MODULE II

Market structure
Introduction
Traditionally a market was regarded as a place where buyers and sellers meet. But
today this concept has undergone a lot of changes. Sitting in the comfort of ones home, one
can engage in buying and selling with persons anywhere in the world. Now it is not necessary
for the buyer to meet the seller to get the product he wants. There are also many ways by
which payments for goods and services can be effected without the actual direct meeting of
buyers and sellers. Hence the concept of market and the definition of market has also changed
to incorporate this modernity. Hence, market is defined as a set of conditions in which
buyers and sellers come in contact for the purpose of exchange.
Structure of market
Market can be classified of the basis of area, time and degree of competition. On the
basis of area the market for a product can be divided into local market, national market and
international market. On the basis of time, the market can be identified as market period,
short period and long period. But, with the development of technology these two
classifications have become outdated. The phenomenal progress made in the fields of
transport and preservation has made international market possible for those commodities
which had only local markets. Moreover, these market structures have had little impact on
pricing decisions.
Based on the degree of competition, a market can be broadly classified into sellers
market and buyers market. Economist have developed market forms from the buyers angle
like monopsony and duopsony. But, it is the market structure from the sellers point of view
which is of real importance.
The nature of competition among the sellers is viewed on the basis of two major
aspects:
i.
ii.

The number of firms in the market.

The characteristics of products, such as whether the products are homogenous
or differentiated.

Individual sellers control over the market supply and his hold on price determination
basically depend upon these factors.
On the selling side or supply side of the market, the following types of market
structures are commonly distinguished:
i.
ii.
iii.
iv.

Perfect competition
Monopoly
Oligopoly
Monopolistic competition and certain minor forms like duopoly and bilateral
monopoly.

Perfect competition and oligopoly are two extremes of market situations. Other forms
of market such as oligopoly and monopolistic competition fall in between these two
extremes.

Perfect Competition
The classical and neo-classical economists believed that a state of perfect competition
always prevailed in the market. All pricing were perfect competition oriented for a long
period. Everyone believed that this market system had found a realistic solution to all pricing
problems. Till the 20th century, perfect competition was the sole market structure that was
prevailing.
Definition of perfect competition:
Perfect competition can be defined as a market situation in which there are large
number of buyers and sellers with perfect knowledge and in close contact, dealing in identical
commodity without price discrimination.
Conditions/ Features/ Characteristics of perfect competition
The following conditions must exist for a market to be perfectly competitive. These
are also distinct features of perfect competition.
Perfect competition and pure competition
Before we proceed to make a study of the main features of this market system, it is
necessary to study the concept of pure competition. Pure competition is a type of perfect
competition, but it has only three features. They are:
1. Large number of buyers and sellers.
2. Homogenous product
3. Free entry and exit of firms.
But in a perfectly competitive market, there are more characteristics in addition to the
three features given above. Therefore the characteristics of the perfect competition are
analysed under the clear assumption that pure competition is a part of perfect competition.
1. Large number of buyers and sellers: Perfect competition is characterised by the
presence of actual and potential buyers and sellers. Since the number of these
participants are very large, no single seller or buyer would be able to influence the
prevailing price. Similarly, this large number prevents either the buyers or the
sellers from a collusion and influence the price.
2. Homogenous or identical product: The industry is defined as a group of firms
producing a homogenous product. The technical characteristics of the product as
well as the services associated with its sale and delivering are identical. There is
no way in which a buyer could differentiate among the products of different firms.
Since each firm produces an identical product, these products can be readily
substituted for each other.
3. Price taker: In a perfectly competitive market, a single market price prevails for
the commodity, which is determined by the forces of total demand and total

4.

5.
6.

7.

8.

9.

supply in the market. In other words, under perfect competition, the industry fixes
the price and the firm accepts it. No firm is in a position to influence the price.
Because each individual firm supplies only a small part of the total quantity
offered in the market.
Freedom of entry or exit of firms: There is no barrier of entry or exit from the
industry. Attracted by excess profit new firms enter into the industry. Firms are
also firm to leave the industry at any time, especially, when they fail in the
struggle for existence (due to sustained loss).
Profit maximisation: The goal of all firms is profit maximisation. No other goals
are pursued.
Perfect mobility of goods and factors: Goods are free to move to those place
where they can get the highest price. Factors can also move from a low paid to a
high paid industry.
Perfect knowledge of market conditions: Perfect competition requires that all the
buyers and sellers must possess perfect knowledge about the existing market
conditions, particularly present and future prices and costs. Nobody behaves
irrationally.
Absence of transport cost: There is absence of transport cost as all firms are close
to the market or there is equal transparent cost faced by all, as all firms are
supposed to be equally far away from the market.
No government regulations: Perfect competition also implies that there is no
government intervention in the working of the market economy. It means, there is
no tariffs, subsidies, rationing of goods, licensing policy or other government
controls.

Short-run equilibrium of the firm under perfect competition

Short-run is a functional time period during which the firm cannot change its size, as certain
fixed factors and the plant cannot be changed. So, the firm produces more only with the help
of variable inputs along with the given fixed factor inputs.
To determine the equilibrium level of the output, at a given price in the short run, the
firm compares its short run marginal cost (SMC) with the short run marginal revenue(SMR)
of the product.
The short run marginal revenue of the firm depends on the price of a product. The
short run equilibrium price is determined in the market by the intersection of a short period
demand and short period supply curves, as shown in the following figure.

In the figure, point Eis the equilibrium point, at which the SMC curve intersects the
SMR curve from below. Consequently, OQ is the equilibrium level of output. Since areas
under the respective average revenue and cost curves measure total revenue and total cost, the
difference between the two show profits. The shaded area PEAB represents the minimised
profits. The condition for equilibrium is:
MR=MC

To summarise the analysis:

1. The firm in the short-run has temporary equilibrium.
2. The firm is at equilibrium in the short run, when the short run marginal cost is
equal to the short run marginal revenue at the given short run equilibrium price.
i.e.(SMC=SMR).
3. The firm gets maximum normal profits when the price is equal to the firms
average total cost. i.e.(P=AC).
4. The firm yields maximum excess profits when the market price is higher than the
firms average total cost. i.e. (P>AC).
5. A maximum loss is incurred by the firm when the price is just equal to the average
variable cost (P=AVC). The loss is equal to the total fixed cost. The loss is
minimised when the price is less than the average total cost but above the average
variable cost.
6. If the price is very low, being less than the average variable costs, the firm stops
production altogether.
Short period equilibrium of the industry
An industry is in equilibrium in the short run when there is no tendency for its total
output to expand or contract, i.e., the output of the industry is steady. When the following
three conditions are satisfied, an industry will be in equilibrium in the short run:
1. All the existing firms must be producing in an equilibrium level of output (at
which MR=MC).
2. It is not necessary that each firm in the industry should be earning normal profits
in the short. Some may be earning normal profits, some super normal profits or
even some may be incurring losses depending on their cost functions. This means,
firms making super normal profits and maximum losses can co-exist along with
the short run equilibrium of the industry.
3. The short period market price and its determining factors viz, Short run demand
and short period supply, are in equilibrium. When the total quantity demanded is
equal to the total quantity supplied at the equilibrium short run market price, the
market is cleared; so there is no reason for the market price to change in the short
run. Thus, the market and all the firms in the industry attains short run equilibrium
at this price.

In figure (a), SS curve represents short run industry supply and DD represents short
run industry demand. Both the curves intersect at point E determining OP as the short run
equilibrium price, at which OQ is the quantity demanded equal to the quantity supplied in the
market. At this price, industry is in equilibrium. The firms are also in equilibrium by equating
MR with MC. But they may be making profits or losses as in figure (b) and (c).
Long run equilibrium of the firm
In the long run, firms are in equilibrium when they have adjusted their plants so as to
produce at minimum points of their long run AC curve, which is tangent to the demand curve
defined by the market price. In the long run, firms will be earning just normal profits, which
are included in the LAC. If they are making excess profits, new firms will be attracted in the
industry. This will lead to a fall in price and an upward shift of the cost curves due to the
increase of the prices of factors as the industry expands. These changes will continue until the
LAC is tangent to the demand curve defined by the market price. If the firms make losses in
the long run, they will leave the industry, price will rise and the cost may fall as the industry
contracts, until the remaining firms in the industry cover their total costs inclusive of the
normal rate of profit.
The following figure explains long run equilibrium of the firm under perfect
competition.

In the above figure, we show how firms adjusts to their long run equilibrium position.
If the price is OP, the firm is making excess profits working with the plant whose cost is
denoted by SAC. It will therefore, have an incentive to increase production. At the same time
the new firms will be entering the industry attracted by excess profits. As a result the quantity
supplied in the market increases and the supply curve in the market will shift to the right and
the price will fall until it reaches the level of OP, at which the firms and the industry are in
long run equilibrium. (The LAC is the final cost curve including any increase in the prices of
factors that may have taken place as the industry expanded).
Condition of a long run equilibrium of a competitive firm:
1. LMC=LMR i.e. profit is maximised.
2. Price (AR) =LAC, therefore normal profit.
3. LMC=LAC i.e. the firm is operating at a minimum average cost.
The last condition indicates that under perfect competition, all firms in the long period
must operate at their most efficient level of output so that AC is at the minimum of this is so,
the resources are utilised in an optimum way.
4. The existence of long run equilibrium conditions of a firm means that short run
equilibrium firm also exists simultaneously, because the long run is composed of a
series of short run phases.
Thus, when a firm is in a long run equilibrium:
Price= LMC = LMR = LAL = SAL = SMC
Equilibrium Price: OP1
Equilibrium output: OQ1
Equilibrium of industry in the long run
The equilibrium of the industry in the perfectly competitive market is established
under the following conditions.
1. Industry being a collection of firms, for an industry to be in long run
equilibrium, apparently all the existing firms in the industry must be producing
an equilibrium level of output by equating the long run marginal cost with the
long run marginal revenue (LMC=LMR). Aggregate of their output constitutes
the total supply of the industry.
2. The number of firms in the industry must be stable. There must be no entry of
a new firm or an exit of firm in the industry. This requires that all the existing
firms in the industry must be earning normal profits. This happens when all
the firms have price or LAR=LAC.
Unless all the firms are earning just the normal profits, industry will not attain
a stable equilibrium in the long run. Because, if some firms are earning excess
profits, it would encourage new entry in the industry will lead to changes in
the industry supply and market prices in the long run.

3. The long run equilibrium price is established so that the total quantities
demanded and supplied in the long run are equal and the market is cleared off.
The long run equilibrium of the industry is shown in the following figure.

In the following figure, the long run equilibrium price OP is determined by the
intersection of the long run supply curve SS and the demand curve DD at the
point F. At this price, the firms equilibrium is determined by equating
LMR=LMC. Thus, OM is the equilibrium output of the firm in the long run.
Thus industry is in long run equilibrium when:
Price= LAR =LMR =LAC = LMC
As such, the firm enjoys just normal profits.

Merits of Perfect Competition

1. Increased production: Since every commodity is produced by large number of
producers, consumers do not feel any scarcity for essential goods.

2. Lowest price: Perfect competition enables the consumers to purchase things at the
lowest possible price without any bargain.
3. Efficient production: Under perfect competition, the general efficiency of production
is very high because inefficient producers who fail to compete with others leave the
industry.
4. Best rewards for factors: The mobility of the factors of the production enables them to
get the best rewards.
5. Absence of waste: Under perfect competition, advertisement is unnecessary. It is
assumed that each producer can sell any quantity at the ruling price.
6. Absence of price discrimination: The absence of price discrimination under perfect
market makes the consumers happy and contended.
7. Technological progress: Competition provides conducive atmosphere for scientific
invention and technological progress. Inventions and innovations lead to economic
development.

Defects of perfect competition:

1. Economic ills: The existence of large number of producers in each industry
generally leads to over production, glut, economic depression and un employment.
Under perfect competition the equality between demand and supply is brought
about only in the long run period.
2. Deception: Under perfect competition, the producers are compelled to sell their
goods at the lowest rate. When this cannot be honestly done, they resort to
adulteration and other forms of deception. E.g.: rice mixed with stones.
3. Unrealistic assumption: Many of the assumptions on the perfect competition like
perfect knowledge on the part of the consumers, perfect mobility of factors of
production etc. are quite unreal. In real life manufacturers attract consumers
through advertisement, publicity. Similarly, the imperfect knowledge of the
labourers may not enable them to get the best rewards.
4. Higher cost: Under perfect competition, many independent firms are engaged in
production in each industry. Therefore, the average cost of production is likely to
be higher. It becomes very low if all the firms merge into a single large scale
production unit.
5. Exploitation of workers: Every producer under perfect competition is compelled
to lower the cost of production per unit of output. This may lead into the
exploitation of ignorant and illiterate workers by giving them hard work and low
wages.
6. Check the progress of the society: If a producer invents a better technique of
production, he keeps it as a business secret. So that, his competitors may not
imitate. But it checks the progress of the society.
7. Bad business atmosphere: The keen competition among the competitors may
make them enemies. The strong enmity that develops in the minds of some
producers may tempt to undersell their goods just to see the ruin of others.
Derivation of supply curve under perfect competition
Short run supply curve of the competitive firm

A supply for a firm shows how much output it will produce at every possible price. The
competitive firms will increase the output to a point at which the price is equal to marginal
cost (P=MC), but will shut down if price is below average variable cost. The supply curve of
the firm is shown in the following figure.

In the following figure, the minimum output the firm will produce is X where price P is equal
to the minimum point on the AVC curve. For any price below P0 is equal, the firms revenues
do not even cover variable costs. So the firm will not supply any quantity (will close down).
As price rises above P0, the quantity supplied increases (X1 and X2). Hence, the short run
supply curve of the firm is the cross hatched portion of the marginal cost curve.
Short run supply curve for the competitive firms slope upward for the same reason
that marginal cost increases- the presence of diminishing returns to one or more factors of
production. As a result an increase in the market price will induce those firms already in the
market to increase the quantities they purchase.

Short run supply curve of the competitive industry or short run market supply curve
The short run market supply curve shows the amount of output that the industry will
produce in the short run for every possible price. The industries output is the sum of the
quantities supplied by all the individual firms, Therefore, the market supply curve can be
obtained by adding their supply curve. In other words, the supply curve of the industry is
obtained by the horizontal summation of short run supply curve of all the individual firms in
the industry.
The following figure shows how this is done when there are only three firms, all of
which have different short run production costs. Each firms MC curve is drawn only for the
portion that lies above its average variable cost curve.

In the figure, at any price below P1, the technology will not produce no output becauseP1 is
the minimum average variable cost of the lowest cost firm. Between P1 and P2, only firm 3
will produce. The industry supply curve, would be therefore identical to that of firm 3s
marginal cost curve MC3. At price P2, the industry supply will be the sum of the quantity
supplied by all three firms. Firm 1 supplies 4 units, firm2 supplies 7 units and firm 3 supplies
10 units; the industry supplies 21 units. Note that the industry supply curve is upward sloping
but has a kink at price P2, the lowest price at which all three firms produce. With many firms
in the market, however, the kink becomes unimportant. Thus, we usually draw industry
supply as a smooth, upward sloping curve.

Shut down period

In the short, the cost of production of a firm is the sum of the fixed costs and variable
costs at the fixed level of output. The total revenue of the firm must cover both these costs.
Otherwise, it will incur losses. But a firm may carry on production in the short run if its
variable costs are covered. This is with the hope that in the long run the conditions will
improve and total revenue will become greater them total costs.
The point at which the firm covers its variable cost is called the shutdown
point(P=AVC). The firm will close down if price falls below the average variable cost
(P<AVC) since by discontinuing its operations the firm is better off: it minimises its losses. If
the firm stops production in the short run, losses will be equal to the fixed cost. Losses will be
less than the fixed cost if a firm while operating earns revenue which covers variable costs
fully as well as a part of the fixed costs. (See figure: Short run supply curve of the
competitive firm).
In the long run, total revenue does not cover the total cost, the firm is to be closed
down (P=ATC).

MONOPOLY
Monopoly is a well-defined market structure where there is only one seller who
controls the entire market supply, as there are no other close substitutes for his product and

there are barriers to the entry of rival producers. The word monopoly comes from the Greek
word monos polein, which mean single seller. This single seller is called a monopolist.
By definition, monopoly is a market situation in which there is only one producer or
seller of a particular commodity which has no close substitutes and he has sufficient control
over the supply of the commodity so as to influence the price. The monopolist is thus a price
maker and not a price taker. Thus, the monopoly market model is the opposite extreme of
perfect competition.
Features or characteristics of monopoly
The main features of a monopoly market are explained below:
1. Single producer or seller: Under monopoly, there is only one producer or seller of a
commodity. Thus, firm and industry are identical.
2. No close substitute: There is no substitute for the commodity produced by the
monopolist. So the buyers have no choice. Therefore, the cross elasticity of demand
for the product of the monopolist is zero.
3. Barriers to entry: A monopolist has no immediate rivals due to the existence of strong
barriers to the entry of firms. The barriers which prevent the firms to enter the
industry maybe legal, technological, economic or natural obstacles.
4. Downward sloping demand curve: The demand curve of the monopolist slopes
downward. This means he cannot sell more output unless the price is lowered.
5. Price maker: In monopoly, the producer or seller has complete control over the supply
of the commodity. Therefore, the monopolist can fix any price for his commodity that
suit him best.
6. Discriminate price policy: The monopolist may follow a discriminative price policy
for his product. He may charge different prices for his product from different buyers.
Sources or reasons of monopoly power
There are major reasons or sources of monopoly. It is because of these reasons that
these monopolists enjoy a high degree of monopoly power. These sources relate to the factors
which prevent the entry of new firms into an industry. They are:
1. Patent or Copyright: First important source of a monopoly is that a firm may possess a
patent or a copyright which prevents others to produce the same product or use a
particular product process. These rights are obtained from the government. These
patent rights are granted for a certain period of time to encourage inventions.
2. Control over key raw materials: Some firms gain monopoly power from their
overtime control over certain scarce and key raw materials that are essential for the
production of certain other goods. E.g.: OPEC (Organisation of Petroleum Exporting
Countries) exercises monopoly power in the world over the supply of petroleum
products as it has control over the supply of crude oil of these countries.
3. Economies of scale: Natural monopoly: The size of the market maybe such as not to
support more than one plant of optimal size. The technology maybe such that to show
substantial economies of scale, which require only a single plant if they are only to be
reaped. For e.g.; in transport, electricity, communications, there are substantial
economies which can be realised only at a large scale of output. The size of the
market may not allow the existence of more than a single large plant. In those

conditions, it is said that the market creates a natural monopoly and it is usually the
case that the government undertakes the production of the commodity or of the
services to avoid exploitation of the consumers. This is the case of public utilities.
4. Market Franchises: The government gives exclusive right to the firm to sell a certain
good or service in a certain area. Usually, this is done with television cable
companies, taxi companies and so on. These franchises create monopoly to profits for
the holders of the franchises.
Price and Output determination or monopoly equilibrium
The objective of the monopoly firm is to gain maximum profit from the sale of its
product. The firm can achieve its ends in two alternative ways. The firm can either fix the
price of its product or it can fix the quantity to be sold to the customers. Given the downward
sloping demand curve, the monopolist cannot fix the price and output simultaneously. He has
to select one of these two alternatives. Either he can fix the price and leave the output to be
determined by the demand of customers or he can fix the output to be produced and leave the
price to be determined by the consumer demand for his product.
The monopolist fixes the price in such a way as to get the maximum profits. The
maximum price he can fix for a commodity depends on the nature of the commodity and its
elasticity of demand. If the commodity is having inelastic demand, the monopolist fixes a
higher price in order to earn maximum profit. On the other hand, if the commodity is having
elastic demand, he can sell more only by reducing the price of the commodity.

Short run Equilibrium

The monopolist maximises his short run profits if the following two conditions are
fulfilled:
1. The MC is equal to the MR.
2. The slope of MC is greater than the slope of MR at the point of intersection.
The short run equilibrium of a monopoly firm is graphically explained below:

In the figure, the equilibrium of the monopolist is defined by point E, at which the
MC intersects the curve from below. Thus both conditions for equilibrium are fulfilled. The
equilibrium price is OP and the equilibrium output is OM. The monopolists realises the

excess profit equal to the shaded area PABC. Note that the price is higher than the MR
(P>MR).

Long run equilibrium

In the long run the monopolist has the time to expand his plant, or to use his existing
plant at any level which will maximise his profit. He will not stay in the business if he makes
losses in the long run. He will most probably continue to earn super normal profit, even in the
long run, given the entry of new firms blocked. However, the size of his plant and the degree
of utilisation of any plant size depend entirely on the market demand. The monopolist may
reach the optimum scale (minimum point of LAC) or remain at the sub optimal scale (falling
part of his LAC) depending on the market conditions.
The most profitable level of output is the case each plant is at the point where the
LMC curve intersects the MR curve from the below and the SMC curve passes through this
point. Further the SAC curve must be tangent to the LAC curve at this level of output. We
discuss below monopoly equilibrium in smaller than the optimum size plant.

Suppose, in the long run, the monopolist installs a plant represented by the curve SAC1 and
SMC1. On this plant, the long run profits are the maximum at the output OM where
LMC=LMR at point A. Since at this level, the short run average cost curve, SAC1, is tangent
to the LAC at point E, the SMC curve is also equal to the LMC curve and to the MR curve,
i.e. (SMC1=LMC=MR) at the equilibrium point A. Thus, when the monopoly firm is in long
run equilibrium, it is in short run equilibrium. The monopolist charges the price OB (=MP),
sells the output OM and earns BPEC monopoly profit. However, this plant is less than the
optimum size since the monopoly firm is not producing at the lowest point L of the LAC
curve. It has some excess capacity. It is not in a position to take full advantage of the
economies of scale due to the small size of the market for its product.

Discriminating monopoly-price discrimination

A monopoly firm which adopts the price of firm discrimination is referred to as a
discriminating monopoly. Price discrimination involves the act of selling the same product at
different prices in different markets or to different buyers. In the words of Mrs. Joan
Robinson, the act of selling the same product produced under a single control, at different
prices to different buyers is known as price discrimination. For e.g. If the manufacturer of a
television of a given variety sells it at rs.5000/- to one buyer and at rs.5500/- to another buyer
(All conditions of sale and delivery are the same in the two cases), then he is practising price
discrimination.
Forms or types of price discrimination
Price discrimination may take many forms. The common forms of price
discrimination maybe stated below:
1. Personal discrimination: Price discrimination is personal when the buyer charge
different prices from different persons. For example, a surgeon may charge a high
operation fee from a rich patient and a lower fee from a poor one.
2. Age discrimination: Price discrimination on the basis of age of the buyers is known as
age discrimination. Usually buyers are grouped into children and adults. E.g.: A
barber may charge higher rate for adults than that he charges for children, in railways
and bus transport services, children between 3 and 12 years are charged only half the
adult rates.
3. Sex discrimination: In selling certain goods, producers may discriminate between
male and female buyers by charging low prices from females. E.g.: A tour organizing
firm may provide seats to ladies at a concessional rates.
4. Locational or place discrimination: When a monopolist charge different prices in
different markets located at different places, it is called locational or geographical
discrimination. E.g.: A producer may sell a commodity at one price at home and at
another price abroad.
5. Use discrimination: Sometimes, depending on the kind of use of product, different
prices may be charged. E.g.: Electricity is usually sold at a cheaper rate for domestic
uses than for commercial purposes.
6. Time discrimination: On the basis of the time of service, different prices may be
charged. E.g.: The telephone companies charges half rates for trunk calls at night.
Necessary conditions for price discrimination:
The necessary conditions which must be fulfilled for the implementation of price
discrimination are the following:
1. Price elasticity is different at different markets: The market must be divided into
submarkets with different price elasticities. It is the difference in price elasticities that
provides opportunity for price discrimination. If price elasticites of demand in
different markets are the same, price discrimination would not be gainful.

2. Markets are so separated that resale is not profitable: There must be effective
separation of submarkets, so that buyers of low-price market do not find it profitable
to resell the commodity in the high priced market because of
Geographical distance involving high cost of transportation.
Exclusive use of commodity. E.g.: Doctor services etc.
Lack of distribution channels. E.g.: transfer of electricity and gas.
3. There must be imperfect competition in the market: The seller must possess some
monopoly power over the supply of the product to be able to distinguish between
different classes of consumers, and to charge different prices.
Degrees of price discrimination:
The degree of price discrimination refers to the extent to which a seller can divide the
market and take the advantage of market division in extracting the consumer surplus.
According to A.C.Pigou, There are three degrees of price discrimination practiced by the
monopolists:
1. First degree price discrimination.
2. Second degree price discrimination.
3. Third degree price discrimination.
1. First degree price discrimination or (perfect price discrimination): The
discriminatory price that attempts to take away the entire consumer surplus is
called first degree price discrimination. It is said to occur when the seller charges a
different price for each unit of output. This involves charging different prices to
different consumers as well as charging different prices for different units sold to
the same consumer. The maximum price that someone is willing to pay for a unit
output is called the reservation price. The perfectly discriminating monopolistic
charges the reservation price for each unit of output. Thus, the MR curve for the
monopolist becomes demand curve. In this case, the equilibrium level of output,
which is given by intersection of the demand curve and the MC curve, is the same
as the output under the perfect competition. This is shown in the following figure:

The monopolists output is OC and revenues are given by the area OABC. Since
the monopolist charges a different price for each unit. Subtracting from this, the
cost (which are OC multiplied by the average cost OCDE), we get the
monopolists profit which is the shaded area ABDE.

2. Second degree price discrimination: This occurs when the monopolist is able to
charge different prices for the different quantities of purchase. The second degree
price discrimination is also called block pricing system. A different price is
charged from different category of consumers. A monopolist adopting the second
degree price discrimination intends to siphon off only the major part of the
consumer surplus, rather than the entire of it. The second degree price
discrimination is feasible where:
The number of consumers are large and the price rationing can be
effective, as in case of utilities like telephone, natural gas and
electricity.
Demand curves of all the consumers are identical.
A single rate is applicable for a large number of buyers.
The second degree price discrimination is explained through the following
diagram:

In the figure, a monopolist sets the price first at OP1 and sells OQ1. After selling
OQ1, he sets a lower price OP2, and sells Q1Q2 units. After the sale of Q1Q2
additional units, he sets still a lower price OP3 for the next additional sale of Q1Q2
units. Thus by adopting a block pricing system, the monopolist maximises his total
revenue (TR) as
TR = (OQ1*AQ1) + (Q1Q2*BQ2) + (Q2Q3*CQ3)
If a monopolist is restrained from price discrimination, and is forced to choose any
one of the three prices, OP1, OP2 or OP3, his total revenue will be much less.

3. Third degree price discrimination: This occurs when monopolists sets different
price at different markets having demand curves with different elasticities. Here,

the monopolist is trying to exploit the different price elasticities of demand for
different markets. The monopolists are therefore required to allocate total output
between different markets so that profit can be maximised in each market. The
profit in each market would be maximum only when the MR=MC in each market.
Equilibrium price and output under discriminating monopoly
Under single monopoly, a single price is charged for the whole output. But under
price discrimination, the monopolist will charge different prices in different submarkets. First
of all, therefore the monopolist has to divide his total market into various submarkets on the
basis of differences in price elasticity demand in them.
The reason for a monopolist to apply price discrimination is to obtain an increase in t
total revenue and his profit. In order to reach the equilibrium position, the discriminating
monopolists has to take three decisions:
1. The total output to be produced.
2. The distribution of supply of outputs in different markets. i.e how much to sell
in each market with a view to maximise profit.
3. The prices of product in different markets.
The equilibrium conditions in this regard are:
1. To determine total output, the monopolist should equate marginal cost (MC)
with combined marginal revenue (AMR) of different markets. I.e. MC=AMR.
2. To maximise the profits, the total output in different markets will be
distributed in such a way that marginal revenue in each market is the same.
3. Prices in different markets will be decided in relation to the quantity of output
allocated for the sale and position of the demand curve.
As a rule, higher prices will be charged in the market with inelastic demand and lower
price in the market with elastic demand. Obviously, lesser quantity will be supplied to the
inelastic market and larger amount to the elastic demand market. Indeed, once allocation of
output is decided, price determination in each market automatically follows directly from the
demand curve.
The model
To explain the equilibrium conditions of the price discriminating monopolist, we may
assume a simple model for graphical analysis as follows:
1.
2.
3.
4.
5.

The monopolist is facing separate markets A and B.

The demand for the product in the market B is relatively inelastic.
The demand for the product in the market B is relatively elastic.
The firms cost conditions are known.
The rationale of price discrimination is maximisation of total profits.

Under these assumptions, comparing per unit cost and revenue conditions, the
equilibrium level of output can be reached by the monopolist when the MC is equal to
the combined MR (MC=MR), as shown in the following figure (panel C).

In the above figure, Panel (a) represents the conditions of market A. Da represents its
demand curve, which is relatively inelastic. Panel (b) represents market B. Its demand curve
is Db which is relatively elastic. Panel (c) represents the condition of aggregate market of the
monopoly firm. AMR represents the combined marginal curve, AMR=MRa + MRb. The
firms marginal cost is shown by MC curve which represents AMR at point E, so at this point,
MC=AMR. It is the profit maximising equilibrium condition. Thus, OQ is the equilibrium
output. The monopolists now allocate the OQ output between the two markets in such a way
that the necessary conditions for profit maximisations is satisfied in both the markets (i.e
MC=MR). Therefore, he will allocate OQ output between the two submarkets in such
proportions that MRa=MRb. The profit maximising output for each market can be obtained
by drawing a line from point E, parallel to x-axis, through MRa(E1) and MRb(E2) determine
the optimum level of output for each market. Hence, the monopolist maximises profit in
market A by selling OQa units at price P1Qa, and by selling OQb units in market B at price
P2Qb.
The firms total equilibrium output is OQ=OQa+OQb. Since at OQa, MRa=MC in
market A, and at OQb, MRa=MC in market B.
MC=AMR=MRa=Mrb
The total profit of the monopolist is shown by the areas between the AMR curve and
the MC curve. Thus, shaded area BEC measures total profit.
Thus, for the discriminating monopolist to be in equilibrium, the following conditions
must be fulfilled:
1. AMR=MC
2. MRa=MRb=MC.

Dumping
The act of selling a commodity produced under a single control, at a higher price in
the home market and at a lower price in the world market is known as dumping.

Objectives
1. A monopolist may resort to dumping to drive out the rivals from the foreign
markets. In order to achieve this objective, he may even sell his product in the
foreign market at a price which is lower than cost of production. Once the market
is conquered he can raise price and earn maximum profits.
2. Dumping may happen because of an error in the demand estimates. The producer
may produce more output than what is necessary for the domestic market. If he
tries to sell the excess output in the home market he will have to lower the price
not only for the excess output but for the entire output. Hence, it will be more
profitable if he disposes of the excess output in a foreign market at a lower price.
3. Another objective of dumping is to reap the advantages of increasing returns.
Together with the home market, if the foreign market is also available, the
monopolist may be able to organise production on a large scale. This will help him
to reap the advantages of increasing returns, therefore, he resorts to dumping.
4. The monopolist may resort to dumping if the demand for his product at home is
inelastic whereas in foreign markets, it is elastic. So dumping will help him to take
full advantage of the elastic demand in the foreign market.
Monopsony
Monopsony refers to a market in which there is a single buyer of a commodity or a
service. It was Mrs. Joan Robinson who coined the term monopsony. Monopsony allows a
buyer to purchase a good less than the price that would exist in a competitive market. Under
this situation, the buyer has the upper hand in fixation of the price of the product. Monopsony
is also very rare in real life.
Sources of monopsony power:
It is possible to draw analogies with monopoly and monopsony power. The monopoly power
depends on three things. The elasticity of market demand, the number of sellers in the market
and the ways those sellers interact.
The monopsony power depends on three similar things:
1. Elasticity of market supply: A monopsonist faces it because it faces an upward
sloping supply curve, so that marginal expenditure exceeds average expenditure.
The less elastic the supply curve, the greater difference is between the marginal
curve and the average expenditure and the monopsony power the buyer enjoys. If
supply is highly elastic monopsony power is small and there is little gain in being
the only buyer.
Marginal Expenditure: The additional cost of buying one more unit of a good.
Average Expenditure: Price is paid per unit of a good. The market supply curve
is monopsonits average expenditure curve.
Marginal Value: The additional benefit from purchasing one more unit of a
good. It is a function of the quantity purchased. Therefore value schedule is the
demand curve for the good.

2. Number of buyers: The number of buyers is an important determinant in the

monopsony power. When the number of buyers is very large, no single buyer can
have much influence over price. Thus each buyer faces an extremely elastic
supply curve, so that the market is almost completely competitive. The potential
for monopsony power arises when the number of buyers is limited.
3. Interaction among buyers: Suppose three or four buyers are in the market. If those
buyers compete aggressively. They will bid up price close to the marginal value of
the product and will thus have a little monopsony power. On the other hand, if
those buyers compete aggressively, or even collude, prices will not be bid up very
much, and the buyers degree of monopsony will be nearly as high as if there were
only one buyer.
Bilateral monopoly
Bilateral monopoly is a market situation where there is only one seller (monopolist)
and only one buyer (monpsonist). Both the buyer and the seller have monopoly power in their
respective fields- The monopsonist in the buying field and the monopolist in the selling field.
Monopsony power and the monopoly power tend to counteract each other. In other words, the
monopsony power of buyers will reduce the effective monopoly power of sellers and vice
versa.
Both parties want to maximise gains from the transactions. The seller wants to get a
high price for his product from the buyer, the buyer wants a lower price from the seller.
Under this situation determination of equilibrium price and output is difficult and can only be
determined by the traditional tools of demand and supply. Hence, price and output
determination under bilateral monopoly is done by on-economic factors such as bargaining
power, skill and other strategies of the participating firm. Bilateral monopoly is rare. Markets
in which a few producers have some monopoly power and sell to a few buyers who have
some monopsony power are more common.
Monopolistic Competition
Product pricing under perfect competition and monopoly are extreme cases which are
seldom found in practice. In fact, there are market situations which fall in between these two
extremes. It was prof. E.H. Chamberlein who in his theory of monopolistic competition and
Mrs. Joan Robinson in her Economics of imperfect competition brought out a synthesis of
perfect competition and pure monopoly independently of each other. A market with blending
of monopoly and competition is known as monopolistic competition.
Definition of monopolistic competition
A monopolistic competition is defined as a market situation in which there are a large
number of buyers and sellers dealing in differential products with different prices.

Features or characteristics

1. Large number of sellers: In a monopolistic competition, the number of sellers is

large which leads to competition. An individual firms supply is just a small part
of the total supply so that it has a very limited degree of control over the market
price. And each firm adopts an independent price and production policy.
2. Product differentiation: It is the most distinguishing feature of monopolistic
competition. The products supplied by various sellers are not identical. They are
differentiated products. They are close substitutes of one another. Through product
differentiation, each seller acquires a limited degree of monopoly power.
3. Large number of buyers: There are large number of buyers in this type of market.
However, each buyer has a preference for a specific brand of the product. Unlike
perfect competition, buying is by choice and not by chance.
4. Freedom of entry and exit of firms: There are no entry barriers under perfect
competition. New firms can enter and old firms can leave the industry.
5. Selling costs: Since products are differentiated and vary from time to time,
advertising and other forms of sale promotions become an important part in
marketing the goods. Expenditure incurred on this account are selling costs.
Selling costs are thus costs which are meant for sales promotion.
6. Two dimensional competition: Monopolistic competition has two faces; Price
competition and non-price competition. Non price competition is in terms of
product variation and selling costs incurred by each sellers to capture his share in
the market.
7. The group: Chamberlein introduced the concept of group to replace the traditional
concept of industry. Monopolistic competition is characterised by product
differentiation. Chamberlein therefore introduced the concept of group. A group is
a cluster of firms producing very closely related but differentiated products.
Product differentiation
Product differentiation is intended to distinguish one producer from that of other
producers in the industry. It can be real when the inherent characteristics of the products are
different. And the basis of differentiation maybe imaginary, when the products are basically
the same yet the consumer is persuaded via advertising or other selling activities that the
products are different.
Real differentiation exists when there are differences in the specification of the
products or differences in the factor inputs or the location of the firm or the services offered
by the producer.
Fancied differentiation is established by advertising differences in packaging,
differences in design and simply the brand name. Whatever the case, the aim of the product
differentiation is to make the product unique in the mind of the consumer.
The effect of product differentiation is that the producer has some discretion in the
determination of the price. He is not a price taker, but has some degree of monopoly power
which he can exploit. However he faces the competition of the close substitutes offered by
firms. Hence the discretion of the price is limited.

(b) Long run equilibrium or group equilibrium under monopolistic competition:

Chamberlain called the long run equilibrium of the industry under monopolistic
competition as equilibrium of the group (group of firms) because product differentiation
creates difficulties in analytical treatment of the industry. Heterogeneous products cannot be
added to form the market demand and supply schedules as in the form of homogenous
products. The concept of industry needs redefinition. Chamberlain uses the concept of
product group which includes products which are closely related or close substitutes.
The major difficulties associated with the group equilibrium are the vast diversity of
conditions which exist in many matters between different firms forming a group or industry.
These difficulties consist of product differentiation, different kinds of consumer preferences
and also variations in cost curves as well as in demand curves and difference in efficiency of
each firm.
In order to simplify the analysis of group equilibrium, Chamberlain suggests four
basic assumptions to be laid down:
1. All firms in the group are producing more or less identical products.
2. The share of each firm in the market is almost equal. The implication of this
assumption is that all firms face similar demand curve.
3. The efficiency of each firm is similar. This implies that all firms have an equal
cost curves.
4. The analysis of firms in the group is sufficiently large so that one firms actions
regarding price and output will have negligible effect upon numerous competitors.
Given these assumptions, it is possible to explain group equilibrium in the long run. In
a monopolistic competition, the full long period equilibrium position is possible only when
both firms and the industry are in equilibrium whereas for each firm, the condition for
equilibrium (MR=MC) will apply whatever the output for the industry, we must allow for
entry of new firms. Existence of supernormal profits in the long run and the anticipation of
the same in the future will attract new firms to enter the industry and also induce existing
firms to expand. On the other hand, existence of losses in the short run and the anticipation of
the same in the long run will induce the existing firms to leave the industry.
If the new firms are set up or the existing firms expand, there will be a tendency for
the prices to decline and equal average cost. At the same time, there is a possibility for prices
to decline and equal average cost. There is a possibility that the long run average cost curve
for every firm rises because of rising demand for the factors of production. These two
tendencies operate simultaneously.- prices to decline and average cost to rise.- will remove
supernormal profits. Profits are normal only when AC=AR. Thus the long run equilibrium
output is where
MC=MR and AC=AR

In the long run, under the monopolistic competitive conditions, every firm will reap
normal profits.

Diagrammatic representation

In the figure, long run equilibrium output is OM where MC=MR and AC=AR.
Equilibrium price is OP or MQ. Each firms earns normal profits only.
As regards under the price and output determination under monopolistic competition,
the following conclusion maybe drawn
1. There is no uniformity of price.
2. The price is not as high as the monopoly price and not as low as the
competitive price.
3. The equilibrium output is less than that under perfect competition and is
greater than under the monopoly.
4. Price is greater than MR- a result of falling demand curve.
5. Each firm incurs advertisement expenditure in addition to production
costs.
6. The optimum output of each firm is that the output at which MC=MR.
Demerits or wastes of the monopolistic competition
1. Excess capacity: Since the demand curve AR of a monopolistic competitive firm
is downward sloping, its tangency point with LAC curve will always occur to the
left of its minimum point. Thus, when the firm is in a long term equilibrium, it
underutilises its optimum scale plant. This is a wastage of resources.
2. Inefficient Firms: In a monopolistic competition, an inefficient firm can survive
under the shade of product differentiation and advertisement.
3. Cross Transport: Each producer tries to sell his product in far off markets rather
than in the markets near to its place of manufacture. This involves huge
transportation cost.

4. Too many varieties: A large number of brands, styles, designs etc. confuses the
consumer. It reduces the chances of large scale production. Then these firms fail to
enjoy the economies of large scale production.
5. Competitive advertising: False advertising designed for false propaganda and
unsubstantiated claims of superiority of the product in order to create a partial
monopoly is regarded as wasteful. The consumers have to pay high prices due to
the cost of advertising.
6. Unemployment: Under monopolistic competition, the productive capacity of the
economy is not used to the fullest extend and this will result in the unemployment
of resources in the economy.
Non price competition and selling costs
Non price competition is a market strategy in which one firm tries to distinguish its
product or service from competing products on the basis of attributes like design and
workmanship. The firm can also distinguish its product offering quality of service, extensive
distribution, customer focus or any other sustainable competitive advantage other than price.
Non-price competition typically involves promotional expenditures (such as advertising,
selling staff, the locations, sales promotions, coupons etc.), marketing research, new product
development and brand management cost.
Firms will engage in non-price competition, in spite of additional costs involved,
because it is usually more profitable than selling for a lower price, and avoid the risk of a
price war. Non-price competition is the most common among oligopolies and monopolistic
competition.
Under monopolistic competition, the firms are reluctant to use price as a competitive
weapon to promote sales. They uses non-price weapons like advertisement, product
modification, introduction of special services etc. The necessary results are selling costs.
Selling costs may be defined as those costs which are incurred by a firm to persuade
the customers to buy its product in preference to those of others. Prof. Chamberlain defines
selling cost as costs incurred in order to alter the position or shape of the demand curve for a
product. By chamberlains definition, selling costs include:
1.
2.
3.
4.
5.

Cost of advertisement.
Expenditure on sales promotion schemes (including gifts and discount to buyers)
Salary and commission paid to sales personnel.
Allowance to retailers for displays and
Cost of after sales service.

According to chamberlain, the selling costs perform the following functions:

1. Informing potential buyers about the availability of the product.
2. Increasing demand for the product by attracting customers of the rival
products and
3. To make the demand curve shift upwards.

Thus, under monopolistic competition, firms use non-price weapons heavily to

promote thir sales which involves huge rise in selling costs.

Ideal output and excess capacity under monopolistic competition

The excess capacity of a firm is defined as the difference between the ideal output
and the actual output attained in the long run. Ideal output can be defined as the output that
can be produced at minimum long run average cost (LAC). This ideal output is linked to
socially optimum output. Excess capacity is also called as idle capacity and unused
capacity.
Theories of chamberlain monopolistic competition and Joan Robinsons imperfect
competition has revealed that a firm under monopolistic competition or imperfect
competition in the long run equilibrium produces an output is less than socially optimum or
ideal output. This means that firms operate at the point on the following portion of long run
average cost curve, i.e. they do not produce the level of output at which LAC is minimum.
The existence excess capacity under monopolistic competition is explained with the
help of the following figure:

A firm under monopolistic competition is in equilibrium at output OM at which its

MR curve is equal to MC (MR=MC) and average revenue is equal to average cost (AR=AC).
It will be noticed that at output OM, the long run average cost is still falling and goes on
falling up to output ON. This means that the firm can expand production up to ON and reduce
its LAC to the minimum. Ideal output is the output at which the LAC is minimum, i.e. ON.
Therefore the firm is producing MN less than the ideal output. Thus MN output represents the
excess capacity which emerges under the monopolistic competition.
Causes of the excess capacity:

1. The most important reason is the downward sloping demand curve (AR curve) of
the firm. The downward sloping AR curve can be tangent to the u shaped AC
curve at the latters minimum point. From this, it also follows that greater the
elasticity of AR curve confronting a monopolistically competitive firm, the less
the excess capacity and vice versa.
2. The second reason for the emergence of excess capacity, as has been emphasised
by Chamberlain is the entry of a very large number of firms in the industry in the
long run. Lured by excess profits in the short run, new firms enter the industry in
the long run. This results in sharing of the market demand among many firms so
that each firm produces a smaller output than its full or optimum capacity.
Oligopoly
Oligopoly is an important form of imperfect competition. Oligopoly is a market
structure in which there are a few sellers selling homogenous or differentiated products. In
other words, oligopoly is said to exist when there are a few sellers or firms in the market
producing or selling a product.
If oligopoly firm sells a homogenous product, it is called pure or homogenous
oligopoly. E.g.: Industries producing bread, cement, steel, cooking gas, chemicals, aluminium
and sugar are industries characterised by homogenous oligopoly. And if firms of an oligopoly
industry sell differentiated products, it is called heterogeneous or differentiated oligopoly.
Automobiles, televisions, soap and detergents, etc. are some examples of industries
characterised by differentiated oligopoly.
Nature of Oligopoly or features of Oligopoly:
In oligopoly, certain characteristics are found which are not present in other market
structures. These features throw some light on the basic nature of oligopoly:
1. Small number of sellers: There are small number of sellers under
oligopoly. How small is not given precisely. It depends largely on the size
of the markets. Since the number of sellers are so small, the market share
of each firm is so large that a single firm can influence the market price
and business strategy of its rival firms,
2. Interdependence: The most striking feature of oligopoly is the
interdependence among the sellers or firms. This is because when the
number of competitors is few, any change in product, price, etc. by a firm
will have a direct effect on the fortune of its rivals, which will then
retaliate in changing their own prices, outputs or the products as the case
maybe. The competition between the firms take the form of action,
reaction and counter action in the absence of collusion between the firms.
The business strategy of each firm in respect to pricing, advertising and
product modification is closely watched by the rival firms and it evokes
imitation and retaliation. What is equally important in the strategic
business decisions is that the firms initiating a new business strategy
anticipate and take into account the counter action by the rival firms.

3. Price stickiness or price rigidity: The price under the oligopoly market is
likely to be sticky or rigid. If any firm tries to reduce its price, the rival
firms retaliate by a higher reduction in their prices. This will lead to a
situation of price war, which benefit none. On the other hand if any firm
increases their price, then other firms will not follow the same. Hence no
firm like to reduce price or increase the price. (refer sweezy model)
4. Presence of monopoly power: If firms under oligopoly industry produce
differentiated products (close substitutes), each firm becomes petty
monopolist. The degree of monopoly enjoyed by each firm depends upon
the attachment of the customers to its product.
5. Lack of uniformity: Another feature of the oligopoly market is the lack of
uniformity in the size of firms. Firms differ considerable in size. Some
may be small, others very large.
6. Collusions and conflicts: Realising the disadvantages of mutual
competition, at times they desire to combine in order to maximise their
joint profits. At the same time, the selfish desire of each firm to amass
maximum profits give chance for conflicts and antagonism. Thus, two
opposite forces are at a work under oligopoly.
7. Barriers to entry: Barriers to entry under oligopoly market arise due to :
Huge investment requirement to match the production capacity
of the existing firms.
The economies of scale and absolute cost advantage enjoyed by
existing firms based on quality and service.
Resistance by the established firm by price cutting. However,
the new entrants that can cross the barriers can and do enter the
industry.
8. Kinked demand curve or indeterminate demand curve: The
interdependence among the firms inevitably lead to another feature of
oligopoly namely indeterminate demand curve. Under oligopoly, a firm
cannot assume that its rivals will keep their prices unchanged when it
makes changes in its own price. As a result, the oligopolist cannot say how
much he would be able to sell if he lowers or raises the price by a certain
percentage. Hence the demand curve cannot be drawn accurately and with
definiteness. Paul M, Sweezy has introduced the kinked demand curve for
oligopoly market situation. It is a downward sloping curve with a bend
(see sweezy model).
Collusive Oligopoly
In order to avoid uncertainty arising out of interdependence and to avoid price wars
and cut throat competition, firms working under oligopolistic conditions often enter into
collusive agreement. The agreement maybe either formal (open) or tacit (secret). But since
formal or open agreement to form monopolies are illegal in most countries, agreements
reached between oligopolists are generally tacit or secret. When the firm the firm enters such
collusive agreements formally or secretly regarding a uniform price output policy to be
pursued by them, collusive oligopoly exists.

Types of collusion
There are two types of collusion-cartels and price leadership.

Cartels
Originally, the term cartel was used for the agreement in which there existed a
common sales agency which alone undertook the selling operations of all the firms that were
party to the agreement. But, nowadays, all types of formal or informal or tacit agreements
reached among the oligopolistic firms of an industry are known as cartels. In such a cartel
type of oligopoly, firms jointly fix a price and output policy towards agreement. There are
two typical forms of cartel: (a) Cartels aiming at joint profit maximisation, and (b) cartels
aiming at sharing of the market.
a) Cartels aiming at joint profit maximisation: Cartels imply direct (although secret)
agreements the competing oligopolists with the aim of reducing the uncertainty
arising out from their mutual interdependence. In this particular case, the aim of the
cartel is maximisation of the industry (joint) profit.
An extreme form of collusion is formed when the member firms agree to
surrender completely their rights of price and output determination to a central agency
so as to secure maximum joint profit for them. Formation of such a joint collusion is
generally known as perfect cartel. Under perfect cartel, the price and output
determination for the whole industry as well as of each member firm is determined by
the central agency so as to achieve a maximum joint profits for the member firms. The
central agency decides the allocation of production among the members of the cartel
and the distribution of the maximum joint profit among the participating members.
The output quota to be produced by each firm is decided by the central agency in such
a way that the total costs of the total output produced is minimum. Total cost will be
minimised when the various firms in the cartel produce such separate outputs so that
their marginal costs are equal. The central agency acting as the multi-plant
monopolist, will set the price and industrys output defined by the intersection of the
industry MR and MC curves. The joint profit made by the cartel will be maximum at
these price and output levels.
b) Market sharing Cartels: This form of collusion is more common in practice because it
is more popular. The firms agree to share the market, but keep a considerable degree
of freedom concerning the style of their output, their selling activities and other
decisions.
There are two basic methods for sharing the market:
i. Non price competition.
ii. Determination of quotas.
i.
Market sharing by non-price competition: In this form of loose cartel,
the firms agree on a common price at which each of them can sell at
any of the quantity demanded. The price is set by bargaining, with the

low cost firms processing for a lower price and the high cost firms for
a high price. The agreed price must be such as to allow some profits to
all the members. The cartel agrees not to sell at a price below the cartel
price. But they are free to vary the size of their product and the
advertising expenditure and to promote sales in other ways. In other
words, the firms compete on a non-price basis.
This form of the cartel is indeed loose in the sense that it is more
unstable than the complete cartel aiming at joint profit maximisation
because the low cost firm will have strong incentives to break away
from the cartel openly and charge a lower price, or to cheat other
members by secret price concessions to the buyers. However, as the
other members gradually lose their customers, the cheating by the low
cost firm will be ultimately discovered and consequently open price
war may start and cartel breaks down.
ii.

Market sharing by output quota: The second type of market sharing

cartel is the agreement reached between the members regarding the
quota of output to be produced and sold by each of them at the agreed
price. If all the firms have identical costs, the monopoly solution will
emerge, with the market being shared equally by member firms.
However, if the costs are different, the quota and market share will
differ. The quotas and market shares in the case of cost difference are
decided by bargaining. The final quota of each firms depend on the
level of its cost as well as on its bargaining skills. During the
bargaining process, the two main criteria are most often adopted:
quotas are decided on the basis of past level of sales and for on the
basis of past level capacity. Ultimately, the quotas fixed for various
firms depend upon their bargaining power and skills.
The second common basis for the quota system and market sharing is
the definition of the region in which the firm is allowed to sell. In this
case of geographical sharing of the market, the price as well as the
style of the product may differ.
Price leadership

Price leadership is an important form of collusive oligopoly. Under price leadership,

one firm assumes the role of a price leader and fixes the price of the product for the entire
industry and the other firms in the industry accept it and adjust their output to this price. Price
leadership may emerge spontaneously due to technical reasons or out of tacit or explicit
agreements between the firms to assign leadership role to one of them. The spontaneous price
leadership maybe the result of such technical reasons as the size of the firm, efficiency of the
firm, ability of the firm to forecast future developments, reputation and goodwill of the firm
etc. This type of pricing is found in industries like coal, cement, petroleum, etc. in USA.
Price leadership is more wide-spread than cartels, because it allows the members
complete freedom regarding their product and selling activities and this is more acceptable to

the followers than a complete cartel, which requires the surrounding of all freedom of action
to the central agency.
Types of price leadership:
1. Price leadership by low cost firms.
2. Price leadership by a large firm.
3. Barometric price leadership.
These are the form of price leadership examined by the traditional theory of leadership
developed by feller and others. The characteristics of the traditional price leader is that he sets
his price on margionalistic rules, that is, at the level defined by the intersection of MC and
MR curves. For the leader the behavioural rule is MC=MR. The other firms are price takers
who will not normally maximize their profit by adopting the price of their leaders.
1. The low cost price leadership model: In this model, an oligopolistic firm having
lower cost than the other firms sets price [normally at which its MC=MR] which
the other firms have to follow. The low cost firm thus becomes the price leader.
Since the high cost firms will not be able to sell their product at the higher price,
they are forced to agree to a lower price set by the lower cost firm. Of course, the
low cost price leader must ensure that the price that he sets must yield some
profits to the high cost firms.
2. Price leadership by a dominant firm: Price leadership by a dominant firm is more
common than a low cost firm. In this firm it is assumed that there is a huge
dominant firm which have considerable share of the total market. The smaller
firms, each of them having a small market share. The dominant firm fixes the
price and the other firms accept it and adjust their output accordingly. The
dominant firm chooses that price and output that maximizes their profit. It fixes
the price and output at that point which is MC=MR. If the smaller firms raise the
price, they will lose customers. Hence, the small firms behave passively as price
takers like a firm in a perfectly competitive market, i.e. smaller firms accept the
price set by the dominant firm. Each small firm will have to adjust its output to the
point at which MC=price.
If the dominant firm is very large in size, the price leadership is also called
partial monopoly.
3. The barometric price leadership: The barometric price leadership is that in which
one firm in the oligopolistic firms which is supposed to have good knowledge
about the prevailing market conditions and has an ability to predict it better than
the others, announces a price change which is accepted by other firms in the
industry. In short, the firm chosen as the leader is considered as a barometer,
which reflects the changes in the conditions and environment of the industry. The
barometric firm may be neither low cost nor a large firm. Usually it is a firm
which from past behaviour has established the reputation of a good forecaster of
economic changes. The price changes announced by the barometric firm serve as a
barometer of changes in demand and supply conditions in the market. A firm
belonging to another industry may be chosen as the barometric leader.

Barometric price leadership may be established for various reasons:

a) The rivalry between several large firms in the industry may make it impossible to accept
one among them as the leader.
b) Most firms in the industry may have neither the capacity nor the desire to make
continuous calculations of cost, demand and supply conditions. Therefore, they find it
advantageous to accept the price changes made by a firm which has the proven ability to
make remarkably good forecasts.
c) As a reaction to earlier experience of violent price changes and cut-throat competition
among oligopolistic firms, they accept one firm as the leader.
Sweezys model of oligopoly: Kinked-demand curve model
The origin of the kinked demand curve can be traced into Chamberlains theory of
monopolistic competition. Later Hall and Hitch used kinked-demand curve to explain rigidity
of prices in their respective theories. It was Paul M. Sweezy who used the kinked demand
curve in his model of price rigidity in oligopolistic market.
Accordingly to the kinked demand curve hypothesis, the demand curve facing an
oligopolist has a kink at the level of the prevailing price. The kink is formed at the
prevailing price because the segment of the demand curve above the prevailing price level is
highly elastic and the segment of the demand curve below the prevailing price level is
inelastic. This difference in elasticities is due to the particular competitive reaction pattern
assumed by the kinked demand curve hypothesis.
The competitive reaction pattern assumed by the kinked demand curve theory of
oligopoly is as follows:
Each oligopolist believes that if he lowers the price below the prevailing level, his
competitors will follow him and will accordingly lower their price in order to avoid losing
their customers. Thus the firm lowering the price will not be able to increase its demand
much. So this portion of the demand curve below the prevailing market price is relatively
inelastic. On the other hand, if the oligopolistic firm rises the price above the prevailing price
level, its rivals will not follow it and increase their prices. Thus, the quantity demanded of
this firm will fall considerably. Therefore, the portion of the demand curve above the
prevailing market price is relatively elastic.
Thus, the demand curve of an oligopolistic firm has a kink at the prevailing market
price which explains price rigidity. An oligopolist facing a kinked demand curve will have no
incentive to rise its price or to lower it. Since the oligopolist will not gain a large share of the
market by reducing his price below the prevailing level and will have substantial increase in
sales by increasing his price above the prevailing level, so, he will not change the prevailing
market price. Thus, price rigidity is explained in this way by the kinked demand curve theory.
It is explained in the following figure:

In the figure, the segment KD of the demand curve, which lies below the prevailing
price OP is inelastic showing that very little increase in sales can be obtained by a reduction
in price by an oligopolist. The segment DK of the demand curve which lies above the current
price level OP is elastic showing a large fall in sales if a producer raises his price. The
demand curve of the oligopolist has a kink (at point K) at the prevailing market price OP.
Price and output determination under Oligopoly
The oligopolist confronting a kinked demand curve will be
maximizing his profit at the current price level. For finding the profit
maximising price output combination, Marginal revenue (MR) curve
corresponding to the kinked demand curve KD has been drawn. It is worth
mentioning that the marginal revenue curve associated with a kinked
demand curve is discontinuous, or in other words, it has a broken vertical
portion. The length of the discontinuity depends upon the relative
elasticities of the two segments dK and KD of the demand curve at point
K. The greater the difference in the two elasticities, the greater the length
of the discontinuity. The MR has two segments- segment dA correspond to
upper part of the demand curve, while the segment from point B
corresponds to the lower part of the kinked demand curve. MR curve has a
discontinuous gap or portion AB.
Suppose that the marginal cost curve is given as MC which
intersects MR at point E, then point E satisfies the necessary conditions for
profit maximization (MR=MC). Therefore, oligopoly firms are in equilibrium
output OM and price OP and they are making maximum profit. As long as
the MC curve cuts the MR curve anywhere in the gap between A and B,
there will not be any change in the price or quantity. Thus, both price and
output are stable. Oligopoly firms would think of charging their price and
output only if MC rises beyond point A or a decrease in C below point B.
Duopoly
An extreme case of oligopoly is duopoly, where there are only two
firms producing homogenous or differentiated products. Duopoly is the
market in which two firms compete with each other.
There are three principal duopoly models: Cournot duopoly model,
Bertrands duopoly model and Stackelbergs duopoly model.
In Cournot model, each firm acts on the assumption that its rival will
not change its output and decides its own output so as to maximise profit.

The Bertrand model assumes that each firms expects that the rival
will keep its price constant, irrespective of its own decision of pricing.
Thus, each firm sets the price of its product to maximize profit on the
assumption that the price of the rival will remain constant.
Finally, The Stackelberg model assumes that one firm will behave as
in the Cournot model by taking the output of rival as constant, but that
the rival incorporate this behaviour into its production decisions.
Market with Asymmetric information
One of the basic conditions for the market to work efficiently is
perfect knowledge. For efficient allocation of resources, consumer
require complete information about market price of the products and their
quality. Producers need to have full information about the market size,
demand for the product, availability of inputs, their prices and
productivity, their cost conditions and so on.
However, in the real world, consumers and producers do not have
full information about the price, quality and availability of the products. In
fact, they have only imperfect information about opportunity set available
to them. A leading example of imperfect information is asymmetric
information about the quality of used goods. [e.g.: used cars in the
market]. By asymmetric information, we mean one party in the market for
used cars (the buyer) does not know about the quality of the product
being sold. In case of the used cars, while the sellers know about the true
quality of their products, the buyers do not know about the quality of the
used cars which may turn out to be lemons(i.e. a defective product).
Similarly asymmetric information occurs in the labour market, where, the
workers who sell their labour services know their ability and efficiency, the
firms who hire them are not well informed about it.
Thus, asymmetric information means the market situation when the
buyers and seller have a different information while making a transaction.
Because of asymmetric information, low quality goods drive high quality
goods out of the market. This phenomenon is referred to as lemons
problem. The problem about the asymmetric information is that it leads to
market failure, i.e. failure to achieve market efficiency.
The implications of the asymmetric information about product
quality were first analysed by George Akerlof.