Unit IVth

Theories of Profit
1. The Rent Theory of Profit:
This theory was developed by an American Economist Francis L.
Walker. Walker has said that Profit is the rent of ability.

He has made a comparative study between different grades of land

and entrepreneur’s different abilities. Entrepreneurs of superior
ability earn Profits just as superior land earns rent.

According to Walker:
“Just as there is the marginal or no rent land, similarly there exists a
marginal or no Profit entrepreneur who earns only wages of
management. The marginal or no-profit entrepreneur is the least
efficient one earning Profit not beyond an amount just sufficient to
keep him or to carry on in his present industry. The industry managed
and run by the marginal entrepreneur is similar to marginal land. Just
as the land which is at margin is no rent, land, similarly, the marginal
entrepreneur earns no profit.”

But there are other industries under the control of entrepreneurs

possessing super abilities which yield Profits. The entrepreneur with
superior ability earns Profit as the reward over the ability of the
marginal or no-profit entrepreneur. Thus it can be said that the
essential nature of Profit does not differ from that of rent because we
are aware that rent is a differential surplus accruing to the superior
land over the marginal or no rent land, similarly profit is a differential
surplus which accrues to the superior ability entrepreneur over the
marginal or no-profit entrepreneur.

It’s Criticisms:
The important criticisms of this theory are as follows:
a. This theory is unrealistic:
Walker’s view of Profit as a surplus like rent is unrealistic and it
cannot be accepted as true approach of Profit.

b. It is not a true surplus as Marshall has said:

In this connection Marshall has said that land can earn positive or zero
rent. But in the case of firm’s entrepreneurs may have negative profits
or losses.

c. Profits only in a dynamic state:

Rent can emerge in both static and dynamic conditions whereas
profits we can find only in a dynamic state.

d. Profit is not gift of ability:

Profit does not arise always due to the superior ability of the
entrepreneur. It may arise due to monopoly, innovation, risk,
uncertainty etc.

e. This theory overlooks the important function of the

entrepreneur as a risk-bearer:
From the profits of entrepreneur we must deduct the losses sustained
by some others, who have been driven to bankruptcy. When this is
done, there may be no surplus element in Profit and the analogy to
rent vanishes. Moreover, it fails to explain the Profit of the ordinary
shareholder of a joint-stock company.

f. This theory fails to explain the main causes of the size of

Profits:
The differential gain arises because of the scarcity of superior units,
either of land or of entrepreneurs. But the real thing is the explanation
of the causes of the scarcity of the superior units. In the case of the
rent of land, the point is not of great importance because the
limitation is due to nature. Here the rent theory can throw no light on
the fundamental questions.

g. Profits do not enter into price this cannot be said here:

The reward for risk-bearing must enter into long-period cost of
production. In the short-period, Profits may not enter into price. But
in the long-run, supply of entrepreneurs not being fixed by nature,
normal Profits must form a part of cost of production.

2. The Wage Theory of Profit:

This theory was popularized and put forward by Prof. Taussig and
Davenport the two most prominent economists. According to them
—”Profits are best regarded as simply a form of wages. They
accrue to the entrepreneur on account of his special
ability.” They have argued that there is very close similarity between
a labourer and entrepreneur. Just as labourers receive wages for his
services, similarly entrepreneurs receive profit for his service.

The entrepreneur performs mental labour like—teachers, doctors,

lawyers etc. But the only difference between entrepreneur and other
mental workers is that the entrepreneur receives profit for his special
ability and hard work. This is a surplus amount which the
entrepreneurs receive after meeting all expenses of production where
as the wage forms a part of the cost of production.

It’s Criticisms:
This theory has been criticised for equating the functions of
an entrepreneur with that of the workers on the following
grounds:
a. Element of risk and uncertainty:
The entrepreneur’s work is full of risk and uncertainty and profit is
given to face this risk. But the workers receive wages simply for his
labour. Risk and uncertainty part do not incorporate anywhere in his
activities. For labourer risk is of losing the job which is an extreme
step.

b. Profit is flexible, it may vary:

Profits may rise or fall. It depends upon the business conditions and
situations. But wage may remain stable and cannot fluctuate more in
the short- period.

c. This theory is silent over the payment to shareholders:

The shareholders of any organisation or company do not perform any
function but they receive the share of profits in the form of dividend
for undertaking risk of money invested. This theory fails to explain
this contention as to why they are paid.

d. Entrepreneurs windfall or chance profits:

The entrepreneur may receive windfall or chance profits but a worker
cannot have opportunity to get wages of chance or windfalls.

3. The Marginal Productivity Theory of Profit:

This theory was propounded by Prof. Marshall. According to
him, “Profit is equal to the marginal productivity of the
entrepreneur. He has said that the amount which the
community is liable to produce with the help of
entrepreneur over and above what it could produce with his
help.”
Recently Stigler and Stonier and Hague have said that “Profit is the
reward of an entrepreneur which is determined by its marginal
revenue productivity, the higher are the profits and lower the marginal
revenue productivity, the lower are the profits of an entrepreneur.”

Its Criticisms:
Important criticisms given by various economists are as
follows:
a. This theory is based on unrealistic assumptions:
These unrealistic assumptions are homogeneity of entrepreneurs in an
industry. As entrepreneurs’ efficiency differ, therefore it is not possible
that there will be one marginal revenue productivity curve for all
entrepreneurs. So Profit cannot be same.

b. This theory fails to determine profit accurately:

Because efficiency of entrepreneurs differs, systems and methods of
doing work differ, therefore. Profit cannot be calculated accurately.

c. The concept of marginal revenue productivity of

entrepreneurship is a meaningless concept:
Because unlike other factors, there can be only one entrepreneur in a
firm.

d. It is one sided theory:

This theory takes into account only the demand for entrepreneurs and
do not take into account the supply or availability of entrepreneurs.

e. This is a static theory:

Where all entrepreneurs earn only normal profits, they have not
considered that the world is dynamic also where some entrepreneurs
can earn more than normal profits.

f. This theory has not taken into account the windfall or chance or gain
or even monopoly profits.

4. The Dynamic Theory of Profit:

Prof. J. B Clark propounded this theory in the year 1900. According to
him—”Profit is the difference between the price and the cost
of the production of the commodity”. But Profit is the result of
dynamic change. Further, Prof. Clark was of this opinion that in a
stationary state having static economic conditions of demand and
supply, there can be no real or pure profit as a surplus. In a stationary
economy, the quantum of capital invested, methods of production,
managerial organisation, technology, demand pattern etc. remain
constant.
Under competitive conditions, price tends to equal average costs;
hence, the surplus is zero. So, no pure profit but there may be some
frictional profits emerging due to frictions in the system. But, this
cannot be regarded as real Profits.

Profit is the result exclusively of six dynamic changes i.e.:

(1) Changes or increase in population,
(2) Changes in tastes and preferences,

(3) Multiplication of wants,

(4) Capital formation,

(5) Technological advancement and

(6) Changes in the form of business organisation.

On account of these changes the economy tends to be dynamic.

Demand and supply conditions are altered. Some entrepreneurs may
get advantageous business positions against others and may reap
surplus over costs, as a real profit. In short, those who takes advantage
of changing situation can earn real profits according to their efficiency.

Inefficient and careless producers who fail to move with dynamic

changes may not get any real profit and may even incur losses. Thus,
Clark’s dynamic theory of Profit has an element of truth as it emphasis
the dynamic aspect of Profit.

Its Criticisms:
Clark’s dynamic theory of Profit has been severely criticised
by Prof. Knight and others on the following grounds:
a. All changes are not foreseen:
Clark’s theory fails to make any difference between a change that is
foreseen and one that is unforeseen in advance. If the six generic
changes as assumed by Prof. Clark are to be foreknown in advance
then the effects of changes will not hold at all. In reality, all changes
are not foreseen. Some are foreseen and some are not. So, to have a
clear understanding of the problem, it is essential to separate its
effects from those of change as such.

b. This theory gives artificial dichotomy:

In this connection Taussig has said that Clark’s theory gives an
artificial dichotomy of ‘Profit’ and ‘Wages of management’.
c. All changes do not lead to Profit:
Clark’s theory suggests that all dynamic changes lead to Profit. But
critics are of this opinion that only unpredictable changes would give
rise to profits. Predictable changes will not cause surplus to emerge on
account of precise adjustments.

d. Here, the concept of frictional Profit is unclear:

Clark’s theory indicates that in a stationary state, there is only a
frictional profit. But the concept of frictional profit is vague. But it is
the normal profit which is earned in a stationary state.

e. Element of risk involved in business:

Clark’s theory of Profit do not stress the element of risk involved in
business due to dynamic changes. The best course is to combine
elements of risk dynamic changes to understand the true nature of
profit in a modern economy.

5. F.W. Hawley’s the Risk Theory of Profit:

This theory of Profit is associated with F. B. Hawley who has
considered the risk-taking as the important function of an
entrepreneur. The entrepreneur exposes his business to risk, and in
turn he receives a reward in the form of Profit because the task of risk-
taking is irksome.

It is definite that no entrepreneur will like to undertake risks if he gets

only the normal return. Therefore, the reward for risk-taking must be
higher than the actual value of the risk. Further, it has been said that
the actual value of the risk.

Further, it has been said that more risky the business, the higher is the
expected Profit rate. As Professor D. M. Holland has said that “riskier
the industry or firm, the higher is its Profit rate.” But he was warned
that this tentative view must be tested in depth.

Its Criticisms:
Like other theories, the risk theory of profit has also been
criticised on the following grounds:
a. There cannot be functional relationship between Risk and
Profit:
Those persons who dare to take high risks in certain businesses may
not necessarily earn high profits.

b. Profit is not based on entrepreneur’s ability:

In this connection Prof. Carve has said that “Profit is not based on
entrepreneur’s ability to undertake the risks of the business, but rather
as his capability of risk avoidance.”

c. It is an incomplete theory:
From business point of view, all enterprises are risky and an element
of uncertainty is present there. But every entrepreneur aims at making
large profits which is also uncertain. Therefore, Hawley’s Risk Theory
can also be called as an incomplete theory of Profit.

d. Amount of Profit not related to size of risk involved:

The amount of Profit is not in any way related to the size of the risk
undertaken. If it were so related then every entrepreneur would
involve himself into huge risks in order to earn larger profits.

e. Concentrates mostly on risk and not on anything else:

This theory mostly disregards many other factors attributable to Profit
and just concentrate on risks and risks alone.

6. Knight’s Theory or the Uncertainty-Bearing Theory:

Prof. Knight’s theory of uncertainty bearing theory of Profit is an
improvement and refinement theory of Profit over Hawley’s risk-
bearing theory of Profit. Here, Profit according to Knight, is the
reward of bearing non-insurable risks and uncertainties. It is a
deviation arising from uncertainty.

Uncertainty prevails in the entire society and profits, positive or

negative, in a way accrues to all factor services. In other words, there is
profits element in all types of income. But the division of social income
between Profit and contractual income depends on the supply of
entrepreneurial ability.
Uncertainty bearing is the most important function in a dynamic state.
It is the entrepreneur who either delegates this function among
different personnel or assumes it himself. The expectation of Profit is,
in a way, the supply price of entrepreneurial uncertainty-bearing. In a
competitive economy where there is no risk, every entrepreneur will
have a minimum supply price.

In short Knight’s theory implies that:

(i) Profit is reward for uncertainty-bearing.

(ii) The un-measurable risks are termed as uncertainty. These un-

measurable risks are true hazards of business.

(iii) Pure Profit is, however, a temporal and unfixed reward. It is

turned with uncertainty. Once the unforeseen circumstances become
known, necessary adjustment would be possible. Then pure Profit
disappears.

Its Criticisms:
Knight’s theory of Profit has been criticised on the following
grounds:
a. This theory does not give clear notion of entrepreneurship
therefore it has been called unrealistic:
In this theory there is no indication as to who are the real owners
because owners are shareholders and policy decision-makers are
salaried people.

b. Difficulty in the distribution of profit:

This theory does not solve the problem of allocation or distribution of
profit among the controlling and ownership group, therefore, this
theory keeps the problem of the determination of Profit unsolved.

c. This theory fails to expose the phenomenon of monopoly

profit:
The theory does not suit well to expose the phenomenon of monopoly
profit. When there is least uncertainty involved in a monopoly
business.
d. Profit is not a residual income:
Knight has mentioned in his theory that Profit is a residual income but
J. F. Weston has said that “the exercise of judgment of Profit may be
sold on a fixed-price basis or on a variable price-basis.” This is how the
expert manager sell their services to earn Profit.

e. This theory has not said anything on monopoly profit:

This theory does not throw any light on the monopoly profit. As we
have studied that monopoly firms earn much larger profits than
competitive firms and they are not due to the presence of uncertainty.

f. Above all, the uncertainty element cannot be qualified to improve

profits.
In-spite of the weaknesses as mentioned above, this theory of Knight is
regarded as the only satisfactory explanation of the nature of profit.

Profit Maximisation Theory:

In the neo-classical theory of the firm, the main objective of a business
firm is profit maximisation. The firm maximises its profits when it
satisfies the two rules. MC = MR and the MC curve cuts the MR curve
from below Maximum profits refer to pure profits which are a surplus
above the average cost of production.

It is the amount left with the entrepreneur after he has made

payments to all factors of production, including his wages of
management. In other words, it is a residual income over and above
his normal profits.

The profit maximisation condition of the firm can be

expressed as:
Maximise p (Q)

Where p (Q) = R (Q) – C (Q)

where p (Q) is profit, R(Q) is revenue, С (Q) are costs, and Q are the
units of output sold The two marginal rules and the profit
maximisation condition stated above are applicable both to a perfectly
competitive firm and to a monopoly firm.

Assumptions:
The profit maximisation theory is based on the following
assumptions:
1. The objective of the firm is to maximise its profits where profits are
the difference between the firm’s revenue and costs.

2. The entrepreneur is the sole owner of the firm.

3. Tastes and habits of consumers are given and constant.

4. Techniques of production are given.

5. The firm produces a single, perfectly divisible and standardised

commodity.

6. The firm has complete knowledge about the amount of output

which can be sold at each price.

7. The firm’s own demand and costs are known with certainty.

8. New firms can enter the industry only in the long run. Entry of
firms in the short run is not possible.

9. The firm maximises its profits over some time-horizon.

10. Profits are maximised both in the short run and the long run.

Sales Maximization Theory

Sales maximization theory is based on the work of American
economist William Jack Baumol. The theory attempts to draw a
conceptual framework to better understand the objectives and
strategies of corporations operating in a competitive marketplace.
Baumol's work helped economists as well as managers make sense
of business decisions that often seemed to conflict with a profit
maximization model and is an important body of work in
microeconomics.
Revenue vs. Profit
A business can focus on maximizing either revenue or profits, but
usually cannot pursue both goals simultaneously. To maximize
profits, the company has to sell its products or services at a
healthy profit margin; in other words, it has to charge significantly
more than what it costs to deliver the product or service. When
attempting to maximize sales, however, a business must cut prices
to very near costs. In fact, it is not uncommon for a newly-
established company to sell at a loss to build a loyal consumer
base and gain name recognition in the industry.
Baumol's Theory
Professor Baumol observed that, contrary to prevailing
assumptions, most businesses pursued maximum sales, as
opposed to maximum profits, and that increasing sales has
become the ultimate objective of most businesses. Maximum sales
occur when further price cuts result in lower total sales revenue,
since the increase in units sold doesn't make up for lower per-unit
sales proceeds. Assume you're selling 1,000 bagels a day at $1.25
apiece and lowering prices to $1.20 will increase sales by 40 units.
Presently, you're making $1,250, while the lower price will yield
1,040*1.2 = $1248. $1.25 therefore represents your revenue-
maximizing price strategy
Benefits
Although the ultimate long-term goal of a business is maximum
profits, a revenue maximizing strategy has various benefits. First,
it allows a business to build consumer loyalty. Once a sufficient
number of buyers habitually buy the product, prices can be gently
raised to increase profits. Secondly, maximum revenue results in
higher output levels, which in turn can help reduce costs over the
long term. Selling 1,000 instead of 200 bagels a day will allows the
baker to buy flour in bulk at lower prices. It can also help move to
larger industrial scale ovens to reduce the per-unit manufacturing
costs.
Exceptions
In some exceptional cases, the strategy that will yield maximum
sales will also maximize, or almost maximize profitability. This
occurs when the marginal cost of delivering the product or service
is nearly zero. Imagine a software developer that invests into
writing the software and then charges end-users per online
download. While it costs substantial amounts to produce the
software, each extra unit downloaded by consumers costs
practically nothing to deliver. Especially if the development
occurred well in the past and has already been recognized by the
accountants, revenue and profits are almost identical, since
practically no costs must be deducted from sales to arrive at gross
profit.

Meaning of Perfect Competition:

The term ‘perfect competition’ in economics has a different as

well as a diametrically opposite view of what a businessman holds.
Competition always involves ‘rivalry’. But as far as economics is
concerned, rivalry is absent in perfect competition; here competition
is entirely impersonal. So, perfect competition refers to a market
situation where competition among economic agents is completely
absent.

Obviously, this sort of market situation is far from reality. Still this
model has usefulness since it provides a very useful analytical
model. Above all, usefulness of any theory “lies in the predictions
it can generate”. That is why the model of perfect competition is
the starting point of business decisions relating to output and price.
The concept of perfect competition is about 235 years old. Adam
Smith used this phrase in a casual way in his celebrated
book “Wealth of Nations” (1776). Later, Edge-worth (1881) and
Frank Knight (1921) gave a complete nature of the model of perfect
competition.
Features of Perfect Competition:
Perfect competition is a market structure characterized by the
following conditions:

(a) Large Number of Sellers and Buyers:

A perfectly competitive firm is characterized by the existence of
innumerable number of sellers or firms and buyers so that everyone
in the market is so small that it cannot exert any influence on the
price. Every firm in the market is so small relative to the market
that it cannot affect market price by changing its output. Similarly,
buyers aim at buying the product at a lower price.

Such is ruled out since their numbers are so large that an

individual cannot obtain special favour from the sellers. Thus, every
economic unit behaves as a ‘price-taker’ or no one
possesses ‘market power’. Price is given to both buyers and sellers.
Only market forces can bring about a change in the price of the
product.

(b) Homogeneous Product:

A closely related provision is that the products sold by all firms are
standardized or homogeneous or identical in quality. In other
words, buyers could not differentiate the product as well as the
services sold by one from those of another. That is to say, goods
and services of each and every seller are perfect substitutes.

It is due to the homogeneity of the product that price is uniform or

same to all. Products are differentiated here by advertising, packa-
ging or quality. Because of this, every participant in the market
has “complete information” about prices ruling in the market. If
products were differentiated, firms would have been able to
influence the price—at least partially.
The assumptions of innumerable number of sellers and buyers and
product homogeneity imply that the individual firm and consumer
are price-takers and the demand curve (AR) faced by a competitive
firm becomes perfectly elastic. Further, the demand curve or the AR
curve coincides with the MR curve.

(c) Free Entry and Exit:

Any firm is free to enter or leave the industry, if situation demands.
If it wishes, a new firm may join the industry; the existing firms will
not put an obstacle. However, new firms become interested in
joining an industry mostly when some or most of the existing firms
enjoy something more than normal profit. Excess profit is, thus, an
incentive on the part of a firm to join the industry.

Similarly, if some of the firms incur losses chronically, they have

the liberty to close down business. No existing firm will ask them to
stay on. As a result, all firms in the long run enjoy only normal
profit. Remember, this particular feature is valid only in the long
run since entry or exit in the short run is not so easy. In other
words, there are barriers to entry and exit in the short run, but not
in the long run.

(d) Perfect Knowledge:

It is assumed that all the participants (consumers, producers, input
suppliers) have perfect knowledge and information regarding the
conditions of the market. If consumers have perfect knowledge of
the market, only then a uniform price will prevail.

If producers and buyers know costs, prices, product quality, etc.,

then there cannot be more than one price. Resource owners also
supply their inputs at the going price. No one has any incentive to
change price. Further, everyone also has complete knowledge of the
future.

(e) Perfect Mobility of Resources:

Resources are completely free to move from one firm to another, not
only geographically, but also among jobs. In other words, mobility
of resources is costless.

(f) Absence of Externalities:

If consumption of one individual or production of one firm is not
influenced by the actions of other individuals, then there exists
absence of externalities—either in consumption or in production.
Under perfect competition, consumption and production decisions
are not interdependent; rather, these are independent decisions.
This means that there is no third-party effect.

Collectively, all these features define perfect competition. No

industry, in actual practice, satisfies all these features. In this
sense, this market form does not fit with the reality.

Anyway, with these assumptions in mind, we will now examine

equilibrium of a firm both in the short run and in the long run.
Buyers are also at liberty to switch over from one seller to another
seller if they desire.

Firm is a Price-Taker

As there are a very large number of buyers and sellers under

perfect competition, every firm is a price-taker. It means that no
single firm has the ability to influence the price of a product in the
market, and has to therefore sell the product at the price
determined by the industry. It is so because the share of firms
under perfect competition in the total market supply is negligible.
A firm is different from an industry. A firm is a single unit producing
or providing the market with goods and services. However, an
industry is the total of all the firms manufacturing the same goods in
the market. For example, Cadbury is a chocolate manufacturing
firm, which comes under the chocolate industry with other firms
producing chocolates.
Hence, it can be concluded that a firm does not play any role in
the price determination of a product, as it can neither affect the
supply of a product nor it can affect its demand in the market.
Therefore, a firm is a Price-Taker and an industry is a Price-
Maker. The price of a product is determined by the industry at the
point where the market demand curve and supply curve of the
product meets, and every firm has to sell their product at this price
only. This concept can be understood with the help of a graphical
representation.

In the above graph, the market demand for a product is shown by

the DD curve and its supply is shown by the SS curve. The DD
curve and SS curve intersect with each other at point E, which
means that the price determined by the industry through demand
and supply of the product is OP. This price is adopted by the price
taker firms, and they are free to sell any unit of quantity OQ,
OQ1, etc., at this price. It means that the AR curve of the product
becomes perfectly elastic and parallel to the X-axis. Besides, when
AR remains constant, it becomes equal to MR (AR = MR).

Demand Curve under Perfect Competition

As the firms under perfect competition sell homogeneous products

at a uniform price fixed by the market and have a large number of
buyers and sellers, each firm in this market is a price-taker and
has a perfectly elastic demand curve.
In the above graph, the X-axis represents the Output of a product,
and the Y-axis represents Price and Revenue. The horizontal
straight line parallel to the X-axis is the demand curve of a firm
under perfect competition. As the price of goods is determined by
the market with the help of demand and supply of the good in the
market, every firm has to sell the goods at this price. In this case,
the price is determined by OP. At price OP, a seller can sell
different quantities like OQ 1, OQ2, etc. However, a firm cannot
change the price of the good.
As each firm (being a price-taker) has to sell the goods at the price
determined by the forces of supply and demand, uniform price
prevails in the market. It means that the revenue generated by the
firm from every extra unit, also known as MR, is equal to the price
of the product, also known as AR.
Therefore, under perfect competition, AR = MR.

Imperfect Competition Market Explained

An imperfect competition market is a market with non-
competitive sellers. The products in such marketplaces differ, as do
the target clients and the segments in which enterprises operate. In
this situation, sellers have the exclusive right to set the market
price of the goods they offer. They do not require the approval of a
higher authority in the regions in which they operate to determine
 the same. In other words, each seller adheres to their price-output
policy.

Product differentiation allows sellers to make more money than

their competitors in an imperfectly competitive market. However, it
causes market inefficiencies, resulting in economic value losses.
Even if there are multiple sellers in a market, if one of them
captures 60% of the market, it indicates imperfect competition. It is
the polar opposite of a perfectly competitive market, in which sellers
compete for the same target customers to persuade and sell goods
and services.
Profits earned in imperfect market competition due to high pricing
attract new market players and allow existing loss-making market
players to exit the market. However, the barriers to entry are
stricter.
In perfect market competition, sellers do not have the freedom to set
the market price because the price ranges of the other participants
in the same product category are similar. On the other hand, in a
market with non-identical goods, sellers have the liberty to set
prices high to maximize profits because they have no one to
compete with. While product information is not always apparent in
an imperfect competition market, it is critical in a perfect
competition market to guarantee customers have enough
information to decide whether to buy a certain product or look for a
better one.
Imperfect Competition Market Structures

The concept of imperfect market competition holds true in the

following types of markets:

1. Oligopoly: It consists of a small group of sellers who can influence

the conduct of other businesses.
2. Monopoly: It is a market in which only one seller offers
heterogeneous goods and services and can affect the price of the
same.
3. Duopoly: It comprises only two sellers, each with absolute power
and control.
4. Oligopsony: It has a very small number of buyers.
5. Monopsony: A market with just one buyer.
Example

The airline sector is one of the best imperfect competition

examples. Because of the high cost of aircraft, there are only a few
airlines to choose from, creating higher barriers to entry. Though
travelers have many options, each airline has its unique features
that stand out from the competitors, making them players in the
market. Similarly, stock markets are imperfect because not all
investors know everything about potential investments.
Characteristics

In 1933, Joan Robinson of England and E.H. Chamberlin of

America introduced the concept of imperfect competition. It exhibits
the following characteristics:

#1 – Multiple Buyers And Sellers

Several sellers operate in the non-competitive market independently,
but none of them influence the performance of the other. It is because
they all deal with different products and services. Therefore, no matter
how many sellers are there, the target customers remain divided, and
hence, the division of buyers is known.

#2 – Product Differentiation
The products and services in a non-competitive market might be
similar but never identical. As a result, customers remain divided.
Sellers understand which segments of customers they should target
for their products. They do not have to worry about competition
because those who favor their brands will stick with them.

Seller A, for example, sells infant food, while seller B sells feeding
bottles. Both sellers sell baby products and target the same customers.
But they are not rivals as their products are not similar.

#3 – Price Decision
The best part of an imperfect competition market is that the sellers are
free to determine the price of their products or services. With respect
to the convenience of customers, they set the market value of their
offerings without having to worry about how their competitors have
priced the same.

#4 – Free Entry & Exit

Firms have the freedom to enter and exit imperfect competition
markets. However, it may be difficult to break into such a market,
especially if the products to be sold are comparable to those offered
by an existing seller.

Monopolistic competition
An industry in monopolistic competition is one made up of a large
number of small firms who produce goods which are only slightly
different from that of all other sellers. It is similar to perfect
competition with freedom of entry and exit for firms and any
supernormal profits earned in the short-run will be competed away
in the long-run as new firms enter the industry and compete away
the profits.
Assumptions of monopolistic competition

In monopolistic competition, as with perfect competition, we make a

number of assumptions. However, do not get muddled by the word
monopolistic in the title. As a form of competition, this is closest to
perfect competition and nowhere near the monopoly end of the
scale. The reason for the name is that in monopolistic competition
we drop the assumption from perfect competition of homogeneity of
products and so each firm can develop their own 'brand' of product.
This means that each firm has a 'monopoly' over their brand, but
there is still a large number of firms.

The main assumptions are:

 Large number of firms - each firm has an insignificantly

small share of the market.
 Independence - as a result of a large number of firms in the
market, each firm is unlikely to affect its rivals to any great
extent. In making decisions it does not have to think about
how its rivals will react.
 Freedom of entry - any firm can set up business in this
market.
 Product differentiation - each firm produces a different
product or service from its rivals. Therefore each firm faces a
downward sloping demand curve. This is the key difference
from perfect competition. Product differentiation involves
creating differences between products, either real or imagined,
in consumers minds and is likely to involve various forms of
non-price competition such as branding and advertising.

Examples of monopolistic competition

Petrol stations, restaurants, hairdressers and builders are all

examples of monopolistic competition. Monopolistic competition is a
common form of competition in many areas. A typical feature is that
there is only one firm in a particular location. There may be many
chip shops in town but only one in a particular street. People may
be prepared to pay higher prices than go elsewhere, or they may
simply prefer this 'brand' of fish and chips.
Monopolistic competition in the short-run

As with other market structures, profits are maximized in

monopolistic competition where MC = MR. The AR and MR curves
are more elastic than for a monopolist as there are more substitutes
available. The profits depend on the strength of demand, the
position and elasticity of the demand curve. In the short run
therefore firms may be able to make supernormal profits. This
situation is shown in the diagram below.

Figure 1 Equilibrium in monopolistic competition in the short-

run

Monopolistic competition in the long run

In the long run firms will enter the industry attracted by the
supernormal profits. This will mean that demand for the product of
each firm will fall and the AR (demand curve) will shift to the left.
Long run equilibrium occurs where only normal profits are being
made as new firms will keep entering as long as there are
supernormal profits to be made. In equilibrium, the demand curve
(AR) will be tangential to the firm's long run average cost curve as
shown in the diagram below.
Figure 2 Equilibrium in monopolistic competition in the long
run

We can see this change between the short-run and long run clearly
if we combine Figures 1 and 2 together. Figure 3 shows the changes
taking place as new firms enter the market.

Figure 3 Changes in equilibrium in monopolistic competition

short-run to long run

Limitations of model

The monopolistic competition model has various limitations and

these include:

 Imperfect information
 Difficulties in deriving the demand curve for the industry as a
whole
  Size and cost structure mean that normal and supernormal
profits can be made in the long run by firms in the same
industry
 The simple model concentrates on price and output. However,
in practice, the firm will need to decide the variety of the
product and advertising

Efficiency in monopolistic competition

 Monopolistically competitive firms may have higher costs than

perfectly competitive firms, but consumers gain from greater
diversity
 Monopolistically competitive firms may have fewer economies
of scale and conduct less research and development, but
competition may keep prices lower than under monopoly
 Neither productive nor allocative efficiency is achieved. AC is
not at its minimum in the long run (productive inefficiency)
and price is greater than marginal cost (allocative efficiency).

Oligopoly: Definition, Characteristics and Concepts

Oligopoly Origin

The word Oligopoly is derived from two Greek words – ‘Oligi’

meaning ‘few’ and ‘Polein’ meaning ‘to sell’.

Oligopoly Definition and Meaning

Oligopoly is defined as a market structure with a small

number of firms, none of which can keep the others from
having significant influence.

Meaning of Oligopoly Market

An Oligopoly market situation is also called ‘competition among

the few’. An oligopoly is an industry which is dominated by a few
firms. In this market, there are a few firms which sell
homogeneous or differentiated products. Also, as there are few
sellers in the market, every seller influences the behaviour of the
other firms and other firms influence it. Oligopoly is either perfect
or imperfect/differentiated. In India, some examples of an
oligopolistic market are automobiles, cement,
steel, aluminium, etc.

Characteristics of Oligopoly

Now that the Oligopoly definition is clear, it’s time to look at the
characteristics of Oligopoly:

Few firms

Under Oligopoly, there are a few large firms although the exact
number of firms is undefined. Also, there is severe competition
since each firm produces a significant portion of the total
output.
Barriers to Entry

Under Oligopoly, a firm can earn super-normal profits in the long

run as there are barriers to entry like patents, licenses, control
over crucial raw materials, etc. These barriers prevent the entry
of new firms into the industry.

Non-Price Competition

Firms try to avoid price competition due to the fear of price wars
in Oligopoly and hence depend on non-price methods like
advertising, after
sales services, warranties, etc. This ensures that firms can
influence demand and build brand recognition.

Interdependence

Under Oligopoly, since a few firms hold a significant share in the

total output of the industry, each firm is affected by the price and
output decisions of rival firms.
Therefore, there is a lot of interdependence among firms in an
oligopoly. Hence, a firm takes into account the action and reaction
of its competing firms while determining its price and output
levels.

Nature of the Product

Under oligopoly, the products of the firms are either homogeneous

or differentiated.

Selling Costs

Since firms try to avoid price competition and there is a huge

interdependence among firms, selling costs are highly important
for competing against rival firms for a larger market share.

No unique pattern of pricing behaviour

Under Oligopoly, firms want to act independently and earn

maximum profits on one hand and cooperate with rivals to
remove uncertainty on the other hand.

Depending on their motives, situations in real-life can vary

making predicting the pattern of pricing behaviour among firms
impossible. The firms can compete or collude with other firms
which can lead to different pricing situations.

Indeterminateness of the Demand Curve

Unlike other market structures, under Oligopoly, it is not

possible to determine the demand curve of a firm. This is because
on one hand, there is a huge interdependence among rivals. And
on the other hand there is uncertainty regarding
the reaction of the rivals. The rivals can react in different ways
when a firm changes its price and that makes the demand curve
indeterminate.

Firms behaviour under Oligopoly

Based on the objectives of the firms, the magnitude of barriers to

entry and the nature of government regulation, there are different
possible outcomes in relation to a firm’s behaviour under
Oligopoly. These are:

1. Stable prices

2. Price wars

3. Collusion for higher prices

Further, Oligopoly can either be collusive or non-collusive.
Collusive oligopoly is a market situation wherein the firms
cooperate with each other in determining price or output or both.
A non-collusive oligopoly refers to a market situation where the
firms compete with each other rather than cooperating.

Non-Collusive Oligopoly-Sweezy’s Kinked Demand Curve Model

(Price-Rigidity)

Usually, in Oligopolistic markets, there are many price rigidities.

In 1939, Paul Sweezy used an unconventional demand curve –
the kinked demand curve to explain these rigidities.

Reason for the kink in the demand curve

It is assumed that firms behave in a two-fold manner in reaction

to a price change by a rival firm. In simple words, firms follow
price cuts by a rival company but not price increases. So, if a
seller increases the price of his product, his rivals do not follow
the price increase.

Therefore, the market share of the firm reduces significantly as a

result of the price rise. On the other hand, if a seller reduces the
price of his product, then the rivals also reduce their price to
bring it at par with the price reduction of the firm.

This ensures that they prevent their market share from falling.
Once the rivals react, the firm lowering the price first cannot gain
from the price cut.
Why the price rigidity?

As can be seen above, a firm cannot gain or lose by changing its

price from the prevailing price in the market. In both cases,
there is no increase in demand for the
firm which changes its price. Hence, firms stick to the same price
over time leading to price rigidity under oligopoly.

Explanation of the Kinked-Demand Curve Model

In the figure above, KPD is the is the kinked-demand curve and

OP0 is the prevailing price in the oligopoly market for the OR
product of one seller. Starting from point P, corresponding to
the point OP1, any increase in price above it will considerably
reduce his sales as his rivals will not follow his price increase.

This is because the KP portion of the curve is elastic and the

corresponding portion of the MR curve (KA) is positive. Therefore,
any price increase will not just reduce the total sales but also his
total revenue and profit. On the other hand, if the seller reduces
the price of the product below OPQ (or P), his rivals will also
reduce their prices.

However, even if his sales increase, his profits would be less

than before. This is because the PD portion of the curve below
P is less elastic and the corresponding part of the marginal
revenue curve below R is negative. Therefore, in both price-
raising and price-reducing situations, the seller is the loser. He
will stick to the prevailing market price OP0 which remains
rigid.

Working of the kinked-demand curve

Let’s analyze the effect of changes in cost and demand conditions

on price stability in the oligopolistic market. Let’s suppose that
the prevailing price in the market is OP0.
Therefore, if one seller increases the price above OP0 and the
rival sellers don’t and keep the prices of their products at OP,
then it will lead to the product becoming costlier than the others.

Subsequently, the demand for the costlier product will fall

significantly. This is seen in the demand curve of a firm for any
price above OP0 or the KP section of the curve, is relatively
elastic. The high elasticity reduces the demand significantly as a
result of the price increase.

On the other hand, if the seller reduces the price below OP 0, the
rivals also follow the price cut to prevent their demand from
falling. This is seen in the demand curve of a firm for any price
below OP0 or the PD segment of the curve is relatively inelastic.
The low elasticity does not increase the demand significantly as a
result of the price cut.

This asymmetrical behavioral pattern results in a kink in the

demand curve and hence there is price rigidity in oligopoly
markets. The prices remain rigid at the kink (point P). In other
words, the price will remain sticky at OP0 and the output = OR
at this price.

Due to the difference in the elasticities, the MR curve becomes

discontinuous corresponding to the point of change in elasticity
of the demand curve. The kink represents this. At the output <
OR, the demand curve is KP and the corresponding MR curve is
KA. For output > OR, the demand curve is PD and the
corresponding MR curve is BMR.