MODULE 4 AND MODULE 5

SYLLABUS
Module 4: Market structure (5 hrs)
Introduction to Markets, Features of Markets, Types of Market, Perfect competition - features,
Price & Output determination; Monopoly - Features, Price & Output determination;
Monopolistic Competition - Features, Price and Output determination; Oligopoly. Price
discrimination, Product differentiation.
Module 5: Imperfect Market Situation (7 hrs)
Price Discrimination. Monopolistic Competition: Features, Pricing competition, Product
differentiation.

MODULE 4 – MARKET STRUCTURE

Introduction to Markets
Meaning of a Market
Ordinarily a market is understood as a place where commodities are bought and sold at retail
or wholesale prices – a market place is thought to consist of a number of big and small shops,
stalls and even hawkers selling various types of goods. In economics, however, the term
“market” does not refer to a particular place, but it refers to a market for a commodity or
commodities – wheat market, tea market, gold market etc.
What is a Market?

• Place where there are many buyers and sellers

• Actively engaged in buying and selling acts
• Contact through different means of communication like letters, telephone, etc.
• Thus, it does not mean a particular place but the entire area where buyers and sellers of
a commodity are in close contact and they have one price of same commodity
Definition - “An arrangement whereby buyers and sellers come in close contact with each
other directly or indirectly, to sell or buy goods is described as market”
The term market implies

• Existence of a commodity to be traded

• Existence of sellers and buyers

• Establishment of contact between sellers and buyers
• Willingness and ability to buy and sell a commodity
• Existence of a price at which the given commodity is to be bought and sold.
Market Structure
Market Structure - It is therefore understood as those characteristics of a market that influence
the behaviour and results of the firm working in that market

Characteristics of Market Structure

Area – A market does not mean a particular place but a whole region where sellers and buyers
of a product are spread. Modern modes of communication and transport have made the market
area of a product very wide
Buyers and Sellers – For exchange at least 1 buyer and 1 seller are needed. In the modern age,
the physical presence of buyers and sellers is not necessary in the market because they can do
transactions of goods through letters, telephones, internet, etc.
One Commodity – A market is not related to a place but to a particular product. Hence, there
are separate markets for various commodities
Free Competition – There should be free competition among buyers and sellers in the market.
It is in relation to the price determination of a product among buyers and sellers.
One Price – The price of a product is the same in the market because of free competition among
buyers and sellers.

Classification of Market Structures

Markets may be classified on the basis of different criteria –

• Geographical space or area

• Time element

• Nature of competition.
• Functions
• On the basis of nature of commodity

• Legality
A market situation relates to the competitive situation of a business identifying a number of
competitive firms, the relative size and strength of the firms, demand condition, cost and supply
condition and the extent of entry business in the industries.
1.Area Wise – In view of the space element or geographical area covered by the market, we
may enlist
i. Local markets – Markets pertaining to local areas are called local markets. When
commodities are bought and sold at one place or in one locality only, they have local
markets. Local markets have a narrow geographical coverage. It is confined to a
particular village, town or city only. Retail trading has a local market only. Perishable
goods like milk, vegetables, fruits, etc. are mostly sold in local markets. Tailoring
 shops, dispensaries, restaurants, coaching classes are confirmed to local markets. Goods
supplied only in local markets are usually produced on a small scale.
ii. Regional Markets – Goods are sold within a particular region. Films produced in
regional languages in India have their regional markets only. Textbooks sanctioned by
State Boards have a regional market.
iii. National Markets – Goods demanded and sold on a nationwide scale. Goods produced
by large scale industries tend to have national markets. Items – TVs, cars, scooters,
fans, cosmetics, etc. produced by big companies have national markets. A good network
of transport and communication and banking facilities help in promoting national
markets
iv. World Markets – Goods are traded internationally – Goods are exchanged between
buyers and sellers from different countries. In world market transaction, we use the
term “exports” and “imports” of goods. Multinational corporations have world markets
for their products. Export business is confined to world market. In geographical or
spatial consideration, trade and markets may also be broadly classified as (a) domestic
or internal and (b) international.
2. Markets Based on Time Elements
Time element – functional or operational time period pertaining to production processes and
market forces at work.
i. Very Short Period Market – It can be classified into daily (perishable products) or
weekly market (on specific day of week). It is which takes part in transactions for a
short period of time as for few hours or a day. In this supply of product cannot be
increased. Here it is physically impossible to change the stock of a commodity even
by a single unit further. The basic characteristic of a very short period market is that
that in this market, it’s not possible to make any adjustments in the supply to the
changing demand condition.
ii. Short Period Market – In this, supply of product can be increased, but we cannot make
any change in production plant according to changed demand. This is a functional time
period during which it is possible for a firm to expand output of a commodity to some
extent by changing the variable inputs such as labor, raw materials etc. under its fixed
plant size. The firm is in a position to make some adjustment in the supply in the
changing demand conditions.
iii. Long Period Market – We can make necessary changes in plant and machinery as
well increase supply of product according to its demand. This refers to a functional time
period which is sufficient to permit changes in the scale of production to a firm by
changing its plant size. Here the firm is in a position to make better and sufficiently
well and even full adjustments in supply to the changing demand conditions.
iv. Very Long Period Market – There can be a large change in supply of product, and
demand also increases because of change in population, habits, tastes, customs, etc.
 This is a secular time period which runs over a series of decades. During such a very
long functional time period, dynamic changes take place in demand and supply
situation. There can be perfect adjustment between demand and supply in the secular
period.
3. On the basis of Function
General Market – When different types of products are transacted at the same time. Ex –
Chandni chowk market in Delhi
Specialized Market – When only one product or any special product is transacted in market.
In this a particular thing is traded with its different brand names Ex. – Bathing soap as Lux,
etc.
Marketing by Samples – In this, the firms need not show whole of their product as they only
send samples through their agents. Ex. – in case of wool, paints, etc.
Marketing by Grading - In this the product is first graded according to its quality and then
put forth for selling
4. On the Basis of nature of Commodity (Product and Factor Market)
Analytically markets can be categorized into
1. Product market – a product market or commodity market refers to an arrangement in
effecting buying and selling of commodities. Ex. Cotton market, automobile market,
tyre market, etc.

• Markets for precious metals such as gold and silver are called the Bullion Exchanges
or Bullion Markets.

• Markets for capital change such as govt. securities bonds, shares, etc. are called Stock
Exchange.

• Markets for commodities are called Produce Exchanges.

2. Factor market – in factor markets factors of production such as land, labor and capital
are transacted. Ex. Labour market, land market, capital market.
5. On the Basis of Legality
Legal Market –Fair Market – In this market, the goods are purchased and sold on the price
fixed by the government and no other price can be charged by any seller.
Black Market or Illegal market – In this market, the seller charges a higher price than the
price fixed by the government. This price is taken by seller secretly. Also known as illegal price
or smuggling price.
6. Type of Market Structures formed by the nature of Competition
Usually the market structures are classified in accordance with the nature of competition among
the sellers which is viewed on the basis of 2 major aspects:
i. The number of firms in the market
ii. The characteristics of the products such as whether the product is homogenous or
differentiated.
Individual seller’s control over the market supply and his hold on price determination depends
basically upon these 2 factors.
On the selling side or supply side of the market, the following types of market structures are
commonly distinguished:
I. Perfect competition
II. Monopoly
III. Duopoly
IV. Oligopoly
V. Monopolistic competition
Among the different market situations, perfect competition and monopoly form the 2 extremes.
In between them we come across a number of market situations called imperfect markets where
we notice elements of competition as well as monopoly – they are duopoly (2 sellers) and
oligopoly (few sellers) and monopolistic competition (many sellers).

1) PERFECT COMPETITION
In perfectly competitive market, a single market price prevails for the commodity, which is
determined by the forces of total demand and total supply in the market. Under perfect
competition, every participant, whether buyer or seller, is a price taker, everyone has to accept
the prevailing market price, as individually no one is in a position to influence it.
Characteristics of Perfect Competition
The following conditions must exist for a market structure to be perfectly competitive. These
are the distinctive features of perfect competition
❑ Existence of very large number of buyers and sellers – A perfectly competitive
market will have large number of sellers and buyers. Output of a seller (firm) will be
so small that is a negligible fraction of the output of the industry. Hence changes in
supply made by a particular firm will not affect the total output and price. Similarly, no
one particular buyer can influence the price of the commodity because the quantity
purchased by him is small fraction of total quantity.
❑ Perfect knowledge of the market – All the sellers and buyers will have the perfect
knowledge of the existing market conditions, especially regarding the market price,
quantities and sources of supply. When there is such perfect knowledge, no buyer could
be charged a price different from the market price. Similarly, no seller would
unnecessarily lose by selling at a lower price than the prevailing market price. This way
perfect knowledge ensures transactions at uniform prices.
❑ Product Homogeneity – The commodity supplied by each firm in a perfectly
competitive market is homogenous – product of each seller is virtually standardized i.e.
there is no identification of the product of each seller, as there is no product
differentiation. Since each firm produces an identical product, their products can be
readily substituted for each other. Hence the buyer has no specific preference to buy
from a particular seller only. His purchase from any particular seller is a matter of
chance and not of choice on account of homogeneity of goods. Vegetables, fruits,
grains, metals, oil, energy goods, etc.
❑ Absence of transport cost element – It is essential that competitive position of no firm
is adversely affected by the transport cost differences. It is thus assumed that there is
absence of transport cost as all firms are closer to the market or there is equal transport
cost faced by all as all firms are equally far away from the market.
❑ Free entry and exit of firms – There is absolute freedom for firms to get in or get out
of the industry. If the industry is making profits, new firms are attracted into the
industry. Conversely, firms will quit the industry if there are losses. There is free entry
of new firms into the market. There is no legal (patent/licensing), technological (high
startup costs/technical knowledge), economic, or any other barrier (brand loyalty) to
their entry. The mobility of firms ensures that whenever there is scope in business, new
entry will take place and competition will remain always stiff. Due to natural stiffness
of competition, inefficient firms would have to eventually quit the industry.

❑ Government non-intervention – Perfect competition also implies that there is no

government intervention in the working of economy – there are no tariffs (charges),
subsidies, rationing of goods, control on supply of raw materials, licensing policy or
other governmental interference. Government non-intervention is essential to permit
 free entry of firms and for automatic adjustment of demand and supply through market
mechanism.

2) MONOPOLY
Monopoly - The word is derived from the Greek words monos (single) and polein (to sell). It
is a market structure in which there is only one seller. Monopoly controls the entire market
supply of a product. There are no rivals producing close substitutes and there are barriers to
entry of rival producers. The monopoly firm itself is an industry so its output constitutes the
total market supply. In a monopoly market, the seller (monopolist) is faced with a large number
of competing buyers. Being the sole supplier, he has strong hold over price determination.
Monopoly usually tries to set the price and output of his product aimed at profit maximization.
Features of Monopoly

• Existence of a single seller - There exists only 1 seller but there are many buyers

• Firm and industry are the same – There exists no differences between firm and
industry. The monopoly firm is the industry

• Entry Barriers - There are many entry barriers – natural, economic, technological,
legal which do not allow competitors to enter the market. So complete control of market
supply and price determination.

• Price Maker - A monopoly firm is a ‘price-maker’. Here the price is determined at the
discretion of the monopolist, since he has control over market supply.

• Absence of Substitutes - There are no close competitive substitutes for the product of
the monopolist, so the buyers have no alternative or choice (have to either buy the
product from him or go without it).
• Control over supply – They will have complete control over output and supply of
commodity

• Existence of supernormal profits - There will be place for supernormal profits (profits
in excess of normal profit TR>TC) under monopoly because market price is greater
than cost of production
Types of Monopoly
1. Pure Monopoly and Impure Monopoly

Pure Monopoly Imperfect Monopoly

Single firm controls the supply of Lacks absolute monopoly power in deciding
commodity which has no substitutes, not price and output policy
even a remote one.

Possess absolute monopoly – very rare Limited degree of monopoly. Degree is less than
perfect – it relates to availability of close
substitute.

Complete negation of competition Does not rule out possibility of competition.

Implies a treat of competition from rivals
producing remote substitutes

Referred to as absolute monopoly Referred to as limited or relative monopoly

2. Simple Monopoly and Discriminating Monopoly

Simple Monopoly Discriminating Monopoly

Charges a uniform price for its product Charges different prices for the same product to
to all buyers. different buyers.

Operates in a single market Operates in more than 1 market

3. Legal, Natural, Technological and Joint Monopolies – on the basis of deriving monopoly
power, monopolies are classified as
(1) Legal - Emerge on account of legal provisions like patents, trademarks, copyrights, etc.
Law forbids potential competitors to imitate the design and form of products registered under
the given brand names, patents or trademarks
(2) Natural - Natural advantages like good location, old-age establishment, involvement of
huge investment, business reputation, etc. confer natural monopolies on many firms.
(3) Technological - Technological expertise, economies of large scale, and efficiency of
superior capital use and process of mechanization, etc. confer technological monopolies to big
firms
(4) Joint - Through business combinations like trusts, cartels, syndicates, etc. some firms may
unite in a group and acquire joint monopolies in the market.
4. Private Monopoly and Public or Social Monopoly – Considering the nature of ownership,
monopolies may be grouped into (1) Private monopolies (2) public or social monopolies

Private Monopoly Public or Social Monopoly

Here an individual or private Here production is solely owned, controlled and

body controls a monopoly firm. operated by the state. Confined to nationalized
industries.

IMPERFECT COMPETITION
TYPES OF IMPERFECT MARKET
DUOPOLY
A true duopoly is a specific type of market structure wherein there are 2 sellers in the market.
Since this is rare, this definition is used generally where 2 firms have dominant control over a
market. Ex. Visa and Mastercard – control a large proportion of electronic payment processing
market.
This is a type of imperfect market, where there are 2 players. If the players are selling identical
products, each seller cannot ignore the price and output policies of the rival seller. In the event
of good understanding and mutual trust between the 2 sellers, competition can be avoided – to
establish a monopoly price (common price) situation in the market. However, if understanding
is absent, each seller tries to outwit the other, thus leading to cut throat competition or price
war. Consequently, price would fall, as each seller would want a greater share of the market.
When there is product differentiation, each seller may have his own customers for the product
and is not afraid of a rival in the market. However, each would try to out beat the other, would
come up with further value adds instead of price war.

OLIGOPOLY MARKET
Oligopoly refers to the market structure where there are few sellers (more than 2 but not too
many) in a given line of production – can be homogeneous products (Pure Oligopoly) or have
product differentiation (Differentiated Oligopoly). Ex. Automobile, manufacturing of electrical
appliances, etc.
Features of oligopolistic market

• Few Sellers – There are few sellers supplying either homogeneous products or
differentiated products.
• Homogenous or distinctive product - Maybe selling a homogenous product ex.
Steel/Aluminum/Copper. These can be unique or distinctive product- ex. Automobile
– passenger car

• Blockaded entry and exit – Firms in this market face strong restrictions in entry and
exit

• Imperfect dissemination of information – Detailed market information relating to

cost, price and quality are usually not publicised
• Interdependence – They have a high degree of interdependence in their business
polices about fixing price and determination of output

• High cross elasticities – They have a high degree of cross elasticities of demand for
their product, so there is always a fear of retaliation by rivals. Each firm consciously
considers the possible action and reaction of the competitors while making changes in
the price or output.

• Advertising – Advertising and selling costs have strategic importance to oligopoly

firms. Each firm tries to attract consumers towards its products by incurring excessive
expenditure on advertisements.

• Constant struggle – Competition is of unique type in oligopolistic market.

Competition consists of constant struggle of rivals against rivals.
• Lack of uniformity in the size of the different oligopolies is also a remarkable
characteristic.

• Lack of certainty – The firms have 2 conflicting motives – (1) to remain independent
in decision making (2) to maximise profits, despite the high degree of interference
among rivals in determining their course of business. To pursue these ends, they act
and react to price output variation of one another in an unending atmosphere of
uncertainty.
 • Price rigidity – Each firm sticks to its own price. This is because it is in constant fear
of retaliation from rivals if it reduces the price. It therefore resorts to advertisement
competition rather than price cut. Hence there is price rigidity.

MONOPOLISTIC COMPETITION
Monopolistic competition refers to the market structure in which there are a large number of
small sellers that sell differentiated products which are close but not perfect substitutes for one
another. Products produced and sold are different but close substitutes for one another. Leads
to competition (“mini-monopolists”).
It is a blend of monopoly and competition. It is similar to perfect competition in that it has a
large number of sellers, but its dissimilarities lie in product differentiation. In perfect
competition, goods are homogenous or identical while in monopolistic competition products
are differentiated through trademarks, brand names etc. Product differentiation confirms a
degree of monopoly to each seller in a market under monopolistic competition.
In this market, many monopolists compete with each other on the selling side. There are a large
number of buyers too, but each buyer has preference for a particular seller or a brand of the
product in the market.

Characteristics of monopolistic competition

• Large number of sellers – A market organization characterized by monopolistic
competition must have a sufficiently large number of sellers or firms selling closely-
related but not identical products. The large number of firms in the same production
line leads to competition. Since there is no homogeneity of good supplied, competition
tends to be impure but keen. The number of firms being relatively large, there are less
chances of collusion of business combines to eliminate competition and to rig prices.
Another impact of large number is that a relatively small percentage of the total market
is shared by individual firms. An individual firm’s supply is just a small part of the total
supply so that it has a very limited degree of control over the market price. Once an
equilibrium point has been set in a particular line of production, the new entrant has to
follow it, though not strictly but in the vicinity of that range. However, in determining
the course of its own price and production policy, each firm can afford to ignore the
rival’s reaction. Because as there are large number of firms, the impact of one firm’s
action upon all rivals will tend to be too insignificant to cause any reaction among
rivals. It can adopt an independent price and production policy (Distinguishes it from
perfect competition). Its independence is attributed to the degree of product
differentiation it adopts.
• Product Differentiation - Here the firm commodities which are similar to one another
but not identical or homogenous, the product of each seller is branded and identified,
ex. Toothpastes, cigarettes, shoes, etc.
• Large number of buyers - There are a large number of buyers in this type of market.
However, each buyer has a preference for a specific brand of the product (brand
 loyalty). The firm becomes a patron of a particular seller. Buying here is by choice and
not by chance.

• Free Entry and Exit – Each firm produces a very close substitute for the existing
brands of a product. Thus, differentiation provides ample opportunity for the firm to
enter with their own brand names. On the contrary, if the firm faces the problem of
product obsolescence, it may be forced to go out of the industry.

• Selling cost – All those expenses which are incurred on sales promotion of a product
are called selling costs. Chamberlin – “selling costs are those which are incurred by the
producers (sellers) to alter the position or shape of the demand curve for a product.”
Selling costs represent all those selling activities which are directed to persuade buyers
to change their preferences so as to maximize the demand for a given commodity. They
include expenses on sales depots, decoration of the shop, commission given to
intermediaries, window displays, demonstrations, exhibitions, printing and distributing
pamphlets, radio, T.V., newspaper advertisements, etc.

• Two-dimensional competition – (1) Price competition – the firms compete with each
other on price issue (2) Non-price competition – this is in terms of product variation
and selling costs incurred by each seller to capture his share in the market and expand
his sales.

• Market is characterized by imperfections (No perfect knowledge) – May arise due

to advertisements, differences in transport cost, ignorance of availability of different
brands of products and prices of products, etc. Sellers may have inadequate knowledge
about market and prices existing at different segments of the markets.

THEORY OF PROFIT MAXIMISATION: CONDITION

FOR EQUILIBRIUM OF A FIRM
MEANING OF PROFIT MAXIMIZATION
In determining the equilibrium of a firm, it is assumed that the firm aims to
maximization of its profits. This assumption is fundamental to the analysis of a firm’s
behaviour whose entrepreneur is assumed to act rationally.
Profit is excess of firm’s total revenue of sales proceeds of a given output over its cost
of production.
P=R-C where P = profit R=total revenue C= total cost
When R > C, then R-C is positive, = profit; when R<C, then R-C is negative = loss.
This is accounting interpretation of profits
Economist calculation of total cost – includes explicit as well as implicit costs. In
managerial economics, 2 interpretations of profit are
1. Economic profit = Total Revenue – Total Economic Cost
 Total Revenue - (Total Explicit Costs + Total Implicit Costs)
2. Accounting profit = Total Revenue – Explicit total cost
Economists have 2 distinct notions of profit – (i) normal profit (ii) supernormal profit.
Normal Profit – Normal profit is the minimum reasonable level of profit which the
entrepreneur must get in the long run, so that he is induced to continue the employment
of his resources in its present form. Normal profit is the opportunity cost of the
entrepreneur. If the entrepreneur does not earn the normal rate of profit in the long run,
he will close down the operation of his firm and quit the industry in order to shift his
resources elsewhere.
Normal profit is always regarded as part of factor costs. Since entrepreneurial service
is a factor of production, the price paid for it is the normal profit and it is to be
incorporated while calculating total cost. In the economic sense, when total cost (C) is
measured it also covers the normal profit of the firm. As such when R=C it is inferred
there is no profit. In the economic sense, though there is no pure business profit, there
is normal profit which is embedded in the total cost.
Supernormal Profit – Profits in excess of normal profit are considered supernormal.
Since normal profit is included in the cost of production, supernormal profit is obtained
when total revenue exceeds total costs (TR>TC) also called pure business profit or
“excess profit.”

Equilibrium of a firm
A firm is said to be in equilibrium when it has no inclination to expand or contract its
output. It will reach its equilibrium when it maximizes the difference between total
revenue and total cost. Conditions of equilibrium
1. Its profit should be maximum
2. MC = MR
3. MC curve cuts MR curve from below (and rises up).
EQUILIBRIUM
The term equilibrium is borrowed from physical science. It is used to describe a position
of even balance between the opposite forces neutralising their effects on motion. It
implies a position of rest or state of balance or no change. But it does not imply that
there is no activity.
In economics, it implies movement or activity, but this movement is regular smooth,
and constant. The equilibrium position is free from violent fluctuations, frequent
variations and sudden jerks and jolts. There is no element of uncertainty. At this point
of equilibrium, an economic unit is maximising its benefits. For ex. At the point of
equilibrium
 • A consumer is maximising his satisfaction,
• A producer is maximising his profits,

• A firm or industry is maximising its output with minimum costs and maximising profits
etc.
These economic units are carrying on their productive activities smoothly without any
interruptions. Hence it is described as the most comfortable position of an economic
unit. Always there is a tendency for economic units to move towards the equilibrium
position and once they reach this position, they have no tendency to move away or
deviate from it.
The objective of attaining equilibrium position is the ultimate objective of all economic
units.

PRICE-OUTPUT DETERMINATION UNDER PERFECT

COMPETITION, MONOPOLY, MONOPOLISTIC MARKET.
PRICE DETERMINATION UNDER PERFECT COMPETITION
Under a perfectly competitive market, the market price is not fixed either by the buyer,
seller, firm, industry or government. It is only the market force i.e., the demand and
supply which determines the equilibrium price of the product.
We can explain how price is determined in the market by the interaction of demand and
supply with the help of the following schedule.

Possible Price Total Demand Total Supply State of the Pressure on

(Rs./kg) (Kg/week) (kg/week) market Price

20 1,000 10,000 Surplus S>D Downward

19 3,000 8,000 Surplus S >D Downward

18 4,000 6,000 Surplus S>D Downward

17 5,000 5,000 Equilibrium Neutral

S=D

16 7,000 4,000 Shortage D >S Upward

Comparing the market demand and supply position at alternative possible prices, we
find that when the price is Rs. 20, supply of wheat is 10,000 kg, but demand for wheat
is only 1,000 kg, hence 9,000 kg of wheat remains unsold. This would bring a
downward pressure on price, as the seller would compete and the force will push down
the price.
When the wheat falls to Rs. 19, demand rises to 3,000, while the supply contracts to
8,000 kg. Still the supply is in excess of demand. This causes a further downward
pressure on price and the price will tend to fall. This process continues till the price
settles at Rs. 17/kg at which the same amount i.e., 5000 kg is demanded as well as
supplied. This is termed as the equilibrium price. It is the market clearing price. In this
price, market demand tends to be equal to the market supply.
If, however, we begin from the low price (Rs.15/kg), we find the demand 10,000 kg
exceeds the supply 2,000 kg. Thus, there is a shortage at Rs. 15/kg. This causes an
upward pressure on the price, so price will tend to move up. When the price rises, the
demand contracts and the supply expands. This process continues till the equilibrium
price is reached. Here, the demand becomes equal to the supply. At equilibrium price,
there is neutral pressure of demand and supply as both are equal in quantity.

Market Price Determination

In general, a pictorial depiction of price, is determined at the intersection point of the

demand curve and supply curve. At point E, the demand curve intersects the supply
curve. In figure, E indicates OP as equilibrium price and OM as equilibrium output.
The price at which demand and supply are equal is known as equilibrium price. The
quantity bought and sold at equilibrium price is known as equilibrium output
To understand the process of equilibrium, suppose the price is not at equilibrium point.
Now if the price is higher than the equilibrium point price as OP1, then at this price,
the supply is P1b while demand is P1a. Thus, there is surplus amounting to ab i.e., more
is offered for sale than what the people are willing to buy at prevailing price. Hence, to
clear the stock of unsold output, the competing sellers will be induced to reduce the
price. Eventually, a downward movement and adjustment as shown by the downward
pointed arrows will begin which would lead to
 (1) The contract of supply as firms will be prompted to reduce their resources in the
industry and
(2) The expansion of demand as the marginal buyers and other potential buyers will be
attracted to buy in the market and old buyers also may be induced to buy more at the
falling price.
If the price is below the equilibrium point price at OP2, the demand is P2d and supply is P2c.
Thus, there is a shortfall of supply amounting to cd i.e., buyers want to purchase more than
what is available in the market at the prevailing price, so an upward push and adjustment will
develop as shown by the arrows pointed upward. Thus the demand contracts as marginal buyers
will be driven away from the market and some buyers will be less than before. On the other
hand, supply expands as the existing firms will increase their output to which new firms will
also add their output.
Evidently, when the price is set at an equilibrium point at which the demand curve intersects
the supply curve, shortages and surpluses will disappear and there will be perfect adjustment
between demand and supply under the given conditions. So long as demand and supply
positions are unchanged, the ruling equilibrium price will prolong over a period of time.

Short Run Equilibrium of the Competitive Firm

The competitive firm is a price taker. It has to accept the market determined price for the
product, it can decide only about the quantity of the product. The firm decides only about the
equilibrium level of the output.
Under the objective of profit maximization, the firm will produce that level of output which
maximizes the profit. The behavioral rule of profit maximization is to equate marginal revenue
with marginal cost. Profit is maximized when MR=MC. Obviously then how much a
competitive firm will produce in the short period depends on its short run marginal cost and
the prevailing market price (since under perfect competition Price = MR in the short run)
To determine the equilibrium level of output at a given price in the short run, the firm compares
its short run marginal cost (SMC) with the short run marginal revenue (SMR) of the product.
The SMR of the firm depends on the price of the product. The competitive price is a market
determined phenomenon.
The short run equilibrium price is determined in the market by the intersection of the short
period demand and short period supply curves as can be seen in the figure.
SHORT RUN PROFIT

The short run equilibrium price is determined in the market by the intersection of the short
period demand and short period supply curves as can be seen in the figure.
At this short run price, the firm obtains its revenue functions from the demand curve for its
products. From the firm’s point of view, the demand for the product is perfectly elastic. Thus,
at the short period market price OP in our illustration, the demand curve SRD is a horizontal
straight curve corresponding to which the short run average revenue (SAR) and the short run
marginal revenue (SMR) are depicted.
Along with this, the SAC and SMC are drawn for comparison. The equilibrium point is
determined by the intersection of the SMC curve from below so that SMC =SMR. In the figure
E is the equilibrium point at which SMC curve intersects SMR curve from below.
Consequently, OQ is the equilibrium level of output determined by the firm in the short run.
Since areas under the respective average revenue and cost curve measure total revenue and
total costs the differences between the two show profit. The shaded area PEAB represents the
maximized profits (Supernormal profits).
RELATIONSHIP BETWEEN PRICE AND REVENUES UNDER PERFECT
COMPETION

Price i.e. Average Total Revenue Marginal

Q Revenue (TR=PQ) Revenue
(P=AR) (MR)

1 250 250 250

2 250 500 250

3 250 750 250

4 250 1000 250

5 250 1250 250

REVENUE CURVE

A firm under perfect competition is a price taker. It sells its output at the prevailing market
price over a period of time. Thus price is constant in a competitive firm’s model. Assuming a
given price, from a revenue schedule of firm, we can trace the unique relationship between
price, TR and MR.
Under conditions of perfect competition, a firm’s MR and AR will be identical and constant.
Since price is constant, AR is also constant. Since price is unchanged, for each additional unit
sold, the same addition is made to TR; therefore, MR also remains constant. MR is same as P
or AR. Therefore, in the case of a firm operating under conditions of perfect competition, its
AR and MR curves will form one identical curve parallel to the x-axis or the quantity axis. In
such a case, where AR i.e., price, remains constant, the AR curve will be a horizontal straight
line parallel to the x-axis. The slopes of AR and MR curves are zero, so both curves coincide.
TR increases at a constant rate (since MR is constant) as the units of output sold increase. The
TR curve moves upwards to the right but its slope is constantly positive at 45 degrees level. It
thus implies that revenue increases in the proportion to the output sold.
Under perfect competition, TR slopes upwards at a given price at 45 degrees level. AR and MR
curves horizontally coincide.
The Short Period Equilibrium of the Industry
An industry is in equilibrium in the short run when there is no tendency for the total output to
expand or contract. When the following 3 conditions are satisfied, an industry will be in
equilibrium:
1. The individual firms comprising the industry have no tendency to vary their output.
This means when each individual firm produces output at which MR=MC, at the
prevailing price, no existing firm will vary its output i.e., all existing firms must be
producing an equilibrium level of output.
2. It is not necessary that each firm in the industry should be earning normal profits in the
short run. Some firms may be earning normal profits, some supernormal profits or even
some may be incurring losses depending on their cost functions. This means firms
making supernormal profits and maximum losses can co-exist along with the short run
equilibrium of the industry.
3. The short period market price and its determining factors viz. short period demand and
short period supply are in equilibrium. When the total quantity demanded is equal to
the total quantity supplied at the equilibrium short run market price, the market is
cleared, so there is no reason for the market price to change in the short run. Thus the
market and all firms in the industry attain short run equilibrium at this price.
 SHORT RUN EQUILIBRUM OF FIRM AND INDUSTRY

In figure, Panel (A) curve SS represents short run industry supply and DD represents short run
industry demand. Both the curves intersect at E determining OP as the short run equilibrium
price at which OQ is the quantity demanded equal to the quantity supplied in the entire market.
At this price, industry is in equilibrium.
The firms are also in equilibrium by equating MR with MC but they may be making profits or
losses as in panels B and C respectively.

Long Run Equilibrium of the Firm

For attaining equilibrium, the same principle of equalizing MR with MC (MR=MC) is applied
in the long run. Thus the firm has to set its long run costs with price and revenues.
In the long run since the firm can adjust its output by changing the scales of plant, the long run
average cost curve is disc shaped. But the competitive firm’s demand curve being perfectly
elastic at a given long run market price, the LMR(=LAR) curve would be a horizontal straight
line. The firm would produce that level of output at which LMR = LMC so that its profits are
maximized. In other words, in the long run, the firm adjusts its output and scales of its plant so
as to equate LMC with price
In the figure, panel (A) represents the market demand and industry’s supply position of a given
product in the long run; panel (B) represents a given firm’s LAC and LMR at various P1P2,
etc.
The firm is a price taker and the market price in the long run (the normal price) is determined
by the intersection of the demand curve DD and supply curve SS of the industry.

Initially suppose S1S1 is the supply curve which intersects the DD curve so that OP1 is the
equilibrium price. At this price, the firm gets LMR1 curves which intersect the LMC curve at
point E1. The firm produces OQ1 of output. At this point, the firm gets excess profits since
LAR >LAC the amount of excess profit earned is denoted by the shaded area P1E1AB.
As such, some new firms are attracted to the business. Because when a firm in the long run
gets pure excess profit, it means that relatively there is a small number of firms in the industry
as compared to the industry’s total demand for the product. When the new firms enter the
industry under consideration, the supply of the industry increases so that the supply curve shifts
to the right. Then the long run equilibrium price will obviously decline with increase in supply,
the demand being unchanged. With the fall in price, the firm contracts its output also, and
obviously its excess profits will decline. But still the firms may yield some excess profits. This
continues to provide an attraction to new producers who enter the industry.
When more new firms enter, the supply curve shifts further downwards to the right. Now the
supply curve may become SS when it intersects the demand curve DD, OP price is obtained.
The firm readjusts its output with the falling price at OP. Now the firm produces OQ level of
output at which LMR=LMC. But at this point LAC=Price. Hence the firm gets only the normal
profit. The attraction for the new firm now ceases.
If the supply curve would have shifted further to S2S2, then the price would have been OP2.
Then the firm would have attained temporary equilibrium point E2. But the firm at this point
incurs losses. The firm in the long run must cover its full costs and should get normal profit. If
it cannot, it has to quit the industry. When some firms due to excessive supply in the industry,
find it difficult to carry on, they may quit as their plants wear out, or shift to another industry.
If this happens, then the supply curve starts shifting to the left, showing a decrease in supply.
When it moves back to SS, the equilibrium normal price OP is obtained. At this position, the
firm will find itself in a stable condition and will not change its output any further in the long
run.
Thus, under perfect competition, long run equilibrium is attained when the number of firms is
so adjusted that an individual firm can get neither excess profit nor suffer any loss, but only
normal profit. This occurs at a point where the long run equilibrium price is equal to minimum
LAC. The long run full equilibrium position of a typical representative firm is therefore
redrawn as can be seen.
LONG RUN FULL EQUILIBRIUM

In panel (A), the firm earns just normal profit under the full equilibrium conditions of the long
run, thus P=LAR=LMR=LAC=LMC {Therefore only normal profit.}
Panel B shows that long run Price = LMC=LMR=LAC=SAC=SMC
Since LMC intersects LAC at the minimum point, LMC=LMR=Price is possible only if the
firm operates at the minimum point of the AC curve in the long run i.e. when it produces the
least cost output. A firm in the long run must operate at this minimum point.

Equilibrium of the Industry in the Long Run

The equilibrium in a perfectly competitive industry is established under the following
conditions:
1. Industry being a collection of firms, for an industry to be in long run equilibrium, all
existing firms in the industry must be producing an equilibrium level of output by
equating the long run marginal cost with the long run marginal revenue (LMC=LMR).
Aggregate of their output constitutes the total supply of the industry.
2. The number of firms in the industry must be stable. There should be no entry of a new
firm. Neither there is exit of any from the existing ones. This requires that all existing
firms must be earning normal profits. This happens when all the firms have Price or
LAR=LAC {Unless all firms are earning just normal profits, industry will not attain
stable equilibrium in the long run. Because if some firms are earning excess profits, it
 would encourage new entrants in the industry which will lead to changes in the industry
supply and market prices in the long run. It is essential that all firms must earn normal
profits in the long run so that the industry attains an equilibrium position.}
3. The long equilibrium price is established so that total quantities demanded and supplied
in the long run are equal and the market is cleared off. The long run equilibrium of the
industry is portrayed in fig.
INDUSTRY’S AND FIRM’S EQUILIBRIUM IN THE LONG RUN

In the figure, the long run price OP is determined by the intersection of the long run supply
curve S and demand curve D. At this price, the firm’s equilibrium is determined by equating
LMR=LMC. Thus OM is the equilibrium output of the firm in the long run. There is a full
equilibrium position Price = LAR= LMR= LAC=LMC. As such the firm enjoys normal profits.
It follows that when all the firms are in equilibrium, and all of them earn normal profits, or
their number being stable, the market supply position becomes stable in the long run and under
the given demand condition (D in fig/ Panel A), the long run equilibrium price (OP) is
established making industry in the long run equilibrium. The firms under homogeneity
conditions are identical- having identical cost functions so they must be operating at minimum
point of LAC (see fig B). Those firms which are inefficient so that their cost functions are at a
higher level i.e. LAC price, have to quit the industry in the long run as they fail to earn normal
profits and losses are not sustainable by them.
To sum, industry and firm’s equilibrium conditions in the long run are Long Run Equilibrium
Price = LAR=LAC=LMR=LMC.
PRICE –OUTPUT DETERMINATION – MONOPOLY
Monopoly Equilibrium in the Short Run: How a Monopolist Determined Price and
Output
To examine the equilibrium price and output determination of a monopoly firm, we must
assume:

• There is only one single firm in the market facing many buyers/ The firm controls the
entire market, there are no substitutes for its product/ There are entry barriers, so
competition from rivals is not possible
 • Demand curve is downward sloping. AR&MR for different quantities of output are
measurable at alternative prices

• Monopoly firm itself is the industry – it is price maker

• The firm attempts to maximise profits.
In such a situation, the firm has to make 2 decisions
i. To determine the price for its product
ii. To determine the equilibrium /optimum level of output.
In view of the downward sloping demand curve, however, these 2 decisions are interdependent.
The firm cannot determine both price and output separately. Either it can decide a price on the
given demand curve and sell the amount demanded by the buyers in the market. Alternatively,
the firm can determine the level of output and has to set the price as per the demand condition.
It cannot have independent decisions about both the price and quantity of output. The firm can
either decide the quantity or price but not both as per his choice.
The monopolist is interested in profit maximisation. So the firm follows the behavioural rule
of equating the marginal cost with the marginal revenue by which profit is maximised. The
monopolist in the short run to maximise profits would produce the level of output at which
short run marginal cost is equal to short run marginal revenue (SMC=SMR).
RELATIONSHIPS BETWEEN PRICE AND REVENUE UNDER MONOPOLY

Output Price TR AR MR (MR=

(TR=PQ) (AR=TR/Q) TRn-Trn-1)
or P=AR

1 25 25 25/1= 25 25

2 24 48 48/2= 24 23

3 23 69 69/3= 23 21

4 22 88 88/4= 22 19

5 21 105 105/5= 21 17

6 20 120 120/6= 20 15

7 19 133 133/7= 19 13
A monopolist has complete control over the market supply and can determine his product’s
price. A monopolist can sell more only by lowering the prices. Price is AR. AR tends to decline
as price declines at each level of increase in output Obviously the TR increases at a diminishing
rate as price (=AR) tends to decline. MR also decreases and it will be less than AR (price) at
all output levels. It can be observed that MR<AR. Again, data assumed here are linear, so
when AR or price falls the MR falls at twice the rate of fall in price. Geometrically this typical
relationship between AR and MR of a monopoly firm is represented through their respective
curves.
Under monopoly, firm’s demand curve represents its revenue curve. AR curve slopes
downward. MR curve lies below it. In figure, AR is linear demand curve as well as average
curve. MR is the marginal revenue curve, which is obviously linear. It can be seen that since
the AR curve has a downward slope, the MR curve too slopes downwards. MR curve lies below
or to the left of the demand or AR curve. This implies that the MR of any monopoly output is
less than its price
SHORT RUN MONOPOLY EQUILIBRIUM

In graphical terms, the crucial conditions for the short run monopoly equilibrium are thus:
The intersection point between SMR and SMC curves.
The SMC curve cuts the SMR curve from below and SMC curve must be rising.
Once the equilibrium or optimum level of output is decided by the monopolist, the price is to
be set in relation to the demand position. He cannot determine price independent of the market
demand.
A monopoly firm equates MC with MR and determined equilibrium output. Price is determined
in view of demand or average revenue.
This point is made clear in figure.

• In figure the equilibrium point E is determined by the intersection of the SMR curve
and the SMC curve, so that SMC=SMR.

• OQ is the equilibrium output by the firm.

• The firm can sell this output only at price OP. Price is determined by drawing a
perpendicular AQ which intercepts demand curve (SAR curve) at point A.

• In this illustration, monopoly profit for output OQ at price OP is PABC

Evidently once the output is decided, price is determined correspondingly in relation to the
given demand curve. Alternatively, if the monopolist fixes the price, the output will be
determined accordingly. But for profit maximisation, he adopts the rationale of equating MC
with MR and the process of adjustment is easily described graphically.
Anyway, though a pure monopolist has full control over the market supply, the firm cannot
determine price independently of the market demand for his product. Thus, when equilibrium
output is decided at the point of equality between MC and MR, the price is automatically
determined in relation to the demand for the product.
In the figure, the firm will not charge higher than OP, because if it does so, it will not be able
to sell OQ output. The firm would not like to lower the price either because that will reduce its
profit margin. Thus, when OP price is charged OQ output is sold, the monopolist obtains
maximum profit which is represented by the shaded rectangle PABC. This is termed as
monopoly profit and it is over and above the normal profit which is already estimated in the
total costs of the firm.
Another important point that must be observed in the diagram is that the monopolist is in
equilibrium on the elastic segment of his demand curve (AR curve). Secondly the monopoly
output is determined at the falling path of the AC curve, which means he restricts output before
producing it at the optimum level of minimum average cost in order to maximise his profits.
LONG RUN MONOPOLY EQUILIBRIUM
A monopolist in the long run will continue to earn supernormal profits; however, the
monopolist will have phases of normal profits also. In the figure, the LAC is tangent to LAR.
At this point, profit maximisation conditions are fulfilled (because corresponding when you
drop the perpendicular down to x axis, we will get LMC=LMR and LMC intersects LMR from
below). At this quantity the monopolist is neither making supernormal profit nor a loss. As
seen in the diagram, the price (or AR) and the AC is the same.
There is a deliberate attempt by the monopolist to show normal profits, this is to avoid
government interference and entry of new players. Therefore a monopolist will have both the
phases of supernormal and normal profits in a long run.
LONG RUN MONOPOLY EQUILIBRIUM

A monopolist in the long run will continue to earn supernormal profits; however, the
monopolist will have phases of normal profits also. In the figure, the LAC is tangent to LAR.
At this point, profit maximisation conditions are fulfilled (because corresponding when you
drop the perpendicular down to x axis, we will get LMC=LMR and LMC intersects LMR from
below). At this quantity the monopolist is neither making supernormal profit nor a loss. As
seen in the diagram, the price (or AR) and the AC is the same.
There is a deliberate attempt by the monopolist to show normal profits, this is to avoid
government interference and entry of new players. Therefore a monopolist will have both the
phases of supernormal and normal profits in a long run.

Monopoly equilibrium with a loss

A monopolist may be operating at a loss in the short run. In fig, equilibrium point E is
determined by the intersection of MR curve with SMC curve. Producing OQ equilibrium output
which is to sold at OP price, the firm incurs loss AR per unit failing to recover full AC Area
PABC measures total loss.
In the long run, when the monopolist finds that the demand condition is such that he cannot
cover up LAC nor is it possible to lower the cost function he quits (fig 5.11) LAC is above
LAR therefore unbearable loss. LAC curve is above LAR curve, therefore any equilibrium
position such as E, suggests that there is a permanent loss to the firm, it must quit.
Benefits of Monopoly
❑ Workers may benefit – workers will tend to be better off when the monopoly profits
are shared with them by providing better working conditions and facilities.
❑ Growth of R&D- Research and Development may be facilitated by reinvestment of a
part of the monopoly markets. Ex. Monopolist pharmaceutical companies – huge profits
– drug research resulting in new and better drugs.
❑ Innovation and growth initiation – High concentration of economic power or large firm
size may be more conducive to a higher rate of innovation.
❑ Economies of scale and scope – can be realized through production of innovation
❑ Availability of Finance – Can easily arrange for financial requirement of R&D through
internal as well as external sources
❑ Contribution to public revenue – Government can obtain good revenues through high
corporate rate taxes imposed on monopoly profit earnings of the firm.

PRICE DISCRIMINATION
❑ A monopoly firm adopting the policy of price discrimination is referred to as
Discriminating Monopoly.
❑ It implies the act of selling the output of the same product at different prices in different
markets or to different buyers.
FORMS OF PRICE DISCRIMINATION
❑ Personal Discrimination – Depending on the economic status of the buyers – for ex.
A surgeon may charge higher operation fee for rich patients and lower fees for poor
patients.
❑ Age Discrimination – Price discrimination may be based on age of the buyers – for ex.
In railways and bus transport services – persons below 12 years of age are charged at
half the rates
❑ Sex Discrimination – In selling some goods, producers may discriminate between male
and female buyers by charging low prices to females for ex. A tour organizing firm may
provide seats to ladies at concessional rates.
❑ Locational or Territorial Discrimination – When a monopolist charges different
prices in different markets located at different places for ex. A film producer may sell
distribution rights to different distributors in different territories at different prices. A
firm may discriminate between domestic and export markets for its products
❑ Size discrimination- on the basis of size or quantity, different prices may be charged.
For ex. A product sold in the retail market at a higher price than the wholesale market
by the producer
❑ Quality variation discrimination – on the basis of some qualitative differences,
different price may be charged for the same product. For ex. A publisher may sell a
deluxe edition of the same book at a higher price than its paperback edition.
❑ Special service or comforts – price discrimination may also be resorted to on the basis
of special facilities or comforts. Railways charge different fares for the first- and
second-class travel
❑ Use Discrimination – Sometimes depending on the kind of use of the product, different
rates may be charged. For ex. different rates may be charged for consumption of
electricity for lighting and productive purposes in industry and agriculture.
❑ Time Discrimination – on the basis of time of service, different rates may be charged.
For ex. Cinemas may charge lower rates for admission for morning shows than for
regular shows.
❑ Distance – Railway companies and other transporters for e.g. - charge lower rates per
km if the distance is long and higher rates if distance is short.
❑ Nature of commodity discrimination – sometimes because of nature of commodity,
price discrimination may be made, for ex. Freight charges by the railways are different
for coal and iron for the same distance.
❑ Convenience of the buyer – if the buyer is in a hurry, more price would be charged.
Otherwise normal price would be charged
❑ Peak-off and peak services – Hotel and transport authorities charge different rates
during peak season and off-peak season.
❑ Geographical area – business enterprises may charge different prices at the national
and international markets. For ex. Dumping – charging lower price in the competitive
foreign market and higher price in protected home market.
*** DUMPING – The practice of discriminating monopoly pricing in the area of foreign
trade is described as “dumping”. It is considered as a form of price discrimination. It occurs
when a manufacturer lowers the price of an item entering a foreign to a level that is less
than the price paid by domestic customers in the originating country. The practice is
considered intentional with the goal of obtaining a competitive advantage in the importing
market. Ex. Japan sold consumer electronics at high prices in its own country. This is
because it has no foreign competition. But it lowered prices in the US markets in order to
maintain market share.

Kinds of Price Discrimination

Prof. A.C. Pigou speaks of three kinds of price discrimination
1. First-Degree Price Discrimination – Here the producer exploits the consumers to the
maximum extent by asking him to pay the maximum he is prepared to pay rather than
go without the commodity. In this case, the monopolist will not allow any consumers
 surplus to the consumer. The entire consumer surplus is converted into producer surplus
(monopolist revenue and profits). This type of price discrimination is called perfect
discrimination. In practice, a consumer’s maximum willingness to pay is difficult to
determine. Therefore such a pricing strategy is rarely employed
2. Second-Degree Price Discrimination – The monopolist charges different prices for
different units of the same commodity – it occurs when a company charges a different
price for different quantities consumed such as quantity discounts on bulk purchases.
Here the consumer is charged not at the maximum possible rate he would be willing to
pay but at a lower rate. The monopolist will leave a certain amount of consumers surplus
with the consumers.
3. Third-Degree Price Discrimination – Here the markets are subdivided into sub
markets or sub groups. It involves charging different prices depending on a particular
market segment or consumer group. This is the most common type of discrimination
followed by a monopolist. The price varies according to consumer attributes such as
age, sex, location, time of use and economic status. Ex. Pensioners get discounted bus
and train tickets, night club may offer discount for female consumers on certain nights,
discounts given to students., splitting the market into peak and off peak, a theatre may
divide movie goers into seniors, adults and children each paying a different price when
seeing the same movie.
SELLING COSTS
Expenditure incurred by a firm on advertising and sales promotion of its product is known
as selling costs. It includes the following:

• Advertising and publicity expenditure of all sorts

• Expenses of sales departments such as commissions and salaries of sales manager, sales
executives and other staff.

• Margins granted to dealers in order to increase their efforts in favour of particular goods
• Expenses for window displays, demonstration of goods, free distribution of samples,
etc.
Economists define selling costs as costs incurred in order to alter the location or shape of
the demand curve or sales curve of a product. The effect of advertising expenses is to shift
the demand curve for a given product to the right by making known to the prospective
buyers its availability, by describing it, and by suggesting the uses it can be put to. Briefly,
the aim of any producer, who incurs advertising expenses, is to sell a larger output at a
given price that what he can sell in the absence of these costs.
Sales promotion is based on 2 important factors
1. Imperfect knowledge on the part of the consumers
2. The possibility of changing their wants through advertising or selling appeal.
PRICE-OUTPUT DETERMINATION UNDER MONOPOLISTIC
COMPETITION: EQUILIBRIUM OF A FIRM

In monopolistic competition, since the product is differentiated between firms, each firm does not
have a perfectly elastic demand for its products. In such a market, all firms determine the price of
their own products. Therefore, it faces a downward sloping demand curve. Overall, we can say
that the elasticity of demand increases as the differentiation between products decreases.

Fig. 1 above depicts a firm facing a downward sloping, but flat demand curve. It also has a U-
shaped short-run cost curve.

Conditions for the Equilibrium of an individual firm - The conditions for price-output
determination and equilibrium of an individual firm are as follows:

1. MC = MR

2. The MC curve cuts the MR curve from below.

In Fig. 1, we can see that the MC curve cuts the MR curve at point E. At this point,

• Equilibrium price = OP and

• Equilibrium output = OQ
Now, since the per unit cost is BQ, we have

• Per unit super-normal profit (price-cost) = AB or PC.

• Total super-normal profit = APCB

The following figure depicts a firm earning losses in the short-run.

From Fig. 2, we can see that the per unit cost is higher than the price of the firm. Therefore,

• AQ > OP (or BQ)

• Loss per unit = AQ – BQ = AB

• Total losses = ACPB

Long-run equilibrium

If firms in a monopolistic competition earn super-normal profits in the short-run, then new firms
will have an incentive to enter the industry. As these firms enter, the profits per firm decrease as
the total demand gets shared between a larger number of firms. This continues until all firms earn
only normal profits. Therefore, in the long-run, firms, in such a market, earn only normal profits.
As we can see in Fig. 3 above, the average revenue (AR) curve touches the average cost (ATC)
curve at point X. This corresponds to quantity Q1 and price P1. Now, at equilibrium (MC = MR),
all super-normal profits are zero since the average revenue = average costs. Therefore, all firms
earn zero super-normal profits or earn only normal profits.

It is important to note that in the long-run, a firm is in an equilibrium position having excess
capacity. In simple words, it produces a lower quantity than its full capacity. From Fig. 3 above,
we can see that the firm can increase its output from Q1 to Q2 and reduce average costs. However,
it does not do so because it reduces the average revenue more than the average costs. Hence, we
can conclude that in monopolistic competition, firms do not operate optimally. There always exists
an excess capacity of production with each firm.

In case of losses in the short-run, the firms making a loss will exit from the market. This continues
until the remaining firms make normal profits only.

Product Differentiation

What makes a firm’s product or service different and more appealing to customers than other
options in its category. Product differentiation is what gives a firm a competitive advantage in
the market. Product differentiators can include better quality and service as well as unique
features and benefits.

What is product differentiation?

Product differentiation is what makes the product or service stand out to a firm’s target
audience. It’s how the firm distinguishes what they sell from what their competitors do, and it
increases brand loyalty, sales, and growth.

Focusing on the customers is a good start to successful product differentiation. What do they
want? What is no one else providing them? What delights them? What frustrates them? What
makes them feel good? What would make them feel even better? The answers to these
questions can kickstart ideas for differentiation. Other differentiators include price, packaging,
quality, customer service, and overall customer experience when buying or using your product.
For example, a makeup company might provide an online tool to help customers find the right
shade of foundation. A tennis shoe producer might give buyers the option to customize their
shoes by choosing the color for each component. Customers are more willing to pay for
products that come with a unique, useful experience.
Why is product differentiation important?

The goal of product differentiation is to create a competitive advantage or to make the product
superior to alternatives on the market. In other words, a firm just does not want to stand out
from the competition, it wants to stand above it.

Kimberly Amadeo breaks down competitive advantage into 3 components: benefits, target
audience, and competition.

• Benefits - Benefits are the values a customer receives when they purchase a product or
service. They’re different from features, which are the things a product can do.
Businesses often focus on features, but customers are interested in benefits. Good
product differentiation emphasizes the unique benefits of a firm’s goods or services.
That’s why it is essential to clearly communicate why your product offers better quality,
a lower price, or a more memorable experience than your competition.
• Target audience – The product's differentiated benefits should align with the interests,
needs, and values of a defined target audience. To differentiate a product, first think
about who wants to buy the product, why they want it, how they want it to look, where
they want to purchase it, and how much they will pay for it. If not sure about any of
those considerations, conducting marketing research is a great way to find answers.
• Competition – A firm can only differentiate your own product once it knows what is
already on the market. Take plenty of time to study products and services that potential
customers might compare to yours. What does a competing product do? Who buys it?
Why? Where? How much do they pay for it? Keep an eye on branding, features, size,
price, and packaging to see what a firm can do differently to appeal to its target
audience.

Types of product differentiation

Vertical differentiation - Vertical differentiation is when customers choose a product by

ranking their options from best to the worst using an objective measurement, like price or
quality. While the measurements are objective, the value each customer places on them might
vary. For example, 1 meal at a restaurant may be lower in calories than another meal. To a
customer who is watching their weight, the lower-calorie meal represents a "better" option.
Another customer might place a higher value on price and choose the higher-calorie meal if it
costs less.

Horizontal differentiation - Horizontal differentiation is when customers choose between

products subjectively, because they have no objective measurement to distinguish between best
or worst. For example, there is no qualitative measurement to rank ice cream flavors. Whether
you choose chocolate, vanilla, or strawberry is entirely a matter of personal taste. If most of
the products on the market cost about the same and have many of the same features or qualities,
the purchase decision comes down to subjective preference.
Mixed differentiation - Customers making more complex purchases tend to use a mix of
vertical and horizontal differentiation when making purchase decisions. Let’s say a customer
is shopping for a car. The customer might consider 2 similarly priced four-door sedans from 2
separate manufacturers. The customer may likely use mixed differentiation to make a decision.
Objective measurements to vertically differentiate between them include gas mileage and
safety ranking. Horizontal differentiation, between subjective preferences like design aesthetic
and impression of the car brand, also plays a role in the decision. As with both horizontal and
vertical differentiation individually, each customer will value the combination of these factors
differently.

Advantages of product differentiation

• Communicating the distinct features and benefits of the product is the secret to
successful marketing.
• Building brand loyalty
• Strong product differentiation makes business memorable. Customers will associate
elements of the brand—like logo, voice and tone, and social media presence—with the
product or service and all of its benefits.
• The more differentiated the product is and the better it meets the target audience’s wants
and needs, the more likely they are to become repeat customers.