LUNAR INTERNATIONAL COLLEGE

MANAGERIAL ECONOMICS

Chapter Five
Market Structure
 CHAPTER FIVE
Market Structure

 Concept of market structure

 Pricing under various markets : Perfect Competition, Monopoly,

Monopolistic competition, oligopoly.

 Pricing methods and strategies

 Organizational Decision making – decision theory

Market structure
■ The type of market structure - has an important implication for strategy decision
– more helpful in price output decisions
– determination of price of the product.
– Managers always try to find out the optimum combination of price and output which
offers the maximum profit to the firm.
■ Thus pricing occupies on important place in economic analysis of firms and it
depends on Market structure
■ Market structures are different market forms based on the degree of competition
prevailing in the market.
■ Broadly the market forms are perfectly competitive market and imperfectly
competitive market.
■ The imperfect market is divided into monopoly market, monopolistic competition
market, oligopoly market and duopoly market.
 Market structure
MARKET PERFECT MONOPOLY MONOPOLISTIC OLIGOPOLY
STRUCTURE COMPETITION COMPETITION
Number Of Sellers Many One Many Few

Types Of Product Homogenous/ Single product/No differentiated Standardized/

Standardized close substitute differentiated

Information Complete and free Less information Less information Restricted access to
information price and product
information
Barriers To Entry None Very High Low High

Power To Affect None High Low Medium

Price
Profit Potential Economic profit in the Economic profit in Economic profit in short Economic profit in
short run and normal both short run and run and normal profit in both short run and
profit in long run long run long run long run
Non Price None Advertising Advert and product Heavy advert and
Competition differentiation product
differentiation
Market structure
■ The market structures characteristics:
– number of sellers, type of product, barriers to entry, power to affect price and the
extent and type of non-price competition.
■ Perfect competition is invariably used as a benchmark for comparison,
– in terms of price, output, profit and efficiency that represents an ideal in certain
respects.
■ Perfect competition represents one extreme of the competition spectrum (maximum
competition), while monopoly represents the other (no competition)
■ Monopoly firms rare in practice, but does tend to occur in public utilities like gas,
water and electricity supply
■ Most real-world firms are along the range of imperfect competition.
■ Monopolistic competition and oligopoly are intermediate cases, and are more
frequently found in practice
– for example restaurants and the car industry respectively.
Perfect Competition Market

■ Perfect competition is characterized by a complete absence of rivalry among the

individual firms.
■ A firm’s output is so small in relation to market volume that its output decisions have
no significant impact on price.
■ No single producer or consumer can have control over the price or quantity of the
product.
■ This form of market structure is not necessarily perfect in an economic sense
– resulting in an optimal allocation of resources.
– represents a situation where competition is at a maximum - pure competition.
■ In perfect market, the price of the commodity is determined based on the demand for
and supply of the product in the market.
■ Perfect competition means all the buyers and sellers in the market are aware of price
of products.
Perfect Competition Market

■ Main conditions or characteristics for perfect competition to exist:

a. Many buyers and sellers - each buy or sell such a small proportion of the total
market output - none is able to have any influence over the market price.
b. Homogeneous product - each firm producing an identical product
c. Free entry and exit from the market - no barriers to entry or exit – gives existing
firms an advantage over potential competitors who are considering entering the
industry.
d. Perfect knowledge - firms and consumers must possess all relevant market
information regarding production and prices.
■ Firms in the market will be price-takers - so that there is only one market price.
– The product price will be the same in all locations.
■ The demand for the output for each producer is perfectly elastic
– no individual firm is in a position to influence the price.
– due to the existence of larger number of firms and homogeneous products
Perfect Competition Market

Graphical analysis of the equilibrium

■ Since the firm is a price-taker each firm faces a perfectly elastic (horizontal) demand
curve at the level of the prevailing market price.
– if the firm charges above the market price it will lose all its customers, who will then
buy elsewhere,
– there is no point in charging below the market price, because the firm can sell all it
wants, or can produce, at the existing price.
■ The level of the prevailing market price is determined by demand and supply in the
industry as a whole.
– The demand curve in this case represents both average revenue (AR) and marginal
revenue (MR), since both of these are equal to the market price.
■ AR = TR/Q = (Q.P)/Q AR = P
■ , Where Price is constant.
■ Thus, in a perfectly competitive market,. AR = MR = P =Demand curve
Perfect Competition Market

Short-run equilibrium
■ A firm will tend to produce more output as the
market price increases, and its supply curve will
be its marginal cost curve,
– In the short- run, firms’ positive or zero or
negative profit depends on the level of ATC at
equilibrium.
– Depending on the relationship between price
and ATC, the firm in the short-run may earn
economic profit, normal profit or incur loss
and decide to shut-down business.
I. Economic/positive profit - If the AC is below
the market price at equilibrium, the firm earns
a positive profit equal to the area between the
ATC curve and the price line up to the profit
maximizing output.
Perfect Competition Market

Short-run equilibrium
ii. Loss - If the AC is above the market price at
equilibrium, the firm earns a negative profit (incurs
a loss) equal to the area between the AC curve and
the price line.
■ If the market price is equal to average total cost (AC), the
firm will just make normal profit.
– This is the profit that a firm must make to remain in its
current business.
■ If P < ATC, then it should leave the industry in the long
run since the owners of the business can use the resources
more profitably elsewhere.
■ If P < AVC then the firm should shut down in the short
run since it cannot even cover its variable costs, let alone
make any contribution to fixed costs.
Perfect Competition Market

Short-run equilibrium
iii. Normal Profit (zero profit) or break-
even point - If the AC is equal to the market
price at equilibrium, the firm gets zero profit
or normal profit.
– This is the profit that a firm must make to
remain in its current business.
■ Since the perfectly competitive firm
always produces where P =MR=MC (as
long as P exceeds AVC),
■ the firm‘s short-run supply curve is given
by the rising portion of its MC curve
above its AVC, or shutdown point
 Perfect Competition Market
■ The market price, P1, is determined by the
demand and supply functions in the industry as
a whole.
■ The firms in the industry, as price-takers, then
have to determine what output they will supply
at that price. This output, q1, is where P1=MC,
since this will maximize profit.
 Perfect Competition Market
■ If the demand increases in the market then the new demand curve D1 intersects the supply curve at the
new equilibrium point ‘E1’ and the price increases to P1.
– At this situation P1= AR1= MR1 but the SMC curve intersects at q1
– if P > ATC, the firm is making abnormal or super normal profit.
■ This means that the industry is more profitable than average and this will in turn attract new firms into
the industry in the long run, since it is assumed that there are no entry or exit barriers.
Profit = TR – TC = 0q1AP1 - 0q1BC = P1ABC (the shaded portion)
■ But in the long run the firm will increase the production and will supply more of the commodity
– Ultimately both the demand and the supply get equalized and the short run abnormal profit becomes
normal. Therefore, even in the perfect market it is possible to earn profit in the short period.
■ It indicates clearly that in the short run, in any perfect market, the increase in demand will increase the
profit to the businessmen. The normal profit will be there until it gets equalized with the demand i.e.
new D1D1 with the increased supply of S1S1. This economic profit attracts new firms into the industry
and the entry of these new firms increases the industry supply. This increased supply pushes down the
price. As price falls, all firms in the industry adjust their output levels in order to remain in profit
maximizing equilibrium. New firms continue to enter the industry and price continues to fall, and
existing firms continue to adjust their outputs until all economic profits are eliminated. There is no
longer an incentive for the new firms to enter and the owners of all firms in the industry will earn only
Pricing Policy: - is The policy by which a company determines the wholesale and retail prices for its
products or services

■Pricing Policies And Strategies Formulating the

Pricing Policy:
• The following considerations involve in formulating the pricing policy (7):
■(i) Competitive Situation:
• Pricing policy is to be set in the light of competitive situation in the market. We have to know whether the firm
is facing perfect competition or imperfect competition. In perfect competition, the producers have no control
over the price. Pricing policy has special signifi•cance only under imperfect competition.
■(ii) Goal of Profit and Sales:
• The businessmen use the pricing device for the purpose of maxim•ising profits. They should also stimulate
profitable combination sales. In any case, the sales should bring more profit to the firm.
■(iii) Long Range Welfare of the Firm:
• Generally, businessmen are reluctant to charge a high price for the product because this might result in bringing
more producers into the industry. In real life, firms want to prevent the entry of rivals. Pricing should take care of
the long run welfare of the company.
 ■ Pricing Policies And Strategies
■Considerations Involved in Formulating the Pricing Policy….
■(iv) Flexibility:
• Pricing policies should be flexible enough to meet changes in economic conditions of various customer industries. If a firm is selling its
product in a highly competitive market, it will have little scope for pricing discretion. Prices should also be flexible to take care of cyclical
variations.
■(v) Government Policy:
• The government may prevent the firms in forming combinations to set a high price. Often the government prefers to control the prices
of essential commodities with a view to prevent the exploitation of the consumers. The entry of the government into the pricing process
tends to inject politics into price fixation.
■(vi) Overall Goals of Business:
• Pricing is not an end in itself but a means to an end. The fundamental guides to pricing, therefore, are the firms overall goals. The
broadest of them is survival. On a more specific level, objectives relate to rate of growth, market share, maintenance of control and
finally profit. The various objectives may not always be compatible. A pricing policy should never be established without consideration
as to its impact on the other policies and practices.
■vii) Price Sensitivity:
• The various factors which may generate insensitivity to price changes are variability in consumer behaviour, variation in the
effectiveness of marketing effort, nature of the prod•uct, importance of service after sales, etc. Businessmen often tend to exaggerate
the importance of price sensitivity and ignore many identifiable factors which tend to minimize it.
Objectives of Pricing strategies
Encourage The Exit Of Marginal Firms From The
Maximize Long-run Profit
Maximize Short-run Profit Industry
Increase Sales Volume (Quantity) Survival
Increase Monetary Sales Avoid Government Investigation Or Intervention
Increase Market Share
Obtain Or Maintain The Loyalty And Enthusiasm Of
Obtain A Target Rate Of Return On Investment (ROI)
Obtain A Target Rate Of Return On Sales Distributors And Other Sales Personnel
Stabilize Market Or Stabilize Market
Enhance The Image Of The Firm, Brand , Or Product
■Price:
An Objective To Stabilize Price Means That The Marketing Manager Be Perceived As “Fair” By Customers And Potential
Attempts To Keep Prices Stable In The Marketplace And To Compete On Customers
Non-price Considerations. Stabilization Of Margin Is Basically A Cost-plus Create Interest And Excitement About A Product
Approach In Which The Manager Attempts To Maintain The Same Margin  Discourage Competitors From Cutting Prices
Regardless Of Changes In Cost. Use Price To Make The Product “Visible"
Company Growth
Maintain Price Leadership Help Prepare For The Sale Of The Business (Harvesting)
Desensitize Customers To Price Social, Ethical, Or Ideological Objectives
Discourage New Entrants Into The Industry
Match Competitors Prices
• The pricing of the products involves
consideration of the following factors:

– (i) Cost Data.

– (ii) Demand Factor.

– (iii) Consumer
Psychology.
– (iv) Competition.

– (v) Profit.

– (vi) Government Policy.

■Five Factors To Consider When want to be the most expensive, luxurious, high-end brand in your
industry, the cheapest, beat it by 10% brand or somewhere in the
Pricing Products Or Services middle? Once you have decided, you will start to get an idea of your
ideal pricing.
1. Costs
• First and foremost you need to be financially informed. Before
4. Competitors
you set your pricing, work out the costs involved with running • This is one of the key times you can give yourself permission to do a
your business. These include your fixed costs (the expenses that little competitor snooping. What are they charging for different
will come in every month regardless of sales) and your direct products and services? What inclusions and level of service are they
costs (the expenses you incur by producing and delivering your offering for those prices? What customers are they attracting with
products and services). their pricing? And how are they positioned in the marketplace? The
answers to these questions will give you an industry benchmark for
your pricing.
2. Customers
• Know what your customers want from your products and services.
Are they driven by the cheapest price or by the value they receive?
5. Profit
What part does price play in their purchase decision? • One of the most important questions business owners neglect to ask
themselves is, “How much profit do I want to make?” They tend to
• Also look at what you are selling, are your current customers buying look at what others charge and then pull a figure out of the air to be
high-end or low-end products and services? This information will help competitive without giving consideration to how much profit the
you determine if your price is right, what level of service or inclusions want and need.
you should be offering and lastly if you are targeting the right
market. It may be that you need to change your market to make your
business more profitable.

3. Positioning
• Once you understand your customer, you need to look at your
positioning. Where do you want to be in the marketplace? Do you
•Pricing Strategy - refers to method companies
use to price their products or services.
• Almost all companies, large or small, base the price of
their products and services on production, labor and
advertising expenses and then add on a certain
percentage so they can make a profit.
■ Types of Pricing Strategies
■There are several different pricing strategies, such as
1)Penetration Pricing,
2)Price Skimming,
3)Discount Pricing,
4)Product Life Cycle Pricing
5)Competitive Pricing
PRICING STRATEGIES- SOMETIMES CAN BE
Monopoly Market structure
■ Where only one firm sells the goods and many buyers buy.
– Monopoly is the extreme opposite of perfect competition on the market structure.
■ a firm that has the power to earn supernormal profit in the long run.
– this ability depends on the conditions of lack of substitutes for the product and
barriers to entry or exit.
1. Lack of substitutes for the product – any existing products are not very close in
terms of their perceived functions and characteristics.
2. Barriers to entry or exit - important in the long run in order to prevent firms
entering the industry and competing away the supernormal profit.
 there are factors that allow incumbent firms to earn supernormal profits in the long
run by making it unprofitable for new firms to enter the industry.
 Thus, there exist structural and strategic barriers.
 Monopoly Market structure
A. Structural barriers - the structural barriers are natural barriers, occur because of factors
outside the firm’s control,
i. Control of essential resources - due to the concentration of resources in certain geographic
areas. E.g oil, gas and diamonds and the expertise of owners.
ii. Economies of scale and scope - new firms to compete in terms of cost they will have to enter
on a large scale. E.g. public utilities, like gas, water and electricity supply - such industries are
sometimes referred to as natural monopolies.
iii. Marketing advantages – this is due to brand awareness and image of industries with consumers
being unwilling to buy unknown brands.
iv. Financial barriers - New firms without a track record find it more difficult and more costly to
raise money - greater risk they impose on the lender.
v. Information costs - market research needs to be carried out to investigate the potential
profitability of such entry - imposes a cost.
vi. Government regulations - Patent laws in pharmaceutical industry - where it takes a long time to
get approval. Licensing system - public utilities and postal services in many countries operate
as legally protected monopolies
Monopoly Market structure
■ Some of the structural barriers also serve as barriers to exit, which are in the form of
sunk costs - advertising costs, market research costs, loss on the resale of assets,
redundancy payments that have to be paid to workers, and so on. The existence of
such costs increases the risk of entering a new industry.
B. Strategic barriers
■ Strategic barriers occur when an incumbent firm deliberately deters entry, using
various restrictive practices, some of which may be illegal
i. Limit pricing - an incumbent firm tries to discourage entry by charging a low price
before any new firm enters. - only works if the potential entrant does not know the
cost structure of the incumbent.
ii. Predatory pricing - tries to encourage exit or drive firms out of the industry by
charging a low price after any new firms enter - only work if the new entrant does
not know the cost structure of the incumbent. – in some countries predatory pricing
is prohibited by law.
Monopoly Market structure
iii. Excess capacity - serve as a credible threat to potential entrants –
 it is easy for incumbents to expand output with little extra cost, thus forcing down the
market price and post-entry profits
 if these profits are less than the sunk costs of entry, the entrant will be deterred from
entering the market.
 This would apply even if the potential entrant had full knowledge of the incumbent’s cost
structure.
iv. Heavy advertising - This forces the potential entrant to respond by itself spending more on
advertising, which has the effect of increasing its fixed costs, thus increasing the minimum
efficient scale in the industry.
 It also adds to the marketing advantages of the incumbent.
 These practices will not be possible if the market is contestable.
 i.e if there are an unlimited number of potential firms that can produce a homogeneous
product, consumers respond quickly to price changes, incumbent firms cannot respond
quickly to entry by reducing price, and entry into the market does not involve any sunk
costs. Example - a firm could enter on a hit-and-run basis, by undercutting the incumbent, and
exiting quickly if the incumbent reacts
Monopoly Market structure
iii. Excess capacity - serve as a credible threat to potential entrants –
 it is easy for incumbents to expand output with little extra cost, thus forcing down the
market price and post-entry profits
 if these profits are less than the sunk costs of entry, the entrant will be deterred from
entering the market.
 This would apply even if the potential entrant had full knowledge of the incumbent’s cost
structure.
iv. Heavy advertising - This forces the potential entrant to respond by itself spending more on
advertising, which has the effect of increasing its fixed costs, thus increasing the minimum
efficient scale in the industry.
 It also adds to the marketing advantages of the incumbent.
 These practices will not be possible if the market is contestable.
 i.e if there are an unlimited number of potential firms that can produce a homogeneous
product, consumers respond quickly to price changes, incumbent firms cannot respond
quickly to entry by reducing price, and entry into the market does not involve any sunk
costs. Example - a firm could enter on a hit-and-run basis, by undercutting the incumbent, and
exiting quickly if the incumbent reacts
Monopoly Market

Graphical analysis of the equilibrium

■ For monopolist there are two options for maximizing the profit
– i.e. maximize the output and limit the price or limit the production of the goods and
services and fix a higher price (market driven price).
■ the demand curve of the firm is identical to the market demand curve of that product.
– the MR is always less than the price of the commodity.
■ the firm and the industry are one and the same thing - only one graph needs to be
drawn.
■ a short-run equilibrium situation is the same in the long run since barriers to entry will
prevent new firms from entering.
– The only difference is that the relevant cost curves would be long-run, as opposed to
short-run, cost curves.
– A monopoly firm is a price-maker.
Monopoly Market

■ the demand curve is less than perfectly elastic, i.e downward sloping.
– This is because in order to sell more of the product the firm must reduce its price not
just on the additional products sold but also on all the other units.
■ This means that marginal revenue will always be less than average revenue.
– There is a specific relationship between AR and MR,
– i.e. the slope of MR is twice that of AR.
– That is, given the linear demand function, marginal revenue curve is twice as steep as
the average revenue curve.

P=a-bQ; TR=Q (a-bQ); ; So MR=dTR/dQ=a-2bQ

■ Note that the slope of the demand curve or the price function equals b, whereas the
slope of MR function equals 2b.
Monopoly Market

Profit Maximization equilibrium in

Monopoly
■ The profit-maximizing output is given by OQ,
where MC = MR and MC is rising.
– Based on the equilibrium point, the output is the
optimum level of production i.e., OQ quantity. The
price of the commodity is determined as OP.
– The total revenue of selling OQ quantity gives
OPBQ amount of total revenue (OQ quantity x OP
price).
– The firm has spent AC as an average cost to
produce OQ quantity and the total cost of
production is OAQC (OQ quantity x AC cost per
unit).
– Thus, the monopolist firm is given as:
Profit = TR – TC = OPBQ – OACQ
= PABC (the shaded portion
Monopoly Market

Profit Maximization equilibrium in Monopoly

■ In the short run, the monopoly firm will earn profit
continuously even with various returns.
– However, a monopoly firm may not avoid a loss as long
as the AC curve lies above the demand curve. In this case
there is no output where the monopoly can cover its costs
unless such a firm is state-subsidized.
– It will not stay in business in the long run with loss, given
by (A – P )Q i.e. the shaded area of APGF
■ In the long run, a monopoly firm is protected from
external competition by the barriers to entry.
– The firm is free to choose between the alternatives
whether to close down in case of losses or to continue in
the business.
– a monopolist firm may produce at under capacity, over
capacity or full capacity.
– Utilization of capacity is defined with reference to the
optimum capacity of the plant size of the firm.
 Monopoly Market

Algebraic analysis of equilibrium

Example
Suppose that the demand and the total cost functions of a monopolist are and respectively. Find the
optimum quantity, price and profit on these levels.
Solution
Given: Demand function - and Cost function
Required: Profit maximization output (Q), Price (P) and Profit (ℼ) levels?

can be written as and Now TR = PQ;

and
The Profit maximization condition is when MR=MC
Thus,
=; ;;
ℼ = TR – TC
= = 36
= = 20
ℼ = TR – TC = 36 – 20 = 16
Exercise
1. Suppose that the demand and the total cost functions of a monopolist are
P=30 - 5Q and ATC=20/Q+4Q - 6 respectively. Find
a. the optimum quantity,
b. price and
c. profit levels of the monopolist
Pricing and price elasticity of demand under monopoly
■ There are some important relationships between profit-maximizing price
and price elasticity of demand (PED).
■ These relationships do not just relate to monopolists but to any firm that
has some element of control over price, or in other words faces a
downward-sloping demand curve.
– The simplest of these relationships involves profit margin and mark-up.
1. Profit margin
– is the difference between the price and the marginal cost, expressed as a
percentage of the price.
Pricing and price elasticity of demand under monopoly
The optimal margin will be - by setting MC equals to MR
We can obtain optimal profit margin

 Hence, products with more elastic demand should have a lower profit
margin.
Pricing and price elasticity of demand under monopoly
2. Mark-up
■ Mark-up refers to as the difference
between the price and the marginal cost,
expressed as a percentage of the marginal
cost.

it can be written as;

It can be written as
Hence,
;
;
Pricing and price elasticity of demand under monopoly

■ products with more elastic demand should have a lower mark-up.

– if PED is (-10), mark-up (MU) will be 11 percent, if PED is (-3), mark-up (MU) will
be 50 percent, and if PED is (-1), mark-up (MU) will be ∞.
– It does not follow that firms or industries with higher margins and mark-ups are
more profitable.
■ A high mark-up does not necessarily indicate high profit, because it does not take
into account the level of fixed costs.
■ In some industries, fixed costs and mark-ups are very high.
– For example, in the airline industry capital costs are very high and in the
pharmaceutical industry huge amounts are spent on R&D.
Pricing and price elasticity of demand under monopoly
■ There arise two common misconceptions regarding monopoly firms.
■ Monopolists always make large profits.
– However, monopolist firms do not always make large profits.
– In Ethiopia and other countries, you may have observed the performance of
monopolist State Owned Enterprises (SOE) making considerable losses.
– Loss is unavoidable for monopolists if their AC curve lies above the demand curve.
Unless such a firm is state-subsidized it will not stay in business in the long run
■ Monopolies have inelastic demand.
– monopolies having inelastic demand can be seen as false as a firm will always
maximize profit by charging a price where demand is elastic.
Comparison between Perfect and Monopoly Market
■ both forms of market structure in the long
run on the same graph.
■ It is assumed that long-run marginal costs
are constant, indicating constant returns to
scale,
a. Price –monopoly price (Pm) higher than Pc
b. Output –monopoly output (Qm) is lower
than Qc
c. Profit - there is a supernormal profit in
monopoly (BCED) Whereas, the perfect
competition earning only a normal profit.
d. Efficiency –productive and allocative
efficiency.
 Comparison between Perfect and Monopoly Market
■ Productive efficiency –
–both the monopolist and a perfectly competitive firm are achieving productive efficiency,
since they both have a constant level of LAC.
–if the monopolist has a rising LMC, it will not be producing at the minimum point of its LAC
curve, but at a lower level.
–It will therefore not be achieving productive efficiency.
–monopolist will be producing at a small scale, less than its optimal capacity
■Allocative efficiency –
–the optimal allocation of resources in the economy as a whole.
–Using concepts of consumer surplus and producer surplus.
–Consumer surplus - the total amount of money that consumers are prepared to pay for a
certain output above the amount that they have to pay for this output.
–It is given by the area between the demand curve and the price line.
–In perfect competition the consumer surplus is given by the area of triangle AFD
 Comparison between Perfect and Monopoly Market
■Producer surplus - the total amount of money that producers receive for selling a certain output over and
above the amount that they need to receive to stay in the long run for all factors of production.
–given by the area between the marginal cost curve and the price line.
–Where MC is constant, producer surplus is equal to supernormal profit BCED
■the total economic welfare of a change from perfect competition to monopoly -
–In perfect competition, total welfare is maximized because output is such that price equals marginal cost.
–total welfare cannot be increased by any reallocation of resources; any gain for producers will be more
than offset by a greater loss for consumers.
–In monopoly, output is such that price exceeds marginal cost;
–consumers would value any additional output more than it would cost the monopolist to produce it.
■the size of the consumer surplus will be reduced from AFD to ACB –
–an overall loss of welfare, a deadweight loss, of CFE.
■Therefore, in terms of allocative efficiency, the monopoly causes loss of social welfare and distortions in
resource allocation. It takes away part of the consumer surplus by charging higher price than the perfectly
competitive firm.
Comparison between Perfect and Monopoly Market

■ Generally, monopoly is considered as an unfavourable.

– However, in industries like public utilities a monopoly may be able to produce more
output more cheaply than firms in perfect competition, since firms can avoid the
wasteful duplication of infrastructure like pipelines, railway tracks and cable lines.
– R&D and innovation, are much more important than efficiency as far as long-run
growth in productivity and living standards is concerned.
– it is not possible to estimate the incentive effects that monopoly may have on R&D
and innovation.
 Example 2
A monopolist's demand function is P = 1624 - 4Q, and its total cost function is
TC = 22,000 + 24Q -4Q2 + 1/3 Q3, where Q is output produced and sold.
i. At what level of output and sales (Q) and price (P) will total profits be maximized?
ii. At what level of output and sales (Q) and price (P) will total revenue be maximized?
iii. At what price (P) should the monopolist shut down?
Answer:
i. Total Profits are maximized where MR = MC, and MR = dTR/dQ, with TR = P(Q), and
MC = dTC/dQ. TR = 1624Q -4Q2, so MR = 1624 - 8Q. MC = 24 - 8Q + Q2.
MR = MC is 1624 - 8Q = 24 - 8Q + Q2, or 1600 = Q2, and Q = 40. With Q = 40, P = 1464.
ii. Total Revenue is maximized when MR = 0, or 1624 - 8Q = 0, or Q = 203 with P = 203.
iii. Shut down would occur whenever price(P) is less than average variable cost (AVC), or below P = AVC,
or 1624 - 4Q = 24 - 4Q + 1/3 Q2, or 1600 =1/3 Q2, or Q2 = 4800, or Q = 69 (approximately). When Q =
69, P = 1348, so any price below 1348 would cause the firm to shut down since it is not covering its
variable costs.
Monopolistic Competition Market structure
■ There are five main conditions for monopolistic competition to exist:
i. There are many buyers and sellers in the industry –
ii. Each firm produces a slightly differentiated product - product differentiation.
 closer substitutes than the product of a monopolist, making demand more elastic.
 implies that firms are not price-takers; rather they have some control over market price.
 any manufacturer has monopoly power over its product,
iii. Minimal barriers to entry or exit - the low barriers to entry mean that any
supernormal profit is competed away in the long run.
iv. All firms have identical cost and demand functions.
v. Firms do not take into account competitors’ behaviour in determining price and
output
Monopolistic Competition Market structure
Graphical analysis of equilibrium for Monopolistic competition
■ Short run equilibrium is very similar to that of the monopolist.
– Profit is again maximized by producing the output where MC = MR.
– Supernormal profit can be made, depending on the position of the AC curve,
– the demand curve is flatter than the demand curve for the monopoly because of the greater
availability of substitutes
– the cost conditions, MC and AC are the same as firms under perfect competition.
■ The difference between perfect and monopolistic competition lies in the perceived
DD curve.
– A firm perceives its demand curve to be less than perfectly elastic (not horizontal).
– The reason is that the output of one firm is close but not perfect substitute for the output of
other firms that produce differentiated products.
– This implies that the firm perceives it must reduce price to get more consumers.
Monopolistic Competition Market structure
Graphical analysis of equilibrium
 Accordingly, the optimal-profit
maximization output and price levels.
– the MR (derived from the perceived
demand curve) = MC curve
– at which MC crosses MR from below
and
– the respective price level at the
equilibrium output on the perceived
demand curve of the firm.
– A firm will obtain excess profit if P >
ATC and loss if P < ATC.
Monopolistic Competition Market structure
Graphical analysis of equilibrium
 In the long run, attracted by the
supernormal profit
 new firms will enter the industry - entry is
relatively easy than monopoly,
 This will have the effect of shifting the demand
curve downwards for existing firms.
 The downward shift will continue until the
perceived demand curve becomes tangential to
the LAC curve at which point all supernormal
profit will have been competed away
 the demand curve D must be tangent at the
falling part of LAC (not at the minimum of
LAC) and hence no excess profit is obtained as
P=LAC.
Monopolistic Competition Market structure
Exercise - Assume a firm engaging in selling its product and promotional activities in
monopolistic competition face short run demand and cost functions as Q = 20-0.5P and
TC= 4Q2-8Q+15, respectively. Having this information

A. Determine the optimal level of output and price in the short run.

B. Calculate the economic profit (loss) the firm will obtain (incur).

C. Show the economic profit (loss) of the firm in a graphic representation.

 Exercise
Solution

Given: Q =20-0.5P and TC= 4Q2- =

8Q+15 = 48

Required: A. Optimal level of Q and

Price;

B. Profit/Loss; and

C. Show in a graph
Optimal level of Q and Price;

You May also use to calculate profit,

) which is 128
Comparison between Monopolistic competition and Perfect competition
Market

■ Price – price in monopolistic competition tends to be higher than the perfect

competition, being above the minimum level of average cost, in both the short run
and the long run (similar to monopoly).
■ Output - tends to be lower than in perfect competition, since firms are using a less
than optimal scale, at less than optimal capacity (similar to monopoly).
■ Productive efficiency - is lower than in perfect competition.
■ Allocative efficiency - there is still a net welfare loss, because P>MC
Oligopoly Market
■ Few firms dominate the industry
■ product may be standardized (steel, chemicals and paper) or differentiated (cars, electronics
products)
■ firms are interdependent - strategic decisions made by one firm affect other firms, who react to
them in ways that affect the original firm.
– firms have to consider these reactions in determining their own strategies.
■ there is a considerable amount of heterogeneity within such markets.
– Some feature one dominant firm (Intel in computer chips);
– two dominant firms, like Coca-Cola and Pepsi in soft drinks;
– some feature half a dozen or so major firms, like airlines, mobile phones or athletic footwear;
– others feature a dozen or more firms with no really dominant firm, like car manufacturers,
petroleum retailers, and investment banks.
Oligopoly Market
■ The main conditions for oligopoly to exist are therefore as follows:
i. Relatively small numbers of firms account for the majority of the market - the degree of
market concentration in an industry
 the Herfindahl index - computed by taking the sum of the squares of the market shares of
all the firms in the industry.
 S = the proportion of the total market sales accounted for by each firm in the industry.
A value of this index above 0.2 normally indicates that the market structure is
oligopolistic.
 Example, if two firms account for the whole market on a 50:50 basis, the Herfindahl
index (H) would be = 0.5.
ii. There are significant barriers to entry and exit –
iii. There is interdependence in decision-making – requires understanding concepts of
decision theory known as game theory.
Oligopoly Market
■ Duopoly is a special case of oligopoly in which there are only two firms in the industry.
■ If one firm reduces its price it will attract consumers and increases its sells, leading to a
substantial loss of sales by other firms in the industry.
– The outcome of his/her decision depends on the reaction of other firms.
– The outcomes (consequences) of price changes by the firm under consideration are
uncertain.
■ Firm under oligopoly market may spend a lot of time
– to guess each other’s action or reaction;
– be bitter rivals of each other;
– competing by price changes (price war),
– tacitly agree to compete by advertising but not by price changes or form a collusion or
cooperation (some kind of agreement) rather than competing.
Oligopoly Market
■ Therefore, there are many solutions to oligopoly problem.

– Collusive oligopoly and Non collusive oligopoly.

■ One way of avoiding the uncertainty that may arise from interdependence of firms in oligopoly
market is to enter in to collusive agreement (that is to adopt more strategic cooperation).
– The collusive oligopoly can be Cartels (i.e cartel aiming at joint profit maximization and Cartel
aiming at sharing the market) and Price leadership.
■ Firms do not necessarily enter in to collusive agreement.
– There are a number of non-collusive oligopoly models that give us stable solution to the
oligopoly problem.
– Example; the Cournot’s model, the Kinked demand (Sweezy’s) model, the Stackelberg’s model,
the Bertrand’s model, the Chamberlain’s model.
 Oligopoly Market - Cartel Arrangements

■ All firms in an oligopoly market benefit if they get together and set prices to
maximize industry profits.
– Cartel - a group of competitors operating under such a formal overt agreement
– Collusion - if an informal covert agreement is reached, the firms are said to be operating in.
– Both practices are illegal in most countries.

■ A cartel that has absolute control over all firms in an industry can operate as a
monopoly.
Oligopoly Market - Cartel Arrangements

■ Profits are often divided among firms on the basis of their individual level of
production,
– other allocation techniques can be employed - Market share, production capacity,
and a bargained solution based on economic power
■ For a number of reasons, cartels are typically rather short-lived - subject to
disagreements among members.
 Oligopoly Market - Cartel arrangements

■ Two forms of cartel - Profit maximization cartel and market sharing cartel.
i. Cartel aiming at joint profit maximization: to set prices and outputs together so as to
maximize total industry (joint) profit not profit of individual firms.
a) The total quantity and the price level so as to attain maximum joint profit
b) The allocation of production among the members of the cartel and
c) The distribution of the maximized joint profits among the participating members.
 Oligopoly Market - Cartel arrangements

■ The central agency has access to the cost figures of individual members
– it calculates the market demand and the corresponding MR.
– the cartel (monopoly) solution output and price levels that maximizes joint industry profit is
determined by allocating the production among firm A and B by equating the MR to
individual firm’s MC.
– MR = MCA and MR = MCB; MCA = MCB.
– So the two MCs will be equal in equilibrium.
 Oligopoly Market - Cartel arrangements

ii. Cartel aiming at sharing the market - the most common type of cartel.
■ through Non price competition and the determination of quotas.
Non-price competition (price matching and competition)
– cartel members agree on a common price informally not by bargaining
– This implies that firms agree not to sell below the cartel price; but they can vary
the style of their products and their selling activities.
– Example - doctors charging the same price, barbers charging the same price,
gasoline stations charge the same price etc.
– These prices are not the result of perfect competition in the market.
– Rather, they result from tacit agreement upon price.
 Oligopoly Market - Price Leadership
Price Leadership
■ An effective means for reducing oligopolistic uncertainty is through an informal
method, price leadership.
– Price leadership results when one firm establishes itself as the industry leader and
other firms follow its pricing policy.
– A typical case is price leadership by a dominant firm, usually the largest firm in
the industry.
– The leader faces a price/output problem similar to monopoly; other firms are price
takers and face a competitive price/output problem.
 Oligopoly Market - Price Leadership
■ the total market demand curve is DT,
the marginal cost curve of the leader is
MCL, and the horizontal summation of
the marginal cost curves for all of the
price followers is labelled as MCf.
■ Because price followers take prices as
given, they choose to operate at the
output level at which their individual
marginal costs equal price, just as they
would in a perfectly competitive
market.
 Oligopoly Market - Price Leadership
Barometric price leadership
■ one firm announces a price change in response to what it perceives as a change in
industry supply and demand conditions.
– the price leader is not necessarily the largest or the dominant firm in the industry.
– The price-leader role might even pass from one firm to another over time.
■ To be effective, the price leader must only be accurate in reading the prevailing
industry view of the need for price adjustment.
– If the price leader makes a mistake, other firms may not follow its price move, and the price
leader may have to withdraw or modify the announced price change to retain its leadership
position.
 Oligopoly Market - The kinked demand curve model
■ originally developed by Sweezy and has been commonly used to explain price
rigidities in oligopolistic markets.
■ Price rigidity or sticky prices refers to a situation where firms tend to maintain their
prices at the same level in spite of changes in demand or cost conditions.
– Once a general price level has been established, whether through cartel agreement or some
less formal arrangement, it tends to remain fixed for an extended period.
■ The model assumes that if an oligopolistic cuts its prices, competitors will quickly
react to this by cutting their own prices in order to prevent losing market share.
– If one firm raises its price, it is assumed that competitors do not match the price rise, in order
to gain market share at the expense of the first firm - the demand curve facing a firm would
be much more elastic for price increases than for price reductions.
– A kinked demand curve is a firm demand curve that has different slopes for price
increases as compared with price decreases.
 Oligopoly Market - The kinked demand curve model
– Suppose - the manager is at point B charging P0 price
– If the manager believes rivals will match price reductions
but will not match price increases, the demand for the
firm’s product look like kinked.

– Thus, if the manager believes rivals will match price

reductions but will not match price increases, the demand
curve for the firm’s product is given by ABD1, a kinked
demand curve
 Oligopoly Market - The kinked demand curve model
■ The firm is producing Q units of output and selling
them at a price of P per unit.
■ Mc=MR applies
■ the firm’s marginal cost curve can fluctuate between MC1
and MC2 without causing any change in the profit-
maximizing price/output combination.
 Price Discrimination
■ Price discrimination exists when the same product is sold at different price to
different buyers under different conditions.
■ It occurs when prices differ even though costs are same.
■ Consumers are discriminated in respect of price on the basis of their income
(purchasing power), geographical location, purchase quantity, association with sellers,
frequency of visit to the shop, etc.
■ The objectives of price discrimination can be to dispose the surpluses, to develop new
market, to maximize use of unutilized capacity, to earn monopoly profit, to retain
export market, and to increase the sales etc.
■ We can classify price discrimination as first degree, second degree and third degree.
 Price Discrimination
■ First degree price discrimination –
– the firm charges a different price for each unit sold to the consumer, depending on
what the consumer is willing to pay,
– it is discriminating pricing that attempts to take away the entire consumers surplus.
■ Second degree price discrimination –
– is charging different prices for different quantity purchase.
– feasible where the number of consumers is large like telephone service, demand
curves of all the consumers are identical, and a single rate is applicable for a large
no of buyers.
 Price Discrimination
■ Third degree price discrimination –
– it is selling the same product with different price in different markets having demand
curves with different elasticity.
– Profit in each market would be maximum only when his MR = MC in each market.
– a monopolist divides his output between the markets so in all markets MR= MC.