Mashinda Commercial Academy 2016 ‘A’ Level Economics notes
THEORY OF THE FIRM commodity on the market, the price will rise. The
Price and output determination
Interaction of demand and supply
In our previous discussion on the theory of demand
we observed that ceter is par ibus, mor e of a
commodity is demanded as the pr ice falls. On the
other hand, the law of supply states that Ceter is
par ibus, less of a commodity is supplied as the
pr ice falls. The following diagram shows a demand
curve and a supply curve plotted on the same
graph.
Interaction of the market forces
E where supply ≠ demand. This implies that a price
 The demand curve and the supply curve
intersect at point E, which is termed the market
equilibrium point.
 The equilibrium point is the point at which
market demand is equivalent to market supply,
implying that at this point both the interests of the
buyers and sellers are satisfied. The market will be
balanced at this point
 The equilibrium point determines the price
and the quantity of a commodity to be supplied on
the market i.e. price P becomes the market price
while firms will supply quantity Q
 Price P is termed the market clearing price
implying that all the products brought on to the
market by firms are bought at the same time all the
consumers who have effective demand for the
product get it
Functions of price
1. Rationing device
 The price acts as a tool to determine who
can consume a product. The price changes as
market forces change e.g. if there is a shortage of a
1
effect of such a price rise is to discourage demand.
When there is a shortage, the price is bid up –
leaving only those with the willingness and ability
to pay to purchase the product.
2. Allocative mechanism
Prices perform the signalling function in a market,
i.e. they adjust to signal where economic resources
are required and where they are not. Prices rise and
fall in response to surpluses and shortages. For
instance, if prices are rising due to excess demand
it signals producers to increase output so as to meet
the increased demand.
Equilibrium & disequilibrium
 The market is in equilibrium if demand =
to supply as shown in the diagram above. At this
point the wishes of the buyers and sellers coincide.
 Market disequilibrium occurs in cases
above or less than P is charged or quantity different
from Q is supplied onto the market.
 Market disequilibrium results in excess
demand, a situation where demand exceeds supply
or excess supply, whereby supply exceeds demand.
Changes in market forces and equilibrium
The term market forces refer to the forces of
demand and supply. Reference is made to the
previous chapters were we discussed changes in
demand and supply. We noted that a change in a
market force is cause by a change in its non price
determinant. It was observed that a change in
supply or demand results in a new curve.
Changes in demand
 A change in demand can be either an
increase in demand or a decrease in demand.
 An increase in demand causes the demand
curve to shift outwards (to the right) as shown on
the diagram below.
 A decrease in demand implies an inward
shift of the demand curve, implying less is being
demanded at the previous price as shown in the
diagram below.
Increase in demand Decrease in demand
Mashinda Commercial Academy 2016 ‘A’ Level Economics notes

Ceteris paribus, Ceteris paribus, a

an increase in decrease in
demand will demand, results in
result in a price a price fall.
increase. Decreased Traditional objective of the firm
Increased demand demand for a
for a product will product will cause Traditional economic theory assumes profit
cause a shortage an excess supply maximisation as the sole objective of a firm.
of that product on of the product on Therefore economic decisions made by the firms
the market. This the market. This
will cause an are motivated by this aspect of maximising profits
will cause a
extension in contraction in (rational behaviour).
supply from Q1 supply from
–Q2 resulting in Q1–Q2 resulting in Profit
new equilibrium a new equilibrium
price P2 & price P2 & The economists’ definition is different from that of
quantity Q2. quantity Q2. the accountant. Economists identify two types of
profits which are normal profit and abnormal profit

Changes in supply  Normal profit

 A change in supply can be either an It is the minimal amount of profit which is

increase in supply or a decrease in supply.
 Supply is said to have changed when more
or less of a product is being supplied at a constant
price.
 The following diagram shows the effect of
changes in supply to the market equilibrium.
necessary to keep a firm in the industry. The firm
has to be able to reward its factors of production
i.e. labour, land and capital for it to continue
operating. The entrepreneur must be rewarded for
his/her investment, if that is not done he/she will
disinvest and invest elsewhere. For instance, if a
business is generating a return of 10% while the
bank is offering interest of 15%, ceteris paribus, a
rational investor disinvests in the business and
invests the funds with the bank.

Economists consider some profit to be a cost of

doing business as measured by the opportunity cost
of the investment. These are implicit costs which
economists consider for decision making purposes.

 Abnormal profit

If normal profit represents the opportunity cost of

Ceteris paribus, Ceteris paribus, a investing capital into the business then any return
an increase in decrease in above this is termed abnormal profit. It is also be
supply will result supply will result called supernormal profit.
in a price fall. in a price
Increased supply increase. Other objectives of the firm
for a product will Decreased supply
cause excess for a product will
supply i.e. cause a shortage
2 supply> Demand. of that product on
This will cause an the market. This
extension of will cause a
demand from Q1 contraction of
–Q2 resulting in demand from Q1
Mashinda Commercial Academy 2016 ‘A’ Level Economics notes
Apart from the traditional objective of profit
maximisation modern businesses pursue a number
of other objectives. These objectives can have their
roots traced to the profit maximising objective.
These are
 Increasing market share
 Increasing productivity [return on factors
of production]
 Customer service
 Growth
 Achieve a targeted return on capital
MARKET STRUCTURES
A market is a set of buyers and sellers, commonly
referred to as agents. These agents through their
interaction, both real and potential, determine the
price of the good and the quantities to be supplied
[market forces]. This topic focuses on those
characteristics that
The main aspects used to determine the structure of
the market are:
1. Number of buyers
2. Number of sellers
3. Nature of the product
4. Degree of freedom of entry
5. Nature of information
We are going to discuss 4 market structures with
perfect competition being the most competitive and
monopoly where the firm is synonymous with the
market.
Perfect competition
For a state of perfect competition to exist the
following conditions have to exist
1. Many buyers and sellers, of which none of
the market participants is able to single handedly,
influence the market decision. This implies that
each market participant is small enough to be a
price taker on the market.
The demand of a individual buyer relative to the
total demand is so small that he cannot influence
the price of the product by his individual action. On
the other hand, the supply of an individual seller is
so small that the supplier cannot influence the price
of the commodity by its action alone.
This means the price is determined by the market
forces and firms become price takers
3
2. Freedom of entry and exit; no barriers to
entry exist in the market, implying that new firms
are free come into the and those that are no longer
interested to participate in the market are free to
leave the industry. This means if the industry is
making abnormal profits new participants are
attracted into the industry and join the industry. On
the other hand if profits fall below normal profits
firms are free to leave the industry. This is based on
the assumption that there is perfect factor mobility
implying that the factors of production are can be
applied to different uses.
3. Homogeneous products; each firm
produces and sells homogeneous products. This
implies that consumers are indifferent as to which
supplier to buy from. The products produced by
each supplier are perfect substitutes e.g. maize, salt
4. Perfect knowledge of market conditions;
all agents have perfect knowledge of the products,
their prices and other information related to these
products. This information is available free of
charge to the consumers. This means there is no
opportunity for consumer exploitation e.g. price
discrimination.
Individual firm’s demand curve
In a perfectly competitive market demand is
perfectly elastic because the presence of
homogeneous products and perfect knowledge
makes it impossible for a firm to sale at a higher
price, at the same time it becomes irrational for a
firm to charge a price below the market clearing
price. This is illustrated by the diagram below
The diagram on the left shows the market demand
and supply with price, P being the market clearing
price. The diagram on the right illustrates that each
firm will therefore face a perfectly elastic demand
as there are so many buyers that any quantity
brought onto market can be sold at the prevailing
market price. This implies that the firms do not
have to reduce price in order to sale more i.e. MR =
P. This implies that the demand curve is the same
Mashinda Commercial Academy 2016 ‘A’ Level Economics notes
as the marginal revenue curve.
Decision making at the marginal:
Pr ofit maximisation theor y
Firms pursue the profit maximising objective
therefore they produce output until MR = MC. It
has been noted that, ceteris paribus the MC rises as
output increases.
In the diagram above, if the MR is above MC it is
profitable to continue production because MR­MC
contributes positively to the firms’ profit. However
if the MC > MR this makes a negative contribution
to the firms profit since producing additional unit
costs more than the revenue it generates.
NB; All pr ofit maximising fir ms pr oduce up to a
point wher e MC=MR
Weaknesses of the theory
1. It assumes that firms will respond to every
shift in the market and alter the price and output
accordingly. This is unlikely to happen in practice
because increasing prices too rapidly may
adversely affect brand loyalty and promotes
speculative tendencies. Also in large firms the cost
of changing brochures and price lists may outweigh
the benefits.
2. It assumes that firms have complete
information about the costs and benefits of each
option they compare i.e. costs, price and demand.
In order to set price firm needs to know the
marginal cost and the elasticity of demand. In
practice such information is difficult as firms can
produce a number of products and detailed
information on marginal cost or demand is rarely
available.
3. Firms may seek to maximise long run
profits thereby pursuing other objectives such as
4
maximising sales or increasing market share.
4. The theory only considers private costs i.e.
it ignores issues to do with externalities. In practice
it has been noted that firms producing negative
externalities are getting negative publicity which
adversely affects their ability to generate profits.
Short run function
 We previously described the short run as
an economic period whereby period at least one
factor of production is fixed in supply. However, in
this context we use it to mean that the firms are
fixed i.e. no new entrants in the market.
 In the short­run period, the firms in
perfectly competitive markets can earn
supernormal profits.
 The short run cost function for perfectly
competitive firm is illustrated in the diagram below
In the short run there are relatively less firms in the
industry thus market supply will be lower enabling
firms to make supernormal profits. The profit is the
difference between AR­AC multiplied by quantity
[AR­AC]Q, this is shown by the shaded area.
NB: the MC curve becomes the supply curve
whenever the MC is greater than the AVC, this is
attributable to the fact that its irrational for a firm to
supply at a price below the AVC (below the shut
down point)
Long­run equilibrium
The supernormal profits earned by firms in the
short run will attract new firms into the industry. In
the absence of barriers to entry, the entry of new
firms will have the effect of increasing market
supply. As the market supply increases the prices
will fall thus eliminating the short­run supernormal
profits. This is shown in the diagram below.
Mashinda Commercial Academy 2016 ‘A’ Level Economics notes
The diagram shows that in the long run all firms
earn normal profits i.e. AR=AC.
Perfect competition and efficiency
Productive efficiency
 It occurs when output is being produced at
the lowest possible average cost.
 Perfectly competitive markets are
productively efficient in the long run as firms
produce at the lowest point of the AC
 In the short run firms produce at
productively inefficient levels as the AC curve
would be rising when output is determined
Allocative efficiency
 It occurs whenever the MC=Price
 Achieved whenever the price of a
commodity reflects the true marginal cost
 We cannot make any agent better without
making another worse off
 At this point both consumer surplus and
producer surplus are maximised
 In other words demand = supply, implying
the market clearing price is used
 In perfectly competitive markets allocative
efficiency is achieved both in the short run and the
long run period
Short run shut down condition
For a firm to continue operating in a particular
industry the selling price (AR) must be above
the variable costs. Fixed costs are sunk costs i.e.
they are not relevant for decision making purposes
because the firm will continue to incur them either
option it takes. If output is nil (shut down) fixed
cost will be incurred in the same way as if
production takes place.
The golden rule is that price must always cover the
AVC, the difference will then make a contribution
towards covering fixed costs. This can be
5
illustrated below
It can be noted from the above diagram that at the
price of $10 the firm earns a normal profit. NB: the
AVC & the ATC curves are not parallel to each
other instead the gap narrows down as output is
increased. This is due to the behaviour of AFC.
This explains why the MC curve becomes the
supply curve whenever it is above the AVC
Merits of perfect competition
1. Allocative efficiency is achieved in both
the short run and the long run (P=MC)
2. Productive efficiency is achieved in the
long run i.e. AC is at its minimum
3. Competition improves efficiency in firms
operations
4. Firms do not incur selling costs because
there is perfect information and products are
identical
Demerits
1. The assumptions of homogeneous
products and perfect information makes it hardly
applicable in practice
2. Small firms do not enjoy economies of
scale, this is worse off compared to having few
large firms in the industry
To sum up, perfect competition is an economic idea
that does not exist in real world but it can be used
as a standard to assess the efficiencies and
effectiveness of real world markets
IMPERFECT COMPETITION
In real world it is difficult to find perfectly
competitive markets. Imperfect competition occurs
whenever the conditions required for a market to be
Mashinda Commercial Academy 2016 ‘A’ Level Economics notes
fully competitive are not fully satisfied.
Imperfect competition is a competitive market
situation where there are many sellers, but they are
selling heterogeneous (dissimilar) goods as
opposed to the perfect competitive market scenario.
As the name suggests, competitive markets that are
imperfect in nature. In this market scenario, the
seller enjoys the luxury of influencing the price in
order to earn more profits.
If a seller is selling a non identical good in the
market, then he can raise the prices and earn
profits. High profits attract other sellers to enter the
market and sellers, who are incurring losses, can
very easily exit the market.
Types of imperfect competition
Monopolistic competition
Monopolistic competition as a market structure was
first identified by Joan Robinson & Edward
Chamberlin in 1932. It has the following
characteristics. It refers to a market situation which
there is a large number of firms which sales closely
related but differentiated products. Under this
market structure each firm is the sole producer of a
particular brand e.g. Uniliver; Geisha soap,
Olivine; Jade soap. This has th e following
implications
 The firm enjoys ‘monopoly position’ as
far as the production of that particular brand is
concerned.
 Since the various brands are close
substitutes the monopoly position is influenced by
still competition from rival brands
Monopoly + competition = Monopolistic
competition
Characteristics of monopolistic competition
1. Many buyers and sellers as the same case
with perfect competition
2. Product differentiation/ heterogeneous
products. Each firm in the industry produces a
similar product but differentiates its product from
those of the competitors’. This gives the firm
considerable influence on the price. Firms are not
price takers in monopolistic competition. The
extent of control over its price varies in accordance
with the manner in which buyers are attached to the
6
brand.
3. Freedom of entry and exit into the market.
There are no barriers to entry in monopolistic
markets. The freedom of entry and exit will explain
the absence of supernormal profits in the long run.
4. Lack of perfect knowledge; agents do not
have perfect knowledge of the market conditions.
Therefore firms incur selling costs when selling
their products as opposed to perfectly competitive
markets were consumers have perfect knowledge,
hence no need to incur selling cost e.g. advertising
as consumers already know about the product
5. Non price competition; in addition to price
wars, firms also engage in non price competition to
increase revenue. This is in addition to price
competition.
Downward sloping demand
Firms operating under monopolistic competitive
markets engage have to reduce price for them to
sell more (price competition). This implies that the
demand for their products increases as the price
falls. Therefore the marginal revenue falls as output
increases.
Demand
 Product differentiation and branding have
the effect of creating brand loyalty implying that
the products are not perfect substitutes.
 Increasing the price of the product does
not result in no sales as some consumers may
become loyal to that particular brand e.g. after a
price cut for Bakers Inn bread, other bakeries was
still made some sales partially because the
consumers were loyal to those particular brands
 Therefore products produced by firms in
monopolistic competitive firm have a downward
sloping demand curve, implying that the firm has to
reduce price in order to sale more (price
competition)
Short­run equilibrium
 As in perfect competition, there is freedom
of entry and exit in the industry. This means firms
in the short run are able to earn supernormal profits
and these profits will attract other firms into the
industry
 The short run equilibrium for a firm in
monopolistic competition is illustrated by the
diagram below.
Mashinda Commercial Academy 2016 ‘A’ Level Economics notes

The following facts must be noted from the The following facts must be noted
diagram
a. Firms produce at MC=MR
a. The demand curve is downward sloping b. Firms earn normal profits i.e. AR = AC
i.e. firms have to reduce price to sale more c. The firms operate at productively
b. The MR < AR because each additional inefficient levels i.e. the AC is still falling, thus
unit can only be sold a reduced price firms are not fully exploiting the economies of
c. Firms are profit maximisers therefore they scale
produce up to a point where MR = MC (profit d. Demand is more elastic in the long run
maximising output) because of increased substitutes
d. The supernormal profits are represented
by the shaded area i.e. (AR – AC)Q
e. Firms are not productively efficient coz
they produce at the point which the average cost is
still declining. The minimum point of the AC is
that where the AC=MC

Long run equilibrium

The assumption of free entry and exit implies that Merits

the presence of supernormal profits imply that new
firms are attracted into the industry by these 1. Consumer sovereignty is upheld as
supernormal profits consumers can choose from the range of products
in the market
 The entry by new firms will increase the 2. The market structure is realistic
market supply and this puts pressure on the prices
to fall Demerits
 Reduced prices and intense competition
1. Productively and allocative inefficient in
will contribute to the erosion of supernormal profits
both the short­run and the long run period
until the firms start earning normal profits
2. Product differentiation reduces the price
 This is illustrated in the diagram below:
elasticity of demand for the product in question,
this exposes the consumers to the risk of
exploitation.
3. Some resources are consumed in the
process of advertising

Monopoly

A monopoly market is a market which has the

following characteristics

7
Mashinda Commercial Academy 2016 ‘A’ Level Economics notes
1. A single supplier: one supplier who is
synonymous to the market because besides that
firm there is no other supplier on the market. This
implies that this supplier has total control over
market supply. The supplier is a big firm which
enjoys economies of scale
2. The industry has entry barriers which
prevent new firms to enter into the market. This
ensures that the monopolist does not face
competition both in the short run and in the long
run, leading to the firm enjoying supernormal
profits in both the short­run period and in the long­
run
3. The monopolist produces a unique
product. This implies that the product has no close
substitutes available e.g. Electricity.
4. The monopolist seeks to maximise profits,
therefore the firm seeks to get the maximum price
on the market to the extent of practicing price
discrimination. The monopolist also restricts
output(market supply) so as to push the prices
5. Price setter: the monopolist determines the
market price by adjusting output. Therefore the
price can be higher than if the market was
competitive
Demand
 The monopolist faces downward sloping
demand for its products. This is attributable to the
fact that market demand is the same as the firms’
demand (law of demand)
 This implies that the monopolist has to
reduce price in order to sale more i.e. AR > MR.
This is similar to a firm operating in monopolistic
competition.
Short run and long run equilibrium
 The existence of barriers to entry makes
the short­run and the long­run period for
monopolies the same.
 Therefore, the monopolist earns
supernormal profits in both the short­run period
and the long­run period
 The following diagram illustrates the
monopolist’s equilibrium
8
The following facts have to be noted:
a. Output is decided at MR=MC
b. The supernormal profits are earned in both
the short­run period and the long run period
c. Output is restricted so as that the firm
produces on the elastic section of the demand curve
were the TR will be rising.
Merits
 Firms have the opportunity to enjoy
economies of scale. If one firm can produce at a
lower cost than a number of firms we have a
natur al monopoly
 The fact that monopolist restricts output
i.e. supplies less than a perfectly competitive
market is only valid if the monopolist’s cost
structure is similar to that of a perfectly competitive
firm.
 Monopoly profits can be invested in
research and development, the barriers such as
patent give an incentive to firms to invest in R&D.
These profits are a necessity for continued
economic growth
 The economy needs large firms such as
monopolies to be able to compete on the domestic
and international market with foreign firms.
Common misconceptions about monopoly
o Some claim that the monopolist charges
any price it wants, this is not true because it faces a
downward sloping demand curve. Less quantity is
demanded at a higher price
o Some claims that the monopolist charges
the highest possible price are not true because it
charges the price that maximises profits [MR= MC]
Oligopoly
Mashinda Commercial Academy 2016 ‘A’ Level Economics notes

It is a market structure which has the following

characteristics

1. Few sellers: there are just few large sellers

who control all or most of the sales in the industry
e.g. the telecommunications market.
2. Barriers to entry: oligopoly firms are large
and they enjoy economies of scale. It therefore
takes considerable know­how and capital to
compete in the industry
3. Interdependence: the firms are large in
relation to the market size. Therefore if one firm
changes its price or marketing strategy it will
The diagram shows that on the first half, the
impact on the rival firms prompting them to take
demand curve is elastic i.e. increasing the price will
action
prompt no action by competitors thus total revenue
4. Price rigidity: the inter dependence of the
will decline. On the other hand, the second half of
market players is the cause of price rigidity. A firm
the demand curve is inelastic, therefore, reducing
cannot increase market share by reducing price
the price will also cause a decline in total revenue.
because other firms will follow suit in retaliation
This implies that oligopoly firms do not engage in
e.g. Bakers’ Inn bread case. On the other hand if a
price wars because they are self defeating.
single firm raises its price it loses its customers.
Therefore oligopoly firms engage in non price Oligopoly equilibrium
competition
5. Selling costs: Marketing costs are high in Several models have been put forward to explain
oligopoly markets because firms engage in non why there is price rigidity in oligopoly markets.
price competition i.e. advertising and branding e.g. These are the kinked demand curve model,
fuel retailers such as Total, Trek, Zuva, etc collusion and price leadership.

Oligopoly and the kinked demand curve Kinked demand curve model

 The kinked demand curve model is based  The marginal revenue for a downward
on the assumption that if an oligopoly firm raises sloping demand curve is located halfway between
its price the other firms will not adjust their prices, the demand curve and the vertical axis.
this prompts consumers to substitute the more  Therefore, the kink in the demand curve
expensive product with the cheaper ones causes discontinuity in the marginal revenue curve
 In the event of a price cut the other firms as illustrated in the diagram below
in the industry will follow suit in an effort to
protect their market share. All dominant firms in
the industry a big enough that they can match any
price set by their competitor because they all enjoy
economies of scale. This explains why there is
price rigidity under the oligopoly market structure.
 This scenario implies that the oligopoly
firms’ demand curve is non linier since changing
the price in either direction is self defeating.
 This implies that there is a kink in the
demand curve as illustrated in the diagram below

The diagram shows the downward sloping MR

curve. The MR makes a sudden drop at point A and
reappears at point B where it will start to decline as
usual. Oligopoly firms are profit maximisers,

9
Mashinda Commercial Academy 2016 ‘A’ Level Economics notes
therefore the produce at the point at which
MC=MR. The case with oligopoly firms is a bit
different because the price remains constant as long
as the MC would cross the MR at any point
between point A and point B, the price would not
change.
Limitation of the model
The model is criticised for failing to explain why
firms start out at that equilibrium price and
quantity.
Merits
1. The firms are big so they enjoy economies
of scale which can translate to increased efficiency
levels
2. Price stability is advantageous to
consumers and the macro economy because it helps
consumers to plan ahead and stabilises their
expenditure.
Demerits
1. High concentration reduces consumer
choice
2. Cartel­like behaviour reduces competition
and can lead to higher prices and reduced output
3. New firms are prevented from entering a
market because of deliberate barriers to entry,
which is a source of inefficiency
4. Oligopolies tend to be allocative
inefficient i.e. the price is above MC. At the same
time they restrict output and produce output at the
point the AC will be still falling
Conduct of oligopoly firms
Pricing policy
 Oligopoly firms are interdependent, this
means the firm has to anticipate the actions of its
rivals to any change in price
 The firm is faced with an option to
compete or to collude with other firms in the
industry
Collusive oligopoly
 Oligopoly firms are interdependent on
each other, therefore they recognise the fact that
price wars are self defeating
 Collusion where firms work together to
10
reduce uncertainty in the market. Firms engage in
cartels to act as though there is a single firm in the
market.
 The promise for bigger profits will
motivate firms to cooperate although the agreement
is unlikely to be sustainable
 Competitive oligopolies pursuing self
interest would produce greater quantity and charge
lower price than in a collusive agreement i.e.
cartels are exploitative to the consumers
 Collusive arrangements are generally
illegal. Moreover it is difficult to coordinate the
actions as there is a constant threat that firms can
defect to undermine others in the arrangement e.g.
a firm can supply more than the agreed quantity
 The defecting firm will increase its profits
at the expense of those firms still holding on to the
agreement
 A defection by one firm will prompt other
firms to defect i.e. and this results in excess supply
causing the prices to fall.
Price leadership model
 Where one firm is dominant in the
oligopoly it assumes the role of a price setter and
other firms will adopt its price.
 The leader may set price that maximises
its profits not necessarily those of other firms
 Price leadership is difficult to prove as a
form of collusion for regulators
Methods of non price competition
1. Better customer service
2. Free deliveries and installations
3. Extended warranties
4. Credit facilities
5. Longer operating hours
6. Product branding
7. After sales services
Contestable markets theory
 According to this theory, even when there
is a monopoly or oligopoly in product markets, the
firms may find it most profitable to behave in
setting price of its products as if they were working
in a perfectly competitive market
 This is attributable to the fact that if it sets
a price higher than a competitive market, this will
attract other firms into the market and compete for
the customers thereby pushing the prices down due
Mashinda Commercial Academy 2016 ‘A’ Level Economics notes

to increased market supply market. The new firm would have to invest heavily
 The constant threat of new entrants forces in advertising which is a sunk cost, after all there is
the existing firms to charge no more than the no guarantee that t will be effective in changing the
competitive price therefore they make normal consumer perceptions
profits
 For a contestable market to exist there has Price discrimination
to be no barriers to entry i.e. the fewer the barriers
It is a practice of charging different prices to
to entry the more contestable the market is.
different consumers for reasons unrelated to costs.
 In cases where there are absolutely no
This strategy cannot be adopted in a competitive
barriers to entry a perfectly competitive market
market because it’s exploitative i n nature. Price
exists
discrimination is classified into three categories
whish are
Barriers to entry
1. First degree price discrimination
1. Legal barriers: the law may prohibit new
The seller charges a different price to each
entrants to enter into a market. This is found in
customer i.e. the firm charges the maximum price
cases of public monopolies whereby the state is of
that the consumer is willing to pay for the product.
the opinion that competition is wasteful and leads
This practice has the effect of converting consumer
to in efficiencies e.g. ZESA.
surplus to producer surplus therefore it exploits the
2. Sunk costs: these are costs which cannot
consumer and reduces the standards of living
be recovered when a firm decides to leave the
industry in future e.g. licensing fees.
3. Legal patents: a patent can provide pure
monopoly because other firms are not permitted to
use it e.g. pharmaceutical company can get a drug
patent for & years
4. Economies of scale: they occur when
increased output leads to reduced average costs.
Therefore, new firms with relatively lower output
will find it difficult to compete because their AC
are higher than incumbent firms i.e. they cannot
compete on equal terms with existing firms (Price
wars)
5. Limiting pricing: This occurs when a firm
sets a price sufficiently low to deter entry.
Although it yields less profits in the short run but
it’s good for the long term profits
The diagram above shows a firm practicing perfect
6. Predatory pricing: the incumbent firm
price discrimination. The firm charges the highest
responds to a new entry by staring a price war and
possible price to each consumer thus exploiting
trying to push the rival firm out of business.
consumer surplus and converting it to producer
7. Vertical integration: if a firm has control
surplus. If P2 is the initial market price, the triangle
over the source of inputs, it can stop other firms
above P2 C would represent consumer surplus. The
from entering the industry because they may not
remaining consumer surplus is depicted by the
have equal access to inputs
smaller triangles remaining. A numerical
8. Capital requirements: some industries
illustration is depicted below.
require huge capital investments e.g. the
telecommunications industry. The new entrants Perfect discrimination has the effect of converting
may find it difficult to enter into such markets due all the consumer surplus to producer surplus, this
to the prohibitive capital requirements would imply that the firms’ demand curve becomes
9. Advertising and brand loyalty: established its MR.
firms have significant brand loyalty e.g. Coca­Cola,
it becomes difficult for a new firm to enter the

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Mashinda Commercial Academy 2016 ‘A’ Level Economics notes

markets, which means the consumer cannot

purchase at a lower price in the elastic­sub market
and resale at higher price to consumers in the
inelastic sub­market, this is easier for services than
goods e.g. one cannot resell the services of a
barber, lawyer or doctor
 The firm must possess a degree of
monopoly power i.e. a price setter.

Advantages of price discrimination

1. Maximise revenue and profits for the

2. Second degree price discrimination
It involves charging different prices for different
quantities purchased e.g. bulky buying discounts
(trade discounts)
3. Third degree price discrimination
It involves charging different prices to different
consumer groups (market segments) depending on
the sensitivity of demand to price changes. A high
price is charged in segments with less sensitive
demand and vice versa e.g. ZUPCO gives 50%
discount for school children. This is illustrated by
the diagram below.
firms. This enables firms to remain in business
2. Increased revenues can be applied for
research and development projects
3. Some consumes will benefit from lower
prices e.g. the old and school children
Disadvantages
1. Some consumers will end up higher
prices, these prices are likely to be allocatively
inefficient i.e. P > MC
2. Exploits the consumer surplus i.e. a
reduction of the living standards
3. Those who pay the lower prices may not
necessarily be the poor, e.g. the adult may pay
higher prices even if they are unemployed

The diagram shows that in both markets the firm

equates MR to MC, this makes the equilibrium
price to be higher in the market with inelastic
demand and a lower price in the elastic demand
market.

Conditions necessary for price discrimination

 The firm must be able to identify different

market segments e.g. domestic consumers and
industrial consumers
 Different segments must have different
price elasticities of demand.
 Markets must be kept separate either by
time, physical distance or nature of use.
 There must be no seepage between

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