8.

COT ANALYSIS
8.1 Cost Concepts
P Production function, being technical, is not much useful for economic analysis.
What firm needs is cost function, which are derived from production function.
When goods and services are produced, expenses incur on factors. The sum total of
expenses incurred plus normal profit decided by the market is called as cost of
production. Different people look the same cost through different angles, as it is
differently important for them. The various concepts of cost are discussed below.
1. Real and Nominal cost: The real cost refers to the physical quantities of
various factors used in production. It is not possible to measure the real cost
explicitly. Nominal cost refers to the payment made to the factors used in
production i.e. the sum total of rent, wages, interest etc. Real cost because of
its heterogeneous nature is difficult to measure. Total money cost can be
classified as explicit and implicit cost.
2. Explicit costs and implicit costs: Explicit cost is an accounting cost or
contractual cash payment, which the firm makes to the factor owners for
purchasing or hiring factors. Explicit cost embraces all money payments made
to the suppliers of factors. Implicit cost is the cost of self-owned factors,
which are employed by the entrepreneur in his own business. The implicit cost
is an opportunity costs of the self-owned and self-employed factors by the
entrepreneur, i. e. money income which these self-owned factors would have
earned in their next best alternative uses.
3. Accounting or Business Cost and Full or Economic Cost: Accounting cost
is an actual or explicit cost that is paid by the entrepreneurs to the owners of
hired factors and services. Accounting cost outlines actual expenditures
incurred during the production. On the other hand, economic cost includes not
only explicit costs but also the implicit cost. Economic cost is an aggregate of
implicit cost, normal profits and explicit cost.
4. Opportunity Cost: It is quite true that the resources are limited; therefore the
production of one commodity can be done at cost of production of other good.
The quantity of the goods that is given up is an opportunity cost of the
commodity manufactured. Opportunity cost is the minimum return which
factor must get in order to prevent it from leaving present use for alternate

 uses. The opportunity cost (or transfer earnings) of given goods is returns from
the next best alternative that is forgone or sacrificed. For example, if a farmer
who is producing a quintal of wheat can also produce potatoes with the same
factors. Then, the opportunity cost of a quintal of wheat is the amount of output
of potatoes given up.
5. Private cost and Social Cost: Private cost is economic cost, actually incurred
by an individual or a firm. It includes both explicit and implicit cost. Social
cost, on the other hand, implies cost which the society bears as a result of
production. Social cost includes both private cost and the external cost.
External cost includes (a) the cost in the form of free resources for which the
firm is not required to pay, e.g., atmosphere, rivers, lakes etc. (b) the cost in the
form of ‘disutility’ caused by air, water, and noise pollution, etc.
6. Short-run and Long-run Cost: Short-run cost vary with the change in
output, the size of the firm remaining the same. Short-run cost is the same as
variable costs. On the other hand, long-run cost is incurred on the fixed assets,
like plant, building, machinery, land etc. Long-run cost is same as fixed-cost.
However, in the long-run, even fixed cost becomes variable.
7. Total Cost: Total cost is an aggregate expenditure incurred by the firm in
producing given level of output. It refers to the total outlays of money
expenditure, both explicit and implicit on the resources used to produce a given
output. It is derived at by adding products factor quantities and their prices.
TC = N·r +L·w + C·i + E·π
In short period total cost consists of total fixed cost (TFC) and total variable
cost (TVC).
TC = TFC + TVC
8. Fixed cost: Fixed cost is expenditure incurred for the factors such as capital,
equipments, plant or factory building, instance, interest, insurance premium,
rent which remain fixed in the short. Therefore, fixed cost is independent of
output. It is short run cost and constant for all the levels of output. Even if no
output is produced in the short run, this cost is to be paid. Therefore, TFC is
graphically denoted by horizontal straight line.
9. Variable cost: Variable cost is incurred on variable factors such as labour, raw
materials, etc, whose amount can be changed in the short run. Variable cost
varies with the level of output in the short run. It starts from zero for zero level

 of output and goes on increasing. Initially at lower level of output due to

economies, it increases at diminishing rate, then at constant rate and at higher
level of output at increasing rate. It increases at diminishing rate if fixed
factors are being under-utilised because of lesser variable factors. It increases
at constant rate when fixed and variable factors are combined optimally. It
increases at increasing rate when variable factors out number fixed factors and
are under utilised.

8.2 Short-Run Cost Behaviour

The Short run relationship between Total, Average and Marginal
Costs.
Producers have a great concern about behaviour cost along with change in output
because it decides their profit. Cost behaviour is not uniform for all the levels of
output. To study cost behaviour we have to classify and calculate in the suitable
way. Total cost can be divided into total fixed cost and total variable cost. Further
they can be calculated as average total cost, average fixed cost and average
variable cost. We can also observe marginal behaviour of cost.
The behaviour of costs can be studied with the help of following table and figures.

Units TFC TVC TC AFC AVC AC MC

0 200 0 200 --- --- --- ---
1 200 105 305 200 105.0 305 105
2 200 175 375 100 87.5 187.5 70
3 200 210 410 66.6 70.0 136.6 35
4 200 235 435 50 58.75 108.7 25
5 200 255 455 40 51.0 91.0 20
6 200 275 475 33.3 45.8 79.1 20
7 200 300 500 28.5 42.8 71.4 25
8 200 335 535 25 41.8 66.8 35
9 200 405 605 22.2 45.0 67.2 70

 10 200 510 710 20 51.0 71.0 105

11 200 670 870 18.1 60.9 79.0 160

If we draw converted above table in to graphical presentation we get following

diagrams.

Fixed, Variable and Total Cost

Fixed, Variable and Average Costs

The above table and figures shows that
1. Fixed Cost: It is independent of output. It is short run cost and constant for all
the levels of output. Therefore, TFC is graphically denoted by horizontal
straight line.

900
TC

TVC
675

450

225

TFC

0
0 2 4 6 8 10 12 14 16 18 20

 2. TVC: It starts from zero for zero level of output and goes on increasing.
Initially, at lower level of output due to economies, it increases at diminishing
rate, then due to at constant rate and at higher level of output due to
diseconomies of scale at increasing rate.
3. TC: Total cost is sum of total fixed and total variable cost. It starts at fixed cost
for zero level of output and goes on increasing in a same pattern as TVC and
for the same reasons. The difference between TVC and TC is always equal to
TFC. Therefore, TVC and TC curve are always equidistant by the value of
TFC.
4. Average Fixed Cost: It is rectangular hyperbole to show that its product with
quantity is always equal to TFC.
5. Average Variable Cost: Initially it decreases along with increase in output,
reaches to minimum and starts to increase. AVC curve is ‘U’ shaped. Decrease
in AVC is caused by economies or scale while increase is caused by
diseconomies of scale.

MC
80

60

AC
40
AVC

20

AFC

0
0 2 4 6 8 10 12 14 16 18 20

 6. Average Total Cost: Initially this also goes on decreasing, reaches to the
minimum and then starts to increase. AC curve is also ‘U’ shaped. For all the
quantity of output AC is higher than AVC, provided fixed cost is positive,
otherwise both are one and the same.
7. Marginal Cost: Marginal cost is an addition made to the total cost as a result
of producing one additional unit of the product. Marginal cost is defined as
TCn – TCn-1. Marginal cost curve is ‘U’ shaped. It means initially it decreases,
reaches to the minimum and then increases, in such a way that it becomes
equal to AVC and AC at their minimum value. In other words, MC intersects
AVC and AC from below at their lowest point
Observations:
1. Minimum value of MC (point of MC curve) appears at a lowest quantity of
output followed by minimum value of AVC (point of AVC) followed by
minimum value of AC (point of AC).
2. MC curve cuts AVC and AC curves from below at their minimum points.
3. The difference between AVC and AC goes on decreasing as fixed cost spread
on larger and larger number of uni

9. REVENUE CONCEPTS
Money received by the firm from sales of output is called revenue. Though it is
received by the firm, it is not same as income to an entrepreneur. It includes cost as
well as profit.
1. Total revenue: Total revenue is money proceeds received by the entrepreneur
from the sale of given quantity of output. It is equal to product of price and
quantity sold. i.e.
Total revenue (TR) = Price (P) × Quantity sold (Q)
TR = P.Q
2. Average revenue: It is revenue per unit of output sold. It is same as price. It can
be calculated as ratio of TR to quantity. i.e.
Average revenue (AR) = Total Revenue/quantity
3. Marginal revenue: Marginal revenue of a given unit of output is an addition
made by that unit to the total revenue. It is calculated as,
Marginal revenue (MR) = TRn – TRn-1

9.1 TR, AR and MR Under Perfect Competition

Perfect competition is a type of market in which there is a large number of buyers
and seller, of whom no one is so significant as to control or even influence the
market, i. e. They are price taker. They sell and buy product at the price, which is
decided by market demand and supply. It means seller can sell as much as he want
and buyer can buy as much as he want, at the prevailing market price.
In other words, the seller needs not to charge lower than market price to sell more
and no one will pay him higher market price. On the other hand, buyer need not to
pay higher than market price to buy larger quantity and cannot buy anything at
lower than market price.
The relationship between TR, AR and MR under perfect competition can be
explained with the help of following table and diagram.

Output 0 1 2 3 4 5 6 7 8 8 10
Price 10 10 10 10 10 10 10 10 10 10 10
TR 0 10 20 30 40 50 60 70 80 90 100
AR — 10 10 10 10 10 10 10 10 10 10
MR — 10 10 10 10 10 10 10 10 10 10

Above table and diagram shows that with increase in output;

 1. Total revenue increases proportionately at constant rate of market price.

Therefore, TR curve is an upward sloping straight line at slope of price.
2. Average revenue and marginal revenue both are constant at market price
for all the levels of sales. Therefore, AR and MR curve superimpose each
other and are parallel to the X-axis.
3. AR or MR are equal to each other at one unit quantity or AR and MR curve
intersect to each other at unit quantity..

9.2 TR, AR and MR Under Imperfect Competition

Imperfect competition is a type of market in which there are many sellers, but
either all of them or few of them, are significant enough as to control or at least
influence the market. Therefore, they are price maker or influencer. They can sell
larger quantity of output by reducing price. This makes market demand curve to
slope downward. It means a seller can sell more quantity by charging lower price
or can charge higher price by accepting lower sales. On the other hand, a buyer will
buy larger quantity at lower price and lower quantity at higher price.
The relationship between TR, AR and MR under imperfect market can be
explained with the help of following table and diagram.

Output 0 1 2 3 4 5 6 7 8 9
Price 20 19 18 17 16 15 14 13 12 11
TR 0 19 36 51 64 75 84 91 96 99
AR — 19 18 17 16 15 14 13 12 11
MR — 19 17 15 13 11 9 7 5 3

Above table and diagram shows that with increase in quantity produced;
1. Average revenue continuously decreases to show that to sell more quantity
seller will have to decrease price of his product. Therefore, AR curve is
downward sloping.
2. Therefore, TR goes on increasing with diminishing rate (MR is decreasing),
then reaches to the maximum when MR =0 and finally starts to decline (MR is
negative) i.e. practically TR curve rises with diminishing slope.
3. Marginal revenue also goes on diminishing but faster than average revenue and
it is always lesser than average revenue. The relationship between AR and MR,
when AR is linear, concave and convex to origin.

Figure 1: When AR is a straight line MR is also a straight and it lies exactly half a
distance away from price and AR curve. i.e. AB =BC.Figure 2: When AR is
Concave to origin MR is also concave and lies nearer to AR curve than price axis.
i. e. AB > BC.Figure 3: When AR is Convex to origin MR is also convex and lies
nearer to price axis than AR curve. i.e. AB < BC.


 10. OBJECTIVES OF FIRM

Firm: A basic unit of organisation for productive activities is called as a firm. It is
an individual production unit.
Industry: When all the business firms producing homogenous or same product in a
country combined together, it forms an industry of that product. It's constituents
may vary in the size.
Normal profit: Factor remuneration to entrepreneur is called normal profit. It is
the minimum amount required by an entrepreneur to stay in the current business. In
other words, normal profit is the minimum returns which entrepreneur must receive
to stay or continue in the current business. Anything less than or in excess of
normal profits is called loss or supernormal profits. Normal profit is a part of total
cost and is decided by the factor market which individual factor owner as well as
business firms have to accept the same.
Supernormal profit: Any profit over and above normal profit is a ‘bonus’ for the
firm, as it is more than that it needs to keep itself in the industry. We call it as
supernormal or excess profit. It is neither a part of production cost nor is
remuneration to any factor, but is received by the entrepreneur because of
imperfections of market. However, supernormal profit signals other firms. A new
business firm will enter an industry if there is supernormal profit and existing one
will leave the industry if there are losses.
Equilibrium of firm: When a business firm for any reasons, generally profit, do
not want to change its output it is call to be in equilibrium. Equilibrium is the best
possible production condition for the firm, in the given set of conditions and
wherefrom it do not want to move. It do not want to change output because any
change will be adverse. Equilibrium is not a static but dynamic concept because
with changes in other things, equilibrium will changes.
Representative firm: A hypothetical business firm whose choices are
representative of the industry is called as representative firm. All business firms
vary in different aspects and their market behaviour may differ widely. But some
features are common amongst most of business firms and may be hold by one or
few business firms. Such business firm(s) is/are called as representative business
firm. The industry, therefore, can be modelled by a representative firm's
technology, capital output ratio and output. To simplify study we assume that all

10

firms in an industry have the same constant returns to scale, technology and every
firm acts as a price taker

10.1 Various Objectives of Firm

Profit is an obvious and general objective of business firms because it helps them
survive and expand. It is true, particularly, when owner and manager of business is
one and the same person. But in today’s globalised world businesses grow
international, to raise required capital, they adopt joint stock nature, in which
management become separate owner who have no control in day to day affair of
business. All the decisions are taken by the management who is answerable to the
board of directors. Because of this managers are free to follow their desired
objectives like staff maximisation, sales maximisation, growth maximisation,
utility maximisation etc. It happens because manager believes that his interest lies
in other than profit. Other probable objectives are.
1. Profit maximisation: Profit is the most common objective of business firm
because it essential for survival and expansion. Therefore, firm has to take care
that they are capable of and are earning enough profit. Profit is of two types;
normal profit and supernormal profit. Normal profit is remuneration of
entrepreneur for his contribution to the business. It can not be controlled by the
entrepreneur but is decided by the factor market. It is residual after the payment
of rent, interest and wages. Supernormal profit is a profit over and above
normal profit. It is received by entrepreneur not for contribution to the business;
but due to imperfection of the market. It is equal to difference between total
revenue and total cost of given level of output. It is supernormal profit which
managers want to maximise. It can be maximised either by increasing total
revenue or by decreasing cost or by doing the both simultaneously.
2. Staff maximisation: When manager is different from the owner, he may prefer
to follow the objective of staff maximisation. It is because he may think he can
derive more satisfaction, more prestige and even more salary, by being a boss of
larger number of employees. Objective of staff maximisation can be explained
with the help of profit curve and managers indifference map.

11

 OP is profit curve which shows that in the beginning profit increases with staff
due to better utilisation of fixed resources, reaches to the maximum and the
starts to fall due to fall in labour productivity as a result of conjunction. IC1,
IC2, IC3 and IC4 are manager’s indifference curve. Diagram shoes that if
business firm employees S2 employees profit would be the maximum possible;
but by doing so manager get lesser satisfaction shown by IC2. If he increased
his staff to S3 level, he would get higher satisfaction shown by IC3. Therefore,
instead of producing with S2 staff with maximum profit, manager produces with
S3 employees at lower profit.
3. Sales maximisation: Manager may also think he can derive more prestige,
satisfaction and even salary by being manager of company with large market
share. Therefore, he may follow sales maximisation rather than profit
maximisation.

Again OP is profit curve which shows initially positive relationship between

profit and sales because of better utilisation of other factors and then turn
negative as a result increase in average cost of production. Instead of producing

12

 and selling S2 quantity with maximum profit, firm produces S3 quantity where
profit is less than the maximum but manager’s interest is maximised.
4. Growth maximisation: Sometimes manager is more inclined towards growth
rate maximisation even knowing growth maximisation does not guarantee
higher profit. He may search his interest in growth rate.
In the following diagram, supply growth function shows positive relationship
between profit and supply growth rate. It means that for higher profit firm
would like to increase its supply growth rate. The demand growth curve,
initially at lower growth rates, shows positive relationship between profit rate
and demand growth rate and then it turns negative for higher demand growth
rate.

When growth rate is less than ge like g1, g2 demand growth rate is higher than
supply growth rate. It shows the scope for expansion of firms output. The firm
which has targeted growth rate maximisation would go on increasing its supply
growth till it equals demand growth rate. Once supply growth equals demand
growth rate it will not increase it further. This is because it will make create
stock, which will bring down prices and profit too. Therefore, firm’s
equilibrium position, irrespective of profit, is determined at the point where
demand and supply growth rate equals i.e. growth rate gE.

10.2 Profit Maximisation with TR and TC

Profit is the most common and an obvious objective of business firms because it
decides survival (normal profit) and expansion (super normal profit). A rational
entrepreneur will expand or contract output if he thinks by doing so he can increase

13

his profit or decrease his loss. A business firm will be in equilibrium when it earns
the maximum possible profit. In other words, the firm will have no inducement
either to expand or contract its output when it is earning maximum possible profit.
Profit will be the maximum, if difference between TR and TC is the maximum. (or
when distance between TR curve and TC curve is the maximum or when at given
quantity of output, tangential to both TR and TC curve are parallel to each other)
The objective of profit maximisation with the help of TR and TC can be explained
by the help of following diagram.
In the following diagram, TC is total cost curve, which shows that with increase in
output; initially TC increases at diminishing rate because of economies of scale and
then increases with increasing rate because of diseconomies of scale. TR is total
revenue curve which shows that TR increases proportionally with increase in
quantity sold1.

In the beginning when output is lower than Q1 firm is in losses, (TC > TR) because
total fixed cost (TFC) spreads thickly on smaller number of units. Therefore, firm
will increase its output to decrease losses. At quantity Q1 firm earns no loss and no
profit, as TR = TC. If output is more than Q1, profit will appear and would go on
rising (due to economies of scale) to become the maximum at quantity Q2, where
difference between TR and TC is maximum or in the diagram distance between TR

1 In perfect competition, with increase in output, TR curve increases proportionally at

constant rate of price or TR curve is a straight positively sloping line starting from origin. In
imperfect competition it increases at diminishing rate.

14

and TC curves is maximum. This distance would be the maximum when tangents
to TR and TC, at any given level of output, are parallel to each other. Thus figure
shows that profit would be the maximum at Q2. If firm produces any quantity more
or less than Q2 profit will be less than maximum. If he dared to produce Q3, profit
will disappear and production more than Q3 will earn losses.
Therefore, producer will be in equilibrium with maximum possible profit at output

10.3 Profit Maximisation with MR and MC

Profit is the most common, an obvious and rational objective of business firm.
Therefore, firms will be in equilibrium when profit is the maximum. As profit is
difference between total revenue and total cost, it would be maximum when
difference between TR and TC is maximum, provided TR > TC, or distance
between TR and TC curve, in the diagram, is maximum. Distance between these
two curve would be maximum when their slopes are same at give quantity output.
Slope of TR and TC curve is nothing but MR and MC respectively. Thus, profit
will be the maximum when MR = MC. This can be explained with the help of
following figure.

Output 0 1 2 3 4 5 6 7 8 9 10 11 12
MR — 20 19 18 17 16 15 14 13 12 11 10 9
MC — 24 21 18 15 12 9 6 9 12 15 18 21
π -4 -2 0 2 4 6 8 4 0 -4 -8 -12

Π -4 -6 -6 -4 0 6 14 18 18 14 6 -6

Assume that there is no fixed cost. Therefore, for zero level of output there is no
revenue and no cost and hence neither profit nor loss.
1. When first unit of output is produced, it adds Rs. 20 to revenue and Rs. 24 to
the cost. Therefore, firm earn loss of Rs. 4.
2. The second unit adds Rs. 19 to revenue and Rs. 21 to the cost. Therefore,
firm’s loss increases by Rs. 2 and become Rs. 6.
3. Production of the third unit adds equally to the cost and revenue, therefore,
loss remains unchanged at Rs. 6.

15

4. The fourth unit adds Rs. 2 more to the revenue than to the cost. Therefore, los
decreases by Rs. 2 and comes at Rs. 4.
5. Production of 5th unit reduces loss to zero.
6. After the fifth unit every unit add more to the revenue than cost. It results into
increase in profit till firm increases production to the 9th unit.
7. Once again 10th unit adds more to the cost and less to revenue, therefore profit
decreases. After this every additional unit add more to the cost and less to the
revenue. This results into decrease in total profit.
Knowing this pattern of changes in revenue and cost, firm will produce only 9
units which maximise its profit. Therefore, firm will be in the equilibrium at
production of nine units with maximum possible profit.

In the above figure MR is marginal revenue curve and MC is marginal cost curve.
MR curve show an addition to the revenue and MC shows an addition to total cost.
At lower level of output MC may be higher than MR because of diseconomies of
scale. As production increases MC come down faster than AR, reaches to the
minimum and then rises. At the output less than Q1, an additional unit of output
adds more to the cost and than revenue, i.e. MC > MR. With every additional unit
loss increases. Even after that production will be increased because with increase
in production difference between MR and MC goes on diminishing, till it becomes
zero at quantity Q1. It means that every additional unit adds less and less to the

16

 losses. Unit Q1 add nothing to the loss. It is sign of forthcoming economies and
profit.
After Q1, every additional unit adds more to the revenue and less to the cost.
Therefore, further production is profit making. Hence, firm will go on producing
more and more units, till an additional unit adds more to the TR and less to the TC
i.e. MR > MC. At quantity Q2, an addition to the TR and TC is equal keeping profit
at the maximum.
If production is increased more than Q2, MR < MC and profit will go on
diminishing, which will not be preferred by the business firm. That is why business
firm will not increase production more than Q2. It means firms profit would be
maximum at quantity Q2, where MR = MC. This is first order or essential
condition for profit maximisation.
In the diagram there are two points (A and B) or quantities (Q1 and Q2) at which
MR = MC. But profit is not maximum at both the points. To identify profit
maximising point we need second order or sufficient condition. Points A and B
differ from each other in the sense that at point A or Q1 quantity, MC intersects MR
from above or slope of MC < slope of MR and at point B or Q2 quantity MC
intersects MR from below or slope of MC > slope of MR. The condition that at
MC intersect MR from below or at intersection of MR and MC, slope of MC
should be greater than that of MR is called the second order condition of
equilibrium.
But profit can not be maximum where MR=MC, but MC intersect MR from above.
For profit maximisation,
First order condition, MR = MC
Second order condition at intersection slope of MC > slope of MR

10.4 Break Even Analysis

The study of interrelationship among cost, scale and profit is known as cost-
volume-profit analysis, or break-even analysis or profit contribution analysis. It
involves study of revenues and costs of the firm in relation to volume of sales. It
analyses the determination of that possible volume of sales at which firm’s total
revenue is equal to total cost.

17

 Break-even analysis may be taken as an analysis which breaks total production

possibilities in profit making or loss making possibilities. In a set of production
possibilities there would be smaller or larger losses and in another set of
possibilities there is smaller or larger profit. Profit and loss making conditions are
separated by a single condition at which total revenue is equal to total cost and
there is neither profit nor loss. This point at which TR and TC curves interest each
other is known as break-even point and the quantity at which it happens is known
as break-even quantity and the whole table or figure is known as break-even chart.

Break-even quantity (QB) can be calculated as,

TR = TC
But TR = P. QB,
TC = TFC + TVC,
P.Q = TFC + TVC
But TVC = AVC. QB
P. QB = TFC + AVC. QB
P. QB – AVC. QB = TFC
QB (P –AVC) = TFC
T FC
QB =
P − AV C

In the above diagram TR, TC and TFC are total revenue, total cost and total fixed
cost curves. TR equals TC at quantity QB, therefore, QB is break-even quantity.
They intersect each other at point B which is, therefore, known as break-even
point.
Figure shows that if firm produces less than breakeven quantity QB there would be
losses and if it produces more than breakeven quantity there would be profit.
Taking into consideration all types of possibilities firm is to decide what quantity is
to produce.

18

 10.5 Managerial use of Breakeven Analysis

Breakeven analysis presents a microscopic picture of profit structure of business. It
enables to plan managerial actions to maintain and increase the profitability of the
firm.
1. Safety margin: The breakeven analysis helps the firm to find safety margin, the
extent to which the firm can afford to reduce sales before it starts incurring
losses. To a firm incurring losses, the concept of safety margin gives an idea to
know the extent sales must be increased to avoid losses.
2. Volume of sales: The break even analysis may be used for determining the
volume of sales necessary to achieve the targeted profit. It can also help the
management to know the required volume of sales to maintain the previous
level of profit. It enables the management to judge whether required increase in
sales will be feasible, when a price change occurs.
3. Change in cost: Breakeven analysis enables management to understand how
change in the cost would affect the profit margin. Change in the cost will shift
TC curve and thereby will change break even quantity.
4. Expansion capacity: Breakeven analysis will help the firm to know whether an
expansion of production capacity is required.
5. Change in prices: Breakeven chart can be modified to show what would be
profit position at different price levels under assumed conditions of cost and
demand.
6. Purchase decision: The breakeven analysis may help in deciding on the
questions of self manufacturing or outsourcing from outside supplier, a certain
component of their finished product.
7. Sales promotion: It may help business firm to decide on the issue of promotion
of product.

Example 1.
Fixed factory overheads cost 60000
Fixed selling overheads cost 12000
Variable manufacturing cost per unit 12
Variable selling cost per unit 3

19

 Selling price per unit 24

Calculate break even point in term of sales and sales value and quantity to be sole
for ₹90000 profit.
T FC
Break even quantity QB =
P − AV C

18000 18000
QB = = = 2000
24 − 15 9
Example 2.
From the following data, calculate:
(a) P/V ratio
(b) Break-even sales with the help of P/V ratio.
(c) Sales required to earn a profit of Rs. 4,50,000
Fixed Expenses = Rs. 90,000
Variable Cost per unit: Direct Material = Rs. 5
Direct Labour = Rs. 2
Direct Overheads = 100% of Direct Labour
Selling Price per unit = Rs. 12
Example 3.
calculate break-even point and net sales value

Direct material cost per unit 10

Direct labour cost per unit 5
Fixed overhead 50000
Variable overheads at 60% on direct labour
Selling price per unit 25
Trade discount 4%
If sales are 10% and 25% above the break-even volume, determine the profit.
Example 4.
Variable cost per unit 15
Fixed expenses 540000
Selling price per unit 20
What should be the selling price per unit, if the break-even point should be brought
down to 6,000 units?
Example 5.
The fixed costs amount to Rs. 50,000 and the percentage of variable costs to sales
is given to be 66 ⅔%.

20

 If 100% capacity sales are Rs. 3,00,000, find out the break-even point and the
percentage sales when it occurred. Determine profit at 80% capacity:

Example 6.
how much the value of sales must be increased by the company to break-even:

Sales 300000
Fixed cost 150000
Variable cost 200000
Example 7.
Calculate:
(i) The amount of fixed expenses.
(ii) The number of units to break-even.
(iii) The number of units to earn a profit of Rs. 40,000.
The selling price per unit can be assumed at Rs. 100.
The company sold in two successive periods 7,000 units and 9,000 units and has
incurred a loss of Rs. 10,000 and earned Rs. 10,000 as profit respectively.
Example 8.
A company is making a loss of Rs. 40,000 and relevant information is as
follows:
Sales Rs. 1,20,000; Variable Costs Rs. 60,000; Fixed costs Rs. 1,00,000.
Loss can be made good either by increasing the sales price or by increasing sales
volume. What are Break even sales if
(a) Present sales level is maintained and the selling price is increased.
(b) If present selling price is maintained and the sales volume is increased. What
would be sales if a profit of Rs. 1,00,000 is required ?
Example 9
A firm has the following income statement For a month.
Sales: 3,000 units at $80/unit
Less: Cost of Goods Sold.
Variable Production Cost 180000
Fixed Production Cost 198006
Gross Margin.
Selling and Administrative Expenses
Variable Selling Cost. 21000
Fixed Selling Expenses 7500
Net Income Before Taxes 11700

21

 1. Find the firm’s breakeven output.

2. If it wishes to have a monthly net income before taxes of $18,000 and its
cost structure remains as above, what quantity of output will it need to
sell?
3. If its variable production costs increase by $4 per unit, what will be its
breakeven output?
4. After the increase in costs in 3, what output will it need to sell if it wishes
to have the $18,000 monthly pretax profit stated earlier?
5. Given the variable production cost increase but no change in fixed costs,
what will be the firm’s monthly profit if it sells 4,000 units of output per
month?
Example 10.
On investigation it was found that variable cost in XYZ Ltd is 80 per cent of
the selling price. If the fixed expenses are Rs 10,000, calculate the break-even
sales of the company. Another firm, IMN Company Ltd, having the same
amount of fixed expenses, has its break-even point at a lower figure than that
of XYZ Ltd. Comment on the causes.
Solution
BEP (amount) = Rs 10,000/ P/V ratio (100 per cent-Variable cost
to volume ratio = 0.80)
= Rs 10,000/0.20 = Rs 50,000 (XYZ Ltd)
The lower break-even point of IMN Ltd vis-à-vis XYZ Ltd is due to its lower
variable expenses to volume ratio, which in turn may be either due to its lower
VC per unit or higher SP per unit, eventually yielding higher contribution
margin and, hence, higher P/V ratio and lower BEP.

11. PERFECT COMPETITION

11.0 Why Is an MC Curve Supply Curve?
An established business firm in a market while changing its output, thinks of
changed cost and expected revenue. In the long run firm neither expect super
normal profit nor losses but just normal profit. Therefore, expected revenue from
marginal or from an additional unit is it marginal cost. If marginal revenue is more
than or equal to its marginal cost, the firm will produce and sell in the market. If
marginal revenue is less than its marginal cost, it will add to the loss of the
business firm. Therefore, at such level of revenue firm will not produce and sell in
the market. In brief, marginal cost shows minimum price at which producer offers.
The same is shown by supply curve.

22

Suppose that a business firm had been established and it has to decide to produce
its first unit which cost ₹ 100 which consists of rent, wages, interest and normal
profit, say ₹ 25 each. If by selling that unit firm receives ₹. 100, it will produce and
sell. Likewise if 2nd unit costs ₹120 (MC) firm will offer it in the market for sell.
Thus, every unit will be offered for sale in the market for sale at its MC. That is
why MC is supply price and MC curve is also supply curve. But this does not
happen when MC is less than AVC. This is because at such a low level of MC it
always benefits the to shut down.
Thus, we can say that MC curve above AVC curve is nothing but supply curve of
individual business firm.
Classification of Markets
Markets are of varied types with smaller or bigger differences. We can classify
them on the basis of different criteria. The basic criteria of classification are
substitutability of products, interdependence and entry criterion.

Types of Market Criterion

Substitutability of Interdependence
Ease of Entry
Products of Sellers
d qj pi d pj qi Pa − Pc
ep, ji  =   eq ji  = E=
d Pi q j d qi pj Pc

Pure competition →∞ →0 →0
Monopolistic 0 < eP·ji < ∞ →0 →0
competition

Pure Oligopoly →∞ 0 < eq ji < ∞ E >0

Heterogeneous 0 < epji < ∞ 0 < eq ji < ∞

Oligopoly
E >0

Monopoly →0 →0 Blocked entry

Firm: A basic unit of organisation for productive activities is called as a firm. It is

an individual production unit.
Industry: When all the business firms producing homogenous or same product in a
country combined together, it forms an industry of that product. It's constituents
may vary in the size.

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 Firstly, the concept of industry is very useful in the study of competition because it
reduces the complexity of relations between all the firms of an economy to
manageable dimensions. In a broad sense each firm competes with every other firm
in the economy and therefore, a general equilibrium approach would be more
appropriate for the study of economic behaviour of an individual firm. But such
aggregate economic models are more suitable in studying and predicting aggregate
aggregate magnitudes. The study of behaviour of a firm makes it necessary to
demarcate study to closely interrelated firms to gain deeper insight into them. The
concept of industry has been developed to include firms which are closely related
with one another.
The concept of industry makes it possible to derive a set of general rules from
which we can predict the behaviour of competing members of a group called
industry.
The concept of industry provides the framework for analysis of the effects of entry
on behaviour of firm.
The empirical research would be unmanageable if one had to work with
wholesome data of a economy.

11.1 Criterion for Classification of Firms Into

Industries
Firms and industries are classified either on the product being produced when their
products are close substitutes or the method of production on the basis of
production processes and/or raw materials being used.
To use criterion of similarity of product we will have to divide them on the basis of
cross elasticity of demand. But value of cross elasticity required to classify them a
priori theoretical ground. For example, in transportation industry we can include
water, road and air transportation. But in pricing decisions this is not useful. In
perfect competition cross elasticity if demand for each product is infinite while in
monopolistic competition cannot be. Both Chamberlin and John Robinson with
differentiated product each firm has it own market and some degree of monopoly
power but also recognised the necessity of retaining the concept. Triffin argued that
all goods are to some degree substitutable for one another in that they compete for
a part of the income of consumer. Every firm compete with all other firms in the
economy. Thus, he concluded into irrelevance of the concept of industry. But for
others rejection is unnecessary and undesirable.
In similarity of processes criterion, similarity may lie in the method of production,
the raw material used or the channels of distribution.

Normal profit: Factor remuneration to entrepreneur is called normal profit. It is

the minimum amount required by an entrepreneur to stay in the current business. In
other words, normal profit is the minimum returns which entrepreneur must receive

24

to stay or continue in the current business. Anything less than or in excess of

normal profits is called loss or supernormal profits. Normal profit is a part of total
cost and is decided by the factor market which individual factor owner as well as
business firms have to accept the same.
Supernormal profit: Any profit over and above normal profit is a ‘bonus’ for the
firm, as it is more than that it needs to keep itself in the industry. We call it as
supernormal or excess profit. It is neither a part of production cost nor is
remuneration to factor, but is received by the entrepreneur because of
imperfections of market. However, supernormal profit is a signal to other firms. A
new business firm will enter an industry if there is supernormal profit and existing
one will leave the industry if there are losses.
Equilibrium of firm: When a business firm for any reasons, generally profit, do
not want to change its output it is call to be in equilibrium. Equilibrium is the best
possible production condition for the firm, in given set of condition and wherefrom
it do not want to move. It do not want to change output because any change will be
adverse. Equilibrium is not a static but dynamic concept because with changes in
other things, equilibrium will changes.
Representative firm: A hypothetical business firm whose choices are
representative of industry is called as representative firm. All business firms vary
in different aspects and their market behaviour may differ widely. But some
features are common among most of business firms and may be hold by one or few
business firms. Such business firm(s) is/are called as representative business firm.
The industry, therefore, can be modelled by a representative firm's technology,
capital output ratio and output. To simplify study we assume that all firms in an
industry have the same constant returns to scale, technology and every firm acts as
a price taker.

11.2 Perfect Competition

According to Boulding, “the competitive market may be defend as a large number
of buyers and sellers all engaged in the purchase and sale of identically similar
commodity, who are in close contact with one another and who buy and sell freely
among themselves”. Perfect competition is that type of market in which there is
large number of buyers and sellers who are too insignificant to influence the
market. Therefore, they are price taker and there is complete absence of rivalry
among the individual firms in the market. They cannot charge higher price because
no one will buy from them at a price higher than market price and need not to
charge lower price to sell more quantity as they can sell any quantity at the market
price. Demand curve in this type of market is horizontal and price elasticity of
demand is infinite.

25

1. Large number of sellers : There is large number of firms in the industry. The
existence of a large number of firms ensures that an individual firm, however
large, supplies only a small part of market supply and exercises no influence on
the working of the market. Number of buyers and seller are so large that none of
them can influence market.
2. Free entry and exit: This assumption is supplementary to the assumption of
large number of firm and no rivalry among sellers. Buyers and sellers are free to
enter or exit market at any point of time without restrictions. As each buyer and
seller is insignificant part of market, new buyers and sellers will not be able to
change the nature of market.
3. Homogenous product: In perfectively competitive market, products of all the
participating firms are identical in technical characteristics. There is no way in
which buyers can differentiate between the products of different firms. If
products were differentiable, it would have conferred some discretion to the
firm in setting price, but in perfect competition this is ruled out ex hypothesi.
Since products are homogenous price prevailing is same.
4. Demand curve: The assumptions of large number of sellers and product
homogeneity implies that every individual firm is price taker or demand curve
is infinitely elastic or horizontal. It also means that firm can sell and buyer can
buy any amount of output at the prevailing market price. Demand curve of an
individual firm is also its AR and MR curve.

5. Perfect knowledge: Buyers and sellers have perfect knowledge about the
market. Sellers cannot charge more than prevailing price and if any seller tries
to charge, he will lose all his customers. Similarly, no buyer can get goods at
lower price than market price.

26

6. Perfect mobility of factors: Factors of production are free to move from one
firm to other or from one line of production to other, form one region to other.
7. No transportation cost: Transportation costs are ignored or are assumed to be
absent in the perfect competition. This assumption is for simplification of model
rather than reality. It is because inclusion of transportation cost would violate
the model of perfect competition.
8. No government intervention: The government follows a laissez faire policy
and does not interfere in the economic activities of people.
8. No advertisement: Since all products are identical in features like quality, taste,
design etc., there is no scope for product differentiation and so for
advertisement. So advertisement cost is nil.
9. Non-increasing returns to scale: The lack of increasing returns to scale (or
economies of scale) ensures that there will always be a sufficient number of
firms in the industry.
If all these conditions are fulfilled there would be perfect competition and only one
price will prevail in the market at a given time.

11.3 Short Run Equilibrium

A short run is a period in which at least few factors are fixed or unchangeable. In
the short run all types of changes in the business firm are not possible. Therefore, a
new business firms can not join or existing one cannot go out of the industry. In
brief, supply of industry would be changeable due to variable factors only because
no new firm can join or existing firm can leave.
In general, the main objective of business firm is profit maximisation, therefore,
we can say that a firm would be in equilibrium when it is earning the maximum
possible profit or when it is charging that price and producing that quantity which
maximises its profit. Profit would be maximum when MR = MC or firm would be
in equilibrium when MR = MC.
In short run firm can be in equilibrium with profit or with no profit no loss or with
losses. This can be explained with the help of following diagram.
It is because when MR > MC, every increase in output will result into greater
increase in TR than increase in TC. Therefore, profit will go on increasing so far as
MR > MC. On the other hand, if MR < MC, every increase in quantity produced

27

 will result into smaller increase in TR than increase in TC. Therefore, profit will go
on decreasing. A producer who is facing MR < MC, if decreases production will
face smaller decrease in TR and larger decrease in TC, thus profit will increase or
losses will decrease. It means that when MR > MC firm will increase it production
and when MR < MC it will decrease production. Thus firm will neither increase or
decrease production, if MR = MC. This can be explained with the help of
following diagram.
Profit earning equilibrium: In the figure 0.0, AC and MC curve shows cost
conditions, whereas revenue or market conditions are shown by AR and MR
curves.

If price decided by the market is P1, firm’s equilibrium point will be E1 where
MR1= MC. In this case AR (P1) is greater than AC (C1); therefore, firm will earn
supernormal profit. Thus, firm will be in equilibrium by producing quantity Q1,
charging price P1 and earning supernormal profit P1E1AC1 shown by shaded area.
If firm produces less than quantity Q1 MR would be larger than decrease in MC,
which also means that with increase in quantity produced, TR would increase more
than increase in TC. Therefore, profit will go up.2
If firm produces more than quantity Q1, MR would be lesser than MC, which also
means that with decrease in quantity produced, TR would decrease lesser than TC.
Therefore profit will increase. Thus, if business firm produces at a point E1, where

28

 MR = MC, it will earn the maximum possible profit and will have no intension of
changing output so far as cost and revenue conditions are the same.
No loss no profit equilibrium: If price decided by the market is P, the firm will be
in equilibrium at point E, where MR = MC. In this case AR = AC, therefore, firm
will have neither supernormal profit nor loss but only normal profit. If firm started
producing more or less than quantity Q losses will appear.
Loss earning equilibrium: If price decided in the market is P2 firm will be in
equilibrium at point E2, where MR = MC. In this case AR < AC, therefore, firm
will earn losses. If firm produced more or less than quantity Q2, losses to the
business firm will go up. Therefore, firm will neither increase or decrease quantity
produced.

11.4 Shut Down Point

When a firm produces and sells, there would be three possibilities; either
supernormal profit (TR > TC) or normal profit (TR = TC|no loss no profit) or
losses (TR < TC). If a firm earns supernormal or normal profit ( i. e. TR ≥ TC or
AR ≥ AC) firm will continue its production. When a firm earns losses in the short
run, if it will continue its production or not, depends on weather TR > or = or <
TVC.

when TR > TVC

Loss < TFC
when
when

29

 when
when
TR = TC when TR = TVC SD
TR > TC
no Profit/ Loss = TFC
Profit
Loss
when TR < TVC
Loss > TFC

If TR > TVC firm will continue its production because losses would be less than
TFC which is otherwise loss. If TR < TVC firm will stop production because by
doing so it would restrict its losses to TFC and if continued production loss will
grow greater than TFC.

When TR = TVC, in the short run, losses would same as TFC, either it produces or
not. Such type of an temporary equilibrium point where loss is equal to TFC or TR
= TVC, and therefore, firm is indifferent when produces or not, is called as shut-
down point. At this point AR = AVC. It is called shut down point because, at this
or any equilibrium below it if firm will shutdown its operation.

To summarise

TR > TVC (AR > AVC) Losses < TFC Production continues

TR = TVC (AR = AVC) Losses = TFC Production stopped

TR < TVC (AR < AVC) Losses > TFC Production stopped

Shut down point can be better explained by the following figure. If market
condition is shown by AR1 = MR1 loss making firm will continue its production. It
is because out of TR firm can pay full TVC and a part of TFC, reducing loss less
than TFC. If it closed down its operation, it will have no TVC as well as TR and
loss equal to TFC.

30

If market condition is given by MR2 = MC2, TR would not be enough to pay even
TVC, making firm’s losses equal to TFC plus a part of variable cost. Therefore, it
is advisable for the firm to close down so that loss would be limited to TFC only.

If market condition is shown by MR = MC, it would be indifferent for a firm to

close down or continue production because in either cases loss would be equal to
TFC. It is because, if it produces TR would be enough to pay TVC only and loss
would be equal to TFC. If it did not produce there would be no revenue as well as
variable cost and again loss would be equal to TFC.

All three cases can be explained through following detailed diagram.

11.5 Long Run Equilibrium

Perfect competition refers to the market where there is large number of buyers and
sellers and none of them is so significant as to influence the market. Therefore, in

31

such market price is decided by the market forces of demand and supply and is
accepted by each buyer and seller. At given market price seller can sell as much as
he wants. He needs not to reduce price to sell more and he cannot charge higher
price than market price. There is free entry and exit.
Long run is a period in which no factors are fixed or unchangeable. In the long run
business firms can make any kind of change in their production as well as they can
exit the industry or new business firms can join the industry. Therefore, changes in
the market supply happen because of expansion or contraction of output of
individual business firm and increase or decrease in number of business firms in
the industry.
Business firm produces for sake of profit, therefore, it will be in equilibrium, if it
earns maximum possible profit. Maximum profit or equilibrium will be attained
where MR = MC.
If market condition is shown by AR = MR there would be supernormal profit for a
representative business firm in the industry. Other business firms outside industry,
which either are not earning supernormal profit at all or are earning but less than
the representative firm, will enter the industry. Then, there will be increase in
industry output and supply, thereby decrease in price. Decreased prices, with the
same cost conditions, will cause decrease in supernormal profit. It will make entry
of new firms lesser attractive, but new firms will be continue to enter till there is
smaller or bigger supernormal profit.
On the other hand, if there are losses for the representative business firm, few
existing high cost business firms will wind up and exit from the industry. This will
reduce supply, increase price and at the same cost conditions losses will come
down. This will be continued till losses are completely eliminated and normal
profit is established. This can be explained with the help of following diagram.

32

Suppose that price prevailing in the market is P1. In perfect competition

P=AR=MR, therefore, AR and MR curve will be AR1=MR1. Business firm will be
in equilibrium by producing quantity Q1 and earning supernormal profit. This
supernormal profit will attract entry of new business firms. Thus, production and
supply will increase causing decrease price. This will shift AR = MR curve in the
downward direction. The equilibrium of representatives business firm will be at
lower price and lower output. The joining of new business firms, decrease in and
downward shift of AR will continue till market price reaches P and AR and MR is
shown by AR=MR. Once price reached to P, there will be only normal profit, no
firm outside industry will enter into. Other things being the same, there is no
increase in supply, decrease in price and change in normal profit. This would be
long run equilibrium of business firm.
On the other hand, if market price is P2, in the short run firm will be in equilibrium
at point E2, with losses. All business firms may not have same cost conditions.
Marginal firm or higher cost firms will have larger losses. Higher losses firm will
find their survival difficult in the industry, so they will move out. This will reduce
number of firms and supply. Reduced supply will result into increase in price and
upward shift of AR2=MR2. With given cost conditions each business firm will face

33

decreasing losses. This process of exit of high cost business firms, decrease in
supply, increase in and upward shift of AR2=MR2 will continue till price reaches to
P, where there is no loss no profit. As there is no loss no profit, any firm will have
no reason to leave the industry. Thus, no exit, no decrease in supply, no increase in
price and the firm will be in equilibrium at point E and production of quantity Q.
Be there losses or profit to business firm in the short run, accordingly there would
be firm’s exit or entry to ensure normal profit for representative firm in the long
run. Once this position is achieved there would be no reasons because of which
existing business firms will leave or new firms will enter industry. Thus, in the
long run firm will be in equilibrium with no loss no profit.
P = AR =MR = MC; and TR = TC

12. MONOPOLY
Monopoly is single producer market. According to Koutsoyiannis, ‘Monopoly is a
market structure in which there is a single seller, there are no close substitutes for
the commodity it produces and there are barriers to entry.”3 In words of Boumol, “a
pure monopoly is defined as a firm that is also industry
This single seller may be in the form of an individual owner or a single partnership
or a Joint Stock Company. Such a single firm in market is called monopolist.
Monopolist is price maker and has a control over the market supply of goods. But
it does not mean that he can set both price and output level. A monopolist can
decide either of the two things i.e. price or output.
In short monopoly is a form of market where there is a single seller without any
rival or competitors. The degree of competition in monopoly is nil. The seller
dictates the price to consumers..

12.1 Features of Monopoly

1. Single seller and negation of competition: Monopoly there is only one seller.
Since the monopolist has an absolute control over the production and sale, entry
of potential rivals is barred. As there is no entry and exist, it is complete
negation of competition.

3 Koutsoyiannis, A, Modern Microeconomics, 2015

34

 2. No entry and exit: In a monopoly market there is complete barrier to the entry
of new firms. As there is only one seller, his exit is same as closure of the
market; therefore, seller cannot exit from the market. The possible barriers are
licensing, franchise, resource ownership, patents and copyright, high start-up
cost, decreasing average total cost.
3. Monopoly as an industry: The characteristic feature of single seller eliminates
the distinction between the firm and the industry. A monopolist firm is itself ‘an
industry’. The whole market demand curve is also demand curve for monopoly
seller.
4. Homogenous product: As there is a single firm in the industry, product is
homogeneous. With the absence of availability of a substitute, the buyer is
bound to purchase what is available at the tagged price.
5. No close substitute: Under monopoly as there is single producer no substitute
for his product. As the commodity in the question has no close substitute, the
monopolist is at liberty to change the price according to his own whimsy. Under
monopoly the cross elasticity of demand is zero.
6. Absence of supply curve: The monopolist does not have supply curve
independent of demand. The monopolist simultaneously examines demand
(hence marginal revenue) and cost (marginal) when deciding how much to
produce and what to charge. Under monopoly marginal cost curve is not supply
curve because monopolist can sell different quantities at different prices.
7. Price Discrimination: Price discrimination is a practice of charging different
prices from different buyers or group of buyers for the same good or service. A
monopolist has the leverage to carry out price discrimination as he is the market
supply and acts as per his suitability.
8. Nature of demand curve: In case of monopoly one firm constitutes the whole
industry. The entire demand of the consumers goes to the monopolist. Since the
demand curve of the individual consumer slopes downward, the monopolist
faces a downward sloping demand curve. It means a monopolist can sell more
of his output at a lower price and can charge higher price at the cost of decrease
in sales.
9. Price maker: Demand curve in monopoly market is downward sloping and
steeper than any other market. Price elasticity of demand is least in monopoly.
Inelastic demand shows higher pricing making power.

35

10.Lack of Innovation: On account of solitary market domination, monopolies

exhibit an inclination towards losing efficiency over a period of time; new
designing and marketing dexterity takes a back seat.

12.2 Types of Monopoly Market

Monopoly is a market where only one seller is occupies market. There can be
various natures of monopolies depending upon style of working, origin, and other
external factors.
1. Perfect Monopoly v/s Imperfect Monopoly: Perfect monopoly is also called
as absolute monopoly. In this case, there is a single seller having no close or far
substitutes for hi product. There are no rivals to him even for consumers
income. There is absolutely zero level of competition. Such monopoly is
practically very rare. Imperfect Monopoly is also called as relative monopoly
or simple or limited monopoly. It refers to a single seller market having no
close substitutes, but may have remote one.
2. Private Monopoly v/s Public Monopoly: When production is owned,
controlled and managed by an individual or a private body or private
organisation, it is called private monopoly. Such type of monopoly is profit
oriented. On the other hand, production is owned, controlled and managed by
the government, it is called public monopoly. It is welfare and service oriented.
So, it is also called as 'Welfare Monopoly.
3. Simple Monopoly v/s Discriminating Monopoly: Simple monopoly firm
charges a uniform price for all units of output from the same or different
customers. He operates in a single market. Discriminating Monopoly firm
charges different price for different units of the same product from the same or
different customers. It prevails in more than one market or single market is
divided into segment.
4. Natural Monopoly v/s Legal Monopoly: Natural Monopoly emerges as a
result of natural advantages like good location, abundant mineral resources,
etc. e.g. Gulf countries are having monopoly power in crude oil exploration
activities because of plenty of natural oil resources. When monopoly exists on
account of trademarks, patents, copy rights, statutory regulation of government
etc., it is called legal monopoly.
5. Technological Monopoly: The size of market may be such as not to support
more than one optimum size plant. It emerges as a result of economies of large-

36

 scale production, use of capital goods, new production methods, etc. e.g.
engineering goods industry, automobile industry, software industry, electricity,
communication etc.
6. Joint Monopoly: When a number of business firms acquire monopoly position
through amalgamation, cartels, syndicates, etc, it becomes joint monopoly. e.g.
Actually, pizza making firm and burger making firm are competitors of each
other in fast food industry. But when they combine their businesses that lead to
reduced competition. So they can enjoy monopoly power in market.
7. Limit pricing: The existing from may adopt a limit-pricing policy to
preventing entry of new business firms Such policy he may combined along
with other policies such as heavy advertising or continuous product
differentiation which render entry unattractive.

12.3 Short Run Equilibrium

Monopoly is a market structure where there is a single seller producing a
commodity having no substitute, close or far. The degree of competition in
monopoly is nil. Thus, if the buyer is to buy the commodity, he can buy it only
from the monopolist seller. But monopolist, as he faces downward sloping demand
curve, can decide price or output but strictly only one. Monopolist can increase his
sales in the market by charging lower price or can charge higher price by accepting
lower quantity sales.

Short run is a period in which firm cannot change all of it factors of production to
make extensive changes in the output. Production can be increased or decreased by
changing quantity of variable factors. Accordingly, firm would make changes in
quantity produced to maximise profit.

In general all firms and in particular monopoly firms will pursue profit
maximisation objective. Therefore, monopolist would be in equilibrium when
profit is the maximum or loss is minimum possible. Profit maximisation (or loss
minimisation) condition is MR = MC. Thus, monopoly firm will be in equilibrium
when MR=MC. In the figure 0.0 cost conditions are shown by AC and MC curve
and revenue or AR and MR curve show market conditions

Fig. A: Profit making Monopoly Fig. B: Loss making Monopoly

37

In Fig A, the firm is in profit making equilibrium (AR > AC) at point is E, where

firm produces quantity Q, charges price P and earn supernormal profit PABC as
AR > AC.

In the case firm produces less than quantity Q, MR > MC, which means if the firm
increased output TR will increase more than increase in TC and profit will go up.
The firm will continue to increase output so far as MR > MC. It will stop to
increase output when it reaches to MR = MC at quantity Q where profit is
maximum. On the other hand, if the firm produces more than quantity Q, MR <
MC, which means that if firm reduces its output, TR will decrease lesser than
decrease in TC. By avoiding an additional losses from marginal units, profit will go
up. Int this case also the firm will continue to decrease output until MR = MC at
quantity Q where profit is maximum.

In both the cases, firm will produce quantity Q, which maximises profit. Further it
will have no intension of changing output, provided cost and revenue conditions
are the same. Thus, firm will be in equilibrium by charging price P and selling
quantity Q.

In Fig. B, the firm is in loss making equilibrium (AR < AC) at point E where it
produces quantity Q, charges price P and earns loss of CBAP. If the firm produces
quantity less than Q, MR would be higher than MC. It means if production is
increased, there would be increase in total revenue more than increase in total cost.
Thus, loss will come down. The firm will continue to increase its output so far as
MR > MC because by doing so losses will decrease. Output increase will be
continued until firm reaches to MR = MC at quantity Q where loss is the minimum.
If the firm produces quantity more than Q, MR would be lower than MC. It means

38

 that if output is decreased, there would be decrease in total revenue lesser than
decrease total cost. Thus, loss will come down. Here also, firm will continue to
reduce output until it reaches to MR = MC at quantity Q where loss is the
minimum.
Mathematical derivation of the equilibrium of the monopoly firm

12.4 no One-To-One Relationship Between Price and

Quantity in Monopoly
The marginal cost curve in monopoly, like that in perfect competition, is not supply
curve. In monopoly there is no unique relationship between price and quantity.

In the above diagrams D1 and D2 are monopolist’s demand curves with different
price elasticities. The diagram (A) shows that the same quantity Q would be sold
by at price P1 if demand curve is D1 and at price P2 if demand and curve is D2.
Similarly, the diagram (B) shows that at the same price P, quantity supplied would
be Q1 if demand curve is D1 and Q2 if demand curves is D2. Thus there is no unique
or one-to-one relationship between price and quantity in monopoly.

39

12.5 Long-Run Equilibrium

In monopoly shot run and long run behaviour of a firm is not very much different
because there is no threat of new entry and comfort of exit. Therefore, market
supply cannot change extensively in the short as well as the long run. But a
monopoly firm itself can contract or expand its own plant as per long run changes
in demand. But it is not necessary for the firm to change plant size to reach at the
long run minimum cost or to use existing plant at optimum capacity. It’s plant size
and the degree of utilisation of plant depends on market demand. Demand may
make the firm to produce at a suboptimal scale or at the optimal scale or may make
to surpass the optimal scale. What is certain is that the firm will remain in
production, if it is earning normal or supernormal profit and will stop production if
there are long term losses.

Long run equilibrium at suboptimal scale with normal profit and

supernormal profit

If demand for monopolist product is not enough, due to which it cannot produce
enough to avoid losses, the firm will stop production in the long run. If the demand
is just enough to guarantee only normal profit the firm will continue to produce in
the long run. In the following diagram LAC and LMC are long run average and
marginal cost curves respectively.

In the above diagrams market size does not permit the firm to expand plant to
optimum size and makes to underutilise it. This is because to the left of the
minimum point of LAC curve, SAC and LAC are tangent to each other at their
negative slope. Also SMC = LMC. In both the diagrams firm is in equilibrium,
with normal profit in the former case (Fig. A) and supernormal profit in the later
case (Fig. B). It leads to higher average cost firstly because plant size is sub-
optimal and secondly is being under-utilised due lack of demand.

40

Long run equilibrium at optimal scale

In the diagram (Fig A), market size is just large enough to to allow the firm to build
an optimum size plant and to use it to the optimum capacity. The is doing this
along with supernormal profit.

Long run equilibrium at optimal plus scale

In the above diagram (Fig. B), SAC curve is tangential to LAC to the right of the
minimum point of LAC or on its upward sloping prong at output Q3. At this output
SMC, LMC and MR. Therefore, Q3 is firm’s equilibrium output. The equilibrium is
neither at minimum SAC nor at minimum LAC. It means that plant is bigger than
optimal size and is also being over-utilised.

It means, unlike perfect competition, there is no guarantee that monopolist firm

will reach the optimum level.

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 12.6 Predictions of Monopoly

In monopoly upward shift of demand curve results in a new equilibrium at which
quantity would larger but price may increase, remain constant or decrease.

Increased quantity but the same price: In the following diagram D1 is firm’s initial
demand curve with which it is in equilibrium at point E1 with quantity Q1. When
original demand curve D1 shifts as D2, the new equilibrium position would be E2,
where price is same but quantity increased to Q2. In this case not only total revenue
of the monopolist will increase but his profit would be larger. This is because the
SMC curve cuts the SAC curve from below at laters minimum point. If monopolist
was earning profit in the initial stage his SAC curve must be above SMC curve and
downward sloping. If SAC is minimum at quantity Q3, at quantity Q2 SAC is
smaller than that at quantity Q1. Therefore, for quantity Q2 with the same price as
at Q1 and decreased average cost profit, profit is larger that at Q1. This is true when
new demand curve D2 is flatter than D1. If they interest each other profit may not
be larger.

In the following diagram if demand curve shifts to D2, a new equilibrium be at E2

where price as well as quantity supplied is greater than before. The next diagram at
new equilibrium quantity is larger than before but price is lesser.

It should be noted that effect of shift in demand depends on the extent of shift and
price elasticity of demand. If the firm will earn more profit or losses depends on if

42

 initial equilibrium was on declining prong of SAC curve or at minimum or at rising

cost. Higher shift and higher demand elasticity promises more to the business firm.

12.7 Change in Cost

If there is an increase in the fixed cost of production, for given demand MR would
be the same and SMC is not affected by change in fixed cost. Therefore, firms
equilibrium bill be unchanged. In the long run also equilibrium of business firm
will not get affected by change in fixed cost, so far as fixed cost is covered with
excess profit. But when increase in the fixed cost is such that its SAC curve shifts
above market demand curve, monopolist will be in long term losses and he will
close down his production.
Change in variable cost:If the variable cost increases, the MC curve of the
monopolist will shift upward and left with reduction in output and increase in the
price. The same kind of changes are there in perfect competition. But changes in
pure competition are greater than in monopoly. This is because monopolist equates
his MC with MR while pure competition equates MC with price. MR in imperfect
competition is always steeper than AR while in pure competition they are the same.
Consequently, the same vertical shift of MC curve results into smaller decrease in
quantity and smaller increase in price. The same had been shown with following
diagrams.

ΔP
ΔP

43

It also means that due to increase in cost price and employment changes would be
larger in perfect competition.

12.8 Imposition of Tax

The imposition of lump sum tax will increase fixed cost and thereby will reduce
supernormal profit. It is because it will not affect MC curve and hence equilibrium,
provided lump sum tax does not exceeds supernormal profit.
Effect of profit tax in the same as lump sum tax. Profit tax reduces supernormal
profit but equilibrium in the market is the same. So long as the profit tax does not
bites into the normal profit.
Imposition of specific tax will shift MC curve upward which will result in a change
in equilibrium with higher price and lower quantity. The change in price may be
smaller, equal or greater than specific tax.

If the MC of the has positive slope, increase in price will be smaller than specific
tax. The monopolist will pass to the customer apart of specific tax. If MC is
horizontal monopolist will raise the price but not by full amount of the tax.
Monopolists will bear some amount of the specific tax.

12.9 Monopoly and Perfect Competition Compared

Goals of firm

44

 A firm in both perfect and monopoly market is considered to be rational if it

behave to maximise profit, provided there is no separation between owner and
manager.
Assumptions

Monopoly Perfect Competition

Sellers Single seller Large number of sellers
Product Product may or may not be Homogeneous product
homogeneous

Openness No entry or exist Free entry and exit

Cost curves U shaped short and long run cost curves i.e. single level of
optimum output. No reserve capacity. In the short run U shape is
due to increasing and diminishing returns to variable factors and
long run it is due to increasing and diminishing managerial
efficiency.
Downward sloping relatively Horizontal perfectly elastic
elastic demand curve demand curve
Uncertaint In both the markets uncertainty is dealt with assumption of perfect
y knowledge.

Determines output or price along Determines output not price

with selling activities and selling activities
Research incentives in product Research incentives in cost cut.
development.
Atomistic profit maximisation decision at marginalistic rule rule
MR = MC, ignoring reactions of other firms
Static models in the sense that decision in one period do not affect
that in other period.
Equilibrium output is lesser and
price is higher

45

Market elasticity is 1 or more Market demand elasticity can

than 1 because if it is less than 1 be anything.
monopolist firm will increase
price to increase revenue.
No such guarantee A firm in perfect competition
produces at cost optimum in
long run with neither there is
underutilisation nor over
utilisation.
In monopoly supply function is In perfect competition supply
not uniquely determined i.e. for function is uniquely determined
the same price different along the MC curve i. e. there
quantities may be offered and for is one-to-ine relationship price
d i ff e r e n t p r i c e s t h e s a m e and quantity supplied.
quantity may be supplied.
Long run supernormal profit or Only normal profit in the long
losses are possible. run.

There is no short or long run. In perfect competition increase

Increase in demand will increase in demand will result into
output which, depending on increase in price and output in
extent of increase in demand, the short run. In the long run
will be sold at lower (if new output will increase but price
demand curve intersect the old may decrease (decreasing cost
one on the left of the minimum industry) or will remain the
of LAC-check) or the same or same (constant cost industry) or
higher price (if new demand will increase (increasing cost
curve is more elastic than before industry).
or interest the old one on the
right of the minimum of LAC).
Th ere is no short and long run. An increase in fixed cost will
If increased fixed cost cut down not affect short run equilibrium
or eliminate its supernormal as MC is the same and in the
profit will not affect equilibrium long run it will close if there
but when it brings losses it will are losses.
close down.

46
 With increase in variable cost output decreases and price is
increases in both then market but changes are more accentuated in
perfect competition.
Imposition of lump sum tax
brings effect same as increase in
fixed tax in both the markets.
If MC curve is parallel to output In perfect competition burden
axis monopolist will bear a part of specific tax is passed partly
of specific tax burden. to the consumer so far as
supply curve is sloping upward.
If it is horizontal whole burden
is passed.

12.10 Multi-Plant Monopoly

Suppose that a monopolist has two plants with which he produces with cost
differences. In this case, like usual case of a firm, he has to decide combined
equilibrium price and output along with proportion of output each of his plant will

produce. If MC1 and MC2 are cost curve of two production units respectively we
can get total MC by adding them together. Assume that market condition is shown
by AR and MR curve. The firm would be in equilibrium at point E with price P
and quantity Q. This output Q will be allotted between two production units on the
basis of marginalistic condition MR= MC. Thus Unit A will produce equilibrium

47

 quantity Q1 and Unit B will produce equilibrium quantity Q2 because MC1 = MC2
= MR.
If any of these units produces lesser it’s equilibrium quantity, decrease in total
revenue (MR) would be greater than decrease in total cost (MC), thereby profit will
decrease. On the other hand, if any unit produces more than its equilibrium
quantity, increase in total revenue (MR) would be lesser than increase in total cost
(MC), thereby profit will decrease.

12.10 Bilateral Monopoly

Bilateral monopoly is a market in which there is a monopolist seller and only one
buyer is known as monopsonist. The equilibrium in this kind of market cannot be
determined by traditional theory of demand and supply or revenue and cost curves.
Such market analysis leads to indeterminacy i.e. neither precise equilibrium price
nor quantity is determined, but there is a range of price and quantity in which
market equilibrium would be settled by extraneous non-economic factors, like
bargaining power, skill and other strategies. Monopsony market is hard to find but,
theoretically it is possible. In such market both supplier as well as buyer are
business firms. Government procurement, like military hardware creates such
market.
In in the following diagram market demand is shown by D (AR) and MR is its
marginal revenue curve. MC is marginal cost curve. AR curve shows the rate
which the buyer is ready to pay for various quantities of producer’s output. By this
virtue, AR is a curve along which the seller is to get his revenue. MR shows how
this revenue increases. On the same line we can say that MC curve, which is
supply curve, shows the rate at which the seller is ready to supply various
quantities of his output. By this virtue MC is a curve along which the buyer spends
his money or it is average expenditure (AE) curve of the buyer. Like AR curve, AE
curve can have marginal expenditure (ME) curve which shows how consumer’s
expenditure increases.
In the normal kind of market monopolist seller maximise his profit at quantity Q1
where MR = MC. But in such market, producer-monopolist is selling his product to
a single buyer (monopsonist) who can influence price through his purchasing
decisions. The buyer-monopsonist, who is also a firm, is rational and he is aware of
his monopoly power in the market. He is tries to maximise his profit by imposing
his price on the producer.
Seller-monopolist’s marginal cost curve is his supply curve. Supply curve is
determined by cost conditions which are outside the control of buyer. Therefore,

48

buyer monopsonist knows that if he increased his purchases he will have to pay
more price.
As buyer is also producer, he buys inputs. He is rational producer, therefore, he
maximises his profit. To increase profit monopsonist will go on buying additional
inputs until P = ME. Thus monopsonist would be in equilibrium at point F with
quantity Q2 and price P2.
However, monopolist want to charge price P1 for quantity Q1. That is why there is
indeterminacy. The two firms will resort upon negotiations and will settle price
somewhere in the range of P1 and P2.
If bilateral monopoly emerges in a commodity market monopsonist will attempt to
buy out monopoly supplier firm. In a case this take over happened, MC curve
would be supply curve and equilibrium would be at b with quantity Q and price P.
In India bilateral monopoly exist in case of sugar. Government is only one buyer
and sugar factories, which had come together in the form of union, is the single
seller. Bilateral monopoly exist in labour market where labour from their union.
Company township is another example of bilateral monopoly where labourers
cannot leave the town because. In case bilateral monopoly emerges in a commodity
market, monopsonist will attempt to buy monopolist firm. The consequence of
such a takeover will result in to equilibrium of market at b.

12.11 Dcriminatory Pricing

Price discrimination is an act of selling a product at different prices to different
buyers in the same market when cost of production is the same or different but not
as much as the difference in the charged prices. The product may be the same or
may have slight differences. The base of price discrimination can be preference of

49

the buyers, their income, their location, time of buying and the ease of availability
of substitutes. Due to these differences elasticity of demand of different buyers is
different. The monopoly firm, which adopts the policy of price discrimination, is
known as discriminating monopoly.
Price discrimination is more easier in monopoly because he controls market but in
other form of imperfect competition also price discrimination is possible. It is
mainly because of product differentiation, which creates a type of monopoly power
for the seller and therefore, a smaller degree of discrimination is possible form the
firm.
For effective implementation of price discrimination the market must be divided
into submarkets with different price elasticities and effectively separated so that no
reselling can takes place.
Price discrimination is not related with production but sales only. The reason for
price discrimination by private business firm is profit maximisation. The firm will
decide output to maximise profit by equating aggregate MR and aggregate MC.
Once production is done and cost of production is paid, the maximisation of profit
is the same as maximisation of revenue. Therefore, firm will sell its every
successive unit of output in that segment of market in which it will get higher
marginal revenue. As he supplies more in any of submarket, marginal revenue
there will decrease. The same is explained by the following diagram in which 1st
unit is being sold in submarket I and 2nd in submarket II, 3rd in submarket I, 4th to
8th in submarket II and 9th in submarket I.

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 So far as individual market MR is higher than aggregate MR monopolist will go on

supplying more in that market. It will be continued until marginal revenue in each
market segment is equal to aggregate marginal revenue. Firm will not sell any of its
product unit in any of market segments at MR lesser than aggregate MR. Because
it will reduce monopolists profit. Thus we can say that like firm in other markets,
monopoly firm decides output by marginalistic rule and thereafter sales in
segregated submarkets to maximise revenue. Revenue with price discrimination
would be greater than revenue without price discrimination to the extent by which
monopolist can bite into consumers surplus.

This can be illustrated with the help of following diagram.

Assume two segregated segments of a market one with elastic demand (D1) and
other with lesser elastic demand (D2). Total demand curve D is derived by
horizontal summation of D1 and D2. Similarly, the aggregate marginal revenue
curve MR is derived by horizontal summation of MR1 and MR2.
D = D1 + D2
MR = MR1 + MR2
The firm will produce output Q decided by intersection of aggregate MR and MC.
If there were no price discrimination total revenue earned would be OPAQ. Now
firm will evaluate marginal revenue for each unit in both the markets and wherever
it is higher there firm will sell the respective unit. While doing so, the firm will
distribute its output Q among two market in such way that MR1 = MR2, which in
turn would be equal to aggregate MR. This will ensure aggregate profit
maximisation of the monopolist. It is because if there is difference between MR1
and MR2, the monopolist can increase his profit by shifting marginal unit(s) from
the market segment where MR
lesser to other market segment where MR is higher. He can repeat this until MR1 =
MR2 = MR.

Assume that a = OP1A1Q1, b = Q1A1NQ2, c =

Q2NLQ, d = NMAL,
e = P1PMN, f =PP2AM
Total profit without price discrimination = a + b + c + d + e
(1)

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 Total profit with price discrimination = (a ) + (a + b + e + f)
(2)
But a = c
= (a ) + (c + b + e + f)
(3)
=a+b+c+e+f
By subtracting (1) from (3) we get difference between revenues with and without
price discrimination
=a+b+c+e+f–a–b–
c–d–e
=f–d
But f > d, therefore we can say that total revenue and therefore profit is increased
due to price discrimination.
In the above diagram firm is equilibrium at point E where aggregate MR =
aggregate MC with quantity Q, price P and total revenue OPAQ. To maximise
revenue firm will ensure that MR1 = MR2 = MR. Therefore, output sold in first

52

 market would be Q1 at price P1 and in second market segment would be Q2 at price
P 2.
Above diagram shows that revenue and therefore profit (as cost is unchanged with
or without price discrimination ) from price discrimination is larger than revenue
without price discrimination.

12.12 Price Discrimination

First-degree price discrimination: When monopolist charges different prices
from different buyers or for each different unit of the same product, is called as
first degree price discrimination. The price charged depends upon the marginal
utility of buyer. Each buyer is charged the maximum price he is willing to pay and
monopolist extracts the whole consumer surplus. Therefore Mrs. John Robinson
called it as perfect discrimination.
The first-degree price discrimination is possible only when buyers are few in
number and monopolist deals with them separately.

Second-degree price discrimination: When buyers or product is divided into

different groups and each group is charged different price, it is called as the second
degree price discrimination. For each group price charged is according to what
marginal buyer or that group or sub-market is prepared to pay. Intra marginal
buyers get a part of consumer surplus, while marginal buyers do not get any
surplus.
In this kind of discrimination, the seller will take a part of consumer surplus away
and rest is available for the consumers. Share of buyers in consumer’s surplus is
directly proportional to size of group.

53

Third Degree Price Discrimination: In this type of discrimination different prices

are charged in different segments of the same market. Quantity supplied in each
segment of market will be in such a way that MR is equal in both. Accordingly,
different prices will prevail in different segments as shown in the following
diagram. By doing so firms revenue and profit would be maximum possible.

12.13 Effect of Price Discrimination

13. MONOPOLISTIC COMPETITION

13.1 Monopolistic Market
Classical economics classified markets in two extreme types, pure competition and
monopoly which were thought to be mutually exclusive alternative. On one side,
according to them monopoly is reached when seller does not face any competition
in absolute sense. But in reality, he has to compete with others, at least, for buyer’s
money income. Therefore, in a sense, every good is a substitute for other goods to
some extent. On the other side, existence of heterogeneous products, advertising,
selling strategies, which are realities of market, could not be explained by pure
competition. Pure competition model predicts that under decreasing cost conditions
firms will grow infinitely large but in the real life they limit their output.

To summarise, monopolistic market is a kind of market in which there are many

sellers and at least few of them are able to influence, if not to control, the market
because either they are quantitatively significant or they produce slightly
differentiated product. The model of monopolistic competition describes a
common market structure in which firms have many competitors, but each one
sells the same but slightly different product. In this type of market seller can
influence market either by changing price or by making product to appear different.
He can decrease price to sell more or can charge higher price by accepting lower
quantity sales. Despite the existence of close substitutes each firm acts like
monopolist of own product which he actually is. Monopolistic competition as a
market structure was first identified in the 1930s by American economist Edward
Chamberlin, and English economist Joan Robinson
Product Differentiation

54

Product differentiation means that products are slightly different and quite similar
so that they are close substitutes. According to Chamberlain demand for goods is
determined also by the style of product, the services associated with it and the
selling activities of the firm along with price. He, therefore, introduced two
additional policy variables in in the theory of firm: product itself and selling
activities. Product differentiation is intended to influence market demand by
differentiating own product from others. It can be real or fancied. Real differences
are in the form of differences in the factor inputs, location of the firm, product
accessibility, the services offered by the firm. Fancied differentiation arises from
advertising, packaging, design or brand name etc. The effect of product
discrimination is increase in monopoly power and discretion in determining price.
Thus, each seller is monopolist of his own product. The greater the differentiation,
the greater would be monopoly power. Discretion would be limited because there
is competition from close substitutes from other firms. Since each seller is
monopolist but has competitors, it is competing monopoly or monopolistic
competition.
Product Group
Heterogeneous products due to product differentiation create difficulties in market
analysis. Therefore, Chamberlin replaced the concept of industry by product group.
Products in a group should be close technological (same want) and economic
(similar prices) substitutes. Theoretically goods with high price and cross
elasticities are in the same product group. But how high is subjective judgement. In
Chamberlin’s group, due to product differentiation, there will be no equilibrium
price but equilibrium cluster of prices, which like market equilibrium price, will
change along with change in market demand and cost.
Features of Monopolistic Competition
The following are the features or characteristics of monopolistic competition:-
1. Large Number of Sellers: There is large number of sellers producing same but
differentiated products. Since number of sellers is large, each seller sells only a
very small part of market supply. So no seller is in the position to control price
of product. So competition among them is very keen.
2. Influence over the price: As the products are close substitutes of each others,
any reduction of price of a commodity by a seller will attract some customers
from other sellers. Therefore, with a fall in price quantity demanded increases.
Thus, under monopolistic competition a firm cannot fix up price but has

55

 influence over price. A firm can increase price by accepting smaller sales or can
sell more by reducing price.
3. Product Differentiation: It is one of the most important features of
monopolistic competition. Every producer tries to keep his product dissimilar
than his rival's product in order to maintain his separate identity. So each firm
has an absolute monopoly in of its differentiated product. The firm brings about
product differentiation in a number of ways like physical product
differentiation, where firms use size, design, colour, shape, performance, and
features to make their products different or marketing differentiation, where
firms try to differentiate their product by distinctive packaging and other
promotional techniques or human capital differentiation, where the firm creates
differences through the skill of its employees, the level of training received,
distinctive uniforms, and so on or differentiation through distribution, including
distribution via mail order or through internet shopping.
4. Freedom of Entry and Exit: There is free entry and exit. Since each firm is
small in size and is producing close substitutes, any new firm can enter into the
industry or groups in the long run. Each new firm produces differentiated
product. Freedom of entry and exit of firms increases competition.
5. Selling Cost: It is another unique feature of this market. Selling cost is the cost
incurred for sales promotion. Since products are differentiated and changes
from time to time, advertising and other forms of sales promotion has become
an integral part of marketing. Through these methods, the firm tries to make a
favourable shift in demand for its product and tries to capture more market. This
cost includes sales promotion expenses, advertisement expenses, salaries of
marketing staff, etc.
6. Absence of Interdependence
Since there is large number of firms, the market share of each firm is
negligible. The firm selling differentiated product has limited monopoly power
and therefore, have independent policies regarding price and output. Any
action of the firm to change price or output has no significant effect on the
other. Thus, the firms are independent.
7. Competition among sellers: Under this market competition among the sellers
take place in two different ways.

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 a. Price competition: Firms produce the same but differentiated products

which are substitutes of each other, thereby they have price competition
with each other. Each firm fixes its price arbitrarily, mostly lowering the
price of the product to take advantage of higher sales.
b. Non-price competition: Firms under monopolistic competition
differentiates their products to attract customers. This differentiation can
be in physical forms, causing market distributions and considerable selling
costs to win over the customers. In order to promote own product many
firms may follow the same method. This results into non-price type of
competition among different firms.
8. Concept of Group: Since products in monopolistic competition are not
homogeneous, which is essence of perfect competition, there is no industry in
monopolistic competition. In place of Marshallian concept of industry,
Chamberlin introduced the concept of group under monopolistic competition. A
group is a cluster of firms producing very closely related but differentiated
products. The collection of firms that produce same type of products with high
positive cross elasticity of demand will constitute a 'group' or a 'product group’.
Through this concept he was able to distinguish between close and far
substitutes. In a way, according to him, group was to include close substitutes
and industry far substitutes with wide variations in because of which it is
meaningless concept.
9. Falling Demand Curve: In monopolistic competition, a firm is facing
downward sloping demand curve i.e. elastic demand curve. It means one can
sell more at lower price and vice versa.
PRICE OUTPUT DETERMINATION
A firm under monopolistic competition faces more complexities than perfectly
competitive market. An equilibrium of individual monopolistic firm involves
equilibrium in regard to the price, the nature of product and advertising outlay.
Chamberlain did not used MR and MC curves, but they are implicit in his analysis.
In order to explain equilibrium of firm and industry Chamberlain had mad ‘heroic’
assumption i.e. all firms have identical costs and in spite of product differentiation
all firms have identical demand or consumers’ preferences for their products are
evenly distributed among firms.

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13.2 Short Run Equilibrium

A monopolistic market is a type of imperfect market in which there are many
sellers of which at least few are so significant as to influence the market by
changing quantity supplied, price charged or differentiating their product from
others. A seller can sell more by reducing price or he can charge higher price by
accepting lower sales. Or he can make his product to appear differently than
other’s product so that he can attract new customers while holding existing one. It
means that demand curve or firm’s average revenue curve is sloping downward
from left to right.
A short run is a period in which at least few factors are fixed or unchangeable. In a
short run all types of changes in the business firm are not possible, therefore,
neither existing business firm can make any extensive changes in the production
unit nor a new business firms can join the industry nor existing one can exit the
industry. In brief production capacity of each business is limited by time horizon
and supply of industry would be changeable because of variable factors only.
In general, all the firms pursue an objective of profit maximisation or loss
minimisation. Therefore, monopolistic firm would be in equilibrium when profit is
the maximum possible or losses are minimum. Profit maximisation condition is
MR = MC at positive slope of MC or MC intersect MR from below. Thus,
monopolistic firm also will be in equilibrium when MR = MC.

58

 Profit making equilibrium : In the above diagram cost conditions are shown by
AC and MC curve and AR and MR curve shows market conditions. The point E is
equilibrium point because MR = MC at laters positive slope. Therefore, the firm
produces quantity Q and charges price P and earns supernormal profit PABC as AR
> AC.

If firm produces less than quantity Q, MR would be greater MC, which means if
firm produces more profit will increase. It is because by doing so TR will increase
more than increase in TC. Therefore, firm will increase it output until MR = MC at
output Q.
In a case firm produces more than quantity Q, MR will be less than MC, which
means that if firm reduces its output profit will increase by avoiding losses due to
marginal units. Or in other words, by decreasing quantity, TR will decrease less
than decrease in TC. Therefore, firm will reduce output until MR = MC at quantity
Q.
In both the cases, firm will change output to produce quantity Q, which maximises
its profit. Further it will have no intension of changing output so far as cost and
revenue conditions are the same. Thus, firm will be in equilibrium by charging
price P and selling quantity Q.
Loss making equilibrium : In the following diagram firm will produce quantity Q
where MR = MC and losses are minimum. If it produced less or more than Q,
losses will increase. Therefore, it will restore itself at quantity Q.

59

Firm in the above diagram is in equilibrium with loss of CBAP at quantity Q and
price P. If the firm produces less than quantity Q, MR would be greater than MC. It
means increase in output will cause TR to increase more than TC, and loss will
come down. Therefore, the will continue to increase output till MR > MC. It will
stop producing more when MR = MC. On the other hand, if the firm produces
more than Q, MR would be lesser than MC. If firm reduces its output, decrease in
TR would be lesser than TC and loss will come down. It will continue to decrease
output until it reaches to MR = MC at quantity Q where profit is maximum.

13.3 The Long Run Equilibrium

Long run is a period in which no factor is fixed or unchangeable. In the long run
existing business firms can make any kind of changes in their business firm as well
as they can exit the industry or new business firms can join the industry. Therefore,
whenever there is supernormal profit to the representative firm, industry will attract
firms outside the industry, or altogether new firms will enter. This will increase
supply and decrease price. Decreased price, with no reason for cost to change, will
reduce profit. Entry of new business firms will continue until supernormal profit is
not completely eliminated. Once supernormal profit is gone, there will be no
reason for new firms to enter this industry. Supply and price will remain
unchanged.

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On the contrary, when there are losses in the industry for a representative firm, few
existing high cost firms will exit the industry. Supply will come down in the
market. It will increase price and being no reason there for cost to decrease, losses
will come down. Exit of high cost firms will continue till normal profit is
established. Once there is normal profit and no firms will give up industry. Thus,
no changes in supply and prices. Hence, under monopolistic market, in the long
run, only normal profit is possible. Chamberlin had developed three models of
equilibrium in the long run.
Model I: Equilibrium with new firms entering the industry
In this model existing firms are assumed to be in short run equilibrium with
supernormal profit. The existing firms do not have any incentive to adjust their
price because any change will make their profit lesser. New firms who are attracted
in group by supernormal profit. This will increase supply and will decrease price.
Thus new equilibrium price would be lower than earlier equilibrium price.
In the following diagram cost structure of business firm in the long run is shown by
LAC and LMC. Demand condition is shown by demand curve dd’ . The firm
would be in equilibrium by setting price at P and quantity Q at which MR = MC.

The supernormal profit will attract new firms into the market. This will increase
total supply in the market while demand is the same.. As the same demand will be
shared among increased number of business firms, each firm in the market will

61

 have decreased demand. Thus, along with entry of new firms supply will increase,
demand and price will decrease. This causes downward shift of demand curve.
With downward shift of demand curve firm makes price adjustment and reaches at
a new equilibrium position with new equality of MR and MC and lower price. This
process will go on until demand curve is tangential to AC curve (like D). Now
supernormal profit is wiped out as AR = AC, therefore, no new firm will join and
no change in equilibrium point. Thus, equilibrium with price = average cost will
remain stable.
Model II: Equilibrium with price competition
In this model it is assumed that number of firms in the industry is compatible with
long run equilibrium which is reached out through price adjustment by the existing
firms. Therefore, neither exit nor entry will take place. Ruling price in the short run
is assumed to be higher.
In the diagram dd is market demand curve and DD is actual sales curve or share of
the market curve which shows actual sales of the firm at different prices after price
adjustment by other firms. A movement along DD shows change in actual sales of
existing firms as all of them adjust their price simultaneously and identically, with
the same market share. A shift in DD is caused by change in number of firms in the
group.
Suppose the firm is at non-equilibrium position at point E1 with price P1 and
quantity X1. As demand curve is downward sloping, the A firm may reduce price
to P2 in a hope that demand will increase to X2. However, change in the price
would not be deliberate action but as an independent action aiming at profit
maximisation. This level of sales will not actually realise because all other firms
will have incentive to act in the same manner. The same course is followed by
other to maximise their own profit, while ignoring reaction of other firms, on the
assumption that effect on the demand of other firms in the group would be
negligible. Thus, all firms, acting independently, reduce their price simultaneously
to P2. As a result d1 curve shifts downward as d2 and firm A sells a smaller
quantity X3, instead of expected quantity X2 on the shifted demand curve and
along D.

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Still firm A thinks that effect of its own decision on other firm’s demand will be
negligible i. e. D2 will not shift further. Again firm A lowers price to P3 in the
hope that others will not follow the same suit and it own sales will increase to X2.
But all other firms think and act identically, they also reduce price to P3. Market
demand shifts to d3 and actual sales of firm A turns X4 rather than expected X2.
It is assumed that the firm would not learn to anticipate similar shifts in the future.
The myopic behaviour of firms will remain and again to increase sales to X2, firm
A would decrease price to P. Other firms will do so and market demand curve will
shift as d in the diagram. With this sales of firm A will turn to X. Now demand
curve d is tangential to LAC curve therefore firm is in normal profit.
If firm reduced price from P, it would be less than average cost and firm will start
to earn losses. Therefore, firm A would not reduce price because it can see
independently along with its myopic behaviour that the is net loss to her.
Thus we can say this adjustment process comes to an end when market demand
curve is tangent to LAC curve.

Model III: Price competition and free entry

According to this model of Chamberlain actual life equilibrium is determined by
both price adjustment of existing firms as well as entry of new firms. Price
adjustments are shown along market or myopic demand curve dd and entry or exist
of firms is shown by shift of share of the market demand curve DD. Equilibrium is

63

 stable if dd is tangent to LAC curve and expected sales are equal to actual sales i.
e. If
Assume that firm A is is in equilibrium at point e1 with supernormal profit.
Therefore, new firms will enter the group. With this firm A’s share in the market
will decrease or DD will shit to the left. Such entry will continue till there is
supernormal profit or share of the market curve reaches to D. If firm produced and
sold at point e2 there would be normal profit. Therefore it seems to be equilibrium
of firm. But each entrepreneur thinks that his demand curve d is downward
sloping, therefore, he can decrease price to expand his sales along d. Since each
firm reduces price market or myopic demand curve slides down as d2 along share
of the market demand curve D. Each firm realises losses because every point of
share of the market demand curve D on which firm produces lies below LAC
curve. But a firm’s myopic behaviour makes it to think that so long as myopic
demand curve intersects LAC, it can reduce price to increase its sales and profit.
Therefore, each will decrease price simultaneously and market or myopic demand
curve will slide down further like d. With this new market demand curve and given
share of the market demand curve firm will produce and sell quantity X1 making
even bigger losses. Myopic behaviour will make all firms to reduce price and
market demand curve falls below LAC and increased losses.
Financially weaker firms will leave up the group. Existing firms will have larger
market share.DD moves to the right along with dd. Exit and shift of dd curve will
continue until dd is tangent to the LAC and DD cuts dd at the point of tangency E.
This equilibrium at E would be stable. It is because, on one hand, if firm decreased
price average cost would be greater and firm would be in losses. Therefore, firms
will not decrease price. On the other hand neither there would be no entry of new
firm nor exit of existing firm because there is just normal profit.

13.4 Critique of Chamberlain’s Model

Chamberlain’s heroic uniformity assumption that cost, demand and prices are
uniform throughout the group had been challenged by Stigler asking that how can
different products have uniform costs and demands. Therefore, Stigler concludes
that this assumption destroys Chamberlain’s monopolistic competition.
Chamberlain’s symmetry assumption is that change in price and product made by
one firm spreads uniformly over the competitors so that it’s effect on demand for
their product is negligible and they do not think of readjusting their prices or
product in retaliation. A fact is that firms are continuously aware of the possible
actions of competitor.

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Chamberlain assumes myopic behaviour of firms. But it is natural that firms will
learn from their past mistakes and those that did not cannot stand in the market for
long but will be wiped out.
The assumption of product differentiation conflicts with the principle of free entry.
Product differentiation creates brand loyalty which in turn causes barriers to entry
of new firm.
The concept of industry is destroyed due to product differentiation. Heterogeneous
product demand and supply cannot be added together to come at market demand
and supply. Therefore his model is not acceptable approximation of real situation.
The model assumes a large number of sellers does not define that crucial number.
The model insists that products in a group should be close substitutes with high
price and high positive cross elasticities but precise value is not stated by
Chamberlain.
Chamberlain’s monopolistic demand curve is downward sloping shows ‘sticky
preferences’ or ‘brand loyalty’ in short and long run. It is observed that due to
brand loyalty consumers will be prepared to pay a higher price for a product sold
by other suppliers at a lower price. This is irrational behaviour4 on the side of
buyer. But the same is not true of manufactures, retailers and wholesalers who try
to maximise their profit. Therefore, a part of demand arising from manufacturers ,
retailers and wholesalers cannot give rise to downward sloping demand curve.
Therefore, downward sloping demand curve is questioned by Andrews. According
to him Chamberlain’s demand curve is applicable where product is directly sold to
the final consumer and that too only in a short run. In the long run consumer will
try lesser expensive and will turn permanently to them.
It has been argued that product changes and selling activities create
interdependence of demand and cost curves rendering the equilibrium
indeterminate. But the fact that the cost and demand curves have some common
determinants does not mean that the equilibrium is indeterminate.
The most important contribution is the introduction of product differentiation and
selling strategy as an additional policy variable.
Another contribution is the development of a model which provided solution to the
dilemma of the filling cost.
The explicit incorporation of selling activities into price theory is an extremely
important step and this was the earliest systematic attempt.
Another contribution is the share of the market demand curve as a tool of analysis.
The combination of dd and DD gave rise to the kinked demand curve.

4Consumer can be judged as irrational only if he exhibit purchasing patterns inconsistent

with his preferences, but not on the nature of his preferences by themselves.

65

Chamberlain’s heroic and unrealistic assumptions and subsequent abandonment of

the group has been rather a drawback in the development of the theory of firm.

13.5 Perfect and Monopolistic Market Compared

Both monopolistic and perfectly competitive companies try to minimise cost and
maximise profit. Cost functions, decided by nature of factor market assumed to be
perfectly competitive, are the same for both kinds of markets. While monopolistic
and perfect competition have marked differences.
1. Number of competitors: Perfect competition markets are populated by a large
number of buyers and sellers where as monopolistic market involves many but
not as large as perfect competition market.
2. Barriers to Entry: Barriers to entry are factors and circumstances that prevent
entry of would-be competitors. Theoretically both markets have free entry and
exit but practically in monopolistic competition market there are barriers,
thought not enough strong to prevent entry.
3. Product differentiation: There is zero product differentiation in a perfectly
competitive market. Products are homogeneous and perfect substitutes for each
other. In monopolistic market, there is a great to an absolute product
differentiation, therefore, firms products are imperfect substitutes for each other.
4. Elasticity of Demand: An elasticity of demand in a perfectly competitive firm
is infinite whereas that in monopolistic market is no infinite but relatively
elastic or greater than one. A low coefficient of elasticity is indicative of barriers
to entry or monopoly power.
5. Excess Profits: Both perfectly competitive business firms as well as
monopolistic business firms can earn supernormal profit (or losses) in the short
run but only normal profit in the long run.
6. Profit Maximisation: Both a perfect competition firm as well as monopolistic
firm maximises its profits by producing the quantity at which MR = MC. But at
perfect competition equilibrium price = MR and under monopolistic
equilibrium price > MR. where MR = MC = price.
7. Demand Curve: The demand curve of a perfectly competitive firm is
horizontal while that of a monopolistic firm is downward sloping.
8. Price: If cost conditions and equilibrium quantity of both perfect competition
firm and monopolistic firm, by chance, happens to be the same, monopolistic
business firm will always charge higher equilibrium price than perfect
competition business firm. This is shown in the following diagram.

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9. Output: If cost conditions and equilibrium price of both perfect competition

firm and monopolistic firm, by chance, happens to be the same, monopolistic
business firm will always produce lower equilibrium quantity than perfect
competition business firm. It is mainly because marginal cost and marginal
revenue curve in perfect competition are one and same; while in monopolistic
competition they separates from each other and slopes downwards. Therefore,
MR curve, compared with perfect competition MR curve, intersect MC curve at
lower quantity and firm achieves equilibrium at smaller output. Thus, out put
produced by a perfectly competitive firm, for given cost conditions, is always
greater than that a monopolistic firm would have produced.

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10.Efficiency: In the long run, both perfectly competitive business firm and
monopolistic business firm are in equilibrium with normal profit. At the long
run equilibrium perfectly competitive business firm produces at the minimum
possible average cost while monopolistic business firm produces always at an
average cost which is higher than the minimum possible. Thus, at the long run
equilibrium an average cost of production in perfect competition is always
lower than that in monopolistic market. We can say, therefore, perfectly
competitive business firms are more efficient than monopolistic business firms
11.Excess Capacity: Production at minimum possible average cost would be an
ideal output. But in monopolistic competition long run equilibrium is attained
when at average cost is higher than minimum possible. Therefore, monopolistic
competition has been attacked on the the ground that it leads to excess capacity.
But according to Chamberlain the criticism of excess capacity and miss-
allocation of resources is valid only if one assume that the demand curve of the
individual form is horizontal. According to him if the demand curve is
download sloping and there is a price competition with free entry and exit, ideal
output cannot be considered as the socially optimal level of output. Consumers
desire variety of products and they are prepared to pay higher price for
differentiated products. Therefore, higher cost resulting from differentiation of
product is socially acceptable. Therefore, difference between actual output and a
minimum cost output is not a measure of excess capital city but of the social
cost of producing and offering greater variety.

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According to Chamberlain equilibrium output will be very close to the minimum

cost output because each firm has to complete with numerous other firms along
very elastic demand curve. But if firm avoid price competition and instead engaged
in non-price competition there would be excess capacity in each firm and thereby
in the industry. In the case, the firm ignores price competition or individual
demand curve dd and concern itself with its market share or DD curve becomes
relevant, the long run equilibrium is reached at tangency between LAC and DD.
According to Chamberlain excess capacity is difference between X and X.
12.Welfare: AR of a business firm is nothing but demand curve of it's product and
MC curve above AVC curve is supply curve. Demand curve shows price offered
by or indirectly marginal utility from respective units to the society. On the
other hand, supply curve shows price sought by or marginal disutility from
respective units to the society. Thus, with increase in output social welfare will
go on increasing till AR > MC. It will reach to the maximum when AR = MC.
Perfectly competitive business firm is in equilibrium when AR = MC while
monopolistic business firm is in equilibrium when AR > MC. It means that if
monopolistic business firm produces more than equilibrium quantity it may not
maximise its profit but will maximise social welfare.

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 From the point of view of social welfare monopolistic competition suffers from the
fact that price is higher than the MC. Socially out put should be increased until
price equals MC. However, this is impossible since all firms would help to produce
at a loss in the long run: the LRMC intersects the DD below the AC curve.
Example 1: A monopolistic business firm produces and x units of a product per
week and sells at a price p = 20 – 0.001x. It's cost is C = 15x + 2000. Calculate it's
maximum profit.
Sol: Profit is given by = TR – TC
TR = p.x = 20 x- 0.001 x2
TC = 15

14. OLIGOPOLY
Oligopoly is “competition among the few". In brief oligopoly is a kind of imperfect
market where few firms produce, either homogeneous or differentiated, products
which are close substitutes of each other. Thus, oligopoly is said to prevail when
there are few interdependent and influensive firms producing and selling
homogenous or differentiated product. Their decisions depend on the ease of entry
and the time lag, which they forecast, between their own action and the rivals’
reactions. The degree of substitutability, interdependence and ease of entry are
important attributes of oligopoly. The degree of substitutability among product on
one and the another firm can be measured by price cross elasticity. The degree of

70

interdependence of firm one firm on the other may be measured by unconventional

quantity cross elasticity. The ease of entry may be measured by Bain’s concept of
P − Pc
the ‘condition of entry’ = a
Pc

There is no clear border line between a few and many. Usually oligopoly is
understood to prevail when the numbers of sellers are two to ten. Oligopoly is of
two types - oligopoly without product differentiation or pure oligopoly and
oligopoly with product differentiation. By number of firms they are classified as:
1. Duopoly: A Duopoly is simplest form of oligopoly in which only two firms
dominate a market.
2. Oligopsony: In oligopsony, there are few buyers and large number of
sellers.The other characteristics are same as oligopoly.
3. Bilateral Oligopoly: A market with a few sellers (oligopoly) and a few buyers
(oligopsony) is referred as bilateral oligopoly.
4. Cartel: When there is a formal collusion (to increase prices and restrict
production in the same way as a monopoly) among oligopolistic firms with an
objective to reduce risk and foster joint profit, it is termed as Cartel.

14.1 Characteristic Features of Oligopoly:

1. Few sellers: Usually oligopoly is understood to prevail when the numbers of
sellers is two to ten. It is dominated by a small number of participants who are
able to exert control over supply and market prices.
2. Entry is possible but difficult: Theoretically, entry and exist in oligopoly are
free but practically there are artificial barriers raised by existing firms for the
new entrant. The barriers can be in the form of patents, copyrights, government
rules/regulations or ownership of scare resources.
3. Homogenous or differentiated products: In this market firms produce close
substitutes of each other. If price competition is not giving desired result firms
may resort on non-price competition. It will make their products differentiated
from each other.
4. Interdependence: The firms in oligopoly are interdependent in making
decision. They are interdependent because the numbers of competitors are few
and any change in price or product design by a firm will have a direct effect on

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 its rival firms, which in turn may retaliate by changing their price and output
affecting first seller. Thus, an oligopoly firm considers not only the market
demand for its product but also reaction-pattern of other firms in the industry.
No firm can fail to take into account the reaction of other firms in its price and
output policies. There is, therefore, a good deal of interdependences of the firm
under oligopoly.
5. Advertising and selling costs: The firms under oligopolistic market employ
aggressive and defensive weapons to gain a greater share in the market and to
maximise sales. So firms have to incur a great expenditure on advertisement and
other measures of sales promotion. In other market advertising and selling cost
plays so important role as in the oligopolistic market. Prof. Baumol has
described it as a matter of life and death5.
6. Group behaviour: Another important feature of oligopoly is group behaviour.
In case of perfect competition, monopoly as well as monopolistic competition,
the business firms are assumed to behave as to maximise their own profits.
Because of strong interdependence among the firms, the profit-maximising
behaviour in oligopoly may not be valid. They will co-operate or fight with
each other to promote interest is not certain. Firms under oligopoly may a group
cooperating with each other or fighting with each other. While fighting with a
firm may be aggressive or passive.
7. Uncertainty: This characteristic is the direct result of the interdependence of
oligopolistic firms. Mutual interdependence creates uncertainty for all the firms.
No firm can predict the consequence of its price-output policy i.e a firm cannot
predict in response to its own price change, if its rival firms will change their
price or not.
8. Indeterminateness of demand curve: In perfect competition every firm’s
demand curve is perfectly elastic at market price. In monopoly there are no
close substitutes to the product, therefore firm will be unaffected due to remote
competitors. In monopolistic competition, competitors are not enough stronger
to influence each other significantly. Therefore, here also a monopolistic firm
can assume that its rival firms will keep themselves unchanged, while it make
changes in its price and product. Thus, demand curve for monopolistic firm can
be take as definite. But in case of oligopoly each firm has capacity to affect

5 Baumol, William J. Economic Theory and Operations Analysis, p 352

72

 other firms. As a result they can change each others demand curve. Therefore,
oligopolistic firm looses definiteness of dead curve.
9. Tendency to form cartel: Oligopoly is intermediate version of both monopoly
and monopolistic competition. To avoid uncertainty arising out of competition
in market oligopolists can came together to form a cartel. By forming cartel
they can assure each other peaceful co-existence, no price war and promotional
expenditure.
10.Elements of monopoly: By the number of sellers oligopoly is nearest to
monopoly; therefore, there exist some elements of monopoly under oligopolistic
situation. Under oligopoly with product differentiation each firm controls a
large part of the market by producing differentiated product. In such a case it
acts in its sphere as a monopolist in lining price and output.
11.Price rigidity: Under oligopoly, price tends to be rigid and sticky. If a firm
reduced its price in expectation that it will attract rivals customers, rival firms,
in fear of loss of customers, will follow the same suit. It will keep the firm
indifferent. On the other hand, if a firm in oligopolistic market increased price
of its product, rivals will not follow and former will end with the loss of
customers. It will result into price rigidity.
12. Sloping demand curve: An oligopolistic firm faces a downward sloping
demand curve; however; the price elasticity depends on the rival’s reaction to
change its price, investment and output.
Many industries experience oligopoly kind of market situation. It is mainly because
there are some factors, related with production techniques and demand conditions,
which give rise to oligopoly. There are other factors which may be created by the
firms themselves.
Why oligopoly?
A modern trend is to develop and design improved variant of existing product. It
requires research and development for which large fixed cost is needed. This is
possible for bigger firms only. If market is too small to support large number of
firms, other will be wiped out from the market. Once few firms established
themselves well in the market, they may create artificial barriers for the new
entrants. To become even bigger and stronger among existing firms, one or more
firms may resort upon take over of the other firms; or two or more firms may
decide to merge. On the demand side also, there are some reasons which give

73

 scope for oligopoly. Customers always prefer differentiated product but within a
range. It means customers want their product to be different form others but not so
different that their comparison is impossible. It is because customers can derive
utility form comparing their own goods with other’s. For example, people would
like to watch different TV programmes but no one want he to be a single watcher
of that programme. Similarly, people would like to buy a car which other people
don’t have but simultaneously they would like to have a club of users of the same
cars. Thus, fixed cost, economies of scale, barriers to entry, product differentiation
and few firm created causes are the causes behind oligopoly.
Indeterminacy
A significant consequence of interdependence of oligopolistic firms is wide variety
of behavioural pattern. Rivals may decide to co-operate in pursuit of objective or
they may prefer to fight each other. If they co-operated it may last long or may turn
into even stronger rivals. Their co-operation agreement may follow variety of
patterns.
While deriving demand curve assumption is ceteris paribus, which is possible in
perfect competition, monopoly and monopolistic markets. It is because either there
is no firm to interdepend (no rival firm a case of monopoly) or even if they are

74

there interdependence is negligible (rivalry is negligible a case of monopolistic

competition) or zero (no rivalry a case of perfect competition). Therefore, while
deriving demand curve in other form of markets assumption of ceteris paribus is
easy to hold. But in case of oligopolistic market individual firm is not insignificant
and have a capacity to decide the fate of other firms, through own actions and
reactions. That is why rivals reaction is uncertain and noticeable. Here we must
remember that there is no rivalry of firms in monopoly and perfect competition.
Thus, we cannot drive demand curve in oligopoly market. There is guessing of
others and outguessing by others. In the absence of demand curve, we cannot
provide solution for price-output determination in oligopoly.
Again, determinate price output solution is reached by assuming profit
maximisation objective. But validity of profit maximisation is challenged in
oligopoly. The enlisted objectives of oligopolistic firm are ‘maximising stable
profit over a long period rather than profit at a time’6, sales maximisation7, utility
maximisation8, growth maximisation9, satisfaction maximisation10. This objective
controversy further deepens indeterminacy.
Because of indeterminacy, there is no single determinate solution but a number of
determinate solutions11.
Approaches to Oligopoly
The difference between an oligopoly firm and market firm is that other market
firms need not to take into account effects of own decisions on their rivals, while
oligopolistic firm has to re about this. It has to decide either to compete with rival
firm to follow individual interest or cooperate with them to promote joint interest.
It has to strategise either for the whole group or individual firm.

6 Rothschild, K. W, Price Theory and Oligopoly, Economic Journal, vol. 57, 1947
7 Boumol, William J,
8

9 Morris, R. L
10

11 Ahuja H. L, Advanced Economic Theory, Ed 17, p 830

75

 Some of economists like Cournot and Bertrand, assumed that oligopolistic firms
ignore interdependence, making their demand curve determinate. With this,
assuming profit maximisation objective, we can apply marginalist theory to
determine price and output. Another approach assumes that an oligopolistic firm is
able to estimate reaction curve of his rival firm. Chamberlin assumed that firms
recognise their interdependence and try to maximise their joint profit. P. M.
Sweezy, Hall and Hitch assume that price reduction will be followed by the rival
firm but not price increase. One more approach assume that firms recognise
interdependence, will pursue common interest will form collusion to maximise
joint profit and will share profit and output. Another variant subscribes that
oligopolist firms will accept one firm as a leader which may be low cost firm or
dominant firm or barometric firm. One moe approach, by Newmann and
Morgenstern, called as game theory assumes that oligopolistic firms calculate
optimum moves by the rival firms and decide own counter moves.

14.2 Cournot’s Duopoly Model

The French economist Augustin Cournout developed duopoly model in 1838. He
illustrated his model with two firms selling mineral water derived at zero cost. He
assumed a straight line market demand curve and assumption by seller that his
rival will not change its output. These assumptions are for simplifying.
Assume that there are two firms A and B each owning a source of cost free mineral
water. Also assume that market demand curve linear. Assume that firm A starts
producing and selling. How much quantity it will produce depends on profit. As
marginal cost is zero profit is same as total revenue. It will produce and sell that
quantity at which profit or total revenue is maximum. E is mid point of demand
curve where elasticity is unit. At any price above P demand is elastic, therefore,
decrease in price will cause increase in total revenue or profit. On the other hand,
for the price lower than P demand is inelastic, therefore, increase in price will
increase total revenue or profit. The total revenue or profit will be maximum at
price P and quantity A at which demand is unitary elastic.
Period I: Thus, seller A will produce and sell quantity Q, which is half of the
market demand. Now seller B, assuming that seller A will continue to sell the same
quantity, will take CD as his demand curve. Like seller A, he will maximise his
profit by supplying half of the market demand available for him i. e. 1/4 of total
demand.

76

 Period II: Reacting to firm B’s entry in the market supplying 1/4 of market
demand, firm A will find that only 3/4 of the market is available for it and will
decide to reduce it supply to half of 3/4 not supplied by B i. e. 3/8 of total market
demand. When firm A had reduced its supply to 3/8 of total market demand, firm B
will find market demand 5/8 market available for it and will supply half of that i. e.
5/16.
Period III: In period third firm A will assume that firm B will continue to produce
5/16 of the total market demand and will produce half of the remainder market
demand i. e. 22/32 of the total market demand.

Product of firms in successive periods.

Peri Firm A Firm B
od
1 1 1 1
I = = ( )=
2 2 2 2
1 1 3 1 1 1 3 5 1 1
II = (1 − ) = = − = (1 − ) = = +
2 2 8 2 8 2 8 16 4 16

77

 1 5 11 1 1 1 1 11 21 1 1 1
III = (1 − )= = − − = (1 − )= = + +
2 16 32 2 8 32 2 32 64 4 16 64
1 42 43 1 1 1 1 1 43 85 1 1 1 1
IV = (1 − = = − − − = (1 − )= = + + +
2 128) 128 2 8 32 128 2 28 256 4 16 64 256

Product of A in equilibrium Product of B in equilibrium

1 1 1 1 1 1 1 1
= − − − = + + +
2 8 32 128 4 16 64 256
1 1 1 1 1 1 1 1 1 1 1 1 1 2 1 1 3
= − [ + ⋅ + ⋅ ( )2 + ⋅ ( )3 + . . . . . . = + ⋅ + ⋅ ( ) + ⋅ ( ) + ....
2 8 8 4 8 4 8 4 4 4 4 4 4 4 4

In case of firm A, the expression in parenthesis and expression is declining

geometric progression.12
1 1
1 1 1 4 1
= − 8 = − 8
= − =
2 1− 1 2 3 2 24 3
4 8
1 1
4 4 1
= 1
= 3
=
1− 3
4 4
Thus, over the period each firm will adjust it own output and supply in such a way
2
that each firm produces and sells of total market demand keeping the remainder
3
1/3 supplied by both the firms. If there are three firms each will supply 1/4 of the
market and the remainder 1/4 demand will not be kept supplied. If thee are four
sellers each will supply 1/5 and the remainder 1/4 will be kept supplied. If there are
n suppliers each will supply 1/(1 + n) and the remaining 1/n would be unsatisfied
demand.
Thus, sellers will keep their supply constant and market will be stable. But it is vey
limited by application because of its assumptions. It is assign that seller do not
learn from the past. Similarly, the assumption of costless production, though can be
relaxed, is not practical.
The model is closed because number of firms are assumed to be constant. But the
beauty of the model is that with entry of new firm unsupplied market demand and

12 Geometric progression where ratio r =1/4, first term of series a = 1

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 price decrease and market moves towards perfect competition. It means market can
be extended to cover any number of sellers.
The model explains that in every succeeding period output of the existing seller(s)
will go on decreasing while that of the new seller will increase. But the model do
not explain how long this adjustment process will take to reach the final
equilibrium.
.
Reaction Curve Approach
Derivation of iso-profit curve:
Firms profit curve is inverted ‘U’ shaped. It is because at lower level of output, MR
> MC, every increase in output adds to profit. At certain quantity (say Q) profit
would be maximum, where MR = MC. If output is increased beyond quantity Q,
MR < MC and every increase in output decreases profit of the firm.
Iso-profit curve for a firm is the locus of points showing different combinations of
outputs of the firm and its rival firm which yield the firm same level of profit. Iso-
profit curve is also inverted ‘U’ shaped. Iso-profit curves are concave to the axis
along which we measure output of the firm. It shows how a firm reacts to its rival
firm’s output, so as to retain a given level of profit. Suppose that the rival firm B
(in fig. ) decides to produce quantity B1. The diagram shows that the firm A earn
the same profit π1 when it produces either A1 or A4 quantity. Suppose the firm A
decideds to produce larger quantity Q4. Now if the rival firm B increases its output,
increased market supply will bring down price and profit of the firm A. To retain
profit firm A will have to sell at increased price. The market price can be increased
by reducing market supply. Therefore, firm A would reduce its own output. Along
with decrease in output by firm A, its revenue and cost will change in such a way
that profit is the same i. e. (TR - TC will not change). This is possible only when
market demand inelastic and the firm A was producing more than optimum
quantity.
If firm A react, to firm B’s decision to produce quantity B1, by producing quantity
Q1, profit will be the same as at quantity Q4. Now if firm B decides to increase its
output, in reaction the firm A also will increase its own output in such a way
revenue and cost will change to keep profit unchanged i. e. (TR - TC will not

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change). It is possible only when market demand is elastic and firm A was
producing less than optimum13.

The farther the iso-profit curve from the axis, the lower is profit and vice versa. If
firm B increased output from Be to B4, firm A would not be able to retain its profit.
Now firm can increase, decrease or retain its output. If firm A increased output, its
profit will come down because of inelasticity of demand and increasing cost. If it
also reduced output, its profit will decrease because of elasticity of demand and
increasing cost. If it retained output fall in the price, due increase supply by firm B,
will result in decrease in revenue and profit of firm A. Thus, firm A will earn lower
profit in all three possible conditions. Thus, reaction point or reaction curve on
which firm A reacts to firm B’s output lies above above profit curve. But iso-profit
curve, so far as cost curves are U shaped, is of inverted ‘U’ shape. Therefore, for
each quantity of output of rival firm B, there will be unique level of output of firm
A which maximises its profit. This point is the highest point of lowest attainable
iso-profit curve (in fig. P2) of firm A. In other words, it point of tangency between
perpendicular (L 2) at output of firm B and lowest attainable iso-profit curve (P2).

13Production is subject to decreasing average cost and revenue is less than

maximum.

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 Firm A’s highest points of successive iso-profit curve lie to the left of each other. It
is because as output of rival firm increases, price will fall. It will shift firm’s
marginal revenue curve to the left and downward, intersecting marginal cost curve
at lower quantity. If we join the highest points of all iso-profit curves, we get firm
A’s reaction curve. Thus, reaction curve of a firm is locus of the highest points of
iso-profit curves that firm can attain, for a given level of output of rival firm. It
shows reaction of a firm to output of its rival firm.
Similarly, we can derive iso-profit curve of firm B, which would be concave to
vertical axis on which we measure its output. The highest point of successive lower
iso-profit curves of firm B lie right and downward. If we join them we get firm B’s
reaction curve or function. Reaction curve shows what quantity of output a firm
will have to produce to maximise its profit for different levels of output of rival
firm.

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Cournot’s equilibrium is decided by intersection of two reaction curves. Assume

that firm A decided to produce quantity A1 , firm B will react by producing B1 ,
given that firm A will keep its quantity constant at A1 . However A reacts by
assuming that firm B will continue with quantity B1 and increases output to A2 .
Now B reacts by assuming that firm A will continue with quantity A2 and reduces
output to B2 . This increase in output by firm A and decrease by B will continue
until they both reached at intersection e, to be in equilibrium.
The following diagram shows that firm is in equilibrium by maximising it own
profit but joint profit of industry is not maximum. In the diagram at equilibrium e
firm A earns πA3 and the firm B earns πB3. If both the firms decided to produce at
point b , firm B will earn higher profit while firm A same as before. If both the
firms decided to produce at point d, firm B will earn the profit same as before but
firm A will earn profit higher than before. If the produced at any point between b
and d , both the firms will earn higher profit. In all these cases joint profit of the

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d

 industry will be the maximum possible. Thus, we can say that industry is in
equilibrium at suboptimal earning less than maximum possible profit. It happens
only because firms do not learn from their past expecting rival will not change its
output.

Mathematical version:
Assume that duopoly market demand is

14.3 Bertrand’s Duopoly Model

Bertrand criticised Cournot’s model and had given his own in 1883. According to
Bertrand there is no limit for the price to fall because firm can lower price to
increase supply until it reaches to average cost. In Bertrand model price is not
decided to sell produced output but output is decided to sell at the determined
price. Bertrand duopoly model (1883) assume that each firm expect rival firm price
constant and assume the same market demand curve for all the firms. Cournet’s
model differs from Bertrand’s model because former assumes output of rival firms
to be constant; while later assumes price of rival firm to be constant. In Cournot’s
model with change rival firm’s output individual firms demand curve changes; but

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in Bertrand’s model price of rival is assumed to be constant therefore, the same

market demand curve is faced by each firm.

Bertrand’s model also is explained with the help of reaction curves or reaction
function derived from firm’s iso-profit curves which are convex14 to the axis on
which firm’s product price is measured. An iso-profit curve of a firm (firm A)
shows a level profit which the firm earns for different market prices. Convexity of
iso-profit curves implies that for less than optimal level utilisation of plant, there is
an inverse relationship between price of firm’s (firm B) product and price of its
rival firm (firm B). Beyond optimal level utilisation of plant, there is direct
relationship between them. And at optimal utilisation there is one-to-one
relationship. That is when firm produces output smaller than optimum quantity
(say Ae in fig. ), to maintain the same level of profit, the firm (A) can increase its
product price when rival firm (B) decreases its own product price: while at larger
than optimal output the firm (A) will have to reduce its price in reaction to rival

In Cournot’s model iso-profit curve is said to be concave while in Bertrand’s

14
model it is said to be convex, but its meaning is the same because in former model
we measure quantity along the axis while I late we measure price along the axis.

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firm’s (B) price cut. For each level of rival firm’s (B) price there is unique price of
the firm (A) which maximises its own profit. This unique profit maximising price
is determined at the lowest point of the highest attainable iso-profit curve. Such
minimum points of the successive iso-profit curves lies to the right of each other. It
is because when rival firm (B) increases price, the firm gains some of the
customers from rival firm, even if it also raises price. If we join the lowest points
of successive iso-profit curve we get reaction curve of the firm. It is locus of points
of maximum profits that the firm can attain by charging a certain price, given the
price of its rival.

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Similarly, we can derive reaction curves of rival firm (B) from its iso-profit curve.
Reaction curves of two rival firms will intersect to each other to give stable
equilibrium as discussed below.
If firm A charges price A1 , firm B will assume that firm A will continue to charge
the same price and will decide its price at B1 , because it will maximise firm B’s
profit. Now the firm A will assume that firm B will keep its price constant at B1 ,
and will raise its price to A2 , which is profit maximising. Then firm B will take
chance to increase price. This action and counter reaction will continue until point
e is reached. The same but reverse process will happen if any firm charges any
price higher than equilibrium price ( Ae or Be).
Bertrand model also does not lead to the maximisation of industry profit because of
their naïve nature, which does not allow the to learn from the past. If firm
recognised their independence and moved to any point between a to c on
Edgeworth’s contract curve profit of at least one firm would increase or both will
increase. This leads to joint profit maximisation.
The model is criticised on the ground of Naïve nature of firms.
There is individual firm profit maximisation but not joint profit maximisation.
The model is closed i. e. does not allow new entry.
Like Cournot’s this model also do not define length of thr adjustment process.

14.4 Edgeworth’s Duopoly Model

F. Y. Edgeworth criticised Cournot’s assumption of duopoly model. According to
him each duopolist believes that his rial firm will keep price constant, irrespective
of what price he does charge. Unlike Bertrand, Edgeworth assumed that productive
capacity of each duopolist is limited. Edgeworth’s duopoly model do not expect
products of both the firms to be identical bur close substitutes of each other, so that
price differential will attract each others customers. But to avoid complications we
will assume that products of both firms is homogeneous.

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If duopolist products are homogeneous, at the same price market would be equally
divided between them. In the following diagram DC and DC’ are dead curves of
duopolist I and II respectively. Suppose OB and OB’ are their maximum output
capacities respectively. If duopolist formed a collusion, to maximise joint profit
they will set price equal to OP. The output of two duopolist will be OA and OA’
respectively.
Each producer believes that his rival will keep his own price constant regardless of
what price he himself charges. Suppose that duopolist I thought if he reduced his
own product price slightly, he can attract rival’s customers, to sell larger quantity
and make larger profit than before. Therefore, he reduced his product price to OR,
attracted rivals customers and was able to sell his entire output OB and making
profit OBSR.

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But duopolist II, to prevent loss of customers will reduce his own price. In the
counter move he will set his price OR’ slightly lower than Duopolist I’s price. Now
duopolist II will be able to attract increased customers, will be able to sell his entire
output OB’ while making profit OR’S’B’.
Then duopolist will react by setting his price lower than duopolist II. This will
continue until price reaches to OQ, at which both duopolist are able to sell their
entire output and making profit OBTQ and OB’T’Q. Now no firm will have
incentive to cut price because both of them are able to sell their entire quantity.
Apparently, it feels that the system is in equilibrium.
Now one of the producers may realise that his rival is selling his entire output and
cannot increase his output further. If he increases price there is no fear of losing
customers. Therefore, duopolist will raise his price to OP, where he is earning
maximum possible profit. But duopolist II will set his price slightly below OP and
will be able to attract duopolist I’s customers. Again duopolist I will retaliate by
setting his price slightly below hi rival. This move and counter move will be
continued until price once again reaches to OQ.
In this way price will oscillate between profit maximising monopoly price OP and
output maximising competitive price OQ. Thus there would be perpetual
disequilibrium. We must note that price decreases gradually but increase in a jump.

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14.5 chamberlin’s Duopoly Modal

According to Chamberlin if firms do not recognise their interdependence, the
industry will reach either Cournot’s or Bertrand’s equilibrium. According to
Chamberlin, if firms recognise their interdependence and act as to maximise the
industry profit, a stable equilibrium can be reached with monopoly price being
charged by all firms.
Chamberlin do not admit naïve nature of business firm. Firms, while changing
prices or output, recognise their interdependence in the form of direct and indirect
effects of their decisions. The direct effects are those which would occur if
competitors were assumed to remain passive. Indirect effects are those which result
when rival firms react to the decisions of firm which changes its price and output.
The recognition of the full effect of a change in the firms output or price result in s
table industry equilibrium with monopoly price and output.
Chamberlin assumed that then monopoly solution can be achieved through without
collusion; if entrepreneurs are enough intelligent to recognise interdependence,
learn from past mistakes and adopt the best position charging monopoly price.
Assume that demand curve is a straight line and production is costless.

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If firm is the first to start production, it will produce profit maximising output M
and will sell it at monopoly price PM . Firm B under Cournet’s assumption will
consider CD as its demand curve and will maximise its profit by producing half of
this demand i.e. quantity M B. Now total market supply is OB and price falls to P.
Firm A will realise that rival firm B does react to its action, therefore, it will reduce
its output to A to restore price at PM. Thus, industry output is M and price charged
is monopoly price PM . The rival firm B also recognises interdependence and will
realise that it is the best to halve market between them. Thus, both the firms
recognise interdependence and share market equally charging monopoly price PM.

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Chamberlin’s model is improvement over Cournot’s and Bertrand model because

in this model firms recognise their interdependence and arrive at stable equilibrium
with monopoly power.
Non-collusive joint profit maximisation implies that firms have perfect knowledge
of market demand and supply curve to decide monopoly price.
Chamberlin’s model ignore entry of new firm.

14.6 Sweezy’s Kinked Demand Model

Market demand curve is derived from horizontal summation of individual demand
curve of firms in the market. As individual firm’s demand curve is downward
sloping, market demand curve is flatter than individual demand curve.

But, in the short run, an individual business firm may attract customers from other
sellers if it reduces price. Similarly, in short run, it will lose customers if it
increases price. It means change in price by an individual firm will cause greater
percentage change in its demand compared to market demand. That is, in the short
run, individual firm’s demand curve is more elastic than market demand curve.
Therefore, an individual firm’s demand curve will intersect market demand curve

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 as shown in the following diagram. This gives rise to kinked demand curve. Hall
and Hitch used kinked demand curve to analyse price stickiness or price rigidity15.
It implies that if the firm increases price it will lose customers and it will not do so.
Theoretically, by reducing price the individual firm may gain customers, provided
all other things are constant. But other firms too, in the fear of loosing customers,
will follow it and practically firm will gain no additional customers. Thus, a change
in price, in either direction, will not benefit the firm and it will not change the
price.
If market demand is less than Q, all buyers will buy from the firm as it offers lower
price than other sellers and no one will buy in the rest market. Conversely, if
demand is more than Q, rest market sells cheaper and no one will buy from the
firm. Thus, dashed part of both demand curves will not be functional. Therefore,
practical or working demand curve in the market will be dKD.

Assume that dd’ is individual firm’s demand curve and DD’ is market demand

curve. Individual firm demand curve dd’ is more elastic than market demand curve
DD’. If price prevailing in the market is more than P, demand curve faced by the
firm is elastic; therefore, the firm can increase its revenue by decreasing price.
Therefore, firm will go on decreasing price so far as it is facing elastic demand
curve or reaches to point K, where price is P. On the other hand, if price is less

15Hall, R. L and C. I Hitch, Price Theory and Business Behaviour, Oxford

Economic Papers (1939) pp. 12-45.

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 than P, the firm will face inelastic demand and can increase revenue by increasing
price. Therefore, firm will go on increasing price so far as demand curve faced is
inelastic or reaches to point K, where price is P.
Once the firm reaches at price P, it will not change the price. It is because, when it
increases price will face elastic demand, which advocates decrease in price. If he
decreases price, he will face inelastic demand curve, which advocates increase in
price. Therefore, there will be no change in the price.
This price rigidity is because of kink in the demand curve at point K. This demand
curve is known as kinked demand curve.
Price and Output Determination or Equilibrium of Firm
Hall and Hitch used Chamberlin’s concept of kinked demand curve to explain price
rigidity phenomenon oligopoly. The concept of kinked demand was used by P.
Sweezy to explain price equilibrium of firm in oligopoly market. Kinked demand
curve is result of intersection of individual demand curve and market demand
curve. It shows certain kind of behavioural pattern of a firm in oligopolistic
market.
Oligopoly market has only few sellers, therefore, they have great interdependence.
Every entrepreneur thinks if increases price, other will not follow him and he will
lose his customers to others, as others are selling same product at the same
previous lower market price. Contrary, if he decided to decrease price, other also
will do so and he will not gain an additional customers. Therefore, change in price
in either direction is not going to help him and sellers will remain sticked to the
same price.
In the above diagram market condition is shown by average revenue curve dKD
and marginal revenue curve dMR, while alternative cost conditions are given by
MCi curves. Average revenue curve is kinked at K. Upper prong of this AR or
demand curve is a part of firm’s demand curve and is elastic while lower one is a
part of market demand curve and is inelastic. MR curve is discontinuous from
point A to B, because AR is kinked at point K.
The firm’s equilibrium is decided by MR = MC. Suppose that initial cost
conditions are by MC1. Thus, at given cost conditions firm will produce quantity Q
and will charge price P.
If costs went up and new cost conditions is shown by MC2, again firm will produce
same Q quantity and will keep price unchanged at P. This is because at this
quantity also MR = MC. Similarly, if cost costs went up as shown by MC3, again
firm will change neither quantity produced nor price charged.

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In the case conditions went up to MC4, equality between MR and MC is at lower

quantity and higher price, as shown in the diagram. The new equilibrium quantity
and price will be Q1 and P1 respectively. On the other hand, if cost conditions came
down below MC1 quantity produced will increase more than Q and price charged
will decrease less than P.

It means that when MC changes but passes through discontinuous part of MR

curve, there will be no change in output and price charged. Thus kink explains
price rigidity in oligopoly. The greater the difference of elasticities if upper and
lower , the segments of demand curves, the wider the discontinuity in MR curve
and the wider will be the rage of cost change in which price does not change.
But in case rise in cost is equally affects all firms, firm will increase pricing
knowing that all other firms will do the same. Point of kink shifts left and upward.
Thus, equilibrium price would be higher and quantity would be lower.

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14.7 Stackelberg’s Muopoly Model

German economist Henrich von Stackelberg extended Cournot’s model.
Stackelberg assumed that one duopolist is enough sophisticated to recognise that
his naïve competitor behaves on Cournot’s assumption. Rival will try to maximise
his profit on the basis of his own reaction curve. Such sophisticated duopolist
recognises his rival firms reaction curve and incorporates it in his own profit
function. Then he tries to maximise his profit as if he is a monopolist.
Assume that firm A is sophisticated oligopolist. The rival firm B is naïve and will
act on the basis of its own reaction curve. The firm A will set its own output at that
level which maximises its own profit. Such point would be a common between
naïve rival firm B’s reaction curve and iso-profit curve of sophisticated firm A, i. e.
where firm B’s reaction curve is tangential to firm A’s iso-profit curve. Firm A will
produce quantity A and rival firm B will react by producing quantity B. In this way
sophisticated firm A become a leader and rival firm B follower. Clearly,
sophistication is rewarding for A because he reaches on that iso-profit curve which
would not have been possible if he behaved with the same naïveté as his rival.
While naïveté is punishing because naïve firm earns profit lower than that it would
have earned in Cournot’s equilibrium.

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If firm B is sophisticated and firm A is naïve, firm B will choose to produce at

point b on firm A’s reaction curve which avails it largest profit given firm A’s
reaction curve and iso-profit curves of B. Now firm B is leader and earns higher
profit and firm A is naïve and earns lower profit compared to Cournot’s
equilibrium.
If both firms are sophisticated both will try to be leader as it is rewarding. In this
case market would be unstable i.e. Stackelberg’s disequilibrium. The effect would
be either price war until one firm sunders or collusion. Both the firms will move a
point closer or on the Edgeworth’s contract curve with both of them
will earn profit more than before. If they reached on Edgeworth’s contract curve
industry profit would be maximised.

Stackelberg’s model implies

Naïve behaviour is punishing.
By recognising rival firm’s reaction each firm can reach higher level of profit.
If each firm ignore other price war will be inevitable, as a result both will be worse
off. Collusive agreement is advantageous. By such collusive agreement both
duopolist can reach to joint profit maximisation.

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Stackelberg’s model is applicable in Cournot’s type market but not Bertrand’s type
of market. Under Cournot type of market the sophisticated firm can bluff the rival
by producing larger than that it would have produced under Cournot’s assumption.
The naïve rival firm will produce lesser than that it would have produced under
Cournot’s assumption. In Bertrand type of market, sophisticated firm can do
nothing which would increase its own profit. At most he can behave as his
opponent expects.

14.4 Collusive Oligopoly

To avoid uncertainty in the market business firms may enter into collusive
agreement like cartels and price leadership. In modern world of competition such
collusion is not only illegal but also punishable offence.
In the absence of collusion, monopoly solution in the industry is very difficult and
can achieved only under rare conditions.
(i) each firm knows the monopoly price i. e. has correct knowledge of the market
demand and of costs of all firms,
(ii) each firm recognises its interdependence with the others in the industry,
(iii) all firms have identical costs and identical demands
Cartels are formed aiming either at joint profit maximisation or at market sharing

A. Cartel
A cartel is direct agreement between competing oligopolistic firm to reduce
uncertainty arising from their interdependence. The agreement may be formal or
tacit. The aim behind a cartel is to avoid uncertainty. A cartel can be joint profit
maximising or aiming at market sharing.
Joint Profit Maximisation
In this form, cartel aims at joint profit maximisation. The firms in the cartel appoint
a agency which decides the total quantity to be produced by each firm in the cartel.
In a way cartel decides total output of industry, price to be charged and distribution
of maximised joint profit among individual firms. The agency has access to costs
of individual firms and calculate market demand (average revenue) and marginal
revenue. Market MC curve is derived from horizontal summation of the MC curves
of individual firms. Like multi-plant monopolist, the agency sets the price defined
by intersection of industry MR and MC curve.

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 In the following diagram there are two business firms (A and B) in the cartel.
Market MC curve is derived from horizontal summation of the MC curves of
individual firms. DD is market demand curve. The profit would be maximum when
MR = MC. The diagram shows that joint profit of the cartel would be maximum
when output is Q (= Q1 + Q2), where MR = MC. Now each firm will produce that
quantity for which its individual MC = MR. Thus firm A will produce Q1 and firm
B will produce Q2. The figure also shows that low cost firm produces larger
quantity than higher cost firm.
Mathematical expression

Flows of joint profit maximisation

Theoretically, it is seems to be easier to attain monopoly solution by cartels but in
practice even identical cost cartels may be unstable. This is because of the
following reasons.
1. Demand estimation mistakes: Usually, each firm believe that elasticity of its
own demand is high due to existence of substitutes; while that of industry
demand is low. This leads to mistake in derivation of MR curve and price higher
than monopoly price.
2. Individual members of cartel may find it beneficial to present low cost figures
to the central agency, because output and profit allocation is based on the level
of cast. Also estimation of market MC from the summation of individual cost,
due to imperfect knowledge, may involve mistakes. This task for all levels of
output

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 3. Cartel forming involves bargaining and negotiations which takes longer period
of time. Even if cost and market demand were correctly estimated during the
negotiations, by the time when the cartel agreement is to be executed, changed
situation may turn it wrong. Thus, monopoly price and market sharing may turn
wrong.
4. Once the agreement is finalised, even if there are changes in the market
situation, cartel cannot change easily. This inflexibility of cartel is result of time
consuming bargaining process.
5. Bluffing: Cartel is formed for joint betterment, but interest of individual
members in the cartel are rival as they have to share common pie. Therefore,
there is bluffing attitude of members. Some firms may report lower costs to
achieve larger market share. If every firm did it cartel will decide larger output
and lower price, resulting into loss of every firm.
6. If a firms can produce, any quantity of output, at marginal cost higher than
equilibrium MC of the cartel, theoretically, such firm should be closed down.
But a firm joining cartel to close down own operation is endorsable. However, it
is possible when other firms are allocating it a part of total cartel profit. But
once such firm lost its customers to the other cartel members and they stoped
sharing total profit with this member, the firm would be helpless. It will have to
start from the beginning.

7. If monopoly price is too high, which cartel do not want to change, but is not
admissible to the government, it may interfere and compel to change it to the
adversaries of the cartel.
8. If profit maximising monopoly price results into lucrative supernormal profit,
the cartel may not dare to charge monopoly. It is because such price makes

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 entry more attractive. The behaviour of the entrant is uncertain. Therefore,

established firms prefer to sacrifice a part of their profit by not charging
monopoly price. It is not endorsable to form cartel but not to charge monopoly
price.
9. Even if firms adhere to the monopoly price defined by the cartel they prefer to
have freedom of deciding style and selling activities. This leads to product
differentiation. It also means that firms charge same price for different products.
It is not fit in the concept of cartel.
10. Similarly, the intension of keeping goodwill may make the cartel to charge
lower price than profit maximising monopoly price.
Cartel and Merger
Cartel is a system which lies between the system of competitive firms and multi-
plant monopoly. It is lesser perfect version of both of these. It is because cartel
firms come together for joint betterment but there are natural reasons for the clash
of their interest. To avoid such clash of interest, the best way out would be merger
of cartel firms to form a single multi-plant monopoly by merger. Therefore, there is
a natural tendency of cartels towards merger. The difference between a cartel and a
merger is legal and of degree rather than kind. In this competitive world cartels are
illegal and mergers are considered as a means of better utilisation of resources.
Merger is not forbidden unless it is proved that it is being formed to restrict
competition.
Market Sharing Cartels
The more common form of collusion is market sharing collusion. The firms share
the market but keep other form of freedom like style of product, selling activities.
Market sharing can be non-price competition or quota system.
Non-price competition
In this type of cartel a price is fixed below which no firm has to sell its output.
Such price is result of hard bargaining between participation oligopolistic firms,
where high cost firms will insist for higher price and lower cost firms for lower
price. The final price is set after agreement. But firms are free to differentiate their
product from the rest producers in the industry and to follow promotional
activities. If all firms produce at the same cost the cartel is workable but if
individual firm’s costs are different it would be rewarding for the low cost firms to
break away form the cartel and charge lower price. The suit may be followed by
other low cost firms, the cartel will come to the end. Once again there would be
price war and instability in the market. The likely result of such war is survival of

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the low cost firms. However, such cheating is not free of cost for the split off firm,
because it will start price war, contrary to the reason for which cartel was formed.
The broke-away business firm may have to fight with rest of the cartel. The result
of price war depends upon cost differences. If cost difference is wider the result
would be survival of broke away low cost firm, eliminating rest firms of the cartel.
Another possibility is that all other member of the cartel will join hands to start
price war to drive away the split off firm.

In the figure there are two firms A and B, a low cost firm. Pm is monopoly price of
cartel. Firm A maximises it profit by producing quantity Q and selling it at
monopoly price pm. But firm B produces quantity Qb less than its profit
maximising quantity B. Therefore, firm B will have natural inclination to charge
lower price P or split off from the cartel, as it would be rewarding. Even if there is
no cost difference among business firm the cartel would be unstable, because split
off firm can charge slightly lower price than Pm and to attract consumers from
others. All firms may have the same incentive and cartel will fail.

Quota Agreements
In this type of system firms agree on the quantity that each member each member
may sell at agreed price or prices. If firms have identical costs, they will share
market equally. If costs are different firms quota will depend upon its cost level and
bargaining skill. Bargaining skill is decided on the basis of past level of sales snd
productive capacity.

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Market is also shared on the regional basis. In geographical sharing of the market
firms are free to differ on the basis of price as well as style of product. Though
lesser, region sharing cartels also are unstable. Agreement is often violated by low
cost firms either mistake or intentionally.
Cartel is a closed model. Entry will intensify instability of cartel. New entrants
would be unpredictable and unwilling to join cartel. It is because by not joining the
cartel, a new firm can charge slightly lower price to attract customers from sellers.
But to avoid entry, the cartel may charge lower price to make entry of the new firm
unattractive or can wage price war with the new entrant. If new player entered and
the cartel carried out price war, survival of new entrant depends on cost
differences,

B. Price Leadership
Under price leadership one firm sets the price and other follow it, either because it
is advantageous or to avoid uncertainty even if profit is not maximised. Price
leadership is more common and acceptable because like cartel it does not demand
complete surrender to the central agency. If the product is homogeneous price
charged by different sellers would be the same; but if the product is differentiated
prices will differ. If firms are concentrated in a location they will tend to reduce
price differences and if they are spread widely, they will tend to charge different
prices. Price leadership may be by a low cost firm or a dominant firm or a
barometric firm. In this case the leader will set his product price by marginalistic
rule (MR = MC) and others will follow it with or without profit maximisation.
Low cost price leader

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Assume that there are two firms A and B, which produce homogeneous product at
different costs. The firms may have equal (fig. 1) or unequal market share (fig 2).
The low cost firm B charges price Pb and high cost firm A follows this price,
though it does not maximise its profit. The follower would obtain higher profit if it
produces lower output (Ae) and selling it at a higher price (PA). However, the
higher cost firm A sacrifices some of its profit to avoid price war, which would
eliminate it being an inefficient producer compared to firm B.
It should be noted that to maximise profit low cost firm B must produce quantity B
and charge price PB. This implies that follower must supply quantity A, enough to
maintain price set by the leader. In this model leader is price setter and other firms
follow him, but firm must enter share-of-the-market agreement. It is because if
follower adopt the price set by the leader; but produces lower quantity to maximise
profit, it will push the leader to non-profit maximising position.

In above diagram fig I shows equal market sharing and fig. II shows unequal
market sharing. In equal market sharing costs curves are different but individual
demand curve is one and the same, while in unequal market sharing cost curves as
well as demand curves are different. The lower cost firm will set the price (PB)
which would maximise it s own profit. The higher cost firm will follows the same
price, because it cannot afford price war with the low cost leader firm. That is why
instead of producing profit maximising quantity Ae, it produces little more
quantity A.
The dominant firm price leader

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In this model it is assumed that there is a large dominant firm occupying

considerable share of market and other smaller firms. It is assumed that the
dominant firm knows market demand curve DD, small firms individual MC curves
and their combined supply curve derived from their MC curves. Thus, by
deducting small firms supply at each price the dominant firm can obtain it s own
demand curve or the part of market demand which is not supplied by the smaller
firms. Form this demand it will derive MR curve. The dominant firm will
maximise its profit by producing the quantity at which MR = MC. It will also
decide price to be charged to maximising it own profit. The dominant firms price
would be followed by small suppliers in the market.

In the figure, at price P1 , there will be no demand for dominant firm’s output as
small firms are satisfying total market demand. If price decreases small firms will
contract their supply and dominant firm will find expansion of its demand. For
example for price P2 small firms will supply quantity P2M and rest market demand
M D2 will be supplied by the dominant firm. For price P3 and lower than this, small
firms will not supply any quantity and total market demand will be available for
dominant firm. In this situation business firm try to maximise its own profit by
producing quantity Q, where MR = MC. Thus, the dominant firm will set price at P
and other firm will follow it while supplying quantity PN. The rest quantity NA of
market demand will be supplied by the dominant firm. Here we must not that the

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 dominant firm maximises profit but profit of small firms may not be maximum.
The dominant firm have ensure that the small firms are following not only price set
by him but also supplying right quantity NA at price P.
Barometric Price Leadership
Some firms in the industry or outside the industry may have good reputation for
their market knowledge. They are better than others in forecasting future changes
in the Behaviour of such firms is seen as a good forecaster of the probable changes
in the market. Such firm neither need not to be a dominant firm nor a lost firm, In
can be any ordinary firm which has established itself as a weathercock. If such firm
is within industry it demands immediate and if it is outside it indicative from far.
Barometric price leadership is useful for various reasons.
1. Rivalry between firms may make it impossible to establish one among as a
leader
2. Continuous cost calculations is difficult.
3. Barometric firm is one which had proven itself as a reasonable forecaster and by
following it firms can make sure that they are following right policies.
Mathematical Expression

C. The Basing Point Price System

In basing point pricing a firm charges price for its product on the basis of two
components, cost of production and an additional cost of freight to deliver the
product at the customer’s location, which varies form customer to customer. This
pricing is followed in case of very heavy, bulky, voluminous and expensive
products. Buyer is to pay base price plus shipping price. Tipically, basing point is
manufacturing location, but sometimes they can be different. Basing point system
can be single or multiple basing point system.
The single basing point system
Under this model oligopolist agree on a common place as the basing point and
quote their product price at different places equal to the production price plus
transportation cost. Assume that town A is agreed as the basing point and PT is
transportation or shipment or freight cost curve. The delivery price at different
places will change along the shipment cost curve PT, depending on the distance
from the basing point. All the firms, irrespective of their location, will calculate

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shipment cost from the basing point town A. That is why, price of every firm would
be the same for the buyers located in a given town i. e. EG in town E, DL in town
D, CE in town C, BM in town B and AP in town A.

If a firm located in town E, it will charge price EG from the local customers,
earning excess profit P’G called as ‘phantom freight’. A firm can sell its product in
any town to the left hand side, because it will cover production cost plus freight. A
firm will not hesitate to sell its output in any town to its right hand side so far as
marginal cost is less than its the mill price minus freight, it will have to cover.
For example, a firm located in town E will find it profitable to sell in town B, if
MC < (E P′ − K M ) . The firm located at basing point, while selling in any
town, covers both production and freight cost. but firms outside basing point may
not be able to sell their product at basing point.
Multiple Basing Point System
The basing price increases along with increase in distance between location of
customer and basing point. The firms which produce at non-basing point and sell
locally earn excess profits or phantom freight. This excess profit may be reduced
under multiple basing point.

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Assume that location A and E are agreed as basing point. The curve PT shows
delivered product price charged at different places by the firms in location A.
While delivered product price of the firm located at E is shown by curve P’R. Only
at the intersection of PT and P’R, delivered product price is identical for firms
located at A and E. To the right of e the delivered product price of firm in location
A is lower than that of firm located in E. While to the left of e the delivered
product price of the firm in location E is lower than that of the firms located in A.
Thus, buyers from market A to C will pay price as per basing price curve Pe and
the buyers from market E to C will pay price as per basing price curve P’R.

The firm located in A will charge the delivered product price on basing point curve
Pe, and firm located in E on the basing point curve P’E, both without any phantom
freight. If both firms want to sell their product to the customers beyond C they will
have to bear a part of freight. But the firms located between basing pints will have
phantom freight. For example, a firm located at D will charge delivered product
price Ce and will gain phantom freight ea, while a firm located ar D will have even
greater phantom freight of eb . Similarly, a firm in location B will have phantom
freight but lesser than firm in location C.

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 If we increased number of basing points phantom freight will come down. When
number of basing point are equal to number of sellers or sellers location phantom
freight will be completely eliminated. Basing point system eliminate price-
competition because firms stick to basing point price. However, non-price
competition in the form of promotions, delivery, product differentiation exists.
Like cartel, open basing point agreements are illegal, but indirectly they can be
implemented through publishing information by informal leaders in the market.
Here also cheater have incentives but their rewards are cut short by basing point
price.
(discuss how the number of basing point is decided)

15. THE MARGINALIST

CONTROVERSY

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 I. Assumptions of the Neo-Classical Theory

1. Single Owner Entrepreneurship
The traditional theory of firm assumes there is no separation between ownership
and management or a single owner entrepreneur. He is assumed to have limitless
information, time and ability to evaluate all possible courses of action for profit
maximisation. In a way traditional entrepreneur is with global rationality.
These assumptions are unrealistic. In the modern world of globalisation single
owner-entrepreneur is obsolete. Unlimited information is over simplification of the
situation and neglect of distortion of information. Global rationality, due to lack of
information, inability to evaluate and compare alternative strategies in modern
complex world, is difficult to assume.
2. Only Goal - Profit maximisation
Firstly, in the absence of perfect knowledge firms do not know their demand and
cost curves, therefore, they cannot apply marginalist principle. Secondly, in this
world of joint stock companies, profit maximisation objective is not principle but
one among many.
Managerialism: In the modern world where ownership and management divorced
from each other, there is scope for managerial discretion. He, therefore, follows the
goals, such as salary, prestige, market share, job security, quiet life and so on,
which maximise his own utility function.
Behaviourism: With the uncertainty in the real world firms seek maximisation of
nothing but instead seek for satisfactory behaviour - satisfactory profit, satisfactory
sales. This is bounded rationality or rationality in the uncertain world.
Long-run-survival and Market-share: Some economists, like Rothschild, have
argued that firms aim at maximisation of probability of long run survival. Other
writes have propounded that objective of firms is to attain and retain maximum
profit.
The price elasticity of market demand is defined as,
dQ P
eQ = ⋅
dP Q
Assume that the firm has a constant share of the market,
q = k .Q
Where,
q - demand for the product of firm

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 k - constant
Q - market demand
The price elasticity of the demand of the firm is defined as,
dq P
eq = ⋅
dP q
Substituting q = k . Q, we obtain,

d(k ⋅ Q) P
eq = ⋅
dP kQ
k being constant, we may rewrite
dQ P
eq = k ⋅ = eQ
dP kQ
The market demand curve is assumed to be known and from this the firm can
estimate its own demand curve. If firm knows its cost it can apply marginalistic
rule MR = MC.
Whether this behaviour will lead to profit maximisation in the long run is not
certain. The firm in this model maximises its profit for given constant market
share. Different market shares yield different maximum level of profit. If firm is
profit maximiser it would choose maximum maximorium. Thus the goal of
constant market share does not imply maximisation of long run profit.
Entry-prevention and risk-avoidance: Some firms set the price at such level that
entry for a new firm is unattractive. The purpose behind barring entry of the new
firms may be diverse viz. to maximise long run profit or to ensure long run survival
or to retain constant market share. Basically, firms, through to experience, become
used to existing firms’ reaction pattern and learn to anticipate their reaction curves.
But new firms behaviour unknown and uncertain for them. By preventing new
entry existing firms avoid uncertainty.
Managerial discretion: There is no unanimity of opinion about the extent of
managerial discretion. There are some evidences that profits are higher in owner
controlled firms than in firms where management and ownership is divorced. It
implies that at least some discretion is available to management in pursuing goals
other than profit maximisation.
The supporters of the profit maximisation argue that in the long run only profit
maximisers will survive, because by maximising profit firms can accumulate
financial assets which will help them to survive during the bad time. Thus, survival
of profit maximiser is larger.
Those who object profit maximisation argues that if all firms deviate from profit
maximisation, there is no reason to believe that certain firm has higher chances of
survival. There is no reason to believe that dynamism in techniques and product
cannot be used as effectively as profit maximisation as a means of survival. It has
been argued that if firms are large and have monopoly power, market would be
imperfect and there would be no threat of survival for such firms. It is also argued
that competition among large firm is stiff and even they cannot deviate from profit
maximisation.

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 This series of arguments for and against profit maximisation will go on endless, but
we can say that there is multiplicity of goals and managers can not have unlimited
discretion in setting goals. There is minimum profit constraint which firms have to
obey whichever objective they may follow.
3. Uncertainty
It was assumed that firms have perfect knowledge of its cost, revenue and market,
giving no place for uncertainty. Later it was recognised that firms don’t have
perfect knowledge but operate in the world of uncertainty. The idea that profit as a
single valued magnitude known with certainty by the firm was abandoned and it
was assumed that expected profit of given action may assume any value in a rage,
where each value has certain probability of being realised. The decision maker
assigns subjective probabilities to possible profit of each strategy and estimates its
mathematical expectation. Having done such computation the entrepreneur choses
highest expected value in each period. Then net profitabilities are discounted at
subjective rate and their present value is estimated. The firm then choses the
strategy that maximises present value of the future stream of net profit, for a
specific period of time.
This probabilistic treatment of uncertainty has been attacked on the several
grounds.
1. It requires lot of knowledge, information and computational skills which are
rare in entrepreneurs.
2. The adoption of the decision rule of choosing the alternative which has
highest expected value does not describe real behaviour of the
firm.Entrepreneurs attitude towards risk is also important in decision making.
Generally, higher profit is associated with higher risk. If entrepreneur is risk
avoider he will not choose project with high risk. Unless we know risk
attitude of entrepreneur, we can not say what his actual decision will be.
3. The length of the time horizon is also important but traditional theory give no
importance to it.
4. Difficulties creep in estimating future costs, future revenues and present value
of future profits.
5. Conventional theory treats expectations of entrepreneurs as exogenous to the
firm. Yet expectations are influenced to a great extent by factors internal to the
firm.
Thus probabilities of future events are subjectively determined. They are
influenced by time horizon, risk attitude and rate of change of environment,
keeping businessman’s expectations cannot come close to objective reality.
Different firms have different assessment of uncertain future events and will
respond differently to the same conditions. Thus, traditional theory was unable to
deal satisfactorily with uncertainty, risk aversion and time horizon.
4. Static Nature

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Time enters into traditional theory in three respects.16 Firstly, as distinction

between short and long run, about which traditional theory is quiet. It is assumed
that firms have some time horizon over which they maximise profit. But the length
of time horizon and its interaction with uncertainty and risk-aversion is not
adequately dealt with. Thirdly, there is time lag between production and demand.
Traditional theory is static. Time is divided into identical and independent period.
Decisions are treated temporarily independent, though reality is that decision taken
in any one period is affected by the past decisions and will influence decisions in
the future. Prof. A Koutsoyiannnis17 has regarded this as the most important
shortcoming of the traditional theory.
5. Entry considerations
Traditional theory considers only actual entry and entry is assumed to take place
only in the long run which not defined. In monopoly entry is blocks, in perfect
competition and monopolistic competition entry is allowed in the long run. While
oligopoly is silent on entry. Classical duopoly model is closed but it can be
extended to larger number, provided the number remains constant. In the cartel it is
assumed that the new entrant will join and in price leadership it is assumed that the
new firm will follow the leader.
6. The Marginal Principles, MR = MC
Firms maximise its short run profit by setting its output and price in such a way
that MR = MC. Given the independent time period, the short run profit
maximisation implies long run profit maximisation. But it has been argued that the
goal of long run profit maximisation not necessarily demand short run profit
maximisation. Profit maximisation as a single objective had been criticised.

II. FULL COST PRINCIPLE

A study of 33 firms was published by Oxford economists Hall and Hitch in 1939
shows that not monopolistic but oligopoly was the most prevalent market structure
and that firms neither maximise profit nor produce at marginalist rule.
1. Firms do not act automistically but are conscious of competitors reactions. It
means not monopolistic but oligopolistic markets are common. Duopoly
based on constant reaction pattern of competitors is inadequate to cope up
with reality of interdependence.
2. Objective of firms: They found that firms did not pursue short profit
maximisation but aim at long run profit or fair level of profit and followed
other goals. It makes them to neglect marginalistic rule.
3. Firms concentrate on price not on the output as suggested by the traditional
theory. Firms do not set price as per marginalist rule but to cover average cost
plus normal profit margin. It is mainly because in this complex and dynamic

16Horowitz, Ira, Decision Making and Theory of the Firm (Holt,

Rinehart and Winston 1970) p. 332.
17 Koutsoyiannis A, Modern Microeconomics, 2nd Edition p. 262

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 world firms don’t know their demand curve and marginal cost curve. Due to
imperfect information application of marginalist rule is impossible.
4. Firms are also prepared to depart from average cost pricing to secure big order
or if they think it is damaging to their goodwill.
5. Traditional theory predicted change in price and output in response to changes
in demand and cost, but Hall and Hitch found that prices were sticky. To
explain stickiness of prices they introduced kinked demand curve out if
intersection of individual firm’s elastic demand curve and more inelastic
market demand curve. It means businessmen believe that if they raised their
price rivals would not and they will lose customers, while if they cut their
price their rivals will do so and sales would increase only insignificantly.18
The price was set at average cost without collusion and kink would appear at
that price. Firms reported that collusive increase in price was avoided in the
fear of loss of sales to potential low price entrants. Similarly, collusive
decrease in price was not done because they believed it will not help the group
because of inelastic market demand curve. The businessmen were also aware
of consumers’ dislike for frequent changes in price. Therefore, price was kept
unchanged until there is general cost increase.
6. The kinked demand theory can not be considered as theory of price output
determination as it explains successfully why prices are constant at kink but
does not explain the level of price or location of kink. They are very
impressive for being different from marginalist and putting an impressive
criticism of their. They discussed long run competition, interdependence,
average cost pricing instead of marginalistic coputations, long run profit, and
goodwill.

III. GORDON’S ATTACK ON MARGINALISM

The real market structure is complex with many variables changing continuously
which prevent entrepreneurs from learning from the past.
Due to lack of sufficient information and knowledge there is uncertainty,
therefore, businesses turn to additional goals apart from profit maximisation to
avoid uncertainty. Such goals are connected to profit maximisation but it is difficult
to find out whether they are complementary or competing.
Empirical evidence had shown that average cost pricing is widely used especially
in multi-product firms where estimation of cost is extremely difficult because so
many variables changes frequently.
Managers concentrate on local problems arising in particular stage of production
and find solution for such problems without applying marginalist rule. Local

18 Price cut by a rm will attract rival rms customers, but when the
same suit is followed by its rivals there is no reason to attract rival
rms customers. But price cut by all rms will increase total market
demand and concerned rm will have its own share in it which is
insigni cant.

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fi
fi

fi
fi

fi
fi

 solutions do not necessarily lead to profit maximisation. It is an effort to maintain

flow of output rather than maximising profit.
Accuracy of demand is always challengeable due to ever changing environment.
Under average cost pricing firm can produce and sell in the market to reduce
uncertainty. Shifts in demand are more important for firm than shape of demand
curve. To follow marginalist rule firm has to pay attention to cost as well as
revenue changes and to follow average cost pricing firm need to pay attention to
cost only.
For marginalist behaviour demand and cost curve must be known objectively,
subjective knowledge of demand and costs make marginalistic rule equal to any
observed behaviour of the firm towards profit maximisation.
Inclusion of additional goals into cost and revenue functions, because whatever the
firm does is because it aims at profit maximisation, marginal equality leads to
tautological predictions.
Similarly, any attempt to account for expectations in cost and revenue function
leads to tautological predictions.
Lasr pra 267

&&&&&&&
I Goal of the The
Average cost pricing assumed that long run profit maximisation is the goal of
business firm and it cannot be attained by maximising short run profit because
individual short run period are not independent.
MR = MC does not maximise long run profit as short runs are not independent
II Demand and Cost Schedule
Both demand and cost schedule are uncertain in the long run. Demand is uncertain
because of unpredictable reactions of competitors and changing taste of consumer.
Extrapolation if past demand is unfit due to dynamic changes in demand
structure.Long run cost is also uncertain because of changing factor prices and
technology. Thus, average cost pricing theorists doubted use of long run demand
and cost schedule and rejected them as tools of analysis.
It is assumed that firms build their plant with excess capacity so that they can meet
seasonal fluctuations, to accommodate break- down of equipments, to meet
growing demand until expansion, etc. It means average variable cost curve is
saucer shaped. short run cost flat stretch or reserve capacity
at output < optimal high cost but price donot cover
at output > optimal high cost but price don't covers
III Mark up Rule
determination involves two stages
1 Price = cost + reasonable profit
2 compare at which entry would occur
firm aims long run profit but due to uncy bases its price on short SAV
SAC is good approximation bcoz cost may fsll but will not increase
gross profit margin will cover AFC and NPM
AFC = TFC/ budgeted output

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 NPM is known from experience covers fair returns and riskthe desired price will be
basis for actual price which depends on entry threat

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