Subject: Economics for Manager

Unit: 3 Market structure Analysis - 2

1. Price determination under monopolistic competition

1.1 Features of monopolistic competition
1.2 Nature of demand curve and Marginal revenue curves
1.3 Price in output determination in short run and long run under monopolistic competition
1.4 Concept of group equilibrium
0. oligopoly:
2.1 features,
2.2 Kinked demand curve
2.3 Price leadership( types, characteristics, advantages)

1 Price determination under monopolistic competition

1.1 Features of monopolistic competition:

1) Fairly large numbers of sellers:

In monopolistic competition there are large numbers of firms but not as large as in perfect
competition. As a result, no one firm controls a significant proportion of total market supply. The
output decision of an individual firm does not affect the output decision of any other firm. Here,
each firm decides about its price and output independently Without considering the possible
reactions of the rival firms.

2) Product differentiation:

Under monopolistic competition various firms produce not the same but differentiated products.
These various products are close substitutes not perfect substitutes to each other. Differentiation
means that the products are different in some ways, but not all together [Link] example, Different
brands of toothpaste like Colgate, close-up, Promise, Babul etc.

3) Selling cost:

Monopolistic competitions have to undertake Sales promotion activity. Expenditure on these

activities is known as selling costs. Such costs are not necessary in perfect competition and
monopoly because of homogeneous product and unique product respectively but in monopolistic
competition it becomes essential to incur selling cost because by incurring selling cost a firm can
increase the demand of its product.

1
4) Different prices for differentiated products:
Under monopolistic competition, each firm produces a differentiated product and through
repeated advertisements and publicity, each firm tries to create an impression on the minds of
customers that its product is superior to that of its rival firms. The Difference may be real or
imaginary, but the fact remains that consumers come to regard the product of one firm as
superior to that of another [Link] incurring such expenses the cost of a company increases and
so it charges a high price in comparison to other firms.

5) Control over price: In monopolistic competition firms have some control over the prices
which a firm under perfect competition does not have. A product difference attaches a group of
buyers to a particular firm. Therefore an individual firm can exercise some control over prices it
can charge high prices without fear of losing all its customers. That is an individual firm under
monopolistic competition enjoys some sort of monopoly power in that it has the power to fix the
price.

6) Free entry and free exit: under monopolistic competition, new firms can and do enter the
industry without any restrictions and existing companies can leave industry whenever they like
[Link] firm which continue to incur losses leave the group in the long run,whereas existence of
super normal profits attracts new firms in the group.

7) Concept of group: Prof. Chamberlain has used the word ‘Group’ instead of industry. Industry
refers to a number of firms producing identical products under perfect competition. Under
monopolistic competition firms are producing not the same but differentiated products which are
a close substitute to each other. so the concept of a group implies a collection of firms producing
closely related products, not same products.

1.2 DEMAND CURVE OF A FIRM UNDER MONOPOLISTIC COMPETITION

We have seen that the demand curve of perfect competition is perfectly elastic because of the
large number of firms selling the same product and demand curve of monopoly market is less
than perfectly elastic because of zero competition.

Here, in monopolistic competition the demand curve is less than perfectly elastic because of the
existence of both monopoly and [Link] implies that the firm cannot sell any amount of
the product at the current ruling price: If it wants to sell more, it has to lower the [Link]
demand curve does not run parallel to X axis; it is downward sloping elastic curve to the right.

In the diagram, AR is the average revenue curve or the demand curve and MR is the marginal
revenue curve which lies below average revenue curve as in a monopoly market.

1.3 EQUILIBRIUM OF FIRM UNDER MONOPOLISTIC COMPETITION

2
Equilibrium of a firm under monopolistic competition can be studied in the short run as well as
long run based on following assumption:

1. There are many firms and each firm is having some monopoly power due to its product
differentiation.
2. Each firm has a demand curve which is less than perfectly elastic.
3. There is free entry and exit of firms.
4. The short run cost curves of each firm differ from each other.

SHORT RUN EQUILIBRIUM OF A FIRM

Same like perfect competition and monopoly market equilibrium of monopolistic competition
market will be determined at the point where marginal revenue is equal to marginal cost.
MC=MR.

Another point to be noted is that in the short run equilibrium of a firm under monopolistic
competition will be attained either at normal profit, super normal profit or at loss. That is in
(AC=P), (AC>P) OR (AC<P).

A firm in the short run may earn supernormal profits because other rival firms are not able to
produce closely competitive substitutes, nor can new firms enter the ‘group’ in the short period.
Likewise some firms in the group may incur losses in the short run , but still they will remain in
business and continue production as long as they are able to cover all of their variable costs and
part of the fixed [Link] we can consider a situation wherein the firm in the short run
earns only normal profits.

This would be clear from the study of following diagrams.

1) Individual firm earning supernormal profit in Short Run under monopolistic

competition:

AC < P 2. MR=MC,

In this diagram, P shows the equilibrium point of the firm where short run marginal cost is equal
to marginal revenue:and it produces OM output at OD price. The average revenue BM is greater
than the average cost BC and which is indicated by rectangle ABCD. This is the super normal
profit which the firm earns in the short period.

The reason a firm earns supernormal profit is that in the short run big existing firms do not face
any competition from existing firms but this condition will not last longer.

3
2) Individual firm incurring loss in short-run under monopolistic competition

1. MC=MR 2. AC > P

In this diagram , at point P, the short run marginal cost curve is equal to marginal revenue and the
firm produces OM output at OD price. But as this price OD or CM is less than the short run
average cost at the equilibrium level of output, the firm incurs a loss of BC which is shown by
the rectangle ABCD.

In the short run under monopolistic competition it may happen that individual firms incur loss
but this situation will not last for a long period.

3) Individual firm earning normal profit in short-run under monopolistic competition

1. MC=MR 2. AC = P

In this diagram at point P, the short run marginal cost equals short run marginal revenue and the
firm produces OM output at OA price. The demand curve or the average revenue curve is a
tangent to the short-run average cost curve at point B at the level of OM output . The firm here
earns only normal [Link] a firm under monopolistic competition is having normal profit.
This condition lasts for a longer period.

4
LONG RUN EQUILIBRIUM OF A FIRM UNDER MONOPOLISTIC COMPETITION

Long run equilibrium of a firm under monopolistic competition is attained when its marginal
revenue equals marginal cost and it earns only normal profits. If some of the firms in the ‘group’
are earning super normal profits these will attract new firms to enter into competition likewise no
firm will run into loss in the long run, because in that case such firms will leave the group and so
the price of the product will rise until it is high enough to cover fully the average cost of the firm
and enable it to earn normal profits.

Here long run equilibrium of a firm under perfect competition and monopolistic competition is
the same that in both situations the firm is earning normal profit. But there is one important
difference.

Under Perfect competition, the firm is in equilibrium at a point where its output is produced at
minimum average cost. But in monopolistic competition the firm does not produce at minimum
average cost.

A monopolistic competition firm does not continue to produce till minimum point of average
cost but stops at a point where MC=MR this is because if it continues production till minimum
point of average cost it has to sell extra units at less price. So the firm does not think it is worth it
to increase production beyond the point of MC=MR and it stops production at the place where
MC=MR.

1.4 GROUP EQUILIBRIUM OF A FIRM UNDER MONOPOLISTIC COMPETITION

Prof. Chamberlain has used the word ‘group’ in place of industry as Industry refers to firms
producing identical products but In monopolistic competition all firms are not producing
identical products but differentiated products. So it is called a group.

Equilibrium of a group under monopolistic competition is attained when the number of firms
composing it tends to remain the same, that is New firms have no incentive to enter the group
and existing firms have no reason to leave the group that is the situation where all firms in a
group earn normal profit.

It should also be noted that in monopolistic competition when a group is in equilibrium then each
firm is producing output at the less than optimum level that is , it does not produce at the
minimum average cost.

5
The firm stops production at a point where MC = MR. But in perfect competition the industry
gets equilibrium at minimum average cost.

In perfect competition demand curve is perfectly elastic and in monopolistic competition demand
curve is less than perfectly elastic so in order to produce at optimum level that is at minimum
average cost firm has to reduce the price to sell extra production. Therefore the firm stops at a
point where MC=MR.

This will be clear from the diagrams below.

In this diagram the average revenue curve is tangent to average cost curve at point B. Marginal
cost and marginal revenue are equal at point [Link] firm, therefore , is in long run equilibrium
producing OM output at OA or MB price. AR is equal to AC; the firm earns only normal profits.

But this firm is nor producing at the lowest AC point which is S and therefore the output OM is
less than the optimum output OM 1.

2 PRICING UNDER OLIGOPOLY

2.1 Features or characteristics of oligopoly

1) Few sellers

Oligopoly is a market situation where there are few firms producing either homogeneous
products or different [Link], it is also referred to as “competition among the
few”. Because of the small number of firms, each firm accounts for a substantial part of total
output of the industry and hence its policies have a notable impact on the market.

2) Interdependence of firms:

In the oligopoly market there are few firms of large size and each firm accounts a large part of
market demand. Therefore, it is in a position to influence the price and output of the industry in a
significant manner. Each firm, as such, has to take into account the action and reaction of its rival
firms while deciding on its price and output policies. Thus, There is interdependence of firms
and decisions taken by one affect other firms. Cross elasticity of demand is very high between
the products of various oligopoly firms as products are close substitutes of each other.

6
3) Importance of selling cost:

Selling cost is of great importance in the oligopoly market. As cross elasticity of demand
between products is very high. All the firms have to do aggressive advertisement in order to
survive in competition. A firm which fails to keep up the advertising budget in line with
competitor firms finds it difficult to stay in the market.

4) Indeterminate demand curve:

In the oligopoly market it is difficult to determine the demand curve because in oligopoly one
cannot predict the reaction of rival firms towards the change in price output policy.

5) Presence of monopoly element:

In oligopoly, as long as products are different each firm enjoys some sort of monopoly as each
firm has some loyal customers attached to [Link] in oligopoly , firms get a partial independent
market for their products, and thus enjoy the freedom to fix price and output at desired level.

6) Conflicting attitude of firms:

In the oligopoly market there is a conflicting attitude between firms. That is on one hand there is
mutual cooperation where they work together and on other hand there is competition and conflict
between the [Link] one hand rival firms realize the disadvantages of mutual competition and
accordingly enter into collusion and tacit agreement with regard to price ,output and market.

7) Price rigidity.

Under oligopoly, prices are sticky, that is firms tend to be sticky on one [Link] one firm reduces
prices it attracts buyer of rival firms and therefore rival firms also reduce the prices and so, no
firm will be benefited same way if one firm increases prices other firm will not increase the
prices and this increase in price will not give any benefit to the firm. So firms tend to be sticky
on single prices.

2.2 Kinked demand curve

The kinked demand curve model was first used by Paul M. Sweezy in 1939. The kinked demand
curve represents the pattern of business behavior of a firm which has no incentives either to
lower or to raise its prices.

The oligopoly firm therefore has every incentive to hold prices where they are because reduction
in prices would be matched quickly by rivals and no firm would gain while increased prices
would not be matched by the rival firms and so the firm which raised price will incur loss. Thus a
firm under oligopoly prefers to stick to the existing prices.

An oligopoly firm faces a kinked demand curve on the assumption that if it decides to raise
prices its rival will not raise prices and if it decides to lower prices rivals to lower the [Link]
oligopoly thus have incentive to hold prices where they are.

7
Reduction in price is quickly matched by the rivals so nobody will gain, while increased prices
would not be matched by the rivals so the firm which raised the price would [Link] oligopoly
firms face a kinked demand curve.

The kinked point of demand curve represents the stickiness of prices. The firm will not move
away from kink.

It will be seen from the above graph that the kinked demand curve ABC is made up of two
segments.

The demand segment corresponding to lower prices is less elastic then the demand segment
corresponding to higher price. The reason for this is that reduction of prices is followed by rivals
but increase in price is not followed by rival firms.

In the above figure if price is OY demand is ON. Now if firms increase price from OY to OX
demand decreases from ON to OM that is decrease in demand is more then increase in price
because rivals will not increase the prices. So most of the customers go to rivals and demand
decreases more than increase in prices. So demand curve AB is more elastic.

Similarly when price decreases from OY to OZ demand increases but here increase in demand is
less than decrease in prices. So here the demand curve is less elastic, because rival firms also
decrease the prices.

2.3 PRICE LEADERSHIP

Under price leadership one of the firms determines and fixes the price and this price is accepted
by all other firms in the industry. Therefore a firm which takes an initiative to decide a price
becomes a price leader and all other firms of industry become price follower.

2.3.1 Types of price leadership

1) Barometric price leadership

In this type of price leadership a firm which is supposed to have good knowledge and experience
of the market is selected as a price leader.

8
The barometric firm is not necessarily a low cost or a large firm. Any firm with a good reputation
and knowledge can be a barometric price leader and all other firms in industry will follow it.

2) Low cost price leadership

When a firm has low cost of production, it has an advantage over other firms and acts as a price
leader. Other firms are not in a position to keep prices above it and even they will not keep prices
below it. So all firms choose to become price follower and low cost firm will become a price
leader.

3) Dominant firm price leadership:

In this type of price leadership a company which has the largest market value, market shares,
market output etc. becomes a price leader. That is, a big company in the industry becomes a
leader irrespective of their knowledge or experience. Other small firms will not be willing to take
the risk of opposing dominant firms, because if they do so they incur loss. So they will become
price followers.

Dominant firms choose the price where it can earn maximum profit because it knows that all
other small firms will follow its price.

2.3.2 Characteristics of price leadership:

1. Usually a price leader firm makes few, but large and dramatic price changes, because
frequent price changes are likely to undermine the loyalty of the follower.
2. Generally the price leader leads only in price rise; in the case of price reduction the leader
actually becomes a follower.
3. The price leader changes the price only when he feels that the change in demand and cost
conditions is of a permanent [Link] case of temporary change in price, he meets it by
offering informal concessions.
4. The price leader must also be ready to incur the risks of a price war in order to establish and
maintain his leadership.
5. The price leader has a significant role to play in forecasting effectively and accurately, the
demand and cost conditions so as to inspire the confidence of its followers.
6. When there are significant differences in quality, service and reputation in an industry, the
price leader himself provides the best of such services and charges a slightly higher price.
7. Once the price leadership is established, it is sustained as much by the followers as by the
leader.
8. Usually the price leader takes a long run point of view, that is, he is willing to sacrifice short
term benefits for long term benefits.

2.3.3 Advantages of price leadership:

1. Very often the small farms have no sufficient inside into the principles of costing.
Accordingly they safely assume that if a big firm with an efficient costing department has
calculated a certain price, it must be reasonably [Link] leadership thus, proves helpful
to small firms in their price fixation policy
2. Price leadership is an easy method of pricing as it requires a simple casual enquiry as to
the prices of other firms. Besides, It avoids the expense of production and cost studies as
also market service to estimate the demand.

9
 3. Price leaders tend to keep the price stable and usually keen to avoid wars. Accordingly
in times of recession, the price leader makes all possible efforts to prevent a rapid fall in
prices on the part of any firm.
4. It has also been said that price leadership has helped in reducing the intensity of cyclical
fluctuations. It is perhaps due to price leadership that prices have not gone as high in
boom periods or as low in depression as they would have otherwise gone.
5. Under price leadership all firms know that there would be no recourse to destruction
price-was that is there is an implicit idea of “live and let live” in price leadership
6. Due to price leadership the number of possible reactions to a price change is
considerably reduced and thus imparts an element of certainty to the pricing aspects of
market forecasting.

10