THEORY OF MARKET

Prepared by
Cassian, A
 Area to be covered;

 [Link] of a market i.e. meaning,

extent, and functions of a market.
 2 Classification of Market.
 [Link] and quantity determination in
the market.
 Objectives;
By the end of this topic, the student should be
able to;
 Explain the meaning, extent, and functions
of a market.
 Show some various essentials of a market
 classify Markets according to types and
structures
 Determine the price and quantity demanded
according to Market structure
 etc.
 Meaning of market;

 A market can be defined as a group of

economic agents, usually firms and
individuals, who interact with each other in
a buyer–seller relationship. It refers to a
place or an area where buyers and sellers
generally meet so as to buy and sell a
particular commodity. In Economics, we
make use of the term ‘market’ in a different
 Cont.

sense. It refers to a particular commodity that

is sold and purchased rather than a place or
an area. For example, cotton market, tea
market etc. In economics, it can be defined
as any effective arrangement for bringing
buyers and sellers into contact with one
another.
 Essentials of a market.

The essentials of a market are the following:

 1. Existence of area or region. Market does
not confine to a particular place but the
whole area wherein buyers and sellers of a
commodity are spread over;
 Cont.

 2. Existence of buyers and sellers; There

must be buyers and sellers and for that
physical presence is not necessary. In
modern days, we sell goods through
websites or electronic shopping markets or
through telephonic media;
 3. Existence of commodity; There must be a
commodity which is bought and sold; and
 Cont.
 4. Existence of contact between buyers and
sellers; There must be communication/
contact between buyers and sellers There
should be free interaction between buyers
and sellers so that only one price is agreed
upon for the commodity.
 5. Existence of price of a commodity. Each
commodity must have a specific price for a
specific unit of it
 Extent of the market.

Is the wideness or narrowness on level of

quantity of commodity sold and bought in
the market. It is a measure of quantity of
any commodity sold and bought in the
market.
 If quantity of commodity are bought and
sold in large amount and large area then the
extent of the market will be bigger/ wider
 Cont.

and if commodity is sold and bought in small

area and in small quantity then a market
will be narrow (limited).
 Determinants of market size/
extent.

 The extent of market depends on the

following factors.
 Nature of the commodity; If the commodity
is durable and valuable, like gold, then the
market will be wider and if the commodity
is perishable and less value like tomatoes,
the market on such a commodity will be
narrow.
 Cont.
 Degree of demand; The commodity which has
greater demand, its market will be wider and
commodities which have smaller demand their
market will be narrow.
 Peace and security; During peace and security
a commodity will be purchased and sold in a
large area, so market will be wider and if there
is no peace and security a commodity will be
narrow.
 Cont.

 Means of transport and communication; If

means of transport and communication are
well developed then it will be possible to
move commodities from one place to
another place more easily , so market will
be wider and vice versa.
 Government policy; If government put some
restrictions on the movement of
 Cont.

commodities from one area to another [Link]

internal to external markets (exportation)
then the market will be narrow. If the
government allows free trade, the market
will be wide internally and externally.
 Banking and monetary system; If banking
and monetary system is sufficient stable and
allow banking services and easy
 Cont.

transactions in an economy the market will be

wider and poor banking and financial
services will result to low market of
commodities. Example, availability of
many financial institutions, Easy conversion
of foreign currency etc.
 Grading of commodity; If a commodity is
divided into different classes (grades) then
the market will be wider because each
 Cont.

individual will be definitely aware about the

quality of any particular grade but ungraded
commodity will result to narrow market.
 Packaging and Branding; A commodity
which is well packed containers and well
branded will result to wide market for such
commodity and if a commodity is not well
packed with unknown name, then the
 Cont.

market will be narrow. Example, Transparent

materials are good in packing liquid
production.
 Functions of market.

The interaction that exists between market

forces of demand and supply ( buyers and
sellers) facilitate the following roles;
 To facilitate transactions; The interaction
between the buyers and sellers lead to
transfer of commodity to consumers and
transfer of money to sellers at given period
of time. Therefore market offer exchange
 Cont.

opportunities between buyers and sellers.

 Source of supply ( production); The
interaction between sellers and buyers
normally determine what to produce in the
market or country. Producers cannot
produce what he/she wish, but will produce
such commodity in which consumers will
prefer more in the market.
 Cont.

 Outlet of products; Outlet of products

means the release of product which have
been produced and stored in various
warehouses/ custody. Therefore various
manufacturers outlet their products after
contact and interact with consumers
( buyers) and not else.
 Contact between buyers and sellers; A
market facilitate (enables) buyers and
 Cont.

sellers to establish communication between

buyers and sellers located in far distance so
as to exchange goods and services through
various communication media.
 Price determination and stability; The
interaction between buyers and sellers can
lead to price determination and stabilization
in the economy through forces of demand
 Cont.

and supply at equilibrium point.

Diagramatically;
 Cont.

 Increase production; The increase in level

of demand (buyers) in the market facilitate /
induce suppliers (producers) to increase
level of supply (production) and hence
utilization of idle resources.
 Cont.
 Diagramatically;

From the above diagram, an increase in

demand from from D1 to D2 brings an
increase in quantity supplied from Q1 to Q2.
 Classification of market

Kinds of market are classified according to

various aspects/ contents as follows;
1. According to place/ area; in this aspects
there are three kinds of market which are;
Local market; Kind of market where by
exchange of commodity is carried out
within the region, example, district, village
level.
 Cont.

 National market; Kind of market whereby

exchange of commodity is carried out
within the country boundary. Example,
cotton from Shinyanga, to Tanga. It is also
known as domestic market.
 World/ International market; Is a market
where commodities are brought and sold in
different countries through import trade and
export trade. In this market the price of
 Cont.

commodity changes in one part tend to affect

the whole world countries price. Example,
oil price.
2. According to size; There are three kinds of
market according to size of quantity bought
and sold.
 Retail market; is a market in which the
commodity is bought in large quantity and
 Cont.

sold in small quantity/ size. In this market

retailer buy commodity from wholesale in
small quantity and sell to final consumer in
smallest units.
 Wholesale market; A market where
commodity is exchanged in large quantity.
In this market wholesalers buy from
manufacturer in largest units and sell to
retailer in large units (quantity).
 Cont

 Super market; A market where large

quantities of commodity are exchanged at
reduced price or trade discount.
3. According to commodity; Here we have,
 Specific market; A kind of market where
there is only one commodity is exchanged.
Example car, in a given or defined place
example Dar es Salaam.
 Cont.
 General market; A kind of market where
variety of commodities are bought and
sold example, Kariakoo in Dar es salaam,
Mwanjelwa in Mbeya, Lumambo in
Kahama(Shinyanga).
 Grading market; a market where
commodities are sold according to
classified grade example, Grade A, B, C,
etc. This is
 Cont.

common in railway transport where there is

VIP class, Economical class.
4. According to control/ Government
intervention; here we have,
 Controlled market; This is a kind of market
where government/central authority put or
impose(exert) some regulation on
controlling the exchange of commodity
 Cont.

between consumer and producer example

Fixing price or selling by quotas as done by
EWURA and SUMATRA.
 Free market; This is where the exchange of
commodities are run/ done by consumer
and sellers through force of demand and
supply without government intervention
within the country example USA, UK.
 Cont.

 Open market; kind of market where country

exchange commodities with other countries
without trade restrictions. That means there
is free trade among the trading countries.
 Cont.

5. According to Time; Under this category,

we have;
 Day to day market/ Very short run market;
Is a kind of market where price is
determined by the forces of demand and
supply within a particular day. In this case,
supply cannot be increased beyond the
existing stock of that commodity in
response to increase in demand. It means,
the supply is perfectly inelastic.
Diagrammatically;
 Cont.

From the diagram, we have demand curves

and a supply curve of a commodity in that
day. When demand changes, the producers
(suppliers) cannot respond to bring any
extra units of a commodity to meet demand
in the market.
 Short run market; Short run period market
is a market that exist with few days and few
months which is just sufficient to change
the quantity of variable factors of
production like raw materials , labour
quantity, working hours, etc but it is
impossible to change the quantity of fixed
factors such as number of firms, buildings,
machines etc. In this market, the price is
determined by the forces of demand and supply,
and the supply can not increase beyond the
existing capacity of present firms in relation to
change in demand. The supply curve is inelastic.
Diagrammatically;
 Cont.

From the above diagram, a large

proportionate change in demand from Dl to
Dh brings a very small proportionate
change in quantity supplied from Ql to Qh
 Long run period market; Is a market that
exist after long period of time example
4years etc, where all factors of production
are variable ( changes). It is a period where
the
 Cont.

 number of producers increases, technology

improves, than short run period. Under this
period the price is much affected by supply
than demand. Diagramatically;
Cont.
 Cont.

From the above diagram, a small

proportionate change in supply from S1 to
S2 brings a fall price from P1 to P2 which
inturn brings an increase in demand from
Q1 to Q2.
 Cont.

6. According to contract; Here we have,

 Spot market. Is a kind of market where
exchange of commodity or currency are
made where buyers and sellers agree each
other terms of trade for immediate
delivery(uses). Example, In air transport. In
this contract buyers and sellers determine
price now and payments for commodity are
made by the time being, delivery
 Cont.

( ownership) of a commodity is meet now( by

the time being)
 Future/ Forward market; Is a kind of
market where buyers and sellers of
commodity enter into contract to make
arrangement and agreements today on
exchange of commodity for some future
days. In this market, buyer and seller
determine and fix
 Cont.

the price of commodity now in order to

exchange (delivery) on future period,
example, example, in foreign exchange
money.
 Cont.

7. According to factor;
 Labour market; This is a kind of of market
where labour forces are traded at a price
expressed in terms of wage/ salary. In this
market, buyer is an entrepreneurs and seller
is labour.
 Land market; Is a kind of market structure
where natural resources in form of water
bodies, buildings, mineral deposits, forests,
 Cont.

etc are sold and bought. In this market, buyers

is an entrepreneur and seller is a landlord.
The price of land is rent.
 Capital market; A kind of market whereby,
capital in form of shares, securities, and
money are sold and bought. Capital market
is divided into two parts; That is;
 Cont.
 Financial/ foreign exchange market or
money market. In this market, it deals with
the buying and selling foreign currency in
terms of domestic currency at price
expressed, in terms of exchange rate
example 1$ = 2500 Tshs.
 Stock exchange market/ Anciary market;
This is a kind of capital market where
shares and long-term securities are sold and
bought between shareholders D.S.E, Bank,
Insurance companies etc.
 Cont.

8. According to levels; under this category

we have,
 Primary market; Is a market where
commodities/ shares are sold and bought for
the first time after their maturity.
 Secondary market; Under this kind of a
market, shares or commodities are are
bought and sold for the second time or next
 Cont.

buyers after being bought from primary

markets. Example, if a company sells the
shares to one shareholder and after a time
that shareholder resale the share to another
interested person. This is what we call
secondary market.
9. According to competition. Under this
category we have;
 Perfect competition market; this is a kind of
market where there are many sellers and
buyers of homogeneous (Similar) product.
In this market there is no one (neither buyer
nor seller) who have a power to determine
the price. Price is constant and determined
by the forces of demand and supply.
 Cont.
 Imperfect market; Is a market where there is a
limited degree of competition resulted from
nature of product produced. It comprises the
following;
 Monopoly market; Is a form of imperfect
market where there is only a single producer/
seller of a unique product with many buyers
example, TANESCO. In this market, there are
no competitors in the market.
 Cont.

 Monopolistic competition market; A market

where there are many firms producing
differentiated/ close substitute products.
 Oligopoly market; A market where there are
few sellers with many buyers in the market
and sell the products which are close
substitute, example, TOYOTA, TATA,
 Cont.
FORD. Cellular networks companies example
Vodacom, Togo, Airtel, Zantel.
 Duopoly; A market structure where there
are only two sellers of close substitute
commodity. Example, Cocacola and Pepsi.

Generally, there are two types of market.

 Commodity market; This is a market which
 Cont.

is concerned with buying and selling of goods

and services which cannot be converted into
further stage. Goods include TV, water,
shoes, clothes, etc. Services include
transport, insurance, banking, education etc.
 Factor market; This is a market which deal
with selling and and buying factors of
production such as labour, land and capital.
 Cont.

Under this market buyers are entrepreneurs

while sellers are householders (owners of
resources). The prices of these factors are;
labour- wages, land-rent, capital-interest.
 Price determination in the
market.
Price is the relative value of commodity in
terms of money that facilitate exchange
between buyers and sellers to occur. In the
market prices, can be determined by the
following ways.
 Cont.

 Bargaining power process (Haggling); This

is a way of price determination which takes
place between a buyer and a seller The
seller tries to increase the price level of a
given good/service and a buyer tries to keep
low the price he/ she is willing to pay. The
process goes on (continue) until the buyer
and a seller are on the same price.
 Cont.

 Fixing treaties; Here the buyer and a seller

of a commodity come together and sign the
treaty that indicates the agreements of a
fixing the the prices of a certain commodity
for some period. Example, in international
trade where industrialised nations come into
agreement with raw material producing
countries in fixing the price of various
products, example, cotton , tea , etc.
 Cont.
 Sales by auction; This is common where
commodities are sold to public ( people)
whereby one seller meet with many buyers.
In this way buyers compete for commodity
by offering various price they are willing to
pay and the commodity is sold for highest
bidder.
 Forces of demand and supply; The
interaction between demand and supply of a
commodity at equilibrium point especially
 Cont.
 in capitalism economy also determine price.
The equilibrium market price is found at a
point where demand equals to supply.
Diagramatically;
 Cont.

 Government authority; Under this method,

the price is fixed by the government
authorities at maximum or minimum level.
Some of such authorities in Tanzania
context include EWURA and SUMATRA.
 Market structures
Is a classification system of market according
to the degree of competition among the
sellers. Economists have classified markets
structures on the basis of:
 (a) The number of buyers and sellers of the
commodity;
 (b) The nature of the commodity produced
by the sellers;
 (c) Degree of freedom in the movement of
goods and factors; and
 Cont.

 (d) Whether knowledge on the part of the

buyers and sellers regarding prices in the
market is perfect or imperfect. On the basis
of these criteria, economists have
distinguished between two basic forms of
the market:
a) Perfect competition market and
b) Imperfect competition market.
 Cont.

Imperfect competitive market is divided into

four categories;
a. Monopoly
b. Monopolistic competition
c. Oligopoly
d. Duopoly
 PERFECT COMPETITION
A perfectly competitive market is a hypothetical
market structure characterized with the highest
degree of competition. Is a market structure where
there is a large number of buyers and sellers of
similar commodity with no power to influence
(determine the price of commodity. The price is
determined by the forces of demand and and supply
conditions. It means buyers and sellers are price
takers. It is sometimes referred to as pure
competition or atomistic competition.
 Features of Perfect Competition

The important features of this type of market

are summarized as follows:
 (1) Large number of buyers and sellers /
Many buyers and sellers. The number of
buyers and sellers is so large that no
individual buyer or seller can influence the
market price and output by his independent
action. The reason for this is that every
buyer and seller purchases or sells a very
 Cont.

insignificant amount of the total output ie.

Each of these must buy or sell such a small
proportion of the total market output that
none is able to have any influence over the
market price. There are very many firms in
the market - too many to measure, a result
of having no barriers to entry.
 Cont.

 (2) Homogeneous products. A firm

produces a product which is accepted by
customers as homogeneous or identical.
There is no way in which a buyer can
distinguish products sold by different
sellers. The assumptions of large numbers
of sellers and buyers and of product being
homogeneous indicate that a single firm is a
price-taker. Demand curve or average
 Cont.

revenue curve is infinitely elastic, i.e.,

demand curve is horizontal straight line
parallel to output axis. Therefore, a firm
under perfect competition sells any amount
of output at the prevailing market price.
 (3) Free entry and exit of the firms ie. Free
entry and exit from the market. Every firm
is free to join or leave the industry. This
means that there are no barriers to entry or
 Cont.

exit that give incumbent firms an advantage

over potential competitors who are
considering entering the industry. If the
industry is making profits new firms can
enter the market to share these profits.
Similarly, if the industry suffers losses the
individual firms can quit the market.
 (4) No government regulation. There is no
government interference in the market in
 Cont.

the form of taxes, subsidies, rationing of

essential goods etc. The government has no
power to intervene the market activities
through fiscal and monetary policies,
example, fixing interest rate, tariff charging
etc. The exchange of goods and services is
regulated by the market forces of demand
and supply
 Cont.

 (5) Uniform price. At a particular time

uniform price of a commodity prevails all
over the market. The above five conditions
are related to pure competition. Perfect
competition requires the following
additional assumptions/conditions to be
fulfilled.
 (6) Perfect knowledge of market
conditions. Buyers and sellers have full
 Cont.

knowledge of the price at which transactions

take place in the market. That is, both firms
and consumers must possess all relevant
market information regarding production
and prices.
 (7) Perfect mobility of the factors. Factors
of production can freely move from one
firm to another in the industry. They can
also move from one job to another and in
 Cont.

this way there is a scope for learning newer

skills.
 (8) Absence of selling and transportation
costs. Selling and other promotional costs are
not present in perfect market. This means that
it does not cost anything for firms to bring
products to the market or for consumers to go
to the market. It assumes a zero cost for the
movement of goods and services from
production area to consumption area.
 Cont.

 (9) Rational consumers and producers;

Given that producers and consumers have
perfect knowledge, it is assumed that they
make rational decisions to maximise their
self interest - consumers look to maximise
their utility, and producers look to maximise
their profits.
 Cont.
 (10) Sellers/ firms are price takers. No single
firm can influence the market price, or market
conditions. The single firm is said to be a price
taker, taking its price from the whole industry.
The single firm will not increase its price
independently given that it will not sell any
goods at all. Neither will the rational producer
lower price below the market price given that
it can sell all it produces at the market price.
 Cont.

 (11) Nature of profit; Firms can only make

normal profits in the long run, although
they can make abnormal (super-normal)
profits in the short run.
 (12) No preferential treatment; There is no
preference given to any firm by government
or anybody. All firms are equally treated.
 Cont.
 (13) The demand curve is perfect elastic;
This is due to constant price charged in the
market. It is horizontally slopping and equal
to Average Revenue and Marginal Revenue.
Diagrammatically;
 Price and output
determination under perfect
competition
 Equilibrium price under perfect competition
is determined not by the seller/firm but by
the industry (all firms together). The price
determined by the industry is accepted by
all firms. Thus, individual seller/firm is a
price taker under perfect market.
Cont.
 Cont.

In the diagram (Industry), DD and SS are the

demand and supply curve respectively. The
equality point of SS and DD is the
equilibrium point. At this point, price OP is
determined. OP price will be accepted by all
firms in the perfect market and sell any
amount of good at this price. Hence,
average revenue curve faced by an
individual firm is horizontal straight line
 Cont.

parallel to the x-axis or perfectly elastic. Now,

the firm’s task is to determine equilibrium
output.
It is to be remembered that any seller will sell
or produce that level of output where its
profit is maximized. And profit is
maximized where the following two
conditions are satisfied:
 Cont.

1. MR = MC
2. MC curve cuts MR from below.
 In the second diagram (Firm), it is seen that
point A satisfies both conditions. Hence the
firm will be in equilibrium at point A and
produce Q level of output at P price.
Similarly any output level greater than Q
will bring losses to the firm as MC > AR
(=MR) beyond point A.
 Cont.
In the short run, there are three possibilities for
a firm. These are;
(a) When a firm makes abnormal profits (AR >
AC);
(b) When it earns only normal profit (AR = AC);
and
(c) When it incurs losses, but does not shut
down.
 Firms will operate till they are able to get
variable costs.
Cont.
 Cont.

From the above diagram, short run

supernormal profit of the firm is indicated
by the shaded area.
In the long run, firms are attracted into the
industry if the incumbent firms are making
supernormal profits. This is because there
are no barriers to entry and because there is
perfect knowledge. The effect of this entry
into the industry is to shift the industry
 Cont.

supply curve to the right, which drives down

price until the point where all super-normal
profits are exhausted. If firms are making
losses, they will leave the market as there
are no exit barriers, and this will shift the
industry supply to the left, which raises
price and enables those left in the market to
derive normal profits.
Cont.
 Cont.

The super-normal profit derived by the firm in

the short run acts as an incentive for new
firms to enter the market, which increases
industry supply and market price falls for
all firms until only normal profit is made.
 Qn. Why should we study
PCM while it is unrealistic?

 It is clear that PCM conditions are rarely

achieved in reality; however, this does not
negate the usefulness of the analysis of
perfect competition. Once again it is
necessary to remember that a theory should
be judged not on the basis of the realism of
its assumptions but on its ability to explain
and predict. The conditions are
approximately approached in some markets,
 Cont.

for example agricultural products and stock

markets. Furthermore, the analysis and
conclusions in terms of conduct and
performance provide a useful benchmark
for comparing other forms of market
structure.
 Advantages/ merits of perfect
competition

It can be argued that perfect competition will yield

the following benefits:
 No consumer exploitation; chances of
consumer exploitation is very low in case of this
type of market structure because in perfect
competition sellers do not have any monopoly
pricing power and hence they cannot influence
the price of product or charge higher than
normal price from consumers.
 Cont.
 Freedom of production to firms. There are no
barriers to entry, so existing firms cannot derive
any monopoly power.
 Fair market. Only normal profits made, so
producers just cover their opportunity cost.
 Advertising and promotional expenses are
eliminated because product is homogeneous and
there is perfect knowledge among the consumers.
 Cont.
 There is also maximum wider choice for
consumers. Perfect competition is
consumer oriented market implying that
consumer is king in case of this type of
market structure and sellers cannot
displease the consumer because consumer
will quickly shift from one seller to another,
hence as far as consumers are concerned
perfect competition market structure gives
 Cont.

them pleasure of shifting from one seller to

another if they are not satisfied from the
product or sellers services.
 There is maximum allocative and
productive efficiency. Competition
encourages efficiency. That is it encourages
optimal allocation of resources.
 Cont.
 Economic welfare. Consumer get
standardized product irrespective of the
place of purchase of product, so for
example if a consumer is living in city A
and he or she travels to city B and he or she
requires soap which normally has perfect
competition then consumer does not have to
worry about quality of product because
product will remain same whether
consumer purchase it from city A or city B.
 Disadvantages of PCM.

 There is no incentive for sellers to

innovate or add more features to the
product because in case of perfect
competition profit margin is fixed and seller
cannot charge higher than normal price
which is prevailing in the market because
consumer will move to other sellers hence
sellers keep selling standardized product at
price fixed by market forces of demand and
supply
 Cont.

 There is a danger of instabilities in the

industry. This is because there are very
little barriers to entry implying that any firm
can enter the market and start selling the
product, hence old firms cannot afford to be
complacent because chances of losing
market share to new firms always loom
over them.
 cont
 Firms which has the best location is likely to
generate more sales then firm which is not
located on prime location and hence location
playing its part rather than customer service of
seller or product features is a limitation in
perfect competition.
 Poor technological developments because
there is no Research and Development
undertaken as the products are homogeneous.
 Cont.
 Limited consumer choice; Perfect competition
does not take into account of the various
consumer preferences for goods produced are
homogeneous. So cannot enjoy the pleasure of
buying things of different patterns in terms of
design brand and packaging design according to
the taste.
 Prices in perfect competition are controlled by
the price mechanism. It may lead to instable
income and prices due to frequent change in
equilibrium prices.
 Cont.

 Firms cannot enjoy economies of scale.

Production on a large scale cannot be done
by individual firms as firm output is
relatively very small compared to the
overall market.
 Expansion of firms may be difficult due to
the existence of normal profit which cannot
be ploughed in the longrun.
 MONOPOLY
 The word ‘Monopoly’ has been derived from
the two Greek words, ‘Monos’ which means
single, and ‘polus’ which means a seller. Thus,
monopoly is a market organization for a
commodity in which there is only one seller of
the commodity and where the commodity has
no substitutes. The seller, being the sole seller,
has full control over the supply of the
commodity. A monopolist is, thus, a price
maker.
 Cont.

However, it is preferable to define a

monopoly as being a firm that has the
power to earn supernormal profit in the long
run. This ability depends on two conditions:
1 There must be a lack of substitutes for the
product. This means that any existing
products are not very close in terms of their
perceived functions and characteristics.
Electricity is a good example.
 Cont.
2 There must be barriers to entry or exit. These
are important in the long run in order to prevent
firms entering the industry and competing away
the supernormal profit.
 To conclude, Monopoly is a market situation
where there is single seller of a product and he
has full control over the supply of that
commodity. He produces such a product which
has no close substitutes.
 Features of monopoly
• There is a single seller of the product. The
producer or seller of the commodity is a single
person, firm or an individual and that firm has
complete control on the output of the
commodity.
• There are no close substitutes of the
commodity produced by monopoly seller. All
the units of a commodity are similar and there
are no substitutes to that commodity.
 Cont.
• There is restriction on entry or exit of other firms.
Monopoly situation in a market can continue only
when other firms do not enter the industry. If new
firms enter the industry, there will not be complete
control of a firm on the supply. As such, whenever a
firm enters the industry, monopoly situation comes to
an end.
• There is no distinction between a firm and an
industry under monopoly. Monopoly industry is
essentially one-firm industry. This signifies that under
monopoly there is no differ­ence between a firm and
an industry.
 Cont.
• Seller is a price maker. A competitive firm is a
price-taker whereas a monopoly firm is a price-
maker. This is be­cause a competitive firm is
small compared to market and therefore, it does
not have market power. This is not true in the
case of a monopoly firm because it has market
power. Hence, it is a price maker.
• A monopoly firm can earn abnormal profits
both in short and long run. A monopolist can
earn abnormal profit even in the long run
 Cont.
because he has no fear of a competitive seller. In
other words, if a monopolist gets abnormal
profits in the long run, he cannot be dislodged
from this position. However, this is not possible
under perfect competition. If abnormal profits
are available to a competitive firm, other firms
will enter the competition with the result
abnormal profits will be eliminated.
• Selling costs are negligible. A producer is not
necessarily needed to carry out advertisement
since he is the sole supplier of the given
commodity.
 Cont.
• Nature of Demand Curve; under monopoly the
demand for the commodity of the firm is less
than being per­fectly elastic and, therefore, it
slopes downwards to the right. The main reason
of the demand curve sloping downwards to the
right is the complete control of the monopolist
on the supply of the commodity. Due to control
on the supply a monopolist makes changes in
the supply which brings about changes in the
price and because of this demand changes in
the opposite direction. In other words, if a
 Cont.
monopolist in­creases the price of the commodity, the
amount of quantity sold decreases. Therefore,
demand curve (AR) slopes down­wards to the right.
The nature of demand curve has been shown in the
diagram. DD is demand curve, which has a
negative slope.
• Price discrimination is possible under monopoly;
A monopolist is capable of carrying out price
discrimination, which means it can charge different
prices for its products from different buyers. This
is done solely for profit
 Cont.
maximization; monopolist can change different
prices from different consumers of his
commodity. He adopts the policy of price
discrimination on various bases such as
charging different prices from different
consumers or fixing different prices at different
places etc.
• Average and Marginal Revenue Curves:
Under monopoly, average revenue is greater
than marginal revenue. Under monopoly, if the
firm wants to increase the sale it can do so only
when it reduces its price. This means AR would
 Cont.

decline when sale increases. In that case MR

would be less than AR. AR slopes downwards
to the right and is greater than MR.
• Objective of a firm: The main objective or goal
of the monopoly firm is to earn maximum
profit.
 Reasons / origin for the emergence
monopoly in the market.

 1. Control over strategic raw material

Monopoly can be the result of exclusive
ownership of important raw materials or
knowledge of production techniques. Some
monopoly can arise naturally due to
concentration of a certain natural resources
which cannot be available in other area.
Example, availability of tanzanite in
Tanzania only.
 Cont.

 2. Patent rights acquired by a firm for its

product; these rights which are granted by
the government to a firm or industry to
produce a commodity or product of
specified character and standard quality as
well as to use a specified technique and
technology in the production process is
called patent rights. Such monopolies are
called patent monopolies.
 Cont.

 3. Protectionism; Foreign trade barriers

imposed by the government, which prevents
any foreign company to enter the industry.
It means the barriers are imposed upon
importation of a certain product which is
being produced by domestic firms. This
will reduce competition from foreign firm's
products and hence result to domestic
producers to become monopolists.
 Cont.
 4. A price policy adopted by the existing firms
which prevents new firms to enter.
 5. Legal Restrictions: Most of the public
monopoly power operating in the public utility
sector such as electricity and power supply, water
supply, postal service and electronic
communication media are government monopoly
that is created by the law of the country or state.
The objective of this policy is to work on the
behalf public welfare.
 Cont.

 6. Local Monopolies: Many local firms may

take pleasure in a monopoly position or
power because of heavy transport cost. For
example, local brick manufacturers and
stone quarries enjoy an element of local
monopoly because the heavy cost of
transportation prohibits the transportation of
these products from the surrounding areas.
 Cont.
 7. Merger and acquisition (take overs); Merger is
a production and market techniques where two or
many firms who produce similar product join
together to become a single firm. This is through
combining the assets and organization of a
particular firms. Take over (acquisition) is a
market technique where one company buy the
assets and management of another rival company
into single company.
 Cont.

 8. Product differentiation; This is where a

certain firm can become monopoly by
differentiating its product from other rival
companies by designing new and unique
color, packaging, branding and advertise its
product so as to acquire large market shares.
This will result to a simple monopoly.
 Cont.

 9. Large scale production advantages; A firm

may become a monopoly by expanding the scale
of production into large scale production. This
will result to a fall in the cost of production (AC)
which will be resulted from market economies,
transport economies which will cause the small
firms to decline (collapse) because of low power
of competing with large scale producing firm
hence monopoly to large firms.
 Types of monopoly

 Natural monopoly; This is a market

structure where by there is a single supplier
of a certain commodity because of owning a
certain natural resources in a particular
geographical area. Example, minerals
( example tanzanite in Tanzania), oil
reserves ( in Saudi Arabia) etc.
 Statutory / Patent monopoly; This is a kind
of monopoly established by the government
 Cont.

laws and orders to perform a certain

undertaking in a country and there should
no other rival firms allowed to perform
such undertaking, example TANESCO.
 Collective / collusive monopoly; Is a kind of
monopoly through formal or informal
agreement of several firms who produce
similar product to become one firm
example OPEC ( organization for petroleum
exporting countries)
 Cont.

 Discriminatory monopoly; Is a monopoly

who sells the same commodity at different
prices to different consumers.
 Simple monopoly; Is a kind of monopoly in
which there is a small number of substitute
product. It means the cross elasticity of
demand is not zero but small / negligible.
Example, TANESCO.
 Cont.

 Pure monopoly; is a kind of monopoly

where there is only one producer with no
close substitute at all. It means, the cross
elasticity of demand is zero.
 Advantages of monopoly

 Monopoly avoids duplication and hence

avoids wastage of resources. (We have to
understand that duplicate and fake products
are a real problem in many countries).
 A monopoly enjoys economies of scale as it
is the only supplier of product or service in
the market. The benefits can be passed on to
the consumers. All supply is concentrated at
one place and that leads to big scale
 Cont.

production which in turn leads to lower cost

per unit for the seller and if the seller passes
it to the consumer that consumer will also
benefit from the lower price of product
being available for consumption.
 Easy to carry out technological
development. Due to the fact that
monopolies make lots of profits, it can be
used for research and development and to
 Cont.

maintain their status as a monopoly. Also a

seller can invest that amount in research and
development of product so that customers
can get better a quality product at reduced
price leading to enhanced consumer surplus
and satisfaction. Also monopolies can
afford to invest in latest technology and
machinery in order to be efficient and to
avoid competition.
 Cont.

 Price discrimination is beneficial to weaker

sections of the economy. Monopolies may
use price discrimination to benefit the
economically weaker sections of the
society.
 Source of revenue for the government; the
government gets revenue in form of
taxation from monopoly firms.
 Cont.

 Less selling costs; as there is no

competition sellers do not resort to unfair
promotional tactics like their product is
better than others or claiming incorrect
features in their product or giving discounts
after increasing the price of product and so
on.
 Disadvantages of monopoly
 No consumer sovereignty. A monopoly
market is best known for consumer
exploitation. There are indeed no competing
products and as a result the consumer gets a
raw deal in terms of quantity, quality and
pricing.
 Consumers may be charged high prices for
low quality of goods and services. The
biggest disadvantage of monopoly is that
seller is the price maker which gives seller
 Cont.

undue advantage of charging exorbitant or

unfair price for the product leading to
exploitation of consumers as they have no
option but to buy it from seller as there is
no competitor of the seller in monopoly
market.
 Lack of competition may lead to low quality
and out dated goods and service. In the
absence of any competition there is
 Cont.

tendency of the seller to be complacent which

in turn leads to seller selling low quality
products and providing poor customer
service as customer has no choice because
there are no substitutes due to lack of
competition.
 Dissatisfaction among consumers.
Monopoly firm may resort to discrimination
pricing that is charging different prices from
 Cont.

different customers which will lead to

dissatisfaction among consumers as same
product will be priced differently for
different markets or consumers; hence there
is no transparency in case of monopoly.
 Harmful to LDCs. Monopolist, by virtue of
his control over the capital and wealth is
able to influence the political affairs of the
economy, especially in under-developed
 Cont.

countries, which lack capital formation. The

political authority in such countries cannot
ignore or dissatisfy the monopolists.
 Cut-throat competition eliminates some
firms. Monopoly firms often resort to a
number of unfair practices to injure or
eliminate the rival firms through cut throat
competition. For this, many times, firms fix
ridiculously low prices far below cost to
 Cont.
 compete away the rivals. The loss in one
market can be compensated by charging a
very high price in other markets.
 Inefficiency in production; Resource
allocation is inefficient under monopoly.
Monopoly firm is inefficient in the sense
that it does not produce at the minimum
point of the average cost curve, as the
demand curve faced by a monopolist is
downward sloping. It leads to situation of
excess capacity. He restricts the output.
 Cont.
 Distortions in the allocation of resources. Since,
monopolist cares only for his monopoly profit,
he does not worry, whether the cost is rising,
falling or is constant. Thus, monopoly implies
distortions in the allocation of resources. It
exploits a smaller number of factors than is
economically necessary. The resources are not
fully exploited and the plant capacity remains
under-utilised. The unused capacity of the firms
can also be called as a social waste.
 Cont.
 Immobility of resources; Presence of single
producer in the market limit the market limit the
mobility of labour to move from one firm to
another firm. It prevents occupational and
geographical mobility.
 They exert pressure to a government and
sometimes they force the government to adopt
some adverse policies, example, by threatening
to stop production if the government refuses to
ban or tax the imported goods.
 Monopoly Regulation

 Monopolies always reduce the economic

wealth of society in many ways. Hence,
governments regulate monopolies with the
objective of benefiting societies more than
would be the case if the
monopolies maximized their profits. There
are 3 major methods to increase the benefits
of monopolies to society:
 Cont.
 Removing or lowering barriers to entry through
antitrust laws so that other firms can enter the
market to compete. This can be done through
passing antitrust laws. The main purpose of
antitrust laws is to prevent business practices that
either create or maintain a monopoly.
 Regulating the prices that the monopoly can
charge; Here the government can fix the price of
the monopoly product to rescue the life of the
low economy agents.
 Cont.

 Operating the monopoly as a public

enterprise. Sometimes the government will
regulate a monopoly by actually owning it.
 Monopoly profit maximization
(How to calculate maximum profit in a monopoly?)
 The monopolist's profit maximizing level of
output is found by equating its marginal revenue
with its marginal cost, which is the same profit
maximizing condition that a perfectly
competitive firm uses to determine its
equilibrium level of output. Indeed, the condition
that marginal revenue equal marginal cost is used
to determine the profit maximizing level of
output of every firm, regardless of the market
structure in which the firm is operating.
 Cont.

 Profit is maximized at the quantity of output

where marginal revenue equals marginal
cost. Marginal revenue represents the
change in total revenue associated with an
additional unit of output ie. is the change in
the total revenue that arises when there is a
change in the quantity produced. The total
revenue is found by multiplying the price of
one unit sold by the total quantity sold. For
example, if the price of a good isTshs 10
 Cont.

and a monopolist produces 100 units of a

product per day, its total revenue is Tshs. 1,
000/=. The marginal revenue of producing
101 units per day is Tshs 10. However, the
total revenue per day increases from Tshs
1,000 to Tshs 1,010. The marginal revenue
of a firm is also calculated by taking the
first derivative of the total revenue
equation.
 Cont.
Generally, The monopolist's profit maximizing level
of output is found by equating its marginal
revenue with its marginal cost, which is the same
profit maximizing condition that a perfectly
competitive firm uses to determine its equilibrium
level of output. Indeed, the condition that marginal
revenue equal marginal cost is used to determine
the profit maximizing level of output of every
firm, regardless of the market structure in which
the firm is operating.
 Cont.
output price (Tshs) TR MR TC ATC MC Monopoly
(Tshs) (Tshs) (Tshs) (Tshs) (Tshs) profit
(Tshs)

0 14 0 - 2 - - -2

1 12 12 12 6 6 4 6

2 10 20 8 8 4 2 12

3 8 24 4 12 4 4 12

4 6 24 0 20 5 8 4

5 4 20 -4 35 7 15 -15
 Cont.

 Marginal cost is the change in total cost for

an additional unit of output ie. is the change
in the total cost that arises when there is a
change in the quantity produced. In calculus
terms, if the total cost function is given, the
marginal cost of a firm is calculated by
taking the first derivative, with respect to
the quantity. For example, basing on the
following table,
 Cont.

 The monopolist will choose to produce 3

units of output because the marginal
revenue that it receives from the third unit
of output, Tshs 4, is equal to the marginal
cost of producing the third unit of output,
Tshs 4. The monopolist will earn Tshs 12 in
profits from producing 3 units of output, the
maximum possible by charging 8 Tshs as a
price.
 Cont.

 Therefore, both marginal revenue and

marginal cost represent derivatives of the
total revenue and total cost functions,
respectively. You can use calculus to
determine marginal revenue and marginal
cost; setting them equal to one another
maximizes total profit.
 Cont.

Given the TC and TR equations, the profit-

maximizing quantity of output is
determined through the following steps:
 Determine marginal revenue by taking the
derivative of total revenue with respect to
quantity.
 Determine marginal cost by taking the
derivative of total cost with respect to
quantity.
 Cont.

 Set marginal revenue equal to marginal cost

and solve for q.
 Substituting q in the demand equation to
enable you to determine price.
The profit-maximizing quantity and price are
the same whether you maximize the
difference between total revenue and total
cost or set marginal revenue equal to
marginal cost.
 Question one.

 Suppose a monopolist's total cost function

is: P = 10Q + Q2, where Q is the quantity.
Its demand function is: P = 25 – Q.
 The total revenue is found by multiplying P
by Q, where P is the price and Q is the
quantity. Therefore,
 The total revenue function is:
TR = 25Q - Q2.
 Cont.

 The marginal cost function is: MC = 10 +

2Q.
 The marginal revenue is: MR = 30 - 2Q.
The monopolist's profit is found by
subtracting total cost from its total revenue.
 In terms of calculus, the profit is maximized
by taking the derivative of this function, π =
TR - TC, and equating it to zero.
 Cont.

Therefore, the quantity supplied that

maximizes the monopolist's profit is found
by equating MC to MR:
ie. 10 + 2Q = 30 - 2Q.
 The quantity it must produce to satisfy the
equality above is 5.
 This quantity must be plugged back into the
demand function to find the price for one
 Cont.

product. To maximize its profit, the firm must

sell one unit of the product for Tshs 20. The
total profit of this firm is 25, or
TR - TC = 100 – 75.
 Question two

Suppose a discriminating monopolist is

selling a product in two separate markets;
mbeya and Moshi in which the respective
demand functions are;
P1 = 12 – Q1
P2 = 20 – Q2
The monopolist’s total cost function is
TC = 3 + 2Q
 Cont.

i. As the economic advisor you are asked to

determine the prices to be charged in the
two markets and amount of output to be
sold in each market so that profits are
maximized.
ii. You are also asked to calculate the total
profit to be made from the strategy of price
discrimination.
iii. What advise will you give?
 Solution

i. As profits in case of price discrimination are

maximized when MR1 = M2 = MC.
Therefore, we have to calculate the marginal
revenue in the two markets from the given
demand functions of the two markets.
Total revenue in the market 1 = P1Q1
= 12Q1 – Q12

MR1 in the market 1 = 12 -2Q1

 Cont.

Total revenue in the market 2 = P2Q2 = 20Q2

– Q22
MR2 in the market 2 = 20 – 2Q2
We can derive the marginal cost from the
total cost function
TC = 3 + 2Q
MC = 2
 Cont.
Profit maximizing amount of output to be sold in
the two markets are determined by applying the
equilibrium condition MR1 = MR2 =MC and
solving the following equations:
MR1 = MC
12 -2Q1 = 2
2Q1 = 12 – 2 =10
Q1 = 5
MR2 =MC
 Cont.
20 – 2Q2 = 2
2Q2 = 20 – 2 = 18
Q2 = 9
Substituting these equilibrium outputs, Q1
and Q2 in the demand functions, we obtain
the profit-maximizing prices:
P1 = 12 – Q1 =12 – 5 =7
P2 = 20 – 2Q2 = 20 – 9 = 11
 Cont.
Mbeya, ( P1, Q1) = ( 7, 5),
Moshi, (P2, Q2 )= (11, 9)
 
ii. Total profits can be obtained in the usual way
Total profits, = (TR1 + TR2) – TC
= (P1Q1 + P2Q2) – TC
= 7(5) + 11(9) – [3 + 2(5+9)]
= (35 + 99) – 31
=103
 Cont.

iii. Advice; to maximize profit, the monopoly

is advised to sell 5 units and charge a price
of 7 Tshs per each unit in Mbeya, and sell
9 units and charge a price of 11 Tshs per
each unit in Moshi. This will generate a
profit of 103 Tshs.
 Graphical illustration of monopoly profit
maximization.
Note that the market demand curve (AR curve),
which represents the price the monopolist can
expect to receive at every level of output, lies
above the marginal revenue curve. ie. Under
monopoly, AR curve lies above the MR curve.
Monopoly profits.
Monopoly will maximize profit by producing and
charging price at a point where Marginal
Revenue (MR) = Marginal Cost (MC).
Diagrammatically it can be shown as follows;
Cont.
 Cont.
From the above illustration, profits are illustrated
by shaded rectangle.
 
Monopoly Profit = (Price - ATC) × Quantity=
(Average Revenue × Quantity) - (ATC ×
Quantity)
= (Average Revenue × Quantity) - (ATC ×
Quantity)
= (Average Revenue × Quantity) - (ATC ×
Quantity)
= Total Revenue - Total Cost
 Monopoly losses.

While you usually think of monopolists as

earning positive economic profits, this is not
always the case. Monopolists, like perfectly
competitive firms, can also incur losses in the
short‐run. Monopolists will experience short ‐
run losses whenever average total costs
exceed the price that the monopolist can
charge at the profit maximizing level of
output. Losses can be caused by a change in
 Cont.

consumer tastes or by changes in the cost of

inputs. However, if the monopolist cannot
make a profit, then it will shutdown the firm
so it can put the resources to better uses. A
monopolist will only produce in the short
run to minimize losses if it perceives that
market conditions will change or that it will
be able to earn a profit in the future.
Cont.
 Cont.

From the above diagram, the monopoly incurs

a short-run loss represented by the above
shaded area (rectangle). Monopoly Loss =
(ATC – Price) × Quantity
 Absence of a monopoly
supply curve.

Under monopolist’s diagrammatical

representation of profit maximization, there
is no representation of the monopolist's
supply curve. In fact, the monopolist's
supply schedule cannot be depicted as a
supply curve that is independent of the
market demand curve. Whereas a perfectly
competitive firm's supply curve is equal to a
portion of its marginal cost curve, the
 Cont.

monopolist's supply decisions do not depend

on marginal cost alone. The monopolist
looks at both the marginal cost and the
marginal revenue that it receives at each
price level. In order to determine marginal
revenue, the monopolist must know market
demand. Therefore, the monopolist's market
supply will not be independent of market
demand.
 Monopolistic competition

Monopolistic competition an industry

structure in which a large number of firms
produce slightly differentiated products that
are reasonably close substitutes for one
another.
The model of monopolistic competition
describes a common market structure in
which firms have many competitors, but
each one sells a slightly different product.
 Cont.

In a monopolistic competitive market the

number of sellers is large but each seller has
a product differentiated from those of his
rivals. What one firm produces is not quite
like what any other firm produces. In fact,
each firm has a kind of limited monopoly of
its own product and hence the name
“monopolistic competition”. The following
are the main features of the monopolistic
competitive market:
 Cont.

 Large number of firms; The number of

firms which constitutes an industry is fairly
large. There are usually a large numbers of
independent firms competing in the market.
 Product Differentiation; A central feature of
monopolistic competition is that products
are differentiated ie. each firm produces a
slightly differentiated product. . The form
or the quality of a product can be
 Cont.
differentiated by using different kinds of raw
materials, through workmanship, colour, packing,
design, durability, etc. For example, different firms
produce soft drinks like coca cola, sprite, 7-up etc.
Though the ingredients are same, products carry a
different brand name.
 Free Entry and Exit; Firms under monopolistic
competition are free to enter and leave the industry
at any time. This means there is freedom to enter or
leave the market, as there are no major barriers to
entry or exit.
 Cont.
 Individual pricing by a Firm; In this type of
market, every individual producer has his
own independent price policy. Each firm
makes independent decisions about price
and output, based on its product, its market,
and its costs of production.
 Selling Costs / advertisement; Firms
operating under monopolistic competition
usually have to engage in advertising. Firms
are often in fierce competition with other
 Cont.
(local) firms offering a similar product or
service, and may need to advertise on a local
basis, to let customers know their differences.
Common methods of advertising for these
firms are through local press and radio, local
cinema, posters, leaflets and special
promotions.
 Fierce competition among the firms; Under
monopolistic competition, both price and non-
price competition prevails.
 cont.

 Firms have power over the products they

produce and sell and that they work
independently; Firms do not take into
account competitors’ behavior in
determining price and output. As far as the
first condition is concerned, there may be a
few large dominant firms with a large fringe
of smaller firms, or there may be no very
large firms but just a large number of small
firms.
 Cont.
 Firms are price makers and are faced with a
downward sloping demand curve; Because
each firm makes a unique product, it can
charge a higher or lower price than its rivals.
The firm can set its own price and does not
have to ‘take' it from the industry as a whole,
though the industry price may be a guideline,
or becomes a constraint. This also means that
the demand curve will slope downwards.
The demand curve is elastic because of
substitutability of products produced in
the market. Diagrammatically;
 Cont.

 From the above diagram, a small change in

price from P1 to P2 brings a larger
proportionate change in quantity demanded
from Q1 to Q2.
 Advantages of Monopolistic
competition

 There are no significant barriers to entry;

therefore markets are relatively contestable.
 Differentiation creates diversity, choice and
utility. In case of monopolistic competition
buyers get plenty of options due to
differentiated products as every product has
some additional feature which is not the
case with perfect competition where sellers
 Cont.
sell homogeneous products or in monopoly where
sellers do not bother to add new features to
product as there is no competition.
 The market is more efficient than monopoly but
less efficient than perfect competition; less
allocatively and less productively efficient.
However, they may be dynamically efficient,
innovative in terms of new production processes
or new products. For example, retailers often
constantly have to develop new ways to attract
and retain local custom.
 Cont.
 Right consumers choice is possible; since
different companies are selling differentiated
products they tend to advertise about it
through various channels of communication
which make customers more aware about the
various products and their features which in
turn helps the customers in making informed
decision by comparing the features of various
products.
 Cont.
 It helps in innovation; because the only thing
which will help the company in surviving in
case of monopolistic competition is to
constantly add new features to product and
hence in a way one can say that monopolistic
competition forces the companies to invest in
research and development so that the company
can produce better quality product at cheaper
rates than their competitor.
 Cont.
 There is no price discrimination; therefore, the
consumers are not exploited in terms of sex,
religion, income, as compared to monopoly
market structure.
 There is high quality and quantity of goods and
services produced because of competition than in
monopoly market.
 High degree of mobility of factors; Resources are
free mobile from one firm to another, example if
laborers are paid low they can move to another
firm where there is a high payment.
 Disadvantages of
monopolistic competition
Despite several advantages, monopolistic
competition market has encountered bitter
criticism both from the Government and
from the general public. Following are
some of the evils of monopolistic
competition.
 Cont.

 Wasteful competition; Too much money on

advertising as it is the most important part
as far as monopolistic competition is
concerned which in turn results in increase
in expenses for the company and company
in turn passes this increased cost to
consumer in the form of higher price for the
product. Advertising has been considered
wasteful, though most is informative rather
than persuasive.
 Cont.
 Consumer exploitation; Due to differentiated
products chances are, companies may charge
more than fair price from the consumers for extra
features in product because unlike perfect
competition where there is no scope for
companies to charge higher price as companies
sell homogeneous products. Some differentiation
does not create utility but generates unnecessary
waste, such as excess packaging.
 Cont.
 In the long run there is a possibility of
getting loss because of free entry by other
firms.
 Because of advertisement, consumer can be
influenced to make a wrong choice in
decision on purchasing of a product which
can be harmful or low standard.
 Duplication of resources on producing close
substitute products which canresult into
wasteful of such resources.
 Cont.

 As one can see from the above that

monopolistic competition has many
advantages as well as disadvantages,
however in real or practical life
monopolistic market structure is present in
the majority of markets all over the world.
 Equilibrium under
monopolistic competition
In the short run supernormal profits are
possible, but in the long run new firms are
attracted into the industry, because of low
barriers to entry, good knowledge and an
opportunity to differentiate.
Equilibrium under monopolistic competition
 Cont.

At profit maximization, MC = MR, and

output is Q and price P. Given that price
(AR) is above ATC at Q, supernormal
profits are possible (area PABC).
As new firms enter the market, demand for
the existing firm’s products becomes more
elastic and the demand curve shifts to the
left, driving down price. Eventually, all
super-normal profits are eroded away.
 In the long-run;
Under Monopolistic competition, in the long run,
Super-normal profits attract in new entrants,
which shifts the demand curve for existing firm
to the left. New entrants continue until only
normal profit is available. At this point, firms
have reached their long run equilibrium.
Monopolistic competition, long run profit maximization
 Cont.

From the diagram above, monopolistic

competitive firm operating in the long-run
will generate only a normal profit by
producing output Q and charging the price
P.
At this point, P = LAR (Long run average
revenue) =LATC (Long run average total
cost)
 Oligopoly

 Oligopoly; an industry structure in which a

small number of large firms produce
products that are either close or perfect
substitutes. Oligopoly is a market structure
where there are only a few producers/sellers
of a commodity (but more than two
producers) competing with one another. TV
manufacturers (BPL, Videocon, Onida, LG,
Samsung, Sony etc) etc are the examples of
oligopoly. Oligopoly is of two kinds:
 i. Pure Oligopoly

 It is a market where the products are

homogenous. There is mutual interdependence
between firms. Any change in price by one firm
has a substantial effect on the sales of other and
cause them to change their price. Examples of
pure oligopoly are found in such industries as
cement, coal, gas, steel, oil companies such as
CALTEX, AGIP, BP, SHELL, TOTAL, OILCOM
etc.
 ii. Differentiated Oligopoly/ imperfect oligopoly

Under differentiated oligopoly, products are

close substitutes for each other. Price change
by one firm has less direct effect upon rival
firms. Examples of differentiated oligopoly
are refrigerators, television sets, air-
conditioners, automobiles, scooters,
motorbikes, and instant coffee producers.
 Characteristics of Oligopoly
Some of the important features of oligopoly are as
follows:
 1. Interdependence: Under oligopoly, a firm
cannot take independent price and output
decision. As the number of competing firms is
limited, therefore, each firm has to take into
account the reactions of the rival firms. Price and
output decisions of one oligopoly firm have
considerable effect on the price and output
decision of the rival firms.
 Cont.
 2. Indeterminate Demand Curve: An oligopoly
firm can never predict sales correctly. It can
never be certain about the nature and position of
its demand curve. Any change in price or output
by one firm leads to a series of reactions by the
rival firms. As a result, the demand curve of the
oligopoly firm remains indeterminate (indefinite
and shifting). Thus, under oligopoly a price,
once determined, continues to prevail for a long
time.
 Cont.

According to Paul M. Sweezy, an

oligopolistic firm faces a kinked demand
curve at the existing price as shown under
in the figure below. If a firm reduces prices
of its products, other firms will also follow
as demand curve is highly inelastic in its
lower part ED1. As a result, the firm which
has lowered the price will not gain anything
out of its act. Now, if it raises its price
 Cont.

above the prevailing price OP, other firms will

not follow this time as demand curve above
the prevailing price (upper part) DE is more
elastic.
 Thus, the firm will lose due to his action.
Therefore, price will remain more or less
stable under oligopoly situation. The
demand curve in the Fig. 45 is kinked (bent)
at E.
Cont.
 Cont.

 3. Role of selling costs: Advertisement,

publicity and other sales techniques play an
important role in oligopoly pricing.
Oligopoly firm employs various techniques
of sales promotion to attract large number
of buyers and maximize the profits. Selling
cost has a direct bearing on the sales of the
oligopoly firm.
 Cont.

 4. Price Rigidity: Oligopoly firm generally

sticks to a price, which is determined after a
lot of planning and negotiations, with the
competing firms. A firm will not resort to
price cut, as it would lead to retaliatory
actions by the rival firms resulting in price
war. An oligopoly firm will also not raise
the price because the rival may not follow
suit and, as a result, the firm will lose many
of its customers.
 Cont.
 5. Group Behaviour/ interdependence among
the competing firms: Price and output
decisions of one oligopoly firm have direct
effect on the competing firms.
Interdependence of the firms compels them to
think in terms of mutual co-operation. Firms
try to maximize their profits through collusive
action. Instead of independent price output
strategy oligopoly firms prefer group
decisions that will protect the interest of all
the firms.
 Cont.
 6. There are few sellers/ producers with many
buyers.
 7. There is identical or differentiated products
produced. Those under perfect oligopoly
identical products while those under imperfect
oligopoly produce differentiated products.
 8. Existence of barriers in entrance of new firms
in terms of technology ( ie. patent right). It
means new firms are not allowed to copy the
technology of another firm but there is free exit
for those who make loss.
 Cont.

 9. Limited entry, under oligopoly entry in

the industry is restricted since the matured
firms in the industry can use unfair
competitive methods to stop entry of new
firms and drive out new ones.
 Cont.

Advantages of oligopoly market.

 Oligopolistic firms in long run experience
abnormal profit since there are limitations of
entries of new firms.
 There is competition, therefore existence of
quality products at affordable price because
price is always rigid (unchanging).
 Cont.

 There is consumer sovereignty; This is

because firms under oligopoly produce both
identical and differentiated products,
example, automobile firms like TOYOTA,
MARK II, RAV 4, etc.
 There is no price discrimination which can
lead to exploitation of consumer.
 Disadvantages of oligopoly
markets
 There is duplication and wastage of
resources through advertisements in order
to maintain their market share.
 Through mutual agreement which result to
cartel, the firms can decide to fix high price
so as to get profit which leads to
exploitation of consumers.
 Inefficiency in production; This is because
of restrictions on new firms, the existing
 Cont.

firms can lead into inefficiency in production

in the sense that poor quality products, and
small in amount, will be produced.
 Due to the restrictions of output under cartel
arrangements, artificial shortage can be
created so as to increase profit and exploit
the consumers.
 Oligopoly Pricing Models

 A pure monopoly maximizes profits by

producing that quantity where marginal
revenue = marginal cost.
 However, it is much more difficult for an
oligopoly to determine at what output it can
maximize its profit. There are 2 major
reasons for this: the interdependence of the
firms and their diversity, especially in terms
 Cont.

of concentration ratios . Some oligopoly's

have a very high concentration ratio,
allowing them to act more like a monopoly,
while other industries have a much lower
concentration ratio, thus, making it more
difficult to determine the best pricing
strategy, since the number of possible
responses by competitors is increased.
 There have been 2 prominent characteristics of
oligopolies observed over the years.

 In a stable economy, oligopolies' prices change

much less frequently than under any other
market model, such as pure competition,
monopolistic competition, and even monopoly.
 When prices do change, the firms generally
move in the same direction and by the same
magnitude in their price changes, which may
be the result of collusion.
 Cont.

 There are 3 basic theories about

oligopolistic pricing: kinked-demand
theory, or non-collusive oligopoly, the cartel
model, and the price leadership model.
 Cont.
 Kinked-Demand Theory
Consider a firm in an oligopoly that wants to
change its price. How will the other firms react?
There are 2 possibilities: they can either match
the price changes or ignore them. But what the
other firms will actually do will probably depend
on the direction of the price change. If one firm
raises its price, the others probably will not
follow, since that will allow them to take market
share
 Cont.

from the price changer. This makes the

demand curve more elastic, since as the
firm raises its price, then many of its
customers will buy from the other firms,
lowering the revenue of the higher-priced
firm.
If the firm lowers its price, then the other
firms would surely follow, to prevent any
loss of market share. This part of the
 Cont.

demand curve is much more inelastic, since

all of the firms are acting in concert. This
creates a kink in the demand curve, where
the change in demand goes from very
elastic at higher prices to inelastic at lower
prices. Since the marginal revenue curve
depends on prices, the marginal revenue
curve is also kinked. At lower prices, the
marginal revenue curve drops downward
 Cont.

creating a gap. The marginal cost curves of

both scenarios will intersect the same
quantity being produced by the oligopoly,
represented by the vertical line in the graph;
therefore, there is no change in quantity
produced as prices are lowered, as long as
the change in marginal cost is within the
marginal revenue gap.
Kinked demand
 From the above diagram,

P1 = Product Price of the Oligopoly

If a firm raises its price (D1), but the others do not
match the increase, then revenue will decline in
spite of the price increase.
If the firm lowers its price (D2), then the other
firms will match the decrease to avoid losing
market share.
Because there is a kink in the demand curve, there
is a gap in the marginal revenue curve (MR 1 -
MR ).
 Cont.
 Since firms maximize profit by producing that
quantity where marginal cost = marginal
revenue, the firms will not change the price of
their product as long as the marginal cost is
between MC1 and MC2, which explains why
oligopolistic firms change prices less frequently
than firms operating under other market models.
 The kinked-demand curve explains why firms in
an oligopoly resist changes to price.
 Cont.
 If one of them raises the price, then it will lose
market share to the others. If it lowers its price,
then the other firms will match the lower price,
causing all of the firms to earn less profit.
 Critics of the kinked-demand model point out
that while the model explains why oligopolies
maintain pricing, it doesn't explain how its
products were initially priced. The other thing it
doesn't explain is that when the economy
changes significantly, especially when there is
 Cont.

high inflation, then the firms of an oligopoly

do change prices often. In some cases,
oligopolistic firms may engage in a price
war, where each firm charges a successfully
lower price to gain market share.
 Contestable Market Model
 The contestable market model is an oligopolistic
model based on barriers to entry and barriers to
exit that determine the firm's price and output. If
the barriers are high, then the oligopolist will set
higher prices. On the other hand, if the barriers
are low, then the oligopolist will set low prices to
prevent new firms from entering the industry or
to promote the exit of its competitors.
 Cartel Model
Sometimes firms in an oligopoly try to form a
cartel by agreeing to fix prices or to divide the
market among them, or to restrict competition
some other way. The primary characteristic of
the Cartel Model is collusion among the
oligopolistic firms to fix prices or restrict
competition so that they can earn monopoly
profits.
 If the dominant firms in an oligopoly can
successfully collude to fix prices, then they can
be certain of each other's output, which
 Cont.
will allow to maximize their profits by producing
that quantity of output where marginal revenue =
marginal cost, just as it would be for a
monopoly. However, if any of the firms cheat,
then a price war may ensue, lowering the profits
of all firms, and maybe even causing them to
operate at a loss. In most modern economies,
collusion is generally against the law, however
there are certain countries that engage in
collusion to maximize their profits from their
natural resources.
 Cont.
The best example of a cartel today is the
Organization of Petroleum Exporting Countries,
otherwise known as OPEC, which comprises 12
oil-producing nations that supply 60% of all oil
traded internationally. Prices are maintained by
restricting each country of the OPEC cartel to a
specific production allocation. The OPEC cartel
is largely responsible for the large fluctuations in
gasoline prices that have occurred in the United
States since 1973, although recently, speculation
in the commodity markets has also increased
volatility.
 Problems Creating and
Maintaining Collusion

Collusion is often difficult to detect, because

it is often based on tacit or covert
agreements that are made during social
interactions between the executives of the
oligopolistic firms. Nonetheless, there are
several obstacles to collusion.
 One common obstacle is differences in
demand and cost. Firms that serve different
geographic markets will have varying levels
 Cont.

 of demand, and, in many cases, they will

also have different efficiencies, resulting in
different production costs. If economies of
scale are steep for an industry, then smaller
firms will aggressively compete on price to
increase their market share, so that they can
earn reasonable profits. In such cases, it will
be difficult for the firms to agree on the
price, because they will have different
marginal cost curves.
 Cont.
 A good example is Saudi Arabia and Venezuela
in the production of oil. Saudi Arabia is efficient
in producing oil, whereas Venezuela, governed
by an inept communist government, is highly
inefficient, so it would be very difficult for
Venezuela to accept a price that would be
suitable for Saudi Arabia. Consequently, there is
a great temptation for inefficient producers to
cheat, and if they cheat, then price competition
ensues.
 Cont.

 Another factor that increases cheating is

recessions. During recessions, demand
declines, which shifts the firm's marginal
cost and demand curve to the left. Firms
often respond by reducing prices so that
they can better utilize their production
capacity and to try to gain market share
from the other firms.
 Cont.

 A larger number of firms in the oligopoly

make it difficult both to create and maintain
collusion. If there are only 2 or 3 firms in
the oligopoly, then it is fairly easy to
collude to set prices or to limit competition.
However, if there are 6 or more firms with a
smaller share of the market, then collusion
becomes increasingly difficult. Indeed, the
likelihood of a successful collusion
decreases as the number of firms increases.
 Cont.

 Another possible barrier to collusion is that

if prices are maintained too high, then it
may allow new entrants into the industry
that will provide more competition, or,
smaller firms that did not have much market
power can cut prices and increase
production to grab market share.
 Cont.
 The other major barrier to collusion is antitrust law.
Most modern economies prohibit collusion, since it
is against the public interest, although there are
some exceptions. A very common exception is the
pricing of insurance products, since many
insurance companies depend on rating companies
that gather information on insurance risks and how
to price them. In the United States, insurance rating
information is exempted from the antitrust
provisions of the United States.
 Price Leadership Model

 In many industries, there is a dominant firm

in an oligopoly, and the other firms often
follow the dominant firm in price changes,
which can be viewed as a type of implicit
price collusion. Hence, the dominant firm
also becomes the price leader. Since most
firms have been in the business for a
number of years, they can observe how
their competitors react to changes in the
industry,
 Cont.

allowing them to reach an understanding of

how their competitors will react to any price
changes. Firms in an oligopoly do not often
change prices, certainly not for minor
changes in costs, but they will change
prices if cost changes are substantial.
Indeed, if there is a general price increase in
the inputs of an industry, then all firms will
surely increase their prices. Increasing price
of
 Cont.
inputs, of course, helps to protect the industries
from antitrust prosecutions since they have a
reasonable basis for increasing the price of their
products that is not related to restricting
competition.
 Oftentimes, the price leader will communicate
the need to raise prices through press releases,
trade publications, and speeches by major
executives, especially when announcing quarterly
earnings.
 Cont.

There are many times when a price leader will

limit price increases to discourage the
entrance of new competitors — a practice
called limit pricing. This will be particularly
true if the economies of scale are not that
steep, since high prices can allow the
entrance of new competitors who will be
able to survive on a small market share.
 Cont.

Sometimes price leadership breaks down and

price wars result. However, price wars are
self-limiting, since they will often lead to
losses. Eventually the firms will capitulate
and return to the practice of following the
price leader.
 Duopoly

 Duopoly is a market situation where there

are only two sellers. Duopoly can be with or
without product differentiation. It is a
special case of oligopoly market under
which there are two producers / sellers who
are selling differentiated or identical
products.
 Characteristics of duopoly
The duopoly markets have some
characteristics which are alike
characteristics of market. So the
characteristics of duopoly market are as
follows:-
 Presences of monopoly element; products
are differentiated and each product enjoy
some amount of customer loyalty as a result
firm enjoy some monopoly power. It means,
 Cont.

so long products are differentiated; the firms

enjoy some monopoly power, as each
product will have some loyal customers.
 Existence of price rigidity. Price rigidity
exists in this type of market structure. It
means price of product in this market does
not change immediately with change in
demand and supply in market.
 Cont.

 Advertising; given high cross elasticity

demand for products and price rigidity in
duopoly the only way open to duopolist is
to raise his sales volume by either
advertising or improving the quality.
Advertisement expenditure is aimed
primarily at shifting the demand in favour
of the product. Example, Pepsi and Coca-
Cola soft drinks.
 Cont.
 There is interdependency among firms as no
firm can ignore the action and reaction of its
rival [Link] important feature of duopoly is
that the individual firm has to carefully
consider the indirect effects of its own decision
to change its price or output or both. It means
when a duopolist (or an oligopolist) takes any
policy decision he also takes into account the
reactions of his rivals. That is, such a market
situation is characteristics by the mutual
interdependence in policy-making.
 Cont.
Any decision one firm makes (be it on price,
product or promotion) will affect the trade
of the competitors and so results in
countermoves.
 The demand curve is indeterminate; any
step taken by rival firm will affect firms
product demand.
 There exists a conflict attitude among a firm
as they have two types of attitude on one
hand they want to have joint venture to
 Cont.

increase their profit and on the other hand

they want to earn profit individually. So
these both attitudes have conflict among
themselves.
 Advantages of the duopoly market

 Large firms have hold on market as there

are fewer competitors.
 Since companies have full control over
market. So they can decide price according
to their choice.
 High profits earned by firms can help in
innovations and development of products
and services.
 Cont.

 It may also helps in lowering the average

cost of production as firms producing
similar goods can jointly produce the goods
and services.
 Firms and even customers can easily
compare prices.
 Firms can compare and set their price
competitively which is advantageous to the
customers.
 cont.

 It helps customer to plan and stabilize their

expenditure which will result in
stabilization in trade cycle and it is only
possible when prices are stable in market.
 Disadvantages of Duopoly

 If prices are set unrealistically by the firms

then it will adversely affect their customers.
 With the presence of little competition the
firms do not focus on improving the product.
 Firms cannot take independent decisions as
they have to consider the view point of their
competitor.
 New firms cannot enter in the market due to
various barriers.
 Cont.

 It leaves customers with fewer choices.

 So all these are the various pros and cons of
the duopoly market which should be kept in
mind by the firm before starting any type of
business and even before choosing the
market structure in which one wants to
enter.
 Cont.
 To conclude, duopoly is a limiting case of
oligopoly, in the sense that it has all the
characteristics of oligopoly except the
number of sellers which are only two
increase of duopoly as against a few in
oligopoly. The main distinguishing feature
of duopoly (and also of oligopoly) from
other market situating is that the sellers’
decisions are not independent of each other.
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•Mudida, R(2003). Modern economics, 2nd edition. English press.
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Revised Edition. Kaveri Print Process (P) Ltd. India { S Chand }
•Dwived DN,(2004). Principles of economics, 2nd Edition. Vikas
publishing house Limited. India
•Colander DC,(2004). Microeconomics, 5th edition. McGrawHill
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