold. The problem faced by a monopolist is to choose a price-
quantity combination which is optimum for him, that is, which yields him
maximum possible profits.
Demand curve facing the monopolist will be his average revenue curve. Thus,
the average revenue curve of the monopolist slopes downward throughout its
length. Since average revenue curve slopes downward, marginal revenue curve
will lie below it. This follows from usual average-marginal relationship. The
implication of marginal revenue curve lying below average revenue curve is
that the marginal revenue will be less than the price or average revenue.

Fig. 10.1: Demand Curve of Monopolist slopes downward

Fig. 10.2: Marginal and Average revenue curves under monopoly

216
When monopolist sells more, the price of his product falls; marginal revenue Monopoly: Price
therefore must be less than the price. In Fig. 10.2, AR is the average revenue and Output
curve of the monopolist and slopes downward. MR is the marginal revenue Decisions
curve and lies below AR curve. At quantity OM, average revenue (or price) is
MP and marginal revenue is MQ which is less than MP. The same can be
shown by a numerical example in the Table 10.1 below:
Table 10.1 : Computation of MR for given AR

Price P=AR Quantity (q) TR= P*Q MR= TR/ q

11 0 0 -
10 1 10 10
9 2 18 8
8 3 24 6
7 4 28 4
6 5 30 2
5 6 30 0
4 7 28 -2
10.2.1 Relationship between Average Revenue, Marginal
Revenue and Price Elasticity under Monopoly
Average and marginal revenue at a quantity are related to each other through
price elasticity of demand and in this connection, we had derived the following
formula in:
( )
MR = AR , where e stands for price elasticity

Since, AR is the same thing as price

( )
Therefore, MR = price

or price = MR ( )

Since the expression (e–1)/e will be less than unity, MR will be less than price,
or price will be greater than MR. The extent to which MR curve lies below AR
curve depends upon the value of the fraction (e – 1)/e.
The monopolist has a clearly distinguished demand curve for his product,
which is identical with the consumers’ demand curve for the product in
question. It is also worth mentioning that, unlike oligopolist or a firm under
monopolistic competition, monopolist does not consider the repercussions of
the price change by him upon those of other firms.
Monopoly, as defined here, requires that the gap between the monopoly
product and those of other firms is so sharp that change — in the price policies
of the monopolist will not affect other firms and will therefore not evoke any
readjustments of the policies by these firms.
The first thing to understand is that, apart from the special case of constant
elasticity where the demand curve is of the form Q = aP-b, the elasticity will
217
Market vary along different points of the demand curve. This is true even when the
Structure gradient of the demand curve is constant (i.e. the demand curve is linear). This
is a point that sometimes confuses you about elasticity, you think “constant
gradient = constant elasticity”…no it doesn’t.
Here is an example, this is a simple demand function Q = 20 – 0.5P.

Fig. 10.3

We can calculate the elasticity at different points, a, b, c, d and e.

With this demand function, = −0.5, so the elasticity at different points will
be e = × −0.5

So at point a, the elasticity is 36/2 × –0.5 = –9

At point b, the elasticity is 24/8 × –0.5 = –1.5
At point c, the elasticity is 20/10 × –0.5 = –1
At point d, the elasticity is 18/11 × –0.5 = –0.818
At point e, the elasticity is 4/18 × –0.5 = –0.111
Notice that at point c, the midpoint of the curve, the elasticity is –1, this is
where the curve is unit elastic. Above point c, the curve is elastic. It gets more
elastic at higher level of price and lower the quantity. At the point where the
price is 40 and the quantity is 0, the elasticity will be infinity. Below point c,
the curve is inelastic and gets less elastic at lower the price and higher the
quantity. At the point where the price is 0 and the quantity is 20, the elasticity
will be 0.
( )
We can now think of this situation with marginal revenue. MR = and TR
( )
= PQ so MR = .
218
Here the inverse demand function is P = 40 – 2Q so PQ = 40Q – 2Q2 Monopoly: Price
( ) and Output
and = 40 − 4Q. So we can draw the marginal revenue curve MR = 40 –
Decisions
4Q:

Fig. 10.4

Notice how the marginal revenue is positive when the demand curve is
elastic, it is zero when the demand curve is unit elastic and it
becomes negative when the demand curve is inelastic.
This is the answer to the question. Given that the marginal revenue is the
amount of revenue gained by selling an extra unit, nobody is going to sell an
extra unit if the marginal revenue is negative (i.e. they lose money by selling
it).
( )
You can also think of this in an algebraic way. Given that MR = , we can
( )
use the product rule to say =P + Q so MR = P + Q

Now multiply both top and bottom parts of the right hand side of that equation
by P so you get MR = P + PQ . We can factorise the P out of this to
get MR = P 1 + Q which can be rewritten slightly differently as MR =
P 1+ .

The right hand side of that equation is the inverse of the elasticity, , so MR =
P 1 + . This is a useful equation to remember.

Elastic demand is where e< –1 and inelastic demand is where –1 < e < 0. So
now we can think of why a monopolist won't produce in the inelastic part of its
demand curve. When demand is inelastic then –1 < e < 0 so 1 + < 0 . And
219
Market
given that the price, P, is positive, it also follows that P 1 + < 0. So the
Structure
marginal revenue will be negative, and no firm will produce an extra unit if it
means it loses money.

10.3 EQUILIBRIUM OF THE MONOPOLY FIRM:

PRICE AND OUTPUT DECISION
Under monopoly, for the equilibrium and price determination, two different
conditions need to be satisfied:
1) Marginal revenue must be equal to marginal cost.
2) MC must cut MR from below.
However, there are two approaches to determine equilibrium price under
monopoly viz.;
1) Total Revenue and Total Cost Approach.
2) Marginal Revenue and Marginal Cost Approach.

10.3.1 Total Revenue and Total Cost Approach

Monopolist can earn maximum profits when difference between TR and TC is
maximum. By fixing different prices, a monopolist tries to find out the level of
output where the difference between TR and TC is maximum. The level of
output where monopolist earns maximum profits is called the equilibrium
situation. This can be explained with the help of Fig. 10.5.

Fig. 10.5

In Fig. 10.5, TC is the total cost curve. TR is the total revenue curve. TR curve
starts from the origin. It indicates that at zero level of output, TR will also be
zero. TC curve starts from P. It reflects that even if the firm discontinues its
production, it will have to suffer the loss of fixed costs.
Total profits of the firm are represented by TP curve. It starts from point R
showing that initially firm is faced with negative profits. Now as the firm
increases its production, TR also increases. But in the initial stage, the rate of
increase in TR is less than that of TC.
Therefore, RC part of TP curve reflects that firm is incurring losses. At point
M, total revenue is equal to total cost. It shows that firm is working under no
profit, no loss basis. Point M is called the breakeven point. When firm
220
produces more, beyond point M, TR will be more than TC. TP curve also Monopoly: Price
slopes upward. It shows that firm is earning profit. Now as the TP curve and Output
reaches point E then the firm will be earning maximum profits. This amount of Decisions
output will be termed as equilibrium output.

10.3.2 Marginal Revenue and Marginal Cost Approach

According to marginal revenue and marginal cost approach, a monopolist will
be in equilibrium when two conditions are fulfilled i.e., (i) MC = MR and (ii)
MC must cut MR from below. The study of equilibrium price according to this
analysis can be conducted in two time periods.
1) The Short Run
2) The Long Run
1) Short Run Equilibrium under Monopoly
Short period refers to that period in which the monopolist has to work with a
given existing plant. In other words, the monopolist cannot change the fixed
factors like, plant, machinery etc. in the short period. Monopolist can increase
his output by changing the variable factors. In this period, the monopolist can
enjoy super-normal profits, normal profits and sustain losses.
These three possibilities are described as follows:
Super Normal Profits
If the price determined by the monopolist in more than AC, he will get super
normal profits. The monopolist will produce up to the level where MC=MR.
This limit will indicate equilibrium output. In Fig. 10.6 output is measured on
X-axis and price on Y-axis. SAC and SMC are the short run average cost and
marginal cost curves respectively while AR and MR are the average revenue
and marginal revenue curves respectively.

Fig. 10.6
The monopolist is in equilibrium at point E because at point E both the
conditions of equilibrium are fulfilled i.e., MR = MC and MC intersects the
MR curve from below. At this level of equilibrium the monopolist will produce
OQ1 level of output and sells it at CQ1 price which is more than average cost
DQ1 by CD per unit. Therefore, in this case total profits of the monopolist will
be equal to shaded area ABDC.

221
Market Normal Profits
Structure
A monopolist in the short run would enjoy normal profits when average
revenue is just equal to average cost. We know that average cost of production
is inclusive of normal profits. This situation can be illustrated with the help of
Fig 10.7.

Fig. 10.7

In Fig. 10.7 above the firm is in equilibrium at point E. Here marginal cost is
equal to marginal revenue. The firm is producing OM level of output. At OM
level of output average cost curve touches the average revenue curve at point
P. Therefore, at point ‘P’ price MR is equal to average cost of the total product.
In this way, monopoly firm enjoys the normal profits.
Minimum Losses
In the short run, the monopolist may have to incur losses. This situation occurs
if in the short run price falls below the variable cost. In other words, if price
falls due to depression and fall in demand, the monopolist will continue to
produce as long as price covers the average variable cost. Once the price falls
below the average variable cost, monopolist will stop production. Thus, a
monopolist in the short run equilibrium may bear the minimum loss, equal to
fixed costs. Therefore, equilibrium price will be equal to average variable cost.
This situation can also be explained with the help of Fig. 10.8.

Fig. 10.8

In Fig. 10.8 above monopolist is in equilibrium at point E. At point E marginal

cost is equal to marginal revenue and he produces OM level of output. At OM
level of output, equilibrium price fixed by the monopolist is OP1. At OP1 price,
AVC touches the AR curve at point A.
222
It signifies that the firm will cover only average variable cost from the Monopoly: Price
prevailing price. At OP1 price, firm will bear loss of fixed cost i.e., A per unit. and Output
The firm will bear the total loss equal to the shaded area PP1 AN. Now if the Decisions
price falls below OP1, the monopolist will stop production. It is so, because, if
he continues production, he will have to bear the loss of variable costs along
with fixed costs.
Illustration 1: Let the cost of production of monopoly firm be given as : C =40
+ Q2 and demand be P = 20 – Q.
Find the profit maximising level of output and price.
Solution: Since cost is given as:
C = 40 + Q2
∆
MC = ∆ = 2Q

and
Since demand is given as:
P = 20 – Q
Total Revenue = P . Q = (20 – Q) Q = 20 Q – Q2
∆
MR = = 20 − 2Q
∆

and
Profit maximisation occurs where:
MR = MC
20 – 2Q = 2Q
Q=5
Thus profit maximising level of output is 5 units and profit maximising price is
P = 20 – Q = 20 – 5 = 15
Illustration 2. Only one firm produces and sells soccer balls in the country of
Wiknam, and as the story begins, international trade in soccer balls is
prohibited. The following equations describe the monopolist’s demand,
marginal revenue, total cost, and marginal cost:
Demand : P = 10 – Q
Marginal Revenue : MR = 10 – 2Q
Total Cost : TC = 3 + Q + 0.5 Q2
Marginal Cost : MC = 1 + Q
Where Q is quantity and P is the price.
(a) How many units does the monopolist produce? At what price are they
sold? What is the monopolist’s profit?
Solution:
P = 10 – Q
223
Market MR = 10 – 2Q
Structure
TC = 3 + Q + 0.5Q2
MC = 1 + Q
Monopolist will produce where:
MR = MC
10 – 2Q = 1 + Q
3Q = 9
Q=3
Quantity are sold at price given by:
P = 10 – Q
= 10 – 3
∴ P = $7

Monopolist profit (Rupees) is given by:

Profit = TR–TC
= [7 × 3] – [3 + 3 + 0.5 × 33 ]

= 21 – [6 + ] = [21 – ] = 10.5

Profit = $10.5

10.3.3 Long Run Equilibrium under Monopoly

Long-run is the period in which output can be changed by changing the factors
of production. In other words, all variable factors can be changed and
monopolist would choose that plant size which is most appropriate for specific
level of demand. Here, equilibrium would be attained at that level of output
where the long-run marginal cost cuts marginal revenue curve from below.
This can be shown with the help of Fig. 10.9.

Fig. 10.9
224
In Fig. 10.9 above monopolist is in equilibrium at OM level of output. At OM Monopoly: Price
level of output marginal revenue is equal to long run marginal cost and the and Output
monopolist fixes OP price. HM is the long run average cost. Price OP being Decisions
more than LAC i.e., HM which fetch the monopolist super normal profits.
Accordingly, the monopolist earns JM – HM = JH super normal profit per unit.
His total super normal profits will be equal to shaded area PJHP1.
Check Your Progress 1
1) How does the monopolist determine his price and output in the short
period?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Based on market research, a film production company in Mumbai obtains
the following information about the demand and production costs of its
new DVD:
Demand: P = 1,000 – 10Q
Total Revenue TR = P × Q = 1000Q – 10Q2
Marginal Revenue: MR = 1,000 – 20Q
Marginal Cost MC = 100 + 10Q
Where Q indicates the number of copies sold and P is the price in dollars.
Find the price and quantity that maximises the company’s profit.
......................................................................................................................
......................................................................................................................
......................................................................................................................

10.4 COMPARISON OF MONOPOLY WITH

PERFECT COMPETITION
Following points make clear difference between both the monopoly and perfect
competition:
1) Output and Price
Under perfect competition, price is equal to average cost which is equal to
marginal cost at the equilibrium output. Under monopoly, the price is always
greater than marginal cost, it may be less than, equal to or greater than average
cost.
2) Equilibrium
Both under perfect competition and monopoly equilibrium is possible only
when MR = MC and MC cuts the MR curve from below.

225
Market 3) Entry
Structure
Under perfect competition, there exists no restrictions on the entry or exit of
firms into the industry. Under simple monopoly, there are strong barriers on
the entry and exit of firms.
4) Discrimination
Under monopoly, a monopolist can charge different prices from the different
groups of buyers. But, in the perfectly competitive market, it is absent by
definition. We shall discuss the price discriminations by a monopolist in
Sections 10.6 below.
5) Profits
The difference between price and average cost under monopoly results in
super-normal profits to the monopolist. Under perfect competition, a firm in
the long run enjoys only normal profits.
6) Supply Curve of Firm
Under perfect competition, supply curve can be known. It is so because all
firms can sell desired quantity at the prevailing price. Moreover, there is no
price discrimination. Under monopoly, supply curve cannot be known. MC
curve is not the supply curve of the monopolist.
7) Slope of Demand Curve
Under perfect competition, demand curve is perfectly elastic. It is due to the
existence of large number of firms. Price of the product is determined by the
industry and each firm has to accept that price. On the other hand, under
monopoly, average revenue curve slopes downward. AR and MR curves are
separate from each other. Price is determined by the monopolist.

Fig. 10.10

8) Goals of Firms
Under perfect competition and monopoly the firm aims at to maximise its
profits. The firm which aims at to maximise its profits is known as rational
firm.
9) Comparison of Price
Monopoly price is higher than perfect competition price. In long period, under
perfect competition, price is equal to average cost. In monopoly, price is higher
as is shown in Fig. 10.11 below. The perfect competition price is OP1, whereas
monopoly price is OP. In equilibrium, monopoly sells ON output at OP price
226 but a perfectly competitive firm sells higher output ON1 at lower price OP1.
 Monopoly: Price
and Output
Decisions

Fig. 10.11

10) Comparison of Output

Perfect competition output is higher than monopoly output. Under perfect
competition the firm is in equilibrium at point M1 where AR = MR = AC = MC
are equal. The equilibrium output is ON1. On the other hand monopoly firm is
in equilibrium at point M where MC=MR. The equilibrium output is ON. The
monopoly output is lower than perfectly competitive firm output.
Summary of Comparison:
A general comparison between monopoly and perfect competition for easy
understanding has been depicted as under:

S. No. Features Monopoly Perfect Competition

1 Description Extreme market A fair, direct
situation, where there is competition between
only one seller. He has buyers and buyers, seller
no competition and so and sellers, and finally
controls supply and between buyers and
price. sellers.
2 Buyers and Only one seller and Large number of buyers
Sellers practically all buyers and sellers. Hence no
depend on him. Hence sellers or buyers can
he has absolute control alter the price in the
over the market. market.
3 Supply Supply from only one i) Supply comes from
seller, hence absolute large number of sellers
control over the supply. ii) Individual supply is
negligible, compared to
market supply.
4 Demand Demand is not perfectly. Demand is perfectly
Demand curve slopes elastic. Demand curve
downward. faced by a seller is a
horizontal straight line.
5 Product Homogeneous product. Homogenous product.
6 Nature of No competition at all. No Pure and perfect
Competition price or product competition in price.
competition.
227
Market
7 Price Higher price, higher than Normal Price P = MR =
Structure
all competitive price. P MC
> MR = MC
8 Output Small output fixed by the Large output fixed by
sole seller. MR = MC
9 Profit Excess profit monopoly Normal profit realised
gain. by price competition.
10 Application Pure Monopoly is rare Quite unreal.
but elements of
monopoly are there in
markets.

10.5 EFFICIENCY AND DEADWEIGHT LOSS

UNDER MONOPOLY
The outcome of a competitive market has a very important property. In
equilibrium, all gains from production activities are realised. This means that
there is no additional surplus to obtain from further trades between buyers and
sellers. In this situation, we say that the allocation of goods and services in the
economy is efficient. However, markets sometimes fail to operate properly and
not all gains from trade are exhausted. In this case, some buyer surplus, seller
surplus, or both are lost. Economists call this a deadweight loss.
The deadweight loss from a monopoly is illustrated in the Fig. 10.12 below.
The monopolist produces a quantity such that marginal revenue equals
marginal cost. The price is determined by the demand curve at this quantity. A
monopoly makes a profit equal to total revenue minus total cost. When the
total output is less than socially optimal, there is a deadweight loss, which is
indicated in the figure.
Deadweight loss arises in other situations, such as when there are quantity or
price restrictions. It also arises when taxes or subsidies are imposed in a
market. Tax incidence is the way in which the burden of a tax falls on buyers
and sellers — that is, who suffers most of the deadweight loss. In general, the
incidence of a tax depends on the elasticities of supply and demand.
Price

Quantity
228 Fig. 10.12
 Monopoly: Price
10.6 PRICE DISCRIMINATION UNDER and Output
MONOPOLY: TYPES AND DEGREES Decisions

In monopoly, there is a single seller of a product called monopolist. The

monopolist has control over pricing, demand, and supply decisions, thus, sets
prices in a way, so that maximum profit can be earned.
The monopolist often charges different prices from different consumers for the
same product. This practice of charging different prices for identical product is
called price discrimination.
According to Robinson, “Price discrimination is charging different prices for
the same product or same price for the differentiated product.”

10.6.1 Types of Price Discrimination

Price discrimination is a common pricing strategy used by a monopolist having
discretionary pricing power. This strategy is practiced by the monopolist to
gain market advantage or to capture market position.
There are three types of price discrimination, which are shown below:

i) Personal
Personal price discrimination refers to a situation when different prices are
charged from different individuals. The different prices are charged according
to the level of income of consumers as well as their willingness to purchase a
product. For example, a doctor charges different fees from poor and rich
patients.
ii) Geographical
This type of price discrimination occurs when the monopolist charges different
prices at different places for the same product. This type of discrimination is
possible if those who buy at lower price cannot sell to those being charged a
higher price by the firm.
iii) On the basis of use
This kind of price discrimination occurs when different prices are charged
according to the use of a product. For instance, an electricity supply board
charges lower rates for domestic consumption of electricity and higher rates for
commercial consumption. Similar discrimination occurs when buyers are
charged different prices at different hours of the day – it is referred to as peak-
load pricing.

229
Market 10.6.2 Degrees of Price Discrimination
Structure
i) First-degree Price Discrimination
Refers to a price discrimination in which a monopolist charges the maximum
price that each buyer is willing to pay. This is also known as perfect price
discrimination as it involves maximum exploitation of consumers. In this price
discrimination, consumers fail to enjoy any consumer surplus. First degree is
practiced by lawyers and doctors.
ii) Second-degree Price Discrimination
Refers to a price discrimination in which buyers are divided into different
groups and different prices are charged from these groups depending upon
what they are willing to pay. Railways and airlines practice this type of price
discrimination.
iii) Third-degree Price Discrimination
Refers to a price discrimination in which the monopolist divides the entire
market into submarkets and different prices are charged in each submarket.
Therefore, third-degree price discrimination is also termed as market
segmentation.
In this type of price discrimination, the monopolist is required to segment
market in a manner, so that products sold in one market cannot be resold in
another market. Moreover, he/she should identify the price elasticity of
demand of different submarkets. The groups are divided according to age, sex,
and location. For instance, railways charge lower fares from senior citizens.
Students get discount in cinemas, museums, and historical monuments. We are
explaining it with help of Fig. 10.13, which has three segments (a), (b) and (c).

Fig. 10.13

Segments (a) and (b) depict markets with inelastic and elastic demand curves
respectively. The segment (c) has horizontal sum of the AR and MR curves of
(a) and (b), denoted as AR t and MR t. The firm has a single Average Total Cost
curve and corresponding Marginal Cost Curve. Inter-section of this MC with
MR t gives us equilibrium output OQ for the firm. It also shows the MR for the
firm, which maximises its profits. The firm will like to realise the same MR
from each of the units sold in either of those two market segments. So,
wherever the extended line EM cuts MRa and MRb (points Ea and Eb
respectively) will be used to determine equilibrium outputs Q aO and Q bO for
the two market segments. The prices will be what the consumers are ready to
pay for the respective quantities, that is, Pa and P b.
230
Note two points: The monopolist offers larger quantities in market with Monopoly: Price
relatively elastic demand curve and smaller in market with inelastic demand. and Output
We find that Q b > Q a. However, the price change in the segment (a)with Decisions
inelastic demand, P a is greater than price in segment (b) P b. So we can say
that buyers with inelastic demand will face a double disadvantage at the hands
of a monopolist: They end up buying smaller quantities and have to pay higher
prices.
Check Your Progress 2
1) What is Price Discrimination?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Explain the degrees of Price Discrimination.
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) How Monopolist firm faces efficiency loss?
......................................................................................................................
......................................................................................................................
......................................................................................................................
4) How is price determination under Monopoly is different from Perfect
Competition?
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......................................................................................................................

10.7 PRICING IN PUBLIC MONOPOLY

So far we have discussed the behaviour of a private monopolist whose
objective is to maximise her profits, given the economic and technical
constraints. In this section, we analyse the behaviour of a public monopoly — a
firm owned and controlled by the government. The objective of a public
monopoly is to provide more output and charge lower price so as to increase
the welfare of people. The optimal pricing and output decisions by such an
undertaking is not based on profit or sales maximisation principles but on
maximisation of welfare.
Average-cost-pricing and marginal-cost-pricing are the two possible options
for the determination of output and price by a public utility firm. In fact, these
two options can become policy guidelines for the government for price
regulation of a private monopoly firm as well.
There is a need to regulate monopoly because monopolists have ability to
restrict output and raise prices of their product and this way earn super normal
231
Market profits. Such behaviour increases inequalities in the distribution of income and
Structure wealth leading to exploitation of the consumers and also causes inefficiency in
allocation of resource. A net result of all these actions is reduction of consumer
welfare in the society. Therefore, the main objective behind regulation of
monopoly is the maximisation of welfare. A monopoly may be regulated either
through fixation of a maximum price that a monopolist may charge or
appropriate taxation policy. Here, we are concerned with price regulation of
monopoly only. The issue involved in average and marginal cost pricing
discussed here are useful in fixing of prices in a public utility as well.

10.7.1 Marginal Cost Pricing

As discussed above, a monopolist sets price of its product higher than marginal
cost. Monopolist maximise profit at the level of output where MR=MC and
charges price according to equilibrium condition. The government may decide
to regulate a monopoly by fixing maximum price that equals marginal cost of
production. The monopolist will be forced to raise the output higher then the
equilibrium level and charges price, which would have prevailed had the
market been perfectly competitive. Such a price would ensure efficiency in
allocation of resources as well, since it is equal to marginal cost. It also
enhances welfare of the consumers, as they get larger output al lower price.
The consumer’s surplus under regulated monopoly is more then it was in non-
regulated monopoly.
It may be noted that given the conditions of demand and cost ‘Marginal cost’
pricing may still allow a monopolist to earn super normal profits as the price
may still be higher than the average cost. This is a case of ‘capacity-
constrained situation’, that is the demand for the product is quite high as
compared to the production capacity. But, in a different situation, when there is
excess capacity, marginal cost pricing results in direct loss to the firm as its
average cost is higher than marginal cost. Thus, the firm will produce marginal
cost price output only if it is compensated by the government for the direct loss
at this level of production.

10.7.2 Average Cost Pricing

The aim of the public policy is to regulate monopoly in such a manner that is
possible to provide maximum output at minimum price. One policy option is to
fix price according to the average cost, i.e, at a point where AR = AC. This
allows the firm to earn normal profit. In case of capacity-constrained situation,
average cost pricing leads to higher output and lower price. This means there
will be higher level of consumer’s surplus compared to marginal cost pricing.
However, in excess capacity situation, there shall be a somewhat higher price
with average cost pricing but there shall be no direct loss to the producer as
P = AC. Marginal cost pricing adopted to reach full economic efficiency or
maximum social welfare. But in case of excess capacity, where AC > MC,
marginal cost pricing necessitates state subsidies to induce the monopolist to
stay in the market.

10.7.3 Mark-up Pricing

It is observed that in real life, prices are not fixed by marginal analysis, viz, by
the use of marginal revenue and marginal cost concepts. An alternative
approach is to set the prices in accordance with the average cost principle.

232
The firm sets a price equal to its average cost which includes some profit Monopoly: Price
margin, that is. and Output
Decisions
P = AVC + GPM
where P is the price, AVC is the average variable cost, and GPM is the gross
profit margin which include average fixed cost and net profit margin.
The purpose of this note is to show that average cost principle and marginal
analysis would give the same long-run profit maximisation solution. The
setting of the price on the basis of the average cost principles incorporates as
estimation of the elastic of demand in the long run equilibrium. Recall that the
necessary condition for profit maximisation is MC=MR. It has already been
proved that MR=P(e–1/e). Given that MC >0. MR must be positive for profit
maximisation. This implies e>1, provided that AVC is constant over the
relevant range of output, that is, AVC=MC. For equilibrium, AVC=MR, that
is, AVC=P(1–1/e)=P{(e–1)/e}. In other words P = AVC {e/(e–1)}. Given that
e>1, we may write {e/(e–1)}=(1+k), where k>0. Therefore, P=AVC(1+k),
where k is the gross profit margin. For example, if the firm sets a 20 per cent of
AVC as its profit margin, we have (1+k) = [1 + 0.20] = . Thus, the
elasticity of demand is 6. Setting a gross profit margin is equivalent to
estimating the price elasticity of demand and applying marginalist analysis.
Check Your Progress 3
1) How a public monopoly is different from a private monopolist firm?
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) How does the public monopoly firm make price and output decisions?
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) What do you mean by Mark up pricing?
......................................................................................................................
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......................................................................................................................

10.8 LET US SUM UP

Monopoly is a market structure in which there is a single seller with large
number of buyers. Assumptions of monopoly are: Single firm, No close
substitutes, Barriers to entry, Goal is profit maximisation, Perfect knowledge.
In monopoly, market Firm’s demand curve is industry’s demand curve. The
demand curve is downward sloping because monopolist is a price maker and
not a price taker. The demand curve of monopolist is the AR curve or the price
line. According to the marginal principle, equilibrium takes place where: MR =
MC and slope of MC should be greater then Slope of MC. In the long-run, the
firm will either continue to earn profit or may breakeven. Two market 233
Market structures, i.e. Perfect Competition and Monopoly are extreme situations.
Structure Monopolist charges higher price and sells lesser output as compared to
perfectly competitive firm. Price discrimination is the practice of charging
different prices from different consumers for the same good. AC and MC
pricing are undertaken by a public monopoly for social or public welfare.

10.9 REFERENCES
1) Dr Deepashree (2016), Introductory Micro Economics, Mayur
Paperbacks, Chapter on Theory of Market structure.

http://www.economicsdiscussion.net

2) Varian, Hal (1999), Intermediate Microeconomics, W.W Norton &Co,

New York, Chapter 24 & 25, page no. 415-455.

10.10 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Sub-section 10.3.2 and answer
2) Q = 30 units
P = Rs. 700
Check Your Progress 2
1) Read Section 10.6 and answer
2) Read Sub-section 10.6.2 and answer
3) Read Section 10.5 and answer
4) Read Section 10.4 and answer
Check Your Progress 3
1) Read Section 10.7 and answer
2) Read Sub-section 10.7.1 and answer
3) Read Sub-section 10.7.2 and answer

234
UNIT 11 MONOPOLISTIC
COMPETITION: PRICE AND
OUTPUT DECISIONS
Structure
11.0 Objectives
11.1 Introduction
11.2 Concept and Features of Monopolistic Competition
11.3 Demand Curve under Monopolistic Competition
11.4 Equilibrium under Monopolistic Competition
11.4.1 Individual Firm’s Equilibrium in Short-Run Period
11.4.2 Individual Firm’s Equilibrium in Long Run
11.4.3 Group Equilibrium in Monopolistic Competition
11.4.4 Equilibirium with Selling Costs

11.5 Perfect Competition, Monopoly and Monopolistic Competition:

Comparison
11.6 Theory of Excess Capacity under Monopolistic Competition
11.7 Let Us Sum Up
11.8 References
11.9 Answers or Hints to Check Your Progress Exercises

11.0 OBJECTIVES
After studying this unit, you will be able to:
 define the term monopolistic competition;
 explain the demand curve under monopolistic competition;
 state the equilibrium conditions of monopolistic competition;
 make comparison under perfect competition, monopoly and monopolistic
competition; and
 explain the theory of excess capacity under monopolistic competition.

11.1 INTRODUCTION
Pure monopoly and perfect competition are two extreme cases of market
structure. In reality, there are markets having large number of producers
competing with each other in order to sell their product in the market. Thus,
there is monopoly on one hand and perfect competition on other hand. Such a
mixture of monopoly and perfect competition is called as monopolistic
competition, it refers to a market situation in which there are large numbers of

Ms. Shruti Jain, Assistant Professor in Economics, Mata Sundari College (University of
Delhi), Delhi. 235
Market firms which sell closely related but differentiated products. Markets of
Structure products like soap, toothpaste AC, etc. are examples of monopolistic
competition.

11.2 CONCEPT AND FEATURES OF

MONOPOLISTIC COMPETITION
Monopolistic competition is a market in which firms can enter freely each
producing its own brand or a differentiated product. Thus, a firm under
monopolistic competition
a) Enjoys ‘monopoly position’ as far as a particular brand is concerned.
b) Since the various brands are close substitutes, its monopoly position is
influenced by the stiff ‘competition’ from other firms.
Examples of Monopolistic Competition:
1) When you walk into a departmental store to buy toothpaste, you will find
a number of brands, like Pepsodent, Colgate, Neem, Babool, etc.
i) On one hand, the market for toothpaste seems to be full of
competition, with thousands of competing brands and freedom of
entry;
ii) On the other hand, its market seems to be monopolistic, due to
uniqueness of each toothpaste and power to charge different price.
Such a market for toothpaste is a monopolistic competitive market.
2) A firm supplies branded good ‘Lux Soap’ in the market. There are many
other firms in the market which sell similar soaps (not identical) with
different brand names like Rexona, Palm Rose, etc., etc. Some times we
can find one company manufacturing and selling similar products with
several brand names at different prices. Their idea is to place each of
their products in ‘niches’ or slots which capture attention of a different
set of consumers. The firm supplying ‘Lux Soap’ enjoys a monopoly in
the sale of its own product. It also faces competition from firms selling
similar products. Same is the case with many other firms in the market
like plywood manufacturing, jewellery making, wood furniture, book
stores, departmental stores, repair services of all kinds, professional
services of doctors, technicians, etc. These firms and others which have
an element of monopoly power and also face competition over the sale of
product or service in the market are called monopolistically competitive
firm.
The following are the features or characteristics of monopolistic competition:-
1) Large Number of Sellers
There are large number of sellers producing differentiated products. So,
competition among them is very keen. Since number of sellers is large, each
seller produces a very small part of market supply. Every firm is limited in its
size.

236
In other words, there are large numbers of firms selling closely related, but not Monopolistic
homogeneous products. Each firm acts independently and has a limited share Competition: Price
of the market. So, an individual firm has limited control over the market price. and Output Decisions
Large number of firms leads to competition in the market.
2) Product Differentiation
It is one of the most important features of monopolistic competition. In perfect
competition, products are homogeneous in nature. On the contrary, here, every
producer tries to keep his product dissimilar than his rival’s product in order to
maintain his separate identity. This boosts up the competition in market and at
the same time every firm acquires some monopoly power. Hence, each firm is
in a position to exercise some degree of monopoly (in spite of large number of
sellers) through product differentiation. Product differentiation refers to
differentiating the products on the basis of brand, size, colour, shape, etc. The
product of a firm is close, but not perfect substitute for products of other firms.
Implication of ‘Product differentiation’ is that buyers of a product differentiate
between the same products produced by different firms. Therefore, they are
also willing to pay different prices for the same product produced by different
firms. This gives some monopoly power to an individual firm to influence
market price of its product. Following points provide insight about the product
differentiation:
a) The product of each individual firm is identified and distinguished from
the products of other firms due to product differentiation.
b) To differentiate the products, firms sell their products with different
brand names, like Lux, Dove, Lifebuoy, etc.
c) The differentiation among different competing products may be based on
either ‘real’ or ‘imaginary’ differences.
i) Real Differences may be due to differences in shape, flavour,
colour, packing, after sale service, warranty period, etc.
ii) Imaginary Differences mean differences which are not really
obvious but buyers are made to believe that such differences exist
through selling costs (advertising).
d) Product differentiation creates a monopoly position for a firm.
e) Higher degree of product differentiation (i.e. better brand image) makes
demand for the product less elastic and enables the firm to charge a price
higher than its competitor’s products. For example, Pepsodent is costlier
than Babool.
f) Some more examples of Product Differentiation: i) Toothpaste:
Pepsodent, Colgate, Neem, Babool, etc., ii) Cycles: Atlas, Hero, Avon,
etc., iii) Tea: Brooke Bond, Tata tea, Today tea, etc.
3) Freedom of Entry and Exit
This feature leads to stiff competition in market. Free entry into the market
enables new firms to come with close substitutes. Free entry or exit maintains
normal profit in the market for a longer span of time.
4) Selling Cost
It is a unique feature of monopolistic competition. In such type of market, due
to product differentiation, every firm has to incur some additional expenditure
in the form of selling cost. This cost includes sales promotion expenses,
advertisement expenses, salaries of marketing staff, etc. 237
Market But on account of homogeneous product in perfect competition and zero
Structure competition in monopoly, selling cost does not exist there.
5) Absence of Interdependence
Large numbers of firms are different in their size. Each firm has its own
production and marketing policy. So no firm is influenced by other firm. All
are independent.
6) Two Dimensional Competition
Monopolistic competition has two types or aspects of competition aspects viz.
Price competition i.e. firms compete with each other on the basis of price. Non-
price competition i.e. firms compete on the basis of brand, product quality
advertisement.
7) Concept of Group
In place of Marshallian concept of industry, Chamberlin introduced the concept
of Group under monopolistic competition. An industry means a number of
firms producing identical product. A group means a number of firms producing
differentiated products which are closely related.
8) Falling Demand Curve
In monopolistic competition, a firm is facing downward sloping demand curve.
It means one can sell more at lower price and vice versa.
9) Lack of Perfect Knowledge
Buyers and sellers do not have perfect knowledge about the market conditions.
Selling costs create artificial superiority in the minds of the consumers and it
becomes very difficult for a consumer to evaluate different products available
in the market. As a result, a particular product (although highly priced) is
preferred by the consumers even if other less priced products are of same
quality.
Check Your Progress 1
1) What is monopolistic competition? Explain with few examples.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) Identify the features that shows the presence of monopolistic competition
in market.
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.....................................................................................................................
.....................................................................................................................
3) A market with few entry barriers and with many firms that sell
differentiated products is
A) purely competitive.
B) a monopoly.
C) monopolistically competitive.
D) oligopolistic.

238
 Monopolistic
11.3 DEMAND CURVE UNDER MONOPOLISTIC Competition: Price
COMPETITION and Output Decisions

Under monopolistic competition, large number of firms selling closely related

but differentiated products make the demand curve downward sloping. It
implies that a firm can sell more output only by reducing the price of its
product.
As seen in Fig. 11.1, output is measured along the X-axis and price and
revenue along the Y-axis. At OP price, a seller can sell OQ quantity. Demand
rises to OQ1, when price is reduced to OP1. So, demand curve under
monopolistic competition is negatively sloped as more quantity can be sold
only at a lower price.

Fig. 11.1

MR < AR under Monopolistic Competition: Like monopoly, MR is also less

than AR under monopolistic competition due to negatively sloped demand
curve.
Demand Curve: Monopolistic Competition Vs. Monopoly:
At first glance, the demand curve of monopolistic competition looks exactly
like the demand curve under monopoly as both faces downward sloping
demand curves. However, demand curve under monopolistic competition is
more elastic as compared to demand curve under monopoly. This happens
because differentiated products under monopolistic competition have close
substitutes, whereas there are no close substitutes in case of monopoly.
Let us prove this with the help of Fig. 11.2.

239
Market
Structure

Fig. 11.2

We know, price elasticity of demand (by geometric method) at a point on the

demand curve is given by: Ed = Lower segment of demand curve / Upper
segment of demand curve.
At price ‘OP’, price elasticity of demand under monopolistic competition is
BC/AB and under monopoly is EF/DE. Fig. 11.2 reveals that BC > EF and DE
> AB. So, BC/AB > EF/DE.
It means, demand curve in case of monopolistic competition is more elastic as
compared to demand curve under monopoly.

11.4 EQUILIBRIUM UNDER MONOPOLISTIC

COMPETITION
A firm under monopolistic competition has to face various problems which are
absent under perfect competition. Since the market of an individual firm under
perfect competition is completely merged with the general one, it can sell any
amount of the good at the ruling market price.
But, under monopolistic competition, individual firm’s market is isolated to a
certain degree from those of its rivals with the result that its sales are limited
and depend upon:
1) Its price,
2) The nature of its product, and
3) The advertising outlay it makes.
Thus, the firm under monopolistic competition has to confront a more
complicated problem than the perfectly competitive firm. Equilibrium of an
individual firm under monopolistic competition involves equilibrium in three
respects, that is, in regard to the price, the nature of the product, and the
amount of advertising outlay it should make.
Equilibrium of the firm in respect of three variables simultaneously – price,
nature of product, selling outlay – is difficult to discuss. Therefore, the method
of explaining equilibrium in respect of each of them separately is adopted,
keeping the other two variables given and constant.
Moreover, as noted above, the equilibrium under monopolistic competition
involves “individual equilibrium” of the firms as well as “group equilibrium”.
We shall discuss these two types of equilibrium first in respect of price and
240 output and then in respects of product and advertising expenditure adjustments.
11.4.1 Individual Firm’s Equilibrium in Short-Run Period Monopolistic
Competition: Price
The demand curve for the product of an individual firm, as noted above, is and Output Decisions
downward sloping. Since the various firms under monopolistic competition
produce products which are close substitutes to each other, the position and
elasticity of the demand curve for the product of any of them depend upon the
availability of the competitive substitutes and their prices.
Therefore, the equilibrium adjustment of an individual firm cannot be defined
in isolation from the general field of which it is a part. However, for the sake of
simplicity in analysis, conditions regarding the availability of substitute
products produced by the rival firms and prices charged for them are held
constant while the equilibrium adjustment of an individual firm is considered
in isolation.
Since close substitutes for its product are available in the market, the demand
curve for the product of an individual firm working under conditions of
monopolistic competition is fairly elastic. Thus, although a firm under
monopolistic competition has a monopolistic control over its variety of the
product but its control is tempered by the fact that there are close substitutes
available in the market and that if it sets too high a price for its product, many
of its customers will shift to the rival products.

Fig. 11.3

Assuming the conditions with respect to all substitutes such as their nature and
prices being constant, the demand curve for the product of a firm will be given.
We further suppose that only variables are price and output in respect of which
equilibrium adjustment is to be made.
The individual equilibrium under monopolistic competition is graphically
shown in Fig. 11.3. DD is the demand curve for the product of an individual
firm, the nature and prices of all substitutes being given. This demand curve
DD is also the average revenue (AR) curve of the firm.
AC represents the average cost curve of the firm, while MC is the marginal
cost curve corresponding to it. It may be recalled that average cost curve first
falls due to internal economies and then rises due to internal diseconomies.
241
Market Given these demand and cost conditions a firm will adjust its price and output,
Structure at the level which gives it maximum total profits. Theory of value under
monopolistic competition is also based upon the profit maximisation principle,
as is the theory of value under perfect competition.
Thus a firm, in order to maximise profits, will equate marginal cost with
marginal revenue. In Fig. 11.3, the firm will fix its level of output at OM, for at
OM output marginal cost is equal to marginal revenue. The demand curve DD
facing the firm in question indicates that output OM can be sold at price MQ =
OP. Therefore, the determined price will evidently be MQ or OP.
In this equilibrium position, by fixing its price at OP and output at OM, the
firm is making profits equal to the area RSQP which is maximum. It may be
recalled that profits RSQP are in excess of normal profits because the normal
profits which represent the minimum profits necessary to secure the
entrepreneur’s services are included in average cost curve AC. Thus, the area
RSQP indicates the amount of supernormal or economic profits made by the
firm.
In the short-run, the firm, in equilibrium, may make supernormal profits, as
shown in Fig. 11.3 above, but it may make losses too if the demand conditions
for its product are not so favourable relative to cost conditions. Fig. 11.4
depicts the case of a firm whose demand or average revenue curve DD for the
product lies below the average cost curve, indicating thereby, that no output of
the product can be produced at positive profits.

Fig. 11.4

However, the firm is in equilibrium at output ON and setting price NK or OT.

By adjusting price at OT and output at ON, it is able to minimise its losses. In
such an unfavourable situation, there is no alternative for the firm except to
make the best of the bad bargain.
We thus see that a firm in equilibrium under monopolistic competition, as
under pure or perfect competition, may be making supernormal profits or
losses depending upon the position of the demand curve relative to the position
of the average cost curve. Further, a firm may be making only normal profits
even in the short run if the demand curve happens to be tangent to the average
242 cost curve.
It should be carefully noted that in individual equilibrium of the firm in Fig. Monopolistic
11.3 and 11.4, the firm having once adjusted price at OP and (respectively will Competition: Price
have no tendency to vary the price any more. If it varies its price upward, the and Output Decisions
loss due to fall in quantity demanded will be more than possible gain owing to
the higher price. If it cuts down its price, the gain due to the increase in
quantity demanded will be less than the loss due to the lower price. Hence,
price will remain stable at OP and OT in the two cases respectively.

11.4.2 Individual Firm’s Equilibrium in Long Run

In the preceding sections, we have discussed that in the short run, firms can
earn supernormal profits. However, in the long run, there is a gradual decrease
in the profits of the firms. This is because in the long run, several new firms
enter the market due to freedom of entry.
When these new firms start production the market supply would increase and
the price would fall. This would automatically increase the level of competition
in the market. Consequently, AR curve shifts from right to left and
supernormal profits are eliminated. The firms will be able to earn normal
profits only.
In the long run, the AR curve is more elastic than that of in the short run. This
is because of an increase in the number of substitute products in the long-run.
The long-run equilibrium of monopolistically competitive firms is achieved
when average revenue is equal to average cost. In such a case, the firms receive
normal profits.

Fig. 11.5: Shows the long-run equilibrium position under monopolistic competition

In Fig. 11.5, P is the point at which AR curve touches the average cost curve
(LAC) as a tangent. P is regarded as the equilibrium point at which the price
level is MP (which is also equal to OP') and output is OM.
In the present case average cost is equal to average revenue that is MP.
Therefore, in long run, the profit is normal. In the short run, equilibrium is
attained when marginal revenue is equal to marginal cost. However, in the long
run, both the conditions (MR=MC and AR=AC) must hold to attain
equilibrium.

11.4.3 Group Equilibrium in Monopolistic Competition

The concept of group equilibrium was introduced by Chamberlin. The price-
output equilibrium of all firms is known as group equilibrium. Group
equilibrium represents the price and output of firms having close substitutes.
243
Market However, due to product differentiation, it is difficult to form market demand
Structure schedules and supply.

For overcoming the problem Chamberlin gave a concept called product group,
which includes products that are technological and economic substitute of each
other. Technological substitutes are the products having technical similarity,
while economic substitutes are the products that have same prices and fulfill
the same want of consumers.

A product group refers to a group in which the demand for each product is
highly elastic. Here, the demand for a product changes with the changes in the
prices of other products within the group, and, the price and cross elasticity of
demand for products forming the group is high.

In an industry, different types of groups exist automatically. In automobile

industry makers of cars and trucks are two different product groups.

The main competition would be among those organisations manufacturing

similar products (cars or trucks) which are close substitutes of each other. Due
to product differentiation, there is a large variation in the demand and cost
curves of firms. Their price, output, and profits also differ.

Therefore, to simplify product group analysis, Chamberlin has given two

assumptions, which are as follows:

i) The demand and cost curves of all products in the group are the same or
uniform. The uniformity assumption. The preferences of consumers are
evenly distributed and the difference in preferences does not lead to
variation in cost.

ii) In monopolistic competition, a large number of sellers are not able to

influence each other’s decisions. The changes in prices or level of output,
of firm would have insignificant influence on its competitors. This is
termed as the symmetry assumption.

These two assumptions form the basis for group equilibrium analysis. If an
organisation within the group has established a popular brand, it is more likely
to earn supernormal profits. However, in the long run, other organisations
would strive to emulate the product design and features. In such a case,
supernormal profits would vanish. This is a general case of all monopolistically
competitive organisations.

On the other hand, if the entire group is earning supernormal profits, then
external organisations would get attracted towards the group, until the legal or
economic barriers are imposed.
In Fig. 11.6, P is the equilibrium point at which output is OM, price is MP, and
average cost is MT. In such a case, marginal cost is equal to marginal revenue.
Therefore, firms are earning supernormal profits (P'PTT'). However, these
supernormal profits disappear in the long run.

244
 Monopolistic
Competition: Price
and Output Decisions

Fig. 11.6: The short-run group equilibrium

Fig.11.7: The long-run group equilibrium

In Fig. 11.7, it can be seen that the supernormal profits have disappeared. It
also depicts that average revenue (AR) is tangent to LAC, which implies that
price is equal to average revenue. Marginal revenue gets equal to marginal cost
at the output level of OM. This shows that in the long run, all firms in the
industry are making normal profits.

11.4.4 Equilibrium with Selling Costs

Selling Costs: Concept
“Selling costs are costs incurred in order to alter the position or shape of the
demand curve for the product.” E.H. Chamberlin
Selling costs play the key role in monopolistic competition and oligopoly.
Under these market forms, the firms have to compete to promote their sale by
spending on advertisements and publicity.
Moreover, producer has not to decide about price and output only. He also
keeps in view how to maximise the profit.
Thus, cost on advertisement, publicity and salesmanship add to the cost or
supply curve of the product while also contributing to rise in its demand. The
Selling costs is a broader concept than the advertisement expenditures.
Advertisement expenditures are part of selling costs.
In selling costs we include the salaries of sales persons, incentives to retailers
to display the products, besides the advertisements. It was Chamberlin who
introduced the analysis of selling costs and distinguished it from the production 245
Market costs. The production costs include all those expenses which are spent on the
Structure manufacturing of the commodity, its transportation cost of handling, storing
and delivering of the commodity to actual customers because these add utilities
to a commodity.
On the other hand, all selling costs include expenditures in order to raise
demand for a commodity. In short, selling costs are those which are made to
‘create’ the demand for the product. Transport costs should not be included in
selling costs; rather these should be included in the production costs. Transport
costs actually do not increase the demand; it only helps in meeting the demand
of the consumers.
In general, “those costs which are made to adopt the product to the demand are
costs of production; those made to adopt the demand to product are costs of
selling.”
The concept of selling cost is based on the following two assumptions:
1) Buyers do not have any perfect knowledge about the different types of
product.
2) Buyers’ demand and tastes can be changed.
While production costs include outlays incurred on services engaged in the
manufacturing of the product like land, labour and capital etc, the selling costs
include all the costs incurred to change the consumer’s preference from one
product to another. These raise the demand of a product at any given price.
“Production costs create utilities in order that demands may be satisfied while
selling costs create and shift the demand curves themselves.”
Selling costs influence equilibrium price-output adjustment of a firm under
monopolistic competition. In the Fig. 11.8 APC is the initial average
production cost. AR1 is the initial average revenue curve or initial demand
curve. The initial price is OP and the firm earns profits shown by the first
shaded rectangle PQRS.

Fig. 11.8: Equilibrium with selling costs

246
ACC1 is the average composite costs curve, which includes the average selling Monopolistic
cost (ASC). Average selling cost is equal to the vertical distance between APC Competition: Price
and ACC1. The new demand curve is AR2. It is obtained after incurring selling and Output Decisions
costs or after making advertisements.
It is, obvious, that the demand for the product has increased as a result of
selling costs. The profits have also increased as a result of selling costs. The
profits after incurring selling costs at OM1 level of output become equal to the
shaded area P1Q1R1S1. Note that these profits are greater than the initial level
of profits when no selling cost was incurred, i.e., P1 Q1 R1 S1 > PQRS.
ACC2 is the average composite cost when more additional selling cost is
incurred, as a result of which the demand for the product further increases. The
new demand curve is AR3 which indicates a higher demand for the product.
The profits are also greater than before since the shaded area P2Q2R2S2 >
P1Q1R1S.
It is, thus, obvious that the demand for the product is increasing as a result of
the selling costs. Since selling costs are included in the cost of production,
therefore price of the product is also increasing as a result of selling costs.
Profits are also increasing as a result of higher selling costs and increased
demand.
Here, question arises, how long a firm may go on incurring expenditure on
selling costs? It will continue to make expenditure on selling costs as long as
any addition to the revenue is greater than the addition to the selling costs. The
firm will stop incurring expenditure on selling costs when the total profits are
at the highest possible level.
This would be the point at which the additional revenue due to advertising
expenditure equals the extra expenditure on advertisement. It should, however,
be noted clearly that the effects of advertisement on prices and output are
uncertain. Advertisement by a firm may be considered successful if the
elasticity of demand for its product falls.
Check Your Progress 2
1) Will the demand curve for a firm under monopolistic competiton be
horizontal or downward sloping?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) On which factors equilibrium of individual firm depend under
monopolistic condition?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) Construct the diagram showing long run equilibrium of firm in
monopolistic competition.
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247
Market
Structure
11.5 PERFECT COMPETITION, MONOPOLY,
AND MONOPOLISTIC COMPETITION:
COMPARISON
The upcoming discussion will help you to make a comparison between perfect
competition, monopoly and monopolistic competition.
1) Structural Differences
Under perfect competition, there are innumerable numbers of firms who
produce homogeneous goods. Each firm in the market is so small that it cannot
exert any influence on price and output. Each firm, thus, behaves as a price-
taker.
Under monopolistic competition, there is quite a large number of sellers who
sell slightly different products. Product differentiation enables a firm to
exercise some power over price and output. This means that sellers behave
as ‘price-makers’. However, a monopoly seller has full control over its price-
output decision.
There is complete freedom of entry and exit of firms — both in perfect
competition and in monopolistic competition. This condition is true during the
long period only. In the short run, entry or exit is ruled out in both these market
forms. But a monopoly business is characterised by the absence of a rival
seller. Entry of new firms is either legally prohibited in monopoly, or may not
be financially feasible.
2) Behavioural Differences
A firm behaves as a price-taker under perfect competition, and the demand
curve faced by it is a horizontal one. Since price is fixed, AR curve coincides
with the MR curve. A monopoly firm, however, faces a negatively sloped
demand curve because it can have perceptible influence over price and output.
Consequently, MR curve is also negative sloping and lies below the AR curve.
This is also true under monopolistic competition. The only difference between
monopoly and monopolistic competition is that the demand curve faced by a
monopolistically competitive seller is relatively more elastic.
Since price is fixed for a competitive firm, it has only to undertake output
decisions. Further, products sold by competitive firms are perfect substitutes.
Because of complete product homogeneity, no firm finds any incentive to
spend money on any kind of sales promotional activity.
A monopoly firm also does not find any urgency to spend money on
advertisement since there is no rival seller. But a monopolistically competitive
seller has to incur some sort of “selling costs” just to provide information
about its product or rivals’ products. In fact, in order to attract more and more
customers, additional expenditure on selling cost is a necessity.
In every market, sellers adopt independent price-output policy. But all sellers
of all market forms follow one basic principle. The basic behavioural rule is
the equality between MC and MR. Under perfect competition, since AR = MR,
MC = MR = AR = P. But, in monopoly and in monopolistic competition, this
behavioural rule is slightly altered to MC = MR < AR = P, since in these two
markets, AR > MR.
248
A monopoly firm or a monopolistically competitive firm produces in that Monopolistic
region of its demand curve where the coefficient of elasticity of demand is Competition: Price
greater than one. But, under perfect competition, coefficient of elasticity of and Output Decisions
demand is infinite.
3) Optimum Capacity and Sub-Optimal Capacity of Production
A competitive firm always produces at the minimum point of its AC curve.
This means that a firm utilises its plant optimally. Since AR curve is a
horizontal one, a competitive firm will always produce at the lowest point of its
AC curve. It is then said that perfect competition leads to optimum economic
efficiency.
But, under monopoly, or under monopolistic competition, the demand curve is
negative sloping. It is due to the nature of this demand curve that a firm fails to
operate at the minimum point of its AC curve. It operates somewhere to the left
of the lowest point of the AC curve.
The implication of this is that resources are not utilised optimally under
imperfect competition. Imperfect competition leads to economic inefficiency.
As a result, a higher price for the product is charged and lower output is
produced. In this sense, perfect competition is an ideal market where social
welfare gets maximised. But social welfare gets reduced in monopoly or in
monopolistic competition.
4) Supply Curve
Under perfect competition, MC curve above the shut-down point is the short
run supply curve. But, under monopoly, or monopolistic competition, the
supply curve remains indeterminate. In other words, in these market forms,
MC curve is not the supply curve.

11.6 THEORY OF EXCESS CAPACITY UNDER

MONOPOLISTIC COMPETITION
The doctrine of excess (or unutilised) capacity is associated with monopolistic
competition in the long-run and is defined as “the difference between ideal
(optimum) output and the output actually attained in the long-run.”

Fig. 11.6
We know that under perfect competition, the demand curve (AR) is tangential
to the long-run average cost curve (LAC) at its minimum point and conditions
of full equilibrium are fulfilled: LMC = MR and AR (price) = Minimum LAC.
This means that in the long-run, the entry of new firms forces the existing firms
to make the best use of their resources to produce at the lowest point of average
total costs. At point E in Fig. 11.6, abnormal profits will be competed away 249
Market because MR = LMC = AR = LAC at its minimum point E and OQ will be the
Structure most efficient output which the society will be enjoying. This is the ideal or
optimum output which firms produce in the long-run.
Under monopolistic competition, the demand curve facing the individual firm
is not horizontal as under perfect competition, but it is downward sloping. A
downward sloping demand curve cannot be tangent to the LAC curve at its
minimum point.
The double condition of equilibrium LMC = MR = AR (P) = Minimum LAC
will not be fulfilled. The firms will, therefore, producing at less than the
optimum level even when they are earning normal profits. No firm will have
the incentive to produce the ideal output, since any effort to produce more than
the equilibrium output would involve a higher long-run marginal cost than
marginal revenue.
Thus each firm under monopolistic competition will be producing at less than
the optimum level and work under excess capacity. This is illustrated in Fig.
11.7 where the monopolistic competitive firm’s demand curve is d and MR1 is
its corresponding marginal revenue curve. LAC and LMC are the long-run
average cost and marginal cost curves.
The firm is in equilibrium at E1 where the LMC curve cuts the MR1curve from
below and OQ1 output is set at the price Q1 A1. OQ1 is the equilibrium output
but not the ideal output because d is tangent to the LAC curve at A1 to the left
of the minimum point E. Any effort on the part of the firm to produce beyond
OQ1 will mean losses as beyond the equilibrium point E1, LMC > MR1. Thus
the firm has negative excess capacity measured by OQ1 which it cannot utilise
working under monopolistic competition.
A comparison of the equilibrium positions under monopolistic competition and
perfect competition with the help of Fig. 11.7 reveals that the output of a firm
under monopolistic competition is smaller and the price of its product is higher
than under perfect competition. The monopolistic competition output OQ1 is
less than the perfectly competitive output OQ, and the monopolistic
competitive price Q1A1 is higher than the competitive equilibrium price QE.
This is because of the existence of excess capacity under monopolistic
competition.

Fig. 11.7
250
Check Your Progress 3 Monopolistic
Competition: Price
1) In what respects monopolistic competition is different from other two and Output Decisions
extreme forms of market structure.

.....................................................................................................................

.....................................................................................................................

.....................................................................................................................

2) What do you understand by the term ‘excess capacity’?

.....................................................................................................................

.....................................................................................................................

.....................................................................................................................

11.7 LET US SUM UP

Monopolistic competition is a market structure in which there are many firms
selling closely related commodities. Its assumptions are: Large number of
buyers and sellers, Differentiated products, Free entry and exit, aim of the firm
is profit maximisation. Product differentiation exist which can be real or
artificial. Its effect is that the firm has some degree of price-making power.
Under monopolistic competition in the short-run, firm maximises profit where
MR=MC and the MC curve intersects MR curve from below. In the long-run,
due to free entry and exit of firms, firm earns normal profit. Economic profits
are zero.
Excess Capacity Theory states that it is a long-run concept and is the difference
between least cost output and profit maximising output. While, under perfect
competition, there is no excess capacity and under monopolistic competition,
excess capacity always exists.

11.8 REFERENCES
1) Dr Deepashree (2016), Introductory Micro Economics, Mayur
Paperbacks, Chapter on Theory of Market structure.
http://www.economicsdiscussion.net

2) Varian, Hal (1999), Intermediate Microeconomics, W.W Norton &Co,

New York, Chapter 24 & 25, page no. 415-455.

11.9 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Section 11.1 and answer
2) Read Section 11.2 and answer
3) (c) 251
Market Check Your Progress 2
Structure
1) Read Section 11.3 and answer
2) Read Section 11.4 and answer
3) Read Sub-section 11.4.1 and answer
Check Your Progress 3
1) Read Section 11.5 and answer
2) Read Section 11.6 and answer

252
UNIT 12 OLIGOPOLY: PRICE AND
OUTPUT DECISIONS
Structure
12.0 Objectives
12.1 Introduction
12.1.1 Definition of Oligopoly
12.1.2 Features of Oligopoly Market
12.1.3 Causes for the Existence of Oligopoly

12.2 Price and Output Determination under Oligopoly

12.2.1 Cournot’s Model
12.2.2 Stackelberg’s Model
12.2.3 Paul Sweezy’s Model: Kinked Demand Curve Analysis
12.2.3.1 Why the Kink in the Demand Curve?
12.2.3.2 Analysis of the Kinked Demand Curve Model

12.3 Co-operative vs. Non-cooperative Behaviour

12.3.1 Co-operative Behaviour and Prisoner’s Dilemma
12.3.2 Types of Co-operative Behaviour
12.3.3 Types of Non-Cooperative Behaviour

12.4 Cartel Theory of Oligopoly

12.5 Let Us Sum Up
12.6 References
12.7 Answers or Hints to Check Your Progress Exercises

12.0 OBJECTIVES
After studying this unit, you shall be able to:
 state the meaning and features of oligopoly;
 discuss the causes of existence of oligopoly;
 throw light on different models that explain the oligopoly price and
output determination;
 explain the co-operative and non-cooperative behaviour of oligopolistic
firms; and
 appreciate cartel theory of oligopolist.

12.1 INTRODUCTION
Oligopoly refers to a market wherein only a few firms account for most or all
of total production.

Ms. Shruti Jain, Assistant Professor in Economics, Mata Sundari College (University of
Delhi), Delhi.
253
Market 12.1.1 Definition of Oligopoly
Structure
Oligopoly referes to the presence of few sellers in the market selling the
homogeneous or differentiated products. In other words, the Oligopoly market
structure lies between the pure monopoly and monopolistic competition, where
few sellers dominate the market and have control over the price of the product.
Under the Oligopoly market, a firm either produces homogeneous or
heterogeneous products:
 Homogeneous Product: The firms producing the homogeneous products
are called as Pure or Perfect Oligopoly. It is found in the case of
industrial products such as aluminum, copper, steel, zinc, iron, etc.

 Heterogeneous Product: The firms producing the heterogeneous

products are called as Imperfect or Differentiated Oligopoly. Such type of
Oligopoly is found in the production of consumer goods such as
automobiles, soaps, detergents, television, refrigerators, etc.

12.1.2 Features of Oligopoly Market

1) Few Sellers: Under the Oligopoly market, the sellers are few, and the
customers are many. Few firms dominating the market enjoy a
considerable control over the price of the product.
2) Interdependence: It is one of the most important features of an
Oligopoly market, wherein, the seller has to be cautious with respect to
any action taken by the competing firms. Since there are few sellers in the
market, if any firm makes a change in the price or promotional scheme,
all other firms in the industry have to comply with it to remain in the
competition.
Thus, every firm remains alert to the actions of others and plan their
counterattack beforehand to escape the turmoil. Hence, there is a
complete interdependence among the sellers with respect to their price-
output policies.
3) Advertising: Under Oligopoly market, every firm advertises their
products on a frequent basis with the intention to reach more and more
customers and increase their customer base. This advertising makes the
competition intense.
If any firm does a lot of advertisement while the other remained silent,
then you will observe that his customers are going to the firm which is
continuously promoting its product. Thus, in order to be in the race, each
firm spends lots of money on advertisement activities.
4) Competition: It is genuine that with a few players in the market, there
will be an intense competition among the sellers. Any move by one firm
will have a considerable impact on its rivals. Thus, every seller keeps an
eye over its rivals and be ready with the counterattack.
5) Entry and Exit Barriers: The firms can easily exit the industry
whenever they want, but has to face certain barriers to enter into it. These
barriers could be Government license, Patent, large firm’s economies of
scale, high capital requirement, complex technology, etc. Also,
sometimes the government regulations favour the existing large firms,
thereby acting as a barrier for the new entrants.
254
6) Lack of Uniformity: There is a lack of uniformity among the firms in Oligopoly: Price and
terms of their size, some are big, and some are small. Since there are less Output Decisions
number of firms, any action taken by one firm has a considerable effect
on the other. Thus, every firm must keep a close eye on its counterpart
and plan the promotional activities accordingly.

12.1.3 Causes for the Existence of Oligopoly

There are certain reasons which have led to the emergence of oligopoly. These
are:
1) Large Investment of Capital
The number of firms in an industry may be small due to the large requirements
of capital. No entrepreneur will like to venture into investing large sums in an
industry in which addition to output to the existing level may depress prices.
Further, the new entrant may also fear of provoking a price-war by the
established firms in the industry. This is always true that in the midst of
differentiated products, it is difficult to introduce a new product.
2) Control of Indispensable Resources
A few firms may control some indispensable resources which may enable them
to secure several advantages in costs over all others. This enables them to
operate profitably at a price at which others cannot survive.
3) Legal Restriction and Patents
In public utility sector, the entry of new firms is closely regulated through the
grant of certificate by the State. This policy of exclusion of rivals may be due
to diseconomies of small scale or of duplication of services. Another factor for
the emergence of oligopoly is the patent right which a few firms acquire in
matter of some goods. Patents have led to many important industrial
monopolies in America and elsewhere.
4) Economies of Scale
Another factor responsible for emergence of oligopoly is the operations at large
scale. In some industries, a few firms can meet the entire demand for the
product. It is possible that the demand may be satisfied by a large number of
firms, but small firms cannot secure the economies of large scale production.
In the industries where there is a lot of mechanisation and where economies of
large scale are considerable, only a few firms will survive.
The firms attain such a huge size that just a few of them can satisfy the entire
demand. For example, automobiles, steel industry, petroleum etc. Oligopolies
are also found in local markets. In small towns, a few firms may be sufficient
to satisfy the demand, e.g., petrol, banks, building material suppliers etc. The
market is small and therefore can be satisfied by a few firms.
5) Superior Entrepreneurs
In some industries there may be some superior entrepreneurs whose costs are
lower than inferior rivals. These entrepreneurs under sell and eliminate most of
their rivals.
6) Mergers
Many oligopolies have been created by combining two or more independent
255
Market firms. The combination of two or more firms into one firm is known a merger.
Structure The main motives of mergers include increasing market powers, more
resources, economies of scale and market extensions etc.
7) Difficulties of Entry into the Industry
Lastly, oligopoly may come to exist because of difficulties of entry into the
industry. One big difficulty in some industries is the large requirements of
capital. Businessmen do not like to venture into those industries entry to which,
even of one firm, is likely to depress prices to such an extent as to make it
unprofitable for all. They may also be afraid of the price war that their entry
may provoke from the established firms in the industry. Prospective entrants to
an industry are also deterred by the difficulty of marketing new products or
new brands in the presence of already well-established, well-entrenched
brands.
Check Your Progress 1
1) What is Oligopoly? Explain with few examples.
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2) Identify and explain the features that shows the existence of oligopoly in
market.
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3) A market with many buyers and a few dominant sellers is :
A) purely competitive
B) a monopoly
C) monopolistically competitive
D) oligopolistic

12.2 PRICE AND OUTPUT DETERMINATION

UNDER OLIGOPOLY
Unlike other market forms, price and output under oligopoly is never fixed.
Interdependence of firms led uncertainty always exists in the market. In such a
situation, it becomes difficult to determine the equilibrium price and output for
an oligopolistic firm. An oligopolist cannot assume that its competitors will not
change their price and/or output if it changes. Price change by one firm will be
followed by other competitors, which will change the demand conditions
facing this firm. Therefore, demand curve for any firm is not fixed like other
markets. Demand curve for a firm keeps changing as firms change their prices.
Therefore, in the absence of a fixed demand (Average Revenue) curve, it is
difficult to determine the equilibrium price and output. However, economists
have developed some price-output models to explain the behaviour of
256 oligopolistic firms. They are as follows:
I. Some economists ignore the interdependence among the firms when they Oligopoly: Price and
explain the oligopoly market. In such case the demand will be known and Output Decisions
equilibrium price and output can be determined.
II. Another approach is based on collusion. Oligopolists can form a group
and maximise their joint output and profit. Best example of such
collusion is Cartel (it is a situation when oligopolists agree to work
together in the international market). One firm is chosen as a leader. The
prices determined by the leader are followed by others in such a case.
III. Third approach assumes that an oligopolist predicts the reaction of its
competitors. Problems regarding prices and output determination are
solved by such assumptions. Various models based on different
assumptions exist in this category. Few of them are: Chamberlin Model,
Cournot’s Model, and Paul Sweezy Kinked Demand curve Model etc.

12.2.1 Cournot’s Model

In 1838, Augustin Cournot introduced a simple model of duopolies that
remains the standard model for oligopolistic competition.
This modal is based on the following assumptions:
1) The two firms produce homogeneous and indistinguishable goods.
2) There are no other firms in the market who produce the same or
substitute goods.
3) No other firms can or will enter the market.
4) Collusive behaviour is prohibited. Firms cannot act together to form a
cartel.
5) There exists one market for the produced goods.
In addition to the assumptions stated above, the Cournot duopoly model relies
on the following:
1) Each firm chooses a quantity to produce.
2) All firms make this choice simultaneously.
3) The model is restricted to a one-stage game. Firms choose their quantities
only once.
4) The cost structures of the firms are public information.
In the Cournot model, the strategic variable is the output quantity. Each firm
decides how much of a good to produce. Both firms know the market demand
curve, and each firm knows the cost structures of the other firm. The essence of
the model is that each firm takes the other firm’s choice of output level as fixed
and then sets its own production quantities.
Before explaining the model, let us define the reaction curve.
A reaction curve for Firm 1 is a function Q1 that takes input as the quantity
produced by Firm 2 and returns the optimal output for Firm 1 given Firm 2's
production decisions. In other words, Q1 (Q2) is Firm 1's best response to Firm
2's choice of Q2. Likewise, Q2 (Q1) is Firm 2's best response to Firm 1's choice
of Q 1.
257
Market Let’s assume that the two firms face a single market demand curve as follows:
Structure
Q = 100 – P
where P is the single market price and Q is the total quantity of output in the
market. For simplicity’s sake, let’s assume that both firms face cost structures
as follows:
MC1 = 10
MC2 = 12
Given this market demand curve and cost structure, we want to find the
reaction curve for Firm 1. In the Cournot model, we assume Q 2 is fixed and
proceed. Firm 1's reaction curve will satisfy its profit maximising
condition, MR = MC . In order to find Firm 1's marginal revenue, we first
determine its total revenue, which can be described as follows:
Total Revenue = PQ1 = (100 – Q) Q1 = 100Q1 – (Q1+ Q2) Q1
= [100 – (Q1 + Q2)] Q1 = 100Q1 – Q12 – Q2Q1
= 100Q1 – Q12 – Q2 Q1
The marginal revenue is simply the first derivative of the total revenue with
respect to Q 1 (recall that we assume Q 2 is fixed). The marginal revenue for
Firm 1 is thus:
MR1 = 100 – 2Q1 – Q2
Imposing the profit maximising condition of MR = MC , we conclude that
Firm 1's reaction curve is:
100 – 2 Q1 – Q2 = 10
90 Q2
Q1 = –
2 2
Q1 = 45 – Q2
That is, for every choice of Q2, Q1 is Firm 1's optimal choice of output. We can
perform analogous analysis for Firm 2 (which differs only in that its marginal
costs are 12 rather than 10) to determine its reaction curve. We find Firm 2's
reaction curve to be:
Q2 = 44 – Q1/2.
The solution to the Cournot model lies at the intersection of the two reaction
curves. We solve now for Q1. Note that we substitute Q2 for Q2 because we are
looking for a point which lies on Firm 2's reaction curve as well.
Q1 = 45 – Q2/2 = 45 – (44 – Q1/2)/2
= 45 – 22 + Q1/4
= 23 + Q1/4
=> Q1 = 92/3
By the same logic, we find:
Q2 = 86/3
Note that Q1 and Q2 differ due to the difference in marginal costs. In a
perfectly competitive market, only firms with the lowest marginal cost would
survive. In this case, however, Firm 2 still produces a significant quantity of
258 goods, even though its marginal cost is 20% higher than Firm 1's.
An equilibrium cannot occur at a point not at the intersection of the two Oligopoly: Price and
reaction curves. If such an equilibrium existed, at least one firm would not be Output Decisions
on its reaction curve and would therefore not be playing its optimal strategy. It
has incentive to move elsewhere, thus invalidating the equilibrium.
The Cournot equilibrium is a best response made in reaction to a best response
and, by definition, is therefore a Nash equilibrium. Unfortunately, the Cournot
model does not describe the dynamics behind reaching equilibrium from a non-
equilibrium state. If the two firms began out of equilibrium, at least one would
have an incentive to move, thus violating our assumption that the quantities
chosen are fixed. Rest assured that for the examples we have seen, the firms
would tend towards equilibrium. However, we would require more advanced
mathematics to adequately model this movement.

Fig. 12.1

12.2.2 Stackelberg’s Model

The Stackelberg duopoly model of duopolies is very similar to the Cournot
model. Like the Cournot model, the firms choose the quantities they produce.
However, here the firms do not move simultaneously. One firm holds the
privilege to choose production quantities before the other. The assumptions
underlying the Stackelberg model are as follows:
1) Each firm chooses a quantity to produce.
2) A firm chooses before the other in an observable manner.
3) The model is restricted to a one-stage game. Firms choose their quantities
only once.
To illustrate the Stackelberg model, let’s take an example. Assume Firm 1 is
the first mover with Firm 2 reacting to Firm 1's decision. We assume a market
demand curve of:
Q = 90 – P
Furthermore, we assume all marginal costs are zero, that is:
MC = MC1 = MC2 = 0
We calculate Firm 2's reaction curve in the same way we did for the Cournot
Model. Verify that Firm 2's reaction curve is:
Q2 = 45 – Q1/2
259
Market To calculate Firm 1's optimal quantity, we look at Firm 1's total revenues.
Structure
Firm 1's Total Revenue = P Q1 = (90 – Q1 – Q2) Q1
= 90 Q1 – Q12 – Q2 Q1
However, Firm 1 is not forced to assume Firm 2's quantity is fixed. In fact,
Firm 1 knows that Firm 2 will act along its reaction curve which varies
with Q1 . Firm 2's quantity very much relies on Firm 1's choice of quantity.
Firm 1's Total Revenue can thus be rewritten as a function of Q1:

R1 = 90 Q1 – Q12 – Q1 (45 – Q1/2)

Marginal revenue for firm 1 is thus:
MR1 = 90 – 2 * Q1 – 45 + Q1
= 45 – Q1
When we impose the profit maximising condition (MR = MC), we find:
Q1 = 45
Solving for Q2 , we find:
Q2 = 22.5
In the Cournot model, both firms make their choices simultaneously and have
no communication beforehand. In the Stackelberg model, Firm 1 not only
announces first, but Firm 2 knows that when Firm 1 announces, Firm 1's
actions are credible and fixed. This demonstrates how a slight change in the
flow of information can drastically impact the outcome of a market. Note that
Firm 1 decided first. Its decision is to meet half of the market demand. The
second firm decides to meet half of remaining market demand. Note that firm
which decides first will be able to produce and sell larger quantity. It amounts
to capturing larger market share. That is why we say that essence of
Stackleberg model lies in its First Movers’ Advantage feature.
Illustration 1:
Two firms have marginal costs of 10. They face a market demand curve of P =
100 – 4Q . The government imposes a tax of 10 dollars per unit sold.
Determine the Cournot equilibrium quantity.
Assuming that the tax will be paid by the consumer, the effective demand
curve becomes 90 – 4Q .
R1 = (90 – 4Q1 –4Q2).Q1
MR 1 = 90 – 8Q1 – 4Q2
Setting MR = MC:
–
Q1 = 10 – Q 2/2 =
By symmetry:
–
Q1 = Q2 =
Illustration 2 :
Assume three firms face identical marginal costs of 20 with fixed costs of 10.
They face a market demand curve of P = 200 – 2Q. Find the Cournot
equilibrium price and quantity.
260
 R1 = (200 – 2(Q1 + Q2 + Q3))Q1 Oligopoly: Price and
Output Decisions
MR1 = 200 – 4Q1 – 2Q2 – 2Q3
Applying MR = MC:
Q1 = 45 – Q2/2 – Q3/2
By symmetry:
Q1 = Q2 = Q3 = 22.5
12.2.3 Paul Sweezy Model : Kinked Demand Curve Analysis
This model was developed independently by Prof. Paul M. Sweezy on the one
hand and Profs. R. C. Hall and C. J. Hitch on the other hand.
The assumptions of this model are:
i) There are only a few firms in an oligopolistic market.
ii) The firms are producing close-substitute products.
iii) The quality of the products remains constant and the firms do not spend
on advertising.
iv) A set of prices of the product has already been determined and these
prices prevail in the market at present.
v) Each firm believes that if it reduces the price of its product, the rival
firms would follow suit, but if it increases the price, the rivals would not
follow it. They would simply keep their prices unchanged. We shall see
presently that, because of this asymmetric pattern of reaction of the
rivals, the demand curve of each firm would have a kink at the prevailing
price of its product.
12.2.3.1 Why the Kink in the Demand Curve?
In the figure we have drawn two negatively sloped straight line demand curves,
viz., dd' and DD'. Of these two curves, dd' is more flat than DD'. Now, when
one particular firm in the industry changes the price of its product, all other
firms keeping their prices constant, the firm’s demand curve will be relatively
flatter like dd', i.e., the magnitude of the change in the demand for its product
as its price changes would be relatively larger.

Fig. 12.2

This is because, as the firm reduces or increases the price of its product, the
prices of the products of other firms remaining constant, the product of the firm
becomes relatively cheaper or dearer, respectively, than those of the other
firms. This will make the demand curve flatter for this firm.
261
Market On the other hand, if a firm increases its price, the office firms will not follow
Structure the suit. So there will be an asymmetry in responses of the rivals.
If one firm reduces price, all others follow the suit – otherwise they run the risk
of losing their customers to this firm.
If one raises the price, others do not as they expect to win some customers
from this firm. Together, these responses create a kink in demand curve.
Let us suppose that initially the price of the product of the firm is p1 or Op1 and
the demand for the product is q1 or Oq1 If the firm now increases its price from
p1, the rival firms would keep their prices unchanged according to assumption
(v) of this model.
In this case, the firm’s demand would decrease along the segment Rd of the
relatively more elastic demand curve dd'. On the other hand, if it goes on
decreasing its price from p1, its rivals also would be decreasing their prices
according to assumption (v). In this case, the quantity demanded of the firm’s
product will increase along the segment RD' of the relatively steeper demand
curve DD'.
Therefore, at the price p1, the firm’s demand curve would be dRD'. Obviously,
because of assumption (v), the segment dR of this demand curve would be
more flat or more elastic than the segment RD' (and the segment RD' would be
more steep or less elastic than the segment dR).
As a result, there would be a kink at the prevailing price p1, or, at the point R
on the firm’s demand curve d RD', i.e., the demand curve in this model would
be a kinked demand curve.
12.2.3.2 Analysis of the Kinked Demand Curve Model
In the oligopoly model under discussion, the properties of the kinked demand
curve as well as its significance are especially discussed. In the first place, as
the demand curve or the average revenue (AR) curve of the firm has a kink, its
MR curve cannot be obtained as a continuous curve. We may, therefore, begin
with the properties of the MR curve of the kinked demand curve with the help
of Fig. 12.3.
The kinked demand curve of the firm in Fig. 12.3 is dRD'. There is a kink at
the point R (p1, q1) on this curve, because the curve consists of a segment dR of
the relatively flatter curve dd' and another segment RD' of the relatively steeper
curve DD'.
Therefore, in the case of the kinked demand curve dRD', the firm’s MR curve,
up to q = q1, would consist of the MR curve dM associated with the dR
segment of the kinked demand curve and for q > q1, the MR curve would be
the segment NB associated with the segment RD' of the demand curve.

262 Fig. 12.3

We have obtained above that the firm’s MR curve for its kinked demand curve Oligopoly: Price and
would consist of two parts, viz., the segments dM and NB, and there would be Output Decisions
a vertical gap between the points M and N at q = q1.
This implies that as the firm’s output goes on increasing up to q1, its MR would
go on decreasing along the segment dM up to the amount Mq1 and if the firm’s
output increases even by an infinitesimally small quantity at q = q1, its MR
would fall to Nq1, and, thereafter, as q increases, MR would decrease along the
segment NB.
In other words, there would be no MR value between Mq1 and Nq1, i.e., the
dotted segment MN is the discontinuity in the firm’s MR curve. We may also
say that at the point R on the dR segment of the kinked demand curve, the
firm’s MR would be Mq1 and, at the point R on the RD' segment of the demand
curve, MR would be Nq1.
We may now easily see that the numerical coefficient of elasticity of demand
(e1) at the point R on the demand curve segment dR is different from the
coefficient (e2) at the point R on the demand curve segment RD', and the larger
the difference between e1 and e2, the larger would be the length of the
discontinuity of the MR curve at the output q1.
As we know, at any point R (p1, q1) on the firm’s demand curve in Fig.12.4,
numerical coefficient (e) of price-elasticity of demand is
e= × reciprocal of the numerical slope at that point on the demand curve

now, the reciprocal of the numerical slope of the demand curve dRd' at the
point R on the segment dR > the reciprocal of the numerical slope of the
demand curve at the point R on the segment RD'.
Because, the segment dR is more flat than the segment RD', therefore, we have
e1 > e2
Now, MR (= MR1, say) at the point R on the segment dR' is

MR1 = Mq1 = p1 1 −

Also, MR (=MR2, say) at point R on the segment RD' is

MR2 = Nq1 = p1 1 −

Therefore, from the above two equations, we obtain

e1 > e2 ⇒ 1 − >1− ⇒ p1 1 − > p1 1 −

⇒MR1 (=Mq1) > MR2 (=Nq1)

That is, at the point of kink, R, on the demand curve dRD', or at q = q1, we
have two different values (e1 and e2) of e, and that is why at q = q1, we obtain
two different values (MR1 and MR2) of MR and two different parts of the MR
curve. The vertical gap between the two parts of the MR curve at q = q1 is
Mq1 – Nq1 = MN.
It follows from the above discussion that the larger the difference between e1,
and e2, i.e., the more flat the segment dR would be than the segment RD', i.e.,
the more prominent the kink would be at the point R, the larger would be the
value of MR1 than that of MR2 and the larger would be the discontinuity in the
MR curve at q = q1. 263
Market Second, in the model under discussion, the prices of the products are given
Structure initially, and a relation between these prices has been established already. The
model does not explain how these prices have been determined.
But there is a good chance that the price of the product of a firm would be
consistent with its goal of profit maximisation. For example, in Fig. 12.4, the
firm’s demand curve is dRD' and the associated MR curve is MR1 – the
discontinuity or the vertical gap between the two parts of the MR1 curve is MN.
Now, if the marginal cost (MC1) curve of the firm passes through this gap of
MN, then the firm’s price-output combination R(p1, q1) is consistent with profit
maximisation although here, at q = q1, we have MR (= Mq1) > MC (= Lq1), and
not MR = MC.
Here we see that at q < q1 MR > MC, making the firm increase its output to
reach the profit-maximising point. Now, as q increases and becomes equal to
q1, then also we have MR > MC. But if the firm increases q beyond q1, MR
becomes less than MC (MR < MC), i.e., from the production and sale of the
marginal unit of its output, the firm now would incur a loss.
Therefore, it would not produce more than q1, and its profit would be
maximum at q = q1, in spite of the fact that at q = q1, we have MR > MC, and
not MR = MC.
Third, although the assumption (v) of the model regarding the reaction pattern
of the rival firms may explain the kink in the firm’s demand curve, it cannot
explain how the price of the firm’s product, or, for that matter, the prices of the
rivals’ products are determined.
However, the reaction pattern of the rivals, as given by assumption (v), is able
to explain why the prices would not tend to change, i.e., why they would be
sticky, once they get determined.
For example, if, in Fig. 12.4, the firm’s quantity sold increases from q1 to q2, it
would not be inclined to change the assumption regarding the reaction pattern
of the rivals, for its conception about the rivals’ reactions, is, by no means,
dependent on its quantity sold.
Therefore, it would regard the increase in quantity sold, or an increase in the
demand for its product, as caused by a rightward shift in its demand curve—it
would think that its demand curve has shifted to the right from dRD' to dR'D''.

Fig. 12.4
264
We may note here that although the demand curve has shifted to the right, it Oligopoly: Price and
has kept the price of its product unchanged, resulting not necessarily in the Output Decisions
unfulfilment of its profit maximising goal.
In Fig. 12.4, we have assumed that the two curves, viz., dRD' and dR'D'', are
iso-elastic, and the MC1 curve passes also through the discontinuity (M1N1) of
the MR2 curve which is the marginal curve for the demand curve dR'D''.
Therefore, here the firm is able to maximise its profit at the same price p1 =
R'q2 = Rq1.
Fourth, in the model under discussion, the firm may not have to change the
price of its product, even if its cost of production rises. For example, let us
suppose that initially the firm’s AR and MR curves are dRD' and MR1, and the
MC, curve is the firm’s MC curve.
In this case, the firm’s profit would be maximised if it sells q1 of output at the
price of p1. Now, if the firm’s cost position changes resulting in an upward
shift in its MC curve from MC1 to MC2, and if the MC2 curve also, like MC1,
passes through the discontinuity (MN) of its MR curve, then the firm would
not have to change the price of its product in order to earn the maximum profit.
It would be able to maximise profit if it, like the previous case, sells of output
at the price of p1.
If the cost of production rises along with a shift in the demand curve, then also,
profit maximisation may not require the firm to change the price of its product.
For example, in Fig.12.4, let us suppose that the firm’s AR, MR and MC
curves are, respectively, dRD', MR1and MC1, In this case, the firm’s profit-
maximising price-output combination would be R (p1 q1).
Now, if the firm’s MC curve rises to MC2 along with a rightward shift in its
demand curve to dR'D'', then also the firm would not be required to change the
price of its product if the MC2 curve passes through both the discontinuities,
MN and M1N1, of its dRD' and dR'D'' curves.
It would still be able to earn the maximum profit at the price P1; but now its
quantity of output produced and sold would be q2; that is, now the firm’s price-
output combination would be obtained at the point R' (p1, q2).
On the basis of the above discussion, we may conclude that in the kinked
demand curve model of oligopoly, the firm would not consider it profitable or
rational to change the prevailing price of its product because of the assumption
(v) relating to the reaction pattern of its rivals.
[This assumption states, that if a particular firm increases the price of its
product, its rivals will not increase theirs, but if it reduces the price, they will
promptly reduce their prices.] We have seen that, because of these reactions,
the demand curve of each oligopolistic firm will be kinked, and the MR curve
of this demand curve will have two separate segments, and there will be a
vertical gap between them.
However, it is not that the firm’s goal of profit maximisation can never be
achieved because of the existence of this vertical gap. Even when the firm’s
demand increases, i.e., its demand curve shifts to the right and/or its MC curve
shifts upwards, it is not impossible for it to achieve profit maximisation at the
prevailing price.
Therefore, although the kinked demand curve model cannot explain the process
265
Market of price determination, it can well explain why the prices are sticky in an
Structure oligopolistic market.
Check Your Progress 2
1) Let there be two firms under Cournot’s model having market demand
curve as P = 20 – Q where Q the total production of the two firms 1 and
2. These firms are assumed to be producing under zero cost of
production. Determine:
i) Reaction curves of the two firms,
ii) Equilibrium level of output for both the firms
iii) Equilibrium market price
iv) Show graphically the Cournot’s equilibrium
......................................................................................................................
......................................................................................................................
......................................................................................................................
2) Let there be two firms which produce output under zero cost of
production. The market demand curve is given by P = 20 – Q (Where Q =
total output). Calculate output solution for the two firms under
Stakelberg’s model.
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) In a duopolist market two firms can produce at a constant average and
marginal cost of AC = MC = 2. They face the market demand curve
P = 14 – Q, Where Q = Q1 + Q2' where Q1 is the output of Firm 1, Q2 is
the output of Firm 2. In the Cournot’s model:
i) Find action-reaction functions of the two firms.
ii) Calculate the profit maximising equilibrium price and output.
iii) What are the profits of the two firms?
iv) Compare it with competitive equilibrium.
......................................................................................................................
......................................................................................................................
......................................................................................................................
4) Assume three firms face identical marginal costs of 20 with fixed costs of
10. They face a market demand curve of P = 200 – 2Q . Find the Cournot
equilibrium price and quantity.
......................................................................................................................
......................................................................................................................
......................................................................................................................
266
5) What do you mean by kink in demand curve? Oligopoly: Price and
Output Decisions
......................................................................................................................
......................................................................................................................
......................................................................................................................

12.3 CO-OPERATIVE VS. NON-

COOPERATIVE BEHAVIOUR
12.3.1 Co-operative Behaviour and Prisoner’s Dilemma
Co-operative behaviour in oligopoly is a situation when firms jointly decide the
prices and output and maximise their joint profit. This situation is called
collusion. In this situation it becomes profitable for one firm if it defects and
undercuts the prices and raises output, as long as others do not do so. Non-
cooperative behaviour is a situation when they do not co-operate and decides
their prices and output separately and compete with each other. When firms in
oligopoly do not co-operate it is called non-cooperative equilibrium or Nash
equilibrium (Named after US mathematician John Nash).
In oligopoly, the basic dilemma the firms face is whether to co-operate or to
compete. If they co-operate, profit will be maximum and if they do not, profit
for all will decrease. Now we will see the behaviour of an oligopolistc firm
through an example of game theory. Game theory is the study of decision
making in situations where strategic interaction (moves and countermoves)
between rival firms occurs. We will assume a case of only two firms in the
market, called Duopoly. The case is as follow:
The Oligopolist’s dilemma: to co-operate or to compete.
Table 12.1

Firm A’s Output

One-half Two-third
Monopoly output Monopoly
output
One-half 20 20 15 22
Monopoly output
Firm B’s Output
Two-third 22 15 17 17
Monopoly output

The figure above explains the dilemma faced by oligopolists of whether to co-
operate or to compete. It is called Payoff Matrix for a two Firm duopoly game.
The right side figures on each cell shows the profits of Firm A and left side
figures on each cell show the profits of Firm B (in Rs. Crores). It can be
explained that if the two firms co-operate and produce one half of market share
each will earn Rs. 20 crores of profit. In case of co-operation they can
maximise their profits. If Firm A defects and produces two thirds of output and
Firm B produces half of monopoly output then Firm A will earn Rs. 22 crores
and Firm B Rs. 15 crores. Similarly if Firm B defects and produces two-third
and Firm A produces one-half then Firm B will earn Rs. 22 crores and Firm A
will earn only Rs. 15 crores. If both decide to compete and produce two-third
267
Market of monopoly output each then profits for both will fall to Rs. 17 crores. This
Structure type of game, where they reach a non-cooperative solution when they could co-
operate, is called Prisoner’s Dilemma. Prisoner’s Dilemma is shown below:
Table 12.2 : The Prisoner's Dilemma

Mr. Ram
Confess Not confess
Mr. Shyam Confess 6 09
Not confess 9 1

Two prisoners Mr. Ram and Mr. Shyam are arrested for committing a crime
and interrogated separately. They are told the following:
a) If both are claimed to be innocent, they will get a light sentence that is 1
year in jail.
b) If one confesses and the other does not, then who confesses will be
released free and the other will be punished for 9 year in jail, and
c) If both confess, then both of them will get a punishment of 6 years in jail.
The payoff matrix presented in Table 12.2 shows the dilemma of the prisoners
about whether to confess or not to confess. If none of them confess then both
will get 1 year of jail, but if Ram confesses and Shyam does not then Ram will
be left free and Shyam will get 9 year of imprisonment and the vise-versa. And
if both of them confess then both will get 6 years of imprisonment. Not
confessing is the best solution in this game (Pareto efficient solution) but this
leaves one always in uncertainty. This solution is not a stable solution as one
gets an imprisonment of 9 years if he/she does not confess and the other does.
Therefore, confession dominates in the mind of both the prisoners. If both of
them confess then they end up with 6 years jail for both. This kind of
equilibrium is called Nash equilibrium. From both the figures above it is clear
that it they co-operate then they will earn the maximum profit than if they
compete.

12.3.2 Types of Co-Operative Behaviour

In order to avoid uncertainty arising out of interdependence and to avoid price
war and cut throat competition, firms under oligopoly often enter into some
agreement about determining uniform price and output. The agreement can be
of the following two types.
 Explicit Collusion: It is situation when firms under oligopoly do formal
(explicit) agreement to determine uniform price and output and maximise
their joint profit. Such an agreement at international level is called Cartel,
Many such agreements have taken place in the past. The best example of
cartel is that of OPEC – Organisation of Petroleum Exporting Countries.
Saudi Arabia and other countries after 1973 formed this cartel. An
individual firm always has incentive to cheat. Possibility of cheating is
larger if number of firms is large. Cheating by a small firm has negligible
effect on the market price.
 Tacit Co-operation: When firms co-operate without any explicit
268 agreement it is called tacit co-operation. For example in Table 12.1, if
 Firm A produces one-half of monopoly output hoping that Firm B will do Oligopoly: Price and
the same and Firm B does so then they achieve the co-operative Output Decisions
equilibrium without any formal agreement.
12.3.3 Types of Non-Cooperative Behaviour
In the absence of formal or informal agreements about co-operation, firms
under oligopoly compete with each other. Non-Cooperative or Competitive
behaviour under oligopoly can be of following types.
Competition for Market Share: Firms under oligopoly always compete with
each other for market share. They use various forms of non-price competition
such as advertising, quality products etc. to increase their market share. For
example in Delhi major mobile service providers like Airtel, Hutch and Idea
compete for increase their mobile connections.
Covert Cheating: In oligopoly, because of huge market share, firms sell their
products through contract. Large scale production and distribution is done
through contracts. When firms provide secret discounts and rebates to their
buyers to increase sales it is called covert cheating.
Contestable Markets and Potential Entry: Theory of contestable markets
explains that in the long-run, abnormal profits earned by oligopolists can be
eliminated without actual entry. Potential entry can also affect the market as
much as an actual entry does. It is possible only when the following two
conditions are fulfilled:
1) Entry must be easy to accomplish: There should not exist any barriers
to entry, either natural or firm created.
2) The existing firms must consider potential entry while making price
and output decisions: The existing firms must react when new firms try
to enter into the market. They must cut their prices and sacrifice profits
(short run) to restrict the new entrants.
Contestable markets always expect potential entry because of huge profits
earned by the existing firms in the market. But entry to such markets is too
costly. Fixed costs are very high. To develop, design, and sale a new product in
such a market involve huge sunk cost. Sunk costs are those costs which cannot
be recovered if a firm leaves the market soon. Firms which produce multiple
and differentiated products can easily distribute these costs among those many
products. For new firms, producing huge number of differentiated products is
not easy. Therefore, these costs are very high for a firm which produces single
product in the market.
If a new firm can enter and leave the market without any sunk costs of entry,
such markets are called perfectly contestable markets. A market can be
perfectly contestable, even if, firms have to pay some costs of entry if these
costs are recovered when firms leave the market. If the sunk costs are lower,
the market will be more contestable and vise-versa.
Sunk costs of entry constitute entry barriers. Higher the sunk costs, larger will
be profits earned by the existing firms. If the firms operate in the market
without large sunk costs of entry, then they will not earn large profits. As part
of strategy, existing firms keep their prices as low as that can only cover the
total costs. If they charge high prices and earn abnormal profits, the new firms
will enter and may capture the profits. Contestability forces the existing firms
to keep the prices low. The threat of entry into a market is as effective as actual
entry to limit profiteering by existing firms. 269
Market
Structure
12.4 CARTEL THEORY OF OLIGOPOLY
A cartel is defined as a group of firms that gets together to make output and
price decisions. The conditions that give rise to an oligopolistic market are also
conducive to the formation of a cartel. In particular, cartels tend to arise in
markets where there are few firms and each firm has a significant share of the
market. In the U.S., cartels are illegal; however, internationally, there are no
restrictions on cartel formation. The Organisation of Petroleum Exporting
Countries (OPEC) is perhaps the best known example of an international
cartel. OPEC members meet regularly to decide how much oil each member of
the cartel will be allowed to produce.
Oligopolistic firms join a cartel to increase their market power. Members of the
cartel work together to determine jointly the level of output that each member
will produce and/or the price that each member will charge. By working
together, the cartel members are able to behave like a monopolist. For example,
if each firm in an oligopoly sells an undifferentiated product like oil, the
demand curve that each firm faces will be horizontal at the market price. If,
however, the oil producing firms form a cartel like OPEC to determine their
output and price, they will jointly face a downward sloping market demand
curve, just like a monopolist. In fact, the cartel’s profit maximising decision is
the same as that of a monopolist. The cartel members choose their combined
output at the level where their combined marginal revenue equals their
combined marginal cost. The cartel price is determined by market demand
curve at the level of output chosen by the cartel. The cartel’s profits are equal
to the area of the rectangular box labelled abcd in Fig. 12.5. Note that a cartel,
like a monopolist, will choose to produce less output and charge a higher price
than would be found in a perfectly competitive market.

Fig. 12.5

Once established, cartels are difficult to maintain. The problem is that cartel
members will be tempted to cheat on their agreement to limit production. By
producing more output than it has agreed to produce, a cartel member can
increase its share of profits. Hence, there is a built in incentive for each cartel
member to cheat. Of course, if all members cheated, the cartel would cease to
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earn monopoly profits, and there would no longer be any incentive for firms to Oligopoly: Price and
remain in the cartel. The cheating problem has plagued the OPEC cartel as well Output Decisions
as other cartels and perhaps explains why so few cartels exist.
Check Your Progress 3
1) Explain the prisoner’s Dilemma in oligopoly market.
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2) State the types of Non-cooperative behaviour under oligopoly.
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3) What do you mean by Cartel?
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12.5 LET US SUM UP

Oligopoly is the most prevailing form of markets. It is defined as a market
structure in which there are a few sellers of the homogeneous or differentiated
products. Oligopoly can be pure or differentiated. Characteristics of Oligopoly
are: Few dominant firms, Mutual interdependence, Barriers to entry,
Homogeneous or differentiated products. Factors causing oligopoly are: Huge
capital investment, Absolute cost advantage to the existing firm, Product
differentiation, Economies of large scale production, Mergers.
Price and Output determination in oligopoly is different from other three forms
of market structure. Since there are few rival firms and there is mutual
interdependence, the price and output policy of a firm will affect the price and
quality sold by other firms. There is no general theory under oligopoly. Price
and output indeterminateness is an essential feature of oligopoly.
Among models of Non-Collusive Oligopoly, Cournot’s Duopoly Model states
that firms attain Nash equilibrium. In equilibrium each firm is doing the best it
can given its competitor’s behaviour. It is based on the assumption that each
firm is attempting to maximise its total profits assuming that other firm holds
its output constant.
Stackelberg’s Duopoly Model is ‘First Mover Advantage’ Model as an
alternative explanation of oligopolistic behaviour. In this model, one firm sets
its output before other firms do. In this model, neither firm has an opportunity
to react. The leader firm produces more output and earns more profit than the
other firm. Sweezy’s ‘Kinked demand’ Curve Model explains price rigidity in
an oligopoly market by postulating that oligopolist’s will match price decrease
but not price increases.
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Market
Structure
12.6 REFERENCES
1) Dr Deepashree (2016), Introductory Micro Economics, Mayur
Paperbacks, Chapter on Theory of Market structure.

http://www.economicsdiscussion.net

2) Varian, Hal (1999), Intermediate Microeconomics, W.W Norton & Co,

New York, Chapter 24 & 25, page no. 415-455.

12.7 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Sub-section 12.1.1 and answer
2) Read Sub-section 12.1.2 and answer
3) (D)
Check Your Progress 2

1) i) Reaction curve for Firm 1: Q1 = 10 – Q2

Reaction curve for Firm 2: Q2 = 10 – Q1

ii) The equilibrium level of output for both the Firms: Q = Q1 + Q2

= 6.67 + 6.67 = 13.34
iii) Equilibrium market price P is: P = 6.66
2) Let Firm 1 set its output first (i.e., be a leader) and Firm 2 be a follower
which makes its output decision after studying Firm 1’s output and
assuming that Firm 1’s output as fixed. Cournot’s reaction curve of Firm
2 will decide Firm 2’s profit maximising output.
The calculation of Firm 2’s profit maximising output is as follows:
MR2 = MC
∆
=0
∆

Or …(MC is zero is given)

R2 (total revenue) is calculated as:
R2 = P.Q2 = (20 – Q) Q2
= 20 Q2 – (Q1 + Q2) Q2

= 20Q2 – Q1Q2 – Q 22
∆
MR2 = ∆ =20 – Q1 – 2Q2

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 Putting MR2 = 0, and solving for P2 we get: Oligopoly: Price and
Output Decisions
2Q2 = 20 – Q1

Q2 = 10 – Q1 (1)

This is Firm 2’s reaction curve.

The calculation of Firm 1’s profit maximising output is as follows:
MR1= MC
R1 = P.Q1 = (20 – Q) Q1= [20 – (Q1 + Q2)] Q1
= 20Q – Q12 – Q1Q2 (2)
It is clear from the above equation that total revenue earned by Firm 1 depends
upon output of Firm 2. Firm 2 will choose Q2 according to its reaction curve Q2
= 10 – Q1 .

Substituting (1) in (2) we get:

R1 = 20 Q1 – Q12 – Q1 (10 – Q1)

= 20Q1 – Q12 – 10Q1 + Q12

= 10Q1 – Q12
∆
MR1 = ∆ = 10 − Q

∴ MR1 = MC = 0 gives Q1 = 10 (3)

Substituting (3) in (1), we get:

Q2 = 10 – . 10

Q2 = 5 (4)
Thus, under the Stackelberg Model, profit maximum output of Firm 1 is
10 and of Firm 2 is 5. Firm 1 produces twice as much as Firm 2.
3) i) Given that the duopolists faces the following market demand curve:
P = 14 – Q
∴ Q = Q1 + Q2
 P = 14 – (Q1 + Q2)
Both the firms have
AC = MC = 2
Case 1:
Reaction Curve for Firm 1
Total revenue R1 is given by
R1 = PQ1 =[14 – ( Q1 + Q2)] Q1
 R1 = 14Q1 – Q12 – Q1Q2 273
Market Marginal revenue, MR1 is just the incremental revenue ΔR1 resulting
Structure from an incremental change in output ΔQ1.
∆
MR1 = ∆ = 14 − 2Q − Q

MR1 = MC…………………………..in equilibrium

∴ 2 = 14 – 2Q1 – Q2

 Q1 = (12 – Q2) Reaction curve of Firm 1

Similarly,

Reaction curve for Firm 2 will be: Q2 = (12 – Q1)

i) Cournot’s Output is:

Q2 = 12 − (12 − Q )

Q2 = 12 − 6 + Q

2Q2 = − 6+ Q

2Q2 – Q =6

=6
×
Q2 = =4

and Q1 = 4
Cournot’s price is:
P = 14 – (Q1 + Q1)
P = 14 – (4 + 4)
P = 14 – 8
P=6
ii) Profit of Firm 1 and Firm 2 is:
= R1 – C1
= PQ1 – AC × Q1
=6×4–2×4
iii) Comparison of output under perfect competition and Duopoly:
Under Perfect Competition:
P = MC
14 – Q = 2
Q = 14 – 2
∴ Q = 12
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4) R 1 = (200 – 2(Q 1 + Q 2 + Q 3))Q 1 Oligopoly: Price and
MR 1 = 200 – 4Q 1 – 2Q 2 – 2Q 3 Output Decisions

Applying MR = MC:
Q 1 = 45 – Q 2/2 – Q 3/2
By symmetry:
Q 1 = Q 2 = Q 3 = 22.5
5) Read Sub-section 12.2.3.1 and answer
Check Your Progress 3
1) Read Sub-section 12.3.1 and answer
2) Read Sub-section 12.3.3 and answer
3) Read Section 12.4 and answer

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