UNIT -5 : MARKET STRUCTURE

STRUCTURE
1. INTRODUCTION
2. OBJECTIVES
3. PERFECT COMPETION
4. MONOPOLY
5. MONOPOLISTIC COMPETITION
6. OLIGOPOLY
7. SUMMING UP
8. KEY WORDS
9. KNOW YOUR PROGRESS
10. FURTHER READINGS/REFERENCES
11. MODEL ANSWERS

1. INTRODUCTION
How do firms determine their prices and output level in order to maximize profits. The
pricing and output decisions can be explained within the framework of four basic types of
market structures: perfect competition, monopoly, monopolistic and oligopoly. The
structure of the market depends on the degree of competition in the market. The degree
of competition in turn depends on the 1) the number of individual buyers and sellers in
the market 2) the degree of differentiation of the product being bought and sold. On
these basis markets are divided into monopoly, duopoly, oligopoly, perfect competition
and monopolistic competition. This is from the side of sellers. From the side of buyers
these markets are classified into monopsony, bilateral monopoly, duopsony, oligopsony.
2. OBJECTIVES
After studying this unit, you will be able to:
• understand the market structure under perfect competition, monopoly,
monopolistic competition and oligopoly
• the short-run and long-run equilibrium of the firm in all these markets
• price and output determination in these markets
3. PERFECT COMPETITION
3.1 Features
 In this type of market structure, there are large number of buyers and sellers in the
market and each seller or buyer is too small to be able to affect the price of the
product by his or her own actions. This means that a change in the output of a
single firm will not significantly affect the market price of the product. Similarly
each buyer of the product is too small to be able to extract from the seller such
things as quantity discounts and special credit terms.
 The product of each competitive firm is homogenous, identical or all are perfect
substitutes.
 There is perfect mobility of resources. That is workers, and other inputs can
move easily from one job to another job and can respond quickly to monitory
incentives.
 Free exit and free entry of the firm from the industry in the long run. There is a
no blockage to entry or exit of the firms in this market
 All economic agents such as consumers, resource owners, and firms in the market
have perfect knowledge as to present and future prices, costs, and economic
opportunities in general. Thus, consumers will not pay higher price than necessary
for the product. Price differences are quickly eliminated and single price prevails
throughout the market for the product.
Example: perfect competition has never really existed. There are some markets like
stock market which tends to be near perfect competition. Example, the markets for
agriculture commodities (eg corn, wheat, rice, coffee, pork etc), financial instruments (eg
stocks, bonds and foreign exchange), and precious metals ( gold, silver and platinum) and
global petroleum industry provide good examples of this type of market.

3.2 Pricing and Output Decision in perfect competition

If a firm decides to enter into the perfectly competitive market, the management should
be concerned about the following questions:
1. how much should it produce at the given market price?
2. if such an amount is produced how much profit will it earn?
 3. if a loss rather than a profit is incurred, will it be worthwhile to continue in this
market or not?
Under perfect competition, the price of a product is determined by the intersection of
market demand and market supply curves of the product. Market demand curve is
obtained by the horizontal summation of the demands of the individuals consumers for
that product. And market supply is horizontal summation of the supply of the product by
individual firms.

Industry Firm

A perfectly competitive firm has to accept this price as he is a price taker. Since the
products of all firms in the industry are homogenous, a firm can not sell at a price higher
than the market price of the product; by doing so it will loose all its customers. On the
other hand, there is no reason for the firm to sell at a price below the given market price,
since it can sell any quantity of the commodity at the given market price. As a result, the
firm faces a horizontal or infinitely elastic demand curve for the product at the market
price determined at the intersection of market demand and market supply curves of the
product (see above figure).
For example: QD (Market Demand) = 625 – 25 P; QS (market supply) = 175+ 15P
QD = QS
625-5 P = 175 + 15P therefore P = $ 45
Substituting the $45 in to demand and supply functions and solving for Q we have
QD = 625 – 5 X 45 = 400
QS = 175 + 15 X45 = 400
Now the concern of the perfectly competitive firm is to decide how much to be produced
at this given price $ 45 in order to maximize its total profits. Let there be 100 identical
firms in the industry (market), each producing 4 units of the product at price = $45. If one
such firm increases its output by 25%, the total quantity of the product sold in the market
would rise by only 1 unit, from 400 to 401, and P would fall from $ 45 to $ 44.999. Of
course, if all firms increase their output, the market supply curve of the product would
shift to the right and intersect the market demand curve at a lower equilibrium price.
When only one firm changes its output, we can assume that it will have an imperceptible
effect on the equilibrium price. We can draw the demand curve for the product that firm
faces as horizontal.

When the product price is constant, the change in the total revenue per unit change in the
output or marginal revenue (MR) is also constant and is equal to the product price. That
is for a perfectly competitive firm P = MR.
Illustration:
Price $ Quantity Total Average Marginal
sold Revenue Revenue Revenue
45 1 45 45 45
45 2 90 45 45
45 3 135 45 45
45 4 180 45 45
45 5 225 45 45

Short Run Analysis of a Perfectly Competitive Firm:

In the short run, some inputs are fixed, and these give rise to fixed costs, which go on
whether the firm produces or not. Thus, it pays for the firm to stay in business in the
short run even if it incurs losses, as long as these losses are smaller than its fixed costs.
Thus the best level of output to the firm in the short run is the one at which the firm
maximizes profits or minimizes losses. The equilibrium or the best level of output of the
firm may shown graphically in two ways. Either by using TR and TC curves, or the MR
and MC curves.
Equilibrium by Total Approach

The above figure shows the total revenue and total cost curves of a firm in a perfectly
competitive market. The total revenue curve is a straight line through the origin, showing
that the price is constant at all levels of output. The firm is a price taken and can sell any
amount of output at the going market price, with its TR increasingly proportionately with
its sales. The firms maximize its profit at the point Xe, where the distance between TR
and TC curves is the greatest. At lower or higher levels of output at xe the profits are not
maximum. At point A left of Xe TC is more TR, still there is scope for the firm to get
profits by expanding output. At point B (the right of Xe) the total cost is more than total
revenue. If output is expanded after Xe level the firm would incur losses.
Marginal Approach
The best level of output of the firm in the short run is the one at which the marginal
revenue (MR) of the firm equals its short run marginal cost (MC).
As long as MR exceeds MC it pays for the firm to expand output because by doing so the
firm would add more to its total revenue than to its total costs. On the other hand, as long
as MC exceeds MR, it pays for the firm to reduce output because by doing so the firm
will reduce its total costs more than its total revenue. Thus the best level of output of any
firm (not just a perfectly competitive firm) is the one at which MR = MC. Since a
perfectly competitive firm faces horizontal or perfectly elastic (infinitely elastic) demand
curve, the best level output can be MR= P= AR = MC.

In the above figure P is the demand curve for the output of the perfectly competitive firm.
The best level output of the firm is given at point E, where MC curve intersects the firms
d or MR Curve. At any output level smaller than E point P = MR > MC, the firm would
be adding more to the total revenue than to its total cost by expanding output. On the
other hand, it does not pay for the firm to expand its output past point E because MC >
MR = P and the firm would be adding more to its total costs than to its total revenues.
Thus, the best level of output for the firm is 4 units at which MR = P = MC and the total
profits of the firm are maximized.

Look at the graph above, firm should choose to produce output Q to maximize profit
since Q is the output level at which point P=MC. The shaded area is total profit for this
profit-maximizing firm. The vertical distance between point A and B = (P-ATC), which
is profit per unit of output.
The profits of firm have three possibilities:

1) P> ATC, firm makes a profit, this case is shown in the above graph.

2) P< ATC, firm experience losses, see right graph below, total loss is the shaded area.

3) P=ATC, firm breaks even (profit=0), see left graph, point A is called the break-even
point (the minimum point of ATC curve).

Shut down point in the short run : When a firm suffers from losses in the short run
(P<ATC), it has two choices:

1) Continue to run the firm: Loss1= (P-ATC)*Q

2) Stop production by shutting down temporarily. Under this choice, firm still need to pay
its fixed cost since fixed cost is kind of sunk cost in the short run.

Therefore, Loss2= -FC= -AFC*Q . So, whether the firm who suffering losses chooses to
shut down in the short run depends on the magnitudes of the two losses:

1) If P> AVC, Loss1>Loss2, firm should continue to run the business although it
experiences losses in the short run.

2) If P< AVC, Loss1<Loss 2, firm should choose to shut down in the short run.

3) If P=AVC, Loss1=Loss 2, firm should be indifferent between still running the firm or
shut it down.

Note: To determine whether a firm makes profit, you compare P and ATC To
determine whether a firm should shut down its business (you already know that
P<ATC), you compare P and AVC
Short Run Supply Curve of the Competitive Firm:

The rising portion of the firm’s MC curve above the AVC curve or Shut down point is
the short run supply curve of the perfectly competitive firm. The reason for this is that
the perfectly competitive firm always produces where P = MR = MC, as long as P
>AVC. That is, given P, we can determine the output supplied by the perfectly
competitive firm by the point where P = MC. Thus the rising portion of the MC curve
above the AVC shows a unique relationship between P and Q which is the definition of
the supply curve (figure).

Long run analysis of a perfectly competitive firm: Economic profit leads to entry of new
firms. Economic Losses lead to exit of existing firms. Due to entry and exit, the long-run
equilibrium market price is at the level equal to the minimum point of firm’s ATC curve. See
graph below. All the firms in a perfectly competitive market earn economic profit equal to
zero. (Since economic profit is the profit after accounting for the implicit cost of a firm, zero
economic profit means positive accounting profit. This is why firms earning zero economic
profit still exist in the market.)
If existing firms earn profits, however, more firms enter the market in the long run. This
increases the market supply of the product and results in a lower produce price until all
profits are squeezed out. On the other hand, if firms in the market incur loses, some firms
will leave the market in the long run. This reduces the market supply of the product until
all firms remaining in the market just break even. Thus, when a competitive market is in
long run equilibrium, all firms produce at the lowest point on their long run average cost
(LAC) curve and break even.

The above figure shows P = LMC = Lowest LAC. Thus, for a competitive market to be
in long run equilibrium, all firms in the industry must produce where P = MR= LMC =
Lowest LAC so that all firms break even.
4. MONOPOLY:

4.1 Meaning: Monopoly is a form of market organization in which a single firm sells a
product for which there are no close substitutes. The monopolist faces a negatively
sloped or downward sloping demand curve for his product. In perfect competition, the
firm earns only normal profits because of free entry and exit into the market where as in
monopoly the monopolist may earn super normal profits even in the long run as there is
no entry into the market. Thus monopoly is at the extreme opposite of the perfect
competition.
4.2 Sources of monopoly power
1. the firm may control the entire supply of raw materials required to produce the
product. For eg the Aluminum Company of America (Alcoa) until World War II,
controlled almost every source of bauxite and thus had a monopoly over the
production of aluminum in the United States.
2. The firm may own a patent or copyright that precludes other firms from using a
particular production process or producing the same product. For eg., when
cellphone was introduced, Du Pont had monopoly power in its production based
patents. Similarly, Xerox had a monopoly on copying machines and Polaroid on
instant cameras. Patents are granted by the government for a period of 17 years as
an incentive to inventors.
3. In some industries, economies of scale may operate (i.e., the long run average cost
curve may fall) over a sufficiently large range of outputs as to leave only one firm
supplying the entire market. Such a firm is called natural monopoly. Examples
of these are public utilities (electrical, gas, water and local transportation
Companies). To have more than one firm in a given market would lead to
duplication of supply lines and to much higher costs per unit. To avoid this, local
governments usually allow a single firm to operate in the market but regulate the
price of the services provided, so as to allow the firm only a normal return on
investment.
4. A monopoly may be established by the government franchise. In this case, the
firm is set up as the sole producer and distributor of a product or service but is
 subjected to government regulation. The best example of a monopoly established
by government franchise is the post office. These are all regulated monopolies.
Cases of pure monopoly are very rare in the past and forbidden today by the
antitrust laws.
4.3 Price and Output determination in Short Run
A monopolist, unlike perfect competition, is a price setter and not a price taker. The
monopolist faces a negatively sloped demand curve which means the monopolist can sell
more units of the product only by lowering its price. Because of this the marginal
revenue is smaller than the price (MR < AR). MR curve lies below the AR curve or the
demand curve.

In this diagram, the monopoly firm is in equilibrium at point K where SMC = MR. The
short run marginal cost (SMC) curve cuts MR from below. At point K both the
equilibrium conditions are fulfilled. As a result, therefore, OE is monopoly price and OB,
the monopoly output. At the monopoly output OB, the average total cost OF = BN. The
profit per unit is FE. The short run monopoly profit is ETNF, It is represented by the area
of shaded rectangle in figure 16.3. At the output smaller than OB (say at point P) MR >
SMC. Therefore, increased output up to B adds more to total receipts than to total costs.
In case, the output is increased beyond OB, the MR < SMC. Hence, the increased outputs
beyond OB adds more to total cost than to total receipts. This causes profits to decrease.
So the best level of output for the monopolist firm is that where SMC curve cuts the MC
curve from below.
4.4 Long Run Price and Output Determination under Monopoly
In the long run all inputs and cost of production are variable and the monopolist can
construct the optimum scale of plant 1 to produce the best level of output. The best level
of output is obtained at which P = LMC and the optimum scale of plant. As contrasted
with perfect competition, entrance into the market is blocked under monopoly and so the
monopolist can earn economic profits in the long run.

In the long run, all the factors of production including the size of the plant are variable. A
monopoly firm will maximize profit at that level of output for which long run marginal
cost (MC) is equal to marginal revenue (MR) and the LMC curve intersects the MR curve
from below. In the figure (16.6), the monopoly firm is in equilibrium at point E where
LMC = MR and LMC cuts MR curve from below. QP is the equilibrium price and OQ is
the equilibrium output. At OQ level of output, the cost per unit is QH (LAC), whereas the
price per unit of the good is QP. HP represents the per unit super normal profit. The total
super normal profit is equal to KPHN. It may here be noted that at the equilibrium output
OQ, the plant is not being fully utilized. The long run average cost (LAC) is not
minimum at this level of output OQ. The firm will build an optimum scale of plant only if
the demand for the product increases.

1
The optimum scale of plant is the one with the short run average cost curve (SATC) is tangent the long
run average cost curve (LAC) at the best level of ouput.
4.5 Comparison Between Monopoly and Competitive Equilibrium or Perfect
Competition:The main points of difference and similarities of monopoly model with
competitive model are as follows:
 Monopoly Perfect Competition or Competitive
Equilibrium
(1) The firm is in equilibrium at that level of (1) The most profitable output is also at a
output where MR equals MC.  point where MR is equal to MC.
(2) The AR and MR curves are negatively (2) The AR and MR curves facing
inclined i.e., a firm can sell more goods at competitive producer are perfectly elastic,
lower and fewer goods at higher prices. The i.e., it is a horizontal straight line. A firm
MR curve ties below the AR curve. cannot alter the market price by selling more
  or by selling less. The AR and MR curves
are equal and, therefore, coincide. 
(3) The monopolist can earn supernormal(3) The firm can earn abnormal profits in the
profits in the short as well as in the longshort run but in the long run only normal
period. The firm need not equate the AR to profits are earned. The firm is in equilibrium
the lowest point of AC in the long run. when MR = MC = AR = Minimum AC in
  the long run.
(4) As the production of a commodity is in(4) The competitive producer has no control
the hands of a single producer, therefore, a over the price of the commodity. It has to
firm has control over the output and  price ofsell at the price determined by the
the commodity. intersection of the forces of demand and
  supply in the market.
(5) The single firm comprises the whole(5) There are many firms comprising an
industry. The firm may not be of theindustry. All the firms are of the optimum
optimum size. The possibility of the new size in the long run. The new firms can enter
firms to enter into the industry, is restricted. the industry.
 

(6) The equilibrium price is higher than MC. (6) The equilibrium price is equal to MC.
The monopolist always tries to maximizeThe entrepreneur charges the price which
profits by fixing the price higher than the gives him the normal profit in the long run.
competitive price. The consumers, therefore,So customers do not stand at a disadvantage.
have to pay a higher price and thus stand at a 
disadvantage. 
7) The monopoly firm is a price seeker The competitive firm is a price taker

(8) A monopoly firm is not a price taker. (8) A competitive firm cannot exert any
Hence, it cannot have a supply curve. It influence on the price. The firm is a price
chooses output and price in a way that gives. taker and so has a supply curve. The portion
It the highest possible profit. of MC curve above AVC curve is supplied.
   
4.6 Monopoly Price Discrimination: 
 Definition of Price Discrimination:
While discussing price determination under monopoly, it was assumed that a monopolist
charges only one price for his product from all the customers in the market. But it often
so happens that a monopolist, by virtue of his monopolistic position, may manage to sell
the same commodity at different prices to different customers or in different markets. The
practice on the part of the monopolist to sell the identical goods at the same time to
different buyers at different prices when the price difference is not Justified by difference
in costs in called price discrimination. In the words of Mrs. Joan Robinson:"Price
discrimination is the act of selling the same article produced under single control at a
different prices to the different buyers".   For instance, a doctor may charge $20000 from
a rich person for an eye operation and $500 only from a poor man for the similar
operation.      A monopolist sells the same commodity at a higher price in one market and
at a lower price in the other. This is called Dumping.    
Degrees of Price Discrimination: There are three main degrees of price discrimination:
(1) First degree price discrimination, (2) Second degree price discrimination and (3)
Third degree price discrimination.
(1) First degree price discrimination. The monopolist charges a different price equal to
the maximum amount for each unit of the commodity from each consumer separately.
The price of each unit is equal to its demand price so that the consumer is unable to enjoy
any consumer surplus. Such prices are charged by doctors, lawyers etc. In fact, the first
degree price discrimination manifests itself in the form of as many prices as many
consumers. 
(2) Second degree price discrimination. Here the monopolist divides his market into
different groups of customers and charges each group the highest price which the
marginal consumer belonging to that group is willing to pay. The railway, airlines etc.,
charge the fares from customers in this way.
 (3) Third degree price discrimination. In the third degree price discrimination, the
monopolist divides the entire market into a few sub-markets and charges different prices
for the same commodity in different sub-markets. The division here is among classes of
consumers and not among individual consumers. Third degree price discrimination is
possible only if the classes of consumers can be kept separate. Secondly, the various
groups of customers must have different elasticities of demand for his commodity. The
segment with a less elastic demand pays a higher price than the segment with a more
elastic demand. The consumer faces a single price in each category of consumers. He can
purchase as much as desired at that price. It is the most common type of price
discrimination. For example, movie theaters, railways, typically charge lower prices to
senior citizens, students etc.
 Conditions of Price Discrimination:  Price discrimination can only be possible if the
following three essential conditions are fulfilled.                             .
(1) Segregation by price. There should be no possibility, of transferring a unit of
commodity supplied from the low priced to the high priced market. For instance, a rich
patient cannot send a poor man to the doctor for his medical cheek up at a cheaper rate
for him. Similarly, if you want to send a kilogram of gold by train to a relative of yours,
you cannot get it converted into coal or iron simply because these metals are transported
at a cheaper rate.                            
(2) Segregation by market. Another essential characteristic of price discrimination is
that there should be no possibility of transferring one unit of demand from the high priced
to the low priced market. For instance, a banana market is divided on the basis of wealth.
The poor are supplied bananas at a concessional rate in one market. The rich people will
not like to become poor in order to get the commodity at a cheaper rate. A monopolist
will maximize his total revenue by equalizing marginal revenue from all the markets. For
instance, if in a particular market, the marginal revenue of a commodity is $20 per quintal
and in the other $15 per quintal, a monopolist will at once shift the supply of the
commodity from the later to the former till the marginal revenue from both
the markets becomes equal.                        
 (3) Segregation by demand. Price discrimination can be possible if there is difference
in the elasticity of demand in different markets. If the demand for a certain commodity is
elastic in a particular market, the monopolist will charge lower prices. But if the demand
is inelastic, the monopolist will fix higher prices for his product.
 
Here, a question can be asked as to how far is a price discrimination beneficial to society.
The answer is that if a monopolist charges low price for his product from the poor people
and higher price from the rich, then certainly we can say that it increases economic
welfare. But if a monopolist dumps his output in a foreign market at a low price and
raises the price of his commodity in the home market, then such a price discrimination is
certainly detrimental to society, if the production of certain commodity is subject to law
of increasing returns, then price discrimination may be to the advantage of the society.
The monopolist increases the sale of output in order to sell the commodities in the foreign
market. The monopolist fixes a low price for his output both for the home market and the
foreign market. It is from this point of view only that we say price discrimination is
desirable and beneficial.
5. MONOPOLISTIC COMPETITION
5.1 Features:
1. Many sellers with differentiated2 / heterogeneous products.
2. Free entry and exit from the industry
3. Examples – numerous brands of breakfast cereals, tooth paste, cigarettes,
detergents, beauty parlors, drug stores etc
4. The differentiation may be real or imaginary. Real for eg – the various breakfast
cereals may have greatly different nutritional and sugar contents)
5. Monopolistic competition is a blend of competition and monopoly.
6. The competitive element in monopolistic competition is that there are many
sellers of the differentiated product, each too small to affect others. The
monopoly features arises from product differentiation. However, the monopoly
power is very limited because if the particular brand of, for instance soap, price is
increased it would stand to loose a great deal of its sales.
7. As each firm sells a different product under monopolistic competition, it is not
possible to derive the market demand and market supply for the product. A single
equilibrium price does not exist. There will be cluster of prices.
8. As a result the analysis should be focused on a typical or a representative firm.
9. In order to make demand for its product more price inelastic the firms in this type
of market structure extra costs will be incurred on product variation and selling
costs.
10. Product variation refers to changes in some of the characteristics of the product
that a monopolistically competitor undertakes in order to make its product more
appealing to consumers. For eg., producers may reduce the sugar content in the
breakfast cereals and include a small surprise gift in each package.
11. Selling expenses are all those expenses the firm incurs to advertise the produce
and other sales promotion measures.

2
Differentiated products are those that are similar but not identical and satisfy the same need.
Product Differentiation and Demand Elasticity

Perfectly competitive firms face a perfectly elastic demand curve for their product
because all firms in their industry produce the exact same product. A monopolistic
competitor faces a downward-sloping firm demand curve. This type of curve is based on
the notion that the firm can change its price without losing all of its business because
buyers do not see any perfect substitute. The fewer the substitutes (i.e., the more the
product differentiation, the less elastic the demand curve will be. The difference is
illustrated in the figure below:

5.2 Short Run price and output determination:

In monopolistic competition the firm faces a negatively sloped demand curve as the firm
is producing a differentiated product. However, due to the existence of a large number of
substitutes the demand curve is highly price elastic. As the demand curve is downward
sloping the corresponding marginal revenue curve lies below the demand curve with
twice the absolute slope. The best level of output is produced when MC = MR, provided
that the price exceeds the average variable cost.
 Since the firm has a downward-sloping demand curve, it will also have a downward-
sloping marginal revenue (MR) curve. A profit-maximizing firm produces where
marginal cost (MC) equals marginal revenue (q0 in the graph above) and charges the
price determined by demand (P0). In panel (a) of the figure, the monopolistic
competitor will make a profit. However, like a monopoly, a monopolistic competitor
is not guaranteed to make a profit in the short run. The firm may make a loss in the
short run; its profitability will depend on the demand. This is shown in panel (b).
1. In the short run, as in perfect competition and monopoly, the monopolistic
competitive firm may break even, or earn profits and incur a loss.
2. If P = ATC – the firm breaks even; if P < ATC, the firm incur losses ; if P > AVC
the incur losses but minimizes the loss by continuing to produce; if P > ATC the
firm earns a profit

5.3 Long Run price and output Determination

If firms in a monopolistically competitive market earns profits in the short run, more
firms will enter the market in the long run. Since other competitors selling a similar good
can enter the market, two changes will occur:
 Firm demand will decrease.
 Firm demand will become more elastic.

As more firms enter the market, the demand for any one firm will decrease, since the firm
is now sharing the market with other firms. A decrease in demand implies a leftward shift
in the demand curve. Since the entering firms are producing substitutes for the existing
firm’s good, the demand for the existing good will become more elastic. An increase in
elasticity implies the demand curve is getting flatter. By combining these effects, as a
monopolistically competitive market moves from short-run profits to the long run, the
firm’s demand curve will move to the left and get flatter. Furthermore, the demand curve
will continue to move until there are no more firms entering the market. Firms will stop
entering the market when profits are zero.

In the below figure, long run demand curve is the demand curve facing a representative
monopolistically competitive firm in the long run. The demand curve is tangent to the
LAC and SATC’ curves at the best level of output (MR’ = MC=MC’). The
monopolistically competitive firm sells q* units of the product at the price P*. The firm
produces to the left of the lowest point on its LAC curve when it is in the long run
equilibrium. This means that the average cost of production and price of the product
under monopolistic competition is higher than under perfect competition. This also means
that each firm operates with excess capacity and that there are many more firms when
the market is organized along monopolistically competitive lines rather than along
perfectly competitive lines.

6. Oligopoly and Strategic Behaviour

6.1 Meaning: Oligopoly is defined as that form of a market organization in which there
are few sellers of a homogenous or differentiated product. If there are only two sellers it
is called duopoly. If the firms are producing homogenous product it is called pure
oligopoly. If the firms are producing differentiated it is called differentiated oligopoly.
Entry into the industry is possible but it is not easy. Examples automobiles, soaps,
detergents, cigarettes etc. Since there are only few firms selling homogenous or
differentiated product the action of each firm affects the other firms in the industry. For
example, when General Motors introduced price rebates in the sale of its automobiles,
Ford immediately followed with price rebates. This will lead to price wars. Due to this
reason, oligopolists generally compete not on price but on product differentiation. Even
here the competing firms will compete. For instance, when Pepsi mounted a major
advertising campaign in the early 1980s, Coca-Cola responded with a large advertising
campaign of its own.
Thus , it is clear that there is interdependence or rivalry among firms in the industry. It is
important for each firm in this type of market structure to take into account the reactions
of rival firms when deciding the pricing policies, product differentiation to introduce, the
level of advertisement etc. Because of this interdependence, managerial decision making
is very difficult in this market structure when compared with other market structures.
6.2 Oligopoly Models:
The Kinked Demand Curve Model
This model is given by Paul Sweezy to explain the price rigidity in the market.According
to him, if an oligopolist increases its product price, it would loose most of its customers
because other firms in the industry would not follow by raising their prices. If he reduces
the price, he could not increase the share of its product because its competitors would
quickly match the price cuts. As a result, the demand curve faces by the oligopolist has a
kink at the prevailing price and highly elastic for price increases and much less elastic for
price cuts.

In the above figure AR is the demand curve of the oligopolist. It has a kink at price P
and quantity Q. Demand curve (AR curve) has much more elastic above the kink than
below the kink. MR is marginal revenue curve; Upper segment of the marginal revenue
curve corresponding to the upper AR curve. The lower portion of MR curve
corresponds to the lower portion of the demand or AR curve. The kink at point B on the
demand curve causes the discontinuity in marginal revenue curve. The best level of
output of the oligopolist is at Q at which MC intersects the vertical portion of MR curve.
Marginal cost curve can rise or fall anywhere within the discontinuous portion of the MR
curve Ii.e from MC1 to MC3) without inducing the oligopolists to change the prevailing
price of P (as long as P > AVC). Only if the MC curve shifts above MC1 the
oligopolists will be induced to increase its price and reduce the quantity. Or only the MC
curve shifts below the MC3 will the oligopolists lower price and increase quantity. With
a right ward or left ward shift in the demand curve, sales will increase or fall,
respectively, but the oligopolist will keep the price constant as long as the kink on the
demand curve will remain at the same price and MC curve continues to intersect the
discontinuous or vertical portion of the MR curve.
Cartel:
Cartels are of two types – 1. centralized cartel 2. market sharing cartel
In market sharing cartel each member of the cartel will have to operate in a particular
geographical area. The centralized cartel is a formal agreement among the oligopolistic
producers of a product to set the monopoly price, allocate output among its members and
determine how profits are to be shared. This was attempted by OPEC, the Organisation
of Petroleum Exporting Countries. Let there be two firms constituted a centralized cartel

In the above figure (right side) demand is the market demand curve. MR is the marginal
revenue curve for the homogenous product produced by two firms forming the
centralized cartel. The total MC of the industry is the horizontal summation of the MCs
of the two firms. The centralized cartel authority will set price and quantity at which
MC and MR curve of the cartel. To minimize the production costs, the centralized
authority will have to allocate some quota to firm 1 (MC1 = MR) and some quota for
firm 2 (MC2 = MR). If MC1 > MC2 at the point of production, the total costs of the
production of the cartel will be reduced by shifting production from firm 1 to firm2 until
MC1 = MC2.
Price Leadership
One way of overcoming the interdependence and the consequent price war is by price
leadership. The price leader initiates a price change and other firms in the industry
quickly follow. The leader will be usually the largest firm or the dominant firm in the
industry or it could be low cost firm or a barometric firm 3. In case of dominant firm price
leadership model, the dominant firm sets the price that maximizes its profits. All other
firms in the industry are allowed to sell all that they want at that price. The dominant
firm takes the share of remaining market. Thus the followers are price takers like in
perfect competition and the dominant firm acts as the monopolist on the residual supplier
of the product.

In the above figure the black line represents industry demand, which is the total demand
for the market (ie. the horizontal sum of individual demands).
The MCcf line represents the marginal cost for the competitive fringe.  This represents
the sum of the individual marginal cost curves for each of the firms participating in the
perfectly competitive side of this market.
The MCdf line represents the marginal cost for the dominant firm.  The dominant firm is
the firm acting as a monopolistically competitive firm, which can choose which price
(within a range) it will charge its consumers.
The Ddf line represents the demand curve for the dominant firm.  Not that the demand
curve for the dominant firm is always below the industry demand curve, and becomes the

3
A barometric firm is able to interpret or predict the changes in industry demand and cost conditions
warranting a price change.
industry demand curve after price level 'F' because all competitive firms exit the market.
Finally, the MRdf line represents the marginal revenue curve for the dominant firm. This
line has twice the slope of the Ddf line and is intuitively identical to the MR line for a
monopoly or monopolistically competitive firm.
The point 'A' represents the intersection of the industry (total) demand curve with the
price axis.  This is the price that must be charged for no quantity to be demanded.  The
point 'B' represents the price level that would be attained if there was no dominant firm. 
This is calculated by looking at where the perfectly competitive firms marginal cost curve
crosses the industry demand curve which occurs at point 'C'. 
Since anyone can acquire the good or service at the price level of 'B', this is the maximum
price that the dominant firm can charge for the good.  This means that the "fringe"
demand curve (the demand curve faced by the dominant firm) will begin at point 'B'.  The
curve will be downward sloping, and will intersect the industry demand curve at a price
of 'F'.  Also note that the point 'F' is where the competitive fringe companie's marginal
cost curve intersects the price axis (where quantity equals zero).
After we draw this "fringe" demand curve, we can derive the associated marginal revenue
curve for the dominant firm.  The point 'G' shows where the marginal revenue curve and
the marginal cost curve of the dominant firm, cross.  This gives us the profit maximizing
output quantity for the dominant firm, and if we draw that line up to the "fringe" demand
curve, we see that it will intersect at point 'D', which is the optimal price charged for the
good by the dominant firm.
Also note that Qcf shows the quantity supplied by the competitive fringe and Qdf shows
the quantity supplied by the dominant firm.  Unlike traditional supply and demand
graphs, the total amount of goods supplied to the market in this graph is Qdf + Qcf, not
simply one or the other.   
 7. SUMMARY
Comparison of Market Types by Degree of Competition
Market Perfect Monopolistic Oligopoly Monopoly
characteristics Competition competition
Number and Very large Large small One
size of firms
Type of Perfectly Homogenous Standardized or Unique
product homogenous but differentiated
differentiated
Market entry Free Free Difficult No entry
and exit (blocked)
Non-price impossible possible Possible or Not necessary
competition difficult
Market power None Low to high Low to high High
Long run None none Low to high High subject
economic profit depends on to regulation
mutual
interdependence
8. KEY WORDS
1. Price-takers: This means that the agents in the market take prices as given. They
have no power to influence the market price.
2. Free Entry and Exit: This implies that any new firm is free to set up production
in the market if it wishes to, and any existing firm can stop production and leave
the industry.
3. Homogeneous Product: The product of one seller is identical to that of the other.
4. Perfect Knowledge: Consumers know the prices, producers know the costs and
workers know the wage rate.
5. Zero Profit: It means that the firms are covering only their total costs. These total
costs are economic costs. In other words, firms are just able to cover their
6. Cartel: When more than one producer join hands to act like a single seller. The
group of producers form a cartel (e.g., OPEC).
7. Entry Barrier: Preventing Entry. In the long run the monopolist creates entry
barriers so that rivals cannot enter the industry. This may be done by: i) Control
over strategic raw materials required for production ii) Product patent or process
patent iii) Acquiring exclusive rights to cater to a market from government iv)
Charging low prices
8. Excess Capacity : The output that corresponds to the minimum average total cost
is called capacity. A producer producing an output smaller than that given by the
minimum average total cost is said to be operating with excess capacity.
9. First Degree Price Discrimination: This is often termed as perfect
discrimination. It means charging different prices to different customers and
different price for different units brought by the same customer. The maximum
price someone is willing to pay is charged by the monopolist.
10. Monopoly: A market structure where there is single seller of a product.
11. Second Degree Price Discrimination: A market situation of charging
 different prices for different ranges or group of output.
12. Third Degree Price Discrimination: It occurs when the monopolists charges
different prices to different groups of customers, while the price charge is same
for each customer within a group.
13. Monopolistic Competition: A market structure characterised by many small
independent sellers of a differentiated product without barriers to entry.
14. Product Differentiation: The case where consumers perceive similar products to
have distinguished characteristics despite being substitutes of each other.
15. Selling Costs: The cost incurred by a firm in order to increase the volume of
sales. This cost is different from production cost
16. Price Leadership: A particular firm from among the colluding members
acting as a price setter.

9. KNOW YOUR PROGRESS

1. What kind of a demand curve does a firm under perfect competition face?
2. What is the short-run equilibrium condition for a firm under perfect
competition?
3. Prove that for a given price, p = AR = MR.
4. What gives the supply curve of the firm?
5. Why do we consider the portion of the MC above the AVC curve to represent
the supply curve of the firm?
6. Is there a difference between the demand curve faced by the firm and
industry? Give reasons
7. Describe the long-run equilibrium condition of the firm and industry in perfect
competition
8. What do you mean by monopoly? What are the various sources of monopoly
power?
9. Explain in brief the price and output determination in monopoly and
monopolistic competition
10. What did you understand the features of monopolistic competition.
11. What is excess capacity in monopolistic competition?
12. What do you mean by collusive oligopoly and non collusive oligopoly?
13. How do you explain the price rigidity in oligopoly market
10. FURTHER READINGS/REFERENCES
1. Mansfield, Edwin, 2003 “Managerial Economics: Theory, Applications and
Cases”, Fifth edition WW. Norton.
2. Petersen, H. Craig and W. Cris Lewis, 2001 “Managerial Economics”, Fourth
Edition, Pearson Education Asia
3. Dominick Salvatore and Ravikesh Srivastava “Managerial Economics:
Principles and World Wide Apllications” Sixth Edition, Oxford University
Press.
4. Ravindra H Dholakia, Ajay N Oza (1996). Microeconomics for Management
Students,Oxford University Press
11. MODEL ANSWERS

1) A typical firm under perfect competition faces a horizontal demand curve. So that
at the given price, p, the firm can sell whatever amount it wishes to sell.
2) The short-run equilibrium condition is given by p = MC = MR = AR
3) Total Revenue (TR) = pq, therefore Average Revenue (AR) = TR/q = pq/q
= p. Marginal Revenue (MR) = TR/q = p. Thus, p= AR= MR.
4) The rising part of the MC curve is the supply curve of the firm.
5) In the short-run the total cost of production consists of the variable as well as the
fixed cost. If price falls below AVC, then for unit cost the revenue earned (which is
price, p) is unable to cover the variable cost. If the producer shuts down, then one has
to incur only the fixed cost. Otherwise, her loss would include both that from the
variable cost as well as from the fixed cost. Being a profit maximiser the producer
would never produce an output when p<AVC. Therefore, the supply is zero for
p<AVC.
6) Yes. The demand curve that the firm faces is a horizontal straight line, whereas the
demand curve of the industry is downward sloping. The firm is a price taker in the
market so that it has to take as given whatever price is determined by the market and
sell whatever amount it wants to in the market. This is not so for the industry as a
whole.