COMPETITIONS TYPES,ITS FEATURE AND PRICE DITERMINATION
Perfect competition
As is evident from the above table, perfect competition is said to prevail where there is a large number of producers (firms) producing a homogeneous product. The maximum output which an individual firm can produce is relatively very small to the total demand of the industry product so that a firm cannot affect the price by varying its supply of output. With many firms and homogeneous product under perfect competition, no individual firm is in a position to influence the price of the product and therefore the demand curve facing it will be a horizontal straight line at this level of the prevailing price of the product in the market, that is price elasticity of demand for a single firm will be infinite.
Features of perfect competition
The model of perfect competition is based on the following features:
1. Large numbers of sellers and buyers: The industry in perfect competition includes a large number of firms (and buyers). The buyers are also numerous so that no monopolistic power can affect the working of the market. Under these conditions each firm alone cannot affect the price in the market by changing its output.
2. Product homogeneity: The technical characteristics of the product as well as the services associated with its sale and delivery are identical. There is no way in which a buyer could differentiate among the products of different firms.
3. Free entry and exit of firms: There is no barrier to entry or exit from the industry. Entry or exit may take time but firms have freedom of movement in and out of the industry.
4. Profit maximisation: The goal of all firms is profit maximisation. No other goals are pursued.
5. No government regulation: There is no government intervention in the market (tariffs, subsidies, rationing of production or demand and so on are ruled out).
6. Perfect mobility of factors of production: The factors of production are free to move from one firm to another throughout the economy. It is also assumed that workers can move between different jobs. Finally, raw materials and other factors are not monopolised and labour is not organised.
7. Perfect knowledge: It is assumed that all the sellers and buyers have complete knowledge of the conditions of the market. This knowledge refers not only to the prevailing conditions in the current period but in all future periods as well. Information is free and cost less.
11.2.2 Imperfect competition
Imperfect competition is an important market category where individual firms exercise control over the price to a smaller or larger degree depending upon the degree of imperfection present in a case.
The existence of imperfect competition can be caused either by the fewness of the firms or by product differentiation. Therefore, imperfect competition has several subcategories.
The first important subcategory of imperfect competition is monopolistic competition.
In monopolistic competition, a large number of firms produce somewhat different products which are close substitutes of each other. For example, private clinics run by individual or group of doctors, nursing homes and the health insurance market represent this type of market.
Features of monopolistic competition
Features of monopolistic competition are:
1. The products of the competing firms are close but not perfect substitutes because buyers do not regard them as identical. This situation arises when the same commodity is being sold under different brand names, each brand being slightly different from the others. For example, Dettol and Savlon are brands of antiseptic soaps and lotions; Soframycin and Betadine are ointments for wounds and burns.
2. Each firm is, therefore, the sole producer of a particular brand or "product". It is a monopolist as far as that particular brand is concerned. However, since the various brands are close substitutes, a large number of "monopoly" producers of these brands are involved in keen competition with one another.
3. The differentiation among competing products or brands may be based on real or imaginary differences in quality. Real differences among brands refer to palpable differences in quality such as shape, flavour, colour, packing, after sales service, warranty period, etc.
4. In addition to product differentiation, the other three basic characteristics of monopolistic competition are:
(a) There are a large number of independent sellers (and buyers) in the market.
(b) The relative (proportionate) market shares of all sellers are insignificant and more or less equal. That is, seller concentration in the market is almost non existent.
(c) There are neither any legal nor any economic barriers against the entry of new firms into the market. New firms are free to enter the market and existing firms are free to leave the market.
(d) In other words, product differentiation is the only characteristic that distinguishes monopolistic competition from perfect competition.
5. The second subcategory is oligopoly without product differentiation which is also known as pure oligopoly. Under this, there is competition among the few firms producing homogeneous or identical products. The fewness of the firms ensures that each of them will have some control over the price of the product and the demand curve facing each firm will be downward sloping which indicates that the price elasticity of demand for each firm will not be infinite. For example, pharmaceutical firms producing similar medicines represent this type of market.
Features of oligopoly
The characteristics of oligopoly are briefly explained below:
1. Under oligopoly the number of competing firms being small, each firm controls an important proportion of the total (industry) supply. Consequently, the effect of a change in the price or output of one firm upon the sales of its rival firms is noticeable and not insignificant. When any firm takes an action its rivals will in all probability react to it (i.e. retaliate). The behaviour of oligopolistic firms is interdependent and not independent or atomistic as is the case under perfect or monopolistic competition.
2. The demand curve of an individual firm under oligopoly is not known and is indeterminate because it depends upon the reaction of its rivals which is uncertain. Each theory of oligopoly therefore makes a specific assumption about how rivals will (or will not) react to an individual firm’s action.
3. In view of the uncertainty about the reaction of rivals and interdependence of behaviour, oligopolistic firms find it advantageous to coordinate their behaviour through explicit agreement (cartel) or implicit, hidden, understanding (collusion). Also because the number of firms is small, it is feasible for oligopolists to establish a cartel or collusive arrangement. However, it is difficult as well as expensive to monitor and enforce an agreement or understanding. Very few cartels last long, particularly when oligopolistic firms significantly differ in their cost conditions.
4. Under oligopoly, new entry is difficult. It is neither free nor barred. Hence the condition of entry becomes an important factor determining the price or output decisions of oligopolistic firms, and preventing or limiting entry an important objective.
5. Given the indeterminacy of the individual firm’s demand and, therefore, the marginal revenue curve, oligopolistic firms may not aim at maximization of profits. Modern theories of oligopoly take into account the following alternative objectives of the firm:
(a) Sales maximization with profit constraint.
(b) Target or "fair" rate of profit and long-run stability.
(c) Maximization of the managerial utility function.
(d) Limiting (preventing) new entry.
(e) Achieving "satisfactory" profits, sales, etc. That is, the firm is a "satisficer" and not "maximizer".
(f) Maximization of joint (industry) profits rather than individual (firm) profits.
6. The third subcategory is called differentiated oligopoly. It is characterised by competition among the few firms producing differentiated products which are close substitutes of each other. The demand curve under this kind of oligopoly is downward sloping and so firms would have control over the price of their individual products. For example, large private hospitals like Apollo, Fortis, Max etc. that provide specialised services represent this type of market.
11.2.3 Monopoly
Monopoly means the existence of a single producer or seller which is producing or selling a product which has no close substitutes. As such it is an extreme form of imperfect competition. Since a monopoly firm wields sole control over the supply of the product which can have only remote substitutes, the expansion and contraction in its output will affect the price of the product. Therefore, the demand curve facing a monopolist is downward sloping and has a steep slope. In many cases, monopolies have arisen because the government has given a firm the exclusive right to sell a particular good or service. For example, when a pharmaceutical company discovers a new drug, it can apply to the government for a patent. If the patent is granted, the firm has the exclusive right to produce and sell the drug for a set number of years. In the case of the pharmaceutical company, the firm is able to charge higher prices for its patented product and, in turn, earn higher profits.
Features of monopoly
Some important features of monopoly are:
1. A monopolist will always produce at a point where demand is elastic.
2. It is impossible to derive a supply curve for a monopolist.
3. A lump sum tax on the profits of a monopolist will leave price and output unchanged.
4. Monopolists arrive at the same conclusion about their production using MC and MR as they do using TC and TR.
5. Monopoly profits are not inequitable.
11.3 Price Determination in Various Types of Market
11.3.1 Price determination under perfect competition
The industry, and not the individual firm, in interaction with demand forces, determines price. The individual firm takes this price as given, and is free to sell any amount without fear or fall in price. This can be shown graphically as shown in Figure 11.1.
The demand curve is based on the inverse relation between price and demand. The supply curve is based on the positive relation between price and supply. Price is determined at E where demand equals supply. The price is OP.
The firm adopts the price and is free to sell any quantity at this price. It makes the demand curve for the firm’s product (curve d=AR) perfectly elastic.
11.3.2 Price determination in monopoly
Short run case
In the short run the monopolist maximises his short run profits or minimises his short run losses if the following two conditions are satisfied
1. MC = MR and
2. The slope of MC is greater than the slope of MR at the point of their intersection (i.e., MC cuts the MR curve from below).
In the short run a monopolist has to work with a given existing plant. He can expand or contract output by varying the amount of variable factors but working with a given existing plant. Maximisation of profits in the short run requires the fixation of output at a level at which marginal cost with a given existing plant is equal to marginal revenue. In Figure 11.2 (a), SAC and SMC are short run average and marginal cost curves. Monopolist is in equilibrium at E where marginal revenue is equal to marginal cost. Price set by him is SQ or OP. He is making profits equal to TRQP.
But in the short run he will continue working so long as price is above the average variable cost. If the price falls below average variable cost the monopolist would shut down even in the short run. In case of losses, monopoly equilibrium is shown in Figure 11.2 (b). The monopolist is in equilibrium at OS level of output with price OP. Since price (or AR) is smaller than average cost, he is making losses which are equal to area of the rectangle PQGH.
Figure 11.2 (b)
Long run case
In the long run, the monopolist has the time to expand his plant or to intensively use his existing plant which will maximise his profits. Since there will be no new entry, it is not necessary for the monopolist to reach an optimal scale. It means that monopolist will not stay in business if he makes losses in the long run.
The size of his plant and the degree of utilisation of any given plant size depend entirely on market demand. He may reach the minimum point of LAC or remain at falling part of his LAC and expand beyond the minimum LAC depending on the market conditions.
In Figure 11.3 (a), we depict the case in which the market size does not permit the monopolist to expand to the minimum point of LAC. This is because to the left of the minimum point of the LAC the SRAC is tangent to the LAC at its falling part and also because the short run MC must be equal to the LRMC. This occurs at E, while the minimum LAC is at b and the optimal use of the existing plant is at a: since it is utilised at the level E, there is excess capacity.
Figure 11.3 (a)
In Figure 11.3 (b), we depict the case where the size of the market is so large that the monopolist, in order to maximise his output, must build a plant larger than the optimal and over utilise it. This is because to the right of the minimum point of the LAC the SRAC and the LAC are tangent at a point of their positive slope and also because the SRMC must be equal to the LAC. Thus, the plant that maximises the monopolist’s profits leads to higher costs for two reasons: firstly, because it is larger than the optimal size and secondly because, it is over utilised.
Figure 11.3 (b)
Finally, in Figure 11.3 (c), we show the case in which the market size is just large enough to permit the monopolist to build the optimal plant and use it at full capacity.
Figure 11.3 (c)
11.3.3 Price determination in monopolistic competition
When firms are competing only through price changes, there are three cases of long run equilibrium of a typical firm under monopolistic competition.
Case 1: When competition takes place only through the entry of new firms.
Case 2: When competition takes place only through price variation (price-cutting).
Case 3: When competition arises through price variation and new entry.
Case 1: Long run equilibrium through new entry competition
Under monopolistic competition, the number of independent firms selling differentiated products or brands of a given commodity is large and the relative market share of every firm is insignificant. Therefore, the entry of a new firm into the market will not have any noticeable adverse effect on the sales (or demand) of any of the established firms. Established firms will have no reason to react to new entry by adopting practices to discourage this.
The process by which competition from the entry of new firms leads an individual firm’s long run equilibrium is explained with the aid of Figure 11.4 (a).
Figure 11.4 (a)
The initial downward sloping demand curve of the firm is DD1 and MR1 is the corresponding marginal revenue curve. SMC and SAC are the short run marginal cost and short run average cost curves. We see that the SMC curve cuts MR1 from below at point E1. The firm maximises profits at output Q1 and charges price OP or Q1D.
At Q1 output SAC = OC1: It makes super-normal profits = area P1DKC1. The super normal profits of existing firms induce new firms to enter this market. As the number of firms and brands increases, the market share of each firm declines and each firm is able to sell less at the same price. Hence, the demand curve of every individual firm slides downwards, remaining parallel to itself.
This process of competition from new entry continues so long as the profits earned by a typical firm are more than normal, i.e., so long as the demand curve lies above the AC curve.
The competition from new entry will stop and every firm will reach its long run equilibrium output when profits are only normal and price is just equal to long run average cost. This happens when the demand curve of an individual firm becomes DD2, which is at a tangent to the LAC curve at
point E2.
The marginal revenue curve MR2 corresponds to demand curve DD2. Here LMC cuts MR2 from below at point G at output Q2. Thus, the maximum profit that each firm can earn is only normal profit which is included in LAC. The point of tangency E2, is therefore the position of the long run equilibrium of a firm where output is Q2 and price is P2.
When there is competition only from new entry, the long run equilibrium of the firm under monopolistic competition is reached under the following conditions:
1. Price = AR = LAC = OP2 {Figure 11.4 (a)}
2. MR = LMC = GQ2 {Figure 11.4 (a)}
3. Maximum Profit = Normal Profits
However, because the firm’s demand or average revenue curve is falling, the price is higher than marginal revenue. Hence, under monopolistic competition, even though the long run equilibrium price is equal to LAC, it is greater than LMC. This is because, at equilibrium, MR = LMC but price is greater than MR. (Under perfect competition, price = minimum LAC = LMC).
Moreover, since the firm’s demand or average revenue DD2 is falling on account of product differentiation, it can be a tangent to the U-shaped LAC curve only when LAC is also falling. As shown in Figure 11.4 (a), the long run equilibrium position E2 will be at a point which is to the left of the minimum LAC. Thus, the long run equilibrium output Q2 is less than optimum output, Qm (where LAC is at its minimum). The difference between Qm and Q2 = (OQm – OQ2) shows the extent of excess or under utilised capacity. Equilibrium with excess capacity is therefore the necessary consequence of product differentiation and monopolistic competition.
Case 2: Long run equilibrium when competition is through price variation
For the purpose of explaining the process of competition through price changes, two demand curves for every individual firm are used.
The change in demand resulting from a change in price undertaken on the basis of assumption that its competitors will not follow suit when it reduces its price leads the firm to expect that the increase in its demand will be proportionately greater than the reduction in its price. The perceived demand curve is therefore highly, though not perfectly, elastic. It falls but falls very gradually and this shows why a firm is induced to cut its price. It is the decision making demand curve because the firm decides to cut price on the basis of the change in demand it perceives or assumes to occur as the result of the change in price.
However, because every firm’s market share is equally insignificant, each firm acts on the assumption that when it lowers it price, the prices of its competing firms will remain constant.
Each firm, therefore, reduces its price on the basis of the same assumption, and consequently all firms in the market reduce their prices simultaneously but independently (i.e., not in retaliation).
Each firm acts on the basis of its perceived demand curve. As a result, the actual increase in demand resulting from a reduction in price is much less than has been ‘imagined’ by each firm.
The actual changes in demand arising from such simultaneous reduction in price by all firms is shown by what is called the actual demand of an individual firm.
Figure 11.4 (b)
Figure 11.4 (b) shows dd1 as the assumed or perceived demand curve and DD1 as the actual demand curve. When price is lowered from P1 to P2the firm assumes the demand to increase from M1 to M2, but as is shown by DD1, it actually increases only to M1N.
The assumed demand curve is much more elastic than the ‘actual’ demand curve. This is because the former ‘assumed’ or ‘perceived’ changes in demand are based on the assumption that only one firm changes its price, while its competitors keep their prices constant. The actual demand curve, however, shows the real changes in demand when all firms simultaneously but independently change their prices acting on the basis of same assumption.
Case 3: Competition through price variation and new entry
We have seen that the actual demand curve DD shows the absolute market share of an individual firm. Because we assume that the position and shape of demand curve are symmetrical for every firm, the market shares of all firms are assumed to be equal in terms of absolute quantity or size of output. It is given by a ratio of total market demand divided by the number of firms. The larger the number of firms in the market, the smaller the absolute market share of each firm. The position of DD, i.e., its distance from the Y-axis therefore depends upon the number of firms in the market. The actual demand curve DD will shift nearer to the Y-axis as the number of firms increases and will move further away from the Y-axis as the number of firms decreases. That is, DD will shift towards the left as new firms enter the industry and it will shift towards right when the existing firms leave the industry.
As shown in Figure 11.4 (c), the initial actual demand curve is shown by DD1. It cuts the AC curve at point J. Let dd1 be the initial perceived demand curve cutting DD1 at point B1. As explained in above, competition among firms through price variation will continue until the perceived demand curve dd1 becomes dd2, which is tangent to AC at point E. Point E shows price to be = OP2. However, point E is not situated on the actual demand curve DD1. Hence, the firm finds that corresponding to point E, the actual demand on DD1 is P2R. Now point R on DD1 is above the AC curve. Therefore output P2R indicates super-normal profits shown by area P2RGC2. These supernormal profits induce new firms to enter the industry. As the number of firms increases the absolute market share of each decreases and the actual demand curve DD1 shifts towards the left.
This process will continue till DD1 shifts to the position of DD2 which intersects the AC curve at point E where the perceived demand curve dd2is a tangent to AC. At this point profits are normal on the basis of perceived demand curve dd2 as well as on the basis of actual demand curve DD2. That is, actual demand and perceived demand are equal when profits are normal. The point of tangency between dd2 and AC is at point E where DD2 cuts AC. Here the long run equilibrium output is Q2 and price is P2.
Figure 11.4 (c)
Here the competition through price variation is shown by the downward shift in the perceived demand curve along the actual demand curve. (From position dd1 to position dd2, which is tangent to AC at point E). And the competition through new entry is shown by the shift in the position of actual demand curve (DD1 shifts to the position of DD2) which intersects AC at the point of tangency of dd2 and AC, i.e., at point E.
Under monopolistic competition, when there is competition through price variation as well as new entry (or exit), the long run equilibrium of the firm will be reached when following conditions are satisfied.
1. Perceived demand curve dd2 is tangent to AC.
2. Price is equal to AC.
3. Maximum profit = Normal profit (economic profit = zero).
4. MR = MC. Here the relevant marginal revenue is derived from the perceived demand curve.
5. The actual demand curve (or ‘market share’ demand curve) DD cuts AC at the point where perceived demand curve (dd) is a tangent to AC.
6. Price is greater than MC because price is greater than MR.
7. The equilibrium output is less than the optimum output.
Here also we find that the long run equilibrium output is determined at the level where AC is falling and therefore the equilibrium output is less than the optimum output, Qm. That is, excess capacity exists at long run equilibrium output.
11.3.4 Price determination in oligopoly
Price determination under oligopoly can be understood in two ways: (a) Cartels where firms jointly fix a price and output policy through agreement, and (b) Price Leadership where one firm sets the price and others follow it.
Cartel
A cartel is a formal collusive organisation of the oligopoly firms in an industry: There may either be an open or secret collusion. A perfect cartel is an extreme form of collusion in which member firms agree to abide by the instructions from a central agency in order to maximise joint profits. The profits are distributed among the member firms in a way jointly decided by the firms in advance and may not be in proportion to its share in total output or the costs it incurs.
If A and B are two firms which join together to form a cartel, the cartel’s marginal cost curve can be shown as a lateral summation of MC1(marginal cost of firm A) and MC2 (marginal cost of firm B), as in Figure 11.5. The cartel is in equilibrium at point E when MC = MR. P is the cartel equilibrium price. Each firm will be in equilibrium when it produces output corresponding to the MC of the cartel equilibrium, i.e., at points E1and E2 respectively. Each firm takes price as given i.e., P. The shaded areas represent the shares of profits contributed to the aggregate cartel profit. The division of this profit between the firms depends upon their relative bargaining strengths.
Figure 11.5
Price leadership
This is more common and happens when a dominant firm shares a larger part of the market along with few small firms. It may become monopolist but compromises with the small rival firms which in turn accept the dominant firm as the price setter and behave as if they are firms under perfect competition i.e., price takers.
It is assumed that the dominant firm knows the aggregate market demand. It finds its own demand curve by setting a price and deducts from the market demand the quantity supplied jointly by the small firms. It also knows the supply curve of the small firms through a knowledge of their individual MC curves. The part of the market demand not supplied by the small firms will be its own share. Given a price, the market share of the dominant firm equals the market demand less the share of small firms. Figure 11.6 shows the aggregate market demand curve (AR) and the supply curve of the small firm (a) and dominant firm (b).
The gap between D and SS of small firm determines the AR curve (DL) of the dominant firm. The dominant firm maximises its profit when MR = MC at point E. It sells Q units at price P. The demand curve for small firm becomes the horizontal line PB which is AR as well as MR curve for them. SSis their MC or supply curve. They supply Q1 units at price P.
Resource allocation under monopoly
The resource allocation is done with respect to ascertain the welfare has been improved or downtrodden. The actuality is monopoly directs to misallocation of resources. In order to investigate, we relate price, output and profits under monopoly and perfect competition.
Specific TaxThe government can also reduce monopoly profits by levying a specific or a per unit tax on the monopolist’s product. As per unit tax on monopoly output has the effect of shifting both the average and marginal cost curves upward by the amount of the tax. Higher the demand elasticity of tax, the higher the price for the product and lower the output; the ultimate loss will be borne by the public rather than by the monopolist.
Perfect competition
As is evident from the above table, perfect competition is said to prevail where there is a large number of producers (firms) producing a homogeneous product. The maximum output which an individual firm can produce is relatively very small to the total demand of the industry product so that a firm cannot affect the price by varying its supply of output. With many firms and homogeneous product under perfect competition, no individual firm is in a position to influence the price of the product and therefore the demand curve facing it will be a horizontal straight line at this level of the prevailing price of the product in the market, that is price elasticity of demand for a single firm will be infinite.
Features of perfect competition
The model of perfect competition is based on the following features:
1. Large numbers of sellers and buyers: The industry in perfect competition includes a large number of firms (and buyers). The buyers are also numerous so that no monopolistic power can affect the working of the market. Under these conditions each firm alone cannot affect the price in the market by changing its output.
2. Product homogeneity: The technical characteristics of the product as well as the services associated with its sale and delivery are identical. There is no way in which a buyer could differentiate among the products of different firms.
3. Free entry and exit of firms: There is no barrier to entry or exit from the industry. Entry or exit may take time but firms have freedom of movement in and out of the industry.
4. Profit maximisation: The goal of all firms is profit maximisation. No other goals are pursued.
5. No government regulation: There is no government intervention in the market (tariffs, subsidies, rationing of production or demand and so on are ruled out).
6. Perfect mobility of factors of production: The factors of production are free to move from one firm to another throughout the economy. It is also assumed that workers can move between different jobs. Finally, raw materials and other factors are not monopolised and labour is not organised.
7. Perfect knowledge: It is assumed that all the sellers and buyers have complete knowledge of the conditions of the market. This knowledge refers not only to the prevailing conditions in the current period but in all future periods as well. Information is free and cost less.
11.2.2 Imperfect competition
Imperfect competition is an important market category where individual firms exercise control over the price to a smaller or larger degree depending upon the degree of imperfection present in a case.
The existence of imperfect competition can be caused either by the fewness of the firms or by product differentiation. Therefore, imperfect competition has several subcategories.
The first important subcategory of imperfect competition is monopolistic competition.
In monopolistic competition, a large number of firms produce somewhat different products which are close substitutes of each other. For example, private clinics run by individual or group of doctors, nursing homes and the health insurance market represent this type of market.
Features of monopolistic competition
Features of monopolistic competition are:
1. The products of the competing firms are close but not perfect substitutes because buyers do not regard them as identical. This situation arises when the same commodity is being sold under different brand names, each brand being slightly different from the others. For example, Dettol and Savlon are brands of antiseptic soaps and lotions; Soframycin and Betadine are ointments for wounds and burns.
2. Each firm is, therefore, the sole producer of a particular brand or "product". It is a monopolist as far as that particular brand is concerned. However, since the various brands are close substitutes, a large number of "monopoly" producers of these brands are involved in keen competition with one another.
3. The differentiation among competing products or brands may be based on real or imaginary differences in quality. Real differences among brands refer to palpable differences in quality such as shape, flavour, colour, packing, after sales service, warranty period, etc.
4. In addition to product differentiation, the other three basic characteristics of monopolistic competition are:
(a) There are a large number of independent sellers (and buyers) in the market.
(b) The relative (proportionate) market shares of all sellers are insignificant and more or less equal. That is, seller concentration in the market is almost non existent.
(c) There are neither any legal nor any economic barriers against the entry of new firms into the market. New firms are free to enter the market and existing firms are free to leave the market.
(d) In other words, product differentiation is the only characteristic that distinguishes monopolistic competition from perfect competition.
5. The second subcategory is oligopoly without product differentiation which is also known as pure oligopoly. Under this, there is competition among the few firms producing homogeneous or identical products. The fewness of the firms ensures that each of them will have some control over the price of the product and the demand curve facing each firm will be downward sloping which indicates that the price elasticity of demand for each firm will not be infinite. For example, pharmaceutical firms producing similar medicines represent this type of market.
Features of oligopoly
The characteristics of oligopoly are briefly explained below:
1. Under oligopoly the number of competing firms being small, each firm controls an important proportion of the total (industry) supply. Consequently, the effect of a change in the price or output of one firm upon the sales of its rival firms is noticeable and not insignificant. When any firm takes an action its rivals will in all probability react to it (i.e. retaliate). The behaviour of oligopolistic firms is interdependent and not independent or atomistic as is the case under perfect or monopolistic competition.
2. The demand curve of an individual firm under oligopoly is not known and is indeterminate because it depends upon the reaction of its rivals which is uncertain. Each theory of oligopoly therefore makes a specific assumption about how rivals will (or will not) react to an individual firm’s action.
3. In view of the uncertainty about the reaction of rivals and interdependence of behaviour, oligopolistic firms find it advantageous to coordinate their behaviour through explicit agreement (cartel) or implicit, hidden, understanding (collusion). Also because the number of firms is small, it is feasible for oligopolists to establish a cartel or collusive arrangement. However, it is difficult as well as expensive to monitor and enforce an agreement or understanding. Very few cartels last long, particularly when oligopolistic firms significantly differ in their cost conditions.
4. Under oligopoly, new entry is difficult. It is neither free nor barred. Hence the condition of entry becomes an important factor determining the price or output decisions of oligopolistic firms, and preventing or limiting entry an important objective.
5. Given the indeterminacy of the individual firm’s demand and, therefore, the marginal revenue curve, oligopolistic firms may not aim at maximization of profits. Modern theories of oligopoly take into account the following alternative objectives of the firm:
(a) Sales maximization with profit constraint.
(b) Target or "fair" rate of profit and long-run stability.
(c) Maximization of the managerial utility function.
(d) Limiting (preventing) new entry.
(e) Achieving "satisfactory" profits, sales, etc. That is, the firm is a "satisficer" and not "maximizer".
(f) Maximization of joint (industry) profits rather than individual (firm) profits.
6. The third subcategory is called differentiated oligopoly. It is characterised by competition among the few firms producing differentiated products which are close substitutes of each other. The demand curve under this kind of oligopoly is downward sloping and so firms would have control over the price of their individual products. For example, large private hospitals like Apollo, Fortis, Max etc. that provide specialised services represent this type of market.
11.2.3 Monopoly
Monopoly means the existence of a single producer or seller which is producing or selling a product which has no close substitutes. As such it is an extreme form of imperfect competition. Since a monopoly firm wields sole control over the supply of the product which can have only remote substitutes, the expansion and contraction in its output will affect the price of the product. Therefore, the demand curve facing a monopolist is downward sloping and has a steep slope. In many cases, monopolies have arisen because the government has given a firm the exclusive right to sell a particular good or service. For example, when a pharmaceutical company discovers a new drug, it can apply to the government for a patent. If the patent is granted, the firm has the exclusive right to produce and sell the drug for a set number of years. In the case of the pharmaceutical company, the firm is able to charge higher prices for its patented product and, in turn, earn higher profits.
Features of monopoly
Some important features of monopoly are:
1. A monopolist will always produce at a point where demand is elastic.
2. It is impossible to derive a supply curve for a monopolist.
3. A lump sum tax on the profits of a monopolist will leave price and output unchanged.
4. Monopolists arrive at the same conclusion about their production using MC and MR as they do using TC and TR.
5. Monopoly profits are not inequitable.
11.3 Price Determination in Various Types of Market
11.3.1 Price determination under perfect competition
The industry, and not the individual firm, in interaction with demand forces, determines price. The individual firm takes this price as given, and is free to sell any amount without fear or fall in price. This can be shown graphically as shown in Figure 11.1.
The demand curve is based on the inverse relation between price and demand. The supply curve is based on the positive relation between price and supply. Price is determined at E where demand equals supply. The price is OP.
The firm adopts the price and is free to sell any quantity at this price. It makes the demand curve for the firm’s product (curve d=AR) perfectly elastic.
11.3.2 Price determination in monopoly
Short run case
In the short run the monopolist maximises his short run profits or minimises his short run losses if the following two conditions are satisfied
1. MC = MR and
2. The slope of MC is greater than the slope of MR at the point of their intersection (i.e., MC cuts the MR curve from below).
In the short run a monopolist has to work with a given existing plant. He can expand or contract output by varying the amount of variable factors but working with a given existing plant. Maximisation of profits in the short run requires the fixation of output at a level at which marginal cost with a given existing plant is equal to marginal revenue. In Figure 11.2 (a), SAC and SMC are short run average and marginal cost curves. Monopolist is in equilibrium at E where marginal revenue is equal to marginal cost. Price set by him is SQ or OP. He is making profits equal to TRQP.
But in the short run he will continue working so long as price is above the average variable cost. If the price falls below average variable cost the monopolist would shut down even in the short run. In case of losses, monopoly equilibrium is shown in Figure 11.2 (b). The monopolist is in equilibrium at OS level of output with price OP. Since price (or AR) is smaller than average cost, he is making losses which are equal to area of the rectangle PQGH.
Figure 11.2 (b)
Long run case
In the long run, the monopolist has the time to expand his plant or to intensively use his existing plant which will maximise his profits. Since there will be no new entry, it is not necessary for the monopolist to reach an optimal scale. It means that monopolist will not stay in business if he makes losses in the long run.
The size of his plant and the degree of utilisation of any given plant size depend entirely on market demand. He may reach the minimum point of LAC or remain at falling part of his LAC and expand beyond the minimum LAC depending on the market conditions.
In Figure 11.3 (a), we depict the case in which the market size does not permit the monopolist to expand to the minimum point of LAC. This is because to the left of the minimum point of the LAC the SRAC is tangent to the LAC at its falling part and also because the short run MC must be equal to the LRMC. This occurs at E, while the minimum LAC is at b and the optimal use of the existing plant is at a: since it is utilised at the level E, there is excess capacity.
Figure 11.3 (a)
In Figure 11.3 (b), we depict the case where the size of the market is so large that the monopolist, in order to maximise his output, must build a plant larger than the optimal and over utilise it. This is because to the right of the minimum point of the LAC the SRAC and the LAC are tangent at a point of their positive slope and also because the SRMC must be equal to the LAC. Thus, the plant that maximises the monopolist’s profits leads to higher costs for two reasons: firstly, because it is larger than the optimal size and secondly because, it is over utilised.
Figure 11.3 (b)
Finally, in Figure 11.3 (c), we show the case in which the market size is just large enough to permit the monopolist to build the optimal plant and use it at full capacity.
Figure 11.3 (c)
11.3.3 Price determination in monopolistic competition
When firms are competing only through price changes, there are three cases of long run equilibrium of a typical firm under monopolistic competition.
Case 1: When competition takes place only through the entry of new firms.
Case 2: When competition takes place only through price variation (price-cutting).
Case 3: When competition arises through price variation and new entry.
Case 1: Long run equilibrium through new entry competition
Under monopolistic competition, the number of independent firms selling differentiated products or brands of a given commodity is large and the relative market share of every firm is insignificant. Therefore, the entry of a new firm into the market will not have any noticeable adverse effect on the sales (or demand) of any of the established firms. Established firms will have no reason to react to new entry by adopting practices to discourage this.
The process by which competition from the entry of new firms leads an individual firm’s long run equilibrium is explained with the aid of Figure 11.4 (a).
Figure 11.4 (a)
The initial downward sloping demand curve of the firm is DD1 and MR1 is the corresponding marginal revenue curve. SMC and SAC are the short run marginal cost and short run average cost curves. We see that the SMC curve cuts MR1 from below at point E1. The firm maximises profits at output Q1 and charges price OP or Q1D.
At Q1 output SAC = OC1: It makes super-normal profits = area P1DKC1. The super normal profits of existing firms induce new firms to enter this market. As the number of firms and brands increases, the market share of each firm declines and each firm is able to sell less at the same price. Hence, the demand curve of every individual firm slides downwards, remaining parallel to itself.
This process of competition from new entry continues so long as the profits earned by a typical firm are more than normal, i.e., so long as the demand curve lies above the AC curve.
The competition from new entry will stop and every firm will reach its long run equilibrium output when profits are only normal and price is just equal to long run average cost. This happens when the demand curve of an individual firm becomes DD2, which is at a tangent to the LAC curve at
point E2.
The marginal revenue curve MR2 corresponds to demand curve DD2. Here LMC cuts MR2 from below at point G at output Q2. Thus, the maximum profit that each firm can earn is only normal profit which is included in LAC. The point of tangency E2, is therefore the position of the long run equilibrium of a firm where output is Q2 and price is P2.
When there is competition only from new entry, the long run equilibrium of the firm under monopolistic competition is reached under the following conditions:
1. Price = AR = LAC = OP2 {Figure 11.4 (a)}
2. MR = LMC = GQ2 {Figure 11.4 (a)}
3. Maximum Profit = Normal Profits
However, because the firm’s demand or average revenue curve is falling, the price is higher than marginal revenue. Hence, under monopolistic competition, even though the long run equilibrium price is equal to LAC, it is greater than LMC. This is because, at equilibrium, MR = LMC but price is greater than MR. (Under perfect competition, price = minimum LAC = LMC).
Moreover, since the firm’s demand or average revenue DD2 is falling on account of product differentiation, it can be a tangent to the U-shaped LAC curve only when LAC is also falling. As shown in Figure 11.4 (a), the long run equilibrium position E2 will be at a point which is to the left of the minimum LAC. Thus, the long run equilibrium output Q2 is less than optimum output, Qm (where LAC is at its minimum). The difference between Qm and Q2 = (OQm – OQ2) shows the extent of excess or under utilised capacity. Equilibrium with excess capacity is therefore the necessary consequence of product differentiation and monopolistic competition.
Case 2: Long run equilibrium when competition is through price variation
For the purpose of explaining the process of competition through price changes, two demand curves for every individual firm are used.
The change in demand resulting from a change in price undertaken on the basis of assumption that its competitors will not follow suit when it reduces its price leads the firm to expect that the increase in its demand will be proportionately greater than the reduction in its price. The perceived demand curve is therefore highly, though not perfectly, elastic. It falls but falls very gradually and this shows why a firm is induced to cut its price. It is the decision making demand curve because the firm decides to cut price on the basis of the change in demand it perceives or assumes to occur as the result of the change in price.
However, because every firm’s market share is equally insignificant, each firm acts on the assumption that when it lowers it price, the prices of its competing firms will remain constant.
Each firm, therefore, reduces its price on the basis of the same assumption, and consequently all firms in the market reduce their prices simultaneously but independently (i.e., not in retaliation).
Each firm acts on the basis of its perceived demand curve. As a result, the actual increase in demand resulting from a reduction in price is much less than has been ‘imagined’ by each firm.
The actual changes in demand arising from such simultaneous reduction in price by all firms is shown by what is called the actual demand of an individual firm.
Figure 11.4 (b)
Figure 11.4 (b) shows dd1 as the assumed or perceived demand curve and DD1 as the actual demand curve. When price is lowered from P1 to P2the firm assumes the demand to increase from M1 to M2, but as is shown by DD1, it actually increases only to M1N.
The assumed demand curve is much more elastic than the ‘actual’ demand curve. This is because the former ‘assumed’ or ‘perceived’ changes in demand are based on the assumption that only one firm changes its price, while its competitors keep their prices constant. The actual demand curve, however, shows the real changes in demand when all firms simultaneously but independently change their prices acting on the basis of same assumption.
Case 3: Competition through price variation and new entry
We have seen that the actual demand curve DD shows the absolute market share of an individual firm. Because we assume that the position and shape of demand curve are symmetrical for every firm, the market shares of all firms are assumed to be equal in terms of absolute quantity or size of output. It is given by a ratio of total market demand divided by the number of firms. The larger the number of firms in the market, the smaller the absolute market share of each firm. The position of DD, i.e., its distance from the Y-axis therefore depends upon the number of firms in the market. The actual demand curve DD will shift nearer to the Y-axis as the number of firms increases and will move further away from the Y-axis as the number of firms decreases. That is, DD will shift towards the left as new firms enter the industry and it will shift towards right when the existing firms leave the industry.
As shown in Figure 11.4 (c), the initial actual demand curve is shown by DD1. It cuts the AC curve at point J. Let dd1 be the initial perceived demand curve cutting DD1 at point B1. As explained in above, competition among firms through price variation will continue until the perceived demand curve dd1 becomes dd2, which is tangent to AC at point E. Point E shows price to be = OP2. However, point E is not situated on the actual demand curve DD1. Hence, the firm finds that corresponding to point E, the actual demand on DD1 is P2R. Now point R on DD1 is above the AC curve. Therefore output P2R indicates super-normal profits shown by area P2RGC2. These supernormal profits induce new firms to enter the industry. As the number of firms increases the absolute market share of each decreases and the actual demand curve DD1 shifts towards the left.
This process will continue till DD1 shifts to the position of DD2 which intersects the AC curve at point E where the perceived demand curve dd2is a tangent to AC. At this point profits are normal on the basis of perceived demand curve dd2 as well as on the basis of actual demand curve DD2. That is, actual demand and perceived demand are equal when profits are normal. The point of tangency between dd2 and AC is at point E where DD2 cuts AC. Here the long run equilibrium output is Q2 and price is P2.
Figure 11.4 (c)
Here the competition through price variation is shown by the downward shift in the perceived demand curve along the actual demand curve. (From position dd1 to position dd2, which is tangent to AC at point E). And the competition through new entry is shown by the shift in the position of actual demand curve (DD1 shifts to the position of DD2) which intersects AC at the point of tangency of dd2 and AC, i.e., at point E.
Under monopolistic competition, when there is competition through price variation as well as new entry (or exit), the long run equilibrium of the firm will be reached when following conditions are satisfied.
1. Perceived demand curve dd2 is tangent to AC.
2. Price is equal to AC.
3. Maximum profit = Normal profit (economic profit = zero).
4. MR = MC. Here the relevant marginal revenue is derived from the perceived demand curve.
5. The actual demand curve (or ‘market share’ demand curve) DD cuts AC at the point where perceived demand curve (dd) is a tangent to AC.
6. Price is greater than MC because price is greater than MR.
7. The equilibrium output is less than the optimum output.
Here also we find that the long run equilibrium output is determined at the level where AC is falling and therefore the equilibrium output is less than the optimum output, Qm. That is, excess capacity exists at long run equilibrium output.
11.3.4 Price determination in oligopoly
Price determination under oligopoly can be understood in two ways: (a) Cartels where firms jointly fix a price and output policy through agreement, and (b) Price Leadership where one firm sets the price and others follow it.
Cartel
A cartel is a formal collusive organisation of the oligopoly firms in an industry: There may either be an open or secret collusion. A perfect cartel is an extreme form of collusion in which member firms agree to abide by the instructions from a central agency in order to maximise joint profits. The profits are distributed among the member firms in a way jointly decided by the firms in advance and may not be in proportion to its share in total output or the costs it incurs.
If A and B are two firms which join together to form a cartel, the cartel’s marginal cost curve can be shown as a lateral summation of MC1(marginal cost of firm A) and MC2 (marginal cost of firm B), as in Figure 11.5. The cartel is in equilibrium at point E when MC = MR. P is the cartel equilibrium price. Each firm will be in equilibrium when it produces output corresponding to the MC of the cartel equilibrium, i.e., at points E1and E2 respectively. Each firm takes price as given i.e., P. The shaded areas represent the shares of profits contributed to the aggregate cartel profit. The division of this profit between the firms depends upon their relative bargaining strengths.
Figure 11.5
Price leadership
This is more common and happens when a dominant firm shares a larger part of the market along with few small firms. It may become monopolist but compromises with the small rival firms which in turn accept the dominant firm as the price setter and behave as if they are firms under perfect competition i.e., price takers.
It is assumed that the dominant firm knows the aggregate market demand. It finds its own demand curve by setting a price and deducts from the market demand the quantity supplied jointly by the small firms. It also knows the supply curve of the small firms through a knowledge of their individual MC curves. The part of the market demand not supplied by the small firms will be its own share. Given a price, the market share of the dominant firm equals the market demand less the share of small firms. Figure 11.6 shows the aggregate market demand curve (AR) and the supply curve of the small firm (a) and dominant firm (b).
The gap between D and SS of small firm determines the AR curve (DL) of the dominant firm. The dominant firm maximises its profit when MR = MC at point E. It sells Q units at price P. The demand curve for small firm becomes the horizontal line PB which is AR as well as MR curve for them. SSis their MC or supply curve. They supply Q1 units at price P.
Resource allocation under monopoly
The resource allocation is done with respect to ascertain the welfare has been improved or downtrodden. The actuality is monopoly directs to misallocation of resources. In order to investigate, we relate price, output and profits under monopoly and perfect competition.
- Excess Capacity-In a perfectly competitive market, in the long run, Price = (AR = MR) = LMC = LAC at its minimum. This means that competitive firms in the industry in the long run are earning profits. They are optimum sized and are producing to their optimum capacity. Since the monopoly firm has excess capacity, there is under allocation of resources to the monopoly firm and misallocation of resources in the economy.
- Loss in Consumer’s Welfare-We presume cost curves and the revenue curves are the same for both the monopoly firm and a perfectly competitive industry. The consumers are worse off under monopoly because they are made to pay a higher price and get a small output than under perfect competition where they get more goods at a lower price. This is a loss in consumer’s welfare.
- Under Utilisation of Factor Input-Presence of monopoly leads to a less utilisation of a factor input than under perfect competition. In perfect competition factor market, the price of a factor input, say labour is given.
- Dead Weight LossFurther monopoly reduces consumer’s surplus. This is for the reason that productivity under monopoly is smaller and the price is higher than perfect competition. The reduction in the welfare of the consumer can be identified as the loss in consumer’s surplus. Hence overall, we can judge that monopoly leads to misallocation and under utilisation of resources and reduction in consumer’s welfare.
Specific TaxThe government can also reduce monopoly profits by levying a specific or a per unit tax on the monopolist’s product. As per unit tax on monopoly output has the effect of shifting both the average and marginal cost curves upward by the amount of the tax. Higher the demand elasticity of tax, the higher the price for the product and lower the output; the ultimate loss will be borne by the public rather than by the monopolist.