Unit IV

1. Market
Basically, a market is a mechanism or an arrangement in which the buyers and the sellers
are involved. The buyers and the sellers of a commodity or service come into contact with one
another and complete the act of sale and/or purchase on mutual agreements by the exchange of
money.
Broadly categorizing, there are two forms of market;
 Perfect competition
 Imperfect competition
2. Perfect Competition

A perfectly competitive market is that type or form of market where there are a large
number of buyers and sellers who are selling and buying identical products at a uniform price.
There is free entry and exit of firms and the absence of government control. Since the price under
perfect competition remains constant, AR and MR curves coincide with each other and become equal and
parallel to the X-axis.

Features of Perfect Competition

 Very large number of buyers and sellers
 Homogeneous or identical products
 Free entry and exit of firms in the market
 Perfect mobility
 Perfect knowledge
 A perfectly elastic demand curve
 No transportation cost involved
Price determination under Perfect competition

 Price is determined by the interaction of 2 forces; viz., demand and supply

(aggregate).
 Individual demand and supply cannot influence price.
Equilibrium Price
 Price is determined by the interaction of demand and supply (D=S).
  Equilibrium price where D=S.
 Equilibrium output is OQ.
 At equilibrium both buyers and sellers are satisfied.
 If price>equilibrium price then S>D (unsold stock is disposed at lower price).
Thereby, price reaches equilibrium.
 If price is below the equilibrium price D>S buyers won’t get the desired quantity.
So, they would bid the prices up. Thereby, price will go on increasing and reaches the
equilibrium.
Conditions for equilibrium of firm and industry

 MC=MR
 MC should cut MR from below

Firm equilibrium when MC=MR=AR (price)

  B is the equilibrium point (both the conditions are satisfied).
Industry equilibrium
 No tendency for the firms to enter or leave the industry (AC=AR; Normal profits).
 Each firm is in equilibrium (implies MC=MR).

Short-run equilibrium of the firm

 Only variable factors can be varied to maximize profits.

 Number of firms is fixed; none of the firms enter or leave the industry.
 In short-run, firms earn super-normal profits, normal profits or they may incur
loss.

 Some firms earn super-normal profits PCDE and some incur loss MPEN.
Short-run equilibrium of the industry

 For full equilibrium of the industry in short run, all firms should earn normal profits.
 Condition for equilibrium is SMC=MR=SAC=AR.
 D=S; equilibrium price OP, equilibrium output OQ.
 At OP price some firms are earning super-normal profits PAEB, some firms incur loss
TPRE.
Long-run equilibrium of the firm
  AC=AR; Normal profits i.e., no profit; no loss.
Conditions for equilibrium
 LMC=MR=LAC=AR=P.
 LMC must cut MR from below.

Long-run equilibrium of the industry

 Full equilibrium where LMC=MR=AR=P=LAC (at its minimum point).

 All firms earn normal profits.
 Industry equilibrium where D=S; E equilibrium.
 The condition is satisfied at OP price.
 There is no tendency to leave the industry.

3. Imperfect competition
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. The types of imperfect market are;
4. Monopoly Market
A monopoly market is that form of market structure where there is a single seller and a
large number of buyers for a product or service. There is an absence of close substitutes to the
products or service. A monopoly firm is regarded as an industry itself and hence can set price to
its maximum advantage.
 Example: State Electricity Board (domestic and commercial charges differ)
 Indian Railways (I class and II class fares are different)
 Hindustan Aeronautics Limited (HAL) has monopoly over the production of aircrafts.
Under a monopoly market structure, the AR curve or the demand curve is downward
sloping from left to right and is less elastic than that of a monopolistic market structure. Hence,
in order to increase demand, the firm has to reduce the price.

Features of Monopoly Market

 Single seller and a large number of buyers
 Restrictions on the entry and exit of new firms into the industry
 Full control over price
 Absence of close substitutes in the market
 Price discrimination
 Price maker
 Downward sloping less elastic demand curve

Price-output determination under monopoly

Short-run equilibrium

 In short-run, a monopolist may earn super-normal profits or they may incur loss.
Profit

 Equilibrium where MC=MR, at E.

 Equilibrium output OQ; equilibrium price OP.
 A monopolist earns super-normal profit i.e., PP’BA
Loss

 Sometimes in short-run, a monopolist may incur loss.

 Loss is PP’BA
Long-run equilibrium

 In long-run, the firm has time to adjust its plant size to maximize profits.
 Equilibrium output OM; equilibrium price OP where LMC=LMR.
 Super-normal profit equal to PTSR.

5. Price Discrimination or Discriminating Monopoly

Price Discrimination
Price discrimination means the practice of selling the same commodity at different prices
to different buyers and is called as discriminating monopoly. It is a technique by which the
monopolist makes the consumers pay according to their ability.
Types of discriminating monopoly
Personal price discrimination
This refers to charging of different prices from different customers for the same product
on the basis of their ability to pay. Rich will be charged more and the poor will be charged less.
Eg: Lawyers (different fees from different clients).
Place of geographical price discrimination
Under this, the monopolist firm charges different prices in different markets for the same
product provided that the locality in which his market is situated will be the criterion in fixing up
the price. Eg: Dumping (low prices in foreign market; high prices in domestic).
Trade or use discrimination
By this method, the monopolist will charge different prices for different types of uses of
the same commodity. (Ex; Electricity charges are higher for domestic consumption and lower for
farming needs)

Degrees of price discrimination

Price discrimination of first degree
Under this, the producer exploits the consumer to the maximum possible extent by asking
him to pay maximum he is prepared to pay rather than go without the commodity. This type is
called perfect discrimination in which the seller charges a price equal to what consumer is
willing to pay.
Price discrimination of second degree
In this, buyers are divided into different groups and from different groups a different
price is charged which is the lowest demand price of that group. In this case, those who are
prepared to pay more will get consumer’s surplus while the poorest will not get any consumer’s
surplus.
Price discrimination of third degree
This will exist when the seller divides his buyers into two or more than two sub-markets
and from each group a different price is charged. It is the exact type that exists in the real world.

6. Monopolistic Market
A monopolistic market structure is a form of market structure where there are a large
number of buyers and sellers and where the sellers sell differentiated products but not identical
or homogenous.
Under the monopolistic market structure, the AR (demand) curve is sloping downward
from left to right. Also, the AR curve is more elastic and flatter than that of the AR curve under
a monopoly market structure. Hence, when there is any change in price, the change in demand
will be relatively more under a monopolistic market structure.
Features of Monopolistic Market
 A large number of buyers and sellers
 Selling costs which include the cost of advertisement and sales promotion
 Product differentiation which means that the products of different producers or sellers are
different on the basis of price, color, taste, packaging, size, shape and etc.
 Free entry and exit of firms
 Partial control over price
 Lack of perfect knowledge
 Imperfect mobility as factors of production and products are not perfectly mobile
 An elastic and downward sloping demand curve

Price determination: Short-run equilibrium

Super-normal profits

 AR curve is neither too steep nor too flat.

 Equilibrium point is determined where MC=MR; equilibrium output OM, equilibrium
price OP
 Super-normal profits = P’T’TP.
 Demand is more sensitive to price (small change in price; large change in demand).
Loss

 In short run, firms may incur loss also.

 The equilibrium point is E1, where MC=MR, OM is equilibrium output.
 The firm incurs minimum losses as C>R.
 Established firms may earn super-normal profits; new firms charge low price and earn
low profits (sometimes incur loss).
 Thus in monopolistic competition, firms may be making either super-normal profits,
normal profits or incur loss in short period.
Long-run equilibrium (Group equilibrium)
  Equilibrium is determined where LRMR=LRMC.
 Equilibrium at E, OQ output and OP price.
 LRAR touches the LRAC. So AC=AR. Therefore, no profit; no loss (normal profits).
 Since the firms get normal profits, new firms won’t enter. Therefore, the group has
come to equilibrium.
 In long run, due to super normal profits, new firms enter and they fix low prices.
Therefore, old firms are compelled to keep prices low. Hence, in long run, firms get
only normal profits.

7. Oligopoly Market
An oligopoly market is that type of market structure in which there are a few large firms
or sellers who compete with each other or against each other and have interdependence in their
decision making.
Example: Cement, Aluminium and Automobile industry, Commercial air travel, Telecom service
providers etc.
On the basis of production, an oligopoly market structure can be categorised into two categories:
 Collusive oligopoly: Where all the firms decide to avoid competition and determine the
price and quantity of output.
 Non- collusive oligopoly: Where all firms determine the price and quantity of output on
the basis of the action and reaction of the competing and rival firms in the market.
On the basis of product differentiation, an oligopoly market structure can be further categorised
into two categories:
 Perfect Oligopoly: It refers to a perfect or pure oligopoly when the firms deal with
homogeneous products.
 Imperfect Oligopoly: Where the oligopoly is said to be imperfect because the firms deal
in heterogeneous products.
Features of Oligopoly Market
 Few but large sellers
 The firms produce homogeneous or differentiated products
 Price rigidity
  Demand cannot be determined under oligopoly as the demand curve is a kinked demand
curve
 All the firms are interdependent with respect to price determination

Pricing under Oligopoly Market

Sweezy’s Model of Kinked demand curve

A kinked demand curve occurs when the demand curve is not a straight line but has a
different elasticity for higher and lower prices. This model of oligopoly suggests that prices are
rigid and that firms will face different effects for both increasing price and decreasing price. The
kink in the demand curve occurs because rival firms will behave differently to price cuts and
price increases.

The logic of the kinked demand curve is based on

 A few firms dominate the industry
 Firms wish to maximize profits
Impact of price rise

 If a firm increases the price, then it becomes more expensive than rivals and therefore,
consumers will switch to its rivals.
 Therefore for a price rise, there is likely to be a significant fall in demand. Demand is,
therefore, price elastic.
 In this case, of increasing price firms will lose revenue because the percentage fall in
demand is greater than the percentage rise in price.
Impact of price cut

 If a firm cut its price, it is likely to lead to a different effect. In the short term, if a firm
cuts price it would cause a big increase in demand and therefore would lead to a rise in
revenue. The firm would gain market share.
 However, other firms will not want to see this fall in market share and so they will
respond by also cutting price to follow the first firm. The net effect is that if all firms cut
price – the individual firm will only see a small increase in demand.
 Because there is a ‘price war’ demand for a firm is price inelastic – there is a smaller
percentage rise in demand.
 If demand is inelastic and price falls, then revenue will fall.
Prices stable
 If the kinked demand curve is true, the firm has no incentive to raise price or to cut price.

8. Duopoly
A duopoly is a market situation that entails two competing companies that share the
market. In this market, two brands can collude to set prices or quantities and make customers pay
more money. A duopoly has a significant impact on how companies interact with each other.
Since there are only two players within the market, the actions of one will affect the other’s
response and activity. They also influence the way a company operates and how it produces and
promotes its products.
Example: PC processor: AMD and Intel, OS: iOS and Android, Electronic
payments: MasterCard and Visa and Soft drinks: Coca-Cola and Pepsi
Types of duopoly
Duopolies can be divided into two main groups:
 Cournot duopoly. According to this duopoly, the output of produced goods and services
shapes the competition between players. Businesses in this market system manufacture a
certain amount of products to maximize their profits. Besides, firms have to negotiate to
divide the market. In the long run, companies establish stable prices and output. This type
also excludes the presence of collusion.
 Bertrand duopoly. In this market situation, prices shape the nature of competition
between companies. Customers opting for the firms with the lowest price can cause price
war and high competition between players. Consequently, brands implement low-pricing
strategies and lose profit while consumers enjoy purchasing products or services for
incredibly low prices.
Features
 Only two sellers in the market
 Each seller is fully aware of his rival’s motive and actions.
 Both sellers may collude (they agree on all matters regarding the sale of the commodity).
 They may enter into cut-throat competition.
 There is no product differentiation.
 They fix the price for their product with a view to maximizing their profit.

Pricing Determination of Duopoly Cournot Model

 In the Figure, the demand curve (AR curve) faced by two organizations for is given by a
straight line AB. The total output produced is equal to OB where maximum daily output of each
mineral spring is ON = NB. Assume that producer A starts the business first. It implies that
he/she is the monopolist and produces ON level of the output, which is the maximum level of
output.

Since costs are zero, the profit will be equal to ONPS. The price charged is equal to OP.
Now, suppose that the producer B enters into business and notices that producer A is producing
ON amount of output. The market which is unsupplied by A is the market open for B equal to
NB. B will produce output assuming that A will not change its price and output (as he is making
maximum profits).

From Figure, it can be seen that with the entry of producer B, price has fallen to P1,
which has decreased the profits of A to ONCP1. Thus, A would make adjustments in price and
output assuming that B would not change his output and price levels. He/she would produce ½ of
the (OB-NH) of the market.