The classical theory of markets considered perfect competition and monopoly as two main models explaining price

determination. These models, however, failed to explain some of the empirical observation like use of advertising by
the firms, heterogeneity of products and so on. Joan Robinson and E. Chamberlin described a new market structure
having features of both perfect competition and monopoly. Under this kind of market, known as monopolistic
competition, in spite of free entry and exit for the firms and existence of large number of firms, each firm enjoys
some degree of monopoly power. This may be because of differentiated products. When there is a large number of
firms producing differentiated products, each one has a monopoly of its own product. But at the same time, there is
also a degree of competition because of competitors producing close substitutes. Under such a market, the demand
curve for the product of individual firm depends upon the nature and prices of its closely competing substitutes.
Thus, according to Chamberlin, “Monopolistic Competition concerns itself not only with the problem of an individual
equilibrium, but also with that of a group equilibrium. A ‘group’ is a number of producers whose goods are fairly good
substitutes.
CHAMBERLIN’S MODEL (LARGE GROUP)
As stated earlier, ‘Group’ refers to the collection of firms that produce closely related but not exactly identical
products. since the firms in a group produce substitutes and not ho9mogenous products, the demand for the product
of one producer is dependent on the price and nature of the products of his rivals. Basic assumptions of the
Chamberlin’s large group model are as follows.
1. There are large number of buyers and sellers in a group.
2. The products of each firm are differentiated but still they are close substitutes of each other.
3. There is free entry and exit in a group.
4. Profit maximisation is an important objective of a firm
5. The prices of factors of production are given.
6. Demand and cost curves for all products in a group are uniform.
Chamberlin’s has accepted traditional cost concepts for his analysis. So the average variable cost (AVC), Marginal cost
(MC) and Average Total Cost (ATC), all are U shaped in nature. He introduced the concept of selling cost for the first
time in his analysis. Because each firm produces differentiated products, advertising and selling costs play important
role in these markets. Selling cost curve is also assumed to be U-shaped in nature.
Product differentiation established by advertising, packaging, differences in design, etc. give some monopoly power to
each producer. So the producer is not price - taken and he enjoys some degree of power in determining price.
Due to product differentiation, it is difficult to get market demand and supply. Summation of individual demand and
cost curves to form ‘Group’ demand and supply requires the use of some common denominator. This compels the
‘Group’ not to have unique equilibrium price

Equilibrium of the firm

The firm has negatively sloped demand curve. It implies that if the firm raises price, it will lose some of its market
share. although it has downward sloping, demand curve, it is highly elastic in nature as shown in the following
diagram.

Fig. 2.1

Firm, in the short run, acts as a monopolis and given its demand and cost curves, it maximizes its profit at the point
where MC = MR. But to be able to understand the equilibrium of an industry, Chamberlin has developed three models.

Model 1 - Equilibrium with new firms entering into industry. Model 2 -Equilibrium with price competition
Model 3 - Equilibrium with price competition and free entry.

Model 1. Equilibrium with new firms entering the industry.

In this model, Chamberlin assumed that the firms are in equilibrium with excess profit (in the short run) and hence,
there new firms can enter the market in the long run. Following diagram shows equilibrium of a firm and industry in
the same diagram.
Model 2. Equilibrium with price competition :
This model is based on the assumption that the number of firms in an industry is exactly compatible with long-run
equilibrium but the existing price charged by the firms is higher than the equilibrium price. The firms charge price not
as a reaction to their competitors, but each firm fixes price independently with an objective of profit maximisation. If
a firm aims at reducing the price to increase its sales, it can not enjoy fullest possible benefit of price reduction
because; all other competition firms would reduce their price and expand their own sales simultaneously. Hence, even
if price reduction takes place, the share of all the firms remain more or less constant. In this model, the firms are
shown to be suffering from myopia. They do not learn from experience and continue to lower price to increase sales.
There is a discrepancy between expected sales (after price reduction) and actual sales because all firms act identically.
The adjustment process will stop at point where the demand curve is tangent to the average cost curve. That means a
point at which a firm enjoys normal profit.

Model 3 : Price Competition and free entry :

In this model, Chamberlin shows how the actual life equilibrium is achieved by both price competition and free entry.
According to him price adjustment by the existing firms and entry of new firms together would work towards stable
equilibrium.

Chamberlin’s theory is criticized on many grounds. It is said that the firms having competitors who produce
substitutes, can not act independently as assumed in this model. Firms will learn from the past experiences or
mistakes and then take decisions regarding price and quantity. Further, it is difficult to define the concept of industry
with product differentiation. Two different products can not form an industry. So some of the assumptions of
Chamberlin seen to be unrealistic. Thirdly, some people have criticized the model on the ground that it is
indeterminate. Effects of product changes and sales. Promotion activity create a situation of indeterminate
equilibrium.

CHAMBERLIN’S OLIGOPOLY MODEL (SMALL GROUP)

The “Small group” model by Chamberlin indicates that if the firms in a small group realize their interdependence, they
can attain stable equilibrium with profit maximisation and in fact all can enjoy monopoly profit. According to him if the
firms do not recognize their interdependence, they may have either Cournot equilibrium (where a firm assumes that
its competitors will keep quantity of output constant) or Bertrand Equilibrium (where firm assumes that its
competitors will keep price constant).
But according to Chamberlin, firms are well aware of the fact that the competitor’s price & quantity decisions are
going to have direct and indirect effect on the firms’ equilibrium position. With the understanding of such effects,
olitopolistic firms can achieve stable equilibrium with monopoly profit for all the firms in a group.

THE KINKED-DEMAND MODEL :

The origin of kinked demand curve can be traced in Chamberlin’s analysis. But he did not explicitly used this tool in his
analysis. Hall and Hitch, in their article ‘Price Theory and Business Behaviour’ used the term kinked demand curve for
explaining the price-stickiness in oligopolistic markets. It was Paul Sweezy, who for the first time, used kinked
demand-curve as a tool for explaining equilibrium in the oligopolic market. In this part of the unit, we will try to focus
on how oligopoly firms will attain equilibrium when the prices are sticky.
It has been observed that under oligopolistic markets, price and quantity tend to remain inflexible. Kinked demand
curve hypothesis is used to explain such a rigidity of prices. Under oligopoly without product differentiation, if a firm
raises the price, it will loose all its customers. So this firm will have no tendency to change its price. Alternatively, firms
without product differentiations may enter into formal or informal agreement and maintain price rigidity.

Demand curve is said to be having a kink of point ‘K’ because each oligopolistic firm believes that though its rivals will
not increase the price, if this firm increases the same, but they will certainly reduce the price, if this firm decides to do
so. If a firm decides to reduce the price below prevailing price level (OP), the competitors will fear that their customers
will start buying from that firm and their market share will go down, so the competitors follow price cut policy and
hence the firm will not gain much in terms of market share. As per the diagram (2.4), firm will reach inelastic part KD1
of the demand curve.
In case a firm decides to increase the price, the competitors may not follow the firm and hence the firm may loose a
large part of its customers. In other words, if firm raises the price, it will reach at the DK part of demand curve which is
highly elastic in nature.
It is obvious from the above discussion that whether a firm reduces the price or increases the price, it will be a loser.
So this firm has no inclination of changing the price. Price remains sticky or rigid at “OP”.

Explanation of Price Rigidity :

As explained in the earlier section, oligopolists will adhere to a certain price and will neither increase the price (as they
will experience substantial fall in sales) nor decrease the price (as they will have no substantial gain in terms of market
share). This situation will not change even if the cost of production or demand for product change.

In fig. 2.5 OP - Prevailing Price (at which there is a kink) which is rigid / sticky.

To understand profit maximising situation of an oligopolist, marginal revenue and marginal cost curves are drawn.

MR – Discontinuous marginal revenue curve with discontinuosu portion HR

E – Equilibrium point where MC = MR

Since at this level of output and price, profits are maximised, the oligopolist has no inclination to change the price.

MC' - New Marginal Cost curve with rise in cost

E' - New equilibrium point

It should be noted that at new equilibrium point, quantity and price remain the same. So even if the costs rise,
equilibrium price remains the same.

In Fig. 2.6, changes in demand curve are depicted, even if the demand curve shifts upward from dKD to d'K 'D' ,
equilibrium price remains the same.

In conclusion it may be noted that under oligopoly, price will remain rigid irrespective of changes in cost of production
or demand conditions.

BAIN’S LIMIT PRICING :

J.Bain, in his article ‘Oligopoly and Entry Prevention’ has touched upon one more aspect influencing the price and
quantity decisions of oligopolistic firms_threat of entry of new firms. Bain maintained that the firms fix the price above
the competitive price (where there are only normal profits) and below monopoly price (where profits are maximised).
Such a price level is called by him as ‘limit price’ which according to him is the highest price that a firm can charge
without the entry of new firms.

His models ofoligopoly pricing are based on following assumptions.

1) The long-run demand curve for industry is determinate and is unaffected by the price adjustments by
the existing firms or by the entry of new firms.
2) There is a collusion (Agreement) among the oligopolists.
3) The firms can calculate limit price.
 4) Below limit price, new firms will not enter the market and above limit price, entry is attracted.
5) Firms aim at maximisation of profits.

Based on these assumptions, Bain presented two version of his model.

1. Model A : With no collusion with the new entrants.
2. Model B : With collusion with the new entrants.

2.5.1 Model A : No collusion with new entrants.

Fig. 2.7

In the diagram,

DABD’ _ Market Demand Curve Dabm _ Marginal Revenue Curve

PL _ Limit price (which is supposed to be known to the oligopolistic
firm. It will be sent depending on :
1) estimation of costs of the potential entrants
2) market elasticity of demand
3) shape and level of long-run average cost curve
4) size of market
5) number of firms in industry
AD' _ Certain part of demand curve
am _ Certain part of marginal revenue curve
DOMINANT FIRM MODEL
In same oligopolistic markets, one large firm has a major share of market while the remaining market is supplied by
the remaining smaller sized firms. Such a large sized firm is called a dominant firm. It sets the price that maximizes its
own profit and the other smaller firms accept that price as given and produce accordingly.
Following diagram explains how a dominant firm determines price and quantity.

part I part II

BUMOL’S SALES MAXIMISATION MODEL OF OLIGOPOLY FIRMS

Why sales Maximisation ?
, the structure of business organisation has undergone transformation in the recent times. In corporate form of
organisation, Mangers dominate in the entire decision making process of business. In such a situation, according to W.
J. Baumol, an American Economist, Sales maximization seems to the more realistic assumption in comparison with the
profit maximization. Baumol advocates sales maximization as an objective of firm under following grounds :
1) Modern firms have separated the managerial functions away from the ownership. In other words,
owners of the firm need not be managing the day to day activities of a firm.
2) Mangers generally pursue maximization of sales, than profit as their earnings are more closely
linked with sales than profit.
3) Raising of funds from banks become easier for the firms with large size and growing sales.
4) Employees can be given better salaries and parts when sales are rising
 5) Firm can be more competitive or can survive better in competition when its sales are rising.

Baumol, however, did not ignore profits. His theory aims at sales maximisation under the condition of minimum profit.
In other words, minimum level of profit must be earned by the manager pursuing the sales maximisation goal to
ensure future growth of a firm and confidence of share holders. It is worth noting Baumol’s words.
“My hypothesis then is that oligopolists typically seek to maximize their sales subject to a minimum profit constraint.
The determination of the minimum just acceptable profits level is a major analytical problem and I shall only suggest
here that it is determined by long-term considerations. Profits must be high enough to provide the retained earnings
needed to finance current expansion plants and dividends sufficient to make future issue of stocks attractive to
potential purchasers. In other words the firm will aim for the stream of profits which allows for the financing of
maximum long-run sales. The business jargon for this is that management seeks to retain earnings in sufficient
magnitude to take advantage of all reasonably safe opportunities for growth and two provide a fair return to share
holders. (W. J. Baumol, “On Theory of Oligopoly Economical, New Series, Vol. 25, 1958)

Oligopoly and interdependence of firms

You are aware that one of the important characteristics of oligopoly is interdependence of firms. Under oligopoly,
there are a few firms and they are interdependent on each other, they have to think about the reaction of their
competitors while taking any decision about price and quantity changes of their product. According to Baumol,
oligopolistic firms, in their day to day operations, need not worry about the competitor’s reaction. In other words,
firms daily decisions are taken on the premise that these will not bring about changes in the behaviour of competition
firms. However, the reaction of competitors becomes more important when oligopolistic firm takes some radical
decision like launching new product or advertising campaign etc. Thus the mangers will ignore the competitors to the
extent that their actions do not encroach on the firm’s market and do not interfere with the desired growth rate and
market share of a firm.
Baumol’s model is based on the following basic assumptions
 It s a single period analysis
 During this period firm aims at maximizing total sales revenue (and not physical quantity of output under
minimum profit constraint)
 Minimum profit level is determined exogenously by the demands and expectations of shareholders, banks
and financial institutions.
 Conventional cost analysis based on ‘U-shaped’ cost curve is assumed under this model
 Based on these models we will understand three different models described by Baumol :-
 Single product without advertising
 Single product with advertising
 Multiple products without advertising

Single product without advertising

We first explain Baumol’s model for a firm which produces a single product and does not incur any advertising

expenditure. It is necessary to understand following diagram to explain price – quantity determination under this
model.

In the diagram
TR – Total Revenue curve for the firm TP – Total Profit curve for the firm
TC – Total Cost curve
ML – Minimum level of profit which the firm must earn.
Total profit is a different between total cost and total revenue of a firm.
We will first understand how a firm determines quantity and price with the objective of profit maximization. Since
profit is a difference between total cost and total revenue, maximum profit will be at that point where the vertical
distance between TR and TC is maximum or where the TP curve reaches to its (highest) level. So under profit
maximisation objective firm will produce “OA” level of output because that level of output corresponds to the highest
point on TP curve (Point H).
Next to understand is the situation in which a firm would aim at sales maximization in the diagram; sales are
maximized at the level of output OC, which corresponds to highest revenue R.
As per the assumption of Baumol’s model a sales revenue maximizing firm has a minimum profit constraint. In other
words, even if the firm is maximizing sales revenue, it has to do so under the conditions of minimum profit level AT
“OC” level of output even though the sales are maximized minimum profit level (ML) is not reached. At “OC” level of
output profit level is less than ML. So this is not what Baumol has contented.
Equilibrium price and quantity under oligopoly with sales maximisation subject to minimum profit constraints is at the
output level OB.
It should be noted that under Baumol’s model of oligopoly firm, sales revenue maximisation leads to more quantity at
lower price as compared to profit maximisation situation.

A single product model with advertising

Under oligopoly, firms compete not only in terms of price but also in terms of advertising expenditure, product
changes, after sales services etc. Baumol presented another version of sales maximisation model with advertising as
one of the policy variables. An important assumption of this model is that advertising expenditure will always shift
demand curve to the right indicating that the firm will be able to sell more and get larger revenue after advertising
expenditure. Following diagram explains this version of Baumol’s model.

As per the diagram advertising expenditure is shown on the x-axis and total cost total revenue and total profit is
shown on the y- axis. As stated earlier according to Baumol, increase in advertising outlay will lead to increase in sales
of the firm (sometimes at diminishing rate) Increase in the physical volume of sales leads to increase in the total
revenue of the same firm
TR – total Revenue OD – advertising cost Production costs (fixed and variable costs) are shown independent of
advertising expenditure. So by adding fixed cost (OT) to the advertising cost curve OD we get total cost curve TC.
Difference between TR and TC is profit Therefore
PP – Total profit curve

Profit maximizing output level will be produced with advertising expenditure equal to
OA1, (because at that level the total profit is highest)
Revenue maximizing output level will be reached with
advertising expenditure equal to OA2, (Where the firm maximizes its total revenue with minimum profit constraint)
As seen in the diagram OA2 is greater than OA
It may be, hence concluded that in order to maximize sales with minimum profit. Constraint greater level of
advertising expenses are to be incurred by the firm as compared to advertising expenses of profit maximizing firm.

Multi product firm without advertising

This version of model explained by Baumol is based on the assumptions such as
1) Costs are given
2) Firm produces two commodities and Y

To explain the equilibrium condition of a firm aiming at sales maximisation with multiple products and without
advertising expenses, Baumol has made use of two apparatus
1) Transformation curve or marginal rate of product transformation, which is a ratio of marginal
costs of two commodities x and y. Product transformation curve is concave to the origin showing
increasing cost of reducing one product (say y) and reallocating the resource to produce other
commodity (say x)
2) The iso-revenue curve is the curve showing same revenue earned by different combinations of x
and y. Higher the iso- revenue curve higher will be the total revenue earned.

Following diagram shows equilibrium of multiproduct firm without advertising.

Firm is in equilibrium at point E where the product transformation curve TT is tangent to the highest possible iso-
revenue curve (R2).

It should be noted that the solution is diagram 3 is identical with the solution for profit maximizing firm. (Students
should recall that the firm maximizes profit at a point where the slopes of product transformation curve and iso-
revenue curve are identical). Thus in this version f Baumol’s model, a firm maximizes sales at that level of output
where the firm maximizes its profit. In other words, whatever output combination maximizes revenue, also maximizes
profit.

Critical Appraisal of Baumol’s sales maximisation model

The sales maximisation theory by Baumol implies of favorable effect on the welfare of people. This is because under
sales maximization with minimum profit constraint, output will be greater and price will be lower than that under
profit maximization.
Shepherd has criticized the model on the ground that the oligoplistic firm faces kinked demand curve and if the kink is
quite large, total revenue and total profits would be maximized at the same level of output.
According to Hawkins in case of single-product firm, as compared to profit maximizing firm, output will greater,
smaller or same and advertising expense also will be greater, smaller or same depending upon the responsiveness of
demand to advertising expenditure and not to price cut.
Another criticism against Baumol’s model is that his theory does not show haw equilibrium in an industry will be
attained. He has not been able to establish relationship between a firm and industry.

MORRIS’S MANAGERIAL THEORY OF FIRM

Another new theory, stressing the role of managers and their behavioural pattern in determining output and price of
firm was put forward by Marris. According to him, Managers do not aim at maximizing profits but they seek to
maximize balanced growth rate of a firm Maximisation of balanced growth rate means maximizing the rate of growth
of demand for the products of firm and the rate of growth of capital supply
Maximise g = gD = gc

Where
g = balanced growth rate
gD = growth of demand for product of a firm gc = growth of supply of capital
While maximizing growth rate, there are two constraints faced by the manager of a firm :-
1) Managerial constraints
2) Finanacial Constraints

Managerial constraints are set by the available managerial team and its skill. Financial constraints are set by desire of
managers to achieve maximum job security. It is important to note here that the managers aim of maximizing rate of
growth of demand to maximize their own utility and they aim at maximisation of growth of capital to maximize the
utility of owners and shareholders.

Manger’s utility Function

Manger’s utility function includes the variables like salaries, status, powers and job security. Owners’ utility function
includes variables like profits, size of output, size of capital, share of market and public image. Thus, due to division of
management and ownership has resulted in setting goals which may not necessarily coincide.

Um = f(salaries, power, status, job security) ® This is mangers utility function.

Utility function

Uo = f* (profits, capital, output, market share, public esteem) ®

This is owners’ utility function
The managers aims at maximizing utility as per Um function and the owners’ aim at maximizing Uo function. According
to
Marris, the difference between these two functions is not wide because most of the variables are strongly correlated
with each other. Marris believes that the size of a firm may be measured by the level of output, capital supply, sales
revenue and market share. Achieving steady balanced growth implies the growth of most of the variable occurring in
above mentioned functions such as sales, output, supply of capital etc. Marris further argues that the maximization of
growth rate of firm is compatible with the interests
of share holders. So growth of demand/output of a firm. (gn) and
growth of capital supply (gc) of a firm need not be differentiated. In other words, when the rate of growth of firm is
higher, manger’s salaries will be higher they will have power and more job security. So mangers’ utility function can
be written as

UM = f(gD, S)
Where gD - growth of demand
S – measure of job security

On the other hand, owner’s utility depends upon the growth of capital supply. So his utility function can be written as
UO = f* (gc)

Following E Penrose’s “Theory of Growth of firm” Marris

argued that gD or growth of demand for product is constrained by decision making capacity of a manager Job Security
S is determined by three financial indicators
1) Liquidity Ratio
2) Debt. Asset. Ratio and
3) Profit Retention Ratio

Marris’s treats ‘s’ as an exogenously determined constraint in the managerial utility function. Taking this factor into
consideration manager’s utility function may be rewritten as
UM = f(gD) s’
Where s’ is a security constraint.

Constraints in the Model

As discussed in the earlier part of the theory, thee are two constraints in the model.
The Managerial constraint and The Job security constraint
Since the decision making and planning of firm’s operation are the result of team work of managers, the efficiency of
top management acts as the managerial constraint in the model. Research and Development (R & D) department also
set limit to the rate of growth of firm. Thus, both gD and gc have managerial constraint.
The job security constraint makes managers become risk- avoiders by choosing steady performance and not risky
ventures which may be highly profitable. Managers also prefer prudent financial policies by determining optimum
levels for the three financial ratios mentioned in the earlier section :- Liquidity Ratio, Debt ratio, and Retention Ratio.
These three financial ratios are combined into a single parameter a which is called ‘financial security constraint’. It is
exogenously determined by the top management.
According to Marris, two ponts need to be stressed regarding the overall financial constraint a .

1) Overall a is negatively related to a, and positively related to a2 and a3.

2) There is a negative relationship between job security (s) and financial constraints ( a )

Equilibrium of a firm
Managers aim at maximisation of their own utility UM = f(gD)
Owners aim at maximisation of their own utility
UO = f*(gc)
Firm is in equilibrium when gD = gc = g* maximum
where g* is maximum balanced growth rate gD will depend upon the rate of diversification or introduction of new
products (d) and the proportion of successful new products (k) which in turn will depend upon price of product (p),
advertising expenditure (A) and expenditure on Research and Development (R & D), Thus
gD = f(d, k)
gc (Rate of growth of capital supply) will depend upon the magnitude of profit
gc = f(p) p = profits
According to Marris, further, growth rate of supply of capital depends upon average rate of profits (m) which is
obtained by deducting cost per unit, advertising expenditure per unit and R & D expense per unit from the price of
product
m = p – c (A) – (R & D)
Growth rate of capital supply also depends upon the rate of diversification (d). So
p = f(m, d)
Substituting this profit function the in the function governing supply of capital, we have
gc = a (p)
Where a is financial security constraints
As long as financial security constraint is constant, growth of capital and magnitude of profit are not competing goals.
Higher levels of profits means the higher growth of capital supply.
Given the above function related to rate of growth of demand for product and the rate of growth of capital supply, the
firm will be in equilibrium when it is achieving the highest rate of balanced growth
gD = gc = g* maximum

Evaluation of Marris’s Model

The most important contribution of Marri’s model of managerial theory of firm is the inclusion of financial policies of
the firm into the decision-making process. The financial constraint coefficient a plays a very important role in the
entire model as a policy variable. However, the model actually does not say much about the value of a . It is assumed
to be exogenously determined.
According to the conclusion of the model balanced growth solution will maximize the utility functions of both mangers
and owners. But it may be so during the periods of steady growth and not during recessions or tight markets.
One of the implications of the model is that both the mangers and owners prefer maximization of rate of growth over
the maximization of profits. Marris does not justify the preference of owners for capital growth over the maximisation
of profits.
The model assumes price and cost to be constant. It fails to take into consideration the interdependence of firms
under the oligopolstic structure.
Further, the model assumes a continuous growth by crating new product. But it fails to realize that new products may
be imitated by the rivals and this, in the longrun will hinder the steady growth of firm.
There are many restrictive assumption on which the Marris model heavily relies. Such as each firm has its own R & D
department, R & D and advertising expenses together influence the growth rate of capital supply etc.