Maryland International College

Managerial Economics

Chapter Seven

Market Structure and Pricing

Chapter Seven
Market Structure and Pricing

 Concept of market structure

 Pricing under various markets :

 Perfect Competition,

 Monopoly,

 Monopolistic competition,

 oligopoly.
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 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

Short-run equilibrium
iii. Shutdown point - A firm will not stop
production simply because AC exceeds price in
the short-run. The firm will continue to produce
irrespective of the existing loss as far as the price
is sufficient to cover the average variable costs.
• But if P is smaller than AVC, the firm minimizes
total losses by shutting down. Thus, P = AVC is
the shutdown point for the firm.
• Economic losses motivate some to exit (shut
down) from the industry.
• industry supply decreases - market price
increases and all the firms will adjust their
output in order to maximize their profit.
 Perfect Competition Market

Long run equilibrium

• It is possible in the long run for firms
to enter or leave the industry;
• this is not feasible in the short
run, since it involves a change in
the level of fixed factors
employed.
• Existing firms can also change their
scale and will maximize profit by
producing where price equals long-
run marginal cost (P=LMC).
• The presence of abnormal profit will
always serve to attract new entrants
into the industry,
• it will shift the industry supply
curve to the right, in turn causing
the market price to fall.
 Perfect Competition Market

Long run equilibrium

• The industry supply curve will shift from S1 to S2
• the market price will fall from P1 to P2.
• It is assumed here that there is no change in
demand.
• At the new equilibrium the price and long-run average
cost (LAC) of the firm are equal,
• the firm is now producing at the minimum level of both its
new SAC curve (SAC2) and its LAC curve at the output q2.
• In the Long run - all the abnormal profit has been
‘competed away’.
• therefore, no further incentive for firms to enter the
industry and the firm and industry are in long-run
equilibrium.
• long-run equilibrium: P = SMC = LMC = SAC = LAC = MR =
AR
 Perfect Competition Market

Long run equilibrium

• The significance of producing at the equilibrium is that both productive and allocative
efficiency are achieved.
• Productive efficiency refers to the situation where the firm is producing at the
minimum level of average cost.
• This is achieved in the long run and the firm is using the optimal scale with
maximum efficiency.
• In the long run, even though the firm is using a larger scale, it is producing less output
than in the short-run situation, q2 compared with q1.
• this is because it was using the scale inefficiently in the short run, producing too
much output.
• Hence, this inefficiency resulted from the firm maximizing its profit, showing that
profit maximization and efficiency are not equivalent.
 Perfect Competition Market

Algebraic analysis of equilibrium

• Since the purely competitive firm is a price taker, it will maximize its economic profit
only by adjusting its output.
• In the short run, the firm has a fixed plant. Thus, it can adjust its output only through
changes in the amount of variable resources.
• It adjusts its variable resources to achieve the output level that maximizes its profit.
• There are two ways to determine the level of output at which a competitive firm will
realize maximum profit or minimum loss.
I. compare total revenue and total cost (total approach) and
II. compare marginal revenue and marginal cost (marginal approach).
Total Approach
• a firm maximizes total profits in the short run when the (positive) difference between
total revenue (TR) and total costs (TC) is greatest.
• The profit maximizing output level is output level that the vertical distance between
the TR and TC curves (or profit) is maximized.
 Perfect Competition Market

Algebraic analysis of equilibrium

Marginal Approach (MR-MC)
• In the short run, the firm will maximize profit or minimize loss by producing the
output at which marginal revenue equals marginal cost.
• the following two conditions should be met:
i. MR = MC and,
ii. The slope of MC is greater than slope of MR; or MC is rising (i.e slope of MC is
greater than zero)
• Mathematically,
• is maximized when, ,
• , that is MR – MC = 0, MR = MC …… First Order Condition
 Perfect Competition Market

Algebraic analysis of equilibrium

Marginal Approach (MR-MC)
• , Second Order Condition
•
• , Where is slope of MR and is slope of MC curve
• Therefore, for the second order condition
• slope of MC > slope of MR,
• Since slope of MR is zero, the second order condition
is Slope of MC > 0
• At Q*, MC=MR, but since MC is falling at this output
level, it is not equilibrium output.
 Perfect Competition Market
Exercise 1
1. Suppose a firm operates in a perfectively competitive market. The market price of its
product is 10 ETB. The firm estimates its cost of production with the cost function of TC
= 2+10Q – 4Q2 + Q3.
A. What level of output should the firm produce to maximize its profit?
B. Determine the level of profit at equilibrium
C. What minimum price is required by the firm to stay in the market?
Home work
Suppose you are the manager of a watch-making firm operating in a competitive
market. Your cost of production is given by TC = 100 + Q2, where Q is the level of
output and C is total cost.
i. If the price of watches is birr 60, how many watches should you produce to
maximize profit?
ii. What will your profit level be?
 Exercise 1 A, MC=10 - 8Q+ 3Q2 and MR = 10
MR=MC __________FOC
1. Given 10 = 10 - 8Q+ 3Q2
P = MR = 10 - 8Q +3Q2 = 0; Q(- 8 + 3Q) = 0; Q=0 or -8 +3Q = 0
TC = TC = 2+10Q – 4Q2 Q = 0 or Q = 8/3 Which one is the profit maximization Q?
+ Q3 _______Use SOC
Required slope of MC > 0
A. Profit maximization = = -8 + 6Q
Q At Q= 0, MC = - 8 --- which is < 0…. SO, Q = 0 – not profit max Q
B. Profit at the At Q = 8/3, MC = 8 , Which > 0
equilibrium B. Profit at Q = 8/3; Profit = TR – TC = 26.67 – 19.18 = 7.49 ETB
C. Minimum Price to C. AVC is minimum when the slope or derivative of AVC = 0
stay in Mkt AVC = = = 10 – 4Q + Q 2

Solution =0; -4 + 2Q = 0 ; Q = 2
So, AVC is minimum when Q=2. The AVC, when output is 2,
Profit maximization
AVC = 10 – 4 (2) + (2)2 = 6
MC=MR and MC>0
To stay in the market the minimum price is 6 ETB
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.
 in a perfectly competitive firm, when PED is infinite or perfectly elastic,
there will be no profit margin as P = MC
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.
• no reason for a firm to charge a price where demand has less than unit elasticity,
in other words where demand is inelastic.
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
• As managerial decision maker in a business, you might ask the relevance of the total
economic welfare for managerial decision-making.
• Since after all, managers are only concerned with the welfare of the firm.
• However, governments monitor monopolistic industries and take an active role in
discouraging restrictive practices that impact firms’ strategies and profits.
• 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.
• Since a monopoly has the ability to profit from these over the long run, it may have
a greater incentive to conduct R&D and develop new products than a firm in PC
Exercise
1. Assume there is a tendency of moving from competitive to monopoly
output. If the demand and total functions are Q=100-2P and TC=14Q+2Q2,
respectively
a. Determine Pc, Qc, Pm, and Qm.
b. Show the equilibrium Q and P you obtained in A above graphically.
c. Calculate the CS and PS under competitive and monopoly market
structure.
d. Calculate part of CS transferred to the monopolist due to inefficiency of
monopoly.
e. Calculate the social cost (net loos or DWL) of monopoly

Pc – price for perfect competition

Qc – output price for perfect competition
Pm - price for monopoly
Qm – output for monopoly
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 - there may be a few large
dominant firms with a large fringe of smaller firms,
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
• Even though no supernormal profit is made in the long run, neither productive nor
allocative efficiency is achieved.
• This activity creates product differentiation and is thus claimed to cause
inefficiency.
• The long run equilibrium of monopolistic competition leads to excess capacity
measured by the difference between the ideal output (long run output of perfect
competition corresponding to the minimum LAC) and the actual output produced
in the long run by a firm monopolistic competition
Comparison between Monopolistic competition and Perfect competition
Market

• firms will typically operate to the left of output where LAC is minimised. This
implies that there is misallocation of resources for P is greater than the minimum
of LAC.
• If there were fewer firms, each could operate at a more efficient scale of
operation, which could be better for consumers. However, if there were fewer
firms there would also be less product variety, and this would tend to make
consumers worse off. Which of the two effects dominates is a difficult question to
answer. However, the extent of excess capacity depends on the condition of entry
and the degree of price competition. If there is free entry and active price
competition, the size of excess capacity (restriction of output) will be small.
• Another limitation of long run equilibrium of a firm in monopolistic competition is
that P > LMC implying welfare loss. To maximize social welfare, output should be
increased until P=LMC. However, this is not possible under monopolistic
competition for the perceived demand curve is downward sloping and P is greater
than the minimum of LAC.
Comparison between Monopolistic competition and Perfect competition
Market

• The higher cost resulting from product differentiation would mean

• higher sales (advertising and promotion) cost and price than perfect competition.
• Society may accept the higher price to have choice among the differentiated
products.
• consumers who desire product differentiation are willing to pay higher price.
• there is welfare loss on the ground that P > MC – not to be overemphasised
• it is much lower than the dead weight loss of monopoly and
• society have option to choose (entertain their preferences) among different brands.
• lessons for managers operating in monopolistically competition market
• A firm must concentrate on differentiation and building brand value.
• The managers must never be satisfied with their profit because of new entrants.
• The market is competing with differentiated products at lowest price.
• The firm need not offer at low price always.
• Through supplying best products a manager can retain his price and profit.
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 –
 in the form of economies of scale, sunk costs and brand recognition that prevent or discourage
entry of new firms and allow existing firms to make supernormal profit, even in the long run.
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.
• The duopoly case allows as capturing many of the important features of firms engaging in strategic
• 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 other firms may or may not reduce their price, but the firm that reduces price can no longer
assume other firms do not notice his/her action.
• 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.
• no unique solution or strategies like that of perfect competition, monopoly, and monopolistic
competition to maximize profit.
• 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.
• The marginal cost curves of each firm are summed horizontally to arrive at an
industry marginal cost curve.
• the profit-maximizing output and the price - equating the cartel’s total marginal
cost with the industry marginal revenue curve
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.
• the long-run problems of changing products
• entry into the market by new producers,
• Although firms usually agree that maximizing joint profits is mutually
beneficial, they seldom agree on the equity of various profit-allocation
schemes.
 Oligopoly Market - Cartel arrangements

• Cartel subversion can be extremely profitable

• In a two-firm cartel in which each member serves 50 percent of the market -
• cheating by either firm is very difficult, because any loss in profits or market share is
readily detected - the offending party also can easily be identified and punished
• Conversely, a 20-member cartel promises substantial profits and market share gains
to successful cheaters.
• detecting the source of secret price concessions can be extremely difficult
• cartels including more than a very few members have difficulty policing and
maintaining member compliance.
 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.
• the firms act together to restrict output so as not to “spoil” the market.
• They recognize the effect on joint profits from producing more output in either
firm.
• consider two oligopoly firms (firm A and B) producing identical (homogenous)
products.
• The firms appoint a central agency (cartel) to which they delegate the authority
to decide on:
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
 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.
• if one firm has lower cost (cost advantage) its MC curve always lies below that of the
other firm
• then it will necessarily produce more output in equilibrium in the cartel solution.
• this does not mean that the firm with lower cost will take the larger share of the joint
profit – it is distributed by the central agency of the cartel according to some agreed
upon criteria.
 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 - Cartel arrangements

• Hence, competition among sellers is through advertising but not by price changes.
• However, cartel sharing market is loose or unstable than the complete cartel that aims
at joint profit maximization among manufacturing firms due to cost difference.
• the cartel is inherently unstable - a temptation to cheat by low cost firm.
• a strong incentive to break away from the cartel and charge lower price (give price
concession to buyers).
• other members from the cartel will soon discover such a cheating when they loose
consumers.
• use your customers to spy on the other firms.
• When firms are not sure that the other firm is not cheating on their agreement and selling
at the implicitly agreed price, price war (instability) may develop and the cartel splits.
 Oligopoly Market - Cartel arrangements

• The other type of sharing market is by agreement on quotas.

• cartel members agree explicitly on the common price and quantity each
member may sell in the market.
• The best example of this cartel is OPEC (Organization of the Petroleum
Exporting Countries).
• If all firms have identical cost, a monopoly solution will emerge with the market
being shared equally - equal quotas will be allocated - if firms have identical costs
• However, if costs are different, the quotas (shares) of the market will differ.
• allocation of quotas on the basis of cost is unstable.
• quotas will be decided by bargaining - to decide the quotas of members of the
cartel
• these are past level (historical) sells and the production capacity of the firm.
 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.
• It may result from the size and strength of the leading firm, from cost efficiency,
or as a result of the ability of the leader to establish prices that produce
satisfactory profits throughout the industry.
• 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
• the MCf curve represents the supply curve for following firms.
• At price P3, followers would supply the entire market, leaving nothing for the
dominant firm.
• At all prices below P3, the horizontal distance between the summed MCf curve and
the market demand curve represents the price leader’s demand.
• At a price of P1, for example, price followers provide Q2 units of output, leaving
demand of Q5 – Q2 for the price leader.
• Plotting all of the residual demand quantities for prices below P3 produces the
demand curve for the price leader, DL and the related marginal revenue curve,
MRL.
 Oligopoly Market - Price Leadership
• More generally, the leader faces a demand curve of the following form:
DL = DT – Sf
• Where DL is the leader’s demand, DT is total demand, and Sf is the followers’
supply curve found by setting P= MCf and solving for Qf, the quantity that will be
supplied by the price followers.
• Because DT and Sf are both functions of price, DL is determined by price.
• the price leader faces the demand curve DL as a monopolist, it maximizes profit by
operating at the point where marginal revenue equals marginal cost, MRL = MCL.
• At this optimal output level for the leader, Q1, market price is established at P2.
Price followers supply a combined output of Q4 – Q1units.
• A stable short-run equilibrium is reached if no one challenges the price leader.
 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.
• It could stem from cost increases that result from a new industry labor agreement, higher
energy or material costs, higher taxes, or a substantial shift in industry demand.
• 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
• Rival firms follow any decrease in price to maintain their
market shares but refrain from following price increases,
allowing their market shares to grow at the expense of the
competitor increasing its price.
• 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.
• If rivals match price reductions, prices below P0 will
induce quantities demanded along curve D1. If rivals
do not match price increases, prices above P0 will
induce quantities demanded along D2.
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 demand curve facing individual firms is kinked at
the current price/ output combination,
• The firm is producing Q units of output and selling
them at a price of P per unit.
• If the firm lowers its price, competitors retaliate by
lowering their prices.
• The result of a price cut is a relatively small increase in
sales.
• Price increases, on the other hand, result in significant
reductions in the quantity demanded and in total
revenue, because customers shift to competing firms
that do not follow the price increase.
 Oligopoly Market - The kinked demand curve model
• Associated with the kink in the demand curve is a point of discontinuity in the marginal
revenue curve. As a result, the firm’s marginal revenue curve has a gap at the current price/
output level, which results in price rigidity.
• To see why, recall that profit-maximizing firms operate at the point where marginal cost equals
marginal revenue
• any change in marginal cost leads to a new point of equality between marginal costs
and marginal revenues and to a new optimal price.
• However, with a gap in the marginal revenue curve, the price/output combination at
the kink can remain optimal despite fluctuations in marginal costs.
• the firm’s marginal cost curve can fluctuate between MC1 and MC2 without causing
any change in the profit-maximizing price/output combination.
• Small changes in marginal costs have no effect; only large changes in marginal cost
lead to price changes.
 Oligopoly Market - The kinked demand curve model
• Therefore, when price cuts are followed but price increases are not, a kink develops in
the firm’s demand curve. At the kink, the optimal price remains stable despite
moderate changes in marginal costs
• In reality firms tend to follow price increases just as much as they follow price
reductions.
• the kinked demand curve model remains a popular approach to analysing oligopolistic
behaviour – as it suggests that firms are likely to co-operate on the monopoly price,
and this fact is easily observed in practice.
• managers should concentrate on their research and development to bring new
products and quality of service to raise their economies of scale;
• due to kinked demand curve, increase in cost of production will not affect their price;
and product differentiation and advertisement play a major role in increasing market
share.
 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.
• Price discrimination is possible as long as there is difference in elasticity.
• 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.
• It is possible only when a seller is in a position to know the price each buyer is
willing to pay i.e. he knows his buyer’s demand curve for his product.
• 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.
• the equilibrium condition is satisfied in the sub-markets and the monopoly firm
adopting the third degree method of price discrimination maximizes its profits.
• The pricing mechanisms in different market structures provide a sound theoretical
base to understand how price and output decisions are made. There are several other
methods commonly followed in practice.
• However, price discrimination does not receive social and moral justification in the
society.