Module II

Syllabus: Market Structures: Characteristics of each; Determination of price and output

decisions under perfect competition, monopoly, oligopoly and monopolistic competition;
Price Determination and Game Theory

Market Structure and Degree of Competition

 The process by which price and output are determined in the real world is strongly
affected by the structure of the market.
 A market consists of all the actual and potential buyers and sellers of a particular product.
 Market structure refers to the competitive environment in which the buyers and sellers of
the product operate.
 Four types of market structures are usually identified.
 These are perfect competition at one extreme, pure monopoly at the opposite extreme,
and monopolistic competition and oligopoly in between.
 These types of market structure or organization are defined in terms of the number and
size of the buyers and sellers of the product, the type of product bought and sold (i.e.
standardized or homogenous as contrasted with differentiated) the degree of mobility of
resources (i.e. the ease with which firms and input owners can enter or exit the market),
and the degree of knowledge that economic agents (i.e. firms, suppliers of inputs, and
consumers) have of prices and costs, and demand and supply conditions.
 These market characteristics are used to define the four types of market structure:
a. Perfect Competition
 Is the form of market organization in which (a) there are many buyers and sellers
of a product, (b) the product is homogeneous; (c) there is perfect mobility of
resources; and (d) economic agents have perfect knowledge of market conditions.

b. Monopoly

 Is the form of market organization in which a single firm sells a product for which
there are no close substitutes. Entry into the industry is very difficult or
impossible (as evidenced by the fact that there is a single firm in the industry).

c. Monopolistic firm

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  Refers to the case where there are many sellers of a differentiated product and
entry into or exit from the industry is rather easy in the long run.

d. Oligopoly

 Is the case where there are few sellers of a homogeneous or differentiated product.
Although entry into the industry is possible, it is not easy (as evidenced by the
small number of firms in the industry).

Monopoly, monopolistic competition and oligopoly are often referred to as imperfect

competition to distinguish them from perfect competition. The definitions of the various types of
market structure presented above are examined in detail when the particular market structure is
analyzed.
a. Perfect Competition
 Perfect competition is an ideal market structure which ensures rational utilization
of resources. Perfect competition avoids exploitation of labourers and consumers.
A perfectly competitive market exhibits the following features:
i. There is large number of sellers. Each seller sells a small fraction of the output. He cannot
influence the price of the commodity by changing his supply. He has to accept the prevailing
price and sell as much as possible at the existing price. Hence a firm under perfect competition is
said to be a price taker.
ii. There is large number of buyers. Each buyer buys a small fraction of the output. Hence he
cannot influence the price through his prices.
iii. All the units of a commodity produced and sold by all the firms are homogeneous in nature.
Hence they are perfect substitutes for each other.
iv. A single price prevails in the market.
v. There is free entry and exit. Any firm can join the industry and any firm can leave the
industry. There are no restrictions on entry and exit.
vi. There is no government intervention. Market mechanism is allowed to play its role in the
determination of equilibrium price and output.
vii. The transport cost is assumed to be nil. It is assumed that either all the firms are close to the
market or are equally far away from the market. Hence the transport cost is assumed to be nil.

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viii. Factors of production are said to be perfectly mobile. This ensures equal factor cost for all
the firms.
ix. Both the sellers and the buyers have perfect knowledge about the market. If any seller tries to
sell at a higher price, the consumers will shift to some other seller. Similarly, no seller would like
to sell at a lower price as all the sellers know about the market price.
Determination of equilibrium price and output
 The term equilibrium refers to a position of rest.
 A firm is said to be in equilibrium when it has no tendency to change the level of output.
 This happens when the firm maximizes its profits.
 One of the aims of any business firm is to maximize its profits and is considered as
rational.
 Profit is the difference between total revenue and total cost.
 Total revenue is the revenue earned by sale of output. It is obtained by multiplying the
price per unit by the quantity of output sold.
 Total cost consists of rent, wages, interest and normal profit.
 Normal profit refers to the remuneration the entrepreneur should get for management and
coordination.
 It is the minimum income that should be earned by the entrepreneur to stay in business.
The difference between total revenue and total cost refers to pure or economic profits.
 Economic profits are also known as super normal profits.
 A firm will be in equilibrium when it produces that level of output at which its profits are
maximized.
 There are two approaches to explain this, viz,
a. Total revenue – total cost approach and
b. Marginal revenue – marginal cost approach
a. Total revenue – total cost approach
 Under this approach the firm is said to be in equilibrium when the difference between
total revenue and total cost is maximum.
 Under perfect competition there is a single price and all additional units are sold at the
same price.

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  The total revenue therefore will increase at the same rate.
 Equilibrium of the firm can be explained with the help of the table and diagram:
Quantity of output Total Revenue (Rs.) Total Cost (Rs.) Economic Profit (Rs.)
(TR – TC)
1 10 14 -4
2 20 15 5
3 30 17 13
4 40 20 20
5 50 26 24
6 60 35 25
7 70 50 20
8 80 70 10

 In the above table when the firm produces the first unit TC is more than TR.
 When more units are produced, the firm starts earning profits.
 Profits start increasing.
 It earns maximum profits when the 6th unit is produced.
 Hence the firm will be in equilibrium when it produces 6 units of the output.

 Quantity Total Total

Revenue Cost Profit
 (Q)
(TR) (TC)

0 $0 $62 −$62

10 $40 $90 −$50

20 $80 $110 −$30

30 $120 $126 −$6

40 $160 $138 $22

50 $200 $150 $50

60 $240 $165 $75

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  Quantity Total Total
Revenue Cost Profit
 (Q)
(TR) (TC)

70 $280 $190 $90

80 $320 $230 $90

90 $360 $296 $64

100 $400 $400 $0

110 $440 $550 $−110

120 $480 $715 $−235

Table 1. Total Revenue, Total Cost, and Profit at

the Raspberry Farm

In Figure 1, the horizontal axis shows the quantity of frozen raspberries produced. The vertical
axis shows both total revenue and total costs, measured in dollars. The total cost curve intersects
with the vertical axis at a value that shows the level of fixed costs, and then slopes upward, first
at a decreasing rate, then at an increasing rate. In other words, the cost curves for a perfectly
competitive firm have the same characteristics as the curves that we covered in the previous
module on production and costs.

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Figure 1: Total Revenue, total cost and profit at the raspberry farm
Total revenue for a perfectly competitive firm is an upward sloping straight line. The slope is
equal to the price of the good. Total cost also slopes up, but with some curvature. At higher
levels of output, total cost begins to slope upward more steeply because of diminishing marginal
returns. Graphically profit is the vertical distance between the total revenue curve and the total
cost curve. This is shown as the smaller, downward-curving line at the bottom of the graph. The
maximum profit will occur at the quantity where the difference between total revenue and total
cost is largest.
Based on its total revenue and total cost curves, a perfectly competitive firm like the raspberry
farm can calculate the quantity of output that will provide the highest level of profit. At any
given quantity, total revenue minus total cost will equal profit. One way to determine the most
profitable quantity to produce is to see at what quantity total revenue exceeds total cost by the
largest amount.
Figure 1 shows total revenue, total cost and profit using the data from Table 1. The vertical gap
between total revenue and total cost is profit, for example, at Q = 60, TR = 240 and TC = 165.
The difference is 75, which is the height of the profit curve at that output level. The firm doesn’t
make a profit at every level of output. In this example, total costs will exceed total revenues at

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output levels from 0 to approximately 30, and so over this range of output, the firm will be
making losses. At output levels from 40 to 100, total revenues exceed total costs, so the firm is
earning profits. However, at any output greater than 100, total costs again exceed total revenues
and the firm is making increasing losses. Total profits appear in the final column of Table
1. Maximum profit occurs at an output between 70 and 80, when profit equals $90.
b. Marginal revenue – marginal cost approach
 An alternative namely MR – MC approach has been developed to determine equilibrium
of the firm.
 The firm is said to be in equilibrium when MR = MC.
 This can be explained with the help of the following table and graph:
Units of output Total revenue Marginal Total cost Marginal cost
revenue
0 0 0 12 ----
1 10 10 14 2
2 20 10 15 1
3 30 10 17 2
4 40 10 20 3
5 50 10 25 5
6 60 10 35 10
7 70 10 50 15
8 80 10 81 31
 In the above table when the firm produces the sixth unit, MR = MC. The firm is said to
be in equilibrium when it produces 6 units which is the profit maximizing level of output.

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 The graph
MC
Revenue and
Cost E1 E
AR = MR

O Q1 Q

Output

 In the above diagram AR and MR coincide with each other and is represented by a
horizontal straight line.
 The MC cuts the MR curve at two points E and E1.
 At E1 MC is cutting MR from above.
 After this point MC lies below MR curve and it is profitable for the firm to produce more.
 At point E, MR = MC and the MC curve cuts the MR curve from below.
 As long as MR is greater than MC, it is profitable to increase production.
 Thus there are two conditions to be satisfied for the firm to attain equilibrium

i. MR = MC and

ii. MC curve cuts MR curve from below.

 The first one is the necessary condition but not a sufficient one.
 The second condition has to be satisfied for the firm to attain equilibrium and maximize
profits.

b. Monopoly

 Monopoly is a market structure characterized by the existence of a single seller. It

exhibits the following features:

i. A single seller has complete control over the supply of the commodity.

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ii. There are no close substitutes for the product.

iii. There is no free entry and exit. There are many restrictions on entry and exit.

iv. It is a complete negation of competition.

v. A monopoly firm has complete control over the price policy. The firm is a price maker under
monopoly.

vi. Since there is a single firm, the firm and industry are one and the same.

vii. The industry faces a downward sloping demand curve. This implies that he can sell more by
reducing the price. Though he is a price maker he does not have unlimited power. He cannot fix
the price and the quantity to be sold. He has to fix either the price or the quantity and leave the
other to the market. The monopolist has to consider the elasticity of demand for his product
while fixing the price.

viii. There are no immediate rivals for the firm.

Monopoly is also defined in terms of absolute monopoly and limited monopoly. Absolute
monopoly implies that a single seller has complete control over the market. There are no
substitutes and no competition. In reality it is not possible to have absolute monopoly. In practice
limited or simple monopoly exists. In limited or simple monopoly, the product will have some
remote substitutes.

Determination of price and output under monopoly

Since a monopolist faces a downward-sloping demand curve, the only way it can sell more
output is by reducing its price. Selling more output raises revenue, but lowering prices reduces it.

Let’s explore this using the data in the table in Fig 9.6, which shows quantities along the demand
curve and the price at each quantity demanded and then calculates total revenue by multiplying
price times quantity at each level of output. (In this example, we give the output as 1, 2, 3, 4, and
so on, for the sake of simplicity. As the figure illustrates, total revenue for a monopolist has the
shape of a hill, first rising, next flattening out, and then falling. In this example, total revenue is
highest at a quantity of 6 or 7.

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 Quantity Price TotalRevenue TotalCost
Q P TR TC

1 1,200 1,200 500

2 1,100 2,200 750

3 1,000 3,000 1,000

4 900 3,600 1,250

5 800 4,000 1,650

6 700 4,200 2,500

7 600 4,200 4,000

8 500 4,000 6,400

However, the monopolist is not seeking to maximize revenue, but instead to earn the highest
possible profit. In the Health Pill example, the highest profit will occur at the quantity where
total revenue is the farthest above total cost.

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A monopolist can determine its profit-maximizing price and quantity by analyzing the marginal
revenue and marginal costs of producing an extra unit. If the marginal revenue exceeds the
marginal cost, then the firm should produce the extra unit.

For example, at an output of 4 marginal revenue is 600 and marginal cost is 250, so producing
this unit will clearly add to overall profits. At an output of 5, marginal revenue is 400 and
marginal cost is 400, so producing this unit still means overall profits are unchanged. However,
expanding output from 5 to 6 would involve a marginal revenue of 200 and a marginal cost of
850, so the sixth unit would actually reduce profits. Thus, the monopoly can tell from the
marginal revenue and marginal cost that of the choices in the table, the profit-maximizing level
of output is 5.

Quantity Total Revenue Marginal Revenue Total Cost Marginal Cost

Q TR MR TC MC

1 1,200 1,200 500 500

2 2,200 1,000 775 275

3 3,000 800 1,000 225

4 3,600 600 1,250 250

5 4,000 400 1,650 400

6 4,200 200 2,500 850

7 4,200 0 4,000 1,500

8 4,000 -200 6,400 2,400

Fig 9.8

Thus, a profit-maximizing monopoly should follow the rule of producing up to the quantity
where marginal revenue is equal to marginal cost—that is, MR = MC. This quantity is easy to
identify graphically, where MR and MC intersect, as shown in Fig 9.9.

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Fig illustrates the three-step process where a monopolist: selects the profit-maximizing quantity
to produce; decides what price to charge; determines total revenue, total cost, and profit.

The Monopolist determines its Profit-Maximizing level of output

The firm can use the points on the demand curve D to calculate total revenue, and then, based on
total revenue, calculate its marginal revenue curve. The profit-maximizing quantity will occur
where MR = MC — or at the last possible point before marginal costs start exceeding marginal
revenue. In Fig MR = MC occurs at an output of 5.

The Monopolist decides what price to charge

The monopolist will charge what the market is willing to pay. A dotted line drawn straight up
from the profit-maximizing quantity to the demand curve shows the profit-maximizing price
which is $800. This price is above the average cost curve, which shows that the firm is earning
profits.

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Distinction between perfect competition and monopoly

Perfect competition Monopoly

1. It is a market structure where there are large 1. It is a market structure where there is a
number of sellers and buyers. single seller.

2. Here firm and industry are different. 2. Here firm and industry are one and the same.

3. The goods are close substitutes for each 3. Goods here do not have close substitutes.
other.

4. There is free entry and exit. 4. There is no free entry and exit.

5. The firm is a price taker. 5. The firm is a price maker.

6. The AR curve for a perfectly competitive 6. In monopoly, the AR curve is a downward

firm is perfectly elastic. It is also the demand sloping one. It indicates that the monopolist
curve. It indicates that the seller can sell any can sell more by reducing the price. Here the
quantity at the given price. average revenue curve is relatively inelastic.

7. There is a single price prevailing in the 7. In this market price is indicated by the AR
market. Hence AR = MR = Price. curve and MR curve lies below the AR curve.

8. Under perfect competition Price = MC. 8. Under monopoly price is greater than
marginal cost.

9. Perfectly competitive firms always aim at 9. In monopoly the firm does not produce the
optimum output. In the long run especially the optimum output. It stops production before the
MC curve cuts the AC curve at its minimum minimum point on the AC is attained.
point.

10. While the price is generally low in perfect 10. Here the price is high and output is less.

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competition the output is more.

11. In the long run, only normal profits are 11. The firm can earn supernormal profits both
earned by a perfectly competitive firm. in the short run and long run.

12. The firm under perfect competition attains 12. Under monopoly the two conditions are
equilibrium only when two conditions are required. However a monopoly firm can attain
satisfied. equilibrium even if the second condition is not
satisfied. A monopoly firm may operate under
different cost conditions like increasing,
decreasing and constant cost conditions.

13. The monopoly power is zero because 13. The monopoly power varies between 0 and
demand is perfectly elastic. 1 as demand is relatively inelastic.

14. Price determination is not possible in 14. In monopoly price discrimination is very
perfect competition as consumers have much possible.
complete knowledge about the market.

c. Oligopoly
Oligopoly occurs in industries where few but large leading firms dominate the market. Firms
that are part of an oligopolistic market structure can’t prevent other firms from gaining
significant dominance in the market. However, as only a few firms have a significant share of the
market, each firm’s behaviour can have an impact on the other.

There must be a lower limit of two firms for a market structure to be considered oligopolistic, but
there’s no upper limit to how many firms are in the market. It is essential that there are a few and
all of them combined have a significant share of the market, which is measured by the
concentration ratio.

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The concentration ratio is a tool that measures the market share of the leading companies in an
industry. You could have maybe five firms, seven, or even ten. How do you know if it’s an
oligopolistic market structure? You have to look at the concentration ratio of the largest firms. If
the most dominant firms have a combined concentration ratio of more than 50%, that market is
considered an oligopoly. That is to say, an oligopoly is about the dominant firms’ market power
in a given industry.

You can usually find typical examples of oligopolistic market structures in oil companies,
supermarket chains, and the pharmaceutical industry.
When companies gain high collective market power, they can create barriers that make it
significantly hard for other firms to enter the market. Additionally, as few firms have a large part
of the market share, they can influence the prices in a way that harms consumers and the general
welfare of society.

Oligopoly characteristics

The most important characteristics of oligopoly are interdependence, product differentiation,

high barriers to entry, uncertainty, and price setters.

Firms are interdependent

As there are a few firms that have a relatively large portion of the market share, one firm’s action
impacts other firms. This means that firms are interdependent. There are two main methods
through which a firm can influence the actions of other firms: by setting its price and output.

Product differentiation

When firms don’t compete in terms of prices, they compete by differentiating their products.
Examples of this include the automotive market, where one producer might add specific features

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that would help them acquire more customers. Although the car price might be the same, they are
differentiated in terms of the features they have.

High barriers to entry

The market share acquired by the top companies in an industry becomes an obstacle for new
companies to enter the market. The companies in the market use several strategies to keep other
companies from entering the market. For instance, if firms collude, they choose the prices at a
point where new companies can’t sustain them. Other factors such as patents, expensive
technology, and heavy advertising also challenge new entrants to compete.

Uncertainty
While companies in an oligopoly have perfect knowledge of their own business operations, they
do not have complete information about other firms. Although firms are interdependent because
they must consider other firms’ strategies, they are independent when choosing their own
strategy. This brings uncertainty to the market.
Price setters

Oligopolies engage in the practice of price-fixing. Instead of relying on the market price
(dictated by supply and demand), firms set prices collectively and maximise their profits.
Another strategy is to follow a recognised price leader; if the leader increases the price, the
others will follow suit.

Oligopoly examples

Oligopolies occur in almost every country. The most recognised examples of oligopoly include
the supermarket industry in the UK, the wireless communications industry in the US and the
banking industry in France.

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Let's take a look at these examples:

1. The supermarket industry in the UK is dominated by four major players, Tesco, Asda,
Sainsbury's, and Morrisons. These four supermarkets control over 70% of the market
share, making it difficult for smaller retailers to compete.
2. The wireless telecommunications industry in the US is dominated by four major
carriers, Verizon, AT&T, T-Mobile, and Sprint (which merged with T-Mobile in 2020).
These four carriers control over 98% of the market share, making it difficult for smaller
carriers to compete.
3. The banking industry in France is dominated by a few large banks, such as BNP
Paribas, SociétéGénérale, and CréditAgricole. These banks control over 50% of the
market share and have a strong influence on the French economy.

Collusive vs non-collusive oligopoly

Collusive oligopoly occurs when firms form an agreement to jointly set prices and choose the
production level at which they can maximise their profits.

Not all firms face the same production costs, so how does it work for firms with higher costs?
Firms that might not be as productive in the market benefit from the agreement, as the higher
price helps them stay in business. Other firms enjoy abnormal profit and keep problems that
come with the competition out of their head. It’s a win-win for both.

Formal collusive agreements between firms are known as cartels. The only difference between
collusion and monopoly is the number of firms, and everything else is the same. Collusion
enables firms to increase prices and gain abnormal profits. One of the most famous cartels is the
Organization of the Petroleum Exporting Countries (OPEC), which has significant influence over
oil prices worldwide.

Cartels are the formal collusive agreements between firms.

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Collusive oligopoly and cartel agreements are significantly harmful to consumers and the
general welfare of society. Governments closely monitor these agreements and prevent them
from taking place via anti-competitive laws.

However, when collusion is in the benefit and interest of the society, it is known as cooperation,
which is legal and encouraged by governments. Cooperation does not involve setting prices to
maximise profit. It instead involves actions such as improving health in a particular sector or
increasing standards of labour.

Cooperation is a legal form of collusion for the benefit and interest of society.
Non-collusive oligopoly involves a competitive type of oligopoly where firms do not form
agreements with one another. Rather, they choose to compete with one another in an
oligopolistic market structure.

Firms will still depend on other firms’ actions as they share a large portion of the market, but
firms are independent in their strategies. As there is no formal agreement, firms will always be
uncertain how other firms in an oligopoly will react when they apply new strategies.

Simply put, in a non-collusive oligopoly, you have firms independently choosing their strategies
whilst there is still interdependence amongst them.

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The kinked demand curve

The dynamics in a non-collusive oligopoly can be illustrated by using the kinked demand curve.
The kinked demand curve shows the possible reactions of other firms to one firm’s strategies.
Additionally, the kinked demand curve helps show why firms don’t change prices in a non-
collusive oligopoly.

Assume that the firm is in an oligopolistic market structure; it shares the market with a few other
firms. As a result, it should be cautious of its next move. The firm is considering changing its
price to increase profit further.

The kinked demand curve illustrates what happens to the firm’s output when it decides to
increase its price. The firm is faced with elastic demand at M, and an increase in price to X leads
to a much higher drop in the output demanded compared to if the firm was faced with inelastic
demand.

The firm then considers decreasing the price, but it knows that other firms will also decrease
their prices. What do you think would happen if the firm decreased the price from P1 to P3?

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As other firms will also reduce their prices, the quantity demanded will respond by very little
compared to the price increase. How?

Other firms reacted by decreasing their prices too, which caused all the firms to share the total
market share gained from the decrease in price amongst themselves. Therefore, none of them
profits as much. That’s why there’s no incentive for firms to change their prices in a non-
collusive oligopoly.

Price agreements, price wars, and price leadership in oligopoly

Price leadership, price agreements, and price wars often occur in oligopolies. Let’s study each of
them independently.

Price leadership

Price leadership involves having a firm leading the market in terms of the pricing strategy and
other firms following by applying the same prices. As cartel agreements are, in the majority of
the cases, illegal, firms in an oligopolistic market look for other ways to maintain their abnormal
profits, and price leadership is one of the ways.

Price agreements

This involves price agreements between firms and their customers or suppliers. This is especially
helpful in case there is turmoil in the market as it allows firms to adjust their strategies better and
address the challenges accordingly.

Price wars

Price wars in an oligopoly are very common. Price wars happen when a firm tries to either take
its competitors out of business or prevent new ones from entering the market. When a firm faces
low costs, it has the ability to decrease the prices. However, other firms have different cost
functions and can't sustain the price decrease. This results in them having to leave the market.

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Advantages and disadvantages of oligopoly

The situation when there are a few, relatively large firms in an industry have its benefits and
drawbacks. Let’s explore some of the advantages and disadvantages of oligopoly for both firms
and customers.

Table 1. Advantages and disadvantages of oligopoly

Advantages Disadvantages

 High prices harm consumers,

particularly those who cannot afford
 Higher profits allow for more
them
investment in RD
 Limited choices for consumers
 Product differentiation leads to
 Incentives to collude and create anti-
better and more innovative products
competitive behavior
 Stable market due to high barriers to
 High barriers to entry prevent new firms
entry
from entering the market
 Firms may benefit from economies
 Lack of competition may lead to
of scale
inefficiencies and reduced social
welfare

Advantages of oligopoly

Both producers and consumers can benefit from the oligopolistic market structure. The most
important advantages of oligopoly include:

 Firms can gain extreme profits due to little to no competition in an oligopoly market
structure, allowing them to charge higher prices and expand their margins.

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  Increased profits allow firms to invest more money into research and development, which
benefits consumers through the development of new and innovative products.
 Product differentiation is a significant advantage of oligopolistic markets, as firms are
constantly looking to improve and differentiate their products to attract more customers.
 Consumers benefit from having firms constantly trying to offer better products.

Disadvantages of oligopoly

The most significant disadvantages of oligopoly include:

 High prices, which can harm consumers, particularly those with low incomes
 Limited choices for consumers due to high market concentration amongst a few firms
 High barriers to entry prevent new firms from joining and offering their products,
reducing competition and potentially harming social welfare
 Oligopolistic firms may collude to fix prices and restrict output, leading to further harm
for consumers and decreased social welfare.
Oligopoly - Key takeaways

 Oligopoly occurs in industries where few but large firms dominate the market.

 The characteristics of oligopoly include interdependence, product differentiation, high

barriers to entry, uncertainty, and price setters.

 The concentration ratio is a tool that measures the market share leading companies have
in an industry.

 Collusive oligopoly occurs when firms form an agreement to jointly set prices and choose
the production level at which they can maximise their profits
 Non-collusive oligopoly involves a competitive type of oligopoly where firms do not
form agreements with one another. Rather, they choose to compete with one another.
 The dynamics within a non-collusive oligopoly can be illustrated by using the kinked
demand curve.

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  Price leadership involves having a firm leading the market in terms of the pricing strategy
and other firms following by applying the same prices.
 Price wars in an oligopoly happen when a firm tries to either take its competitors out of
business or prevent new ones from entering the market.

d. Monopolistic competition
Monopolistic competition is a type of market structure where many companies are present in an
industry, and they produce similar but differentiated products. None of the companies enjoy a
monopoly, and each company operates independently without regard to the actions of other
companies. The market structure is a form of imperfect competition.
The characteristics of monopolistic competition include the following:
 The presence of many companies
 Each company produces similar but differentiated products
 Companies are not price takers
 Free entry and exit in the industry
 Companies compete based on product quality, price, and how the product is marketed
Companies in a monopolistic competition make economic profits in the short run, but in the long
run, they make zero economic profit. The latter is also a result of the freedom of entry and exit in
the industry. Economic profits that exist in the short run attract new entries, which eventually
lead to increased competition, lower prices, and high output.
Such a scenario inevitably eliminates economic profit and gradually leads to economic losses in
the short run. The freedom to exit due to continued economic losses leads to an increase in prices
and profits, which eliminates economic losses.
In addition, companies in a monopolistic market structure are productively and allocatively
inefficient as they operate with existing excess capacity. Because of the large number of
companies, each player keeps a small market share and is unable to influence the product price.
Therefore, collusion between companies is impossible.
In addition, monopolistic competition thrives on innovation and variety. Companies must
continuously invest in product development and advertising and increase the variety of their

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products to appeal to their target markets. Competition with other companies is thus based on
quality, price, and marketing.
Quality entails product design and service. Companies able to increase the quality of their
products are, therefore, able to charge a higher price and vice versa. Marketing refers to different
types of advertising and packaging that can be used on the product to increase awareness and
appeal.

Industries Exhibiting Features of Monopolistic Competition

Examples of industries in monopolistic competition include the following:
 Clothing and apparel
 Sportswear products
 Restaurants
 Hairdressers
 PC manufacturers
 Television services

Short-Run Decisions on Output and Price

The short-run equilibrium under monopolistic competition is illustrated in the diagram below:

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Profits are maximized where marginal revenue (MR) is equal to marginal cost (MC). The
point determines the company’s equilibrium output. The price is determined at a point where the
imaginary line from the equilibrium output passes through the point of intersection of the MR,
and MC curves and meets the average revenue (AR) curve, which is also the demand curve.
Total profit is represented by the cyan-colored rectangle in the diagram above. It is determined
by the equilibrium output multiplied by the difference between AR and the average total cost
(ATC). Companies in monopolistic competition determine their price and output decisions in the
short run, just like companies in a monopoly.

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Companies in monopolistic competition can also incur economic losses in the short run, as
illustrated below. They still produce equilibrium output at a point where MR equals MC in which
losses are minimized. The cyan-colored rectangle shows the economic loss incurred.

Long-Run Decisions on Output and Price

In the long run, companies in monopolistic competition still produce at a level where marginal
cost and marginal revenue are equal. However, the demand curve will have shifted to the left due

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to other companies entering the market. The shift in the demand curve is a result of reduced
demand for an individual company’s products due to increased competition.
Such action reduces economic profits, depending on the magnitude of the entry of new players.
Individual companies will no longer be able to sell their products at above-average cost.

Companies in monopolistic competition will earn zero economic profit in the long run. At this
stage, there is no incentive for new entrants in the industry.

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Monopolistic Competition vs. Perfect Competition
Companies in monopolistic competition produce differentiated products and compete mainly on
non-price competition. The demand curves in individual companies for monopolistic competition
are downward sloping, whereas perfect competition demonstrates a perfectly elastic demand
schedule.
However, there are two other principal differences worth mentioning – excess capacity and
mark-up. Companies in monopolistic competition operate with excess capacity, as they do not
produce at an efficient scale, i.e., at the lowest ATC. Production at the lowest possible cost is
only completed by companies in perfect competition.
Mark-up is the difference between price and marginal cost. There is no mark-up in a perfect
competition structure because the price is equal to marginal cost. However, monopolistic
competition comes with a product mark-up, as the price is always greater than the marginal cost.
Inefficiencies in Monopolistic Competition
 The equilibrium output at the profit maximization level (MR = MC) for monopolistic
competition means consumers pay more since the price is greater than marginal revenue.
 As indicated above, monopolistic competitive companies operate with excess capacity.
They do not operate at the minimum ATC in the long run. Production capacity is not at
full capacity, resulting in idle resources.
 Monopolistic competitive companies waste resources on selling costs, i.e., advertising
and marketing to promote their products. Such costs can be utilized in production to
reduce production costs and possibly lower product prices.
 Since companies do not operate at excess capacity, it leads to unemployment and social
despondency in society.
 Inefficient companies continue to exist under monopolistic competition, as opposed to
exiting, which is associated with companies under perfect competition.
 Another scope of inefficiency for monopolistic competitive markets stems from the fact
that the marginal cost is less than the price in the long run.
 Monopolistic competitive market structures are also allocative inefficient. Their prices
are higher than the marginal cost.
Limitations of Monopolistic Competition Market Structure

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  Companies with superior brands and high-quality products will consistently make
economic profits in the real world.
 Companies entering the market will take a long time to catch up, and their products will
not match those of the established companies for their products to be considered close
substitutes. New companies are likely to face barriers to entry because of strong brand
differentiation and brand loyalty.
Price discrimination

 Price discrimination exists in a monopoly market. It implies the practice of selling the
same product at different prices to different buyers.

 Price discrimination is also defined in another way. To practice price discrimination, the
monopolist may make some slight differences in the product and sells it to different
customers at different prices.

 Prof. Stigler defines this type of price discrimination as, “the sale of technically similar
product at prices which are not proportional to marginal costs.”

 This statement implies that differences in prices are not proportionate to the differences
in cost of production.

 For the sake of simplicity, the former definition of price discrimination is often used.
Price discrimination is of various types. Some of them are as follows:
1. Personal price discrimination

 When different prices are charged from different buyers, it is called personal
discrimination. For example, professionals like doctors, lawyers, teachers etc. charge a
lower amount from the poor people and a higher amount from the rich people.
2. Local discrimination

 It refers to charging different prices from people according to the locality. For example,
in a posh locality, a beauty parlour may be charging more while charging less price for
the same service in the common locality.
3. Age discrimination

 Here different prices are charged according to the age group. For instance railways
charge less for children and senior citizens and more for others for the same service.

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4. Gender discrimination

 In some cases women may be offered goods and services at a lesser rate compared to
men. In many states in India there is no fees for girls in schools and colleges while boys
have to pay the full fees.
5. Size discrimination

 When a commodity is sold in a larger quantity like tooth paste, washing powder, etc. the
price is quoted on the lower side and vice versa.
6. Quality wise price discrimination

 Different prices are charged when there is a difference in the quality of the product. For
example deluxe edition of a book is expensive than that of an ordinary edition.
7. Use discrimination

 Prices differ according to the use to which the commodity is utilised. For instance
electricity is supplied to agriculture freely in many states in India, while industries have
to pay reasonable charges and households have to pay more charges.
8. Discrimination based on the nature of product

 Certain goods are bulky while certain goods are light weight. When railways carry light
goods like coal, the charges are less whereas when they transport heavy goods like iron,
the charges are more.
9. Time discrimination

 Different rates may be charged for a service depending upon the time of service.
Advertising will be less expensive in the non-prime time compared to the prime time in
the electronic media. Similar is the case with telephone services, cinema halls etc.
Degrees of price discrimination
Prof. Pigou developed three degrees of price discrimination, namely:
a. First degree price discrimination
b. Second degree price discrimination
c. Third degree price discrimination
a. First degree price discrimination

 This is also known as perfect price discrimination.

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  Here the seller takes maximum advantage of his position in the market and sells each unit
of the commodity at a different price to the customers.

 The price charged by him indicates the marginal utility that will be obtained by the
consumer by consuming the commodity.

 In other words, the monopolist will charge from every consumer what he is willing to
pay.

 It implies that there is no consumer’s surplus in first degree price discrimination.

 Consumer’s surplus is the difference between what the consumer is willing to pay and
what he actually pays.
 If the price he pays is less than what he is willing to pay, then he gets surplus satisfaction
which is called consumer’s surplus.

 The entire consumer’s surplus is converted into producer’s surplus in the case of first
degree price discrimination.

 This type of discrimination is possible only when the following conditions prevail.
i. There are few buyers in the market.
ii. The monopolist knows them individually and able to estimate what price they are willing to
pay.
iii. There is no possibility of resale.
These conditions are very difficult to realize in practice. Hence price discrimination of the first
degree is very rare in reality.
b. Second degree price discrimination

 In this type the monopolist will divide the output into blocks of output and sell it at
different prices.

 The output sold in one block may be priced higher than the other one.

 In a particular block all the units of the output will be sold at the same price.

 This type of price discrimination allows some amount of consumer’s surplus for the intra
marginal buyers whereas for the marginal buyers, there is no consumer surplus.

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  It is easy to practice this type of discrimination when there is a wide market, number of
buyers are large, difference income levels and different taste and preferences.

 This type of discrimination is generally found in telephone services, transport services

and supply of electricity.
c. Third degree price discrimination

 This is the most common type of discrimination.

 Here the monopolist divides his output among the various submarkets.

 How much output he will divide among the markets and what price he will charge
depends upon elasticity of demand.
 If demand is relatively inelastic he will charge a higher price and if it is elastic he will
charge a lower price.

 To distribute the output, the monopolist will follow the principle of equi-marginal
revenue, i.e. he will distribute the output in such a way that the marginal revenue from
each market will be the same. When marginal revenue is equalised, profits will be
maximum.
Price discrimination – When is it possible?

 Price discrimination is possible under the following conditions:

1. Monopoly market structure should prevail for the practice of price discrimination. In perfect
competition it is not possible to follow price discrimination as all the units are homogeneous, the
buyers and sellers have perfect knowledge about the market and there is a single price prevailing
in the market. In monopolistic competition and oligopoly close substitutes are available. Hence
there is no scope for price discrimination. Monopoly market provides considerable scope for
price discrimination.
2. There is no possibility of resale. That is it should not be possible for the buyers in the dearer
market to go and buy the commodity from the cheaper market. For example government gives
subsidised food grains to the poor people. If the rich people pretend to be poor and buy the
subsidised food grains then the price discrimination will break down. Thus to practice price
discrimination neither the unit of the commodity nor the consumer can be transferred from one

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market to the other. Thus a monopolist can easily practice price discrimination if he can keep the
market quite separate.
3. It should be possible to divide the markets into various submarkets.
4. If the monopolist can bring about some product differentiation like changing the packaging
style, improving the quality, promoting after sales service, etc. then price discrimination can be
easily practiced.
5. Buyer’s illusion also helps the monopolist to adopt price discrimination. Sometimes buyers
have a wrong conception that higher the price, better the quality. This misconception can be
exploited by the monopolist.
6. Sometimes buyers have a let go attitude. A slight rise in price does not bother them and this
enables the monopolist to indulge in price discrimination.
7. Legal sanction provided by the government helps the monopolist to adopt price
discrimination. As per the legal provisions the consumers can be segregated into different groups
and each group can be charged different prices.
8. Sometimes consumers are not aware of the policy of price discrimination followed by the
monopolist. This ignorance of the consumers helps the monopolist to charge different prices.
9. Certain services are non-transferable, example services of a doctor, teacher, professionals like
Cam etc. are non-transferable. They generally practice price discrimination. They charge a lower
price from the poor people and a higher price from the richer class. A poor person cannot avail of
the services provided to a richer section. This non-transferability helps the monopolist to charge
different prices.
10. When the markets are separated by long distances and when there are tariff barriers it is
possible to adopt price discrimination. In the case of foreign trade it is possible to have price
discrimination. When the monopolist charges a lower price in the foreign market and a higher
price in the domestic market there is said to be price discrimination and this type is referred to as
dumping.
Price discrimination – When is it profitable?
Price discrimination may be possible when the above conditions are satisfied but it may not be
profitable always. For price discrimination to be profitable two conditions are to be satisfied.
1. The elasticity of demand should be different in different markets.

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2. The cost differentials in supplying the output in the different markets should not be large in
relation to price differentials based on elasticity of demand.

 Of these two conditions, the first condition is very important. If elasticity of

demand is the same in both the markets, there is no point in practising price
discrimination. This is because the monopolist will not be able to maximise his
profits by adopting price discrimination.

 The monopolist will aim at equating the marginal revenue from the various
markets. If the price is the same and elasticity of demand is the same, then
profitability will not be there by transferring certain quantity of output from one
market to another. Thus price discrimination to be profitable elasticity of demand
should be different.
Game Theory

 Game theory was pioneered by the mathematician John von Neumann and the economist
Oskar Morgenstern in 1944 and it was soon hailed as a breakthrough in the study of
oligopoly.

 In general, game theory is concerned with the choice of the best or optimal strategy in
conflict situations.

 For example, game theory can help a firm determine the conditions under which lowering
its price would not trigger a ruinous price war; whether the firm should build excess
capacity to discourage entry into the industry, even though this lowers the firm’s short-
run profits; and why cheating in a cartel usually leads to its collapse.

 In short, game theory shows how an oligopolistic firm makes strategic decisions to gain a
competitive advantage over a rival or how it can minimize the potential harm from a
strategic move by a rival.

 Every game theory model includes players, strategies and payoffs.

 The players are the decision makers (here, the managers of oligopolist firms) whose
behaviour we are trying to explain and predict.

 The strategies are the choices to change price, develop new products, undertake a new
advertising campaign, build new capacity, and all other such actions that affect the sales
and profitability of the firm and its rivals.
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 The payoff is the outcome or sequence of each strategy.

 For each strategy adopted by a firm, there are usually a number of strategies (reactions)
available to a rival firm.

 The payoff is the outcome or consequence of each combination of strategies by the two
firms.

 The payoff is usually expressed in terms of the profits or losses of the firm that we are
examining as a result of the firm’s strategies and the rivals’ responses.

 The table giving the payoffs from all the strategies open to the firm and the rivals’
responses is called the payoff matrix.
 There are two important games in Game theory: they zero-sum games and non-zero sum
games.

 A zero-sum game is one in which the gain of one player comes at the expense and is
exactly equal to the loss of the other player.

 An example of this occurs if firm A increases its market share at the expense of firm B by
increasing its advertising expenditures (in the face of unchanged advertising by firm B).

 On one hand, if firm B also increased its advertising expenditures firm A might not gain
any market share at all.

 On the other hand if firm A increased its price and firm B did not match it firm A might
lose market to firm B.

 Games of this nature where the gains of one player equal the losses of the other (so that
total gains plus losses sum to zero) are called zero-sum games.

 If the gains or losses of one firm do not come at the expense of or provide equal benefit
to the other firm, however we have a non-zero sum game.

 An example of this might arise if increased advertising leads to higher profits of both
firms and we use profits rather than market share as the payoff.

 In this case, would have a positive-sum game.

 If however increased advertising raises costs more than revenues and the profits of both
firms decline, we have a case of negative sum-game.

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 xxx-----xxx-----xxx
Case Study – Military strategy and Strategic Business Decisions
1. The key strategies commonly being used in both are to attack weaknesses, concentrate
resources, attack relentlessly, bring in change, use speed and control bottlenecks. What is most
important about these strategies is that they do not stand in isolation, but are interlinked in a free-
flowing manner. A business or an army can begin with any desirable strategy, but it needs to
move rapidly from one to the next in a free flow, taking advantage of opportunities as they arise.
2. During the late 1980s, India had a closed economy and government intervention in the
corporate sector was quite high. However, multinational companies, such as PepsiCo, had been
eyeing the Indian market for a long time for a host of reasons. PepsiCo joined hands with the
RPG group and came up with a proposal that revolved around promoting and developing the
export of Indian agro-based products from operations to be established in the north Indian state
of Punjab, to introducing and developing PepsiCo’s products in the country. The proposal was
initially rejected, but with persistent efforts, PepsiCo came up with another proposal. The new
proposal heavily emphasized on the effects of PepsiCo’s entry on agriculture and employment in
Punjab. The company claimed that it would play a central role in bringing about an agricultural
revolution in the state and would create many employment opportunities. To make its proposal
even move lucrative, PepsiCo claimed that these new employment opportunities would tempt
many of the terrorists to return to the society. Till today, Pepsi is an aggressive player in the
Indian beverage market and has a major share. This shows the strategy of a player who is
attacking the opponent’s weak points (here, that of a developing economy) and being persistent.
xxx-----xxx-----xxx

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