UNIT-3:

EQUILIBIRIUM IN PERFECT COMPETITION:

In a perfectly competitive market, a firm cannot change the price of a

product by modifying the quantity of its output. Further, the input and
cost conditions are given.

Therefore, the firm can alter the quantity of its output without changing
the price of the product. We know that a firm is in equilibrium when its
profits are maximum, which relies on the cost and revenue conditions
of the firm.

These conditions can vary in the long and short-term. Before we

take a look at the equilibrium states, let’s look at the demand curve
of a product Demand Curve of a Product in a Perfectly
Competitive Market

Let’s derive the firm’s demand curve with the help of the market’s

demand and supply curve. In perfect competition, the equilibrium
of the market’s demand and supply determines the price.under
perfect comShort-run Equilibrium of a Competitive Firm

In the short-run, there the following assumptions:

 The price of the product is given and the firm can sell any quantity
at that price
 The size of the plant of the firm is constant
 The firm faces given short-run cost curves
petition.

In a perfectly competitive market, a firm can earn a normal profit,

super-normal profit, or it can bear a loss. At the equilibrium quantity, if
the average cost is equal to the average revenue, then the firm is earning
a normal profit.
On the other hand, if the average cost is greater than the average
revenue, then the firm is bearing a loss. However, if the average cost is
less than average revenue, then the firm is earning super-normal profits.

Normal Profit

In the above figure, you can see that the costs and revenue are on the Y-
axis and the Quantity is on the X-axis. Further, marginal costs cut the
marginal revenue curve from below at point A. At point ‘A’, P is the
equilibrium price and ‘Q’ is the equilibrium quantity.

Note that corresponding to the equilibrium quantity, the average cost is

equal to the average revenue. It also means that the firm is earning a
normal profit.

Loss
In the figure above, the cost and revenue curves are on the Y-axis and
the quantity demanded is on the X-axis. Further, the marginal cost
curve cuts the marginal revenue curve from below at point ‘A’, the
equilibrium point.

Corresponding to point ‘A’, P* and Q* are the equilibrium price and

quantity respectively. Also, corresponding to Q*, the average cost is
more than the average revenue.

In this case, the per unit cost of OQ* (average cost) is more than the per
unit revenue of OQ* (average revenue). As per the figure, the per unit
revenue is OP and the per unit cost is OP’. this means that the per unit
loss is PP’. Also, the total loss on quantity OQ* is P*P’BA.

Super-normal Profit
In the figure above, the per unit revenue or average revenue is OP*
while the per unit cost or average cost is OP’. Therefore, the per unit
receipts are high in comparison with the per unit cost.

That’s why the average revenue curve lies above the average cost curve
corresponding to Q*. The firm is earning super-normal profits. The per
unit profit is P’P* and the total profit is for quantity OQ* is P’P*BA.

Equilibrium in Monopoly

The conditions for Equilibrium in Monopoly are the same as those

under perfect competition. The marginal cost (MC) is equal to the
marginal revenue (MR) and the MC curve cuts the MR curve from
below. In this article, we will understand Equilibrium in Monopoly in
detail.

A Firm’s Short-Run Equilibrium in Monopoly

Like in perfect competition, there are three possibilities for a firm’s

Equilibrium in Monopoly. These are:

1. The firm earns normal profits – If the average cost = the average
revenue
2. It earns super-normal profits – If the average cost < the average
revenue
3. It incurs losses – If the average cost > the average revenue

Normal Profits

A firm earns normal profits when the average cost of production is

equal to the average revenue for the corresponding output.

In the figure above, you can see that the MC curve cuts the MR curve at
the equilibrium point E. Also, the AC curve touches the AR curve at a
point corresponding to the same point. Therefore, the firm earns normal
profits.

Super-normal Profits

A firm earns super-normal profits when the average cost of production

is less than the average revenue for the corresponding output.
In the figure above, you can see that the price per unit = OP = QA.
Also, the cost per unit = OP’. Therefore, the firm is earning more and
incurring a lesser cost. In this case, the per unit profit is

OP – OP’ = PP’

Also, the total profit earned by the monopolist is PP’BA.

Losses

A firm earns losses when the average cost of production is higher than
the average revenue for the corresponding output.
In the figure above, you can see that the average cost curve lies above
the average revenue curve for the same quantity. The average revenue =
OP and the average cost = OP’. Therefore, the firm is incurring an
average loss of PP’ and the total loss is PP’BA. In the short-run, a
monopolist sometimes sets a lower price and incurs losses to keep new
firms away.

Equilibrium under Monopolistic Competition

Before determining a firm’s equilibrium under Monopolistic
Competition, it is important to note that there are two possible
demand curves – both sloping downwards. In this article, we will
look at a firm’s short-run and long-run equilibrium under
Monopoli

Equilibrium under Monopolistic Competition

The two types of demand curves of a firm under monopolistic

competition are due to the following reasons:

 When a firm revises the price of its product, the rival firms don’t
always increase the prices of their products too. Therefore, the
demand curve has a smaller slope and the demand for the product
is more elastic.
 If the rival firms follow the price revision by the first firm, then the
demand for its product becomes less elastic. In such cases, the firm
needs to slash its prices further to achieve an increase in demand.
In this case, the demand curve has a steeper slope.

A Firm’s Short-Run Equilibrium under Monopolistic Competition

Under Monopolistic Competition, the revenue curves are downward

sloping (like under Monopoly). This is because, in order to sell more,
the firm has to decrease the price.
A firm under Monopolistic Competition can either earn normal profits,
super-normal profits, or incur losses. Also, like under Monopoly, a firm
earns super-normal profits if the demand for its product is very high.

Also, in the short-run, new firms cannot enter the group and enhance
the supply of the product group. Therefore, they cannot compete away
the super-normal profits of the firm. Also, in the short-run, a firm faces
certain fixed costs. These can include production as well as selling
costs.

In the figure above, you can see that the AR and MR curves of the firm
have negative slopes. Further, the AVC curve includes the production
costs as well as the variable components of selling expenses.
Furthermore.

The MC curve cuts the AVC curve at its lowest point. Also, the ATC
curve represents the average of the total cost of the firm including the
fixed selling expenses.

The MC curve intersects the MR curve from below at point I. Hence,

the firm decides to produce a quantity of OM and charge a price of EM
per unit.
By doing so, the firm earns a profit of EK per unit and the entry of rival
firms do not compete it out. However, based on the relative location of
the cost and revenue curves, it is possible that the firm is in equilibrium
with:

 Only normal profit

 Covering a part of fixed costs. Therefore, incurring a loss less than
its fixed costs
 Loss equal to the fixed costs (where AR is tangent to the AVC
curve)
To discuss a firm’s long-run equilibrium under Monopolistic
Competition, it is important to remember the following points:

 There are no fixed costs in the long-run. The firm can vary its
inputs as well as its selling costs. Further, the firm can choose
between various product qualities.
 There is no compulsion on a firm to operate at a loss. It can leave
the industry whenever it wants. When a firm leaves the industry,
the absolute market shares of the remaining firms, increase.
Further, their demand curve shifts right and upwards. This
continues until other firms can produce without incurring a loss.
 On the other hand, if the demand is so strong that the existing firms
make super-normal profits, then new firms can enter the group.
 They produce close substitutes of the existing products and
increase the total product supply. Therefore, the demand shares of
the existing firms reduce. Hence, the demand curve of a firm
cannot stay above its long-run average cost curve.
 All firms operating under Monopolistic Competition can make a
choice between combinations of:
o Product quality
o Product Differentiation
 o Selling costs
 A firm must consider the fact that any variation of price on its part
can attract a reaction from its rivals. Therefore, it faces a much
steeper demand curve.
Therefore, under Monopolistic Competition, a firm is exposed to
constant interaction with the rest of the firms in the group. Its decisions
are not independent of the decisions of the other firms.

Further, the firm’s demand curve depends on its actions AS WELL AS

on the actions of its rivals. Therefore, it must consider different
combinations of its cost components pertaining to the product quality
and its selling expenses, etc. This helps the firm estimate the slope and
position of the demand curve.

Oligopoly Definition and Meaning

Oligopoly is defined as a market structure with a small number of

firms, none of which can keep the others from having significant
influence.

Meaning of Oligopoly Market

An Oligopoly market situation is also called ‘competition among the

few’. In this article, we will look at Oligopoly definition and some
important characteristics of this market structure.

An oligopoly is an industry which is dominated by a few firms. In this

market, there are a few firms which sell homogeneous or differentiated
products.

Also, as there are few sellers in the market, every seller influences the
behavior of the other firms and other firms influence it.

Oligopoly is either perfect or imperfect/differentiated. In India, some

examples of an oligopolistic market are automobiles, cement,
steel, aluminum, etc.
Characteristics of Oligopoly

Now that the Oligopoly definition is clear, it’s time to look at the
characteristics of Oligopoly:

Few firms

Under Oligopoly, there are a few large firms although the exact number
of firms is undefined. Also, there is severe competition since each firm
produces a significant portion of the total output.

Barriers to Entry

Under Oligopoly, a firm can earn super-normal profits in the long run
as there are barriers to entry like patents, licenses, control over crucial
raw materials, etc. These barriers prevent the entry of new firms into
the industry.

Non-Price Competition

Firms try to avoid price competition due to the fear of price wars in
Oligopoly and hence depend on non-price methods like advertising,
after sales services, warranties, etc. This ensures that firms can
influence demand and build brand recognition.

Interdependence

Under Oligopoly, since a few firms hold a significant share in the total
output of the industry, each firm is affected by the price and output
decisions of rival firms. Therefore, there is a lot of interdependence
among firms in an oligopoly. Hence, a firm takes into account the
action and reaction of its competing firms while determining its price
and output levels.

Nature of the Product

Under oligopoly, the products of the firms are either homogeneous or

differentiated.
Selling Costs

Since firms try to avoid price competition and there is a huge

interdependence among firms, selling costs are highly important for
competing against rival firms for a larger market share.

No unique pattern of pricing behavior

Under Oligopoly, firms want to act independently and earn maximum

profits on one hand and cooperate with rivals to remove uncertainty on
the other hand.

Depending on their motives, situations in real-life can vary making

predicting the pattern of pricing behavior among firms impossible. The
firms can compete or collude with other firms which can lead to
different pricing situations.

Indeterminateness of the Demand Curve

Unlike other market structures, under Oligopoly, it is not possible to

determine the demand curve of a firm. This is because on one hand,
there is a huge interdependence among rivals. And on the other hand
there is uncertainty regarding the reaction of the rivals. The rivals can
react in different ways when a firm changes its price and that makes the
demand curve indeterminate.

Firms behaviour under Oligopoly

Based on the objectives of the firms, the magnitude of barriers to entry

and the nature of government regulation, there are different possible
outcomes in relation to a firm’s behavior under Oligopoly. These are:

1. Stable prices
2. Price wars
3. Collusion for higher prices
Further, Oligopoly can either be collusive or non-collusive. Collusive
oligopoly is a market situation wherein the firms cooperate with each
other in determining price or output or both. A non-collusive oligopoly
refers to a market situation where the firms compete with each other
rather than cooperating.

Non-Collusive Oligopoly-Sweezy’s Kinked Demand Curve Model

(Price-Rigidity)

Usually, in Oligopolistic markets, there are many price rigidities. In

1939, Paul Sweezy used an unconventional demand curve – the kinked
demand curve to explain these rigidities.

Reason for the kink in the demand curve

It is assumed that firms behave in a two-fold manner in reaction to a
price change by a rival firm. In simple words, firms follow price cuts by
a rival company but not price increases. So, if a seller increases the
price of his product, his rivals do not follow the price increase.

Therefore, the market share of the firm reduces significantly as a result

of the price rise. On the other hand, if a seller reduces the price of his
product, then the rivals also reduce their price to bring it at par with the
price reduction of the firm.

This ensures that they prevent their market share from falling. Once the
rivals react, the firm lowering the price first cannot gain from the price
cut.

Why the price rigidity?

As can be seen above, a firm cannot gain or lose by changing its price
from the prevailing price in the market. In both cases, there is no
increase in demand for the firm which changes its price. Hence, firms
stick to the same price over time leading to price rigidity under
oligopoly.
DIFFERENT METHODS OF PRICING:

The following points highlight the seven main methods of pricing

policies. The methods are:- 1. Marginal Cost Pricing 2. Limit
Pricing 3. Market Skimming Pricing 4. Penetration Pricing 5.
Bundling Pricing 6. Peak Load Pricing 7. Internet Pricing Models.
Policy # 1. Marginal Cost Pricing:
Social welfare is maximum or, in other words, economic efficiency in
resource allocation is achieved when price is set equal to marginal
cost. It has been suggested that non-profit enterprises should pursue
marginal cost pricing policy so as to achieve economic efficiency in
resource allocation. However, marginal cost pricing does not ensure
positive profits when the enterprise is enjoying very large economies
of scale.
To induce the enterprise to continue producing the product as it is
socially beneficial, subsidies should be paid to the enterprise or else
the government should itself undertake the production of the product
and meet its losses from the budgetary resources. Thus, in such
enterprises where large economies of scale occur, marginal cost
pricing is non-viable.
Policy # 2. Limit Pricing:
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Limit pricing refers to the pricing by incumbent firm(s) to deter or

inhibit the entry or the expansion of fringe firms.
Limit pricing implies that firms sacrifice current profits in order to
deter entry of new firms and earn future profits. It is not clear whether
this strategy is always superior to one where current prices (and
profits) are higher, but decline over time as an entry occurs.
Limit pricing thus involves charging prices below the monopoly price
in order to make entry appear unattractive (to limit entry). A low price
would discourage entry if prices had a commitment value. But they do
not, because prices can be changed quickly. Hence, if a potential
entrant has complete information about the incumbent, limit pricing
would be useless.
It is the policy adopted by firms already in a market to reduce their
prices so as to make it unprofitable for other firms to try to enter the
market. The price so established is called an entry forestalling price.
Policy # 3. Market Skimming Pricing:
ADVERTISEMENTS:

Skimming is adopted where a new product is launched and the seller

has little information on the acceptable price in the market. The seller,
therefore, starts by setting a high price on the launch of the product
and then, over a period of time, lowers the price to meet the varying
price elasticities of demand.
This enables gradual expansion in capacity by the seller. This practice
is followed in the consumer durables market. The seller chooses to
start by setting at a high price to avoid the risk of losing on customers
who are willing to pay a high price.
Policy # 4. Penetration Pricing:
Penetration pricing is a strategy employed by businesses introducing
new goods or services into the marketplace. With this policy, the
initial price of the good or service is set relatively low in hopes of
‘penetrating’ into the marketplace quickly and securing significant
market share.
A penetration policy is even more attractive if selling larger quantities
results in lower costs because of economies of scale. Penetration
pricing may be wise if the firm expects strong competition very soon
after introduction. A low penetration price may be called a ‘stay out’
price. It discourages competitors from entering the market. Once the
product has secured a desired market share, its producers can then
review business conditions and decide whether to gradually increase
the price.
ADVERTISEMENTS:

Penetration pricing involves the setting of lower, rather than higher

prices in order to achieve a large, if not dominant, market share.
This strategy is most often used in businesses wishing to enter a new
market or build on a relatively small market share.
This will only be possible where demand for the product is believed
to be highly elastic, i.e., demand is price-sensitive and either new
buyers will be attracted or existing buyers will buy more of the
product as a result of a low price.
A successful penetration pricing strategy may lead to large sales
volumes/market shares and therefore lower costs per unit. The effects
of economies of both scale and experience lead to lower production
costs, which justify the use of penetration pricing strategies to gain
market share. Penetration strategies are often used by businesses that
need to use up spare resources (e.g., factory capacity).
ADVERTISEMENTS:

A penetration pricing strategy may also promote complementary and

captive products. The main product may be priced with a low mark-
up to attract sales (it may even be a loss-leader). Customers are then
sold accessories (which often only fit the manufacturer’s main
product) which are sold at higher mark-ups.
The most obvious potential disadvantage of implementing a
penetration pricing strategy is the likelihood of competing suppliers
following suit by reducing their prices also, thus nullifying any
advantage of the reduced price (if prices are sufficiently differentiated
the impact of this disadvantage may be diminished).
A second potential disadvantage is the impact of the reduced price on
the image of the offering, particularly where buyers associate price
with quality.
Policy # 5. Bundling Pricing:
It is a pricing practice when two or more products are sold as bundle.
Also, the constituent products of the bundle are not sold individually.
ADVERTISEMENTS:

Price bundling is a strategy whereby a seller bundles together many

different goods/items being sold and offers the entire bundle at a
single price.
There are two forms of price bundling—pure bundling, where the
seller does not offer buyers the option of buying the items separately,
and mixed bundling, where the seller offers the items separately at
higher individual prices. Mixed bundling is usually preferable to pure
bundling, both because there are fewer legal regulations forbidding it,
and because the reference price effect makes it appear even more
attractive to buyers.
Suppose there are two buyers, A and B, and two products, X and Y.
Suppose buyer A values product X at 20 units above the cost of
production, and values 7 at 15 units above the cost of production.
Suppose buyer B values Y at 20 units above the cost of production,
and X at 15 units above the cost of production.
The ideal thing for the seller would be to practice price
discrimination: charge each buyer the maximum that buyer is willing
to pay. However, this may be forbidden by law or otherwise difficult
to implement.
Instead, the seller can pursue the following bundling strategy- charge
slightly under 35 units above production cost for the combination of
X and Y. Since both buyers value the combination at 35 units, this
deal appeals to both buyers. This allows the seller to obtain the entire
social surplus as producer surplus.
The seller can even make this a mixed bundling strategy – offer both
X and Y individually for 20 units, and offer the combination for
slightly less than 35 units.
Policy # 6. Peak Load Pricing:
It is a pricing practice where price varies with time of the day. When
demand for a commodity or service varies at different periods of time,
it has been generally suggested that higher price of a commodity or
service be charged for the peak period when demand is greater and
lower price be charged for off-peak period when demand is lower.
This dual pricing, that is higher price for peak period and lower price
for off-peak period is known as peak-load pricing.
It may be noted that peak-load pricing is suggested when not only the
demand varies between peak and off-peak periods but also cost of
production is different in the two time periods. In the peak period
when capacity is strained marginal cost is higher as compared to the
off-peak period. Thus, different prices of a commodity for two
periods also reflect the different costs of production of the commodity
in the two periods.
Various examples of peak load pricing can be given. In India charges
for trunk or STD calls during day time which is the peak period is
higher and charges for the off-peak period from 9 P.M. to 6 A.M. are
lower. In many countries, electric companies are permitted to charge
higher rates during the day time which is the peak period for the use
of electricity and lower rates for the night which is off-peak period for
the use of electricity. Similarly, airlines often follow peak-load
pricing; in off season they often lower their rates as compared to the
peak periods of travel.
1. Cost-plus Pricing
It is the simplest pricing method. The firm calculates the cost of
producing the good and adds on a percentage (profit) to that price to
give the selling price.

2. Limit Pricing
A limit price is a price set by a monopolist to discourage economic
entry into a market. The limit price is often lower than the average cost
of production.

3. Penetration Pricing
Setting the price lower than what it is offered by other competitors in
order to attract customers and gain market share. The price can be
raised later once this market share is gained.

4. Price Discrimination
Price discrimination is setting a different price for the same product in
different segments to the market. For example, this can be for different
classes of buyers, such as ages, or for different opening times.

5. Psychological Pricing
In this pricing designed to have a positive psychological impact on the
customers. For example, selling goods on profit at ₹ 4.95 or ₹ 4.99,
rather than ₹ 5.00.

Learn more about Pricing and Output Determination under Oligopoly

here in detail
6. Dynamic Pricing
A flexible pricing mechanism made possible by advances in
information technology and this strategy is mostly employed by
internet-based companies.

7. Price Leadership
In oligopolistic business market usually, the dominant competitor
among several leads the way in determining prices, and the others soon
follow.

8. Target Pricing
Target pricing is a pricing method whereby the selling price of a
product is calculated to produce a particular rate of return on
investment for a specific volume of production.

Companies with high capital investment and public utilities like gas and
electrical companies use this strategy.

9. Absorption Pricing
It is a method of pricing which recovers all costs. The price of the
goods or services includes the variable cost of each item plus a
proportionate amount of the fixed costs and is a form of cost-plus
pricing.

10. High-low Pricing

High-Low pricing is a method of pricing where the goods or services
offered by the organization are regularly priced higher than
competitors, but through promotions, advertisements, and coupons,
lower prices are offered on key items.
11. Marginal Cost Pricing
This pricing method is a practice of setting the price of products and
goods to be equal to the additional cost of producing an extra unit of
output.