MARKET STRUCTURE : PRICE – OUTPUT DECISIONS

- The price-output decision is one of the key management decisions.

What to produce and how much of it to sell to whom, at what price, and
what discount, if any, constitute a set of very important managerial
decisions.

- The product line being given, managers have to continuously bother

about the pricing and quantity to be sold. This crucial decision area
which occupies so much of the day – to – day managerial attention is
referred to as PRICE – VOLUME determination in Managerial
Economics.

Factors influencing price – volume decision

- Different factors will carry different weightages in different situations but

they will all having to the considered by the manager.

a) Demand
b) Cost of production & capacity
c) Objectives of the firm
d) Nature of the product
e) Nature of competition in the market.
f) Government policy

 Classification of market structures

- Market structure refers to the number & size distribution of buyers and
sellers in the market for a good or service. Implicit in this concept is an
idea that the market structure for a product not only includes firms &
individuals currently engaged in buying and selling but also the
potential entrants.

- Two Basic parameters :

a) Number of firms
b) Degree of product differentiation

Other factors like product characteristics & entry of new firms are also
important but these determine the level of competition in a given
market structure.
 - Market structures can be classified in only two fundamental forms:

a) Perfect competition

b) Imperfect competition

Monopoly Oligopoly Monopolistic Comptt.

PERFECT COMPETITION

 A perfectly competitive market is characterized by the following main

features:

a) Many buyers & sellers exist so that no one can influence the
price.

b) All firms sell identical products or are perceived so by the

buyers.

c) All resources & inputs like materials, labour & capital are
perfectly mobile so that firm can enter the market and fold up
shop as and when they wish.

d) Members in the market have perfect knowledge ; decisions

are made as if everything was certain.

 With such unrealistic conditions no one expects to see a real world

operating on these lines.

- However, analysis of such situations gives insights into the efficiency of

resource use. It is used as a yardstick for measuring efficient allocation
of resources.

- To the extent real world markets deviate from this ideal case we get an
idea about the inefficiency of resource use prevailing in them.

- Also, the analysis of PC illuminates several basic principles under lying

business behaviour.
 Q. Imagine a firm operating in a perfectly competitive market. The
following data are available :

P = A R = M R = Rs. 20/- unit.

Total cost function is C (Q) = 8 + 17 Q – 4 Q2+ Q3

Find out the profit maximizing output & the maximum profit.

SHORT – RUN EQUILIBRIUM

- The equilm. of a firm in PC is always at a point where its marginal

revenue is equal to its Marginal cost.

- A firm in PC may face any of the five situations in the short run :

(i) AR > AC (Abnormal profits )

(ii) AR = AC (No profit no loss )
(iii) AR > AVC (Partial losses )
(iv) AR = AVC (Maximum permissible losses )
(v) AR < AVC (Shutdown situation where production Is stopped)

LOSSES & THE SHUTDOWN DECISION

- In the short run, managers of a firm should shut down the operation if
price is below average variable cost.
- If price is greater than average variable cost but less than average total
cost, the firm should continue to produce in the short run because a
contribution can be made to fixed costs.

Long – run Equilibrrium

- Over the long – run, any positive economic profits will attract new firms
in the industry or an expansion by the existing firms or both. As this
happens, the industry supply gets expanded depressing the price of the
product.

- Long – run equilm. is reached when

P= MC = AC = AR

- When every firm is making just the normal profit, no new firms enter,
none of the existing firms quit and equilm. prevails. The industry as
such is in equilm. when no firm is earning above – normal profits.
 THE THEORY OF MONOPOLY

 The market form of monopoly lies at the other extreme as compared to

that of PC. It exists when only one firm is the sole producer or seller of
a product, which has no close substitutes.

- The Cross n of dd between the product of the monopolist & the product
of any other producer is very small.

- There exist strong barriers to the entry of new firms into the industry.

- Under Monopoly, the firm is the industry. Naturally, a monopolist faces

a downward sloping dd curve.

- The monopolist can set either the price or the quantity but not both.
Given a dd curve, if the monopolist decides to change the price, he has
to accept the volume that it will accompany. Similarly, with the volume
determination, the price gets automatically established through the dd
curve.

- The monopolist will operate at that level where his profits are maximum
i.e. where MR = MC

 Price Discrimination under Monopoly

- A seller indulges in PD when he sells the same product at different

prices to different buyers.

- Price discrimination is :

a) Personal when different prices are charged from different persons.

b) Local when different price are charged from people living in different
localities.
c) According to use when e.g. higher rates are charged for
commercial use of electricity as compared to the domestic use.

 Equilm. under price discrimination:

- Case I : A monopolist firm sells a single product in two different

markets with different elasticities of dd. Resale among the customers is
not possible.

- Suppose the monopolist faces a less elastic dd curve in sub – market

(2) as compared to sub market (1).

- The monopolist would produce Q units of output. In order to know the

distribution of Q in two sub-markets, the equilm. aggregate MR is
 equated to MR, & MR2 at points E1 & E2 respectively. The monopolist
would sell amount Q1 in sub-market 1 at a price P1 . He would sell
amount Q2 in sub-market (2) at price P2.

- Case II : Dumping. This is a special case when the firm is a

monopolist in the domestic market but faces perfect competition in the
world market. Because of this condition, the producer charges less
price in the world market than in the home market.
Q. Assume that a monopolist has segmented his markets such that the total
demand is X = 50 – 5 P & the dd functions of the segmented markets
are:

X 1 = 32 – 04. P1 & X 2 = 18 – 0.1 P2.

Suppose the cost function is C = 50 + 40 x.

Calculate : (i) The profit maximizing o/t.

(ii) The profit maximizing price.
(iii) The profit.
(iv) The elasticities in each market.

 (i) The Profit maximizing condition for the discriminating monopolist is :

MR1 = MR2 = MC

X1 = 32 – 0.4 P1 or P1 = 80 – 2.5. X1
TR1 = X1 P1 = ( 80 – 2.5. X1) X1 = 80 X1 – 2.5 X1 2

MR1 = d ( TR1 )
------------- = 80 – (5) X1
dx1

X2 = 18 – 0.1 P2 or P2 = 180 – 10 X2

TR2 = X2 : P2 = (180 – 10 X2 ) X2 = 180 X2 – 10 X22

MR2 = 180 – 20 X2

C= 50 + 40 x  MC = 40

Now we have:

MR1 = MC  80 – 5 x1 = 40  X1 = (8)

MR2 = MC  180 – 20 X 2 = 40  X2 = (7)

Total Output = 8 + 7 = 15 units

(ii) The prices are:

P1 = 80 – 2.5 X1 = 60

P2 = 180 – 10 X2 = 110
(iii) The profit is:

 = TR1 + TR2 – C = 600

(iv) The elasticities are :

e1 = - d X1 . P1
------ ---- = - (-0.4) . 60
d P1 . X1 ---- = (3)
8

e2 = - d X2 . P2
------ ---- = - (-0.1) . 110
d P2 . X2 ----- = (1.57)
7

BILATERAL MONOPOLY

- It is a market consisting of a single seller ( monopolist) & a single buyer

( monopsonist )

- e.g. if a single firm produced all the copper in a country & if only one
firm used this metal, the copper market would be a bilateral monopoly
market.

- The equilm. In such a market can not be determined by the traditional

tools of dd & ss, The precise level of the price & o/t will ultimately be
defined by non-economic factors, such as the bargaining power, skill &
other strategies of the participant firms.

- Under conditions of BM economic analysis leads to indeterminacy

which is finally resolved by exogenous factors.

- PRICE DISCRIMINATION & CONSUMER SURPLUS :

- First degree PD: take it or leave it PD. In negotiating with each buyer
the monopolist charges him the maximum price he is willing to pay
under threat of denying the selling of any quantity to him: he offers each
buyer a ‘ take – it – or – leave – it choice’ and tries to extract the
maximum consumer surplus from the consumers.
 MONOPOLISTIC COMPETITION

- The theory of M.comptt. has elements of both monopoly & PC.

- Like PC, it is assumed that there are a large no. of small sellers. Thus
the actions of any single seller do not have a significance effect on other
seller in the market. Also like PC, it’s assumed that there are many
buyers & that resources can easily be transferred into & out of the
industry.

- However, the model of M. Comptt , resembles the monopoly models in

that products of individual firms are considered to be slightly
differentiated. ie . the product of one firm is assumed to be a close, but
not a perfect substitutes for that of other firms.

- The result is that each firm faces a dd curve with a sight downward
slope, implying that the individual firm has some control over price.
Although ↑ing its price will cause the firm to lose sales, some Crs will be
willing to buy at the higher price becoz the product is slightly
differentiated from that of competitors.

- Market structure characteristics:

1. No. & size distn. of sellers Many small sellers

2. No. & size distn. of buyers Many small buyers

3. Product differentiation Slightly differentiated

Product of one firm is a
fairly close substitute for
that of other sellers

4. Conditions of entry & exit Easy entry & exit.

 Profit – Maximizing Price & Output in the short Run :

 - The results in the short run are similar to those of Monopoly.

 In the long run, M. Comptt. generates results similar to those of PC. Becoz
entry into the industry is easy, economic profit induces other firms to enter
the market. As this entry occurs, the market shares of existing firms decrease.
Thus the dd curve faced by these firms shifts down till the time it becomes
tangent to the AC curve.

- We find that the profit – maximizing o/t does not occur at the minimum
point on the firm’s AC curve. I.e. the firm is operating at an inefficient
output rate.

- However, the above result does not necessarily imply inefficiency. The
downward slope of the dd curve is the result of product differentiation
in the market. There differences are of value to consumers as they
select goods that meet their particular needs.

- In general, the validity of the claim that M. Comptt. is inefficient depends

on a comparison of the benefits derived from product differentiation and
the ↑ed costs caused by differentiated products.

OLIGOPOLY

 Oligopolies exist at the local as well as the national levels.e.g. although

there are thousands of gas stations scattered throughout the nation, the
typical Cr considers a few nearby stations. Other sellers who are
farther away may offer lower prices or better service, but proximity is
probably the dominant consideration.

- Hence the market for gasoline faced by the individual consumer could
be described as an oligopoly.

- The key issue is not numbers, but rather the reaction of sellers to one
another.

- The actions of each firm in an oligopoly do affect the other sellers in the
market. Price cutting by one firm will reduce the market share of other
firms, Similarly, clever advertising or a new product line may ↑se sales
at the expense of other sellers.

- Market structure characteristics of Oligopoly:

- No. & size distribution of sellers: small No. of sellers. Each firm must
consider the effect of its actions on other firms.

- No. & size distribution of buyers : Unspecified.

 - Product differentiation : may be either homogeneous ( Pure oligopoly)
or differentiated.

- Conditioned of entry & exit : entry difficult.

PRICE LEADERSHIP

- Barometric price leader.

- Dominant Firm Price leader
- Low cost price leader

1. Barometric price leader : An experienced firm which possesses an ability to

accurately predict demand conditions & knowledge of market supply, takes
leadership in fixing a higher price.

2. The dominant firm price leader: The dominant firm is a relatively large firm
in the sense that it produces a very large part of the market output. Other
firms are smaller in comparison & accept the price leadership of the
dominant firm. The dominant firm knows well that the small firms will follow
its price; and hence it chooses that price where it can make maximum
profits.

3. The low cost price leader: when one firm has a substantial cost advantage
over others, it assumes the role of a price leader. If the other firms try to
wage a price war and fix their prices at still a lower level, it is conceivable
that they may lose the battle becoz their average cost is much higher than
that of the leader firm. The price leader firm with lower marginal cost, will
set that price where its MC & MR are equal. Other rival firms with higher
MC, will have to fix the same price, becoz if they fix higher prices, they will
lose a substantial share of the market.

 PRICE RIGIDITY : The kinked demand model (Paul. Sweezy)

- The kink in the dd curve stems from an asymmetry in the response of

other firms to one firm’s price change.

- As long as the new marginal cost curve intersects the vertical portion of
the MR cure, there will be no change in the profit –maximizing price &
Qy . For price & Qy. to change, the MC curve must shift enough to
cause it to intersect the MR either above point ‘a’ or below point ‘b’.

- The impt. Implication of the kinked dd curve model is that firms in

oligopolistic market structures could experience substantial shifts in
marginal costs & still not vary their prices.
 If there are few, if any, examples of pure monopoly & PC, why expends the
time & effort required to discuss those extreme conditions?

- The value of the extreme models is that they serve as benchmarks.

Industries that approx. PC are likely to function much like those in the
PC Model. In contrast, those that have many of the characteristics of
monopolies will generate monopoly- like results.
- The monopoly model may be applicable in many situations where
producers sell a differentiated product & believe that they have some
control over price.
- In addition to providing information on the likely behaviour and result of
specific market structures, the extreme models of comptt. & monopoly
provide guidance in making public policy.
- As a general rule, economists favour policies that move industries
towards the competitive end of the spectrum.