R12 Topics in Demand and Supply Analysis

Part 1

1.  Introduction
Economics is a discipline that deals with factors affecting the production, distribution, and
consumption of goods and services. It is divided into two broad areas: microeconomics and
macroeconomics.

Macroeconomics deals with the production and consumption of the overall economy. It

focuses on aggregate economic quantities such as gross domestic product, gross national
income, and national output.

Microeconomics deals with demand and supply of goods and services at a micro level, such
as individual consumers and businesses. According to microeconomics, private economic
units can be divided into two groups of study:

 The theory of the consumer that focuses on the consumption of goods and services.
 The theory of the firm that focuses on the supply of goods and services.

This reading focuses on microeconomics and covers the demand and supply side of the
market.

2.  Demand Analysis: The Consumer

2.1.     Demand Concepts
Demand is the willingness and ability of consumers to purchase a given amount of good or
service at a given price. The law of demand states that as the price of a good rises,
consumers will want to buy less of it. Similarly, as price falls, the quantity demanded
increases. Apart from the good’s own price, other factors that impact consumer demand
include prices of other substitute and complement goods, customers’ incomes, and
individual tastes and preferences.

The general form of a demand function is shown below:

Demand function for good A: QD = f(PA, I, PB … … )

where:

QD = quantity demanded of some good.

I = consumer’s income.

PA = price per unit of a related good A.

PB = price per unit of a related good B.

Let us take a hypothetical example of a demand function for the quantity of chairs
demanded in a small town. The demand function is given by:

QD = 10 – 0.5P + 0.06I – 0.01PT

In the equation above, I is the consumers’ income and PT is the price of tables. Note the signs of the
coefficients for income and price of tables. Chairs and tables are complementary products as they
sell together. The quantity demanded for chairs, QD, and price of tables, PT, are inversely related. If
the price of a table increases, then the quantity demanded for chairs decreases. Similarly, income has
a positive coefficient. If income increases, then the quantity demanded for chairs increases.
Now, let us assume that the consumers’ income and the price of the table are fixed at a
particular point in time. If the values of I and PT are 1633.33 and 800.00 respectively, then the
quantity demanded can be rewritten as:

QD = 100 – 0.5P

The inverse demand function expresses the simple demand function in terms of price. The
above function can be rearranged and expressed in terms of P as:

P = 200 – 2Q

A demand curve is a graphical representation of the inverse demand function. The demand
curve plots the price on the y-axis and the quantity on the x-axis.  It shows the quantity of a
good that consumers are willing to buy at any given price, all else equal.

Let us plot the demand curve given by the equation P = 200 – 2Q. Here, the intercept is 200
and the slope of the curve is -2. The slope of the demand curve is measured as the change
in price divided by the change in quantity.

Interpretation of the graph:

 The demand curve shows the highest quantity consumers are willing to purchase at
each price. When P = 200, the highest quantity consumers are willing to purchase is
0.
  Similarly, the demand curve also shows the highest price consumers are willing to
pay for each quantity. When Q = 50, the highest price consumers are willing to pay is
100.
 The slope of the demand curve is negative. This implies that as price decreases, the
quantity demanded increases.
 Movement along the demand curve: When a good’s own price changes, the quantity
demanded changes, all else equal. This change is called a movement along the
demand curve. For instance, as price increases from 100 to 110, quantity decreases
along the line (demand curve) from 50 to 45.
 Shift in the demand curve: A change in the value of any other variable will cause the
demand curve to shift. This is called change in demand. For instance, shift in demand
is caused by changes in consumers’ incomes, price of substitutes, and price of
complements.

2.2.     Own Price Elasticity of Demand

Own-price elasticity of demand can be expressed as the percentage change in quantity
divided by the percentage change in price.

Before we go further, let us refresh a basic mathematical principle. Consider a simple

equation:

A = 10 + 5B – 6C + 8D. Given this equation,  is equal to the coefficient of B which is 5.

Similarly,  is equal to the coefficient of C which is -6.

Going back to our demand function, QD = 100 – 0.5P. Based on the mathematical principle
we just discussed,   = -0.5. Assume the price is $60; the quantity demanded at this price
will be 70. The own-price elasticity of demand is: -0.5 x 60/70 = -0.4. This implies that when
the price is $60, a 1% increase in price results in a 0.4% decrease in the quantity demanded
for chairs.

Instructor’s Note

Own-price elasticity of demand is usually negative.

Elastic, Inelastic, and Unit Elastic

For all linear demand curves, elasticity varies depending on where it is calculated. Let us go
back to the own-price elasticity of demand for chairs to see which parts of the demand
curve are inelastic, elastic and unit elastic.

 Inelastic: When elasticity is less than one, demand is inelastic. At low prices, quantity
demanded is high. This causes the P/Q ratio to be small which results in low
elasticity.
 Unit elastic: An elasticity of 1 is said to be unit elastic.
  Elastic: When elasticity is greater than one, demand is elastic. At high prices, quantity
demanded is low. This causes the P/Q ratio to be high which results in high elasticity.

These scenarios are shown in the figure below:

Inference:

 The top part of the demand curve is elastic.

 Somewhere in the middle, it is unit elastic.
 The bottom part of the demand curve is inelastic.
 If the demand curve is steeper, it will be relatively more inelastic.
 If the demand curve is flatter, it will be relatively more elastic.

Extremes of Price Elasticity

There are two special cases of linear demand curves in which the elasticity is the same at all
points – perfectly elastic and perfectly inelastic – though it is difficult to find real life
examples. Demand is perfectly inelastic (represented by a vertical demand curve) when the
quantity demanded is the same over a price range. Demand is perfectly elastic for a given
price (represented by a horizontal demand curve) when a change in price will cause the
quantity demanded to reduce to zero.

Elasticity
Perfectly Elastic Perfectly Inelastic
Horizontal demand curve Vertical demand curve.
Elasticity = ∞ Elasticity = 0
A small change in price can lead to
infinitely large change in quantity. All A change in price has no change in quantity
producers must sell at the market price, or demanded.
else consumers will shift to substitutes. Example: generic food such as bread.
Example: Gourmet food items.
 

Factors that affect Demand Elasticity

The factors that help in determining whether the demand for a product is highly elastic are
as follows:

 Substitutes: If there are close substitutes for a good and the price of the good
increases, then the quantity demanded for the good will decrease substantially
implying the demand is highly elastic. If there are no close substitutes, the demand is
less elastic.
 Portion of budget spent on a good: If people spend a large part of their income on a
good, then the demand is likely to be elastic, e.g. cars. On the other hand, if people
spend only a small portion of their income on a good, then the demand is likely to be
inelastic, e.g. chocolates.
 Time horizon: Long-run demand is more elastic than the short-run demand for most
products as people take time to adjust their consumption (quantity demanded) to
the new prices. In the long run, consumers will find alternatives. For instance, if
prices of cars increase, consumers will find alternative modes of transport in the
long run.
 Discretionary vs. nondiscretionary : The demand for necessary goods is less elastic,
e.g. bread. While the demand for discretionary goods is more elastic, e.g. vacations.

Elasticity and Total Expenditure

Total expenditure is the total amount consumers spend on a product. It is the price
multiplied by the quantity.

Total expenditure = P x Q = Price per unit x quantity or number of units sold

Elastic demand: When demand is elastic, a 1% decrease in price causes a quantity

demanded to increase by more than 1%. As a result, total expenditure increases.

Inelastic demand: When demand is inelastic, a 1% decrease in price causes quantity

demanded to increase by less than 1%. As a result, total expenditure decreases.

Unit elastic: Total expenditure does not change at the point where demand is unit elastic.

The relationship between change in price and total expenditure is summarized in the table
below:

Elasticity and Expenditure

 Own-price elasticity of demand = 
Total expenditure = P x Q = Price per unit x quantity or number of units sold

Ed > 1: elastic demand Price and total expenditure move in opposite directions

Ed = 1: unitary elastic Change in price has no effect on total expenditure

Ed < 1: inelastic demand Price and total expenditure move in the same direction

Part 2

2.3.     Income Elasticity of Demand

Income elasticity of demand is the percentage change in the quantity demanded divided by
a percentage change in income, all else constant. It measures how sensitive the quantity
demanded is to changes in income. It is expressed as:

If income elasticity of demand is 0.6, then it means that for every 1% increase in income, the
quantity demanded will increase by 0.6%. While own-price elasticity is usually negative,
income elasticity of demand can be positive, negative, or zero.

Positive income elasticity means that as income increases, quantity demanded also
increases. Negative income elasticity means that as income increases, quantity demanded
for these goods decreases.

Based on income elasticity, goods can be categorized as normal or inferior:

 Normal good: Income elasticity is positive. That is, as income rises, quantity
demanded (consumption of the good) also rises.
 Inferior good: Income elasticity is negative. That is, as income rises, people buy less
of these goods. For example, bicycles in South Asia and fast food in US.

As discussed earlier a change in any variable other than own price would cause the demand
curve to shift. Therefore, a change in income will cause a shift in the demand curve.

2.4.     Cross-Price Elasticity of Demand

Cross-price elasticity of demand measures how sensitive the quantity demanded of a good,
X, is to changes in the price of another related good, Y, all else constant. The equation for
the cross-price elasticity of demand is similar to the own-price elasticity of demand except
that the denominator uses the price of another good, Y. It is expressed as:

Substitutes: Two goods are substitutes if one can be used instead of the other. The cross-
price elasticity of demand is positive for substitute goods.  An increase in the price of a
substitute good would increase the quantity demanded of the subject good.

Complements: Two goods are complements if they are used together. The cross-price
elasticity of demand is negative for complement goods.  An increase in the price of a
complement good would decrease the quantity demanded of the subject good. Example:
cereal and milk, and petrol and cars.

Example

A consumer’s weekly demand for coffee is given by the following demand function:

Assume the price of coffee is PA = 10, the price of tea is PB = 55, the price of lemon water is
PC = 10, and income is I = 2,000. Given this data, calculate the following:

1. Own-price elasticity of demand for A.

2. Income elasticity of demand for A.
3. Cross-price elasticity of demand of A against price of B.
4. Are A and B substitutes or complements?
5. Cross-price elasticity of demand of A against price of C.
6. Are A and C substitutes or complements?

Solution:

1. First, calculate the value of Q by plugging in the values for PA = 10, PB = 55, PC = 10, I =
2,000 in the demand function.
2.

1.
2.

3.
4.
5.  is the own-price elasticity coefficient, which is -0.4 from the equation.
6. So, own-price elasticity of demand = = – 1.333

2. Income elasticity of demand for A =

3. Cross-price elasticity of demand of A against price of B =
4. A and B are substitutes because as the price of B goes up, the quantity demanded of
A goes up. A positive relationship indicates the products are substitutes.
5. Cross-price elasticity of demand of A against price of C = = -0.5
 6. A negative relationship between the price of C and the quantity demanded of A
means the two products are complements.

2.5.     Substitution and Income Effects

The law of demand states that when a good’s own-price falls, its quantity demanded
increases, all else equal. Let us take an example of a hypothetical two-goods economy
consisting of bread and milk to understand the two reasons why quantity demanded rises
when price falls. Assume the price of bread decreases.  Bread is now cheaper relative to
milk, so consumers buy more bread. This is called the substitution effect. A lower price of
bread means the consumer has greater buying power, which implies that the real income
has increased. The change in income will impact how much bread consumers buy. This is
called the income effect.

2.6.     Normal and Inferior Goods

The table below summarizes the substitution and income effects of a price decrease for
normal and inferior goods:

Substitution Effect Income Effect

Buy more because when the good’s Buy more because there is an increase
Normal good price decreases, it is relatively cheaper in real income that increases the
than its substitutes. consumption.

Buy more because when the good’s Buy less because the increase in real
Inferior good price decreases, it is relatively cheaper income causes the consumer to buy less
than its substitutes. of the inferior good.

Giffen goods:

A Giffen good is an extreme case of an inferior good where the income effect dominates the
substitution effect. In this case, a decrease in price causes a decrease in quantity demanded
which implies a positively sloped demand curve. Hence Giffen goods are an exception to the
law of demand. The curriculum identifies rice in rural China as a possible Giffen good. When
the price of rice decreased, consumers in rural China with very low incomes decreased their
intake of rice and switched to alternatives such as meat that provided more calories.

Veblen goods

Like Giffen goods, Veblen goods also have an upward sloping demand curve and hence they
also violate the law of demand. However, the similarity ends there.  The characteristics of
Veblen goods are described below:

 Veblen goods are status goods; an increase in price increases the value to some
consumers and therefore their quantity demanded increases.
 Veblen goods are based on the concept of conspicuous consumption. This means
that consumers derive utility from the fact that others regard them as someone who
consumes an expensive good. As the price of such products increase, consumers will
 be inclined to purchase more to flaunt their affluence. For example, a Bugatti Veyron
car, a yacht, or a private island.

Part 3

3.  Supply Analysis: The Firm

3.1.     Marginal Returns and Productivity
Factors of production are the inputs used by a firm to produce goods and services. These
inputs include land, labor, capital, and raw materials. For simplicity, we will consider only
two inputs:

 Labor (L): skilled, unskilled, management personnel, etc.

 Capital (K): physical capital such as machinery, equipment, and tools used by labor to
produce output.

Before moving on, let us understand a few basic terms.

 Marginal product of labor: Increase in the quantity of output from an additional unit of

labor.
 Marginal product of capital: Increase in the quantity of output from an additional unit of
capital.
 Productivity: Average output per unit of input (such as labor or capital).
 Increasing marginal returns: Increase in productivity as the quantity of an input increases.
 Law of diminishing marginal returns: As more and more units of an input resource are
added, productivity will eventually decrease.

Cost of production. The total cost of production is given by the equation below:

where:
w is the wage rate per hour
L is the number of labor hours
r is the cost per hour of capital and
K is number of hours for which capital is used.
Two factors that lower the cost of producing at a given level of output are:

 Increase in input productivity.

 Decrease in input prices.
Total Product, Average Product, and Marginal Product
Total product is the total output from all inputs during a time-period. It is denoted by TP or
Q. Total product gives information about the total production of a firm during a time-period,
but reveals very little about how efficient the firm is.
Average product is the total product divided by the quantity of a given input.  It measures the
productivity of an input. The average product of labor is given by:   or  .
Marginal product is the amount of additional output resulting from using one more unit of
input, assuming other inputs are fixed. It is calculated by dividing the change in total product
by the change in the quantity of input. Hence, the marginal product of labor is:  or 
Let us take an example of three companies X, Y and Z whose total product and average
product of labor are given below:

Company Output (TP) Labor hours AP = TP/L

Company X 250,000 250 1,000

Company Y 450,000 500 900

Company Z 500,000 625 800

It is not possible to identify the most efficient company by looking at just the TP values. AP
is a better measure of efficiency. Company X has the highest AP and is therefore the most
efficient.
The table below shows TP, AP and MP of labor for a firm across different levels of labor:

Units of Labor (L) TP AP MP

1 100 100 100

2 210 105 110

3 300 100 90

4 360 90 60

5 400 80 40

6 420 70 20

7 350 50 -70

Interpretation:

 The total product (output) increases till the sixth unit of labor and declines when the seventh
unit of labor is added. Hence the total product is maximum (420) with 6 units of labor.
  When we go from one unit of labor to two units of labor the marginal product (MP)
increases. This implies increasing marginal returns. The marginal product for the second unit
of labor is calculated as: 
 When a third unit of labor is added the MP decreases. This implies diminishing marginal
returns.

3.2.     Breakeven and Shutdown Analysis

Economic profit vs. accounting profit
Economic profit is the difference between the total revenue and total economic costs. It is
also known as abnormal profit. Another definition of profit is accounting profit. Accounting
profit is the difference between the total revenue and total accounting costs.
Economic profit = Total revenue – Total economic costs
Economic profit = Accounting profit – Total implicit opportunity costs
Accounting profit = Total revenue – Total accounting costs
Economic cost considers opportunity costs, while accounting cost does not. Economic cost is
the sum of accounting cost and opportunity cost. Let us take an example. Assume Megan
starts a business with an equity capital of $100 million. The required return on the invested
amount is 10%.  Hence, the opportunity cost is 10% of $100 million = $10 million. If the
accounting cost is $190 million, then the total economic cost is $200 million. Continuing with
this example, if the revenue is $200 million, the economic profit is zero and the accounting
profit is $10 million. In this case, it can be said that the business is earning a normal profit of
$10 million.
Instructor’s Note:
In this reading, ‘cost’ refers to economic cost and ‘profit’ refers to ‘economic profit’.
If a firm’s revenue is equal to the firm’s total economic cost, the economic profit is zero and
the firm is said to be earning a normal profit.
Accounting profit = economic profit + normal profit.
Normal profit = implicit costs or opportunity costs.
Marginal Revenue
Marginal revenue is defined as the change in total revenue divided by the change in
quantity. It is the incremental revenue because of producing an additional unit per time-
period. It is expressed as:

We will now analyze marginal revenue under two market conditions: perfect
competition and imperfect competition.
Marginal revenue under perfect competition
In a perfectly competitive market:

 There are many buyers and sellers and the interaction between them determines the
equilibrium price.
  All the firms are relatively small and the products sold by the firms are identical, or
homogeneous.
 All the firms are price takers. They have no pricing power – that is, the individual consumers
and sellers cannot influence the market price of a good/service in any way.
 Any quantity of the product can be sold at the market price. But, a small increase in price
would mean losing all sales. Example: wheat.
 The demand curve is horizontal or perfectly elastic.
 In a perfectly competitive market, MR = AR = P. Price is constant. This implies that total
revenue increases by P if the quantity increases by one unit.

Marginal revenue under imperfect competition

In an imperfect competitive market:

 The firms sell differentiated products and have a large market share.
 There may not be any close substitutes.
 Marginal revenue intersects the x-axis at the point where total revenue is maximized.
 The marginal revenue and demand curve are downward sloping.

Marginal Cost
Marginal cost is the incremental cost of producing one more unit.  It can be calculated by
dividing the change in total cost by the change in quantity. It is expressed as:

Economists distinguish between short-run and long-run marginal cost. Short-run marginal
cost is the cost of producing an additional unit assuming only labor costs vary and all other
factors of production are constant. Short-run marginal cost is directly related to wage price
and inversely related to productivity. Short-run marginal cost,  . Long-run
marginal cost is the cost of producing one more unit assuming all factors of production are
variable.
Fixed and Variable Costs
Total cost can be broken down into fixed and variable costs. Fixed costs do not change with
the quantity of output.  Variable costs change with the quantity of output. Average variable
cost is the ratio of total variable cost to quantity. It is expressed as:

Profit Maximization
A firm’s profit is maximized at a level of output where marginal revenue is equal to marginal
cost (MR = MC).  If marginal revenue exceeds marginal cost, a firm can increase profits by
producing more. If marginal revenue is less than marginal cost, the firm should scale back. 
This discussion assumes that marginal cost is rising with increased output.
Understanding the Interaction between Total, Variable, Fixed, and Marginal Cost
and Output
All the graphs we look at in this section are from a short-run perspective. In the short
run, one or more factors of production are fixed. Usually capital is fixed in the short run
while labor may change. The graph below shows the cost curves for a firm in the short
run.

Interpretation of the graph:

 Total fixed cost is constant or flat for any given output level. It does not change as
production varies.
 Total variable cost increases as the quantity of output increases. For simplicity, it is assumed
to have a linear relationship with quantity. If there is no production, then TVC is zero.
 The total cost for any quantity of output is the sum of total fixed cost and total variable cost.
It also increases as production increases and the quantity of output increases.

The graph below shows the MC, ATC and AVC curves for a firm in the short run.
Interpretation of the graph:
AVC Curve

 The AVC curve is U-shaped but this can vary from company to company, or industry to
industry.
 As output increases, average variable cost falls to a minimum and then increases. It falls,
because the total fixed cost is distributed over a large number of units.

ATC Curve

 Like the AVC curve, the ATC curve is also U-shaped but higher than the AVC curve because:
o AFC is added to AVC for any given quantity of output.
o AVC increases more quickly than AFC decreases.
 The distance between the ATC and AVC for any output quantity will be AFC.

Marginal cost curve

 MC intersects AVC at its lowest point, S. The corresponding quantity is . MC is greater than
AVC beyond
 If the marginal cost of producing one more unit is less than the average variable cost (to the
left of the minimum point), then it will pull the AVC down.
 Similarly, if the marginal cost of producing one more unit is greater than the average
variable cost (to the right of the minimum AVC point), then it will pull the AVC up.
 The lowest point for the ATC is T, where MC equals ATC. Beyond T, MC is greater than ATC.

AFC

 The difference between ATC and AVC for any quantity will be AFC. AFC is also the total fixed
cost divided by the quantity.
 Average fixed cost falls as output increases because the numerator in the above formula is
constant while the denominator increases. Put differently, the total fixed cost is spread over
a larger output, so it slopes downward as output quantity increases.

Revenue under Conditions of Perfect and Imperfect Competition

Total revenue under perfect competition:

 Total revenue is the price multiplied by quantity (TR = P x Q).

 The firm has no pricing power, and price is decided by the market.
 The demand curve is horizontal and slope is zero.
 Market price is equal to marginal revenue, which is equal to average revenue. P = MR = AR.
 TR increases by the price for every incremental increase in output. The TR curve is linear and
positively sloped.

Total revenue under imperfect competition

 The firm has a large market share.

 The demand curve is downward sloping. The firm must decrease the price in order to sell
more.
  Total revenue increases with greater quantity. However, there is a quantity at which the
profit is maximized. Beyond this, any price decrease will result in a decrease in total revenue
as the effect of the decrease in price will be greater than the quantity sold.
 The TR curve for such a firm is initially zero, then it increases and subsequently decreases. It
increases when MR is positive and demand is elastic. It falls when MR is negative and
demand is inelastic. TR is maximum when MR is zero.

Profit Maximization, Breakeven, and Shutdown Points of Production

Profit is maximized when:

 Marginal revenue equals marginal cost. MR = MC.

 MC is rising.
 Alternatively, when the difference between total revenue and total cost is the greatest.

The graph below shows the TR, TC, demand curve, and profit maximization under perfect
competition.

Q is the profit maximizing quantity where MR = MC and MC is rising.

max 

Breakeven Analysis
A firm is said to breakeven under the following conditions:

 total revenue equals total costs (TR = TC).

 price (average revenue) equals average total costs (AR = ATC).

When a firm is operating at its breakeven point, the economic profit is zero.  It might still be
earning a positive accounting profit.
A perfectly competitive market with no barriers to entry will attract new entrants. The
increased competition will lead to increased output and lower prices in the long run where no
firm is able to earn an excess return or positive economic profit.
Instructor’s Note
If economic profit is zero, accounting profit is called normal profit.
Under perfect competition, firms earn only normal profits in the long run.
The Shutdown Decision
The relationships that show when a firm must operate or shutdown are given in the table
below:

Short-run effect of the relationship between price and ATC on a firm

Situation Short run Long run

Operate Operate

 but TR < TC Operate Exit

TR < TVC Shutdown Exit

 
Let us understand a firm’s breakeven and shutdown point using the graph below.

Interpretation of the graph:

 Assume the price at P3 is 150. If the competition is perfect, then P3 is the demand
curve and MR = AR.
 At any point on the MC between P2 and P3, the firm is profitable because the average
revenue is greater than the average total cost.
 The breakeven point is the point where P = ATC = MC. Graphically, it is the point
where MC intersects ATC. The corresponding quantity is the breakeven quantity, . Suppose
this price is 100.
 Between A and B, the price is greater than AVC. The firm will continue to operate in
the short run even though it is not profitable.
 To the left of A, the price is less than AVC. The firm will shut down.

Part 4

 
3.3.     Understanding Economies and
Diseconomies of Scale
Economists use two time horizons based on how firms are able to vary the quantity of input:
short run and long run. In the short run, at least one of the inputs or factors of production is
constant. In the long run, all factors of production are variable.

Short- and Long-Run Cost Curves

The graph below shows a set of short-run total cost curves for each level of capital input.

In the long run:

 All factors of production (both labor and capital) are variable.

 Think of the long-run total cost curve (LTC) as a combination of several STCs. By
drawing a tangent to the minimum point of all the SRATC curves and connecting
them, we get the LTC curve for the firm.
 The LTC is called the envelope curve. It envelops or encompasses all combinations of
technology, plant size, and physical capital.

Defining Economies of Scale and Diseconomies of Scale

Each STC curve has a corresponding short-run average total cost curve (SRATC). The STCs for
different plant sizes and the corresponding long-run average total cost curve (LRATC) is
shown in the exhibit below.

Interpretation of the graph:

  The SRATC defines what the per-unit cost will be for any quantity in the short run.
 The SRATC shifts down and to the right. Note that as plant size increases, the per-
unit cost decreases as can be seen in the case of SRATC
 The LRATC is derived from connecting the lowest level of STC for each level of
output.
 The shape of the long-run cost curve depends on whether the firm is facing
economies of scale or diseconomies of scale.
 Economies of scale is the decrease in the long-run cost per unit as output increases.
LRATC has a negative slope when there are economies of scale. The portion to the
left of Q3 represents economies of scale.
 Q3 represents the minimum efficient scale. It is the output level at which the long-
run average total cost is the lowest and the output is optimal. This portion exhibits
constant returns to scale where long-run average total costs do not change as
output quantity increases.
 Beyond Q3, the LRATC goes up. This portion represents diseconomies of scale. Here
there is an increase in long-run cost per unit as output increases. LRATC has a
positive slope when there are diseconomies of scale. The right side of LRATC curve
represents diseconomies of scale.

The factors contributing to economies of scale and a lower ATC are as follows:

 Increasing returns to scale: increase in output is relatively larger than the increase in
input. The left side of Q3 shows increasing returns to scale.
 Division of labor/management.
 Technologically/economically efficient equipment that results in increased
productivity.
 Effective decision-making.
 Reduce waste and lowering costs through better quality control.
 Bulk purchases resulting in lower prices.

The factors contributing to diseconomies of scale are as follows:

 Decreasing returns to scale: Increase in output is relatively less than the increase in
input. The right side of Q3 shows decreasing returns to scale.
 Higher resource costs due to supply bottlenecks.
 Improper management because of size.
 Duplication of product lines.
 Higher labor costs.

R13 The Firm and Market Structures

Part 1
 

1.  Introduction
This reading covers:

 Analysis of market structures: degree of competition, how the management

determines pricing and output strategy.
 Characteristics, demand, supply, optimal price, and output for different types of
market structures: perfect competition, monopolistic competition, oligopoly, and
pure monopoly.
 Techniques used by analysts to identify what market structure a firm is operating in.

2.  Analysis of Market Structures

The market is defined as a group of buyers and sellers that are aware of each other, and are
able to agree on a price for the exchange of goods and services.

2.1. Economists’ Four Types of Structures

The market structure is classified into the following four categories:

 Perfect competition
 Monopolistic competition
 Oligopoly
 Monopoly

Perfect competition and monopoly are two extremes of the market structure in terms of
number of firms and profits with the other types falling somewhere in between.

2.2. Factors that Determine Market Structure

The five factors that determine market structure are:

 The number and relative size of firms supplying the product. The higher the number
of firms, the higher the degree of competition.
 The degree of product differentiation.
 Pricing power of the sellers. Are they price takers, or can they influence market
prices?
 The relative strength of the barriers to market entry and exit.
 The degree of non-price competition.

The table below summarizes the basic characteristics of the four market structures:
 Perfect Monopolistic
  Oligopoly Monopoly
Competition Competition

Number of Sellers Many firms Many firms Few firms Single firm

Barriers to Entry
Very low Low High Very high
and Exit

Product Substitutes but Close substitutes

Homogeneous Unique product
Differentiation differentiated or differentiated

Advertising and Advertising and

Non-price
None product product Advertising
Competition
differentiation differentiation

Some to
Pricing Power None. Price taker. Some Considerable
significant

Electricity
provider/any
utility company
Prices of
(water, cooking
Oranges; Milk; commercial
Example Toothpaste gas) as they are
Wheat airlines for a given
typically
route
controlled by a
government
authority

Note: This table is  important from an exam perspective.

The most preferred market structure by producers is monopoly/oligopoly because they

offer the highest pricing power. The most preferred market structure by consumers is
perfect competition as prices are lower.

3.  Perfect Competition

The characteristics of perfect competition are as follows:

 There are a large number of potential buyers and sellers.

 The products offered by the sellers are homogenous i.e. they are identical.
 There are few or easily surmountable barriers to entry and exit.
 Sellers have no market-pricing power. Each firm is so small relative to the market
that it does not have any influence on market prices.
 Non-price competition is absent.

3.1. Demand Analysis in Perfectly Competitive

Markets      
The graph below shows the market demand curve for a perfectly competitive market. Here
price is plotted on the y-axis and quantity on the x-axis and the market demand curve is
downward sloping:

To understand this curve, let’s assume that the market demand is given by the following
equation:

Q = 50 – 2P where Q = quantity demanded and P = product’s price.

Rearranging, we get P = 25 – 0.5Q

Total revenue: TR = P * Q = 25 Q – 0.5Q2

(Using calculus, the first derivative of 0.5 * Q2 is 2 * 0.5 * Q = Q)

We derived this based on two assumptions which are often not true in the real world:

 Only price determines quantity demanded.

 A linear relationship between price and quantity demanded.

Movement along the demand curve happens only if the price and quantity demanded of the
product changes, all else constant. If any factor other than price/quantity demanded
changes, then there is a shift in the demand curve. For instance, an increase in income will
cause the demand curve to shift up.

Elasticity of Demand

Price elasticity of demand measures the sensitivity of quantity demanded to a change in

price. It depends on the following three factors:

Factors affecting price elasticity of demand

Elasticity is high if there are more close substitutes i.e. customers

are more sensitive to price changes. If the price of a substitute goes
Substitutes
down, the quantity demanded of the substitute goes up and the
quantity demanded of the original product goes down.
 The greater the share, the higher the price elasticity.

Ex: Expensive goods such as cars are highly elastic.

The share of the consumer’s
budget spent on the item Grocery essentials such as cereals, sugar and salt are inelastic.
A 10% increase in the price of cars and cereals will affect the
demand for cars but not that of cereals.

The longer the period, the higher the elasticity.

Length of time within which
demand schedule is being Ex: If the price of cooking gas increases, the demand will not
considered change much in the short run; however, demand will decline in
the long run as consumers switch to electric stoves.

Numerically, price elasticity of demand falls into three categories:

Price elasticity of demand

|ε| > 1; a 1% change in price will cause a more than 1% change in

Elastic demand
quantity demanded. Ex: furniture (ε = 3.15).

Unitary elastic demand |ε| = 1

|ε| < 1; a 1% change in price will cause a less than 1% change in

Inelastic demand
quantity demanded. Ex: coffee (ε = 0.16).

Special Cases

Perfectly elastic or horizontal Horizontal demand curve. At a given price, quantity demanded is
demand schedule infinite. ε = ∞. Ex: corn.

Perfectly inelastic or vertical Vertical demand curve. Quantity demanded is fixed irrespective of
demand schedule price. ε = 0. Ex: insulin.

Income elasticity of demand is the percentage change in the quantity demanded, divided
by a percentage change in income, all else equal. It measures how sensitive the quantity
demanded is to changes in income.

 For normal goods, income elasticity is positive.

 For inferior goods, income elasticity is negative.

Cross-price elasticity of demand measures how the quantity demanded of a good

changes when there is a change in the price of another good.

 If the cross price elasticity is positive, then the two products are substitutes. Ex:
cereals and oats.
 If the cross price elasticity is negative, then the two products are complements. Ex:
cereals and milk.
Instructor’s Note: Changes in own price causes a movement along the demand curve,
whereas, changes in income and price of substitutes cause a shift in the demand curve.

Part 2

3.2. Supply Analysis in Perfectly Competitive

Markets
When market prices increase, firms supply greater quantities. The market supply curve is
the sum of the supply curves of the individual firms. Some key terms (covered earlier) are:

 Economic costs: These include all explicit costs and implicit opportunity costs that
are required to acquire a resource or keep it in production.
 Opportunity cost: This is the value of the next best opportunity that is foregone
when another alternative is chosen. For example, if a stay-at-home mom was
employed, she would earn $90,000 a year. In this case, the mother staying home had
given up the opportunity to work, and with it an income of $90,000.
 Economic profit = total revenue minus opportunity cost.

3.3. Optimal Price and Output in Perfectly

Competitive Markets
To determine the equilibrium price and quantity, we must equate market supply and
demand functions. Say for a given industry the demand function is: P = 25 – 0.5Q D and the
supply function is P = -2 + 0.2QS. We would solve for the equilibrium quantity and price by
using the equation: P = 25 – 0.5QD = -2 + 0.2QS. Solving for Q, we get 38.57. Similarly, P = 5.71.

The equilibrium (optimal) price and quantity are 5.71 and 38.57 respectively. Each firm is a
price taker, which means each firm in the market must sell the product at 5.71. The
equilibrium price is determined by the market and each firm is too small to influence the
price. If a firm decides to sell the product at 6 instead of 5.71, then it will not find any
consumers who are willing to buy at that price. The quantity produced by each firm is not
determined by the market. A firm may produce 10 or 10,000 units of the product to sell at
5.71 each. The optimal quantity is determined by the firm’s cost curves.

The graph below plots MC and ATC curves for an individual firm in a perfectly competitive
market selling oranges at the market price of 5.71.

Interpretation of the graph:

 This graph plots cost per unit on the y-axis and output quantity on the x-axis.
 Generally, cost curves are U-shaped because of the law of diminishing returns. The
cost of selling oranges comes down as the quantity increases until it reaches a
minimum. Beyond that point (optimal quantity), increasing the output quantity
increases the cost.
 MC curve intersects the ATC curve at its minimum point.
 The horizontal line shows the market price of 5.71. It is also the marginal revenue,
average revenue and the demand curve (perfectly elastic). P = MR = AR = D.
 Profit-maximization condition: The firm’s profit-maximizing condition is MR = MC.
The corresponding quantity is QC.
 Link between a firm’s supply and MC curve: A firm’s supply curve is the portion of the
firm’s MC curve above the minimum point of its AVC curve. This is the upward-
sloping portion of the MC curve.
 Assume the market price of oranges comes down to 4, the total fixed cost is 0, and
the variable cost of producing each orange is 5; ATC is 5. So, will the firm sell
oranges? No, as the cost is more than the market price. The supply will be zero. That
explains why the firm’s supply curve is an MC curve above the minimum point of
ATC.
 Economic profit = TR – TC.

3.4. Factors Affecting Long-Run Equilibrium in

Perfectly Competitive Markets
  Let us continue our orange example. Other firms will be attracted to enter the
market to sell oranges when they see this firm makes a positive economic profit. This
means more output (supply of oranges), which shifts the supply curve to the right.
 For a given demand curve, the supply curve shifts to the right. Because of the
increase in output quantity, the price comes down.
 In the long run, the firm will operate at a point where equilibrium price = MC = MR =
minimum ATC. Economic profit will be zero because TR = TC. As economic profit is
zero, no more firms will enter the perfectly competitive market.

4.  Monopolistic Competition

This is a market where there are many sellers of slightly differentiated products. Product
differentiation is the key here.  Ex: Burgers sold by KFC, McDonalds, Burger King, etc.

If the firm is able to successfully differentiate the product (e.g. Harley Davidson
motorcycles), then the firm acts like a small monopoly.

Characteristics:

 There are a large number of potential buyers and sellers.

 The products offered by each seller are close substitutes for the products offered by
other firms, and each firm tries to make its product look different.
 Entry into and exit from the market is possible at fairly low costs.
 Firms have some pricing power.
 Firms differentiate their products through advertising and other non-price strategies.

4.1. Demand Analysis in Monopolistically

Competitive Markets
The graph below shows the marginal cost (MC), demand and marginal revenue (MR) curve
for a monopolistic firm.
  Since the products are unique, a monopolistic firm has a downward sloping demand
curve. MR is steeper and lies below the demand curve.
 Let us consider the toothpaste market. If consumers believe using Sensodyne
toothpaste will relieve them of toothaches, then they will buy the product. However,
the firm will have a downward sloping curve because if the prices are very high, then
consumers will not buy the product, and will look for alternatives. Conversely,
demand increases when the price decreases.
 Price and quantity demanded are inversely related.
 In the short run, the profit-maximizing quantity is MR = MC. This is Q1 in the graph.
The price is then determined based on the demand curve. This is P1 in the graph.
 Because the product is differentiated, firms have some pricing power and charge
what is determined by the demand curve. But each time a new firm enters the
market, the demand curves of other firms fall (i.e., they lose a part of the market
share). Since there is high competition, the products are often priced closed to each
other.
 Demand is elastic at higher prices and inelastic at lower prices.
 Total revenue = P1 * Q1
 Cost = C1 * Q1
 In the short run, economic profit = (P1 * Q1) – (C1 * Q1)

4.2. Supply Analysis in Monopolistically

Competitive Markets

4.3 Optimal Price and Output in Monopolistically

Competitive Markets
Key points related to supply analysis in the context of monopolistic completion are:

 Output is based on MR = MC.

 Price is determined based on the demand curve.
 The supply function is not well-defined in monopolistic competition.
o Recall that in perfect competition, a firm’s output does not affect the price as
all units sell at the same price (horizontal demand curve). They are price
takers. P = MR = MC. But, how much a firm produced was dependent on its
 MC curve. In the short run, the firm’s supply curve was the MC curve above
the minimum point of the AVC curve. The MR curve was a flat line and the
same as the market price at that point.
o But, in monopolistic competition there is no single price as the firm can set its
own price, and does not have to take the price determined by the market.
The price here is determined by the demand curve. The firm’s supply curve
must show the quantity the firm is willing to supply at various prices, which is
not shown by the MC curve here. MR is a downward sloping curve. The
optimal output is still the intersection of MR and MC.
 Prices are higher and quantity is lower relative to perfect competition (covered in the
next section).
 Total profit = TR – TC.

4.4. Factors Affecting Long-Run Equilibrium in

Monopolistically Competitive Markets
The graph below shows the long-run marginal cost (MC), long-run average cost (ATC),
demand and marginal revenue (MR) curve for a monopolistic firm.

Interpretation of the graph:

 The solid lines show the original demand and MR curves.

 The dashed lines show the shift in the demand and MR curves when a new firm
enters the market.
 Short-run economic profits of existing firms encourage new firms to enter the
market as the barriers to entry are low. When new firms enter, the demand curve
shifts to the left and the market share of existing firms falls. The number of products
in the market increases.
 In the long run, firms will enter and exit until P = ATC. At this point, economic profit
will be zero and there will no longer be an incentive for new firms to enter the
market. Therefore, long-run equilibrium is established.
 QMC and PMC are the equilibrium quantity and price respectively, for monopolistic
competition. QPC and PPC are the equilibrium quantity and price respectively, for
perfect competition. As you can see, the equilibrium price is higher and the quantity
is lower for monopolistic competition.

The table below summarizes the similarities and differences between perfect competition
and monopolistic competition.
 Perfect Competition (PC) vs. Monopolistic Competition (MC)

Similarities Ways in which MC is different from PC.

In the long run, profit-maximizing output

Long-run economic profit is zero
quantity of MC is lower than PC.

Economic cost in MC includes advertising cost for

Profit-maximizing output: MR = MC
product differentiation.

PC is efficient as surplus is maximized.

PC: Price = Marginal Cost

MC: Price > Marginal Cost
Deadweight loss in MC because firms have
some amount of pricing power and consumer
surplus is lost.

Prices are lower in PC, but consumers have little

variety.

Part 3

5.  Oligopoly
An oligopoly market has few sellers of a product and many buyers. These sellers are large
players in their industry who determine the prices or quantities. For example, credit card
companies such as Visa, MasterCard, and Amex.

Characteristics:

 There are a small number of potential sellers.

 The products offered by each seller are close substitutes for the products offered by
the other firms and may be differentiated by brand or be homogeneous and
unbranded.
 Entry into the market is difficult with fairly high costs and significant barriers to
competition.
 Firms typically have substantial pricing power. Since there are very few firms, the
pricing decisions are interdependent. Whenever a firm makes a decision, it must
take into account how the competing firms will react.
  Products are often highly differentiated through marketing, features, and other non-
price strategies.
 The pricing is strategic and firms in an oligopoly have a temptation to collude.

5.1. Demand Analysis and Pricing Strategies in

Oligopoly Markets
If firms collude, the total market demand is divided among the individual participants. The
firms act like a cartel and decide how to divide the demand, and what price to set for the
products in order to maximize profit.

If firms do not collude, each firm faces an individual demand curve and a market demand
curve. There are several models that try to explain pricing in oligopoly markets:

 Pricing interdependence
 Cournot assumption
 Nash equilibrium
 Stackelberg model

Pricing Interdependence – Kink Demand Curve

According to this theory, a competitor will not follow a price increase, but will cut prices in
response to a price decrease.

Example: Let us assume a town has two cola suppliers: Coke and Pepsi. This type of
oligopoly is called a duopoly. Now, assume the initial equilibrium price of 1 liter Coke bottle
is 100 and the quantity is 5000.

Effect of price increase: If Coke increases its price from 100 to 105, what will Pepsi do?
According to the interdependence theory, Pepsi will not increase the price and consumers
will switch from Coke to Pepsi. The quantity demanded of Coke will decrease (see the elastic
portion of the demand curve).

Effect of price decrease: Instead, if Coke decreases the price to 95, then Pepsi will also
decrease the price to 95. The quantity demanded of Coke will increase when the price
decreases, but not by much because there is no substitution effect. Consumers do not
switch from Pepsi to Coke as both are selling at the same price. To the right of the kink, the
demand curve is inelastic.
Some important points:

 There are two different demand curves in the model; combining them gives us the
overall demand, which is a kinked (bent) curve. A kink in the demand curve leads to a
discontinuous (with a gap) marginal revenue curve. One part of the MR curve
corresponds to the price increase part of the demand curve and the other to the
price decrease part of the demand curve.
 Profit-maximizing rule: MR = MC.
 Equilibrium price and quantity do not change so long as the marginal-cost curve of
the firm falls between the gaps in the MR curve.
 The MC must change considerably for the firms to change their price.
 Advantage: The model helps explain stable prices.
 Disadvantage: It does not tell us what the prices should be.

Cournot Assumption

Firms compete simultaneously to determine a profit-maximizing output, based on the

assumption that the other firms’ output will not change.  In the long run, change in price or
quantity will NOT increase profits. As the number of firms in an oligopoly increase, the
equilibrium point moves closer to perfect competition.

Assume there are two firms with the output levels q1 and q2 respectively. Firm 1 chooses its
output as q1 to maximize profit based on the assumption that firm 2’s output level q 2 is
constant in the future. Similarly, firm 2 chooses its output as q2 to maximize profits by
assuming that firm 1’s output level is constant. Firms choose q1 and q2 simultaneously. Let us
now look at the price and quantity numbers associated with the Cournot assumption.

 With a monopoly, the price is highest and quantity is lowest.

 In a perfect competition market structure, the price is lowest and quantity is highest.
 In a duopoly market characterized by the Cournot assumption, both the price and
quantity will lie somewhere in between. As the number of firms increase, the
equilibrium point moves towards perfect competition.

The Nash Equilibrium in a Duopoly Market

Unlike perfect competition, in oligopoly there is a lot of strategic interdependence between

firms. Since the number of firms are few, the actions one takes affects the others.
Nash Equilibrium: A set of choices/strategies among two or more participants is called a
Nash equilibrium if, holding the strategies of all other participants constant, no participant
has an incentive to choose a different strategy. In an oligopoly, firms arrive at an equilibrium
strategy after considering the actions of other firms (interdependence). Once they arrive at
equilibrium, no firm wants to change its strategy.

Assumptions made in Nash equilibrium:

 The firms do the best they can, given the actions of their rivals.
 The actions are interdependent.
 The firms do not cooperate (collude); each firm wants to maximize its own profits.

Example: WesCo and RifCo sell a similar product. Each company can employ a high-price
strategy or a low-price strategy. The profit for each strategy is shown. What is the Nash
equilibrium?

The four possible strategies are shown in the four boxes. For example, box 1 on the top-left
corner has WesCo adopting a low price strategy and RifCo adopting a low price strategy as
well. The profit for WesCo is 50 and that for RifCo it is 70. At any point in time, the
companies can be in only one box. It is not possible for WesCo to adopt a low price strategy
with profit of 50 (box 1) and RifCo to adopt a high price strategy with profit of 0 (box 2).

No matter where the companies start, they will end up in box 4 (lower left box).

Let’s start with box 1. The total profit of WesCo and RifCo is 120. They are both selling the
products at a lower price. It is in WesCo’s best interest to increase prices, and their profits
jump from 50 to 300 in box 4. It is in RifCo’s best interest as well if WesCo increases the
price, as RifCo can also increase the price. RifCo’s profit jumps from 70 to 350. The
combined profit of box 4 now is 650.

The combined profits are the highest in box 3, which is 800. Both the companies are
charging high prices. Box 3 is in WesCo’s best interest as it earns its maximum profit of 500,
but it’s possible only if RifCo also charges the high price. But RifCo is not happy here and
would lower the prices to increase its profit from 300 (box 3) to 350 (box 4).

When RifCo lowers its price to make a profit of 350 in box 4, WesCo’s profit falls from 500 to
300. The Nash equilibrium position in box 4 is what they arrive at finally.

Can both companies be better if they collude? Yes, if both the companies agree to collude
and charge high prices. If WesCo and RifCo agree to split the maximum profit of 800 equally,
then each company makes a profit of 400, which is better than the Nash equilibrium profit
of 300 and 350 profit respectively. Companies are said to form a cartel when they engage in
collusive agreements openly.
Factors that affect the chances of successful collusion:

1. Number and size of sellers: The number of firms should be small.

2. Similarity of products: Products must be homogeneous.
3. Cost structure: Firms must have a similar cost structure.
4. Order size and frequency: Orders must be small and frequent.
5. Retaliation: Threat from competitors is weak.
6. Degree of external competition: High external competition.

Stackelberg Model

There is one dominant large firm and many small firms. The large firm sets the price and
has the first mover advantage.

In the Stackelberg model, the decision-making happens sequentially (recall it happens

simultaneously in the Cournot assumption). The leader firm chooses the output first and
then the follower firm chooses its output.

5.2. Supply Analysis in Oligopoly Markets

The curriculum discusses the supply analysis for only one type of oligopoly – the dominant
firm oligopoly.

 As in monopolistic competition, the supply function is not well defined.

 We cannot determine equilibrium output and price without considering the demand
function and competitive strategies.
 Profit-maximizing condition: MR = MC.
 The equilibrium price is based on the demand curve.

Example: Say we have an oligopoly market where one firm has a significantly lower cost of
production than its competitors and has a 40% market share. A dominant or leader firm is
a firm with at least 40 % market share, greater capacity, lower cost structure, and is price
maker. A follower firm is a small firm that is a price taker – i.e. it accepts the price set by the
leader firm. Let us say there are five such firms in this market.

The graph below shows the quantity that will be supplied and the price charged by the
market leader, as well as by the other firms.

Interpretation of the graph:

  Price is plotted on the y-axis and quantity on the x-axis.
 The solid line represents an aggregate market demand. The following are the curves
for the dominant firm:
o Dashed line – the demand curve.
o MRL – the marginal revenue curve; it lies below the demand curve and is
steeper
o MCL – the marginal cost curve.
o PL – optimal price.
 Assuming the other five firms will take the price established by the leader, the overall
market demand is given as QT. The small/follower firms have no incentive to slash
prices as it will lead to price wars with the leader, who is a low-cost producer.
 Quantity supplied by the leader firm = QL; quantity supplied by the other firms = QT –
Q L.
 Notice that the demand curves of the industry and of the dominant firm are not
parallel to each other. As the price decreases, the difference between the curves
diminishes. The reasons are:
o The dominant firm is a low cost producer. When prices start falling, the other
smaller firms exit the industry because they do not want to sell below cost.
o The dominant firm gets a greater market share as other firms exit, and
QL (quantity supplied by the leader) increases.

5.3. Optimal Price and Output in Oligopoly

Markets
There is no single optimum price and output model that works for all oligopoly market
situations because of different strategies and pricing methods. The process for determining
the optimal price for a few methods is listed below:

 Kinked demand curve: Price at the kink in demand function.

 Dominant firm: Price at the quantity where MR = MC. Followers take the leader’s
price.
 Cournot assumption: No changes in price and output by other firms once the
dominant firm chooses its output level where MR=MC.
 Nash equilibrium: Each firm acts in its best interest under the given circumstances.
No certainty of price and output level.

5.4. Factors Affecting Long-Run Equilibrium in

Oligopoly Markets
Long-run economic profits are possible, but empirical evidence suggests that over time the
market share of the dominant firm declines.

Part 4
 

6.  Monopoly
This is a market structure in which a single company makes up the entire market. It is on the
opposite end of the spectrum as compared to perfect competition.

Characteristics:

 Single seller of a highly differentiated product.

 No close substitute.
 Significant barriers to entry.
 Considerable pricing power.
 Product is differentiated through non-price strategies such as advertising.

Ex: Government created monopolies such as electricity or water supply in a major city.

How monopolies are created:

 Patent or copyright.
 Control over critical resources – Ex: De Beers’ control of mining resources in South
Africa.
 Government authorization – Ex: utilities like electricity, water, etc.
 Strong brand loyalty which creates high barriers to entry (Rolex watches).
 Network effect (Microsoft).

A natural monopoly is one where cost decreases with quantity. The firm is able to meet
most of the quantity demanded at a low cost, making it difficult for new firms to enter the
market.

6.1. Demand Analysis in Monopoly Markets

The demand curve in a monopoly is downward sloping. Let us take the example of
electricity. As a consumer, the quantity demanded is still dependent on the price. To sell an
additional unit of the good, the producer must lower the price to increase quantity. This
explains why the demand curve is downward sloping.

Let us say the quantity demanded is given by:

Q = 400 – 0.5P

Rewriting the demand function, we get P = 800 – 2Q

TR = P * Q = 800Q – 2Q2

MR =    = 800 – 4Q

AR = 800 – 2Q

The average revenue for a demand curve is the same as the demand curve.
6.2. Supply Analysis in Monopoly Markets
The graph below shows the demand, MR, AC, and MC curves for a monopoly firm.

The profit maximizing level of output, Q, is when MR = MC. The corresponding price, PE, at
this level of output is determined by the demand curve.

Profit is based on the demand curve = TR – TC. Let’s say TC is given by:

TC = 20000 + 50Q + 3Q2 (the TC equation will be given; you need not derive it)

From TC, we can derive MC =   = 50 + 6Q.

Given the total cost function, you can derive the MC curve as shown above. Supply and
demand can be equated to determine the profit-maximizing output.

800 – 4Q = 50 + 6Q

Q =   = 75

6.3. Optimal Price and Output in Monopoly

Markets
In the previous section, we calculated the optimal output by equating MR = MC.
Another way of determining the profit-maximizing output is to equate  = 0. At this point
there is no change in profit when output changes.

The price at the profit-maximizing output level of 75 is:

P = 800 – 2 (75) = 650

If π = -20000 + 750Q – 5Q2, at what quantity is profit maximized?

= 750 – 10 Q.

Equating it to 0, we get 750 – 10Q = 0 → Q = 75.

Relationship between MR and price elasticity is: MR = P [1-  ]

Profit maximization condition in monopoly: MR = MC

MC = P [1-  ]

Profit-maximizing price = 

If MC = 75 and the own price elasticity of demand = 1.5, what is the profit-maximizing price?

Profit-maximizing price =   = 225.

Natural Monopoly in Regulated Pricing Environment

A natural monopoly is a market where the average cost of production falls over the relevant
range of consumer demand. There are three possible cases for output and pricing:

Natural Monopoly Under Different Environments

Case Condition Output Price Comments

Profit is maximized by
PM (the corresponding
No regulation producing this output. Notice
LRMC = MR QM price on the demand
of monopoly. that the price is highest and
curve)
quantity produced is lowest.

Perfect P = MC QC PC Quantity produced is higher

 while the price is lower. Price
does not cover the average cost
of production, and there is an
competition
economic loss. So the
government must subsidize the
monopoly: LRAC- PC

Set price such The monopoly earns a normal

Regulated
that LRAC = QR PR profit, i.e. economic profit is
monopoly
AR zero at this output level.

 Left unregulated, monopoly will maximize profits by producing the quantity for
which MR = MC
 Government regulation may attempt to improve resource allocation by requiring
average cost pricing or marginal cost pricing.

6.4. Price Discrimination and Consumer Surplus

What a monopolist charges for their product and how much quantity is supplied lie on two
extremes: on one end the price and quantity supplied may be equal to that of perfect
competition where there is a uniform price, and on the other end is discriminating
consumers on some grounds, which leads to different prices for the same product.

Ex: In restaurants, lunch is cheaper than dinner, or weekday prices are different than Friday-
Sunday prices.

First degree price discrimination:

 Consumer is charged maximum he is willing to pay; sellers are able to capture all
consumer surplus.
 Consumers are charged different prices for the same product (airline tickets).
 The monopolist is able to measure exactly how much each consumer is willing to pay
and what their preferences are. Prices vary for each consumer and unit. In some
cases, public price disclosure may not be permitted. So, one customer is not aware
of how much another customer is paying for the same product.

Second degree price discrimination:

 Unlike first degree, the monopolist is not able to exactly measure consumer’s
preferences, or his willingness to pay before pricing the product.
 Consumer charged differently based on how much he values the product. Ex: a TI
BAII Plus Professional.
 Another instance is where consumers are charged differently based on the quantity
sold. Ex: Quantity discounts (the price per unit decreases as the number of units sold
to a consumer are higher) are often seen. Family fare airline tickets (different fare if
the number of passengers traveling is more than 2) is another example.
 Some amount of consumer surplus is captured in this form of discrimination.

Third degree price discrimination:

  Consumers segregated based on demographic or other traits (gender, age).
 Example: One-day (business travelers) vs. round-trip airline tickets, milk prices within
the state/outside state. Student vs. professional version of many software packages.

Example

My monthly demand for visits to the local gym is given by: Q = 25 – 5P where Q is the
number of visits per month and P is the price per visit. The gym’s marginal cost is 1 per visit.

1. What the X-axis and Y-axis intercepts for the demand curve?
2. If the gym charged a price per visit equal to its marginal cost, how many visits would
I make per month?
3. What is my surplus at this price?
4. How much could the club charge per month for a membership fee?

Solution:

1. Q = 25 – 5P, P = 5 –

X-axis intercept when P = 0 is Q = 25.

Y-axis intercept when Q = 0 is P = 5.

2. If P = 1, then Q = 25 – 5 * 1 = 20

I would make 20 visits per month.

3. Consumer surplus = 
4. The club could charge a membership fee of 40 to extract all the consumer surplus. In
addition, it must charge 1 per visit. This pricing method is called a two-part tariff.

Example

Monopolists have considerable pricing power and may charge consumers in different ways.
Exporters charging higher prices for denim jeans in the international market compared to
local markets is an example of:

1. First-degree price discrimination.

2. Second-degree price discrimination.
3. Third-degree price discrimination.

Solution: C

Third-degree price discrimination occurs when customers are segregated by demographics.

Dividing the customers into two groups, local and international; and charging two different
prices is an example of third-degree price discrimination. The first degree of price
discrimination allows a monopolist to charge the highest price each customer is willing to
pay. The second degree of price discrimination is when the monopolist charges different
people different prices using the quantity purchased as an indicator of how highly the
customer values the product.
6.5. Factors Affecting Long-Run Equilibrium in
Monopoly Markets
Unregulated monopolies can earn economic profits in the long run as all factors of
production are variable in the long run.

For regulated monopolies, there are several possible solutions in the long run:

 Price = marginal cost. But this will be less than long-run average cost. So there must
be a government subsidy to compensate for the loss. Ex: Amtrak.
 National ownership. But the problem is consumers are not willing to accept price
increases once the price is fixed even if the input price increases.
 Regulated, authorized monopoly. P = LRAC. Investors make a normal profit, but the
challenge is to identify the monopolist’s realistic LRAC.
 Franchise monopolistic firm through a bidding war to select a firm whose P = LRAC.

Part 5

7.  Identification of Market Structure

Analysts are interested in investing in markets with high pricing-power as it drives
profitability. If there are very few large firms in an industry, then the price tends to be high
and the quantity supplied low. When there is a possible merger, analysts should consider
the impact of competition law (anti-trust law) as regulators might prevent the merger to
keep the industry competitive. In many countries, competition law has been introduced to
regulate the degree of market competition in different industries of different countries.

7.1. Econometric Approaches

Econometric approaches can be used for measuring market concentration or market power.
Some key points in this context are as follows:

 Use regression analysis to estimate elasticity of demand and supply.

 If demand is inelastic, then it indicates companies may have market power.
 The disadvantage is that though it is theoretically appealing, but data is not easily
available.

7.2 Simpler Measures

Simpler approaches to estimate elasticity that avoid the drawbacks in regression analysis
include the N-firm concentration ratio and Herfindahl-Hirshman Index (HHI).

N-Firm Concentration Ratio and HHI

N-Firm concentration ratio: It is the sum of the market shares of the largest N firms. It is
almost zero for perfect competition and 100 for monopoly.

For example, in an industry, assume the five largest firms in the industry have a market
share of 25%, 15%, 10%, 10% and 10%. The 5-firm concentration ratio would be 70%.

Advantages:

 Data is easily available.

 Simple to use and understand.

Disadvantages:

 Unaffected by mergers among top firms. Assume the top two firms by market share
merge and the market shares of five largest firms are 40%, 10%, 10%, 10% and 2%
now. The 5-firm concentration ratio would be 72% instead of 70%, which is not very
different from what it was earlier. But the largest firm has a high market share of
40%, which is not evident in the concentration ratio number.
 Does not quantify market power.
 Does not consider barriers to entry.
 Does not consider elasticity of demand.

Herfindahl-Hirschman Index (HHI)

 Sum of squared market shares of N largest firms in a market (ranges from 0 to 1). A
number close to 1 indicates it is concentrated or monopolistic.
 For example, assume the market shares of four firms are 50%, 20%, 10% and 20%.
The HHI is 0.52 + 0.22 + 0.12 + 0.22 = 0.34.

Advantage:

Simple and commonly used by regulators.

Disadvantage:

 Does not consider barriers to entry.

 Does not consider elasticity of demand.