FUNDAMENTAL THEORY OF INDUSTRIAL ORGANISATION

STRUCTURE – CONDUCT –PERORMANCE

The S - C- P paradigm was the dominant paradigm in industrial

organization from 1950, is even today the basic framework for studies on market
power - profitability relationship. It argues that the performance of an industry or firm
is determined by the behaviour (conduct ) of buyers and sellers, which in turn is
determined by structural attributes of the market in which it operates.
Structure: Structure refers to the character and composition of the markets and
industries. It describes the environment within which firms in a particular market
operate Structure refers to the number and size distribution of the firms in an industry.
The main structural characteristics are :
• Number and size distribution of the firms.
• Degree of product differentiation
• Condition of entry / exit
• The extent to which firms are integrated or diversified.
Number and size distribution of the firm:
Number of firms gains significance because of the notion that the fewer the number of
firms in the market, the more likely is the firm to perform like a monopolist. For
example, under perfect competition , s firm which is one among many, sells the product
at a market price that is equal to marginal cost. From the society’s point of view a
competitive firm’s outcome is efficient and hence perfect competition is an efficient
market structure. In contrast the equilibrium outcome is inefficient with price > MC.
Fewer the number of sellers, the more likely is the market to perform like a monopolist
and produce inefficient outcome.
The size distribution of the firm is also a significant factor because a market with one
large firm and several small firms is likely to perform like a monopolist than a market
with few firms of roughly equal size.
Number and size distribution of buyers affects conduct and performance. Fewer the
buyers greater will be their bargaining strength and buyers will gain monopsony power
which will affect efficient outcome.
Product Differentiation: Differentiated products give monopoly power to the seller.
In markets with product differentiation, P > MC and hence market outcome is
inefficient. Product variety increases monopoly power of the firm.
Entry conditions: Entry conditions affect number and size distribution of the firms and
thus influence the performance of the firms in the market.
Conduct refers to the behavior of firms in a market. It explains the decisions firms
make and the way in which these decisions are taken. It focuses on how firms set prices,
whether independently or in collusion with others in the market, how firms decide on
their advertisement and research budgets and how much expenditure is devoted for these
activities.
Performance: Performance refers to productive and allocative efficiency of the firms
and social welfare. The essential question is whether or not firm’s operations enhance
economic welfare. Productive efficiency requires avoiding wasteful use of resources and
allocative efficiency is producing the right good in right quantities. Perfect competition

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is a market structure that guarantees both productive and allocative efficiency. Under
perfect competition, when the firms are in long run equilibrium, P = MC and LAC is at
its minimum thus assuring both allocative and productive efficiency. Under imperfect
competition, when firm is in equilibrium, P > MC and inevitably there is excess capacity
since the demand curve is downward sloping due to monopoly power of the firms.
Hence any market that is imperfectly competitive is characterised by allocative and
productive inefficiency.
The SCP Paradigm
The S – C- P paradigm was based on the following hypotheses:
i) Structure influences Conduct:
Lower concentration → more competitive the behavior of firms.
ii) Conduct influences Performance.
More competitive behavior → less market power (i.e., greater social efficiency).
iii) Structure influences Performance:
Lower concentration leads to lower market power. As number of firms increase (i.e.,
market concentration falls), market power declines (i.e., price gets closer to marginal
cost). ( i),( ii) and ( iii) imply that directly and indirectly, structure determines
performance .
STRUCTURE -- CONDUCT - PERFORMANCE

Empirically, when comparing industries, we observe that industries with lower

concentration have less of market power..

The basic tenet of the S-C-P paradigm is that the economic performance of an industry
is a function of the conduct of buyers and sellers which, in turn, is a function of the
industry's structure. Economic performance is measured in terms of welfare
maximization (resources employed where they yield the highest valued output). Conduct
refers to the activities of the industry's buyers and sellers. Sellers' activities include
installation and utilization of capacity, promotional and pricing policies, research and
development, and inter firm competition or cooperation. Industry structure (the
determinant of conduct) includes such variables as the number and size of buyers and
sellers, technology, the degree of product differentiation, the extent of vertical
integration, and the level of barriers to entry.

The relationship between industry structure and performance in this paradigm is derived
from the perfectly competitive market model. Because this is a static model, competition
is viewed in terms of the equilibrium condition. In the long run equilibrium, perfectly
competitive markets will result in the optimal (welfare maximizing) allocation of
resources in an economy. Under conditions of perfect competition , and in the absence
of public goods and externalities, economic welfare would be maximized when the
Pareto marginal conditions of welfare are fulfilled.
The three marginal conditions are :
Efficiency in Consumption :
MRS XY for A = MRS XY for B
Efficiency in Production :

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MRTS LK in the production of X = MRTS LK in Y
Efficiency in product mix :
MRPT XY = MRS XY

The essence of these conditions is that price should be equal to Marginal Cost ( P =
MC). This condition is satisfied only under perfect competition. In the long run under
perfect competition MR = MC = Ar ( P ) = LAC ( min ). The equality of price to MC
ensures allocative efficiency; while LAC being at minimum at equilibrium ensures
productive efficiency. All other allocations of resources are judged relative to the
allocation that is obtained under perfect. competition.

Under imperfect competition the AR curve and MR curve are downward sloping and
hence at equilibrium, when MR = MC, Price ( AR ) is greater than Marginal Cost ( AR
( P ) > MC ) This is sown in the following figure.

In the figure , due to the monopoly power of the imperfectly competitive firm, the firm’s
AR curve and MR curve are downward sloping. An imperfectly competitive firm
derives its monopoly power from restricted entry that puts a limit on the number of

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sellers and product differentiation. The firm’s equilibrium is at e, at which MC = MR.
However, corresponding to equilibrium, LAC is still falling and not at minimum point.

This shows that there is excess capacity to the extent of M Xc. This excess
capacity is termed as production inefficiency. The equilibrium price OP = RM is
greater than marginal cost, eM by eR. Thus there is allocative inefficiency also. Hence
it is inferred that under imperfect competition, firms enjoy monopoly power due to
features such as few selles, high entry barriers, differentiated products etc, which result
in inefficent outcomes.

As indicated earlier, an industry's structure includes several important elements. Some

of these elements, including buyer and/or seller concentration, product differentiation,
and the elasticity of demand for the product have obvious effects on structure. Another
element of structure is barriers to entry,. The concept of entry barriers in the S-C-P
paradigm was popularized by Bain who defined entry barriers as:

"the advantage of established sellers in an industry over potential entrant sellers, these
advantages being reflected in the extent to which established sellers can persistently
raise their prices above a competitive level without attracting new firms to enter the
industry" (Bain, 1956:3) Such barriers as: economies of scale, absolute cost advantages
(independent of scale), product differentiation, and capital requirements (Bain, 1956).

The S C P paradigm was popularised by Joe Bain ( !949, 1950, 1951). Bain argued that
barriers to entry and market concentration ( number and size distribution of firms), are
essential to the relationships between industry structure and performance. Barriers to
entry involve economies of scale, entry capital requirements s and product
differentiation that separate the established firms in the market from the potential
entrants. Firms operating in the market that is costly to enter will reap high profits
without attracting entry as compared to the market with low entry costs ( barriers).
Moreover high level of concentration makes leading firms aware of their market power
and inter dependence which intensifies the possibility of collusive pricing.

Entry barriers are essential to the link between industry structure and performance; in
the absence of entry barriers, above normal (monopoly) profits can not exist in long run
equilibrium. All such profits are eliminated by the entry of new firms as the industry
moves toward long run equilibrium. Because entry barriers must be present in an
industry for above normal profits to persist, structure determines potential performance.
Of course, appropriate conduct is necessary to realize the potential.

The S-C-P paradigm implies that the structural characteristics of an industry,

particularly the level of concentration of firms and the height of entry barriers, have a
significant influence on the ability of firms within an industry to price above the
competitive price. Consequently, these structural characteristics can be expected to
determine the performance potential of individual firms.
While cost advantages, economies of scale, product differentiation and initial high
capital requirements are strong barriers to entry , there are also proxies for entry barriers.

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Minimum efficient scale is a possible proxy that can be used to capture scale economies
in a market.

In the figure drawn, Xmes is the minimum efficient scale.Minimum efficient scale is the
size of the firm at which long run average cost curve is at its minimum and can be
measured as the average size of the assets of the firms that account for 50% of the
industry turnover. Capital assets ratio measured as assets to sales ratio is another proxy
for barrier. High industry capital intensity gives evidence of large sunk costs which
yields monopoly profits to incumbent firms thus deterring new firms from entering the
industry.
At firm level, market share and concentration are strong determinants of
profitability(performance ). Studies show a negative relationship between very high
market share and profitability ( indicator of performance), due to X inefficiency. X
inefficiency is defined as the ability of a firm to maximise the value of outputs from a
given set of inputs. It mainly occurs due to the misalignment of manager’s personal
growth with the goals of the owners. For example, manager’s objective such as empire
building, excessive remuneration and aversion to risk result in sub optimal use of
resources. In competitive markets with small profit margins, the disincentives for X
inefficiencies are strong since even a small decrease in cost will result in substantial
increase in profits. Inefficient firms can not survive competitive pressure. X inefficiency
is strongly related to market power since it is mostly observed in monopolies and
oligopolies. Concentration affects profitability via market share, leading to higher
profitability of firms in highly concentrated industries.

Under perfect competition and monopoly the performance can be predicted from
structural features of the market. The features of large number of buyers, homogeneous
products and free entry and exit conditions imply efficient outcome of P = MC and
Least cost production at equilibrium. Similarly, single seller, closed entry conditions,
and absence of good substitutes imply inefficient outcome. Structural features give
sufficient information to predict the performance. However it is not always possible to
predict the performance of the firm from structural characteristics. In the case of
Oligopoly, one can not predict the performance from structural features. The firms under
Oligopoly may react in a collusive or non collusive manner ; that is there may be

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collusive or non collusive price war or output war . Bypassing the conduct may lead to
misleading inferences.
In the traditional approach of S –C- P paradigm, structure is determined exogenously
which has been criticised by many. Market structure is determined by performance and
conduct. This rules out the linear relationship between structure, conduct and
performance. Instead the S C P relationship is circular as given below.

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3. STRUCTURE
Economic theory suggests that structural features of an industry influence the behaviour
of firms that is, the price, costs, and innovative activity of the firms. The market
structure gains importance from the hypothesis that the performance of a market is
influenced by the decisions taken by the firms in the market (conduct) and that these
decisions reflect the amount of autonomy firms have in terms of competitive
environment in which they make decisions. This environment is the market structure
and this hypothesis is the S- C P paradigm. The S-C-P paradigm identifies structure as
those elements over which the firm has little control , that is , which provide constraints
on its decisions. It suggests that structural features are the most important of
determinants of industrial performance. However it is important to recognise that
structure of individual industries is not fixed and exogenous but is changing and
endogenous. Some of the factors which influence structure are aspects of conduct and
performance of the firms in the industry. For example, firms may create barriers to entry
by engaging in advertising.

The various dimensions market structure are:

1. Seller concentration
2. Barriers to entry
3. Product differentiation
4. Vertical integration
5. Growth and elasticity of demand
6. Buyer concentration
7. Foreign competition
1. SELLER CONCENTRATION:
Seller or market concentration refers to the extent to which production in a
particular market is controlled by few firms. This is determined by the number and size
distribution of sellers. Buyer concentration is similarly defined by the number and size
distribution of buyers operating in a particular market. Seller concentration is a
significant dimension of market structure because of its influence on conduct and
performance of the firms.

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 The most widely used measure of concentration is the concentration ratio,
which measures the shares of the top ‘n’ firms and is expressed as :

CRi = ∑ Pi
P
where i is the market share of the ith firm. All the firms included in the measure are
treated equally. In other words, they are al given a weight of one. The choice of one is
arbitrary and in fact is dictated by information available in the census of production. The
concentration ratio obviously gives only very limited information on the number and
size distribution of the firm.
The concentration measure CR i is simply the sum of the market share of the ‘i’
largest firms in the market , where ‘i’ is a small number. Thus if i = 5, then CR5 = 90,
means that five largest firms in the market control 90% of the industry size. The five
firm concentration ratio CR5 is commonly used in UK while CR3 or CR4 are more
common in USA and other countries. Yet another measure of market concentration is
the Herfindahl index.
The Herfindahl index takes account of all the firms in an industry. It can be
defined as :
H = ∑ Pi2
Where Pi is the share of the ith firm and ‘n’ is the number of firms in the industry. The
maximum value of the index equals 1 and occurs where there is only one firm. The
minimum value, when firms are of equal size, depends on the number of firms and is
the reciprocal of ‘n’. Thus when n = 100, the minimum value of the index is 0.01.
The squaring of the index means that smaller firms contribute less than
proportionately to the value of the index. The various indices of concentration available
such as CR, and HI are all concerned with absolute inequality and the most fundamental
differences among them is with reference to the weight they assign to the market share
of the firms. Other indices have been divised emphasising relative inequality. Relative
inequality measures of concentration focus on the degree of size in equality rather than
on number of firms operating in a market. They are summary indices and their graphical
representation is called as the “Lorenze Curve”. A Lorenze curve relates the cumulative
percentage of market output or size ) to the cumulative percentage of firms starting
from the smallest
Seller concentration has important implications for the behaviour of the firms in
both differentiated and homogeneous product markets for several reasons:
• The cost of search and acquisition of information by consumers may depend
crucially on the number of firms operating in a market. When sellers are known to charge
different prices for the same (or similar) product, consumes would benefit by the
acquisition of relevant information, which can be obtained by visiting or contacting the
firms prior to purchasing. Getting such information however involves cost. While several
factors may contribute to search costs, the number of firms in the market is very
significant. The fewer the firms, the easier it is for the consumers to acquire information
and therefore the more difficult it is for sellers to maintain price differentials. Factors
affecting the cost of time, such as occupation, age, income level vary among markets
with the same number of firms. Similarly, factors which facilitate the flow of information
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such as the localisation of markets or improvements in information technology make
consumer search easier which tend to reduce price differentials.
• Seller concentration can influence oligopolistic interdependence and price- cost
margins. When a few firms produce a homogeneous product, which is sold at a uniform
price, if one seller were to increase his output, the market price and the revenues of all
other firms would fall, thus inducing them to consider an appropriate response. The effect
on market price and competitor’s revenue will depend on the number of firms and their
relative size. Thus a 20%expansion in output by a firm controlling, say, just 10% of the
market is unlikely to have a significant impact on prices and market share while the 20%
expansion by a firm controlling 50% of the market will have a significantly large impact
and trigger fierce competitive reactions. In short the extent of interdependence depends on
both the number and size distribution of the firms in the market.
• Concentration may considerably influence inter firm knowledge. Information
about rival’s behaviour regarding price policies, advertising budgets, expenditure on
research and development or product investment decision is not usually easily available.
As a rule the cost of search and collection of information increases with the number of
firms producing the same or a strongly similar product. This is particularly true when
firms are of equal size, when substantial differences in firm size exist, it may be only
necessary to consider the behaviour of the dominant firm.
As the number of firms declines, a firm’s own sales figure becomes a
good source of information about the rival’s behaviour. This is because, given the
general market conditions a loss in sales or market share might be due to a successful
change in the rival’s behaviour. Indeed the higher the concentration the smaller the
probability of random sales fluctuations and the easier it becomes to detect secret price
cuts. Thus a higher degree of concentration not only contributes to a strengthening of
oligopolistic inter dependence, it also facilitates co- operation by making easier, the
detection of cheating.
Higher the level of concentration in a market, the less competitively the firms
are likely to behave , with consequent effect on performance. Concentration also plays
an important role in merger and monopoly policy. For instance in U K a monopoly
situation is defined in law with reference to simply a market share criterion : a
monopoly exists if one firm accounts for 25% or more of the sales of a product. In the
USA also restrictions have been placed on both horizontal and vertical mergers through
reference to market concentration levels.
BARRIERS TO ENTRY :
An important aspect of market structure is the height of the entry barrier that new firms
have to face if they wish to enter an industry. Entry conditions determine the extent to
which existing firms can pursue monopoly behaviour without inducing a response from
potential competitors.
The theory of entry barrier originates from the work of Joe Bain. He suggested that
when entry into a market is possible , firms may choose to charge a price lower than the
full monopoly price in order to discourage or prevent entry so as to maximize their
profits in the long run.
Bain defined entry as the extent to which established firms can persistently raise their
price above competitive level without attracting new firms in to the industry. Barriers
are therefore anything that allows a high price to prevail in the long run. Bain defined

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 the height of the barrier or the condition of entry as the percentage mark up of maximum
entry forestalling price over the minimum average cost of the established firms, that is,

Or , in terms of competitive price ,

The barriers to entry refer to the cost advantages of the established firms over the
potential entrants or product differentiation which enhances consumer choice . Hence
barriers need not necessarily have adverse welfare effects.
Bain distinguishes four main barriers to entry.
 Product differentiation or preference barrier
 Absolute cost advantage of the established firm
 Economies of scale
 Large initial capital requirement.
Product differentiation barrier: The product differentiation barrier gives the firm a
degree of control on its price. It refers to the extent to which consumers perceive
products to be different. Product differentiation can have a significant influence on
consumer preference which in turn influences the shape and position of the firm’s
demand curve. This affects distribution of market shares and degree of market
concentration. Product differentiation creates brand loyalty to products for which firm
incurs heavy expenditure on R & D and advertisements. Newly entering firms will have
to spend heavily to break existing consumer preferences and brand loyalty. This will
reduce their profit and hence deter entry.
A second possible entry barrier is economies of scale. If the minimum efficient size of
the firm is large in relation to the size of the market, if there is substantial cost
disadvantage in operating at a sub optimal size, there will be a sizable obstacle to the
entry of new firm. When MES occurs at large output level, new entrant firm must be at a
large scale if the potential entrant is to achieve the same per unit cost as the existing
firm. But given the market size this increase in output will reduce market price. If price
falls below average cost (P< MC) the prospects for losses will discourage new entrants.
The strength of this barrier depends on the size of the MES in relation to market and on
the price elasticity of demand.
A third possible barrier exists in the form of absolute cost advantage that the existing
firms will have over entrants. This cost advantage to existing firms may arise from:
• Possession and control by established firms of exceptionally skilled management
team or other scarce resources.
• Possession of superior techniques, and know how, possibly protected by patents.

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• Control of supply of raw materials.
• Cost of capital may be low for existing firms.
• Production costs of established firms may be lower than that of entrants because
of vertical integration.
A fourth possible barrier to entry arises due to the existence of imperfect capital market
because the initial capital requirement of potential entrant may be heavy which may be
difficult to raise for the entrant. Besides these, institutional barriers like patent
legislation, which provides a firm exclusive rights to manufacture a specific product or
to use a specific process , can also discourage entry.
As a result of all these factors that strengthen barriers to entry, new firms may not
enter an industry easily, which makes the structure concentrated by new firms.
VERTICAL INTEGRATION: Vertical integration refers to a situation in which two
companies, who are not producing the same product but who are at different stages of
the same production process, come together. If paper maker A buys saw mill company
C, they are both in the same industry , but at different stages of production. This is
vertical integration - more specifically backward integration because the paper mill has
taken over the saw mill company which is in an earlier stage of production process.
There can also be forward vertical integration when a company chooses to integrate with
another company that is closer to the market. If paper maker A integrates with retailer D
it is forward integration.
Vertical integration confers market power on a firm over and above the level that the
firm’s sales in the market would suggest. If the integration had been brought about by
efficiency conditions, then the integrated firm would have competitive advantage over
the non integrated firms - thus allowing it to under cut its rivals or earn higher profits at
the same price. The advantage is higher if the integrated firm is larger than rivals.
Vertical integration will act as a barrier to entry. If one of the firms in the industry owns
a major input supply or a significant number of sales outlets, then it may become more
difficult for new firms to enter the market. The integrated firm refuse to supply to new
firms with the necessary inputs or may supply at unfavourable terms. Therefore the new
firm will have to enter with its own source of supply for which it will need more capital
and hence entry becomes more difficult.
DIVERSIFICATION: Diversification is similar to vertical integration – a diversified
firm has activities outside the market under consideration which will confer cost
advantages. Also a diversified firm will may be able to compete more fiercely in one of
its market than a specialist firm can, since any losses caused in any one market can be
made good by the profits in another market. This advantage of diversification acts as an
entry barrier and influences structure.
GROWTH AND ELASTICITY OF DEMAND: Market growth influences entry -
entry is much more attractive in growing markets than in markets which are stagnant
and declining. Elasticity of demand influences structure by determining the extent to
which firms can increase the price over competitive price. In a market with relatively
more inelastic demand price can be set at a higher level than in a market with elastic
demand. This will affect entry and market structure.
BUYER CONCENTRATION: Number and size of consumers influences the nature of
competition in a market. The firm will discriminate among buyers depending on
whether it is selling to many small customers or to a few large customers. Large buyers

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will be able to make contacts with sellers on terms which are more favourable to the
buyers than a small buyer would be able to secure. Large buyers will enjoy real and
pecuniary economies by virtue of their bargaining position. The simultaneous existence
of buyer concentration with seller concentration is known as “counter veiling power”.
FOREIGN COMPETITION: Competition from imports has become an increasingly
important aspect of market structure as trade liberalisation has lead to an expansion in
foreign trade in many industrial products. Competition form imports will make existing
firms more efficient , make them more competitive and influence the structure.
Competition from imports is to be considered like entry by new firms.
CONCLUSION:
Market structure is amore complex concept than is often recognised. The complexity
arises because structure is multi dimentional and not exogenous. The link between
structure conduct and performance is not unidirectional but inter dependent. Hence
structure is influenced by conduct of the firm and its performance as much as it
influences conduct and performance.

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4. CONCENTRATION

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Concentration is the most frequently used feature of the market structure , by market
analysts and policy makers who are involved in making policy regarding monopoly and
competition. A measure of the size of concentration is required to assess its influence on
firm’s behaviour and performance. There are several measures of concentration, some
attempting to measure absolute inequalities in concentration and others measure relative
inequalities in concentration. The two important measures of concentration are :
 Concentration Ratio Measure
 Herfindahl Index
THE CONCENTATION RATIO:
The most widely used measure of concentration is the concentration ratio, which
measures the shares of the top ‘n’ firms and is expressed as :
CRi = ∑ Pi
P
where i is the market share of the ith firm. All the firms included in the measure are
treated equally. In other words, they are al given a weight of one. The choice of one is
arbitrary and in fact is dictated by information available in the census of production. The
concentration ratio obviously gives only very limited information on the number and
size distribution of the firm.
The concentration measure CR i is simply the sum of the market share of the
‘i’ largest firms in the market , where ‘i’ is a small number. Thus if i = 5, then CR5 =
90, means that five largest firms in the market control 90% of the industry size. The five
firm concentration ratio CR5 is commonly used in UK while CR3 or CR4 are more
common in USA and other countries. The CR measure provides useful information
regarding the extent of market concentration at a particular point of time as well as its
trend over time. The CR measure is simple in construction and interpretation.

Limitations :
The limitation of CR measure is its focus on few large firms rather than on the whole
industry. Suppose for example CR4 = 80, this clearly indicates that the industry
described is an oligopoly in which four firms control 80% of the market. This is useful
information but we can not infer from this the likely behaviour of the industry. We have
no information about the relative size of the four leading firms, which can have an
important influence on the way in which firms respond to each other’s action.
Competitive behaviour would be different when the four firms are equal in size than
when one firm controls 40% and the other three share remaining 40 %.
The CR measure gives no information on the number or size distribution of the firms not
included in it. Market behaviour could be very different when two rather than 20 firms
account for the remaining market share not included in the CR4.
The following figure shows the concentration curves for two industries A and
B. The concentration ratio shows only one point on each of these curves. It gives no
information on the number and size distribution of the firms outside the ‘n’ group and
no information on the size distribution of the firms inside the ‘n’ group.
In the figure a four firm concentration ratio (CR4) shows industry A to be more
concentrated than industry B, but if the eight firm concentration is used for comparison,

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the ranking is reversed. From the figure we can also find out the minimum number of
firms that account for a specified share of the market. In A three firms account for 50%
of the market while in B the number is 4. However 8 firms in B account for 80% of the
market where as in A 10 firms account for 80% of the market.
If the concentration curves of the firms do not intersect, the ranking of industries is
unaffected by the choice of ‘n’. Care must be taken in comparing industries since the
outcome of comparison based on CR may depend on how many firms are included in it.
CR emphasizes on the share of the few largest firms ignoring the significance of the
relative shares and any influence that the smaller firms may have on industrial
behaviour.

HERFINDAHL INDEX
If firms hold unequal market shares, number of firms is not likely to capture
concentration.
Example:
Industry I : Two firms each with 50% market share Industry II: Three firms - one with
90% and the other two with 5 % market share Obviously, industry II is more
concentrated in terms of distribution of market shares, though it has more firms than
Industry I.
Herfindahl index of market concentration:
Suppose there are n firms in an industry. For each firm i, let Xi be the output produced
by firm i. Total output in the industry:
X = X1 + X2 + ... + Xn
The market share of each firm C is denoted by
Pi = Xi / X
Herfindahl index, H = P12 + P 22 + ...+ P n2
In the earlier example:
Industry I:
n = 2, P 1 = P 2 = 1 /2 ,

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 H = 1 /4 + 1/4 = 0.5
Industry II:
n = 3, P 1 = 0.9, P2 = P3 = 0.05,
H = (0.9)2 + (0.05) 2 + (0.05) 2 = 0.815
So, the Herfindahl index tells us that industry II is more concentrated.
The Herfindahl index takes account of all the firms in an industry. It can be defined
as :
H = ∑ Pi2
Where Pi is the share of the ith firm and ‘n’ is the number of firms in the industry. The
maximum value of the index equals 1 and occurs where there is only one firm. The
minimum value, when firms are of equal size, depends on the number of firms and is
the reciprocal of ‘n’. Thus when n = 100, the minimum value of the index is 0.01.
The squaring of the index means that smaller firms contribute less than
proportionately to the value of the index. A simple example will illustrate this and also
show how two industries will be ranked differently by alternative measures that use
different weighting system. In the following table, in the two industries C and D, the
two firm concentration ratio CR2 is 90%. The Herfindahl index is however equal to 0.42
for C and 0.66 for industry D.
The concentration ratio takes no account of the relative size of the two largest firms,
whereas the Herfindahl index does consider this Further more it is clear that the
contribution of the firm to the overall index diminishes rapidly with size. In C, for
instance, the smallest firm is 1/5 the size of the largest, but it contributes only 1/25 as
much to the index.

Industry C Industry D
Market Square of Market Square
Share Market share - Share of
( %) Pi 2 (% ) Market
Share -
Pi 2
50 0.25 80 0.64
40 0.16 10 0.01
10 0.01 10 0.01
100 0.42 100 0.66

The Herfindahl index satisfies all the desirable conditions for a concentration
index. It takes in to account both the number of firms and size distribution of the firms
in the industry. Squaring of market shares implies that smaller a firm, smaller is its
contribution to the index.

LORENZ CURVE - RELATIVE MEASURE OF CONCENTRATION

The various indices of concentration available such as CR, and HI are

all concerned with absolute inequality and the most fundamental differences among

14
them is with reference to the weight they assign to the market share of the firms. Other
indices have been divised emphasising relative inequality. Relative inequality measures
of concentration focus on the degree of size in equality rather than on number of firms
operating in a market.
They are summary indices and their graphical representation is called as the
“Lorenze Curve”. A Lorenze curve relates the cumulative percentage of market output
( or size ) to the cumulative percentage of firms starting from the smallest. In the
following figure a hypothetical Lorenze curve is drawn. In the figure drawn, the Lorenze
curve lies below the diagonal line and is concave from below. Since equality here all
the firms in the market have the same size, so that 10% of the firms account for 10% of
the market size, 20% of the firms account for 20% of the market and so on, the diagonal
line represents absolute equality. In a market of equally sized firms the Lorenze curve
coincides with the diagonal line. Otherwise it is below it and further away from the
diagonal it is, higher the extent of inequality in the market it describes. Graphically the
larger the area between the two curves
( the striped area in the figure), the more significant will be the size of inequality. The
shaded area is called area of inequality, An index of inequality commonly used is the
Gini Coefficient. This measures the area of inequality as a % of the total area below the
diagonal of the triangle OAB.

Area of inequality

Gini coefficient= Area below the diagonal line

An obvious weakness of the Lorenze curve is that it ignores numbers altogether. An

industry of four equally sized firms would have the same Lorenze curve as that
consisting of 40 equally sized firms.

15
 Desirable properties of a concentration measure
The desirable properties of concentration measure are :
 The measure used must yield an unambiguous ranking of industries. A
concentration curve that lies entirely above another represents a higher level of
concentration.
 The measure should be independent of the size of an industry but be a function
of the combined market share of firms.
 Concentration should increase if the market share of any firm is increased. If a
large firm wins a customer from a small firm, concentration increases; ie, the principle f
transfer must hold.
 The concentration measure should be a decreasing function of the number of
firms.
 The limits of a concentration measure should be between zero and one.
 Mergers increase concentration.
 The entry of a new firm below some significant size reduces concentration

DETERMINANTS OF CONCENTRATION
The various determinants of concentration are :

 Economies of scale
 Entry barriers
 Mergers
 Government policy
 Technological change
 Vertical integration
 Market growth
 Advertising

16
Economies of scale : Economies of scale is a very crucial determinant of concentration.
A firm enjoys both plant economies of scale as well as economies of size arising from
multi plant operations. Some of these may be real economies while there are also
pecuniary economies. On the production side the firm enjoys cost advantages arising
from production technological economies such as specialization and division of labour.
Besides these, the firm enjoys firm specific economies related to major functions of the
firm. Such economies are managerial economies, economies of bulk ordering,
economies of R& D, and financial economies. The various economies reduce the cost
per unit of the firm and is responsible for the downward slope of the firm’s average cost
curve. However the firm also suffers diseconomies of scale arising from increased cost
of materials and transport and distribution and diseconomies from deteriorating labour
relations. But these diseconomies are specific to the plant and will not affect the growth
of the firm since the firm can grow by operating a large number of plants, all of
optimum size. At the firm level the most prominent diseconomies are the diseconomies
of management. The diseconomies will increase the cost per unit of the product for the
firm and if they are stronger than economies, the average cost curve will slope upwards.
The relative strength of the economies and diseconomies are responsible for the shape of
the firm’s average cost curve in the long run . In the following figure economies are
shown by the downward sloping portion of the LRAC, over the output range, OM. At
the output level OM, Economies and diseconomies cancel out each other and Lac
becomes constant thereafter. LRAC beyond OM is horizontal and parallel to X axis. OM
is the minimum efficient output or scale (MES). MES is the minimum (smallest ) size of
the firm that can exploit all economies of scale and thus minimize average cost in the
long run.

The economies of scale and MES raise two important questions:

1.How large is OM, in relation to size of the market? If it is half the market size , the
market can spore only two firms of optimum size; if it is I/50 of market size, the market
is large enough to support 50 firms of optimum size and so on. In the extreme case
where MES represents 100% or more of market size the industry is called a natural
monopoly. The higher the MES in relation to market size, higher would be
concentration, ceteris paribus.

17
 2.How steep is the cost curve to the left of MES? The answer to this tells us the cost the
disadvantages suffered by firms of sub optimal size, i.e, it tells us how important
economies of scale are in a quantitative sense.
Given the ‘L’ shaped LRAC, firms at or above OM output level are equally efficient.
Therefore it is not appropriate to say that concentration will be at the level consistent
with ‘n’ firms of optimal size, where n is equal to market size / MES. It is more realistic
to assume that n / MES defines the upper limit rather than the number of firms in the
industry. Another relevant issue is the slope of the average cost curve to the left of OM –
steeper the curve indicates greater cost disadvantage from being sub optimal in size and
makes it difficult for smaller firms to survive.
Empirical research indicated that economies of scale are an important determinant of
concentration in the following sense:
 The higher is MES in relation to market size, the higher concentration tends to
be.
 Increased concentration was due to technological change which generated
economies of scale (chemical, vehicle and metal industries)
 Technological economies have not increased concentration in plastics and
electronics.
 The relationship between economies of scale and concentration may be high in a
relatively small closed economy and may be low in an economy with a large domestic
market or one in which international trade is important.Further the relationship
between economies of scale and concentration is an equilibrium relationship which
can not be expected to hold in every industry all the time.
ENTRY BARRIERS: Entry conditions determine the extent to which existing firms
can pursue monopoly behaviour with out inducing a response from potential
competitors. Since entry barriers slow down or prevent new entry, they may, ceteris
paribus, contribute to a more concentrated market structure. When incumbent firms are
protected from potential competition, they are more likely to restrict production in order
to charge a price higher than the competitive price ( P > Pc ). As a result the market size
declines which will increase concentration. Further more large established firms may be
able to expand output at a constant cost increasing their market share at the expense of
smaller firms which enhances the existing size inequalities.
MERGERS: Merger activity can have significant and positive influence on
concentration. It is believed that the flurry of merger activity that followed second world
war is one of the most important contributory factor to increased aggregate
concentration in U.K
GOVERNMENT POLICY: This can take many forms. The granting of patent rights
on inventions will increase concentration in some industries. As a major buyer of goods
and services , governments may show a bias in favour of large firms. Government’s
attitude towards monopoly
merger policy will determine concentration.
Technological change: Technological change has been recognized as a major influence
on market structure. Many economists like Karl Marx, and John Kenneth Galbraith have
argued that technological change tends to increase plant size and the level of industrial
concentration. This is because the term technological change usually refers to
improvements in production process which enhance economies of scale, increase

18
Minimum Efficient Size ( MES) and the degree of concentration. Technological change
can also lead to introduction of new products and major product innovations are almost
by definition characterized by a uniqueness which is likely to give monopoly power to
the producer.
Vertical Integration can influence both the nature and strength of oligopolistic
interdependence and the ease or difficulty with which new firms can enter the market .
Thus vertical integration can be a strong influence on concentration ., through its impact
on barriers to entry.
Market Growth: Market size has always been recognised as a factor of concentration.
Market size in relation to MES can influence the number of firms operating in the
market. For a given MES, larger the market, larger the number of firms can be and
smaller the market, fewer the firms. Therefore concentration will be higher. It is
observed that slow growing markets tend to be monopolised easily and in general an
inverse relationship exists between concentration and market growth.
Advertisement is an important factor that increases market concentration, particularly
in consumption goods industries. Heavy advertising may be possible only by large
established firm which enjoys economies of advertising. This increases concentration by
creating strong consumer preferences for the product of few large firms which advertise
heavily.
************
CASE STUDIES: MARKET FOR MOSQUITO
REPELLER
Tortoise losing the repellent race
In real life, slow and steady does not always win the race. Tortoise, the over 30-year old
mosquito repellent brand is losing out. A look at the AC Nielsen data for the household
insecticide market shows that Tortoise coil, the market leader in the ‘90s, has witnessed
a dramatic fall in its market share. From a share of 32.9 per cent in 1998, the Tortoise
brand has slid to 2.3 per cent in 2003. A relatively new player, Maxo coils from the
stable of Jyothy Laboratories, has reached the number two slot after Reckitt Benckiser’s
Mortein . From a meagre share of 0.3 per cent in 2000, Maxo’s share has been on an
upward curve, topping 22 per cent in 2003. Of the Rs 835.65 crore household insecticide
market, coils form 52 per cent of the pie of around Rs 439.34 crore. The coil category is
spilt into two — green and red coils. Preferences are increasingly shifting towards red
coils as these last longer. Godrej Sara Lee’s flagship brand Good Knight and regional
brand Jet have recorded a share of 20.2 and 14.1 per cent, respectively, in 2003. Both
the brands have maintained their shares of 2002. Refills, the second largest category in
the household insecticide market, has a share of 19.7 per cent, accounting for about Rs
164.4 crore. All Out refills from Karamchand Industries has eaten into GoodKnight’s
market share. To retain its position as market leader with a share of 63.3 per cent.
GoodKnight’s share has slipped from 35.4 per cent in 2002 to 29.6 per cent in 2003.
Mats form 10.9 per cent — about Rs 91.28 crore of the household insecticide market —
while aerosols have a share of 6.6 per cent (about Rs 55.16 crore). In the mats category,
Mortein’s share has slid to 6.4 per cent in 2003 from 7.4 per cent in 2002, while
GoodKnight maintains its leadership position with a share of 58.8 per cent. In the
aerosol category, Hit is the market leader with a share of 64.5 per cent in 2003.

19
 TYRE INDUSTRY
Major players in the tyre industry.
MRF
MRF Ltd has drawn up extensive plans to guard its position as the leading tyre
company in the country. R&D spend rose from Rs 7.92 crore in 1994-95 to Rs 11.45
crore in 1995-96. The company has a 28 per cent share of the overall market. It has a
presence in practically every segment from tractors to animal-drawn vehicles, and from
cross-plies to radial tyres. Around 60 per cent of its turnover comes from the truck and
bus segment, which accounts for 75 per cent of the total tyre market. A leading original
equipment manufacturer (OEM), it is the exclusive supplier to Ford, General Motors and
Fiat Uno.
MRLs manufacturing capacity of 91 lakh tyres per annum is spread over facilities
located at Tiruvattiyur and Arkonam in Tamil Nadu, Kottayam in Kerala, Medak in
Andhra Pradesh and at Goa. Now, a greenfield Rs 200 crore manufacturing unit is being
set up at Pondicherry. This is the first phase of the expansion plan. The 1.5 million
capacity plant will exclusively manufacture radial tyres for the truck and car segment. It
is expected to commence operations by early 1998.
This multi-locational capability has been MRF's greatest competitive strength. It not
only ensures optimum production levels but also enables it to quickly service different
markets.
Apollo tyres
A fast-growing Apollo Tyres is giving tyre leader MRF a run for its money. In fact, the
company emerged as the market leader in the all-important truck and bus segment with a
market share of over 23 per cent in 1995-96. Its share in 1994-95 was 18 per cent.
Turnover in 1996-97 crossed the Rs 1,400 crore mark from Rs 1,237 crore in 1995-96.
Five years ago, its turnover was Rs 190 crore. Profits fell from Rs 33 crore in 1991-92 to
Rs 16 crore in 1993-94 but rose again to Rs 33 crore in 1995-96. Nevertheless, Apollo
has been rated as the fastest-growing tyre company in the country, and the seventh
fastest in the world by the European Rubber Journal. The company is the leasty cost
producer
The countrywide network of more than 1,100 exclusive Apollo tyre dealers, 2,500 main
dealers and 100 marketing offices is primarily responsible for the growth. So in the light
commercial vehicles (LCV) and tractor segments, market share increased from seven
per cent in 1995-96 to 18 per cent in 1996-97.
Apollo has tied up with Continental AG of Germany, the fourth-largest tyre company in
the world, to make car radials. Also, it enhanced capacity by acquiring Kerala-based
Premier Tyres with its six lakh tyres per annum plant in April 1995. Apart from
increasing its presence in the domestic market, the company aims to become a global
player. So exports are a thrust area. A pollo was the largest tyre exporter in 1995-96
with earnings of Rs 170 crore, up from Rs 84 crore in 1994-95.
Ceat Ltd
The Rs 4,769 crore group CEAT aims to touch the Rs 5,000 crore mark by 2001. As
per its Vision 2001 strategy, it aims to be a market leader with a 29 per cent share. Its
current market share is 17 per cent. For now, however, it is grappling with falling
profits. For the 18-month period ending March 1996, net profits fell to Rs 17.72 crore
from Rs 26.45 crore in September 1994.

20
The thrust now is on the truck and bus segment, where Ceat has a 13 per cent market
share. Ceat is also looking at joint-ventures to spur growth. Last year, it entered a 50:50
joint venture with Goodyear Tire Co, USA, to form South Asia Tyre Ltd (SATL). Ceats
Aurangabad plant was transferred to SATL. Devoted to radial tyres for cars and jeeps, it
has a capacity of 7.20 lakh tyres per annum. The production is equally shared by the
partners. Ceat's own capacity of 50.7 lakh tyres a year is spread over its Bhandup and
Nashik units.
The tie-up also enables Ceat to access the latest technology.
Ceat has also been focusing on brand-building. Marketing and advertisement costs went
up from Rs 18 crore in 1994 to Rs 51 crore in 1996.
Exports account for 12 per cent of the turnover. Ceat exports to over 30 countries. It is
among the biggest cross-ply exporters to USA. In 1993, it promoted a joint venture in
Sri Lanka with Associated Motorways called Associated Ceat Pvt Ltd. This has
cornered 40 per cent of that market. Now Ceat is studying the Vietnam market.
J K Industries
Mercedes Benz, Cielo, Maruti Zen, Tata Estate, Tata Sierra, the Armada. The list goes on.
A leading original equipment manufacturer with a significant present in the passenger cars
segment, JK Tyres, a division of JK Industries, has a 32 per cent share of the total radial
market.
JK Tyres accounts for almost 90 per cent of the over Rs 1,000 crore JK Industries group.
It reported a net profit of Rs 25.58 crore in 1995-96 on a turnover of Rs 1,002 crore. The
turnover witnessed a 26 per cent increase over the Rs 797 crore turnover in 1994-95. It
went up in spite of the four-month labour unrest at its Jakayram plant in Rajasthan. OE
sales account for 15 per cent of the turnover.
But the attention is currently focused on its takeover of the joint-sector Vikrant Tyres. It
will spend Rs 6.84 to acquire 90 lakh fresh shares of Vikrant Tyres at Rs 76 each. It is also
acquiring 20 per cent of the expanded equity base through open market purchases. The
acquisition will enable it to tap the 1.03 lakh tyres per annum capacity of Vikrant Tyres.
Besides, JK plans to invest Rs 260 crore over the next few years in capacity expansion and
modernisation at Vikrant Tyres. JK also has plans to augement its own capacity to 30 lakh
tyres per annum in stages. So far, additional capacity of 1.65 lakh tyres per annum was
added in 1995 at a cost of Rs 400 crore. The current capacity is 21.26 lakh tyres per
annum.
Most of the expanded capacity will be used for exports. JK was the first Indian company
to export radials to Europe. Exports to over 30 countries account for nearly 17 per cent of
the turnover. In fact, the exports models of the Maruti 1000, Esteem, Zen, Tata Sierra,
Tata Estate and Armada are fitted with JK steel radials.
Dunlop India Ltd
With factories in Sahagunj in West Bengal and Ambattur in Tamil Nadu, Dunlop has one
of the widest range in tyres and industrial rubber products. This includes radial tyres, aero
tyres, off the road (OTR) tyres, steel-cord beltings and heavy duty hoses.
To combat rising raw materials costs and dipping capacity utilisation, the management
tried to streamline operations and realign the product mix. As part of a cost reduction
exercise, the company consciously pulled out of high-volume segments like truck tyres,
focusing instead on the industrial rubber segment, value-added aero tyres and the low-
volume but high margin radial car tyres.

21
The company has also been emphasising on sectors that allow a quicker turnaround of
working capital like original equipment and exports. Dunlop's average exports are around
Rs 40 crore per annum.
Turnover for the 15-month period ending March 1996 was Rs 824.03 crore with a net
profit of Rs 39 crore. It recorded remarkable results for the first half of 1996 with a sales
turnover of Rs 336.37. This was a 22 per cent growth over the previous period. Also, net
profits in September 1996 grew by a phenomenal 206 per cent to Rs 18.52 crore. It is
believed that the lending banks have demanded an auditors' certified copy challenging the
half-yearly performance in spite of the credit squeeze and downturn in the economy. And
with a working capital shortage still bogging it down, it seems the company's troubles are
far from over.

Goodyear India
With a low installed capacity of 1.17 million tyres, Goodyear's turnover growth has been
restricted in this high-volumes business. Its turnover in 1995 was Rs 495.79 crore with
profits falling to Rs 5.09 crore from Rs 5.69 crore in 1994.
It hopes to increase its nine per cent share in the car segment to 14 per cent in three years.
In the truck and bus segment, Goodyear has a seven per cent market share, while in
tractors, its share is 9.1 per cent.
At Rs 268 crore, Goodyear recorded a 22 per cent growth in turnover in the first half of
1996. Profits at Rs 4.15 crore too rose by 300 per cent during the same period. The
strategy now is to avail of the latest technology offered by its parent. Ever since
liberalisation, the company’s strategy has been to add capacity in areas where our
products will command a sizeable market share in future. These are mainly radial tyres,
particularly in the passenger and LCV categories.
Srichakra Tyres
Continuous expansion and upgradation has been the mantra at Srichakra Tyres, part of the
Rs 1,480 crore TVS group. The company is a leading player in the two- and three-wheeler
tyre segment with a 28.56 per cent market share. And it is determined to further
consolidate this. The future focus will also be on this segment, especially the replacement
market, as well as on exports.
From a start-up capacity of four lakh tyres per annum in 1984, Srichakra now has a 33
lakh tyres per annum capacity. Plans are afoot at the sole manufacturing unit in
Vellaripatti village in Madurai district of Tamil Nadu to further augment this to 40 lakh
tyres per annum.
Turnover in 1995-96 grew by 36 per cent from Rs 76.12 crore the previous year to Rs
103.66 crore. Profit after tax rose by 90 per cent from Rs 193.34 lakh in 1994-95 to Rs
366.77 lakh in 1995-96. Around 65 per cent of the turnover comes from the original
equipment (OE) segment. It is OE supplier to Bajaj Auto, Hero Honda, Escorts, Yamaha
and, group company TVS Suzuki, which accounts for nine per cent of OE sales.
Although Srichakra has focused on its core business, there have been some
diversifications. Last year, it entered a 50:50 joint-venture with Reichle De Massari AG of
Switzerland to manufacture and market electronic connectors. Then there is a 49:51 joint-
venture with Dupont, entered in 1992, to manufacture and market stefflon coating and
tymex bristles, and a 50:50 joint-venture with Cherry Corporation, USA, since 1993 to

22
manufacture electronic switches.Srichakra also manufactures a range of industrial tyres
and tubes, primarily for exports to USA and Europe. Exports turnover has grown nearly
ten-fold from a mere Rs 1.24 lakh in 1991-92 to Rs 12.74 in 1995-96. Srichakra has also
invested Rs 3.15 crore in setting up non-conventional energy sources for captive
consumption. This investment is expected to be a hedge against any escalation in power
and fuel costs.
Falcon Tyres
Dunlop's subsidiary, Falcon Tyres, based at Mysore, Karnataka, has seen a remarkable
turnaround in recent years. A prominent player in the two-wheeler tyres segment, it is now
diversifying into passenger cars as well. Iit was only in 1995 that the company wiped out
its entire carried-forward losses, thereby coming out of the BIFR dragnet. It actually
registered increases on several fronts that year. Turnover at Rs 68 crore rose by 37 per
cent while the net profit at Rs 1.03 crore witnessed a 148 per cent increase. In 1996, the
company recorded a turnover of Rs 83.18 crore with a net profit of over Rs 6 crore, which
was an increase of 55 per cent .
Falcon has been both increasing capacity and launching new products in the last few
years. It introduced 15 new and improved tyre designs, including those for the latest
models of Bajaj Auto, TVS Suzuki, Escorts, Yamaha and Kinetic Honda.

5.CONDUCT – PRICING

LIMIT PRICING
Limit Price is the price charged by the firms under imperfect competition,
particularly by firms with high monopoly power, such as oligopoly, to entry of new firms.
The price is higher that competitive price but is lower than profit maximizing price. The
firms are willing forego some profits by charging a lower price as long as the potential
entrants find entry non attractive. The extent to which price is lower than the profit
maximizing level depends on the strength of the barriers to entry and the cost of
production of the entrants. The various entry barriers give cost advantages to the
incumbent ( established) firms. Hence the cost of the entrant is higher than the cost of the
incumbent firms. Therefore the incumbent firms charge a price that is lower than their
profit maximizing price level but higher than the competitive price. ie., the lower limit for
the price is the competitive price level. The price will not cover the cost of production for
the entrants. Thus entry is prevented.
The following figure shows limit price.

23
In the figure the profit maximising price and output is PM and XM. The competitive price
and output is PC and XC. It is assumed that the industry is subject to constant cost
conditions . Hence AC= MC in the figure. Below the monopoly price PM, demand is
uncertain, due to possible entry. Hence to prevent entry, the incumbent firms charge a
price of P L , and sell X L . The price P L is the limit price. It prevents entry of new firms in
the industry. By charging P L, firms are able to forestall entry and retain their market share
which would reduce if entry was possible. The PL will be less than the cost of the new
potential entrants who don’t find entry in to the industry attractive any more. The
incumbent firms will reduce price and prevent entry as long as the entry preventing price
is not less than competitive price. That is the lower limit of limit price is PC. Hence the
limit price PL will be less than PM but greater than PC. ie..,

( PM < PL > PC ) . Limit price PL is defined as :

PL = PC ( 1+ E ) , where E is the condition of entry. Condition of Entry E is expressed

as:

The extent of deviation of from competitive price depends on the strength of the barriers
to entry.When entry barriers such as product differentiation and advertisements are high ,
limit price PL will be high and closer to profit maximising price PM and entry barriers are
weak, PL will be low and closer to competitive price. Thus strong barriers result in high
limit price and weak barriers result in low limit price.

The limit price is based on the differences in costs between the incumbent firm (already
inside the market) and the potential entrant. If the existing firms have managed to exploit
some of the economies of scale that are available to firms in a particular industry, they

24
 have developed a cost advantage over potential entrants. They might use this advantage to
cut prices if and when new suppliers enter the market, moving away from short run profit
maximisation objectives - but designed to inflict losses on new firms and protect their
market position in the long run.

Bain considered entry as the establishment of a new firm which builds or introduces new
productive capacity that was not used for production in the industry prior to the
establishment of the new firm. Thus for Bain entry is setting up of a new firm. Bain
excluded from his entry concept the following:

• Take over of an existing firm by some other firm.

• The expansion of capacity by an established firm.
• Cross entry., entry by a firm that is already established in another industry.

Barriers to entry are those factors that deter entry by new firms in to the industry.
Barriers to entry allow incumbent firms to earn positive economic profits, while making it
unprofitable for newcomers to enter in to the industry. Barriers to entry are designed to
block potential entrants from entering a market profitably. They seek to protect the
monopoly power of existing (incumbent) firms in an industry and therefore maintain
supernormal (monopoly) profits in the long run. Barriers to entry have the effect of
making a market less contestable. If the barriers to entry are stronger the difference
between PL and PC will be high. That is with strong barriers PL is closer to PM and with
weak barriers PL is closer to PC.

Barriers to entry may be structural or strategic. Structural entry barriers result when the
incumbent has natural cost or marketing advantages or benefits from favourable
regulations. Strategic entry barriers result when the incumbent aggressively prevents
entry. Such entry deterring strategies include limit pricing, predatory pricing and capacity
expansion.

Barriers to entry into markets for firms include;

• Investment, especially in industries with economies of scale and/or natural

monopolies.
• Government regulations may make entry more difficult or impossible. In the
extreme case, a government may make competition illegal and establish a statutory
monopoly. Requirements for licenses and permits, for example, may raise the investment
needed to enter a market.
• Predatory pricing - the practice of a dominant firm selling at a loss to make
competition more difficult for new firms who cannot suffer such losses, as a large dominant
firm with large lines of credit or cash reserves can.
• Patents give a firm the sole legal right to produce a product for a given period of
time. Patents are intended to encourage invention and technological progress by offering
this financial incentive.
• Economy of scale - Large, experienced firms can generally produce goods at lower
costs than small, inexperienced firms.

25
• Customer loyalty - large incumbent firms may have existing customers loyal to
established products. The presence of established strong Brands within a market can be a
barrier to entry in this case.
• Advertising - incumbent firms can seek to make it difficult for new competitors by
spending heavily on advertising that new firms would find more difficult to afford.
• Research and development & Product differentiation - some products, such as
microprocessors, require a massive upfront investment in technology which will deter
potential entrants.
• Sunk costs - sunk costs cannot be recovered if a firm decides to leave a market; they
therefore increase the risk and deter entry.
• Network effect - when a good or service has a value that depends on the number of
existing customers, then competing players may have difficulties to enter a market where a
strong player has already captured a significant user base.
• Restrictive practices, such as air transport agreements that make it difficult for new
airlines to obtain landing slots at some airports.
• Distributor agreements, exclusive agreements with key distributors or retailers can
make it difficult for other manufacturers to enter the industry.
• Supplier agreements, exclusive agreements with key links in the supply chain can
make it difficult for other manufacturers to enter the industry.
• Inelastic demand, a strategy of selling at a lower price in order to penetrate markets
is ineffective with price-insensitive consumers.

Porter classifies the markets into four general cases:

• High barrier to entry and high exit barrier - Examples: Telecommunications, Energy
• High barrier to entry and low exit barrier - Examples: Consulting, Education
• Low Barrier to entry and high exit barrier - Examples: Hotels, Siderurgy
• Low barrier to entry and low exit barrier - Examples: Retail, E-commerce

Those markets with high entry barriers have few players and thus high profit margins.
Those markets with low entry barriers have lots of players and thus low profit margins.
Those markets with high exit barriers are unstable and not self-regulated, so the profit
margins fluctuate very much along time. Those markets with a low exit barrier are stable
and self-regulated, so the profit margins do not fluctuate along time.

The higher the barriers to entry and exit the more prone a market tend to be a natural
monopoly. The reverse is also true. The lower the barriers the more likely to become a
perfect competition

Theoretically Bain has classified barriers in to four categories:

• Absolute cost advantage barrier

• Economies of scale barrier
• Product Differentiation Barrier
• High initial capital requirement barrier.

26
 Absolute Cost Advantage Barrier arise from the following situatios:
1. skilled, expert management personnel not easily available to the new firms.
2. control of supply of key raw material by established firms which makes these
available to new firms only at a very high price or compel them to substitute inferior raw
material.
3. Patents and superior techniques available only to the established firms.
4. lower price of raw material to established firms due to exclusive arrangement with
suppliers or because of bulk buying.
5. lower cost of capital for established firms.
Product Differentiation barrier :: Differentiated products make entry difficult for new
firms. Product differentiation gives monopoly power to the firm and hence the firm is
able to set a price that is closer to profit maximisation price. Product differentiation
creates a brand loyalty among buyers for the firm’s product and thus acts as a strong
barrier to entry. The entrant is at a disadvantage because he has to make his products
known and attract some of the customary buyers of the established firms. To overcome
this obstacle , either the new firm has to offer tits product a substantially low price than
the established firms, or do heavier advertising or both. Such activities lead to higher costs
for the new firms. Product differentiation strengthens barriers. If product differentiation is
mild, then the barrier is weak and the firm will be forced to keep the price closer to
competitive price. Strong product differentiation on the other hand will permit a price
closer to monopoly power.

If price increases above PL , new firms enter and the demand curve of the entrant is d2.
This will decrease the market share of the established firms. But if the established firms
differentiates its product, raising the price above PL will not attract entry and the entrants
demand curve will remain to be d1.
Barriers form Initial Capital Requirement: Capital markets are almost inaccessible to
new firms which has not established its reputation and banks are reluctant to finance new
business. Hence new firms face high interest rates and thus new firms have a absolute
cost disadvantage over established firms.

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Economies of scale Barrier: Economies of scale may be real or pecuniary. Real
economies are those which reduce the input of factors per unit of output. Pecuniary factors
are those which result from paying a lower price for the inputs purchased by the firm. Real
economies are technical, managerial and labour economies while pecuniary economies
arise from bulk buying at lower prices, lower transport cost etc. Established firms enjoy
these economies extensively which reduces their production cost.
As a result of these barriers the LAC of the established firms is always below the LAC of
the entrant as shown below:

PREDATORY PRICING

Predatory pricing may be broadly defined as “pricing low with the intention of driving
rivals out of a market or preventing new firms from entering. This activity can be harmful
to new firms wanting to enter a new market. For consumers, predatory pricing is good in
the short-run, but may be bad in the long-run if a firm which has used predatory pricing to
establish a monopoly position then raises its prices to monopoly levels. The best example
of predatory pricing is Microsoft's practice of giving away its Internet Explorer software
during its browser war with Netscape.

Predatory pricing is one of the oldest big business conspiracy theories. It was
popularized in the late 19th century by journalists such as Ida Tarbell, who in History of
the Standard Oil Company severely criticised John D. Rockefeller because Standard Oil's
low prices had driven her brother's employer, the Pure Oil Company, from the petroleum-
refining business.(1) "Cutting to Kill" was the title of the chapter in which Tarbell
condemned Standard Oil's allegedly predatory price cutting.

The predatory pricing argument is very simple. The predatory firm first lowers its price
until it is below the average cost of its competitors. The competitors must then lower their
prices below average cost, thereby losing money on each unit sold. If they fail to cut their
prices, they will lose virtually all of their market share; if they do cut their prices, they will
eventually go bankrupt. After the competition has been forced out of the market, the
predatory firm raises its price, compensating itself for the money it lost while it was
engaged in predatory pricing, and earns monopoly profits forever after.

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 The classic article on predatory pricing was written by economist John McGee in
1958.(4) McGee examined the famous 1911 Standard Oil antitrust decision that required
John D. Rockefeller to divest his company. Although at that time popular folklore held
that Rockefeller had "monopolized" the oil refinery business by predatory pricing, McGee
showed that Standard Oil did not engage in predatory pricing; it would have been
irrational to have done so. McGee was the first economist to think through the logic of
predatory pricing. He concluded that not only would it have been foolish for Standard Oil
to have engaged in predatory pricing; it would also be irrational for any business to
attempt to monopolize a market in that way.

• In the first place, such practices are very costly for the large firm, which is always
assumed to be the predator. If price is set below average cost, the largest firm will incur the
largest losses by virtue of having the largest volume of sales.
• Second, there is great uncertainty about how long a price war would last. The
prospect of incurring losses indefinitely in the hope of someday being able to charge
monopolistic prices will give any business person pause. A price war is an extremely risky
venture.
• Third, there is nothing stopping the competitor (or "prey") from temporarily
shutting down and waiting for the price to return to profitable levels. If that strategy is
employed, price competition will render the predatory pricing strategy unprofitable--all loss
and no compensatory benefit. Alternatively, even if the preyed-upon firms went bankrupt,
other firms could purchase their facilities and compete with the alleged predator. Such
competition is virtually guaranteed if the predator is charging monopolistic prices and
earning above-normal profits.
• Fourth, there is the danger that the price war will spread to surrounding markets
and cause the alleged predator to incur losses in those markets as well
• Fifth, the theory of predatory pricing assumes the prior existence of a monopoly
profits that the predator can use to subsidize its practice of pricing below average cost. But
how does that monopoly profits come into being if the firm has not yet become a
monopoly?
• Sixth, the opportunity cost of the funds allegedly used to try to bankrupt rivals
must be taken into account. For predatory pricing to seem rational, the rate of return on
predation must be higher than the market rate of interest; in fact, it must be higher than the
expected rate of return on any other investment the predator might make, including
"investment" in lobbying for protectionism, monopoly franchises, and the like. Predation is
unlikely, given the great uncertainties about whether it would have any positive return at all.
• Eighth, the predator can recoup its losses only if consumers cooperate. That is, the
strategy will fail if consumers are able to stock up during the low-price predation period. If
they do so, there can never be a post-predation recoupment period for the predator. And if
the predator responds by limiting quantity, its rivals can step in and make up the difference
by supplying additional quantities at a higher price. "A predator that puts a cap on sales thus
[preys] against itself."
• Ninth, is another problem related to the predator's ability to recoup his losses: the
"victims" have strong incentives to ride out the price war, as discussed above, because of
the lure of monopoly profits when the war is over. The capital markets, moreover, should be
willing to finance the victims because they, after all, are not incurring as large a loss as is

29
the predator. There is a risk, of course, in providing capital to the victims, but that risk can
be attenuated by charging an appropriate interest rate. Thus, lenders may have a financial
incentive to aid the prey. There is also the possibility that larger firms, which have their own
"deep pockets," will acquire the victims if it seems profitable to do so.
• Even if the victim goes bankrupt, the predator is by no means guaranteed a
monopoly. The bankrupt firm's resources do not simply disappear; they may be acquired by
another firm (possibly at fire-sale prices). Because the acquiring firm has lower fixed costs
than the predator, it may be able to underprice the predator. The victim could also approach
its customers and arrange for long-term contracts at a price above the predatory price. The
customers would be willing to enter into such contracts if they realized that the current low
price was to be followed by a monopolistic price.
• Finally, it should be kept in mind that the anticipated monopoly profits of the
predator must be discounted to their present value. The predator firm may realize that
possible monopoly profits in the future are not worth lost profits today. If that is the case,
predatory pricing clearly does not pay.
• Predatory pricing is successful only under the following conditions:
• When the discount rate is low.
• When the predator has a large cost advantage over its rivals.
• When the competitive fringe is relatively large.
• When the members of the fringe exit quickly in response to price cuts.
• When the market is segmented.
• When there is asymmetric information and uncertainty and substantial inter
temporal linkages, the successful predation expands.
• Establishment of reputation for toughness by predators.
• Consumers do not stock up during low price predation period.
• The victim firms are not able to make arrangements with finance companies or
consumers to survive the predatory pricing attempt.

**************

CASE STUDY
The Times is or was a venerable newspaper. Since the 18th century, it was the most
authoritative newspaper of Britain. It was almost royal. It displayed its heraldic arms on
the masthead, and told its readers whom the King had given audience the previous day.
. It had no news on its front page only classified advertisements which the nobility and the
gentry used to communicate with one another. It had amazing access to the corridors of
power; for that reason all in power, and many who did not, read it. Then came the
swinging 60s; Britains post-war generation found The Times too stodgy. Professionals
started reading The Daily Telegraph, while progressive intellectuals preferred The
Guardian. Then came The Independent in the 70s; it combined news sense with excellent
features.The Times was bought up by Rupert Murdoch, but it still lost readership. Then
Murdoch started cutting the price, and making The Times more populist. Today it costs an
absurd 10 pence on Monday; its content is populist. As a result, other newspapers are in
serious trouble; The Independent is so badly off that it may close down. There is a

30
 Competition Bill in the British Parliament. On February 10, the House of Lords voted by
121 to 93 for an amendment to the Competition Bill outlawing predatory pricing.

Cellular operators have accused Reliance Info comm of offering predatory prices in
Chennai and Tamil Nadu circles, and have sought telecom regulator Trai’s intervention
immediately In a letter to Trai Chairman Pradip Baijal, the Cellular Operators Association
of India (COAI) has said tariffs for pre-paid subscribers in Chennai and Tamil Nadu, for
national and inter-circle calls, have been reduced to an extent, non-complying with Trai’s
prescribed IUC regime. Trai had once dismissed the COAI’s allegation against Reliance,
saying “differential tariffs in the retail segment were permissible and the service provider
must be able to meet the IUC expenses on weighted average basis. But, the COAI has
once again petitioned Trai citing reasons that the authority had applied different yardsticks
in the case of Reliance for dismissing the charges. We are perplexed to note that the
authority has applied different yardsticks for different service providers on the issue of
weighted average IUC charges,” the association said.

PRICING BY DOMINANT FIRM

In the dominant firm pricing method, one of the firm in the oligopolistic market that emerges
as a dominant firm by virtue of its higher market share emerges as a leader. Market
dominance is an important feature of industrial structure that is attributed to mergers and
innovations. The merger of Ponds with Hindustan Lever made Ponds a market leader. The
Eastman Kodak, Gillette, AICOA, IBM and Xerox are example of firms that that emerged as
dominant firms through innovations.
The dominant firm has a considerable market share and the smaller firms have smaller market
shares. Assuming homogeneous products, the dominant firms set the price and the smaller
firms take this price as given. The dominant firm has complete information about market
demand and is assumed to know the marginal cost curve of the smaller firms. From the
marginal cost of the smaller firms the dominant firm derives the supply curve of the smaller
firms. The dominant firm assesses its own demand curve by deducting from the market
demand the supply made by the small firms. This is shown in the following figure.

31
In the figure, at each price, the dominant firm will be able to supply that part of the total
market demand that is not supplied by the small firms. Thus at price OP 1 the demand for the
dominant firm is zero because the entire market demand is supplied by the small firms. As
price falls below P1 the demand for the dominant firm. increases At price P2 > P1, supply by
small firms is P2B and BL (P2L – P2B ) is demand for leader’s product. At P3 price supply by
small firms is zero and the entire market demand belongs to the dominant firm. In his way the
demand curve of the dominant firm is derived from which its MR curve is derived.
Equilibrium of the dominant firm is where its MR = MC. The equilibrium price is OP and
output is OX. At this price small firms will supply PA and dominant firms demand is AK =
OX= PM. Dominant firm will maximize profit while small firms may or may not maximize
profit.
Pricing by dominant firm is adopted and followed by firms under oligopoly to avoid the
uncertainty that arises from their inter dependence.
PRICING BY LOW COST FIRM: Oligopolistic firms also adopt the strategy of following the
price of low cost firm to avoid uncertainty. This typically happens under price leadership
collusive models of oligopoly. In this a firm which has the lowest cost emerges as the leader
and others follow its decision regarding price. At the price set by the leader the follower sell
the output that their demand curve would permit. This type of pricing is illustrated in the
following figure drawn assuming that there are just two firms A and B, of which firm A is the
low cost firm and hence the leader.

32
It is assumed that the market is equally shared by the two firms in the market. Firm’s MC
curve is below firm B’s MC curve. By virtue of its low cost firm A is the leader and B
becomes the follower. Firm A’s equilibrium is at eA where MCA cuts MRA ( = MRB). The
equilibrium price and output is PA and XA. B would sell the quantity at the same price. Thus
XA = XB. Instead if B were to act independently, it would charge a price according to its MC
curve, MCB and the equilibrium is at eB. The equilibrium price for B is PB at which it will sell
X’B. and earn super normal profits. But soon A would react to this and a price war would
follow. Such price war can be avoided if B chooses to follow A and sell at the price fixed at
A’s equilibrium.
Discriminatory Pricing: Read from Micro Economics Text Book.

6. CONDUCT – PRODUCT DIFFERENTIATION

PRODUCT DIFFERENTIATION

Product differentiation is an important strategy for market dominance, in which

firms develop distinctive varieties that are close but not perfect substitutes. Firms produce
differentiated products to increase their market share and to limit entry. Product

33
differentiation acts as a strong barrier to entry. Product differentiation as the basis for a
downward sloping demand curve was first introduced in economic theory by Sraffa. The
implications of using product differentiation as a selling strategy by the firm was
analysed by Chamberlin.

Product differentiation is intended to alter the shape and position of the demand
curve. It is intended to distinguish the product of one firm from that of the other in the
industry. The aim of product differentiation is to make the product unique in the mind of
the consumer. It can be real or fancied. It is real when the inherent characteristics of the
product are different. It is fancied when the products are basically the same, yet the
consumer is persuaded via selling and other 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. Fancied differentiation is established by advertising,
differences in packages, differences in design or simply by brand name.

Product differentiation could be horizontal or vertical. Horizontal

differentiation occurs when a market contains a range of similarly priced products. An
increase in the range of products means that consumers will on an average be able to find
a product which meets their preferences more exactly.

Example: (a) competing firms may produce the same quality of carpets, but each carpet
has a different colour or design.
(b) recording firms produce records of the same quality but with different types of music
such as classical, jazz, disco etc.
Vertical differentiation occurs when products differ in respect of quality and there is
difference in the cost of producing the various products.
Example: Cotton- polyester mix in textile, cassets playing for 60 mnts / 90mnts
A general model of product differentiation
The basic model of product differentiation as explained by Lancaster considers
characteristics of good rather than the good itself to be the object of consumer preferences.
Goods are seen as bundles of characteristics and differentiated goods are treated as goods
which combine the same characteristics in different proportion. Lancaster model considers
product ( soap ) with 2 characteristics. Let these two characteristics be fragrance ( α ) and
lather ( β).
In the following diagram 3 rays A, B and C are shown for 3 soaps with 3 different
proportions of α and β. Ray A shows most lathering soap and ray C shows most fragrant
soap while Ray B shows a soap with a modest combination of both fragrance and lather.
Points E , F, and G are show amounts of each good that can be bought for equal
expenditure on each. The location of these points, hence, depends on the price of each
soap.

34
 In the figure Within the characteristics space between the X and Y axis, any number of
rays could be drawn representing different combinations of fragrance and lather. The
interdependence between firms depend on two things.
a. number of characteristics in the market
b. number of firms in the industry.
The stronger the products are differentiated, weaker will be the interdependence , the
further apart will be the rays in the diagram.
A firm can change the nature of its product and there by move the ray in the characteristic
space or introduce a new differentiated product and introduce a new ray. It is more likely
to be profitable if a gap in the market can be spotted. An area of characteristic space
already crowded with rays, that is, a market crowded with varieties of product, is less
attractive.
Vertical product differentiation:
Vertical product differentiation brings about changes inherent quality of the product and
results in significant changes in cost. The firm in its pursuit of increasing the market
share brings out improvement in quality which shifts demand and cost curves upwards. In
the following figure, with every improvement in quality, demand curve shifts upwards
from D1 to D5, but at a decreasing rate, implying that consumer’s tastes become saturated
as quality improves. The unit cost to the firm for each quality is X1a1, X2a2, X3a3 and so on.
The firm breaks even with grade 3 – average cost X 3 e is equal to price P. Further
improvements in products do not bring profits. In fact beyond X 3 output level, firm incurs
losses. Joining the relevant unit cost pints for respective out put level we get the Average
Cost Option Curve (ACOC ).

35
The ACOC shows the unit cost of supplying the different quantities demanded of different
qualities at a given price P. As quality improves ACOC shifts upward. Shape of ACOC
shape and position of the average cost curves. In the figure, upward slope of ACOC is
because of the higher unit cost of producing an improved quality of the product. Upward
shift. of the demand curve is because of the improved quality.
Initially ACOC will decline because shift of demand curve will be greater than shift of
cost curve but eventually ACOC will rise upward because the shift of the cost curve will
be greater than the shift of the demand curve. Since it always pays the firm to improve its
quality the rising segment of the ACOC is relevant for decision making.
The firm is in equilibrium when MCO cuts price line at e in the following figure. At
equilibrium the firm is making a profit of PeBA. This profit will attract entry and ACOC
shifts upward while demand curve shifts downward. This will stop when ACOC becomes
tangent to price line as shown in the diagram. This is a long run equilibrium and the firm
may be producing the same level of output at higher cost.

Product Differentiation And Barriers to Entry: Differentiated products make entry

difficult for new firms. Product differentiation gives monopoly power to the firm and
hence the firm is able to set a price that is closer to profit maximisation price. Product
differentiation creates a brand loyalty among buyers for the firm’s product and thus acts

36
as a strong barrier to entry. The entrant is at a disadvantage because he has to make his
products known and attract some of the customary buyers of the established firms. To
overcome this obstacle , either the new firm has to offer tits product a substantially low
price than the established firms, or do heavier advertising or both. Such activities lead to
higher costs for the new firms. Product differentiation strengthens barriers. If product
differentiation is mild, then the barrier is weak and the firm will be forced to keep the
price closer to competitive price. Strong product differentiation on the other hand will
permit a price closer to monopoly power.

The figure illustrates the significance of product differentiation as an entry barrier. The
firm’s profit maximising price is PM and entry preventing price is PL. With PL as the price,
entry is prevented and the entrant’s demand curve is d1or may be even below that.

If price increases above PL , new firms enter and the demand curve of the entrant is d2.
This will decrease the market share of the established firms. But if the established firms
differentiates its product, raising the price above PL will not attract entry and the entrants
demand curve will remain to be d1.

Product Differentiation and Performance

Product differentiation is the cause for the downward slope of the demand curve. By
making the product unique in the mind of the consumer and by creating brand loyalty,
product differentiation confers monopoly power to the firm to some extent. As result the
output of the firm is not an efficient output. With a downward sloping demand curve the
firms’s long run equilibrium is established with excess capacity. Even if number of firms
is large and long run equilibrium generates just normal profit as under monopolistic
competition, the excess capacity can not be avoided. There is always an unused capacity
in the plant at equilibrium. The inefficiency will be larger when the number of firms if
fewer as under oligopoly. The price will be greater than marginal cost ( P > MC) . The
difference between price and marginal cost will be greater with restricted entry. This is
shown in the following figure.

37
 ****************

7.CONDUCT – ADVERTISEMENT

38
Advertising is any paid form of non personal presentation and promotion of ideas, goods,
or services by an identified sponsor. For the firms in any industry it is an important tool
of marketing. Its role is to implement product flow through the channels of distribution: to
act as a catalyst in acquainting the consumer and to induce him to buy the product. Form
the point of view of economic theory advertisement is the expense incurred by the firm as
part of its selling strategy to alter the shape and position of the demand curve. Advertising
is the selling expense incurred by firms to alter the shape and position of its demand
curve. Selling expenses such as advertisement add to costs in order to add to demand.
They are an alternative to price – cutting as a competitive tactic. They are safer than price
cutting and are not likely to cause as much mutual harm among rivals as price - cutting
would.
Advertising and market structure:
Advertising has become a major means of competition in the modern oligopolistic world.
In pure competition selling expenses are irrelevant. Price is given by the market and the
firm’s selling efforts can not influence the flat demand curve. In pure monopoly selling
expenses can have a limited role. They can used to reduce demand elasticity so as to
increase profits to the firm. Advertising may also sharpen any difference in elasticity
among consumer groups which will increase the scope for price discrimination. Yet on the
whole monopolist need not make much selling effort. It is in the intermediate range of
monopolistic competition that advertising becomes a significant tool of competition.
Advertising is essential not only for increasing ones’s market share but even for
maintaining existing market or sales. Defensive advertising is routine under oligopoly.
The greater the consumer’s responsiveness to changes in the product price, higher
will be the optimal level of advertising relative to sales. In markets characterized by
oligopoly it is usually argued that advertising and other forms of promotional activity play
a more important role than price competition. Advertising intensity hence varies with the
level of concentration as shown in the figure below:

39
Under oligopoly changes in price can be spotted easily by rival firms and generate a rapid
response that may have a detrimental impact on the initial firm’s profit which is
compelled to counteract with heavy advertisement. Hence advertisement is higher under
oligopoly. Dorfman and Steiner state that advertising will tend to be higher when demand
is inelastic and MC < price. In short advertising is related to monopoly power of the firm.
Impact of Advertisement on Demand:
Advertising shifts the demand curve of the product upwards thus increasing the
quantity demanded at the given price P. Initially advertising shifts the demand curve at an
increasing rate. However beyond a certain level of advertising, demand increases at a
decreasing rate since the preferences of the consumer gets saturated for the product. The
shift of the demand curve with advertisement is shown below.

In the figure an advertising expenditure of a constant amount of , say , “k”, shifts demand
curve from D1 to D6 position. With price constant at P, initially advertising increases
quantity demanded by Q1Q2, then by Q2Q3. Further doses of advertisement increases
quantity demanded by Q3Q4, Q4Q5, and Q5Q6 . It can be seen in the figure that Q3Q4 > Q2Q3
> Q1 Q2 and Q4Q5 < Q3Q4 and Q5Q6 < Q4Q5. Thus it is clear that demand increases in
response to advertisement but at a decreasing rate. The advertising expenditure curve
takes a sigmoid shape.

40
 The shape of the advertising expenditure curve implies that initially advertising
increases the demand at an increasing rate. However beyond a certain level of advertising,
A3 in the figure, demand increases at a decreasing rate. The economic meaning of
sigmoid shape is the following: at low levels of advertising expenditure, its effect on the
quantity demanded is negligible as the number of advertising message and / or number of
the media is small. As advertising increases consumers are attracted to a great extent.
However beyond a certain level it becomes difficult to persuade consumers through
advertising.
Advertisement as entry barrier
Oliver Williamson has developed a model in which an oligopolistic firm uses
advertising to prevent entry. Thus the goal of the firm is to prevent entry by choosing an
appropriate level of advertisement and charge a price that impedes entry of new firms into
the industry. Advertisement will help the firm to charge a price closer to profit
maximizing price. With increase in advertisement expenditure the price approaches profit
maximizing price. This is shown in the following figure.
Williamson assumes that barriers to entry increases with advertising expenses. Hence the
limit price PL is an increasing function of advertising. Any point on PL PL curve and
below it implies a price advertisement strategy that prevents entry. At any point above PL
PL entry is not prevented. At equilibrium the firm will choose a point on PL PL. The
intercept PL is the limit price without advertising. It reflects barriers arising from scale
economies and absolute cost advantage. As advertising increases, so does entry barrier
and hence the price PL, which the advertising firm can charge with out attracting entry will
also increase.
The shape of the P L PL curve indicates that low levels of advertising would
not erect high barriers since potential entrants can match the advertisement expenditure of
the established firms fairly easily.

41
At high levels of advertising however the burden from selling expenses increases on
potential entrants increases strengthening the barrier and PL. However eventually the
curve flattens out because of limit to the effectiveness of advertising in deterring entry.
The position of the curve depends on the nature of the product. Three curves
corresponding to high, substantial and low barriers to entry are shown below.

Cosmetics, drugs liquor,, soft drinks would have a high PL curve since for these products
advertisement can create strong buyer preferences. Canned food, furniture and house hold
goods have a substantial PL curve and some textile forms such as rayon have a low PL
curve.

Advertising, Barriers to entry and Profitability:

Advertising perpetuates oligopolistic market structure by creating or strengthening
existing barriers to entry in the following ways.

42
1. Advertisement and preference barrier: Advertising is one of the most important
ways of differentiating a product. To the extent that advertising creates brand loyalty ,
potential entrants face a significant obstacle to attracting customers from existing firms.
2. Advertising and absolute cost advantage: A new entrant must incur some penetration
cost in order to establish himself in the market. In general the penetration cost represents
an investment in order to establish a market position. They consist mainly of extra
advertisement outlays which are required for entry. Established firms need not incur
penetration costs, while an entrant must advertise heavily to break buyer’s brand loyalty
and inertia. The unit cost of market penetration are likely to increase as output expands
because it becomes increasingly more difficult to attract customers who are more inert or
loyal, with strong brand preferences. This effect of advertising creates absolute cost
advantage for established firms.
3.Advertising and scale economies: There are real and pecuniary economies of scale of
advertising. In each industry there is a certain amount of advertising expense that must be
incurred by each firm in order to stay in the market and maintain its share. Larger firms
have the advantage of being able to spread this cost over a larger output, so that the unit
cost of advertising is less for larger firms than for smaller firms. As a result, smaller firms,
including most entrants, are placed at a strong disadvantage. The scale disadvantage of a
new entrant will be greater if the established firms react to entry by increasing their
advertising. To sum up, there is minimum optimum scale of advertising , which if super
imposed on the production scale economies, may result in a larger amount of output which
the entrant must sell in order to reap all the economies of scale.(production and
advertising) . Thus advertising may increase the minimum efficient plant size.
4.Advertising and the initial capital requirement barrier: The market penetration costs
increase the capital requirements of a new entrant. If there are economies of scale in
advertising, entrants will have to spend more on advertising ; thus financing of advertising
will not only require additional initial funds but will also be more costly. The above
effects of advertising on the various barriers are shown in the following figure.

To enter a market of advertised goods, a new firm must meet penetration cost
which are rising in the figure shown as by AMPC curve. This is because gaining a larger
market share requires sharply rising advertisement efforts. In the figure curve total cost for

43
 an entrant ( production cost + advertising cost + penetration cost ) are higher than those
for an established firm with established brand images. This opens up a barrier whose
height is shown. It also reduces slightly the optimal scale for the entrant from Q2 to Q3.
Among established firms, advertising has a further effect. Average advertising
costs
( AAC ) show economies of scale. This increases the optimal size of the firm from Q1 to
Q2. This places smaller firms at a cost disadvantage and tightens oligopoly.
The whole effect is to let established firms raise price up to the limit price level
of P3. Without selling costs price would instead be at price P1.The increase from P1 to P3
is advertising’s effect. The degree of market power is higher and entry is impeded.
Factors determining advertising outlay:
Differences in advertising level are influenced by differences in product characteristics
and by differences in market characteristics. Consumer goods are more heavily advertised
than industrial products. Within consumer goods sector, advertising intensity is generally
higher for non durable goods. Advertising intensity is the ratio of advertising expenditure
to sales revenue, ( A / P.Q ). Consumer goods have a longer life, are often more complex
goods and tend to involve a greater outlay than consumer non durables. Hence an error of
judgement in purchasing a durable good will have a greater effect on the consumer’s
welfare. Consequently consumers will require more information than can be effectively
communicated via advertising. The more complex a product, the greater the greater the
use consumers make of alternative information sources such as consumer publication.
Hence with durable goods advertising is also likely to be less effective in promoting sales
than competition on the basis of price. When knowledge is imperfect consumers can
improve their decisions by searching for information on product characteristics, product
availability and alternative prices. Search for durable goods will be higher than for non
durable goods. Search will be lower for goods purchased frequently and for goods which
account for a low proportion of consumer’s total expenditure.
The more a market is changing the higher will be the level of advertising. Where there is
rapid turnover of customers as in the case of baby food market, there will be heavy
advertising to inform new consumers. Where product characteristics change rapidly, there
will be a need to advertise to increase consumer’s awareness. Advertising levels will also
be relatively high where the entry of new firms is rapid. Firms entering the market will
have to counter act the influence of past advertising of existing firms by advertising
heavily to inform consumers of the attributes of their own products.
****************
8. MERGERS

Mergers involve the amalgamation of two or more independent firms under one control. A
merger combines two or more firms into one. The firms may differ in size with one
absorbing the other. The merger may occur amicably or under tension or both. Merger
may be of three kinds.
a. Horizontal merger
b. Vertical merger
c. Conglomerate merger.
Horizontal merger involves merger among firms selling a similar commodity. If two
manufacturing firms merge, it is a horizontal merger. If a group of firms, all producing

44
 steel, merge into one, that is also horizontal merger. Horizontal merger invariably raises
market power by eliminating side by side competition between firms. The effect may be
small or large, depending on the two firms’ market and on other conditions of market.
The merger of Ponds with Hindustan Lever is an example of horizontal merger.
Vertical merger occurs when one firm merges either with a firm from which it purchases
an input or with a firm to which it sells its output. Vertical merger occurs when, for
example, when a coal using electric utility purchases a coal mining firm or when a shoe
manufacturer purchases a retail sale unit. Steel industry is an example when a larger firm
tries to embrace all stages – mining, shipping, ore blast furnaces, rough rolling, steel
furnaces, finished rolling, fabricated products. The vertical merger ties together firms in a
chain of production.
A conglomerate merger does not have any technical relationship or connections among
the activities of the firm. Conglomerate mergers could be product extension or market
extension. A product extension merger occurs when firm X adds a product related to its
existing product line by buying up firm Y.
Example; A diversified food product firm buys a company selling coffee.
A market extension merger combines two firms selling the same product in different
geographical locations.
A pure conglomerate merge has none of these connections not any technical relationships
among the activities of the firm.
Motives for Merger
There are several motives for merger, the most significant among them being:
1. Search for market power.
2. Search for efficiency.
3. Motive for maximizing profits
4. Reducing tax liability
5. Diversification of risk
1.Search for market power: A merger can increase the market power of the merged
firm. In the case of the horizontal merger, if all or most of the firms in an industry merge,
the survivor becomes a dominant firm. The survivor firm will be able to exercise control
over price: it will charge limit price, restrict entry and maintain its position. Vertical
merger by one or more established firms in an industry can have a profound effect on
market share and on the degree of competitiveness by erecting barriers to entry. The
merger firm will be able to prevent entry altogether if it controls either the supply of an
essential input or all distributive outlets. Barriers to entry may be heightened if an existing
merged firm refuses to supply or purchase from new entrants or will do so only on
favourable terms.
The merger of Universal Luggage with Blow Plast is an example of merger
to limit competition and to enhance market power. Before merger both the companies
were competing with each other leading to a severe price war. After the merger Blow
Plast obtained strong hold on the market and now operates under near monopoly
situation.
Yet another example is the acquisition of TOMCO with Hindustan Lever in 1993. Lever
expected to cover one third of the market for soaps and detergents after the merger.
2.Search for efficiency:

45
 Mergers have the effect of transferring control of the firm from less efficient to more
efficient administrative terms. Horizontal merger is a way for a firm to acquire additional
plants. By so doing a firm will be able to take advantage of any available economies of
multi plant operations. By operating more than one plant a firm can spread the fixed cost
of administration over a larger output. The result is a multi plant economy of scale that
will encourage multi plant operations at least to the point where the firm becomes so large
that management loses administrative control. If transportation costs are high firm will
choose to operate several plants in each geographic market.
There will often be product specific economies of multi plant operation. If a firm
produces different products in a single plant, production time will inevitably be lost as
assembly lines are switched from one product to another. By operating more than one
plant the firm can specialise in the production of high volume products in single plants.
This will result in run length economies.
A firm that assumes control of many plants will be able to close the oldest and least
efficient ones which eliminates excess capacity.
Vertical economies arise from joining firms at two levels of production. For example,
combining iron and steel operations so that pig iron and steel ingots can be sent to the
processing level directly without losing heat thus reducing operating costs; saving of
transporting cost from locating two vertically integrated processes in the same plant.
Economies arise from conglomerate mergers too. The whole firm may be stabilised by
combining disparate activities. Financial guidance and flows may be superior in
diversified firms. Also synergy may result from interaction among differing technology
and management within a conglomerate.
Merger and profits : Horizontal merger increases the market share of the dominant firm,
at least marginally. The economies from merger reduces cost while demand curve shifts
upward due to increasing market share facilitated by merger. In the post merger period
output will increase, but price will increase or decrease depending on elasticity of demand.
Even if demand remains unchanged in the post merger period, or leads to only
insignificant changes in market share of the firm the lower cost in the post merger period
will increase profits. In the following figure the increase in profits arising from horizontal
merger, with demand remaining unaffected is shown.

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 In the figure profits before merger is P1AB C and profits after merger is P2 DKR. It is clear
in the picture that P2 DKR > P1AB C .

Vertical merger also increases profits of the firm. Since vertical merger integrates two firms
in different stages of the same product , substantial reduction in transaction cost results from
vertical merger. By integrating vertically and turning suppliers of inputs into employees the
firm can ensure their loyalty and straight forwardness with certainty which is not possible
across markets. Vertical integration solves the small number bargaining problem that arises
when there are only few possible suppliers.
Merger increases profits due to cost reduction and efficient utilization of resources. This
may happen because of the following reasons:
• Economies of scale leading to optimum size
• Operating economies
• Synergy

A firm in the post merger period can consolidate its management functions and
reduce operating costs. For example a combined firm can eliminate duplicate channels of
distribution or create a centralised training centre or introduce an integrated planning and
control system. An example of a merger resulting in operating economies is the merger of
Sundaram Clayton with TVS Suzuki Ltd. By this merger, TSL became the second largest
producer of two wheelers.
Synergy refers to benefits other than those related to economies of scale.
Operating costs are one for of synergy benefits. But apart from operating economies
synergy may also arise from enhanced managerial capabilities, creativity, innovativeness,
and R & D and market coverage capacity due to complementarity of resources and a
widened horizon of opportunities.
Apart from reasons like efficiency, market power, and greater profits , mergers arise due to
strategic reasons too, such as
• to raise rival’s input cost.
• to increase the absolute cost of entry
• to save a failing firm – a failing firm may be salvaged by merger with a healthy firm.

47
The presence of negative externalities from inefficient services may serve as an impetus fro
merger. Large petroleum companies may own filling stations rather than supply independent
retailers since the retailers may provide inefficient service which will affect the business of
the petroleum company. Merger ensures efficiency of service at retail stage in service.
• Tax benefits arise when a profit making firm merges with a loss making unit thus
using the loss to evade the tax.
• To spread risks. This is particularly rue of conglomerate mergers which combines
firms in unrelated business by stabilising the firm’s income in the post merger period. For a
firm that operates in a single market, its sales and profits are tied to the market conditions
that is beyond its control . If the firm diversifies into unrelated markets it may be able to
even out fluctuations in income stream. If a firm operates in 3 or 4 markets, all the four will
not fail at a time. If one is sick , one of the other three will compensate losses from the sick
unit. Hence large firms which seek to spread risk and seek fast growth prefer conglomerate
merger.
9. INVENTION AND INNOVATION

The use of product differentiation as an instrument of competition depends

on the level of expenditure and effort committed by firms to the development and
introduction of new products and also new methods of production, that is , funds allocated
for R & D activities. R & D department of any firm conducts research aimed at the
discovery of new knowledge, its applications as well as application of existing knowledge
to the production of new products or for introducing new processes of production. Such
activities of the firm are in simple terms termed as “technological change.”
The process of technological change is a complex one. Schumpeter distinguishes
between three main stages: invention, innovation, and diffusion. Invention is the
production of new knowledge in the form of a new product or new process for production.
It is the creation of a new technology.
Innovation is the process of adopting an invention in a practical use. Innovation is a
multi dimensional concept. A change in the existing product line of a firm through the
introduction of a new product, is product innovation. If a new method of producing the
existing product is introduced it is process innovation. Changes in product line and
production process by a new product and production method respectively are instances
of technological innovation. Market innovation on the other hand is the change in the
marketing strategies.
Similarly one may have innovation in organizational practices, financing and any other
aspect of business conduct. The concept of innovation is thus very broad. The third stage
diffusion is the stage when a product or process innovation is spread throughout the
market either through the efforts of the innovator or as a result of imitations by other
firms.
Diffusion is a situation when an innovation is copied by others, that is, innovation
spreads across the market.
The three stages, invention, innovation and diffusion are the successive stages of
technological change. Imitation is not possible without innovation and innovation is not
possible with out invention.
Innovation and market concentration

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In Schumpeter’s terminology, innovation is the intrusion in to the system of new
production functions by exploiting an invention .. by opening up a new source of supply
of materials or a new outlet for products by reorganising an industry and so on.”
Schumpeter identifies five types of innovation.
• the introduction of a new product or a service or an improvement in the quality of an
existing product or service.
• The introduction of a new method of production.
• The development of a new market.
• The exploitation of a new source of supply
• The reorganisation of methods of operations.

Firms have an incentive to innovate and introduce new ideas. The assumption of imperfect
knowledge ensures that innovators will be rewarded by a period of abnormal profits
before it is subsequently eroded by rivals. Patenting the new process or product can only
slow down the diffusion process. This is because the published patent specification itself
acts as a source of information which rivals may use to help develop methods of imitation
that circumvent the existing patent.
Innovation ( R & D ) and firm size: Empirical studies reveal that large firms have
certain crucial advantage. Galbraith argued that the high costs of modern day research are
such that only large firms have the necessary resources to carryout the work. In addition
large firms are better placed to handle the high risks associated with R & D work. The
small form may have to concentrate its efforts on developing a single innovative idea, the
success or failure of which may make or break the firm. The large fir on the other hand is
able to support several projects simultaneously and failure in one area will be more than
made good by success else where. Large firms have a further advantage when there are
substantial economies of scale in R and D work. For instance they are better able to afford
the specialist staff and expensive equipment which may be needed. The marketing power
of large firms may also be important in inducing a high level of R & D expenses .
Established links with distributive outlets, heavy advertising and other sales promotion
expenditure will allow large firms to penetrate the market more quickly with new products
and increase their return on R & D investment. In the case of process innovations that
reduce cost, the larger firm’s advantage is that the lower unit cost apply to a larger output
total savings are greater than they will be for a small firm. Empirical studies reveal that
almost all large firms engage in R & D activities but only a fraction of small firms do so.
The contribution of small firms to invention is found to be much greater than their
contribution to the commercial application of new ideas where the costs involved are so
much higher.
R & D and market structure:
From the point of view of industrial policy a crucial question is what kind of market
structure is most conducive to R & D and thus to the promotion of technological change.
Arrow argued that a purely competitive industry would provide greater incentive for cost
reducing innovations than would be simple monopoly. The argument for a large cost
reduction is shown below.

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The figure compares the results of process innovation under pure competition and
monopoly. Process innovation results in a downward shift in the marginal cost curve from
MC1 to MC2. Cost conditions are assumed to be identical for the monopolist and the
perfectly competitive industry and pre innovation output for both is OQ. As a result of
innovation the monopolist expands output to OQM where MRM = MC2. The competitive
firm expands output to OQc where MRc = MR2. Given the cost of innovation the return to
competitive firm exceed that of the monopolist by ABC.

Monopolist’s position before and after innovation:

Change in output as a result of innovation = QQM
Change in TR = QABQM
Change in TC = QDBQM
Net benefit from innovation = QABQM -- QDBQM = DAB ( in the figure).

Results of innovation under perfect competition:

Change in output as a result of innovation = QQC

Change in TR = QACQC
Change in TC = QDCQC
Net benefit from innovation = QACQC -- QDCQC = DACB ( in the figure).
Difference between the benefit under monopoly and perfect is:
DACB – DAB = ABC.

Thus the return to the competitive firm exceed that of the monopolist by ABC. This result
is due to the fact that following a cost reduction output is expanded more by the
competitive firm than by the monopolist. However this results on the assumption that a
single firm in the competitive industry is of the same size as a firm with monopoly power.
In fact if, following an innovation all firms in the competitive industry were to expand
output price would fall and the above analysis may not hold.
Oligopoly, market power and innovation:

50
 Schumpeter felt that high concentration encourages innovation. He argued that monopoly
power is necessary for a high level of R & D activity. A firm with substantial degree of
monopoly power is necessary for a high level of R & D activity. Tjis is because:
1) A firm with monopoly power has greater incentive to innovate in the form of
either creating or strengthening market power further. The innovating firm can expect to
appropriate a larger share of gains from any innovation. In highly competitive market with
large number of firms innovation is rapidly imitated by a large number of competitors
leaving insignificant financial gain to the innovating firm. Thus there will be no incentive
to invest in R& D if the market is shared by large number of firms. Thus large number of
equally matched firms and easy entry conditions may not encourage innovation.
2) Firms with market power has large profits from which it can finance R & D
activity.
3) Firms with market power have a greater degree of certainty about their future
prospects which gives them incentive to face risks associated with R & D also equip
themselves adequately for R & D effort. This market power makes it easier for
them to engage staff on projects which may take several years to yield result. A firm with
market power is thus in a better position to take the long run view necessary for mush R &
D work because management is not completely absorbed in the short run struggle for
survival.
4) Besides the gains arising from market power oligopolistic firms also have the
competitive advantage that provide the best frame work for a high level of R & D.
Although firms in an oligopolistic industry may collude on price it is more difficult to
collude on R & D. Unlike a price cut successful innovation will atleast give it a temporary
advantage over its competitors.
5) Competition between firms has the advantage that there are several centers of
initiative so that different approaches to design or solving a technical problem will be
adopted.
6) However the case for oligopoly as the most conducive market structure is limited
since innovation does not offer any for an appreciable increase in market share in an
already concentrated market. Further a dominant firm which is not threatened by entry
may be slow to innovate because of its vested interest in existing products or processes.
Innovation brings an end to the monopoly profits from outmoded products or processes
and the protected dominant firm will thus tend to delay the introduction of the innovation.
However a dominant firm react vigorously to the innovative activity of a smaller firm by
rapid imitation or acquisition.
7) Having competitors will give incentive to innovate and result in improvement in
the quality of innovation. Starting from monopoly, an increase in the number of firms
could up to a certain point have beneficial effects. It would increase the competitive
stimulus to innovate.
Besides the size of the firm and market structure, size and growth of markets also
affect R & D. For a given size distribution of firms, larger the market greater the
expected returns from successful innovation. Similarly a rapidly increasing
industry will promise higher returns to R& D than a declining one. Opportunities
for innovations are higher in science based industries such as pharmaceuticals,
electrical, electronics and engineering than most others.
8) Innovation as market failure:

51
 There are reasons to believe that the amount of resources allocated to R & D will not
be optimal. Three main arguments have been given to suggest that too few resources
will be allocated to R & D activity so that some action by government is called for.
These arguments are associated with:
• The cost and risk of R & D
• The public good nature of R & D
• The distinction between basic and applied research
Cost and Risks of R& D: For an individual firm the return to R & D expenditure can not
be predicted; large amounts may be spent on research with out making any worthwhile
discoveries. The element of risk inherent in R & D activity means that risk averse firms
will invest too little on R & D activity from the resource allocation point of view. The
more risky the project the more serious the under investment. This can be overcome if
firms insure against the probable losses from R & D activity. However the risks from R &
D are not insurable because of the unpredictability and moral hazard. Moral hazard is an
hidden action problem where the insure does not have any incentive to be efficient in
innovation; once it is insured the firms could commit resources to extravagant projects.
Instead the government can bear the risk of failure through the specification and funding
of cost plus research contracts which also eliminates incentive to minimize costs.
Public good characteristics of R &D: The information of the R & D expenditure possess
two characteristics of indivisibility and inappropriability. Information is indivisible
because its use by person or firm does not prevent it being used at the same time by
others. Thus the opportunity cost of using information is zero. In order to achieve a social
optimum it should be available a zero price.( MC = P ). But to encourage firms to invest in
R & D it is necessary to guarantee an inventing firm exclusive rights on the information it
produces for a limited period atleast. But such a guarantee can not be made because
information is inappropriable. It is extremely costly to exclude interested parties from the
benefits of information. This applies particularly to product inventions – as soon as new
product is available on the market other firms will be able to copy it and thus appropriate
some of the benefits of R & D paid for by the initiating firm. Where the invention is a new
manufacturing process rather than a new product it is easier for the firm that did the
research to keep the new knowledge to itself, but the firms in the same industry may have
the know how to work out how the new process functions.
Once a new invention has been developed it is therefore impossible for the
inventor to secure all the economic gains from his inventions: the costs of excluding other
interested parties from the benefits may be too high. Also efficient resource allocation
insists that knowledge should be freely available and rules out exclusion. But treating
knowledge as a public good and making it generally available would completely destroy
the individual firm’s incentive to innovate.
Basic Vs applied Research: Applied research has a reasonably immediate commercial
application to one particular technology, particular product or industry. Basic research on
the other hand is concerned with the advance of scientific knowledge generally and may
come up with findings of interest to a number of different industries or to none. Basic
research is of fundamental importance because its discoveries will later serve as the inputs
for further applied research project with commercial outputs. Therefore in order to
encourage R & D expenditure as whole it is essential to invest sufficient funds in basic
research. The problem of uncertainty and public good characteristic apply most strongly

52
to basic research than applied research. From the point of view of an individual investing
firm, the pay off is more uncertain, the further the research project is towards the basic
end of the spectrum. The wide implications of the basic scientific discoveries increase the
desirability of making the results freely available and hence spillovers are higher. Hence
basic research suffers face the problem of inadequate funding.
The problems arising due to public good characteristic features of invention the risks and
uncertainty associated with innovations may be over come by direct allocation to
R & D by the government , particularly for basic research, and by encouragement for joint
venture and by patenting. Joint venture is a co operative approach to R & D with the
benefits of risk spreading and limiting fast diffusion of knowledge. It ensures that benefits
of invention are appropriated by the co operating firms.
A patent system gives the legal protection against the appropriation of the benefits from
this information by other interested parties, for a certain period of time. But to obtain a
patent the inventor has to disclose full details of the process or products concerned. This
ensures that as patent expires the information becomes freely available. While the patent
is in operation other firms have no legal right of access to the information unless the
patent holder abuses his monopoly position. The patent holder may license other firms to
use it if they pay either a flat sum or a royalty payment which depends on the amount of
the product made under license. Patent protection increases the market power of the
existing firm by creating another barrier to entry. A patent holder can restrict output and
raise price for the product for which it holds patent. Hence it is suggested that there should
be a reduction in the degree of protection extended to a patent holder for the sake of both
reducing market power and for encouraging rapid dissemination of new knowledge. This
could be done by limiting the length if the period for which the patent I s given.
Conclusion:
Innovation measured by the R & D expenditure of a firm is thus a crucial component of
decision making of the firm. It influences the performance of the firm - whether the firms
are productively efficient, avoiding wasteful use of available resources. By influencing
cost, price, output and profit of the firm, innovation influences allocative and productive
efficiency of the firm.
*************

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 10. PERFORMANCE

Performance of a firm is in general measured in terms of

• Profit
• Efficiency
• Capacity utilization
• Profitability - Returns to capital
Profits: Economic theory views firms as profit maximisers. Profits are maximized when the
two marginal conditions are satisfied. These are:
1. Marginal Cost = Marginal Revenue
2. Marginal Cost curve cuts Marginal Revenue from below.
The profit maximising equilibrium of a monopolist is shown below:
Figure 10.1 Equilibrium of a Monopolist

The monopoly firm in the figure drawn above is making a super normal profit of PRFT at
the equilibrium price OP by selling OX.
Performance in terms of Efficiency: Efficiency in simple terms refers to maximizing output
from a given total of inputs. It implies absence of wastages. There are two categories of
efficiency:
1. Internal efficiency or productive efficiency – X efficiency and X inefficiency
2. Allocative efficiency.
Internal or productive efficiency is achieved by excellent management within the firm.
The objective of a firm is to minimize cost and maximize profit. When actual costs are greater
than minimum possible costs due to factors such as managerial deficiencies, X inefficiency
arises. x-efficiency is the effectiveness with which a given set of inputs are used to produce
outputs. If a firm is producing the maximum output it can, given the resources it employs,
such as men and machinery, and the best technology available, it is said to be x-efficient. x-
inefficiency occurs when x-efficiency is not achieved. The concept of x-efficiency was
introduced by Harvey Leibenstein in 1966.
X efficiency and x inefficiency are illustrated in the following figure.
Figure 10.2 X - Inefficiency

54
In the figure output Q’ and Q” can be produced at the lowest cost Q’M and Q”M respectively
if the average cost curve is AC. The same outputs cost Q’A and Q”C on AC’ and Q’B and
Q”D on AC” respectively. Measures of X inefficiency simply take the excess of unnecessary
cost as a percentage of actual cost. Thus:

Under All firms yield the same long run equilibrium outcome: price is equal to marginal cost
and to average cost at its minimum. Production is efficient. Under perfect competition, there
will in general be no x-inefficiency because inefficient firms can not survive in the long term.

Figure 10.3 Equilibrium of a Perfectly Competitive Firm.

55
Under imperfect competition of any form firms have monopoly or market power. Monopoly
power exists when a firm has control over the market’s outcome. As a result of monopoly
power the firm will raise price, reduce quantity, retard innovation and discriminate among
buyers. Monopoly power gives rise to a downward sloping demand curve, making the firm a
price maker. If the firm is a pure monopolist, then the market and firm’s demand schedule
will be identical. If the firm has less than 100% of the market, its demand curve will lie below
or to the left of the market demand curve The two main indicators of monopoly power are
market share and barriers to entry.

High market share: A firm’s market share is measured by its own sales, taken as a
percentage of total sales in the market. A 10 % market share or lower usually gives the firm
little market power. Between 10 and 100 % the degree of monopoly power rises as the share
rises. A market share above 40% generally provides substantial monopoly power.

Barriers to entry : Any obstacle to entry will enhance the market power of the firms already
established there. In the absence of entry barriers even a monopolist will have only limited
market power.

The most important sources of market power are:

Mergers, Economies of scale, superior innovation or efficiency. Unfair competitive tactics

such as predatory pricing, control of key inputs, and government policy towards patenting.

Presence of monopoly power distorts efficient allocation of resources. Allocative efficiency

exists if price is equal to marginal cost for each product of each firm. Price will also equal
minimum possible average cost in the long run. Allocative efficiency is guaranteed under
perfect competition as shown in figure 10.3, in which long run equilibrium of the firm ensures
that price is equal to marginal cost ( P = MC) and minimum of LAC is reached at equilibrium.
On the other hand, under any form of market structure other than perfect competition,
( monopoly, monopolistic competition or oligopoly) , the equilibrium price is greater than
marginal cost – P > MC as can be seen in figure 10.4. ( OP . e’XM. The presence of monopoly
power thus distorts allocative efficiency.

Output is below the competitive level and Price is greater than marginal cost. However, with
other market forms such as monopoly, oligopoly and monopolistic competition, it may be
possible for x-inefficiency to persist, because the lack of competition makes it possible to use
inefficient production techniques and still stay in business.

Figure 10.4 Equilibrium of an Imperfectly Competitive Firm

56
Included in X- inefficiency are wasteful expenditures such as maintenance of excess capacity,
luxurious executive benefits, political lobbying seeking protection and favourable regulations,
and litigation.

Capacity utilization: Capacity utilization is closely related to the concept of efficiency. An

firm utilizes the entire built incapacity. Unused capacity is referred to as excess capacity.
Excess capacity is the characteristic feature under imperfect competition. Under imperfect
competition the firms face downward sloping demand curve due the market power it enjoys
that arises from differentiated products or entry barriers. As a result the point of equilibrium
corresponds to falling portion of the LAC . The output of the firm is less than the competitive
output, at which LAC is minimum. Even in the case of monopolistic competition, in which
the firm earns only normal profit in the long run, in which entry barriers are absent, the
equilibrium output is not at minimum LAC. Thus under any form of imperfect competition,
there is excess capacity, as shown by XM XC in figure 10.4.
PROFITS IN ACCOUNTING SENSE :
The concept of profit to an accountant takes different interpretations. In an accounting sense,
profit is the difference between turnover, or sales, and costs: that is,

Profit ( GROSS) = Turnover – Costs

Net Profit = Gross Profit – Expenses

Some of the basic concepts of profits used by accountants are:

Profitability Ratios:
A class of financial metrics that are used to assess a business's ability to generate earnings as
compared to its expenses and other relevant costs incurred during a specific period of time.
For most of these ratios, having a higher value relative to a competitor's ratio or the same ratio
from a previous period is indicative that the company is doing well. Some examples of
profitability ratios are profit margin, return on assets and return on equity.
Some industries experience seasonality in their operations. The retail industry, for
example, typically experiences higher revenues and earnings for the Christmas season.
Therefore, it would not be too useful to compare a retailer's 4th quarter profit margin with
its 1st quarter profit margin. On the other hand, comparing a retailer's 4th quarter profit

57
margin with the profit margin from the same period a year before would be far more
informative.
PROFIT MARGIN :

A profit margin tell us how much profit, on average, a business has earned per Rupee of
turnover.

The gross profit margin ratio tells us the profit a business makes on its cost of sales, or cost
of goods sold.

where turnover is sales.

Profit margin is very useful when comparing companies in similar industries. A higher profit
margin indicates a more profitable company that has better control over its costs compared
to its competitors. Profit margin is displayed as a percentage; a 20% profit margin, for
example, means the company has a net income of Rs 0.20 for each Rupee of sales.
Looking at the earnings of a company often doesn't tell the entire story. Increased earnings are
good, but an increase does not mean that the profit margin of a company is improving. For
instance, if a company has costs that have increased at a greater rate than sales, it leads to a
lower profit margin. This is an indication that costs need to be under better control.
Imagine a company has a net income of Rs10 million from sales of Rs100 million, giving it a
profit margin of 10% (Rs10 million/Rs100 million). If in the next year net income rose to
Rs15 million on sales of Rs200 million, its profit margin would fall to 7.5%. So while the
company increased its net income, it has done so with diminishing profit margins.

The net profit margin ratio tells us the amount of net profit per Rupee of turnover a business
has earned. That is, after taking account of the cost of sales, the administration costs, the
selling and distributions costs and all other costs, the net profit is the profit that is left, out of
which the will pay interest, tax, dividends and so on.

OR

58
When we compare the gross and the net profit margins we can gain a good impression of their
non-production and non-direct costs such as administration, marketing and finance costs. The
following example makes this clear .

Gross profit is the profit we earn before we take off any administration costs, selling costs and
so on. So we should have a much higher gross profit margin than net profit margin. The gross
profit margins vary from business to business and from industry to industry. For example, the
international airline has a gross profit margin of only 5.62% yet the accounting software
business has a gross profit margin of 89.55%. If a company's raw materials and factory wages
go up a lot, the gross profit margin will go down unless the business increases its selling
prices at the same time.

Just like the gross profit margins, the net profit margins also vary from business to business
and from industry to industry. A comparison of the gross and the net profit margins gives
information on their non-production and non-direct costs such as administration, marketing
and finance costs.

59
Table 10.1 Gross and Net Profit Margin – Example

60
In the example, the international airline's gross profit margin is the lowest of this group of
eight businesses at only 5.62%; but its net profit margin is 4.05%, only a little bit lower than
its gross profit margin. On the other hand, the discount airline's gross profit margin is 27.46%
but its net profit margin is a lot less than that at 10.87%. These comparisons give us a great
insight into the cost structure of these businesses.

Look at the software business too, a very high gross profit margin of 89.55% but a net profit
margin of 27.15%. This is still high, but this implies that the administration and similar
expenses are very high whilst its cost of sales and operating costs are relatively very low.

After tax profit Margin

A financial performance ratio, calculated by dividing net income after taxes by net sales. A
company's after-tax profit margin is important because it tells investors the percentage of
money a company actually earns per dollar of sales. This ratio is interpreted in the same way
as profit margin - the after-tax profit margin is simply more stringent because it takes taxes
into account.

Net Income
Net income is a company's total earnings (or profit).
Net income is calculated by taking revenues and adjusting for the cost of doing business,
depreciation, interest, taxes and other expenses. This number is found on a company's income
statement and is an important measure of how profitable the company is over a period of time.
The measure is also used to calculate earnings per share. Often referred to as "the bottom line"
since net income is listed at the bottom of the income statement.

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Return on Investment Capital
A calculation used to assess a company's potential to be a quality investment by
determining how well (i.e.. profitably) a company's management is able to allocate capital
into its operations. Comparing a company's ROIC with its cost of capital reveals whether
invested capital was used effectively.
The general equation for ROIC is as follows:

Total capital includes long term debt, common and preferred shares. Since some companies
receive income from other sources or have other conflicting items in their net income, net
operating profit after tax (NOPAT) will be used instead.
This is always calculated as a percentage. Invested capital can be in buildings, projects,
machinery, other companies etc. One downside of ROIC is it tells nothing about where the
return is being generated. For example, it does not specify if it is from continuing operations
or from a one-time event, such as a gain from foreign currency transactions.
Returns on Capital - ROCE
Return on Capital Employed (ROCE) is used in finance as a measure of the returns that a
company is realizing from its capital employed. The ratio can also be seen as representing the
efficiency with which capital is being utilized to generate revenue. It is commonly used as a
measure for comparing the performance between businesses and for assessing whether a
business generates enough returns to pay for its cost of capital.

ROCE compares earnings with capital invested in the company. It is similar to Return on
Assets, but takes into account sources of financing. In the denominator we have capital
employed instead of total assets. In the numerator we have Pretax operating profit or EBIT.
(Earnings Before Interest and Tax)

The main drawback of ROCE is that it measures return against the book value of assets in the
business. As these are depreciated the ROCE will increase even though cash flow has
remained the same. Thus, older businesses with depreciated assets will tend to have higher
ROCE than newer, possibly better businesses. In addition, while cash flow is affected by
inflation, the book value of assets is not. Consequently revenues increase with inflation while
capital employed generally does not (as the book value of assets is not affected by inflation).
Return on Equity: A measure of a corporation's profitability that reveals how much profit a
company generates with the money shareholders have invested. It is calculated as

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 Also known as "return on net worth (RONW)", the ROE is useful for comparing the
profitability of a company to that of other firms in the same industry. There are several
variations on the formula that investors may use:

1. Investors wishing to see the return on common equity may modify the formula above
by subtracting preferred dividends from net income and subtracting preferred equity
from shareholders' equity, giving the following:
ROCE = net income - preferred dividends / common equity.
2. Return on equity may also be calculated by dividing net income by average
shareholders' equity. Average shareholders' equity is calculated by adding the
shareholders' equity at the beginning of a period to the shareholders' equity at period's
and dividing the result by two.
3. Investors may also calculate the change in ROE for a period by first using the
shareholders' equity figure from the beginning of a period as a denominator to
determine the beginning ROE. Then, the end-of-period shareholders' equity can be
used as the denominator to determine the ending ROE. Calculating both beginning and
ending ROEs allows an investor to determine the change in profitability over the
period.

============================

ECONOMIES OF SCOPE

Economies of scope are cost advantages that result when firms provide a variety of
products rather than specializing in the production or delivery of a single output. They
are potential cost savings from joint production – even if the products are not related to
one another. Economies of scope can arise from the sharing or joint utilization of inputs
and lead to reductions in unit costs.

Figure 1. Economies of Scope

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As shown in Figure 1, the cost for an enterprise is cut in half if the resources are used in
two enterprises rather than just one. If the use of the resources is spread over three
enterprises, the cost per enterprise is reduced to a third.

METHODS OF ACHIEVING ECONOMIES OF SCOPE

Flexible Manufacturing: The use of flexible processes and flexible manufacturing

systems has resulted in economies of scope because these systems allow quick, low-cost
switching of one product line to another. If a producer can manufacture multiple
products with the same equipment and if the equipment allows the flexibility to change
as market demands change, the manufacturer can add a variety of new products to their
current line. The scope of products increases, offering a barrier to entry for new firms
and a competitive synergy for the firm itself.

Related Diversification: Economies of scope often result from a related diversification

strategy and may even be termed "economies of diversification." This strategy is
operationalized when a firm builds upon or extends existing capabilities, resources, or
areas of expertise for greater competitiveness. Firms select related diversification as
their corporate-level strategy in an attempt to exploit economies of scope between their
various business units. The cost-savings result when a business transfers expertise in one
business to a new business. The businesses can share operational skills and know-how in
manufacturing or even share plant facilities, equipment, or other existing assets. They
may also share intangible assets like expertise or a corporate core competence. Such
sharing of activities is common and is a way to maximize limited constraints.

Mergers: The merger wave in the world today is, in part, an attempt to create scope
economies. Pharmaceutical companies frequently combine forces to share research and
development expenses to bring new products to market. Pharmaceutical firms involved
in drug discovery realize economies of scope by sustaining diverse portfolios of research
projects that capture both internal and external knowledge spillovers.

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 Linked supply chains: Today's linked supply chains among raw material suppliers,
other vendors, manufacturers, wholesalers, distributors, retailers, and consumers often
bring about economies of scope. Integrating a vertical supply chain results in
productivity gains, waste reduction, and cost improvements. These improvements,
which arise from the ability to eliminate costs by operating two or more businesses
under same corporate umbrella, exist whenever it is less costly for two or more
businesses to operate under centralized management than to function independently.

Cost savings opportunities can stem from interrelationships anywhere along businesses'
value chain. As firms become linked in supply chains, particularly as part of the new E-
economy, there is a growing potential for economies of scope. Scope economies can
increase a firm's value and lead to increases in performance and higher returns to
shareholders. The scope economies can also help a firm to reduce risks.

The factors causing economies of scope for a multi product firm are:

• Cost complementarity
• Economies of initial capital requirement.

The cost advantages giving rise to economies of scope is expressed as:

Where S is the percentage cost reduction through joint production.CQ 1 is the cost of
producing good 1 if products are made separately; CQ2 is the cost of producing another
different good. If we add these two we get the total cost of producing the two goods
separately. But if they are produced jointly, the cost is C ( Q1 Q2 ). If there are
economies of scope, C Q1+ C Q2 > C ( Q1Q2)

Economies of scope are not the same as economies of scale. Whereas economies of
scale apply to efficiencies associated with increasing or decreasing the scale of
production, economies of scope refer to efficiencies associated with increasing or
decreasing the scope of marketing and distribution. Whereas economies of scale refer to
changes in the output of a single product type, economies of scope refer to changes in
the number of different types of products. Whereas economies of scale refer primarily to
supply-side changes (such as level of production), economies of scope refer to demand-
side changes (such as marketing and distribution). Because they frequently involve
marketing and distribution efficiencies, economies of scope are more dependent upon
demand than economies of scale. Economies of scope are one of the main reasons for
such marketing strategies as product bundling, product lining, and family branding.
However, economies of size and scope are not mutually exclusive. While economies of scope
allow costs to be spread over several products, the volume of each product can be increased to
also achieve economies of size

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Economies of scope can help companies gain a significant competitive advantage. Not
only do they trim expenses on a per-unit basis and improve profitability, but they can
also force less cost-efficient competitors out of the industry or discourage would-be
rivals from even entering the market.

Section A questions

1.Distinguish between substitutes and complements.

Goods that are substitutes satisfy the same set of goals or preferences. An example of a
substitute for coffee is tea. If coffee prices are high, people are tempted to shift away from coffee
to tea, and if coffee prices are low, people are tempted to shift from tea to coffee.
Complements: A complement is a good that helps complete consumption of another good in
some way. Complement goods are used together. The opposite of a substitute is a complement.
The demand for complements move in the same direction. Ink is a complement to pen, and if pen
is priced low enough, consumption of ink may rise. Car and petrol are complements. Sometimes
goods are such good complements that they are sold together and we think of them as a single
item. Left shoes and right shoes are an example.

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-----------------------------------------------------------------------
2.Bring out the relationship between slope of a demand curve and elasticity of demand.

Elasticity and demand slope: The slope of a straight-line demand curve, one with a constant
slope, has constantly change elasticity. No two points on a straight-line demand curve as the same
elasticity. The point of intersection between the demand curve and the vertical, price axis is
perfectly elastic (E = ∞). The intersection point between the demand curve and the horizontal,
quantity axis is perfectly inelastic (E = 0). The exact middle, or midpoint, of the demand curve is
unit elastic (E = 1). The segment between the midpoint and the price-axis intercept is relatively
elastic (1 < E < ∞). The segment between the midpoint and the quantity axis intercept is relatively
inelastic (0 < E < 1).
It is observed that an elastic demand curve has low slope while an inelastic demand curve is steep
and has a high slope. However slope depends on the scale we choose for both price and quantity.

_______________________________________________

3.Write a note on : rectangular hyperbola demand curve.

A demand curve of constant elasticity of -1 will be a rectangular hyperbola. A rectangular

hyperbola is a curve which joins all the P: Qd points for which P x Qd (total sales revenues, or
total consumer spending) is constant. Thus all rectangles under the demand curve have the same
area ( P.Q). Such a unitary elastic demand curve is asymptotic, ie, it approaches the axis but will
never touch it.

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_____________________________________________
4.Distinguish between fixed cost and variable cost.

Total cost can be divided into two portions: Fixed Cost and variable cost.
Fixed cost is the part of the budget that stays the same regardless of production level, even if
production is zero. Overhead, rent on buildings, and interest on loans are in fixed cost.
Variable Cost is the rest of total cost, the part that varies with production level. Producing more
adds to Variable Cost. Producing less reduces it. Thus variable cost is a function of output.
Expenditure on raw material and labour employed is variable cost.

_____________________________________________

5.Show that the average fixed cost curve is a rectangular hyperbola.

AFC = TFC/q, where TFC is constant. Since total fixed costs are constant , as output increases,
fixed costs per unit of output decline—a process that many managers describe as “spreading
overhead” through high volume. If we arbitrarily select any two points on the AFC curve (say, a
and b), the rectangles formed by dropping horizontal and vertical lines to the axes have identical
areas. Since AFC = TFC/q, multiplication of AFC by q yields TFC - ( TFC/q x q = TFC, which is
constant.) Thus, the AFC curve is a rectangular hyperbola and they resemble unitarily elastic
demand curves, which are also rectangular hyperbolas.

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 6.Why is SAC ‘U’ shaped?
The short run average cost curve is u shaped because of the Law of Variable Proportions,
which is the short run production function. In the short run since quantity of some factors such as
machines , ( capital) can not be increased, the variable factor does not get adequate capital to work
with as output increases. As a result initially when capital is in surplus, that is proportion of
capital to labour is high, the marginal product and average product of the variable input ( labour)
increases ( TP of the variable input increases at increasing rate ), and subsequently as the
proportion of capital to labour becomes less and less, the marginal product and average product of
starts decreasing ( TPL increases at decresing rate) and eventually MPL may even become negative
if production continues beyond the point where TPL is maximum. Correspondingly, when AP
increases the SAC initially decreases, reaches a minimum ( where AP L is maximum) and after
reaching minimum starts increasing, as APL starts decreasing. Thus the U shape of SAC may be
attributed to Law of Variable Proportions. This is illustrated below.

________________________________________________________
7.What are economies of scale?

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When more units of a good or a service can be produced on a larger scale, yet with (on average)
less input costs, economies of scale (ES) are said to be achieved. Alternatively, this means that as
a company grows and production units increase, a company will have a better chance to decrease
its costs. Thus economies of scale are reductions in cost enjoyed by the firm as it expands its
output either because of its own action or because of an action or decision external to the firm.
Adam Smith identified the division of labor and specialization as the two key means to achieve a
larger return on production. Through these two techniques, employees would not only be able to
concentrate on a specific task, but with time, improve the skills necessary to perform their jobs.
The tasks could then be performed better and faster. Hence, through such efficiency, time and
money could be saved while production level increased. The downward sloping portion of Lac is
because of the strong economies of scale.

8. Distinguish between internal and external economies of scale

Alfred Marshall made a distinction between internal and external economies of scale. When the
increase in production of a firm reduces its cost internal economies of scale have been achieved.
External economies of scale occur outside of a firm, within an industry. Thus, when an industry's
scope of operations expands due to, for example, the creation of a better transportation network,
resulting in a subsequent decrease in cost for the firm working within that industry, external
economies of scale are said to have been achieved. With external economies , all firms within the
industry will benefit.

9. How are economies different from diseconomies

Economies of scale are reductions in cost enjoyed by the firm as it expands its output either
because of its own action or because of an action or decision external to the firm. Division of labor
and specialization as the two key means to achieve a larger return on production.
Diseconomies stem from inefficient managerial or labor policies, over-hiring or deteriorating
transportation networks (external DS). Furthermore, as a firm’s scope increases, it may have to
distribute its goods and services in progressively more dispersed areas. This can actually increase
average costs resulting in diseconomies of scale. Thus economies reduce cost for the firm as it
expands while diseconomies increase cost for the firm as production is increased.

10.The wages paid to workers – is it a fixed cost or variable cost. Account for your answer.
The wages paid to workers is variable cost since it varies with output. An expansion in output
requires more labour and hence the wage bill component of the total cost will increase with
increase in output.Hence wages paid to labour is a variable cost

11.The expenditure on maintenance of machines and equipments – fixed or variable cost. Explain.
The expenditure on maintenance of machines and equipments is a fixed cost. Fixed costs such
as expenditure on maintenance of machines and equipments is an expenditure incurred per time
period and do not change with output and must be incurred even if the output level is zero.

12.What are the components of fixed cost?

Components of fixed cost are:
• salaries of administrative staff
• depreciation ( wear and tear ) of machinery
• expenses for building depreciation and repairs
• expenses for land maintenance and depreciation.

13.What is excess capacity.

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 Excess capacity is the unutilized capacity in the plant corresponding to equilibrium output.
It is the difference between the output corresponding to minimum cost ( more often referred to as
the competitive output) and the equilibrium output. Excess capacity exists under imperfect
competition since firms under imperfect competition have a downward sloping demand curve
depicting their monopoly power. Excess capacity is undesirable because it leads to higher unit

cost.

14. Can a firm under monopolistic competition make super normal profits in the long run.
Firms under monopolistic competition can make only normal profit, in spite of a downward
sloping demand curve because of the condition of free entry and exit. As a result any excess
profit that arises due to differentiated products or advertisements or due to price reductions will be
wiped out by the entry of new firms. The long run equilibrium for a firm under monopolistic
competition is illustrated below:

15.How is monopolistic competition different from perfect competition

Monopolistic competition is different from perfect competition on following grounds:

Monopolistic competition is characterised by large number of firms but not as large as under perfect
competition.
Under monopolistic competition the firm is a price maker and it indulges in price competition
A firm under monopolistic competition indulges in non price competition through product
differentiation and selling costs which gives some monopoly power to the firms. As a result the

71
firm’s demand curve is not perfectly elastic as under perfect competition but downward sloping
and fairly elastic.
A perfectly competitive firm earns only normal profit in the long run because of free entry
conditions and the long run equilibrium ensures productive and allocative efficiency. That is,
corresponding to long run equilibrium, P = MC, and LAC is at its minimum as shown in the
figure.
A firm under monopolistic competition also makes only normal profit in the long run like a
competitive firm but the normal profit comes with excess capacity. Due the downward sloping AR
curve, there is unused capacity in the plant at equilibrium and P > MC. Thus the firm at
equilibrium is characterised by both productive and allocative inefficiency, as shown in the figure.

16.Distinguish between monopoly and monopsony. Give examples.

Monopoly is characterized by single seller where as monopsony is characterized by single buyer.

Indian railways is an example of monopoly where as Integrated coach factory that used to be the
exclusive supplier of coaches to Indian railways was a good example of monopsony until some
years back.

17.What are economies of scope.

Economies of scope are changes in average costs because of changes in the mix of
output between two or more products. This refers to potential cost savings from joint
production even if the products are not directly related to each other. For example a
company’s management structure , administrative systems and marketing departments are
capable of carrying out these functions for more than one product. Warehouse facilities
may be used to maximum advantage by storing a range of the company’s product lines.
Often, as the number of products promoted is increased and broader media used, more
people can be reached with each rupee spent. This is one example of economies of
scope. . In the publishing industry there might be substantial cost savings from using a
team of journalists produce more than one magazine
Example: The Hindu group of publications producing Business Line, Front Line, the
Survey of Industries and the Survey of Environment. etc apart from The Hindu.
Economies of scope occur when there are potential cost savings from by products in the
production process.
18. Distinguish between economies of scale and economies of scope

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 Economies of scope are changes in average costs because of changes in the mix of
output between two or more products while economies of scale are change in average cost
due to changes in scale of output. Economies of scale refers to the notion of increasing
efficiencies of the production of goods as the volume of output increases.
Economies of scope are similar to Economies of scale. Whereas economies of scale refer
to changes in the output of a single product type, economies of scope refer to changes in
the number of different types of products. Whereas economies of scale apply to
efficiencies associated with increasing or decreasing the scale of production, economies of
scope refer to efficiencies associated with increasing or deceasing the scope of marketing
and distribution.. Economies of scale refer primarily to supply-side changes (such as level
of production), but economies of scope refer to demand-side changes (such as marketing
and distribution). Economies of scope are one of the main reasons for such marketing
strategies as product bundling, product lining, and family branding.
19. What is product differentiation.
Products are differentiated when the products of different firms are not perfect substitutes
-- instead, "every firm has a monopoly of its own product." Nevertheless, firms may
compete by changing the characteristics of the product they sell. The idea is not
necessarily to make a better product than the competitor, just different -- to appeal to a
different "market niche."

• It increases variety, thus increasing the range of consumer choice.

• It divides up the market, leading to higher prices and costs

Product differentiation is a salient feature of imperfect competition , particularly

monopolistic competition. Product differentiation is intended to distinguish product of one
firm from that of other firms in the industry. It creates brand loyalty of the consumer and
gives rise to a downward sloping demand curve.
20 How does product differentiation influence concentration.
Product differentiation increases concentration by acting as an entry barrier. In markets
where product differentiation is intense, entry barriers are strengthened and hence the
entry preventing price PL will be closer to the profit maximizing price. Product
differentiation gives monopoly power to the firm and increases concentration.
21.Will advertisement for a firm’s product increase concentration of firms in the market.
Advertising expenses are basically expenses incurred to alter the shape and
position of the demand curve. More specifically they make the demand curve for the
firm’s product more inelastic and shifts it upward by altering peoples preferences in
favour of the firm’s product. As a result it acts as an entry barrier and enables the firm to
increase its limit price, closer to monopoly profit maximizing price and yet prevent entry.
Thus advertisement increase concentration .
22. What can you infer about market concentration from elasticity of demand?
In a concentrated market elasticity of demand is low or demand is relatively less elastic.
On the other hand , in a market with fairly elastic demand concentration is low. Monopoly
is the example of extremely high concentration while perfect competition, in which firms
have with perfectly elastic demand curve, is best example of zero or low concentration
with high elasticity. Oligopoly wit fewer firms and greater concentration had relatively

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inelastic demand curve. Monopolistic competition with relatively elastic demand curve for
the firm, has low concentration.
23.What are contestable markets.?
A contestable market is a market with low barriers to entry, and a perfectly contestable
market requires a total absence of barriers to entry. If super-normal profits are earned
potential competitors may enter the market, so it is argued that the existing firm(s) will
keep prices and output at a level where only normal profits are made. In some cases
potential competitors may engage in hit-and-run behaviour. A hit-and-run competitor will
notice when super-normal profit is being made, enter the market and take advantage of the
situation. As prices settle down once more the hit-and-run competitor exits the market
again. Thus the incumbent firms become wary of the potential competitor and set prices so
that hit-and-run competitors are discouraged. For hit-and-run competition to be a threat,
not only must the costs of entry to the market be low, the costs of exit need to be low too.
The costs of exit are sometimes called ‘sunk costs’. These are costs that cannot be
recovered when the firm leaves the market. Thus a contestable market requires both low
entry and exit barriers.
UNIT 3
24. Define selling costs
Selling costs are costs incurred to alter the shape and position of the demand curve. These
are undertaken by the firm to create brand loyalty and to make the product unique in the
mind of the consumer. They are additions to production cost incurred to persuade the
consumer and to change the preferences of the consumer towards the product that is
promoted. Selling costs serve as barrier to entry for the incumbent firms.
25. Barriers to entry are those factors that allow incumbent firms to earn positive
economic profits, while making it unprofitable for newcomers to enter in to the industry.
Barriers to entry may be structural or strategic. Structural entry barriers result when the
incumbent has natural cost or marketing advantages or benefits from favourable
regulations. Strategic entry barriers result when the incumbent aggressively prevents
entry. Such entry deterring strategies include limit pricing, predatory pricing and capacity
expansion.
26.Collusive oligopoly --A market situation in which the sellers have entered into express
agreements on price and output, i.e., a cartel. In general, the smaller the number of firms
in a market (and the larger their respective market shares), the less their need to use actual
collusion as a coordinating device; "oligopolistic interdependence" is frequently sufficient
in the tight-knit oligopolies. (See Oligopoly.) In the looser oligopolies, however, the larger
number of firms and their smaller individual market shares greatly weakens that sense of
interdependence and hence increases the difficulty of maintaining coordinated prices
except through the cartel apparatus of agreements, sanctions, and so forth.
.27. Concentration—Concentration is the combined market share of the leading firms or
oligopolists .It is the number and size distribution of the firms in an industry or market,
most commonly expressed in terms of a "concentration ratio," i.e., the percentage of
production or sales accounted for by some relatively small number of firms, generally the
"four largest" and the "eight largest." The competitive significance of these ratios is said to
lie in the proposition that they are correlated with price levels--the higher the
concentration ratio, the further the price is expected to rise above the competitive floor and
toward the monopoly ceiling. In substance, as the number of firms decline and the size of

74
their respective shares increases, the incentive to engage in price competition is lessened
and their incentive (and capacity) to collude, either expressly or tacitly, is increased.
28. Monopsony--A market with only a single buyer, the buying-side counterpart of
Monopoly (a single firm on the selling side). Just as the monopolist finds it profitable to
restrict output below the competitive level in order to raise the price, the monopsonist
finds it profitable to restrict its purchases--to buy fewer units than would have been
purchased by a group of competing buyers under similar conditions--and thereby depress
the price it has to pay below the competitive level, i.e., below that which a group of
competing buyers would have offered.
29. Limit pricing: Limit pricing refers to the practice whereby an incumbent firm
discourages entry by charging a low price lower so that in the post entry period the price
would not cover the cost of the entrant and thus make entry unprofitable for the entrant.
Thus limit price will dissuade the entrant from entering the industry. Limit price is given
as :

PL = PC ( 1+ E )
Where E is the condition of entry
E can be expressed as
PL – PC
E = ----------
PC

30.Predatory pricing refers to the practice of setting a low price in order to drive other
firms out of business. The predatory firm expects that whatever losses it incurs while
driving competitors from the market can be made up later through the exercise of market
power. The predatory firm first lowers its price until it is below the average cost of its
competitors. The competitors must then lower their prices below average cost, thereby
losing money on each unit sold. If they fail to cut their prices, they will lose virtually all of
their market share; if they do cut their prices, they will eventually go bankrupt. After the
competition has been forced out of the market, the predatory firm raises its price,
compensating itself for the money it lost while it was engaged in predatory pricing, and
earns monopoly profits forever after. The difference between predatory pricing and limit
pricing is that limit pricing is directed at firms that have not at entered the market
( potential entrant) where as predatory pricing is aimed at firms that are already in the
market. In the late nineteenth century, Standard Oil's allegedly predatory price cutting
,drove out the Pure Oil Company, from the petroleum-refining business.
31.Discriminatory pricing refers to the charging of different prices for different
quantities of a commodity or in different markets which are not justified by cost
differences. By practicing price discrimination the monopolist can increase its total
revenue and profits. Price discrimination is practiced by the monopolist when the demand
for the commodity in the different markets is not isoelastic, that is , elasticity of demand
for the differs in different parts of the market.
32. Elasticity of demand and price discrimination : An important condition for price
discrimination is that the demand for the commodity in the different segments of the
markets should not be isoelastic. The monopolist will charge a high price in the market

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 where demand is relatively inelastic and a lower price in the market with relatively elastic
demand.
33. PL, PC, PM - Comparison
Limit price, PL, is the price that deters entry. It is normally lower than profit maximizing
price and higher than competitive price depending on ht strength of the barriers. If barriers
are strong the limit price PL is closer or in the extreme case equal to profit maximizing
price. If entry barriers are weak the limit price may equal competitive price. Competitive
price is equal to marginal cost and monopoly profit maximizing price is given by MC =
MR condition and is greater than MC. The three are shown in the following diagram that
is drawn on the assumption of constant cost conditions so that AC = MC .

The limit price PL shown in figure will move toward PM if barriers to enter are strong and
will move towards PC if barriers to enter the industry are weak.

34. Relation ship between limit price and entry barrier

Limit price PL is defined as :
PL = PC ( 1+ E ) , where E is the condition of entry.
When entry barriers such as product differentiation and advertisements are high , limit
price PL will be high and closer to profit maximising price P M and entry barriers are weak,
PL will be low and closer to competitive price. Thus strong barriers result in high limit
price and weak barriers result in low limit price.

Unit 4 – Mergers
35.Which kind of merger always increases market power?
Horizontal mergers invariably increases market power, since by definition they eliminate
side by side competition between two firms. The effect may be small or large depending
on the two firms market share and on other conditions of market. Horizontal merger
occurs between companies producing similar goods or offering similar services and hence
increases market power and market concentration. This type of merger occurs frequently
as a result of larger companies attempting to create more efficient economies of scale. The
amalgamation of Ponds and Hindustan Lever is a popular example of a horizontal merger.
36.The main goals of the merger are:
• increased market share

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• profit maximisation
• improving efficiency
• risk spreading
These goals can be reached by internal growth and long term contracts.
37. Reasons for the break of merger
1.Not having clear goals and plans to achieve them
2.Skimping on the merger integration budget. Companies often think they can save by
cutting costs on the merger integration process. This is not the place to skimp.
Management often miscalculates the length of time the merger will take, and the
complexity of the merger.
3.Moving too slowly. Allowing things to settle down before making changes is dangerous.
Moving too slowly increases the uncertainty and anxiety felt by employees. Many
companies believe they can conduct business as usual while they figure out the best course
to take with the merged companies. This is a big mistake because once employees and
customers smell the scent of a merger, business is never the same.
4.Not clearly defining roles, responsibilities, and working relationships. People are
worried about their short-term and long-term futures. Without clear responsibilities and
lines of authority, workers go into idle mode as they wait and see what happens. They
hesitate when making decisions because they do not understand the rules for making
decisions, the rewards for making correct decisions, and the penalties for making
mistakes.
38.Mergers in Indian business scenario:
In India since the 1970s both MRTP and non-MRTP companies have used mergers and
take-overs as an important means of growth. Second, there was acceleration in the merger
movement in the liberalisation years of the 1990s. The total number of amalgamations
during the period 1975-76 to 1979-80 was 156. The figure remained at 156 during 1980-
81to 1984-85, and then fell to 113 during the period 1985-86 to 1989-90. However,
facilitated by changes in the policy environment, the number of mergers rose sharply to
236 during the period 1990-91 to 1994-95. The participation of manufacturing firms in the
merger movement was always higher than that of the non manufacturing firms However,
the participation of non-manufacturing firms in the amalgamation trend increased sharply
in the 1990s. the average number of non manufacturing firms resorting to mergers during
the period 1990-94 had touched 22, which was not far below the 25 recorded in the case of
manufacturing firms. One reason for this was the financial liberalisation of the 1990s
which increased mergers with a dormant finance companies to facilitate early listing in
the stock market which allowed the private limited companies to exploit the capital
market boom through the private placement of shares.

Unit 5
39. Indicators of performance:
The main indicators of performance are:
Efficiency – referring to maximum value of output for given values of input. His is
productive efficiency.
Efficiency also includes allocative efficiency which requires that at equilibrium, P =
Marginal cost.

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 Profit: Profit is the difference between turnover, or sales, and costs. There are several
ways of measuring profit: gross profit; net profit before and after taxation; and retained
profit are just some of them

Gross profit margin is :

Gross Profit Gross Profit

= * 100
Margin Turnover

The gross profit margin ratio tells us the profit a business makes on its cost of sales, or
cost of goods sold. It is a very simple idea and it tells us how much gross profit per Re1 of
turnover our business is earning. Gross profit is the profit firms earn before deducting
any administration costs, selling costs and so on. G Hence gross profits are higher than net
profit margin.

Net Profit = Gross Profit – Expenses

Net Profit
Net Profit Margin = * 100
Turnover

The net profit margin ratio tells us the amount of net profit per Re of turnover a business
has earned. That is, after taking account of the cost of sales, the administration costs, the
selling and distributions costs and all other costs, the net profit is the profit that is left, out
of which firms will pay interest, tax, dividends and so on.

40. Can competition optimize the conservation of resources?

Perfect competition ensures optimum allocation of resources and least cost production
when all firms are in long run equilibrium. The features of perfect competition
.particularly the features of large number of buyers and sellers, homogeneous products
and fee entry and exit conditions make the firm a price taker. Hence the demand curve of
the firm is perfectly elastic at the given price level. Free entry conditions wipe out all the
short period profits. In the long run at equilibrium , not only is the firm’s MC = MR, the
condition necessary for profit maximization, but P is also equal to MC and LAC is at its
minimum at equilibrium. The equality of P to MC indicated allocative efficiency and
minimisation of cost indicates productive efficiency. Plant is fully utilizes and there is no
unused capacity in the plant. There is no X inefficiency. The fulfillment of productive and

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allocative efficiency indicate that optimum conservation of resources. The following

figure illustrates this condition:

41. Will monopoly illustrates this condition distort optimum allocation of resources

Monopoly distorts optimum allocation of resources because under monopoly the firm
( industry) is a price maker and given closed entry conditions the monopolists exploits the
consumers by charging high price and restricts output. The price charged by the
monopolist is greater than marginal cost indicating allocative inefficiency and the
equilibrium of the monopolist corresponds to falling portion of the AR ( Dd) curve. Thus
there is productive inefficiency and the output is less than competitive output. This implies
that there is excess capacity under monopoly. The productive and allocative inefficiencies
resulting in distortion of optimal results is shown below:

42. What is monopoly burden

Monopoly charges a price that is greater than marginal cost and hence there is a dead
weight loss under monopoly. Under perfect competition P = MC and hence aggregate
social welfare measured by consumer surplus and producer surplus is maximized. This
dead weight of monopoly is illustrated below. The assumption of constant cost conditions
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gives rise to a long run supply curve that is a horizontal straight line. If this line is treated
as the competitive supply curve, long run competitive equilibrium is at E C with an output
XC price PC = LMC. Consumer surplus is equal to the triangle DP CEC and producer surplus
is zero. The same diagram can be used to show the position of the monopolist, considering
the LRS of the competitive firm as the LMC. The monopolist will set a price and output
using the MC = MR condition. He will produce QMamount of output and charge PM
price .His consumers surplus is the area DAPM and producer surplus is the area PM ABPC.
Comparing this with perfect competition , there is a dead weight loss under monopoly
equal to the area ABEC. Therefore the monopoly of the firm under monopoly creates
greater producer surplus and lower consumer surplus in comparison to perfect
competition which is termed as dead weight loss or monopoly burden.

43. Allocative efficiency and X efficiency

Allocative efficiency occurs when output is at the level where marginal cost is equal to
price in each product of each firm throughout the economy. X-efficiency is the
effectiveness with which a given set of inputs are used to produce outputs. If a firm is
producing the maximum output it can, given the resources it employs, such as men and
machinery, and the best technology available, it is said to be x-efficient. X-inefficiency,
on the other hand, is the difference between efficient behavior of firms assumed or
implied by economic theory and their observed behavior in practice. In perfect
competition, the free entry and exit of firms enable firms to produce at the point where
price equals long run average costs and long run average costs are minimized. Thus firms
earn zero economic profits and consumers pay a price equal to the marginal cost of
producing the good. This result defines economic efficiency or, more precisely, allocative

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 economic efficiency. Perfect competiton satisfies Xefficiency too. X-efficiency is also
known as technical efficiency.

In a market with perfect competition, there will in general be no X-inefficiency because if

any firm is less efficient than the others it will not make sufficient profits to stay in
business in the long term. However, with other market forms such as monopoly it may be
possible for x-inefficiency to persist, because the lack of competition makes it possible to
use inefficient production techniques and still stay in business.

44. State the factors giving rise to in efficiency in production

Some of the important factors giving rise to inefficiency in production are:

• lack of competition
• obsolete production technology
• product differentiation and advertisemen that increase cost that resultin a
downward sloping demand curve.
• Strong entry and exit barriers

45. Which market structure is favourable for invention? Why?

The inventive effort will normally be optimised by competitiors. Effective competition –
from atomistic to loose oligopoly structure tends to opitmise both invention and
innovation. It also passes on the benenfits to consumers.Monopolists, by contrast, tend to
invent and innovate below optimum levels.They also retain much of the value of progress
in their excess profits. Therefore the monopolist will apply a restrictive policy to
inventions seeking and using them less fully than would occur under competition.
Similarly a monopolist believes that a new innovation will destry some or all th evalueof
its existing technology.For example, satellite communication can make telephone cables
worthless. Hence a monopolist always will bring in new processes and products at below
the social optimal rate and competitiors will innovate more fully than mnopolist.
46.Is R & D to be maximised or optimised?
R &D is to be optimised because it is an input.It is to be minimised for any given level of
yield.Opimum R & D is given by the equlity of marginal cost of R & D to marginal rate of
return from R & D’ as shownin the following figure:

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47.Two industries with high degree of technological opportunity :
Electricals and electronics, automobile industry etc.
Two industries with low degree of technological opportunity : Paper industry,

48.Competition optimises innovation while monopoly optimises innovation – This is not a

valid statement since both invention and innovation are optimised only under competition
and monopoly tends to restrict them.. Effective competition – from atomistic to loose
oligopoly structure tends to opitmise both invention and innovation. It also passes on the
benenfits to consumers.Monopolists, by contrast, tend to invent and innovate below
optimum levels.They also retain much of the value of progress in their excess profits.
Therefore the monopolist will apply a restrictive policy to inventions seeking and using
them less fully than would occur under competition. Similarly a monopolist believes that a
new innovation will destry some or all th evalueof its existing technology.For example,
satellite communication can make telephone cables worthless. Hence a monopolist always
will bring in new processes and products at below the social optimal rate and competitiors
will innovate more fully than mnopolist.

49 Normal profit denotes the minimum return required to induce an individual or a firm
to invest in a particular productive activity. Normal profits are in effect the minimum
required return to capital in risky ventures, they are treated by economists as being
essentially costs of production and are therefore included in the cost functions of the firm.
A firm is said to be earning normal profits when its average cost is equal to its average
revenue. If we define profits as Π = R – C , then normal profits are included in the term C.
In the figure, at the equilibrium point e , the firm’s AC is tangent to AR and hence the
firm is making only normal profits. The symbol Π denotes any profit the firm earns
over this normal amount, and so is called super normal profit. Normal profits for a
competitive firm and super normal profit for an imperfectly competitive firm are shown
below.

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50. Firms under perfect competition and monopolistic competition can make only normal
profits in the long run as shown below:

A firm under any form of imperfect competition except monopolistic competition can earn
super normal profits both in the short run and long run. as shown below:

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 51.Market concentration and profits:
Profits are higher in markets that are concentrated such as oligoploy and monopoly. Firms
in such markets can enjoy super normal profits in both short run and long run.Firms in
markets such as perfect competition and monopolistic competition which are not
concentrated do not earn super normal profits in ht elong run because of absence of entry
barriers.however th efirms in such markets will earn super normal profit in the short run.
In general, in highly concentrated markets profits are higher than in markets where
concentration is insignificant.

52.Will barriers to entry affect profits: Barriers to enter a market will increase the
profits of an incumbent firm. Barriers to entry will increase concentration and market
share and thus enhance profits of a existing firm. The various barriers are :
Product differentiation ,advertisement ,absolute cost advantage barrier ,high initital capital
requirement barrier
In the presence of such barriers the limit proce of the firm will be closer to or equal to
profit maximising price and the firms will earn higher profits than in the absence of such
barriers. When these barriers are weak the firm will have to charge a price as low as
competiitve priceand forego market as well as profits in the post entry period. The figure
below shows the limit price the firms can charge under different strengths of barriers . A
higher limit price gives the firm higher profit and a lower limit price reduces the profit to
normal profit level.

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