Microeconomics

Theory of cost
An amount that has to be paid or given up in order to get something.

In business, cost is usually a monetary valuation of (1) effort, (2) material, (3) resources, (4) time and utilities consumed,
(5) risks incurred, and (6) opportunity forgone in production and delivery of a good or service. All expenses are costs, but
not all costs (such as those incurred in acquisition of an income-generating asset) are expenses.
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cost
(kôst)
n.
1. An amount paid or required in payment for a purchase; a price.
2. The expenditure of something, such as time or labor, necessary for the attainment of a goal: "Freedom
to advocate unpopularcauses does not require that such advocacy be without cost" (Milton Friedman).
3. costs Law Charges incurred in bringing litigation, including court fees and charges that may be payabl
e by the losing party, butusually not including attorneys' fees.
v. cost, cost·ing, costs
v.intr.
To require a specified payment, expenditure, effort, or loss: It costs more to live in the city.
v.tr.
1. To have as a price.
2. To cause to lose, suffer, or sacrifice: Participating in the strike cost me my job.
3. past tense and past participle costed To estimate or determine the cost of: The accountants costed
Full Definition of COST

1
a : the amount or equivalent paid or charged for something : PRICE
b : the outlay or expenditure (as of effort or sacrifice) made to achieve an object
2
: loss or penalty incurred especially in gaining something
3
plural : expenses incurred in litigation; especially : those given by the law or the court to the
prevailing party against the losing party
— cost·less \-ləs\ adjective
Types of Costs
Tejvan Pettinger January 15, 2012 economics
A list and definition of different types of economic costs
Fixed Costs (FC). The costs which don’t vary with changing output. Fixed costs might
include the cost of building a factory, insurance and legal bills. Even if your output
changes or you don’t produce anything, your fixed costs stays the same. In the above
example, fixed costs are always £1,000.
Variable Costs (VC). Costs which depend on the output produced. For example, if you
produce more cars, you have to use more raw materials such as metal. This is a
variable cost.
Semi-Variable Cost. Labour might be a semi-variable cost. If you produce more cars,
you need to employ more workers; this is a variable cost. However, even if you didn’t
produce any cars, you may still need some workers to look after empty factory.
Total Costs (TC) – Fixed + Variable Costs
Marginal Costs – Marginal cost is the cost of producing an extra unit. If the total cost of
3 units is 1550, and the total cost of 4 units is 1900. The marginal cost of the 4th unit is
350.
Opportunity cost – Opportunity cost is the next best alternative foregone. If you invest
£1million in developing a cure for pancreatic cancer, the opportunity cost is that you
can’t use that money to invest in developing a cure for skin cancer.
Economic Cost. Economic cost includes both the actual direct costs (accounting costs)
plus the opportunity cost. For example, if you take time off work to a training scheme.
You may lose a weeks pay £350, plus also have to pay the direct cost of £200. Thus
the total economic cost = £550.
Accounting Costs – this is the monetary outlay for producing a certain good.
Accounting costs will include your variable and fixed costs you have to pay.
Sunk Costs. These are costs that have been incurred and cannot be recouped. If you
left the industry you cannot reclaim sunk costs. For example, if you spend money on
advertising to enter an industry, you can never claim these costs back. If you buy a
machine, you might be able to sell if you leave the industry.
Avoidable Costs. Costs that can be avoided. If you stop producing cars, you don’t
have to pay for extra raw materials and electricity. Sometimes known as an escapable
cost.
Market Failure
 Social Costs. This is the total cost to society. It will include the private costs plus also the
external cost (cost incurred by a third party). May also be referred to as ‘True costs’
 External Costs. This is the cost imposed on a third party. For example, if you smoke, some
people may suffer from passive smoking. That is the external cost.
 Private costs. The costs you pay. e.g. the private cost of a packet of cigarettes is £6.10
 Social Marginal Cost. The total cost to society of producing one extra unit. Social Marginal
Cost (SMC) = Private marginal cost (PMC) + External marginal Cost (XMC)
Diagram of Costs
For diagrams of costs see: Diagrams of cost curves
Average Cost Curves
 ATC (Average Total Cost) = Total Cost / quantity

 AVC (Average Variable Cost) = Variable cost / quantity
 AFC (Average Fixed Cost) = Fixed cost / quantity
All Types of Costs in Economics with Examples?

8:45 AM Costs, Economics No comments
There are several costs that a firm should consider under relevant circumstances. It is quite essential for a firm to
understand the difference between various cost concepts for the purpose of production/business decision making.
The following are the various cost concepts/types of costs.
(A) Actual Cost

Actual cost is defined as the cost or expenditure which a firm incurs for producing or acquiring a good or
service. The actual costs or expenditures are recorded in the books of accounts of a business unit. Actual
costs are also called as "Outlay Costs" or "Absolute Costs" or "Acquisition Costs".
Examples: Cost of raw materials, Wage Bill etc.
(B) Opportunity Cost

Opportunity cost is concerned with the cost of forgone opportunities/alternatives. In other words, it is the
return from the second best use of the firms resources which the firms forgoes in order to avail of the return
from the best use of the resources. It can also be said as the comparison between the policy that was
chosen and the policy that was rejected. The concept of opportunity cost focuses on the net revenue that
could be generated in the next best use of a scare input. Opportunity cost is also called as "Alternative
Cost".
If a firm owns a land, there is no cost of using the land (ie., the rent) in the firms account. But the firm has
an opportunity cost of using the land, which is equal to the rent forgone by not letting the land out on rent.
(C) Sunk Cost

Sunk costs are those do not alter by varying the nature or level of business activity. Sunk costs are
generally not taken into consideration in decision - making as they do not vary with the changes in the
future. Sunk costs are a part of the outlay/actual costs. Sunk costs are also called as "Non-Avoidable
costs" or "Inescapable costs".
Examples: All the past costs are considered as sunk costs. The best example is amortization of past
expenses, like depreciation.
(D) Incremental Cost

Incremental costs are addition to costs resulting from a change in the nature of level of business activity. As
the costs can be avoided by not bringing any variation in the activity in the activity, they are also called as
"Avoidable Costs" or "Escapable Costs". More ever incremental costs resulting from a contemplated change
is the Future, they are also called as "Differential Costs"
Example: Change in distribution channels adding or deleting a product in the product line.
(E) Explicit Cost

Explicit costs are those expenses/expenditures that are actually paid by the firm. These costs are recorded
in the books of accounts. Explicit costs are important for calculating the profit and loss accounts and guide
in economic decision-making. Explicit costs are also called as "Paid out costs"
Example: Interest payment on borrowed funds, rent payment, wages, utility expenses etc.
(F) Implicit Cost

Implicit costs are a part of opportunity cost. They are the theoretical costs ie., they are not recognised by the
accounting system and are not recorded in the books of accounts but are very important in certain
decisions. They are also called as the earnings of those employed resources which belong to the owner
himself. Implicit costs are also called as "Imputed costs".
Examples: Rent on idle land, depreciation on dully depreciated property still in use, interest on equity capital
etc.
(G) Book Cost

Book costs are those business costs which don't involve any cash payments but a provision is made in the
books of accounts in order to include them in the profit and loss account and take tax advantages, like
provision for depreciation and for unpaid amount of the interest on the owners capital.
(H) Out Of Pocket Costs

Out of pocket costs are those costs are expenses which are current payments to the outsiders of the firm.
All the explicit costs fall into the category of out of pocket costs.
Examples: Rent Payed, wages, salaries, interest etc
(I) Accounting Costs

Accounting costs are the actual or outlay costs that point out the amount of expenditure that has already
been incurred on a particular process or on production as such accounting costs facilitate for managing the
taxation need and profitability of the firm.
Examples: All Sunk costs are accounting costs
(J) Economic Costs

Economic costs are related to future. They play a vital role in business decisions as the costs considered in
decision - making are usually future costs. They have the nature similar to that of incremental, imputed
explicit and opportunity costs.
(K) Direct Cost

Direct costs are those which have direct relationship with a unit of operation like manufacturing a product,
organizing a process or an activity etc. In other words, direct costs are those which are directly and
definitely identifiable. The nature of the direct costs are related with a particular product/process, they vary
with variations in them. Therefore all direct costs are variable in nature. It is also called as "Traceable
Costs"
Examples: In operating railway services, the costs of wagons, coaches and engines are direct costs.
(L) Indirect Costs

Indirect costs are those which cannot be easily and definitely identifiable in relation to a plant, a product, a
process or a department. Like the direct costs indirect costs, do not vary ie., they may or may not be
variable in nature. However, the nature of indirect costs depend upon the costing under consideration.
Indirect costs are both the fixed and the variable type as they may or may not vary as a result of the
proposed changes in the production process etc. Indirect costs are also called as Non-traceable costs.
Example: The cost of factory building, the track of a railway system etc., are fixed indirect costs and the
costs of machinery, labour etc.
(M) Controllable Costs
Controllable costs are those which can be controlled or regulated through observation by an executive and therefore
they can be used for assessing the efficiency of the executive. Most of the costs are controllable.
Example: Inventory costs can be controlled at the shop level etc.
(N) Non Controllable Costs
The costs which cannot be subjected to administrative control and supervision are called non controllable costs.
Example: Costs due obsolesce and depreciation, capital costs etc.
(O) Historical Costs and Replacement Costs.
Historical cost or original costs of an asset refers to the original price paid by the management to purchase it in the
past. Whereas replacement costs refers to the cost that a firm incurs to replace or acquire the same asset now. The
distinction between the historical cost and the replacement cost result from the changes of prices over time. In
conventional financial accounts, the value of an asset is shown at their historical costs but in decision-making the firm
needs to adjust them to reflect price level changes.
Example: If a firm acquires a machine for $20,000 in the year 1990 and the same machine costs $40,000 now. The
amount $20,000 is the historical cost and the amount $40,000 is the replacement cost.
(P) Shutdown Costs
The costs which a firm incurs when it temporarily stops its operations are called shutdown costs. These costs can be
saved when the firm again start its operations. Shutdown costs include fixed costs, maintenance cost, layoff
expenses etc.
(Q) Abandonment Costs
Abandonment costs are those costs which are incurred for the complete removal of the fixed asset from use. These
may occur due to obsolesce or due to improvisation of the firm. Abandonment costs thus involve problem of disposal
of the asset.
(R) Urget Costs and Postponable Costs
Urgent costs are those costs which have to be incurred compulsorily by the management in order to continue its
operations. If urgent costs are not incurred in time the operational efficiency of the firm falls.
Example: Cost of material, labour, fuel etc
Postponable costs are those which if not incurred in time do not effect the operational efficiency of the firm.
Examples are maintenance costs.
(S) Business Cost and Full Cost
Business costs include all the expenses incurred by the firm to carry out business activities. Costs Include all the
payments and contractual obligations made by the firm together with the book cost of depreciation on plant and
equipment.
Full costs include business costs, opportunity costs, and normal profits. Opportunity costs is the expected
return/earnings from the next best use of the firms resources like capital, land and building, owners efforts and time.
Normal profits is necessary minimum earning in addition to the opportunity costs, which a firm must receive to remain
in its present occupation.
(T) Fixed Costs

Fixed costs are the costs that do not vary with the changes in output. In other words, fixed costs are those which are
fixed in volume though there are variations in the output level.. If the time period in volume under consideration is
long enough to make the adjustments in the capacity of the firm, the fixed costs also vary.
Examples: Expenditures on depreciation costs of administrative, staff, rent, land and buildings, taxes etc.
(U) Variable Costs
Variable Costs are those that are directly dependent on the output ie., they vary with the variation in the volume/level
of output. Variable costs increase in output level but not necessarily in the same proportion. The proportionality
between the variable costs and output depends upon the utilization of fixed facilities and resources during the
production process.
Example: Cost of raw materials, expenditure on labour, running cost or maintenance costs of fixed assets such as
fuel, repairs, routine maintenance expenditure.
(V) Total Cost, Average Cost and Marginal Cost
Total cost (TC) refers to the money value of the total resources/inputs required for the production of goods and
services by the firm. In other words, it refers to the total outlays of money expenditure, both explicit and implicit, on
the resources used to produce a given level output. Total cost includes both fixed and variable costs and is given by
TC = VC + FC
Average Cost (AC) , refers to the cost per unit of output assuming that production of each unit incurs the same cost.
It is statistical in nature and is not an actual cost. It is obtained by dividing Total Cost(TC) by Total Output(Q)
AC= TC/Q
Marginal costs(MC), refers to the additional costs that are incurred when there is an addition to the existing output
level of goods ans services. In other words, it is the addition to the Total Cost(TC) on account of producing additional
units.
(W) Short Run Cost and Long Run Cost
Both short run and long run costs are related to fixed and variable costs and are often used in economic analysis.
Short Run Cost: These costs are which vary with the variation in the output with size of the firm as same. Short run
costs are same as variable costs. Broadly, short run costs are associated with variable inputs in the utilization of
fixed plant or other requirements.
Long Run Cost: These costs are which incurred on the fixed assets like land and building, plant and machinery etc.,
Long run costs are same as fixed costs. Usually, long run costs are associated with variations in size and kind of
plant.
DEFINITION OF 'FIXED COST'

A cost that does not change with an increase or decrease in the amount of goods
or services produced. Fixed costs are expenses that have to be paid by a
company, independent of any business activity. It is one of the two components
of the total cost of a good or service, along with variable cost.
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BREAKING DOWN 'FIXED COST'

An example of a fixed cost would be a company's lease on a building. If a
company has to pay $10,000 each month to cover the cost of the lease but does
not manufacture anything during the month, the lease payment is still due in full.
In economics, a business can achieve economies of scale when it produces

enough goods to spread fixed costs. For example, the $100,000 lease spread out
over 100,000 widgets means that each widget carries with it $1 in fixed costs. If
the company produces 200,000 widgets, the fixed cost per unit drops to 50 cents.
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Fixed Costs
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What it is:
Fixed costs are costs that do not change when the quantity of output changes. Unlike variable
costs, which change with the amount of output, fixed costs are not zero when production is zero.
How it works/Example:
Some examples of fixed costs include rent, insurance premiums, or loan payments. Fixed costs can
create economies of scale, which are reductions in per-unit costs through an increase in
productionvolume. This idea is also referred to as diminishing marginal cost.
For example, let's assume it costs Company XYZ $1,000,000 to produce 1,000,000 widgets
per year($1 per widget). This $1,000,000 cost includes $500,000 of administrative, insurance, and
marketing expenses, which are generally fixed. If Company XYZ decides to produce 2,000,000
widgets next year, its total production costs may only rise to $1,500,000 ($0.75 per widget) because
it can spread its fixed costs over more units. Although Company XYZ's total costs increase from
$1,000,000 to $1,500,000, each widget becomes less expensive to produce and therefore more
profitable.
Some fixed costs change in a stepwise manner as output changes and therefore may not be totally
fixed. Also note that many cost items have both fixed and variable components. For example,
management salaries typically do not vary with the number of units produced. However, if production
falls dramatically or reaches zero, layoffs may occur. Economically, all costs are variable in the end.
Why it Matters:
A company with a relatively large amount of variable costs may exhibit more predictable per-
unit profit margins than a company with a relatively large amount of fixed costs. This means that if a
firm has a large amount of fixed costs, profit margins can really get squeezed when sales fall, which
adds a level of risk to the stocks of these companies. Conversely, the same high-fixed-costs
company willexperience magnification of profits because any revenue increases are applied across
a constant cost level. Thus, as you can see in the example, fixed costs are an important part
of profit projections and the calculation of break-even points for a business or project.
In some cases, high fixed costs discourage new competitors from entering a market and/or help
eliminate smaller competitors (that is, fixed costs can be a barrier to entry). Typical fixed costs differ
widely among industries, and capital-intensive businesses obv more long-term fixed costs than other
businesses. Airlines, auto manufacturers, and drilling operations usually have high fixed costs.
Businesses focused on services like website design, insurance, or tax preparation generally depend
on labor rather than physical assets and are thus don't have as many fixed costs. This is why
comparison of fixed costs is generally most meaningful among companies within the same industry,
and investors should define "high" or "low" ratios within this context.
Variable Cost
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DEFINITION OF 'VARIABLE COST'

A corporate expense that varies with production output. Variable costs are those
costs that vary depending on a company's production volume; they rise as
production increases and fall as production decreases. Variable costs differ from
fixed costs such as rent, advertising, insurance and office supplies, which tend to
remain the same regardless of production output. Fixed costs and variable costs
comprise total cost.
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BREAKING DOWN 'VARIABLE COST'

Variable costs can include direct material costs or direct labor costs necessary to
complete a certain project. For example, a company may have variable costs
associated with the packaging of one of its products. As the company moves
more of this product, the costs for packaging will increase. Conversely, when
fewer of these products are sold the costs for packaging will consequently
decrease.
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What it is:
Variable costs are corporate expenses that vary in direct proportion to the quantity of output.
Unlikefixed costs, which remain constant regardless of output, variable costs are a direct function of
production volume, rising whenever production expands and falling whenever it contracts. Examples
of common variable costs include raw materials, packaging, and labor directly involved in a
company's manufacturing process.
The formula for calculating total variable cost is:
Total Variable Cost = Total Quantity of Output x Variable Cost Per Unit of Output
The term variable cost is not to be confused with variable costing, which is an accounting method
related to reporting variable costs.
How it works/Example:
Let's assume XYZ Company has received an order for 5,000 widgets for a total sales price of $5,000
and wants to determine the gross profit that will be generated by completing the order. First, the
variable costs per widget must be determined.
Let's assume the following:
Annual Widgets Produced: 100,000

Raw Materials Costs: $10,000
Direct Labor Costs: $50,000
From this information, we can conclude that each widget costs 10 cents ($10,000 / 100,000 widgets)
inraw materials and 50 cents ($50,000 / 100,000 widgets) in direct labor costs. Using the formula
above, we can calculate that XYZ Company's total variable cost on the order is:
5,000 x ($0.10 + $0.50) = $3,000
Therefore, the company can reasonably expect to earn a $2,000 gross profit ($5,000 - $3,000) from
the order.
Why it Matters:
While fixed costs, such as rent or other overhead, generally remain level, variable costs will correlate
with the number of products manufactured. Because average variable costs differ widely among
industries, comparisons are generally most meaningful among companies operating within the same
industry.
When analyzing a company's income statement, it should be remembered that rising costs are not
necessarily a troubling sign. Whenever sales rise, more units must first be produced (excluding the
impact of stronger pricing), which in turn means that variable production costs must also increase.
Thus, for revenues to climb, expenses must also rise accordingly.
It is important, though, that revenues increase at a faster rate than expenses. If, for example, a
company reports volume growth of 8%, while cost of goods sold (COGS) only rises 5% over the
same span, then costs have likely declined on a per unit basis. If a company can find ways to reduce
the input costs associated with producing each item it sells, then its profitability will improve. One
way to monitor this aspect of a company's business is to divide variable costs by total revenues to
figure costs as a percentage of sales.
Variable costs frequently factor into profit projections and the calculation of break-even points for a
business or project. Some costs change in a piecewise manner as output changes and therefore
may not remain constant per unit of output. Also, note that many cost items have both fixed and
variable components. For example, management salaries typically do not vary with the number of
units produced. However, if production falls dramatically or reaches zero, then layoffs may occur.
This is evidence that all costs are variable in the long run.
A company with a large number of variable costs (compared to fixed costs) may exhibit more
consistent per-unit costs and hence more predictable per-unit profit margins than a company with
fewer variable costs. However, a company with fewer variable costs (and hence a larger number
offixed costs) may magnify potential profits (and losses) because revenue increases (or decreases)
are applied to a more constant cost level.
Part of being a successful investor involves making an educated forecast about how a
company willrespond under different operating conditions, and one of the key determinants is the
proportion offixed costs to variable costs.
Margin analysis will help you identify companies that can best convert sales into profits. See
examples of how to use this technique in How to Use Margin Analysis as an Investment Tool.
total cost
Definition Add to FlashcardsSave to FavoritesSee Examples

(1) The addition of all costs-direct and indirect, or (2) how much an investor paid
to acquire an investment. The cost includes commissions and trading fees.
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Total cost
Economics
 Contribute your ideas for this topic
This topic is discussed in the following articles:
 form of cost
Cost
More conventionally, cost has to do with the relationship between the value of production inputs
and the level of output. Total cost refers to the total expense incurred in reaching a particular
level of output; if such total cost is divided by the quantity produced, average or unit cost is
obtained. A portion of the total costknown as fixed cost—e.g., the costs of a building lease or
of...
TOTAL COST:
The opportunity cost incurred by all of the factors of production used by a firm to produce a
good or service, including wages paid to labor, rent paid for the land, interest paid to capital
owners, and a normal profit paid to entrepreneurs. Total cost is most important in the
analysis a firm's short-run production decision and is frequently separated into total variable
cost and total fixed cost. Two other cost measures directly related to total cost are marginal
cost and average total cost. Total cost is half of the information a firm uses to determine
profit, the other half is total revenue.
Total cost is the overall opportunity cost incurred by a firm in production. For short-run
production, total cost consists of variable cost, which depends on the quantity produced,
and fixed cost, which does not vary with production. The variable component of total cost, is
guided by thelaw of diminishing marginal returns and is key to short-run production
and supply decisions.
Consider the cost incurred by The Wacky Willy Company in the production of Wacky Willy
Stuffed Amigos (a complete line of adorable, huggable, collectable stuffed animals). The
production of Stuffed Amigos requires materials from the land (fuzzy cloth, soft stuffing,
thread), labor to do the fabrication and assembly (cloth cutters, seam sewers, stuffing
stuffers), and capital equipment to make the workers more efficient (sewing machines,
scissors). Of course, Stuffed Amigos production also requires entrepreneurs to organize and
finance the whole process.
Each of these resources incur an opportunity cost to produce Stuffed Amigos. Each could
have been used to produce other goods. Wages compensate workers who could have been
producing Hot Momma Fudge Bananarama Ice Cream Sundaes. The material suppliers could
have supplied their materials for the production of OmniHome pillows and sheets. The
capital and equipment could have been used in the production of the Prancing Pistachio line
of pet clothing. And the organizers, the entrepreneurs, could have organized the production
of Flex-Star Interactive Trophy Plaques, Auntie Noodles Frozen Macaroni Dinner, or Double-
Dot Carmel Nougat Clusters. Total cost includes the compensation to all of these resources
for NOT doing other production.
Total Stuffed Animal Cost Total Cost

The table to the right provides hypothetical cost numbers incurred by The
Wacky Willy Company in the production of Stuffed Amigos. These numbers
can provide a little insight into total cost.
The column to the left presents the quantity of Stuffed Amigos produced
each minute, ranging from 0 to 10 stuffed animals. The column to the
right then presents the total cost incurred in this production, ranging from
a low of $3 to a high of $46. If, for example, 5 Stuffed Amigos rolls off the
assembly line per minute, then the total cost incurred in their production is
$16. The production of 9 Stuffed Amigos, in comparison, incurs a total cost
of $34.
Closer consideration of these total cost numbers is in order.
 Short-run Production: This table of numbers is for the short-run production of

Stuffed Amigos, which means at least one input is fixed and at least one input is
variable. The fixed input is the Wacky Willy factory and associated capital equipment,
and the variable inputs are workers and materials.
 Increasing Total Cost: The most obvious point, as such, is that total cost increases
with increased production. Producing more Stuffed Amigos means higher total cost.
This makes sense. To produce more Stuffed Amigos, The Wacky Willy Company
needs to hire more labor and buy more materials. Because these inputs are not free,
total cost rises with extra production.
 Fixed Cost: However, total cost is not zero when no Stuffed Amigos are produced.
Curious, eh? The Wacky Willy Company incurs $3 of cost even if they employ no
workers or buy no materials--their variable inputs. The reason is that they must
continue to pay the costs of any fixed inputs, especially capital. This $3 is the total
fixed cost incurred in the short-run production of Stuffed Amigos. It is paid whether
or not any Stuffed Amigos are produced.
 Marginal Cost: A last point to note in passing is that the incremental increase in total
cost is NOT the same for each quantity. In other words, total cost does not rise at a
constant rate. This is reflected by the notion of marginal cost, which plays a pivotal
role in the short-run production analysis.
Fixed and Variable

The total cost incurred in the short-run production of goods like Wacky Willy Stuffed Amigos
can be divided into two components--fixed and variable.
 Fixed Cost: This is the opportunity cost of production that does NOT vary with the
quantity of output produced. In other words, the same level of fixed cost is incurred
regardless of the quantity produced. Most, not all but most, fixed cost is associated
with the use of fixed inputs in the short run.
The Wacky Willy Company, for example, incurs a fixed level of "overhead expenses"
that include administrative salaries, interest on the loan used to buy capital
equipment, and rent on the building. Whether The Wacky Willy Company produces
one Stuffed Amigo or one million Stuffed Amigos, this fixed cost does not change.
The table above indicates that The Wacky Willy Company incurs $3 of fixed cost each
minute of production, which is the cost incurred if production is zero.
 Variable Cost: This is the opportunity cost of production that does vary with the
quantity of output produced. In other words, if production changes, then variable
cost changes, too. Most, not all but most, variable cost is based on the use of
variable inputs.
The Wacky Willy Company, for example, incurs variable cost when it hires a different
number of workers or buys a different quantity of material inputs, both of which are
done as it changes the quantity of output produced. That is, if The Wacky Willy
Company wants to produce more Stuffed Amigos, then it must buy more materials
and hire more workers. The table above indicates any cost greater than $3 per
minute incurred by The Wacky Willy Company is variable cost.
The division of total cost between total fixed cost and total variable costis often summarized
in this handy equation:
total cost = total fixed cost + total variable cost
The Total Cost Curve

Like most relations found in the study of economics, Total Cost Curve
that between total cost and the quantity of
production can be represented by a curve. The total
cost curve is presented in the exhibit to the right.
As might be expected the total cost curve has a

positive slope. As the quantity of output produced
increases, so too does total cost. However, the slope
of the total cost curve is not constant. It is relatively
steep for small quantities, flattens for intermediate
levels of production, then once again steepens for
the largest quantities. The shape of the total cost
curve is based on short-run production returns,
especially the law of diminishing marginal returns.
Another observation is that the total cost curve does

not go through theorigin, but rather begins at a
positive value on the vertical axis. In other words, if
the quantity of output is zero, total cost is positive. This vertical intercept indicates fixed
cost.
Short-run Production Returns

The shape of the total cost curve reflects short-run production returns. In the short run,
with at least one fixed input and at least one variable input, production is guided
by increasing marginal returns for small quantities of output, then decreasing marginal
returns for larger quantities.
 Increasing Marginal Returns: Increasing marginal returns are reflected by the

flattening slope for small quantities. With increasing marginal returns, fewer variable
inputs are needed to produce a given incremental increase in output. As such, total
cost increases, but at a lessening pace.
 Decreasing Marginal Returns: In contrast, decreasing marginal returns are reflected

by the increasing slope for larger quantities. With decreasing marginal returns, more
variable inputs are needed to produce a given incremental increase in output. As
such, total cost increases at an increasing rate.
Most important to these observations is the role played by the law of diminishing marginal
returns. Decreasing returns incurred for larger quantities of output are caused by the law of
diminishing marginal returns. As such, total cost increases at an increasing pace, and the
total cost curve becomes increasingly steeper, due to the law of diminishing marginal
returns.
Average and Marginal

Total cost provides the foundation for short-run production analysis. Two key cost concepts
derived from total cost are average cost and marginal cost.
 Average Cost: In general, average cost is simply the cost per unit of output. It is the
total cost divided by the quantity of output produced. If, for example, the total cost
of producing 10 Stuffed Amigos is $46, then the average cost is $4.60 (= $46/10). A
specific average derived from total cost is termed average total cost.
 Marginal Cost: A second cost concept is the change in total cost resulting from a
change in quantity of output. Marginal cost is specified as the change in total cost
divided by the change in the quantity of output produced. If, for example, the total
cost is $34 for producing 9 Stuffed Amigos and $46 for producing 10 Stuffed Amigos,
then the marginal cost is $12. Total cost increases by $12 with the production of one
additional Stuffed Amigos.
While average cost (especially average total cost) plays a key role in the analysis of short-
run production, marginal cost is far and away more important. Marginal cost guides the
short-run production decision of a firm as it selects the profit maximizing quantity of output
to supply.
Marginal Cost Of Production

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DEFINITION OF 'MARGINAL COST OF PRODUCTION'

The change in total cost that comes from making or producing one additional
item. The purpose of analyzing marginal cost is to determine at what point an
organization can achieve economies of scale. The calculation is most often used
among manufacturers as a means of isolating an optimum production level.
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BREAKING DOWN 'MARGINAL COST OF PRODUCTION'

Manufacturing concerns often examine the cost of adding one more unit to their
production schedules. This is because at some point, the benefit of producing
one additional unit and generating revenue from that item will bring the overall
cost of producing the product line down. The key to optimizing manufacturing
costs is to find that point or level as quickly as possible.
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marginal cost
The increase or decrease in the total cost of a production run for making one
additional unit of an item. It is computed in situations where the breakeven point has
been reached: the fixed costs have already been absorbed by the
already produced items and only the direct (variable) costs have to be accounted for.
Marginal costs are variable costs consisting of labor and material
costs, plus an estimated portion of fixed costs (such
as administration overheads and selling expenses). In companies where average
costs are fairly constant, marginal cost is usually equal to average cost. However,
in industries that require heavy capital investment(automobile plants, airlines, mines)
and have high average costs, it is comparatively very low. The concept of marginal cost
is critically important in resource allocation because,
for optimum results, management must concentrate its resources where
the excess of marginal revenue over the marginal cost is maximum.
Also calledchoice cost, differential cost, or incremental cost.
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Definition of Marginal Cost

Tejvan Pettinger April 11, 2008 concepts
Readers Question what is the marginal cost measured at a particular level of output
defined as?
Definition: Marginal cost is the extra total cost of producing one extra unit of output.
 For example, suppose the cost of producing 10 bikes is £2,000. If you produce 11 bikes and the
total cost increases to £2,150.
 This means the marginal cost of the 11th bike is £150. (Note, the marginal cost is less than the
average cost of the first 10 bikes)
Diagram Marginal Cost
Because the short run Marginal cost curve is sloped like this, mathematically the
average cost curve will be U shaped. Initially average costs fall. But, when marginal cost
is above the average cost, then average cost starts to rise.
Marginal cost always passes through the lowest point of the average cost curve.
Implicit Cost
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DEFINITION OF 'IMPLICIT COST'

A cost that is represented by lost opportunity in the use of a company's own
resources, excluding cash. The implicit cost for a firm can be thought of as the
opportunity cost related to undertaking a certain project or decision, such as the
loss of interest income on funds, or depreciation of machinery used for a capital
project.
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BREAKING DOWN 'IMPLICIT COST'

Implicit costs can also be thought of as intangible costs that are not easily
accounted for. For example, the time and effort that an owner puts into the
maintenance of the company, rather than working on expansion, can be viewed
as an implicit cost of running the business. In corporate finance decisions, implicit
costs should always be considered when coming to a decision on how to allocate
resources.
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implicit cost

The costs associated with an action's tradeoff. It is related to explicit costs, which
represent the actual costs of an activity, and represents a cost that is not recorded but
instead implied. For example, an employee could take a vacation and travel. The
explicit costs would include travel expenses, the cost of a hotel room, and costs related
to entertainment. The implicit costs relate to the tradeoff, namely the wages that the
employee could have earned if the vacation was not taken.
As another example, not paying rent on the self-owned property (called implicit rent) is
an implicit cost, because rent is a tax deductible expense but implicit rent is not.
Similarly, implicit cost of liquid assets or stockholders' (shareholders') capital is the
maximum interest that would be earned on them as a fixed deposit or as
aninvestment in a mutual fund (unit trust). Implicit costs must be added to
actual cash outlays to establish a true estimate of the cost of production or of running
a business. Also called imputed cost, implied cost, or notional cost.
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Explicit Cost
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DEFINITION OF 'EXPLICIT COST'

A business expense that is easily identified and accounted for. Explicit costs
represent clear, obvious cash outflows from a business that reduce its bottom-
line profitability. This contrasts with less-tangible expenses such as goodwill
amortization, which are not as clear cut regarding their effects on a business's
bottom-line value.
BREAKING DOWN 'EXPLICIT COST'

Good examples of explicit costs would be items such as wage expense, rent or
lease costs, and the cost of materials that go into the production of goods. With
these expenses, it is easy to see the source of the cash outflow and the business
activities to which the expense is attributed.
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explicit cost
Expense that is contractual in nature and definite in amount, such

as rent, salaries, wages, or utility bills. Explicit costs are easily recognizable
for classification and recording.
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Sunk Cost
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DEFINITION OF 'SUNK COST'

A cost that has already been incurred and thus cannot be recovered. A sunk cost
differs from other, future costs that a business may face, such as inventory costs
or R&D expenses, because it has already happened. Sunk costs are
independent of any event that may occur in the future.
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BREAKING DOWN 'SUNK COST'
When making business or investment decisions, individuals and organizations
typically look at the future costs that they may incur, by following a certain
strategy. A company that has spent $5 million building a factory that is not yet
complete, has to consider the $5 million sunk, since it cannot get the money
back. It must decide whether continuing construction to complete the project will
help the company regain the sunk cost, or whether it should walk away from the
incomplete project.
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Definition:
Sunk costs are unrecoverable past expenditures. These should not normally be taken into
account when determining whether to continue a project or abandon it, because they cannot
be recovered either way. It is a common instinct to count them, however.
Terms related to Sunk Costs:

 Average Total Cost
 Transaction Costs
 The Cost Curve
Incremental Cost
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DEFINITION OF 'INCREMENTAL COST'

The encompassing change that a company experiences within its balance sheet
due to one additional unit of production.
Also referred to as "marginal cost".
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BREAKING DOWN 'INCREMENTAL COST'

Incremental cost is the overall change that a company experiences by producing
one additional unit of good.
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Incremental cost is the cost associated with increasing production by one unit. Because some costs
are fixed and other variable, the incremental cost will not be the same as the overall average cost
per unit. The cost figure can be used for a variety of economic calculations, most notably the point at
which increasing production ceases to be efficient.
A very simple example would be a factory making widgets where it takes one employee an hour to
make a widget. As a simple figure, the incremental cost of a widget would be the wages for the
employee for an hour plus the cost of the materials needed to produce a widget. A more accurate
figure could include added costs, such as shipping the additional widget to a customer, or the
electricity used if the factory has to stay open longer.
The incremental total is always made up of purely variable costs. It represents the added costs that
would not exist if the extra unit was not made. That means that many fixed costs such as rent on a
factory or buying a machine are not usually represented. However, if an economist wanted to be
extremely precise, they might include some element of these fixed costs where they could
specifically link them to the production of the extra unit. For example, producing even one extra
widget would cause a tiny bit extra wear and tear on the machine.
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In many cases, the average cost of a unit will be higher than the incremental cost. This is because
the average cost takes account of fixed costs. For example, if a company spends a set sum on
machines each year, this cost will be represented in the average cost of each unit produced on
those machines. It will not be included in the cost because producing one extra unit does not require
any more spending on buying machines. Where this happens, the incremental expense is lower than
the existing average cost and thus increasing production by one unit slightly lowers the average
cost: this is known as economy of scale.
This is not always the situation, however. In most situations there will eventually come a point where
increasing production gives an incremental cost which is higher than existing average cost. Perhaps
the most common example would be where a factory’s workforce is working to full capacity. Adding
just one more unit to output would either require paying overtime or spending money on recruiting
new staff. In this situation, the incremental cost is higher than the existing average cost and thus
drives the average cost upwards.
Out-Of-Pocket Expenses
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DEFINITION OF 'OUT-OF-POCKET EXPENSES'

An expense incurred and paid for by an individual for personal use, or relating to
one's employment or business. This can also relate to ongoing costs of operating
a fixed asset, such as a car or a home.
Some out-of-pocket expenses may be reimbursed by an employer or other group

if the expense is incurred directly on their behalf. In addition, some out-of-pocket
expense categories can be deducted from one's personal income taxes.
BREAKING DOWN 'OUT-OF-POCKET EXPENSES'

Common examples of out-of-pocket expenses include gasoline for a car, taking a
business client to lunch and certain medical payments such as prescription costs.
Income tax deductions are often available for expenses related to education,
healthcare, home upkeep and charitable donations. While tax deductions don't
represent a direct reimbursement, there is an ancillary benefit to paying what is
typically something that must be paid anyway.
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What are out-of-pocket costs?
Out-of-pocket costs are those costs or expenses that require a cash payment in the current period or
during a project.
For example, the wages of the person setting up a machine for a new production run are an out-of-
pocket cost. However, the cost of the lost opportunity to be producing profitable output during the
setup time is not an out-of-pocket cost. (The cost of not earning profits during the setup time, known as
an opportunity cost, is often far greater than the out-of-pocket costs.)
Another example of out-of-pocket costs are the current year's repairs and maintenance expenses on a
church that was constructed 15 years ago. However, the current depreciation expense on the church
is not an out-of-pocket cost. The current period's depreciation is also referred to as a noncash expense.
Social Cost
Tejvan Pettinger September 19, 2013
Definition of social cost – Social cost is the total cost to society. It includes both
private costs plus any external costs.
The social costs of smoking include the passive smoking that other people experience.
The social cost involved in building and running an airport can be split up into:
Private costs of airport
 Cost of constructing airport.

 Cost of paying workers to run airport
External Cost of airport
 Noise and air pollution to those living nearby.

 Risk of accident to those living nearby.
 Loss of landscape.
Importance of Social Cost

Rational choice theory suggests individuals will only consider their private costs. For
example, if deciding how to travel, we will consider the cost of petrol and time taken to
drive. However, we won’t take into consideration the impact on the environment or
congestion levels for other members in society.
Therefore, if social costs significantly vary from private costs then we may get a socially
inefficient outcome in a free market.
Marginal Social Cost (MSC)
The cost to society of producing / consuming one extra unit of output.
Q MPC MXC MSC
1 5 3 8
2 6 3 9
3 7 3 10
4 8 3 11
5 9 3 12
Diagram showing marginal social costs

For goods with negative externalities the social cost is greater than the private cost.
Short Run Costs of Production
Geoff Riley
24th October 2014
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Type:
Study notes
Levels:
A Level
Exam boards:
AQA, Edexcel, OCR, IB, Other
An introduction to fixed and variable costs for businesses in the short run
In the short run, at least one factor of production is fixed; this means that output
can be increased by adding more variable factors such as employing more workers
and buying in more raw materials
Fixed costs
 Fixed costs do not change with output, firms must pay these even if they shut down
 Examples include the rental costs of buildings; the costs of leasing or purchasing capital
equipment; the annual business rate charged by local authorities; the costs of employing
full-time contracted salaried staff; the costs of meeting interest payments on loans; the
depreciation of fixed capital (due solely to age) and also the costs of business insurance.
 Any business with significant capacity will have high fixed costs, for example a vehicle
manufacturer that spends millions of pounds building a new factory and installing
expensive and bulky capital equipment.
Fixed costs are the overhead costs of a business.
Total fixed costs (TFC)
Average fixed cost (AFC) = TFC / output
Average fixed costs must fall continuously as output increases because total fixed
costs are being spread over a higher level of production.
A change in fixed costs has no effect on marginal costs. Marginal costs relate only to
variable costs!
Fixed costs of production in the short run
Variable Costs
Variable costs vary directly with output – when output is zero, variable costs will be
zero but as production increases, total variable costs will rise
Examples of variable costs include the costs of raw materials and components,
packaging and distribution costs, the wages of part-time staff or employees paid by the
hour, the costs of electricity and gas and the depreciation of capital inputs due to wear
and tear
Average variable cost

(AVC) = total variable costs (TVC) /output (Q)
Examples of Variable Costs
Total Cost (TC)
Total cost = fixed costs + variable costs
Average Total Cost (ATC or AC)
 Average total cost is the cost per unit produced

 Average total cost (ATC) = total cost (TC) / output (Q)
Marginal Cost
 Marginal cost is the change in total costs from increasing output by one extra unit
 The marginal cost of supplying extra units of output is linked with the marginal
productivity of labour
 The law of diminishing returns implies that marginal cost will eventually rise as output
increases
 At some point, rising marginal cost will lead to a rise in average total cost. This happens
when the rise in AVC is greater than the fall in AFC as output (Q) increases
Calculating Costs – A Numerical Example
A numerical example of short run costs is shown in the table below. Fixed costs are
assumed to be constant at £200. Variable costs increase as more output is produced.
Output Total Fixed Total Variable Marginal Cost (the change in total cost
(Q) Costs (TFC) Costs (TVC) from a one unit change in output) (TC= TFC + (AC =
TVC) TC/Q)
0 200 0 200
50 200 100 300 6 2
100 200 180 400 4 2
150 200 230 450 3 1
200 200 260 460 2.3 0.2

250 200 280 465 1.86 0.1
300 200 290 480 1.6 0.3
350 200 325 525 1.5 0.9
400 200 400 600 1.5 1.5
450 200 610 810 1.8 4.2
500 200 750 1050 2.1 4.8
In our example, average cost per unit is minimised at a range of output - 350 and 400
units.
Thereafter, because the marginal cost of production exceeds the previous average, so
average cost rises (for example the marginal cost of each extra unit between 450 and
500 is 4.8 and this increase in output has the effect of raising the cost per unit from 1.8
to 2.1).
An example of fixed and variable costs in equation format
If for example, the short-run total costs of a firm are given by the formula
SRTC = $(10 000 + 5X2) where X is the level of output.
The firm’s total fixed costs are $10,000
The firm’s average fixed costs are $10,000 / X
If the level of output produced is 50 units, total costs will be $10,000 + $2,500 = $12,500
Derivation of Long-run Cost Curves

IN COST AND REVENUE CURVES, MICRO-ECONOMICS - ON DEC 10, 2012 - 1 COMMENT
Long-run cost curves are associated with the long-run production

activity in which all the factors of production are variable. As a result, we
have no fixed cost in long-run. This article tires to derive the long run
average and marginal cost curves based on the short run average and
marginal cost curves. Long run average and marginal cost curves are per
unit cost because they are treated in terms of unit basis. Average cost is
defined as the cost per unit of output, while the marginal cost is defined
as the change in total cost.
Derivation of Long-run Aarginal Cost (LAC) Curve: LAC is also

called “planning curve” because on the basis of this curve firm makes
decision regarding the optimal production. That is, the firm decides the
optimal size of plants to set up at the minimum cost so that the expected
demand of output can be met. This curve is aka “envelop curve” for
that it envelops the short run average cost curve (SACs). Basically, the
derivation of the LAC curve rests on the following assumptions:
a) Technology remains constant.
b) Prices of the factor inputs remain constant.
Suppose that there are only three alternative plants of different sizes viz.
small, medium, large plants. This supposition is similar to assuming that
there are only three production methods supported by the existing
technologies. As we move forward to the derivation, we relax the
assumption of only three methods of production because the long run is
a time period in which everything can be changed in a desired way. Let
SAC1, SAC2, and SAC3 be the short run cost structures corresponding to
small, medium, large plants, and on the basis which cost structures we
derive the LAC.
If we keep on installing larger and larger plants over the time period, the
cost continuously decreases to a certain size of production because of
the economies of scale (aka internal economies of scale); as a result,
each successive larger plants are positioned lower than the previous one.
But after a certain size of production,diseconomies of
scale (aka internal diseconomies of scale, especially managerial
diseconomies of scale) more than offsets the economies of scale;
accordingly, the position of plants raises upwards. This phenomenon
results in the 'U' shaped long run average cost curve.
Derivation of LAC
In figure A, firm utilizes the small size plant to produce x1 level of output
with the cost structure SAC1, which we know is U-shaped. As the
demand for output increases, the firm is unable to produce more output
beyond the x1' level at the lower cost. After x1' level, the optimal level for
small size plant, the cost of production increases. If the firm wishes to
produce the x1" level of output, it has two choices – either to use small
size plant SAC1 or to use medium size plant SAC2. If the firm expects the
future demand for output likely to increase, it uses medium size plant
and produces more output at lower cost. If the firm does not perceive any
increase in demand for output, it continues to use the small size pant
because medium size plant will be costly. Similar consideration holds for
the firm in making decision when such situations result in, the situation
x2" for example. Installing only three plants, gives the gig-gag long-run
average cost curve as formed by the segments of the short-run cost
curves.
Derivation of LAC
But in the long run, the number of plants suitable for each level of output
may be infinitely large. Hence, we can relax the assumption of only three
alternative plants and consider an infinitely large number of plants as
shown in figure B. If we keep on installing larger and larger plants over
the time period, the cost continuously decreases up to the certain scale of
production and starts to raise thereafter. This phenomenon gives us the
smooth long run average cost curve (LAC) derived from the combination
of the short run average cost curves (SACs). Note that the LAC is the
locus of the points of SACs and shows the minimum cost for each level of
output.
Each point on LAC to the left of optimal level, XM, corresponds to the
falling part of SACs. Hence, plants operate at the under capacity
utilization or shows the prevailing economies of scale. In contrast,
each point on LAC to the right of the optimal level, XM, corresponds to
the increasing part of SACs thereby leading to theover utilization of
the plant or the prevalence of diseconomies of scale. The traditional
theory of cost provides only the optimal level of output production and
neglects the excess capacity of firm to meet the seasonal demand for
output.
Derivation of Long-run Marginal Cost (LMC) Curve: The main

trick in deriving the LMC is that we have to show SMC = LMC at the level
of output where SAC = LAC. This trick enables us to find the LMC, which
is equal to SMC, corresponding to the point of tangency between SAC
and LAC by drawing the vertical line from that point of tangency to the
output axis.
To the left of point a (corresponding to X1 level): SMC < LMC

If we move from point a’ to a, the SAC1 falls faster than LAC. This implies
that SMC is smaller than LMC, that is why SAC declines faster than the
LAC. Because, we know that when SMC < SAC, SAC starts to decline and
when SMC > SAC, SAC starts to increase. Similar consideration holds for
the case of LMC and LAC. Putting in the straight forward way, short run
marginal cost is smaller than the long run marginal cost, and thus the
SAC1 declines faster than LAC to the left of point a. This implies that to
the left of point a in figure, SMC < LMC.
To the right of point a (corresponding to X1 level): SMC > LMC

If we move from point a to a’’, the SAC1 rises faster than LAC, which
implies that marginal cost contributes relatively more to the total cost in
short run (i.e. SAC1) than in long run (i.e. LAC). In other words,
marginal cost is larger or increase fasters in short run (i.e. SAC1) than in
the long run (i.e. LAC). This implies that to the right of point a in figure
C, SMC > LMC.
The above remark follows that at point a, SMC = LMC. Hence, drawing
the vertical line form point a to the output axis we can find the
corresponding point on LMC. Joining the points so found we obtain the
LMC curve, which cuts LAC at its minimum point.
7 (A) market structure
Definition Add to FlashcardsSave to Favorites
The interconnected characteristics of a market, such as the number and

relative strength of buyers and sellers and degree of collusion among them, level
and forms of competition, extent of product differentiation, and ease of entry into
and exit from the market
Four basic types of market structure are (1) Perfect competition: many buyers and
sellers, none being able to influence prices. (2) Oligopoly: several large sellers who
have some control over the prices. (3) Monopoly: single seller with considerable control
over supply and prices. (4) Monopsony: single buyer with considerable control
over demand and prices.
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Market structures: definition

A market is a set of buyers and sellers, commonly referred to as agents, who through their
interaction, both real and potential, determine the price of a good, or a set of goods. The concept of a
market structure is therefore understood as those characteristics of a market that influence the
behaviour and results of the firms working in that market.
The main aspects that determine market structures are: the number of agents in the market, both
sellers and buyers; their relative negotiation strength, in terms of ability to set prices; the degree of
concentration among them; the degree of differentiation and uniqueness of products; and the ease, or
not, of entering and exiting the market. The interaction and differences between these aspects allow
for the existence of several market structures, from which we can highlight the following:
-Perfect competition: the efficient market where goods are produced using the most efficient
techniques and the least amount of factors. This market is considered to be unrealistic but it is
nevertheless of special interest for hypothetical and theoretical reasons.
-Imperfect competition, which includes all situations that differ from perfect competition. Sellers and
buyers can influence in the determination of the price of goods, leading to efficiency losses.
Imperfect competition includes market structures such as:
-Monopoly: it represents the opposite of perfect competition. This market is composed of a sole seller
who will therefore have full power to set prices.
-Oligopoly: in this case, products are offered by a series of firms. However, the number of sellers is
not large enough to guarantee perfect competition prices. These markets are usually studied by
analysingduopolies, since these are easier to model and the main conclusions can be extrapolated to
oligopolies.
-Monopolistic competition: this market is formed by a high number of firms which produce a similar
good that can be seen as unique due to differentiation, that will allow prices to be held up higher than
marginal costs. In other words, each producer will be considered as a monopoly thanks to
differentiation, but the whole market s considered as competitive because the degree of
differentiation is not enough to undermine the possibility of substitution effects.
-Monopsony: it’s similar to a monopoly, but in this case there are many firms selling products, but
only one buyer, the monopsonist, who will have full power when negotiating prices.
-Oligopsony: similar to oligopolies, but with buyers. Sellers will have to deal with the increased
negotiating power of the only few buyers in the market, the oligopsonists.
competitive market
A competitive market is one in which a large numbers of producers compete

with each other to satisfy the wants and needs of a large number of
consumers. In a competitive market no single producer, or group of
producers, and no single consumer, or group of consumers, can dictate how
the market operates. Nor can they individually determine the price of goods
and services, and how much will be exchanged. Competitive markets will form
under certain conditions.
The formation of competitive markets

For markets to form a number of necessary conditions must be met, including:
1. The profit motive. Free markets form when the profit motive can be
satisfied .... more
2. The principle of diminishability. Stocks of pure private goods will
diminish as the good is purchased. .... more
3. The principle of rivalry. Consumers must compete with each other to get
the benefit provided by the good or service...more
4. The principle of excludability. For markets to form it is essential
that consumers can be excluded from gaining the benefit that comes
from consumption. .... more
5. The principle of rejectability. It is also necessary that consumers can
reject goods if they do not want or need them.... more
The necessary conditions for market formation and success:
The profit motive

Free markets form when the possibility of profits provides an incentive for
firms to enter the market. Basic economic theory states that profits are earned
when firms gain a revenue which exceeds the costs of production. However,
more advanced micro-economic theory offers two definitions of profit - normal
and super-normal. When revenue exceeds costs supernormal profit is earned,
and when revenue equals costs the firm makes normal profits.
Diminishability of private goods
A further condition for market formation is that stocks of goods will diminish as
the good is purchased. For example, the purchase of a laptop computer by
one consumer means there is one less available for other consumers. This is
referred to as the principle of diminishability. Eventually, stocks will diminish to
zero and as this happens, price will be driven up. Higher prices create an
incentive for the producer to increase production.
Rivalry
In addition, free markets will only form when consumers are forced to compete
with obtain the benefit of the the good or service. For example, to be
guaranteed a good seat at a restaurant, or at a music venue, consumers need
to book in advance, or get there early - there is clearly a need to be
competitive to secure the benefit of the good. This is called the principle of
rivalry, and is clearly closely related to the principle of diminishability. Indeed,
many consider it to be just another way to explain the need for consumers to
compete when stocks diminish.
Excludability
For markets to form it is essential that consumers can be excluded from
gaining the benefit that comes from consumption. A storekeeper can stop
consumers gaining the benefit of a product if they are unable or unwilling to
pay. For example, a market for music can only be formed if the musicians
perform in a venue where access is denied to those without a ticket, or where
the songs can be recorded and sold through shops, via downloads, or through
other media. This is called the principle of excludability. If consumers cannot
be excluded they may become free-riders and, as will be seen later, the
possibility of free riders can prevent the formation of fully fledged market.
Rejectability
It is also necessary that consumers can reject goods if they do not want or
need them. For example, a supermarket employee could not place an
unwanted product into a shopper’s basket and expect the shopper to pay for it
at the checkout. This is called the principle of rejectability.
Ability to charge
When the conditions of diminishability, rivalry, excudability and rejectability are
present it is possible for a market to form and for the seller to charge the
buyer a price and for the buyer to accept or reject that price. It is also possible
for the buyer to make a bid for a good or service, and for it to be accepted or
rejected by the seller.
No information failure
For markets to work effectively there can be no significant information
failure affecting the decisions of consumers and producers. It is assumed that
the consumer of a private good or service knows what they are getting - they
are able to estimate accurately the net benefit they are likely to derive. Net
benefit is the private benefit to a consumer in terms of satisfaction, or
utility, less the private cost associated with buying the product. It equates to
the concept of consumer surplus.
For example, when a consumer purchases a coffee from their favourite cafe
they will feel that they clear about the net benefit they will derive. Consciously
or instinctively they will make a calculation that buying a coffee is worth the £2
they are asked to pay. It can be assumed that the decision to make this, and
similar purchases, is guided by the consumer’s rational expectations. In
other words, consumers base their decision to consume on a complete range
of information gathered over the past, together with a prediction of the future.
In terms of the coffee example, the consumer may have bought many coffees
at this cafe before, and has always been satisfied with the quality of the
coffee, and the service provided - hence the £2 expenditure is a ‘safe bet’. As
will be seen, there may be many situations where not all the information
regarding the product is available to the consumer, and in these cases
markets may fail to work efficiently. For example, what if consuming coffee on
a regular basis increases blood pressure and might trigger other health
problems? This is unknown information to the individual consumer at the point
of consumption, and because there is a gap in knowledge, there is information
failure, and choices may be irrational - perhaps the consumer should cut back
on their coffee consumption? Free markets do not work effectively when
significant gaps in knowledge exist when either the producer or consumer can
exploit.
No time lags
For markets to form and work effectively there will be no significant time lags
between the purchase of the private product and the net benefit derived by the
consumer. For example, if a consumer buys a newspaper with their morning
coffee they can read it immediately. Who would bother to purchase a
newspaper if they could not read it for several days? Of course, where mail
order or online deliveries are concerned, a short time lag is acceptable.
No externalities
Markets are said to work at their best when there are no effects on parties not
involved in the market transaction. This means that during the production of
the good, and during its consumption and disposal after use, there is no
positive or negative impact on other citizens. A positive impact is called
a positive externality or external benefit, and a negative impact is called
a negative externality or external cost. For example, a positive externality
associated with a cafe would be the benefit to a nearby newsagent of
customers purchasing their newspaper to read with their morning coffee. An
example of a negative externality is the litter created outside the cafe when
consumers throw away their used coffee cups into the street. When such
externalities exist, free markets may not form or, more likely, may not work
efficiently.
However, even when negative externalities exist, such as waste or potential
damage to the environment, markets may form to eliminate the waste or
prevent damage to the environment. For example, the cafe owner may install
a litter bin outside the cafe so that litter can be disposed of. This may help
attract more customers, and so the profit motive may come into play to help
deal with the externality.
Property rights
For markets to form and operate successfully, consumers and
producers must have property rights. Property rights mean that they have
the right to own private property and protect it from theft or damage, or from
other people’s waste, and from the pollution of others. If property rights cannot
be established, the good is not a pure private good.
Incentives for entrepreneurs

The combined effects of the above characteristics means that markets will
form because entrepreneurs will be willing to take risks associated with
producing and supplying pure private goods. This is
because consumers would be prepared to pay for the good, and producers
can charge consumers at the point of consumption, from which they can earn
revenue and make a profit.
When some of these conditions are absent, it is likely that market failure will
exist.
perfect competition
(redirected from Competitive market)
Also found in: Financial, Wikipedia.
perfect competition
n
1. (Economics) economics a market situation in which there exists a homogeneous product, freedom of e
ntry, and a large number ofbuyers and sellers none of whom individually can affect price
Collins English Dictionary – Complete and Unabridged © HarperCollins Publishers 1991, 1994, 1998,
2000, 2003
Definition of 'Perfect Competition'

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Perfect competition describes a market structure where competition is at its greatest possible level.
Definition: Perfect competition describes a market structure where competition is at its greatest
possible level. To make it more clear, a market which exhibits the following characteristics in its
structure is said to show perfect competition:
1. Large number of buyers and sellers
2. Homogenous product is produced by every firm
3. Free entry and exit of firms
4. Zero advertising cost
5. Consumers have perfect knowledge about the market and are well aware of any changes in the
market. Consumers indulge in rational decision making.
6. All the factors of production, viz. labour, capital, etc, have perfect mobility in the market and are
not hindered by any market factors or market forces.
7. No government intervention
8. No transportation costs
9. Each firm earns normal profits and no firms can earn super-normal profits.
10. Every firm is a price taker. It takes the price as decided by the forces of demand and supply. No
firm can influence the price of the product.
Description: Ideally, perfect competition is a hypothetical situation which cannot possibly exist in a
market. However, perfect competition is used as a base to compare with other forms of market
structure. No industry exhibits perfect competition in India.
Perfect competition
A perfectly competitive market is a hypothetical market where competition is
at its greatest possible level. Neo-classicaleconomists argued that perfect
competition would produce the best possible outcomes for consumers, and
society.
Key characteristics
Perfectly competitive markets exhibit the following characteristics:
1. There is perfect knowledge, with no information failure or time lags.

Knowledge is freely available to all participants, which means that risk-
taking is minimal and the role of theentrepreneur is limited.
2. Given that producers and consumers have perfect knowledge, it is
assumed that they make rational decisions to maximise their self
interest - consumers look to maximise their utility, and producers look to
maximise their profits.
3. There are no barriers to entry into or exit out of the market.
4. Firms produce homogeneous, identical, units of output that are not
branded.
5. Each unit of input, such as units of labour, are also homogeneous.
6. No single firm can influence the market price, or market conditions. The
single firm is said to be a price taker, taking its price from the whole
industry.
7. There are a very large numbers of firms in the market.
8. There is no need for government regulation, except to make markets
more competitive.
9. There are assumed to be no externalities, that is no external costs or
benefits.
10. Firms can only make normal profits in the long run, but they can
make abnormal profits in the short run.
The firm as price taker
The single firm takes its price from the industry, and is, consequently, referred
to as a price taker. The industry is composed of all firms in the industry and
the market price is where market demand is equal to market supply. Each
single firm must charge this price and cannot diverge from it.
Equilibrium in perfect competition

In the short run
Under perfect competition, firms can make super-normal profitsor losses.
In the long run
However, in the long run firms are attracted into the industry if the incumbent
firms are making supernormal profits. This is because there are no barriers to
entry and because there is perfect knowledge. The effect of this entry into the
industry is to shift the industry supply curve to the right, which drives down
price until the point where all super-normal profits are exhausted. If firms are
making losses, they will leave the market as there are no exit barriers, and
this will shift the industry supply to the left, which raises price and enables
those left in the market to derive normal profits.
In the long run
The super-normal profit derived by the firm in the short run acts as an
incentive for new firms to enter the market, which increases industry supply
and market price falls for all firms until only normal profit is made.
Evaluation
The benefits
It can be argued that perfect competition will yield the following benefits:
1. Because there is perfect knowledge, there is no information failure and

knowledge is shared evenly between all participants.
2. There are no barriers to entry, so existing firms cannot derive
any monopoly power.
3. Only normal profits made, so producers just cover their opportunity cost.
4. There is no need to spend money on advertising, because there is
perfect knowledge and firms can sell all they can produce. In addition,
selling unbranded goods makes it hard to construct an effective
advertising campaign.
5. There is maximum possible:
o Consumer surplus
o Economic welfare
6. There is maximum allocative and productive efficiency:
o Equilibrium will occur where P = MC, hence allocative efficiency.
o In the long run equilibrium will occur at output where MC = ATC, which
is productive efficiency.
7. There is also maximum choice for consumers.
How realistic is the model?

Very few markets or industries in the real world are perfectly competitive. For
example, how homogeneous is the output of real firms, given that even the
smallest of firms working in manufacturing or services try to differentiate their
product.
The assumption that producers and consumers act rationally is questioned

by behavioural economists, who have become increasingly influential over
the last decade. Numerous experiments have demonstrated that decision
making often falls well short of what could be described as perfectly rational.
Decision making can be biased and subject to rule of thumb ‘guidance’ when
consumers and producers are faced with complex situations.
Although unrealistic, it is still a useful model in two respects. Firstly, many

primary and commodity markets, such as coffee and tea, exhibit many of the
characteristics of perfect competition, such as the number of individual
producers that exist, and their inability to influence market price. Secondly, for
other markets in manufacturing and services, the model is a useful yardstick
by which economists and regulators can evaluate levels of competition that
exist in real markets.
Perfect Competition
AAA |
DEFINITION OF 'PERFECT COMPETITION'

A market structure in which the following five criteria are met:1) All firms sell an
identical product;2) All firms are price takers - they cannot control the market
price of their product;3) All firms have a relatively small market share;4) Buyers
have complete information about the product being sold and the prices charged
by each firm; and5) The industry is characterized by freedom of entry and
exit.Perfect competition is sometimes referred to as "pure competition".
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BREAKING DOWN 'PERFECT COMPETITION'

Perfect competition is a theoretical market structure. It is primarily used as a
benchmark against which other, real-life market structures are compared. The
industry that most closely resembles perfect competition in real life is agriculture.
Perfect competition is the opposite of a monopoly, in which only a single firm

supplies a particular good or service, and that firm can charge whatever price it
wants because consumers have no alternatives and it is difficult for would-be
competitors to enter the marketplace. Under perfect competition, there are many
buyers and sellers, and prices reflect supply and demand. Also, consumers have
many substitutes if the good or service they wish to buy becomes too expensive
or its quality begins to fall short. New firms can easily enter the market,
generating additional competition. Companies earn just enough profit to stay in
business and no more, because if they were to earn excess profits, other
companies would enter the market and drive profits back down to the bare
minimum.
Real-world competition differs from the textbook model of perfect competition in

many ways. Real companies try to make their products different from those of
their competitors. They advertise to try to gain market share. They cut prices to
try to take customers away from other firms. They raise prices in the hope of
increasing profits. And some firms are large enough to affect market prices. But
the perfect competition model is not an ideal that we should try to achieve in the
real world.
Read more: Perfect Competition Definition |

Investopedia http://www.investopedia.com/terms/p/perfectcompetition.asp#ixzz3lMwMmJtg
Market structures: Perfect competition

Perfect competition or competitive markets -also referred to as pure, or free competition-, expresses
the idea of the combination of a wide range of firms, which freely enter or leave the market and
which considers prices as information, since each bidder only provides a relative small share of
the good to the market and thus do not exert a noticeable influence on it. Therefore, perfect
competitors cannot influence the levels of market clearing prices. Also, buyers are numerous and
disperse, which also means that they cannot influence prices.
This market model is based on a set of assumptions, each of them representing a necessary but
insufficient condition to ensure perfect competition. These assumptions are:
-Homogeneous product: all firms offer the same goods, with the same characteristics and quality as
the others, without any variations.
-Large number of agents: there should be a sufficient quantity of buyers and sellers, so that no action
from a single agent will affect the market structure or its prices.
-No entry or exit barriers: there has to be free entry and exit of agents in the market. This assumption
is of special interest for firms, which must be able to enter or leave the market freely.
-Price flexibility: price adjustments to changes happen as fast as possible. Usually, price changes are
assumed instantaneous.
-Free and perfect information: all agents have perfect knowledge of products and their prices, and
everything else related to them, as well as free access to this information.
-Perfect factor mobility: all factors should be able to change so adjustments processes can be carried
out with the greatest efficiency.
-No government intervention: markets should be left alone as government intervention would only
lead to imbalances in perfectly competitive markets.
Perfect competition markets are almost impossible to find in the real word as all markets have some
type of imperfection. This is the reason they are mostly considered only theoretically. However, its
study helps understand real world markets and their phenomena.
It must be noted that the theory of contestable markets, developed by William J. Baumol in his
“Contestable Markets: An Uprising in the Theory of Industry Structure”, 1982, that perfect
competition prices and output can be reached with just a few of these assumptions.
Furthermore, Bertrand’s duopoly model determines thatoligopolistic markets can reach the same
prices as in perfect competition as long as oligopolists compete by changing their prices, instead of
the quantity offered.
Market structures: Imperfect competition

Imperfect competition or imperfectly competitive markets is one in which some of the rules
of perfect competition are not followed. Virtually, all real world markets follow this model, as in
practice, all markets have some form of imperfection. When dealing with imperfect competition
the equilibrium price can be influenced by the actions of agents. In imperfect competition the price of
goods can increase above theirmarginal cost and thus have customers decrease their level of
purchase, and so reach inefficient levels ofproduction. Governments try to avoid these situations and
take measures to stop imperfect competition.
The most common forms of imperfect competition
include: monopolies, oligopolies, duopolies, monopolistic competition and monopsony.
Roy Harrod was the first economist to develop the theory of imperfect competition and, other
authors, such as Edward Chamberlin and Joan Robinson renewed its interest and made major
contributions. Nevertheless, it is important to point out that Cournot, in his “Researches into the
Mathematical Principles of the Theory of Wealth”, 1838, was the first to model this kind of markets.
What is the difference

between perfect and imperfect
competition?
By InvestopediaAAA |
A:
Perfect competition is a microeconomics concept that describes a market
structure controlled entirely by market forces. In a perfectly competitive market,
all firms sell identical products and services, firms cannot control prevailing
market prices, market share per firm is small, firms and customers have perfect
knowledge about the industry, and no barriers to entry or exit exist. If any of
these conditions are not met, a market is not perfectly competitive.
Perfect competition is an abstract concept that occurs in economics textbooks

but not in the real world. Imperfect competition, in which a competitive market
does not meet the above conditions, is very common. Examples of imperfect
competition include oligopoly, monopolistic competition, monopsony and
oligopsony.
In an oligopoly, there are many buyers for a product or service but only a few
sellers. The cable television industry in most areas of the United States is a
prototypical oligopoly. While an oligopolistic market is competitive - the few active
firms within an industry compete with one another - it falls well short of perfect
competition in several key areas. The firms involved usually sell similar products,
but they are not identical. Because of the small number of firms, a singular firm
has the power to influence market prices; in fact, collusion, an underhanded
tactic in which competing firms join forces to manipulate market prices, has
historically been rampant in oligopolies. By its very nature, an oligopoly provides
large market share to each firm. Perfect knowledge does not exist, and the
barriers to entry are typically high, ensuring the number of players remains small.
Monopolistic competition describes a market that has a lot of buyers and sellers,
but whose firms sell vastly different products. Therefore, the condition of perfect
competition that products must be identical from firm to firm is not met. The
restaurant, clothing and shoe industries all exhibit monopolistic competition; firms
within those industries attempt to carve out their own subindustries by offering
products or services not duplicated by their competitors. In many ways,
monopolistic competition is closer than oligopoly to perfect competition. Barriers
to entry and exit are lower, individual firms have less control over market prices
and consumers, for the most part, are knowledgeable about the differences
between firms' products.
Monopsony and oligopsony are counterpoints to monopoly and oligopoly. Instead

of being made up of many buyers and few sellers, these unique markets have
many sellers but few buyers. The defense industry in the U.S. constitutes a
monopsony; many firms create products and services and attempt to sell them to
a singular buyer, the U.S. military. An example of an oligopsony is the tobacco
industry. Almost all of the tobacco grown in the world is purchased by less than
five companies, which use it to produce cigarettes and smokeless tobacco
products. In a monopsony or an oligopsony, it is the buyer, not the seller, who
has the ability to manipulate market prices by playing firms against one another.
Read more: What is the difference between perfect and imperfect

competition? http://www.investopedia.com/ask/answers/032515/what-difference-between-
perfect-and-imperfect-competition.asp#ixzz3lMwoBAs6
Equilibrium of the Firm and
Industry under Perfect
Competition | Economics
by Smriti Chand Economics
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Equilibrium of the Firm and Industry under Perfect Competition!

Contents:
1. Meaning of Firm and Industry
2. Equilibrium of the Firm
3. Equilibrium of the Industry under Perfect Competition
Meaning of Firm and Industry:
It is essential to know the meanings of firm and industry before analysing the
two. A firm is an organisation which produces and supplies goods that are
demanded by the people. According to Prof. S.E. Lands-bury, “Firm is an
organisation that produces and sells goods with the goal of maximising its
profits. In the words of Prof. R.L. Miller, “Firm is an organisation that buys and
hires resources and sells goods and services.”
Industry is a group of firms producing homogeneous products in a market. In

the words of Prof. Miller, “Industry is a group of firms that produces a
homogeneous product.” For example, Raymond, Maffatlal, Arvind, etc., are
cloth manufacturing firms, whereas a group of such firms is called the textile
industry.
Equilibrium of the Firm:
Meaning:
A firm is in equilibrium when it has no tendency to change its level of output. It
needs neither expansion nor contraction. It wants to earn maximum profits. In
the words of A.W. Stonier and D.C. Hague, “A firm will be in equilibrium when
it is earning maximum money profits.”
Equilibrium of the firm can be analysed in both short-run and long-run periods.
A firm can earn the maximum profits in the short run or may incur the
minimum loss. But in the long run, it can earn only normal profit.
Short-run Equilibrium of the Firm:

The short run is a period of time in which the firm can vary its output by
changing the variable factors of production in order to earn maximum profits
or to incur minimum losses. The number of firms in the industry is fixed
because neither the existing firms can leave nor new firms can enter it.
It’s Conditions:
The firm is in equilibrium when it is earning maximum profits as the difference
between its total revenue and total cost.
For this, it essential that it must satisfy two conditions:

(1) MC = MR, and (2) the MC curve must cut the MR curve from below at the
point of equality and then rise upwards.
The price at which each firm sells its output is set by the market forces of
demand and supply. Each firm will be able to sell as much as it chooses at
that price. But due to competition, it will not be able to sell at all at a higher
price than the market price. Thus the firm’s demand curve will be horizontal at
that price so that P = AR = MR for the firm.
1. Marginal Revenue and Marginal Cost Approach:

The short-run equilibrium of the firm can be explained with the help of the
marginal analysis as well as with total cost-total revenue analysis. We first
take the marginal analysis under identical cost conditions.
This analysis is based on the following assumptions:

1. All firms in an industry use homogeneous factors of production.
2. Their costs are equal. Therefore, all cost curves are uniform.
3. They use homogeneous plants so that their SAC curves are equal.
4. All firms are of equal efficiency.
5. All firms sell their products at the same price determined by demand and
supply of the industry so that the price of each firm is equal to AR = MR.
Determination of Equilibrium:
Given these assumptions, suppose that price OP in the competitive market for
the product of all the firms in the industry is determined by the equality of
demand curve D and the supply curve S at point E in Figure 1(A) so that their
average revenue curve (AR) coincides with the marginal revenue curve (MR).
At this price, each firm is in equilibrium at point L in Panel (B) of the figure
where (i) SMC equals MR and AR, and (ii) the SMC curve cuts the MR curve
from below. Each firm would be producing OQ output and earning normal
profits at the maximum average total costs QL. A firm earns normal profits
when the MR curve is tangent to the SAC curve at its minimum point.
If the price is higher than these minimum average total costs, each firm will be
earning supernormal profits. Suppose the price rises to 0Рг where the SMC
curve cuts the new marginal revenue curve MR2 (=AR2) from below at point A
which now becomes the equilibrium point. In this situation, each firm produces
OQ2 output and earns supernormal profits equal to the area of the rectangle
P2 ABC.
If the price falls below OP1the firm would make a loss because the SAC would
be higher than the price. In the short-run, it would continue to produce and sell
OQ1 output at OP1price so long as it covers its AVC. S is thus the shut-down
point at which the firm is incurring the maximum loss equal to SK per unit of
output. If the price falls below OP1 the firm will close down because it would
fail to cover even the minimum average variable cost. OP1 is thus the shut-
down price.
We may conclude from the above discussion that in the short-run each firm
may be making either supernormal profits, or normal profits or losses
depending upon the price of the product.
2. Total Cost Revenue Analysis:

The short-run equilibrium of the firm can also be shown with the help of total
cost and total revenue curves. The firm is able to maximize its profits at that
level of output where the difference between total revenue and total cost is the
maximum. This is shown in Figure 2 where TR is the total revenue curve and
TC total cost curve.
The total revenue curve is an upward sloping straight line curve starting from
O. This is because the firm sells small or large quantities of its product at a
constant price under perfect competition. If the firm produces nothing, total
revenue will be zero. The more it produces, the larger is the increase in total
revenue. Hence the TR curve is linear and slopes upward.
The firm will maximize its profits at that level of output where the gap between
the TR curve and the 1C curve is the maximum. Geometrically, it is that level
at which the slope of a tangent drawn to the total cost curve equals the slope
of the total revenue curve. In Figure 2, the maximum amount of profit is
measured by TP at OQ output. At outputs smaller or larger than OQ between
A and В points, the firm’s profits shrink. If the firm produces OQ1 output, its
losses are the maximum because the TC curve is i above the TR curve. At
Q1 its profits are zero. Similar situation prevails at Q2.
Since the marginal revenue equals the slope of the total о revenue curve and
the marginal cost equals the slope of the tangent to the total cost curve, it
follows that where the slopes of the total cost and revenue curves are equal
as at P and T, the marginal cost equals the marginal revenue. It should be
clear of that the point of maximum profits lies in the region of rising marginal
cost (when TC is below TR) and of maximum loss in the falling marginal cost
region (where TC is above TR).
The explanation of the equilibrium of the firm by using total cost-revenue

curves does not throw more light than is provided by the marginal cost-
marginal revenue analysis. It is useful only in the case of certain marginal
decisions where the total cost curve is also linear over a certain range of
output.
But it makes the equilibrium of the firm a cumbersome and difficult analysis
particularly when one has to compare the change in cost and revenue
resulting from a change in the volume of output. Further, maximum profits
cannot be known at once. For this, a number of tangents are required to be
drawn which is a real difficulty.
Long-run Equilibrium of the Firm:
In the long-run, it is possible to make more adjustments than in the short-run.
The firm can adjust its plant capacity and scale of operations to the changed
circumstances. Therefore, all costs are variable. Firms must earn only normal
profits. In case the price is above the long-run AC curve firms will be earning
supernormal profits.
Attracted by them, new firms will enter the industry and supernormal profits
will be competed away. If the price is below the LAC curve firms will be
incurring losses. As a result, some of the firms will leave the industry so that
no firm earns more than normal profits. Thus “in the long-run firms are in
equilibrium when they have adjusted their plant so as to produce at the mini-
mum point of their long-run AC curve, which is tangent (at this point) to the
demand (AR) curve defined by the market price” so that they earn normal
profits.
It’s Assumptions:
This analysis is based on the following assumptions:
1. Firms are free to enter into or leave the industry.
2. All firms are of equal efficiency.
3. All factors are homogeneous. They can be obtained at constant and

uniform prices.
4. Cost curves of firms are uniform.
5. The plants of firm: are equal having given technology.
6. All firms have perfect knowledge about price and output.

Determination:
Given these assumptions, each firm of the industry will be in the following two
conditions.
(1) In equilibrium, its short-run marginal cost (SMC) must equal to its long-run
marginal cost (LMC) as well as its short-run average cost (SAC) and its long-
run average cost (LAC) and both should be equal to MR=AR=P. Thus the first
equilibrium condition is:
SMC = LMC = MR = AR = P = SAC = LAC at its minimum point, and
(2) LMC curve must cut MR curve from below.
Both these conditions of equilibrium are satisfied at point E in Figure 3 where

SMC and LMC curves cut from below SAC and LAC curves at their minimum
point E and SMC and LMC curves cut AR = MR curve from below. All curves
meet at this point E and the firm produces OQ optimum quantity and sell it at
OP price.
Since we assume equal costs of all the firms of industry, all firms will be in
equilibrium m the long-run. At OP price a firm will have neither a tendency to
leave nor enter the industry and all firms will earn normal profit.
Equilibrium of the Industry under Perfect
Competition:
Conditions of Equilibrium of the Industry:

An industry is in equilibrium:
(i) When there is no tendency for the firms either to leave or enter the industry,
and (ii) when each firm is also in equilibrium. The first condition implies that
the average cost curves coincide with the average revenue curve of all the
firms in the industry. They are earning only normal profits, which are
supposed to be included in the average cost curves of the firms. The second
condition implies the equality of MC and MR. Under a perfectly competitive
industry, these two conditions must be satisfied at the point of equilibrium, i.e.,
SMC = MR
SAC = AR
P = AR = MR
SMC = SAC = AR = P
Such a situation represents full equilibrium of the industry.
Short-Run Equilibrium of the Industry:

An industry is in equilibrium in the short run when its total output remains
steady, there being no tendency to expand or contract its output. If all firms
are in equilibrium, the industry is also in equilibrium. For full equilibrium of the
industry in the short run, all firms must be earning only normal profits. The
condition for this is SMC = MR = AR = SAC. But full equilibrium of the industry
is by sheer accident because in the short run some firms may be earning
supernormal profits and some incurring losses.
Even then, the industry is in short- run equilibrium when its quantity
demanded and quantity supplied are equal at the price which clears the
market. This is illustrated in Figure 4, where in Panel (A), the industry is in
equilibrium at point E where its demand curve D and supply curve S intersect
which determine OP price at which its total output OQ is cleared. But at the
prevailing price OP some firms are earning supernormal profits PE1ST as
shown in Panel (B), while some other firms are incurring FGE2P losses as
shown in Panel (C) of the figure.
Long-Run Equilibrium of the Industry:
The industry is in equilibrium in the long run when all firms earn normal profits.
There is no incentive for firms to leave the industry or for new firms to enter it.
With all factors homogeneous and given their prices and the same
technology, each firm and industry as a whole are in full equilibrium where
LMC = MR =AR(=p) =LAC at its minimum. Such an equilibrium position is at-
tained when the long-run price for the industry is determined by the equality of
total demand and supply of the industry.
The long-run equilibrium of the industry is illustrated in Figure 5(A) where the
long-run price op and OQ output are determined by the intersection of the
demand curve d and the supply curve s at point E. At this price op, the firms
are in equilibrium at point A in Panel (B) at OM level of output where LMC
=SMC= MR= p (=AR) =SAC= LAC at its minimum. At this level, the firms are
earning normal profits and have no incentive to enter or leave the industry. It
follows that when the industry is in long-run equilibrium, each firm in the
industry is also in long-run equilibrium. If both the industry and the firms are in
long-run equilibrium, they are also in short-run equilibrium.
Even though all firms in a perfectly competitive industry in the long run have
the same cost curves, the firms can be of different efficiency. Firms using
superior resources or inputs such as superior management must pay them
higher rewards, otherwise they will shift to new firms which offer them higher
prices.
So the forces of competition will force the more efficient firms to pay superior
resources higher prices at their opportunity cost. As a result, the lac curve of
the more efficient firms will shift upwards and they will benefit in the form of
higher output at the higher long-run equilibrium price set by the industry.
Unable to pay higher prices to resources or inputs, less efficient firms will be
competed away. New firms which are able to pay more and attracted by the
new higher market price will enter the industry. But at the new long-run
equilibrium price of the industry, all firms will be producing at the minimum
LAC.
This is illustrated in Figure 6 where the industry is in initial equilibrium at point

E with price OP m Panel (A) and the more efficient firms like all other firms are
in equilibrium at point A in Panel (B). As the industry is in equilibrium, the new
firms do not exist as they are not in a position to cover their costs at OP price.
When the more efficient firms pay higher prices to resources or inputs, their
LAC curve rises to LAC1 At the new long-run equilibrium price of the industry
set at OP 1 the more efficient firms are in equilibrium where P1 = LAC1 at its
minimum point A1 in Panel (B). They are now producing larger output
OM1 even though they earn normal profits. The new firms also earn normal
profits at point A2, as shown in Panel (C). But they produce less output
OM2 than OM1 produced by the more efficient firms.
Equilibrium Of The Firm And Industry Under Perfect

Competition
Meaning of Firm and Industry

According to Miller, “Firm is an organisation that buys and hires resources and sells goods and services”. Lipsey has
defined as “firm is the unit that employs factors of production to produce commodities that it sells to other firms, to
households, or to the government.”
Industry is a group of firms producing standardised products in a market. According to Lipsey, “Industry is a group
of firms that sells a well defined product or closely related set of products.”
Conditions of Equilibrium of the Firm and Industry
A firm is in equilibrium when it has no propensity to modify its level of productivity. It requires neither extension
nor retrenchment. It wants to earn maximum profits in by equating its marginal cost with its marginal revenue, i.e. MC =
MR. Diagrammatically, the conditions of equilibrium of the firm are (1) the MC curve must equal the MR curve.
This is the first order and essential condition. But this is not a sufficient condition which may be fulfilled yet the firm may not
be in equilibrium. (2) The MC curve must cut the MR curve from below and after the point of equilibrium it must be above
the MR.
This is the second order condition. Under conditions of perfect competition, the MR curve of a firm overlaps with the AR
curve. The MR curve is parallel to the X axis. Hence the firm is in equilibrium when MC = MR = AR.
The first order figure (1), the MC curve cuts the MR curve first at point X. It contends the condition of MC = MR, but it is
not a point of maximum profits for the reason that after point X, the MC curve is beneath the MR curve. It does not pay the
firm to produce the minimum output OM when it can earn huge profits by producing beyond OM. Point Y is of maximum
profits where both the situations are fulfilled.
Amidst points X and Y it pays the firm to enlarges its productivity for the reason that it’s MR > MC. It will nevertheless stop
additional production when it reaches the OM1 level of productivity where the firm fulfils both the circumstances of
equilibrium. If it has any plants to produce more than OM1 it will be incurring losses, for its marginal cost exceeds its
marginal revenue beyond the equilibrium point Y. The same finale hold good in the case of straight line MC curve and it is
presented in the figure (2).
An industry is in equilibrium, first when there is no propensity for the firms either to leave or either the industry and next,
when each firm is also in equilibrium. The first clause entails that the average cost curves overlap with the average revenue
curves of all the firms in the industry.
They are earning only normal profits, which are believed to be incorporated in the average cost curves of the firms. The
second condition entails the equality of MC and MR. Under a perfectly competitive industry these two circumstances must
be fulfilled at the point of equilibrium i.e. MC = MR…. (1), AC = AR…. (2), AR = MR. Hence MC = AC = AR. Such a position
represents full equilibrium of the industry.
Short Run Equilibrium of the Firm and Industry
1. Short Run Equilibrium of the Firm
A firm is in equilibrium in the short run when it has no propensity to enlarge or contract its productivity and needs
to earn maximum profit or to incur minimum losses.
The short run is an epoch of time in which the firm can vary its productivity by changing the erratic factors of
production. The number of firms in the industry is fixed since neither the existing firms can leave nor new firms
can enter it.
Postulations
1. All firms use standardised factors of production

2. Firms are of diverse competence
3. Cost curves of firms are dissimilar from each other
4. All firms sell their produces at the equal price ascertained by demand and supply of the industry so that
the price of each firm, P (Price) = AR = MR
5. Firms produce and sell various volumes
The short run equilibrium of the firm can be described with the helps of marginal study and total cost revenue
study.
 Marginal Cost, Marginal Revenue analysis – During the short run, a firm will produce only its price equals
average variable cost or is higher than the average variable cost (AVC). Furthermore, if the price is more
than the averages total costs, ATC, i.e. P = AR > ATC the firm will be earning super normal profits. If
price equals the average total costs, i.e. P = AR = ATC the firm will be earning normal profits or break
even.
 If price equals AVC, the firm will be incurring losses. If price drops even a little below AVC, the firm will
shut down since in order to produce it must cover atleast it’s AVC through short run. So during the short
run, under perfect competition, affirm is in equilibrium in all the above mentioned stipulations.
 Super normal profits – The firm will be earning super normal profits in the short run when price is higher
than the short run average cost.
 Normal Profits = The firm may earn normal profits when price equals the short run average costs.
 Total Cost – Total Revenue Analysis – The short run equilibrium of the firm can also be represented with
the help of total cost and total revenue curves. The firm is able to maximise its profits when the positive
discrimination between TR and TC is the greatest.
Short Run Equilibrium of the Industry
An industry is in equilibrium in the short run when its total output remains steady there being no propensity to enlarge or
contract its productivity. If all firms are in equilibrium the industry is also in equilibrium. For full equilibrium of the industry
in the short run all firms must be earning normal profits.
But full equilibrium of the industry is by sheer accident for the reason that in the short rum some firms may be earning
super normal profits and some losses. Even then the industry is in short run equilibrium when its quantity demanded and
quantity supplied is equal at the price which clears the market.
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Other topics under Product Pricing:
 Applications of Demand and Supply Analysis under Perfect Competition

 Concepts of Revenue
 Derived Demand, Joint Supply
 Determination of Profit Maximisation under monopolist situation
 Duopoly and Oligopoly
 Forms of Market Structure
 Importance of Time Element in Price Theory
 Joint Demand Supply
 Linear Programming
 Long Run Equilibrium of Firm and Industry
 Market Structures
 Monopolistic Competition
 Monopsony and Bilateral Monopoly, Price output Determination
 Objectives of Business Firm
 Oligopoly, Cournot's Oligopoly Model
 Pricing of Public Undertakings
 Profit Maximisation, Full cost, Pricing and Sales Maximisation
 Pricing Under Perfect Competition - Demand Supply - Basic Framework
 Profit Price Policy
 Resource allocation under monopoly
 Short, Long Run Supply Curve of the Firm and Industry
 Similarities and Dissimilarities between Monopoly Competition and Perfect Competition
 Supply Its Law - Elasticity and Curve
 The Nature of Costs and Cost Curves
 Williamson's Utility Maximisation
Monopoly and Marginal Revenue
Monopolies are, literally, the "single seller" in a particularindustry. While perfectly

monopolized markets are as rare as perfectly competitive markets, there are
elements of monopoly power in many markets, and understanging those elements is
easiest if we consider the actions which would be taken by a perfect monopoly.
There are two categories of monopoly:
 A natural monopoly, with its market dominance resting on high fixed costs
(making entrance difficult for other firms) and on low marginal costs of
production and -- as a result -- declining average costs. Declining average costs
imply that large scale producers can produce more cheaply and hence
undersell new entrants.
 Legal monopolies , where market dominance does not rest on a cost
advantage but on a legal prohibition of other firms entering. If a state-owned
telecommunications service or postal service prohibits other firms from
entering, we have a legal monopoly. If patents prevent other firms from
entering an industry, we have a legal monopoly granted to the firm owning
the patent.
Both categories will make decisions in the same manner; it is however simpler to
begin with the natural monopoly and to assume that the lower marginal costs of the
natural monopoly may be modelled asconstant rather than rising marginal costs.
The basic economic logic used by the monopolist is the same as that used by the
competitive firm --
 INCREASE output if marginal benefits are ABOVE marginal costs.

 DECREASE output if marginal benefits are BELOW marginal costs.
 STAY AT THE CURRENT LEVEL of output if marginal benefits are EQUAL to
marginal costs.
Understanding the application of this logic by a monopolist requires, however, careful

attention to both the COST side and the BENEFIT side.
COSTS of a NATURAL MONOPOLIST

the cost graph of a natural monopolist is constructed on the assumption of constant
marginal costs.
Let us assume that:
MC = k
where k is a constant marginal cost.
We know that Variable cost = sum of the marginal costs,

but if marginal cost is constant at k, we can compute this more easily as
VC = kQ , where Q is the Quantity of output.
Since total cost = fixed cost + variable cost, and
since average cost = Total Cost/Quantity,
we have for the natural monopoly:
AC = ( FC + kQ)/Q = FC/Q + k
As Q becomes larger, the first term will tend to zero; another way of saying this is that
average cost will fall as output increases, and as output becomes very large, AC will
approach MC.
Graphically, the average cost curve for a natural monopoly looks like this:
MARGINAL REVENUE
While marginal revenue is the same as price for a competitive firm, it is less than
price for a monopolist.
A competitive wheat farmer will take the price of wheat as given by the market at
(say) $5 a bushel. Sellinganother bushel of wheat brings the farmer a marginal
revenue of another $5.
The monopolist does not take the price of his product as given. Indeed, he knows that
in order to sell more he will have to REDUCE the price of his product. In our
introductory model of monopoly, we assume that the monopolist cannot price
discriminate ; that is, that he must sell all output at the same price.
In calculating marginal revenue, the monopolist will have to consider consumer

demand. Monopolists may be the only one selling the product, but they cannot force
consumers to buy more than they wish.
Let us assume thAt demand is given by the equation
P = 3000 - 2 Q
Note that it is convenient to write the demand equation with price on the left hand side
of the equation. To find REVENUE we need only multiply the demand equation
through by Q.
REVENUE = PQ = 3000 Q - 2 Q*Q
This equation may be used to calculate marginal revenue. Simply consider the
revenue at quantities of (say) 500 and 501 and calculate the CHANGE IN REVENUE.
At Q = 500, P = 3000 - 2(500) = 2000 and hence revenue = PQ = 1,000,000. At Q =
501, P = 3000 - 2(501) = 1998 and hence revenue = PQ = 1,000,998.
Marginal revenue at Q = 500 is $ 998.
Note that Marginal revenue is less than price ; marginal revenue is $998 and price
was $2000.
Note for those who haVe taken calculus:

marginal revenue, like all marginal concepts, deals with changes.
In calculus, you learn that to find the change in a function, you differentiate the
function; if we differentiate the revenue function above with the aid of the power
rule we find that
MR = 3000 - 4 Q
Note for those who have not taken calculus:

The MARGINAL REVENUE function may be derived from a straight line demand
equation by:
1. Arranging the demand equation with price on the left hand side.
That is, given the equation Qd = 1500 - .5 P,
rearrange it to read P = 3000 - 2Q
2. Doubling the coefficient on the quantity term.
With the previous demand equation, marginal revenue is:
MR = 3000 - 4 Q
A full justification of this trick requires calculus, but note that it works:
at Q = 500, MR = 3000 - 4 (500) = $1000,
close to the $998 calculated above.
(If we had used 500.5, halfway between our two values, we would be exactly
on target)
GRAPHICALLY, the marginal revenue curve will be sloping downward and

falling exactly twice as steeply as the demand curve.
Monopoly Output and Pricing Decisions
OUTPUT
Choose the output level at which MC = MR.
If we assume that MC = 500 and DEMAND is given by Q = 1500 - .5 P

we find as above that MR = 3000 - 4 Q.
Monopoly output will be found by setting
MR = MC
3000 - 4 Q = 500
4 Q = 3000 - 500
Q = 2500/4 = 625
PRICE
Monopoly price will be found by looking at the demand curve and charging as
much as the market will bear for the level of output chosen.
Since DEMAND is
P = 3000 - 2 Q
at Q = 375, the price charged by the monopoly will be
P = 3000 - 2 (625) = 3000 - 1250 = $ 1750.
Price is much higher than the marginal cost of $ 500.
Profits
Operating profit = REVENUE - VARIABLE COST
In the case above, REVENUE = PQ = ($1750) (625) = $ 1,093,750

VARIABLE COST = MC x Q = $500 x 625 = $ 312,500
OPERATING PROFIT = PQ - VC = 1,093,750 - 312,500 = $781,250
Without a figure given for fixed costs, we cannot tell if the monopoly is making
an overall profit or not.
You can however vary the output decision and see if the monopoly has in fact
found the profit-maximizing output level.
o Assume the monopoly decided to produce 600 units of output. What

would its revenues, variable costs and operating profit be?
Click here for answer
o Assume the monopoly decided to produce 700 units of output. What
would its revenues, variable costs and operating profit be?
Click here for answer
Pricing under monopolistic and

oligopolistic competition
Introduction
Pricing decisions tend to be the most important decisions made by any firm in any kind
of market structure. The concept of pricing has already been discussed in unit . The
price is affected by the competitive structure of a market because the firm is an integral
part of the market in which it operates.
We have examined the two extreme markets viz. monopoly and perfect competition in
the previous unit. In this unit the focus is on monopolistic competition and oligopoly,
which lie in between the two extremes and are therefore more applicable to real world
situations.
Monopolistic competition normally exists when the market has many sellers
selling differentiated products, for example, retail trade, whereas oligopoly is said to be
a stable form of a market where a few sellers operate in the market and each firm has a
certain amount of share of the market and the firms recognize their dependence on
each other. The features of monopolistic and oligopoly arediscussed in detail in this unit.
MONOPOLISTIC COMPETITION
Edward Chamberlin, who developed the model of monopolistic competition, observed

that in a market with large number of sellers, the products of individual firms are not at
all homogeneous, for example, soaps used for personal wash. Each brand has a
specific characteristic, be it packaging, fragrance, look etc.,though the composition
remains the same. This is the reason that each brand is sold Pricing
Decisions individually in the market. This shows that each brand is highly differentiated
in the minds of the consumers. The effectiveness of the particular brand may be
attributed to continuous usage and heavy advertising. As defined by Joe S.Bain
‘Monopolistic competition is found in the industry where there are a large number of
sellers, selling differentiated but close substitute products’. Take the example of Liril and
Cinthol. Both are soaps for personal care
but the brands are different. Under monopolistic competition, the firm has some freedom
to fix the price i.e. because of differentiation a firm will not lose all customers when it
increases its price. Monopolistic competition is said to be the combination of perfect
competition as well as monopoly because it has the features of both perfect competition
and monopoly. It is closer in spirit to a perfectly competitive market, but because
of product differentiation, firms have some control over price. The characteristic features
of monopolistic competition are as follows:
Also read
Pricing Strategies Market structure and microbes ba
 A large number of sellers: Monopolistic market has a large number of sellers of a
product but each seller acts independently and has no influence on others.
 A large number of buyers: Just like the sellers, the market has a large number of
buyers of a product and each buyer acts independently.
 Sufficient Knowledge: The buyers have sufficient knowledge about the product to
be purchased and have a number of options available to choose from.
For example, we have a number of petrol pumps in the city. Now it depends on the
buyer and the ease with which s/he will get the petrol decides the location of the petrol
pump. Here accessibility is likely to be an important factor. Therefore, the buyer will go
to the petrol pump where s/he feels comfortable and gets the petrol filled in the vehicle
easily.
 Differentiated Products: The monopolistic market categorically

offers differentiated products, though the difference in products is marginal, for
example, toothpaste.
 Free Entry and Exit: In monopolistic competition, entry and exit are quite easy
and the buyers and sellers are free to enter and exit the market at their own
will.Nature of the Demand Curve
The demand curve of the monopolistic competition has the following characteristics:
 Less than perfectly elastic: In monopolistic competition, no single firm dominates

the industry and due to product differentiation, the product of each firm seems to
be a close substitute, though not a perfect substitute for the products of the
competitors. Due to this, the firm in question has high elasticity of demand.
 Demand curve slopes downward: In monopolistic competition, the demand curve

facing the firm slopes downward due to the varied tastes and preferences of
consumers attached to the products of specific sellers. This implies that
the demand curve is not perfectly elastic.
PRICE AND OUTPUT DETERMINATION INSHORT RUN
In monopolistic competition, every firm has a certain degree of monopoly power

i.e.every firm can take initiative to set a price. Here, the products are similar but
notidentical, therefore there can never be a unique price but the prices will be in agroup
reflecting the consumers’ tastes and preferences for differentiated products.In this case
the price of the product of the firm is determined by its cost function,demand, its
objective and certain government regulations, if there are any.
As the price of a particular product of a firm reduces, it attracts customers from its
rival groups (as defined by Chamberlin). Say for example, if ‘Samsung’ TV reduces
its price by a substantial amount or offers discount, then the customers from the
rival group who have loyalty for, say ‘BPL’, tend to move to buy ‘Samsung’ TV sets. As
discussed earlier, the demand curve is highly elastic but not perfectly elastic and slopes
downwards.
The market has many firms selling similar products, therefore the firm’s output is quite
small as compared to the total quantity sold in the market and so its price and output
decisions go unnoticed. Therefore, every firm acts independently and for a given
demand curve, marginal revenue curve and cost curves, the firm maximizes profit or
minimizes loss when marginal revenue is equal to marginal cost. Producing an output of
Q selling at price P maximizes the profits of the firm.
In the short run, a firm may or may not earn profits. Figure shows the firm, which is
earning economic profits. The equilibrium point for the firm is at price P and quantity Q
and is denoted by point A. Here, the economic profit is given as area PAQR. The
difference between this and the monopoly case is that here the barriers to entry are low
or weak and therefore new firms will be attracted to enter. Fresh entry will continue to
enter as long as there are profits. As soon as the super normal profit is competed away
by new firms, equilibrium will be attained in the market and no new firms will be
attracted in the market. This is the situation corresponding to the long run and is
discussed in the next section.
PRICE AND OUTPUT DETERMINATION INLONG RUN

We have discussed the price and output determination in the short run. We now discuss
price and output determination in the long run. You will notice that the long run
equilibrium decision is similar to perfect competition. The core of the discussion under
this head is that economic profits are eliminated in the long run, which is the only
equilibrium consistent with the assumption of low barriers to entry. This occurs at an
output where price is equal to the long run average cost. Thedifference between
monopolistic competition and perfect competition is that in monopolistic competition the
point of tangency is downward sloping and does not occur at minimum of the average
cost curve and this is because the demand curve is downward sloping.
Looking at figure , under monopolistic competition in the long run we see that LRAC is
the long run average cost curve and LRMC the long run average marginal curve. Let us
take a hypothetical example of a firm in a typical monopolistic situation where it is
making substantial amount of economic profits.
Here it is assumed that the other firms in the market are also making profits.
This situation would then attract new firms in the market. The new firms may not sell the
same products but will sell similar products. As a result, there will be an increase in the
number of close substitutes available in the market and hence the demand curve would
shift downwards since each existing firm would lose market share. The entry of new
firms would continue as long as there are economic profits.
The demand curve will continue to shift downwards till it becomes tangent to LRAC at a
given price P1 and output at Q1 as shown in the figure. At this point of equilibrium, an
increase or decrease in price would lead to losses. In this case the entry of new firms
would stop, as there will not be any economic profits.
Due to free entry, many firms can enter the market and there may be a condition
where the demand falls below LRAC and ultimately suffers losses resulting in the exit
of the firms. Therefore under the monopolistic competition free entry and exit must lead
to a situation where demand becomes tangent to LRAC, the price becomes equal to
average cost and no economic profit is earned. It can thus be said that in the long run
the profits peter out completely.
One of the interesting features of the monopolistically competitive market is the variety
available due to product differentiation. Although firms in the long run do not produce at
the minimum point of their average cost curve, and thus there is excess capacity
available with each firm, economists have rationalized this by attributing the higher price
to the variety available. Further, consumers are willing to pay the higher price for the
increased variety available in the market.
OLIGOPOLISTIC COMPETITION
We define oligopoly as the form of market organization in which there are fewsellers of
a homogeneous or differentiated product. If there are only two sellers, we have a
duopoly. If the product is homogeneous, we have a pure oligopoly. If the product is
differentiated, we have a differentiated oligopoly.
While entry into anoligopolistic industry is possible, it is not easy (as evidenced by the
fact that thereare only a few firms in the industry).
Oligopoly is the most prevalent form of market organization in the manufacturingsector

of most nations, including India. Some oligopolistic industries in India areautomobiles,
primary aluminum, steel, electrical equipment, glass, breakfast cereals,cigarettes, and
many others. Some of these products (such as steel and aluminum)are homogeneous,
while others (such as automobiles, cigarettes, breakfast cereals,and soaps and
detergents) are differentiated.
Oligopoly exists also whentransportation costs limit the market area. For example, even
though there aremany cement producers in India, competition is limited to the few local
producers ina particular area.Since there are only a few firms selling a homogeneous or
differentiated product inoligopolistic markets, the action of each firm affects the other
firms in the industryand vice versa.
For example, when General Motors introduced price rebates in thesale of its
automobiles, Ford and Maruti immediately followed with price rebates oftheir own.
Furthermore, since price competition can lead to ruinous price wars,oligopolists usually
prefer to compete on the basis of product differentiation,advertising, and service.
These are referred to as nonprice competition. Yet, evenhere, if GM mounts a major
advertising campaign, Ford and Maruti are likely tosoon respond in kind. When Pepsi
mounted a major advertising campaign in theearly 1980s Coca-Cola responded with a
large advertising campaign of its own inthe United States.From what has been said, it is
clear that the distinguishing characteristic ofoligopoly is the interdependence or rivalry
among firms in the industry.
This is the natural result of fewness. Since an oligopolist knows that its own actions will
have a significant impact on the other oligopolists in the industry, each oligopolist
mustconsider the possible reaction of competitors in deciding its pricing policies,
the degree of product differentiation to introduce, the level of advertising to
be undertaken, the amount of service to provide, etc. Since competitors can react
in many different ways (depending on the nature of the industry, the type of
product, etc.) We do not have a single oligopoly model but many-each based on
the particular behavioural response of competitors to the actions of the first. Because of
this interdependence, managerial decision making is much more complex
under oligopoly than under other forms of market structure. In what follows we
present some of the most important oligopoly models. We must keep in mind, however,
that each model is at best incomplete. The sources of oligopoly are generally the same
as for monopoly. That is,
(1) economies of scale may operate over a sufficiently large range of outputs as
to leave only a few firms supplying the entire market;
(2) huge capital investments and specialized inputs are usually required to enter an
oligopolistic industry (say, automobiles, aluminum, steel, and similar industries), and this
acts as an important natural barrier to entry;
(3) a few firms may own a patent for the exclusive right to produce a commodity or to
use a particular production process;
(4) established firms may have a loyal following of customers based on product quality
and service that new firms would find very difficult to match;
(5) a few firms may own or control the entire supply of a raw material required in the
production of the product; and
(6) the government may give a franchise to only a few firms to operate in the market.
The above are not only the sources of oligopoly but also represent the barriers to other
firms entering the market in the long run. If entry were not so restricted, the industry
could not remain oligopolistic in the long run. A further barrier to entry is provided by
limit pricing, whereby, existing firms charge a price low enough to discourage entry into
the industry. By doing so, they voluntarily sacrifice short-run profits in order to maximize
long-run profits. As discussed earlier oligopolies can be classified on the basis of type of
product produced. They can be homogeneous or differentiated. Steel, Aluminium etc.
come under homogeneous oligopoly and television, automobiles etc. come
under heterogeneous oligopoly.
The type of product produced may affect the strategic behaviour of oligopolists.
According to economists, two contrasting behaviour of oligopolists arise that is the
cooperative oligopolists where an oligopolist follows the pattern followed by rival firms
and the non-cooperative oligopolists where the firm does not follow the pattern followed
by rival firms. For example, a firm raises price of its product, the other firms may keep
their prices low so as to attract the sales away from the firm, which has raised its price.
But as stated above, price is not the only factor of competition. As a matter of fact other
factors on the basisof which the firms compete include advertising, product quality and
other marketing strategies. Therefore, we normally have four general oligopolistic
market structures, two each under cooperative as well as non-cooperative structures.
We have firms producing homogeneous and differentiated products under each of the
two basic structures. All these differences exist in the oligopolistic market. This shows
that each firm tries to make an impact in the existing market structure and have
an effect on the rival firms. This tends to be a distinguishing characteristic of
anoligopolistic market.Price Rigidity: Kinked Demand CurveOur study of pricing and
market structure has so far suggested that a firmmaximizes profit by setting MR = MC.
While this is also true for oligopoly firms, itneeds to be supplemented by other
behavioural features of firm rivalry.
This becomes necessary because the distinguishing feature of oligopolistic markets is

interdependence. Because there are a few firms in the market, they also need toworry
about rival firm’s behaviour. One model explaining why oligopolists tend notto compete
with each other on price, is the kinked demand curve model of PaulSweezy. In order to
explain this characteristic of price rigidity i.e. prices remainingstable to a great extent,
Sweezy suggested the kinked demand curve model for theoligopolists. The kink in the
demand curve arises from the asymmetric behaviour ofthe firms. The proponents of the
hypothesis believe that competitors normallyfollow price decreases i.e. they show the
cooperative behaviour if a firm reducesthe price of its products whereas they show the
non-cooperative behaviour if a firmincreases the price of its products.Let us start from
P1 in Figure .
If one firm reduces its price and the other firmsin the market do not respond, the price
cutter may substantially increase its sales.This result is depicted by the relative elastic
demand curve, dd. For example, aprice decrease from P1 to P2 will result in a
movement along dd and increase salesfrom Q1 to Q2 as customers take advantage of
the lower price and abandon othersuppliers. If the price cut is matched by other firms,
the increase in sales will be less.
lSince other firms are selling at the same price, any additional sales must result from
increased demand for the product. Thus the effect of price reduction is a movement
down the relatively inelastic demand curve, DD, then the price reduction from P1 to P2
only increases sales to Q2.
Here we assume that P1 is the initial price of the firm operating in a

noncooperative oligopolistic market structure producing Q1 units of output. P is also the
point of kink in the demand curve and is the initial price and DD is the relatively elastic
demand curve above the existing price P1.
When the firm is operating in the non-cooperative oligopolistic market it results in

decline in sales if it changes its price to P1. Now if the firm reduces its price below P1
say P2, the other firms operating in the market show a cooperative behaviour and follow
the firm. This is shown in the figure as the curve below the existing price P1.
The true demand curve for the oligopolistic market is dD and has the kink at the existing
price P1. The demand curve has two linear curves, which are joined at price
P. Associated with the kinked demand curve is a marginal revenue function. This
is shown in Figure . Marginal Revenue for prices above the kink is given by MR1 and
below the kink as MR2.
At the kink, marginal revenue has a discontinuity at AB and this depends on the
elasticities of the different parts of the demand curve. Therefore, in the presence of a
kinked demand curve, firm has no motive to change its price. If the firm is a profit
maximizing firm where MR=MC, it would not change its price even if the cost changes.
This situation occurs as long as changes in MC fall within the discontinuous range i.e.
AB portion.
The firm following kinked model has a U-shaped marginal cost curve MC. The new MC
curve will be MC1 or MC2 and will remain in the discontinued area and the equilibrium
price remains the same
at P .
Price Competition: Cartels and Collusion

Cartel Profit Maximization
We already know now that in an oligopolistic competition, the firms can compete
in many ways. Some of the ways include price, advertising, product quality, etc.
Many firms may not like competition because it could be mutually disadvantageous.
For example, advertising. In this case many oligopolies end up selling the products
at low prices or doing high advertising resulting in high costs and making lower
profits than expected. Therefore, it is possible for the firms to come to a consensus
and raise the price together, increasing the output without much reduction in sales.
In some countries this kind of collusive agreement is illegal e.g. USA but in some it is
legal. The most extreme form of the collusive agreement is known as a cartel. A cartel is
a market sharing and price fixing arrangement between groups of firms where the
objective of the firm is to limit competitive forces within the market.
The forms of cartels may differ. It can be an explicit collusive agreement where
the member firms come together and may reach a consensus regarding the price
and market sharing or implicit cartel where the collusion is secretive in
nature. Throughout the 1970s, the Organization of Petroleum Exporting Countries
(OPEC) colluded to raise the price of crude oil from under $3 per barrel in 1973 to over
$30 per barrel in 1980.
The world awaited the meeting of each OPEC price-setting meeting with anxiety. By the
end of 1970s, some energy experts were predicting that the price of oil would rise to
over $100 per barrel by the end of the century. Then suddenly the cartel seemed to
collapse. Prices moved down, briefly touching $10 per barrel in early 1986 before
recovering to $18 per barrel in 1987. Today the price of a barrel is about $24. OPEC is
the standard example used in textbooks when explaining cartel behaviour. The cartel
profit maximizing theory can be explained using figure
The market demand for all members of the cartel is given by DD and marginal revenue
(represented by dotted line) as MR. The cartels marginal cost curve given by MCc is the
horizontal sum of the marginal cost curves of the member firms. In this the basic
problem is to determine the price, which maximizes cartel profit. This is done by
considering the individual members of the cartel as one firm i.e. a monopoly. In the
figure this is at the point where MR= MCc, setting price = P.
The problem is regarding the allocation of output within the member firms. Normally a
quota system is quite popular, whereby each firm produces a quantity such that its MC
= MCc. One serious problem that arises from this analysis is that while the joint profits
of the cartel as a whole are maximised, each individual member of the cartel has an
incentive to cheat on its quota. This is because the price for the product is greater than
the members marginal cost of production. This implies that an individual member can
increase its profit by increasing production. What would happen if all members did the
same?
The market sharing arrangement will breakdown and the cartel would collapse. Here
lies the inherent instability of cartel type arrangement and can be summarized as
follows.There is an incentive for the cartel as a whole to restrict output and raise
price, thereby achieving the joint profit maximizing result, but there is an incentive on
the part of the members to increase individual profit. If this kind of situation occurs,
it leads to break-up of the cartel. The difficulty with sustaining collusion is often
demonstrated by a classic strategic game known as the prisoner’s dilemma. The story is
something like this. Two KGB officers spotted an orchestra conductor examining the
score of Tchaikovsky’s Violin Concerto.
Thinking the notation was a secret code, the officers arrested the conductor as a spy.
On the second day of interrogation, a KGB officer walked in and smugly proclaimed,
“OK, you can start talking. We have caught Tchaikovsky”. More seriously, suppose the
KGB has actually arrested someone named Tchaikovsky and the conductor separately.
If either the conductor or Tchaikovsky falsely confesses while the other does not, the
confessor earns the gratitude of the
KGB and only one year in prison, but the other receives 25 years in prison. If both
confess each will be sentenced to 10 years in prison; and if neither confesses
each receives 3 years in prison. Now consider the outcome. The conductor knows that if
Tchaikovsky confesses, he gets either 25 years by holding out or 10 years by
confessing. If Tchaikovsky holds out, the conductor gets either 3 years by holding out or
only one year confessing. Either way, it is better for the conductor to confess.
Tchaikovsky, in a separate cell, engages in the same sort of thinking and also decides
to confess. The conductor and Tchaikovsky would have had three-years rather than 10-
year jail sentences if they had not falsely confessed, but the scenario was such that,
individually, false confession was rational. Pursuit of their own self interests made each
worse off.
This situation is the standard prisoner’s dilemma and is represented in the above matrix.
This first payoff in each cell refers to Tchaikovsky’s, and the second is the conductors.
Examination of the payoffs shows that the joint profit maximizing strategy for both is
(Cooperate-Cooperate).2 The assumption in this game is that both the parties decided
their strategies independently. Let us assume both parties are allowed to consult each
other before the interrogation.
Do you think cooperation will be achieved? It is unlikely since each of them will
individually be concerned about the worst outcome that is 25 years in jail. Cooperation
in this prisoner’s dilemma becomes even more difficult, because it is a one shot
game. This scenario is easily transferred to the pricing decision of a company.
Consider two companies setting prices. If both companies would only keep prices high,
they will jointly maximise profits.
If one company lowers price, it gains customers and it is thus in its interests to do so.
Once one company has cheated and lowered price, the other company must follow suit.
Both companies have lowered their profits by lowering price. Clearly, companies
repeatedly interact with one another, unlike Tchaikovsky and the conductor. With
repeated interaction, collusion can be sustained. Robert Axelrod, a well-known political
scientist, claims a “tit-for-tat” strategy is the best way to achieve co-operation. A tit-for-
tat strategy always co-operates in the first period and then mimmics the strategy of its
rival in each subsequent period. Axelrod likes the tit-for-tat strategy because it is nice,
retaliatory, forgiving the clear. It is nice, because it starts by co-operating, retaliatory
because it promptly punishes a defection, forgiving because once the rival returns to co-
operation it is willing to restore co-operation, and finally its rules are very clear:
precisely, an eye for an eye.
A fascinating example of tit-for-tat in action occurred during the trench warfare of

the First World War. Front-line soldiers in the trenches often refrained from shooting to
kill, provided the opposing soldiers did likewise. This restraint was often in direct
violation of high command orders.
Price Leadership
Price leadership is an alternative cooperative method used to avoid tough competition.
Under this method, usually one firm sets a price and the other firms follow. It is quite
popular in industries like cigarette industry. Here any firm in the oligopolistic market can
act as a price leader. The firm, which is highly efficient, and having low cost can be a
price leader or the firm, which is dominant in the market acts as a leader. Whatever the
case may be, the firm, which sets the price, is the price leader. We have two forms of
price leadership-Dominant price leadership and Barometric price leadership.
In dominant price leadership, the largest firm in the industry sets the price. If the small
firms do not conform to the large firm, then the price war may take place due to which
the small firms may not be able to survive in the market. It is more or less like a
monopoly market structure. This can be seen in the airlines industry in India where the
dominant firm Indian Airlines (IA) sets prices and the others Jet and Sahara follow the
price changes of IA.
Barometric price leadership is said to be the simpler of the two. This normally occurs in
the market where there is no dominant firm. The firm having a good reputation in the
market usually sets the price. This firm acts as a barometer and sets the price to
maximize the profits. Here it is important to note that the firm in question does not have
any power to force the other firms to follow its lead. The other firms will follow only as
long as they feel that the firm in action is acting fairly. Though this method is quite
ambiguous regarding price leadership, it is legally accepted. These two forms are an
integral part of different types of cooperative oligopoly. Barometric price leadership has
been seen in the automobile sector.
ILLUSTRATION
Reestablishing Price Discipline in the Steel industry Until the 1960s, U.S. Steel was the
leader in setting prices in the steel industry. However, in 1962, a price increase
announced by U.S. Steel provoked so much criticism from customers and elected
officials, especially President john F. Kennedy, that the firm became less willing to act
as the price leader. As a result, the industry evolved from dominant firm to barometric
price leadership. This new form involved one firm testing the waters by announcing a
price change and then U.S. Steel either confirming or rejecting the change by its
reaction. In 1968, U.S. Steel found that its market share was declining.
The responded by secretly cutting prices to large customers. This action was
soon detected by Bethlehem Steel, which cut its posted price of steel from
$113.50 to $88.50 per ton. Within three weeks, all of the other major
producers, U.S. Steel included, matched Bethlehem's new price.
The lower industry price was not profitable for the industry members.Consequently, U.S.
Steel signaled its desire to end the price war by posting a higher price. Bethlehem
waited nine days and responded with a slightly lower price than that of U.S. Steel. U.S.
Steel was once again willing to play by industry rules. Bethlehem announced a price
increase to $125 per ton.
All of the other major producers quickly followed suit, and industry discipline was
restored. Note that the price of $125 per ton was higher than the original price of
$113.50. Source: Peterson and Lewis, 2002. Managerial Economics. Pearson
Education Asia.
CONCENTRATION RATIOS, HEIRFINDAHL INDEX AND CONTESTABLE MARKETS

The degree by which an industry is dominated by a few large firms is measured
byConcentration ratios. These give the percentage of total industry sales of 4, 8,
orPricing Under Monopolisticand OligopolisticCompetition1312 largest firms in the
industry. An industry in which the four-firm concentrationratio is close to 100 is clearly
oligoplistic, and industries where this ratio is higherthan 50 or 60 percent are also likely
to be oligopolistic.
The four-firm concentrationratio for most manufacturing industries in the United States
is between 20 and 80percent.Another method of estimating the degree of concentration
in an industry is theHeirfindahl index (H). This is given by the sum of the squared values
of themarket shares of all the firms in the industry. The higher the Heirfindahl index,
thegreater is the degree of concentration in the industry.
Monopoly - Price and Output for a Monopolist
Geoff Riley
14th February 2015
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Type:
Study notes
Levels:
A Level
Exam boards:
AQA, Edexcel, OCR, IB, Other, Pre-U
A pure monopolist in an industry is a single seller. It is rare for a firm to have a pure
monopoly – except when the industry is state-owned and has a legally protected
monopoly
 The Royal Mail used to have a statutory monopoly on delivering household mail. This
is changing fast as the industry seen fresh competition. The Royal Mail was part-
privatised in 2013.
 A working monopoly: A working monopoly is any firm with greater than 25% of the
industries' total sales. In practice, there are many markets where businesses enjoy a
degree of monopoly power even if they do not have a 25% market share.
 A dominant firm is a firm that has at least forty per cent of their given market
Price and output under a pure monopoly
 A monopolist can take market demand as its own demand curve

 The firm is a price maker but it cannot charge a price that the consumers will not bear
 A monopolist has market power which is the power to raise price above marginal cost
without fear of losing supernormal profits to new entrants to a market
 In this sense, price elasticity of demand acts as a constraint on the pricing-power of the
monopolist
 Assuming that the monopolist aims to maximise profits (where MR=MC), we establish a
short run price and output equilibrium as shown in the diagram below
Short run equilibrium
First of all, we need to look at the possible situations in which firms may find themselves in the short run.
With each of the three diagrams above, the situation for the firm is only drawn. The 'market' diagram, from
which the given price is derived, is the same every time, so I've missed it out. The main thing is that you
understand that the prices P1, P2 and P3 are determined by market demand and market supply. Also note that in
all three diagrams, the MC curve cuts the AC curve at its lowest point. Look back at the 'Costs and revenues'
topic if you don't remember why.
The three diagrams show the three situations in which a firm could find itself in the short run.
In the top diagram, the given price is P1. The firm wants to maximise profits, so it produces at the level of
output where MC = MR. This occurs at point A. Drop a vertical line to find the firm's output (Q1). At Q1, AR >
AC and the difference between average revenue and average cost is the distance AB. This is the profit per unit.
To find the total super normal profit, we must multiply the profit per unit per the number of units. In the
diagram, this is the area ABCP1 (the red box).
In the middle diagram, the given price is P2. In this case, it is clear that the firm will not be making a profit.
The AC curve is above the AR curve at all levels of output. The firm will still want to minimise its losses,
though. This can be done, again, with the trusty old formula, MC = MR. This occurs at point D giving output
Q2. At Q2, AR < AC and the difference between average revenue and average cost is the distance DE. This is
the loss per unit. To find the total losses, we must multiply the loss per unit per the number of units. In the
diagram, this is the area DEFP2 (the red box).
In the final diagram, at the bottom, the given price is P3. Again the firm will produce the level of output for
which MC = MR. This occurs at point G, giving a level of output of Q3. Notice that at this point, AR = AC, so
the firm is making normal profit.
So, in the short run, a perfectly competitive firm could be making super normal profit, or a loss,or just normal
profit, depending on the given market price. Note that if the firm's losses get too big in the short run (i.e. AR <
AVC) then it will have to shut down (see the section above).
Long run equilibrium
The two sets of diagrams below will help to show that in the long run, all firms in a perfectly competitive
market earn only normal profit.
In the diagrams above, the initial price is P1, due to the fact that the initial demand and supply curves, D1 and
S1, cross at point C. This given price means that each firm's demand curve is D1. MC = MR occurs at point A.
AR > AC, so each firm is making super normal profits. But what will happen as we move towards the long
run? Remember that there are no barriers to entry orexit in a perfectly competitive market. This means that
new firms will be attracted, in quite large numbers, into the market. This will increase market supply, shifting
the supply curve to the right. This will keep happening until the given price is such that all firms in the market
earn only normal profit. All of the super normal profit will have been competed away. Once the supply curve
has shifted all the way to S2, with a given price of P2, then every firm in the industry will be earning normal
profit and there will be no incentive for any firm to enter or leave the industry. This is, therefore, the long run
equilibrium.
In the second set of diagrams above, each firm is making a loss at the initial price P1. MC = MR occurs at point
F, where AR < AC. As we said earlier, firms can take a reasonable sized loss in the short run, but this is not
sustainable as we move into the long run. Again, there are nobarriers to exit, so some firms will leave the
industry, causing the market supply curve to shift to the left. This will keep happening until the given price is
such that all firms in the market earn only normal profit. Once the supply curve has shifted all the way to S3,
with a given price of P3, then every firm in the industry will be earning normal profit and there will
be noincentive for any firm to enter or leave the industry. This is, therefore, the long run equilibrium.
Notice that I haven't drawn a set of 'long run' diagrams for the situation where firms earn normal profit in the
short run. This is because nothing happens. If firms are earning normal profit in the short run, there is no
incentive for any firms to leave or enter the industry. The diagram stays the same so that the long run
equilibrium looks the same as the short run equilibrium.
It is also important to note that, in the long run, all firms in a perfectly competitive market are
both allocatively efficient (because price = MC) and productively efficient (because at the equilibrium
output, MC = AC). In the topic on 'Market failure', the fact that a market has notfailed if it is efficient in both
these ways was discussed.
For example, if there is onlyone firm in the industry so that its market share is 100%,
H=1002=10,000. If thereare two firms in an industry, one with a 90 percent share of the
market and theother with a 10 percent share, H = 902 + 102 =8,200. If each firm had a
50 percentshare of the market, H = 502 + 502 = 5,000. With four equal-sized firms in
theindustry, H = 2,500. With 100 equal-sized firms in the (perfectly competitive)industry,
H = 100. This points to the advantage of the Heirfindahl index over theconcentration
ratios discussed above. Specifically the Heirfindahl index usesinformation on all
the firms in the industry- not just the share of the market by thelargest 4, 8, 12
firms in the market.
Furthermore, by squaring the market share ofeach firm, the Heirfindahl index
appropriately gives a much large weight to largerthan to smaller firms in the
industry. The Heirfindahl index has become of greatpractical importance since
1982 when the Justice Department in the US announcednew guidelines for
evaluating proposed mergers based on this index.In fact, according to the
theory of Contestable markets developed during the1980s, even if an industry
has a single firm (monopoly) or only a few firms(oligopoly), it would still
operate as if it were perfectly competitive if entry is“absolutely free” (i.e. if
other firms can enter the industry and face exactly thesame costs as existing
firms) and if exit is “entirely costless” (i.e., if there are nosunk costs so that the
firm can exit the industry without facing any loss of capital).
An example of this might be an airline that establishes a service between two

citiesalready served by other airlines if the new entrant faces the same costs
as existingairlines and could subsequently leave the market by simply
reassigning its planes toother routes without incurring any loss of capital.
When entry is absolutely free andexit is entirely costless, the market is
contestable. Firms will then operate as if theywere perfectly competitive and
sell at a price which only covers their average costs(so that they earn zero
economic profit) even if there is only one firm or a few ofthem in the market.
- See more at: http://www.jbdon.com/pricing-under-monopolistic-and-oligopolistic-
competition.html#sthash.6TuoM5zv.dpuf
Microeconomics - Effects on
Equilibrium in the Short and Long Run
The Firm vs. the Industry's Short-Run Supply Curve
A company will continue to produce output until marginal revenue (MR) is equal to marginal
cost (MC).
In other words, the condition for maximum profit occurs where:

MR = MC
Another condition for profit to be maximized, because it is possible that MR=MC at a point
where MC is falling, is that the marginal cost curve must be rising. Therefore, the supply
curve for a competitive firm will be that part of the marginal cost curve which lies above the
low point of the average cost curve. The supply curve slopes upward because marginal
costs increase with the greater quantity supplied in the short run. With a competitive market,
the supply curve will be a summation of the individual firms' supply curves.
Long-Run Effects on Equilibrium

In the short-run, increases (decreases) in demand in a competitive market will cause prices
and output to increase (decrease).
In the long-run, increases (decreases) in demand in a competitive market will cause

increases (decreases) in output. Initially, markets with an increase (decrease) in demand
will have firms experiencing economic profits (losses). Over time, markets with firms
experiencing economic profits (losses) will have additional firms enter (existing firms will
exit) the market, and prices will decrease (increase) towards previous levels. If cost
conditions remain the same, then prices will revert to what they were before the increase
(decrease) in demand.
If the market price falls below a firm's average total cost, the firm will incur economic losses.
The firm may be able to lower its average total cost by changing to a different plant size.
Suppose a firm increases its plant size, and lowers its average total costs. If other firms
follow, then the industry supply curve will shift to the right. This will result in lower prices and
less economic profit.
If a firm does not expect market conditions to improve then it may decide to go out of
business. This would be the preferred option as, by selling out, neither fixed nor variable
costs would be incurred.
Impact From Changes in Technology

The impact of a permanent change of demand on price and output for a market will be
influenced by the cost structure of suppliers in the market. The long-run market supply
curve in a competitive industry will depend on the returns to scale.
For a constant-cost industry, if demand increases, then firms temporarily will make a profit
as price will go above the minimum needed for the firms to stay in business. This will cause
firms to expand output or new firms to enter the industry. Because costs are constant in the
long run, the long-run supply curve will be horizontal. In the graph below, as demand shifts
from D1 to D2, over the long run quantity will increase from Q1 to Q2. However, price will
remain the same.
Figure 3.12: Long Run Supply: Constant Cost Industry
For an increasing cost industry, if demand increases, firms will need higher prices over the
long run in order to justify higher levels of production. For example, prices for raw materials
used in the industry may go up with higher levels of production, which will force the long-run
supply curve to slope upward.
Figure 3.10: Long Run Supply: Increasing Cost Industry
For a decreasing cost industry, if demand increases, in the long run firms can provide more
output at lower prices. The need to produce larger quantities of goods and services in
response to increased demand induces technological change, which lowers costs for the
producer and these savings are passed on to consumers in the long run.
Figure 3.11: Long Run Supply: Decreasing Cost Industry

Read more: Effects on Equilibrium in the Short and Long Run - CFA Level 1 |
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Short-run and long-run equilibrium (Monopolistic

Competition)
Short-run equilibrium
Producers in monopolistically competitive markets, as well as all market types, are profit maximizers.
This means they will produce at the quantity for which their Marginal Benefit is maximized; a.k.a.
where Marginal Cost equals their Marginal Revenue (MC=MR). If you draw a vertical line from the
intersection point down to the x-axis, that is the market quantity. To find the price, you must extend
the vertical line up to the Demand curve because Demand relates market price to quantity, not the
Marginal Cost curve. Then draw a horizontal line to the y-axis and that is the market price. These
two values represent the short-run equilibrium for a monopolistically competitive market.
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Long-run equilibrium Edit
Since producers are profit maximizers, they will produce the quantity where MC=MR (same
procedure as for the short-run equilibrium). In a monopolistically competitive market there are low
barriers to entry so it is easy for other firms to come in and steal economic profit from the firms
currently in the market
(Theory of Contestable Markets). To counteract this, producers in the market will produce at a
quantity that yields zero economic profit, because why would you join this market if there's no
supernormal profit? This means the quantity the firm produces will be both where MC=MR and Price
(the Demand curve) intersects the Average Total Cost curve. If you draw a vertical line up from the
market quantity, it will go through both of these points. The price is again found by drawing a
horizontal line to the y-axis.
Two-part tariffs
Nikolaos Vettas
From The New Palgrave Dictionary of Economics, Online Edition, 2011
Edited by Steven N. Durlauf and Lawrence E. Blume

Back to top
Abstract
A two-part tariff is a pricing scheme according to which the buyer pays to the seller a fixed fee
and a constant charge for each unit purchased. When it is used, the average price paid
decreases as more units are purchased. Further, it is the marginal charge and not the fixed fee
that determines how many units will be purchased. Therefore, a two-part tariff can be used as a
vehicle for price discrimination and also for manipulating the incentives given to the buyers,
allowing also the sellers to capture part of the residual surplus through an appropriately chosen
fixed fee.
Barry Haworth
University of Louisville
Department of Economics
Economics 201
Two-Part Tariff, A Numerical Example
Suppose the campus bookstore has a monopoly over the supply of textbooks. The
bookstore hires someone to estimate their (market) demand curve and receives the
following information (where P = price and Q = quantity demanded):
P = 100 - 1.5Q
Marginal revenue (MR), in this case, would be MR = 100 - 3Q. The firm buys
all of its books from a book publisher at $40 per book, making the bookstore’s
average and marginal cost (AC and MC, respectively) always equal to $40. The
bookstore’s AC and MC equations would be:
AC = 40
MC = 40
If the firm was to charge one price for book it sells, the demand, MR, MC and
AC curves help us in determining that the bookstore will sell 20 books at a
price of $70 per book. Economic profits would be $600 (you may want to
verify this on your own).
Let’s assume that the bookstore owner hears about two-part tariffs and would
like to implement this pricing strategy. Students are asked to pay a cover
charge, just to enter the store, and may then buy all the textbooks they want at
some pre-determined price.
The lower the textbook price, the more consumers save. More specifically, the
lower the price, the greater the consumer surplus. The bookstore knows that the
two-part tariff pricing approach allows them to recover any lost profits (from
lower prices) by raising the cover charge, so the firm will adjust the cover
charge and textbook price to a point where profits are as high as possible.
Given the demand for economics textbooks, the bookstore decides on a price of
$40 per book. That is, the bookstore decides to sell the textbooks at cost. To
determine how many books are sold at this price, we take the demand curve
and plug the price of $40 in for P before solving for the quantity sold (Q).
P = 100 - 1.5Q
40 = 100 - 1.5Q
Q = 40
In the absence of any cover charge, this would allow consumers to obtain
(overall) consumer surplus of $1200. This is illustrated in the graph below,
where the blue area represents consumer surplus.
Because consumer surplus is the area of the triangle bordered by the demand
curve, price and vertical axis, we can calculate the area of this triangle as:
CS = 0.5("base" x "height")
CS = 0.5(Q* x ["y-intercept" - P*])
CS = 0.5(40 x [100 – 40])
CS = 1200
Because we don't have enough specific information about the various

consumers making up this market, including how many consumers there will
be, we can only make guesses at the cover charge.
For example, suppose there are 30 students who think they can save money by
paying the cover charge to enter the bookstore. If the bookstore sets the cover
charge at $25 per person and there are 30 students willing to enter, then the
firm can earn total profits (i.e. profits from booksales + revenues from the
cover charge) of $750.
Intertemporal Price Discrimination with
Forward-Looking Consumers: Application to
the US Market for Console Video-Games
By Harikesh S. Nair
2006Working Paper No. 1947
Marketing
Firms in durable good product markets face incentives to intertemporally price

discriminate, by setting high initial prices to sell to consumers with the highest
willingness to pay, and cutting prices thereafter to appeal to those with lower
willingness to pay. A critical determinant of the profitability of such pricing
policies is the extent to which consumers anticipate future price declines, and
delay purchases. We develop a framework to investigate empirically the
optimal pricing over time of a firm selling a durable-good product to such
strategic consumers. Prices in our model are equilibrium outcomes of a game
played between forward-looking consumers who strategically delay purchases
to avail of lower prices in the future, and a forward-looking firm that takes this
consumer behavior into account in formulating its optimal pricing policy. The
model incorporates first, a method to infer estimates of demand under
dynamic consumer behavior, and second, an algorithm to compute the
optimal sequence of prices given these demand estimates. The model is
solved using numerical dynamic programming techniques. We present an
empirical application to the market for video-games in the US. The results
indicate that consumer forward-looking behavior has a significant effect on
optimal pricing and profits of games in the industry. Simulations reveal that the
profit losses of ignoring forward-looking behavior by consumers are large and
economically significant, and suggest that market research that provides
information regarding the extent of discounting by consumers is valuable to
video-game firms.
Peak Pricing
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DEFINITION OF 'PEAK PRICING'

A form of congestion pricing where customers pay an additional fee during
periods of high demand. Peak pricing is most frequently implemented by utility
companies, who charge higher rates during times of the year when demand is
the highest. The purpose of peak pricing is to regulate demand so that it stays
within a manageable level of what can be supplied.
BREAKING DOWN 'PEAK PRICING'

If periods of peak demand are not well managed, demand will far outstrip supply.
In the case of utilities, this may cause brownouts. In the case of roads, it may
cause congestion. Brownouts and congestion are costly for all users. Using peak
pricing is a way of directly charging customers for these negative effects. The
alternative is for municipalities to build up more infrastructure in order to
accommodate peak demand. However, this option is often costly and is less
efficient as it leaves a large amount of wasted capacity during non-peak demand.
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peak-load pricing
Definition Add to FlashcardsSave to Favorites
Charging the highest possible prices in accordance with the rising demand for
a service with few competitive peers. Often used by electricity companies during the
summer, to capture the highest load of demand at the highest prices for the
highest profit.
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peak load pricing

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Annie Barrow
Peak Load Pricing

Peak Load Pricing is a pricing strategy that implies price will be set at the highest level during times when
demand is at a peak. The pricing strategy is an attempt to shift demand, or at least consumption of the
good or service, to accomodate supply. The idea is that pricing higher when demand is at its peak will
balance out the supply and demand so that there is no shortage on either end of the spectrum. If a good
is priced at a high cost and many demand it, a capacity will be balanced. This is a type of price
discrimination; a firm discriminates between high-traffic, high usage or high demand times and low usage
time periods. The consumer that purchases during high usage times has to pay a higher price than that of
the consumer that can delay his purchase or demand.
Graphically, Marginal Cost is constant until the quantity being produced is the maximum that the firm can
produce. At this quantity, Marginal Cost becomes vertical. Since firms optimize profits when MC=MR,
shifts in MR and MC effect the price. As demand shifts outward, Marginal Revenue increases. As a result,
the point where MR=MC increases and higher prices result.
Real World Examples:
Gas prices in the 1970's and Utility companies are good examples of peak load pricing. When a good or
service is limited in availability, peak load pricing can effectively reduce consumer consumption because
consumers are swayed by the high prices. On the other hand, when prices are lower, consumers are
more likely to purchase more. Another example would be tourist pricing. In a tourist town, one might see
prices of many goods rise during tourist season. Or another example would be pizza prices. On the
weekend, there are a limited number of specials, however on Monday and Tuesday (slow days for pizza
shops), many more low cost deals are available.
Test Questions:
1. What objective does peak load pricing serve?
a. it increases demand
b. it increases supply
c. it balances supply and demand
d. it is a constant pricing strategy
1. Answer: C - it balances supply in demand by encouraging consumers to purchase at lower prices and
still provides consumers wiling to pay the increased price the good or service.
2. True or False: Peak Load Pricing is a strategy that benefits only the supplier.
2. Answer: Peak Load Pricing allows the firm to supply enough of the good it produces to those that
demand it; peak load pricing helps to avoid shortages during peak hours and times of high demand.
Natural Monopoly
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DEFINITION OF 'NATURAL MONOPOLY'
A type of monopoly that exists as a result of the high fixed or start-up costs of
operating a business in a particular industry. Because it is economically sensible
to have certain natural monopolies, governments often regulate those in
operation, ensuring that consumers get a fair deal.
BREAKING DOWN 'NATURAL MONOPOLY'

The utilities industry is a good example of a natural monopoly. The costs of
establishing a means to produce power and supply it to each household can be
very large. This capital cost is a strong deterrent for possible competitors.
Additionally, society can benefit from having natural monopolies because having
multiple firms operating in such an industry is economically inefficient.
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natural monopoly
Situation where one firm (because of a unique raw material, technology, or

other factors) can supply a market's entire demand for a good or service at
a price lower than two or more firms can. Such situations occur usually in case
of utilities or where a market can support only one producer (because the
decreasing returns to scalemake the optimum plant size large in relation to the
demand) or where long-range average total cost is declining with
higher output throughout the range of the possible demand.
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Pricing under monopolistic and
oligopolistic competition
Introduction
Pricing decisions tend to be the most important decisions made by any firm in any kind
of market structure. The concept of pricing has already been discussed in unit . The
price is affected by the competitive structure of a market because the firm is an integral
part of the market in which it operates.
We have examined the two extreme markets viz. monopoly and perfect competition in
the previous unit. In this unit the focus is on monopolistic competition and oligopoly,
which lie in between the two extremes and are therefore more applicable to real world
situations.
Monopolistic competition normally exists when the market has many sellers
selling differentiated products, for example, retail trade, whereas oligopoly is said to be
a stable form of a market where a few sellers operate in the market and each firm has a
certain amount of share of the market and the firms recognize their dependence on
each other. The features of monopolistic and oligopoly arediscussed in detail in this unit.
MONOPOLISTIC COMPETITION
Edward Chamberlin, who developed the model of monopolistic competition, observed

that in a market with large number of sellers, the products of individual firms are not at
all homogeneous, for example, soaps used for personal wash. Each brand has a
specific characteristic, be it packaging, fragrance, look etc.,though the composition
remains the same. This is the reason that each brand is sold Pricing
Decisions individually in the market. This shows that each brand is highly differentiated
in the minds of the consumers. The effectiveness of the particular brand may be
attributed to continuous usage and heavy advertising. As defined by Joe S.Bain
‘Monopolistic competition is found in the industry where there are a large number of
sellers, selling differentiated but close substitute products’. Take the example of Liril and
Cinthol. Both are soaps for personal care
but the brands are different. Under monopolistic competition, the firm has some freedom
to fix the price i.e. because of differentiation a firm will not lose all customers when it
increases its price. Monopolistic competition is said to be the combination of perfect
competition as well as monopoly because it has the features of both perfect competition
and monopoly. It is closer in spirit to a perfectly competitive market, but because
of product differentiation, firms have some control over price. The characteristic features
of monopolistic competition are as follows:
Also read
Pricing Strategies Market structure and microbes ba
 A large number of sellers: Monopolistic market has a large number of sellers of a

product but each seller acts independently and has no influence on others.
 A large number of buyers: Just like the sellers, the market has a large number of
buyers of a product and each buyer acts independently.
 Sufficient Knowledge: The buyers have sufficient knowledge about the product to
be purchased and have a number of options available to choose from.
For example, we have a number of petrol pumps in the city. Now it depends on the
buyer and the ease with which s/he will get the petrol decides the location of the petrol
pump. Here accessibility is likely to be an important factor. Therefore, the buyer will go
to the petrol pump where s/he feels comfortable and gets the petrol filled in the vehicle
easily.
 Differentiated Products: The monopolistic market categorically

offers differentiated products, though the difference in products is marginal, for
example, toothpaste.
 Free Entry and Exit: In monopolistic competition, entry and exit are quite easy
and the buyers and sellers are free to enter and exit the market at their own
will.Nature of the Demand Curve
The demand curve of the monopolistic competition has the following characteristics:
 Less than perfectly elastic: In monopolistic competition, no single firm dominates

the industry and due to product differentiation, the product of each firm seems to
be a close substitute, though not a perfect substitute for the products of the
competitors. Due to this, the firm in question has high elasticity of demand.
 Demand curve slopes downward: In monopolistic competition, the demand curve

facing the firm slopes downward due to the varied tastes and preferences of
consumers attached to the products of specific sellers. This implies that
the demand curve is not perfectly elastic.
PRICE AND OUTPUT DETERMINATION INSHORT RUN
In monopolistic competition, every firm has a certain degree of monopoly power

i.e.every firm can take initiative to set a price. Here, the products are similar but
notidentical, therefore there can never be a unique price but the prices will be in agroup
reflecting the consumers’ tastes and preferences for differentiated products.In this case
the price of the product of the firm is determined by its cost function,demand, its
objective and certain government regulations, if there are any.
As the price of a particular product of a firm reduces, it attracts customers from its
rival groups (as defined by Chamberlin). Say for example, if ‘Samsung’ TV reduces
its price by a substantial amount or offers discount, then the customers from the
rival group who have loyalty for, say ‘BPL’, tend to move to buy ‘Samsung’ TV sets. As
discussed earlier, the demand curve is highly elastic but not perfectly elastic and slopes
downwards.
The market has many firms selling similar products, therefore the firm’s output is quite
small as compared to the total quantity sold in the market and so its price and output
decisions go unnoticed. Therefore, every firm acts independently and for a given
demand curve, marginal revenue curve and cost curves, the firm maximizes profit or
minimizes loss when marginal revenue is equal to marginal cost. Producing an output of
Q selling at price P maximizes the profits of the firm.
In the short run, a firm may or may not earn profits. Figure shows the firm, which is
earning economic profits. The equilibrium point for the firm is at price P and quantity Q
and is denoted by point A. Here, the economic profit is given as area PAQR. The
difference between this and the monopoly case is that here the barriers to entry are low
or weak and therefore new firms will be attracted to enter. Fresh entry will continue to
enter as long as there are profits. As soon as the super normal profit is competed away
by new firms, equilibrium will be attained in the market and no new firms will be
attracted in the market. This is the situation corresponding to the long run and is
discussed in the next section.
PRICE AND OUTPUT DETERMINATION INLONG RUN

We have discussed the price and output determination in the short run. We now discuss
price and output determination in the long run. You will notice that the long run
equilibrium decision is similar to perfect competition. The core of the discussion under
this head is that economic profits are eliminated in the long run, which is the only
equilibrium consistent with the assumption of low barriers to entry. This occurs at an
output where price is equal to the long run average cost. Thedifference between
monopolistic competition and perfect competition is that in monopolistic competition the
point of tangency is downward sloping and does not occur at minimum of the average
cost curve and this is because the demand curve is downward sloping.
Looking at figure , under monopolistic competition in the long run we see that LRAC is
the long run average cost curve and LRMC the long run average marginal curve. Let us
take a hypothetical example of a firm in a typical monopolistic situation where it is
making substantial amount of economic profits.
Here it is assumed that the other firms in the market are also making profits.
This situation would then attract new firms in the market. The new firms may not sell the
same products but will sell similar products. As a result, there will be an increase in the
number of close substitutes available in the market and hence the demand curve would
shift downwards since each existing firm would lose market share. The entry of new
firms would continue as long as there are economic profits.
The demand curve will continue to shift downwards till it becomes tangent to LRAC at a
given price P1 and output at Q1 as shown in the figure. At this point of equilibrium, an
increase or decrease in price would lead to losses. In this case the entry of new firms
would stop, as there will not be any economic profits.
Due to free entry, many firms can enter the market and there may be a condition
where the demand falls below LRAC and ultimately suffers losses resulting in the exit
of the firms. Therefore under the monopolistic competition free entry and exit must lead
to a situation where demand becomes tangent to LRAC, the price becomes equal to
average cost and no economic profit is earned. It can thus be said that in the long run
the profits peter out completely.
One of the interesting features of the monopolistically competitive market is the variety
available due to product differentiation. Although firms in the long run do not produce at
the minimum point of their average cost curve, and thus there is excess capacity
available with each firm, economists have rationalized this by attributing the higher price
to the variety available. Further, consumers are willing to pay the higher price for the
increased variety available in the market.
OLIGOPOLISTIC COMPETITION
We define oligopoly as the form of market organization in which there are fewsellers of
a homogeneous or differentiated product. If there are only two sellers, we have a
duopoly. If the product is homogeneous, we have a pure oligopoly. If the product is
differentiated, we have a differentiated oligopoly.
While entry into anoligopolistic industry is possible, it is not easy (as evidenced by the
fact that thereare only a few firms in the industry).
Oligopoly is the most prevalent form of market organization in the manufacturingsector

of most nations, including India. Some oligopolistic industries in India areautomobiles,
primary aluminum, steel, electrical equipment, glass, breakfast cereals,cigarettes, and
many others. Some of these products (such as steel and aluminum)are homogeneous,
while others (such as automobiles, cigarettes, breakfast cereals,and soaps and
detergents) are differentiated.
Oligopoly exists also whentransportation costs limit the market area. For example, even
though there aremany cement producers in India, competition is limited to the few local
producers ina particular area.Since there are only a few firms selling a homogeneous or
differentiated product inoligopolistic markets, the action of each firm affects the other
firms in the industryand vice versa.
For example, when General Motors introduced price rebates in thesale of its
automobiles, Ford and Maruti immediately followed with price rebates oftheir own.
Furthermore, since price competition can lead to ruinous price wars,oligopolists usually
prefer to compete on the basis of product differentiation,advertising, and service.
These are referred to as nonprice competition. Yet, evenhere, if GM mounts a major

advertising campaign, Ford and Maruti are likely tosoon respond in kind. When Pepsi
mounted a major advertising campaign in theearly 1980s Coca-Cola responded with a
large advertising campaign of its own inthe United States.From what has been said, it is
clear that the distinguishing characteristic ofoligopoly is the interdependence or rivalry
among firms in the industry.
This is the natural result of fewness. Since an oligopolist knows that its own actions will
have a significant impact on the other oligopolists in the industry, each oligopolist
mustconsider the possible reaction of competitors in deciding its pricing policies,
the degree of product differentiation to introduce, the level of advertising to
be undertaken, the amount of service to provide, etc. Since competitors can react
in many different ways (depending on the nature of the industry, the type of
product, etc.) We do not have a single oligopoly model but many-each based on
the particular behavioural response of competitors to the actions of the first. Because of
this interdependence, managerial decision making is much more complex
under oligopoly than under other forms of market structure. In what follows we
present some of the most important oligopoly models. We must keep in mind, however,
that each model is at best incomplete. The sources of oligopoly are generally the same
as for monopoly. That is,
(1) economies of scale may operate over a sufficiently large range of outputs as
to leave only a few firms supplying the entire market;
(2) huge capital investments and specialized inputs are usually required to enter an
oligopolistic industry (say, automobiles, aluminum, steel, and similar industries), and this
acts as an important natural barrier to entry;
(3) a few firms may own a patent for the exclusive right to produce a commodity or to
use a particular production process;
(4) established firms may have a loyal following of customers based on product quality
and service that new firms would find very difficult to match;
(5) a few firms may own or control the entire supply of a raw material required in the
production of the product; and
(6) the government may give a franchise to only a few firms to operate in the market.
The above are not only the sources of oligopoly but also represent the barriers to other
firms entering the market in the long run. If entry were not so restricted, the industry
could not remain oligopolistic in the long run. A further barrier to entry is provided by
limit pricing, whereby, existing firms charge a price low enough to discourage entry into
the industry. By doing so, they voluntarily sacrifice short-run profits in order to maximize
long-run profits. As discussed earlier oligopolies can be classified on the basis of type of
product produced. They can be homogeneous or differentiated. Steel, Aluminium etc.
come under homogeneous oligopoly and television, automobiles etc. come
under heterogeneous oligopoly.
The type of product produced may affect the strategic behaviour of oligopolists.
According to economists, two contrasting behaviour of oligopolists arise that is the
cooperative oligopolists where an oligopolist follows the pattern followed by rival firms
and the non-cooperative oligopolists where the firm does not follow the pattern followed
by rival firms. For example, a firm raises price of its product, the other firms may keep
their prices low so as to attract the sales away from the firm, which has raised its price.
But as stated above, price is not the only factor of competition. As a matter of fact other
factors on the basisof which the firms compete include advertising, product quality and
other marketing strategies. Therefore, we normally have four general oligopolistic
market structures, two each under cooperative as well as non-cooperative structures.
We have firms producing homogeneous and differentiated products under each of the
two basic structures. All these differences exist in the oligopolistic market. This shows
that each firm tries to make an impact in the existing market structure and have
an effect on the rival firms. This tends to be a distinguishing characteristic of
anoligopolistic market.Price Rigidity: Kinked Demand CurveOur study of pricing and
market structure has so far suggested that a firmmaximizes profit by setting MR = MC.
While this is also true for oligopoly firms, itneeds to be supplemented by other
behavioural features of firm rivalry.
This becomes necessary because the distinguishing feature of oligopolistic markets is

interdependence. Because there are a few firms in the market, they also need toworry
about rival firm’s behaviour. One model explaining why oligopolists tend notto compete
with each other on price, is the kinked demand curve model of PaulSweezy. In order to
explain this characteristic of price rigidity i.e. prices remainingstable to a great extent,
Sweezy suggested the kinked demand curve model for theoligopolists. The kink in the
demand curve arises from the asymmetric behaviour ofthe firms. The proponents of the
hypothesis believe that competitors normallyfollow price decreases i.e. they show the
cooperative behaviour if a firm reducesthe price of its products whereas they show the
non-cooperative behaviour if a firmincreases the price of its products.Let us start from
P1 in Figure .
If one firm reduces its price and the other firmsin the market do not respond, the price
cutter may substantially increase its sales.This result is depicted by the relative elastic
demand curve, dd. For example, aprice decrease from P1 to P2 will result in a
movement along dd and increase salesfrom Q1 to Q2 as customers take advantage of
the lower price and abandon othersuppliers. If the price cut is matched by other firms,
the increase in sales will be less.
lSince other firms are selling at the same price, any additional sales must result from
increased demand for the product. Thus the effect of price reduction is a movement
down the relatively inelastic demand curve, DD, then the price reduction from P1 to P2
only increases sales to Q2.
Here we assume that P1 is the initial price of the firm operating in a

noncooperative oligopolistic market structure producing Q1 units of output. P is also the
point of kink in the demand curve and is the initial price and DD is the relatively elastic
demand curve above the existing price P1.
When the firm is operating in the non-cooperative oligopolistic market it results in

decline in sales if it changes its price to P1. Now if the firm reduces its price below P1
say P2, the other firms operating in the market show a cooperative behaviour and follow
the firm. This is shown in the figure as the curve below the existing price P1.
The true demand curve for the oligopolistic market is dD and has the kink at the existing
price P1. The demand curve has two linear curves, which are joined at price
P. Associated with the kinked demand curve is a marginal revenue function. This
is shown in Figure . Marginal Revenue for prices above the kink is given by MR1 and
below the kink as MR2.
At the kink, marginal revenue has a discontinuity at AB and this depends on the
elasticities of the different parts of the demand curve. Therefore, in the presence of a
kinked demand curve, firm has no motive to change its price. If the firm is a profit
maximizing firm where MR=MC, it would not change its price even if the cost changes.
This situation occurs as long as changes in MC fall within the discontinuous range i.e.
AB portion.
The firm following kinked model has a U-shaped marginal cost curve MC. The new MC
curve will be MC1 or MC2 and will remain in the discontinued area and the equilibrium
price remains the same
at P .
Price Competition: Cartels and Collusion

Cartel Profit Maximization
We already know now that in an oligopolistic competition, the firms can compete
in many ways. Some of the ways include price, advertising, product quality, etc.
Many firms may not like competition because it could be mutually disadvantageous.
For example, advertising. In this case many oligopolies end up selling the products
at low prices or doing high advertising resulting in high costs and making lower
profits than expected. Therefore, it is possible for the firms to come to a consensus
and raise the price together, increasing the output without much reduction in sales.
In some countries this kind of collusive agreement is illegal e.g. USA but in some it is
legal. The most extreme form of the collusive agreement is known as a cartel. A cartel is
a market sharing and price fixing arrangement between groups of firms where the
objective of the firm is to limit competitive forces within the market.
The forms of cartels may differ. It can be an explicit collusive agreement where
the member firms come together and may reach a consensus regarding the price
and market sharing or implicit cartel where the collusion is secretive in
nature. Throughout the 1970s, the Organization of Petroleum Exporting Countries
(OPEC) colluded to raise the price of crude oil from under $3 per barrel in 1973 to over
$30 per barrel in 1980.
The world awaited the meeting of each OPEC price-setting meeting with anxiety. By the
end of 1970s, some energy experts were predicting that the price of oil would rise to
over $100 per barrel by the end of the century. Then suddenly the cartel seemed to
collapse. Prices moved down, briefly touching $10 per barrel in early 1986 before
recovering to $18 per barrel in 1987. Today the price of a barrel is about $24. OPEC is
the standard example used in textbooks when explaining cartel behaviour. The cartel
profit maximizing theory can be explained using figure
The market demand for all members of the cartel is given by DD and marginal revenue
(represented by dotted line) as MR. The cartels marginal cost curve given by MCc is the
horizontal sum of the marginal cost curves of the member firms. In this the basic
problem is to determine the price, which maximizes cartel profit. This is done by
considering the individual members of the cartel as one firm i.e. a monopoly. In the
figure this is at the point where MR= MCc, setting price = P.
The problem is regarding the allocation of output within the member firms. Normally a
quota system is quite popular, whereby each firm produces a quantity such that its MC
= MCc. One serious problem that arises from this analysis is that while the joint profits
of the cartel as a whole are maximised, each individual member of the cartel has an
incentive to cheat on its quota. This is because the price for the product is greater than
the members marginal cost of production. This implies that an individual member can
increase its profit by increasing production. What would happen if all members did the
same?
The market sharing arrangement will breakdown and the cartel would collapse. Here
lies the inherent instability of cartel type arrangement and can be summarized as
follows.There is an incentive for the cartel as a whole to restrict output and raise
price, thereby achieving the joint profit maximizing result, but there is an incentive on
the part of the members to increase individual profit. If this kind of situation occurs,
it leads to break-up of the cartel. The difficulty with sustaining collusion is often
demonstrated by a classic strategic game known as the prisoner’s dilemma. The story is
something like this. Two KGB officers spotted an orchestra conductor examining the
score of Tchaikovsky’s Violin Concerto.
Thinking the notation was a secret code, the officers arrested the conductor as a spy.
On the second day of interrogation, a KGB officer walked in and smugly proclaimed,
“OK, you can start talking. We have caught Tchaikovsky”. More seriously, suppose the
KGB has actually arrested someone named Tchaikovsky and the conductor separately.
If either the conductor or Tchaikovsky falsely confesses while the other does not, the
confessor earns the gratitude of the
KGB and only one year in prison, but the other receives 25 years in prison. If both
confess each will be sentenced to 10 years in prison; and if neither confesses
each receives 3 years in prison. Now consider the outcome. The conductor knows that if
Tchaikovsky confesses, he gets either 25 years by holding out or 10 years by
confessing. If Tchaikovsky holds out, the conductor gets either 3 years by holding out or
only one year confessing. Either way, it is better for the conductor to confess.
Tchaikovsky, in a separate cell, engages in the same sort of thinking and also decides
to confess. The conductor and Tchaikovsky would have had three-years rather than 10-
year jail sentences if they had not falsely confessed, but the scenario was such that,
individually, false confession was rational. Pursuit of their own self interests made each
worse off.
This situation is the standard prisoner’s dilemma and is represented in the above matrix.
This first payoff in each cell refers to Tchaikovsky’s, and the second is the conductors.
Examination of the payoffs shows that the joint profit maximizing strategy for both is
(Cooperate-Cooperate).2 The assumption in this game is that both the parties decided
their strategies independently. Let us assume both parties are allowed to consult each
other before the interrogation.
Do you think cooperation will be achieved? It is unlikely since each of them will
individually be concerned about the worst outcome that is 25 years in jail. Cooperation
in this prisoner’s dilemma becomes even more difficult, because it is a one shot
game. This scenario is easily transferred to the pricing decision of a company.
Consider two companies setting prices. If both companies would only keep prices high,
they will jointly maximise profits.
If one company lowers price, it gains customers and it is thus in its interests to do so.
Once one company has cheated and lowered price, the other company must follow suit.
Both companies have lowered their profits by lowering price. Clearly, companies
repeatedly interact with one another, unlike Tchaikovsky and the conductor. With
repeated interaction, collusion can be sustained. Robert Axelrod, a well-known political
scientist, claims a “tit-for-tat” strategy is the best way to achieve co-operation. A tit-for-
tat strategy always co-operates in the first period and then mimmics the strategy of its
rival in each subsequent period. Axelrod likes the tit-for-tat strategy because it is nice,
retaliatory, forgiving the clear. It is nice, because it starts by co-operating, retaliatory
because it promptly punishes a defection, forgiving because once the rival returns to co-
operation it is willing to restore co-operation, and finally its rules are very clear:
precisely, an eye for an eye.
A fascinating example of tit-for-tat in action occurred during the trench warfare of

the First World War. Front-line soldiers in the trenches often refrained from shooting to
kill, provided the opposing soldiers did likewise. This restraint was often in direct
violation of high command orders.
Price Leadership
Price leadership is an alternative cooperative method used to avoid tough competition.
Under this method, usually one firm sets a price and the other firms follow. It is quite
popular in industries like cigarette industry. Here any firm in the oligopolistic market can
act as a price leader. The firm, which is highly efficient, and having low cost can be a
price leader or the firm, which is dominant in the market acts as a leader. Whatever the
case may be, the firm, which sets the price, is the price leader. We have two forms of
price leadership-Dominant price leadership and Barometric price leadership.
In dominant price leadership, the largest firm in the industry sets the price. If the small
firms do not conform to the large firm, then the price war may take place due to which
the small firms may not be able to survive in the market. It is more or less like a
monopoly market structure. This can be seen in the airlines industry in India where the
dominant firm Indian Airlines (IA) sets prices and the others Jet and Sahara follow the
price changes of IA.
Barometric price leadership is said to be the simpler of the two. This normally occurs in
the market where there is no dominant firm. The firm having a good reputation in the
market usually sets the price. This firm acts as a barometer and sets the price to
maximize the profits. Here it is important to note that the firm in question does not have
any power to force the other firms to follow its lead. The other firms will follow only as
long as they feel that the firm in action is acting fairly. Though this method is quite
ambiguous regarding price leadership, it is legally accepted. These two forms are an
integral part of different types of cooperative oligopoly. Barometric price leadership has
been seen in the automobile sector.
ILLUSTRATION
Reestablishing Price Discipline in the Steel industry Until the 1960s, U.S. Steel was the
leader in setting prices in the steel industry. However, in 1962, a price increase
announced by U.S. Steel provoked so much criticism from customers and elected
officials, especially President john F. Kennedy, that the firm became less willing to act
as the price leader. As a result, the industry evolved from dominant firm to barometric
price leadership. This new form involved one firm testing the waters by announcing a
price change and then U.S. Steel either confirming or rejecting the change by its
reaction. In 1968, U.S. Steel found that its market share was declining.
The responded by secretly cutting prices to large customers. This action was
soon detected by Bethlehem Steel, which cut its posted price of steel from
$113.50 to $88.50 per ton. Within three weeks, all of the other major
producers, U.S. Steel included, matched Bethlehem's new price.
The lower industry price was not profitable for the industry members.Consequently, U.S.
Steel signaled its desire to end the price war by posting a higher price. Bethlehem
waited nine days and responded with a slightly lower price than that of U.S. Steel. U.S.
Steel was once again willing to play by industry rules. Bethlehem announced a price
increase to $125 per ton.
All of the other major producers quickly followed suit, and industry discipline was
restored. Note that the price of $125 per ton was higher than the original price of
$113.50. Source: Peterson and Lewis, 2002. Managerial Economics. Pearson
Education Asia.
CONCENTRATION RATIOS, HEIRFINDAHL INDEX AND CONTESTABLE MARKETS

The degree by which an industry is dominated by a few large firms is measured
byConcentration ratios. These give the percentage of total industry sales of 4, 8,
orPricing Under Monopolisticand OligopolisticCompetition1312 largest firms in the
industry. An industry in which the four-firm concentrationratio is close to 100 is clearly
oligoplistic, and industries where this ratio is higherthan 50 or 60 percent are also likely
to be oligopolistic.
The four-firm concentrationratio for most manufacturing industries in the United States
is between 20 and 80percent.Another method of estimating the degree of concentration
in an industry is theHeirfindahl index (H). This is given by the sum of the squared values
of themarket shares of all the firms in the industry. The higher the Heirfindahl index,
thegreater is the degree of concentration in the industry.
For example, if there is onlyone firm in the industry so that its market share is 100%,
H=1002=10,000. If thereare two firms in an industry, one with a 90 percent share of the
market and theother with a 10 percent share, H = 902 + 102 =8,200. If each firm had a
50 percentshare of the market, H = 502 + 502 = 5,000. With four equal-sized firms in
theindustry, H = 2,500. With 100 equal-sized firms in the (perfectly competitive)industry,
H = 100. This points to the advantage of the Heirfindahl index over theconcentration
ratios discussed above. Specifically the Heirfindahl index usesinformation on all
the firms in the industry- not just the share of the market by thelargest 4, 8, 12
firms in the market.
Furthermore, by squaring the market share ofeach firm, the Heirfindahl index
appropriately gives a much large weight to largerthan to smaller firms in the
industry. The Heirfindahl index has become of greatpractical importance since
1982 when the Justice Department in the US announcednew guidelines for
evaluating proposed mergers based on this index.In fact, according to the
theory of Contestable markets developed during the1980s, even if an industry
has a single firm (monopoly) or only a few firms(oligopoly), it would still
operate as if it were perfectly competitive if entry is“absolutely free” (i.e. if
other firms can enter the industry and face exactly thesame costs as existing
firms) and if exit is “entirely costless” (i.e., if there are nosunk costs so that the
firm can exit the industry without facing any loss of capital).
An example of this might be an airline that establishes a service between two

citiesalready served by other airlines if the new entrant faces the same costs
as existingairlines and could subsequently leave the market by simply
reassigning its planes toother routes without incurring any loss of capital.
When entry is absolutely free andexit is entirely costless, the market is
contestable. Firms will then operate as if theywere perfectly competitive and
sell at a price which only covers their average costs(so that they earn zero
economic profit) even if there is only one firm or a few ofthem in the market.
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Monopolistic Competition: Short-Run Profits and Losses, and

Long-Run Equilibrium
Monopolistic competition is the economic market model with many sellers

selling similar, but not identical, products. The demand curve of monopolistic
competition is elastic because although the firms are selling differentiated
products, many are still close substitutes, so if one firm raises its price too
high, many of its customers will switch to products made by other firms.
This elasticity of demand makes it similar to pure competition where elasticity
is perfect. Demand is not perfectly elastic because a monopolistic competitor
has fewer rivals then would be the case for perfect competition, and because
the products are differentiated to some degree, so they are not perfect
substitutes.
Monopolistic competition has a downward sloping demand curve. Thus, just as

for a pure monopoly, its marginal revenue will always be less than the market
price, because it can only increase demand by lowering prices, but by doing so,
it must lower the prices of all units of its product. Hence, monopolistically
competitive firms maximize profits or minimize losses by producing that
quantity where marginal revenue equals marginal cost, both over the short run
and the long run.
Short-Run Profit Or Loss
In the short run, a monopolistically competitive firm maximizes profit or

minimizes losses by producing that quantity that corresponds to when marginal
revenue equals marginal cost. If average total cost is below the market price,
then the firm will earn an economic profit.
 D = Market Demand
 ATC = Average Total Cost
 MR = Marginal Revenue
 MC = Marginal Cost
As can be seen in the graph, the market pricecharged by the monopolistic competitive firm
is equal to the point on the demand curvewhere MR = MC.
Short-Run Profit = (Price - ATC) × Quantity
However, if the average total cost is above the market price, then the firm will
incur losses, which will be equal to the average total cost minus the market
price multiplied by the quantity produced. It will still minimize losses by
producing that quantity where marginal revenue equals marginal cost, but
eventually the firm will either have to reverse the losses, or it will have to exit
the industry.
Short-Run Loss = (ATC - Price) × Quantity
Long-Run Equilibrium: Normal Profits
If the competitive firms in an industry earn an economic profit, then other firms
will enter the same industry, which will reduce the profits of the other firms.
More firms will continue to enter the industry until the firms are earning only
a normal profit.
However, if there are too many firms, then firms will start to incur losses,
especially the inefficient ones, which will cause them to leave the industry.
Consequently, the remaining firms will return to normal profitability. Hence, the
long-run equilibrium for monopolistic competition will equate the market price
to the average total cost, where marginal revenue equals marginal cost, as
shown in the diagram below. Remember, in economics, average total cost
includes a normal profit.
Note that where MC rises above MR, the firm would incur greater costs than it would
receive in additional revenue, which is why the firm maximizes its profit by producing only
that quantity where MR = MC, and charging the price at 1.
2 Market Price = Marginal Cost = Allocative Efficiency
3 Productive Efficiency = Minimum ATC
Excess Capacity = Quantity Produced at Minimum ATC - Quantity that yields the
greatest profit (MR = MC).
Because monopolistically competitive firms do not operate at their minimum

average total cost, they, therefore, operate withexcess capacity. Note in the
above diagram that firms would lose money if they produced more to achieve
either allocative or productive efficiency. That most firms operate with excess
capacity is evident when looking at most monopolistically competitive firms,
such as restaurants and other retailers, where salespeople are often idle.
In some cases, a firm will have enough of an advantage to continue earning

economic profits, even in the long run. For instance, a business can have an
excellent location relative to other locations in the area, which will always give
it an advantage over other firms in that local market. Or a firm may have a
patent or trademark on its product that prevents competition. In such cases,
firms have some degree of market power that would allow them to price their
products above competitors' prices without losing too much business.
Productive And Allocative Efficiency Of Monopolistic Competition
Productive efficiency requires that:
Price = Minimum Average Total Cost
Pure competition can achieve productive efficiency, but most monopolistic

competitive firms do not, since they sell at a price higher than the minimum
average total cost, and would actually lose money selling at their minimum
ATC. To use their excess capacity, they would have to produce a quantity equal
to their minimum ATC, but they would not be able to sell that amount without
lowering their prices, which would either reduce their profits or actually incur
losses.
The monopolistic firm also does not achieve allocative efficiency. Allocative
efficiency requires that:
Price = Marginal Cost
The monopolistic firm exhibits a downward sloping demand curve. That means
that in order to sell more units, it must lower its price, but if it lowers its price,
then it must lower its price on all of its units. Thus, like a monopoly, marginal
revenue continually declines as quantity is increased. The firm maximizes
profits when marginal revenue equals marginal cost, but this only occurs at a
quantity that is less than what a purely competitive firm would produce, where
marginal cost equals market price. The marginal cost curve will always
intersect the marginal revenue curve before it intersects the demand curve,
because as previously stated, at any given quantity, marginal revenue is
always less than the market price. Because of this allocative inefficiency, some
consumers must forgo the product because of its higher price.
While monopolistic competitive firms achieve neither productive nor allocative
efficiency, they do provide a variety of products. The greater the differentiation
of the products, the greater the inefficiency. However, this greater diversity is
more likely to satisfy consumer tastes, which leads to a more desirable market.
Efficiency
AAA |
DEFINITION OF 'EFFICIENCY'
A level of performance that describes a process that uses the lowest amount of
inputs to create the greatest amount of outputs. Efficiency relates to the use of all
inputs in producing any given output, including personal time and energy.
BREAKING DOWN 'EFFICIENCY'

Efficiency is an important attribute because all inputs are scarce. Time, money
and raw materials are limited, so it makes sense to try to conserve them while
maintaining an acceptable level of output or a general production level.
Being efficient simply means reducing the amount of wasted inputs.
efficiency
The comparison of what is actually produced or performed with what can be achieved
with the same consumption of resources (money, time, labor, etc.). It is an
important factor in determination of productivity. See also effectiveness.
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Excess Capacity
AAA |
DEFINITION OF 'EXCESS CAPACITY'

A situation in which actual production is less than what is achievable or optimal
for a firm. This often means that the demand in the market for the product is
below what the firm could potentially supply to the market.
BREAKING DOWN 'EXCESS CAPACITY'

The amount of excess capacity within an industry is a signal of both the health of
that industry and the demand for the products it produces. Excess capacity is
also seen as a good thing for consumers, as it is not likely to lead to the price
inflation that would be seen in periods of near-full capacity. A company with
sizable excess capacity can often lose a considerable amount of money if it is not
able to meet the high fixed costs that are associated with producers.
Read more: Excess Capacity Definition |

Investopedia http://www.investopedia.com/terms/e/excesscapacity.asp#ixzz3lSfA87sU
excess capacity
Output volume at which marginal cost is less than the average cost and, hence, where
it is possible to decrease average cost by increasing the output. Excess capacity may be
measured by the amount of additional output that will reduce the average cost to a
minimum.
Read more: http://www.businessdictionary.com/definition/excess-capacity.html#ixzz3lSfFPq6B
EXCESS CAPACITY
Definition:
Excess capacity refers to a situation where a firm is producing at a lower scale of

output than it has been designed for.
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advertising

The activity or profession of producing information for promoting the sale of commercial
products or services.
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advertising
noun ad·ver·tis·ing
: published or broadcast advertisements
: the business of creating advertisements
How "Spam" became something on

your phone and not on your plate. »
Full Definition of ADVERTISING

1
: the action of calling something to the attention of the public especially by paid announcements
: ADVERTISEMENTS <the magazine contains much advertising>
: the business of preparing advertisements for publication or broadcast
See advertising defined for English-language learners
See advertising defined for kids
ADVERTISEMENT
Examples of ADVERTISING
1. These is a lot of advertising in that magazine.
2. He is looking for a job in advertising.
Definition of 'Advertising'
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Advertisements are messages paid for by those who send them and are intended to inform or
influence people who receive them.
Definition: Advertising is a means of communication with the users of a product or service.

Advertisements are messages paid for by those who send them and are intended to inform or
influence people who receive them, as defined by the Advertising Association of the UK.
Description: Advertising is always present, though people may not be aware of it. In today's world,
advertising uses every possible media to get its message through. It does this via television, print
(newspapers, magazines, journals etc), radio, press, internet, direct selling, hoardings, mailers,
contests, sponsorships, posters, clothes, events, colours, sounds, visuals and even people
(endorsements).
The advertising industry is made of companies that advertise, agencies that create the
advertisements, media that carries the ads, and a host of people like copy editors, visualizers, brand
managers, researchers, creative heads and designers who take it the last mile to the customer or
receiver. A company that needs to advertise itself and/or its products hires an advertising agency.
The company briefs the agency on the brand, its imagery, the ideals and values behind it, the target
segments and so on. The agencies convert the ideas and concepts to create the visuals, text,
layouts and themes to communicate with the user. After approval from the client, the ads go on air,
as per the bookings done by the agency's media buying unit.
\ MARKET STRUCTURE AND PRICING UNDER OLIGOPOLY
1. Introduction
A market is a place where the sellers of a particular good or service can meet with the buyers of that goods
and services where there is a potential for transaction to take place. The buyers must have something they
can offer in exchange for there to be a potential transaction. Market structure is best defined as the
organizational and other characteristics of a market. It refers to the size and design of the market. It relates
to those organizational characteristics of a market which influence the nature of competition and pricing
and affect the conduct of the business firms. Market structure commonly called as market is the whole set
of conditions under which a commodity is marketed (chopra, 2002). We focus on those characteristics
which affect the nature of competition and pricing – but it is important not to place too much emphasis
simply on the market share of the existing firms in an industry.
The most important features of market structure are:
ü The number of firms (including the scale extent of foreign competition).
ü The market share of the largest firms.
ü The nature of costs including the potential for firms to exploit economies of scale and also the presence of
sunk costs which affects market contestability in the long term.
ü The degree to which the industry is vertically integrated -vertical integration explains the process by which
different stages in production and distribution of a product are under the ownership and control of a single
enterprise. The extent of product differentiation, which affects cross-price elasticity of demand.
ü The structure of buyers in the industry including the possibility of monopsony power.
ü The turnover of customers – i.e. how many customers are prepared to switch their supplier over a given
time period when market conditions change. The rate of customer churn is affected by the degree of consumer
or brand loyalty and the influence of persuasive advertising and marketing.
2. Types of market structures

Market structure is commonly known as market and of following types:
1. 1. Monopolistic competition, also called competitive market, where there are a large
number of firms, each having a small proportion of the market share and slightly differentiated
products.
2. 2. Oligopoly, in which a market is dominated by a small number of firms that together
control the majority of the market share.

3. 3. Duopoly, a special case of an oligopoly with two firms.
4. 4. Oligopsony, a market, where many sellers can be present but meet only a few buyers.
5. 5. Monopoly, where there is only one provider of a product or service.
6. 6. Natural monopoly, a monopoly in which economies of scale cause efficiency to
increase continuously with the size of the firm. A firm is a natural monopoly if it is able to serve the
entire market demand at a lower cost than any combination of two or more smaller, more specialized
firms.
7. 7. Monopsony, when there is only one buyer in a market.
3. Concept of perfect and imperfect market structure

Perfect competition is a theoretical market structure that features unlimited contestability (or no barriers to
entry), an unlimited number of producers and consumers, and a perfectly elastic demand curve. Drummond &
Goodwin (2004) has given the necessary conditions for the existence of perfect condition market, which are as:
 Individual consumer or producer is insignificant in relation to the total market because there are so
many producers and consumers.
 Products are homogenous.
 No artificial limitations on entry and exit in the market.
The imperfectly competitive structure is quite identical to the realistic market conditions where
some monopolistic competitors, monopolists, oligopolists, and duopolists exist and dominate the market
conditions. Imperfect competition market consists of many market conditions having two sellers to a large
number of buyers and sellers (Chopra, 2006). The elements of Market Structure are: the number and size
distribution of firms, entry conditions, and the extent of differentiation.
3.1. Types of imperfect market

The four market structures that are technically included in the category of imperfect competition are
monopolistic competition, oligopoly, Monopsonistic competition, and Oligopsony. The first two are the most
noted participants. The second two are often overlooked, but justifiably included. Here in this paper we are
more focused in oligopoly market structure.

 Monopolistic Competition: This market structure is characterized by a large number of relatively
small competitors, each with a modest degree of market control on the supply side. A key feature of
monopolistic competition is product differentiation. The output of each producer is a close but not
identical substitute to that of every other firm, which helps satisfy diverse consumer wants and needs.
 Oligopoly: This market structure is characterized by a small number of relatively large competitors,
each with substantial market control. Oligopoly sellers exhibit interdependent decision making which
can lead to intense competition among the few and the motivation to cooperate through mergers
and collusion.
 Monopsonistic Competition: This market structure is characterized by a large number of relatively
small competitors, each with a modest degree of market control on the demand side. Monopsonistic
competition represents the demand-side counterpart to monopolistic competition on the supply side. A
key feature of Monopsonistic competition is also product differentiation as each buyer seeks to
purchase a slightly different product.
 Oligopsony: This market structure is characterized by a small number of relatively large competitors,
each with substantial market control on the buying side. Oligopsony represents the demand-side
counterpart to oligopoly on the supply side. Oligopsony buyers exhibit interdependent decision
making which can lead to intense competition and the motivation to cooperate.
4. Market Structure
No. of Producers &
Firm’s degree Methods of
Degree of Product Part of economy where
Structure
prevalent Of control over price Marketing
Differentiation
Many producers, Financial markets, & Market exchange

Perfect
None
competition Identical products Some agricultural products or auction
Imperfect
competition
Many producers,
Retail trade
Monopolistic Many real or perceived
competition (Gasoline, PCs, etc.)
differences in product
Advertising and
Few producers,
Quality rivalry,
No differences in Steel, chemicals, etc. Some
product.
Administered prices
Oligopoly
Few producers,
Some differentiation
Autos, aircraft, etc.
of products
Single producer,
Local telephone, Advertising and
Product without close Considerable but usually
Monopoly
electricity, and gas regulated Service promotion
Substitutes
5. Monopoly
The term monopoly is derived from Greek words ‘mono’ which means single and ‘poly’ which means seller.
So, monopoly is a market structure, where there only a single seller producing a product having no close
substitutes and has complete control over the supply of the commodity. This single seller may be in the form of
an individual owner or a single partnership or a Joint Stock Company. Such a single firm in market is called
monopolist. Monopolist is price maker and has a control over the market supply of goods. But it does not mean
that he can set both price and output level. There is no free entry and exit because of some restrictions. A
monopolist can do either of the two things i.e. price or output. It means he can fix either price or output but not
both at a time. Since there is a single firm, the firm and industry are one and same i.e. firm coincide with the
industry. Monopoly firm faces downward sloping demand curve. It means he can sell more at lower price and
vice versa. Therefore, elasticity of demand factor is very important for him.
6. Monopsony
A market structure characterized by a large number of small buyers, that purchase similar but not identical
inputs, have relative freedom of entry into and exit out of the industry, and possess extensive knowledge of
prices and technology. Monopsonistic competition is the buying-side equivalent of a selling-side monopolistic
competition. Much as a monopolistic competition is a competitive market containing a number of small sellers,
and a number of small buyers. While monopsonistic competition could be analyzed for any type of market it
tends to be most relevant for factor markets. Two related buying-side market structures are monopsony and
oligopsony.
While the market for any type of good, service, resource, or commodity can, in principle, function as
monopsonistic competition, this form of market structure tends to be most pronounced for the exchange of
factor services.Thismarket structure is the somewhat obscure and less noted buying counterpart
of monopolistic competition. However, monopsonistic competition tends to be just as prevalent in the real
world. In fact, firms operating as monopolistic competition in an output market often operate as monopsonistic
competition in an input market.
In much the same way the monopolistic competition is a cross between perfect competition and monopoly,
monopsonistic competition is a cross between perfect competition and monopsony. While each
monopolistically competitive buyer has very little market control, it does have some market control, each has
its own little monopsony, each faces an input supply curve that is relatively elastic but NOT perfectly elastic.
7. Oligopoly
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers
(oligopolists). The word is derived, by analogy with “monopoly“, from the Greek (oligoi) “few” + (pólein) “to
sell”. Because there are few sellers, each oligopolists is likely to be aware of the actions of the others. The
decisions of one firm influence, and are influenced by, the decisions of other firms. Strategic planning by
oligopolists needs to take into account the likely responses of the other market participants.
Oligopoly is imperfect competition among the few; it applies to an industry that contains only a few competing
firms. Each firm has enough market power to prevent its being a price-taker, but each firm is subject to enough
inter-firm rivalry to prevent it considering the market demand curve as its own. In most modern economies this
is the dominant market structure for the production of consumer and capital goods as well as many basic
industrial materials such as steel and aluminium. Services, however, are often produced in industries
containing a larger number of firms although product differentiation prevents them from being perfectly
competitive. In contrast to a monopoly, which has no competitors, and to a monopolistically competitive firm,
which has many competitors, an oligopolistic firm faces a few competitors. Because there are only a few firms
in an oligopolistic industry, each firm realizes that its competitors may respond to any move it makes.
Oligopoly is that market situation in which the number of firms is small but each firm in the industry takes into
consideration the reaction of the rival firms in the formulation of price policy. The number of firms in the
industry may be two or more than two but not more than 20. Oligopoly differs from monopoly and
monopolistic competition in this that in monopoly, there is a single seller; in monopolistic competition, there is
quite a larger number of them; and in oligopoly, there are only a small number of sellers.
7.1 Classification of oligopoly

The oligopolistic industries are classified in a number of ways:
(a) Duopoly: If there are two giant firms in an industry it is called duopoly. Duopoly is further classified as
below:
(i) Perfect or Pure Duopoly: If the duopolists in an industry are producing identical products it is called
perfect or pure duopoly.
(ii) Imperfect or Impure Duopoly: If the duopolists in an industry are producing differentiated products it is
called imperfect or impure duopoly.

(b) Oligopoly: If there are more than two firms in an industry and each firm takes consideration the reactions
of the rival firms in formulating its own price policy it is called oligopoly. Oligopoly is further classified as
below:
(i) Perfect or Pure Oligopoly: If the oligopolists in an industry are producing identical products it is called
perfect or pure oligopoly.
(ii)Imperfect or Impure Oligopoly: If the oligopolists in an industry are producing differentiated products it
is called imperfect or impure oligopoly.
7.2 Causes of oligopoly

1.Economies of Scale: The firms in the industry, with heavy investment, using improved technology and
reaping economies of scale in production, sales, promotion, etc, will compete and stay in the market.
2.Barrier to Entry: In many industries, the new firms cannot enter the industry as the big firms have
ownership of patents or control of essential raw material used in the production of an output. The heavy
expenditure on advertising by the oligopolistic industries may also be a financial barrier for the new firms to
enter the industry.
3.Merger: If the few firms in the industry smell the danger of entry of new firms, they then immediately
merge and formulate a joint policy in the pricing and production of the products. The joint action of the few
big firms discourages the entry of new firms into the industry.
1. Mutual Interdependence: As the number of firms is small in an oligopolistic industry, therefore,
they keep a strict watch of the price charged by rival firms in the industry. The firm generally avoids
price ware and tries to create conditions of mutual interdependence.
7.3. Characteristics of oligopoly

Ability to set price: Oligopolies are price setters rather than price takers.
Profit maximization conditions: An oligopoly maximizes profits by producing where marginal revenue
equals marginal costs.
Entry and exit: Barriers to entry are high. The most important barriers are economies of scale, patents,
access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage
or destroy nascent firms. Additional sources of barriers to entry often result from government regulation
favoring existing firms making it difficult for new firms to enter the market.
Number of firms: “Few” – a “handful” of sellers. There are so few firms that the actions of one firm can
influence the actions of the other firms.
Long run profits: Oligopolies can retain long run abnormal profits. High barriers of entry prevent sideline
firms from entering market to capture excess profits.
Product differentiation: Product may be homogeneous (steel) or differentiated (automobiles).
Perfect knowledge: Assumptions about perfect knowledge vary but the knowledge of various economic
actors can be generally described as selective. Oligopolies have perfect knowledge of their own cost and
demand functions but their inter-firm information may be incomplete. Buyers have only imperfect knowledge
as to price cost and product quality.
Interdependence: The distinctive feature of an oligopoly is interdependence. Oligopolies are typically
composed of a few large firms. Each firm is so large that its actions affect market conditions. An oligopolistic
firm must consider not only the market demand for its product, but also the possible moves of other firms in
the industry(Gopal etal.2007) .Therefore the competing firms will be aware of a firm’s market actions and will
respond appropriately. This means that in contemplating a market action, a firm must take into consideration
the possible reactions of all competing firms and the firm’s countermoves. It is very much like a game of
chess or pool in which a player must anticipate a whole sequence of moves and countermoves in determining
how to achieve his objectives. For example, an oligopoly considering a price reduction may wish to estimate
the likelihood that competing firms would also lower their prices and possibly trigger a ruinous price war. Or if
the firm is considering a price increase, it may want to know whether other firms will also increase prices or
hold existing prices constant. This high degree of interdependence and need to be aware of what the other guy
is doing or might do is to be contrasted with lack of interdependence in other market structures. In a PC market
there is zero interdependence because no firm is large enough to affect market price. (Koutsoyiannis, 1979).
All firms in a PC market are price takers, information which they robotically follow in maximizing profits. In a
monopoly there are no competitors to be concerned about. In a monopolistically competitive market each
firm’s effects on market conditions is so negligible as to be safely ignored by competitors.
The demand curve under oligopoly is indeterminate because any step taken by his rivals may change the
demand curve. It is more elastic than under simple monopoly and not perfectly elastic as under perfect
competition.
It is often noticed that there is stability in price under oligopoly. This is because the oligopolist avoids
experimenting with price changes. He knows that if raises the price, he will lose his customers and if he lowers
it he will invite his rivals to price war.
Price and Output Determination under Oligopoly

The price and output behaviour of the firms operating in oligopolistic market condition can be studied as:
a.If an industry is composed of few firms each selling identical or homogenous products and having powerful
influence on the total market, the price and output policy of each is likely to affect the other appreciably,
therefore they will try to promote collusion.
b.The price will be fixed in oligopoly without product differentiation is indeterminate.(Dewett,2001)
c. In case there is product differentiation, an oligopolist can raise or lower his price without any fear of losing
customers or of immediate reactions from his rivals. However, keen rivalry among them may create condition
of monopolistic competition.
There is no single theory which satisfactorily explains the oligopoly behavior regarding price and output in the
market. There are set of theories like Cournot Duopoly Model, Bertrand Duopoly Model, the Chamberlin
Model, the Kinked Demand Curve Model, the Centralized Cartel Model, Price Leadership Model, etc., which
have been developed on particular set of assumptions about the reaction of other firms to the action of the firm
under study.
9. Collusive Oligopoly
The degree of imperfect competition in a market is influenced not just by the number and size of firms but by
how they behave. When only a few firms operate in a market, they see what their rivals are doing and
react. ‘Strategic interaction’ is a term that describes how each firm’s business strategy depends upon its rivals’
business behaviour. When there are only a small number of firms in a market, they have a choice between
‘cooperative’ and ‘non-cooperative’ behaviour:
 Firms act non-cooperatively when they act on their own without any explicit or implicit agreement
with other firms. That’s what produces ‘price wars’.
 Firms operate in a cooperative mode when they try to minimise competition between them. When
firms in an oligopoly actively cooperate with each other, they engage in ‘collusion’. Collusion is an
oligopolistic situation in which two or more firms jointly set their prices or outputs, divide the market
among them, or make other business decisions jointly.
A ‘cartel’ is an organisation of independent firms, producing similar products, which work together to raise
prices and restrict output. It is strictly illegal in Pakistan and most countries of the world for companies to
collude by jointly setting prices or dividing markets. Nonetheless, firms are often tempted to engage in ‘tacit
collusion’, which occurs when they refrain from competition without explicit agreements. When firms tacitly
collude, they often quote identical (high) prices, pushing up profits and decreasing the risk of doing
business. The rewards of collusion, when it is successful, can be great. It is more illustrated in the following
diagram:
The above diagram illustrates the situation of oligopolist A and his demand curve DaDa assuming that the
other firms all follow firm A’s lead in raising and lowering prices. Thus the firm’s demand curve has the same
elasticity as the industry’s DD curve. The optimum price for the collusive oligopolist is shown at point G on
DaDa just above point E. This price is identical to the monopoly price, it is well above marginal cost and earns
the colluding oligopolists a handsome monopoly profit
10. Price Determination Models of Oligopoly

10.1. Kinked Demand Curve: The kinky demand curve model tries to explain that in non-collusive
oligopolistic industries there are not frequent changes in the market prices of the products. The demand curve
is drawn on the assumption that the kink in the curve is always at the ruling price. The reason is that a firm in
the market supplies a significant share of the product and has a powerful influence in the prevailing price of the
commodity. Under oligopoly, a firm has two choices:
(a) The first choice is that the firm increases the price of the product. Each firm in the industry is fully aware
of the fact that if it increases the price of the product, it will lose most of its customers to its rival. In such a
case, the upper part of demand curve is more elastic than the part of the curve lying below the kink.
(b) The second option for the firm is to decrease the price. In case the firm lowers the price, its total sales will
increase, but it cannot push up its sales very much because the rival firms also follow suit with a price cut. If
the rival firms make larger price cut than the one which initiated it, the firm which first started the price cut
will suffer a lot and may finish up with decreased sales. The oligopolists, therefore avoid cutting price, and try
to sell their products at the prevailing market price. These firms, however, compete with one another on the
basis of quality, product design, after-sales services, advertising, discounts, gifts, warrantees, special offers,
etc.
In the above diagram, we shall notice that there is a discontinuity in the marginal revenue curve just below the
point corresponding to the kink. During this discontinuity the marginal cost curve is drawn. This is because of
the fact that the firm is in equilibrium at output ON where the MC curve is intersecting the MR curve from
below.
In the above diagram, the demand curve is made up of two segments DB and BD’. The demand curve is
kinked at point B. When the price is Rs. 10 per unit, a firm sells 120 units of output. If a firm decides to charge
Rs. 12 per unit, it loses a large part of the market and its sales come down to 40 units with a loss of 80 units. In
case, the producer lowers the price to Rs. 4 per unit, its competitors in the industry will match the price cut. Its
sales with a big price cut of Rs. 6 increases the sale by only 40 units. The firm does not gain as its total revenue
decreases with the price cut.
10.2. Price Leadership Model: Under price leadership, one firm assumes the role of a price leader and fixes the
price of the product for the entire industry. The other firms in the industry simply follow the price leader and
accept the price fixed by him and adjust their output to this price. The price leader is generally a very large or
dominant firm or a firm with the lowest cost of production. It often happens that price leadership is established
as a result of price war in which one firm emerges as the winner.
In oligopolistic market situation, it is very rare that prices are set independently and there is usually some
understanding among the oligopolists operating in the industry. This agreement may be either tacit or explicit.
Types of Price Leadership: There are several types of price leadership. The following are the principal types:
(a) Price leadership of a dominant firm, i.e., the firm which produces the bulk of the product of the industry. It
sets the price and rest of the firms simply accepts this price.
(b) Barometric price leadership, i.e., in the case of price leadership of a dominant firm the price leadership of
an old, experienced and the largest firm assumes the role of a leader, but undertakes also to protect the interest
of all firms instead of promoting its own interests(Dewett,2001).
(c) Exploitative or Aggressive price leadership, i.e., one big firm built its supremacy in the market by
following aggressive price leadership. It compels other firms to follow it and accept the price fixed by it. In
case the other firms show any independence, this firm threatens them and coerces them to follow its leadership.
Price Determination under Price Leadership:
There are various models concerning price-output determination under price leadership on the basis of certain
assumptions regarding the behavior of the price leader and his followers. In the following case, there are few
assumptions for determining price-output level under price leadership:
(a) There are only two firms A and B and firm A has a lower cost of production than the firm B.
(b) The product is homogenous or identical so that the customers are indifferent as between the firms.
(c) Both A and B have equal share in the market, i.e., they are facing the same demand curve which will be
the half of the total demand curve.
In the above diagram, MCa is the marginal cost curve of firm A and MCb is the marginal cost curve of firm
B. Since we have assumed that the firm A has a lower cost of production than the firm B, therefore, the MCa is
drawn below MCb.

Now let us take the firm A first, firm A will be maximising its profit by selling OM level of output at price
MP, because at output OM the firm A will be in equilibrium as its marginal cost is equal to marginal revenue
at point E. Whereas the firm B will be in equilibrium at point F, selling ON level of output at price NK, which
is higher than the price MP. Two firms have to charge the same price in order to survive in the
industry. Therefore, the firm B has to accept and follow the price set by firm A. This shows that firm A is the
price leader and firm B is the follower.
Since the demand curve faced by both firms is the same, therefore, the firm B will produce OM level of output
instead of ON. Since the marginal cost of firm B is greater than the marginal cost of firm A, therefore, the
profit earned by firm B will be lesser than the profit earned by firm A.
11. Economic costs of imperfect competition and oligopoly:

(a) The cost of inflated prices and insufficient output: The monopolist, by keeping the output a little scarce,
raises its price above marginal cost. Hence, the society does not get as much of the monopolist’s output as it
wants in terms of product’s marginal cost and marginal value. The same is true for oligopoly and monopolistic
competition.
(b) Measuring the waste from imperfect competition: Monopolists cause economic waste by restricting
output. If the industry could be competitive, then the equilibrium would be reached at the point where MC = P
at point E. Under perfect competition, this industry’s quantity would be 6 with a price of 100. The monopolist
would set its MC equal to MR (not to P), displacing the equilibrium to Q = 3 and P = 150. The GBAF is the
monopolist’s profit, which compares with a zero-profit competitive equilibrium. Economists measure the
economic harm from insufficiency in terms of the deadweight loss; this term signifies the loss in real income
that arises because of monopoly, tariffs and quotas, taxes, or other distortions. The efficiency loss is the
vertical distance between the demand curve and the MC curve. The total deadweight loss from the
monopolist’s output restriction is the sum of all such losses represented by the grey triangle ABE:
In the above diagram, DD curve represents the consumers’ marginal utility at each level of output, while the
MC curve represents the opportunity cost of the devoting production to this good rather than to other
industries. For example, at Q = 3, the vertical difference between B and A represents the utility that would be
gained from a small increase to the output of Q. Adding up all the lost social utility from Q = 3 to Q = 6 gives
the shaded region ABE.
12.Evils of Oligopoly
There is generally a continuous price war which finally results in disastrously low level of prices. When some
of the producers find themselves at an anomalous and discriminatory pattern of prices charged from the
consumers. Such cut throat competition in industry characterized by heavy overheads and increasing costs
proves ruinous to all producers. Realising this, they may tacitly or explicitly enter into price agreements; which
may result in the exploitation of the consumers. A tendency to earn a fair return on past capacity is detrimental
to consumer’s welfare, because they face scarce output and high prices. Hence, cut throat competition may be,
essential to liquidate excess capacity through losses or sub-normal profits.
Unlike perfect competition, under which price falls when demand decreases, output remaining the same, in
oligopoly, prices stay firm, and only output varies resulting in idle plants. This is bad for the society and bad
for the consumers.
13. Intervention Strategies

According to a Nobel Prize winner Milton Friedman, basically there are three choices – private unregulated
monopoly, private monopoly regulated by the government, or the government operation. In most market
economies of the world, the monopolists are regulated by the State. There are several methods and tools for
controlling the power misuse by monopolistic and oligopolistic firms:

1.Anti-trust Policy: Anti-trust policies are laws that prohibit certain kinds of behaviour (such as firm’s joining
together to fix prices) or curb certain market structures (such as pure monopolies and highly concentrated
oligopolies).
2.Encouraging Competition: Most generally, anticompetitive abuses can be avoided by encouraging
competition whenever possible. There are many government policies that can promote vigorous rivalry even
among large firms. In particular, it is crucial to keep the barriers to entry low.
3.Economic Regulations: Economic regulation allows specialised regulatory agencies to oversee the prices,
outputs, entry, and exit of firms in regulated industries such as public utilities and transportation. Unlike
antitrust policies, which tell businesses what not to do, regulation tells businesses what to do and how to do.
4.Government Ownership of Monopolies: Government ownership of monopolies has been an approach
widely used. In recent years, many governments have privatised industries that were in former times public
enterprises, and encouraged other firms to enter for competition.
5.Price Control: Price control on most goods and services has been used in wartime, partly as a way of
containing inflation, partly as a way of keeping down prices in concentrated industries.
6.Taxes: Taxes have sometimes been used to alleviate the income-distribution effects. By taxing monopolies,
a government can reduce monopoly profits, thereby softening some of the socially unacceptable effects of
monopoly.
14.Conclusion
Perfect competition is a theoretical market structure that features unlimited contestability (or no barriers to
entry), an unlimited number of producers and consumers, and a perfectly elastic demand curve while the
imperfectly competitive structure is quite identical to the realistic market conditions where some monopolistic
competitors, monopolists, oligopolists, and duopolists exist and dominate the market conditions. The elements
of Market Structure include the number and size distribution of firms, entry conditions, and the extent of
differentiation. The four market structures that are technically included in the category of imperfect
competition are monopolistic competition, oligopoly, monopsonistic competition, and Oligopsony. The first
two are the most noted participants. The second two are often overlooked, but justifiably included.
References:
Ahuja.H.L.2003.Advanced economic theory:Microeconomic analysis.S Chand and company Ltd.,New
Delhi,India.
Chopra.P.N.2006. Principle of economics.(9th ed.).Kalyani publishers,New Delhi, India.
Dewett.K.K.2001. Modern Economic Theory.(21st ed.) Shyam Lal Charitable Trust,New Delhi.
Drummond.EvanH. and John W. Goodwin.2004.Agriultural Economics.(2nd ed.).Pearson
education,pte.Ltd.,IndianBranch,New Delhi,India.
Gopal M. R., Singari M., Rajasekaran V., Rajendran S., Neelavathy P., Kennedy S.R.2007.Economic
Theory.(1st ed.) Tamilnadu Textbook Corporation,Chennai, India
Hall.R.E.and M.Lieberman.2007.Microeconomics:Principles and application.(4th ed.).Lachina publishing
services.U.S.A.
Koutsoyiannis, A.1979.Modern microeconomics.(2nd ed.).Macmillan Press Ltd,Houndsmill, London.
Mankiw.N.Gregory.2008.Principles of Microeconomics.(6th ed.) South-Western Cengage Learning,USA
Cournot Competition
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DEFINITION OF 'COURNOT COMPETITION'

An economic model that describes an industry structure in which competing firms
that make the same homogeneous and undifferentiated product choose a
quantity to produce independently and simultaneously. The Cournot Competition
model makes a number of assumptions – the firms cannot collude or form a
cartel, and they seek to maximize profit based on their competitors’ decisions. In
addition, each firm’s output decision is assumed to affect the product price.
French mathematician Augustin Cournot introduced the model in 1838. The basic
version of the Cournot model dealt with a duopoly, or two main producers in a
market. While it remains the standard for oligopolistic competition, the model can
be extended to include multiple firms.
BREAKING DOWN 'COURNOT COMPETITION'

The Cournot model has some significant advantages. The model produces
logical results, with prices and quantities that are between monopolistic (i.e. low
output, high price) and competitive (high output, low price) levels. It also yields a
stable Nash equilibrium, which is defined as an outcome from which neither
player would like to deviate unilaterally.
However, the model also has some drawbacks based on its assumptions that
may be somewhat unrealistic in the real world. First, the Cournot classic duopoly
model assumes that the two players set their quantity strategy independently of
each other. This is unlikely to be the case in a practical sense. When only two
producers are in a market, they are likely to be highly responsive to each other’s
strategies rather than operating in a vacuum.
Second, Cournot shows that a duopoly could form a cartel and reap higher profits
by colluding than from competing against each other. But game theory shows
that a cartel arrangement would not be in equilibrium, since each company would
tend to deviate from the agreed output (for proof, one need look no further than
OPEC).
Third, the model's critics question how often oligopolies compete on quantity
rather than price. French scientist J. Bertrand in 1883 attempted to rectify this
oversight by changing the strategic variable choice from quantity to price. The
suitability of price, rather than quantity, as the main variable in oligopoly models
was confirmed in subsequent research by a number of economists.
Finally, the Cournot model assumes product homogeneity with no differentiating
factors. While Cournot developed his model after observing competition in a
spring water duopoly, it is ironic that even in a product as basic as bottled mineral
water, one would be hard-pressed to find homogeneity in the products offered by
different suppliers.
Read more: Cournot Competition Definition |

Investopedia http://www.investopedia.com/terms/c/cournot-competition.asp#ixzz3lSgyJiMP
Strategic Entry Barriers:

The Dominant Firm and Limit Pricing
In some highly concentrated industries, a single ("dominant") firm serves a majority

of the market and a group of smaller ("fringe") firms supply the rest. Martin (1994)
summarizes the difference between a monopolist and a dominant firm as follows:
"A dominant firm differs from a monopolist in one important respect. The only
constraint on the monopolist's behavior is the market demand curve: if the monopolist
raises price, some customers will leave the market. Like the monopolist, the dominant
firm is large enough to recognize that a price increase will drive some customers from
the market. But the dominant firm faces a problem that the monopolist does not: the
possibility that a price increase will induce some customers to begin to buy from firms
in the fringe of small competitors. That dominant firm, in other words, must take into
account the reaction of its fringe competitors."
To best understand how the dominant firm may attempt to prevent entry by
strategically setting its price, we need to examine how the dominant firm and its
competitive fringe determine output. In the graph (below), we derive the residual
demand curve - facing the dominant firm (Dd) - from the MC, or supply curve, of the
fringe (MCf) and market demand (Dmkt). That is, we find the "new" demand curve
faced by the dominant firm when the market is shared with a competitive fringe. As a
monopolist, the dominant firm would charge pm and produce qm.
With entry by the fringe, the dominant firm now faces a residual demand curve, rather
than the market demand curve. Notice that if the market price falls below the point
where the residual demand curve, Dd, crosses the market demand curve, Dmkt, the
dominant firm is (once again) a monopolist. This point corresponds with where
MCf crosses the vertical axis (where the fringe produces zero output).
Since the dominant firm chooses to produce where current profits are maximized (i.e.
where MRd = MCd) the price falls to p* and output responds by rising to q*. The
competitive fringe induces the dominant firm to exercise some restraint in price
setting. As long as this restraint is present, the market price will remain lower. At the
price p*, consumers will be willing to buy more than q* units and so we find the
fringe producing as well. The fringe firm(s) will produce at qf (where p* = MCf).
As the dominant firm confronts the entry of the fringe, what is the proper course of
action? One answer concerns the strategic use of pricing. There are several
approaches: static limit pricing and dynamic limit pricing. Let's examine these
individually.
Static Limit pricing. One option is that the firm sets a price that prevents the fringe
from entering the market (i.e. causes qf = 0). The dominant firm could do this by
lowering the price - from pm to MCd - causing the dominant firm's economic profits to
fall to zero. One problem with static limit pricing concerns whether a rational firm
would ever engage in non-profit maximizing behavior. That is, the firm could make
higher (current) profits by setting a different price. Naturally, the dominant firm is
concerned with future profits as well, and so the answer depends upon both current
and future profits.
Dynamic Limit pricing. Another option is one where the firm considers what is
called the present discounted value of the stream of profits it receives over time. There
are two ways of viewing this approach. Each way concerns how the firm is able to
"gaze into the future." Suppose the firm has myopic foresight, and can only view each
period as it occurs. In this event, they will take entry as given and maximize current
profits. In the graph above, this leads to the price p*. As entry continues to expand the
size of the fringe, the fringe "supply" curve becomes flatter. A flatter fringe supply
curve causes a flatter residual demand curve for the dominant firm. Thus, the
dominant firm's price will fall as the fringe expands.
If the dominant firm has perfect foresight, then they will maximize the present
discounted value of profits. Likewise, the firm takes entry as given and allows the
fringe to expand over time. Essentially, the difference is that the myopic foresight
price will exceed the perfect foresight price. In both cases, however, the price falls
over each successive period until reaching the limit price (here, note that the limit
price is MCd - the perfectly competitive price).
Either way, whether there is perfect or myopic foresight, the dominant firm reacts
passively to the expansion of the fringe. The dominant firm seeks only to maximize
their profits in some sense (either the present discounted value or current value per
period). As a result, this model becomes a way of predicting movements in price and
market share for industries like the auto or steel industry where a dominant firm or set
of firms face competition from smaller entrants.
What is a Dominant Firm, or a Price Leadership Model?

Labels: dominant firm, market structures
While dominant firm or price leadership models are not common in basic economic theory, there are some courses
that do go over this concept. It is a neat model, because it combines aspects from both a monopoly market and
perfect competition. The basic idea behind this model is that there is one large firm, that behaves monopolistically
(meaning that it has a marginal revenue curve, and is not a price taker), and the rest of the firms are so small and
numerous that they behave according to perfectly competitive rules.
The dominant firm is the price leader, and the rest of the firms take this price as given, and respond to it by producing
at a quantity where marginal cost is equal to this price (which is also the marginal revenue for these "fringe" firms).
The graph below shows a typical dominant firm model:
The black line represents industry demand, which is the total demand for the market (ie. the horizontal sum of
individual demands).
The blue MCcf line represents the marginal cost for the competitive fringe. This represents the sum of the individual
marginal cost curves for each of the firms participating in the perfectly competitive side of this market.
The green MCdf line represents the marginal cost for the dominant firm. The dominant firm is the firm acting as a
monopolistically competitive firm, which can choose which price (within a range) it will charge its consumers.
The purple Ddf line represents the demand curve for the dominant firm. Not that the demand curve for the dominant
firm is always below the industry demand curve, and becomes the industry demand curve after price level 'F' because
all competitive firms exit the market.
Finally, the orange MRdf line represents the marginal revenue curve for the dominant firm. This line has twice the
slope of the Ddf line and is intuitively identical to the MR line for a monopoly or monopolistically competitive firm.
The important points to are labeled with different letters. The point 'A' represents the intersection of the industry
(total) demand curve with the price axis. This is the price that must be charged for no quantity to be demanded. The
point 'B' represents the price level that would be attained if there was no dominant firm. This is calculated by looking
at where the perfectly competitive firms marginal cost curve crosses the industry demand curve which occurs at point
'C'.
Since anyone can acquire the good or service at the price level of 'B', this is the maximum price that the dominant
firm can charge for the good. This means that the "fringe" demand curve (the demand curve faced by the dominant
firm) will begin at point 'B'. The curve will be downward sloping, and will intersect the industry demand curve at a
price of 'F'. Also note that the point 'F' is where the competitive fringe companie's marginal cost curve intersects the
price axis (where quantity equals zero).
After we draw this "fringe" demand curve, we can derive the associated marginal revenue curve for the dominant
firm. The point 'G' shows where the marginal revenue curve and the marginal cost curve of the dominant firm, cross.
This gives us the profit maximizing output quantity for the dominant firm, and if we draw that line up to the "fringe"
demand curve, we see that it will intersect at point 'D', which is the optimal price charged for the good by the
dominant firm.
Also note that Qcf shows the quantity supplied by the competitive fringe and Qdf shows the quantity supplied by the
dominant firm. Unlike traditional supply and demand graphs, the total amount of goods supplied to the market in this
graph is Qdf + Qcf, not simply one or the other.
Economics Basics: Supply

and Demand
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1. Economics Basics: Introduction
2. Economics Basics: What Is Economics?
3. Economics Basics: Production Possibility Frontier, Growth, Opportunity Cost and Trade
4. Economics Basics: Supply and Demand
5. Economics Basics: Elasticity
6. Economics Basics: Utility
7. Economics Basics: Monopolies, Oligopolies and Perfect Competition
8. Economics Basics: Conclusion
Economics Basics: Supply and

Demand
By Reem Heakal
Supply and demand is perhaps one of the most fundamental concepts of

economics and it is the backbone of a market economy. Demand refers to how
much (quantity) of a product or service is desired by buyers. The quantity
demanded is the amount of a product people are willing to buy at a certain price;
the relationship between price and quantity demanded is known as the demand
relationship. Supply represents how much the market can offer. The quantity
supplied refers to the amount of a certain good producers are willing to supply
when receiving a certain price. The correlation between price and how much of a
good or service is supplied to the market is known as the supply relationship.
Price, therefore, is a reflection of supply and demand.
The relationship between demand and supply underlie the forces behind the
allocation of resources. In market economy theories, demand and supply theory
will allocate resources in the most efficient way possible. How? Let us take a
closer look at the law of demand and the law of supply.
A. The Law of Demand

The law of demand states that, if all other factors remain equal, the higher the
price of a good, the less people will demand that good. In other words, the higher
the price, the lower the quantity demanded. The amount of a good that buyers
purchase at a higher price is less because as the price of a good goes up, so
does the opportunity cost of buying that good. As a result, people will naturally
avoid buying a product that will force them to forgo the consumption of something
else they value more. The chart below shows that the curve is a downward slope.
A, B and C are points on the demand curve. Each point on the curve reflects a
direct correlation between quantity demanded (Q) and price (P). So, at point A,
the quantity demanded will be Q1 and the price will be P1, and so on. The
demand relationship curve illustrates the negative relationship between price and
quantity demanded. The higher the price of a good the lower the quantity
demanded (A), and the lower the price, the more the good will be in demand (C).
B. The Law of Supply

Like the law of demand, the law of supply demonstrates the quantities that will be
sold at a certain price. But unlike the law of demand, the supply relationship
shows an upward slope. This means that the higher the price, the higher the
quantity supplied. Producers supply more at a higher price because selling a
higher quantity at a higher price increases revenue.
A, B and C are points on the supply curve. Each point on the curve reflects a
direct correlation between quantity supplied (Q) and price (P). At point B, the
quantity supplied will be Q2 and the price will be P2, and so on. (To learn how
economic factors are used in currency trading, read Forex Walkthrough:
Economics.)
Time and Supply

Unlike the demand relationship, however, the supply relationship is a factor of
time. Time is important to supply because suppliers must, but cannot always,
react quickly to a change in demand or price. So it is important to try and
determine whether a price change that is caused by demand will be temporary or
permanent.
Let's say there's a sudden increase in the demand and price for umbrellas in an
unexpected rainy season; suppliers may simply accommodate demand by using
their production equipment more intensively. If, however, there is a climate
change, and the population will need umbrellas year-round, the change in
demand and price will be expected to be long term; suppliers will have to change
their equipment and production facilities in order to meet the long-term levels of
demand.
C. Supply and Demand Relationship

Now that we know the laws of supply and demand, let's turn to an example to
show how supply and demand affect price.
Imagine that a special edition CD of your favorite band is released for $20.
Because the record company's previous analysis showed that consumers will not
demand CDs at a price higher than $20, only ten CDs were released because
the opportunity cost is too high for suppliers to produce more. If, however, the ten
CDs are demanded by 20 people, the price will subsequently rise because,
according to the demand relationship, as demand increases, so does the price.
Consequently, the rise in price should prompt more CDs to be supplied as the
supply relationship shows that the higher the price, the higher the quantity
supplied.
If, however, there are 30 CDs produced and demand is still at 20, the price will
not be pushed up because the supply more than accommodates demand. In fact
after the 20 consumers have been satisfied with their CD purchases, the price of
the leftover CDs may drop as CD producers attempt to sell the remaining ten
CDs. The lower price will then make the CD more available to people who had
previously decided that the opportunity cost of buying the CD at $20 was too
high.
D. Equilibrium
When supply and demand are equal (i.e. when the supply function and demand
function intersect) the economy is said to be at equilibrium. At this point, the
allocation of goods is at its most efficient because the amount of goods being
supplied is exactly the same as the amount of goods being demanded. Thus,
everyone (individuals, firms, or countries) is satisfied with the current economic
condition. At the given price, suppliers are selling all the goods that they have
produced and consumers are getting all the goods that they are demanding.
As you can see on the chart, equilibrium occurs at the intersection of the demand
and supply curve, which indicates no allocative inefficiency. At this point, the
price of the goods will be P* and the quantity will be Q*. These figures are
referred to as equilibrium price and quantity.
In the real market place equilibrium can only ever be reached in theory, so the
prices of goods and services are constantly changing in relation to fluctuations in
demand and supply.
E. Disequilibrium
Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.
1. Excess Supply
If the price is set too high, excess supply will be created within the economy and
there will be allocative inefficiency.
At price P1 the quantity of goods that the producers wish to supply is indicated by
Q2. At P1, however, the quantity that the consumers want to consume is at Q1, a
quantity much less than Q2. Because Q2 is greater than Q1, too much is being
produced and too little is being consumed. The suppliers are trying to produce
more goods, which they hope to sell to increase profits, but those consuming the
goods will find the product less attractive and purchase less because the price is
too high.
2. Excess Demand
Excess demand is created when price is set below the equilibrium price.
Because the price is so low, too many consumers want the good while producers
are not making enough of it.
In this situation, at price P1, the quantity of goods demanded by consumers at
this price is Q2. Conversely, the quantity of goods that producers are willing to
produce at this price is Q1. Thus, there are too few goods being produced to
satisfy the wants (demand) of the consumers. However, as consumers have to
compete with one other to buy the good at this price, the demand will push the
price up, making suppliers want to supply more and bringing the price closer to
its equilibrium.
F. Shifts vs. Movement

For economics, the "movements" and "shifts" in relation to the supply and
demand curves represent very different market phenomena:
1. Movements
A movement refers to a change along a curve. On the demand curve, a
movement denotes a change in both price and quantity demanded from one
point to another on the curve. The movement implies that the demand
relationship remains consistent. Therefore, a movement along the demand curve
will occur when the price of the good changes and the quantity demanded
changes in accordance to the original demand relationship. In other words, a
movement occurs when a change in the quantity demanded is caused only by a
change in price, and vice versa.
Like a movement along the demand curve, a movement along the supply curve
means that the supply relationship remains consistent. Therefore, a movement
along the supply curve will occur when the price of the good changes and the
quantity supplied changes in accordance to the original supply relationship. In
other words, a movement occurs when a change in quantity supplied is caused
only by a change in price, and vice versa.
2. Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded or
supplied changes even though price remains the same. For instance, if the price
for a bottle of beer was $2 and the quantity of beer demanded increased from Q1
to Q2, then there would be a shift in the demand for beer. Shifts in the demand
curve imply that the original demand relationship has changed, meaning that
quantity demand is affected by a factor other than price. A shift in the demand
relationship would occur if, for instance, beer suddenly became the only type of
alcohol available for consumption.
Conversely, if the price for a bottle of beer was $2 and the quantity supplied
decreased from Q1 to Q2, then there would be a shift in the supply of beer. Like
a shift in the demand curve, a shift in the supply curve implies that the original
supply curve has changed, meaning that the quantity supplied is effected by a
factor other than price. A shift in the supply curve would occur if, for instance, a
natural disaster caused a mass shortage of hops; beer manufacturers would be
forced to supply less beer for the same price.
Read more: Economics Basics: Supply and Demand |

Investopedia http://www.investopedia.com/university/economics/economics3.asp#ixzz3lWh
cMEmq
Factors affecting demand

The individual demand curve illustrates the price people are willing to pay for a particular
quantity of a good.
The market demand curve will be the sum of all individual demand curves. It shows the quantity
of a good consumers plan to buy at different prices.
1. Change in price
A change in price causes a Movement along the Demand Curve.
E.g. if there is an increase in price from £9 to £12 then there will be a fall in demand from 30 to
22
Shifts in the demand curve
This occurs when, even at the same price, consumers are willing to buy a higher (or lower)
quantity of goods. This will occur if there is a shift in the conditions of demand.
Diagram to show shift in demand
A shift to the right in the demand curve can occur for a number of reasons:
1. Income. An increase in disposable income enabling consumers to be able to afford more goods. Higher
income could occur for a variety of reasons, such as higher wages and lower taxes.
2. Quality. An increase in the quality of the good e.g. better quality digital cameras encourage people to buy
one.
3. Advertising can increase brand loyalty to the goods and increase demand. For example, higher spending
on advertising by Coca Cola has increased global sales.
4. Substitutes. An increase in the price of substitutes, e.g. if the price of Samsung mobile phones increases,
this will increase the demand for Apple iPhones – a major substitute for the Samsung.
5. Complements. A fall in the price of complements will increase demand. E.g. a lower price of Play
Station 2 will increase the demand for compatible Play Station games.
6. Weather: In cold weather there will be increased demand for fuel and warm weather clothes.
7. Expectations of future price increases. A commodity like gold may be bought due to speculative reasons;
if you think it might go up in the future, you will buy now.
Fall in demand
A fall in demand could occur due to lower disposable income or decline in popularity of the
good.
Evaluation
For some luxury goods income will be an important determinant of demand. e.g. if your income
increased you would buy more restaurant meals, but probably not more salt.
Advertising is important for goods in which branding is important, e.g. soft drinks but not for
bananas.
Other types of demand
 Effective demand: This occurs when a consumers desire to buy a good can be backed up by his ability to
afford it.
 Derived demand: This occurs when a good or factor of production such as labour is demanded for another
reason
 A Giffen good is a good where an increase in price of a basic item leads to an increase in demand,
because very poor people cannot afford any other luxury goods.
 An ostentatious good, is a good where an increase in price leads to an increase in demand because people
believe it is now better.
 Composite demand – A good which is demanded for multiple different uses
 Joint demand – goods bought together e.g. printer and printer ink.
Nine Factors to Consider

When Determining Your
Price
by Collis Ta'eed29 May 201256 Comments
12

Share
Part guesswork, part experience, part number crunching - how ever you look at it,
determining your price is a difficult task. Here are nine factors to take into consideration
when pricing your services:
1. Your Costs
If your rate doesn't include enough just to break-even, you're heading for trouble. The
best thing to do is sum up all your costs and divide by the number of hours you think
you can bill a year. Whatever you do, DON'T think you can bill every hour. You must
account for sick days, holidays, hours working on the business, hours with no work and
so on.
Also make sure you factor in all the hidden costs of your business like insurance,
invoices that never get paid for one reason or another, and everyone's favourite - taxes.
2. Your Profit
Somewhat related to your costs, you should always consider how much money you are
trying to make above breaking even. This is business after all.
3. Market Demand
If what you do is in high demand, then you should be aiming to make your services
more expensive. Conversely if there's hardly any work around, you'll need to cheapen
up if you hope to compete.
Signs that demand is high include too much work coming in, other freelancers being
overloaded and people telling you they've been struggling to find someone to do the job.
Signs that demand is low include finding yourself competing to win jobs, a shortage of
work and fellow freelancers reentering the workforce.
4. Industry Standards
It's hard to know what others are charging, but try asking around. Find out what larger
businesses charge as well as other freelancers. The more you know about what others
are charging and what services they provide for the money, the better you'll know how
you fit in to the market.
5. Skill level
Not every freelancer delivers the same goods and one would expect to pay accordingly.
When I was a freelancing newbie I charged a rate of $25 an hour for my design, when I
stopped freelancing recently my rate was $125 an hour. Same person, but at different
times I had a different skill level and hence was producing a different result. Whatever
your rate, expect it to be commensurate with your skill.
6. Experience
Although often bundled with skill, experience is a different factor altogether. You may
have two very talented photographers, but one with more experience might have better
client skills, be able to foresee problems (and thus save the client time and money),
intuitively know what's going to work for a certain audience and so on. Experience
should affect how much you charge.
7. Your Business Strategy

Your strategy or your angle will make a huge difference to how you price yourself. Think
about the difference between Revlon and Chanel, the two could make the same
perfume but you would never expect to pay the same for both. Figure out how you are
pitching yourself and use that to help determine if you are cheap'n'cheerful, high end or
somewhere in between.
8. Your Service
What you provide for your clients will also make a big difference to your price tag. For
example you might be a freelancer who will do whatever it takes to get a job just right,
or perhaps you are on call 24-7, or perhaps you provide the minimum amount of
communication to cut costs. Whatever the case, adjusting your pricing to the type and
level of service you provide is a must.
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9. Who is Your Client

Your price will often vary for different clients. This happens for a few reasons. Some
clients require more effort, some are riskier, some are repeat clients, some have jobs
you are dying to do, some you wouldn't want to go near with a stick. You should vary
your price to account for these sorts of factors.
Give it Lots of Thought
The more you think about your reasoning behind your price, the easier your quoting will
become. Like all these things there is a large amount of trial and error and often you will
find yourself constantly changing up your pricing and gauging the ratio of jobs lost to
jobs won.
This article has been translated into Italian by Giuseppe at GL SEO Blog, and into
French by Céline at NakedTranslations.com
Note: A few times a month we revisit some of our reader’s favorite posts from
throughout the history of FreelanceSwitch. This article by Collis Ta'eed was first
published May 26th, 2007, yet is just as relevant and full of useful information today.
Options Pricing: Factors That

Influence Option Price
AAA |
1. Options Pricing: Introduction
2. Options Pricing: A Review Of Basic Terms
3. Options Pricing: The Basics Of Pricing
4. Options Pricing: Intrinsic Value And Time Value
5. Options Pricing: Factors That Influence Option Price
6. Options Pricing: Distinguishing Between Option Premiums And Theoretical Value
7. Options Pricing: Modeling
8. Options Pricing: Black-Scholes Model
9. Options Pricing: Cox-Rubenstein Binomial Option Pricing Model
10. Options Pricing: Put/Call Parity
11. Options Pricing: Profit And Loss Diagrams
12. Options Pricing: The Greeks
13. Options Pricing: Conclusion
Options Pricing: Factors That Influence

Option Price
By Jean Folger
There are six primary factors that influence option prices, as shown in Figure 2
and discussed below.
Figure 2: Six factors that affect option prices are shown on the
top row. As indicated, the underlying price and strike price
determine the intrinsic value; the time until expiration and
volatility determine the probability of a profitable move; the
interest rates determine the cost of money; and dividends can
cause an adjustment to share price.
Underlying Price
The most influential factor on an option premium is the current market price of
the underlying asset. In general, as the price of the underlying increases, call
prices increase and put prices decrease. Conversely, as the price of the
underlying decreases, call prices decrease and put prices increase.
Call prices will ... Put prices will ...
Increase Decrease
Decrease Increase
Expected Volatility
Volatility is the degree to which price moves, regardless of direction. It is a
measure of the speed and magnitude of the underlying's price
changes. Historical volatility refers to the actual price changes that have been
observed over a specified time period. Option traders can evaluate historical
volatility to determine possible volatility in the future. Implied volatility, on the
other hand, is a forecast of future volatility and acts as an indicator of the current
market sentiment. While implied volatility is often difficult to quantify, option
premiums will generally be higher if the underlying exhibits higher volatility,
because it will have higher expected price fluctuations.
The greater the expected volatility, the higher the option value
Strike Price
The strike price determines if the option has any intrinsic value. Remember,
intrinsic value is the difference between the strike price of the option and the
current price of the underlying. The premium typically increases as the option
becomes further in-the-money (where the strike price becomes more favorable in
relation to the current underlying price). The premium generally decreases as the
option becomes more out-of-the-money (when the strike price is less favorable in
relation to the underlying).
Premiums increase as options become further in-the-money
Time Until Expiration

The longer an option has until expiration, the greater the chance that it will end
up in-the-money, or profitable. As expiration approaches, the option's time value
decreases. In general, an option loses one-third of its time value during the first
half of its life and two-thirds of its value during the second half. The underlying's
volatility is a factor in time value; if the underlying is highly volatile, one could
reasonably expect a greater degree of price movement before expiration. The
opposite holds true where the underlying typically exhibits low volatility; the time
value will be lower if the underlying price is not expected to move much.
The longer the time until expiration, the higher the option price
The shorter the time until expiration, the lower the option price
Interest Rate and Dividends

Interest rates and dividends also have small, but measurable, effects on option
prices. In general, as interest rates rise, call premiums will increase and put
premiums will decrease. This is because of the costs associated with owning the
underlying; the purchase will incur either interest expense (if the money is
borrowed) or lost interest income (if existing funds are used to purchase the
shares). In either case, the buyer will have interest costs.
Increase Decrease
Decrease Increase
Dividends can affect option prices because the underlying stock's price typically
drops by the amount of any cash dividend on the ex-dividend date. As a result, if
the underlying's dividend increases, call prices will decrease and put prices will
increase. Conversely, if the underlying's dividend decreases, call prices will
increase and put prices will decrease.
Decrease Increase
Increase Decrease
Read more: Options Pricing: Factors That Influence Option Price |

Investopedia http://www.investopedia.com/university/options-pricing/option-price-
influence.asp#ixzz3lWj9aG1x
Factors Affecting Pricing Decision
For the remainder of this tutorial we look at factors that affect how marketers set price. The final price for
a product may be influenced by many factors which can be categorized into two main groups:
 Internal Factors - When setting price, marketers must take into consideration several factors which
are the result of company decisions and actions. To a large extent these factors are controllable by
the company and, if necessary, can be altered. However, while the organization may have control
over these factors making a quick change is not always realistic. For instance, product pricing may
depend heavily on the productivity of a manufacturing facility (e.g., how much can be produced within
a certain period of time). The marketer knows that increasing productivity can reduce the cost of
producing each product and thus allow the marketer to potentially lower the product’s price. But
increasing productivity may require major changes at the manufacturing facility that will take time (not
to mention be costly) and will not translate into lower price products for a considerable period of time.
 External Factors - There are a number of influencing factors which are not controlled by the
company but will impact pricing decisions. Understanding these factors requires the marketer conduct
research to monitor what is happening in each market the company serves since the effect of these
factors can vary by market.
Below we provide a detailed discussion of both internal and external factors.

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Business
Wages: Factors That Affect Wage Levels And Wage Determination

under Pure Competition
Most people work to earn a living, which they do by supplying their labor in return for
money. Laborers consist of unskilled workers, blue and white collar workers, professional
people, and small business owners.
Wages are the price that workers receive for their labor in the form of salaries, bonuses,
royalties, commissions, and fringe benefits, such as paid vacations, health insurance, and
pensions. The wage rate is the price per unit of labor. Most commonly, workers are paid
by the hour. For instance, in 2011, the legal minimum wage rate for most employees in the
United States is $7.25 per hour.Earnings is equal to the wage rate multiplied by the
number of hours worked, so an employee learns minimum wage and work the typical 40
hour week earns $7.25 × 40 = $290 per week and $15,080 per year.
Nominal wage is the amount earned in terms of dollars or other currency, while
the real wage is the amount earned in terms of what it can actually buy. If the nominal
wage does not increase as much as the inflation rate, then real wages decline.
Wage Levels
Wages differ among nations, regions, occupations, and individuals. Generally, wages will
be higher where the demand for labor is greater than the supply. Nominal wages vary more
than real wages, since the purchasing power of different currencies varies
considerably. For instance, in those countries with low-priced labor, such as China and
India, most household goods and services also have lower prices than what they would
generally cost in more advanced economies.
The main factor that will determine the upper limits of wages is the productivity of the
business in combining inputs to produce socially desirable outputs. Obviously, more
productive workers can be paid more. Productivity largely depends on the availability of
real capital, in the form of machinery and automation, and on the availability of natural
resources, which are required as inputs in the production of products and services.
The amount of education or training also largely determines how much a worker can
earn, not only by making the worker more productive but by also making the worker more
desirable to employers, who compete for workers through the level of wages that they offer.
If the time required for training or education is long, then it must lead to higher paying jobs;
otherwise, people would pursue easier work or work that can be attained in less time if there
was no difference in pay.
The quality of the entrepreneurs who start a business will also determine the
efficiency of the business since they lay down the initial organization of how the business
will be conducted to produce its output from its various inputs. Afterwards, the quality of
the management will also affect the efficiency of the business, and therefore, the
workers, by how effectively they control costs and produce the desired output.
Another factor that will affect productivity is the political and social environment of the
country or region in which the business is located. Many governments, especially in corrupt
countries, interfere with the development of businesses or try to extract payments, in the
form of bribes, from businesses for the enrichment of particular people in the government
rather than using it as tax revenue for the benefit of society. In the same way that
mismanagement can reduce the efficiency of workers in a business, the mismanagement of
a country can likewise reduce the efficacy of its people. Many businesses that are unionized
are often less productive, since they are constrained by the demands of the union or by
union contracts. For instance, unions often resist automation, and other cost-saving changes
to project jobs. The size of the market also matters. Larger markets can help promote
efficiency and that economy Economies of scale can be reached. Wage determination in a
purely competitive labor market
Wage Determination under Pure Competition
A purely competitive labor market exists when:
 many firms compete for specific labor;

 the laborers have identical skills;
 both the firms and the workers are wage takers, since neither can influence the wage rate;
 there are no unions, since union wages are generally not the result of market supply and demand.
The market demand for labor is for a specific type of labor and not necessarily for a specific
industry. If one industry paid more than another for a specific type of labor, then more
laborers would work for that industry until the wages are equalized.
Under pure competition, the wage rate is set by the intersection of the labor supply curve
and the demand curve of employers, as seen in Graph #1. As is true ofsupply curves in
general, the higher the wage rate, the higher the supply of labor and the lower the demand.
In economics, labor is considered as a resource. Therefore, the price of labor is represented
as a marginal resource cost (MRC) and the employer's demand for labor is
represented by the marginal revenue product (MRP). Employers will continue to
hire workers as long as the marginal revenue product of the last worker is greater than his
marginal revenue cost. In other words, as long as the revenue earned by the workers is
greater than their cost, the employer will increase profits by hiring more workers.
The labor market equilibrium occurs at the intersection of labor supply curve and the labor
demand curve. In a perfectly competitive labor market, the supply of labor is perfectly
elastic, so a firm can hire all the workers that it wants for the market wage rate. The firm
will hire enough labor until the MRP of the last laborer hired is equal to his MRC. MRC is
constant and is equal to the resource price, or in this case, the wage rate (Graph #2). The
area represented under the MRC line is equal to the cost of labor. Above that line and below
the MRP line is the cost for land, capital, and entrepreneurship, which includes a normal
profit.
◄ Previous Next ►
Resource Demand Elasticity Labor Unions
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Wage Determination in Perfectly

Competitive Labour Markets
How wages are determined in a perfectly competitive labour market. A perfectly competitive
labour market will have the following features
 Many firms
 Perfect information about wages and job conditions
 Firms are offering identical jobs
 Many workers with same skills
Diagram of Wage Determination
 The equilibrium wage rate in the industry is set by the meeting point of the industry supply and industry
demand curves.
 In a competitive market firms are wage takers because if they set lower wages workers would not accept
the wage.
 Therefore they have to set the equilibrium wage We.
 Because firms are wages takers the supply curve of labour is perfectly elastic therefore AC = MC
 The firm will maximise profits by employing at Q1 where MRP of Labour = MC of Labour
Comparing Wage of Lawyers and McDonalds workers
 Lawyers get higher pay for 2 reasons
1. Supply is inelastic because of the qualifications required

2. MRP of lawyers is high. If they are successful they can make firms a lot of revenue.
McDonalds workers however get lower pay because:
1. Supply is elastic, because there are many 1000s of people who are suitable for working, qualifications are
not really required
The MRP of a McDonalds worker is much lower because there is a limited profit to be made
from selling Big Macs.
Diagram of Wage Determination for Lawyers and
McDonald’s Workers
Karl Marx
Wage Labour and Capital
By what are wages determined?
Now, the same general laws which regulate the price of

commodities in general, naturally regulate wages, or the
price of labour-power. Wages will now rise, now fall,
according to the relation of supply and demand, according
as competition shapes itself between the buyers of labour-
power, the capitalists, and the sellers of labour-power, the
workers. The fluctuations of wages correspond to the
fluctuation in the price of commodities in general. But
within the limits of these fluctuations the price of labour-
power will be determined by the cost of production, by the
labour-time necessary for production of this commodity:
labour-power.
What, then, is the cost of production of labour-power?
It is the cost required for the maintenance of the

labourer as a labourer, and for his education and training
as a labourer.
Therefore, the shorter the time required for training up

to a particular sort of work, the smaller is the cost of
production of the worker, the lower is the price of his
labour-power, his wages. In those branches of industry in
which hardly any period of apprenticeship is necessary
and the mere bodily existence of the worker is sufficient,
the cost of his production is limited almost exclusively to
the commodities necessary for keeping him in working
condition. The price of his work will therefore be
determined by the price of the necessary means of
subsistence.
Here, however, there enters another consideration. The

manufacturer who calculates his cost of production and,
in accordance with it, the price of the product, takes into
account the wear and tear of the instruments of labour. If
a machine costs him, for example, 1,000 shillings, and
this machine is used up in 10 years, he adds 100 shillings
annually to the price of the commodities, in order to be
able after 10 years to replace the worn-out machine with a
new one. In the same manner, the cost of production of
simple labour-power must include the cost of
propagation, by means of which the race of workers is
enabled to multiply itself, and to replace worn-out
workers with new ones. The wear and tear of the worker,
therefore, is calculated in the same manner as the wear
and tear of the machine.
Thus, the cost of production of simple labour-power

amounts to the cost of the existence and propagation of
the worker. The price of this cost of existence and
propagation constitutes wages. The wages thus
determined are called the minimum of wages. This
minimum wage, like the determination of the price of
commodities in general by cost of production, does not
hold good for the single individual, but only for the race.
Individual workers, indeed, millions of workers, do not
receive enough to be able to exist and to propagate
themselves; but the wages of the whole working class
adjust themselves, within the limits of their fluctuations,
to this minimum.
Now that we have come to an understanding in regard

to the most general laws which govern wages, as well as
the price of every other commodity, we can examine our
subject more particularly.
Frequently Asked Questions (FAQs)

Question: What is a Wage Determination?
Answer: A "wage determination" is the listing of wage rates and fringe benefit rates for each
classification of laborers and mechanics which the Administrator of the Wage and Hour Division of
the U.S. Department of Labor has determined to be prevailing in a given area for a particular type of
construction (e.g., building, heavy, highway, or residential).
The Wage and Hour Division issues two types of wage determinations: general determinations, also
known as area determinations, and project determinations. The term "wage determination" is defined
as including not only the original decision but any subsequent decisions modifying, superseding,
correcting, or otherwise changing the rates and scope of the original decision.
In accordance with the provisions of 29 CFR Part 1 and Part 5, the wage rates and fringe benefits in
the applicable Davis-Bacon wage determination shall be the minimum paid by contractors and
subcontractors to laborers and mechanics.
Oligopoly Pricing Models
A pure monopoly maximizes profits by producing that quantity where marginal revenue
equals marginal cost. However, it is much more difficult for an oligopoly to determine at
what output it can maximize its profit. There are 2 major reasons for this: the
interdependence of the firms and their diversity, especially in terms of concentration ratios.
Some oligopoly's have a very high concentration ratio, allowing them to act more like a
monopoly, while other industries have a much lower concentration ratio, thus, making it
much more difficult to determine the best pricing strategy, since the number of possible
responses by competitors is greatly increased.
There have been 2 prominent characteristics of oligopolies observed over the years.
1. In a stable economy, oligopolies' prices change much less frequently than under any other market
model, such as pure competition, monopolistic competition, and even monopoly.
2. When prices do change, the firms generally move in the same direction and by the same
magnitude in their price changes, which may be the result of collusion.
There are 3 basic theories about oligopolistic pricing: kinked-demand theory, or non-
collusive oligopoly, the cartel model, and the price leadership model.
Kinked-Demand Theory
Consider a firm in an oligopoly that wants to change its price. How will the other firms
react? There are 2 possibilities: they can either match the price changes or ignore them. But
what the other firms will actually do will probably depend on the direction of the price
change. If one firm raises its price, the others probably will not follow, since that will allow
them to take market share from the price changer. This makes the demand
curve more elastic, since as the firm raises its price, then many of its customers will buy
from the other firms, lowering the revenue of the higher-priced firm.
If the firm lowers its price, then the other firms would surely follow, to prevent any loss of
market share. This part of the demand curve is much more inelastic, since all of the firms
are acting in concert. This creates a kink in the demand curve, where the change in demand
goes from very elastic at higher prices to inelastic at lower prices. Since the marginal
revenue curve depends on prices, the marginal revenue curve is also kinked. At lower
prices, the marginal revenue curve drops downward creating a gap. The marginal cost
curves of both scenarios will intersect the same quantity being produced by the oligopoly,
represented by the vertical line in the graph; therefore, there is no change in quantity
produced as prices are lowered, as long as the change in marginal cost is within the
marginal revenue gap.
 P1 = Product Price of the Oligopoly
 If a firm raises its price (D1), but the others do not match the increase, then revenue will decline in
spite of the price increase.
 If the firm lowers its price (D2), then the other firms will match the decrease to avoid losing market
share.
 Because there is a kink in the demand curve, there is a gap in the marginal revenue curve (MR1 -
MR2). Since firms maximize profit by producing that quantity where marginal cost equals marginal
revenue, the firms will not change the price of their product as long as the marginal cost is
betweenMC1 and MC2, which explains why oligopolistic firms change prices less frequently than
firms operating under other market models.
The kinked-demand curve explains why firms in an oligopoly resist changes to price. If one
of them raises the price, then it will lose market share to the others. If it lowers its price,
then the other firms will match the lower price, causing all of the firms to earn less profit.
Critics of the kinked-demand model point out that while the model explains why oligopolies
maintain pricing, it doesn't explain how its products were initially priced. The other thing it
doesn't explain is that when the economy changes significantly, especially when there is
high inflation, then the firms of an oligopoly do change prices often. In some cases,
oligopolistic firms may engage in a price war, where each firm charges a successfully
lower price to gain market share.
Cartel Model
Sometimes firms in an oligopoly try to form a cartel by agreeing to fix prices or to divide
the market among themselves, or to restrict competition some other way. The primary
characteristic of the Cartel Model is collusion among the oligopolistic firms to fix prices
or restrict competition so that they can earn monopoly profits.
If the dominant firms in an oligopoly can successfully collude to fix prices, then they can be
certain of each other's output, which will allow to maximize their profits by producing that
quantity of output where marginal revenue equals marginal cost, just as it would be for a
monopoly. However, if any of the firms cheat, then a price war may ensue, lowering the
profits of all firms, and maybe even causing them to operate a loss. In most modern
economies, collusion is generally against the law, however there are certain countries that
engage in collusion to maximize their profits from their natural resources.
The best example of a cartel today is the Organization of Petroleum Exporting Countries,
otherwise known as OPEC, which comprises 12 oil-producing nations that supply 60% of
all oil traded internationally. Prices are maintained by restricting each country of the OPEC
cartel to a specific production allocation. The OPEC cartel is largely responsible for the
large fluctuations in gasoline prices that have occurred in the United States since 1973,
although recently, speculation in the commodity markets has also increased volatility.
Problems Creating and Maintaining Collusion
Collusion is often difficult to detect, because it is often based on tacit or covert agreements
that are made during social interactions between the executives of the oligopolistic firms.
Nonetheless, there are several obstacles to collusion.
One common obstacle is differences in demand and cost. Firms that serve different
geographic markets will have varying levels of demand, and, in many cases, they will also
have different efficiencies, resulting in different production costs. If economies of scale are
steep for an industry, then smaller firms will aggressively compete on price to increase their
market share, so that they can earn reasonable profits. In such cases, it will be difficult for
the firms to agree on the price, because they will have different marginal cost curves. A
good example is Saudi Arabia and Venezuela in the production of oil. Saudi Arabia is
efficient in producing soil, whereas Venezuela, governed by an inept communist
government, is highly inefficient, so it would be very difficult for Venezuela to accept a
price that would be suitable for Saudi Arabia. Consequently, there is a great temptation for
inefficient producers to cheat, and if they cheat, then price competition ensues.
Another factor that increases cheating is recessions. During recessions, demand declines,
which shifts the firm's marginal cost and demand curve to the left. Firms often respond by
reducing prices so that they can better utilize their production capacity and to try to gain
market share from the other firms.
A larger number of firms in the oligopoly make it difficult both to create and maintain
collusion. If there are only 2 or 3 firms in the oligopoly, then it is fairly easy to collude to
set prices or to limit competition. However, if there are 6 or more firms with a smaller share
of the market, then collusion becomes increasingly difficult. Indeed, the likelihood of a
successful collusion decreases as the number of firms increases.
Another possible barrier to collusion is that if prices are maintained too high, then it may
allow new entrants into the industry that will provide more competition, or, smaller firms
that did not have much market power can cut prices and increase production to grab market
share.
The other major barrier to collusion is antitrust law. Most modern economies prohibit
collusion, since it is against the public interest, although there are some exceptions. A very
common exception is the pricing of insurance products, since many insurance
companies depend on rating companies that gather information on insurance risks and how
to price them. In the United States, insurance rating information is exempted from the
antitrust provisions of the United States.
Price Leadership Model
In many industries, there is a dominant firm in an oligopoly, and the other firms often
follow the dominant firm in price changes, which can be viewed as a type of implicit
price collusion. Hence, the dominant firm also becomes the price leader. Since
most firms have been in the business for a number of years, they can observe how their
competitors react to changes in the industry, allowing them to reach an understanding of
how their competitors will react to any price changes. Firms in an oligopoly do not often
change prices, certainly not for minor changes in costs, but they will change prices if cost
changes are substantial. Indeed, if there is a general price increase in the inputs of an
industry, then all firms will surely increase their prices. Increasing price of inputs, of course,
helps to protect the industries from antitrust prosecutions since they have a reasonable basis
for increasing the price of their products that is not related to restricting competition.
Oftentimes, the price leader will communicate the need to raise prices through press
releases, trade publications, and speeches by major executives, especially when announcing
quarterly earnings.
There are many times when a price leader will limit price increases to discourage the
entrance of new competitors — a practice called limit pricing. This will be particularly
true if the economies of scale are not that steep, since high prices can allow the entrance of
new competitors who will be able to survive on a small market share.
Sometimes price leadership breaks down and price wars result. However, price wars are
self-limiting, since they will often lead to losses. Eventually the firms will capitulate and
return to the practice of following the price leader.
Productive And Allocative Efficiency Of Oligopolies

Pure competition achieves productive efficiency by producing products at the minimum
average total cost. They also achieve allocative efficiency because they produce until their
marginal cost equals price. However, because oligopolies produce only until marginal cost
equals marginal revenue, they lack both the productive and allocative efficiency of pure
competition.
Because oligopolies can successfully thwart competition, they restrict output to maximize
profits, producing only until marginal cost equals marginal revenue — hence oligopolies
exhibit the same inefficiencies as a monopoly. Because the marginal cost curve intersects
the marginal revenue curve before it intersects the average total cost curve, oligopolies
never reach an efficient scale of production efficiency since they never operate at their
minimum average total cost. Similarly, the marginal cost curve never intersects the market
demand curve; therefore, oligopolies produce less product than what the market desires, so
oligopolies lack allocative efficiency.
The graph below shows the long run equilibrium for monopolies, which is similar for
oligopolies. Oligopolies, like monopolies andmonopolistic competitors, also have excess
capacity.
 ATC = Average Total Cost
 MR = Marginal Revenue
 MC = Marginal Cost
Note that where MC rises above MR, the firm would incur greater costs than it would
receive in additional revenue, which is why the firm maximizes its profit by producing only
that quantity where MR = MC, and charging the corresponding price.
1 Productive Efficiency: MC = Minimum ATC
2 Allocative Efficiency: MC = Market Price
Oligopoly Profit = (Price - ATC) × Quantity
Although there are many major industries dominated by oligopolies, there are rarely
prosecuted under antitrust laws. However, there are several factors that limit the pricing
power of oligopolies, including foreign competition and technological advances. Before
extensive world trade, oligopolies developed independently in many modern economies. As
trade barriers fall, oligopolies find they must compete with oligopolies from other countries,
which diminishes their pricing power. Technology can also diminish the pricing power of
oligopolies by producing better products, by lowering the fixed costs of developing a
product, and by opening markets to more competitors. For instance, brick-and-mortar
retailers now have much more competition from the Internet.
Many of the technological advances originate in oligopolies, because they have a greater
amount of money to invest in research and development (R&D). While monopolies also
have money for R&D, the need to conduct research is lessened by the fact that the
monopoly has no real competition. However, over time, technological advances eventually
rode even a monopoly's power. Hence, oligopolies invest heavily in research and
development to maintain their pricing power.
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Game Theory of Oligopolistic Pricing Technological Advances: Discovery, Invention, Innovation, Diffusion, Research
Strategies and Development
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Theory of cost

An amount that has to be paid or given up in order to get something.

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Full Definition of COST

Total Costs (TC) – Fixed + Variable Costs

 ATC (Average Total Cost) = Total Cost / quantity

All Types of Costs in Economics with Examples?

(A) Actual Cost

(B) Opportunity Cost

(C) Sunk Cost

(D) Incremental Cost

(E) Explicit Cost

(F) Implicit Cost

(G) Book Cost

(H) Out Of Pocket Costs

(I) Accounting Costs

(J) Economic Costs

(K) Direct Cost

(L) Indirect Costs

(M) Controllable Costs

Example: Inventory costs can be controlled at the shop level etc.

(N) Non Controllable Costs

Example: Costs due obsolesce and depreciation, capital costs etc.

(O) Historical Costs and Replacement Costs.

(Q) Abandonment Costs

(R) Urget Costs and Postponable Costs

Example: Cost of material, labour, fuel etc

(S) Business Cost and Full Cost

(T) Fixed Costs

(U) Variable Costs

(V) Total Cost, Average Cost and Marginal Cost

(W) Short Run Cost and Long Run Cost

DEFINITION OF 'FIXED COST'

BREAKING DOWN 'FIXED COST'

In economics, a business can achieve economies of scale when it produces

Read more: Fixed Cost Definition |

DEFINITION OF 'VARIABLE COST'

BREAKING DOWN 'VARIABLE COST'

The formula for calculating total variable cost is:

Let's assume the following:

Annual Widgets Produced: 100,000

5,000 x ($0.10 + $0.50) = $3,000

Definition Add to FlashcardsSave to FavoritesSee Examples

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Total Stuffed Animal Cost Total Cost

Closer consideration of these total cost numbers is in order.

 Short-run Production: This table of numbers is for the short-run production of

Fixed and Variable

total cost = total fixed cost + total variable cost

The Total Cost Curve

As might be expected the total cost curve has a

Another observation is that the total cost curve does

Short-run Production Returns

 Increasing Marginal Returns: Increasing marginal returns are reflected by the

 Decreasing Marginal Returns: In contrast, decreasing marginal returns are reflected

Average and Marginal

Marginal Cost Of Production

DEFINITION OF 'MARGINAL COST OF PRODUCTION'

BREAKING DOWN 'MARGINAL COST OF PRODUCTION'

Read more: Marginal Cost Of Production Definition |

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Definition of Marginal Cost