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Course

:
Economics and Econometrics

Unit-3:
Market Structure

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Table of Contents

3.1. Learning Objectives.........................................................................................................................4
3.2. Introduction......................................................................................................................................4
3.3. Market Structure..............................................................................................................................5
3.3.1. Summary of Market Structures...................................................................................................8
3.3.2. Perfect Competition.....................................................................................................................8
3.3.3. Revenue in a Competitive Business............................................................................................8
3.3.4. Profit Maximisation.....................................................................................................................9
3.4. Monopoly.........................................................................................................................................11
3.4.1. Pricing and Production Decisions.............................................................................................12
3.4.2. Revenue for a Monopoly...........................................................................................................12
3.4.3. Profit Maximisation in Monopoly.............................................................................................13
3.4.4. Price Discrimination..................................................................................................................14
3.4.5. Two-Part Tariffs........................................................................................................................16
3.4.6. Peak Load Pricing.....................................................................................................................17
3.4.7. Social Costs of Monopoly Power..............................................................................................17
3.4.8. Measure of Monopoly Power....................................................................................................18
3.4.9. Concentration Ratio...................................................................................................................18
3.4.10. Monopsony..............................................................................................................................19
3.5. Monopolistic Competition.............................................................................................................20
3.5.1. Long Run Equilibrium..............................................................................................................20
3.5.2. Monopolistic Competition and Welfare....................................................................................20
3.6. Oligopoly.........................................................................................................................................21
3.6.1. Duopolies and Cartels...............................................................................................................21
3.6.2. Size of an Oligopoly and the Markets.......................................................................................22
3.6.3. Game Theory and Prisoners' Dilemma.....................................................................................22
3.6.4. Real World Applications of Game Theory...............................................................................24
3.6.5. Nash Equilibrium......................................................................................................................24
3.7. Principal Agent Problem...............................................................................................................27
3.8. Adverse Selection............................................................................................................................27
3.9. Uncertainty.....................................................................................................................................28
3.10. Wage Efficiency Theory...............................................................................................................29
3.11. Summary.......................................................................................................................................29
3.12. References.....................................................................................................................................30
3.12.1. Book References.....................................................................................................................30
3.12.2. Web References.......................................................................................................................30

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3.12.2. Web References

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3.1. Learning Objectives
By the end of this unit, you will be able to:

• Identify the main characteristics of perfect and monopolistic competitions
• Outline implications of pricing behaviour of individual firms
• Identify the behaviour of the monopolist
• Identify the oligopoly market structure
• Apply the game theory to practical business situations

3.2. Introduction
The theory of a firm is an analysis of the behaviour of companies that examine the following:

• Inputs
• Production methods
• Outputs
• Prices

The traditional theory assumes that profit maximisation is the goal of a firm. Where profit
maximisation is the goal of the firm, economists have developed a set of rules to guide decision makers
to achieve it.

If the associated revenue and cost functions of a firm producing and selling a single
product is given, the profit will be the difference between total revenue (TR) and total
cost (TC).

The profit function shows a range of outputs at which the firm makes positive or super-normal profits.
If the decision maker wishes to maximise the profits, he/she must have information about the firm’s:

• Revenue
• Cost functions
• Marginal revenue and marginal cost curves

Total profit is equal to total revenue minus total cost. Therefore, it is equal to the vertical distance
between the total revenue and total cost curves at any output level. At a point, when marginal revenue
MR, and marginal cost MC, are equal, one finds maximum profit.

The relations among marginal revenue, marginal cost, and profit maximisation can also
be demonstrated by considering the general profit expressions. Total profit and
marginal profit are represented by equations 3.1 and 3.2 respectively.

Total profit is total revenue minus total cost. Marginal profit (Mπ) is marginal revenue
(MR) minus marginal cost (MC).Page 4Maximisation
of 29 of any function requires the marginal
function to be set equal to zero.
π = TR – TC …… Eq. 3.1

Mπ = MR – MC…… Eq. 3.2

That is, profit maximisation occurs when,

Mπ = MR – MC = 0

Therefore, marginal revenue (MR) is equal to marginal cost (MC).

In determining the optimal activity level for a firm, the marginal relation is helpful. Marginal relation
tells us that when the increase in revenues associated with expanding output exceeds the increase in
costs, continued expansion will be profitable.

The optimal output level is determined when the following are fulfilled.

• Marginal revenue is equal to marginal cost
• Marginal profit is zero
• Total profit is maximised

We will now examine these issues with respect to different market structures.

3.3. Market Structure
Market structure is central to both economics and marketing. Both disciplines are concerned with
strategic decision making. In decision-making analysis, market structure has an important role through
its impact on the decision-making environment. The extent and characteristics of competition in the
market affect choice behaviour among the factors.

In economics, markets are classified based on the structure of the industry serving that particular
market. Industry structure is categorised on the basis of market structure variables which are believed to
determine the extent and characteristics of competition.
The most important market structure variables are listed below.

• Number of buyers and sellers
• Extent of product substitutability
• Costs
• Ease of entry and exit
• Extent of mutual interdependence

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Traditionally these structural variables are categorised into four types of market structures as shown in
figure 3.1.

Figure 3.1. Types of Market Structures

Market structure affects the market outcomes by impacting the motivations, opportunities and decisions
of economic actors participating in the market. It attempts to explain and predict market outcomes
through the extent of market competition. Market structure is best defined as the organisational and
other characteristics of a market.

But, in general, we focus mainly on those characteristics which affect the nature of competition and
pricing. It is important not to place too much emphasis simply on the market share of the existing firms
in an industry.

The most important features of the market structure are:

• Number of firms
The number of firms participating in the market includes the scale and extent of foreign
competition.

• Market Share of the Largest Firms
The market share of the largest firms is measured by the concentration ratio.

• Nature of Costs
The nature of costs includes the potential for firms to exploit economies of scale and also the
presence of sunk costs which affects market contestability in the long term.

• Degree to which the Industry is Vertically Integrated
The degree to which the industry is vertically integrated is another important feature of market
structure.

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Vertical integration explains the process by which different stages in production
and distribution of a product are under the ownership and control of a single
enterprise.

Reliance’s oil business, where it owns the rights to extract oil from oilfields, run a
fleet of tankers, operate refineries and have control of sales at their own filling
stations.

• Product Differentiation
The extent of product differentiation which affects cross-price elasticity of demand, that is, to
what extent a company can differentiate its products in the eyes of consumers than rival company.

Consumer durables, FMCG goods, soft drinks, economic textbooks, and others are
the examples.

• Structure of Buyers
The structure of buyers in the industry that includes the possibility of monopsony power.

• Turnover of Customers (also known as “market churn”).
How many customers are switching the supplier over a given time period when market conditions
change. The factors affecting the turnover are brand loyalty and the influence of persuasive
advertising and marketing.

• Barriers to Entry
Barriers to entry depend on how difficult for companies to enter a particular market. The factors
making it difficult for a new company to enter the market are control of the necessary resources or
inputs, government regulations, economies of scale, network externalities, or technological
superiority.

3.3.1. Summary of Market Structures

Table 3.1 represents the summary of market structure.

Table 3.1. Summary of Market Structure
Characteristic Perfect Competition Oligopoly Monopoly
Number of firms Many Few One
Type of product Homogenous Differentiate Limited
d
Barriers to entry None High High
Pricing Price taker Price maker Price maker
Economic efficiency High Low Low
Innovative behaviour Weak Very Strong Potentially strong

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3.3.2. Perfect Competition

Perfect competition is a market structure, characterised by a large number of buyers and sellers of
essentially the same product. Each market participant is too small to influence market prices. Individual
buyers and sellers are price takers. Firms take market prices as given and devise their production
strategies accordingly. Free and complete demand and supply information is available in a perfectly
competitive market, and there are no meaningful barriers to entry and exit. As a result, vigorous price
competition prevails. Only a normal rate of return on investment is possible in the long run. Economic
profits are possible only during periods of short-run disequilibrium before rivals mount an effective
competitive response.

In highly competitive markets, there are:

• Many buyers and sellers, where individual firms have little effect on the price.
• Goods offered that are very similar and the demand is very elastic for individual firms.
• Firms that can freely enter or exit the industry. Hence, there are no substantial barriers to entry.
• Competitive firms, which have no market power. Hence, no firm has substantial market share.

3.3.3. Revenue in a Competitive Business

The organisations operating in competitive markets are price takers, that is, they sell their goods or
services at a price dictated by the market, which is nothing but the market price (P).

Average revenue (AR) is the revenue that the organisation earns for a typical unit.
Average revenue is expressed in equation 3.3.

…… Eq. 3.3
TR  P × Q 
AR = = =P
Q  Q 

where,
• TR = Total revenue
• Q = Quantity sold
• P = Market price

So average revenue is equal to price, and is constant. When we divide the change in TR by the change
in quantity we get "marginal revenue" (MR). In competitive market, MR is also equal to the price and is
constant. It also equals to average revenue (AR).

3.3.4. Profit Maximisation

Figure 3.2 represents the relationship between marginal revenue and marginal cost. A firm maximises
profit when marginal revenue is equal to marginal cost.

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Figure 3.2. Relationship between Marginal Revenue and Marginal Cost

where,

• MC = Marginal cost
• MR = Marginal revenue

So at various prices:

• As price increases, quantity produced also increases, because MC curve is upward sloping.
• As price falls, quantity produced falls.

We saw that in each case, the marginal cost curve determines how much the firm is willing to produce
given the price, and hence, it translates into the supply curve. Figures 3.3 and 3.4 represent the
equilibrium of firm under the perfect competition in the short run and in the long run respectively.

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Industry Firm

Figure 3.3. Equilibrium of a Firm under Perfect Competition in the Short Run

Figure 3.4. Equilibrium of a Firm under Perfect Competition in the Long Run
3.4. Monopoly
Exhibit 3.1

The Rational Investor, 1st July, 1999, vol. III, No. 7
http://www.valuenotes.com/rat/99jul1.pdf?ArtCd=3016

Abstract:
Page 10amongst
Gujarat Gas: A stock that has excited interest of 29 investors by its excellent results for FY99.
Analysts are talking about near-monopoly advantages and MNC parentage.
A monopoly is a single producer of a product which does not have close substitute. A
monopoly is characterised by barriers to entry.

Sources of a monopoly include:

1. Ownership/Control of a Key Resource

• Control over the rainforests, or the ownership of rare minerals (De Beers diamond monopoly)
are the key sources of monopoly.. For almost the whole of the twentieth century, the South
African mining giant De Beers had monopolised the diamond industry. It is controlling
around 90% of the share in the world’s rough diamond market until the early 1990s.
1. Economies of Scale

• An industry such as public utilities has more fixed costs. The largest firm in the industry has
a lower fixed cost per unit, because it is able to spread the fixed costs over a larger volume of
output. Hence, a larger firm will have lower average fixed costs and lower average total costs
than a smaller firm. Consider the laying of gas lines or water lines throughout a community.

• A natural monopoly is a firm that produces the entire output of the market at a lower cost
than what it would be if there were several firms. In this case, the marginal cost curve is
always below the average cost curve, so average cost is always declining.

Falling average total cost which makes one company more efficient than others (also known
as a natural monopoly), arising from economies of scale over the relevant range of output.
Reliance Industries often uses this technique in establishing large scale plants. Industries like
oil, gas require huge infrastructure and long gestation periods which act as a barrier to entry.
As we observed in unit 2, falling average total cost over large scale production leads to
economies of scale, firms use it to establish monopoly.

• Public utilities such as, electricity, cable television and water provision which often results
from practical considerations.
The available space in the streets limits the number of lines that can be laid to supply
electricity. Similarly, space constraint can affect the number of railway lines that can be laid
between two cities.

1. Technological Superiority

• A firm that is able to maintain a consistent technological advantage over potential
competitors can establish itself as a monopolist. For example, Intel computer chips, though
AMD occasionally rivals Intel.

1. Network Externalities
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• If we consider Microsoft’s Windows Operating System, there are other alternatives to it. But
the externalities it generates make it a case for monopoly.

1. Government-Created Barriers

• Patents for goods such as pharmaceutical drugs (usually last 20 years).
• Copyrights granted to authors and composers (usually last the lifetime of author plus 70
years)
• Patents and copyrights encourage innovation through the promise of monopoly profits. These
are exclusive rights given by government in respect of patents, copyrights, franchises
(pharmaceutical companies, research, authors and so on).

Intellectual property rights (IPR) refer to the right that owners of ideas, technology, research and
development have to gain economic payments for their products. Any firm or individual wishing
to reproduce the same good will have to pay royalty to the owner of IPRs. The protection period
varies across products. Thus, IPRs becomes a barrier to entry for the competitors. In this view,
creators are motivated largely by the prospect that they will have a monopoly right to exploit
their work economically in the marketplace, under the protective umbrella of IPR laws.
Exhibit 3.2
3.4.1. Pricing and Production Decisions
If a company sells more units at a price low enough to reduce total revenue, then marginal
A monopoly,
revenuebeing
(MR)incana position to influence
be negative. its own price,
This happens functions
if reduction in asprices
a price
is setter
more rather than taker.
than increase in
Monopolists are constrained by the negative relationship
quantity, that is, elasticity of demand (E). between price and quantity demanded but the
freedom to set the price is quite high compared to the perfect competition.

3.4.2. Revenue for a Monopoly

An organisation having monopoly may raise its price, but as a result it will lose sales. In order to sell
more, it must lower its price.

There are two effects on total revenue:

1. Output effect: More revenue generated due to selling more units
2. Price effect: Less revenue because it earns less from each unit sold due to the lower price
Figure 3.5. Relationship between Marginal Revenue and Elasticity of Demand

Therefore, when MR is negative (inelastic demand curve) the monopolist will never produce. A
straight-line demand has elasticity that varies from zero to infinity.

Assuming a linear demand curve, (price and quantity can be expressed as shown in equation 3.4,
which is a straight line) the MR curve for a straight line will:

• Be a straight line with the same intercept
• Have twice the slope of the demand curve (that is, it is zero at the halfway point of the
demand curve)
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.....Eq. 3.4
P = a − bQ
3.4.3. Profit Maximisation in Monopoly

As we know, profit maximisation is the most important objective of a firm. So, the firm would produce
that level of output where profit is maximised. Figure 3.6 explains the relationship between total

Profit
Producing
MRMC=isMC
>maximised.
< one
and extra unit will increase TC
total
more
revenue
than
MC cutsMR increase
(TR)
MR from more
in TR,
than
so the
increase
monopolist
in total
should
cost
(TC), so the
decrease
below themonopolist
quantity produced.
should increase the
quantity produced.

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Figure 3.6. Relationship between Total Revenue and Total Cost

A monopolist generally produces less output than a socially efficient level of output, and charges a very
high price. Are the above normal profits of monopoly a social cost? Not usually, since profit is still a
part of surplus but has been transferred from consumers to producers. Social cost arises from
inefficiently low output which leads to the dead weight loss.

However, if the monopolist uses some of its normal profits to lobby in order to maintain a monopoly
(rent seeking), then this can be a welfare cost to society.

3.4.4. Price Discrimination

Price discrimination refers to selling the same good or service to different customers or different
markets at different prices. For example, movie tickets, airline tickets, and so on. Price discrimination
can be practiced, where it is easy to separate customers or markets into groups. These groups are
determined based on their elasticities to demand. The company needs to be in a position to prevent
resale between groups and also arbitrage activities.

Price discrimination is a favourable situation for monopolies. A monopolist can charge a higher price to
the segment with less elastic demand and a lower price to the segment with more elastic demand. In this
manner, a business does not have to lower prices to all buyers in order to sell more goods.

Economists classified price discrimination into three types. Figure 3.7 illustrates the three types of price
discrimination.

Figure 3.7. Types of Price Discrimination

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• First Degree Price Discrimination
First degree price discrimination occurs where a firm charges a different price for each unit sold.
Thus, the price paid is the marginal revenue to the firm of each extra unit sold. All available
consumers’ surplus is now translated into monopoly profit, to the benefit of the seller. The
mechanisms to achieve this end are difficult to find.

The usual examples of perfect price discrimination relate to the supply of personal services, where
the supplier is able to charge each customer according to his willingness or ability to pay. Other
examples relate to the use of auctions.

• Second Degree Price Discrimination
Second degree price discrimination occurs where the monopolist charges different prices for
different quantities, or blocks, of the same product. The consumer benefits from larger output and
retains some consumer surplus.

Examples of block tariffs are to be found in the utility industries, such as gas and electricity. The
consumer is charged a price that varies with consumption in which initial units incur a higher
price than later units. This is a similar practice to quantity discounts where the more one buys, the
cheaper the product becomes.

• Third Degree Price Discrimination
Third degree price discrimination occurs where the monopolist is able to separate the market
demand into two or more groups of customers. Each group is charged a different price for the
same product. In addition, the price elasticity of demand must be different for each group of
customers, so that market separation is profitable.
To be able to achieve such market separation, there must be some barriers to prevent:

 Consumers moving from the expensive to the cheaper market
 Consumers in the cheaper market selling to consumers in the more expensive one

Third degree price discrimination tends to be found in many industries, but particularly transport.
Railway companies offer a variety of prices for a given journey in terms of class of travel, day of
travel, season of travel, time of travel and how many weeks in advance the journey was booked.

Low-cost airlines also offer low prices for journeys booked in advance with prices increasing the
closer the date of the actual journey and the proportion of seats unfilled. Those wanting to travel
closer to the time of the journey are willing to pay higher prices and their elasticity of demand is
lower.

3.4.5. Two-Part Tariffs

An alternative strategy, much used by monopolists, is to adopt a variation of second degree price
discrimination and use a two-part tariff, or pricing structure. This combines a fixed charge and a
variable rate. Such pricing is sometimes referred to as non-linear pricing.

Variations on such pricing structures are not only widely used in the telephone, electricity and gas
markets but also by sports clubs who charge a membership fee and a charge per session. There is also a

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practice of offering consumers of telephone services varying combinations of fixed charges and prices
per unit.

A higher fixed charge means that the consumer pays a lower unit price. This structure is intended to
encourage additional consumption, as the marginal cost of additional calls is lower than under a single-
price tariff. An extreme version of this strategy is a fixed charge and the zero consumption charge used
by, for example, internet providers.

A two-part tariff pricing strategy has been employed, in utility industries where the fixed charge is
designed to recover fixed costs and the variable element is intended to reflect more closely the marginal
cost of consumption. This encourages additional consumption, particularly in industries with high fixed
cost, declining average costs and excess capacity.

However, while the marginal price might more closely reflect the marginal cost of supply. This method
has adverse distributional consequences for those who consume small quantities, especially if these
consumers are the poorest members of the community. This is best observed in telecom sector,
electricity industry, and internet service providers. All of them charge a minimum rental, irrespective of
the usage. The variable component is charge based on the usage of the good.

3.4.6. Peak Load Pricing

When demand varies significantly by time of the day, the week or the year and costs of supply vary
with the level of demand, then price structures may be constructed to reflect the variations in costs or to
limit investment in capacity.

A hairdresser’s salon may find that demand for its services are significantly higher
on Friday and Saturday, so that demand exceeds the capacity of the establishment,
whereas on other days of the week demand is much less than capacity.

One way for the hairdresser to bring demand into line with available capacity is to
lower prices on Mondays to Thursdays and to increase prices on Friday and
Saturday.

If demand exceeds capacity sufficiently, then it may be in the interests of the firm
at some point to invest in new capacity, to employ more hairdressers and to meet a
higher level of demand. In this instance, the variation in price at peak is intended
to limit demand, so that the peak price is not explicitly related to costs.

The hairdresser is also exploiting differences in the willingness of individual
consumers to pay higher prices on peak days.

Time-of-day pricing in electricity at both peak and off-peak can be justified by cost variations because
electricity is produced by power stations. Electricity costs are higher at peak than at off-peak. Railway
pricing tends to be similar to that of the hairdresser, with higher prices at morning peak to restrict
demand and lower prices off-peak to encourage greater usage of unused capacity.
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In the electricity industry, price differences are justified by cost differences and are not regarded as
price discrimination. Whereas on the railways, differential pricing is regarded as price discrimination
because prices do not closely reflect cost differences.

3.4.7. Social Costs of Monopoly Power

• There is a loss of consumer surplus and a deadweight loss from monopoly pricing

• Government Regulation of Monopolies
Public ownership of natural monopolies, for example, Amtrak; U.S. Post Office; some publicly-
owned electric power companies; wireless internet service in some towns. This is typically
viewed as a bad idea. But the wireless internet service seems to be a success.

• Price regulation.
Unlike in the perfectly competitive market case, imposing a price ceiling on a monopolist is not
necessarily a bad thing.
• Imposing a price gap on a natural monopoly can increase consumer surplus.

3.4.8. Measure of Monopoly Power

A natural way to measure monopoly power is to examine the extent to which the profit-maximising
price exceeds marginal cost. In particular, we can use the mark-up ratio of price minus marginal cost to
price that we introduced earlier as part of a rule of thumb for pricing.

Measure of monopoly power was introduced by economist Abba Lerner in 1934 and is
called Lerner's Degree of Monopoly Power and is given by equation 3.5.

…… Eq. 3.5
P − MC
L=
P

where,
• Exhibit
L = Lerner’s
3.3 index
• P = Price
• Indian
MC = Insurance
Marginal cost
Market

Lerner’s
Theindex
Indian
always
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value between
was mainly
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1956isuntil
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For a perfectly
for private
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companies. firm,
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= MC so points
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show
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market share dominance by public sector and private sector:
Note: Considerable monopoly power does not necessarily imply high profits. Profit depends on average
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A private
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ICICI Lombard enjoys a whopping 53 % market share in Accident Insurance while the remaining
47 % is shared by New India Assurance and United India Insurance, both belonging to the public
sector. Page 17 of 29

Source: http://business.mapsofindia.com
3.4.9. Concentration Ratio

The concentration ratio of an industry is used as an indicator of the relative size of
firms in relation to the industry as a whole. It is calculated as the sum of the percent
market share of the top ‘n' firms.

The concentration ratio may also assist in determining the market structure of the industry. One
commonly used concentration ratio is the four-firm concentration ratio, or ‘C4’, which consists of the
market share, as a percentage of the four largest firms in the industry.

Another way of measuring monopoly power is using Herfindahl index. It is an economic concept,
widely applied in competition law, antitrust and also technology management.

Herfindahl index is defined as the sum of the squares of the market shares of the 50
largest firms (or summed over all the firms if there are fewer than 50) within the
industry, where the market shares are expressed as percentages.

The result is proportional to the average market share, weighted by market share. As such, it can range
from ‘0’ to ‘10,000’, moving from a huge number of very small firms to a single monopolistic producer.
Increases in the Herfindahl index generally indicate a decrease in competition and an increase of market
power, whereas decreases indicate the opposite.

The major benefit of the Herfindahl index in relationship to such measures as the concentration ratio is
that it gives more weight to larger firms.

Let us assume in a market 4 firms have a market share of 10% each and the remaining
is held by 60 firms, having a market share of 1% each. The Herfindahl (H) index of
the industry is:

5(10)2 + 50(1)2 = 500+50 =550

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3.4.10. Monopsony

Monopsony refers to the case where there is a single buyer for a good.

Some examples of monopsony are listed below:

• U.S. Government with military equipment
• U.S. Government and pharmaceutical drugs – NOPE
• Hospitals in small cities and nurses
• Wal-Mart and some consumer goods

According to monopsony, one can make a case for the minimum wage in the labour market case.

Oligopsony is a complementary form of oligopoly. According to oligopsony, there
are few buyers and large number of sellers wherein the other conditions remain the
same as oligopoly.

3.5. Monopolistic Competition
Monopolistic competition has characteristics of both competition and monopoly. It is similar to
competition where there are many firms and low entry and exit barriers. It also has characteristics of
monopoly such as the products are differentiated and each company faces a downward sloping demand
curve.

In the short-run,

• Marginal revenue is always less than demand
• Profit is maximised where MR = MC
• Profit = price (average total cost) x quantity

3.5.1. Long Run Equilibrium

In the long run, entry and exit of a company into competition are both possible. If profit is greater than
zero, businesses will enter the competition, and each company's market share will fall. As a result, each
company’s demand curve will decrease, along with price and quantity. If profit is less than zero,
businesses will exit, and each company’s market share will increase. This will cause the remaining
companies' demand curves to increase, along with the price and quantity.

Note: If profit is equal to zero, there will be no entry into or exit for the industry. In the long run, all the
companies' economic profits must be zero.

3.5.2. Monopolistic Competition and Welfare

The two main differences between a company in monopolistic competition and a company in perfect
competition (both in a long-run equilibrium and have profit equal to zero) are jotted down in the form of
a table 3.2.
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Table 3.2. Differences between a company in Monopolistic Competition and
a company in perfect Competition
Differences Monopolistic Competition Perfect Competition

Companies in monopolistic
Companies in perfect
competition produce where quantity
competition produce
of output is smaller and on a
Excess where average total cost is
downward sloping part of average
Capacity at a minimum (efficient
total cost (excess capacity) and could
scale)
increase capacity and lower average
costs.

For a monopolistic competition firm,
Make-up
price > marginal cost. There is a For a competitive firm,
Over
mark-up above MC even though the price = marginal cost
Marginal Cost
firm makes zero profits.

3.6. Oligopoly
Oligopolies lie between the perfect competition and pure monopoly. An oligopoly is where there are a
few sellers with similar or identical products. Monopolistic competition has many companies with
similar but not identical products, such as cigarettes, CDs, and computer games. Examples of
oligopolies include crude oil businesses and auto manufacturers.

The main behaviour in an oligopoly is that companies must take into account what other companies will
do. In perfect competition, firms are price-takers, whereas in a monopoly, there is only one firm, and it
does not take into account what competitors will do.

Oligopolists either:

• Cooperate to increase profits by obtaining the monopoly outcome or
• Compete to try to gain an advantage over competitors

3.6.1. Duopolies and Cartels

A duopoly is when there are only two businesses in a market. Their best outcome is to cooperate and
agree to restrict output to the monopoly quantity, where price is greater than marginal cost, and profit is
maximised. Usually, a duopoly trying to maximise profits will produce more than a monopolist but less

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than a competitive industry. Duopolies come from collusion where firms agree to share output and set
prices such as in a cartel.

A great example of a non-collusive duopoly is Coca-Cola and Pepsi Co. Both
have eliminated most of the other players. Another example is Airbus and
Boeing. Since 1970, the two companies, Airbus and Boeing, supported by their
respective governments, took their battle to every corner of the world to capture
greater share of the market. This often resulted in quarrels over trade practices
adopted by the two players. Both the US and European governments accused
each other of supporting the respective companies to drive the other out of
business.

A cartel is a group of companies acting in union, such as the Organisation of the
Petroleum Exporting Countries (OPEC).

If the competing companies cannot agree, then they may end up with the competitive position with
profits equal to zero. Cartels are known to restrict output quantities in order to raise prices, and
consequently profits.

3.6.2. Size of an Oligopoly and the Markets

Generally, the more companies in the industry, the harder it is to form a cartel and to enforce it. As the
number of companies increases, it takes a form of a competitive outcome, since each company has a
smaller market share. The mentality where each company tends to think only of its own profits and
strategic behaviour is reduced. Each company will increase production as long as price is greater than
marginal cost.

3.6.3. Game Theory and Prisoners' Dilemma

Game theory is the study of how people behave when they must consider the effect of other people’s
responses to their own actions. In an oligopoly, each company knows that its profits depend on actions
of other firms. This gives rise to the ‘prisoners’ dilemma’.

The game theory is commonly known as the ‘prisoners’ dilemma’. It is a situation
where two prisoners are being questioned over their guilt or innocence of a crime. They
are given two choices, either to confess to the crime and accept the consequences, or to
deny all involvement and hope that their partner does likewise.

The prisoners' dilemma is a particular game that illustrates the oligopoly situation, that is why it is
difficult to cooperate, even when it is in the best interest of both the companies. Both players select their
own dominant strategies for short-sighted personal gain. Eventually, they reach an equilibrium in which
they are both worse off than they would have been.

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The pay-off is measured in terms of years in prison arising from each of their choices. Table 3.3
summarises the prisoners’ dilemma. No communication is allowed between the two prisoners but
clearly they will take into account the likely behaviour of the other when under interrogation.

Payoffs shown in the matrix are years in prison from their chosen course of action.
Decisions are made under uncertainty.

Table 3.3. Prisoners’ Dilemma
Prisoner-A
Confess Deny

Each prisoner gets‘A’
Confess 3 gets
years1of
year,
punishment.
and ‘B’ gets 10 years of punishmen

Prisoner-B

‘A’ gets 10 years and ‘B’ gets 1 yearEach
of punishment.
prisoner gets 2 years.
Deny

Source: http://tutor2u.net.html

Two prisoners are held in a separate room and cannot communicate. They are both suspected of a
crime. They can either confess or deny the crime.

In the prisoners’ dilemma, the best strategy for each player is to confess since this is a course of action
which will minimise the average number of years they might expect to remain in prison. But if both
prisoners choose to confess, their pay-off, that is, 3 years each in prison is higher than if they both
choose to deny any involvement in the crime.

However, if both prisoners chose to deny the crime then each prisoner has an incentive to cheat on any
agreement and confess, thereby reducing their own stay in custody.

The equilibrium in the prisoners’ dilemma occurs when each player takes the best possible action for
themselves given the action of the other player. The dominant strategy is each prisoner’s unique best
strategy regardless of the other players’ action. A bad outcome; prisoners could do better by both
denying. But once collusion sets in, each prisoner has an incentive to cheat.

3.6.4. Real World Applications of Game Theory

We can apply ‘game theory’ analysis to study the behaviour of players operating in oligopolistic
markets relating the decisions regarding pricing of products and how much money to invest in research
and development activities, and so on.
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If a firm invests in costly research and development project which represent a risk another rival firm
need to decide whether to follow or not? They might lose the competitive edge in the market and suffer
a long term decline in market share and profitability. The best strategy for both the firms is to go ahead
with research and development (R&D) spending. If they do not and the other firm does, then their
profits fall and they lose market share.

However, there are only a limited number of patents available to be won. If all of the leading firms in a
market spend heavily on R&D, this may ultimately yield a lower total rate of return than if only one
firm opts to proceed.

Conventional economics assumes the structure of markets as fixed. With sellers and buyers assuming
that products and prices are fixed, they optimise production and consumption accordingly. Conventional
economics, therefore, does not capture people’s creativity in finding new ways of interacting with one
another.

The game theory assumes that the economy is dynamic and evolving. The players create new markets
and take on multiple roles. They innovate. No one takes products or prices as given. If this sounds like
the free-form and rapidly transforming marketplace, that’s why game theory may be the kernel of new
economics for the new economy.1

The prisoners’ dilemma is useful in explaining:

• Breakdown of price fixing agreements between producers
• Out-break of price wars among suppliers
• Break-down of joint ventures between producers
• Collapse of free-trade agreements between countries

3.6.5. Nash Equilibrium

Nash equilibrium is a set of strategies, one for each player operating in the market, such that no player
has incentive to change its action towards one’s own advantage. Players are in equilibrium if a change
in strategies by any one of them would lead that player to earn less. For games in which players
randomise (mixed strategies), the expected or average payoff must be at least as large as that obtainable
by any other strategy.

Mathematically, a Nash equilibrium of a strategic game is a profile of strategies

, where is the strategy set of player ‘i’, such that for each player ‘i’,
s1* , s 2 * , ......., s n * s i * ∈ S i (S i

∀ s i ∈ S i , u i (s i * , s − i * ) ≥ u i (s i , s − i * ),

1 Source: Brandenburger & Nalebuff- Foreword to Co-opetition (http://tutor2u.net/economics/)
Page 23 of 29
where, and
s −i = (s) j∈M|i| u i : S ≡ X j∈ N S j → R

Nash equilibrium has been used to analyse hostile situations such as war and arms races and also used
to know how conflict may be mitigated by repeated interaction.

Apart Caselet
from the1above, Nash equilibrium is also used to study the:

• Adoption of technical
Coordination standards
between Players with Different Preferences
• Occurrence of bank runs and currency crises
• Traffic
Two firmsflow
are merging into two divisions of a large firm, and have to choose the computer system
• toOrganising
use. In thethe auctions
past the firms have used different systems, I and A; each prefers the system it has
• Penalty
used kicks
in the in They
past. soccerwill both be better off if they use the same system then if they continue to
use different systems. We can model this situation by the two-player strategic game represented in
table 3.4. To find the Nash equilibrium, we examine each action profile in turn.

Table 3.4. Payoff Matrix for Two-Player Strategic Game
Player-2
I A

2, 0,0
I 1
Player-1
0, 1,
A 0 2

If (I, I) are considered:
Neither player can increase his/her payoff by choosing an action different from his/her current
one. Thus this action profile is Nash equilibrium.

If (I, A) are considered:
By choosing ‘A’ rather than ‘I’, player 1 obtains a payoff of ‘1’ rather than ‘0’, given player 2's
action. Thus, this action profile is not Nash equilibrium. [Also, player 2 can increase his/her
payoff by choosing ‘I’ rather than ‘A’.]

If (A, I) are considered:
By choosing ‘I’ rather than ‘A’, player 1 obtains a payoff of ‘2’ rather than ‘0’, given player 2's
action. Thus, this action profile is not Nash equilibrium. [Also, player 2 can increase his/her
payoff by choosing ‘A’ rather than ‘I’.]

If (A, A) are considered:
Neither player can increase his/her payoff by choosing an action different from his/her current
one. Thus, this action profile is Nash equilibrium.

We conclude that the game has two Nash equilibriums, (I, I) and (A, A).
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Source: http://www.economics.utoronto.ca/osborne/2x3/tutorial/NEFEX.HTM
3.7. Principal Agent Problem
The principal-agent problem or agency dilemma treats the difficulties that arise under conditions of
incomplete and asymmetric information when a principal hires an agent. For example, the problem that
the two may not have the same interests, while the principal is, presumably, hiring the agent to pursue
the interests of the former. This creates a potential for two outcomes notably moral hazard and adverse
selection.

Moral hazard is the prospect that a party insulated from risk may behave differently from the way it
would behave if it were fully exposed to the risk. An example could be cited of the insurance industry.
Insurance is a way of dealing with risk by pooling it.

Note: In insurance, a hazard that occurs without conscious or malicious action is called moral hazard.

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Insurance changes the costs of misfortune. People's choices depend on costs and benefits. Hence, we
can conclude that insurance should change people's behaviour. Change in behaviour makes people do
less effort to avoid misfortune. This change in behaviour is called moral hazard.

If an accident costs a person Rs.50, 000 but insurance pays Rs. 40,000, the insured
person has less incentive to avoid the accident. In an another situation, if the
accident costs the person Rs. 50,000 but he ends up paying Rs. 75,000, the person
not only has no incentive to avoid the accident but may have an incentive to seek it
out.

3.8. Adverse Selection

Adverse selection, anti-selection, or negative selection is a term used in economics,
insurance, statistics, and risk management. It refers to a market process in which
‘bad’ results occur when buyers and sellers have asymmetric information (that is,
access to different information).

The ‘bad’ products or customers are more likely to be selected. A bank that sets one price for all its
checking account customers runs the risk of being adversely selected against by its low-balance, high-
activity (and hence least profitable) customers.

Exhibit 3.4

Adverse Selection in Insurance

There can be a problem of adverse selection when there is asymmetric information between the
seller of insurance and the buyer of insurance. The problem is more intense when a buyer has
better knowledge about his/her risk of claiming than the seller. Ideally, insurance premiums
should be set according to the risk of a randomly selected person from the insured population, for
example, male smokers of certain age. This is nothing but the average risk of that group.

In the problem of adverse selection, people whose risk of claiming is higher than the average risk
of the group, will buy the insurance. Whereas, people will not buy the insurance if the risk of
claiming is less than the average risk of the group. This is because they will find the premium
expensive.

In this case, premiums set according to the average risk will not be sufficient to cover the claims
that eventually arise. The reason being that the people who have bought the policy are mostly
having above average risk.

Increasing the premium will not solve this problem, because increase in the premiums will make
insurance policy unattractive to more of the people who know they have a lower risk of claiming.
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One way to reduce adverse selection is to make the purchase of insurance compulsory, so that
those for whom insurance priced for average risk is unattractive are not able to opt out.
3.9. Uncertainty
Uncertainty refers to outcomes where estimates have been made but no probabilities can be attached to
the expected outcomes. This is because there is no experience to guide decision makers about possible
outcomes. Therefore, no objective probabilities can be assigned to outcomes, though subjective
likelihood or confidence levels can be ascribed on statistically unverifiable grounds.

The source of expected probabilities is the decision maker’s guesses and hunches about future patterns
of events (for example, future movements in interest rates).

Introducing a completely innovative product has to be based on positive expectations of how the
product might or might not sell, for example, the introduction of the home computer was successful,
though many firms tried but failed to sell sufficient machines and make a profit.

Similarly, the next major innovations in terms of new products or new technology which might
adversely affect the sales or costs of existing products may, at present, be completely unknown.

3.10. Wage Efficiency Theory
The efficiency wage hypothesis argues that wages, at least in some markets, are determined by more
than simply supply and demand. Specifically, it points to the incentive for managers to pay their
employees more than the market-clearing wage in order to increase their productivity or efficiency. This
increased labour productivity pays for the higher wages.

In other words, you will pay way above-average wages and attract the best employees to your
organisation. These bright workers will be very productive, more than most employees, because you
will have a group of the best and the brightest in your field working together. These workers, because of
their high wage and fear of losing it, would not be slacking off and there will be less risk of them
leaving to work elsewhere.

3.11. Summary

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Here is a quick recap of what we have learnt so far.

• In competitive markets, price taking behaviour arises because each individual firm is so small
relative to the total market. Further, all firms produce a homogeneous or perfectly standardised
output.
• Firms face perfectly elastic demand and possess no market power to change the price. The
demand curve is a horizontal line at the market determined price. It is also equal to firm’s
marginal revenue curve because price equals marginal revenue for a competitive firm.
• A monopoly exists if a single firm produces and sells a good or service for which there are no
close substitutes and new firms are prevented from entering the market in the long run, while
these conditions are rare, many firms do have the power to make price and output decisions in a
similar manner that monopolist chooses price and output to maximise profit.
• Market power is the ability of the firm to raise price without losing all its sales. Market power is
possessed in varying degrees.
• The profit maximising decision of the manager in a firm with market power resets on the
condition ‘MR=MC’.
• When the number of firms competing in a market is small any decision one firm’s makes about
pricing, output, expansion, advertising and so forth will affect the demand, marginal revenue
and profit conditions of every other firm in the market. Consequently profits of oligopolistic
firms are interdependent on each other.
• Strategic decision making means managers must estimate decisions of their competitors.
• Game theory offers solutions to decision making when interdependence makes it impossible to
ignore rival’s reactions to managerial decisions.

3.12. References
3.12.1. Book References

• Pindyck and Rubinfeld, Microeconomics, Prentice Hall publications, 6th edition, 2008, chapter
10 (pg 339 to 380), chapter 11 (pg 381 to 403), and chapter 12 (pg 435 to 472)
• Ahuja, Principles of Microeconomics, S. Chand Publications, 16th edition, 2008, chapter 21 (pg
429 to 445), chapter 23 (pg 458 to 486), chapter 26 (pg 519 to 543), chapter 28 (pg 558 to 583),
chapter 29 (pg 584 to 608), and chapter 31 (pg 623 to 635)
• Berheim and Whinston, Microeconomics, Tata Mc-Graw Hill Publications, 2009, chapter 17 (pg
602 to 643), chapter 18 (pg 644 to 677) and chapter 19 (pg 678 to 725)
• Mankiw, Principles of Microeconomics, Thomson Publications, 4th edition, chapter 15 (pg 311
to 344), chapter 16 (pg 345 to 372) and chapter 10 (pg 373 to 390)
• Krister Ahlersten, Microeconomics, chapter 9 (pg 65 to 73), chapter 11 (pg 77 to 81), chapter 12
(pg 82 to 84), chapter 13 (pg 85 to 91), chapter 14 (pg 93 to 97) and chapter 15 (pg 99 to 100)
http://bookboon.com/in/student/economics/microeconomics-uk

3.12.2. Web References

• Market Structure (video)
http://www.youtube.com/watch?v=xmPSwLmY1dQ&NR=1
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• Cartel (video)
http://www.youtube.com/watch?v=RihcRrezcjI&NR=1&feature=fvwp
• Play the prisoner's dilemma against five different "personalities."
http://www.gametheory.net/Web/PDilemma/
• Oligopoly Game Theory
http://tutor2u.net/economics/revision-notes/a2-micro-oligopoly-game-theory.html
• Nash equilibrium: bad fashion and bank runs (video)
http://www.youtube.com/watch?hl=en&v=Ac2vCCuf8-s

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