Unit IV

Market Structure

Types of Market Structures

Structure

No. of Producers &

Degree of Product

Differentiation

Part of economy

where prevalent

Firm’s degree

of control over price

Methods of

Marketing

Perfect

competition

Many producers,

Identical products

Financial markets, &

Some agricultural

products

NoneMarket exchange

or auction

Imperfect

competition: 

Monopolistic

competition

Many producers,

Many real or perceived

differences in product

Retail trade

(Gasoline, PCs, etc.)

Some

Advertising and

Quality rivalry,

Administered

pricesOligopoly

Few producers,

No differences in

product.

Steel, chemicals, etc.

Few producers,

Some differentiation

of products

Autos, aircraft, etc.

Monopoly

Single producer,

Product without close

substitutes

Local telephone,

electricity, and gas

Considerable but

usually regulated

Advertising and

Service promotion

PERFECT COMPETITION

In economic theory, perfect competition describes markets such that no participants are large

enough to have the market power to set the price of a homogeneous product. Because the

conditions for perfect competition are strict, there are few if any perfectly competitive markets.

Still, buyers and sellers in some auction-type markets, say for commodities or some financial

assets, may approximate the concept. Perfect competition serves as a benchmark against which

to measure real-life and imperfectly competitive markets.

BASIC STRUCTURAL CHARACTERISTICS

Generally, a perfectly competitive market exists when every participant is a "price taker", and no

participant influences the price of the product it buys or sells. Specific characteristics may

include:

Infinite buyers and sellers – Infinite consumers with the willingness and ability to

buy the product at a certain price, and infinite producers with the willingness and

ability to supply the product at a certain price.

Zero entry and exit barriers – It is relatively easy for a business to enter or exit in

a perfectly competitive market.

Perfect factor mobility - In the long run factors of production are perfectly mobile

allowing free long term adjustments to changing market conditions.

Perfect information - Prices and quality of products are assumed to be known to

all consumers and producers.

Zero transaction costs - Buyers and sellers incur no costs in making an exchange

(perfect mobility).

Profit maximization - Firms aim to sell where marginal costs meet marginal

revenue, where they generate the most profit.

Homogeneous products – The characteristics of any given market good or service

do not vary across suppliers.

Non-increasing returns to scale - Non-increasing returns to scale ensure that there

are sufficient firms in the industry.

PRICE DETERMINATION UNDER PERFECT COMPETITION

In prefect competition, price is determined by the market forces of demand and supply. All

buyers and sellers are price takers and not price makers. Buyer represents demand side in the

market. Every rational buyer aims at maximising his satisfaction by purchasing more at lower

price and lower at higher price. This is called demand behaviour of buyer i.e. Law of Demand

Seller represents supply side in the market. Every rational seller aims at maximizing his profits

by selling more at higher price and lesser at lower price. This is called supply behaviour of seller

i.e. Law of supply.

But at a common price, buyer is ready to demand a particular quantity of goods and seller is also

ready to supply exactly the same quantity of goods to buyer, such common price is called

'Equilibrium Price' and such quantity is called 'Equilibrium Quantity'

In the above graphical diagram, the following points have been observed :-

1. On X axis, quantity demand and supplied per week has been given and on Y axis, price

has been given.

2. Buyers are purchasing more at lower price and vice versa. This negative relationship is

shown by downward sloping DD curve.

3. Sellers are selling more at higher price and vice versa. This positive relationship is shown

by upward sloping SS curve.

4. Rs. 30 is that price at which demand equates supply (300 units). So, Rs. 30 is an

equilibrium price and 300 units is an equilibrium quantity.

5. Suppose, price fails to Rs. 20/-, So this results into increase in demand (as per Law of

Demand) and decrease in supply (as per Law of Supply). Since DD > SS, i.e. because of

low supply, sellers will be dominant and competition will be among buyers, this leads to

rise in price level. (i.e. from Rs. 20 to Rs. 30) Again price will come back at original level

i.e. equilibrium price (Rs. 30).

6. Suppose, supply exceeds demand (DD < SS) now buyers become dominant and

competition will be among sellers. This leads to downfall in price. (i.e. from Rs. 40 to

Rs.30). Again price will come back to original level. i.e. equilibrium price (Rs. 30).

7. Such automatic adjustment by demand and supply forces will keep single price in market.

SHORT RUN AND LONG RUN CURVES

In the short-run, it is possible for an individual firm to make an economic profit. This situation is

shown in this diagram, as the price or average revenue, denoted by P, is above the average cost

denoted by C.

However, in the long period, economic profit cannot be sustained. The arrival of new firms or

expansion of existing firms (if returns to scale are constant) in the market causes the (horizontal)

demand curve of each individual firm to shift downward, bringing down at the same time the

price, the average revenue and marginal revenue curve. The final outcome is that, in the long run,

the firm will make only normal profit (zero economic profit). Its horizontal demand curve will

touch its average total cost curve at its lowest point.

In a perfectly competitive market, a firm's demand curve is perfectly elastic.

OLIGOPOLY

Oligopoly is that market situation in which the number of firms is small but each firm in the

industry takes into consideration the reaction of the rival firms in the formulation of price policy.

The number of firms in the industry may be two or more than two but not more than 20.

Oligopoly differs from monopoly and monopolistic competition in this that in monopoly, there is

a single seller; in monopolistic competition, there is quite a larger number of them; and in

oligopoly, there are only a small number of sellers.

CLASSIFICATION OF OLIGOPOLY:

The oligopolistic industries are classified in a number of ways: 

(a) Duopoly: If there are two giant firms in an industry it is called duopoly. Duopoly is

further classified as below:

(i)  Perfect or Pure Duopoly: If the duopolists in an industry are producing identical products

it is called perfect or pure duopoly.

(ii)  Imperfect or Impure Duopoly: If the duopolists in an industry are producing

differentiated products it is called imperfect or impure duopoly.

 (b) Oligopoly: If there are more than two firms in an industry and each firm takes

consideration the reactions of the rival firms in formulating its own price policy it is called

oligopoly. Oligopoly is further classified as below:

(i)  Perfect or Pure Oligopoly: If the oligopolists in an industry are producing identical

products it is called perfect or pure oligopoly.

(ii)  Imperfect or Impure Oligopoly: If the oligopolists in an industry are producing

differentiated products it is called imperfect or impure oligopoly.

CAUSES OF OLIGOPOLY:

1. Economies of Scale: The firms in the industry, with heavy investment, using improved

technology and reaping economies of scale in production, sales, promotion, etc, will

compete and stay in the market.

2. Barrier to Entry: In many industries, the new firms cannot enter the industry as the big

firms have ownership of patents or control of essential raw material used in the

production of an output. The heavy expenditure on advertising by the oligopolistic

industries may also be a financial barrier for the new firms to enter the industry.

3. Merger: If the few firms in the industry smell the danger of entry of new firms, they then

immediately merge and formulate a joint policy in the pricing and production of the

products. The joint action of the few big firms discourages the entry of new firms into the

industry.

4. Mutual Interdependence: As the number of firms is small in an oligopolistic industry,

therefore, they keep a strict watch of the price charged by rival firms in the industry. The

firm generally avoid price ware and try to create conditions of mutual interdependence.

CHARACTERISTICS OF OLIGOPOLY:

1.      Every seller can exercise an important influence on the price-output policies of his rivals.

Every seller is so influential that his rivals cannot ignore the likely adverse effect on them of

a given change in the price-output policy of any single manufacturer. The rival consciousness

or the recognition on the part of the seller is because of the fact of interdependence.

2.      The demand curve under oligopoly is indeterminate because any step taken by his rivals

may change the demand curve. It is more elastic than under simple monopoly and not

perfectly elastic as under perfect competition.

3.      It is often noticed that there is stability in price under oligopoly. This is because the

oligopolist avoids experimenting with price changes. He knows that if raises the price, he

will lose his customers and if he lowers it he will invite his rivals to price war.

PRICE DETERMINATION UNDER OLIGOPOLY

EFFECTS OF OLIGOPOLY:

1.      Small output and high prices: As compared with perfect competition, oligopolist sets the

prices at higher level and output at low level.

2.      Restriction on the entry: Like monopoly, there is a restriction on the entry of new firms

in an oligopolistic industry.

3.      Prices exceed Average Cost: Under oligopoly, the firms fixed the prices at the level

higher than the AC. The consumers have to pay more than it is necessary to retain the

resources in the industry. In other words, the economy’s productive capacity is not

utilized in conformity with the consumers’ preferences.

4.      Lower efficiency: Some economists argued that there is a low level of production

efficiency in oligopoly. There is no tendency for the oligopolists to build optimum scales

of plant and operate them at the optimum rates of output. However, the Schumpeterian

hypothesis states that there is high tendency of innovation and technological

advancement in oligopolistic industries. As a result, the product cost decreases with

production capacity enhancement. It will offset the loss of consumer surplus from too

high prices.

5.      Selling Costs: In order to snatch markets from their rivals, the oligopolistic firms may

engage in aggressive and extensive sales promotion effort by means of advertisement and

by changing the design and improving the quality of their products.

6.      Wider range of products: As compared with pure monopoly or pure competition,

differentiated oligopoly places at the consumers’ disposal a wider variety of

commodities.

7.      Welfare Effect: Under oligopoly, vide sums of money are poured into sales promotion to

create quality and design differentiations. Hence, from the point of view of economic

welfare, oligopoly fares fairly badly. The oligopolists push non-price competition beyond

socially desirable limits.

 

PRICE DETERMINATION UNDER DUOPOLY

The price and output behaviour of the firms operating in oligopolistic or duopolistic market

condition can be studied under two main heads: 

1. Price and Output Determination under Duopoly:

(a)    If an industry is composed of two giant firms each selling identical or homogenous

products and having half of the total market, the price and output policy of each is likely

to affect the other appreciably, therefore there is every likelihood of collusion between

the two firms. The firms may agree on a price, or divide the total market, or assign quota,

or merge themselves into one unit and form a monopoly or try to differentiate their

products or accept the price fixed by the leader firm, etc.

(b)   In case of perfect substitutes the two firms may be engaged in price competition. The

firm having lower costs, better goodwill and clientele will drive the rival firm out of the

market and then establish a monopoly.

(c)    If the products of the duopolists are differentiated, each firm will have a close watch on

the actions of its rival firms. The firm good quality product with lesser cost will earn

abnormal profits. Each firm will fix the price of the commodity and expand output in

accordance with the demand of the commodity in the market.

 2. Price and Output Determination under Oligopoly:

(a)    If an industry is composed of few firms each selling identical or homogenous products

and having powerful influence on the total market, the price and output policy of each is

likely to affect the other appreciably, therefore they will try to promote collusion.

(b)   In case there is product differentiation, an oligopolist can raise or lower his price without

any fear of losing customers or of immediate reactions from his rivals. However, keen

rivalry among them may create condition of monopolistic competition.

There is no single theory which satisfactorily explains the oligopoly behaviour regarding price

and output in the market. There are set of theories like Cournot Duopoly Model, Bertrand

Duopoly Model, the Chamberlin Model, the Kinked Demand Curve Model, the Centralised

Cartel Model, Price Leadership Model, etc., which have been developed on particular set of

assumptions about the reaction of other firms to the action of the firm under study.

PRICE DETERMINATION MODELS OF OLIGOPOLY:

1. Kinky Demand Curve: The kinky demand curve model tries to explain that in non-collusive

oligopolistic industries there are not frequent changes in the market prices of the products. The

demand curve is drawn on the assumption that the kink in the curve is always at the ruling price.

The reason is that a firm in the market supplies a significant share of the product and has a

powerful influence in the prevailing price of the commodity. Under oligopoly, a firm has two

choices:

 (a)    The first choice is that the firm increases the price of the product. Each firm in the industry

is fully aware of the fact that if it increases the price of the product, it will lose most of its

customers to its rival. In such a case, the upper part of demand curve is more elastic than the part

of the curve lying below the kink.

(b)   The second option for the firm is to decrease the price. In case the firm lowers the price, its

total sales will increase, but it cannot push up its sales very much because the rival firms also

follow suit with a price cut. If the rival firms make larger price cut than the one which initiated it,

the firm which first started the price cut will suffer a lot and may finish up with decreased sales.

The oligopolists, therefore avoid cutting price, and try to sell their products at the prevailing

market price. These firms, however, compete with one another on the basis of quality, product

design, after-sales services, advertising, discounts, gifts, warrantees, special offers, etc.

  In the above diagram, we shall notice that there

is a discontinuity in the marginal revenue curve just below the point corresponding to the kink.

During this discontinuity the marginal cost curve is drawn. This is because of the fact that the

firm is in equilibrium at output ON where the MC curve is intersecting the MR curve from

below. The kinky demand curve is further explained in the following diagram:

   

In the above diagram, the demand curve is made up of two segments DB and BD’. The demand

curve is kinked at point B. When the price is Rs. 10 per unit, a firm sells 120 units of output. If a

firm decides to charge Rs. 12 per unit, it loses a large part of the market and its sales come down

to 40 units with a loss of 80 units. In case, the producer lowers the price to Rs. 4 per unit, its

competitors in the industry will match the price cut. Its sales with a big price cut of Rs. 6

increases the sale by only 40 units. The firm does not gain as its total revenue decreases with the

price cut.

MONOPOLY

Monopoly is that market form in which a single producer controls the whole supply of a single

commodity which has no close substitute.

From this definition there are two points that must be noted:

 (i) Single Producer: There must be only one producer who may be an individual, a partnership

firm or a joint stock company. Thus single firm constitutes the industry. The distinction between

firm and industry disappears under conditions of monopoly.

(ii)  Close Substitute : The commodity produced by the producer must have no closely competing

substitutes, if he is to be called a monopolist. This ensures that there is no rival of the

monopolist. Therefore, the cross elasticity of demand between the product of the monopolist and

the product of any other producer must be very low.

PRICE DETERMINATION UNDER MONOPOLY

A firm under monopoly faces a downward sloping demand curve or average revenue curve.

Further, in monopoly, since average revenue falls as more units of output are sold, the marginal

revenue is less than the average revenue. In other words, under monopoly the MR curve lies

below the AR curve.

 The Equilibrium level in monopoly is that level of output in which marginal revenue equals

marginal cost. The producer will continue producer as long as marginal revenue exceeds the

marginal cost. At the point where MR is equal to MC the profit will be maximum and beyond

this point the producer will stop producing.

It can be seen from the diagram that up till OM output, marginal revenue is greater than marginal

cost, but beyond OM the marginal revenue is less than marginal cost. Therefore, the monopolist

will be in equilibrium at output OM where marginal revenue is equal to marginal cost and the

profits are the greatest. The corresponding price in the diagram is MP’ or OP. It can be seen from

the diagram at output OM, while MP’ is the average revenue, ML is the average cost, therefore,

P’L is the profit per unit. Now the total profit is equal to P’L (profit per unit) multiply by OM

(total output).

 In the short run, the monopolist has to keep an eye on the variable cost, otherwise he will stop

producing. In the long run, the monopolist can change the size of plant in response to a change in

demand. In the long run, he will make adjustment in the amount of the factors, fixed and

variable, so that MR equals not only to short run MC but also long run MC.

 

PRICE DISCRIMINATION IN MONOPOLY:

Price discrimination may be (a) personal, (b) local, or (c) according to trade or use:

 (a)   Personal: It is personal when different prices are charged for different persons.

(b)   Local: It is local when the price varies according to locality.

(c)   According to Trade or Use: It is according to trade or use when different prices are charged

for different uses to which the commodity is put, for example, electricity is supplied at cheaper

rates for domestic than for commercial purposes. 

Some monopolists used product differentiation for price discrimination by means of special

labels, wrappers, packing, etc. For example, the perfume manufacturers discriminate prices of

the same fragrance by packing it with different labels or brands.

 Conditions of Price-Discrimination: There are three main types of situation:

 (a)   When consumers have certain preferences or prejudices. Certain consumers usually have

the irrational feeling that they are paying higher prices for a good because it is of a better quality,

although actually it may be of the same quality. Sometimes, the price differences may be so

small that consumers do not consider it worthwhile to bother about such differences.

(b)   When the nature of the good is such as makes it possible for the monopolist to charge

different prices. This happens particularly when the good in question is a direct service.

(c)   When consumers are separated by distance or tariff barriers. A good may be sold in one

town for Re. 1 and in another town for Rs. 2. Similarly, the monopolist can charge higher prices

in a city with greater distance or a country levying heavy import duty.

 Conditions making Price Discrimination Possible and Profitable: The following conditions

are essential to make price discrimination possible and profitable:

 (a)   The elasticities of demand in different markets must be different. The market is divided into

sub-markets. The sub-market will be arranged in ascending order of their elasticities, the higher

price being charged in the least elastic market and vice versa.

(b)   The costs incurred in dividing the market into sub-markets and keeping them separate

should not be so large as to neutralise the difference in demand elasticities.

(c)   There should be complete agreement among the sellers otherwise the competitors will gain

by selling in the dear market.

(d)   When goods are sold on special orders because then the purchaser cannot know what is

being charged from others.

 

Price Determination under Price Discrimination:

(i)  First of all, the monopolist divides his total market into sub-markets. In the following

diagrams, the monopolist has divided his total market into two sub-markets, i.e., A and B:

 

 

 (ii)  The monopolist has now to decide at what level of output he should produce. To achieve

maximum profit, hence, he will be in equilibrium at output at which MR=MC, and MC curve

cuts the MR curve from below. In the above diagram (c) it is shown that the equilibrium of the

discriminating monopolist is established at output OM at which MC cuts CMR. The output OM

is distributed between two markets in such a way that marginal revenue in each is equal to ME.

Therefore, he will sell output OM1 in Market A, because only at this output marginal revenue

MR’ in Market A is equal to ME (M1E’ = ME). The same condition is applied in Market B

where MR” is equal to ME (M2E” = ME). In the above diagram, it is also shown that in Market

B in which elasticity of demand is greater, the price charged is lower than that in Market B

where the elasticity of demand is less.