UNIT 1: MARKET STRUCTURE-1

Perfect Competition: Meaning, Characteristics, Equilibrium of a Firm and Industry in Short

Run and Long Run, Shut Down Point.

Monopoly: Meaning, Characteristics, Equilibrium of a firm in Short Run and Long Run, Price
Discrimination- Meaning, Types, Essential Conditions, Profitability and Possibility of Price
Discrimination.

Ø PERFECT COMPETITION:
Pure or perfect competition is said to prevail in the market when there is (1) a large number
of firms producing a product, (2) products of all firms are homogeneous (3) there is free
entry into and free exit from the industry, and (4) firms possess perfect knowledge or full
information about the demand and cost conditions of the product. As a result, no single firm
in a purely competitive market can change the prevailing price as determined by demand
for and the supply of industry's product.

Ø MEANING OF EQUILIBRIUM OF THE FIRM:

A firm is said to be in equilibrium when it has no tendency to change its level of output, that
is, when it has no tendency either to increase or contract its level of output. The firm will
produce the equilibrium output and will charge the price at which this equilibrium output
can be sold. But now the question arises as to when a firm will have no tendency to change
its level of output. In this regard economists make an important assumption about the
objective of the firm or the entrepreneur controlling it. It is that a firm aims to maximise its
profits.

The profits are the difference between total cost incurred and total revenue obtained from
the sale of the output produced. It may be noted that total costs include not only the costs,
incurred on labour, raw materials, capital equipment, land etc., but also the wages of
management and supervision done by the entrepreneur himself. These wages of
management and routine supervision of the entrepreneurs are often called normal
profits. These normal profits are the minimum income that must be earned by the
entrepreneur if he is to stay in an industry. The pure or economic profits are thus the
excess of income or revenue over all costs including normal profits. In other words, pure
economic profits are supernormal profits.

Ø THE DEMAND CURVE OF A PERFECTLY COMPETITIVE FIRM

The first two conditions of perfect competition ensure that a single price must prevail in
perfect competition and the demand curve or average revenue curve faced by an individual
under perfect competition is perfectly elastic at the ruling price in the market. Perfectly
elastic demand curve signifies that the firm does not exercise any control over the price of
the product and can sell any amount of the product as it likes at the ruling price. Once the
market is established, the firm accepts the price as a given datum and adjusts its output
level which gives it maximum profits. Consider the following figure:

Suppose OP is the price of a commodity which prevails in the market. An individual firm
having no influence over the price will take the price OP as given and constant and therefore
demand curve or average revenue curve facing it will be perfectly elastic at the prevailing
price OP. Since Average Revenue (AR) is constant, marginal revenue will be equal to it. If the
price changes, the demand curve facing the firm will change but it will be perfectly elastic at
the new price.

The third condition of perfect or pure competition, namely, free entry and free exit, ensures
that the firm will make only normal profits in the long run. On the one hand, in the long run
supernormal profits will disappear by the entry of new firms in the industry, and on the
other, losses will disappear as a result of some firms leaving the industry.
Ø SHORT-RUN EQUILIBRIUM OF THE FIRM UNDER PERFECT COMPETITION:
In order to know whether the firm is making profits or losses and how much of them,
average-cost curve must be introduced. SAC and SMC curves are short-run average cost and
short-run marginal cost curves respectively. Profit per unit of output is the difference
between average revenue (price) and average cost. In following figure, equilibrium output is
OM, average revenue is equal to ME, and average cost is equal to ME Therefore, the profit
per unit of output is EF, the difference between ME and ME. The total profits earned by the
firm will be equal to EF (profit per unit) multiplied by OM or HF (total output). Thus, the
total profits will be equal to the area HFEP. Because, normal profits are included in average
cost the area HFEP indicate super-normal profits.

As mentioned before, short run means period of time within which the firms can alter their
level of output only by increasing or decreasing the unit of variable factors such as labour
and raw materials, while fixed factors like capital equipment remain unchanged. Moreover,
in the short run, new firms can neither enter the industry, nor the existing firms can leave it.
Short-run Equilibrium of the firm under perfect competition is depicted in the following
figure:

The short run is not a period long enough for the new firms to enter the industry. The
existing firms will therefore continue earning super-normal profits equal to HFEP in the
short period. It is evident that in the situation depicted in the figure all firms will be in
equilibrium at E and each will be producing OM output but the tendency for the new firms
to enter the industry will be present, though they cannot enter during the short period.
Ø SHORT-RUN EQUILIBRIUM OF A FIRM IN PERFECT COMPETITION:
MINIMISING LOSSES
Suppose that the prevailing market price of the product is such that the price line or average
and marginal revenue curve lies below average cost throughout. In the following figure, the
prevailing market price is OP, which is taken as given by the firm; P' L' is the price line which
lies below AC curve at all levels of output. The firm will be in equilibrium at point E' at which
marginal cost is equal to price (or marginal revenue) and marginal cost curve is rising. Firm
would be producing OM output but would be parking losses since average revenue (or
price) which is equal to M’E’ is less than average cost which is equal to MP.

The loss per unit of output is therefore equal to E’F’ and total loss will be equal to P’E’F’H
which is the minimum loss that a firm can make under the given price-cost situation. Since
all the firms are working under same cost conditions, all would be in equilibrium at point E'
or output OM and everyone will be making losses equal to P’E’F’H. As a result, the firms will
have a tendency to quit the industry in order to make a search for earning at least normal
profits elsewhere. There will be a tendency for firms to leave it though they cannot quit it
during the short period.

Ø SHUTTING DOWN DECISION IN THE SHORT RUN:

In the analysis of firm's decision to continue operating or to shut down in the short run, the
difference between variable costs and fixed costs is important. When a firm shuts down in
the short run and stops producing the commodity, the variable costs also fall to zero. On the
other hand, a firm cannot escape from fixed costs even if it ceases to produce in the short
run. Thus rent of factory building, costs on machinery purchased, wages of a certain
minimum managerial staff are examples of fixed costs. When a firm stops production, that
is, shuts down in the short run, it will bear losses equal to the fixed costs. Therefore, it will
be wise to continue operating in the short-run when the firm’s total revenue exceeds total
variable costs because in that case it will be recovering some fixed costs and therefore its
losses will be less than the fixed costs. Following are the three situations:

1. Situation when a firm decides to continue operating in the short run even when
incurring losses.
2. Situation when a firm decides to shut down in the short run.
3. Situation when it is not rational for the firm to operate and produce in the short run.

1. Situation when a firm decides to continue operating in the short run even when
incurring losses.

§ It is prudent on the part of the firm to continue producing in the situation when losses
are less than total fixed costs. But it will minimise losses by producing a level or output
at which price equals marginal cost (P= M). This situation is illustrated in following figure
where the various short-run cost curves SAC, AVC and MC are shown. Price of the
product prevailing in the product is OP which is taken as given by the firm. The firm is in
equilibrium at point E where it produces OQ output at which the given price OP is equal
to short run marginal cost of production (SMC). It will be seen from figure that at the
equilibrium output OQ, average variable cost (AVC) is QL, which is less than the price OP
(= QE) or Price > AV. This means the firm is recovering variable costs plus a part of the
fixed cost. Total revenue (TR) earned by producing output OQ is equal to the area OPEQ,
while the total costs are equal to the area ORTQ.
§ It is evident from figure that when price is OP total revenue is less than the total costs
and the firm is making losses equal to the area RTEP. It should be noted that average
fixed cost at output level OQ is given by the vertical distance TL between SAC and AVC,
Multiplying this average fixed cost by output OQ (= KL) we get the total fixed costs being
equal to the area RTLK.
§ It is thus clear by working point E and producing output OQ, the firm is recovering the
entire variable costs equal to the area OQLK and a part of the fixed cost equal to the
dotted area KLEP. Thus losses made which are equal to the area RTEP are less than the
 total fixed costs equal to the area RTLK. If a firm shuts down in the short run and ceases
to produce the product, its losses will be equal to the total fixed costs RTLK. It will
therefore be a rational decision on the part of the firm to continue operating as shutting
down in this situation will mean greater losses equal to the total fixed cost.
§ To conclude, the firm will continue operating in the short run at a loss when total
revenue exceeds total variable costs. This enables the firm to earn revenue large enough
to cover not only the variable costs but also to cover a part of the fixed costs. We state
below the condition when it is rational for the firm to continue production in the short
run even when it is incurring losses:
§ Since, TR > TVC, TR = P.Q and TVC= AVC.Q. Therefore, P.Q > AVC.Q and P > AVC

It is rational to operate: Losses < TFC.

2. Situation when a firm decides to shut down in the short run.

This situation is depicted in Fig. 19.6 where it will be seen that price has fallen to the level
OP1. With price OP1, equilibrium is attained at point D corresponding to output OQ, at
which price is equal to both marginal cost (MC) and minimum AVC. By producing OQ1
output and selling it at price OP1, the firm earns total revenue equal to the area OQ1DP1.
The total cost of producing OQ output is equal to the area OQ1HB. Thus at price OP1 the
firm is incurring losses equal to the area P1DHB. It should be noted that AFC is DH at OQ1
output, that is, the vertical distance between SAC and AVe. The total fixed cost is then given
by the area P1DHB. Thus when price falls to OP1, firm’s losses are equal to the total fixed
cost. Even when the firm closes down, its losses will be equal to the total fixed cost.
Therefore, if price falls below OP1 which is equal to the minimum possible AVC, the losses
will become greater than the fixed costs and the firm will shut down. Point D which
indicates the minimum possible average variable cost represents the shut-down point.

3. Situation when firm actually shuts down and does not operate.
When price of the commodity falls below minimum possible AVC, the losses would exceed
TFC at the output for which price equals marginal cost. This means that the firm will not
fully recover even variable costs which can be avoided by stopping operations. This is
illustrated in Fig. 19.7 where price has fallen to OP2, which lies below the minimum possible
point of average variable cost curve AVe. Price OP2, is equal to marginal cost at point B
corresponding to output OQ2. As will be seen from Fig. 19.7 the total losses (TR- TC) are
equal to the area JGBP2, while total fixed costs are JGKL. Thus total losses exceed total fixed
cost by the dotted area KLBP2, which is a part of the variable costs not being recovered.
Since losses are greater than fixed costs, it is not rational for the firm to continue
operating. Therefore, the firm will shut down in' the short run and bear losses equal to the
fixed-costs. In the short run firm cannot go out of the industry but will wait for the better
time to come.

Ø LONG-RUN EQUILIBRIUM OF THE FIRM UNDER PERFECT COMPETITION

§ The long run is a period of time which is sufficiently long to allow the firms to make
changes in all factors of production. In the long run, all factors are variable and none
fixed. The firms, in the long-run, can increase their output by changing their capital
equipment; they may expand their old plants or replace the old lower-capacity plants by
the new higher-capacity plants or add new plants. Besides, in the long run, new firms
 can enter the industry to compete the 'existing firms. Similarly, can decrease the output
too.
§ The long-run equilibrium then refers to the situation when free and full adjustment in
the capital equipment as well as in the number of firms has been allowed to take
place. It is therefore long-run average and marginal' cost curves which are relevant for
deciding about equilibrium output in the long run. Moreover, in the long run it is the
average total cost which is of determining importance, since all costs are variable and
none fixed.
§ For the firm to be in long-run equilibrium, besides marginal cost being equal to price, the
price must also be equal to average cost. This is because if the price is greater or less
than the average cost, there will be tendency for the firms to enter or leave the industry.
It, therefore, follows that for a perfectly competitive firm to be in long-run
equilibrium, the following two conditions must be fulfilled: (1) Price =Marginal Cost (2)
Price =Average Cost. lf price is equal to both marginal cost and average cost, then we
have a double condition for long run equilibrium of a firm: Price = Marginal Cost =
Average Cost
§ But from the relationship between marginal cost and average cost we know that
marginal cost is equal to average cost only at the minimum point of the average cost
curve. Therefore, the condition for long-run equilibrium of the firm can be written as:
Price = Marginal Cost = Minimum Average Cost

§ The above figure represents long-run equilibrium of the firm under perfect competition.
The firm cannot be in the long-run equilibrium at a price greater than OP in figure. If
price is greater than then the price line (demand curve) would be somewhere above the
minimum point of (LAC) so that marginal cost and price will be equal where the firm will
 be earning more than economic profits. Since there will be tendency for new firms to
enter the industry and compete away these supernormal profit, the firm cannot be in
long- run equilibrium at any price higher than OP.
§ Likewise, the firm cannot be in long- run equilibrium at a price lower than OP under
perfect competition. If price is lower than OP the demand curve facing the firm will lie
below the average cost curve (LAC) so that the marginal cost and price will be equal at a
point where the firm is making losses. Therefore, there will be tendency for some of the
firms in the industry to go out with the result that price will rise and the firms left in the
field make at least normal profits. We therefore conclude that the firm can be in long-
run equilibrium under perfect competition only, when price is at such a level that the
horizontal demand curve is tangent to the long-run average cost curve so that price
equals average cost and firm makes only normal profits.
§ Double condition of long-run equilibrium is fulfilled at the minimum point of long-run
the average cost curve. Long-run equilibrium of the firm under perfect competition is
established at the minimum point of the long-run average cost curve. Operating at the
minimum point of the long-run average cost curve signifies that firm is of optimum size,
that is, it is producing output at the lowest possible cost.

Ø EQUILIBRIUM OF THE INDUSTRY

§ An industry is in equilibrium when there is no tendency on the part of the industry to
vary its output, that is, neither to expand output and nor to contract it. And, the
essential condition for the absence of any tendency for expansion or contraction of
output of an industry is that the demand for the product of the industry and the supply
of it by the industry are in balance or in equilibrium.
§ Unless the quantity demanded of the industry's product and the quantity supplied of it is
equal, there will always be a tendency for output of the industry to vary. If at the given
price the quantity demanded of the product exceeds the quantity supplied of it by the
industry, price of the product will tend to rise and also the output of the industry will
tend to be increased. On the other hand, if at a price the quantity demanded of the
product falls short of the quantity supplied of it, the price and output of the industry will
tend to fall.
§ Thus, only when the quantity demanded and quantity supplied of the product of an
industry is equal, there will be no tendency for the industry either to expand its output
or to contract it. We therefore conclude that industry is in equilibrium at the level of
output at which the quantity demanded and quantity supplied of its product are
equal, or in other words, at which the demand curve for the product of the industry
and the supply curve of it by the industry intersect each other.
§ The output or supply of the product of an industry can vary in two ways. First, the
output of an industry can vary if the existing firms in it 'vary their output levels’.
Secondly, the output and therefore the supply of the product of the industry can vary by
a change in the number of firms in it: the industry output will increase if new firms enter
the industry and the industry output will decline if some of the existing firms leave it. So,
an industry would be in equilibrium when neither the individual firms have incentive
to change their output nor there is any tendency for the new firms to enter or for the
existing firms to leave it.
§ Therefore, besides the equality of demand and supply of the industry's product, two
conditions which must be satisfied if there is to be the equilibrium of the industry. First,
each and every firm should be in equilibrium. Secondly, the number of firms should be
in equilibrium, i.e., there should be no tendency for the firms either to move into or
out of the industry.
§ This will happen when all the entrepreneurs, i.e., owners of the firms of the industry, are
earning only 'normal profits 'that is, profits which are just sufficient to induce them to
stay in the industry and when no entrepreneur outside the industry thinks that he could
earn at least normal profits if he were to enter it. Thus, the concept of normal profits is
important in defining and describing equilibrium of the industry.
§ If all the firms in the industry are earning profits above normal, there will be incentive
for the firms outside the industry to enter it and if the firms in industry and search for
normal profits elsewhere. And if, they are earning profits below normal, they will leave
the industry. So, number of firms should also be in equilibrium.
Ø SHORT-RUN EQUILIBRIUM OF THE INDUSTRY
§ In short run only existing firms can make adjustment in their output while the number
of firms remains the same. Since the entry or exit of the firms is not permitted; for
short-run equilibrium of the industry, the condition of making only normal profits is not
required. Thus, the industry is in short-run equilibrium when the demand for and
short-run supply of the industry's product are equal and all the firms in it are in
equilibrium.
§ In the short-run equilibrium of the industry, though all firms must be in equilibrium, all
may be making super-normal profits or all may be having losses depending upon the
demand conditions for the industry's product.
§ Short-run equilibrium of the industry is illustrated in Fig. 19.11 in which in the right hand
panel, industry's short-run demand and supply curves DD and SS respectively are shown.
These curves intersect at point E and thereby determine the equilibrium price OP, and
the equilibrium output OQ1 of the industry. Firms will take price OP as given and will
adjust their output at the profit-maximising level.
§ The left hand panel of Fig. 19.11 shows that a firm in the industry will be in equilibrium
at OM output. With OM output, the firm is making profits equal to the area KRST If it is
assumed, as is being done here, that all firms in the industry are alike in respect of cost
conditions, then all firms like the one shown in Fig. 19.9 (left-hand panel) will be making
profits.
§ Thus, while the industry is in short-run equilibrium, that is, the demand and supply of
its product are equal and also all firms in it are in equilibrium; the firms are making
supernormal profits.
§ If the demand conditions for the product of the industry are not so favourable, for
instance, if the demand curve of the industry's product is at a much lower position than
shown in Fig. 19.9, then the intersection of demand and supply curves may take place at
the price at which the firms will be having losses in their equilibrium position.
§ We, therefore, reach the following two conditions for the short-run equilibrium of the
industry under perfect competition:
- The short-run demand for and supply of the product of the industry must be equal.
- All firms in the industry should be in equilibrium whether they are making profits or
having losses.
Ø LONG-RUN EQUILIBRIUM OF THE INDUSTRY
§ In the long-run, number of firms can vary. Lured by the super normal profits earned by
the existing firms in the short run, the new firms will enter the industry and compete
away these abnormal profits As a result of the entry of new firms, the supply of the
product will increase which will result in lowering the price of the product. New firms
will continue entering the industry until price of the product becomes equal to the
minimum run average cost (LAC).
§ Thus, all firms will be in long-run equilibrium at the minimum points of their long-run
average cost curve and will therefore be making only normal profits.
§ In the short run, if the existing firms make losses, some of the firms will leave the
industry so that the output of the industry will fall and as a result the price will go up to
the level of average cost. Thus, the remaining firms come to be in long-run equilibrium
where they are earning only normal profits.
§ The industry is in long-run equilibrium when besides the equality of long-run supply of
and demand for the industry's product, all firms are in equilibrium and further there is
neither a tendency for the new firms to enter the industry, nor for the existing firms to
leave it. The long-run equilibrium of the industry is depicted in Fig. 19.10 in which, in the
right hand panel, demand and short-run supply curves of the industry are shown which
intersect at point R and thereby determine the price 0P1. It will be seen from left-hand
panel of Fig. 19.10 that with price OP1, the firm is in equilibrium point E and producing
0Q1, output and making supernormal profits.
§ The short-run supply curve of the industry will continue shifting to the right until it
intersects the demand curve DD at point T at which price OP2, is determined. It will be
seen from the left-hand panel of Figure 19.10 that price OP2 is equal to the minimum
long-run average cost curve LAC and the firm is making only normal profits.

1. The supply of the product has been fully adjusted to the given demand for the product of
the industry and the two are in balance.
2. All firms in the industry must be in equilibrium.
3. There must be no tendency for the new firms to enter the industry or for the existing
firms to leave it. In other words, number of firms should be in equilibrium. This implies that
all firms in the industry will be earning only normal profits in the long run.

Ø MONOPOLY: It is an extreme form of market structure. In monopoly, there is a single

producer and seller of a product which has no close substitutes. It has originated from
the Greek words Mono meaning "single" and poly meaning "seller. Thus, monopoly
means single seller. It means the existence of a single producer or seller which is
producing or selling a product which has no close substitutes. And as such it is an
extreme form of imperfect competition. Since a monopoly firm has a sole control over
the supply of a product which do not have close substitutes, the increase and decrease
in its output will greatly affect the price of its product. Reduction in output by the
monopolist will raise its price and expansion in output will lower it. Therefore, the
demand curve facing a monopolist is downward sloping.
Ø PRICE AND OUTPUT UNDER MONOPOLY
§ The equilibrium of a single monopolist firm tells us what price and output will be
determined under monopoly. The rational behaviour demands that firms should try to
maximise profits. It is demand and cost conditions facing the monopolist that make the
difference in the results in respect of price charged and output produced by him.
§ The equilibrium of the monopolist regarding price and output is shown in following
figure. Since a monopolist has a control over the price of his product, he does not take
price as given and constant. But, if he raised the price of his product, the quantity
demanded of it will fall and if he lowers the price, the quantity demanded of his
product will increase.
§ He will therefore choose price-output combination which maximises his profits.
Profits are maximised at the level of output at which revenue (MR) of an extra unit of
output is equal to marginal cost (MC) of the extra unit. Thus, to achieve maximum
profit the monopolist follows the following rule: MR = MC.
§ He will go on producing additional units of output so long as marginal revenue exceeds
marginal cost. This is because it is profitable to produce an additional unit if it adds
more to revenue than to cost. His profits will be maximum and he will attain
equilibrium at the level of output at which marginal revenue equals marginal cost.
§ If he stops short of the level of output at which MR equals MC, he will be unnecessarily
forgoing some profits which otherwise he could make. In the figure marginal revenue is
equal to marginal cost at OM level of output.
§ The monopolist will be earning maximum profit and will therefore be in equilibrium
when he is producing and selling OM quantity of the product. If he increases his output
beyond OM, marginal revenue will be less than marginal Cost and he will be incurring
loss on the additional units beyond OM. Therefore, the monopolist will be reducing his
total profit by producing more than OM. Thus, he is in equilibrium at OM level of
output at which marginal cost equals marginal revenue.
§ It will be seen from the AR curve in the figure that he will be charging the price MS or
OP by selling quantity of output. The difference between average revenue and average
cost, that is, TS in figure represent the supernormal profits earned per unit of output by
 the monopolist. The total supernormal profits are equal to area of the rectangle HTSP.

Ø LONG-RUN EQUILIBRIUM UNDER MONOPOLY

§ In the long run monopolist would make adjustment in the size of his plant. The long-run
average cost curve and its corresponding long-run marginal cost curve portray the
alternative plant, i.e., various plant sizes from which the firm has to choose for
operation in the long run. The monopolist would choose that plant size which is most
appropriate for a particular level of demand.
§ In the short run the monopolist adjusts the level of output while working with a given
existing plant. His profit maximizing output in the short run will be where only the short-
run marginal cost curve is equal to marginal revenue. But in the long run he can further
increase his profit by adjusting the size of the plant. So, in the long run he will be in
equilibrium at the level of output where given marginal revenue curve cut the long-run
marginal cost curve.
§ Fixing output level at which marginal revenue is equal to long- run marginal cost shows
that the size of the plant has also been adjust. That is, a plant size has been chosen
which is most optimal for a given demand for the product.
§ We should note that, in long run, marginal revenue is also equal to short-run marginal
cost. But this short-run marginal cost is the plant which has been selected in the long run
keeping in view the given demand for the product. Thus while, in the short run, marginal
revenue is equal only to the short-run marginal cost given existing plant in the long run
 marginal revenue is equal to the long-run marginal cost as well as to short-run
marginal cost of that plant which is appropriate for a given demand for the product.
§ In the long-run equilibrium, therefore, both the long-run marginal cost curve and short-
run marginal cost curve of the relevant plant intersect the marginal revenue curve at the
same point.
§ Further, the firm will operate at a point on LAC at which the short-run average cost is
tangent to it. This is because it is only at such tangency point that SMC of a plant equals
the LMC. Following figure portrays the long- run equilibrium of the monopolist. He is in
equilibrium at OL output at which long-run marginal curve LMC intersects marginal
revenue curve MR. Given the level of demand a indicated by position of AR and MR
curves he would choose the plant size whose short-run average and marginal cost curves
are SAC and SMC. He will be charging price equal to LQ or OP and will be making profit
equal to the area of THQP.

§ It therefore follows that for the monopolist to maximize profit in the long run, the
following conditions must be fulfilled:
MR = LMC = SMC,
SAC = LAC,
P >= LAC
Ø MEANING OF PRICE DISCRIMINATION
§ Price discrimination refers to the practice of a seller of selling the same product at
different prices to different buyers. A seller makes price discrimination between
different, buyers when it both possible and profitable for him to do so. If the
manufacturer of a refrigerator of a given variety sells it at 5000 to one buyer and at
5,100 to another buyer, he is practising price discrimination.
§ It is not a very common phenomenon. It is very difficult to charge different prices for the
identical product from the different buyers. More often, the product is slightly
differentiated to successfully practise price discrimination. Thus, the concept of price
discrimination can be broadened to include the sale of the various varieties of the same
good at prices which are not proportional to their marginal costs. Prof. Stigler defines
price discrimination as "the sales of technically similar products at prices which are not
proportional to marginal costs."
§ Three types of price discrimination may be noted. Price discrimination may be (a)
personal (b) local or (c) according to use or trade. Price discrimination is personal when a
seller charges different prices from different persons. It is local when the seller charges
different prices from people of different localities or places. It according to use when
different prices of a commodity are charged according to the uses to which the
commodity is put.

Ø Degrees of Price Discrimination

§ Prof. A.C, Pigou has distinguished between the following three types of price
discrimination on another ground (i) price discrimination of the first degree; (ii) price
discrimination of the second degree, and (iii) price discrimination of the third degree.
§ Price Discrimination of First Degree. It involves maximum possible exploitation of each
buyer in the interest of a seller's profits. It is also called perfect price discrimination. It
is said to occur when the monopolist is able to sell each separate unit of the output at
a different price. Thus under discrimination of the 'first degree` every buyer is forced to
the price which is equal to the maximum amount he is willing to pay rather than do
without the good altogether.
§ Price Discrimination of the Second Degree. It would occur if a monopolist were able to
charge separate prices in such a way that all units with a demand greater than, say X,
 were sold at a price X, all units with a demand price greater than Y but less than X at a
price Y, and so on. In this, buyers are divided into different groups and from each group
a different price is charged which is the lowest demand price that group.
§ Price Discrimination of Third Degree. It is said to occur when the seller divides his
buyers into two or more than two sub-markets or groups and charges a different price
in each sub-market. The price charged in each sub-group depends upon the output sold
in that sub-market and demand conditions. A common example of such discrimination
is found in the practice of manufacturer who sells his product at a higher price at home
and at a lower price abroad. It is also found when an electric company sells electric
power at a lower price to the households and at a higher price to the manufacturers
who use it for industrial purposes.

Ø WHEN IS PRICE DISCRIMINATION POSSIBLE?

§ Two fundamental conditions are necessary for the price discrimination to become
possible. First, it can occur only if it is not possible to transfer any unit of the product
from one market to another. He can practise this only when he is selling in different
markets which are divided in such a way that product sold by him in cheaper market
cannot be resold in dearer market. Buyers In the dearer market of the original seller
will instead of buying from him will by the product from the buyers of his cheaper
market. Thus, a seller can charge different prices in the two markets when here is no
possibility of the product being transferred from the cheaper market to the dearer
market.
§ Second essential condition for it to occur is that it should not be possible for the buyers
in the dearer market to transfer themselves into the cheaper market to buy the product
or service at the lower price. For instance, 'if a doctor is charging a smaller fee from the
poor than from the rich, then it break down if a rich man can pretend to be poor and
pay poor man’s charges to the doctor.
§ It is now clear that for the price discrimination to become practicable, neither the unit
of the good, nor the unit of demand can be transferred from one market to another. It
is possible in the following cases:
1. Nature of the Commodity. The nature of the commodity or service may be such h that
there is no possibility of transference from one market to the other. The most usual case is
the sale of direct personal services like that of a surgeon or lawyer. The surgeons usually
charge different fees from the rich and the poor for the same kind of operation.

2. Long Distances or Tariff Barriers. It often occurs when the markets are separated by large
distance or tariff barriers so that it is very expensive to transfer goods from a cheaper
market to be resold in the dearer market. A monopolist manufacturer at Madras may sell his
product in one town, say Calcutta, at 20 and in another town, say Delhi, at 15. Similarly, if a
seller is selling his good in two different markets, say, in a home market which is protected
by a tariff and in a foreign market without a tariff, he can take advantage of the tariff barrier
and can raise the price of his product in the home market. As a result, he will be selling the
product in the foreign market at a lower price than at home. This practice of selling the
product at cheaper rates abroad than at home is known as dumping.

3. Legal Sanction. In some cases there may be legal sanction for price discrimination. For
example, an electricity company sells electricity at a lower price if it is used for domestic
purposes and at a higher price if it is used for commercial purposes. In this case customers
are liable to be fined if they use electricity for commercial purposes if the sanction has been
granted for domestic purposes only. The same is the case with railways which charge
different fares for travelling in First Class, and Second Class compartments. Though the
service of carrying rendered in three classes of compartments slightly differs in each case
but the differences in fares are out of proportion to differences in comforts provided. So this
is a clear case of price discrimination by legal sanction.

4. Preferences or Prejudices of the Buyers. Price discrimination may become possible due
to preferences or prejudices of the buyers. The same is good is converted into different
varieties by providing different packings, different names or labels in order to convince the
buyer that certain varieties are superior to others. Different prices are charged for different
varieties, although they differ only in name or label. Sometimes there is some actual
difference in the various varieties of the good. For instance, generally there is a difference in
the paper used and quality of the binding between the deluxe edition and ordinary edition
of a book, but the difference in prices of the two kinds of editions is more than proportional
to the extra costs incurred on the deluxe edition. So, this is a clear case of price
discrimination based on the preferences or prejudices of the various buyers of the product.

Another case of price discrimination falling in this category is that when some people prefer
to buy goods in a particular locality at a higher price.

5. Ignorance and Laziness of Buyers. Price discrimination may become possible due to
ignorance and laziness of buyers. If a seller is discriminating between two markets but the
buyers of the dearer market are quite ignorant of that fact that the seller is selling the
product at a lower price in another market, then price discrimination by the seller will
persist. It will also persist if the buyers of the dearer market are aware of the seller's act of
selling the same product at a lower price in another market but due to laziness may not go
for shopping in the cheaper market.

6. Price discrimination may become possible when several groups of buyers require the
same service for clearly differentiated commodities. For example, railways charge different
rates of fare for the transport of cotton and coal. In this case price discrimination is possible
since bales of cotton cannot be turned into loads of coal in order to take advantage of the
cheaper rate of transport for coal.

Ø WHEN IS PRICE DISCRIMINATION PROFITABLE?

Price discrimination is profitable only if elasticity of demand in one market is different from
elasticity of demand in the other. Therefore, the monopolist will discriminate prices
between two markets only when he finds that the price elasticity of demand of his product
is different in the different sub-markets. Below are the conditions for the profitability of
price discrimination.

(a) When Demand Curves in the Separate Markets are Iso-elastic.

If the demand curves in the two markets are iso-elastic so that at every price the elasticity of
demand in the two markets is the same, then it will not pay the monopolist to charge
different prices in the two markets. Because, when elasticity of demand is the same in the
two markets, it follows that marginal revenues in the two markets at every price of the good
will also be the same. Now, if marginal revenues at every price of the product are same in
the two markets, it will not be profitable for the monopolist to transfer any amount of the
good from one market to the other and thus to charge different prices of the good in the
two markets.

(b) When Elasticity of Demand is Different in Various Markets at the Single Monopoly
Price.

It will be to the advantage of the monopolist to set different prices if price elasticities of
demand in the two markets at the single monopoly price are not the same. In fact, if he
wants to maximize profits he must discriminate prices if the price elasticities of demand in
the two markets at the single monopoly price are different. If the producer regards the two
markets as one and charges a single monopoly price on the basis of aggregate marginal
revenue and marginal cost of the output, he would not be maximizing profits if elasticities of
demand in the two markets at the single monopoly price are; different. If price elasticity of
demand is the same in the two markets at the single monopoly price, it will not pay the
monopolist to discriminate between the two markets, even if the elasticities are different at
other prices.