UNIT 4

Market, a means by which the exchange of goods and services takes place as a result
of buyers and sellers being in contact with one another, either directly or through
mediating agents or institutions.

Markets in the most literal and immediate sense are places in which things are
bought and sold. In the modern industrial system, however, the market is not a
place; it has expanded to include the whole geographical area in which sellers
compete with each other for customers.

Types of the market:

Monopoly:
A monopolistic market is a market formation with the qualities of a pure market. A pure monopoly can only
exist when one provider gives a specific service or a product to numerous customers. In a monopolistic
market, the imposing business organisation, or the controlling organisation, has the overall control of the
entire market, so it sets the supply and price of its goods and services. For example, the Indian Railway,
Google, Microsoft, and Facebook.

Oligopoly:
An oligopoly is a market form with a few firms, none of which can hold the others back from having a critical
impact. The fixation or concentration proportion estimates the piece of the market share of the biggest
firms. For example, commercial air travel, auto industries, cable television, etc.

Perfect competition:
Perfect competition is an absolute sort of market form wherein all end consumers and producers have
complete and balanced data and no exchange costs. There is an enormous number of makers and
customers rivalling each other in this sort of environment. For example, agricultural products like carrots,
potatoes, and various grain products, the securities market, foreign exchange markets, and even online
shopping websites, etc.

Monopolistic competition:
Monopolistic competition portrays an industry where many firms offer their services and products that are
comparative (however somewhat flawed) substitutes. Obstructions or barriers to exit and entry in
monopolistic competitive industries are low, and the choices made of any firm don’t explicitly influence
those of its rivals. The monopolistic competition is firmly identified with the business technique of brand
separation and differentiation. For example, hairdressers, restaurant businesses, hotels, and pubs.

Perfect competition is a unique form of the marketplace that allows multiple companies to sell the same
product or service. Many consumers are looking to purchase those products. None of these firms can set a
price for the product or service they are selling without losing business to other competitors. There are no
barriers to any firm that is looking to enter or exit the market. The final output from all sellers is so similar
that consumers cannot differentiate the product or service of one company from its competitors.

Features of Perfect Competition

The main features of perfect competition are as follows:

 Many Buyers and Sellers – There will always be a huge number of buyers and sellers in this form of
marketplace. The advantage of having a large number of small-sized producers is that they cannot combine to
influence the market price. If the quantity offered by an individual seller is very small compared to the total
market produce, they cannot influence the market price independently.

Similarly, if there are many buyers, then an individual will not have the power to dictate conditions
to the market or influence the price by altering demand for a product. The individual demand will
not be large enough to change the price.

 Homogeneity – The product or service produced by the buyers in a perfectly competitive market should be
homogenous in all respects. There should be no differentiation between them in terms of quantity, size, taste,
etc., so that the products are perfect substitutes for each other. If a seller tries to charge a higher price for
products that are so similar, they will lose their customers immediately.
 Free Entry and Exit – Another condition of a perfectly competitive market is that no artificial restrictions
prevent a firm’s entry, or compel an existing firm to stay put when they want to leave. Their decision to enter,
stay or leave the market depends purely on economic factors.
 Perfect Knowledge – The buyers and sellers have perfect knowledge about the market conditions. The
buyers are aware of the details of the product sold as well as its price. At the same time, the sellers know
about the potential sales of their products at different price points. Since the buyers are already informed
about the product, there is no need for advertising or sales promotion. So firms don’t have to invest a single
penny in these activities. It also helps sellers save on advertising or other marketing activities, which keeps the
price of their products low.
 Mobility of Factors of Production – The factors of production like labour, raw materials and capital should
have total mobility under perfect competition. The labour should have the freedom to move from one place
(industry, market or production unit) to another depending on their remuneration. Even the raw materials and
capital should not have any restrictions in movement.
 Transport Cost – In the perfectly competitive market, the costs for transporting goods, services or factors of
production from one place to another is either zero or constant for all sellers. The assumption is that all sellers
are equally near or farther away from the market. Thus, the transport cost is uniform for all of them. The result
is that the overall costs for production and the selling price are the same across the board.
 Absence of Artificial Restrictions – There is no interference from the government or any other regulatory
body to hinder the smooth functioning of the perfect competition. There are no controls or restrictions over the
supply or pricing and the price can change solely based on the demand and supply conditions.
 Uniform Price – There is a single uniform price for all products and services in a perfectly competitive market.
The forces of demand and supply determine it.
Short-Run Equilibrium of the Firm under perfect competition (MR- MC Approach)

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.

Assumptions: This analysis is based on the following assumptions: 1. All firms use homogeneous
factors of production. 2. Firms are of different efficiency. 3. Cost curves of firms vary from each
other. 4. All firms sell their products at the same price determined by demand and supply of the
industry so that the price of each firm, P (Price) = AR = MR. 5. Firms produce and sell different
quantities.

The short-run equilibrium of the firm can be explained with the help of marginal analysis and total
cost- total revenue analysis.
 (1) Marginal Cost-Marginal Revenue Analysis:
During the short run, a firm will produce only if its price equals the average variable cost or is
higher than the average variable cost (AVC). Further, if the price is more than the averages
total costs (SAC or АТС), i.e., P— AR > SAC, the firm will be earning supernormal (or
abnormal) profits If price equals the average total costs, i.e., P = AR = SAC, the firm will be
earning normal (or zero) profits or breaks-even. If price equals AVC, the firm will be incurring
a loss. If price falls even a little below AVC, the firm will shut down because in order to
produce it must cover at least its AVC during the short-run. So during the short-run under
perfect competition, a firm is in equilibrium in all the above noted situations. We illustrate
them diagrammatically as under.
Supernormal Profits:
The firm will be earning supernormal profits in the short-run when price is higher than the
short-run average cost, as shown in Figure 2 (A). The firm is in equilibrium at point E1 where
SMC=MR and SMC cuts MR from below. OQ, is the equilibrium output and OP (=Q1E1) is the
equilibrium price. Q1S are the short-run average costs. SE1 (=Q1E1-Q1S) is the profit per
unit. TS (equilibrium output) (per unit profit) = TSE1P area is the supernormal profits.

We illustrate them diagrammatically as under.

Supernormal Profits:

The firm will be earning supernormal profits in the short-run when price is higher than the short-run
average cost, as shown in Figure 2 (A). The firm is in equilibrium at point E1 where SMC=MR and
SMC cuts MR from below. OQ, is the equilibrium output and OP (=Q1E1) is the equilibrium price.
Q1S are the short-run average costs. SE1 (=Q1E1-Q1S) is the profit per unit. TS (equilibrium output)
(per unit profit) = TSE1P area is the supernormal profits.

Normal Profits:

The firm may earn normal profits when price equals the short-run average costs as shown in Figure 2
(B). The firm is in equilibrium at point E2 where SMC =MR and SMC cuts MR from below. OQ2 is the
equilibrium output and OP (=Q2E) is the equilibrium price. The firm is earning normal profits
because Price = AR = MR =SMC= SAC at its minimum point E2

Minimum Loss:

The firm may be in equilibrium and yet incur a loss when price is less than the short-run average
costs, as shown in Figure 2 (C). The firm is in equilibrium at point E3 where SMC = MR and SMC cuts
MR from below. OQ3 is the equilibrium output and OP (=Q3E3) is the equilibrium price. Since the
average costs Q3B are higher than the price Q3E3, E3B is the loss per unit (Q3B-Q3E3). The total loss
is PE3 x E3B = PE3BA. The firm will continue to produce OQ3 output so long as it is covering its
average variable cost plus some of its fixed cost.

Maximum Loss: If the price fig. 2 falls to the level of AVC, the firm will just cover its average variable
cost, as shown in figure 2 (D). It is indifferent whether to operate or close down because its losses
are the maximum. It will pay such a firm to continue producing OQ4 output and incur PE4GF losses
rather than close down in the short-run. OQ4 is the shutdown output because if the price falls below
OP, the firm will stop production. E4 is, therefore, the shutdown point.
Shut Down Stage: Figure 2. (E) shows a firm which is unable to cover even its AVC at OQ0 level of
output because the price OP is below the AVC curve. It must shut down.

(For the diagram follow the book)

Long-Run Equilibrium in Perfect Competition

Long-run equilibrium in perfect competition is the outcome in which the firms settle after
the supernormal profits were competed away. The only profits that firms do make in the
long run are normal profits. Normal profits occur when the firms are just covering their
costs to remain in the market.

Let's go through some diagrammatic analysis to visualize it!

Figure 1 below shows how the entry of new firms in a perfectly competitive market in the
short run eventually establishes the long-run competitive equilibrium.
Fig. 1 - Entry of new firms and the establishment of the long-run competitive equilibrium

Figure 1 above shows the entry of new firms and the establishment of the long-run
competitive equilibrium. The graph on the left-hand side shows the individual firm view,
whereas the graph on the right-hand side shows the market view.

Initially, the price in the market in the short run is PSR, and the total quantity sold on the
market is QSR. Firm A sees that at this price, it can enter the market as it evaluates that it can
make supernormal profits, shown by the rectangle highlighted in green in the graph on the
left-hand side.

Several other firms, similar to Firm A, decide to enter the market. This results in the market
supply increasing from SSR to S'. The new market price and quantity are correspondingly P'
and Q'. At this price, some firms find that they cannot remain in the market as they are
making losses. The loss area is represented by the red rectangle in the graph on the left-hand
side.

The exit of firms from the market shifts the market supply from S' to SLR. The established
market price is now PLR, and the total quantity sold on the market is QLR. At this new price, all
individual firms earn only normal profits. There is no incentive for firms to enter or leave the
market anymore, and this establishes the long-run competitive equilibrium.

A monopoly is a business that is characterized by a lack of competition within a market and

unavailable substitutes for its product. Monopolies can dictate price changes and create
barriers for competitors to enter the marketplace.
Companies become monopolies by controlling the entire supply chain, from production to
sales through vertical integration, or buying competing companies in the market
through horizontal integration, becoming the sole producer.

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

A Firm’s Short-Run Equilibrium in Monopoly

Like in perfect competition, there are three possibilities for a firm’s Equilibrium in
Monopoly. These are:

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

Normal Profits

A firm earns normal profits when the average cost of production is equal to the average
revenue for the corresponding output.

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

A firm earns super-normal profits when the average cost of production is less than the
average revenue for the corresponding output.

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

OP – OP’ = PP’

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

Losses

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

A Firm’s Long-run Equilibrium in Monopoly

In the long-run, a monopolist can vary all the inputs. Therefore, to determine the
equilibrium of the firm, we need only two cost curves – the AC and the MC. Further,
since the monopolist exits the market if he is operating at a loss, the demand curve must
be tangent to the AC curve or lie to the right and intersect it twice.
 As you can see above, there are two alternative cases for the determination of
Equilibrium in Monopoly:

 With normal profits

 With super-normal profits
We have not taken the loss scenario here because if the monopolist incurs losses in the
long-run, he will stop operating.

Case 1
The demand curve AR1 is tangent to AC or LAC at point E. Remember, if the demand
curve lies to the left of the AC curve, then the monopolist is unable to recover his costs
and closes down.

However, if the AR curve is tangent to the AC curve, then the monopolist can recover
his costs and stay in the market.

Further, note that the perpendicular drawn from point E to the X-axis, the MC curve, and
the MR curve are concurrent at point A.

Therefore, all the conditions of equilibrium are satisfied. The monopolist produces OM
quantity and sells it at a price of EM per unit which covers its average costs + normal
profits.
Case 2
The marginal revenue curve MR2 cuts the MC curve from below at point B. The
corresponding height of the AR2 curve is E’M1.

Hence, the monopolist produces OM1 quantity and sells it at E’M1 per unit to earn an
extra profit of E’B per unit. Being a monopoly, this extra profit is not lost to competition
or newer firms entering the industry.

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.

Equilibrium under Monopolistic Competition

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

Equilibrium under Monopolistic Competition

The two types of demand curves of a firm under monopolistic competition are due to
the following reasons:

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

A Firm’s Short-Run Equilibrium under Monopolistic Competition

Under Monopolistic Competition, the revenue curves are downward sloping (like under
Monopoly). This is because, in order to sell more, the firm has to decrease the price.

A firm under Monopolistic Competition can either earn normal profits, super-normal
profits, or incur losses. Also, like under Monopoly, a firm earns super-normal profits if
the demand for its product is very high.
Also, in the short-run, new firms cannot enter the group and enhance the supply of the
product group. Therefore, they cannot compete away the super-normal profits of the
firm. Also, in the short-run, a firm faces certain fixed costs. These can include
production as well as selling costs.

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

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

The MC curve intersects the MR curve from below at point I. Hence, the firm decides to
produce a quantity of OM and charge a price of EM per unit.

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

 Only normal profit

 Covering a part of fixed costs. Therefore, incurring a loss less than its fixed costs
 Loss equal to the fixed costs (where AR is tangent to the AVC curve)

Group Equilibrium

Group equilibrium is the simultaneous equilibrium of all the firms in the group. We
know that the cost and demand conditions of individual firms differ from each other.
Further, they produce differentiated products making it impossible to derive demand and
supply curves for the group as a whole.

Chamberlin assumed that all firms in the group have identical demand and cost
conditions. Therefore, when in equilibrium, all firms produce the same quantities of their
respective products and sell them at the same prices.

This, however, is a little unrealistic assumption. For all practical purposes, it is important
to determine a firm’s equilibrium under Monopolistic Competiton individually.

A Firm’s Long-Run Equilibrium under Monopolistic

Competition
To discuss a firm’s long-run equilibrium under Monopolistic Competition, it is important
to remember the following points:

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

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

Let’s say that the LAC curve in Fig. I represent the product quality and selling expenses
that a firm selects. This has a corresponding long-term MC curve (LMC) which
intersects the MR curve from below at point I.

Therefore, the firm decides to produce a quantity of OM and sell it a per unit price of
EM. This gets a profit of EK per unit. However, soon new firms enter the market and
start offering close substitutes and bring the profit down.

Therefore, there is a reduction in the market shares of the existing firms. The firm’s AR
curve shifts left until it becomes tangent to the LAC curve at point E as shown in Fig. ii.
This ensures that the firm earns only normal profit. Once this stage is reached, there is no
incentive for new firms to enter the market.

This results in the firm’s long-term equilibrium under Monopolistic Competition. The
equilibrium is given by the point of tangency between the firm’s AR curve and LAC
curve, which is at point E in Fig. ii. Therefore, in the long-run, under monopolistic
competition, firms earn only normal profits.

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.

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 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.

Kinked demand curve

A kinked demand curve illustrates the interdependent behaviour of firms in oligopolies.
It suggests that if one firm raises its price, the other firms in the market will not follow,
leading to a sharp drop in demand for the first firm's products, which can result in reduced
profits. If a firm lowers its price below the market price, its competitors will quickly follow
suit, assuming they will lose market share if they do not match the lower price.

The reason why there is a kink in the demand curve is that there are two demand curves: one
that is inelastic and one that is elastic. The kink occurs at a current market price.

As shown in Figure 1 below, the MR curve is vertical at the kink. The MC curve intersects the MR
curve in that vertical section.

This kinked demand model shows how firms in this market suffer from price rigidity when they
choose to increase or decrease their prices.

Price Leadership under Oligopoly (With Diagram)

In certain situations, organizations under oligopoly are not involved in collusion.

There are a number of oligopolistic organizations in the market, but one of them
is dominant organization, which is called price leader.

Price leadership takes place when there is only one dominant organization in the
industry, which sets the price and others follow it.
Sometimes, an agreement may be developed among organizations to assign a
leadership role to one of them. The dominant organization is treated as price
leader because of various reasons, such as large size of the organization, large
economies of scale, and advanced technology. According to the agreement, there
is no formal restriction that other organizations should follow the price set by the
leading organization. However, sometimes agreement is formal in nature.

Price leadership is assumed to stabilize the price and maintain price discipline.

This also helps in attaining effective price leadership, which works

under the following conditions:

i. When the number of organizations is small

ii. Entry to the industry is restricted

iii. Products are homogeneous

iv. Demand is inelastic or less elastic

v. OrganTypes of Price Leadership:

Price leadership helps in stabilizing prices and maintaining price discipline. There
are three major types of price leadership, which are present in industries over a
passage of time.

These three types of price leadership are explained as follows:

i. Dominant Price Leadership:

Refers to a type of leadership in which only one organization dominates the entire
industry. Under dominant price leadership, other organizations in the industry
cannot influence prices. The dominant organization uses its power of monopoly to
maximize its profits and other organizations have to adjust their output with the
set price.

The interests of other organizations are ignored by the dominant organization.

Therefore, dominant price leadership is sometimes termed-as partial monopoly.
Price leadership by the leading organization is most commonly seen in the
industry.

ii. Barometric Price Leadership:

Refers to a leadership in which one organization declares the change in prices at

first and assumes that other organizations would accept it. The organization does
not dominate others and need not to be the leader in the industry. Such type of
organization is known as barometer.

Price-Output Determination under Price Leadership:

Price leadership takes place when there is only one dominant organization in t he
industry, which sets the price and others follow it. Different economists have
developed different models for determining price and output in price leadership.
Here, we would discuss a simple model for determining price and
output in price leadership, which is shown in Figure-4:

Suppose there are two organizations, A and B producing identical products

where organization A has a lower cost of the production than organization B.
Therefore, consumers are indifferent between these two organizations due to
identical products. This implies that both the organizations would face same
demand curve, which further represents equal market share.

In Figure-4, DD is the demand curve of both the organizations and MR is their

marginal revenue. MCa and MCb are the marginal cost curves of organization A
and B respectively. As stated earlier, the cost of production of organization A is
less than B, thus, MC a is drawn below MCb.

Let us first start the discussion of price leadership with the case of organization A.
The profits of organization A would be maximized at a point where MR intersects
MCa. At this point, the output of organization A would be OQ with the price level
OP. On the other hand, the profits of organization B would be maximized at a
point where MR intersects MCb with output OQ 1 and price OP1.

In such a case, the price of organization B is more as compared to organization A.

However, both the organizations have to charge the same price as products are
homogeneous. In this case, organization A is the price leader and organization B
is the follower.

Collusive oligopoly refers to a situation where firms cooperate with each other
rather than compete in setting price and output. Agreement may be entered to
cooperate by raising prices, restricting output, dividing markets or otherwise,
with the objectives of restraining competition and to keep their bargaining
position stronger against the buyer.
Non-collusive oligopoly refers to the situation where the firms compete with
each other and follow their own price and quantity and output policy
independent of its rival firms. Every firm tries to increase its market share
through competition.
Merger
A merger is an agreement that unites two existing companies into one new company. There
are several types of mergers and also several reasons why companies complete
mergers. Mergers and acquisitions (M&A) are commonly done to expand a company’s
reach, expand into new segments, or gain market share. All of these are done to
increase shareholder value. Often, during a merger, companies have a no-shop clause to
prevent purchases or mergers by additional companies.