LESSON – 4
MARKET STRUCTURE
OBJECTIVES
After going through this chapter, you should be able to
- Understand the meaning and features of perfect competition, monopoly and monopolistic competition.
- Understand price – output determination under perfect competition, monopoly and monopolistic competition.
- Know the meaning of price discrimination.
- Know price determination under price discrimination.
STRUCTURE
4.1. Meaning of Perfect competition
4.1.1 Features of Perfect Competition
4.1.2 Equilibrium of the Firm and Industry under Perfect Competition
4.1.3 Equilibrium in the Short-run
4.1.4 Equilibrium in the Long-run
4.2. Monopoly
4.2.1 Features of Monopoly
4.2.2 Short-run Equilibrium under Monopoly
4.2.3 Long-run Equilibrium under Monopoly
4.2.4 Price Discrimination under Monopoly
4.2.5 Degrees of Price Discrimination
4.3. Monopolistic Competition
4.3.1 Features
4.3.2 Price determination under Monopolistic Competition.
Unit Questions
4.1. MEANING OF PERFECT COMPETITION
Perfect competition is the name given to an industry or to a market characterised by a large number of buyers and sellers all engaged in the purchase and sale of a homogeneous commodity with perfect knowledge of market prices and quantities, no discrimination and perfect mobility of resources.
4.1.1 Features of the perfect competition
Large Number of Buyers and Sellers
The first condition of perfect competition is that there are a large number of buyers and sellers in the market. No single firm is in a position to affect the market price by varying its own output. The output of a single firm is only a small portion of the total output in the industry and the demand of any single buyer is only a small portion of the total demand. The individual seller is a price taker and not a price maker. The buyer cannot influence the market price by changing his demand for the product.
Homogeneous Product
The products produced by all firms in the industry are fully homogeneous and identical so that buyers do not distinguish between products supplied by the various firms.. That is to say that the product of each firm is regarded as a perfect substitute for the product of other firms. Hence no firm can gain any competitive advantage over the other firms.
Perfect Knowledge of the Market
Both the buyers and sellers are fully aware of the going price in the market. Because all buyers know fully the current price of the products in the market, sellers cannot charge more than the going price. If any seller tries to charge a price higher than the prevailing price in the market, then the buyers will shift to some other sellers and buy the products at prevailing price. Similarly, all the sellers are aware of the prevailing price in the market and hence no seller will charge less price than this since his objective is to maximise profits.
Free Entry and Exist
There should be no restrictions, legal or otherwise on the firms’ entry into or exit from the industry. In this situation, all the firms will earn normal profit. If the profit is more than normal, new firms will enter and if on the other hand, profit is less than normal, some firms will quit from the industry.
Absence of Transport Costs
In this market situation the prevailing market price is accepted and acted upon by all the dealers. If the same price is to rule in a market, it is necessary that no cost of transport has to be incurred. If there is transport cost, then the prices must differ to that extent in different sectors in the market.
Indifference
No buyer has a preference to buy from a particular seller and no seller has a preference to sell the products to a particular buyer.
Absence of Collusion
There should not be any kind of agreement between the sellers nor between the buyers so that each seller or buyer acts independently. The firms in the industry enjoy the freedom of independent decisions.
Perfect Mobility of Resources
For a market to be perfectly competitive there should be perfect mobility of resources. Factors of production must be in a position to move freely into or out of industry and from one firm to the other. If the demand exceeds the supply, factors will move into the industry and in the opposite case move out.
4.1.2 Equilibrium of the Firm and Industry under Perfect Competition
A firm or an industry is said to be in equilibrium when there is no tendency for its output to increase or decrease. Under perfect competition firm will adjust its output at the point where its marginal cost is equal to marginal revenue or price and marginal cost curve cuts the marginal revenue curve from below. The demand curve or the average revenue curve facing a firm under perfect competition is a horizontal straight line parallel to x axis.
Conditions of equilibrium under perfect competition
In the Figure the average revenue curve and marginal revenue curve coincide with each other at the ruling price OP. Given OP price, the firm will fix its output only at OM, This is so because at output OM, MR = MC and MC curve cuts MR curve from below. At point R, profits would be maximum and the firm would be in equilibrium.
4.1.3 Equilibrium in the Short-run
If OP is the ruling price in the perfectly competitive market situation, firm A will be in equilibrium at E and will be producing OM output, firm B will be in equilibrium at L with ON output and firm C will be in equilibrium at K with OT output. The cost in firm A is less than firm B and the cost in firm B is less than firm C. That is why firm A is making super normal profits, firm B is earning only normal profits and firm C is making losses. The firm’s equilibrium is the same as that of industry’s equilibrium only in the second category.
4.1.4 EQUILIBRIUM IN THE LONG-RUN
In the long-run, a firm or an industry is in equilibrium only when the following two conditions are satisfied.
1. Price = MC of all firms
2. Price = Minimum AC of the marginal firm. Under conditions of different costs and in long-run equilibrium, some firms may be earning super-normal profits and some may be making only normal profits. This is shown in Figure.
In Figure the long-run price is OP which is equal to the marginal cost of firm A, B and C. Besides, price OP is also equal to average cost of the marginal firm C. The marginal firm is the highest-cost firm which earns only normal profits. (Fig. iii). If price falls below OP,then the marginal firm will leave the industry as with the fall in price its profits will sink below normal.
In firm A and firm B, the price OP is greater than average cost and therefore they make super normal profits. Firm A’s super normal profit is more than firm B because of the differential cost conditions. Firms having lower cost than firm C will enter in the industry and hence super normal profits will be converted into normal profits. Full equilibrium in the long- run is achieved when price is equal to marginal cost of all firms and minimum AC of the marginal firm. Working at optimum size in the long-run, the firm will enable the consumers to get the products at the lowest possible price.
2.2. MONOPOLY
Monopoly is a market situation in which one firm is the sole producer or seller of a product which has no close substitutes. Mono means one, poly means seller. Thus monopoly means one seller or one producer.
4.2.1 FEATURES OF MONOPOLY
1. Under monopoly there is a single seller or producer. The single seller may be an individual or group of individuals or a company.
2. In monopoly, there is no difference between firm and industry. The firm itself is the industry.
3. Under monopoly as there is only one firm producing a product, it has not close substitutes.
4. As the monopolist is the sole producer or seller, he has the power to control price or output. But he cannot control both. The control over price is the unique feature of monopoly.
5. There exists strong barriers to entry in monopoly.
4.2.2 SHORT RUN EQUILIBRIUM UNDER MONOPOLY
In the short run, the monopolist has to work with a given plant. He can increase or decrease his output only by changing variable factors. The equilibrium of a monopolist in the short run is illustrated in Fig.
Monopolist is in equilibrium at E where marginal revenue is equal to marginal cost. Price is OP and his profit is equal to TRQP.
It is generally thought that monopolists always earn profits. But it is not so. In the short run he can make losses also. It is shown in Figure.
The monopolist is in equilibrium at level of OS output at OP price. Since price is lower than average cost, he is making losses equal to PQGH. However as price is higher than average variable cost he will continue his production.
4.2.3 LONG-RUN EQUILIBRIUM UNDER MONOPOLY
In the long run, monopolist can adjust his size of the plant. In the short- run, the monopolist adjusts the level of output with a given plant. His profit maximising output in the short run will be at a point where short-run marginal cost curve is equal to marginal revenue curve. But in the long-run he can further increase his profits by adjusting the size of the plant. So in the long run he will be in equilibrium at the level of output where the marginal revenue curve cuts the long-run marginal cost curve. The long run equilibrium of the monopolist is portrayed in Figure.
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The monopolist is in equilibrium at OL output where LMC cuts MR. He will fix the price equal to OP and will be making profits equal to THQP.
4.2.4 PRICE DISCRIMINATION UNDER MONOPOLY
Price discrimination can be defined as the act of selling the same article (a good or service) produced under single control (that is by a single firm) at different prices to different buyers. Usually this is possible only in monopoly as there is the sole seller controlling the entire supply. Thus price discrimination cannot prevail in perfect competition. This practice of charging different prices to different consumers or discriminating among the buyers in the prices to be paid by them is also referred to as discriminating monopoly.
Price discrimination is of different types. It is personal discrimination if a monopolist charges different prices for different individuals. For example, professionals like doctors, lawyers or tax consultants may collect more fees from the rich patients than from a poor one. Firms also sell the same product under two name brands, one at a higher and the other at a lower price to increase sales among rich and poor buyers. Secondly, there can be local discrimination. This involves different prices being charged over different localities. Thus the monoplist may charge a higher price from the domestic consumers and a lower price from the foreign consumers just to capture the foreign market. Universities in USA charge higher tuition fees from foreign students only. The third type is trade discrimination. Here the monopolist charges different prices from different trades or occupations. Firms offer lower prices for whole sale or bulk purchasers and higher prices from retailers. Similarly publishers of journals charge lower prices from individual members and higher prices from institutions.
2.5 DEGREES OF PRICE DISCRIMINATION
The extent to which a seller can divide the market to charge different prices is known as the degree of price discrimination. Professor A.C. Pigou has explained three degrees of price discrimination.
First Degree Price Discrimination
Price discrimination of the first degree occurs when the monopolist is able to sell each separate unit of the output at a different price. Entire consumers surplus is shifted to the seller as shown in Figure.
When the monopolist knows the price each consumer is willing to pay, he can charge the same price and take away the entire consumer’s surplus as shown by the shaded area. The monopolist first sells the product at the highest price to those who are willing to buy at that price. The consumer’s surplus becomes nil. Then he lowers the price for the second set of consumers who also will not have any consumers’ surplus. This is possible for instance in the case of doctors who charge differently according to the financial ability of the patients. Mrs. Joan Robinson describes this as perfect discrimination.
Second degree price discrimination
Second Degree Price Discrimination
In the second degree price discrimination a monopolist takes away only a portion of the consumers’ surplus and not the whole of it. This is possible only when the number of consumers is large and price rationing can be done. It is also assumed that the demand curve for all the consumers is identical.
Figure shows that the monopolist practising price discrimination charges OP price which is the lowest demand price for OM quantity. For the next lot of MM the price charged is OP1 which is again the- lowest demand price for that lot. The consumers enjoy a limited consumer’s surplus as shown by the shaded area for each level of output. By adopting such a block pricing method, the monopolist gets the maximum revenue.
TR = OPAM + OP1 BM1 + OP2 CM2
Second degree price discrimination
If the monopolist does not adopt price discrimination but adopts any one of these prices as the single price, his total revenue will be much less.
Third Degree Price Discrimination
A monopolist is said to practice third degree price discrimination when he charges different price in different markets which have different elasticity of demand. The price charged in each sub-market depends upon the output sold in the submarket and the demand conditions in that submarket. He has to make two decisions (1) How much total output should he produced by him. (2) In what way will the total output be divided between the two markets to get the maximum profits. A uniform price cannot be set for all the markets without losing profits if the elasticities are different. The monopolist has to decide the price-quantity combination which will maximise his revenue in each market and thus maximise his total revenue. In terms of marginal cost pricing, he should equalise marginal cost and marginal revenue in each market and fix the price in each market.
In Figure the monopolist faces a very elastic demand curve (DA) in market A and inelastic demand curve (DB) in market B. The curve AD in figure C, shows the summation of the demand in both the markets. The equilibrium output for the monopolist is OM where his marginal cost interests the marginal revenue.
The total output OM will be divided and sold in the two submarkets in such a way that the marginal revenue ME will be equal to the marginal cost in each submarket. Thus he will sell OM2 in market B at a high price of P2 M2 since the demand is inelastic and will sell OM1 in market A at a price of P1 since the demand is elastic. Price in market A is lesser than in market B. The monopolist makes the maximum profit as shown by the shaded area in figure C. Thus for equilibrium to be determined for a discriminating monopolist two conditions must be satisfied (1) marginal revenue in two markets should be the same (2) they should also be equal to the marginal cost of the whole output, i.e., (1) Aggregate marginal revenue = Marginal cost of total output (2) MRa = MRb = MC. On the whole there is every reason to believe that output under discriminating monopoly will be larger than under simple monopoly.
4.3. MONOPOLISTIC COMPETITION
The concept of monopolistic competition was put forth by Prof. Chamberlin. It is a blending of competition and monopoly and therefore it is more realistic than pure competition or monopoly. Chamberlin argues that monopoly is unreal as absence of competition, absence of substitutes and control over price are not found in the market situation. Similarly it is rare to find perfect competition because it is impossible to fulfill the conditions of perfect competition such as uniform price, homogeneity of products, absence of transport cost etc. Monopolistic competition refers to competition among large number of sellers producing close but not perfect substitutes.
4.3.1 Features
1. The number of sellers under monoplistic competition is larger. Each firm has very limited control over the price of the product.
2. The distinguishing feature of monopolistic competition is product differentiation. The products of various firms are heterogeneous. Product differentiation does not mean that the products of various firms are completely different. They are slightly different and serve as close substitutes. Products may be differentiated on the basis of the characteristics of the product itself such as trade marks, peculiarities of packages or wrappers, or differences in quality, design, colour or style. The differentiation may be due to the conditions surrounding the sale of the product. This implies the difference in the services rendered by the sellers. Products are differentiated to promote sales by influencing the demand for the products. This is done through advertisement.
3. The firms under monoplistic competition have freedom to enter or leave the industry. Product differentiation increases the entry of new firms because each firm produces a different product.
4. Selling cost is another important features of monopolistic competition. As competition is very keen, the firms have to advertise to sell more of their products. Thus selling cost influences the determination of price under monopolistic competition.
5. Chamberlin has used the word group instead of industry. Industry refers to a collection of firms producing homogeneous products But Chamberlin’s concept of group refers to collection of firms producing closely related but not identical products.
6. The demand curve of a firm under monopolistic competition slopes downwards. This is because a reduction in price will lead to increase in sales and vice versa. Further the demand curve is highly elastic because the firm has some control over price due to product differentiation.
4.3.2 PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION
Equilibrium of a firm under monopolistic competition involves three variables viz., price, product and selling outlay. Therefore equilibrium is explained with respect to each of these variables, keeping the other two variables given and constant. Further equilibrium under monopolistic competition involves individual equilibrium of the firms as well as group equilibrium.
INDIVIDUAL EQUILIBRIUM AND PRICE VARIATION
In individual equilibrium, the product and selling outlay are held constant and the only variable is price with respect to which equilibrium adjustment is made. The individual equilibrium under monopolistic competition is graphically shown in the Figure.
DD is the demand curve which is also the average revenue curve of the firm. AC is the average cost and MC is the marginal cost of the firm. The equilibrium level of output is OM for at OM output MC is equal to MR. The equilibrium price is OP. The firm makes maximum profits equal to RSQ P.
A firm in the short run may incur losses also, which is shown in the Figure.
The firm is in equilibrium by producing ON level of output and the equilibrium price is 0T. The firm incurs losses equal to TKHG.
GROUP EQUILIBRIUM AND PRICE VARIATION
Due to differences in cost and demand curves of various firms, it is difficult to describe the group equilibrium. Hence to overcome this difficulty, Chamberlin makes uniformity assumption, It implies that both demand and cost curves of all the products are uniform through out the group. Added to this, Chamberlin introduces another assumption namely “symmetry assumption”. It means that the individuals action regarding price and output will have negligible effect on the competitors as the number of firms under monopolistic competition is large. Based on these assumptions, group equilibrium can be explained with the help of a Figure.
DD is the demand curve and AC is the average cost curve. Each firm will set the price at OP at which MC is equal to MR and profits are maximum.
Attracted by the abnormal profits, new firms will enter. As a result the market would be shared by more firms and abnormal profits will be completely wiped out as shown in the Figure.
The firm is in long run equilibrium by producing OL quantity of output and fixing the price at OK. As average revenue curve is tangent to average cost curve, the firm will be making only normal profits. There is no tendency for the competitors to enter the field as the firms are earning only normal profits.
PRODUCT VARIATION
Under product variation, price of the product is assumed to be constant. Therefore, the firm has to choose among the various possible quantities and attributes of the product. A special characteristic of product variation is that it alter the cost curve and demand for the product. Yet another feature is that product variation is quantitative and therefore quantitative measurement is not possible.
INDIVIDUAL EQUILIBRIUM AND PRODUCT VARIATION
The equilibrium of the firm under monopolis tic competition with respect to product variation is shown in the Figure.
In the figure, two cost curves have been drawn representing two varieties of the product, A and B. AA is the average cost curve of the product A and BB is the average cost curve of the product B. If the price of the product is OP, the quantity demanded of product A is OM. The total cost is OMRs, and the total profits is SRQP. If the quantity demanded of product B is ON, then the total cost is ONFG and profit is GFEP. Since product B yields greater profits than A, the entrepreneur will choose the product B.
Group Equilibrium and Product Variation
It is assumed that the demand is uniform and the possibility of product variation is also uniform. The equilibrium adjustment of the product is shown in Figure.
CC is the average cost curve, If the quantity demanded is OM then the total cost is OMHG. The firm earns supernormal profits equal to GHQP. This supernormal profits should be wiped away to achieve group equilibrium. Attracted by the supernormal profits, new competitors may enter the group. The quantity demanded will come down to 0T. Price will cover only cost of product. Besides the adjustment in the number of firms, product improvement may also take place. When alt entrepreneurs improve their products, cost will increase as shown by DD and becomes equal to the price at point S.
Group equilibrium must satisfy the following conditions:
1. The average cost must be equal to price.
2. It is not possible for any one to increase his profits by making further adjustment or improvement in his product.
Selling Cost and Price Determination
Selling cost is another important factor which influnece pricing under monoplistic competition. Selling costs are costs incurred on advertising, publicity, salesmanship, free sampling, free service, door to door canvassing and so on. Selling costs are ‘the costs necessary to persuade a buyer to buy one product rather than another or to buy from one seller rather than another”.
Under perfect competition, there is no need for advertising as the product is homogeneous. Similarly under monopoly also, selling costs are not needed as there are no rivals. But under conditions of monopolistic competition as the products are differentiated, selling costs are essential to increase sales. Chamberlin defines selling cost, “as costs incurred in order to alter the position or shape of the demand curve for a product”.
Advertisement may be classified into two types; informative and competitive. Informative advertisement enables the buyers to know about the existence and uses of the product. It also helps to increase sales of all firms in the group. Competitive advertisement refers to the expenses incurred to increase the sales of the product of a particular firm as against other products.
Production Cost versus Selling Cost
Watson feels that it is difficult to differentiate selling cost from cost of production. However Chamberlin states that these two costs are basically different from one another. Production costs include all expenses incurred in producing a product and transporting it to its destination for consumers. Selling costs are incurred to change the preferences of a consumer for a particular product. Prof. Chamberlin distinguishes between the two in these words: “The former (Production) costs create utilities in order that demands may be satisfied, the latter create and shift the demand curves themselves”. Those which alter the demand curve for a product are selling costs and those which do not are production costs. In other words. ‘those made to adapt the product to the demand are production costs and those made to adapt the demand to the product are selling costs”. The production cost affects the supply but selling cost affects the demand. While the production cost influences the volume of production, the selling cost influences the volume of sales. ‘
Individual Equilibrium and Selling Cost
Here it is assumed that the seller adjusts his selling cost keeping the price and product constant. It is also assumed that one seller alone advertises, while all others do not. As a result he attracts new buyers, sells more and makes profit. This is illustrated in Figure.
PC is the production cost curve. CC is the combined production and selling cost curve. MC is the marginal cost curve. If the seller sells OQ level of output at OP price, he has no profit. His cost of production is equal to price. Therefore, he advertises his product which increases his cost. His production cost is equal to 0Q S R His selling cost is R S SR. He earns an abnormal profit equal to PRST.
Group Equilibrium and Selling Cost
The abnormal profit earned by the firm makes all other firms in the group advertise. When all firms advertise total cost of all will increase. Price will be equal to cost. There is no abnormal profit. All firms earn only normal profit. This is shown in Figure.
PC is the production cost curve. TC is the total cost curve of the single firm. Due to competition from others, the cost is equal to price. CC is the total cost curve of all the firms in the group. As it is tangent to the price line there is no abnormal profit.
Questions
1. State the features of perfect competition.
2. Discuss the equilibrium of a firm under perfect competition.
3. How is price determined under monopoly?
4. What is price discrimination? Explain its various degrees.
5. Describe equilibrium under discriminating monopoly.
6. Describe the features of monopolistic competition.
7. Analyse price output determination under monopolistic competition.
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