Perfect Competition

Roger L. Miller and R. E Miners has defined “In essence, a market characterized by perfect competition
is also in which no individual buyer or seller can influence the price by his purchases or sales alone.” A
market in which all goods are perfect substitute there are no barriers to entry and no firm and affect the
market price.

Perfect competition is a market structure characterised by a complete absence of rivalry among the
individual firms. Thus perfect competition in economic theory has a meaning diametrically opposite to
the everyday use of this term. In practice businessmen use the word competition as synonymous to
rivalry. In theory, perfect competition implies no rivalry among firms.

I. Assumptions
The model of perfect competition is based on the following assumptions.

Large numbers of sellers and buyers

The industry or market includes a large number of firms (and buyers), so that each individual firm,
however large, supplies only a small part of the total quantity offered in the market. The buyers are also
numerous so that no monopolistic power can affect the working of the market. Under these conditions
each firm alone cannot affect the price in the market by changing its output.

Product homogeneity
The industry is defined as a group of firms producing a homogeneous product. The technical
characteristic of the product as well as the services associated with its sale and delivery are identical.
There is no way in which a buyer could differentiate among the products of different firms. If the product
were differentiated the firm would have some discretion in setting its price. This is ruled out ex hypothesi
in perfect competition.

The assumptions of large numbers of sellers and of product homogeneity imply that the individual firm in
pure competition is a price-taker, its demand curve is infinitely elastic, indicating that the firm can sell
any amount of output at the prevailing market price. The demand curve of the individual firm is also its
average revenue and its marginal revenue curve.

Free entry and exit of firms

There is no barrier to entry or exit from the industry. Entry or exit may take time, but firms have freedom
of movement in and out of the industry. This assumption is supplementary to the assumption of large
numbers. If barriers exist the number of firms in the industry may be reduced so that each one of them
may acquire power to affect the price in the market.

Profit maximization
The goal of all firms is profit maximisation. No other goals are pursued.

No government regulation
There is no government intervention in the market (tariffs, subsidies, rationing of production or demand
and so on are ruled out).

The above assumptions are sufficient for the firm to be a price-taker and have an infinitely elastic demand
curve. The market structure in which the above assumptions are fulfilled is called pure competition. It is
different from perfect competition, which requires the fulfillment of the following additional assumptions.
Perfect mobility of factors of production
The factors of production are free to move from one firm to another throughout the economy. It is also
assumed that workers can move between different jobs, which implies that skills can be learned easily.
Finally, raw materials and other factors are not monopolised and labour is not unionised. In short, there is
perfect competition in the markets of factors of production.

Perfect knowledge
It is assumed that all sellers and buyers have complete knowledge of the conditions of the market. This
knowledge refers not only to the prevailing conditions in the current period but in all future periods as
well. Information is free and costless. Under these conditions uncertainty about future developments in
the market is ruled out.

Under the above assumption we will examine the equilibrium of the firm and the industry in the short run
and in the long run.

Q. Explain short-run and long-run equilibrium of a firm under perfect competition.

Short-run equilibrium
In order to determine the equilibrium of the industry we need to drive the market supply. This requires the
determination of the supply of the individual firms, since the market supply is the sum of the supply of all
the firms in the industry.

Equilibrium of the firm in the short-run

The firm is equilibrium when it maximises its profits (Π), defined as the difference between total cost and
total revenue:
Given that the normal rate of profit is included in the cost of the firm, Π is the profit above the normal
rate of return on capital and the remuneration for the risk-bearing function of the entrepreneur. The firm is
in equilibrium when it produces the output that maximises the difference between total receipts and total
costs. The equilibrium of the firm may be shown graphically in two ways. Either by using the TR and TC
curves, or the MR and MC curves.

We show the total revenue cure is a straight line through the origin, showing that the price is constant at
all levels of output. The firm is a price-taker and can sell any amount of output at the going market price,
with its TR increasing proportionately with its sales. The slope of the TR curve is the marginal revenue. It
is constant and equal to the prevailing market price, since all units are sold at the same price. Thus in pure
competition MR = AR = P.

The shape of the total-cost curve reflects the U shape of the average-cost curve, that is, the law of variable
proportions. The firm maximises its profit at the output X, where the distance between the TR and TC
curves is the greatest. At lower and higher levels of output profit is not maximised: at level smaller than
XA and larger than XB the firm has losses.

The total-revenue-total-cost approach is awkward to use when firms are combined together in the study of
the industry. The alternative approach, which is based on marginal cost and marginal revenue, uses price
as an explicit variable, and shows clearly the behaviorual rule that leads to profit maximisation.

We show the average- and marginal-cost curves of the firm together with its demand curve. We said that
the demand curve is also the average revenue curve and the marginal revenue of the firm in a perfectly
competitive market. The marginal cost cuts the SATC at its minimum point. Both curves are U-shaped,
reflecting the law of variable proportions which is operative in the short run during which the plant is
constant. The firm is in equilibrium (maximises its profit) at the level of output defined by the intersection
of the MC and the MR curves (point e in figure 5.3). To the left of e profit has not reached its maximum
level because each unit of output to the left of Xe brings to the firm revenue which is greater than its
marginal cost. To the right of X4 each additional unit of output costs more than the revenue earned by its
sale, so that a loss is made and total profit is reduced. In summary:

(a) If MC > MR total profit has not been maximised and it pays the firm to expand its output.
(b) it MC > MR the level of total profit is being reduced and it pays the firm to cut its production.
(C) If MC = MR short-run profits are maximised.

Thus the first condition for the equilibrium of the firm is that marginal cost be equal to marginal revenue.
However, this condition is not sufficient, since it may be fulfilled and yet the firm may not be in
equilibrium. In figure 5:4 we observe that the condition MC = MR is satisfied at point é, yet clearly the
firm is not equilibrium, since profit is maximized at Xe > Xe. The second condition for equilibrium
requires that the MC be rising at the point of its intersection with the MR curve. This means that the MC
must cut the MR curve from below, i.e. the slope of the MC must be steeper than the slope of the MR
curve. In figure the slope of MC is positives at e, while the slope of the MR curve is zero at all levels of
output. Thus at e both conditions for equilibrium are satisfied.

(i) MC = MR
and
(ii) (slope of MC) > (slope of MR).

It should be noted that the MC is always positive, because the firm must spend some money in order to
produce an additional unit of output. Thus at equilibrium are the MR is also positive.

The fact that a firm is in (short-run) equilibrium does not necessarily mean that it makes excess profits.
Whether the firm makes excess profits or losses depends on the level of the ATC at the short-run
equilibrium. If the ATC is below the price at equilibrium the firm earns excess profits (equal to the area
PABe). If, however, the ATC is above the price the firm makes a loss (equal to the area FPeC). In the
latter case the firm will continue to produce only if it covers its variable costs. Otherwise it will close
down, since by discontinuing its operations the firm is better off: it mimimises its losses. The point at
which the firm covers its variable costs is called ‘the closing-down point.’ In figure the closing-down
point of the firm is denoted by point w. If price falls below P the firm does not cover its variable costs and
is better off if it closes down.

Mathematical derivation of the equilibrium of the firm

The firm aims at the maximisation of its profit

Π=R–C
where Π = profit
R = total revenue
C = total cost

Long-run equilibrium
Equilibrium of the firm in the long-run
In the long run firms are in equilibrium when they have adjusted their plant so as to produce at the
minimum point of their long-run AC curve, which is tangent (at this if) to the demand curve defined by
the market price. In the long-run the firm will arming just normal profits, which are included in the LAC.
If they are making excess its new firms will be attracted in the industry, this will lead to a fall in price (a
down ward shift in the individual a demand curves) and an upward shift of the cost curves due to the
increase of the prices of factors as the industry expands. These changes will continue until the LAC is
tangent to the demand curve defined by the market price. If the firms make losses in the long-run they
will leave the industry, price will rise and costs may fall as the industry contracts, until the remaining
firms in the industry cover their total costs inclusive of the normal rate of profit.

In figure 5.14 we show how firms adjust to their long-run equilibrium position. If the price is P, the firm
is making excess profits working with the plant whose cost is denoted by SAC. It will therefore have an
incentive to build new capacity and it will move along its LAC. At the same time new firms will be
entering the industry attracted by the excess profits. As the quantity supplied in the market increases (by
the increased production of expanding old firms and by the newly established ones) the supply curve in
the market will shift to the right and price will fall until it reaches the level of P (in figure 5.13) at which
the firms and the industry are in long-run equilibrium. The LAC in figure 5.14 is the final-cost curve
including any increase in the prices of factors that may have taken place as the industry expanded.

The condition for the long-run equilibrium of the firm is that the marginal cost be equal to the price and to
the long-run average cost.

LMC = LAC = P

The firm adjusts its plant size so as to produce that level of output at which the LAC is the minimum
possible, given the technology and the prices of factors of production. At equilibrium the short-run
marginal cost is equal to the long-run marginal cost and the short-run average cost is equal to the long-run
average cost. Thus, given the above equilibrium condition, we have

SMC = LMC = LAC = LMC = P = MR

This implies that at the minimum point of the LAC the corresponding (short-run) plant is worked at its
optimal capacity, so that the minima of the LAC and SAC coincide. On the other hand, the LMC cuts the
LAC at its minimum point and the SMC cuts the SAC at its minimum point. Thus at the minimum point
of the LAC the above equality between short-run and long-run costs is satisfied.

Q. What is meant by equilibrium of national income? Explain with the help of diagram.
National Income
National income means the value of all final goods and services which are produced during one year in a
country.

Components used to determine aggregate demand and aggregate supply

There are three components:
(i) Consumption
(ii) Saving
(iii) Investment

(i) Consumption
Consumption is the portion of income which is consumed.
C = f(y)
Consumption is the function of income, this is the positive relationship.

Income ↑ Consumption ↑
If
 Income ↓ consumption ↓

(ii) Saving
Saving is that part of income, which is not consumed or it is the part of income left after making
consumption expenditure.

Saving = Income – Consumption

S=Y–C

Saving is the function of income, this is a positive relationship i.e.

Income ↑ Saving ↑
If
Income ↓ Saving ↓

(iii) Investment
The expenditure done by the individuals, firms or countries to increase their incomes is called investment.

Investment

Autonomous Induced
Investment Investment

Investment = Autonomous Investment + Induced Investment

(i) Autonomous Investment (Io)

Autonomous investment cannot be effected by income, it remains constant at every level of income.

Income Io
1000 300
2000 300
3000 300

(ii) Induced Investment (Iy)

Induced investment is affected by income or demand.

I = 300 + 1/100 Y

Income Iy
1000 310
2000 320
3000 330
4000 340

Methods for the equilibrium level of national income

Two methods are used for the determination of equilibrium level of national income.

(i) Aggregate demand and aggregate supply approach

(ii) Saving investment approach

Aggregate demand and aggregate supply approach

Aggregate demand
Aggregate demand is defined as the total spending in a country on buying consumer goods and
investment goods. Aggregate demand consist of consumption and investment.

Aggregate supply
Aggregate supply is defined as the total value of goods and services produced in a country during a
period. Aggregate supply consists of consumption and saving.

Aggregate supply = consumption + saving

A. S = C + S

Determination of national incomes

According to Keynes, equilibrium level of income as at the point where A.D = A.S

Income(y) C S I C+I C+S

0 300 -300 600 900 0
1000 1000 0 600 1600 1000
2000 1800 200 600 2400 2000
3000 2600 400 600 3200 3000
4000 3400 600 600 4000 4000
5000 4200 800 600 4800 5000

Explanations
In the above diagram determination of national income is shown. Income is measured along x-axis and
agg.D and Agg.S is shown along y-axis. C+S is the consumption plos saving curve and C+I is the
consumption plus investment curve. Initially when income is 0 consumption is 300 and saving is negative
i.e. investment remains constant. According to Keynes, equilibrium level of national income takes place
at the point where aggregate demand equal to aggregate supply.

The point where income is 4000 that is the equilibrium point.

(ii) Saving = Investment Approach

According to saving investment approach, equilibrium level of national income is determined at the point
where S = I

C = 300 + 4/5Y, S = –300 + 1/5Y

Income C S I C+S
0 300 -300 600 0
1000 1000 0 600 1000
2000 1800 200 600 2000
3000 2600 400 600 3000
4000 3400 600 600 4000

Explanation
In the above diagram income is measured horizontally and saving and investment vertically. SS is the
saving curve and it is the investment curve. When income 0y is 2000 investment is greater than saving
higher investment will lead to a rise in income and saving till saving and investment are equal at the
equilibrium income level at point E where S = I.
 ECONOMIC
1. Optimum Factor Combination:
“The optimum factor combination will be represented by a point of tangency between the given
ISO-QUANT and the lowest possible ISO-Cost line”.

In production process the firm will try to get the combination of factors, which minimizes his
cost of production. This will be the optimum combination for him.

Explanation:
In the above diagram, units of capital are measured on Y-axis and the units of labour along X-
axis MN is the Iso-cost-line. Which is tangent to the ISO-Quant curve at point E, at point E the
firm purchases OL1 units of labour and OKI units of capital. Such combination represents and
optimal combination because at that combination the output of the firm is minimized and costs
have been minimized.

The Iso-cost-line MN also interesting at point A and B which are on the lower ISO-Quant that
has lesser production, so these points are not equilibrium point. IQ3 has more level of output
than IQ2 but it is not attainable due to the cost-constraint out of budget of the firm. Therefore,
“E” is an equilibrium point where the slope of ISO-cost-line is equal to the slope of ISO-Quant
Curve.
i.e., MPL/MPK

2. Minimization of Cost:
The condition for the equilibrium of the firm is that these must be tangency of the ISO-Quant
and the ISO-Cost curve must be convex to the origin.

In this case we have a single ISO-Quant curve, which denotes the desired level of output, but we
have a set of ISO-Cost lines. The producer wants to produce a given output with the minimum
Cost. The firm minimizes its cost by employing the combination of labour and capital
determined by the point of tangency of ISO-Quant with the lowest possible ISO-Cost curve.

Explanation:
In the above diagram labour is measured on X-axis and units of capital is on Y-axis. At point “E”
the slope of ISO-Cost line (CD) and slope of ISO-Quant curve an equal. So equilibrium point
“E” and OLI units of labour & OK1 units of capital are being utilized. The Iso-cost line
interesting the ISO-Quant at point M and N but there are not equilibrium points because these
point’s lies on higher cost line. While AB line represents such a lower cost but fail to produce the
output of IQ. Point “E” is a point where firm’s costs are minimized and IQ is convex to the
origin. Because at the point of tangency the ISO-Quant and Iso-cost line have the same slopes.

Explanation path:
The point of tangency between an Iso-quant and Iso-cost line indicates the least cost combination
of inputs that can produce the specific output. If all points of tangency are connected by a line, it
is called the expansion path of a firm.
Explanation:
In the above diagram firm is in equilibrium at point “E” producing 100 units to use OL1 labour
and OK1 capital. We suppose that the recourses of the increases, now the firm wishes to produce
200 units of output, the firm should operate at a point where an Iso-cost line is tangent to higher
Iso-quant curve at E point. At that the firm hires more units of input (labour and capital) to
produce 200 units of output. Like this we get point E”. Connecting these point (E,E’E”), we get
expansion path of the firm. It identifies the least cost input combination for each rate of output
and will generally slope upward, employing that the firm will expand the use of both inputs as it
increases output.

Total Demand for Money:

Transaction and precautionary motives are denoted by M1 and the speculative motive for holding
by Ma, then M = M1 + M2 M1 = f(y) and M2 = f(r), the total liquidity preference function is
expressed as M = f (y; r)

In this diagram LPC is the liquidity preference curve if the rate of interest is O 10, OM0 amount of
money is preferred for liquidity. If the rate of interest falls to Oi1, liquidity preference will
increase to M1.

Supply of Money:
Supply of Y money is the total quantity of money in the country for all purposes at any time.
Supply of money consists of currency notes and coins. The supply of money curve is taken
perfectly inelastic.

Determination of Interest Rate:

The rate of interest, like the price of any product is determined at the level where demand for
money and supply of money are equal.

In diagram SS represents the supply of money and LPC demand for money. Both intersect at E
where the equilibrium rate of interest is determined. If the demand for money increase and LPC
shifts upward, given the supply of money, the rate of interest rises. If the deamdn for money
decreases and LPC shifts downward, the rate of interest decreases. Thus the theory explains that
the rate of interest is determined at a point where the liquidity preference curve equals the supply
of money curve.

Q.3(a): Explain the concept of marginal propensity to save and marginal propensity to
consume. Also discuss the existing relationship between marginal propensity to consume
and multiplier.
Ans: Meaning of Consumption
Consumption means the utilization of goods and services to meet human needs. It involves
expenditure on consumer goods which is the same thing or retail sales to the consumers.

Consumption Function:
Consumption function is also called propensity to consume. It is functional relationship between
two aggregates, total consumption and gross national income C = f(Y) where C is consumption,
Y is income, and f is the functional relationship.

Infact, propensity to consume is a schedule of various amounts of consumption expenditure

corresponding to different levels of income.

Consumption Schedule:
0 Million 20 Million
100 Million 100 Million
200 Million 180 Million
300 Million 260 Million
400 Million 340 Million

Explanation:
In the above table when income is “zero” consumption expenditure of the people are “20”
million. When income increases to 100 million, it is equal to consumption, it is the basic
consumption level. After this, income is shown by 200 million and consumption to increase by
180 M. after that point, income and consumption increase but consumption increases with slow
ration as compared to income.

In the diagram OC curve indicates consumption level and oy income level 45 o line shows unity
line where at all levels income and consumption are equal. ‘E’ point shows equality of income
and consumption. It is the break-even point where c = Y when income rises to oy, consumption
also increase to oc, but increase in consumption is less than increase in income. The portion of
income which is not consumed is called saving. In the above diagram at oy1, income level
consumption is oc, thus the different between cc curve and oc1 curve is ss that portion is called
saving.

Properties of Consumption Function:

The propensity to consume has two properties.
(i) Average propensity to consume.
(ii) Marginal propensity to consume.

(i) Average Propensity to Consume:

Average propensity to consume means the proportion of consumption expenditure to total
income at various levels of income. It is found by dividing consumption expenditure by income.

. It is expressed as the percentage of income consumed.

For example: If the income of the family is 100 million and expenditure is 80 million, the APC
will be
The APC declines as income increases because the proportion of income spent on consumption
decreases.

(ii) Marginal Propensity to Consume:

Marginal propensity to consume is the ratio of the change in consumption expenditure to a given
change in income. It can be found by dividing change in consumption by a change in income.

For Example. If income increases from Rs. 100/= Rs. 200/= as a result, consumption also
increase from Rs. 80/= to Rs. 150/= million. Then the marginal propensity to consume is as
under:

= 0.7

The following table is constructed with the help of that consumption function.

C = Co + cY
C= 20 + 0.8y

Income Consumption APC AY AC MPC

0 20 - - - -
100 100 1.0 100 80 0.8
200 180 0.9 100 80 0.8
300 260 0.88 100 80 0.8
400 340 0.87 100 80 0.8

Income is measured along the x-axis and consumption expenditure along y-axis. Y = C + S is the
helping line drawn at 45o that line indicates the income and consumption.

Expenditure are equal at every point on that line. CC curve shows consumption expenditure. At
point B CC curve intersect holding line here disposable personal income is equal to consumption
that point is called “break-even point,” at that point APC = I on left side of that point APC>I and
on right side PAC<___. According to Keynes marginal propensity to consume is always greater
than “zero” and less than “one”.

Meaning of Saving:
Whatever portion of disposable income is not spent on consumption goods is called saving.

Propensity to Save:
Propensity to save means the saving function and saving schedule showing difference amount
that would be saved at different levels of income.

S = Y-C
S = f(y) saving is a function of income where S is the dependent and Y is the independent
variable, thus the saving function indicates a functional relationship between S and Y.

Income Consumption Saving

50 60 -10
100 100 0
150 140 10
200 180 20
250 220 30

In the above diagram the level of incomes measure on x-axis and saving on y-axis SS shows the
propensity to save at different levels of income. At Rs. 50 million level of income, saving is
negative. When income increases to 100 million, at that level there is no saving. After that
income level saving becomes positive.

Properties of the Saving Function:

There are two attributes of propensity to save like propensity to consume.

(i) Average propensity to Save

“The APS means the ratio of saving to any particular level of income.” The Average propensity
saved at a given level of income.

For example, if income is 100 million and consumption is Rs.80/- million, then the saving will
be equal to Rs.20/-.

APS = I – APC

(ii) Marginal Propensity to Save

“Marginal propensity to save means the proportion saved out of marginal increment of income.”

MPS = I – MPC

Saving Schedule:
The average propensity to save and marginal propensity to save are illustrated in the following
table.

Income Saving APS MPS Consumption

Rs. 50 -10 - - 69
100 0 0.0 0.2 100
 150 10 0.07 0.2 140
200 20 0.10 0.2 180
250 30 0.12 0.2 220

In the above table, as income increases, the average to consume also increases. But marginal
propensity to save remains constant. This can be illustrated in the following diagram.

In the above diagram disposable income is indicated on the x-axis and net saving at each level of
income on y-axis. The coordinates of income and saving have been plotted and the curve
ABODE obtained. Negative saving is indicated by point A below and to the left of x-axis, when
income is 50 saving would be negative. At point B of saving curve, there is no saving because
that point falling on the x-axis in the curve. The points CD and E are above the axis and indicate
positive saving.

Relationship between martial propensity to consume and multiplier

Keynes considers his theory of multiplier as an integral part of his theory of employment. The
multiplier, according to Keynes, “establishes” a precise relationship, given the propensity to
consume, between aggregate employment and income and the rate investment. It tells us that,
when there is an increment of investment, income will increase by an amount which is k times
the increment of investment” i.e. ΔY=kI, Δ. In the words of Hansen, Keynes’ investment
multiplier is the coefficient relating to an increment of investment to an increment of income, i.e.
k=ΔY/ΔI, where Y is the investment, is change (increment or decrement) and k is the multiplier.

In the multiplier theory, the important element is the multiplier coefficient, k which refers to the
power by which any initial investment expenditure is multiplied to obtain a final increase in
income. The value of the multiplier is determined by the marginal propensity to consume, the
higher is the value of the multiplier, and vice versa. The relationship between the multiplier and
the marginal propensity to consume is as follows:

ΔY = ΔC + ΔI
or ΔY = cΔY + Δ[ΔC = cΔY]
ΔY = cΔY + ΔI
ΔY (I – c) = ΔI
Since c is the marginal propensity to consume, the multiplier k is, by definition, equal to .
The multiplier can also be derived from the marginal propensity to save (MPS) and it is the
reciprocal, of MPS,

Table I: Derivation of the Multiplier

ΔC/ΔY (MPC) ΔS/MPS K (Multiplier
[I – (MPS)] coefficient)
0 1 1
2

3 3
4

10

1 0 X (Infinity)

The table shows that the size of the multiplier varies directly with the MFC and inversely with
MPS. Since the MFC is always greater than zero and less than one (i.e., O < MPC < I), the
multiplier is always between one and infinity (i.e., I< k <α). If the multiplier is one, it means that
the whole increment is saved and nothing is spent because the MFC is zero. On the other hand,
an infinite multiplier implies that MFC is equal to one and the entire increment of income is
spent on consumption. It will soon lead to full employment in the economy and then create a
limitless inflationary spiral. But these are rare phenomena: Therefore, the multiplier coefficient
varies between one and infinity.

Q.4(a). What is meant by oligopoly? Explain “Zero-sum” game in relation to game

Theory?

OLIGOPOLY
Definition:
Oligopoly is an industry structure characterized by a few large firms producing most or all of the
output of some product. They are mutual inter dependence; each firm realizes its actions will
effect its rivals, and vice versa. Some important industries like automobile, steel and electrical
equipment industries are included oligopoly.
Features of Oligopoly
1. New Firms
In oligopolistic model there are few firms, which are producing homogeneous product. When the
firms are considerable fraction of the total output of industry and can have a noticeable effect on
market conditions. The firm has direct influences upon every other firm in the industry.”

2. Interdependence
In oligopolistic model that the policies of every producer directly effect each other because the
products are substitutes for one another. Therefore, pricing and output decisions of one firm are
considered by other firms. Every move by one firm leads to counter moves by the others.

3. Advertisement
Oligopolistic firm sells its product through advertisement. For this purpose the firm has to spend
much in advertisement.

4. Lack of Uniformity
In oligopolistic model the lack of uniformity in the size of firms. Firms are differing considerably
in size, some may be small, and other may be large.

5. Demand Curve
In oligopoly an individual seller’s price of output move will lead to unpredictable reactions on
price policies of his rivals. Nature of demand curve depends upon expectation in future.

Game Theory
Game theory is the study of interacting decision-makers firm or a consumer – in very simple
environments. The strategic interactions of the agents were not very complicated. In this chapter
we will lay the foundations for a deeper analysis of the behavior of economic agents in more
complex environments.

There are many directions from which one could study interacting makers. One could examine
behavior from the viewpoint of sociology, psychology, biology, etc. Each of these approaches is
useful in certain contexts. Game theory emphasizes a study of cold-blooded “rational” decision-
making, since this is left to be the most appropriate model for most economic behavior.

Game theory has been widely used in economics in the last decade, and much progress has been
made in clarifying the nature of strategic interaction in economic models. Indeed, most economic
behavior can be viewed as special cases of game theory, and a sound understanding of game
theory, and a sound understanding of game theory is a necessary component of any economist’s
set of analytical tools.

Zero Sum Game

A game in which winnings for or one player are losses for the other players.

Q.10(c) What is monopoly? How price is determined under monopoly?

OR
How does a firm achieve equilibrium under monopoly?
Ans: Monopoly
The monopoly is that market form in which a single producer controls the whole supply of a
single commodity which has no close substitutes.

Monopoly is a market situation in which there is one seller of a product. The product has no
close substitute.

Following points should be noted in regard of monopoly.

1. Single Producer or Seller

A single producer or seller controls the whole supply of the product in monopoly. A single
producer or seller may increase or decrease the supply.

2. Distinction Between the Firm and Industry Disappears

Monopoly the distinction between the firm and industry disappears.

3. No Close Substitute
The commodity produced by the producer must have no close competing substitute, if he is to be
called monopolist.

4. Inelastic Demand
In monopoly demand is inelastic. Price may increase but demand remain the same.

5. Control Over Price

A monopolist has considerable control over the price of commodity.

6. Power to Influence
Power to influence price is the very essence of monopoly.

7. No Entry of New Firm

In monopoly it is a legal restriction that a new firm cannot enter the market.

8. Negative Slope of Demand Curve

The monopolist faces the negative slope of demand curve as he can increase the sale by lowering
the price.

Pure Monopoly
In pure monopoly one firm produces and sells a product which has no substitute. The cross-
elasticity of demand with every other product is zero. Prof. is of the view that pure monopoly is
that situation when a producer is so powerful, that he is always able to take the whole of all
consumer’s incomes whatever the level of his output.”

In the words of Professor Triffins, “Pure monopoly is that where the cross-elasticity of demand
of the monopolist’s product is zero”.
The monopolist has absolutely no rivals. His price-output policy does not influence firms in
other Industry. Nor is he affected by others.

Pure monopoly occurs when a producer is so powerful that he is always able to take the whole of
all consumers incomes whatever the level of his output and this will happen, when the average
revenue curve for the monopolists firm has unitary elasticity and is at such a level that all
consumers spend all their income on the firm’s product whatever its price. Since the elasticity of
the firm’s average revenue curve is equal to one, total outlay on the firm’s produce will be the
same at every price. The pure monopolist takes all consumer’s incomes all the time.

Explanation
AR is demand curve facing the pure monopolist. Since AR is a rectangular hyperbola. MR
coincides with the OX, axis. The monopolists can fix either price or output. If ________ by his
customers. If he fixed his output at OA, then price is OP to be paid for that is also decided by the
customers. Thus even a pure monopolists with no rivals at a_______nnot fix both price and
output at the same time.

Since a pure monopolist earns the whole income of the community all the time, he will maximise
his profits when his total costs are the lowest. It implies that his profits are the maximum when
he sells a very small output. Only one unit at a very high price and in the process takes away the
entire income of consumers. This is, however, not possible. So pure monopoly is only a
theoretical possibility. It has never existed and will never exist.

Prices or Output Determination Under Monopoly

The aim of the monopolist, like every other producer is to maximize his total money profits. He
will produce up to a point and charge a price which gives him the maximum money profit. In
other words, he will be in equilibrium at that price output level at which his profits are the
maximum. He will go on producing so long as additional units add more revenue than to cost. He
will stop at that point beyond which additional units add more revenue then ID the cost. He will
stop at that point beyond which additional units of production add more cost than to revenue. He
will be in equilibrium position at that level of output at which MR = MC. That is, he will
continue producing so long as marginal revenue exceeds marginal cost. He does so because
profits will go on increasing as long as the MR exceeds the MC. At the point where MR is equal
to MC the profit will be maximised and here he stops production. If the production is carried
beyond his point profits will start decreasing.

Explanation
AR is the demand curve average revenue curve which lies below the average revenue curve AR
AC is the average cost curve, MR is the marginal cost curve. It can be seen from the diagram that
uptill OQ output, MR is greater than MC but beyond OQ the MR is less that MC. Therefore the
monopolist will be in equilibrium at the output, OQ, whereas MR = MC and profit are the
greatest. The price at which output OQ is sold in the market can be known from AR curve. It can
be seen from the diagram that corresponding to equilibrium out-put OD, the price on the demand
OR AR curve is QF = OP

Total Revenue = Average revenue x units of output

Total Revenue = OQ x FQ’OQFP
Total Cost = Average cost = units of output
Profit = Total Revenue = Total Cost
Profit = OQBC – OQEP
= CBFP
Π =R–C

MR = MC
Here π = (Profit)
R = (Revenue)
C = (Cost)

Q.10.(d) What is monopolistic competition? How is price and output determined under
monopolistic competition?
OR
What do you understand by the monopolistic competition? Discuss the equilibrium of a
firm under monopolistic competition.
Ans. Monopolistic Competition
Monopolistic competition refers to a market situation where there are many sellers of a
differentiated product. There is competition which is keen though not perfect, between many
firms making very similar products. No seller can have any perceptible influence on the price
output policies sellers nor can he be influenced much by their actions. Thus monopolist
competition refers to competition among a larger number of sellers producing close but not
prefect substitute products.

In short monopolist competition refers to a market situation in which there are many producers
producing output is differentiated.

Features of Monopolist Competition

1. Large number of sellers.
2. Products differentiation.
3. Freedom of entry and exist of firm.
4. Nature of demand curve.
5. Goods made by the firm are close substitute.
6. Large number of Buyers.
7. Control over price.
8. Advertisement and propaganda.
9. Hard competition.

Price Determination of a Firm Under Monopolist Competition

1. Short-Run Equilibrium
In short-run equilibrium of a firm under monopolist competition the same and each firm trys to
earn maximum profit. Same firms can fix the different prices keeping in view of their total cost
and sometimes a view numbers of the firms earn abnormal profits as compare to other firms due
to proper advertising and propaganda of their products. A firm is in equilibrium position when
MC = MR.

In short-run a firm can earn abnormal profit or face loss.

Abnormal Profit Explanation

AR is average revenue curve MR is marginal revenue curve SMC is the short-run marginal cost
curve. SAC is the short-run average curve. MR curve and MC curve (SMC) intersect each other
at point E at the output OQ at which price is OH (=MQ) because point M is a point on AR that is
price.

The firm is earning abnormal profit. Abnormal profit per unit of output is the difference between
average revenue and average cost at the equilibrium point. In this equilibrium the AR is MQ and
AC is LQ (L is an SAC) therefore, ML is the abnormal profit per unit. Abnormal profit will be
measured by the area of the rectangle ML HR that is output multiplied by the abnormal profit
per unit of output.

Loss
If cost of production as well as the market demand situation (condition is unfavouable for the
firm then a firm under monopolist competition (under short-run) faces a loss.

Explanation
Here is the price is OQ (QL) which is less than the average cost KQ. KL is the loss per unit of
the output OQ (=LA) hence, the total loss is represented by PK AL

In short there is only one condition of equilibrium that is

MR = MC

Long-Run Equilibrium
Under monopolist competition under long-run equilibrium general earn normal profit. In long-
run new firms enter into industry so the concept to abnor_____ profit and loss will be converted
into normal profit.

Explanation
AR curve is tangent to LAC curve at point K. The equilibrium output in the long-run is OQ and
the price is KQ (=OP). At this point AC is also KQ and so is average revenue. Firm earns only
normal profit.

In long-run, therefore, in long-run, however, both the condition must hold that is MR = MC AR
= AC the firm is in equilibrium when output is OQ and the price is KQ (=OP). In long-run
however, both the conditions must hold that is

MR = MC
AR = AC

Money Supply
Equation (7) defines money supply in terms on high powered, money. It expresses the money
supply in terms four determinants, H, Cr, RRr, and Err. The equation stated that the higher the
supply of high-powered money, the high ______ the money supply. Further; the lower the
currency ratio ________ the reserve ration (RRr), and the excess reserve ration (Err), the higher
the money supply; and vice versa.

The relation between the money supply and high powered money is illustrated in Figure 10.1.
The horizontal curve Hs shows the given supply of high-powered money. The curve Hd shows
the demand for high-powered money associated with each level of money supply and represents
equation (6). The slope of the Hd curve is equal to the term (Cr+RRr+ERr)\(I+Cr). Given Cr,
RRr, Err and the high-powered money Us, the equilibrium money supply is OM. If the money
supply is large than this, say OM1, there will be excess demand of high-powered money. On the
contrary, _______ less than OM money supply will mean less demand for high-powered money.

If there is an increase in any one of the ratios Cr or RRr or Err, there would be an increase in the
demand for high-powered money. This is shown by the Hd’ curve in Figure U-I______ where
the increase in the demand for high-powered money leads to decline in the money supply to
OM’.

The quotient of equation (7) is the money multiplier m.

Thus

Now the relation between the money supply and high-powered money of equation (7) becomes
M = mH …(9)

Equation (9) expresses the money supply as a function of m and H. In other words, the money
supply is determined by high powered money (H) and the money multiplier (m). The size of the
money multiplier is determined by the currency ration (CV) of the public, the required reserve
ratio (RRr) at the central bank, and the excess reserve ratio (ERr) of commercial banks. The
lower these ratios are, the larger the money multiplier is. If m is fairly stable, the central bank
can-manipulate the money supply (M) by manipulating H. The central bank can do so byopen
market operations. But the stability of m depends upon the stability of the currency ratio and the
reserve ratios ERr and ERr. Or, it depends upon oft-setting changes in RRr and ERr ratios. Since
these ratios and currency with the public arc liable to change, the money multiplier is quite
volatile in the short run.

Given the division of high-powered money between currency held by the public, the required
reserves at the central bank, and the excess reserves of commercial banks, the money supply
varies inversely with Cr, RRr and ERr. But the supply of money varies directly with changes in
the high-powered money. This is shown in Figure 2. An increase in the supply of high-powered
money by ΔH shifts the Hs curve upward to Hs’. At E, the demand and supply of high-powered
money is in equilibrium and money supply is OM. With the increase in the supply of high-
powered money to Hs’, the supply of money also increases to OM1 at the new equilibrium point
E1. Further, Figure 2 reveals the operation of the money multiplier. With the increase in the high-
powered money by Δ.H, the money supply increases by ΔM. An increase in high-powered
money by Re 1 increases by a multiple of Re 1.

Some economists do not take into consideration excess reserves in determining high-powered
money and consequently the money supply. But the monetarists give more-importance to excess
reserves. According to them, due to uncertainties prevailing in banking operations as in business,
banks always keep excess reserves, and the cost generated by deficiency in excess reserves. The
first cost is in terms of the market rate of interest at which excess reserves are maintained. The
second cost is in terms of the bank rate which is a sort of penalty to be paid to the central bank
for failure to maintain the legal required reserve ratio by the commercial bank. The excess
reserve ratio varies inversely with the market rate of interest and directly with the bank rate.
Since the money supply is inversely related to the excess reserve ratio, decline in the excess
reserve ratio of banks tends to increase the money supply and vice versa. Thus the money supply
is determined by high-powered money, the currency ratio, the required reserve ratio and the
market rate of interest and the bank rate.