MARKET

STRUCTURE
By : Divya Mathur
The Four Types of Market Structure

Number of Firms?

Many
firms

Type of Products?

One Few Differentiated Identical

firm firms products products

Monopolistic Perfect
Monopoly Oligopoly Competition Competition

• Tap water • Tennis balls • Novels • Wheat

• Cable TV • Crude oil • Movies • Milk

© 2007 Thomson South-Western

Market Morphology
PERFECT COMPETITION

◦ Assumptions of Perfect Competition

◦ Many independent firms

◦ Each seller is small relative to the whole market

◦ Homogeneous (identical) product

◦ Easy entry and exit (no barriers to entry)

Price Taking

◦ The perfectly competitive firm is said to be a price-taker, because it takes the

market price as given and has no control over the price. Why?...

◦ If the firm tried to charge a higher price, it would lose all its business. Customers
could go elsewhere to buy the same product for less.

◦ Since the firm is very small, it can sell as much as it wants at the market price. So
there’s no reason to charge a lower price.
◦ The demand curve for the product of the perfectly competitive firm shows
how much can be sold at specific prices. Let’s see what it would look like...

◦ The firm can sell as little or as much as it wants at the market price.
Suppose, for example, the market price is $5.
 The firm can sell 10 units for $5.

price

$5

10 quantity
 The firm can sell 20 units for $5.

price

$5

20 quantity
 The firm can sell 30 units for $5.

price

$5

30 quantity
 The firm can sell 40 units for $5.

price

$5

40 quantity
 The firm can sell 50 units for $5.

price

$5

50 quantity
 So all these points are on the demand
curve for the firm’s product.
price

$5

quantity
Connecting these points, we have the
demand curve for the firm’s product.

price

$5 demand

quantity
 The demand curve for the perfectly
competitive firm’s product is a
horizontal line at the market price.

price

market price demand

quantity
 Recall: Total Revenue

Total Revenue = Price x Quantity

TR = P Q
 Recall: Marginal Revenue (MR)

Marginal Revenue is the additional revenue

earned from selling one additional unit of
output.
MR = TR / Q
 comment

For ease of writing, instead of writing the

“perfectly competitive” firm we will
frequently write the “p.c.” firm.
 The MR Curve
for the p.c. Firm
For the p.c. firm, MR is equal to the market price.
So MR is a horizontal line at the level of that price.
The demand curve for the p.c. firm is also a
horizontal line at the level of the market price. So,
for the p.c. firm, the demand curve and the MR
curve are the same horizontal line.
 The demand curve (D) and the MR
curve for the perfectly competitive
firm’s product.

price

market price D = MR

quantity
 Optimal Output Level
Recall:
To maximize profit, the firm will produce at the output level
where MR = MC.
So the firm will produce where the MR and MC curves
intersect.
 Total Marginal
Total Cost Marginal Profit (TR -
Quantity (Q) Price (P) Revenue Revenue
(TC) Cost (MC) TC)
(TR) (MR)
1 50 50 50 30 30 20
2 45 90 40 55 25 35
3 40 120 30 75 20 45
4 35 140 20 95 20 45
5 30 150 10 115 20 35
Draw your axes; label them quantity and $.

Quantity
Draw your ATC, AVC, and MC curves. (Make sure
MC intersects ATC and AVC at the minimum.)
$

ATC AVC

MC
Quantity
Draw the D = MR curve horizontal
at the market price.
$ D = MR

ATC AVC

MC
Quantity
 If the market price is P1 ,
the quantity produced will be Q1.
$ D = MR
P1
ATC AVC

MC
Q1 Quantity
 If the market price is P2 ,
the quantity produced will be Q2.
$
ATC D = MR
P2

AVC

MC
Q2 Quantity
 If the market price is P3 ,
the quantity produced will be Q3.
$

ATC AVC
P3
D = MR

MC
Q3 Quantity
 If the market price is P4 ,
the quantity produced will be Q4.
$

ATC AVC
P4
D = MR

MC
Q4 Quantity
 If the market price is P5 ,
the quantity produced will be Q5.
$

ATC AVC

D = MR
P5

MC
Q5 Quantity
Price P5 was the minimum of the AVC curve (the shutdown
point). If the price fell any lower than P5 the firm would
produce no output.
 The p.c. firm’s short run supply curve
The firm’s supply curve shows the quantity the firm
will produce at each price.
The P, Q values we have shown, therefore, are
points on the firm’s supply curve.
But those points are all on the firm’s MC curve.
So, the firm’s supply curve is the part of the MC
curve that is above the minimum of the AVC curve.
The p.c. firm’s short run supply curve

$ Supply
ATC
AVC

MC
Quantity
 The market short run supply curve

To determine the total amount that all the

firms will produce at each price, we simply
add up the amounts that each of the firms will
produce at that price.
Graphing Profit
A little trick for graphing a firm’s profit
Recall for a rectangle: Area = length . width

length Area

width
We also know TR = P . Q.
So, if we can find a rectangle
P TR
whose length is P and whose
width is Q, then its area must Q
be total revenue.
To determine Total Cost, first remember
ATC = TC / Q
So, ATC . Q = TC
To determine Total Cost, first remember
ATC = TC / Q
So, ATC . Q = TC
ATC TC
Now, if we can find a rectangle
Q
whose length is ATC and whose
width is Q, then its area is TC.
 Then to determine profit,
we just subtract the TC area from the TR area.
Graphing Profit:
The six steps
Step 1 a. Draw your axes and label them Q and $.
( Label the origin 0.)
$

0 Quantity
Step 1b. Draw the firm’s ATC curve. (If the price is below the
minimum of ATC, you will also need to draw the AVC curve.)

$ MC
ATC
P

0 Quantity
Step 1 c. Draw the MC curve and D=MR curve. (For a
positive profit, D must be at least partly above ATC.)

$ MC
ATC
P
D = MR

0 Quantity
Step 2: Determine the profit-maximizing output (Q*) by
finding where MR = MC.
$ MC ATC
P
D = MR

0
Q* Quantity
Step 3: Find your TR = PQ rectangle.

$ MC ATC
P
D = MR

0
Q* Quantity
Step 4: Determine ATC at the profit-maximizing
output level.
$ MC ATC
P
D = MR
ATC

0
Q* Quantity
Step 5: Find your TC = ATC . Q rectangle.

$ MC ATC
P
D = MR

Q* Quantity
 SHORT RUN EQUILIBRIUM
Step 6: Find profit  = TR - TC.
$ MC ATC
P
profit D = MR

Q* Quantity
 You follow the same steps to
draw a firm that is making a loss
or breaking even (zero profits).

Let’s do a firm with a loss.

Step 1: Draw & label the curves & axes. For a loss, put D
above the minimum of AVC & below the minimum of ATC.

$ MC
ATC

AVC
P
D = MR

0 Quantity
Step 2: Determine the profit-maximizing output (Q*) by
finding where MR = MC.
$ MC
ATC
AVC
P
D = MR

0 Quantity
Q*
Step 3: Find your TR = PQ rectangle.

$ MC
ATC
AVC
P
D = MR

0 Quantity
Q*
Step 4: Determine ATC at the profit-maximizing
(or loss-minimizing) output level.
$ MC
ATC
ATC
AVC
P
D = MR

0 Quantity
Q*
Step 5: Find your TC = ATC . Q rectangle.

$ MC
ATC
ATC
AVC
P
D = MR

0 Quantity
Q*
 Case of Loss (or Subnormal Profit)
Step 6: Find profit (or loss)  = TR - TC.
$ MC
ATC
AVC
loss
P
D = MR

0 Quantity
Q*
A firm that is breaking even
(zero profits)
Step 1: Draw & label the curves & axes. To break even, make D tangent to
the minimum of ATC.

$ MC
ATC

D = MR
P

0 Quantity
Step 2: Determine the profit-maximizing output (Q*) by
finding where MR = MC.
$ MC
ATC

D = MR
P

0 Q* Quantity
Step 3: Find your TR = PQ rectangle.

$ MC
ATC

D = MR
P

0 Q* Quantity
Step 4: Determine ATC at the profit-maximizing
output level.
$ MC
ATC

D = MR
ATC = P

0 Q* Quantity
Step 5: Find your TC = ATC . Q rectangle.

$ MC
ATC

D = MR
ATC = P

0 Q* Quantity
 Case of Normal Profit
Step 6: Find profit  = TR - TC.
$ MC
ATC

D = MR
ATC = P

0 Q* Quantity
 Special Case: Exit or Shut Down Point
If the prevailing price in the market is more than the
average variable cost (AVC) of production, the firm would
continue production. But if AVC exceeds AR the firm
would shutdown.
 Perfectly Competitive market in long run
Over the long-run, if firms in a perfectly competitive market
are earning positive economic profits, more firms will enter
the market, which will shift the supply curve to the right. As
the supply curve shifts to the right, the equilibrium price will
go down. As the price goes down, economic profits will
decrease until they become zero.
When price is less than average total cost, firms are making a loss.
Over the long-run, if firms in a perfectly competitive market are
earning negative economic profits, more firms will leave the market,
which will shift the supply curve left. As the supply curve shifts left,
the price will go up. As the price goes up, economic profits will
increase until they become zero.
In sum, in the long-run, companies that are engaged in a
perfectly competitive market earn zero economic profits.
The long-run equilibrium point for a perfectly competitive
market occurs where the demand curve (price) intersects the
marginal cost (MC) curve and the minimum point of the
average cost (AC) curve.
LONG RUN EQUILIBRIUM
Perfect Competition in the Long Run: In the long-run, economic
profit cannot be sustained. The arrival of new firms in the market
causes the demand curve of each individual firm to shift downward,
bringing down the price, the average revenue and marginal revenue
curve. In the long-run, the firm will make zero economic profit. Its
horizontal demand curve will touch its average total cost curve at its
lowest point.
CASE
MONOPOLY
◦ A monopoly is the sole supplier of a product with no close
substitutes.
◦ Monopoly definition by Prof. A.J. Braff – ‘Under pure monopoly,
there is a single seller in the market. The monopolist’s demand is
the market demand. The monopolist is a price maker. Pure
monopoly suggests a no substitute situation.‘
Features of Monopoly

◦ Single seller and several buyers

◦ No close substitute

◦ Strong barriers to the entry of new firms

 Barriers to entry are restrictions on the entry
of new firms into an industry

◦ Legal restrictions

◦ Economies of scale

◦ Control of an essential resource

Legal Restrictions

◦ One way to prevent new firms from entering a market is to make entry illegal.
◦ Patents, licenses, and other legal restrictions imposed by the government
provide some producers with legal protection against competition.
◦ A patent awards an inventor the exclusive right to produce a good or service for
20 years
◦ Patent laws encourage inventors to invest the time and money required to discover and
develop new products and processes.
◦ Also provide the stimulus to turn an invention into a marketable product, a process
called innovation
Licenses and other Entry Restrictions

◦ Governments often confer monopoly status by awarding a single

firm the exclusive right to supply a particular good or service.

◦ Broadcast TV and radio rights

◦ State licensing of hospitals
◦ Cable TV and electricity on local level
Economies of Scale

◦ A monopoly sometimes emerges naturally when a firm experiences economies of scale as

reflected by the downward-sloping, long-run average cost curve
◦ In these situations, a single firm can sometimes supply market demand at a lower average
cost per unit than could two or more firms at smaller rates of output
Natural Monopoly

◦ Because such a monopoly emerges from the nature of costs, it is called a natural monopoly.
◦ A new entrant cannot sell enough output to experience the economies of scale enjoyed by
an established natural monopolist -entry into the market is naturally blocked.
Control of Essential Resources
◦ Alcoa was the sole U.S. maker of aluminum for a long period of time because it controlled the
supply of bauxite
◦ China is the monopoly supplier of pandas
◦ DeBeers controls the world’s diamond trade
Revenue for the Monopolist

◦ Because a monopoly, by definition, supplies the entire market, the

demand for goods or services produced by a monopolist is also the
market demand
◦ The demand curve for the monopolist’s output therefore slopes
downward, reflecting the law of demand
◦ As seen in the following discussion this has important implications
for revenues
Demand, Average and Marginal Revenue

◦ Suppose De Beers controls the entire diamond market and suppose they can sell
three diamonds a day at $7,000 each -total revenue of $21,000
◦ Total revenue divided by quantity is the average revenue per diamond which is also
$7,000
◦ Thus, the monopolist’s price equals the average revenue per diamond.
◦ To sell a fourth diamond, De Beers must lower the price to $6,750- total revenue for 4
diamonds is $27,000 and average revenue is again $6,750
◦ The marginal revenue from selling the fourth diamond is $6,000-marginal revenue is
less than the price or average revenue
◦ Recall that these were equal for the perfectly competitive firm
 Loss or Gain from Selling
By selling another diamond, De Beers gains the revenue from that
$7,000
LOSS sale, $6,750 from the 4th diamond as shown by the blue-shaded
6,750 vertical rectangle marked gain.

Price per However, to sell that 4th unit, De Beers must sell all four diamonds
Diamond
for $6,750 each ➔ it must sacrifice $250 on each of the first three
diamonds which could have sold for $7,000 each.
D = Average
G
revenue
A
I The loss in revenue from the first three units, $750, is shown by the
N red shaded horizontal rectangle marked Loss.

The net change in total revenue from selling the 4th diamond equals
the gain minus the loss ➔ $6,750 - $750 = $6,000.

0 3 4
Revenue Schedule
The first two columns contain the pertinent price and quantity
information.

Total revenue (quantity times price) is provided in the third

column. As De Beers expands output, total revenue increases
until quantity reaches 15 diamonds when total revenue tops
out.
Marginal revenue (the change in total revenue from selling one
more diamond) appears in the fourth column. Note that for all
units of output except the first, marginal revenue is less than the
price, and the gap between the two widens as the price declines
because the loss from selling all diamonds at this lower price
increases.
 Short-Run Revenues and Costs for the Monopolist
Short-run Costs and Revenue for a Monopolist
Price Marginal Marginal Average Total
Diamonds (average Total Revenue Total Cost Total Cost Profit or ◦ The profit-maximizing
per day revenue) revenue (MR = Cost ( MC = (ACT = Loss =
(Q) (p) (TR = Q x p) TR / Q) (TC) TC / Q) TC/Q) TR - TC monopolist employs the same
(1) (2) (3) =(1) x (2) (4) (5) (6) (7) (8)
decision rule as the competitive
0 $7,750 0 - $15,000 - - -$15,000
1 7,500 $7,500 $7,500 19,750 4,750 $19,750 -12,250 firm - the monopolist produces
2
3
7,250
7,000
14,500
21,000
7,000
6,500
23,500
26,500
3,750
3,000
11,750
8,830
9,000
-5,500
that quantity where total revenue
4 6,750 27,000 6,000 29,000 2,500 7,750 -2,000 exceeds total cost by the greatest
5 6,500 32,500 5,500 31,000 2,000 6,200 1,500
6 6,250 37,500 5,000 32,500 1,500 5,420 5,000 amount -$12,500 per day when
7 6,000 42,000 4,500 33,750 1,250 4,820 8,250
8 5,750 46,000 4,000 35,250 1,500 4,410 10,750 output is 10 units per day.
9 5,500 49,500 3,500 37,250 2,000 4,140 12,250
10 5,250 52,500 3,000 40,000 2,750 4,000 12,500 ◦ Total revenue is $52,500 and total
11 5,000 55,000 2,500 43,250 3,250 3,930 11,750
12 4,750 57,000 2,000 48,000 4,750 4,000 9,000 cost is $40,000
13 4,500 58,500 1,500 54,500 6,500 4,190 4,000
14 4,250 59,500 1,000 64,000 9,500 4,570 -4,500
15 4,000 60,000 500 77,500 13,500 5,170 -7,500
16 3,750 60,000 0 96,000 18,500 6,000 -36,000
17 3,500 59,500 -500 121,000 25,000 7,120 -61,500
 Short-Run Revenues and Costs for the Monopolist
Short-run Costs and Revenue for a Monopolist
Price Marginal Marginal Average Total
Diamonds (average Total Revenue Total Cost Total Cost Profit or
per day revenue) revenue (MR = Cost ( MC = (ACT = Loss = ◦ Applying the marginal rule would
(Q) (p) (TR = Q x p) TR / Q) (TC) TC / Q) TC/Q) TR - TC
(1) (2) (3) =(1) x (2) (4) (5) (6) (7) (8) imply that the monopolist
0 $7,750 0 - $15,000 - - -$15,000 increases output as long as selling
1 7,500 $7,500 $7,500 19,750 4,750 $19,750 -12,250
2 7,250 14,500 7,000 23,500 3,750 11,750 9,000 additional diamonds adds more to
3
4
7,000
6,750
21,000
27,000
6,500
6,000
26,500
29,000
3,000
2,500
8,830
7,750
-5,500
-2,000
total revenue than to total cost.
5 6,500 32,500 5,500 31,000 2,000 6,200 1,500
6 6,250 37,500 5,000 32,500 1,500 5,420 5,000 ◦ Again profit is maximized at
7 6,000 42,000 4,500 33,750 1,250 4,820 8,250
8 5,750 46,000 4,000 35,250 1,500 4,410 10,750 $12,500 when output is 10
9
10
5,500
5,250
49,500
52,500
3,500
3,000
37,250
40,000
2,000
2,750
4,140
4,000
12,250
12,500
diamonds per day, per unit costs
11 5,000 55,000 2,500 43,250 3,250 3,930 11,750 are $4,000 and the price is $5,250.
12 4,750 57,000 2,000 48,000 4,750 4,000 9,000
13 4,500 58,500 1,500 54,500 6,500 4,190 4,000
14 4,250 59,500 1,000 64,000 9,500 4,570 -4,500
15 4,000 60,000 500 77,500 13,500 5,170 -7,500
16 3,750 60,000 0 96,000 18,500 6,000 -36,000
17 3,500 59,500 -500 121,000 25,000 7,120 -61,500
Equilibrium in Monopoly

◦ The conditions for Equilibrium in Monopoly are the same

as those under perfect competition.
◦ The marginal cost (MC) is equal to the marginal revenue
(MR) and the MC curve cuts the MR curve from below.
A Firm’s Short-Run Equilibrium in Monopoly

◦ Like in perfect competition, there are three possibilities for a

firm’s Equilibrium in Monopoly. These are:

◦ The firm earns normal profits – If the average cost = the average
revenue
◦ It earns super-normal profits – If the average cost < the average
revenue
◦ It incurs losses – If the average cost > the average revenue
Normal Profits
◦ A firm earns normal profits when the average cost of production is equal to the
average revenue for the corresponding output.

◦ In the figure above, you can see that the MC curve cuts the MR curve at the
equilibrium point E. Also, the AC curve touches the AR curve at a point
corresponding to the same point. Therefore, the firm earns normal profits.
 Super-normal Profits
◦ A firm earns super-normal profits when the average cost of production is less than the average revenue for the
corresponding output.

◦ In the figure above, you can see that the price per unit = OP = QA. Also, the cost per unit = OP’. Therefore, the firm is earning
more and incurring a lesser cost. In this case, the per unit profit is
◦ OP – OP’ = PP’
◦ Also, the total profit earned by the monopolist is PP’BA.
Losses
◦ A firm earns losses when the average cost
of production is higher than the average
revenue for the corresponding output.
◦ In the figure, the average cost curve lies
above the average revenue curve for the
same quantity. The average revenue = OP
and the average cost = OP’. Therefore, the
firm is incurring an average loss of PP’
and the total loss is PP’BA. In the short-
run, a monopolist sometimes sets a lower
price and incurs losses to keep new firms
away.
A Firm’s Long-run Equilibrium in Monopoly

◦ In the long-run, a monopolist can vary all the inputs. Therefore, to determine the
equilibrium of the firm, we need only two cost curves – the AC and the MC.
◦ Further, since the monopolist exits the market if he is operating at a loss, the
demand curve must be tangent to the AC curve or lie to the right and intersect it
twice.
◦ There are two alternative cases for the
determination of Equilibrium in
Monopoly:

◦ With normal profits

◦ With super-normal profits
◦ We have not taken the loss scenario
here because if the monopolist incurs
losses in the long-run, he will stop
operating.
Case 1

◦ The demand curve AR1 is tangent to AC or LAC at point E. Remember, if the

demand curve lies to the left of the AC curve, then the monopolist is unable to
recover his costs and closes down.
◦ However, if the AR curve is tangent to the AC curve, then the monopolist can
recover his costs and stay in the market.
◦ Further, note that the perpendicular drawn from point E to the X-axis, the MC
curve, and the MR curve are concurrent at point A.
◦ Therefore, all the conditions of equilibrium are satisfied. The monopolist
produces OM quantity and sells it at a price of EM per unit which covers its
average costs + normal profits.
Case 2

◦ The marginal revenue curve MR2 cuts the MC curve from below at point B. The
corresponding height of the AR2 curve is E’M1.
◦ Hence, the monopolist produces OM1 quantity and sells it at E’M1 per unit to
earn an extra profit of E’B per unit.
◦ Being a monopoly, this extra profit is not lost to competition or newer firms
entering the industry.
Long-Run Profit Maximization

◦ A monopolist that earns economic profit in the short-run may find that profit
can be increased in the long run by adjusting the scale of the firm
◦ Conversely, a monopoly that suffers a loss in the short run may be able to
eliminate that loss in the long run by adjusting to a more efficient size
Monopolistic Competition
• Monopolistic Competition is a market
structure in which many firms sell products
that are similar but not identical.
• Examples of monopolistic competition:
Books, toothpaste, computer software,
restaurants, furniture, and so on.

© 2007 Thomson South-Western

Monopolistic Competition

• Markets that have some features of

competition and some features of monopoly.
• Attributes of monopolistic competition:
– Many sellers
– Product differentiation
– Free entry and exit

© 2007 Thomson South-Western

Example of Monopolistic Competition:
Toothpaste Market:
• In a departmental store to buy toothpaste, there are 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.
• 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.
© 2007 Thomson South-Western
Monopolistic Competition-CHARACTERISTIC

• Large number of sellers and buyers–

• There are large numbers of firms selling closely related, but not
homogeneous products. Each firm acts independently and has a
limited share of the market. So, an individual firm has limited
control over the market price. Large number of firms leads to
competition in the market.

© 2007 Thomson South-Western

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 of
another firm.

© 2007 Thomson South-Western

 Major sources of product differentiation
•Branding (LG, Sony, Bata, PES..)
•Quality differences (Size, design, model, taste, contents etc)
•Product prestige (Sony, Coach, Fossil, Crocs, Iphone)
•Location (Hotels near colleges, workplaces, near tourist place)
•Additional services (KSRTC, Airlines ……)
•After-sales service (TV, Fridge, AC, Car )
 In the process of differentiation…
• Five levels of products are identified:
(Worthington, Brittan & Rees, 2000)
•Core product
•Generic product
•Tangible product
•Augmented product
•Potential product
Car market : Small economy car, family car, luxury
car, augmented etc..
Product differentiation : a facet of non-price
competition
•Competition is in terms of product variation and product
promotion not price
•Moulding a variant of the product item that makes a greater
and wider appeal to the consumers.
•Creating differences between products of similar category
through some means such as brand names, packaging material
differences and so on.
Selling cost –
• Selling costs refer to the expenses incurred on marketing, sales
promotion and advertisement of the product. Cost of all those selling
activities which are directed to persuade the buyers to change their
preferences, so as to raise the demand for a given product
• Need for selling costs: imperfect knowledge and possibility of altering
desires through advertisements
• Varying returns to selling costs: advertisements intend to increase
demand for the product. It may result in increased sales.

© 2007 Thomson South-Western

Lack of perfect knowledge –

• Buyers and sellers do not have perfect knowledge about the

market conditions.
• As a result, a particular product is preferred by the consumers
even if other less priced products are of same quality.

© 2007 Thomson South-Western

Pricing Decision –

• A firm under monopolistic competition is neither a price- taker

nor a price-maker.

© 2007 Thomson South-Western

Free Entry or Exit
• Firms can enter or exit the market without restriction.
• The number of firms in the market adjusts until economic
profits are zero.

© 2007 Thomson South-Western

Non-Price Competition –

• Non-Price Competition refers to competing with other firms by

offering free gifts, making favourable credit terms, etc., without
changing prices of their own products.

© 2007 Thomson South-Western

Four Conditions:
Characteristics of Goods-
The simplest way for a firm to distinguish its products is to offer a
new size, color, shape, texture, or taste.
Location of Sale
A convenience store in the middle of the desert differentiates its
product simply by selling it hundreds of miles away from the
nearest competitor.

© 2007 Thomson South-Western

Service Level
Some sellers can charge higher prices because they offer
customers a higher level of service.

Advertising Image
Firms also use advertising to create apparent differences between
their own offerings and other products in the marketplace.

© 2007 Thomson South-Western

DEMAND AND MARGINAL REVENUE
CURVES OF A FIRM

© 2007 Thomson South-Western

COMPETITION WITH DIFFERENTIATED
PRODUCTS
• The Monopolistically Competitive Firm in the Short Run
– Short-run economic profits encourage new firms to enter the market.
This:
• Increases the number of products offered.
• Reduces demand faced by firms already in the market.
• Incumbent firms’ demand curves shift to the left.
• Demand for the incumbent firms’ products fall, and their profits decline.

© 2007 Thomson South-Western

Figure 1 Monopolistic Competition in the Short Run
(a) Firm Makes Profit

Price

MC

ATC

Price
Average
total cost
Profit Demand

MR

0 Profit- Quantity
maximizing
quantity © 2007 Thomson South-Western
The Monopolistically Competitive Firm in the Short Run

• Short-run economic losses encourage firms to exit the market.

• Decreases the number of products offered.
• Increases demand faced by the remaining firms.
• Shifts the remaining firms’ demand curves to the right.
• Increases the remaining firms’ profits.

© 2007 Thomson South-Western

Figure 1 Monopolistic Competitors in the Short Run
(b) Firm Makes Losses

Price

MC
ATC
Losses

Average
total cost
Price

MR Demand

0 Loss- Quantity
minimizing
quantity © 2007 Thomson South-Western
The Long-Run Equilibrium

• Firms will enter and exit until the firms are making exactly zero
economic profits.

© 2007 Thomson South-Western

Figure 2 A Monopolistic Competitor in the Long Run
Price

MC
ATC

The demand curve is

tangent to the ATC
P = ATC curve.
And this tangency lies
vertically above the
intersection of MR and
MC.
Demand
MR
0
Profit-maximizing Quantity
quantity
© 2007 Thomson South-Western
The Long-Run Equilibrium

• Two Characteristics
• As in a monopoly, price exceeds marginal cost.
• Profit maximization requires marginal revenue to equal marginal cost.
• The downward-sloping demand curve makes marginal revenue less than price.
• As in a competitive market, price equals average total cost.
• Free entry and exit drive economic profit to zero.

© 2007 Thomson South-Western

 Group equilibrium under monopolistic
competition………………
•Price-output adjustment of many firms whose products are close substitutes
•Prof.Chamberlin :Product group. Ex. Motor car industry
•Product differentiation allows each firm to charge a different price
•Each firm in the group is monopoly, but there is competition among the closely
related products
•Equilibrium occurs at a smaller output than perfect competition.
•Short run: Super normal profits & Long run : Normal profits
 Wastes in monopolistic competition
•‘Wasteful competition’
•Under monopolistic competition, output is slightly less and prices are
higher than perfect competition
•Firms don’t produce the optimal output i.e. Don’t produce when LAC
is minimum
•That means, productive resources are not fully utilised
•There is excess capacity which is unutilised----called WASTE
 Types of wastes
•Excess capacity : underemployment equilibrium and least optimisation,
higher prices, lesser quantity of output
•Unemployment
•Competitive advertising: Advertisement becomes competitive not
informative
•Cross transport : due to product differentiation
•Insufficient specialisation: costs and benefits of specialisation are not
fully enjoyed.
•Inefficiency : as cost structure is high, and firms survive by charging
higher prices.
Oligopoly

• Oligopoly is the most interesting among all the market forms. It

is one of the most realistic types of markets and yet it is the
most complicated to be defined as a theory.
• Oligopoly is a market where a few dominant sellers sell
differentiated or homogenous products under continuous
consciousness of rivals’ actions.

© 2007 Thomson South-Western

Features of Oligopoly
• Few Sellers-
• In Indian automobile industry, major players like Maruti Suzuki, Honda, Toyota and
Ford are examples of oligopoly since one can count the number of players in this
market. Indian Oil, IPCL and Hindustan Petroleum are another set of example. In the
case of cars, each seller tries to differentiate its product by name, shape and other
features, whereas in the second case, the product (petrol or diesel) is identical and the
buyer is indifferent among all the players. Hence, the case of car manufacturers
represents differentiated oligopoly and that of petroleum refers to pure Oligopoly. In
FMCG sector, Coke and Pepsi represent an extreme case of oligopoly where there are
two players, this situation is Duopoly.

© 2007 Thomson South-Western

• Product-
• The product under oligopoly may be differentiated (like cars,
motorbikes, televisions, washing machines, and soft drinks) or
homogenous (like petrol, cement, steel and aluminium).

© 2007 Thomson South-Western

• Entry Barriers-
– Huge Investment Requirements
– Strong Consumer Loyalty for Existing Brands
– Economies of Scale

© 2007 Thomson South-Western

• Interdependent Decision-Making-
• There are few firms in the industry and each is selling a product
which is either a perfect substitute or a close substitute of each
other. This interdependence of decision making is the
consequence of continuous consciousness of rivals move or
counter move and is quintessential to Oligopoly.

© 2007 Thomson South-Western

• Non-Price Competition

© 2007 Thomson South-Western

© 2007 Thomson South-Western
DUOPOLY

© 2007 Thomson South-Western

PRICE AND OUTPUT DECISIONS
• In the following sections, we shall discuss some important
models including those by Cournot, Stackleberg and Sweezy;
we shall also talk about cartels, price leadership and barometric
firms.

© 2007 Thomson South-Western

Cournot’s Model
Augustine Cournot has illustrated the market situation under oligopoly with an example
of two firms engaged in the production and sale of mineral water. The crux of this model
is the situation in which the firms ignore interdependence and takes decisions as if they
are operating interdependently in the market.

© 2007 Thomson South-Western

© 2007 Thomson South-Western
© 2007 Thomson South-Western
Stackelberg Model
• A Stackelberg oligopoly is one in which one firm is a leader and other
firms are followers. This model applies where: (a) the firms sell
homogeneous products, (b) competition is based on output, and (c) firms
choose their output sequentially and not simultaneously.
• The leader is typically a first-mover who chooses its output before other
firms can do it. Since other firms must set their output decision given the
leader’s output decision, the leader in a Stackelberg oligopoly typically
has a bigger market share and higher profit than other firms in the
oligopoly.

© 2007 Thomson South-Western

Sweezy’s kinked demand curve-model of oligopoly
Assumptions:
1. If a firm raises prices, other firms won’t follow and the firm
loses a lot of business. So demand is very responsive or elastic to
price increases.
2. If a firm lowers prices, other firms follow and the firm doesn’t
gain much business. So demand is fairly unresponsive or inelastic
to price decreases.

© 2007 Thomson South-Western

The Kinked Demand Curve

P*

D
Q* quantity
© 2007 Thomson South-Western
MR Curve
for the top part of the Demand Curve
$
D
P*
MR

Q* quantity
© 2007 Thomson South-Western
Drawing MR Curve
for the bottom part of the Demand
Curve
$

P*
MR

D
Q* quantity
© 2007 Thomson South-Western
MR Curve
for the bottom part of the Demand
Curve
$

P*
MR

D
Q* quantity
© 2007 Thomson South-Western
The Kinked Demand Curve
and the MR Curve
$

P*
MR

D
Q* quantity
© 2007 Thomson South-Western
The MC curve intersects the MR curve
in the vertical segment.
$
MC
P*
MR

D
Q* quantity
© 2007 Thomson South-Western
If costs shift up slightly, but MC still
intersects MR in the vertical segment, there
will be no
change in price.
$ MC’ This price
MC rigidity is seen in
real world
P*
oligopoly
markets.

D
Q* MR quantity
© 2007 Thomson South-Western
The ATC curve can be added to the graph. To
show positive profits, part of ATC curve must
lie under part of the demand curve.
$
MC ATC
P*

D
Q* MR quantity
© 2007 Thomson South-Western
The ATC* value can be found on the ATC
curve above Q*.

$
MC ATC
P*
ATC*

D
Q* MR quantity
© 2007 Thomson South-Western
 TC = ATC . Q

$
MC ATC
P*
ATC*

D
Q* MR quantity
© 2007 Thomson South-Western
 TR = P . Q

$
MC ATC
P*
ATC*

D
Q* MR quantity
© 2007 Thomson South-Western
 Profit = TR - TC

$
MC ATC
P* profit
ATC*

D
Q* MR quantity
© 2007 Thomson South-Western
To show a firm with a loss, the ATC curve
must be entirely above the demand curve.
ATC
$
ATC* loss MC AVC
P*

D
Q* MR quantity
© 2007 Thomson South-Western
 To show a firm breaking even, the ATC curve
must be tangent to the demand curve at the
kink.
$
MC ATC
ATC*= P*

D
Q* MR quantity
© 2007 Thomson South-Western
GAME THEORY AND THE ECONOMICS OF COOPERATION

• Game theory is the study of how people

behave in strategic situations.
• Strategic decisions are those in which
each person, in deciding what actions to
take, must consider how others might
respond to that action.

© 2007 Thomson South-Western

GAME THEORY AND THE ECONOMICS OF COOPERATION

• Because the number of firms in an

oligopolistic market is small, each firm
must act strategically.
• Each firm knows that its profit depends not
only on how much it produces but also on
how much the other firms produce.

© 2007 Thomson South-Western

The Prisoners’ Dilemma

• The prisoners’ dilemma is a particular “game” between

two captured prisoners that illustrates why cooperation
is difficult to maintain even when it is mutually
beneficial.

© 2007 Thomson South-Western

Figure 2 The Prisoners’ Dilemma

Bonnie’ s Decision

Confess Remain Silent

Bonnie gets 8 years Bonnie gets 20 years

Confess

Clyde’s Clyde gets 8 years Clyde goes free

Decision Bonnie goes free Bonnie gets 1 year

Remain
Silent

Clyde gets 20 years Clyde gets 1 year

© 2007 Thomson South-Western

Oligopolies as a Prisoners’ Dilemma

• The dominant strategy is the best strategy for a player

to follow regardless of the strategies chosen by the
other players.
• Cooperation is difficult to maintain, because
cooperation is not in the best interest of the individual
player.

© 2007 Thomson South-Western

Figure 3 Jack and Jill’s Oligopoly Game

Jack’s Decision

High Production: 40 Gal. Low Production: 30 gal.

Jack gets $1,600 profit Jack gets $1,500 profit

High
Production
40
Jill gets $1,600 profit Jill gets $2,000 profit
Jill’s gal.
Decision Jack gets $2,000 profit Jack gets $1,800 profit

Low
Production
30
Jill gets $1,500 profit Jill gets $1,800 profit
gal.

© 2007 Thomson South-Western

Oligopolies as a Prisoners’ Dilemma

• Self-interest makes it difficult for the oligopoly to

maintain a cooperative outcome with low production,
high prices, and monopoly profits.

© 2007 Thomson South-Western

Figure 4 An Arms-Race Game

Decision of the United States (U.S.)

Arm Disarm

U.S. at risk U.S. at risk and weak

Arm

Decision
USSR at risk USSR safe and powerful
of the
Soviet Union U.S. safe and powerful U.S. safe
(USSR)

Disarm
USSR at risk and weak USSR safe

© 2007 Thomson South-Western

Figure 5 A Common-Resource Game
Exxon’s Decision

Drill Two Wells Drill One Well

Exxon gets $4 Exxon gets $3

million profit million profit
Drill Two
Wells
Chevron gets $4 Chevron gets $6
million profit million profit
Chevron’s
Decision Exxon gets $6 Exxon gets $5
million profit million profit
Drill One
Well
Chevron gets $3 Chevron gets $5
million profit million profit

© 2007 Thomson South-Western

Why People Sometimes Cooperate

• Firms that care about future profits will cooperate in

repeated games rather than cheating in a single game
to achieve a one-time gain.

© 2007 Thomson South-Western

PRICE DISCRIMINATION: DEFINITIONS, TYPES, CONDITIONS AND DEGREES

• Price discrimination refers to the charging of different prices

by the monopolist for the same product.
• The difference in the product may be on the basis of brand,
wrapper etc. This policy of the monopolist is called price
discrimination.
• Definitions:
• “Price discrimination exists when the same product is sold at
different prices to different buyers.” -Koutsoyiannis
© 2007 Thomson South-Western
• “Price discrimination refers to the sale of technically similar products
at prices which are not proportional to their marginal cost.” -Stigler
• “Price discrimination is the act of selling the same article produced
under single control at a different price to the different buyers.” -Mrs.
Joan Robinson
• “Price discrimination refers strictly to the practice by a seller of
charging different prices from different buyers for the same good.” -
J.S. Bain
• “Discriminating monopoly means charging different rates from
different customers for the same good or service.” -Dooley

© 2007 Thomson South-Western

Types of Discriminating Monopoly

• Price discrimination is of following three types:

1. Personal Price Discrimination:
Personal price discrimination refers to the charging of different prices from different
customers for the same product. For example, a doctor charges different fees for the
same operation from rich and poor patients.
• 2. Geographical Price Discrimination:
Under geographical price discrimination, the monopolist charges different prices in
different markets for the same product. It also includes dumping where a producer
may sell the same commodity at one price at home and at the other price abroad.

© 2007 Thomson South-Western

3. Price Discrimination according to Use:
ADVERTISEMENTS:
When the monopolist charges different prices for the different
uses of the same commodity is called the price discrimination
according to use.

© 2007 Thomson South-Western

Conditions for Price Discrimination:

These are:
1. Difference in Elasticity of Demand:
Price discrimination is possible only when elasticity of demand will be different in different
markets. The monopolist will fix higher price where demand is inelastic and low price where
the demand will be elastic. In this way, he will be able to increase his total revenue.
2. Market Imperfections:
Generally, price discrimination is possible only when there is some degree of market
imperfections. The individual seller is able to divide his market into separate parts only if it is
imperfect.
3. Differentiated Product:
Price discrimination is possible when buyers need the same service in connection with
differentiated products. For example, railways charges different rates for the transport of
coal and copper.

© 2007 Thomson South-Western

• 4. Legal Sanction:
• In some cases price discrimination is legally sanctioned. As,
Electricity Board charges lowest for electricity for domestic use and
highest for commercial houses.
• 5. Monopoly Existence:
• Price discrimination is also called discrimination monopoly. It is
evident that price discrimination is possible only under conditions of
monopoly.

© 2007 Thomson South-Western

Degree of Price Discrimination:

• 1. Price Discrimination of First Degree:

• Price discrimination of first degree is said to exist when the monopolist is
able to sell each separate unit of his product at different prices. It is also
known as the perfect price discrimination. In case of first degree price
discrimination, a seller charges a price equal to what the consumer is
willing to pay. It means the seller leaves no consumer’s surplus with the
consumer. Apart from above, under perfect price discrimination the
demand curve of the buyer, like under simple monopoly, becomes the
marginal revenue curve of the seller.

© 2007 Thomson South-Western

First Degree Price Discrimination Examples

First-degree price discrimination doesn’t exist as it is just too expensive and difficult to specifically obtain
each consumer’s maximum willingness to pay. Not only is it difficult to find out, but it is practically
impossible to do. There is also the element of each individual’s cognitive ability. The maximum price they
are willing to pay can fluctuate rapidly. For instance, when a consumer is looking through the store, they
may find something they like, but when they see something they prefer, they put the first good back as
this has changed their valuation.

© 2007 Thomson South-Western

Airlines

• Most airlines operate a form of price discrimination by using dynamic pricing. This is
simply where prices fluctuate depending on current demand. For instance, if tickets are
selling quickly, then prices will start to rise. If tickets are hardly selling, then the prices
may fall to attract more customers.
• Whilst this form of price discrimination doesn’t necessarily maximize revenue from the
consumer, it does increase the firm’s profits by taking advantage of some consumer’s
higher willingness to pay. For example, those consumers who are price-sensitive are
more likely to book when the tickets come out and are at their cheapest. By contrast,
those who are not so sensitive to prices may book last minute when prices may be
significantly higher.
• Therefore, airlines are able to segment between more price-sensitive consumers and
those who are not. For instance, those who need to travel for last-minute business will
have a higher willingness to pay than a family of four looking for a holiday.

© 2007 Thomson South-Western

2. Price Discrimination of Second Degree:
In the price discrimination of second degree buyers are divided
into different groups and from different groups a different price is
charged which is the lowest demand price of that group. This
type of price discrimination would occur if each individual buyer
had a perfectly in- elastic demand curve for good below and
above a certain price.

© 2007 Thomson South-Western

• Unlike other forms of price discrimination, second-degree price
discrimination requires little effort to segment customers. For
instance, first-degree price discrimination requires the firm to
calculate each consumer’s maximum willingness to pay. By
comparison, third-degree price discrimination requires the firm
to segment into groups such as age or income group. Yet
second-degree price discrimination only requires the firm to
segment into those who want to buy in bulk and those who do
not.

© 2007 Thomson South-Western

Examples

Coupons
Many customers get coupons in the post or at the store as a way to encourage existing customers to
come back and buy more. By offering a discount to those customers, the firm is able to attract repeat
custom and increase sales. These are commonly adopted by retailers – usually in conjunction with a
loyalty card. By offering coupons, customers are encouraged to come back and buy more goods from
the store – albeit at a lower price.

© 2007 Thomson South-Western

• Loyalty Cards
• Loyalty cards are used by most supermarket retailers as well as restaurants and cafes. For example, some
cafes offer a ticket whereby the customer receives a stamp with every visit. After 6 visits, the customer then
receives a free coffee as thanks for their custom.
• There are also loyalty cards at supermarkets which generally track the customer’s buying habits. They can
then use that data to send through personalized promotional material to offer discounted goods. So consumers
essentially sell their data to supermarkets in return for discounted prices to encourage them to come back and
buy more goods.
• Three for two
• Three for two is a common offer that retailers use to increase sales by making subsequent purchases more
appealing. Most customers only want the one good, but the thought of such a big discount on the next can
attract many to spend more. This works in tandem with diminishing marginal utility whereby the customer starts
to value each additional good less and less. The retailer’s solution is to offer a big discount on the subsequent
purchase.
• Bulk-buy
• Bulk-buying is a classic form of second-degree price discrimination which offers a lower price per unit for
customers that buy larger packs. For example, a can of Coca-Cola may cost $1, whilst a pack of 12 costs $6.
That’s a discount of roughly 50 percent on the per-unit price as the multipack costs 50 cents each. Other
examples include large tubs of ice cream, 24 packs of toilet papers, 6 pack of canned beans, and a 6 pack of
doughnuts. All of which cost less per unit than individually.

© 2007 Thomson South-Western

• 3. Price Discrimination of Third Degree:
• Price discrimination of third-degree is said to exist when the seller
divides his buyers into two or more than two sub markets and from
each group a different price is charged. The price charged in each sub-
market depends on the output sold in that sub-market along with the
demand conditions of that sub-market. In the real world, it is third-
degree price discrimination that exists.

© 2007 Thomson South-Western

Third Degree Price Discrimination Examples

Cinemas
Cinemas are another example of third-degree price discrimination. They do so by segmenting the
market between children, adults, and seniors. Usually, children and seniors receive a discounted rate,
which adults pay the highest price. The reason being is that children will most often come with an
adult.
It is cheaper than child care and makes it cheaper overall for the adult to go to the cinema. Adults
benefit from having to pay lower prices to bring their children, but the cinema also benefits from higher
expenditures on related items such as popcorn. Quite simply, by offering children lower rates, it not
only brings in more children but also more adults.
© 2007 Thomson South-Western
• Restaurants
• Some restaurants offer discounts for customers that come at a specific time. This might
include a cheaper ‘lunch-time’ menu or some kind of ‘early-bird’ menu for customers
who come during non-peak hours. This attracts customers who are more price-
sensitive, whilst also benefiting the firm by utilizing its capacity during less busy hours.
Some restaurants also offer discounts for veterans and healthcare workers.

• Student Discounts

• Most firms recognize that students demand is very elastic – meaning they are more
sensitive to changes in price. As a result, many firms offer substantial discounts for
students in order to win their business. Not only does this win their custom in the short-
term, but it could also win their custom for their adult life too. After all, students are
likely to be curious and try new brands and experiment. If one firm does well with their
offering, they may in fact win a customer for life.

© 2007 Thomson South-Western

• Taxis
• Another example of third-degree price discrimination are taxi drivers.
They use timing to help segment the market between peak and non-peak
hours. During peak hours, taxi drivers are likely to be busy, and
customers are in a rush. In turn, this drives up the willingness of
customers to pay higher fees – thereby creating an inelastic demand
curve.
• By contrast, in non-peak hours, customers will most likely be traveling at
their leisure and not have the same urgency as those traveling in peak
hours. Therefore, their demand curve is more elastic – meaning they are
more sensitive to changes in price.

© 2007 Thomson South-Western

Case on Revenue & Profit function

© 2007 Thomson South-Western

© 2007 Thomson South-Western
Profit Maximization

© 2007 Thomson South-Western

© 2007 Thomson South-Western