UNIT 3 : Market Structure

1-1
 MARKET
• Markets can differ by products (goods, services) or factors
(labour and capital) sold, product differentiation, place in
which exchanges are carried, buyers targeted, duration,
selling process, government regulation, taxes, subsidies, 
minimum wages, price ceilings, legality of exchange,
liquidity, intensity of speculation, size, concentration,
exchange asymmetry, relative prices, volatility and
geographic extension. The geographic boundaries of a
market may vary considerably, for example the food
market in a single building, the real estate market in a
local city, the consumer market in an entire country, or the
economy of an international trade bloc where the same
rules apply throughout.
Physical consumer markets
• Food retail markets: farmers' markets, fish markets, 
wet markets and grocery stores
• Retail marketplaces: public markets, market squares, 
Main Streets, High Streets, bazaars, night markets and 
shopping malls
• Big-box stores: supermarkets, hypermarkets and 
discount stores
• Ad hoc auction markets: process of buying and selling goods
or services by offering them up for bid, taking bids and then
selling the item to the highest bidder
• Used goods markets such as flea markets
• Temporary markets such as fairs
• Real estate markets
 Market Structure
• Market : Any arrangement that enables buyers and sellers
to contact for transactions.
• The term market is derived from the Latin word “Marcatus”
which means merchandise or trade.
• Market is an area or atmosphere of potential exchange
-Phillip Kotler
• Market structure – identifies how a market is made up in
terms of:
– The number of firms in the industry
– The nature of the product produced
– The degree of monopoly power each firm has
– The degree to which the firm can influence price
– Firms’ behavior – pricing strategies, non-price competition, output
levels, Profit levels
– The extent of barriers to entry
1-4
 Market Structure
• Market contains 2 kinds of competition :
1) Price competition - Seller competes among each
other by setting a lower price.

2) Non-price competition - Sellers compete in area like

product quality, advertising, packaging and service
other than price.

1-5
 Market Classification

1-6
 Market Structure
• There are 2 types of Market Structure:
1) Perfect Competition
2) Imperfect Competition

1)Perfect Competition and its features

• Homogenous Products: The goods are sold by
different sellers as exactly alike from the consumers
regard. Consumer has no reason to express a
preference for any firm.

1-7
 1)Perfect Competition
• Free entry and exit: Firms are free to enter or leave
the market. They do not face restriction on
competing with other sellers.

• Perfect Information: All the buyers and sellers know

the aspects of the market, including price, quality
and quantity of the good. Consumers and producers
have perfect knowledge about the market.

1-9
 1)Perfect Competition
• Individual sellers have no influence on the market: In a
perfectly competitive market, there are many buyers
and sellers, since all the buyers and sellers know the
aspects of the market, goods are homogenous, so no
individual seller can affect the market price, because
his output just takes up a little part of the whole market
output. Firms are price takers as they have no control
over the price they charge for their product. Each
producer supplies a very small proportion
of total industry output.

• Every firm has only one goal of maximising its profits.

1-
EXAMPLE:
• Consider the situation at a farmer’s market, a place
characterized by a large number of small sellers and
buyers. Typically, there is little differentiation between
products and their prices from one farmer’s market to
another.

• The average revenue and marginal revenue for firms in a

perfectly competitive market are equal to the product’s
price to the buyer. A
 Demand Curve

1-
 Demand Curve
• The demand curve for an individual firm is different from a market
demand curve. The market demand curve slopes downward,
while the firm's demand curve is a horizontal line.
• The market demand curve is a downward sloping line, reflecting
the fact that as the price of an ordinary good increases, the
quantity demanded of that good decreases.
• Price is determined by the intersection of market demand and
market supply; individual firms do not have any influence on the
market price in perfect competition.
• Once the market price has been determined by market supply
and demand forces, individual firms become price takers.
• Individual firms are forced to charge the equilibrium price of the
market or consumers will purchase the product from the
numerous other firms in the market charging a lower price.
• The demand curve for an individual firm is thus equal to the
1-9 equilibrium price of the market .
 1-17

Price Determination
• The twin forces of market demand and market supply
determine price.
• The level of price at which demand and supply curves
interact each other will finally prevail in the market.
• The price at which quantity demanded equals quantity
supplied is called equilibrium price.
• The quantity of the good bought and sold at this price is
called equilibrium price.
• Thus the interaction of demand and supply curves
determines price-quantity equilibrium.
• At the equilibrium price the buyers and sellers are
satisfied.
 AR and MR Curves
•
• AR(Average revenue) curve and MR(Marginal Revenue) curve under
perfect competition becomes equal to D(Demand) curve and it would
be a horizontal line or parallel to the X-axis

• The curve simply implies

that a firm under Perfectly Elastic
perfect competition can Demand
sell Curve(AR=MR=D)
Price D
as much quantity as
it likes at the given
price determined by the
industry 0 1 2 3 4
i.e. a perfectly Commodity
elastic demand curve
Now the Meaning of Firm equilibrium
 „Equilibrium means a state of rest from which
there is no net tendency to move
 So the Firm’s Equilibrium means, “the level of output
where the firm is maximizing its profits and therefore,
has no tendency to change its output”.
 In this situation either the Firm will be earning
maximum profit or incurring minimum loss i.e. it
refers to the profit maximization
 In the words of Hansen, “A Firm will be in
equilibrium when it is of no advantage to increase or
decrease its output”.
Necessary Conditions For The Firm Equilibrium
 Profit of a Firm is equal to the difference between its
total revenue (TR) and the total cost (TC) i.e.,
(Profit=TR-TC) and so for the equilibrium of the Firm
it should be maximum
 Marginal cost should be equal to Marginal revenue
(MC=MR)
And when these are equal profit is maximum
 Equality of MR and MC is necessary but not
sufficient, so the sufficient condition is that MC curve
should cut the MR curve from below not from the
above
 No firm has an incentive to change its behavior

2
 There are two points at which MR (=AR) =MC but at
both the points the Firm can't be in equilibrium or can't
have maximum profit
 As stated before, as a sufficient
condition for the
equilibrium MC curve
MC
should cut the MR curve
from below which is

Cost / Revenue
point A B A

AR=MR

O N M
Output
Short Run Firm Equilibrium
 In Short run, the Firm output (supply) can be changed
only by the variable factors (like labor force through
overtime),
fixed factors (like machinery) can‟t be changed
 There is not enough time for new Firms to enter
the Industry.
 Further, if the demand is increased, the supply can be
increased only up to its existing production capacity
 A firm in Short Run Equilibrium may face one of
these
situations
 Super Normal Profits
 Normal Profits
 Suffer Minimum Losses
 Shut Down Point
 For the analysis of these situations Short-run
Average Cost curve (SAC) will be introduced
Super-Normal Profits : AR>SAC
 A Firm in Equilibrium earns super normal profit, when
average revenue (price per unit) determined by the
Industry is more than its short-run average cost (SAC)
 Firm equilibrium point=E, where MR (=AR) = SMC
 Equilibrium output=EM
 Since AR(EM)>SAC(AM) Super Normal Profit
Firm is earning EA super SMC

Cost / Revenue
normal profit per unit of SAC
P E
output
Total super normal profit
of the Firm on OM B AA
AR=MR
output
=BAxEA (OMxEA)=EABP
=Shaded area
O M
Output
Normal Profits : AR=SAC
 A Firm in Equilibrium earns normal profit, when average
revenue (price per unit) determined by the Industry is
equal to its short-run average cost (SAC)
 Firm equilibrium point=E, where MR (=AR) = SMC
 Equilibrium output=EM
 At this output AR and SAC
SAC SMC
both are equal to EM and

Cost / Revenue
Firm is earning normal E
P
profit per unit of output
 It results in no gain in AR=MR
terms of money for an
entrepreneur as this
profit is included in the
cost of product
O M
Output
Minimum Loss : AR<SAC
 A Firm may continue production even if it is incurring
losses because in sort run, it can't leave the Industry
 Obviously in this situation of loss, a Firm will be in
equilibrium at that level of output where it gets the
minimum losses i.e. when
SAC is more than AR
 At equilibrium AR=EM and
SAC=AM and also from SAC
Loss
graph AR<SAC SMC

Cost / Revenue
 Firm's per unit loss=AE B A
i.e. (AM-EM) Total loss
at OM level of output
=OMxAE i.e. EABP
P E AR=MR
 Even if Firm discontinues
the production, it will have
to bear the loss of fixed
cost which is minimum
possible loss of a Firm O M
Output
 1-26

Long run equilibrium

Long run equilibrium of the firm :
• In the long run, the firms are in equilibrium when they
have adjusted their plant so as to produce at the
minimum point of their long run AC curve. In the long
run, the firms will be earning only normal profits.
• If they are making super normal profits in the short run,
new firms will be attracted in the industry which will lead
to a fall in price and an upward shift of the cost curves
due to increase in the prices of the factors as the
industry expands.
• If the firm makes losses in the short term, they will leave
the industry in the long run. This will raise the price and
costs may fall as the industry contracts.
 Long run equilibrium
Long run equilibrium of the industry:
• A perfectly competitive industry is in long run equilibrium
when:
1. all the firms are earning normal profits only i.e. all the
firms are in equilibrium
2. There is no further entry or exit from the market.
• The following conditions are associated with the long run
equilibrium of the industry:
1. The output is produced at the minimum feasible cost.
2. Consumers pay the minimum possible price which just
covers the Marginal cost i.e. MC=AC
3. Firms earn only normal profits i.e. AC=AR
4. Firms maximise profits(i.e. MC=MR) but the level of
1-27 profits will be just normal.
 1-28

Imperfect
Competition
 Monopoly
• The word monopoly is derived from two Greek words-Mono
and Poly. Mono means single and Poly means 'seller‘.
• Monopoly is a situation in which there is a single seller of a
product which has no close substitute.
• Under monopoly there is no rival or competitors. The
degree of competition in monopoly is nil. Thus if the buyers
is to purchase the commodity, he can purchase it only
from that seller.
• The seller dictates the price to consumers. Unlike perfect
competition a monopolist can fix up the price.
• As monopoly is a form of imperfect market organization,
there is no difference between firm and industry. A
monopoly firm is said to be an industry.
1-30 • Eg: Railways, electricity
 1-30

Monopoly
• Features:
– Single seller of the product – In a monopoly market,
there is only one firm producing and selling a
product. This single firm constitutes the industry as
there is no distinction between firm and industry.
– Restrictions to entry – There are strong barriers to
entry to this market. It could be economic,
institutional or legal. Entry is almost blocked.
– No close substitutes – This market sells a product
which has no close substitute.
– The products sold in a monopoly market may be
homogenous or heterogeneous.
 1-31

Price Discrimination in monopoly

• The seller may use his monopoly power in any manner in order
to realize maximum revenue. He may also adopt price
discrimination.
• One of the important feature of monopoly is price discrimination i.e.
charging different prices for same product from different consumers.
• Price discrimination is a method of pricing adopted by the
monopolist in order to earn abnormal profits.
• Eg : The family doctor in your neighborhood charges a higher fees
from a rich patient compared to the fees charged from a poor patient
even though both are suffering from viral fever. Electricity
companies sell electricity at cheaper rates for home consumption in
rural areas than for industrial use.
• Price Discrimination cannot persist under perfect competition
because the seller has no influence over market determined rate.
Price Discrimination requires an element of monopoly so that the
seller can influence the price of his product.
 Price Discrimination in monopoly
Conditions for price discrimination:
• The seller should have some control over the supply of his product i.e.
monopoly power in some form is necessary to discriminate price.
• The seller should be able to divide his market into 2 or more sub
markets.
• It should not be possible for the buyers of low priced market to resell
the product to the buyers of high-priced market.
• The price elasticity of the product should be different in different sub
markets. The monopolist fixes a high price for his product for those
buyers whose price elasticity of demand for the product is less than
one. This means that if monopolist charges high price from them, they
do not significantly reduce their purchases in response to high price.

A monopoly charges higher price in a market which has a relatively

inelastic demand. The market which is highly responsive to price
changes is charged less. On the whole, the seller benefits from
1-34 such a discrimination.
 1-33

Objectives of Price discrimination

• To earn maximum profit
• To dispose off surplus stock
• To enjoy economies of scale
• To capture foreign markets
• To secure equity through
pricing
Price discrimination is carried out to capture consumer
surplus that is enjoyed by consumers. Consumer surplus is
the difference between the total amount that consumers are
willing and able to pay for a good or service and the total
amount that they actually do pay (i.e. the market price).
Professor Pigou classified 3 degrees of price discrimination.
 1-34

Degrees of Monopoly
• First degree Price Discrimination – Under the first degree
price discrimination, the monopolist will fix a price which will
take away the entire consumer’s surplus i.e. their
maximum willingness to pay. It is also known as perfect
price discrimination. Eg: Auctions
• Second Degree Price Discrimination - Under the second
degree price discrimination, he will take away only a part of
the consumer’s surplus. Here price varies according to the
quantity sold. Larger quantities are available at lower unit
price.
• Third Degree Price Discrimination - Under third degree price
discrimination, the price varies by attributes such as location
or by consumer segment. Here the monopolist, will divide the
consumers into separate sub markets and charge different
prices in different sub- markets. Eg: Dumping, Bus passes
 1-35

Price and Output determination

• The aim of a monopoly is to maximize his profits. For that, he
has 2 choice:
1. He can fix the price for his good and leave the market to decide
what output will be required.
2. Or he can fix the output and leave the price to be determined by
the interaction of supply and demand.
In other words, he can either fix the price or the output. If the
demand for the commodity is elastic, the seller cannot fix a very
high price because a rise in price may result in a fall of demand.
So he cannot sell much and he may not get large profits. In
such a case, the monopolist will fix a low price.
If the commodity has inelastic demand, the seller may fix a high
price. Even if the price is high, there will not be a fall in demand.
Then he will get maximum profits by fixing a high price.
 Demand Curve of monopoly
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• Since the monopoly firm is assumed to be the only producer of a

particular product, its demand curve is identical with the market
demand curve for the product.
• The demand curve is downward sloping because of law of
demand.
 1-37

Demand Curve of monopoly

• The seller can’t sell anything if he charges Rs10. If he wishes to sell 10 units, he needs
to sell it at Rs 5.
• In monopoly the seller can increase the sales by decreasing the price of the product.
Hence MR is less than the price, because firm has to lower the price to sell an extra
unit.
The relationship between AR and MR of a monopoly firm can be stated as follows:
1. AR and MR are both negatively sloped.
2. MR curve lies half way between AR curve and Y.
 1-38

Equilibrium of the monopoly firm

• Firms in a perfectly competitive market are price
takers so they are only concerned about
determination of output. But this isn’t a case with a
monopolist. A monopolist not only has to determine
his output but also the price of his product.
• Since he faces downward sloping demand curve, if
he raises the price of his product, his sales will go
down. On the other hand, if he wants to improve his
sales volume, he will have to be content with lower
price.
• He will try to reach the level of output at which the
profits are maximum i.e. he will try to attain the
equilibrium level of output.
 Short run equilibrium
A Firm’s Short-Run Equilibrium in Monopoly
• Like in perfect competition, there are three possibilities for
a firm’s Equilibrium in Monopoly.
These are:
• The firm earns normal profits – If the average cost = the
average revenue
• It earns super-normal profits – If the average cost < the
average revenue
• It incurs losses – If the average cost > the average
 revenue
Normal Profits
• A firm earns normal profits when the average cost of 
production is equal to the average revenue for the
corresponding output.

• In the figure above, you can see that the MC curve cuts the
MR curve at the equilibrium point E. Also, the AC curve
touches the AR curve at a point corresponding to the same
point. Therefore, the firm earns normal profits.
• Super-normal Profits
• A firm earns super-normal profits when the average cost of production
is less than the average revenue for the corresponding output.

• In the figure above, you can see that the price per unit = OP = QA.
Also, the cost per unit = OP’. Therefore, the firm is earning more and
incurring a lesser cost. In this case, the per unit profit is
• OP – OP’ = PP’
• Also, the total profit earned by the monopolist is PP’BA .
Losses
• A firm earns losses when the average cost of production is higher than the
average revenue for the corresponding output.

• In the figure above, you can see that the average cost curve lies above the
average revenue curve for the same quantity. The average revenue = OP and
the average cost = OP’. Therefore, the firm is incurring an average loss of PP’
and the total loss is PP’BA. In the short-run, a monopolist sometimes sets a
lower price and incurs losses to keep new firms away.
Can a monopolist incur losses?
• One of the misconceptions about a
monopolist is that it always makes profit.
• It is to be noted that nothing guarantees that
a monopolist makes profit.
• It all depends on his demand and cost
conditions.
• If he faces very low demand for his product
and his cost conditions are such that
ATC>AR, he will not be making profits,
rather he will incur losses.
 Long run equilibrium
• Long run is a period long enough to allow the
monopolist to adjust his plant size or use his
existing plant at any level that maximises his
profit.
• In the absence of competition, the monopolist
need not produce at optimal level.
• The monopolist will not continue if he makes
losses in the long run.
• He can make super normal profits in the long
run as the entry of outside firms are
blocked.
 Monopolistic Competition
• Monopolistic competition is another type of
imperfect competition other than
monopoly
• Monopolistic Competition refers to a market
situation in which there are large numbers of
firms which sell closely related but differentiated
products. Markets of products like soap,
toothpaste AC, etc. are examples of monopolistic
competition.
 1-46

Features of Monopolistic market

• Features of both perfect competition and monopoly are
present.
Similar features to perfect competition
1. A large no. of sellers and buyers – In a monopolistic
market, there are large number of sellers who individually
have a small share in the market. Eg: FMCG - HUL
2. Free entry and exit :New firms have to compete with
existing firms for business. Entry and exit is not restricted.

Different features from perfect competition

3. Imperfect information of the market: Neither the sellers nor
buyers know all aspect of the market.
 1-47

4. The goods sold are heterogeneous: The product

sold by different sellers are different. The
differentiation may rise from differences in quality,
package design, advertisements, etc. Product
differentiation gives rise to an element of monopoly to
the producer over the competing product. The
producer of a brand can raise the price of his product
knowing that he will not lose all the customers to
other brands because of lack of perfect
substitutability.
 1-48

5.Non price competition: In addition to price

competition, non-price competition also exists under
monopolistic competition. Non-Price Competition refers
to competing with other firms by offering free gifts,
making favorable credit terms, etc without changing
prices of their own products. Firms under monopolistic
competition compete in a number of ways to attract
customers.
6.Pricing Decision: A firm under monopolistic
competition is neither a price- taker nor a price-maker.
However, by producing a unique product or establishing a
particular reputation, each firm has partial control over
the price. The extent of power to control price depends
upon how strongly the buyers are attached to his brand.
7.Firms make normal profits in the long run but could
make supernormal profits in the short term
 1-49

• Example of Monopolistic Competition: Toothpaste

Market:
• When you walk into a departmental store to buy
toothpaste, you will find a number of brands, like
Pepsodent, Colgate, Neem, Babool, etc.
i.On one hand, the market for toothpaste seems to be full
of competition, with thousands of competing brands and
freedom of entry.
ii.On the other hand, its market seems to be monopolistic,
due to uniqueness of each toothpaste and power to charge
different price.
Such a market for toothpaste is a monopolistic competitive
market.
 1-50

Demand Curve in Monopolistic market

• Under monopolistic competition, large number of firms
selling closely related but differentiated products makes the
demand curve downward sloping. It implies that a firm can
sell more output only by reducing the price of its product.
At OP price, a seller can sell OQ
quantity. Demand rises to OQ1,
when price is reduced to OP1. So,
demand curve under monopolistic
competition is negatively sloped as
more quantity can be sold only at a
lower price. As a result, revenue
generated from every additional unit
is less than price of the product.
Hence MR < AR just like it is in
monopoly.
 Demand Curve: Monopolistic
1-51

Competition Vs. Monopoly:

• The demand curve of monopolistic competition
looks exactly like the demand curve under
monopoly as both faces downward sloping
demand curves.
• However, demand curve under monopolistic
competition is more elastic as compared to
demand curve under monopoly.
• This happens because differentiated products
under monopolistic competition have close
substitutes, whereas there are no close
substitutes in case of monopoly.
 1-52

Price and output determination

• In a monopolistically competitive market, each firm is a price maker
since the product is differentiated.
• The 2 conditions of price and output determination and equilibrium of a
firm are MC = MR and MC curve should cut MR curve from below.
• At E, the equilibrium price is OP and the equilibrium output is OM. Per
unit cost is SM, per unit super normal profit is QS and the total
supernormal profit is PQSR.
 1-53

Price and output determination

• Monopolistic firms may also incur losses in short term.
• Per unit cost HN is higher than OT/KN and the loss per unit
in KH. The total loss is GHKT.
 1-54

Price and output determination

Long run equilibrium :
• If the firms in the industry earn super normal
profits in the short run, there will be an incentive
for new firms to enter the industry.
• As more firms enter, profits per firm will go on
decreasing as the total demand for the product will
be shared among large number of firms.
• This will happen till all the profits are wiped away
and all the firms earn only normal profits. Thus
in the long run all the firms will earn only normal
profits.
 1-55

Oligopoly
• Oligopoly is described as competition among the few.
• An oligopoly is a market structure in which a few firms
dominate. When a market is shared between a few firms, it is
said to be highly concentrated. Although only a few firms
dominate, it is possible that many small firms may also operate
in the market.
• For example, major airlines like British Airways and Air
France operate their routes with only a few close competitors,
but there are also many small airlines catering for the
holidaymaker or offering specialist services.
• An oligopoly is similar to a monopoly, except that rather than
one firm, two or more firms dominate the market. There is no
precise upper limit to the number of firms in an oligopoly, but
the number must be low enough that the actions of one firm
significantly impact and influence the others.
 1-56

Features of Oligopoly
• 1. Interdependence: The most important feature of
oligopoly is the interdependence in decision making of the
few firms which comprise the industry. This is because
when the number of competitors is few, any change in
price, output, product etc. by a firm will have a direct effect
on the fortune of its rivals, which will then retaliate in
changing their own prices, output or products as the case
may be. It is, therefore, clear that the oligopolistic firm must
consider not only the market demand for the industry’s
product but also the reactions of the other firms in the
industry to any action or decision it may take.
• Oligopolies tend to compete on terms other than price.
Loyalty schemes, advertisement, and product differentiation
are all examples of non-price competition.
 1-57

Features of Oligopoly
• 2.Group Behavior: Oligopoly market is about group
behavior not of mass or individual behavior. There are few
firms in a group which are very much interdependent.
Each oligopolist closely watches the business behavior of
other oligopolists in the industry and designs his moves
on the basis of how they behave or likely to behave.
• 3.Barriers to entry: The main reason for few firms under
oligopoly is the barriers, which prevent entry of new firms
into the industry. Patents, requirement of large capital,
control over crucial raw materials, etc are some of the
reasons which prevent new firms from entering into
industry. Only those firms enter into the industry which are
able to cross these barriers.
 Features of Oligopoly
• 4. Importance of advertising and selling costs: In an oligopoly
market, firms have to employ various aggressive and defensive
marketing weapons to gain a greater share in the market or to
prevent a fall in their market share. For this various firms have to
incur a good deal of costs on advertising and on other measures of
sales promotion.

• Under perfect competition, advertising by an individual firm is

unnecessary. A monopolist may perhaps advertise when he has to
inform the public about his introduction of a new model of his
product or he may advertise in order to attract potential consumers
who have not yet tried his product. Under monopolistic
competition advertising plays an important role because of the
product differentiation that exists under it, but not as much
important as under oligopoly.
•
Under oligopoly, advertising can become a life-and-death matter
where a firm which fails to keep up with the advertising budget of its
1-59
 Types of Oligopoly
1.Pure or Perfect Oligopoly: If the firms produce homogeneous
products, then it is called pure or perfect oligopoly. Though, it is
rare to find pure oligopoly situation, yet, cement, steel, aluminum
and chemicals producing industries approach pure oligopoly.
2.Imperfect or Differentiated Oligopoly: If the firms produce
differentiated products, then it is called differentiated or imperfect
oligopoly. For example, cigarettes or soft drinks. The goods
produced by different firms have their own distinguishing
characteristics, yet all of them are close substitutes of each other.
3.Open Vs Closed Oligopoly: This classification is made on the
basis of freedom to enter into the new industry. An open
Oligopoly is the market situation wherein firm can enter into the
industry any time it wants, whereas, in the case of a closed
Oligopoly, there are certain restrictions that act as a barrier for a
new firm to enter into the industry.
1-60
 Types of Oligopoly
4.Partial Vs Full Oligopoly: This classification is done on
the basis of price leadership. The partial Oligopoly refers to
the market situation, wherein one large firm dominates the
market and is looked upon as a price leader. Whereas in full
Oligopoly, the price leadership is conspicuous by its
absence.
5.Collusive Vs Non-Collusive Oligopoly: This
classification is made on the basis of agreement or
understanding between the firms. In Collusive Oligopoly,
instead of competing with each other, the firms come
together and with the consensus of all fixes the price and
the outputs. Eg: OPEC. Whereas in the case of a non-
collusive Oligopoly, there is a lack of understanding among
the firms and they compete against each other to achieve
1-61 their respective targets.
 Collusive oligopoly
• Collusion refers to the agreement between few firms of an
industry. It may either be formal or tacit agreement. If it is a
tacit one the firms follow a secret agreement. Here there is
no direct conduct among firms. But in a formal agreement all
conditions and conducts are open. So, they take decisions
jointly by a direct discussion or meeting.

Why Collusion?: Few firms in an Oligopoly industry collude

on the basis of certain agreements. So, they may have the
following purposes.
a)Reduce the competition between themselves and
increase profits.
b)To create a collective or group monopoly and thereby
create a barrier for new firms which want to enter to the
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 Pricing under perfect collusion
There are two types of collusion in a oligopoly market.
1. Cartel : A oligopoly industry can be said to be cartel when
all the individual firms are running on the basis of the
agreements. So, each firm can earn monopoly profits by
cooperating with other firms in the agreement. It may be
either international or domestic cartel. Oil and Petroleum
Exporting Countries (OPEC) is an example for international
cartel.
2. Price Leadership: Price leadership is another form of
collusion of Oligopoly firms. One firm assumes the role of a
price leader and fixes the price of the product on the entire
industry. All the firms in the Oligopoly industry will follow the
rules fixed by the leader. Here there is no possibility of
competition between leader and individual firms.
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 Price Leadership
Generally three types of price leadership can be seen-
i)low cost price leadership - It can be seen in an industry where
each firm produces homogenous products with various costs. So,
it is easier to sell large quantity by the firm which produces with
low cost. So, other firms may suffer losses.
ii)Dominant price leadership - In some market, we can see
that, a few firms are producing large amount of commodity and by
getting huge market share. So, they will fix their own prices and
related things. Here any small firm cannot influence to fix the
price. So, all the firms will follow the price which fixed by the
dominant firm in the industry.
iii)Barometric price leadership - Here a firm acts as a leader of
others. The leader considered as the large or most experienced or
an old firm. Such firm has enough knowledge about market. So,
all other firms follow his actions in price. It may be a low cost firm
1-64 or a dominant firm.
Oligopoly –Demand curve – Kinked curve
• A kinked demand curve occurs when the demand curve is
not a straight line but has a different elasticity for higher
and lower prices.
• One example of a kinked demand curve is the model for
an oligopoly. This model of oligopoly suggests that prices
are rigid and that firms will face different effects for both
increasing price or decreasing price. The kink in the
demand curve occurs because rival firms will behave
differently to price cuts and price increases.
• The logic of the kinked demand curve is based on
A few firms dominate the industry
Firms wish to maximise profits
The kinked demand curve makes certain assumptions
• Firms are profit maximisers.
• If one firm increases the price, other firms won’t follow
suit. Therefore, for a price increase, demand is price
elastic.
• If one firm cuts price, other firms will follow suit because
they don’t want to lose market share. Therefore, for a
price cut, demand is price inelastic.
• This is how we get the ‘kinked demand curve
However, the kinked demand curve has limitations
• It doesn’t explain how the price was arrived at in the first
place.
• Firms may engage in price competition.
Impact of price rise
• If a firm increases the price, then it becomes more expensive than rivals and
therefore, consumers will switch to its rivals.
• Therefore for a price rise, there is likely to be a significant fall in demand.
Demand is, therefore, price elastic.
• In this case, of increasing price firms will lose revenue because the percentage
fall in demand is greater than the percentage rise in price.
Impact of price cut
• If a firm cut its price, it is likely to lead to a different effect. In the short term, if a
firm cuts price it would cause a big increase in demand and therefore would
lead to a rise in revenue. The firm would gain market share.
• However, other firms will not want to see this fall in market share and so they
will respond by also cutting price to follow the first firm. The net effect is that if
all firms cut price – the individual firm will only see a small increase in demand.
• Because there is a ‘price war’ demand for a firm is price inelastic – there is a
smaller percentage rise in demand.
• If demand is inelastic and price falls, then revenue will fall.
Prices stable
• If the kinked demand curve is true, the firm has no incentive to raise price or to
cut price.
Collusive Oligopoly
• If firms in oligopoly
collude and form a
cartel, then they will
try and fix the price
at the level which
maximises profits for
the industry.
Example of a kinked demand curve in practice
• One possibility is the market for petrol. It is homogenous and
consumers are price sensitive.
• If one petrol station increased the price there would be a shift to
other petrol stations.
• However, if one petrol station cuts price, other firms may feel
obliged to follow suit and also cut price – therefore a price cut
would be self-defeating for the first firm.
How realistic is the kinked demand curve in practice?
• In many oligopolies, firms may have a degree of brand
differentiation. Mobile phone companies can increase the price but
consumers are willing to pay because the price is not the dominant
factor. Some petrol stations may increase price and not see elastic
demand because they have the best location.
• Firms may not want to defend market share. Rather than getting
pulled into a price war, some firms may not respond to price cut but
concentrate on non-price competition to retain an advantage.
 Summary

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