Unit 9 - Perfect Competetion
Unit 9 - Perfect Competetion
INTRODUCTORY
MICROECONOMICS
BLOCK 1 INTRODUCTION
UNIT 1 Introduction to Economics and Economy 7
UNIT 2 Demand and Supply Analysis 26
UNIT 3 Demand and Supply in Practice 50
193
Production
and Costs
BLOCK 4 MARKET STRUCTURE
Block 4 essentially concentrates on output markets i.e. markets for goods and
services that firms sell and consumers purchase under the different market
structures i.e. perfect competition, various forms of imperfect competition i.e.
monopoly, monopolistic competition and oligopoly. The Block comprises four
units.
Unit 9 on Perfect Competition: Firm and Industry Equilibrium provides
the characteristics of perfectly competitive market and exposes the learners to
equilibrium of Firm and Industry under perfect competition. Unit 10 on
Monopoly: Price and Output Decision deals with pricing and output
decisions and price discrimination under monopoly condition. The concept of
deadweight loss under monopoly has also be discussed in this unit. The
equilibrium conditions of monopolistic competition in short-run and long-run
period, theory of excess capacity, the comparison of the various market forms
have been provided in Unit 11. Price and Output determination under
oligopoly have been covered in Unit 12.
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UNIT 9 PERFECT COMPETITION:
FIRM AND INDUSTRY
EQUILIBRIUM
Structure
9.0 Objectives
9.1 Introduction
9.2 Perfect Competition: Characteristics of a Perfectly Competitive Market
9.3 The Firm as a Price Taker in Perfectly Competitive Market (PCM)
9.4 The Price-Taking Firm’s Cost Structure
9.5 The Perfectly Competitive Market: Firm in the Short Run and Long Run
9.5.1 Short Run Price and Output
9.5.2 Short Run Abnormal Profit – Market Entry
9.5.3 Short Run Loss
9.5.4 Long Run Price and Output of a PC Firm
9.5.5 Conclusions
9.6 Shut Down Point and Break-Even Output for PCM Firm
9.7 Supply Curve for a PC Firm and for PC Market
9.7.1 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries
9.0 OBJECTIVES
After reading this unit, you will be able to :
identify the characteristics a perfectly competitive market and their
implications;
talk about the shut Down Point and Break-Even Output for a PC Firm;
Dr. S.P. Sharma, Associate Professor in Economics, Shyam Lal College (University of
Delhi), Delhi. 195
Market construct the short-run market supply curve from the short-run supply
Structure curves of individual firms;
9.1 INTRODUCTION
Market structure refers to arrangements that bring buyers and sellers together.
The market for a product may also refers to the whole region where buyers and
sellers of that product are spread and there is such free competition that one
price for the product prevails in the entire region. Whether a firm can be
regarded as competitive depends on several factors such as the number of firms
in the industry, degree of rivalry, degree of homogeneity of the product,
economies of scale and easiness with which any firm can enter in the market
and exit from it. On the basis of these characteristics, especially in terms of
degree of competition, a market can be classified as a perfectly competitive
market, monopoly, duopoly, oligopoly and monopolistic competition. In this
unit, we aim to explore the features of a perfectly competitive market,
equilibrium of industry and firms under such a market.
197
Market Internet based markets: The internet has made many markets closer to
Structure perfect competition because the internet has made it very easy to compare
prices, quickly and efficiently (perfect information). Owing to the
relatively low cost of doing business through internet, it has become
easier to enter in the market. For example, selling a good on internet
through a service like Amazon or e-kart etc. is close to perfect
competition. Equal access to the market and availability of full
information about the prices of the products, enable the price of goods to
fall in line with the market price making the firms to earn only normal
profit in the long run.
Fig. 9.1 : Demand and Revenue for a Perfectly Competitive Market (PCM)
198
In case for the perfectly competitive market firm, the price will be the same. Perfect Competition:
The horizontal demand curve, is also the average revenue (AR) and marginal Firm and Industry
revenue curve (MR), i.e. P = AR = MR. This can be verified as follows: Equilibrium
Supply curve for the firm. To know about the supply curve of the firm, it
would be necessary to look into the profit1 maximising behaviour of the price
taker firm.
Assuming that the firm produces and sells a quantity Q, its economic profit is
= TR(Q) – TC(Q), where TR(Q) is the total revenue derived from selling the
quantity Q and TC(Q) is the total economic cost of producing the quantity Q.
As the firm is a price taker, it perceives that its volume decision has a
negligible impact on market price and its goal is to choose a Q to maximise its
total profit. To illustrate the firm’s problem, suppose that a rose grower
anticipates that the market price for fresh-cut roses will be P = `1.00 per rose.
Table 9.1 shows total revenue, total cost, and profits for various output levels
and Fig. 9.2(a) graphs these numbers.
Table 9.1: Total Revenue, Cost and Profit for a Price Taking Rose
producer Firm
Fig. 9.2(a) shows that profit is maximised at Q = 300 (i.e., 300,000 roses per
month). It also shows that the graph of total revenue is a straight line with a
slope of 1. Thus, as we increase Q, the firm’s total revenue goes up at a
constant rate equal to the market price, `1.00 which is also equal to MR.
1
A distinction is to be made between economic profit and accounting profit, i.e.
economic profit = sales revenue - economic costs
accounting profit = sales revenue - accounting costs
That is, economic profit is the difference between a firm’s sales revenue and the totality of its
economic costs, including all relevant opportunity costs, for example, reward or return of the
labour put in by the owner of the firm which is treated equivalent to the return expected in his
next best alternative use. Therefore, whenever we discuss profit maximisation, we are talking
about economic profit maximisation. 199
Market Marginal cost (MC), the rate at which cost changes with respect to a change in
Structure output, following usual return to scales, is exhibited as U-shaped curve.
Fig. 9.2 shows that for quantities between Q = 60 and the profit-maximising
quantity Q = 300, producing more roses increases profit. Increasing the
quantity in this range increases total revenue faster than total cost, i.e. MR >
MC or in our case P>MC.
When P > MC, each time the rose producer increases its output by one rose, its
profit goes up by P – MC, the difference between the marginal revenue and the
marginal cost of that extra rose.
Further, for quantities greater than Q = 300, producing fewer roses increases
profit. Decreasing quantity in this range decreases total cost faster than it
decreases total revenue – that is, marginal revenue is less than marginal cost, or
P < MC. When P < MC, each time the producer reduces its output by one rose,
its profit goes up by MC – P, the difference between the marginal cost and the
marginal revenue of that extra rose.
The producer can increase its profit when either P > MC or P < MC, quantities
at which these inequalities hold cannot maximise its profit. It must be the case,
then, that at the profit-maximising output, P = MC, i.e. a price-taking firm
maximises its profit when it produces a quantity Q* at which the marginal cost
equals the market price.
Fig. 9.2
Fig. 9.2 (b) however shows that there are two points (Q = 60, and Q = 300) at
which MR = MC. The difference between Q = 60 and Q = 300 is that at Q =
300, the marginal cost curve is rising, while at Q = 60 the marginal cost curve
is falling. The point at which Q = 60 represents the point at which profit is
200
minimised rather than maximised. This shows that there are two profit- Perfect Competition:
maximisation conditions for a price-taking firm: Firm and Industry
Equilibrium
a) P = MC.
b) MC must be increasing.
If either of these conditions does not hold, the firm cannot maximise its profit.
It would be able to increase profit by either increasing or decreasing its output.
Thus the rising part of the MC curve reflects the firm’s supply curve, and
horizontal summation of the entire firms’ supply curve will be the
market’s supply curve which is upward slopping. This concept would be
further elaborated in the later part of this Unit. Any change in market demand
will also shift the demand curve for the firm which would change the MC=MR
point along the MC curve. Fig. 9.3 shows that when market demand increases
from D0 to D1 and decreases to D2, the demand curve (which is also the MR
and AR curve) for the firm shifts upwards or downwards, along the upward-
sloping MC curve. Any change in MR will change the profit maximising
intersection of MC = MR, would accordingly change the supply of the firms,
whose horizontal summation would indicate the market supply curve.
SFC represents the firm’s sunk fixed costs. A sunk fixed cost is a fixed
cost that a firm cannot avoid if it temporarily suspends operations and
produces zero output. For this reason, sunk fixed costs are often also
called unavoidable costs. For example, suppose that a rose grower has
signed a long-term lease (e.g., for five years) to rent land on which to
grow roses and that the lease prevents it from subletting the land to
anyone else. The lease cost is fixed because it does not vary with the
quantity of roses that the firm produces. It is output insensitive. It is also
sunk because the firm cannot avoid the rental payments, even by
producing zero output.
NSFC represents the firm’s non-sunk fixed costs. A non-sunk fixed cost
is a fixed cost that must be incurred if the firm is to produce any output,
but it does not have to be incurred if the firm produces no output. Non-
sunk fixed costs, as well as variable costs, are also often called avoidable
costs. For a rose grower, an example of a non-sunk fixed cost would be
the cost of heating the greenhouses. Because greenhouses must be
maintained at a constant temperature whether the firm grows 10 or
10,000 roses within the greenhouses, so the cost of heating the
greenhouses is fixed (i.e., it is insensitive to the number of rose stems
produced). But the heating costs are non-sunk because they can be
avoided if the grower chooses to produce no roses in the greenhouses.
The firm’s total fixed (or output-insensitive) cost, TFC, is thus given by TFC =
NSFC + SFC. If NSFC = 0, there are no fixed costs that are non-sunk. In that
case, TFC = SFC.
Check Your Progress 2
1) Why a firm is always a price taker in a perfectly competitive market?
Give adequate justification for your answer.
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2) Briefly explain the cost structure of a PC firm and its relevance in
determining the price and output of such a firm?
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Loss: Finally, when the price is below any point on the AC-curve, the
firm will operate at a loss, as profit maximising output (Qπ -max – which is
the same as the loss minimising level of output; Qloss-min in the diagram)
results in an AR below AC.
A firm in a perfectly competitive environment can only enjoy abnormal profits
in the short run. The same holds for losses, which makes intuitive sense as no
firm will be willing/able to uphold long term losses. The market mechanism
together with the assumptions will act to create long run equilibrium where the
PC firm will earn normal profits only.
What then happens, keeping in mind the assumptions of free market entry and
perfect knowledge/information, is that new firms will be attracted and of
course enter the market. This increases supply from S0 to S1 causing the price
to fall from P0 to P1. Falling market price will lower AR for the single PC firm,
creating a long run equilibrium where once again AR = AC. The firm’s short
run profit is thus eroded in the long run by market entry.
In the LR, some firms will exit the market and market supply will decrease –
shown by the shift from S0 to S1 in the market diagram on the right. As the
market price rises, the firm’s AR rises and when AR = AC once again, there is
LR equilibrium and every firms makes normal profits. What the firms can do
in the short run? As a PC firm is a price taker, not much can be done to
influence the AR side of the coin, so firms are focused on lowering costs. A
firm running at a loss will have to find ways to become more efficient (i.e.
lower MC) and/or decrease costs in general. One of the most common methods
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used to decrease costs is to decrease the amount of labour used in production Perfect Competition:
and to try to use remaining labour more efficiently. Firm and Industry
Equilibrium
9.5.4 Long Run Price and Output of a PC Firm
A long-run PC firm’s equilibrium occurs at a price at which supply equals
demand and firms have no incentive to enter or exit the industry. More
specifically, a long-run PC equilibrium firm is characterised by a market price
P*, a number of identical firms’ n*, and a quantity of output Q* per firm that
satisfies three conditions:
a) Each firm maximises its long-run profit with respect to output and plant
size. Given the price P*, each active firm chooses a level of output that
maximises its profit and selects a plant size that minimises the cost of
producing that output. This condition implies that a firm’s long-run
marginal cost equals the market price, or P* = MC (Q*).
b) Each firm’s economic profit is zero. Given the price P*, a prospective
entrant cannot earn positive economic profit by entering this industry.
Moreover, an active firm cannot earn negative economic profit by
participating in this industry. This condition implies that a firm’s long-
run average cost equals the market price, or P* = AC(Q*).
c) Market demand equals market supply. At the price P*, market demand
equals market supply, given the number of firms n* and individual firm
supply decisions Q*. This implies that D(P*) = n*Q*, or equivalently, n*
= D(P*)/Q*.
Fig. 9.7 shows these conditions graphically. Because the equilibrium price
simultaneously equals long-run marginal cost and long-run average cost, each
firm produces at the bottom of its long-run average cost curve.
9.5.5 Conclusions
The PCM firm’s behaviour in determining its output in the short and long run
leads to make the following conclusions:
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Market a) The PC firm can make abnormal profits in the short run, but will make a
Structure normal profit in the long run as lack of entry barriers allows new firms to
enter the market and increase supply and lower the market price.
b) The firm cannot run at a loss in the long run either since some firms will
leave the market and supply will converge to a long run equilibrium
which allows the (surviving) firms a normal profit once again.
c) The LR equilibrium level of output is thus: P = ACmin = MC = AR = MR.
Check Your Progress 3
1) State whether following statements are true or false:
a) A competitive firm in the long run will produce output up to the
point where price equals average variable cost.
b) A firm’s shutdown point comes where price is less than minimum
average cost.
c) A firm’s supply curve depends only on its marginal cost. Any other
cost concept is irrelevant for supply decisions.
d) The P = MC rule for competitive industries holds for upward-
sloping, horizontal, and downward-sloping MC curves.
e) The competitive firm sets price equal to marginal cost.
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2) Interpret this dialogue:
A: “How can competitive profits be zero in the long run? Who will
work for nothing?”
B: “It is only excess profits that are wiped out by competition.
Managers get paid for their work; owners get a normal return on
capital in competitive long-run equilibrium – no more, no less.”
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3) A firm is operating at a loss. Explain why the firm might stay rather than
exit the market.
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4) Why can a PC firm only make a normal profit in the long run according
to our model?
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Perfect Competition:
9.6 SHUT DOWN POINT AND BREAK-EVEN Firm and Industry
OUTPUT FOR PC FIRM Equilibrium
When a firm is earning normal profit, output is at the point where AR = AC,
this is the break-even point of output. The shut-down point, the point at which
firm is likely to leave the market, is the output level where it is equally costly
for the firm to continue producing as it is for the firm to leave the market. If the
firm can cover all of the variable costs and at least some of the fixed costs (i.e.
non-sunk fixed costs as defined above) then it has an incentive to remain on the
market. If the price falls below the AVC then the firm will not cover even the
variable costs – and leave the market. Hence, the point where the firm must
decide whether to remain on the market or leave is when AR = AVC. This is
the shut-down point.
It will be easier to understand these critical issues clearly in a figure using the
actual numbers rather than points A, B, and C etc. Fig. 9.8 attempts to explain
these points. Assume that the original demand on the market gives a market
price of `10, which are the PCM firm’s MR and AR. This is the long run
equilibrium and also the break-even point, as the firm covers all its costs –
even opportunity costs – earning it a normal profit. Assume that for some
reason (either increasing supply or decreasing demand) the market price starts
to fall and subsequently the firm’s AR, MR, D-curve falls to a price level of `6.
Being a profit maximiser, the firm sets output where MC = MR, which is now
at 80 units rather than 100. At this output level the firm cannot cover all its
costs; ATC at an output of 80 is `11. The firm loses `5 on each unit produced,
giving an overall loss of `400 (`5 × 80 units).
Fig. 9.8: Shut Down and Break-even Price for a PCM Firm
Why doesn’t the firm leave the market at a price level of `6? Consider the
choices facing the firm:
a) Stay in the business and make a loss of `400
b) Leave the business and make a loss of `560, which is the total fixed cost
(see TFC calculation in Fig. 9.7), i.e. TFC = (ATC – AVC) × Q. At an
output of 70, we get (`12 – `4) × 70 = `560.
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Market This is not much of a choice, rather a lack of options. The firm will have a
Structure strong incentive to stay in the market during the short run, hoping perhaps that
either market price will increase or that increased efficiency and/or cost-cutting
can lower MC and AC to a normal profit level again.
If, however, the market price falls even further, to `4, then the options become:
a) Stay in the business and make a loss of `560
b) Leave the business and make a loss of `560
The firm’s TR (`4 × 70 = `280) will be identical to the TVC, which means that
there is no contribution towards covering the fixed costs. The firm is making a
loss of `560 by staying in the business and would make the same loss by
leaving it. The point where P (AR) = AVC is therefore the shut-down point for
the firm. The firm will not produce at a lower price level – just consider the
options at a price of `2. The firm’s TR would be `120 (`2 × 60) and TC would
be `720 (`12 × 60) leading to a loss of `600. The reason is that at a price (e.g.
AR) of `2 the firm would not even be covering all its variable costs so total
costs would be greater than total fixed costs alone. At any price below AVC
the firm will leave the market.
Therefore the important consideration for a PC firm will be: as long as the
firm has an AR above AVC, the firm covers variable costs and at least some of
the fixed costs (i.e. non-sunk fixed costs) – therefore there is an incentive to
stay in the business in the short run. The shut-down point is when P (AR) =
AVC
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Perfect Competition:
Firm and Industry
Equilibrium
Fig. 9.9: Supply Curve for PCM FIrms and Markets (∑MCPCM firm = Market Supply)
209
Market Check Your Progress 4
Structure
1) Explain why the sum of individual firms’ MC curves is the market
supply curve.
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2) What is the shutdown price when all fixed costs are sunk? What is the
shutdown price when all fixed costs are non-sunk?
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3) Would a perfectly competitive firm produce if price were less than the
minimum level of average variable cost?
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Because firms can adjust production over time, we distinguish two Perfect Competition:
different time periods: (a) short-run equilibrium, when variable factors Firm and Industry
like labour can change but fixed factors like capital and the number of Equilibrium
firms cannot, and (b) long-run equilibrium, when the numbers of firms
and plants, and all other conditions, adjust completely to the new
demand conditions.
In the long run, when firms are free to enter and leave the industry and no
one firm has any particular advantage of skill or location, competition
will eliminate any excess profits earned by existing firms in the industry.
So, just as free exit implies that price cannot fall below the zero-profit
point; free entry implies that price cannot exceed long-run average cost in
long-run equilibrium.
When an industry can expand its production without pushing up the
prices of its factors of production, the resulting long-run supply curve
will be horizontal. When an industry uses factors specific and scarce
factors, its long-run supply curve will slope upward, e.g. important
special cases include relatively or completely inelastic supply which
produces economic rent shared between the firm and that factor of
production.
Disadvantages of Perfect Competition Generally Mentioned
No scope for economies of Scale, this is because there are many small
firms producing relatively small amounts.
Industries with high fixed costs would be particularly unsuitable to
perfect competition. This is one reason why existence of such a market is
highly unlikely in the real world.
Undifferentiated products lead to a monotonous situation for the
consumers as little choice available to them. Differentiated products are
very important in industries in FMCGs.
Lack of supernormal profit may make investment in R&D unlikely. This
would be important in an industry such as pharmaceuticals which require
significant investment.
With perfect knowledge there is no incentive to develop new technology
because it would be shared with other companies.
Notwithstanding these facts, perfect competition is worth studying for two
reasons. First, a number of important real-world markets consist of many small
firms, each producing nearly identical products, each with approximately equal
access to the resources needed to participate in the industry. The theory of
perfect competition developed in this unit will help us to understand the
determination of prices and the dynamics of entry and exit in these markets.
Second, the theory of perfect competition forms an important foundation for
understanding theory of price determination as many of the key concepts such
as the vital roles of marginal revenue and marginal cost in output decisions will
apply when we study other market structures such as monopoly, duopoly,
monopolistic and oligopolistic competitive markets
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Market
Structure
9.9 REFERENCES
1) Koutsoyiannis, A. (1979), Modern Micro Economics, London:
Macmillan, p. 67-103
2) Sanjay Rode, (2013), Modern Microeconomics, First Edition,
bookboon.com, First Edition, 2008, bookboon.com,
3) KristerAhlersten, (2008) Essentials of Microeconomics, First Edition,
bookboon.com, p. 76-87
4) David A. Besanko, Ronald R. Braeutigam and Michael J. Gibbs,
Microeconomics, 4th Edition, John Wiley and Sons, p. 327-376
5) Lipsey, RG (1979), An Introduction to Positive Economics, English
Language Book Society, p. 201-259
212
UNIT 10 MONOPOLY: PRICE AND
OUTPUT DECISIONS
Structure
10.0 Objectives
10.1 Introduction
10.1.1 Meaning of Monopoly
10.1.2 Some Definitions
10.1.3 Characteristics of Monopoly
10.1.4 Causes of Monopoly
10.0 OBJECTIVES
We have learned in Unit 9 that there are different forms of market. Broadly
speaking market can either be perfectly competitive or imperfectly
competitive. In Unit 9 we have already discussed price and output decisions of
a firm and industry under perfectly competitive market. There are various
forms of market under imperfect competition. These include monopoly,
oligopoly, and monopolistic competition. Some of them are extreme forms. In
this unit we will discuss an extreme form of market, that is monopoly, where,
there is only one seller.
After going through this unit, you will be able to:
state the meaning, causes and characteristics of monopoly;
Ms. Shruti Jain, Assistant Professor in Economics, Mata Sundari College (University of
Delhi), Delhi. 213
Market explain pricing and output decision under monopoly;
Structure
discuss the concept of deadweight loss under monopoly;
10.1 INTRODUCTION
10.1.1 Meaning of Monopoly
The word monopoly has been derived from the combination of two words i.e.,
‘Mono’ and ‘Poly’. Mono refers to a single entity and poly to control. In this
way, monopoly refers to a market situation in which there is only one seller of
a commodity.
There are no close substitutes for the commodity that monopoly firm produces
and there are barriers to entry. The single producer may be in the form of
individual owner or a simple partnership or a joint stock company. In other
words, under monopoly there is no difference between firm and industry.
Monopolist has full control over the supply of commodity. Having control over
the supply of the commodity, it exercises the market power to set the price.
Thus, as a single seller/producer monopolist may be a king without a crown. If
there is to be an effective monopoly, the cross elasticity of demand between the
product of the monopolist and the product of any other seller must be very
small.
10.1.2 Definitions
“Pure monopoly is represented by a market situation in which there is a single
seller of a product for which there are no substitutes; this single seller is
unaffected by and does not affect the prices and outputs of other products sold
in the economy.” -Bilas
“Monopoly is a market situation in which there is a single seller. There are no
close substitutes of the commodity it produces, and there are barriers to entry”.
-Koutsoyiannis
“Under pure monopoly there is a single seller in the market. The monopolist’s
demand is market demand. The monopolist is a price-maker. Pure monopoly
suggests no substitute situation”. -A. J. Braff
“A pure monopoly exists when there is only one producer in the market. There
are no dire competitors.” -Ferguson
11 0 0 -
10 1 10 10
9 2 18 8
8 3 24 6
7 4 28 4
6 5 30 2
5 6 30 0
4 7 28 -2
10.2.1 Relationship between Average Revenue, Marginal
Revenue and Price Elasticity under Monopoly
Average and marginal revenue at a quantity are related to each other through
price elasticity of demand and in this connection, we had derived the following
formula in:
( )
MR = AR , where e stands for price elasticity
or price = MR ( )
Since the expression (e–1)/e will be less than unity, MR will be less than price,
or price will be greater than MR. The extent to which MR curve lies below AR
curve depends upon the value of the fraction (e – 1)/e.
The monopolist has a clearly distinguished demand curve for his product,
which is identical with the consumers’ demand curve for the product in
question. It is also worth mentioning that, unlike oligopolist or a firm under
monopolistic competition, monopolist does not consider the repercussions of
the price change by him upon those of other firms.
Monopoly, as defined here, requires that the gap between the monopoly
product and those of other firms is so sharp that change — in the price policies
of the monopolist will not affect other firms and will therefore not evoke any
readjustments of the policies by these firms.
The first thing to understand is that, apart from the special case of constant
elasticity where the demand curve is of the form Q = aP-b, the elasticity will
217
Market vary along different points of the demand curve. This is true even when the
Structure gradient of the demand curve is constant (i.e. the demand curve is linear). This
is a point that sometimes confuses you about elasticity, you think “constant
gradient = constant elasticity”…no it doesn’t.
Here is an example, this is a simple demand function Q = 20 – 0.5P.
Fig. 10.3
With this demand function, = −0.5, so the elasticity at different points will
be e = × −0.5
Fig. 10.4
Notice how the marginal revenue is positive when the demand curve is
elastic, it is zero when the demand curve is unit elastic and it
becomes negative when the demand curve is inelastic.
This is the answer to the question. Given that the marginal revenue is the
amount of revenue gained by selling an extra unit, nobody is going to sell an
extra unit if the marginal revenue is negative (i.e. they lose money by selling
it).
( )
You can also think of this in an algebraic way. Given that MR = , we can
( )
use the product rule to say =P + Q so MR = P + Q
Now multiply both top and bottom parts of the right hand side of that equation
by P so you get MR = P + PQ . We can factorise the P out of this to
get MR = P 1 + Q which can be rewritten slightly differently as MR =
P 1+ .
The right hand side of that equation is the inverse of the elasticity, , so MR =
P 1 + . This is a useful equation to remember.
Elastic demand is where e< –1 and inelastic demand is where –1 < e < 0. So
now we can think of why a monopolist won't produce in the inelastic part of its
demand curve. When demand is inelastic then –1 < e < 0 so 1 + < 0 . And
219
Market
given that the price, P, is positive, it also follows that P 1 + < 0. So the
Structure
marginal revenue will be negative, and no firm will produce an extra unit if it
means it loses money.
Fig. 10.5
In Fig. 10.5, TC is the total cost curve. TR is the total revenue curve. TR curve
starts from the origin. It indicates that at zero level of output, TR will also be
zero. TC curve starts from P. It reflects that even if the firm discontinues its
production, it will have to suffer the loss of fixed costs.
Total profits of the firm are represented by TP curve. It starts from point R
showing that initially firm is faced with negative profits. Now as the firm
increases its production, TR also increases. But in the initial stage, the rate of
increase in TR is less than that of TC.
Therefore, RC part of TP curve reflects that firm is incurring losses. At point
M, total revenue is equal to total cost. It shows that firm is working under no
profit, no loss basis. Point M is called the breakeven point. When firm
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produces more, beyond point M, TR will be more than TC. TP curve also Monopoly: Price
slopes upward. It shows that firm is earning profit. Now as the TP curve and Output
reaches point E then the firm will be earning maximum profits. This amount of Decisions
output will be termed as equilibrium output.
Fig. 10.6
The monopolist is in equilibrium at point E because at point E both the
conditions of equilibrium are fulfilled i.e., MR = MC and MC intersects the
MR curve from below. At this level of equilibrium the monopolist will produce
OQ1 level of output and sells it at CQ1 price which is more than average cost
DQ1 by CD per unit. Therefore, in this case total profits of the monopolist will
be equal to shaded area ABDC.
221
Market Normal Profits
Structure
A monopolist in the short run would enjoy normal profits when average
revenue is just equal to average cost. We know that average cost of production
is inclusive of normal profits. This situation can be illustrated with the help of
Fig 10.7.
Fig. 10.7
In Fig. 10.7 above the firm is in equilibrium at point E. Here marginal cost is
equal to marginal revenue. The firm is producing OM level of output. At OM
level of output average cost curve touches the average revenue curve at point
P. Therefore, at point ‘P’ price MR is equal to average cost of the total product.
In this way, monopoly firm enjoys the normal profits.
Minimum Losses
In the short run, the monopolist may have to incur losses. This situation occurs
if in the short run price falls below the variable cost. In other words, if price
falls due to depression and fall in demand, the monopolist will continue to
produce as long as price covers the average variable cost. Once the price falls
below the average variable cost, monopolist will stop production. Thus, a
monopolist in the short run equilibrium may bear the minimum loss, equal to
fixed costs. Therefore, equilibrium price will be equal to average variable cost.
This situation can also be explained with the help of Fig. 10.8.
Fig. 10.8
and
Since demand is given as:
P = 20 – Q
Total Revenue = P . Q = (20 – Q) Q = 20 Q – Q2
∆
MR = = 20 − 2Q
∆
and
Profit maximisation occurs where:
MR = MC
20 – 2Q = 2Q
Q=5
Thus profit maximising level of output is 5 units and profit maximising price is
P = 20 – Q = 20 – 5 = 15
Illustration 2. Only one firm produces and sells soccer balls in the country of
Wiknam, and as the story begins, international trade in soccer balls is
prohibited. The following equations describe the monopolist’s demand,
marginal revenue, total cost, and marginal cost:
Demand : P = 10 – Q
Marginal Revenue : MR = 10 – 2Q
Total Cost : TC = 3 + Q + 0.5 Q2
Marginal Cost : MC = 1 + Q
Where Q is quantity and P is the price.
(a) How many units does the monopolist produce? At what price are they
sold? What is the monopolist’s profit?
Solution:
P = 10 – Q
223
Market MR = 10 – 2Q
Structure
TC = 3 + Q + 0.5Q2
MC = 1 + Q
Monopolist will produce where:
MR = MC
10 – 2Q = 1 + Q
3Q = 9
Q=3
Quantity are sold at price given by:
P = 10 – Q
= 10 – 3
∴ P = $7
= 21 – [6 + ] = [21 – ] = 10.5
Profit = $10.5
Fig. 10.9
224
In Fig. 10.9 above monopolist is in equilibrium at OM level of output. At OM Monopoly: Price
level of output marginal revenue is equal to long run marginal cost and the and Output
monopolist fixes OP price. HM is the long run average cost. Price OP being Decisions
more than LAC i.e., HM which fetch the monopolist super normal profits.
Accordingly, the monopolist earns JM – HM = JH super normal profit per unit.
His total super normal profits will be equal to shaded area PJHP1.
Check Your Progress 1
1) How does the monopolist determine his price and output in the short
period?
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......................................................................................................................
......................................................................................................................
2) Based on market research, a film production company in Mumbai obtains
the following information about the demand and production costs of its
new DVD:
Demand: P = 1,000 – 10Q
Total Revenue TR = P × Q = 1000Q – 10Q2
Marginal Revenue: MR = 1,000 – 20Q
Marginal Cost MC = 100 + 10Q
Where Q indicates the number of copies sold and P is the price in dollars.
Find the price and quantity that maximises the company’s profit.
......................................................................................................................
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225
Market 3) Entry
Structure
Under perfect competition, there exists no restrictions on the entry or exit of
firms into the industry. Under simple monopoly, there are strong barriers on
the entry and exit of firms.
4) Discrimination
Under monopoly, a monopolist can charge different prices from the different
groups of buyers. But, in the perfectly competitive market, it is absent by
definition. We shall discuss the price discriminations by a monopolist in
Sections 10.6 below.
5) Profits
The difference between price and average cost under monopoly results in
super-normal profits to the monopolist. Under perfect competition, a firm in
the long run enjoys only normal profits.
6) Supply Curve of Firm
Under perfect competition, supply curve can be known. It is so because all
firms can sell desired quantity at the prevailing price. Moreover, there is no
price discrimination. Under monopoly, supply curve cannot be known. MC
curve is not the supply curve of the monopolist.
7) Slope of Demand Curve
Under perfect competition, demand curve is perfectly elastic. It is due to the
existence of large number of firms. Price of the product is determined by the
industry and each firm has to accept that price. On the other hand, under
monopoly, average revenue curve slopes downward. AR and MR curves are
separate from each other. Price is determined by the monopolist.
Fig. 10.10
8) Goals of Firms
Under perfect competition and monopoly the firm aims at to maximise its
profits. The firm which aims at to maximise its profits is known as rational
firm.
9) Comparison of Price
Monopoly price is higher than perfect competition price. In long period, under
perfect competition, price is equal to average cost. In monopoly, price is higher
as is shown in Fig. 10.11 below. The perfect competition price is OP1, whereas
monopoly price is OP. In equilibrium, monopoly sells ON output at OP price
226 but a perfectly competitive firm sells higher output ON1 at lower price OP1.
Monopoly: Price
and Output
Decisions
Fig. 10.11
Quantity
228 Fig. 10.12
Monopoly: Price
10.6 PRICE DISCRIMINATION UNDER and Output
MONOPOLY: TYPES AND DEGREES Decisions
i) Personal
Personal price discrimination refers to a situation when different prices are
charged from different individuals. The different prices are charged according
to the level of income of consumers as well as their willingness to purchase a
product. For example, a doctor charges different fees from poor and rich
patients.
ii) Geographical
This type of price discrimination occurs when the monopolist charges different
prices at different places for the same product. This type of discrimination is
possible if those who buy at lower price cannot sell to those being charged a
higher price by the firm.
iii) On the basis of use
This kind of price discrimination occurs when different prices are charged
according to the use of a product. For instance, an electricity supply board
charges lower rates for domestic consumption of electricity and higher rates for
commercial consumption. Similar discrimination occurs when buyers are
charged different prices at different hours of the day – it is referred to as peak-
load pricing.
229
Market 10.6.2 Degrees of Price Discrimination
Structure
i) First-degree Price Discrimination
Refers to a price discrimination in which a monopolist charges the maximum
price that each buyer is willing to pay. This is also known as perfect price
discrimination as it involves maximum exploitation of consumers. In this price
discrimination, consumers fail to enjoy any consumer surplus. First degree is
practiced by lawyers and doctors.
ii) Second-degree Price Discrimination
Refers to a price discrimination in which buyers are divided into different
groups and different prices are charged from these groups depending upon
what they are willing to pay. Railways and airlines practice this type of price
discrimination.
iii) Third-degree Price Discrimination
Refers to a price discrimination in which the monopolist divides the entire
market into submarkets and different prices are charged in each submarket.
Therefore, third-degree price discrimination is also termed as market
segmentation.
In this type of price discrimination, the monopolist is required to segment
market in a manner, so that products sold in one market cannot be resold in
another market. Moreover, he/she should identify the price elasticity of
demand of different submarkets. The groups are divided according to age, sex,
and location. For instance, railways charge lower fares from senior citizens.
Students get discount in cinemas, museums, and historical monuments. We are
explaining it with help of Fig. 10.13, which has three segments (a), (b) and (c).
Fig. 10.13
Segments (a) and (b) depict markets with inelastic and elastic demand curves
respectively. The segment (c) has horizontal sum of the AR and MR curves of
(a) and (b), denoted as AR t and MR t. The firm has a single Average Total Cost
curve and corresponding Marginal Cost Curve. Inter-section of this MC with
MR t gives us equilibrium output OQ for the firm. It also shows the MR for the
firm, which maximises its profits. The firm will like to realise the same MR
from each of the units sold in either of those two market segments. So,
wherever the extended line EM cuts MRa and MRb (points Ea and Eb
respectively) will be used to determine equilibrium outputs Q aO and Q bO for
the two market segments. The prices will be what the consumers are ready to
pay for the respective quantities, that is, Pa and P b.
230
Note two points: The monopolist offers larger quantities in market with Monopoly: Price
relatively elastic demand curve and smaller in market with inelastic demand. and Output
We find that Q b > Q a. However, the price change in the segment (a)with Decisions
inelastic demand, P a is greater than price in segment (b) P b. So we can say
that buyers with inelastic demand will face a double disadvantage at the hands
of a monopolist: They end up buying smaller quantities and have to pay higher
prices.
Check Your Progress 2
1) What is Price Discrimination?
......................................................................................................................
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2) Explain the degrees of Price Discrimination.
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3) How Monopolist firm faces efficiency loss?
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4) How is price determination under Monopoly is different from Perfect
Competition?
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232
The firm sets a price equal to its average cost which includes some profit Monopoly: Price
margin, that is. and Output
Decisions
P = AVC + GPM
where P is the price, AVC is the average variable cost, and GPM is the gross
profit margin which include average fixed cost and net profit margin.
The purpose of this note is to show that average cost principle and marginal
analysis would give the same long-run profit maximisation solution. The
setting of the price on the basis of the average cost principles incorporates as
estimation of the elastic of demand in the long run equilibrium. Recall that the
necessary condition for profit maximisation is MC=MR. It has already been
proved that MR=P(e–1/e). Given that MC >0. MR must be positive for profit
maximisation. This implies e>1, provided that AVC is constant over the
relevant range of output, that is, AVC=MC. For equilibrium, AVC=MR, that
is, AVC=P(1–1/e)=P{(e–1)/e}. In other words P = AVC {e/(e–1)}. Given that
e>1, we may write {e/(e–1)}=(1+k), where k>0. Therefore, P=AVC(1+k),
where k is the gross profit margin. For example, if the firm sets a 20 per cent of
AVC as its profit margin, we have (1+k) = [1 + 0.20] = . Thus, the
elasticity of demand is 6. Setting a gross profit margin is equivalent to
estimating the price elasticity of demand and applying marginalist analysis.
Check Your Progress 3
1) How a public monopoly is different from a private monopolist firm?
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2) How does the public monopoly firm make price and output decisions?
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3) What do you mean by Mark up pricing?
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10.9 REFERENCES
1) Dr Deepashree (2016), Introductory Micro Economics, Mayur
Paperbacks, Chapter on Theory of Market structure.
http://www.economicsdiscussion.net
234
UNIT 11 MONOPOLISTIC
COMPETITION: PRICE AND
OUTPUT DECISIONS
Structure
11.0 Objectives
11.1 Introduction
11.2 Concept and Features of Monopolistic Competition
11.3 Demand Curve under Monopolistic Competition
11.4 Equilibrium under Monopolistic Competition
11.4.1 Individual Firm’s Equilibrium in Short-Run Period
11.4.2 Individual Firm’s Equilibrium in Long Run
11.4.3 Group Equilibrium in Monopolistic Competition
11.4.4 Equilibirium with Selling Costs
11.0 OBJECTIVES
After studying this unit, you will be able to:
define the term monopolistic competition;
explain the demand curve under monopolistic competition;
state the equilibrium conditions of monopolistic competition;
make comparison under perfect competition, monopoly and monopolistic
competition; and
explain the theory of excess capacity under monopolistic competition.
11.1 INTRODUCTION
Pure monopoly and perfect competition are two extreme cases of market
structure. In reality, there are markets having large number of producers
competing with each other in order to sell their product in the market. Thus,
there is monopoly on one hand and perfect competition on other hand. Such a
mixture of monopoly and perfect competition is called as monopolistic
competition, it refers to a market situation in which there are large numbers of
Ms. Shruti Jain, Assistant Professor in Economics, Mata Sundari College (University of
Delhi), Delhi. 235
Market firms which sell closely related but differentiated products. Markets of
Structure products like soap, toothpaste AC, etc. are examples of monopolistic
competition.
236
In other words, there are large numbers of firms selling closely related, but not Monopolistic
homogeneous products. Each firm acts independently and has a limited share Competition: Price
of the market. So, an individual firm has limited control over the market price. and Output Decisions
Large number of firms leads to competition in the market.
2) Product Differentiation
It is one of the most important features of monopolistic competition. In perfect
competition, products are homogeneous in nature. On the contrary, here, every
producer tries to keep his product dissimilar than his rival’s product in order to
maintain his separate identity. This boosts up the competition in market and at
the same time every firm acquires some monopoly power. Hence, each firm is
in a position to exercise some degree of monopoly (in spite of large number of
sellers) through product differentiation. Product differentiation refers to
differentiating the products on the basis of brand, size, colour, shape, etc. The
product of a firm is close, but not perfect substitute for products of other firms.
Implication of ‘Product differentiation’ is that buyers of a product differentiate
between the same products produced by different firms. Therefore, they are
also willing to pay different prices for the same product produced by different
firms. This gives some monopoly power to an individual firm to influence
market price of its product. Following points provide insight about the product
differentiation:
a) The product of each individual firm is identified and distinguished from
the products of other firms due to product differentiation.
b) To differentiate the products, firms sell their products with different
brand names, like Lux, Dove, Lifebuoy, etc.
c) The differentiation among different competing products may be based on
either ‘real’ or ‘imaginary’ differences.
i) Real Differences may be due to differences in shape, flavour,
colour, packing, after sale service, warranty period, etc.
ii) Imaginary Differences mean differences which are not really
obvious but buyers are made to believe that such differences exist
through selling costs (advertising).
d) Product differentiation creates a monopoly position for a firm.
e) Higher degree of product differentiation (i.e. better brand image) makes
demand for the product less elastic and enables the firm to charge a price
higher than its competitor’s products. For example, Pepsodent is costlier
than Babool.
f) Some more examples of Product Differentiation: i) Toothpaste:
Pepsodent, Colgate, Neem, Babool, etc., ii) Cycles: Atlas, Hero, Avon,
etc., iii) Tea: Brooke Bond, Tata tea, Today tea, etc.
3) Freedom of Entry and Exit
This feature leads to stiff competition in market. Free entry into the market
enables new firms to come with close substitutes. Free entry or exit maintains
normal profit in the market for a longer span of time.
4) Selling Cost
It is a unique feature of monopolistic competition. In such type of market, due
to product differentiation, every firm has to incur some additional expenditure
in the form of selling cost. This cost includes sales promotion expenses,
advertisement expenses, salaries of marketing staff, etc. 237
Market But on account of homogeneous product in perfect competition and zero
Structure competition in monopoly, selling cost does not exist there.
5) Absence of Interdependence
Large numbers of firms are different in their size. Each firm has its own
production and marketing policy. So no firm is influenced by other firm. All
are independent.
6) Two Dimensional Competition
Monopolistic competition has two types or aspects of competition aspects viz.
Price competition i.e. firms compete with each other on the basis of price. Non-
price competition i.e. firms compete on the basis of brand, product quality
advertisement.
7) Concept of Group
In place of Marshallian concept of industry, Chamberlin introduced the concept
of Group under monopolistic competition. An industry means a number of
firms producing identical product. A group means a number of firms producing
differentiated products which are closely related.
8) Falling Demand Curve
In monopolistic competition, a firm is facing downward sloping demand curve.
It means one can sell more at lower price and vice versa.
9) Lack of Perfect Knowledge
Buyers and sellers do not have perfect knowledge about the market conditions.
Selling costs create artificial superiority in the minds of the consumers and it
becomes very difficult for a consumer to evaluate different products available
in the market. As a result, a particular product (although highly priced) is
preferred by the consumers even if other less priced products are of same
quality.
Check Your Progress 1
1) What is monopolistic competition? Explain with few examples.
.....................................................................................................................
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.....................................................................................................................
2) Identify the features that shows the presence of monopolistic competition
in market.
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3) A market with few entry barriers and with many firms that sell
differentiated products is
A) purely competitive.
B) a monopoly.
C) monopolistically competitive.
D) oligopolistic.
238
Monopolistic
11.3 DEMAND CURVE UNDER MONOPOLISTIC Competition: Price
COMPETITION and Output Decisions
Fig. 11.1
239
Market
Structure
Fig. 11.2
Fig. 11.3
Assuming the conditions with respect to all substitutes such as their nature and
prices being constant, the demand curve for the product of a firm will be given.
We further suppose that only variables are price and output in respect of which
equilibrium adjustment is to be made.
The individual equilibrium under monopolistic competition is graphically
shown in Fig. 11.3. DD is the demand curve for the product of an individual
firm, the nature and prices of all substitutes being given. This demand curve
DD is also the average revenue (AR) curve of the firm.
AC represents the average cost curve of the firm, while MC is the marginal
cost curve corresponding to it. It may be recalled that average cost curve first
falls due to internal economies and then rises due to internal diseconomies.
241
Market Given these demand and cost conditions a firm will adjust its price and output,
Structure at the level which gives it maximum total profits. Theory of value under
monopolistic competition is also based upon the profit maximisation principle,
as is the theory of value under perfect competition.
Thus a firm, in order to maximise profits, will equate marginal cost with
marginal revenue. In Fig. 11.3, the firm will fix its level of output at OM, for at
OM output marginal cost is equal to marginal revenue. The demand curve DD
facing the firm in question indicates that output OM can be sold at price MQ =
OP. Therefore, the determined price will evidently be MQ or OP.
In this equilibrium position, by fixing its price at OP and output at OM, the
firm is making profits equal to the area RSQP which is maximum. It may be
recalled that profits RSQP are in excess of normal profits because the normal
profits which represent the minimum profits necessary to secure the
entrepreneur’s services are included in average cost curve AC. Thus, the area
RSQP indicates the amount of supernormal or economic profits made by the
firm.
In the short-run, the firm, in equilibrium, may make supernormal profits, as
shown in Fig. 11.3 above, but it may make losses too if the demand conditions
for its product are not so favourable relative to cost conditions. Fig. 11.4
depicts the case of a firm whose demand or average revenue curve DD for the
product lies below the average cost curve, indicating thereby, that no output of
the product can be produced at positive profits.
Fig. 11.4
Fig. 11.5: Shows the long-run equilibrium position under monopolistic competition
In Fig. 11.5, P is the point at which AR curve touches the average cost curve
(LAC) as a tangent. P is regarded as the equilibrium point at which the price
level is MP (which is also equal to OP') and output is OM.
In the present case average cost is equal to average revenue that is MP.
Therefore, in long run, the profit is normal. In the short run, equilibrium is
attained when marginal revenue is equal to marginal cost. However, in the long
run, both the conditions (MR=MC and AR=AC) must hold to attain
equilibrium.
For overcoming the problem Chamberlin gave a concept called product group,
which includes products that are technological and economic substitute of each
other. Technological substitutes are the products having technical similarity,
while economic substitutes are the products that have same prices and fulfill
the same want of consumers.
A product group refers to a group in which the demand for each product is
highly elastic. Here, the demand for a product changes with the changes in the
prices of other products within the group, and, the price and cross elasticity of
demand for products forming the group is high.
i) The demand and cost curves of all products in the group are the same or
uniform. The uniformity assumption. The preferences of consumers are
evenly distributed and the difference in preferences does not lead to
variation in cost.
These two assumptions form the basis for group equilibrium analysis. If an
organisation within the group has established a popular brand, it is more likely
to earn supernormal profits. However, in the long run, other organisations
would strive to emulate the product design and features. In such a case,
supernormal profits would vanish. This is a general case of all monopolistically
competitive organisations.
On the other hand, if the entire group is earning supernormal profits, then
external organisations would get attracted towards the group, until the legal or
economic barriers are imposed.
In Fig. 11.6, P is the equilibrium point at which output is OM, price is MP, and
average cost is MT. In such a case, marginal cost is equal to marginal revenue.
Therefore, firms are earning supernormal profits (P'PTT'). However, these
supernormal profits disappear in the long run.
244
Monopolistic
Competition: Price
and Output Decisions
In Fig. 11.7, it can be seen that the supernormal profits have disappeared. It
also depicts that average revenue (AR) is tangent to LAC, which implies that
price is equal to average revenue. Marginal revenue gets equal to marginal cost
at the output level of OM. This shows that in the long run, all firms in the
industry are making normal profits.
Fig. 11.6
We know that under perfect competition, the demand curve (AR) is tangential
to the long-run average cost curve (LAC) at its minimum point and conditions
of full equilibrium are fulfilled: LMC = MR and AR (price) = Minimum LAC.
This means that in the long-run, the entry of new firms forces the existing firms
to make the best use of their resources to produce at the lowest point of average
total costs. At point E in Fig. 11.6, abnormal profits will be competed away 249
Market because MR = LMC = AR = LAC at its minimum point E and OQ will be the
Structure most efficient output which the society will be enjoying. This is the ideal or
optimum output which firms produce in the long-run.
Under monopolistic competition, the demand curve facing the individual firm
is not horizontal as under perfect competition, but it is downward sloping. A
downward sloping demand curve cannot be tangent to the LAC curve at its
minimum point.
The double condition of equilibrium LMC = MR = AR (P) = Minimum LAC
will not be fulfilled. The firms will, therefore, producing at less than the
optimum level even when they are earning normal profits. No firm will have
the incentive to produce the ideal output, since any effort to produce more than
the equilibrium output would involve a higher long-run marginal cost than
marginal revenue.
Thus each firm under monopolistic competition will be producing at less than
the optimum level and work under excess capacity. This is illustrated in Fig.
11.7 where the monopolistic competitive firm’s demand curve is d and MR1 is
its corresponding marginal revenue curve. LAC and LMC are the long-run
average cost and marginal cost curves.
The firm is in equilibrium at E1 where the LMC curve cuts the MR1curve from
below and OQ1 output is set at the price Q1 A1. OQ1 is the equilibrium output
but not the ideal output because d is tangent to the LAC curve at A1 to the left
of the minimum point E. Any effort on the part of the firm to produce beyond
OQ1 will mean losses as beyond the equilibrium point E1, LMC > MR1. Thus
the firm has negative excess capacity measured by OQ1 which it cannot utilise
working under monopolistic competition.
A comparison of the equilibrium positions under monopolistic competition and
perfect competition with the help of Fig. 11.7 reveals that the output of a firm
under monopolistic competition is smaller and the price of its product is higher
than under perfect competition. The monopolistic competition output OQ1 is
less than the perfectly competitive output OQ, and the monopolistic
competitive price Q1A1 is higher than the competitive equilibrium price QE.
This is because of the existence of excess capacity under monopolistic
competition.
Fig. 11.7
250
Check Your Progress 3 Monopolistic
Competition: Price
1) In what respects monopolistic competition is different from other two and Output Decisions
extreme forms of market structure.
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11.8 REFERENCES
1) Dr Deepashree (2016), Introductory Micro Economics, Mayur
Paperbacks, Chapter on Theory of Market structure.
http://www.economicsdiscussion.net
252
UNIT 12 OLIGOPOLY: PRICE AND
OUTPUT DECISIONS
Structure
12.0 Objectives
12.1 Introduction
12.1.1 Definition of Oligopoly
12.1.2 Features of Oligopoly Market
12.1.3 Causes for the Existence of Oligopoly
12.0 OBJECTIVES
After studying this unit, you shall be able to:
state the meaning and features of oligopoly;
discuss the causes of existence of oligopoly;
throw light on different models that explain the oligopoly price and
output determination;
explain the co-operative and non-cooperative behaviour of oligopolistic
firms; and
appreciate cartel theory of oligopolist.
12.1 INTRODUCTION
Oligopoly refers to a market wherein only a few firms account for most or all
of total production.
Ms. Shruti Jain, Assistant Professor in Economics, Mata Sundari College (University of
Delhi), Delhi.
253
Market 12.1.1 Definition of Oligopoly
Structure
Oligopoly referes to the presence of few sellers in the market selling the
homogeneous or differentiated products. In other words, the Oligopoly market
structure lies between the pure monopoly and monopolistic competition, where
few sellers dominate the market and have control over the price of the product.
Under the Oligopoly market, a firm either produces homogeneous or
heterogeneous products:
Homogeneous Product: The firms producing the homogeneous products
are called as Pure or Perfect Oligopoly. It is found in the case of
industrial products such as aluminum, copper, steel, zinc, iron, etc.
Fig. 12.1
Fig. 12.2
This is because, as the firm reduces or increases the price of its product, the
prices of the products of other firms remaining constant, the product of the firm
becomes relatively cheaper or dearer, respectively, than those of the other
firms. This will make the demand curve flatter for this firm.
261
Market On the other hand, if a firm increases its price, the office firms will not follow
Structure the suit. So there will be an asymmetry in responses of the rivals.
If one firm reduces price, all others follow the suit – otherwise they run the risk
of losing their customers to this firm.
If one raises the price, others do not as they expect to win some customers
from this firm. Together, these responses create a kink in demand curve.
Let us suppose that initially the price of the product of the firm is p1 or Op1 and
the demand for the product is q1 or Oq1 If the firm now increases its price from
p1, the rival firms would keep their prices unchanged according to assumption
(v) of this model.
In this case, the firm’s demand would decrease along the segment Rd of the
relatively more elastic demand curve dd'. On the other hand, if it goes on
decreasing its price from p1, its rivals also would be decreasing their prices
according to assumption (v). In this case, the quantity demanded of the firm’s
product will increase along the segment RD' of the relatively steeper demand
curve DD'.
Therefore, at the price p1, the firm’s demand curve would be dRD'. Obviously,
because of assumption (v), the segment dR of this demand curve would be
more flat or more elastic than the segment RD' (and the segment RD' would be
more steep or less elastic than the segment dR).
As a result, there would be a kink at the prevailing price p1, or, at the point R
on the firm’s demand curve d RD', i.e., the demand curve in this model would
be a kinked demand curve.
12.2.3.2 Analysis of the Kinked Demand Curve Model
In the oligopoly model under discussion, the properties of the kinked demand
curve as well as its significance are especially discussed. In the first place, as
the demand curve or the average revenue (AR) curve of the firm has a kink, its
MR curve cannot be obtained as a continuous curve. We may, therefore, begin
with the properties of the MR curve of the kinked demand curve with the help
of Fig. 12.3.
The kinked demand curve of the firm in Fig. 12.3 is dRD'. There is a kink at
the point R (p1, q1) on this curve, because the curve consists of a segment dR of
the relatively flatter curve dd' and another segment RD' of the relatively steeper
curve DD'.
Therefore, in the case of the kinked demand curve dRD', the firm’s MR curve,
up to q = q1, would consist of the MR curve dM associated with the dR
segment of the kinked demand curve and for q > q1, the MR curve would be
the segment NB associated with the segment RD' of the demand curve.
now, the reciprocal of the numerical slope of the demand curve dRd' at the
point R on the segment dR > the reciprocal of the numerical slope of the
demand curve at the point R on the segment RD'.
Because, the segment dR is more flat than the segment RD', therefore, we have
e1 > e2
Now, MR (= MR1, say) at the point R on the segment dR' is
MR1 = Mq1 = p1 1 −
MR2 = Nq1 = p1 1 −
Fig. 12.4
264
We may note here that although the demand curve has shifted to the right, it Oligopoly: Price and
has kept the price of its product unchanged, resulting not necessarily in the Output Decisions
unfulfilment of its profit maximising goal.
In Fig. 12.4, we have assumed that the two curves, viz., dRD' and dR'D'', are
iso-elastic, and the MC1 curve passes also through the discontinuity (M1N1) of
the MR2 curve which is the marginal curve for the demand curve dR'D''.
Therefore, here the firm is able to maximise its profit at the same price p1 =
R'q2 = Rq1.
Fourth, in the model under discussion, the firm may not have to change the
price of its product, even if its cost of production rises. For example, let us
suppose that initially the firm’s AR and MR curves are dRD' and MR1, and the
MC, curve is the firm’s MC curve.
In this case, the firm’s profit would be maximised if it sells q1 of output at the
price of p1. Now, if the firm’s cost position changes resulting in an upward
shift in its MC curve from MC1 to MC2, and if the MC2 curve also, like MC1,
passes through the discontinuity (MN) of its MR curve, then the firm would
not have to change the price of its product in order to earn the maximum profit.
It would be able to maximise profit if it, like the previous case, sells of output
at the price of p1.
If the cost of production rises along with a shift in the demand curve, then also,
profit maximisation may not require the firm to change the price of its product.
For example, in Fig.12.4, let us suppose that the firm’s AR, MR and MC
curves are, respectively, dRD', MR1and MC1, In this case, the firm’s profit-
maximising price-output combination would be R (p1 q1).
Now, if the firm’s MC curve rises to MC2 along with a rightward shift in its
demand curve to dR'D'', then also the firm would not be required to change the
price of its product if the MC2 curve passes through both the discontinuities,
MN and M1N1, of its dRD' and dR'D'' curves.
It would still be able to earn the maximum profit at the price P1; but now its
quantity of output produced and sold would be q2; that is, now the firm’s price-
output combination would be obtained at the point R' (p1, q2).
On the basis of the above discussion, we may conclude that in the kinked
demand curve model of oligopoly, the firm would not consider it profitable or
rational to change the prevailing price of its product because of the assumption
(v) relating to the reaction pattern of its rivals.
[This assumption states, that if a particular firm increases the price of its
product, its rivals will not increase theirs, but if it reduces the price, they will
promptly reduce their prices.] We have seen that, because of these reactions,
the demand curve of each oligopolistic firm will be kinked, and the MR curve
of this demand curve will have two separate segments, and there will be a
vertical gap between them.
However, it is not that the firm’s goal of profit maximisation can never be
achieved because of the existence of this vertical gap. Even when the firm’s
demand increases, i.e., its demand curve shifts to the right and/or its MC curve
shifts upwards, it is not impossible for it to achieve profit maximisation at the
prevailing price.
Therefore, although the kinked demand curve model cannot explain the process
265
Market of price determination, it can well explain why the prices are sticky in an
Structure oligopolistic market.
Check Your Progress 2
1) Let there be two firms under Cournot’s model having market demand
curve as P = 20 – Q where Q the total production of the two firms 1 and
2. These firms are assumed to be producing under zero cost of
production. Determine:
i) Reaction curves of the two firms,
ii) Equilibrium level of output for both the firms
iii) Equilibrium market price
iv) Show graphically the Cournot’s equilibrium
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2) Let there be two firms which produce output under zero cost of
production. The market demand curve is given by P = 20 – Q (Where Q =
total output). Calculate output solution for the two firms under
Stakelberg’s model.
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3) In a duopolist market two firms can produce at a constant average and
marginal cost of AC = MC = 2. They face the market demand curve
P = 14 – Q, Where Q = Q1 + Q2' where Q1 is the output of Firm 1, Q2 is
the output of Firm 2. In the Cournot’s model:
i) Find action-reaction functions of the two firms.
ii) Calculate the profit maximising equilibrium price and output.
iii) What are the profits of the two firms?
iv) Compare it with competitive equilibrium.
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4) Assume three firms face identical marginal costs of 20 with fixed costs of
10. They face a market demand curve of P = 200 – 2Q . Find the Cournot
equilibrium price and quantity.
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266
5) What do you mean by kink in demand curve? Oligopoly: Price and
Output Decisions
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The figure above explains the dilemma faced by oligopolists of whether to co-
operate or to compete. It is called Payoff Matrix for a two Firm duopoly game.
The right side figures on each cell shows the profits of Firm A and left side
figures on each cell show the profits of Firm B (in Rs. Crores). It can be
explained that if the two firms co-operate and produce one half of market share
each will earn Rs. 20 crores of profit. In case of co-operation they can
maximise their profits. If Firm A defects and produces two thirds of output and
Firm B produces half of monopoly output then Firm A will earn Rs. 22 crores
and Firm B Rs. 15 crores. Similarly if Firm B defects and produces two-third
and Firm A produces one-half then Firm B will earn Rs. 22 crores and Firm A
will earn only Rs. 15 crores. If both decide to compete and produce two-third
267
Market of monopoly output each then profits for both will fall to Rs. 17 crores. This
Structure type of game, where they reach a non-cooperative solution when they could co-
operate, is called Prisoner’s Dilemma. Prisoner’s Dilemma is shown below:
Table 12.2 : The Prisoner's Dilemma
Mr. Ram
Confess Not confess
Mr. Shyam Confess 6 09
Not confess 9 1
Two prisoners Mr. Ram and Mr. Shyam are arrested for committing a crime
and interrogated separately. They are told the following:
a) If both are claimed to be innocent, they will get a light sentence that is 1
year in jail.
b) If one confesses and the other does not, then who confesses will be
released free and the other will be punished for 9 year in jail, and
c) If both confess, then both of them will get a punishment of 6 years in jail.
The payoff matrix presented in Table 12.2 shows the dilemma of the prisoners
about whether to confess or not to confess. If none of them confess then both
will get 1 year of jail, but if Ram confesses and Shyam does not then Ram will
be left free and Shyam will get 9 year of imprisonment and the vise-versa. And
if both of them confess then both will get 6 years of imprisonment. Not
confessing is the best solution in this game (Pareto efficient solution) but this
leaves one always in uncertainty. This solution is not a stable solution as one
gets an imprisonment of 9 years if he/she does not confess and the other does.
Therefore, confession dominates in the mind of both the prisoners. If both of
them confess then they end up with 6 years jail for both. This kind of
equilibrium is called Nash equilibrium. From both the figures above it is clear
that it they co-operate then they will earn the maximum profit than if they
compete.
Fig. 12.5
Once established, cartels are difficult to maintain. The problem is that cartel
members will be tempted to cheat on their agreement to limit production. By
producing more output than it has agreed to produce, a cartel member can
increase its share of profits. Hence, there is a built in incentive for each cartel
member to cheat. Of course, if all members cheated, the cartel would cease to
270
earn monopoly profits, and there would no longer be any incentive for firms to Oligopoly: Price and
remain in the cartel. The cheating problem has plagued the OPEC cartel as well Output Decisions
as other cartels and perhaps explains why so few cartels exist.
Check Your Progress 3
1) Explain the prisoner’s Dilemma in oligopoly market.
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2) State the types of Non-cooperative behaviour under oligopoly.
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3) What do you mean by Cartel?
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http://www.economicsdiscussion.net
= 20Q2 – Q1Q2 – Q 22
∆
MR2 = ∆ =20 – Q1 – 2Q2
272
Putting MR2 = 0, and solving for P2 we get: Oligopoly: Price and
Output Decisions
2Q2 = 20 – Q1
Q2 = 10 – Q1 (1)
= 10Q1 – Q12
∆
MR1 = ∆ = 10 − Q
Q2 = 10 – . 10
Q2 = 5 (4)
Thus, under the Stackelberg Model, profit maximum output of Firm 1 is
10 and of Firm 2 is 5. Firm 1 produces twice as much as Firm 2.
3) i) Given that the duopolists faces the following market demand curve:
P = 14 – Q
∴ Q = Q1 + Q2
P = 14 – (Q1 + Q2)
Both the firms have
AC = MC = 2
Case 1:
Reaction Curve for Firm 1
Total revenue R1 is given by
R1 = PQ1 =[14 – ( Q1 + Q2)] Q1
R1 = 14Q1 – Q12 – Q1Q2 273
Market Marginal revenue, MR1 is just the incremental revenue ΔR1 resulting
Structure from an incremental change in output ΔQ1.
∆
MR1 = ∆ = 14 − 2Q − Q
Similarly,
Q2 = 12 − (12 − Q )
Q2 = 12 − 6 + Q
2Q2 = − 6+ Q
2Q2 – Q =6
=6
×
Q2 = =4
and Q1 = 4
Cournot’s price is:
P = 14 – (Q1 + Q1)
P = 14 – (4 + 4)
P = 14 – 8
P=6
ii) Profit of Firm 1 and Firm 2 is:
= R1 – C1
= PQ1 – AC × Q1
=6×4–2×4
iii) Comparison of output under perfect competition and Duopoly:
Under Perfect Competition:
P = MC
14 – Q = 2
Q = 14 – 2
∴ Q = 12
274
4) R 1 = (200 – 2(Q 1 + Q 2 + Q 3))Q 1 Oligopoly: Price and
MR 1 = 200 – 4Q 1 – 2Q 2 – 2Q 3 Output Decisions
Applying MR = MC:
Q 1 = 45 – Q 2/2 – Q 3/2
By symmetry:
Q 1 = Q 2 = Q 3 = 22.5
5) Read Sub-section 12.2.3.1 and answer
Check Your Progress 3
1) Read Sub-section 12.3.1 and answer
2) Read Sub-section 12.3.3 and answer
3) Read Section 12.4 and answer
275
GLOSSARY
Average Product : Total product divided by the number of units of
the input used is average product
345
Introductory Consumer : The point at which a consumer reaches optimum
Microeconomics Equilibrium utility, or satisfaction, from the goods and
services purchased, given the constraints of
income and prices.
Constant Returns to : Constant returns to scale implies that when all
Scale inputs are increased in a given proportion, output
increases in the same proportion.
Complementary : It is the commodity whose demand is directly
Commodity related to the demand of the commodity in
question.
Collusive Behaviour : In collusive oligopoly industry contains few
producers wherein producers agree among one
another as to pricing of output and allocation of
output among themselves. Cartels, such as
OPEC, are collusive oligopolies.
Cournot Model : The Cournot model of oligopoly assumes that
rival firms produce a homogenous product, and
each attempts to maximise profits by choosing
how much to produce. All firms choose output
(quantity) simultaneously.
Cartel : An association of manufacturers or suppliers
with the purpose of maintaining prices at a high
level and restricting competition.
Common Resources : These are resources where there are many users
but no owner.
Demand : The amount of goods which the buyers are ready
to buy, per period of time, at a given price per
unit.
Dependent Variable : A variable which changes only with the change
in the independent variable.
Decrease in Supply : The decrease in quantity supplied at a given price
of the commodity.
Diminishing Returns : Diminishing returns to scale refers to the case
to Scale when output grows proportionally less than
input.
Derived Demand : Refers to demand for factors of production as
their demand is derived from the demand for
goods and services.
Economic Laws : Statements of tendencies. They depict the
standardised or generalised response of
economic units to different forces and stimuli.
Exchange Value : The price which an item commands in the
market.
346
Elasticity of Demand : It quantifies the strength relationship between the Glossary
quantity demanded of commodity and the price
of the commodity or income of the consumer or
price of another commodity which is related to
the commodity in question.
Elasticity of Supply : The responsiveness of quantity supplied to a
given percentage change in the price of the
commodity.
Extension in Supply : The rise in quantity supplied due to a rise in the
price of the commodity.
External Economies : When a firm enters production, it obtains a
number of economies for which the firm’s own
strategies/policies are not responsible. These are
economies external to the firm.
External : When the scale of operations is expanded, many
Diseconomies such diseconomies accrue that have no particular
ill-effect on the firm itself but their burden falls
on the other firms. These are known as external
diseconomies.
Explicit cost : Explicit costs arise from transaction between the
firm and other parties in which the former
purchases inputs or services for carrying out
production.
Economic Profit : A firm’s revenues less its economic cost.
Economic Cost : The economic cost includes the accounting cost
and the opportunity cost of the factor of
production in its next best alternative use.
Excess Capacity : Excess capacity is a situation in which actual
production is less than what is achievable or
optimal for a firm. This often means that the
demand for the product is below what the
business could potentially supply to the market.
Economic Rent : Refers to payment for the use of something
which is fixed in supply.
Externalities : Externalities occur in an economy when the
production or consumption of a specific good
impacts a third party that is not directly related to
the production or consumption.
Efficient Allocation of : That combination of inputs, outputs and
Resources distribution of inputs, outputs such that any
change in the economy can make someone better
off (as measured by indifference curve map) only
by making someone worse off (Pareto
efficiency).
347
Introductory Flow Variable : A variable which can be measured only with
Microeconomics reference to a period of time.
Free Rider : It means one person is using the benefits of a
good without paying anything for it.
Goods : Items which have a utility or can be used for the
production of other goods or services
Giffen Good : A commodity in which there is a direct
relationship between the price of a commodity
and its quantity demanded.
Historical Cost : Historical cost is the cost that was actually
incurred at the time of purchase of an asset.
Inductive Reasoning : The technique of analysis in which factual
information is used to discover the behaviour
pattern of different economic units in response to
various forces and stimuli.
Inferior Commodity : A commodity in which there is an inverse
(Good) relationship between the income of the consumer
and quantity demanded of a commodity.
Income Effect : It shows the effect of a change in income of the
consumer on the quantity demanded of a
commodity.
Income Elasticity of : It is the responsiveness of demand to a given
Demand proportional change in the income of the
consumer.
Inequalities of : The distribution of income among different
Income income groups of an economy.
Increase in Supply : The rise in quantity supplied at a given price of
the commodity.
Income effect : A change in the demand of a good or service,
induced by a change in the consumers’ real
income.
Any increase or decrease in price
correspondingly decreases or increases
consumers’ real income which, in turn, causes a
lower or higher demand for the same or some
other good or service.
Isocost Line : An isocost line represents various combinations
of inputs that may be purchased for a given
amount of expenditure.
Isoquant : An isoquant is the of all the combination of two
factrors of production that yield the same level of
output.
Increasing Returns to : Increasing returns to scale refer to the case when
Scale output grows proportionally more than inputs.
348
Internal Economies : Those economies that accrue to a firm on Glossary
expansion of its own size are known as internal
economies.
Internal : When the scale of production is continuously
Diseconomies expanded, a point is reached where the increase
in production becomes less than proportionate to
the increase in the factors of production. As this
point, internal diseconomies set in.
Implicit Cost : Implicit costs are the costs associated with the
use of firm’s own resources. Since these
resources will bring returns if employed
elsewhere, their imputed values constitute the
implicit costs.
Incremental Cost : An incremental cost is the increase in total costs
resulting from an increase in production or other
activity.
Interest : Refers to payment for the use of capital. Interest
is paid for man-made goods which are used for
production of goods and services.
Imperfect : Imperfect information is a situation in which the
Information parties to a transaction have different
information, as when the seller of a used car has
more information about its quality than the
buyer. In other words, a situation when
information about the goods and services
available to buyers’ and sellers are not
symmetric.
Indifference Curve or : An indifference curve represents a series of
Utility Frontier combinations between two different economic
goods, between which an individual would be
theoretically indifferent regardless of which
combination he received.
Isoquants : The isoquant curve is a graph that charts all input
combinations that produce a specified level of
output.
Imperfect : Imperfect competition exists whenever a market,
Competition hypothetical or real, violates the abstract tenets
of neoclassical pure or perfect competition
Law of Supply : It shows the direct relationship between the price
of a commodity and its quantity supplied, other
factors influencing supply (except price of the
commodity) remaining constant.
Law of Diminishing : As more units of an input are used per unit of
Returns time with fixed amounts of another input, the
marginal product of the variable input declines
after a point.
349
Introductory Linear Homogeneous : When output increases in the same proportion in
Microeconomics Production Function which inputs are increased, the production
function is linear homogeneous. For example, if
labour and capital are increased λ by times and,
as a result, output also increases by λ times, the
production function is linear homogeneous.
Long Run : The time period when all inputs including plant
capacity are variable.
Labour Union : A recognised organisation of workers that seeks
protection of their rights.
Merit Goods : The goods whose consumption is believed to be
desirable for the benefit of the society and the
consuming individuals.
Macroeconomics : Branch of economic analysis that focuses on the
workings of the whole economy or large sectors
of it.
Margin : The value of the variable under consideration
related to the last unit of an item.
Marginal Utility : The additional or extra satisfaction yielded from
consuming one additional unit of a commodity.
Microeconomics : Branch of economic analysis that focuses on
individual economic units or their small groups
and micro-variables like individual prices of
individual commodities, etc.
Money Exchange : Sale of goods/services against money.
Monopolist : A producer who controls the whole supply of a
commodity.
Marginal utility : Marginal utility is the additional satisfaction a
consumer gains from consuming one more unit
of a good or service. Marginal utility is an
important economic concept because
economists use it to determine how much of an
item a consumer will buy.
Marginal Product : Marginal product of an input is defined as the
change in total output due to a unit change in the
amount of an input while quantities of other
inputs are held constant.
Marginal Rate of : Marginal rate of technical substitution of factor L
Technical Subsitution for factor K ( , ) is the quantity of K that
( , ) is to be reduced on increasing the quantity of L
by one unit for keeping the output level
unchanged.
Monopoly : A firm that is the sole seller of a product without
close substitutes.
350
Monopolistic : There are a large number of firms that produce Glossary
Competition differentiated products which are close
substitutes to each other. In other words, large
sellers sell the products that are similar, but not
identical and compete with each other on other
factors besides price.
MRP : Marginal revenue product i.e. Marginal revenue
times the marginal product of factor.
Marginal Physical : Change in quantity produced as one additional
Product unit of the variable factor keeping all other
factors constant.
Marginal Revenue : Marginal physical product multiplied by
Product marginal revenue.
Minimum Wage Act : Government law which fixes the minimum level
of wages payable.
Marginal Rate of : The marginal rate of substitution is the amount
Substitution of a good that a consumer is willing to give up
for another good, as long as the new combination
of the two goods is equally satisfying. It's used in
indifference theory to analyse consumer
behaviour.
Marginal Rate of : The marginal rate of transformation or technical
Technical substitution is the rate at which one good must be
Substitution sacrificed in order to produce a single extra unit
(or marginal unit) of another good, assuming that
both goods require the same scarce inputs. The
marginal rate of transformation is tied to the
production possibilities frontier (PPF), which
displays the output potential for two goods using
the same resources.
Market Imperfection : Conditions in market which are not conclusive to
perfect competition.
Moral Hazard : Deliberate concealment of some information
from the other party.
Market Failure : It refers to failure of market mechanism to
achieve efficient allocation of resources in the
economy.
Necessities : Goods which are used for satisfying basic of
existence.
Normative Economics : That part of economic analysis which is
concerned with what ought to be, and the way it
can be achieved by changing the existing
situation.
Normal Profits : Normal Profit is an economic condition
occurring when the difference between a firm’s
total revenue and total cost is equal to zero.
351
Introductory Simply, normal profit is the minimum level
Microeconomics of profit needed for a company to remain
competitive in the market.
Non Collusive : Oligopoly is best defined by the actual conduct
Behaviour (or behaviour) of firms within a market. The
concentration ratio measures the extent to which
a market or industry is dominated by a few
leading firms. When these firms agree to behave
in a particular manner it is said to be collusive
behaviour of oligopoly market.
Non-exclusion : It means that we cannot exclude non-payers from
consuming it.
Non-rival : It means that when person consume a good, it
will not diminish other person’s share.
Ordinal Utility : The Ordinal Utility approach is based on the fact
that the utility of a commodity cannot be
measured in absolute quantity. However, it will
be possible for a consumer to tell subjectively
whether the commodity gives more or less or
equal satisfaction when compared to another.
Optimality : The point where maximum possible output is
being achieved given the use of different factors
of production.
Oligopoly A state of limited competition, in which a market
is shared by a small number of big producers or
sellers.
Optimal Output Mix : The optimal mix of output is known in
economics as the most desirable combination of
output attainable with available resources,
technology, and social values.
Private Goods : Goods whose availability can be restricted to
selected users. It is divisible in that sense.
Production Possibility : A graphic representation of the combinations of
Curve maximum amounts of goods X and Y which can
be produced with the given productive resources
of the economy and under certain other
simplifying assumptions.
Public Goods : Goods or services whose availability cannot be
restricted to selected users only. The benefits of
the goods are indivisible and people cannot be
excluded.
Positive Economics : That part of economic reasoning which covers
what is, without going into its desirability or
otherwise, and without suggesting ways for
changing the existing state of affairs.
352
Price Effect : The impact that a change in its price has on the Glossary
consumer demand for a product or service in the
market. The price effect can also refer to the
impact that an event has on something’s price.
The price effect is a resultant effect of the
substitution effect and the income effect.
Point of Inflexion : The point where total product stops increasing at
an increasing rate and begins increasing at a
decreasing rate is called the point of inflexion.
Production Function : The technical law which expresses the
relationship between factor inputs and output is
termed production function.
Perfectly Competitive : A market is perfectly competitive if it consists of
Market many consumers and firms, none of whom have
any appreciable market share, all firms produce
identical products, and there are no barriers to
entry or exit, and consumers have perfect
information about prices.
Price Discrimination : When a firm charges different prices to different
groups of consumers for an identical good or
service, for reasons not associated with costs, it
is termed as price discrimination.
Product : The marketing of generally similar products with
Differentiation minor variations that are used by consumers
while making a choice.
Prisoner’s Dilemma : A situation in which two players each have two
options whose outcome depends crucially on the
simultaneous choice made by the other, often
formulated in terms of two prisoners separately
deciding whether to confess to a crime.
Profits : Are returns to entrepreneurs for use of their
organisation and management skills in the
production process, as well as bearing risks.
Productive Efficiency : Production efficiency is an economic level at
which the economy can no longer produce
additional amounts of a good without lowering
the production level of another product. This
happens when an economy is operating along its
production possibility frontier.
Production Possibility : A graphical representation of the alternative
Curve combinations of the amounts of two goods or
services that an economy can produce by
transferring resources from one good or service
to the other. This curve helps in determining
what quantity of a nonessential good or a service
an economy can afford to produce without
jeopardising the required production of an
essential good or service.
353
Introductory Public Goods : A public good is a product that one individual
Microeconomics can consume without reducing its availability to
another individual, and from which no one is
excluded. Economists refer to public goods as
“non-rivalrous” and “non-excludable.”
Price Ratio or : Price of a commodity as it compares to another.
Relative Price The relative price is usually presented as a ratio
between the two prices.
Public Interventions : Actions of the government in the markets for
goods, services and factors.
Public Provision : Direct supply of certain socially desirable
services /goods by the government authorities/
agencies to the end users.
: It occurs when the government puts a legal limit
Price Ceiling
on how high the price of a product can be.
Quasi-Rent : Return to a factor of production over and above
its average cost; it is a short-run concept.
Rectangular : It is a curve in which every rectangle drawn with
Hyperbola one corner on the curve has the same area.
Ridge Lines : The lines forming the boundaries of the
economic region of production are known as the
ridge lines.
Replacement Cost : Replacement cost is the cost that will have to be
incurred now to replace that asset (i.e., the
replacement cost is the current cost of the new
asset of the same type).
Rent : Refers to payment for the use of land. Land
refers to all natural resources available for the
purpose of production.
Stock Variable : A variable which can be measured only with
reference to a point of time.
Supply : The quantity of goods which the sellers are ready
to sell, per unit of time, at a given price per unit.
Substitution Effect : It shows how with a change in the price of a
commodity, prices of other commodities
remaining unchanged, a consumer substitutes
one commodity for the other.
Substitute : It is the commodity whose demand is inversely
Commodity related to the demand of the commodity in
question.
Supply Schedule : A table having two columns, one showing
different prices of the commodity and the other
showing quantities supplied during a given
period at each of these prices.
354
Supply Curve : A curve showing the relationship between price Glossary
of a commodity and its quantity supplied during
a given period, other factors influencing supply
remaining unchanged.
Substitution Effect : An effect caused by a rise in price that induces a
consumer (whose income has remained the
same) to buy more of a relatively lower-priced
good and less of a higher-priced one.
Sub-optimality : It is a point where optimality has not been
achieved, i.e. output is less than the possible
maximum given the use of the resources.
Sunk Cost : Sunk cost is a cost that has already been incurred
and can’t be recovered.
Short Run : The time period when at least one of the inputs
(size of the plant) is fixed.
Supernormal Profit : A firm earns supernormal profit when its profit is
above that required to keep its resources in their
present use in the long run i.e. when price >
average cost.
Stackelberg Model : The Stackelberg leadership model is a strategic
game in economics in which the leader firm
moves first and then the follower firms move
sequentially. ... There are some further
constraints upon the sustaining of a Stackelberg
equilibrium.
Technology : The method employed to produce a commodity
or service.
Total Utility : The total satisfaction derived from all the units of
an item.
Transfer Earnings : Minimum payment to be made to a factor of
production to retain it in present employment. It
refers to the earnings in the next best
employment.
Use Value : Utility of goods
Utility : The want satisfying capacity of goods. It is the
service or satisfaction an item yields to the
consumer
VMP : Value of Marginal Product, i.e. price times the
marginal product of factor.
Wages : Refers to payment for the use of labour which
refers to the human effort made for production of
goods and services through technical expertise or
manual labour.
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Introductory
Microeconomics
SOME USEFUL BOOKS
1) Kautsoyiannis, A. (1979), Modern Micro Economics, London:
Macmillan.
2) Lipsey, RG (1979), An Introduction to Positive Economics, English
Language Book Society.
3) Pindyck, Robert S. and Daniel Rubinfield, and Prem L. Mehta (2006),
Micro Economics, An imprint of Pearson Education.
4) Case, Karl E. and Ray C. Fair (2015), Principles of Economics, Pearson
Education, New Delhi.
5) Stiglitz, J.E. and Carl E. Walsh (2014), Economics, viva Books, New
Delhi.
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