III Sem - BA Economics - Core-Micro Economics - II

MICRO ECONOMICS-II
III SEMESTER
CBCSS
(2019 Admission onwards)
BA ECONOMICS
Core Course
UNIVERSITY OF CALICUT
School of Distance Education,
Calicut University (P.O), Malappuram, Kerala, India 673635
19356
School of Distance Education
UNIVERSITY OF CALICUT
Study Material
BA ECONOMICS
III SEMESTER (CBCSS)
Core Course (ECO3 B04)
(2019 Admission onwards)
MICRO ECONOMICS-II
Prepared by:
Dr. Shiji O.
Assistant Professor,
SDE, University of Calicut.
Scrutinised by:
Dr. Shabeer K.P.

Assistant Professor,
Research Department of Economics,
Government College Kodenchery, Kozhikode.
Micro Economics-II 2
Detailed Syllabi
MICROECONOMICS II
Module I: Market Structure: Perfect Competition
Market-Functions-Market structure-Types of markets-Perfect competition-Characteristics-
Demand AR and MR curves-Price determination in the market period- Short run equilibrium
of the firm and industry- Shut down point-Long run equilibrium of the firm and industry-
Constant, increasing and decreasing cost industries- Welfare effects of government
intervention- Impact of a tax and subsidy.
Module II: Monopoly
Monopoly- Sources of monopoly-Types of monopoly-AR and MR curve of a monopolist -
Short run and long run equilibrium- Supply curve of a monopolist- The multiplant firm-
Monopoly power-Measurement of monopoly power-Social cost of monopoly- Regulation
of monopoly -Price discrimination-First degree, second-degree and third degree-
International price discrimination (Dumping- types)-Two part tariff, tying and bundling-
Peak load pricing- Monopsony- Bilateral monopoly.
Module III: Monopolistic Competition and Oligopoly
Monopolistic competition- Features of monopolistic competition-Short run and long run
equilibrium- Excess capacity-Product differentiation and selling costs-Oligopoly-
Characteristics- Collusive versus non-collusive oligopoly-Cournot model- Kinked demand
curve model - Cartel and price leadership.
Module IV: Pricing and Employment of Inputs
Competitive factor markets -Demand curve of the firm for one variable input-Demand curve
of the firm for several variable inputs- Market demand curve for an input - Supply of inputs
to a firm- The market supply of inputs- Equilibrium in a competitive factor market- Factor
market with monopoly power- Factor market with monopsony power-Marginal Productivity
theory of input demand.
Module I
Market Structure: Perfect Competition
Market
In ordinary speech, the term ‘market’ refers to a place where buyers and sellers meet
for transactions, e.g., Vardaan Market of Calcutta, Palika Bazar of New Delhi, Crawford
Market of Mumbai and so on. But in economics it is used in a different sense. In economics,
the term ‘market’ does not mean a particular palace, rather it refers to a particular
commodity which is bought and sold, e.g., the rice market, the cloth market, the gold market
and so on. It is used to indicate a commodity or service as also their buyers and sellers who
are in direct competition with one another. So, a market consists of a group of buyers and
sellers in sufficiently close contact with one another for exchange to take place among them.
In the above sense there is no restriction of locality. The market may be local,
national or international depending on the commodities which are bought and sold. Local
markets are found for the local produce or for the perishable commodities (e.g., vegetables,
milk, eggs, etc.) or for animals like goats, horses, cows, etc. The market of wheat or cloth
or gold is both national and international as these goods are bought and sold widely.
Thus, the essential elements of an economic market are:
(i) A particular commodity or a factor, and
(ii) A large number of buyers and sellers in direct contact as also in competition with one
another.
The function of a market is to enable an exchange of goods and services to take place
a means by which buyers and sellers are brought into contact with one another. The market
may be small or large in size. The market of fish or milk or perishable good is small and
narrow, as it covers only a small area. But the market of goods like wheat, cement,
automobiles, petrol, steel or gold is very wide as these are bought and sold all over the world.
In modern times the use of cold storage has widened the market for some commodities (e.g.,
potatoes, fruits, fishes, eggs, etc.) which had previously very limited markets.
Markets are valuable institutions. They facilitate trade. More trade means more
production. More production means more employment and a higher national income.
Markets are, therefore, essential for the development of industries and the economic growth
of a country. Markets and consumers are never static. They may change because of changes
in buyers’ incomes, or changes in tastes or preferences, or increasing competition. The
changes may be due to changes in population, birth rates, marriage rates, age structure of
the population, its geographical distribution and so on.
Functions
Organised markets are concerned with the distribution of goods from the
manufacturers via the wholesalers and retailers to the final consumers. These markets are
vital to the whole process of production. The functions of markets are:
(a) Their most obvious function is to bring together buyers and sellers usually in the same
place.
(b) They also reduce price fluctuations due to the seasonal nature of the product. One
function of market specialists is to carry stocks of goods in order to prevent prices falling
too rapidly in periods of high output, or rising too rapidly in periods of low output. They
thus benefit producers in the first case and consumers in the second.
(c) In this connection speculators, who are often condemned, contribute to stability by
buying when prices are low (thus preventing prices falling further) and releasing their stocks
as prices rise (thus preventing prices rising too far).
(d) Finally, the establishment of centralised markets allows both producers and consumers
to take advantage of the specialised services which can only be sustained where markets are
large enough to lead to economies of scale.
Market structure
The behaviour of individuals, firms, and organizations within a market context is

thought to be a function of their objectives and the constraints that exist because of
technology, quantity/quality of inputs and market structure. Market structures can be
characterized by sellers or buyers or both. Generally, four basic types of markets: (1) pure
(or perfect) competition, (2) monopolistic (or imperfect) competition, (3) oligopolistic
competition, and (4) monopoly. Pure competition is believed to produce ideal results in the
allocation of resources. Monopoly is usually depicted as having less than optimal outcomes.
The basic market structures based on sellers is as perfect competition, monopolistic

competition, oligopoly and monopoly. Pure competition and Monopoly are at each end of
the spectrum of markets. In fact, probably neither occurs in market economies. Pure
competition and monopoly are the boundaries and the “real world” (wherever that is) lies
somewhere between the two extremes. Pure competition provides the benchmark that can
be use to evaluate markets.
Perfect Competition
Perfect competition a market structure characterized by a large number of small firms

such that no single firm can affect the market price or quantity exchanged. Perfectly
competitive firms are price takers. They set a production level based on the price determined
in the market. If the market price changes, then the firm re-evaluates its production decision.
The idealized purely competitive market insures that no buyer or seller has any market
power or ability to influence the price. The sellers in a purely competitive market are price
takers. The market sets the price and each seller reacts to that price by altering the variable
input and output in the short run. In the long rung they can alter the scale of plant (size of
the fixed input in each short run period). The conditions that ensure no seller has any market
pose are:
Large number of sellers (and buyers), no one of which can influence the market.
Homogeneous output, buyers see goods as perfect substitutes.
Relatively “free” entry and exit to and from the market.
Sellers cannot charge a price above the market price because sellers see all other
goods in the market as perfect substitutes. They can buy those goods at the market
price.
In a perfectly competitive market, the price of the commodity is determined exclusively

by the intersection of the market demand curve and the market supply curve for the
commodity. The perfectly competitive firm is then a “price taker” and can sell any amount
of the commodity at the established price.
Characteristics
1. Large Number of Small Firms: A perfectly competitive industry contains a large

number of small firms, each of which is relatively small compared to the overall size
of the market. This ensures that no single firm can influence market price or quantity.
If one firm decides to double its output or stop producing entirely, the market is
unaffected. The price does not change and there is no remarkable change in the
quantity exchanged in the market.
2. Price Taker: No single firm can influence the market price, or market conditions.
The single firm is said to be a price taker, taking its price from the whole industry.
3. Identical Products (Homogenous product): Each firm in a perfectly competitive
market sells an identical product, what is often termed “homogeneous goods.” The
essential result of this feature is that the buyers are unable to identify any difference
among them. There are no brand names or distinguishing features that differentiate
products.
4. Perfect Mobility of Factors and Products: Under perfect competition, products as
well as resources are freely mobile within the market. It normally results in the
existence of same price for same products throughout the market.
5. Freedom to Entry and Exit of firms: Perfectly competitive firms are free to enter
and exit an industry. They are not restricted by government rules and regulations,
start up cost, or other entry. Likewise, a perfectly competitive firm is not prevented
from leaving an industry as is the case for government-regulated public utilities. This
ultimately results in the existence of normal profit in the long run.
6. Perfect Knowledge: There exists perfect knowledge in the market. Buyers are
completely aware of sellers’ prices, such that one firm cannot sell its good at a higher
price than other firms. Each seller also has complete information about the prices
charged by other sellers. Perfect knowledge also extends to technology. No firm can
produce its good faster, better, or cheaper because of special knowledge of
information.
7. No Externalities: There are assumed to be no externalities so there are no external
costs or benefits.
8. Normal profits in the long run: Firms can only make normal profits in the long
run, but they can make abnormal profits in the short run.
Demand AR and MR curves
A firm under perfect competition is price-taker. This simply means it can alter its
volume of output and sales level without significantly affecting the market price of its
product. This explains why a firm operating in a perfectly competitive market has no power
to influence that market through its own individual actions. It must passively accept
whatever price happens to prevail in the market.
At the prevailing market (ruling) price it can sell as much as it likes. This means that
the demand for its product is completely elastic at a particular (market determined) price.
As R.G. Lipsey put it, “The demand curve facing each firm in perfect competition is
horizontal, because variations in the firm’s output over the range that it needs to
consider have no noticeable effect on price”.
Lipsey has also clarified an important point accepted by economists for a long time. As
he put it, “The horizontal (perfectly elastic) demand curve does not mean that the firm could
actually sell an infinite amount at the given price. It means, rather, that the variations in
production that will normally be possible for the firm to make will leave price virtually
unchanged because their effect on total industry output will be negligible.”
1. The Revenue Concepts:
To study the nature of a firm’s demand curve as also the revenues that firms receive
from the sales of their products, economists define 3 concepts, viz., TR, AR and MR. TR is
the total amount received by the firm from the sale of a product. If q units are sold at price
of p rupees, TR = pq. AR is the amount of revenue per unit sold.
Since this is equal to the price at which the product is sold (AR = TR/q = pq/q = p) it is
called the seller’s demand curve or the demand curve for the product of an individual seller.
MR is the change in a seller’s TR resulting from a change in its sales level by one unit. In
economics, the word ‘margin’ always refers to anything extra. This means at the existing
level of sales, MR shows what revenue the firm could gain by selling one unit more and
what revenue it would lose by selling one unit less.
2. Industry Demand and Firm Demand:
Figure 1.1 shows both the demand curve for the product of a single firm under perfect
competition.
Figure 1.1: AR Curve and MR Curve
The industry demand curve slopes downward from left to right, but the firm’s demand
curve horizontal because the firm’s output variation (measured in thousands of tonnes) has
hardly as percentage effect so an industry output (measured in millions of tonnes). At the
prevailing market price (Rs. 3), industry output is 200 million tonne. At this price, the firm
considers producing a maximum output of 60,000 tonne.
Table 1.1: Revenue Schedule of a Firm under Perfect Competition
Quantity Price TR AR MR
10 3 30 3 -
11 3 33 3 3
12 3 36 3 3
13 3 34 3 3
To illustrate these three revenue concepts, let us consider a firm which is selling an
agricultural product in a perfectly competitive market (such as wheat) at a price of Rs. 3 per
tonne. Since price remains fixed, TR rises by Rs. 3 for every tonne sold. Since every unit
brings in Rs. 3, the AR per unit sold is surely Rs. 3. Moreover; since each additional unit
sold brings in Rs. 3, the MR of an extra unit sold is also Rs. 3. Table 1.1 shows revenue
figures for certain range of output (between 10 and 13 units). Figure 1.2 illustrates the
corresponding total revenue (TR) curve.
Figure 1.2: TR Curve
The most important point to note here is that, as long as the volume of the firm’s
output does not significantly affect the price at which that output sells, MR = AR (which is
always equal to p which is Rs. 3). We see that AR and MR are the same horizontal line
(drawn at the level of market price) and parallel to the x-axis. In short if the market price is
unaffected by variations in the firm’s output, then the firm’s demand curve, its AR curve
and MR curve will coincide in the same horizontal line. This means that for a firm in perfect
competition, p = MR. For such firm TR increases in direct proportion to output.
Price Determination in the Market Period
The market period, or the very short run, refers to the period of time in which the
market supply of the commodity is completely fixed. When dealing with perishable
commodities in the market period, costs of production are irrelevant in the determination of
the market price and the entire supply of the commodity is offered for sale at whatever price
it can fetch. In the figure 1.3, S represents the fixed market supply of a commodity in the
market period. If the market demand curve for the commodity is given by D, the equilibrium
market price is $8 per unit in the market period. If we had D’ instead, the equilibrium price,
would be $24.
Figure 1.3: Fixed Market Supply
Short-Run Equilibrium of the Firm

A firm is in equilibrium in the short-run when it has no tendency to expand or contract its
output and wants to earn maximum profit or to incur minimum losses. The short-run is a
period of time in which the firm can vary its output by changing the variable factors of
production. The number of firms in the industry is fixed because neither the existing firms
can leave nor new firms can enter it. The short-run equilibrium of the firm can be explained
with the help of marginal analysis and total cost- total revenue analysis.
1) Total Approach
Total profits equal total revenue (TR) minus total costs (TC). Thus, total profits are
maximized when the positive difference between TR and TC is greatest. The equilibrium
output of the firm is the output at which total profits are maximized.
In the table 1.2, quantity [column (1)] times price [column (2)] gives us TR [column (3)].
TR minus TC [column (4)] gives us total profits [column (5)]. Total profits are maximized
(at $1690) when the firm produces and sells 650 units of the commodity per time period.
Table 1.2: Short Run Equilibrium
Q P TR TC Total Profits
0 8 0 800 -800
100 8 800 2000 -1200
200 8 1600 2300 -700
300 8 2400 2400 0
400 8 3200 2524 676
500 8 4000 2775 1225
600 8 4800 3200 1600
650 8 5200 3510 1690
700 8 5600 4000 1600
800 8 6400 6400 0
The profit-maximizing level of output for this firm can be represented in figure 1.4 (obtained
by plotting the values of columns 1, 3, 4, and 5 of Table 1.1).
Figure 1.4: Short run Equilibrium
In Figure 1.4, the arrows indicate parallel lines. The TR curve is a positively sloped
straight line through the origin because P remains constant at $8. At 100 units output, this
firm maximizes total losses or negative profits (points A and A’). At 300 units of output,
TR equals TC (point B) and the firm breaks even (point B’). The firm maximizes its total
profits (point D’) when it produces and sells 650 units of output. At this output level, the
TR curve and the TC curve have the same slope and so the vertical distance between them
is greatest.
2) Marginal Approach
In general, it is more useful to analyze the short-run equilibrium of the firm with the
marginal revenue–marginal cost approach. Marginal revenue (MR) is the change in TR for
a one-unit change in the quantity sold. Thus, MR equals the slope of the TR curve. Since in
perfect competition, P is constant for the firm, MR equals P. The marginal approach tells us
that the perfectly competitive firm maximizes its short-run total profits at the output level,
where MR or P equals marginal cost (MC) and MC is rising. The firm is in short-run
equilibrium at this best, or optimum, level of output.
Table 1.3: Short run Equilibrium
Q P=MR MC Ac Profits/Unit Total Profits
100 8 12 20 -12 -1200
200 8 3 11.60 -3.5 0700
300 8 1 8 0 0
400 8 1.25 6.31 1.69 676
500 8 2.50 5.55 2.45 1225
600 8 4.25 5.33 2.67 1602
650 8 8 5.40 2.60 1690
700 8 8 5.71 2.29 1603
800 8 24 8 0 0
In the Table 1.3, columns (3) and (4) are calculated directly from column (4) and column
(1) of Table 1.2. The values in column (5) are obtained by subtracting each value of column
(4) from the corresponding value in column (2). The values of column (6) are then obtained
by multiplying each value of column (5) by the values in column (1). Note that the values
of total profits are the same as those in Table 1.2 (except for two very small rounding errors).
The firm maximizes total profits when it produces 650 units of output. At that level of
output, MR = MC and MC is rising.
The profit-maximizing, or best, level of output for this firm can also be viewed from Figure
1.5 (obtained by plotting the values of the first four columns of Table 1.2).
Figure 1.5: Profit Maximising Output
As long as MR exceeds MC (from A’ to D’), it pays for the firm to expand output. The firm
would be adding more to its TR than to its TC and so its total profits would rise. It does not
pay for the firm to produce past point D’, since MC exceeds MR. The firm would be adding
more to its TC than to its TR and so its total profits would fall. Thus, the firm maximizes its
total profits at the output level of 650 units (given by point D’, where P or MR equals MC
and MC is rising). The profit per unit at this level of output is given by D’D” or $2.60, while
total profit is given by the area of rectangle D’D”FG, which equals $1690.
Short-Run Equilibrium of the Industry:
An industry is in equilibrium in the short-run when its total output remains steady, there
being no tendency to expand or contract its output. If all firms are in equilibrium, the
industry is also in equilibrium. For full equilibrium of the industry in the short-run, all firms
must be earning only normal profits.
The condition for this is SMC = MR = AR = SAC. But full equilibrium of the industry is by
sheer accident because in the short- run some firms may he earning supernormal profits and
some incurring losses. Even then, the industry is in short-run equilibrium when its quantity
demanded and quantities supplied are equal at the price which clears the market.
This is illustrated in Figure 1.6 where in Panel (A), the industry is in equilibrium at point E
where its demand curve D and supply curve S intersect which determine OP price at which
its total output OQ is cleared. But at the prevailing price OP, some firms are earning
supernormal profits PE1ST, as shown in Panel (B), while some other firms are incurring
FGE2P losses, as shown in Panel (C) of the figure.
Figure 1.6: Industry Equilibrium
Shut Down Point

If, at the best, or optimum, level of output, P exceeds AC, the firm is maximizing total
profits; if P is less than AC but greater than AVC, the firm is minimizing total losses; if P is
less than AVC, the firm minimizes its total losses by shutting down. It is shown in figure
1.7.
Figure 1.7: Shutdown Point
Figure 1.7 shows hypothetical MC, AC, and AVC curves for a “representative” firm; d1 to
d4 (and MR1 to MR4) are alternative demand (and marginal revenue) curves that might face
the perfect competitive firm. The results with each alternative demand curve are
summarized in Table 1.4.
Table 1.4
Long Run Equilibrium of the Firm

In the long run, all factors of production and all costs are variable. Therefore, a firm
will remain in business in the long run only if (by constructing the most appropriate plant
to produce the best level of output) its TR equals or is greater than its TC. The best, or
optimum, level of output for a perfectly competitive firm in the long run is given by the
point where P or MR equals LMC and LMC is rising. If, at this level of output, the firm is
making a profit, more firms will enter the perfectly competitive industry until all profits are
squeezed out.
Figure 1.8: Long Run Equilibrium
In Figure 1.8, at the market price of $16, the perfectly competitive firm is in long-
run equilibrium at point A, where P or MR = SMC = LMC> SAC = LAC. The firm produces
and sells 700 units of output per time period, utilizing the most appropriate scale of plant
(represented by SAC2) at point B. The firm makes a profit of $5 per unit (AB) and a total
profit of $3500.
Since the firm is making profits, in the long run more firms will enter the industry,
attracted by those profits. The market supply of the commodity will increase, causing the
market equilibrium price to fall. This will continue until all firms just break even. In Figure
1.8, this occurs at point E, where P = MR = SMC= LMC = SAC = LAC = $8. The firm will
operate the optimum scale of plant (represented by SAC1) at the optimum rate of output
(400 units) and will make zero profits. All firms in the industry find themselves in the same
situation (if all firms have identical cost curves), and so there is no incentive for any of them
to leave the industry or for new firms to enter it.
Constant, Increasing and Decreasing Cost Industries
1. Constant Cost Industries
In the long-run equilibrium for the perfectly competitive firm and industry, if the market
demand curve for the commodity increases, thus giving a higher market equilibrium price,
each firm will expand output within its existing plant in the short run and make some pure
economic profit. In the long run, more firms will enter the industry, and if factor prices
remain constant, the market supply of the commodity will increase until the original market
equilibrium price is re established. Thus, the long-run market supply curve for this industry
is horizontal (at the level of minimum LAC) and the industry is referred to as a “constant
cost industry.” It is shown in the figure 1.9.
Figure 1.9: Constant Cost
In panel B of figure 1.9, the original market equilibrium price of $8 is established

by the intersection of the short-run industry or market demand curve (D) and supply curve
(S) for the commodity. At this price, the perfectly competitive firm (panel A) is in long-run
equilibrium at point E. If all firms have identical cost curves, there will be 100 identical
firms in the industry, each producing 400 units of the 40,000 units equilibrium output for
the industry. If, for some reason, the short-run market demand curve shifts up to D’, the new
market equilibrium price of this commodity becomes $16 (point 2 in panel B). At this new
price, each of the identical 100 firms will expand output within its existing scale of plant in
the short run to 600 units (given by point C) and will make a profit of $5 per unit (CF) and
$3000 in total.
Since all firms in make profits, in the long run more firms will enter the industry. If
factor prices remain constant, the short-run market supply curve will shift to S’, giving (at
the intersection with D’) the original market equilibrium price of $8 per unit. At this price,
each perfectly competitive firm will return to the original long-run equilibrium point (point
E in panel A). There will now be 200 identical firms, each producing 400 units of the 80,000
units new equilibrium output for the industry. By joining equilibrium points 1 and 3, we get
the long-run supply curve (LS) for this perfectly competitive industry. Since the LS curve
is horizontal (at the level of minimum LAC), this is a constant cost industry.
2. Increasing Cost Industries
If factor prices rise as more firms (attracted by pure economic profits in the short run)
enter a perfectly competitive industry in the long run and as the industry output is expanded,
we have an increasing cost industry. In this case, the industry long-run supply curve is
positively sloped, indicating that greater outputs of the commodity per unit of time will be
forthcoming in the long run only at higher prices.
Figure 1.10: Increasing Cost
In figure 1.10 the perfectly competitive industry and the firm are originally in long-run
equilibrium at points 1 and E, respectively. If the short-run market demand curve shifts from
D to D’ the new equilibrium price becomes $16 (point 2) and each established firm will
expand output in the short run to point C and make CF profits per unit. If factor prices rise
as more firms enter this industry, the firm’s entire set of cost curves will shift up (from LAC,
SAC, and SMC to LAC’, SAC’, and SMC’). The firm and industry will return to long-run
equilibrium when the short-run industry supply curve has shifted from S to S’, giving the
new equilibrium price of $12 (point 3) at which all firms just break even (point E’). We will
now have 175 firms, each producing 400 units of the new equilibrium output of 70,000 units
for the industry. Joining market equilibrium points 1 and 3, we get the rising industry LS
curve.
3. Decreasing Cost Industries
If factor prices fall as more firms (attracted by the short-run pure economic profits) enter a
perfectly competitive industry in the long run and as the industry output is expanded, we
have a decreasing cost industry. In this case, the industry long-run supply curve is negatively
sloped, indicating that greater outputs per unit of time will be forthcoming in the long run
at lower prices
Impact of Tax and Subsidy
Governments will choose to implement taxes to either individuals or firms in order to

increase its revenue. When considering taxes to firms, it must be noted that these taxes will
increase the price of goods being produced and sold, which translates into a welfare loss.
However, a distinction between the loss in consumer and producer surplus must be made.
The impact on both surpluses depends on the period analysed.
Short and long run analysis:
In the short run, both consumers and producers will suffer from the tax imposed. A new tax
increases the price of goods. Let’s say this tax is imposed to firms, which increase their
prices in order to cover their losses. In this case, as shown in the adjacent figure, supply will
shift to the left, decreasing the quantity being produced, which increases its prices
since demand remains unchanged: the new equilibrium price will be pD (if the tax was to be
imposed to consumers, there would be a shift in demand instead). A corresponds to the
amount of the tax paid by consumers, while B is the amount paid by producers. Only
consumers actually pay more, but producers are getting less out of the sale. The loss in
consumer and producer surplus will depend on the elasticity of the demand curve, as shown
in the figure1.11.
Figure 1.11
The lower the elasticity in absolute terms (left figure), the higher the loss in consumer
surplus, and the lower in producer surplus. Higher elasticity (figure 1.12) will have the
opposite effect.
Figure 1.12
In the long run, since the supply curve is completely elastic, the new tax will reduce only
consumer surplus. Producer surplus will remain equal to zero, since there are no profits to
be made. It is shown in the figure 1.13.
Figure 1.13
Welfare analysis and government’s revenue:

Governments usually increase taxes to increase their revenue, which they use to
relocate wealth and increase social welfare. The figure 1.14 shows the effects of imposing
a new tax on a good. P0 was the price before the tax was imposed, pD is the price consumers
pay and pS the price producers receive. Consumer surplus is reduced by B and E, producer
surplus decreases by C and F, while government increases its revenue from zero to B and C.
Consumers and producers lose B+E+C+F and the tax revenue is B+C, which determines
the deadweight loss, the reduction in total surplus: E+F. The deadweight loss depends on
the elasticity of both the supply and demand curves: the higher the elasticity in absolute
terms, the larger the deadweight loss.
Figure 1.14
Also, depending on the size of a tax, the tax revenue may be bigger or smaller. In the figure
1.15 we see how as the tax increases, the deadweight loss (grey) increases too.
Figure1.15
However, the tax revenue will first increase, and then will start to shrink. This
relationship is known as the Laffer curve, shown in the figure 1.16 (being t the tax size
and T the tax revenue). The Laffer curve might seem as an incredibly useful tool
for government intervention. However, it has been widely criticized, mainly because
empirical evidence to support it is rarely found, and because even if the relationship was
accurate, it’s quite hard to know at which point of the curve a country actually is.
Figure 1.16: Laffer curve
Taxing firms:
There are three main possible ways the government can impose taxes on firms: lump-sum
tax, tax on profits and tax on output.
1.Lump-Sum Tax:
A certain amount of money has to be paid by the firm over a period of time. This kind of
tax represents an increase in fixed costs and they consequently treat it as one. It holds the
entry of firms in the market as it acts as an entry barrier, and will force some inefficient
firms out of the market.
2.Tax on Profits:
Firms have to pay the government a percentage of their profits. This kind of tax is also
considered a fixed cost. Sometimes the application this tax will cause profits to be negative,
thus forcing some firms to exit the market. The effects on total quantity sold and the quantity
produced by a given firm of both lump-sum taxes and taxes on profits can be analysed with
the figure 1.17:
Figure 1.17
3.Tax on Output (or output tax):

In this case, firms pay a certain amount for each unit of output produced. As it has a direct
relationship with the output level it is considered an increase in variable costs. The least
efficient firms will be forced to exit the market.
The effects on total quantity sold and the quantity produced by a given firm of an output tax
can be analysed with the figure 1.18:
Figure 1.18
Module II
Monopoly
Monopoly
A monopoly is a market characterized by a single seller of a good with no close
substitutes and barriers to entry. Monopolies rarely occur in a pure form. There are almost
always substitutes or methods of possible entry into a market. When the term “monopoly”
is used it is usually referring to a degree of monopoly or market power. In many cases the
existence of a monopoly results in regulation or the enforcement of antitrust laws that
attempt to introduce competition to reduce market power.
The definition of monopoly requires a judgment about the phrase “no close
substitutes” and what “barriers to entry” mean. I might be the only producer of mink lined,
titanium trash cans. This is not relevant as a monopoly since there are many good substitutes:
plastic or steel containers or even brown paper bags will serve as trash containers. There are
substitutes for the electricity (KWH) produced by a public utility. It is possible to purchase
a portable generator powered by an internal combustion engine or use candles for use in
your home. However, neither of these can be regarded as a close substitute. The concept of
cross elasticity of demand can be used to identify whether two goods are substitutes on not.
The main causes that lead to monopoly are the following.
Firstly, ownership of strategic raw materials, or exclusive knowledge of production

techniques.
Secondly, patent rights for a product or for a production process.
Thirdly, government licensing or the imposition of foreign trade barriers to exclude
foreign competitors.
Fourthly, the size of the market may be such as not to support more than one plant
of optimal size.
Fifthly, the existing firm adopts a limit-pricing policy, that is, a pricing policy aiming
at the prevention of new entry. Such a pricing policy may be combined with other
policies such as heavy advertising or continuous product differentiation, which
render entry unattractive. This is the case of monopoly established by creating
barriers to new competition.
Sources of monopoly
The conditions that can lead to domination of a market by a single firm and create
barriers that prevent the entry of new firms are:
1. Barriers to Entry
Barriers to entry are characteristics of a particular market that block new firms from
entering it. They include economies of scale, special advantages of location, high sunk costs,
a dominant position in the ownership of some of the inputs required to produce the good,
and government restrictions. These barriers may be interrelated, making entry that much
more formidable. Although these barriers might allow one firm to gain and hold monopoly
control over a market, there are often forces at work that can erode this control.
2. Economies of Scale
Scale economies and diseconomies define the shape of a firm’s long-run average cost
curve as it increases its output. If long-run average cost declines as the level of production
increases, a firm is said to experience economies of scale.
A firm that confronts economies of scale over the entire range of outputs demanded in
its industry is a natural monopoly. Utilities that distribute electricity, water, and natural gas
to some markets are examples. In a natural monopoly, the LRAC of any one firm intersects
the market demand curve where long-run average costs are falling or are at a minimum. If
this is the case, one firm in the industry will expand to exploit the economies of scale
available to it. Because this firm will have lower unit costs than its rivals, it can drive them
out of the market and gain monopoly control over the industry.
3. Location
Sometimes monopoly power is the result of location. For example, sellers in markets
isolated by distance from their nearest rivals have a degree of monopoly power. The local
movie theatre in a small town has a monopoly in showing first-run movies. Doctors, dentists,
and mechanics in isolated towns may also be monopolists.
4. Sunk Costs
The greater the cost of establishing a new business in an industry, the more difficult it
is to enter that industry. That cost will, in turn, be greater if the outlays required to start a
business are unlikely to be recovered if the business should fail.
An expenditure that has already been made and that cannot be recovered is called a sunk
cost. If a substantial fraction of a firm’s initial outlays will be lost upon exit from the
industry, exit will be costly. Difficulty of exit can make for difficulty of entry. The more
firms have to lose from an unsuccessful effort to penetrate a particular market, the less likely
they are to try. The potential for high sunk costs could thus contribute to the monopoly
power of an established firm by making entry by other firms more difficult.
5. Restricted Ownership of Raw Materials and Inputs
In very few cases the source of monopoly power is the ownership of strategic inputs. If
a particular firm owns all of an input required for the production of a particular good or
service, then it could emerge as the only producer of that good or service.
The Aluminum Company of America (ALCOA) gained monopoly power through its
ownership of virtually all the bauxite mines in the world (bauxite is the source of aluminum).
The International Nickel Company of Canada at one time owned virtually all the world’s
nickel. De Beers acquired rights to nearly all the world’s diamond production, giving it
enormous power in the market for diamonds. With new diamond supplies in Canada,
Australia, and Russia being developed and sold independently of DeBeers, however, this
power has declined, and today DeBeers controls a substantially smaller percentage of the
world’s supply.
6. Government Restrictions
Another important basis for monopoly power consists of special privileges granted to
some business firms by government agencies. State and local governments have commonly
assigned exclusive franchises—rights to conduct business in a specific market—to taxi and
bus companies, to cable television companies, and to providers of telephone services,
electricity, natural gas, and water, although the trend in recent years has been to encourage
competition for many of these services. Governments might also regulate entry into an
industry or a profession through licensing and certification requirements. Governments also
provide patent protection to inventors of new products or production methods in order to
encourage innovation; these patents may afford their holders a degree of monopoly power
during the 17-year life of the patent.
Types of monopoly
The different types of monopoly are:
1. Simple Monopoly and Discriminating Monopoly:
A simple monopoly firm charges a uniform price for its output sold to all the
buyers. While a discriminating monopoly firm charges different prices for the same
product to different buyers. A simple monopoly operates in a single market a
discriminating monopoly operates in more than one market.
2. Pure Monopoly and Imperfect Monopoly:
Pure monopoly is that type of monopoly in which a single firm which controls the
supply of a commodity which has no substitutes not even a remote one. It possesses an
absolute Monopoly power. Such a Monopoly is very rare. While imperfect monopoly means
a limited degree of Monopoly. It refers to a single firm which produces a commodity having
no close substitutes. The degree of Monopoly is less than perfect in this case and it relates
to the availability of the closeness of a substitute. In practice, there are many cases of such
imperfect monopoly.
3. Natural Monopoly:
When a Monopoly is established due to natural causes then it is called natural

monopoly. To-day India has got Monopoly in mica production and Canada has got
Monopoly in nickel production. These Monopoly natures has provided to these countries.
4. Legal Monopoly:
When anybody receives or acquires Monopoly due to legal provisions in the country.
For example, when legal monopolies emerge on account of legal provisions like
patents, trade-marks, copyrights etc. The law forbids the potential competitors to imitate the
design and form of products registered under the given brand names, patent or trade-marks.
This is done to safeguard the interests of those who have done much research and undertaken
risks of innovating a particular product.
5. Industrial Monopolies or Public Monopolies:
In the general interest of the nation, when a government nationalises certain

industries in the public sector, thereby industrial or public monopolies are created. The
Industrial Policy Resolution 1956, in India, for instance, categorically lays down that certain
fields like arms and ammunition, atomic energy, railways and air transport will be the sole
monopoly of the Central Government. In this way industrial monopolies are created through
statutory measures.
AR and MR curve of a monopolist
Since there is a single firm in the industry, the firm's demand curve is the industry
demand curve. This curve is assumed known and has a downward slope (figure 2.1).
Figure 2.1
We will use a linear demand function for simplicity. The properties of this form of demand
may be summarised as follows:
1. The demand equation, ceteris paribus, is
∗ ∗
= −
The clause ceteris paribus implies that all the other factors (such as income, tastes, other
prices) which affect demand are assumed constant. Changes in these factors will shift the
demand curve.
2. The slope of the demand curve is
∗
=−
3. The price elasticity of demand is
= . = − ∗.
That is, elasticity changes at any one point of the demand curve.
4. The total revenue of the monopolist is
R=P·X
Solving the demand equation for P we find
= −
Substituting into the revenue equation we find
= =( − )
Or = −
5. The average revenue is equal to the price:
= = = = −
Thus the demand curve is also the AR curve of the monopolist.

6. The marginal revenue is:
( − )
= = −2
That is, the M R is a straight line with the same intercept as the demand curve, but twice as
steep.
7. The relationship between MR and price elasticity e is
1
= (1 − )
Short Run Equilibrium

The monopolist maximises his short-run profits if the following two conditions are fulfilled:
Firstly, the MC is equal to the MR.

Secondly, the slope of MC is greater than the slope of the MR at the point of
intersection.
Figure 2.2: Monopolist’s Equilibrium
In figure 2.2 the equilibrium of the monopolist is defined by point e, at which the
MC intersects the MR curve from below. Thus both conditions for equilibrium are fulfilled.
Price is PM and the quantity is XM. The monopolist realises excess profits equal to the
shaded area APMCB. Note that the price is higher than the MR.
In pure competition the firm is a price-taker, so that its only decision is output determination.
The monopolist is faced by two decisions: setting his price and his output. However, given
the downward-sloping demand curve, the two decisions are interdependent. The monopolist
will either set his price and sell the amount that the market will take at it or he will produce
the output defined by the intersection of MC and MR, which will be sold at the
corresponding price, P. The monopolist cannot decide independently both the quantity and
the price at which he wants to sell it. The crucial condition for the maximisation of the
monopolist's profit is the equality of his MC and the MR, provided that the MC cuts the MR
from below.
Long-Run Equilibrium
In the long run the monopolist has the time to expand his plant, or to use his existing plant
at any level which will maximise his profit. With entry blocked, however, it is not necessary
for the monopolist to reach an optimal scale (that is, to build up his plant until he reaches
the minimum point of the LAC). Neither is there any guarantee that he will use his existing
plant at optimum capacity. What is certain is that the monopolist will not stay in business if
he makes losses in the long run. He will most probably continue to earn supernormal profits
even in the long run, given that entry is barred. However, the size of his plant and the degree
of utilisation of any given plant size depend entirely on the market demand. He may reach
the optimal scale (minimum point of LAC) or remain at suboptimal scale (falling part of his
LAC) or surpass the optimal scale (expand beyond the minimum LAC) depending on the
market conditions.
Figure 2.3
In figure 2.3 we depict the case in which the market size does not permit the
monopolist to expand to the minimum point of LAC. In this case not only is his plant of
suboptimal size (in the sense that the full economies of scale are not exhausted) but also the
existing plant is underutilised. This is because to the left of the minimum point of the LAC
the SRAC is tangent to the LAC at its falling part, and also because the short-run MC must
be equal to the LRMC. This occurs at e, while the minimum LAC is at band the optimal use
of the existing plant is at a. Since it is utilised at the level e', there is excess capacity.
Figure 2.4
In figure 2.4 we depict the case where the size of the market is so large that the monopolist,
in order to maximise his output, must build a plant larger than the optimal and over utilise
it. This is because to the right of the minimum point of the LAC the SRAC and the LAC are
tangent at a point of their positive slope, and also because the SRMC must be equal to the
LAC. Thus the plant that maximises the monopolist's profits leads to higher costs for two
reasons: firstly because it is larger than the optimal size, and secondly because it is over
utilised. This is often the case with public utility companies operating at national level.
Figure 2.5
Finally in figure 2.5 we show the case in which the market size is just large enough to permit
the monopolist to build the optimal plant and use it at full capacity. It should be clear that
which of the above situations will emerge in any particular case depends on the size of the
market (given the technology of the monopolist). There is no certainty that in the long run
the monopolist will reach the optimal scale, as is the case in a purely competitive market. In
monopoly there are no market forces similar to those in pure competition which lead the
firms to operate at optimum plant size (and utilise it at its full capacity) in the long run.
Supply curve of a monopolist
Under perfect competition, short run MC curve above the shut-down point is the supply
curve which shows a unique relationship between price and quantity. At a particular price,
a particular amount of the commodity will be supplied. Under monopoly, there is no such
one-to-one correspondence between price and quantity supplied. This is because of the fact
that output decision of a monopolist not only depends on marginal cost but also on the shape
of the demand curve. “As a result, shifts in demand do not trace out a series of prices
and quantities as happens with a competitive supply curve.”It may happen that a
monopolist, given his MC curve, may supply a particular quantity at different prices
depending on the elasticity of demand. Thus, the construction of supply curve from the MC
curve is impossible under monopoly or under any branch of imperfect competition.
With a fixed market demand curve, the supply “curve” for a monopoly will be only one
point—namely, that price-quantity combination for which MR = MC. If the demand curve
should shift then the marginal revenue curve would also shift, and a new profit maximizing
output would be chosen. However, connecting the resulting series of equilibrium points on
the market demand curves would have little meaning. This locus might have a very strange
shape, depending on how the market demand curve’s elasticity (and its associated MR
curve) changes as the curve is shifted. In this sense the monopoly firm has no well defined
“supply curve.” Each demand curve is a unique profit-maximizing opportunity for a
monopolist.
The Multiplant Firm
This is the case of a monopolist who produces a homogeneous product in different

plants. We shall restrict the analysis to two plants for simplicity. Assume that the monopolist
operates two plants, A and B, each with a different cost structure (figure 2.6). He has to
make two decisions: Firstly, how much output to produce altogether and at what price to
sell it so as to maximise profit. Secondly, how to allocate the production of the optimal
(profit-maximising) output between the two plants.
Figure 2.6
Plant A Plant B Total market

The monopolist is assumed to know his market demand (and the corresponding MR
curve) and the cost structure of the different plants. The total MC curve of the monopolist
may be computed from the horizontal summation of the MC curves of the individual plants.
MC=MC1+MC2
Given the MR and MC curves, the monopolist can define the total output and the
price at which it must be sold in order to maximise his profit from the intersection of these
two curves (point e in figure 2.6).
The allocation of production between the plants is decided by the marginalistic rule
MC1=MC2=MR
In other words, the monopolist maximises his profit by utilising each plant up to the
level at which the marginal costs are equal to each other and to the common marginal
revenue. This is because if the MC in one plant, say plant A, is lower than the marginal cost
of plant B, the monopolist would increase his profit by increasing the production in A and
decreasing it in B, until the condition MC1 = MC2 = MR is fulfilled.
Graphically the equilibrium of the multiplant monopolist may be defined as follows.

The total profit-maximising output and its price is defined by the intersection of MC and
MR curves (point e in figure 2.6). From the point of intersection we draw a line, parallel to
the X axis, until it intersects the individual MC1 and MC2 curves of the two plants. At these
points the equilibrium condition (MC = MR = MC1 = MC2) is satisfied. If from these points
(e1 and e2) we draw perpendiculars to the X axis of figures 2.5, we find the level of output
that will be produced in each plant. Clearly X 1 + X 2 must be equal to the profit maximising
output X. The total profit is the sum of profits from the products of the two plants. The profit
from plant A is the shaded area abcd and the profit from plant B is the shaded area gfjh.
Monopoly power
Pure monopoly is rare. Markets in which several firms compete with one another are
much more common. Each firm in a market with several firms is likely to face a downward-
sloping demand curve and, as a result, to produce so that price exceeds marginal cost.
Suppose, for example, that four firms produce toothbrushes and have the market demand
curve Q =50,000 − 20,000P, as shown in figure 2.7 (a).
Figure 2.7
Let’s assume that these four firms are producing an aggregate of 20,000 toothbrushes per
day (5000 each per day) and selling them at $1.50 each. Note that market demand is
relatively inelastic. Now suppose that Firm A is deciding whether to lower its price to
increase sales. To make this decision, it needs to know how its sales would respond to a
change in its price. In other words, it needs some idea of the demand curve it faces, as
opposed to the market demand curve. A reasonable possibility is shown in Figure 2.7 (b),
where the firm’s demand curve DA is much more elastic than the market demand curve. For
several reasons, sales won’t drop to zero as they would in a perfectly competitive market.
First, if Firm A’s toothbrushes are a little different from those of its competitors, some
consumers will pay a bit more for them. Second, other firms might also raise their prices.
Similarly, Firm A might anticipate that by lowering its price from $1.50 to $1.40, it can sell
more toothbrushes—perhaps 7000 instead of 5000. But it will not capture the entire market:
Some consumers might still prefer the competitors’ toothbrushes, and competitors might
also lower their prices. Thus, Firm A’s demand curve depends both on how much its product
differs from its competitors’ products and on how the four firms compete with one another.
Firm A is likely to face a demand curve which is more elastic than the market demand curve,
but which is not infinitely elastic like the demand curve facing a perfectly competitive firm.
Let’s assume that Firm A has a good knowledge of its demand curve. The profit-maximizing
quantity equates marginal revenue and marginal cost. In Figure 2.7 (b), that quantity is 5000
units. The corresponding price is $1.50, which exceeds marginal cost. Thus, although Firm
A is not a pure monopolist, it does have monopoly power—it can profitably charge a price
greater than marginal cost. Of course, its monopoly power is less than it would be if it had
driven away the competition and monopolized the market, but it might still be substantial.
Measurement of monopoly power
The important distinction between a perfectly competitive firm and a firm with monopoly
power is that for the competitive firm, price equals marginal cost; for the firm with
monopoly power, price exceeds marginal cost. Therefore, a natural way to measure
monopoly power is to examine the extent to which the profit maximizing price exceeds
marginal cost. In particular, we can use the mark up ratio of price minus marginal cost to
price that we introduced earlier as part of a rule of thumb for pricing. This measure of
monopoly power, introduced by economist Abba Lerner in 1934, is called the Lerner Index
of Monopoly Power. It is the difference between price and marginal cost, divided by price.
Mathematically:
L = (P - MC)/P
The Lerner index always has a value between zero and one. For a perfectly competitive firm,
P = MC, so that L = 0. The larger is L, the greater is the degree of monopoly power. This
index of monopoly power can also be expressed in terms of the elasticity of demand facing
the firm. Using equation
− 1
=−
we know that
L = (P - MC)/P = - 1/Ed
Remember that Ed is now the elasticity of the firm’s demand curve, not the market demand
curve. In the example toothbrush discussed previously, the elasticity of demand for Firm A
is −6.0, and the degree of monopoly power is 1/6 = 0.167.8. So that considerable monopoly
power does not necessarily imply high profits. Profit depends on average cost relative to
price. Firm A might have more monopoly power than Firm B but earn a lower profit because
of higher average costs.
Social cost of monopoly
In a competitive market, price equals marginal cost. Monopoly power, on the other
hand, implies that price exceeds marginal cost. Because monopoly power results in higher
prices and lower quantities produced, we would expect it to make consumers worse off and
the firm better off. But suppose we value the welfare of consumers the same as that of
producers.
Table 2.8
Under monopoly, the price is higher and consumers buy less. Because of the higher
price, those consumers who buy the good lose surplus of an amount given by rectangle A.
Those consumers who do not buy the good at price Pm but who would buy at price Pc also
lose surplus—namely, an amount given by triangle B. The total loss of consumer surplus is
therefore A+B. The producer, however, gains rectangle A by selling at the higher price but
loses triangle C, the additional profit it would have earned by selling Qc − Qm at price Pc.
The total gain in producer surplus is therefore A − C. Subtracting the loss of consumer
surplus from the gain in producer surplus, we see a net loss of surplus given by B + C. This
is the deadweight loss from monopoly power. Even if the monopolist’s profits were taxed
away and redistributed to the consumers of its products, there would be inefficiency because
output would be lower than under conditions of competition. The deadweight loss is the
social cost of this inefficiency.
Rent Seeking
In practice, the social cost of monopoly power is likely to exceed the deadweight loss in
triangles B and C of figure 2.8. The reason is that the firm may engage in rent seeking:
spending large amounts of money in socially unproductive efforts to acquire, maintain, or
exercise its monopoly power. Rent seeking might involve lobbying activities (and perhaps
campaign contributions) to obtain government regulations that make entry by potential

competitors more difficult. Rent-seeking activity could also involve advertising and legal
efforts to avoid antitrust scrutiny. It might also mean installing but not utilizing extra
production capacity to convince potential competitors that they cannot sell enough to make
entry worthwhile. We would expect the economic incentive to incur rent-seeking costs to
bear a direct relation to the gains from monopoly power (i.e., rectangle A minus triangle C.)
Therefore, the larger the transfer from consumers to the firm (rectangle A), the larger the
social cost of monopoly.
Price Regulation
Because of its social cost, antitrust laws prevent firms from accumulating excessive amounts
of monopoly power.
Figure 2.9
Figure 2.9 illustrates price regulation. Pm and Qm are the price and quantity that
result without regulation—i.e., at the point where marginal revenue equals marginal cost.
Now suppose the price is regulated to be no higher than P1. To find the firm’s profit-
maximizing output, we must determine how its average and marginal revenue curves are
affected by the regulation. Because the firm can charge no more than P1 for output levels up
to Q1, its new average revenue curve is a horizontal line at P1. For output levels greater than
Q1, the new average revenue curve is identical to the old average revenue curve: At these
output levels, the firm will charge less than P1 and so will be unaffected by the regulation.
The firm’s new marginal revenue curve corresponds to its new average revenue curve. For
output levels up to Q1, marginal revenue equals average revenue. For output levels greater
than Q1, the new marginal revenue curve is identical to the original curve. Thus the complete
marginal revenue curve now has three pieces: (1) the horizontal line at P1 for quantities up
to Q1; (2) a vertical line at the quantity Q1 connecting the original average and marginal
revenue curves; and (3) the original marginal revenue curve for quantities greater than Q1.
To maximize its profit, the firm should produce the quantity Q1 because that is the point at
which its marginal revenue curve intersects its marginal cost curve. As the price is lowered
further, the quantity produced continues to increase and the deadweight loss to decline. At
price Pc where average revenue and marginal cost intersect, the quantity produced has
increased to the competitive level; the deadweight loss from monopoly power has been
eliminated. Reducing the price even more—say, to P3—results in a reduction in quantity.
This reduction is equivalent to imposing a price ceiling on a competitive industry. A
shortage develops, (Q3 = - Q3), in addition to the deadweight loss from regulation. As the
price is lowered further, the quantity produced continues to fall and the shortage grows.
Finally, if the price is lowered below P4, the minimum average cost, the firm loses money
and goes out of business.
Regulation of monopoly
a) Price Control
By setting a maximum price at the level where the SMC curve cuts the D curve, the
government can induce the monopolist to increase output to the level the industry would
have produced if organized along perfectly competitive lines. This also reduces the
monopolist’s profits.
If the government imposed a maximum price of $5 (i.e., at the level where the SMC
curve cuts the D curve), the new demand curve facing the monopolist becomes ABK. The
corresponding MR curve becomes ABCL and is identical with the new D curve over the
infinitely elastic range, AB. Thus, the regulated monopolist will behave as a perfectly
competitive firm and produce at point B, where P or MR = SMC and the SMC curve is
rising. The result is that price is lower ($5 rather than the $5.50 in the absence of price
control), output is greater (3 units rather than 2.5 units), profit per unit is less ($1 rather than
$1.50), and total profits are reduced (from $3.75 to $3).
Figure 2.10
b) Lumsum Tax
By imposing a lump-sum tax (such as a license fee or a profit tax), the government can
reduce or even eliminate the monopolist’s profits without affecting either the commodity
price or output.
Table 2.1
P Q TR MR STC SMC SAC STC| SAC|
8 0 0 - 6 - - 9.75 -
7 1 7 7 8 2 8 11.75 11.75
6 2 12 5 9 1 4.5 12.75 6.38
5.5 2.5 13.75 3 10 3 4 13.75 5.5
5 3 15 3 12 3 4 15.75 5.25
4 4 16 1 20 8 5 23.75 5.94
If the government imposed a lump-sum tax of $3.75, all of the monopolist’s profits would
be eliminated. So STC| is obtained by adding the lump-sum tax of $3.75 to the STC values.
Since a lump-sum tax is like a fixed cost, it does not affect SMC [compare STC| to STC].
With his or her MR and SMC curves unchanged, the monopolist’s best level of output
remains at 2.5 units and the monopolist continues to charge a price of $5.50. But now, since
SAC| at 2.5 units of output is also $5.50, the monopolist breaks even. It is shown in the
figure 2. 11.
Figure 2. 11
c) Per Unit Tax

The government can also reduce the monopolist’s profit by imposing a per-unit tax.
However, in this case the monopolist will be able to shift part of the burden of the per-unit
tax to consumers, in the form of a higher price and a smaller output of the commodity.
Suppose that the government imposes a tax of $2 per unit of output on the monopolist. Then
the values of STC| of Table 2.2 are obtained by adding the tax of $2 on each unit of output
to the STC values.
Table 2.2
P Q TR MR STC SMC SAC STC| SMC| SAC|
7 1 7 7 8 - 8 10 - 10
6 2 12 5 9 1 4.5 13 3 6.5
5 3 15 3 12 3 4 18 5 6
4 4 16 1 20 8 5 28 10 7
Note that the per-unit tax is like a variable cost and thus causes an upward shift in both the
monopolist’s SAC and SMC curves (to SAC| and SMC|). The new equilibrium output is 2
units (and is given by the point where the SMC | intersects the unchanged MR curve from
below); P = $6, SAC| = $6.50, and the monopolist now incurs a short-run loss of $0.50 per
unit and $1 in total (shown in Figure 2.dddd). If TR > TVC at this new best level of output,
the monopolist stays in business in the short run, but will produce 0.5 unit less than without
the per-unit tax and will charge $0.50 more for each of the 2 units sold.
Figure 2.12
Price discrimination
Price discrimination exists when the same product is sold at different prices to different
buyers. The cost of production is either the same, or it differs but not as much as the
difference in the charged prices. The product is basically the same, but it may have slight
differences (for example, different binding of the same book; different location of seats in a
theatre; different seats in an aircraft or a train). We will concentrate on the typical case of
an identical product, produced at the same cost, which is sold at different prices, depending
on the preference of the buyers, their income, their location and the ease of availability of
substitutes. These factors give rise to demand curves with different elasticities in the various
sectors of the market of a firm. It is also common to charge different prices for the same
product at different time periods. For example, a new product is often sold at a high price,
accessible only to the rich, while subsequently it is sold at lower prices which can be
afforded by lower-income consumers.
The necessary conditions, which must be fulfilled for the implementation of price
discrimination, are the following:
1. The market must be divided into sub-markets with different price elasticities.
2. There must be effective separation of the sub-markets, so that no reselling can take place
from a low-price market to a high-price market. This condition shows why price
discrimination is easier to apply with commodities like electricity or gas, and services (like
services of a doctor, transport, a show), which are 'consumed' by the buyer and cannot be
resold. The reason for a monopolist (or any other firm) to apply price discrimination is to
obtain an increase in his total revenue and his profits. By selling the quantity defined by the
equation of his MC and his MR at different prices the monopolist realises a higher total
revenue and hence higher profits as compared with the revenues he would polist who sells
his product at two different prices.
It is assumed that the monopolist will sell his product in two segregated markets, each of
them having a demand curve with different elasticity. In figure 2.13 the demand curve D1
has higher price elasticity than D2 at any given price. The total-demand curve D is found by
the horizontal summation of D1 and D2. The aggregate marginal revenue (MR) is the
horizontal summation of the marginal-revenue curves MR1 and MR2. The marginal-cost
curve is depicted by the curve MC.
Figure 2.13
The price-discriminating monopolist has to decide (a) the total output that he must produce,
(b) how much to sell in each market and at what price, so as to maximise his profits.
The total quantity to be produced is defined by the point of intersection of the MC and the
aggregate M R curves of the monopolist. In figure 2.13 the two curves intersect at point E,
thus defining a total output OX which must be produced. If the monopolist were to charge
a uniform price this would be P, and his total revenue would be OX AP. His profit would
be the difference between this revenue and the cost for producing OX. However, the
monopolist can achieve a higher profit by charging different prices in the two markets. The
price and the quantity in each market is defined in such a way as to maximise profit in each
market. Thus in each market he must equate the marginal revenue with the MC. However,
the marginal cost is the same for the whole quantity produced, irrespective of the market in
which it is going to be sold. The marginal revenue in each market differs due to the
difference in the elasticity of the two demand curves. The profit in each market is maximised
by equating MC to the corresponding MR:
In the first market profit is maximised when
MR1 =MC
In the second market profit is maximised when
MR2 = MC
Clearly the total profit is maximised when the monopolist equates the common MC to the
individual revenues
MC = MR1 = MR2
If MR in one market were larger, the monopolist would sell more in that market and less in
the other, until the above condition was fulfilled.
The total revenue from price discrimination is larger than the revenue OX AP which
would be received by charging a uniform price P. With price discrimination the total
revenue is
(P1) (0X1) + (P2) (0X2) = 0P1 FX1 + 0P2 EX2
PDEP2 is the additional revenue from selling 0X 2 at price P2 which is higher than P, while
CBAD is the loss in revenue from selling 0X1 at price P1 which is lower than P. The
additional revenue from selling 0X2 at a higher price more than offsets the loss of revenue
from selling 0X1 at a lower price, so that total revenue from price discrimination is larger.
Since the cost of producing 0X is the same irrespective of the price at which it will be sold,
the profits from price discrimination are larger as compared with those that would be
obtained from selling all the output at the uniform price P.
This case has been called third-degree price discrimination by the British economist Pigou.
The increase in total revenue is achieved by taking away part of the consumers’ surplus. To
understand this let us concentrate on the demand curve, D (figure 2.14).
Figure 2.14
If the monopolist sold all OX at P he would receive OX AP, and the consumers would have
a surplus of PAD. Assume now that the monopolist sells OX 1 at the price P1 and the
remaining quantity X 1X at the price P. His total revenue will be
OX1CP1 + X1XAB = OXAP + PBCP1
that is, the monopolist has managed to take the part PBCP1 from the consumers surplus.
Figure 2.15
If the monopolist can negotiate and sell at more than two prices (higher than P), for example
to sell OX1 at P1, X 1 X 2 at P2 , X 2 X 3 at P3 and X 3 X at P, he will receive a still larger part
of the consumers' surplus (figure 1.15). This is called second-degree price discrimination.
Figure 2.16
In the limiting case in which the monopolist can negotiate individually with each
buyer and sell each unit of output at its corresponding price as shown from the DD' curve,
then he will receive the entire consumers' surplus (figure 2.16). This is known as first-degree
price discrimination or as ‘take-it-or-leave-it’ price discrimination; because in negotiating
with each buyer the monopolist charges him the maximum price he is willing to pay under
threat of denying the selling of any quantity to him: he offers each buyer a ‘take-it-or-leave-
it’ choice. In this case the demand curve also becomes the M R curve of the monopolist.
International price discrimination (Dumping- types)
Dumping is an international price discrimination in which an exporter firm sells a

portion of its output in a foreign market at a very low price and the remaining output at a
high price in the home market. Haberler defines dumping as: “The sale of goods abroad at
a price which is lower than the selling price of the same goods at the same time and in the
same circumstances at home, taking account of differences in transport costs”. Viner’s

definition is simple. According to him, “Dumping is price discrimination between two
markets in which the monopolist sells a portion of his produced product at a low price and
the remaining part at a high price in the domestic market.”
Objectives of Dumping:
The main objectives of dumping are as follows:
1. To Find a Place in the Foreign Market:
A monopolist resorts to dumping in order to find a place or to continue himself in the foreign
market. Due to perfect competition in the foreign market he lowers the price of his
commodity in comparison to the other competitors so that the demand for his commonly
may increase. For this, he often sells his commodity by incurring loss in the foreign market.
2. To Sell Surplus Commodity:
When there is excessive production of a monopolist’s commodity and he is not able to sell
in the domestic market, he wants to sell the surplus at a very low price in the foreign market.
But it happens occasionally.
3. Expansion of Industry:
A monopolist also resorts to dumping for the expansion of his industry. When he expands
it, he receives both internal and external economies which lead to the application of the law
of increasing returns. Consequently, the cost of production of his commodity is reduced and
by selling more quantity of his commodity at a lower price in the foreign market, he earns
larger profit.
4. New Trade Relations:
The monopolist practices dumping in order to develop new trade relations abroad. For this,
he sells his commodity at a low price in the foreign market, thereby establishing new market
relations with those countries. As a result, the monopolist increases his production, lowers
his costs and earns more profit.
Two part tariff
A two-part tariff is a price discrimination technique in which the price of a product or service
is composed of two parts - a lump-sum fee as well as a per-unit charge. General, price
discrimination techniques only occur in partially or fully monopolistic markets. It is
designed to enable the firm to capture more consumer surplus than it otherwise would in a
non-discriminating pricing environment. One form of pricing schedule that has been
extensively studied is a linear two-part tariff, under which demanders must pay a fixed fee
for the right to consume a good and a uniform price for each unit consumed. The prototype
case, first studied by Walter Oi, is an amusement park (perhaps Disneyland) that sets a basic
entry fee coupled with a stated marginal price for each amusement used. Mathematically,
this scheme can be represented by the tariff any demander must pay to purchase q units of
a good:
T (q) = a+ pq,
Where, a is the fixed fee and p is the marginal price to be paid. The monopolist’s goal then
is to choose a and p to maximize profits, given the demand for this product. Because the
average price paid by any demander is given by
̅= = +
this tariff is feasible only when those who pay low average prices (those for whom q is large)
cannot resell the good to those who must pay high average prices (those for whom q is
small). One approach described by Oi for establishing the parameters of this linear tariff
would be for the firm to set the marginal price, p, equal to MC and then set a so as to extract
the maximum consumer surplus from a given set of buyers. One might imagine buyers being
arrayed according to willingness to pay. The choice of p = MC would then maximize
consumer surplus for this group, and could be set equal to the surplus enjoyed by the least
eager buyer. He or she would then be indifferent about buying the good, but all other buyers
would experience net gains from the purchase.
This feasible tariff might not be the most profitable. Consider the effects on profits of a
small increase in p above MC. This would result in no net change in the profits earned from
the least willing buyer. Quantity demanded would drop slightly at the margin where p =MC,
and some of what had previously been consumer surplus (and therefore part of the fixed fee,
a) would be converted into variable profits because now p > MC. For all other demanders,
profits would be increased by the price rise. Although each will pay a bit less in fixed
charges, profits per unit bought will rise to a greater extent. In some cases it is possible to
make an explicit calculation of the optimal two-part tariff.
Tied sales
Sometimes a monopoly will market two goods together. This situation poses a number of
possibilities for discriminatory pricing schemes. Consider, for example, laser printers that
are sold with toner cartridges or electronic game players sold with patented additional
games. Usually consumers buy only one unit of the basic product (the printer or camera)
and thereby pay the “entry” fee. Then they consume a variable number of tied products
(toner and film). Because the monopoly will choose a price for its tied product that exceeds
marginal cost, there will be a welfare loss relative to a situation in which the tied good is
produced competitively. Perhaps for this reason, tied sales are prohibited by law in some
cases. Prohibition may not necessarily increase welfare, however, if the monopoly declines
to serve low-demand consumers in the absence of such a practice (Oi, 1971).
One way in which tied sales can be accomplished is through creation of a multiplicity of
quality variants that appeal to different classes of buyers. Automobile companies have been
especially ingenious at devising quality variants of their basic models (for example, the
Honda Accord comes in DX, LX, EX, and SX configurations) that act as tied goods in
separating buyers into various market niches. Generally, this sort of price discrimination in
a tied good will be infeasible if that good is also produced under competitive conditions. In
such a case the tied good will sell for marginal cost, and the only possibility for
discriminatory behaviour open to the monopolist is in the pricing of its basic good (that is,
by varying “entry fees” among demanders). In some special cases, however, choosing to
pay the entry fee will confer monopoly power in the tied good on the monopolist even
though it is otherwise reduced under competitive conditions.
Bundling
Bundling refers to selling more than one product at a single price. Bundling is applicable
when:
a) The firm has market power
b) Price discrimination is not possible (inability to offer different prices to different

customers or segments)
c) Demand for two or more goods to be sold is negatively correlated (the more consumers
demand one good, the less they will demand of the other good)
Pure Bundling: Consumers must buy both goods together; the choice of buying one good
without buying the other is NOT given.
Mixed Bundling: Consumers have the choice of buying one good without the other.
Peak load pricing
When demand for a commodity varies at different periods of time, higher price of a
commodity or service are charged for peak period when demand is greater and lower price
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. Examples
of peak-load pricing are many. In India internet charges of BSNL Broadband during day
time, which is the peak time, is higher compared to off-peak period from 11.00 PM to 6.00
AM. Peak-load pricing is generally recommended for regulated companies such as electric
company, telephone company etc. In many countries electric companies are permitted to
charge higher rates during 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.
Monopsony
Monopsony is similar to monopoly in many regards. A monopolistic market has one seller
and many competitive buyers. A monopsonistic market has one buyer and many competitive
sellers. Thus monopsony refers to a market in which there is only a single buyer. With only
one buyer or few buyers as in oligopoly, some buyers may have monopsony power, a
buyer’s ability to affect the price of a good. Monopoly power enables the buyer to purchase
a good for less than the price that would prevail in a competitive market. However, a buyer
with monopsony power can purchase goods at a price below marginal value.
Much more common than pure monopsony are markets with a few firms competing among
themselves as buyers. For Example, the major Indian automobile manufacturers compete
with one another as buyers of tyres. Because each of them accounts for a large share of the
tyre market, each has some monopsony power in that market. Maruti Suzuki, the largest
buyer, may be able to exert considerable monopsony power while giving contract for the
supply of tyres.
Bilateral Monopoly
Bilateral monopoly is a market consisting of a single seller (monopolist) and a single buyer
(monopsonist). For example, if a single firm produced all the copper in a country and if only
one firm used this metal, the copper market would be a bilateral monopoly market. The
equilibrium in such a market cannot be determined by the traditional tools of demand and
supply. Economic analysis can only define the range within which the price will eventually
be settled. The precise level of the price (and output), however, will ultimately be defined
by non-economic factors, such as the bargaining power, skill and other strategies of the
participant firms. Under conditions of bilateral monopoly economic analysis leads to
indeterminacy which is finally resolved by exogenous factors.
To illustrate a situation of bilateral monopoly assume that all railway equipment is produced
by a single firm and is bought by a single buyer, British Rail. Both firms are assumed to aim
at the maximisation of their profit. The equilibrium of the producer monopolist is defined
by the intersection of his marginal revenue and marginal cost curves (point e 1 in figure 2.17).
He would maximise his profit if he were to produce X 1 quantity of equipment and sell it at
the price P 1 .
Figure 2.17
However, the producer cannot attain the above profit-maximising position, because he does
not sell in a market with many buyers, each of whom would be unable to affect the price by
his purchases. The producer-monopolist is selling to a single buyer who can obviously affect
the market price by his purchasing decisions. The buyer is aware of his power, and, being a
profit maximiser, he would like to impose his own price terms to the producer. Clearly the
MC curve of the producer represents the supply curve to the buyer: the upward slope of this
curve shows that as the monopsonist increases his purchases the price he will have to pay
rises. The MC (= S) curve is determined by conditions outside the control of the buyer, and
it shows the quantity that the monopolist-seller is willing to supply at various prices. The
increase in the expenditure of the buyer (his marginal outlay or marginal expenditure)
caused by the increases in his purchases is shown by the curve ME in figure 2.17. In other
words, curve ME is the marginal cost of equipment for the monopsonist-buyer (it is a
marginal-outlay curve to the total-supply curve MC, with which the buyer is faced). The
equipment is an input for the buyer. Thus in order to maximise his profit he would like to
purchase additional units of X until his marginal outlay is equal to his price, as determined
by the demand curve DD. The equilibrium of the monopsonist is shown by point e in figure
2.17: he would like to purchase X2 units of equipment at a price P2, determined by point a
on the supply curve MC (= S). However, the monopsonist does not buy from a lot of small
firms which would be price takers (that is, who would accept the price imposed by the single
buyer), but from the monopolist, who wants to charge price P1. Given that the buyer wants
to pay P2 while the seller wants to charge P1, there is indeterminacy in the market. The two
firms will sooner or later start negotiations and will eventually reach an agreement about
price, which will be settled somewhere in the range between P1 and P2, (P2 ≤P ≤P1),
depending on the bargaining skill and power of the firms.
It should be obvious that a bilateral monopoly is rare for commodity markets, but is quite
common in labour markets, where workers are organised in a union and confront a single
employer (for example, the miners’ unions and the Coal Board) or firms organised in a trade
association. If a bilateral monopoly emerges in a commodity market the buyer may attempt
to buy out the seller-monopolist, thus attaining vertical integration of his production. The
consequences of such take-over are interesting. The supply curve MC (= S) becomes the
marginal-cost curve of the monopsonist, and hence his equilibrium will be defined by point
b in figure 2.17 (where the ‘new’ marginal-cost curve intersects the price demand curve
DD): output will increase to the level X* and the marginal cost will be P*, lower than the
price P1 that the ex-monopolist would like to charge.
The result of the vertical integration in these conditions is an increase in the production of
the input, which will lead to an increase in the final product of the ex-monopsonist and a
reduction in his price, given that he is faced by a downward-sloping market demand curve.
The examination of the welfare implications of such a situation is beyond the scope of this
elementary analysis.
Module III
Monopolistic Competition and Oligopoly
Monopolistic competition
The model of monopolistic competition describes a common market structure in which firms
have many competitors, but each one sells a slightly different product. Monopolistic
competition as a market structure was first identified in the 1930s by American economist
Edward Chamberlin, and English economist Joan Robinson. Many small businesses operate
under conditions of monopolistic competition, including independently owned and operated
high-street stores and restaurants. In the case of restaurants, each one offers something
different and possesses an element of uniqueness, but all are essentially competing for the
same customers.
Characteristics
Monopolistically competitive markets exhibit the following characteristics:
Large number of firms:
There are usually a large numbers of independent firms competing in the market.
Independent Action by firms:
Each firm makes independent decisions about price and output, based on its product, its
market, and its costs of production.
Imperfect but wide spread knowledge:
Knowledge is widely spread between participants, but it is unlikely to be perfect.
More roles to the producer:
The entrepreneur has a more significant role than in firms that are perfectly competitive
because of the increased risks associated with decision making.
Existence of freedom to entry and exit:
There is freedom to enter or leave the market, as there are no major barriers to entry or exit.
Product differentiation:
A central feature of monopolistic competition is that products are differentiated. There are
four main types of differentiation:
-Physical product differentiation, where firms use size, design, colour, shape, performance,
and features to make their products different. For example, consumer electronics can easily
be physically differentiated.
-Marketing differentiation, where firms try to differentiate their product by distinctive

packaging and other promotional techniques. For example, breakfast cereals can easily be
differentiated through packaging. Human capital differentiation, where the firm creates
differences through the skill of its employees, the level of training received, distinctive
uniforms, and so on.
-Differentiation through distribution, including distribution via mail order or through

internet shopping, such as Amazon.com, which differentiates itself from traditional
bookstores by selling online.
Firms are facing down ward slopping demand curve:
Firms are price makers and are faced with a downward sloping demand curve. Because each
firm makes a unique product, it can charge a higher or lower price than its rivals. The firm
can set its own price and does not have to ‘take' it from the industry as a whole, though the
industry price may be a guideline, or becomes a constraint. This also means that the demand
curve will slope downwards.
Existence of selling cost:
Firms operating under monopolistic competition usually have to engage in advertising.

Firms are engaged in competition with other firms offering a similar product or service, and
may need to advertise to let customers know their differences. Common methods of
advertising for these firms are through local press and radio, local cinema, posters, leaflets
and special promotions.
Objective of profit maximisation:
Monopolistically competitive firms are assumed to be profit maximisers because firms tend
to be small with entrepreneurs actively involved in managing the business.
Monopolistic competition in the short run:
I. Abnormal Profit
In the short run supernormal profits are possible, but in the long run new firms are attracted
into the industry, because of low barriers to entry, good knowledge and an opportunity to
differentiate. Two important conditions are to be satisfied to attain short run equilibrium
under monopolistically competitive firms. They are:
1. Marginal Cost = Marginal Revenue (MC=MR)
2. MC should Cut MR curve from below
Such a condition is explained in the figure 3.1

Figure 3.1
At profit maximisation, equilibrium point is attained at point E where, MC = MR, and the
firm is producing output OM and price is OP. At this stage:
AR = MA AC= MB
Since AR > AC, the firm is gaining abnormal profit
Profit per unit = MA – MB = AB
Total abnormal profit of the firm at OQ output = OM x AB = PABC (Shaded area).
As new firms enter the market, demand for the existing firm’s products becomes more
elastic and the demand curve shifts to the left, driving down price. Eventually, all
supernormal profits are eroded away.
II. Loss Position
In the short run, there is a possibility of loss also to a firm under monopolistic competition.
Such a case is demonstrated in the figure 3.2.
Figure 3.2
The equilibrium point is attained at point E where, MC = MR, and the firm is producing
output OQ and price is OC. At this stage:
AR = QA
AC= QB
Since AR < AC, the firm is suffering loss.
Loss per unit = QB – QA = AB
Total loss of the firm at OQ output = OQ x AB = ABCD (the shaded area)
As loss suffering firms leave the market, demand for the existing firm’s products becomes
less elastic and the demand curve shifts to the right, which push the price up. Eventually, all
loss will be covered and the firm starts to earn normal profit in the long run.
Monopolistic competition in the long run
The freedom to enter and to leave the industry in a monopolistically competitive market will
lead to changes in the supply of the products in the market. Abnormal profit of the existing
firm in the short run will attract new firms to the industry. Similarly firms suffering with
loss will leave the industry. Therefore, in the long run all the existing firms will earn only
normal profit.
Three conditions are to be satisfied for long run equilibrium under MPC.
1. Marginal Cost= Marginal Revenue (MC=MR)

2. MC should Cut MR curve from below
3. Average Revenue should be equal to Average Total cost(AR=ATC)
The normal profit of firm in the long run is demonstrated in the figure 3.3.
Figure 3.3
The equilibrium point is attained at point E where MC = MR, and the firm is producing
output OM and price is OP. At this stage:
AR = MF
AC= MF
Since AR = AC, the firm is earning only normal profit
Hence the three conditions of equilibrium for the long run are satisfied. Since the firm is
earning normal profit, it has no tendency to change its scale of operation.
Excess capacity
Firms under monopolistic competition restrict output in order to maintain higher prices than
firms in competitive markets. Firms under monopolistic competition operate at higher
average total cost than equivalent firms in competitive markets. This implies that not all
production efficiencies are being captured in monopolistically competitive markets. The
amount by which the average-cost-minimizing quantity exceeds the quantity produced by a
firm under monopolistic competition is referred to as “excess capacity.”
Excess Capacity = Optimum production capacity - Equilibrium output under MP

The firm is allocatively and productively inefficient in both the long and short run. Consider
the comparative analysis of long run equilibrium under perfect competition and
monopolistic competition.
Figure 3.4
In the figure 3.4, Ideal output is produced by perfect competitive firm because the firm is
producing at the minimum of its long run average cost. It means that the firm is using its
optimum capacity. But under monopolistic competitive market, the firm is operating before
the optimum because they are forced to stop production when average cost is decreasing.
So the cost and prices are higher in monopolistically competitive market. Here MN level of
output cannot be produced by the firm and this unproduced output is termed as excess
capacity. This means they are productively inefficient in both the long and short run. As an
economic model of competition, monopolistic competition is more realistic than perfect
competition - many familiar and commonplace markets have many of the characteristics of
this model.
Selling Costs
Under monopolistic competition, products are differentiated and these differences are made
known to the buyers through selling costs. Selling costs refer to the expenses incurred on
marketing, sales promotion and advertisement of the product. Such costs are incurred to
persuade the buyers to buy a particular brand of the product in preference to competitor’s
brand. Due to this reason, selling costs constitute a substantial part of the total cost under
monopolistic competition.
The selling costs, according to Chamberlin, include “advertising in its many forms, salaries
of salesmen and the expenses of sales departments and sales agencies (except where these
agencies actually handle the goods), window displays, and displays and demonstration of
all kinds.” It must be noted that there are no selling costs in perfect competition as there is
perfect knowledge among buyers and sellers. Similarly, under monopoly, selling costs are
of small amount (only for informative purpose) as the firm does not face competition from
any other firm.
Oligopoly
The term oligopoly is derived from two Greek words “oligos” meaning few and “pollen”
meaning to sell. Oligopoly is that form of imperfect competition where there are a few firms
in the market producing either homogenous or differentiated products. In other words, an
oligopoly is a market structure in which a few firms dominate. When a market is shared
between a few firms, it is said to be highly concentrated. Modern economists used the term
concentration ratio to define monopoly. It represents the combined market share of the
largest four firms in the market. Although only a few firms dominate, it is possible that
many small firms may also operate in the market.
Classification of oligopoly
Table 3.1
Basis of classification Types of oligopoly Basic feature

Perfect oligopoly Selling Homogenous product
Nature of product Imperfect Differentiated
Selling Differentiated products
oligopoly)
Existence of freedom to enter in the
Open oligopoly
Freedom to entry and Exit market
Closed oligopoly No freedom to entry and exit
Agreement or understanding between
On the basis of Agreement Collusive oligopoly
firms (Explicit and Tacit)
or understanding
Non collusive oligopoly Lack of understanding or agreement
Partial Oligopoly One large firm (Price leadership)
Price leadership
Full oligopoly No firm is a price leader
Sell the products of firms through a

Syndicated oligopoly
Degree of Co ordination centralised syndicate
Organise themselves into a central
Organised oligopoly
association for fixing output price etc
Concentration Ratio Tight oligopoly Concentration ratio 60 %
Loose oligopoly Concentration ratio 40% to 20%
Important features of oligopoly
The main characteristics of firms operating in a market with few close rivals include:
1. Interdependence:
Firms that are interdependent cannot act independently of each other. A firm operating in a
market with just a few competitors must take the potential reaction of its closest rivals into
account when making its own decisions. For example, if a petrol retailer like Indian Oil
Corporation wishes to increase its market share by reducing price, it must take into account
the possibility that close rivals, such as HP and BP, may reduce their price in retaliation. An
understanding of game theory and the Prisoner’s Dilemma helps appreciate the concept of
interdependence.
2. Strategy
Strategy is extremely important to firms that are interdependent. Because firms cannot act
independently, they must anticipate the likely response of a rival to any given change in
their price, or their non-price activity. In other words, they need to plan, and work out a
range of possible options based on how they think rivals might react. Oligopolists have to
make critical strategic decisions, such as:
Whether to compete with rivals, or collude with them.

Whether to raise or lower price, or keep price constant.
Whether to be the first firm to implement a new strategy, or whether to wait and see
what rivals do.
The advantages of ‘going first’ or ‘going second’ are respectively called 1st and 2nd-mover
advantage. Sometimes it pays to go first because a firm can generate head-start profits. 2nd
mover advantage occurs when it pays to wait and see what new strategies are launched by
rivals, and then try to improve on them or find ways to undermine them.
3. Barriers to entry
Oligopolies and monopolies frequently maintain their position of dominance in a market

might because it is too costly or difficult for potential rivals to enter the market. These
hurdles are called barriers to entry and the incumbent can erect them deliberately, or they
can exploit natural barriers that exist.
Natural entry barriers include:
a. Economies of large scale production:
If a market has significant economies of scale that have already been exploited by the
incumbents, new entrants are deterred.
b. Ownership or control of a key scarce resource:
Owning scarce resources that other firms would like to use creates a considerable barrier to
entry, such as an airline controlling access to an airport.
c. High set-up costs:
High set-up costs deter initial market entry, because they increase break-even output, and
delay the possibility of making profits. Many of these costs are sunk costs, which are costs
that cannot be recovered when a firm leaves a market, and include marketing and advertising
costs and other fixed costs.
d. High R&D costs:
Spending money on Research and Development (R & D) is often a signal to potential

entrants that the firm has large financial reserves. In order to compete, new entrants will
have to match, or exceed, this level of spending in order to compete in the future. This deters
entry, and is widely found in oligopolistic markets such as pharmaceuticals and the chemical
industry.
Artificial barriers include:
a. Predatory pricing:
Predatory pricing occurs when a firm deliberately tries to push prices low enough to force
rivals out of the market.
b. Limit pricing:
Limit pricing means the incumbent firm sets a low price, and a high output, so that entrants
cannot make a profit at that price. This is best achieved by selling at a price just below the
average total costs (ATC) of potential entrants. This signals to potential entrants that profits
are impossible to make.
c. Superior knowledge :
An incumbent may, over time, have built up a superior level of knowledge of the market,
its customers, and its production costs. This superior knowledge can deter entrants into the
market.
d. Predatory acquisition :
Predatory acquisition involves taking-over a potential rival by purchasing sufficient shares

to gain a controlling interest, or by a complete buy-out. As with other deliberate barriers,
regulators, like the Competition Commission, may prevent this because it is likely to reduce
competition.
e. Advertising :
Advertising is another sunk cost - the more that is spent by incumbent firms the greater the
deterrent to new entrants.
f. A strong brand :
A strong brand creates loyalty, ‘locks in’ existing customers, and deters entry.
g. Loyalty schemes:
Schemes such as Tesco’s Club Card, help oligopolists retain customer loyalty and deter
entrants who need to gain market share.
h. Exclusive contracts, patents and licences:
These make entry difficult as they favour existing firms who have won the contracts or own
the licenses. For example, contracts between suppliers and retailers can exclude other
retailers from entering the market.
i. Vertical integration :
Vertical integration can ‘tie up’ the supply chain and make life tough for potential entrants,
such as an electronics manufacturer like Sony having its own retail outlets (Sony Centres
4. Indeterminateness of demand curve facing an oligopolist:
The interdependence between firms results in the indeterminateness of AR and MR curves

faced by an oligopolistic market.
5. Conflicting attitudes of the firms
6. Element of monopoly
7. Indeterminateness of demand curve:
Due to strong interdependence between firms, the demand curve becomes indeterminate.
The uncertainty prevailing in the market restricts a firm to follow an independent price
policy and thus demand curve cannot be determined.
8. Price rigidity:
The basic feature of oligopoly market is that their price is rigid. If a firm tend to decrease
the price of their product, all other firms will follow it, and no firm will be benefited with
the price decrease. If a firm increases the price of their product, no other firm will follow it
and the price increased firm will lose their customers. So a firm under oligopoly has no
tendency either to increase or decrease their price.
Collusive versus non-collusive oligopoly
Another key feature of oligopolistic markets is that firms may attempt to collude, rather than
compete. If colluding, participants act like a monopoly and can enjoy the benefits of higher
profits over the long term.
Types of collusion
Overt: Overt collusion occurs when there is no attempt to hide agreements, such as the
when firms form trade associations like the Association of Petrol Retailers.
Covert: Covert collusion occurs when firms try to hide the results of their collusion, usually
to avoid detection by regulators, such as when fixing prices.
Tacit: Tacit collusion arises when firms act together, called acting in concert, but where
there is no formal or even informal agreement. For example, it may be accepted that a
particular firm is the price leader in an industry, and other firms simply follow the lead of
this firm. All firms may ‘understand’ this, but no agreement or record exists to prove it. If
firms do collude, and their behaviour can be proven to result in reduced competition, they
are likely to be subject to regulation. In many cases, tacit collusion is difficult or impossible
to prove, though regulators are becoming increasingly sophisticated in developing new
methods of detection.
Non Collusive or Competitive oligopolies
When competing, oligopolists prefer non-price competition in order to avoid price wars. A
price reduction may achieve strategic benefits, such as gaining market share, or deterring
entry, but the danger is that rivals will simply reduce their prices in response. In such a case
no conditions of collusion exist. This leads to little or no gain, but can lead to falling
revenues and profits. Hence, a far more beneficial strategy may be to undertake non-price
competition.
Cournot Model of Duopoly (Oligopoly)
Monopoly power comes from a firm’s ability to set prices and quantity. This ability is
dictated by the shape of the demand curve facing that firm. In our perfect competition model,
we assume the operation of large number of firms, the demand curve faced by each firm is
a flat line. These firms are price takers. There is a medium between monopoly and perfect
competition in which only a few firms exist in a market. As against monopoly, no firm in
oligopoly faces the entire demand curve, but each does have some power to set prices. A
small collection of firms who dominate a market is called an oligopoly. A duopoly is a
special case of an oligopoly, in which only two firms exist.
Cournot Duopoly
In 1838, Augustin Cournot introduced a simple model of duopolies that remains the standard
model for oligopolistic competition. The original version is quite limited in that it makes the
assumption that the duopolists have identical products and identical costs. Actually Cournot
illustrated his model with the example of two firms each owning a spring of mineral water,
which is produced at zero costs. Following are the assumptions of Cournot duopoly model.
1. The two firms A & B produce homogeneous and indistinguishable goods.
2. There are no other firms in the market and no new firm can enter into the market.
3. Each firm takes their output decision independently. It means that Collusive behaviour is
prohibited. Firms cannot act together to form a cartel.
4. There exists one market for the produced goods and there is a market demand curve for
the product.
5. Each firm chooses a quantity to produce.
6. The cost of production is zero or negligible.
7. A firm thinks that the rival will continue with their present level of output.
Cournot Equilibrium can be explained with the help of the figure 3.5.
Figure 3.5
In the figure 3.5 there are three stages in the Equilibrium analysis of Cournot.
Stage 1: At the first stage there is only one firm (Firm A) in the market. The market demand
curve is DD’ and corresponding MR curve is MR1. The total output that can be sold by all
the firms in the market is OD’. Since cost of production is zero, MC also will be equal to
zero and MR will be equal to MC at half of the total output. (½ of 100% is 50%). So he fixes
his output OA where the firm A is producing half of the total output OD’ and he charges
monopoly price OP.
Stage 2: In this stage firm B enter in to the market. Firm B understands that firm A is
producing half of the total demand. Besides firm B thinks that the remaining portion of the
market is AD’ and its corresponding demand curve CD’ is his demand curve. So Firm B
produces his equilibrium quantity AB and sells it at the equilibrium price P’ by assuming
that firm A is not going to change his output. Firm B produces half of the remaining quantity.
(It is ½ of (100%-50%) = 25%).
Stage 3: After the entry of firm B to the market, Firm A realises that his profit has been
decreased due to the entry of a new firm. Firm A realises that firm B is producing 25% of
output. By assuming that firm B is not going to change their output firm A alter its output.
Here in this stage Firm A produces half of the ‘unproduced portion’ by firm 2. (It is ½ of
(100%-25%) = 37.5%).
Here Firm A is reacting by decreasing their output level, but firm B is reacting by increasing
their output level. This process of changing output will be continued until both the firms are
producing 1/3 (33.33%) of output each and charging same price OPF. The remaining 1/3
output will be unproduced.
Let us assume that the total market demand is 100 units; then the actions and reactions of
both the firms can be summarised as in the table 3.2:
Table 3.2
Stages FIRM A FIRM B Unproduced
Half of 100 units = 50

Level 1 Half of (100-50) = 25 units 25 Units
units
Half of (100-25) = 37.5
Level 2 Half of (100-37.5) = 32.25 units 30.25 Units
units
Half of (100-32.25) = Half of (100-33.875) = 33.0625
Level 2 33.0625 Units
33.875 units units
This process continues until all the existing firms are producing same Quantity
Final 33.333 Units 33.333 Units 33.333 Units
The equilibrium of Cournot model can also be explained with the help of reaction curves of
two firms. A reaction curve with respect to output simply explains the reactions of the firm
to the output changes of his rival firm. Such an equilibrium is explained in the figure 3.6.
Figure 3.6
In the figure 3.6, the reaction curves intersect at Point E and it is the equilibrium point here
firm A is producing OM output and Firm B is producing ON output. The Cournot
equilibrium is a best response made in reaction to a best response and, by definition, is
therefore a Nash equilibrium. Unfortunately, the Cournot model does not describe the
dynamics behind reaching equilibrium from a non-equilibrium state. The basic model of
Cournot duopoly can be extended to any number of firms. In such a case the output of a firm
will be in accordance with the number of firms.
Kinked Demand Curve Model
Many explanations have been given of this price rigidity under oligopoly and most popular
explanation is the so-called kinked demand curve hypothesis. The kinked demand curve
hypothesis was put forward independently by PAUL M. SWEEZY, an American economist,
and by Hall and Hitch, Oxford economists. It is for explaining price and output under
oligopoly with product differentiation, that economists often use the kinked demand curve
hypothesis. This is because when under oligopoly products are differentiated, it is unlikely
that when a firm raises its price, all customers would leave it because some customers are
intimately attached to it due to product differentiation.
As discussed above, the concept of kinked demand curve is used to explain price rigidity of
oligopoly market situation. The reaction of rivals to a price change depends on whether price
is raised or lowered. The theory of oligopoly suggests that, once a price has been determined,
will stick it at this price. This is largely because firms cannot pursue independent strategies.
For example, if a firm raises the price of its product, rivals will not follow this strategy and
the firm who decreased price will lose their revenue. And so the demand curve for the price
increase is relatively elastic. Rivals have no need to follow suit because it is to their
competitive advantage to keep their prices as they are. But in the same manner, when a firm
decrease their price rivals would be forced to follow suit and drop their prices in response.
Again, the firm will lose sales revenue and market share because of the imitation of the
policy by other firms. The demand curve is relatively inelastic in this context. The elasticity
of demand, and hence the gradient of the demand curve, will be also be different. The
demand curve will be kinked, at the current price. The concept of kinked demand curve is
explained in the figure 3.nnnn. Since Demand curve has a kink, MR curve is indeterminate
corresponding to the kink of AR curve.
In the figure 3.7 Demand curve (AR Curve) has a kink at point K and corresponding to point
K, there is a discontinuity range MN on the MR Curve. Price is determined at the point of
kink where the producer has no tendency to either to increase or to decrease the price of the
product.
Figure 3.7
Maximising profits
If marginal revenue and marginal costs are added it is possible to show that profits will also
be maximised at price P. Profits will always be maximised when MC = MR, and so long as
MC cuts MR in its vertical portion, then profit maximisation is still at P. Furthermore, if
MC changes in the vertical portion of the MR curve, price still sticks at P. Even when MC
moves out of the vertical portion, the effect on price is minimal, and consumers will not
gain the benefit of any cost reduction.
The equilibrium point is attained by equating MC and MR (figure 3.8).
Figure 3.8
In the figure 3.8 MC curve passes through the discontinuity range of MR curve. So the
equilibrium quantity and price will be corresponding to the kink. Here OQ is the output and
OP is the price. Even when there is a large rise in marginal cost, price tends to stick close to
its original, given the high price elasticity of demand for any price rise.
Figure 3.9
In the figure 3.9, when the cost condition is changed, Marginal cost curve shift from MC 1
to MC2 curve. This large increase in cost affect price but price increase is only negligible
amount from P1 to P2.
Critical Appraisal of Kinked Demand Curve Theory:
We saw above how the kinked demand curve theory of oligopoly provides an explanation
of price rigidity under oligopoly. But there is a major drawback in the theory.
1. It only explains why once an oligopoly price has been determined it would remain rigid
or stable it does not explain how the price has been determined.
2. Another shortcoming of the kinked-demand oligopoly theory is that it does not apply to
the oligopoly cases of prices leadership and price cartels which account for quite a large part
of the oligopolistic markets. When price leadership and price cartels exist in oligopolistic
markets there is concerted behaviour in regard to the price changes and hence there is no
kink in the demand curve in these cases.
3. In the case of pure oligopoly (i.e. oligopoly with homogenous products), the kinked
demand curve theory does not furnish a complete explanation for price rigidity observed in
oligopolistic markets. From the kinked demand curve analysis it follows that prices are
likely to remain stable when demand or cost conditions decrease, whereas under pure
oligopoly prices are likely to rise in the case of increase in cost or demand.
4. Finally, it has been rightly asserted that explanation of price stability by Sweezy’s kinked
demand curve theory applies only to depression periods. In periods of depression, demand
for the products decreases. As has been explained above, in the context of decreased
demand, price in kinked demand curve theory is likely to remain sticky. But in periods of
boom and inflation when the demand for the product is high and increasing, the price is
likely to rise rather than remaining stable
Cartel
An organization created from a formal agreement between a group of producers of a good

or service, to regulate supply in an effort to regulate or manipulate prices. It is a formal
organization of sellers or buyers that agree to fix selling prices, purchase prices, or reduce
production using a variety of tactics. Cartels usually arise in an oligopolistic industry. The
aim of such collusion (also called the cartel agreement) is to increase individual members'
profits by reducing competition. Organization of Petroleum Exporting Countries (OPEC) -
the world’s largest cartel - is protected by U.S. foreign trade laws.
Price Leadership
Price leadership is when a firm that is the leader in its sector determines the price of goods
or services. Price leadership can leave the leader's rivals with little choice but to follow its
lead and match these prices if they are to hold onto their market share. Alternatively,
competitors may also choose to lower their prices in the hope of gaining market share as
discounters. Price leadership can be positive when the leader sets prices higher, since its
competitors would be justified in ratcheting their prices higher as well, without the threat of
losing market share. In fact, higher prices may improve profitability for all firms.
Different kinds of Price Leadership are given below:
Dominant firm price leadership: A large firm fixes the price and other small firms
act as Price-takers.
Collusive Price leadership: as a result of an explicit or a tacit collusion.
Low cost firm price leadership: A low cost firm fixes the price and other small firms
act as Price-takers.
Barometric Price Leadership: Efficiency or Technological skill
Module IV
Pricing and Employment of Inputs
Competitive factor markets
Factor markets are much like output markets, but with one important difference. The
demand for factors is a derived demand. For example, a firm’s demand for labour depends
upon how much output the firm will produce. More output leads to a greater demand for
labourers, less output leads to a lower demand for labourers.
Consider the case where there is one variable factor called labour and that this labour is
bought and sold in a competitive labour market. The use of the term competitive designates
a situation that is similar to what we would find in a competitive output market. In this case,
each buyer of labour is one of many buyers in the market. The labour market determines the
wage facing individual buyers, who purchase as many workers as needed at the given wage
rate. As a result, the supply of labour facing any individual buyer is a horizontal line at the
going wage rate (figure 4.1).
Figure 4.1
The quantity of labour hired by each firm depends on where the marginal benefit of each
hired factor equals the cost of hiring that factor. The marginal benefit (MB) is given by how
each extra labourer affects the firm’s revenues, whereas the marginal cost (MC) of each
additional labourer is how each labourer affects the firm’s total costs. In equation form, MB
and MC are given as:
MB = ΔTR/ΔL
MC = ΔTC/ΔL
Because firms can hire as many workers as needed at the existing wage rate, we know that
the second equation (which describes the supply of labour) can be rewritten as MC = w.
The first equation (which gives us the demand for labour) can be rewritten as: MB =
(ΔTR/ΔQ)(ΔQ/ΔL). That is, the marginal benefit of hiring additional workers is the product
of a firm’s marginal revenue and marginal product of labour.
Note that marginal revenue is determined by the firm’s output decision in the output market,
while marginal product is determined by the firm’s hiring decision in the factor market.
Because a firm’s marginal revenue curve depends on the market structure of the output
market, the firm’s demand for labour will depend on the market structure in the output
market as well. For example, if a firm operates in a perfectly competitive output market,
then the firm’s marginal revenue is equal to the market price. If a firm is a monopolist in the
output market, then the firm’s marginal revenue is less than the price.
Let’s compare the demand for labour between a perfectly competitive industry and a
monopoly that operate in identical output markets. Assume that both industries draw from
the same labour market (e.g. the unskilled labour market) and that there are many other
firms doing the same thing.
The demand for labour by firms in any industry is the product of marginal revenue and the
marginal product of labour. Perfectly competitive firms have a marginal revenue that equals
the market price (i.e. MR = P). If MR = P, then we can rewrite the demand for labour by
firms in a perfectly competitive industry as (P×MPL). This term can be refered to as the
marginal value product of labour (MVPL).
Monopolists produce where their marginal revenue is less than the market price. Therefore,
we cannot rewrite the monopolist's demand for labour as (P×MPL). The monopolist will
have a demand for labour equal to (MR× MPL), which we call the marginal revenue product
of labour (MRPL).
Demand curve of the firm for one variable input
A profit-maximizing firm will employ an input as long as the extra income from the sale of
the output produced by the input is larger than the extra cost of hiring the input. If input A
is the only variable input used by the firm to produce commodity X, the extra income or
marginal revenue product of input A (MRPa ) is given by the marginal product of input A
(MPa) times the marginal revenue of the firm (MRx). That is, MRPa = MPa.MRx.
If the firm is a perfect competitor in the product market, MRx = Px and MRPa = VMPa (the
value of the marginal product of input A). That is, VMPa = MPa . Px = MPa . Px = MRPa.
As more units of input A are hired, the MPa , and thus the MRPa , eventually decline. The
declining portion of the MRPa schedule is the firm’s demand schedule for input A.
Table 4.1
qa qx MPa MRx = Px MRPa= VMPa Pa
3 6 .. $10 .. $20
4 11 5 10 $50 20
5 15 4 10 40 20
6 18 3 10 30 20
7 20 2 10 20 20
8 21 1 10 10 20
In Table 4.1, column (1) shows the units of input A (the only variable input) used by the
firm. Column (2) gives the total quantities of commodity X produced. Column (3) refers to
the change in total output per unit change in the use of input A. The MPa declines because
we are in stage II of production (the only relevant stage), where the law of diminishing
returns is operating. Column (4) gives MRx; MRx = Px and remains constant because of
perfect competition in the commodity market. Column (5) is obtained by multiplying each
value of column (3) by the value in column (4). The MRPa declines because the MPa
declines. Column (6) gives the price at which the firm purchases input A; Pa remains
constant because of perfect competition in the input market. In order to maximize profits,
the firm will hire more units of input A as long as the MRPa. Pa and until MRPa = Pa. Thus,
this firm will hire seven units of input A. When columns (5) and (1) of Table 4.1 are plotted,
we get thisfirm’s MRPa curve (Figure 4.2). This is the firm’s demand curve for input A, da.
Figure 4.2
Demand Curve of the Firm for Several Variable Inputs
When input A is only one of several variable inputs, the MRPa no longer represents the
firm’s demand curve for input A. The reason for this is that, given the price of the other
variable inputs, a change in the price of input A will bring about changes in the quantity
used of these other variable inputs. These changes, in turn, cause the entire MRPa curve of
the firm to shift. The quantities of input A demanded by the firm at different prices of input
A will then be given by points on different MRPa curves.
Suppose that a firm is initially producing its best level of output with the least-cost
combination of variable inputs and is using three units of input A at Pa ¼ $8 (point A on the
MRPa curve in figure 4.2. If, for some reason, Pa falls from $8 to $4 in the face of constant
prices for other variable inputs, the firm will want to hire more units of input A, since the
MRPa.Pa now. But as this occurs, the MP curve (and thus the MRP curve) of variable inputs
complementary to input A will shift to the right, and the firm will hire more of these
complementary inputs at their given prices. In addition, the MP curve (and thus the MRP
curve) of variable inputs which are substitutes for input A will shift to the left, so the firm
will purchase fewer of these inputs at their given prices. Both of these effects will cause this
firm’s MPa and MRPa curves to shift to the right, as the firm attempts to maximize profits
and re establish a least-cost combination of inputs. This shift in the firm’s MRPa curve as
Pa changes is referred to as the internal effect (i.e., the effect internal to the firm) resulting
from the change in Pa.
Thus, if the firm’s MRPa curve shifts to MRP’a as Pa falls from $8 to $4, the firm will
increase the quantity it uses of input A from three units ( point A on the MRPa curve) to
eight units (point C on the MRP’a curve). Point A and point C are then two points on this
firm’s demand curve for input A. Other points could be obtained in a similar way. Joining
these points, we get this firm’s demand curve for input A (da in figure 4.2).
Market Demand Curve for an Input
We cannot get the market demand curve for input A by simply summing horizontally the
individual firms’ demand curves for input A. A so-called external effect on the firm resulting
from the reduction in the price of input A must also be considered. That is, da in figure 4.2
was drawn on the assumption that the price at which the firm sells commodity X remains
constant. However, when Pa falls, all firms producing commodity X will increase their
quantity of input A demanded, and produce more of commodity X. This will increase the
market supply of commodity X, and given the market demand for X, will result in a fall in
Px. This fall in Px will cause a leftward shift in the firm’s MRPa curves and thus in da. It is
the quantity of input A demanded by each firm on this lower da that is summed to get the
market quantity demanded of input A when Pa falls.
Figure 4.3
In figure 4.3, da is the same as in figure 4.2. When Pa = $8, the firm demands three units of
input A (point A on da). If there are 100 identical firms demanding input A, we get point A’
on Da. When Pa falls to $4, each firm using input A will expand its use of input A. Thus,
QSx increases and Px falls. This shifts da to the left, say to d’a, and the firm demands six
units of input A at Pa = $4 (point E on d’a). With 100 identical firms in the market, we get
point E’ on Da. Other points can be similarly obtained. By joining these points, we get Da.
Supply of Inputs to a Firm

The supply side of input markets is complicated because the shape of the supply curve
depends on the type of input under consideration. Inputs can be broadly defined as labour,
land, or capital. More narrow definitions might distinguish between skilled and unskilled
workers, land in Santa Monica and land in Northridge, and computer equipment and
buildings. Here we focus on broad classifications to make general points. The shape of an
input supply curve depends on the market for which the supply curve is drawn. Consider
the supply curve of labour to all industries in the economy. To simplify matters, assume that
workers are identical so there is only one wage rate. Will the total amount of labour supplied
increase if wages rise? The total amount of labour supplied can only increase if workers
decide to work more hours or if more individuals enter the labour force. If the workers’
response to higher wages is slight, then the labour supply to all industries may be vertical.
This is shown in the figure 4.4.
Figure 4.4
An increase in wages from W1 to W2 leaves the number of workers unchanged in the overall
economy. Although the labour supply to all industries could be vertical, the labour supply
to a single industry should be much more elastic. For example, if wages rise in the auto
industry, workers will leave their jobs in other industries to acquire the higher wages in the
auto industry. This adjustment doesn’t change the total number of workers employed, but it
does change the number of workers in the auto industry. Thus, the supply curve of workers
to the auto industry is upward sloping. When wages rise from W 1 to W2, 10,000 workers
leave their previous industries to enter the auto industry. Because the auto industry is only
a fraction of the overall labour market, its labour supply curve is more elastic than the labour
supply curve of the economy. This concept applies to inputs other than labour. Although the
total supply of land to an economy may be fixed, the supply curve to any one industry is
not. The dairy industry can bid land away from other uses, like chicken farming. Thus, the
input supply curves for individual industries will usually be very elastic. Yet, the supply
curves to more broadly defined markets will be less elastic.
The Market Supply of Inputs
The market supply curve of an input is obtained by the straightforward horizontal

summation of the supply curve of the individual suppliers of the input. Thus, the supply
curve of the input to an individual firm is infinitely elastic. The market supply curve of an
input is usually positively sloped, however, indicating that greater quantities of the input
will be placed on the market only at higher input prices.
Equilibrium in a Competitive Factor Market
Here we examine how a single industry fits into the broader input market, wherein several
industries compete for an input. Particular attention is given to the factors that determine the
shape and position of the input supply curve confronting an industry. The market for
identical engineers is shown in the figure 4.5.
Figure 4.5
Various industries hire engineers. Let DB reflect just one industry's demand for engineers,
while DA combines the demands from all other industries that hire engineers (excluding B).
The total market demand for engineers is DT, which equals DA + DB. The market supply of
engineers (ST) is not vertical because higher wages encourage more people to enter the
engineering field over time. The very short run supply of engineers (not shown) is vertical,
because there is not enough time for individuals to receive engineering training. The initial
equilibrium (point 0) in the total labour market suggests that 6,000 engineers are hired for
$350 a day. Industry B employs 1,000 engineers at the prevailing wage, while the other
industries combined hire 5,000 engineers. To explore the shape of the supply curve of
engineers to one industry, consider an unexpected increase in the demand (from DB to D'B)
for engineers in industry B. This leads to a smaller increase in the overall market demand
for engineers (from DT to D'T). The equilibrium wage is bid up to $400 a day and total
employment rises to 6,500. At the new wage of $400, industry B will hire 2,000 engineers
(point 1). Point 1 is another point on industry B's input supply curve. Notice that 500
engineers have left the other industries. This is shown by the inward shift in the supply to
industry A. In addition, 500 additional workers have entered the engineering field in
response to the higher market wage of $400. After deriving the supply of engineers to
industry B, it should be clear why the input supply curve to an industry is more elastic than
the market supply curve. For the same $50 wage increase, 1,000 engineers entered industry
B while only 500 individuals entered the overall market for engineers. Industry B is only
part of the market for engineers and it can bid some engineers away from other industries
without dramatically increasing wages. Thus, the smaller the share of the total market
accounted for by an industry, the more elastic its input supply curve.
Factor Market with Monopoly Power
Firms that are monopolies in their output market may still be price takers in their input
markets. A firm can be the sole producer of a product, yet still compete with large numbers
of other firms when hiring inputs. A monopoly follows the same optimal purchase rule as a
competitive firm when hiring inputs. A monopolist will hire an input up until the point where
MRP input = P input. The only difference between the two markets is how hiring one more
input affects the firm’s revenues. Recall that a monopolist has P > MR while a competitive
firm has P = MR. For a monopoly, the additional revenue that is generated by hiring one
more unit of the input is the additional output (i.e., MPP input) multiplied by the MR
associated with the additional output. The MRP of an input differs for a competitive firm
and a monopolist.
Monopoly: MRP input = MR output x MPP input
Competitive Firm: MRP input = P output x MPP input
The figure 4.6 examines how this difference in MRP affects the employment decisions of a
monopolist versus a competitive firm.
Figure 4.6
Assume labour is the only variable input so that the MRPL reflects the demand for labour.
The MRPL curve for a monopoly (denoted by M) is below that of the competitive firm
(denoted by C) because MR < P. If the prevailing wage rate is $400, then the monopolist
hires LM workers while the competitive firm hires LC workers. Thus, the monopoly hires
fewer workers than the competitive firms. This is not surprising given our discussion of how
monopoly restricts output and allocates too few resources toward the production of a good
when compared to perfect competition. The area MAC shows the deadweight loss from
monopoly.
Factor Market with Monopsony Power

Monopsony means “single buyer.” Pure monopsony occurs when a firm is the single buyer
of an input. For example, GM is the only buyer of parts that are tailored to its car models.
The monopsonist faces the entire market supply of the input and can reduce the input price
without losing all of its input supply. This case is similar to an output monopolist that faces
the entire market demand for a product -it can raise the product price without losing all of
its customers. The presence of monopsony is indicated by an upward sloping input supply
curve as shown in the figure 4.7.
Figure 4.7
The upward sloping supply curve indicates the firm must pay higher wages to secure more
workers. Until now, we have assumed that each firm faces a perfectly elastic supply of
labour. When the input supply is upward sloping, the MC of an input does not equal its AC.
If the monopsonist wants to hire one more worker it must raise wages somewhat to all
workers. The wage rate is the AC of labour. If AC rises as more workers are hired, then MC
is greater than AC. The firm maximizes profits by hiring L1 workers, where the MCL equals
the MRPL. The firm pays a wage ($300) that is less than the MRPL ($400). Equating MC L
and MRPL gives the employment level, while the wage is determined by the height of the
supply curve at that employment level. Employment and wages are lower under monopsony
than under competitive input market conditions. Wages and employment (L2) would be
higher with competition. The similarity between output monopolists and monopsonists is
striking. The output monopolist restricts output to charge a higher price for its product, while
the monopsonist restricts employment to reduce the price of its input.
Marginal Productivity Theory of Input Demand
A theory used to analyze the profit-maximizing quantity of inputs (that is, the services of
factor of productions) purchased by a firm in the production of output. Marginal-
productivity theory indicates that the demand for a factor of production is based on the
marginal product of the factor. In particular, a firm is generally willing to pay a higher price
for an input that is more productive and contributes more to output. The demand for an input
is thus best termed a derived demand.
Marginal productivity theory is a cornerstone in the analysis of factor markets and

the input side of short-run production. It provides insight into the demand for factors of
production based on the notion that a profit-maximizing firm hires inputs based on a
comparison between the productivity of the input and the cost of the input.
• The Law of Diminishing Marginal Returns
The central principle underlying marginal-productivity theory is the law of diminishing

marginal returns. This law states that as additional units of a variable input are added to
a fixed input, eventually the marginal product of the variable input decreases. This principle
is an essential component of short-run production analysis, which offers insight into the
positively-sloped marginal cost curve and the law of supply.
The law of diminishing marginal returns also plays a key role in the demand for an input. It
works like this: As more of an input is employed, marginal productivity declines. Because
each unit is less productive and generates less revenue, the firm is inclined to pay less to use
the input. As such, an inverse relation exists between the price of the input and the quantity
of the input demanded, which traces out a negatively-sloped factor demand curve.
• Three (or Four) Marginals:
The focus of marginal productivity theory and the law of diminishing marginal returns is on
marginal product. There are, however, three related "marginals" that need to be noted:
Marginal Product: This is the change in total product resulting from an incremental
change in the quantity of the variable factor input used.
Marginal Physical Product: This is another term for marginal product which serves
to emphasize that production is measured in physical units rather than monetary
units.
Marginal Revenue: This is the change in total revenue resulting from an incremental
change in the quantity of the output produced.
Marginal Revenue Product: This is the change in total revenue resulting from an
incremental change in the quantity of the variable factor input used.
Marginal revenue product is marginal product stated in monetary units rather than physical
units. Rather than stating productivity of an input in terms of the physical quantity of
production, marginal revenue product states productivity in terms of the revenue generated.
Suppose, for example, that Edgar Mill bottom contributes 5 tacos per hour of production
when hired by Waldo's Tex Mex Taco World. Edgar's marginal (physical) product is thus 5
tacos per hour. However, because each taco sells for $2 each (marginal revenue), Edgar
contributes $10 per hour of revenue to Waldo's Tex Mex Taco World.
Waldo, the owner of Taco World, is more interested in the amount of revenue Edgar
generates when it comes to making out a pay check, than just the number of tacos produced.
This connection between marginal product, marginal revenue, and marginal revenue
product is summarized in by the following equation:
Marginal Revenue Product = Marginal product x Marginal revenue
• A Derived Demand
Marginal productivity theory reveals that the demand for a factor input is not based so much
on the factor itself, but on the contribution the input makes to the firm's revenue and profit.
The demand for an input is thus a derived demand.
In particular, an input is highly valued if it produces an output that is highly valued.

Alternatively, an input is not highly valued if it produces an output that is not highly valued.
For example, Harold “Hair Doo” Dueterman thrills millions of fans from April to September
as a superstar baseball player for the Shady Valley Primadonnas. His efforts contribute to
the production of a highly valued entertainment product. Although he works only six months
each year and usually only a few hours a day, he is paid millions of dollars for his productive
services.
In contrast, George Grumpinkston, an economics professor at the Ambling Institute of

Technology, works longer and harder for twelve full months of the year. However, the
educational service that he provides is not has highly valued. As such, his annual income is
measured in thousands of dollars, rather than millions.
• Factor Market Structures

The structure of a factor market depends on the number of competitors on the demand side,
which determines the market control of each firm. This gives rise to four alternative market
structures.
Perfect Competition: This contains a large number of relatively small buyers, each
with no market control.
Monopsonistic Competition: This contains a large number of relatively small buyers,
each with a small degree of market control.
Oligopsony: This contains a small number of relatively large buyers, each with
extensive market control.
Monopsony: This contains a single buyer with complete control of the demand-side
of the market.
If a factor market is perfectly competitive such that the buyers have no market control, then
inputs are paid a price exactly equal to the value of their contribution to the firm, that is,
marginal revenue product. However, if the buyers have any market control, then the inputs
are paid a price less than the value of their contribution to the firm.
&&&&&

III Sem - BA Economics - Core-Micro Economics - II

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III Sem - BA Economics - Core-Micro Economics - II

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MICRO ECONOMICS-II

Core Course (ECO3 B04)

(2019 Admission onwards)

Dr. Shabeer K.P.

Thus, the essential elements of an economic market are:

(i) A particular commodity or a factor, and

The behaviour of individuals, firms, and organizations within a market context is

The basic market structures based on sellers is as perfect competition, monopolistic

Perfect competition a market structure characterized by a large number of small firms

In a perfectly competitive market, the price of the commodity is determined exclusively

1. Large Number of Small Firms: A perfectly competitive industry contains a large

Demand AR and MR curves

1. The Revenue Concepts:

2. Industry Demand and Firm Demand:

Short-Run Equilibrium of the Firm

100 8 800 2000 -1200

200 8 1600 2300 -700

300 8 2400 2400 0

400 8 3200 2524 676

500 8 4000 2775 1225

600 8 4800 3200 1600

650 8 5200 3510 1690

700 8 5600 4000 1600

800 8 6400 6400 0

Figure 1.4: Short run Equilibrium

100 8 12 20 -12 -1200

200 8 3 11.60 -3.5 0700

400 8 1.25 6.31 1.69 676

500 8 2.50 5.55 2.45 1225

600 8 4.25 5.33 2.67 1602

650 8 8 5.40 2.60 1690

700 8 8 5.71 2.29 1603

Figure 1.5: Profit Maximising Output

Figure 1.6: Industry Equilibrium

Shut Down Point

Long Run Equilibrium of the Firm

Constant, Increasing and Decreasing Cost Industries

1. Constant Cost Industries

In panel B of figure 1.9, the original market equilibrium price of $8 is established

2. Increasing Cost Industries

3. Decreasing Cost Industries

Impact of Tax and Subsidy

Governments will choose to implement taxes to either individuals or firms in order to

Short and long run analysis:

Welfare analysis and government’s revenue:

3.Tax on Output (or output tax):

The main causes that lead to monopoly are the following.

Firstly, ownership of strategic raw materials, or exclusive knowledge of production

5. Restricted Ownership of Raw Materials and Inputs

The different types of monopoly are:

1. Simple Monopoly and Discriminating Monopoly:

2. Pure Monopoly and Imperfect Monopoly:

When a Monopoly is established due to natural causes then it is called natural

5. Industrial Monopolies or Public Monopolies:

In the general interest of the nation, when a government nationalises certain

AR and MR curve of a monopolist

3. The price elasticity of demand is

Thus the demand curve is also the AR curve of the monopolist.

Short Run Equilibrium

Firstly, the MC is equal to the MR.

Supply curve of a monopolist

The Multiplant Firm