CP 102 UNIT 3

Q.1. Concept of Price; Factors for price; Different Prices and Price Strategies.
Ans: Pricing is a key element of the marketing mix. All the other elements –
Product, Packaging, and Promotion are cost generators, i.e. they cost the company money.
But pricing is an income generator. Let us look at the factors that determine the pricing of a
product.
Pricing
A price is a value in monetary terms that one party pays to another in a transaction in
exchange for some goods or services. So the definition of price is the amount of money the
buyer will pay as consideration to the seller in exchange for goods or services.
Pricing isn’t always as easy as setting a price the seller hopes to obtain. It involves aspects
such as demand and supply, cost of the product, its perception and value for the customer
and many such factors.
So while pricing a product, the company has to take immense care and consideration. If the
price is too high or even too low the product will fail in the market. This is also the reason
why the determination of price is not a one-time event. A company changes the prices
according to the market conditions and other circumstances.

Factors Affecting Price Determination

A company has to keep in mind various factors while determining the price of a product.
Some such important factors are given here.
1] Cost of the Product
The most important factor affecting the price of a product is the product cost. The same
principle also applies in case of services. The product cost will be inclusive of the cost of
production, the distribution costs and the selling and promotion costs. This cost will act as a
benchmark for setting the price.
In the long run, the company will obviously try to cover the entire cost of the product. And in
addition, it will set for itself a profit margin over and above such cost. But perhaps in the
short run, the company may set a price lower than the cost of the product. This is a
marketing strategy to boost sales and capture a share in the market. But in the long run, no
company can survive unless the prices of the products/services do not even cover their
costs.
Let us also learn about the three types of costs of a company
 Fixed Cost: These costs are fixed. They have no relation to the level of activity or
production of the company. Even if there is no production of goods these costs will
occur. For example, the rent of the factory is a fixed cost.
 Variable Cost: These are the costs that vary in direct proportion to the production
levels of an entity. Higher the production, higher the cost and vice versa. The raw
material is a classic example of a variable cost
 Semi-Variable Costs: These costs also vary with the production levels. But they are
not directly proportional. Say for example the salary of a manager is 10,000/- a month
fixed and then 10% of his sales. This is a semi-variable cost.
2] The Demand for the Product
 The cost of the product will only give you a benchmark to determine the price. The upper
limit of the price range will depend on the utility the product has and hence its demand in
the market. So the cost of the product is the seller’s concern. The buyer’s concern is the
utility of the product. The demand for the product will depend on its utility and its price. The
law of demands states that lower the price higher the demand.
Another factor to consider when determining the price is the elasticity of demand. This
means the corresponding change in demand to the change in the price of a product. If the
demand is inelastic then the company can charge a higher price for their products.
3] Price of Competitors
One factor that affects price termination is the price the competition charges for
their product. Not only their price but their products, its features and other factors
like distribution channel, promotions etc. should also be studied.
In a market, with free competition, the prices have to be very competitive. You cannot risk
pricing yourself out of the market. But on the other hand, if your products have special r
additional features this must be reflected in the price.
4] Government Regulation
The government has a duty to protect its citizens from unfair practices and pricing. So it may
impose certain laws and regulations with regards to the pricing of a product. It can even
regulate the prices of goods that it considers essential goods.
This generally happens in the pharmaceutical industries. Manufacturers charge exuberant
prices for life-saving drugs and the buyers have no choice but to pay. In such cases, the
government may step in and regulate the prices of these essential medicines.
There are other factors also which help a company in their pricing aspect of the marketing
mix. Here we have covered the four most important ones.
(iv) Purchasing Power of Customers:
What are the purchasing power of the customers and at what price and how much they
can purchase? It should also be taken into consideration.
(vi) Objective:
Usually, at the time of price fixation a certain amount of profit is added to the cost of
production. If company’s objective is to earn higher profit it may add higher amount of it.
(vii) Marketing Method Used:
Price is also influenced by the marketing method used by the company, e.g., commission
which is to be paid to the middlemen for sale of the goods is also added to the price.
Similarly, if the customers are to be provided “after sale service” facility, then those
expenses are also added to the price.

Concept of Factor Pricing:

Factor pricing is associated with the prices that an entrepreneur pays to avail the services
rendered by the factors of production. For example, an entrepreneur needs to pay wages
to labor, rents for availing land, and interests for capital so that he/she can earn maximum
profit. These factors of production directly affect the production process of an
organization.
In context of an economy, these four factors of production when combined together
produce a net aggregate of products, which is termed as national income. Therefore, it is
important to determine the prices of these four factors of production. The theory of factor
pricing deals with the determination of the share prices of four factors of production,
namely land, labor, capital and enterprise.
In other words, the theory of factor pricing is concerned with the principles according to
which the price of each factor of production is determined and distributed. Therefore, the
theory of factor pricing is also known as theory of distribution. According to Chapman, the
theory of distribution, “accounts for the sharing of the wealth produced by a community
among the agents, or the owners of the agents, which have been active in its production.”
There are two aspects of each factor of production, which are as follows:
i. Price Aspect:
Refers to the aspect in which an organization pays a certain amount to avail the services of
factors of production. For example, wages, rents, and interests constitute the price of
factors of production.
ii. Income Aspect:
Refers to another aspect in which a certain amount is received by a factor of production.
For instance, rents received by a landlord and wages received by labor constitute the
income generated from the factors of production.
Generally, it is assumed that factor pricing theory is similar to product pricing theory.
However, there are certain differences between the two theories. Both the theories
assume the determination of prices by the interaction of two market forces, namely
demand and supply.
However, there are differences in the nature of demand and supply of factors of
production with respect to that of products. The demand for factors of production is
derived demand, while demand for products is direct demand. Moreover, the demand for
the factors of production is joint demand.
This is because a product cannot be produced using a single factor of production. On the
other hand, the supply of products is closely related with the cost of production, whereas
there is no cost of production for factors. For example, there is no cost of production for
land, labor, and capital. Therefore, the factor pricing is separated from product pricing.
Theories of Factor Pricing:
The theory of factor pricing is concerned with the principles according to which the price
of each factor of production is determined and distributed. The distribution of factors of
production can be of two types, namely personal and functional. Personal distribution is
concerned with the distribution of income among different individuals.
It is associated with the amount of income generated not with the source of income. For
example, an individual earns Rs. 20,000 per month; this income can be earned by him/her
by wages, rents, or dividends. On the other hand, functional distribution is associated with
the distribution of income among different factors of production as per their functions.
It is concerned with the source of income, such as wages, rents, interests, and profits. In
regard of distribution of factors of production, there are two theories, namely marginal
productivity theory and modern theory of factor pricing.

DIFFERENT PRICES:
11 different types of pricing
1) Premium pricing
It is a type of pricing which involves establishing a price higher than your competitors to
achieve a premium positioning. You can use this kind of pricing when your product or
service presents some unique features or core advantages, or when the company has a
unique competitive advantage compared to its rivals. For example, Audi and Mercedes are
premium brands of cars because they are far above the rest in their product design as well
as in their marketing communications.
2) Penetration pricing
It is a commonly used pricing method amongst the various types of pricing is designed to
capture market share by entering the market with a low price as compared to the
competition. The penetration pricing strategy is used in order to attract more customers
and to make the customer switch from current brands existing in the market. The
main target group is price sensitive customers. Once a market share is captured, the prices
are increased by the company.
However, this is a sensitive strategy to apply as the market might be penetrated by yet
another new entrant. Or the margins are so low that the company does not survive. And
finally, this strategy never creates long term brand loyalty in the mind of customers. This
strategy is used mainly to increase brand awareness and start with a small market share.
3) Economy pricing
This type of pricing takes a very low cost approach. Just the bare minimum to keep prices
low and attract a specific segment of the market that is highly price sensitive. Examples of
companies focusing on this type of pricing include Walmart, Lidl and Aldi.
4) Skimming price
Skimming is a type of pricing used by companies that have a significant competitive
advantage and which can gain maximum revenue advantage before other competitors
begin offering similar products or substitutes. It can be the case for innovative electronics
entering the marketing before the products are copied by close competitors or Chinese
manufacturers.
After being copied, the product loses its premium value and hence the price has to be
dropped immediately. Thus, to get maximum margins from their products, innovative
companies keep launching new variants so that customers are always in the discovery
phase and paying the required premium.
5) Psychological pricing
It is a type of pricing which can be translated into a small incentive that can make a huge
impact psychologically on customers. Customers are more willing to buy the necessary
products at $4,99 than products costing $5. The difference in price is actually completely
irrelevant. However, it makes a great difference in the mind of the customers. This
strategy can frequently be seen in the supermarkets and small shops.
6) Neutral strategy
This type of pricing focuses on keeping the price at the same level for all four periods of
the product lifecycl. However, with this type of strategy, there is no opportunity to make
higher profits and at the same time, it doesn’t allow for increasing the market share. Also,
when the product declines in turnover, keeping the same price effects the margins thereby
causing an early demise. This pricing is used very rarely.
7) Captive product pricing
It is a type of pricing which focuses on captive products accompanying the core products.
For example, the ink for a printer is a captive product where the core product is the
printer. When employing this strategy companies usually put a higher price on the captive
products resulting in increased revenue margins, than on the core product.
8) Optional product pricing
It can be frequently observed in the case of airline companies. For example, the basic
product of KLM Airlines is offering or providing seats in the airplane for different flights.
However, once the customers start purchasing these seats, they are offered optional
features along with the seats. Examples may be extra seat space, more drinks etc. Because
of this optional product, there is more revenue generated from the main product.
Customers are willing to spend for the optional product as well.
9) Bundling price
Ever hear of the offer of 1 + 1 free? In the supermarket, when two different products are
combined together such as a razor and the lotion for shaving, and they are offered as a
deal, then we get to experience the bundling type of pricing first hand. This strategy is
mainly used to get rid of excess stocks.
10) Promotional pricing strategy
It is just like Bundling price. But here, the products are bundled so as to make the
customer use the bundled product for the first time. This type of pricing focuses on buying
one, and getting a new type of product for free. Promotional pricing can also serve as a
way to move old stock as well as to increase brand awareness.
11) Geographical pricing
It involves variations of prices depending on the location where the product and service is
being sold and is mostly influenced by the changes in the currencies as well as inflation.
An example of geographic pricing can also be the sales of heavy machinery, which are sold
after considering the transportation cost of different locations. Click here to read more
on geographical pricing strategy.
Depending on the goals and objectives of your company, and the strategies decided by
your company, you can use any of the 11 types of pricing mentioned above. One can
identify what strategy should be applied by analyzing the market and also the
product/service lifecycle they are present in.

Pricing Strategies:
Definition: Price is the value that is put to a product or service and is the result of a
complex set of calculations, research and understanding and risk taking ability. A pricing
strategy takes into account segments, ability to pay, market conditions, competitor
actions, trade margins and input costs, amongst others. It is targeted at the defined
customers and against competitors.

Description: There are several pricing strategies:

Premium pricing: high price is used as a defining criterion. Such pricing strategies work in
segments and industries where a strong competitive advantage exists for the company.
Example: Porche in cars and Gillette in blades.

Penetration pricing:  price is set artificially low to gain market share quickly. This is done
when a new product is being launched. It is understood that prices will be raised once the
promotion period is over and market share objectives are achieved. Example: Mobile
phone rates in India; housing loans etc.

Economy pricing: no-frills price. Margins are wafer thin; overheads like marketing and
advertising costs are very low. Targets the mass market and high market share. Example:
Friendly wash detergents; Nirma; local tea producers.

Skimming strategy:  high price is charged for a product till such time as competitors allow
after which prices can be dropped. The idea is to recover maximum money before the
product or segment attracts more competitors who will lower profits for all concerned.
Example: the earliest prices for mobile phones, VCRs and other electronic items where a
few players ruled attracted lower cost Asian players.

The 10 Types Of Pricing strategies

Here are 10 different types of pricing strategies you can use to sell your products in a
competitive market and still make profits.
 
Premium pricing
Premium pricing, also called image pricing or prestige pricing, is a pricing strategy of
marking the price of the product higher than the industry standards/competitors’
products. The idea is to encourage a perception among the buyers that the product has a
more utility or a higher value when compared to competitors’ products just because it is
sold at a premium price.
The premium pricing strategy has the advantages of producing higher revenues and
building a premium brand image. However, to make this pricing strategy a success, a
business has to work really hard on the quality of the product and the brand to create a
value perception. Spending a substantial amount on building a premium or luxury brand
helps the business create a barrier for the competitors to position their products in the
same class.
Premium Pricing Example
Branded unleaded petrol is sold at a higher price than regular unleaded petrol. The
consumer never gets to test if the branded is better, yet he buys the branded offering
thinking if it’s expensive, it must be better.
Penetration Pricing
Penetration pricing is a pricing strategy where the price of the product is initially kept
lower than the competitors’ products to gain most of the market share and to trigger word
of mouth marketing.
Even though this strategy leads to losses initially, it results in many customers shifting to
the brand because of the low prices. Once these customers become loyal and the brand
achieves a strong market penetration, marketers increase the prices to a point where they
get optimum profits without 0much loss of customers.
Penetration Pricing Example
Oneplus launched its flagship product Oneplus 1, which had all the features of an iPhone,
at a highly affordable price of $299. Once the company acquired a good market share, it
started launching its products at a premium. The recent phones from Oneplus are priced
in the range of $500-$700.
Economy Pricing
Economy pricing is a no-frills pricing strategy followed by generic food suppliers and
discount retailers where they keep the prices of the product minimal by reducing the
expenditure on marketing and promotion. This strategy is used essentially to attract most
price-conscious consumers.
The key to success using economy pricing strategy is to sell a large volume of product and
services at low prices. The strategy is most suited to big businesses like Aldi and Walmart.
Economy Pricing Example
Aldi uses this no-frills economy pricing strategy where it operates small stores, only sells
products which have a good demand, keep products in their original shipping containers,
and even charges the customers if they ask for carry-bags.
Price Skimming
Price Skimming is a strategy of setting a relatively high introductory price of the product
when the product is new and unique and the market has fewer competitors. The idea is to
maximise the profits on early adopters before competitors enter the market and make the
product more price sensitive.
The strategy got its name from successive skimming of layers of cream or the customer
segments as the prices are lowered over time.
The initial high price not only helps the business to recover its development costs but also
gives the product a perception of being an exclusive and premium product.
Price Skimming Example
Smartphones (both iPhones and Android) are introduced in the market at a higher price,
but the price is reduced as the time passes.
Psychological Pricing
Psychological pricing refers to the psychological pricing strategies marketers use to make
customers buy the products, triggered by emotions rather than logic. Such strategies come
in the form of:
 Charm Pricing: This involves reducing the price by a minimal amount (say 1 cent)
which makes the customer perceive the price to be less. For example – the price of a
$3 product is set as $2.99 in supermarkets as customers’ brains process $2.99 to be
nearer to $2 and not $3.
 Prestige Pricing: This involves rounding off and setting a higher price for premium
and exclusive products as rounded figures are easily processed and are preferred in
such cases.
 BOGOF: Buy one, get one free offers trigger the greed among the customers as they
get two products for the price of one. This strategy is often used to clear up the stock
or increase the volume of sales.
 Price Anchoring: Anchor is the first (higher or lower) price communicated to the
customer to make their mind revolve around that price and buy the product the
retailer wants. For example – printing double price label showing a regular price and a
sale price, keeping a higher priced and medium quality product along with a lower
priced but good quality product to increase its sale, etc.
Bundle Pricing
Bundle pricing involves selling packages or set of goods or services at lower prices than
they would have actually cost if sold separately. This is an effective strategy to bundle
unsold products or products with less demand with the high selling products to clear up
the shelf space and to increase the profits.
Bundling works wonders when two complementary products are bundled together.
Bundle Pricing Example
Mcdonald’s happy meal is a perfect example of bundle pricing.
Freemium
Freemium is an Internet-based pricing strategy where basic services are provided free of
charge but charges are levied on additional premium features. The freemium strategy is
different from premium with free samples strategy as you don’t pay anything to utilize the
free services provided under the freemium business model.
Freemium Example
Candy Crush Saga is a great example of freemium pricing strategy where the game is
provided for free but a price is levied if you want more lives to play.

Q.2. Different Markets with examples.

Ans: Types of Market Structures
A variety of market structures will characterize an economy. Such market structures
essentially refer to the degree of competition in a market.
There are other determinants of market structures such as the nature of the goods
and products, the number of sellers, number of consumers, the nature of the product or
service, economies of scale etc. We will discuss the four basic types of market structures in
any economy.
One thing to remember is that not all these types of market structures actually exist. Some of
them are just theoretical concepts. But they help us understand the principles behind the
classification of market structures.

(Source: BusinessJargons)
1] Perfect Competiton
In a perfect competition market structure, there are a large number of buyers and sellers. All
the sellers of the market are small sellers in competition with each other. There is no one big
seller with any significant influence on the market. So all the firms in such a market are price
takers.
There are certain assumptions when discussing the perfect competition. This is the reason
a perfect competition market is pretty much a theoretical concept. These assumptions are as
follows,
 The products on the market are homogeneous, i.e. they are completely identical
 All firms only have the motive of profit maximization
 There is free entry and exit from the market, i.e. there are no barriers
 And there is no concept of consumer preference
2] Monopolistic Competition
This is a more realistic scenario that actually occurs in the real world. In monopolistic
competition, there are still a large number of buyers as well as sellers. But they all do not sell
homogeneous products. The products are similar but all sellers sell slightly differentiated
products.
Now the consumers have the preference of choosing one product over another. The sellers
can also charge a marginally higher price since they may enjoy some market power. So the
sellers become the price setters to a certain extent.
For example, the market for cereals is a monopolistic competition. The products are all
similar but slightly differentiated in terms of taste and flavours. Another such example is
toothpaste.
3] Oligopoly
In an oligopoly, there are only a few firms in the market. While there is no clarity about the
number of firms, 3-5 dominant firms are considered the norm. So in the case of an oligopoly,
the buyers are far greater than the sellers.
The firms in this case either compete with another to collaborate together, They use their
market influence to set the prices and in turn maximize their profits. So the consumers
become the price takers. In an oligopoly, there are various barriers to entry in the market,
and new firms find it difficult to establish themselves.
4] Monopoly
In a monopoly type of market structure, there is only one seller, so a single firm will control
the entire market. It can set any price it wishes since it has all the market power. Consumers
do not have any alternative and must pay the price set by the seller.
Monopolies are extremely undesirable. Here the consumer loose all their power and market
forces become irrelevant. However, a pure monopoly is very rare in reality.
Solved Question on Market Structures
Q: The cellular industry is an example of which of the following?
a. Monopolistic Competition
b. Monopoly
c. Perfect Competition
d. Oligopoly
 Ans: The correct option is D. In the cellular industry there are 3-5 dominant firms (Airtel,
Vodafone, Jio etc). These are the price setters. And consumers have a limited choice between
these few choices.
OR
In market economies, there are a variety of different market systems that exist, depending
on the industry and the companies within that industry. It is important for small business
owners to understand what type of market system they are operating in when making
pricing and production decisions, or when determining whether to enter or leave a
particular industry.

 The five major market system types are Perfect Competition, Monopoly, Oligopoly,
Monopolistic Competition and Monopsony.
Perfect Competition with Infinite Buyers and Sellers
Perfect competition is a market system characterized by many different buyers and
sellers. In the classic theoretical definition of perfect competition, there are an infinite
number of buyers and sellers. With so many market players, it is impossible for any one
participant to alter the prevailing price in the market. If they attempt to do so, buyers and
sellers have infinite alternatives to pursue.
Monopoly with One Producer
A monopoly is the exact opposite form of market system as perfect competition. In a pure
monopoly, there is only one producer of a particular good or service, and generally no
reasonable substitute. In such a market system, the monopolist is able to charge whatever
price they wish due to the absence of competition, but their overall revenue will be limited
by the ability or willingness of customers to pay their price.
Oligopoly with a Handful of Producers
An oligopoly is similar in many ways to a monopoly. The primary difference is that rather
than having only one producer of a good or service, there are a handful of producers, or at
least a handful of producers that make up a dominant majority of the production in the
market system. While oligopolists do not have the same pricing power as monopolists, it is
possible, without diligent government regulation, that oligopolists will collude with one
another to set prices in the same way a monopolist would.
Monopolistic Competition with Numerous Competitors
Monopolistic competition is a type of market system combining elements of a monopoly
and perfect competition. Like a perfectly competitive market system, there are numerous
competitors in the market. The difference is that each competitor is sufficiently
differentiated from the others that some can charge greater prices than a perfectly
competitive firm.
An example of monopolistic competition is the market for music. While there are many
artists, each artist is different and is not perfectly substitutible with another artist.
Monopsony with One Buyer
Market systems are not only differentiated according to the number of suppliers in the
market. They may also be differentiated according to the number of buyers. Whereas a
perfectly competitive market theoretically has an infinite number of buyers and sellers, a
monopsony has only one buyer for a particular good or service, giving that buyer
significant power in determining the price of the products produced.

Q.3. Price and Output in the Perfect Competition.

Ans: Perfect competition refers to a market situation where there are a large number of
buyers and sellers dealing in homogenous products.
Moreover, under perfect competition, there are no legal, social, or technological barriers
on the entry or exit of organizations.
In perfect competition, sellers and buyers are fully aware about the current market price
of a product. Therefore, none of them sell or buy at a higher rate. As a result, the same
price prevails in the market under perfect competition.
Perfect competition refers to a market situation where there are a large number of buyers
and sellers dealing in homogenous products.
Moreover, under perfect competition, there are no legal, social, or technological barriers
on the entry or exit of organizations.
In perfect competition, sellers and buyers are fully aware about the current market price
of a product. Therefore, none of them sell or buy at a higher rate. As a result, the same
price prevails in the market under perfect competition.
Under perfect competition, the buyers and sellers cannot influence the market price by
increasing or decreasing their purchases or output, respectively. The market price of
products in perfect competition is determined by the industry. This implies that in perfect
competition, the market price of products is determined by taking into account two
market forces, namely market demand and market supply.
In the words of Marshall, “Both the elements of demand and supply are required for the
determination of price of a commodity in the same manner as both the blades of scissors
are required to cut a cloth.” As discussed in the previous chapters, market demand is
defined as a sum of the quantity demanded by each individual organizations in the
industry.
On the other hand, market supply refers to the sum of the quantity supplied by individual
organizations in the industry. In perfect competition, the price of a product is determined
at a point at which the demand and supply curve intersect each other. This point is known
as equilibrium point as well as the price is known as equilibrium price. In addition, at this
point, the quantity demanded and supplied is called equilibrium quantity. Let us discuss
price determination under perfect competition in the next sections.
Demand under Perfect Competition:
Demand refers to the quantity of a product that consumers are willing to purchase at a
particular price, while other factors remain constant. A consumer demands more quantity
at lower price and less quantity at higher price. Therefore, the demand varies at different
prices.
Figure-1 represents the demand curve under perfect competition:

As shown in Figure-1, when price is OP, the quantity demanded is OQ. On the other hand,
when price increases to OP1, the quantity demanded reduces to OQ1. Therefore, under
perfect competition, the demand curve (DD’) slopes downward.
Supply under Perfect Competition:
Supply refers to quantity of a product that producers are willing to supply at a particular
price. Generally, the supply of a product increases at high price and decreases at low price.
Figure-2 shows the supply curve under perfect competition:

In Figure-2, the quantity supplied is OQ at price OP. When price increases to OP1, the
quantity supplied increases to OQ1. This is because the producers are able to earn large
profits by supplying products at higher price. Therefore, under perfect competition, the
supply curves (SS’) slopes upward.
Equilibrium under Perfect Competition:
As discussed earlier, in perfect competition, the price of a product is determined at a point
at which the demand and supply curve intersect each other. This point is known as
equilibrium point. At this point, the quantity demanded and supplied is called equilibrium
quantity.
Figure-3 shows the equilibrium under perfect competition:

In Figure-3, it can be seen that at price OP1, supply is more than the demand. Therefore,
prices will fall down to OP. Similarly, at price OP2, demand is more than the supply.
Similarly, in such a case, the prices will rise to OP. Thus, E is the equilibrium at which
equilibrium price is OP and equilibrium quantity is OQ.

Q.4. Monopoly, Monopolistic and Oligopoly Market situation.

Ans: Monopoly:
Meaning:
The word monopoly has been derived from the combination of two words i.e., ‘Mono’ and
‘Poly’. Mono refers to a single and poly to control.
In this way, monopoly refers to a market situation in which there is only one seller of a
commodity.
There are no close substitutes for the commodity it produces and there are barriers to
entry. The single producer may be in the form of individual owner or a single partnership
or a joint stock company. In other words, under monopoly there is no difference between
firm and industry.
Monopolist has full control over the supply of commodity. Having control over the supply
of the commodity he possesses the market power to set the price. Thus, as a single seller,
monopolist may be a king without a crown. If there is to be monopoly, the cross elasticity
of demand between the product of the monopolist and the product of any other seller
must be very small.
Definitions:
“Pure monopoly is represented by a market situation in which there is a single seller of a
product for which there are no substitutes; this single seller is unaffected by and does not
affect the prices and outputs of other products sold in the economy.” Bilas
“Monopoly is a market situation in which there is a single seller. There are no close
substitutes of the commodity it produces, there are barriers to entry”. -Koutsoyiannis
Under pure monopoly there is a single seller in the market. The monopolist demand is
market demand. The monopolist is a price-maker. Pure monopoly suggests no substitute
situation”. -A. J. Braff
“A pure monopoly exists when there is only one producer in the market. There are no dire
competitions.” -Ferguson
“Pure or absolute monopoly exists when a single firm is the sole producer for a product
for which there are no close substitutes.” -McConnel
Features:
We may state the features of monopoly as:
1. One Seller and Large Number of Buyers:
The monopolist’s firm is the only firm; it is an industry. But the number of buyers is
assumed to be large.
2. No Close Substitutes:
There shall not be any close substitutes for the product sold by the monopolist. The cross
elasticity of demand between the product of the monopolist and others must be negligible
or zero.
3. Difficulty of Entry of New Firms:
There are either natural or artificial restrictions on the entry of firms into the industry,
even when the firm is making abnormal profits.
4. Monopoly is also an Industry:
Under monopoly there is only one firm which constitutes the industry. Difference between
firm and industry comes to an end.
5. Price Maker:
Under monopoly, monopolist has full control over the supply of the commodity. But due to
large number of buyers, demand of any one buyer constitutes an infinitely small part of
the total demand. Therefore, buyers have to pay the price fixed by the monopolist.
Nature of Demand and Revenue under Monopoly:
Under monopoly, it becomes essential to understand the nature of demand curve facing a
monopolist. In a monopoly situation, there is no difference between firm and industry.
Therefore, under monopoly, firm’s demand curve constitutes the industry’s demand
curve. Since the demand curve of the consumer slopes downward from left to right, the
monopolist faces a downward sloping demand curve. It means, if the monopolist reduces
the price of the product, demand of that product will increase and vice- versa. (Fig. 1).
In Fig. 1 average revenue curve of the monopolist slopes downward from left to right.
Marginal revenue (MR) also falls and slopes downward from left to right. MR curve is
below AR curve showing that at OQ output, average revenue (= Price) is PQ where as
marginal revenue is MQ. That way AR > MR or PQ > MQ.
Costs under Monopoly:
Under monopoly, shape of cost curves is similar to the one under perfect competition.
Fixed costs curve is parallel to OX-axis whereas average fixed cost is rectangular
hyperbola. Moreover, average variable cost, marginal cost and average cost curves are of
U-shape. Under monopoly, marginal cost curve is not the supply curve. Price is higher than
marginal cost. Here, it is of immense use to quote that a monopolist is not obliged to sell a
given amount of a commodity at a given price.
Monopoly Equilibrium and Laws of Costs:
The decision regarding the determination of equilibrium price in the long run depends on
the elasticity of demand and effect of law of costs on monopoly price determination.
1. Nature of Elasticity of Demand:
If the demand is inelastic, the monopolist will fix high price of his product. Inelastic
demand refers to the situation in which consumers must have to buy the commodity
what-so-ever may be the price. On the other hand, if demand is elastic, the monopolist will
fix low price per unit.
2. Effects of Laws of Costs:
The monopolist also takes into consideration laws of costs while determining the prices.
In the long run, output may be produced under law of diminishing costs, increasing costs
and constant costs
A brief description of these laws has been given as under:
Increasing Costs:
If the monopolist produces the commodity under the law of Diminishing Returns or
Increasing costs, he will get the maximum profit at point E where marginal revenue is
equal to marginal cost. This is indicated in Fig. 7. Here he produces OM units of the
commodity and gets PM as the price. His monopoly profit is represented by the shaded
area PQRS. No other alternative will give him this much of profit and hence this is the best
position for him provided he produces goods under the Law of Increasing Costs.
Diminishing Costs:
The same approach will be applicable under the Law of Increasing Returns or Diminishing
Cost as explained in Fig. 8. Here AC and MC are falling. The MC and MR are equal at point
E. accordingly; the monopolist will produce OM units of commodity and sell the same at
PM Price. His net monopoly revenue will be PQRS indicated by shaded area.

Constant Costs:
The determination of monopoly price under constant costs can be shown with the help of
Fig. 9. In the diagram, the AC curve will be a horizontal line running parallel to OX and for
all the levels of output AC will be equal to MC. AR and MR represent the average revenue
curve and marginal revenue curve respectively. The equilibrium between MC and MR is
brought at point E when the output is OM. Thus, the monopolist will produce OM and will
sell it at PM Price. The monopoly profit will, therefore, be equal to PERS which is
represented by the shaded area.
Misconceptions Concerning Monopoly Pricing:
Our analysis explodes some popular fallacies concerning the behavior of monopolies.
1. Monopolist is Interested in Maximum Profits and not in Maximum Price:
Because monopolist can manipulate output and price so it is often alleged that a
monopolist “will charge the highest price he can get”. It is generally believed that prices
under free competition are lower than under monopoly. This is clearly a misguided
assertion. Under certain conditions, things may be altogether different. As explained in the
previous table and diagram, there are many prices above the one he charges but the
monopolist shuns them for the simple reason that they entail a smaller than maximum
profits.
2. Maximum Total Profits and not Maximum Profit per Unit:
The monopolist seeks maximum total profits, not maximum per unit profits. The profits
per units may be higher at higher price but the total profits will be higher at lower price. It
is; therefore, better to sell more at a lower price than to sell less at a higher price.
3. Economies of Scale:
The monopolist may enjoy certain economies like a better and cheaper utilization of by-
products, cheaper raw material, better and cheaper methods of production, lower cost of
advertisement and so on than under free competition. Evidently, the monopolist may be
able to charge prices lower than under free competition.
4. Law of Increasing Returns:
If the commodity is produced under the Law of Increasing Returns, the monopolist may be
producing more at lower costs and selling at lower prices. This policy may help him to
earn higher total revenue. The consumer may also buy larger output at lower prices.
Multiplied Plant Monopoly:
Under monopoly, multiple plants are a situation where a monopolist produces in two or
more plants. Each plant has different cost structure. In this situation, multi plant
monopoly takes two decisions.
They are:
(i) To decide the amount of output to be produced and the price at which it will be sold to
maximize profits.
(ii) To decide the allocation of production between different plants.
Assumptions:
The multi-plant monopoly is based on following assumptions:
(i) There are two plants X and Y.
(ii) Plant X is more efficient than Y plant
(iii) Cost structure of both plants is different.
(iv) The monopolist knows the market demand curve and corresponding MR curve.
The multiple plant monopoly can be illustrated with the help of Fig. 14.

In Fig. 14, we get:

SMC = horizontal summation of MQ and MC2 i.e. SMC = MC1 + MC2 at point E = MR = SMC.
Here, monopolist will sell OX output at price OP to get maximum profit. At point e 1 and
e2 = By extending point E leftwards to cut MQ at e1 and MC 2 at e2 > producer decides the
allocation of production of OX units between plant 1 and plant 2. In short, from point e 1,
we draw perpendicular to the X-axis. It gives O1 as the level of output produced by plant 1.
Again OX2 is the level of output produced by plant 2 and OX = OX1 + OX2
.’. Total profit = Total profit is the sum of the two shaded rectangles shown by a and n 2.
Labour Exploitation under Monopoly:
Monopolistic exploitation of labour can be discussed under:
(i) Exploitation of labour by a monopoly firm, and
(ii) Exploitation of labour under monopolistic competition.
(1) Exploitation of Labour by a Monopoly Firm:
The fact that market demand curve for labour by a monopoly firm in product market is
based on MRPC rather than on its VMPL leads to monopolistic exploitation of labour. There
is exploitation because labour is paid wages equal to its MRP which is lower than its VMP.

According to Joan Robinson, a productive factor is exploited if it is paid a price less than
the value of its marginal product (VMP). Robinson’s analysis of monopolistic exploitation
of labour (a variable factor) by an individual monopoly firm is illustrated in Fig. 15.
It is shown in Fig. 15, the MRP1 and S1 curves, a profit maximizing monopolist will employ
OL) units of labour determined by point E and pay wage OW (= EL 1). But, under perfect
competition in the product market, VMP1 is the relevant labour demand curve. Therefore,
OL1 units of Labour would be demanded at wages FL1 or else, the employment will be OL2.
Thus, the difference between monopoly wage rate (FL1) and competitive wage rate (EL1),
i.e., FL1 – EL1 = EF) is the extent of monopolistic exploitation of labour. The monopolist
restricts employment of labour to OL1 units where as the perfectly competitive firm would
have employed OL2 units of labour. The lower level of employment by a monopolist also
result in the loss of output.
(ii) Exploitation of Labour under Monopolistic Competition:
Figure 16 describes the exploitation of labour under monopolistic competition at the
market level. In this figure, curve D1 represents the market demand curve for labour by
the monopolistic firms; curve D0 represents the market demand curve for labour by the
perfectly competitive firms, and curve S1, represents the market supply curve of labour.
Under monopoly, labour market will be in equilibrium at point E m wage rate will be OW1.

Under monopolistic competitions, equilibrium wage rate will be at OW 2 and employment

OL1 units of labour. Obviously, imperfect competition in the product market causes wage
rate to be lower than the value of marginal product (VMPL) as is the case in a perfectly
competitive product market. Thus, according to Joan Robinson, OW2 – OW1 = W2 – W1 is
the extent of exploitation under monopolistic competition.
Criticism:
This monopolistic exploitation of labor can be criticized on the ground that lower wage
payment is inevitable because of divergence between MRPL and VMPL. The MRPL is lower
than VMP1, (at all levels of employment) not because of monopoly powers of the
monopolistic sellers but because of product differentiation. Product differentiation creates
brand loyalty which makes the demand curve slope downward to the right.
In case of a downward sloping demand curve, there is bound to be a diversion between
price (AR) and the marginal revenue (MR), marginal revenue being lower than the price.
Since all the firms, whether in perfect or in imperfect market, attempt at profit
maximization, monopolistic firm will have to pay labour a wage rates that equal MRP L .
Therefore, the difference between OW2 and OW1 cannot be considered as exploitation. The
difference arises due to the market conditions. However, if product differentiation is
excessive and commodities are imposed on the consumers by the monopolistic sellers,
then the argument of monopolistic exploitation may be acceptable.

Monopolistic
A monopolistic market is a theoretical construct that describes a market where only one
company may offer products and services to the public. A monopolistic market is the
opposite of a perfectly competitive market, in which an infinite number of firms operate.
In a purely monopolistic model, the monopoly firm can restrict output, raise prices, and
enjoy super-normal profits in the long run.
Causes of Monopolistic Markets
Purely monopolistic markets are scarce and perhaps even impossible in the absence of
absolute barriers to entry, such as a ban on competition or sole possession of all-natural
resources.

Meaning and Definition of Monopolistic Competition:

Before 1933, the traditional Marshallian theory of value was prevalent.
But in 1933 a revolution in the approach to price theory was initiated by the publication of
two works of modern economists, Chamberlin and Mrs. Joan Robinson.
E.H. Chamberlin’s work was entitled “The Theory of Monopolistic Competition” and Mrs.
Robinson’s “The Economics of Imperfect Competition”.
Both economists challenged the concept of perfect competition and monopoly as
unrealistic and attempted to present a new theory which is more realistic of the two new
approaches, the view of Chamberlin’s theory of monopolistic competition received wide
acclamation. Critics also regarded Chamberlin’s contribution as novel and superior to that
of Mrs. Robinson’s. In fact the real credit goes to Chamberlin for setting a new and realistic
trend in the economics value.
Concept of Monopolistic Competition:
Monopolistic Competition refers to the market situation in which there is a keen
competition, but neither perfect nor pure, among a group of a large number of small
producers or suppliers having some degree of monopoly because of the differentiation of
their products. Thus, we can say that monopolistic competition (or imperfect competition)
is a mixture of competition and a certain degree of monopoly, on the basis of a correct
appraisal of the market situation.
Chamberlin has asserted that monopoly and competition are not mutually exclusive rather
both are frequently blend together. In short, we can say that a market with a blending of
monopoly and competition is called monopolistic competition or imperfect competition.
Definition:
1. Monopolistic Competition refers to competition among a large number of sellers
producing close but not perfect substitutes for each other.
2. According to Prof. Lerner – “The condition of imperfect competition arises when a
seller has to face the falling demand curve.”
3. According to Prof. J. K. Mehta – “It has been more fully realised that every case of
exchange is a case of what may be called partial monopoly and partial monopoly is looked
at from the other said a case of imperfect competition. There is a blending of both
competition element and monopoly element in each situation.”
4. According to Prof. Leftwich – “Monopolistic Competition (or imperfect competition) is
that condition of industrial market in which a particular commodity of one seller creates
an idea of difference from that of the other sellers in the minds of the consumers.”
Characteristics or Main Features of Monopolistic Competition:
Important characteristics of monopolistic competition are as follows:
1. Less Number of Buyers and Sellers:
In this market neither buyers nor sellers are too many as under perfect competition nor
there is only one seller as under monopoly. Mostly, it is a situation in between. Every
producer for his produced commodity has some special buyers. Every consumer and seller
can influence demand and supply in the market.
2. Difference in the Quality and Shape of the Goods:
Although the commodities produced by different producers can serve as perfect
substitutes to those produced by others, yet they are different in colour, form, packing,
design, name etc. So there is product differentiation in the market.
3. Lack of Knowledge on the Part of Consumers:
Neither consumers nor sellers have full knowledge of market conditions, so there is
international difference in the price of goods from those of others.
4. High Transportation Cost:
In this high transportation cost play an important role in order to create discrimination
among commodities. Similar goods because of different transport costs are bought and
sold at different prices.
5. Advertisement:
Here, advertisement plays an important role because buyers are influenced to prefer by
advertisement, which plays upon their mind and makes them the product of one firm to
those of another. Through advertisement, they are brought to his notice through radio,
television and other audio-visual aids in a more pleasing and more forceful manner. Thus,
rival firms compete against each other in quantity, in facilities as well as in price.
6. Ignorance of the Buyers:
There are some people who think that high priced goods will be better and of higher
quality. So, they avoid buying low priced goods.
7. Differences in the Establishment of Industry:
In the imperfect competitive market, there is neither freedom of entry or exit as is under
perfect competition nor there is perfect control as in monopoly but there are some
restrictions on the entry of industry only.
Oligopoly
What is an Oligopoly?
Oligopoly is a market structure with a small number of firms, none of which can keep the
others from having significant influence. The concentration ratio measures the market share
of the largest firms. A monopoly is one firm, duopoly is two firms and oligopoly is two or more
firms. There is no precise upper limit to the number of firms in an oligopoly, but the number
must be low enough that the actions of one firm significantly influence the others.

Meaning of Oligopoly:
Oligopoly refers to a market situation or a type of market organisational in which a few
firms control the supply of a commodity. The competing firms are few in number but each
one is large enough so as to be able to control the total industry output and a moderate.
However, increase of its output or sales will reduce the sales of rival firms by a noticeable
amount.

This is surely the case if three to six or even ten firms control an industry’s output, with
each controlling enough to exert influence on price. Oligopoly is the most prevalent form
of market organisation in the manufacturing sector at modern times and arises due to
various reasons (such as, economies of scale, patents and trademarks, control over the
sources of raw materials, government’s sanction, need of a large capital, and so on). The
chief characteristic of oligopoly is the interdependence among the rival sellers.

Types of Oligopoly:
Oligopoly is of two types:
(a) Pure Oligopoly:
Here, the oligopolists sell practically homogeneous products. This type is found in steel,
copper, cement petrol and a few other industries.

(b) Differential Oligopoly:

In such a case a few firms sell similar but not identical products under the same
conditions. It is found in automobiles, tyres, electrical appliances, cigarettes, baby food
and a few other industries.

Problems of Price Determination under Oligopoly:

In an oligopoly market the determination of price and output by a firm creates problems.
The main problem arises in the construction of a stable and a certain demand curve for
the product of an oligopolist. This point may be explained further.

The Nature of the Demand Curve Facing an Oligopolist Seller:

In oligopoly, the dominant feature of the individual seller’s demand curve or average
revenue curve is that it is at least potentially uncertain. It happens so because his own
output adjustment will induce significant effects on his rival firms’ prices or output levels
which are not uniquely predictable.
Such an interdependence among the rival produces is the key feature in an oligopoly
market. Each seller controls enough of the industry output so that a moderate change in
his output will tend to bring about changes in his rivals’ prices and output levels sufficient
to affect his own sales. These changes are not uniquely predictable.

Oligopoly refers to competition among ‘few’ or, to be more specific, among a few dominant
firms. An oligopolist is not a big enough part of the market (like a monopolist) to be able to
act as a price-maker. It is not a small enough part of the market (like a competitive seller)
to be able to act as a price-taker. So, an oligopolist is neither a price-taker nor a price-
maker. It is essentially a price-searcher.

An oligopolist cannot set any price for its product independent. It is so because there is
interdependence among the oligopolistic firms. The most important aspect of oligopoly
market is reaction of rival films. A firm has to take into consideration the readiness of rival
firms before taking any decision on pricing or even advertising. However, rivals’ reactions
cannot be predicted with accuracy.

This introduces an element of uncertainty in oligopoly markets. Since rivals’ reactions to

an individual’s firm’s actions are uncertain it is difficult to estimate the total demand for
the product of an oligopolist. Audit is still more difficult to arrive at an estimate of an
individual firm’s share in industry output (sales).

For example, it is easy to determine the total demand for electricity or wheat. But is it that
easy to estimate the demand for cars, or the share of Hindustan motors in the car market?
Just to eliminate oligopolistic uncertainty and to oligopoly behaviour economists make
use of models. And oligopoly litterateur is hill of models.

Some of the major models are:

(i) The Cournot (duopoly) Model,

(ii) The Edge-worth (duopoly) Model,

(iii) The Chamberlin (duopoly) Model,

(iv) Sweezy’s Kinked Demand Curve Model,

v) The Centralised Cartel Model (a Perfect Collusion Model),

(vi) The Market Sharing Cartel Model, and

(vii) Price-leadership Model.

(a) Price leadership is “the form of imperfect collusion in which the firms in an
oligopolistic industry tacitly (i.e., without formal agreement) decide to set the same
price as the leader for the industry”. The price-leader may be the lowest cost firm, or
which is more likely, the dominant or largest firm in the industry. In the latter case, the
dominant firm sets the price, allows the other firms belonging to the industry to sell all
they want at that price, and then the dominant firm enters the market to meet the residual
element.
(b) Sweezy Model:
Paul Sweezy has developed his model on the basis of the kinked demand curve. This
model tries to explain the price-rigidity often observed in oligopolistic markets.

The oligopoly situation (as also the duopoly situation) has one feature which has drawn
the attention of economists. This is the interdependence in the decision making of the few
dominant firms and this interdependence is recognised by all of them.

In an industry which consists of a small number of big companies or dominant firms, if

one of them opens a tremendous advertising campaign or designs a new model of his
product which captures the market, he can be fairly sure that this will lead to reactions
and countermoves on the part of his rival producers. Every businessperson in such a
situation knows that at least some of his rivals’ decisions depend on his own behaviour,
and he must take this fact into account in his own decision making.

The reason for this interdependence in decision making is, of course, simple enough — a
major policy change on the part of one firm is likely to have obvious and immediate effects
on the other companies which belong to the industry. As a result the oligopolist develops
various aggressive and defensive marketing weapons.

For example, it is only under oligopoly that advertising assumes full significance. Under
oligopoly, advertising can become a life-and-death question, where a firm which fails to
keep up with the advertising budget of its competitors may find its customers switching to
rival products.

Oligopolistic interdependence has another consequence which is more significant for the
economic literature than for the operation of the economy. This feature of oligopoly has
made the formulation of a systematic analysis of oligopoly virtually impossible. Under the
circumstances a very wide variety of behavioural patterns seems possible.

Rivals may decide to join hands and cooperate to fulfil their objectives; at least so far as
the law permits, or at the other extreme, they may try to fight each other out. Even if they
enter into an agreement it may last for sometimes or it may break down quickly. And the
agreements may follow a wide variety of patterns.

As a result oligopoly theory is full of different models. A model shows the interrelationship
among a few economic variables (such as price, advertising expenditure, sales volume,
etc.) in a systematic manner. It is, of course an abstraction. Economists make models just
to keep the analysis simple and manageable.
Generally, oligopolistic models are of two types: one presumes conjectural behaviour on
the part of the oligopolist, another presumes non-conjectural behaviour.

Stability of Oligopoly Arrangements: The Kinked Demand Curve Model:

There are several oligopoly models which have attracted attention of economists. First,
there is the kinked (kinky) demand curve model of Paul Sweezy. It is not designed to deal
with oligopolistic price and output determination. Rather, it seeks to explain why, once a
price-quantity combination has been arrived at, it is not changed frequently.

Most oligopolistic industries are characterised by a feature:

Price cuts are matched by price cuts but price increases are not. This has been the case
with U.S. steel and aluminium industries. In fact, prices in many oligopolistic industries
appear to have exhibited a remarkable degree of stability, particularly in their resistance
to change in the downward direction. The kinked demand curve model provides one
possible explanation of the ‘stickiness’ or rigidity (inflexibility) or rigidly (inflexibility) of
oligopoly prices.

Let us consider the effect on quantity demanded of a reduction in the price of a

commodity. This is, as usual, shown by the demand curve for the firm’s product. Suppose,
first, that the reduction in the price which is charged by our firm is matched by other
competing firms.

In that case the company may expect to increase its sale only marginally, but since it is not
likely to get any customers away from its rivals in these circumstances, no large addition
to its sales is to be expected. Its demand curve (DD’ in Fig. 4) will be relatively inelastic.

Now, we may suppose, on the other hand, that the company alone reduces its price. In that
case a much larger increase in its demand may be expected. Thus, where no one else raises
its price the firm is likely to have a relatively elastic demand curve like dd’.

Here point C represents the oligopolist’s current price-quantity combination.

Sweezy argued that the large oligopolistic firm is likely to anticipate the following
competitive reaction pattern to a price change:
1. Price reductions:
If the oligopoly, in our example, reduces its price, competitors will lose their customers
quickly and so they will be forced to match this price cut. This implies that for downward
price movements from point C, the relevant portion of this firm’s demand curve will be
segment CD’ of the inelastic demand curve DD’.

2. Price increases:
If an oligopolist raises its price. No other firm will raise its price. Rather the rivals will feel
happy as they will be able to attract new customers who will gain from lower price. So,
rivals will have no motivation or desire to match the price rise. Hence, for price rise the
relevant part of the oligopolists demand curve will be the elastic segment dC.

In short, given this view of competitive reaction patterns the oligopolist’s demand curve
will be the combined demand curve dCD’ characterised by a kink (a sharp corner) at the
point C, which represents the current price- output combination.

Now it is quite clear that an oligopolist with such a competitive response pattern will be
extremely reluctant to change its price. For a fall in its price will yield no large increase in
sales revenue, while a price increase will result in a substantial fall in market share and
sales turnover and neither of these is desirable.

An Example:
A simple example will classify the point. Suppose at the original price of Rs.10, an
oligopolist is able to sell 1,000 units of its product and its total revenue is Rs. 10,000. Or,
suppose it reduces its price by 20%, i.e., to Rs.8 and as a result its sales level goes up by
10%, i.e., to 1,100 Units.

Since demand is inelastic price cut leads to a fall in revenue. As all the rival firms reduce
their prices by the same percentage, no one can gain at the expense of others. However,
price out brings new consumers into the market and sales level goes up from 1100 units.

Now, suppose, the oligopolist raises its price by 10% Rs.10 per unit to Rs.11 and as a
result its sales level falls by 60%, i.e., from 1,000 to 400. In this case its total revenue will
be Rs.4, 400 which is much less than Rs.10, 000.

Inflexible Price:
Thus neither price cut nor price increase is desirable in oligopoly, because in each case the
acting firm (the firm which reduces or rises looses). Thus oligopoly is characterised by
rigid or inflexible prices. Such prices are inflexible both upward and downward. Even a
shift of the marginal cost curve in the vertical segment of the kinked demand curve will
have no effect on price.
Such prices are not market prices and thus not determined by demand and supply but are
administered or managed by the firms themselves either through leader-follow
relationship or some sort of collusion overt or covert. A firm may try a price cut or a price
increase, on an experimental basis, just to discover that at the end of the journey all firms
are in the same boat.

Long-run Equilibrium:
The above analysis refers to the short-run equilibrium of an oligopolist. In the short-run,
an oligopolist, just like any other firm, can make a profit, break even, or incur a loss. In the
long-run, the oligopolist will leave the industry, unless he can make a profit (or at least to
break even) by making the best scale of plant to produce the anticipated best long-run
level of output.

Criticisms:
The greatest gap in the Sweezy model is that it fails to explain why the kink occurs at a
particular price (OP). It merely explains how a kink occurs at a given price. In other words,
the model fails to explain how the price (at which the demand curve is kinked) is set in the
first instance. Secondly, empirically it has been found that in some industries price
increases by one firm were followed by others and in some others a price decrease was
not followed.

Thirdly, the kinked demand curve is said to be subjective — it is what the firm thinks. Its
actual demand curve may be something different. Fourthly, the model rules out the
possibility of price and output fluctuations due to cost changes. This is not supported by
empirical evidence. In practice, we observe that cost changes lead to output and price
changes.

In the opinion of P. A. Samuelson:

“A ‘cornered’ or ‘kinked’ demand curve around an administered level of mark-up price —
because price cuts are matched and price increases are not—can help explain rigidity of
oligopoly price compared with both perfect competition and complete-monopoly flexible
price. Also, this rigidity makes tacit agreement more easily possible.”

The idea of a kinked demand curve was first developed in the 1939 and it has had
continuing appeal as a way of explaining why oligopoly prices are stable, and, in
particular, why they often remain stable during recessions when demand declines.

Classification of Oligopoly:
Oligopoly situation can be classified on different bases:
1. Basis of Product Differentiation:
On the basis of product differentiation, oligopoly may be classified as Pure or Perfect
Oligopoly and Imperfect or Differentiated Oligopoly. In the case of pure oligopoly, the
product of different firms in the industry is identical or homogeneous while in the case of
differentiated oligopoly, the products of different firms are not identical but rather
differentiated products. Thus, differentiated oligopoly will exist where the competing
firms produce products which are close substitutes but not perfect substitutes.

The distinction between pure oligopoly and differentiated oligopoly does not play a
significant role in the analysis. In real situation, firms in most oligopolistic industries
produce differentiated products. But theoretically we may determine price and output in
both kinds of oligopoly.

2. Basis of Entry of Firms:

On the basis of the possibility of entry of new firms into the industry, oligopoly may be
classified as Open Oligopoly and Closed Oligopoly. An open oligopoly provides full
freedom to new firms to enter into the industry. In the situation of open oligopoly there is
no restriction of any kind for the desiring firms to enter into the market. A closed
oligopoly, on the other hand, refers to that market situation where only the few firms
control the entire market and new firms are not allowed to enter the industry.

3. Basis of Price Leadership:

On the basis of presence or absence of price leadership, oligopoly may be classified as
Partial Oligopoly and Full Oligopoly. Partial oligopoly refers to that market situation
where the industry is dominated by one large firm (known as the leader) and the other
firms (known as the followers) of the industry follow the price policy determined by their
leader. Full oligopoly, on the other hand, refers to that market situation where there is no
leader and no followers.

4. Basis of Agreement:
On the basis of agreement, oligopoly is classified as Collusive Oligopoly and Non-collusive
Oligopoly. A collusive oligopoly refers to that market situation where the firms of the
industry follow a common policy of pricing. In other words, they combine together to
avoid competition among themselves regarding the price and output of the industry. A
non- collusive oligopoly refers to that market situation where there is no agreement
 among the firms regarding the price and output of the entire market. In other words, the
firms under non-collusive oligopoly act independently.

Oligopoly Market
Definition: The Oligopoly Market characterized by few sellers, selling the homogeneous
or differentiated products. In other words, the Oligopoly market structure lies between
the pure monopoly and monopolistic competition, where few sellers dominate the market
and have control over the price of the product.

Under the Oligopoly market, a firm either produces:

 Homogeneous product: The firms producing the homogeneous products are called

as Pure or Perfect Oligopoly. It is found in the producers of industrial products such as
aluminum, copper, steel, zinc, iron, etc.
 Heterogeneous Product: The firms producing the heterogeneous products are
called as Imperfect or Differentiated Oligopoly. Such type of Oligopoly is found in the
producers of consumer goods such as automobiles, soaps, detergents, television,
refrigerators, etc.
There are five types of oligopoly market, for detailed description, click on the link below:

Types of Oligopoly Market

 

1. Open Vs Closed Oligopoly: This classification is made on the basis of freedom to

enter into the new industry. An open Oligopoly is the market situation wherein firm can
 enter into the industry any time it wants, whereas, in the case of a closed Oligopoly, there
are certain restrictions that act as a barrier for a new firm to enter into the industry.
2. Partial Vs Full Oligopoly: This classification is done on the basis of price
leadership. The partial Oligopoly refers to the market situation, wherein one large firm
dominates the market and is looked upon as a price leader. Whereas in full Oligopoly, the
price leadership is conspicuous by its absence.
3. Perfect (Pure) Vs Imperfect (Differential) Oligopoly: This classification is made
on the basis of product differentiation. The Oligopoly is perfect or pure when the firms
deal in the homogeneous products. Whereas the Oligopoly is said to be imperfect, when
the firms deal in heterogeneous products, i.e. products that are close but are not perfect
substitutes.
4. Syndicated Vs Organized Oligopoly: This classification is done on the basis of a
degree of coordination found among the firms. When the firms come together and sell
their products with the common interest is called as a Syndicate Oligopoly. Whereas, in
the case of an Organized Oligopoly, the firms have a central association for fixing the
prices, outputs, and quotas.
5. Collusive Vs Non-Collusive Oligopoly: This classification is made on the basis of
agreement or understanding between the firms. In Collusive Oligopoly, instead of
competing with each other, the firms come together and with the consensus of all fixes the
price and the outputs. Whereas in the case of a non-collusive Oligopoly, there is a lack of
understanding among the firms and they compete against each other to achieve their
respective targets.

Thus, oligopoly market is a market structure that lies between the monopolistic
competition and a pure monopoly.

Features of Oligopoly Market

1. Few Sellers: Under the Oligopoly market, the sellers are few, and the customers are
many. Few firms dominating the market enjoys a considerable control over the price of
the product.
2. Interdependence: it is one of the most important features of an Oligopoly market,
wherein, the seller has to be cautious with respect to any action taken by the competing
firms. Since there are few sellers in the market, if any firm makes the change in the price
or promotional scheme, all other firms in the industry have to comply with it, to remain in
the competition.

Thus, every firm remains alert to the actions of others and plan their counterattack
beforehand, to escape the turmoil. Hence, there is a complete interdependence among the
sellers with respect to their price-output policies.

3. Advertising: Under Oligopoly market, every firm advertises their products on a

frequent basis, with the intention to reach more and more customers and increase their
customer base.This is due to the advertising that makes the competition intense.

If any firm does a lot of advertisement while the other remained silent, then he will
observe that his customers are going to that firm who is continuously promoting its
product. Thus, in order to be in the race, each firm spends lots of money on advertisement
activities.

4. Competition: It is genuine that with a few players in the market, there will be an
intense competition among the sellers. Any move taken by the firm will have a
considerable impact on its rivals. Thus, every seller keeps an eye over its rival and be
ready with the counterattack.
5. Entry and Exit Barriers: The firms can easily exit the industry whenever it wants,
but has to face certain barriers to entering into it. These barriers could be Government
license, Patent, large firm’s economies of scale, high capital requirement, complex
technology, etc. Also, sometimes the government regulations favor the existing large firms,
thereby acting as a barrier for the new entrants.
6. Lack of Uniformity: There is a lack of uniformity among the firms in terms of their
size, some are big, and some are small.

Since there are less number of firms, any action taken by one firm has a considerable
effect on the other. Thus, every firm must keep a close eye on its counterpart and plan the
promotional activities accordingly.

Learning Outcomes:
Q.1. Discuss about various types of Market Structure.
Ans: Types of market structure
1. Perfect competition – Many firms, freedom of entry, homogeneous product, normal
profit.
2. Monopoly – One firm dominates the market, barriers to entry, possibly supernormal
profit.
1. Monopoly diagram
3. Oligopoly – An industry dominated by a few firms, e.g. 5 firm concentration ratio of
> 50%. Interdependence of firms
1. Oligopoly diagram
2. Collusive behaviour – firms seek to form agreement to increase prices.
4. Monopolistic competition – Freedom of entry and exit, but firms have differentiated
products. Likelihood of normal profits in the long term.
5. Contestable markets – An industry with freedom of entry and exit, low sunk costs.
The theory of contestability suggests the number of firms is not so important, but the
threat of competition.
Types of Market Structures
A variety of market structures will characterize an economy. Such market structures
essentially refer to the degree of competition in a market.
There are other determinants of market structures such as the nature of the goods
and products, the number of sellers, number of consumers, the nature of the product or
service, economies of scale etc. We will discuss the four basic types of market structures in
any economy.
One thing to remember is that not all these types of market structures actually exist. Some of
them are just theoretical concepts. But they help us understand the principles behind the
classification of market structures.

(Source: BusinessJargons)
1] Perfect Competiton
In a perfect competition market structure, there are a large number of buyers and sellers. All
the sellers of the market are small sellers in competition with each other. There is no one big
seller with any significant influence on the market. So all the firms in such a market are price
takers.
There are certain assumptions when discussing the perfect competition. This is the reason
a perfect competition market is pretty much a theoretical concept. These assumptions are as
follows,
 The products on the market are homogeneous, i.e. they are completely identical
 All firms only have the motive of profit maximization
  There is free entry and exit from the market, i.e. there are no barriers
 And there is no concept of consumer preference
2] Monopolistic Competition
This is a more realistic scenario that actually occurs in the real world. In monopolistic
competition, there are still a large number of buyers as well as sellers. But they all do not sell
homogeneous products. The products are similar but all sellers sell slightly differentiated
products.
Now the consumers have the preference of choosing one product over another. The sellers
can also charge a marginally higher price since they may enjoy some market power. So the
sellers become the price setters to a certain extent.
For example, the market for cereals is a monopolistic competition. The products are all
similar but slightly differentiated in terms of taste and flavours. Another such example is
toothpaste.
3] Oligopoly
In an oligopoly, there are only a few firms in the market. While there is no clarity about the
number of firms, 3-5 dominant firms are considered the norm. So in the case of an oligopoly,
the buyers are far greater than the sellers.
The firms in this case either compete with another to collaborate together, They use their
market influence to set the prices and in turn maximize their profits. So the consumers
become the price takers. In an oligopoly, there are various barriers to entry in the market,
and new firms find it difficult to establish themselves.
4] Monopoly
In a monopoly type of market structure, there is only one seller, so a single firm will control
the entire market. It can set any price it wishes since it has all the market power. Consumers
do not have any alternative and must pay the price set by the seller.
Monopolies are extremely undesirable. Here the consumer loose all their power and market
forces become irrelevant. However, a pure monopoly is very rare in reality.
Solved Question on Market Structures
Q: The cellular industry is an example of which of the following?
a. Monopolistic Competition
b. Monopoly
c. Perfect Competition
d. Oligopoly
Ans: The correct option is D. In the cellular industry there are 3-5 dominant firms (Airtel,
Vodafone, Jio etc). These are the price setters. And consumers have a limited choice between
these few choices.
Characteristics of Market:

The essential features of a market are:

(1)  An Area:
In economics, a market does not mean a particular place but the whole region where
sellers and buyers of a product ate spread. Modem modes of communication and transport
have made the market area for a product very wide.
(2)  One Commodity:
In economics, a market is not related to a place but to a particular product.
Hence, there are separate markets for various commodities. For example, there are
separate markets for clothes, grains, jewellery, etc.
(3)  Buyers and Sellers:
The presence of buyers and sellers is necessary for the sale and purchase of a product in
the market. In the modem age, the presence of buyers and sellers is not necessary in the
market because they can do transactions of goods through letters, telephones, business
representatives, internet, etc.
(4)  Free Competition:
There should be free competition among buyers and sellers in the market. This
competition is in relation to the price determination of a product among buyers and
sellers.
(5)  One Price:
The price of a product is the same in the market because of free competition among
buyers and sellers.
On the basis of above elements of a market, its general definition may be as follows:
The market for a product refers to the whole region where buyers and sellers of that
product are spread and there is such free competition that one price for the product
prevails in the entire region.
Market Structure:

Meaning:
Market structure refers to the nature and degree of competition in the market for goods
and services. The structures of market both for goods market and service (factor) market
are determined by the nature of competition prevailing in a particular market.
Determinants:
There are a number of determinants of market structure for a particular good.
They are:
(1) The number and nature of sellers.
(2) The number and nature of buyers.
(3) The nature of the product.
(4) The conditions of entry into and exit from the market.
(5) Economies of scale.
They are discussed as under:
1. Number and Nature of Sellers:
The market structures are influenced by the number and nature of sellers in the market.
They range from large number of sellers in perfect competition to a single seller in pure
monopoly, to two sellers in duopoly, to a few sellers in oligopoly, and to many sellers of
differentiated products.
2. Number and Nature of Buyers:
The market structures are also influenced by the number and nature of buyers in the
market. If there is a single buyer in the market, this is buyer’s monopoly and is called
monopsony market. Such markets exist for local labour employed by one large employer.
There may be two buyers who act jointly in the market. This is called duopsony market.
They may also be a few organised buyers of a product.
This is known as oligopsony. Duopsony and oligopsony markets are usually found for cash
crops such as rice, sugarcane, etc. when local factories purchase the entire crops for
processing.
3. Nature of Product:
It is the nature of product that determines the market structure. If there is product
differentiation, products are close substitutes and the market is characterised by
monopolistic competition. On the other hand, in case of no product differentiation, the
market is characterised by perfect competition. And if a product is completely different
from other products, it has no close substitutes and there is pure monopoly in the market.
4. Entry and Exit Conditions:
The conditions for entry and exit of firms in a market depend upon profitability or loss in a
particular market. Profits in a market will attract the entry of new firms and losses lead to
the exit of weak firms from the market. In a perfect competition market, there is freedom
of entry or exit of firms.
But in monopoly and oligopoly markets, there are barriers to entry of new firms. Usually,
governments have a monopoly in public utility services like postal, air and road transport,
water and power supply services, etc. By granting exclusive franchises, entries of new
supplies are barred. In oligopoly markets, there are barriers to entry of firms because of
collusion, tacit agreements, cartels, etc. On the other hand, there are no restrictions in
entry and exit of firms in monopolistic competition due to product differentiation.
5. Economies of Scale:
Firms that achieve large economies of scale in production grow large in comparison to
others in an industry. They tend to weed out the other firms with the result that a few
firms are left to compete with each other. This leads to the emergency of oligopoly. If only
one firm attains economies of scale to such a large extent that it is able to meet the entire
market demand, there is monopoly.
Forms of Market Structure:

On the basis of competition, a market can be classified in the following ways:

1. Perfect Competition
2. Monopoly
3. Duopoly
4. Oligopoly
5. Monopolistic Competition
1. Perfect Competition Market:
A perfectly competitive market is one in which the number of buyers and sellers is very
large, all engaged in buying and selling a homogeneous product without any artificial
restrictions and possessing perfect knowledge of market at a time. In the words of A.
Koutsoyiannis, “Perfect competition is a market structure characterised by a complete
absence of rivalry among the individual firms.” According to R.G. Lipsey, “Perfect
competition is a market structure in which all firms in an industry are price- takers and in
which there is freedom of entry into, and exit from, industry.”
Characteristics of Perfect Competition:
The following are the conditions for the existence of perfect competition:
(1) Large Number of Buyers and Sellers:
The first condition is that the number of buyers and sellers must be so large that none of
them individually is in a position to influence the price and output of the industry as a
whole. The demand of individual buyer relative to the total demand is so small that he
cannot influence the price of the product by his individual action.
Similarly, the supply of an individual seller is so small a fraction of the total output that he
cannot influence the price of the product by his action alone. In other words, the
individual seller is unable to influence the price of the product by increasing or decreasing
its supply.
Rather, he adjusts his supply to the price of the product. He is “output adjuster”. Thus no
buyer or seller can alter the price by his individual action. He has to accept the price for
the product as fixed for the whole industry. He is a “price taker”.
(2) Freedom of Entry or Exit of Firms:
The next condition is that the firms should be free to enter or leave the industry. It implies
that whenever the industry is earning excess profits, attracted by these profits some new
firms enter the industry. In case of loss being sustained by the industry, some firms leave
it.
(3) Homogeneous Product:
Each firm produces and sells a homogeneous product so that no buyer has any preference
for the product of any individual seller over others. This is only possible if units of the
same product produced by different sellers are perfect substitutes. In other words, the
cross elasticity of the products of sellers is infinite.
No seller has an independent price policy. Commodities like salt, wheat, cotton and coal
are homogeneous in nature. He cannot raise the price of his product. If he does so, his
customers would leave him and buy the product from other sellers at the ruling lower
price.
The above two conditions between themselves make the average revenue curve of the
individual seller or firm perfectly elastic, horizontal to the X-axis. It means that a firm can
sell more or less at the ruling market price but cannot influence the price as the product is
homogeneous and the number of sellers very large.
(4) Absence of Artificial Restrictions:
The next condition is that there is complete openness in buying and selling of goods.
Sellers are free to sell their goods to any buyers and the buyers are free to buy from any
sellers. In other words, there is no discrimination on the part of buyers or sellers.
Moreover, prices are liable to change freely in response to demand-supply conditions.
There are no efforts on the part of the producers, the government and other agencies to
control the supply, demand or price of the products. The movement of prices is unfettered.
(5) Profit Maximisation Goal:
Every firm has only one goal of maximising its profits.
(6) Perfect Mobility of Goods and Factors:
Another requirement of perfect competition is the perfect mobility of goods and factors
between industries. Goods are free to move to those places where they can fetch the
highest price. Factors can also move from a low-paid to a high-paid industry.
(7) Perfect Knowledge of Market Conditions:
This condition implies a close contact between buyers and sellers. Buyers and sellers
possess complete knowledge about the prices at which goods are being bought and sold,
and of the prices at which others are prepared to buy and sell. They have also perfect
knowledge of the place where the transactions are being carried on. Such perfect
knowledge of market conditions forces the sellers to sell their product at the prevailing
market price and the buyers to buy at that price.
(8) Absence of Transport Costs:
Another condition is that there are no transport costs in carrying of product from one
place to another. This condition is essential for the existence of perfect competition which
requires that a commodity must have the same price everywhere at any time. If transport
costs are added to the price of the product, even a homogeneous commodity will have
different prices depending upon transport costs from the place of supply.
(9) Absence of Selling Costs:
Under perfect competition, the costs of advertising, sales-promotion, etc. do not arise
because all firms produce a homogeneous product.
Perfect Competition vs Pure Competition:
Perfect competition is often distinguished from pure competition, but they differ only in
degree. The first five conditions relate to pure competition while the remaining four
conditions are also required for the existence of perfect competition. According to
Chamberlin, pure competition means, competition unalloyed with monopoly elements,”
whereas perfect competition involves perfection in many other respects than in the
absence of monopoly.” The practical importance of perfect competition is not much in the
present times for few markets are perfectly competitive except those for staple food
products and raw materials. That is why, Chamberlin says that perfect competition is a
rare phenomenon.”
Though the real world does not fulfil the conditions of perfect competition, yet perfect
competition is studied for the simple reason that it helps us in understanding the working
of an economy, where competitive behaviour leads to the best allocation of resources and
the most efficient organisation of production. A hypothetical model of a perfectly
competitive industry provides the basis for appraising the actual working of economic
institutions and organisations in any economy.
2. Monopoly Market:
Monopoly is a market situation in which there is only one seller of a product with barriers
to entry of others. The product has no close substitutes. The cross elasticity of demand
with every other product is very low. This means that no other firms produce a similar
product. According to D. Salvatore, “Monopoly is the form of market organisation in which
there is a single firm selling a commodity for which there are no close substitutes.” Thus
the monopoly firm is itself an industry and the monopolist faces the industry demand
curve.
The demand curve for his product is, therefore, relatively stable and slopes downward to
the right, given the tastes, and incomes of his customers. It means that more of the product
can be sold at a lower price than at a higher price. He is a price-maker who can set the
price to his maximum advantage.
However, it does not mean that he can set both price and output. He can do either of the
two things. His price is determined by his demand curve, once he selects his output level.
Or, once he sets the price for his product, his output is determined by what consumers will
take at that price. In any situation, the ultimate aim of the monopolist is to have maximum
profits.
Characteristics of Monopoly:
The main features of monopoly are as follows:
1. Under monopoly, there is one producer or seller of a particular product and there is no
difference between a firm and an industry. Under monopoly a firm itself is an industry.
2. A monopoly may be individual proprietorship or partnership or joint stock company or
a cooperative society or a government company.
3. A monopolist has full control on the supply of a product. Hence, the elasticity of demand
for a monopolist’s product is zero.
4. There is no close substitute of a monopolist’s product in the market. Hence, under
monopoly, the cross elasticity of demand for a monopoly product with some other good is
very low.
5. There are restrictions on the entry of other firms in the area of monopoly product.
6. A monopolist can influence the price of a product. He is a price-maker, not a price-taker.
7. Pure monopoly is not found in the real world.
8. Monopolist cannot determine both the price and quantity of a product simultaneously.
9. Monopolist’s demand curve slopes downwards to the right. That is why, a monopolist
can increase his sales only by decreasing the price of his product and thereby maximise
his profit. The marginal revenue curve of a monopolist is below the average revenue curve
and it falls faster than the average revenue curve. This is because a monopolist has to cut
down the price of his product to sell an additional unit.
3. Duopoly:
Duopoly is a special case of the theory of oligopoly in which there are only two sellers.
Both the sellers are completely independent and no agreement exists between them. Even
though they are independent, a change in the price and output of one will affect the other,
and may set a chain of reactions. A seller may, however, assume that his rival is unaffected
by what he does, in that case he takes only his own direct influence on the price.
If, on the other hand, each seller takes into account the effect of his policy on that of his
rival and the reaction of the rival on himself again, then he considers both the direct and
the indirect influences upon the price. Moreover, a rival seller’s policy may remain
unaltered either to the amount offered for sale or to the price at which he offers his
product. Thus the duopoly problem can be considered as either ignoring mutual
dependence or recognising it.
4. Oligopoly:
Oligopoly is a market situation in which there are a few firms selling homogeneous or
differentiated products. It is difficult to pinpoint the number of firms in ‘competition
among the few.’ With only a few firms in the market, the action of one firm is likely to
affect the others. An oligopoly industry produces either a homogeneous product or
heterogeneous products.
The former is called pure or perfect oligopoly and the latter is called imperfect or
differentiated oligopoly. Pure oligopoly is found primarily among producers of such
industrial products as aluminium, cement, copper, steel, zinc, etc. Imperfect oligopoly is
found among producers of such consumer goods as automobiles, cigarettes, soaps and
detergents, TVs, rubber tyres, refrigerators, typewriters, etc.
Characteristics of Oligopoly:
In addition to fewness of sellers, most oligopolistic industries have several common
characteristics which are explained below:
(1) Interdependence:
There is recognised interdependence among the sellers in the oligopolistic market. Each
oligopolist firm knows that changes in its price, advertising, product characteristics, etc.
may lead to counter-moves by rivals. When the sellers are a few, each produces a
considerable fraction of the total output of the industry and can have a noticeable effect on
market conditions.
He can reduce or increase the price for the whole oligopolist market by selling more
quantity or less and affect the profits of the other sellers. It implies that each seller is
aware of the price-moves of the other sellers and their impact on his profit and of the
influence of his price-move on the actions of rivals.
Thus there is complete interdependence among the sellers with regard to their price-
output policies. Each seller has direct and ascertainable influences upon every other seller
in the industry. Thus, every move by one seller leads to counter-moves by the others.
(2) Advertisement:
The main reason for this mutual interdependence in decision making is that one
producer’s fortunes are dependent on the policies and fortunes of the other producers in
the industry. It is for this reason that oligopolist firms spend much on advertisement and
customer services.
As pointed out by Prof. Baumol, “Under oligopoly advertising can become a life-and-death
matter.” For example, if all oligopolists continue to spend a lot on advertising their
products and one seller does not match up with them he will find his customers gradually
going in for his rival’s product. If, on the other hand, one oligopolist advertises his product,
others have to follow him to keep up their sales.
(3) Competition:
This leads to another feature of the oligopolistic market, the presence of competition.
Since under oligopoly, there are a few sellers, a move by one seller immediately affects the
rivals. So each seller is always on the alert and keeps a close watch over the moves of its
rivals in order to have a counter-move. This is true competition.
(4) Barriers to Entry of Firms:
As there is keen competition in an oligopolistic industry, there are no barriers to entry
into or exit from it. However, in the long run, there are some types of barriers to entry
which tend to restraint new firms from entering the industry.
They may be:
(a) Economies of scale enjoyed by a few large firms; (b) control over essential and
specialised inputs; (c) high capital requirements due to plant costs, advertising costs, etc.
(d) exclusive patents and licenses; and (e) the existence of unused capacity which makes
the industry unattractive. When entry is restricted or blocked by such natural and
artificial barriers, the oligopolistic industry can earn long-run super normal profits.
(5) Lack of Uniformity:
Another feature of oligopoly market is the lack of uniformity in the size of firms. Finns
differ considerably in size. Some may be small, others very large. Such a situation is
asymmetrical. This is very common in the American economy. A symmetrical situation
with firms of a uniform size is rare.
(6) Demand Curve:
It is not easy to trace the demand curve for the product of an oligopolist. Since under
oligopoly the exact behaviour pattern of a producer cannot be ascertained with certainty,
his demand curve cannot be drawn accurately, and with definiteness. How does an
individual seller s demand curve look like in oligopoly is most uncertain because a seller’s
price or output moves lead to unpredictable reactions on price-output policies of his
rivals, which may have further repercussions on his price and output.
The chain of action reaction as a result of an initial change in price or output, is all a guess-
work. Thus a complex system of crossed conjectures emerges as a result of the
interdependence among the rival oligopolists which is the main cause of the
indeterminateness of the demand curve.
If the oligopolist seller does not have a definite demand curve for his product, then how
does he affect his sales. Presumably, his sales depend upon his current price and those of
his rivals. However, a number of conjectural demand curves can be imagined.
For example, in differentiated oligopoly where each seller fixes a separate price for his
product, a reduction in price by one seller may lead to an equivalent, more, less or no price
reduction by rival sellers. In each case, a demand curve can be drawn by the seller within
the range of competitive and monopoly demand curves.
Leaving aside retaliatory price movements, the individual seller’s demand curve under
oligopoly for both price cuts and increases is neither more elastic than under perfect or
monopolistic competition nor less elastic than under monopoly. It may still be indefinite
and indeterminate.
This situation is shown in Figure 1 where KD1 is the elastic demand curve and MD is the
less elastic demand curve. The oligopolies’ demand curve is the dotted kinked KPD. The
reason is quite simple. If a seller reduces the price of his product, his rivals also lower the
prices of their products so that he is not able to increase his sales.
So the demand curve for the individual seller’s product will be less elastic just below the
present price P (where KD1and MD curves are shown to intersect). On the other hand,
when he raises the price of his product, the other sellers will not follow him in order to
earn larger profits at the old price. So this individual seller will experience a sharp fall in
the demand for his product.
Thus his demand curve above the price P in the segment KP will be highly elastic. Thus the
imagined demand curve of an oligopolist has a comer or kink at the current price P. Such a
demand curve is much more elastic for price increases than for price decreases.
(7) No Unique Pattern of Pricing Behaviour:
The rivalry arising from interdependence among the oligopolists leads to two conflicting
motives. Each wants to remain independent and to get the maximum possible profit.
Towards this end, they act and react on the price-output movements of one another in a
continuous element of uncertainty.
On the other hand, again motivated by profit maximisation each seller wishes to cooperate
with his rivals to reduce or eliminate the element of uncertainty. All rivals enter into a
tacit or formal agreement with regard to price-output changes. It leads to a sort of
monopoly within oligopoly.
They may even recognise one seller as a leader at whose initiative all the other sellers
raise or lower the price. In this case, the individual seller’s demand curve is a part of the
industry demand curve, having the elasticity of the latter. Given these conflicting attitudes,
it is not possible to predict any unique pattern of pricing behaviour in oligopoly markets.
5. Monopolistic Competition:
Monopolistic competition refers to a market situation where there are many firms selling
a differentiated product. “There is competition which is keen, though not perfect, among
many firms making very similar products.” No firm can have any perceptible influence on
the price-output policies of the other sellers nor can it be influenced much by their actions.
Thus monopolistic competition refers to competition among a large number of sellers
producing close but not perfect substitutes for each other.
It’s Features:
The following are the main features of monopolistic competition:
(1) Large Number of Sellers:
In monopolistic competition the number of sellers is large. They are “many and small
enough” but none controls a major portion of the total output. No seller by changing its
price-output policy can have any perceptible effect on the sales of others and in turn be
influenced by them. Thus there is no recognised interdependence of the price-output
policies of the sellers and each seller pursues an independent course of action.
(2) Product Differentiation:
One of the most important features of the monopolistic competition is differentiation.
Product differentiation implies that products are different in some ways from each other.
They are heterogeneous rather than homogeneous so that each firm has an absolute
monopoly in the production and sale of a differentiated product. There is, however, slight
difference between one product and other in the same category.
Products are close substitutes with a high cross-elasticity and not perfect substitutes.
Product “differentiation may be based upon certain characteristics of the products itself,
such as exclusive patented features; trade-marks; trade names; peculiarities of package or
container, if any; or singularity in quality, design, colour, or style. It may also exist with
respect to the conditions surrounding its sales.”
(3) Freedom of Entry and Exit of Firms:
Another feature of monopolistic competition is the freedom of entry and exit of firms. As
firms are of small size and are capable of producing close substitutes, they can leave or
enter the industry or group in the long run.
(4) Nature of Demand Curve:
Under monopolistic competition no single firm controls more than a small portion of the
total output of a product. No doubt there is an element of differentiation nevertheless the
products are close substitutes. As a result, a reduction in its price will increase the sales of
the firm but it will have little effect on the price-output conditions of other firms, each will
lose only a few of its customers.
Likewise, an increase in its price will reduce its demand substantially but each of its rivals
will attract only a few of its customers. Therefore, the demand curve (average revenue
curve) of a firm under monopolistic competition slopes downward to the right. It is elastic
but not perfectly elastic within a relevant range of prices of which he can sell any amount.
(5) Independent Behaviour:
In monopolistic competition, every firm has independent policy. Since the number of
sellers is large, none controls a major portion of the total output. No seller by changing its
price-output policy can have any perceptible effect on the sales of others and in turn be
influenced by them.
(6) Product Groups:
There is no any ‘industry’ under monopolistic competition but a ‘group’ of firms producing
similar products. Each firm produces a distinct product and is itself an industry.
Chamberlin lumps together firms producing very closely related products and calls them
product groups, such as cars, cigarettes, etc.
(7) Selling Costs:
Under monopolistic competition where the product is differentiated, selling costs are
essential to push up the sales. Besides, advertisement, it includes expenses on salesman,
allowances to sellers for window displays, free service, free sampling, premium coupons
and gifts, etc.
(8) Non-price Competition:
Under monopolistic competition, a firm increases sales and profits of his product without
a cut in the price. The monopolistic competitor can change his product either by varying
its quality, packing, etc. or by changing promotional programmes.
The features of market structures are shown in Table 1.  

Q.2. How Price is Fixed in Perfect Competition?

Ans: In a perfectly competitive market, the number of buyers and sellers is large. The
buyers and sellers are in competition to buy and sell a homogeneous product. The number
of buyers and sellers in such a market is so large that each of them buys or sells a
negligible fraction of the total quantity bought and sold in the market. As a consequence,
none of them has any individual influence on the process of price determination.
In a perfectly competitive market, equilibrium price of the product is determined through
a process of interaction between the aggregate or market demand and the aggregate or
market supply. Equilibrium price is the price at which the market demand becomes equal
to market supply.
If, at any particular price, demand and supply are equal, the buyers and sellers both
remain satisfied, for at the said price the sellers supply what the buyers demand, and the
buyers demand what the sellers supply.
Therefore, the buyers and sellers accept this price, and buy and sell accordingly. None of
them is dissatisfied, and so, none of them would want a change in the price. That is why
this price is called the equilibrium price.
We may explain the process of price determination as a matter of interaction between
demand and supply with the help of Fig. 10.14. The DD curve in this figure is the aggregate
or market demand curve for the product. This curve tells us what is the aggregate demand
of the buyers for the good at any particular price, and, as such, this curve is the horizontal
summation of the individual demand curves of all the buyers.
For example, from the DD curve of Fig. 10.14 we come to know that at the price p = p,, the
market demand for the good is P1G. Again, at p = p2, the market demand amounts to p2H.
Owing to the law of demand, the individual demand curves are downward sloping
towards right. That is why the market demand curve as a horizontal summation of the
individual demand curves would also be downward sloping towards right (or negatively
sloped).

On the other hand, the SS curve in Fig. 10.14 is the aggregate or market supply curve for
the good. We may know from this curve the market supply of the good at any particular
price, and so, this curve is the horizontal summation of the individual supply curves of the
sellers. For example, from the supply curve, SS, we can know that at p = p 1, the market
supply of the good is p1F, or at p = p2, the market supply is p2K.
Since the supply curves of individual sellers are sloping upwards towards right owing to
the law of supply, the aggregate supply curve as the horizontal summation of the
individual supply curves would also be sloping upwards towards right or positively
sloped, like the SS curve in Fig. 10.14.
The price, p0, of the good that would be obtained at the point of intersection, E, of the
aggregate demand curve, DD, and the aggregate supply curve, SS, would itself be the
equilibrium price of the good. At p = p0, the market demand and market supply of the good
are equal, both being equal to q = q0 in Fig. 10.14. That is why, here p = p0 is the
equilibrium price and q = q0 is the equilibrium quantity demanded and supplied.
If we assume:
(i) That if, at any particular price, the market demand for the good is larger than the
market supply, then the dissatisfied buyers (who cannot buy all they want to buy) would
be willing to pay a higher price for the good and
(ii) That if, at any particular price, the market supply of the good is greater than the
market demand, then the dissatisfied sellers (who cannot sell all they want to sell) would
be willing to accept a lower price for the good, then the equilibrium that would be
obtained at the point E in Fig. 10.14 would be a stable equilibrium.
For, here, if for any reason, the price of the good be more or less than the equilibrium
price, then the behaviour pattern of buyers and sellers mentioned above ensures that the
price would again come back to the level of equilibrium price, i.e., the market equilibrium
will be restored. The two assumptions mentioned above are known as the behavioural
assumptions.
We may illustrate the matter with the help of Fig. 10.14. Here, if the price of the good be
less than p0, if it is p1 < p0, then the quantity demanded would be more than the
equilibrium quantity, q0, and the quantity supplied would be less than q0. We shall get this
because of the laws of demand and supply.
As a result, there would be excess demand—demand in excess of supply— in the market.
At p = p1, the quantity of excess demand would be FG. In this case, the buyers are not able
to buy what they want to buy, and so they would be willing to pay a higher price.
Consequently, the price of the good would be increasing from p1 till it becomes equal to p0.
As price increases from p1, the quantity demanded would fall and the quantity supplied
would rise leading to a fall in excess demand and when p rises to the level of p 0, the whole
of excess demand would be wiped out and the market would be in equilibrium.
On the other hand, if the price of the good is p = p2 > p0, supply in the market would be in
excess of demand, i.e., there would be a negative excess demand in the market. In this case,
the sellers would not be able to sell what they want to sell.
As a result, they would be willing to accept a lower price, and p would be falling. As p falls
from p2, supply would fall and demand would rise leading to a fall in excess supply. This
would go on till p falls to the level of p0 and market equilibrium is restored.
We have discussed above how the price is determined in a perfectly competitive market
through the process of interaction between demand and supply for the good. We have also
seen when and why the market equilibrium may be considered to be stable.
Importance of Time in Price Determination under Perfect Competition:
As we have seen above, price is determined in a perfectly competitive market through
interactions between demand and supply. That is, demand and supply have an equally
important role to play in the process of price determination. According to the law of
demand, as price of the good increases or decreases, the quantity demanded of it decrease
or increases.
Again, because of the law of supply, as price increases or decreases, the quantity supplied
also increases or decreases. We generally assume that if the price of good changes, its
buyers may instantly change the quantity of its purchase. They do not require any time lag
to do this.
On the other hand, if the price of a good changes, then, whether quantity produced and
supplied of it would actually change, and by how much, would depend on the length of
time given for adjustment. For example, if the price of a good increases, then its producer
will want to supply more.
But within a short span of time he might not be able to increase supply as such as he
wished. However, if he is allowed a longer span of time, he might be able to produce more.
This is because, as we know, in the short run, he cannot change the quantities of the fixed
inputs which he may do in the long run.
Now, as we have seen above, the length of time obtained for necessary adjustments will
determine the extent of change in quantity supplied and thereby influence the price. That
is why it is said that time plays an important role in price determination in a perfectly
competitive market. We may discuss the process of price determination in this market in
three phases, depending on the length of time given for adjustment.
These are price determination:
i) In the very short period,
(ii) In the short period, and
(iii) In the long period.
(i) Price Determination in the Very Short Period:
Very short period is a short span of time during which the supply of the good, generally,
cannot be changed. For example, the market for a good during the morning of a day may
be called a very short period market.
The supply curve of the good in such a market would be like the SS curve in Fig. 10.15. In
this market, since the quantity supplied cannot change in response to a change in price,
most of the supply curve would be a vertical straight line.
However, if the price falls below a certain low level, the sellers might think it prohibitively
low and then, as price decreases further, they might attempt to reduce the quantity
supplied of the good. In Fig. 10.15, this particular price is OR.
This price is known as the reservation price. If the price of the good is smaller than the
reservation price (p < OR in Fig. 10.15), the very short period supply curve would be
backward bending towards the origin like the segment OT of the SS curve.
For the price of the good equal to or greater than the reservation price (for p > OR), the
supply curve SS would be a vertical straight line, i.e., then the quantity supplied would be a
constant w.r.t. price. In Fig. 10.15, this constant quantity of supply is q 1 (or Oq1).
Now, how small or how large would be the reservation price would depend on some
considerations like the perishability of the good, the sellers’ need for cash, the probability
of the price of the good to change in near future, etc.
For example, the more is the perishability of the good, the more is the sellers’ need for
cash and the more is the probability of the price of the good not to rise in near future, the
smaller would be the reservation price of the good.
In Fig. 10.15, in the initial situation, the demand curve for the good is D 1D1. Therefore, at
the point of intersection, E1, of the DD1 and SS curves, the very short period market price
of the good, p1, and the equilibrium quantity, q1, would be determined.
In order to see the importance of time in price determination in a competitive market, let
us suppose that there has been an increase in demand due to some reason, and the
demand curve for the good has shifted to the right from D1D1 to D2D2.
At any particular price, demand for the good would now increase, and the buyers would
now be willing to pay a higher price. Consequently, the price of the good would be rising.
Since supply cannot increase in the very short period in response to a rise in price, price
would rise by a relatively large amount from p1 to p’1.
At p = p’1, the demand curve D2D2 has intersected the supply curve SS at the point E’1(p’1,
q1). Therefore, E’1 would be the new point of market equilibrium in the very short period.
Since the supply curve, SS, is a vertical straight line, the shift in the demand curve would
cause the equilibrium quantity bought and sold to remain constant at q 1.
We have seen, therefore, that in the very short period, demand plays an active role in price
determination and supply’s role here would be, at best, passive. If demand increases in the
very short period, only price would change, by a rather large amount, and, supply would
remain constant. The new equilibrium point E’1 would lie vertically above the initial point
E 1.
(ii) Price Determination in the Short Period:
Time span in the short period is larger than that in the very short period. We have already
known what we understand by the short period or short run in our discussion of the
theories of production and cost. We know that the firm can change the quantity of output
produced and supplied in the short run by changing its use of the variable inputs.
Therefore, the firm can increase the quantity supplied of the good in the short run in
response to an increase in its price. In other words, the short-run supply (SRS) curve of
the firm would be sloping upward towards right like the SRS curve in Fig. 10.15.
In Fig. 10.15, the short period market price of the good would be determined at the point
of intersection E2 (p2, q2) between the demand curve D2D2 and the SRS curve. At the
equilibrium point E2, price of the good would be p2 < p’1 and the quantity bought and sold
would be q2 > q1.
That is, in the short period, since supply can respond to a change in price, the market price
would not be as high as the very short period price, viz., p’ 1—it would fall to p2 in the short
period. The short period equilibrium price p = p 2 is called the short period normal price.
As we have seen, the short-run normal price would be smaller than the very short period
market price.
(iii) Price Determination in the Long Period:
The length of the long period is so long that in this period, the firm would be able to
change the quantities used of the fixed factors along with those of the variable factors to
produce a larger or a smaller quantity of output.
We have already seen what is meant by long run or long period in our discussion of the
theories of production and cost. We have also discussed about the long-run supply (LRS)
curve of a perfectly competitive industry.
If we assume that the industry concerned is an increasing cost industry, then its LRS curve
would be sloping upwards towards right like the one shown in Fig. 10.15.
In the long run, since the firm can change the quantities used of both the variable and the
fixed factors, the supply of the good, in response to an increase in its price, may increase at
a larger rate (w.r.t. price) in the long run than in the short run. Therefore, the LRS curve of
the good (or of the industry) would be flatter than its SRS curve.
In Fig. 10.15, the long-period equilibrium price of the good will be determined at the point
of intersection, E3 (p3, q3) between the demand curve D2D2 and the LRS curve of the good
(or of the industry). Here this price has been p3. At this price the quantity demanded and
the quantity of long-period supply, both have been equal to q3.
Here, if long period means one year, then for one year after the increase in demand, the
long-period period price would be diminishing from p1 till it comes down to the level of
p3 after one year, and the quantity demanded and supplied would increase from q 1 to q3.
The price p3 is called the long-period normal price.
Generally, this price would be considerably less than the very short period price pi, for, in
the long run, along with the increase in demand, supply also increases. Again, the long-run
normal price p3 would be smaller than the short-run normal price p2, because, the LRS
curve of the good is flatter than the SRS curve, i.e., supply increases at a larger rate in the
long run than in the short run.
This is because, in the long run adjustment, the quantities used of both fixed and variable
inputs can change while, in the short run, those of variable inputs only can change.
Q.3.What is Price Discrimination? Who does do price discrimination? Explain the
techniques of price discrimination for profitability.
Ans: Price discrimination refers to the charging of different prices by the monopolist for
the same product.
The difference in the product may be on the basis of brand, wrapper etc. This policy of the
monopolist is called price discrimination.
Definitions:
“Price discrimination exists when the same product is sold at different prices to different
buyers.” -Koutsoyiannis
“Price discrimination refers to the sale of technically similar products at prices which are
not proportional to their marginal cost.” -Stigler
“Price discrimination is the act of selling the same article produced under single control at
a different price to the different buyers.” -Mrs. Joan Robinson
“Price discrimination refers strictly to the practice by a seller of charging different prices
from different buyers for the same good.” -J.S. Bain
“Discriminating monopoly means charging different rates from different customers for the
same good or service.” -Dooley
Types of Discriminating Monopoly:
Price discrimination is of following three types:
1. Personal Price Discrimination:
Personal price discrimination refers to the charging of different prices from different
customers for the same product. For example, a doctor charges different fees for the same
operation from rich and poor patients.
2. Geographical Price Discrimination:
Under geographical price discrimination, the monopolist charges different prices in
different markets for the same product. It also includes dumping where a producer may
sell the same commodity at one price at home and at the other price abroad.
3. Price Discrimination according to Use:
When the monopolist charges different prices for the different uses of the same
commodity is called the price discrimination according to use.
Conditions for Price Discrimination:
For price discrimination to exist, it requires the basic conditions.
These are:
1. Difference in Elasticity of Demand:
Price discrimination is possible only when elasticity of demand will be different in
different markets. The monopolist will fix higher price where demand is inelastic and low
price where the demand will be elastic. In this way, he will be able to increase his total
revenue.
2. Market Imperfections:
Generally, price discrimination is possible only when there is some degree of market
imperfections. The individual seller is able to divide his market into separate parts only if
it is imperfect.
3. Differentiated Product:
Price discrimination is possible when buyers need the same service in connection with
differentiated products. For example, railways charges different rates for the transport of
coal and copper.
4. Legal Sanction:
In some cases price discrimination is legally sanctioned. As, Electricity Board charges
lowest for electricity for domestic use and highest for commercial houses.
5. Monopoly Existence:
Price discrimination is also called discrimination monopoly. It is evident that price
discrimination is possible only under conditions of monopoly.
Degree of Price Discrimination:
Prof. A.C. Pigou has given the following three degrees of discriminating monopoly:
1. Price Discrimination of First Degree:
Price discrimination of first degree is said to exist when the monopolist is able to sell each
separate unit of his product at different prices. It is also known as the perfect price
discrimination. In case of first degree price discrimination, a seller charges a price equal to
what the consumer is willing to pay. It means the seller leaves no consumer’s surplus with
the consumer. Apart from above, under perfect price discrimination the demand curve of
the buyer, like under simple monopoly, becomes the marginal revenue curve of the seller.
2. Price Discrimination of Second Degree:
In the price discrimination of second degree buyers are divided into different groups and
from different groups a different price is charged which is the lowest demand price of that
group. This type of price discrimination would occur if each individual buyer had a
perfectly in- elastic demand curve for good below and above a certain price.
3. Price Discrimination of Third Degree:
Price discrimination of third degree is said to exist when the seller divides his buyers into
two or more than two sub markets and from each group a different price is charged. The
price charged in each sub-market depends on the output sold in that sub-market along
with demand conditions of that sub-market. In the real world, it is the third degree price
discrimination which exists.
What Is Price Discrimination?
Price discrimination is a selling strategy that charges customers different prices for the
same product or service based on what the seller thinks they can get the customer to
agree to. In pure price discrimination, the seller charges each customer the maximum
price he or she will pay. In more common forms of price discrimination, the seller places
customers in groups based on certain attributes and charges each group a different price.

Forms of Price Discrimination

There are a variety of ways in which industries legally use price discrimination. It is not
important that pricing information be restricted, or that the price discriminated groups be
unaware that others are being charged different prices:
 Coupons: coupons are used in retail as a way to distinguish customers by their
reserve price. The assumption is that individuals who collect coupons are more
sensitive to a higher price than those who don’t. By offering coupons, a producer can
charge a higher price to price-insensitive customers and provide a discount to price-
sensitive individuals.
 Premium pricing: premium products are priced at a level that is well beyond their
marginal cost. For example, a regular cup of coffee might be priced at $1, while a
premium coffee is $2.50.
 Discounts based on occupation: many businesses offer reduced prices to active
military members. This can increase sales to the target group and provide positive
publicity for the business which leads to increased sales. Less publicized discounts
are also offered to off duty service workers such as police.
 Retail incentives: retail incentives are used to increase market share or revenues.
They include rebates, bulk and quantity pricing, seasonal discounts
 Gender based discounts: gender based discounts are offered in some countries
including the United States. Examples include free drinks at bars for women on
“Ladies Night,” men often receive lower prices at the dry cleaners and hair salons
than women because women clothes and hair generally take more time to work with.
In contrast, men usually have higher car insurance rates than women based on the
likelihood of being in an accident based on their age.
 Financial aid: financial aid is offered to college students based on either the student
and/or the parents economic situation.
 Haggling: haggling is a form of price negotiation that requires knowledge and
confidence from the customer.

Industries that Use Price Discrimination

The airline industry uses price discrimination regularly when they sell travel tickets
simultaneously to different market segments. Price discrimination is evident within
individual airlines, but also in the industry as a whole. Tickets vary based on the location
within the plane, the time and day of the flight, the time of year, and what city the aircraft
is traveling to. Prices can vary greatly within an airline and also among airlines. Customers
must search for the best priced ticket based on their needs. Airlines do offer other forms
of price discrimination including discounts, vouchers, and member perks for individuals
with membership cards.

The pharmaceutical industry experiences international price discrimination. Drug

manufacturers charge more for drugs in wealthier countries than in poor ones. For
example, the United States has the highest drug prices in the world. On average,
Europeans pay 56% less than Americans do for the same prescription medications.
However, in many countries with lower drug costs, the difference in price is absorbed into
the taxes which results in lower average salaries when compared to those in the United
States.

Academic textbooks are another industry known for price discrimination. Textbooks in
the United States are more expensive than they are overseas. Because most of the
textbooks are published in the United States, it is obvious that transportation costs do not
raise the price of the books. In the United States price discrimination on textbooks is due
to copyright protection laws. Also, in the United States textbooks are mandatory where as
in other countries they are viewed as optional study aids.

Analysis of Price Discrimination

Price discrimination is present in commerce when sellers adjust the price on the same
product in order to make the most revenue possible.

Key Points
 Three factors that must be met for price discrimination to occur: the firm must have
market power, the firm must be able to recognize differences in demand, and the firm
must have the ability to prevent arbitration, or resale of the product.
 First degree price discrimination – the monopoly seller of a good or service must
know the absolute maximum price that every consumer is willing to pay.
 Second degree price discrimination – the price of a good or service varies according
to the quantity demanded.
 Third degree price discrimination – the price varies according to consumer
attributes such as age, sex, location, and economic status.
 Price discrimination is present throughout commerce. Examples include airline and
travel costs, coupons, premium pricing, gender based pricing, and retail incentives.

Key Terms
 price discrimination: The practice of selling identical goods or services at different
prices from the same provider.

Price Discrimination

Price discrimination exists within a market when the sales of identical goods or services
are sold at different prices by the same provider. The goal of price discrimination is for the
seller to make the most profit possible. Although the cost of producing the products is the
same, the seller has the ability to increase the price based on location, consumer financial
status, product demand, etc.
Sales Revenue: These graphs shows the difference in sales revenue with and without
price discrimination. The intent of price discrimination is for the seller to make the most
profit possible.

Price Discrimination Criteria

Within commerce there are specific criteria that must be met in order for price
discrimination to occur:
 The firm must have market power.
 The firm must be able to recognize differences in demand.
 The firm must have the ability to prevent arbitration, or resale of the product.

Types of Price Discrimination

In commerce there are three types of price discrimination that exist. The exact price
discrimination method that is used depends on the factors within the particular market.
 First degree price discrimination: the monopoly seller of a good or service must
know the absolute maximum price that every consumer is willing to pay and can
charge each customer that exact amount. This allows the seller to obtain the highest
revenue possible.
 Second degree price discrimination: the price of a good or service varies
according to the quantity demanded. Larger quantities are available at a lower price
(higher discounts are given to consumers who buy a good in bulk quantities).
 Third degree price discrimination: the price varies according to consumer
attributes such as age, sex, location, and economic status.

Examples of Price Discrimination

Price discrimination is a driving force in commerce. It is evident throughout markets and

generates the highest revenue possible by shifting the price of a product based on the
consumer’s willingness to pay, quantity demanded, and consumer attributes. Many
examples of price discrimination are present throughout commerce including:
 Travel industry: airlines and other travel companies use price discrimination
regularly in order to generate commerce. Prices vary according to seat selection, time
of day, day of the week, time of year, and how close a purchase is made to the date of
travel.
 Coupons: coupons are used in commerce to distinguish consumers by their reserve
price. A manufacturer can charge a higher price for a product which most consumers
will pay. Coupons attract sensitive consumers to the same product by offering a
discount. By using price discrimination, the seller makes more revenue, even off of
the price sensitive consumers.
  Premium pricing: uses price discrimination to price products higher than the
marginal cost of production. Regular coffee is priced at $1 while premium coffee is
$2.50. The marginal cost of production is only $0.90 and $1.25. The difference in
price results in increased revenue because consumers are willing to pay more for the
specific product.
 Gender based prices: uses price discrimination based on gender. For example, bars
that have Ladies Nights are price discriminating based on gender.
 Retail incentives: uses price discrimination to offer special discounts to consumers
in order to increase revenue. Incentives include rebates, bulk pricing, seasonal
discounts, and frequent buyer discounts.

Examples of Price Discrimination

The purpose of price discrimination is to capture the market’s consumer surplus and
generate the most revenue possible for a good.

Key Points
 Price discrimination occurs when identical goods or services are sold at different
prices from the same provider.
 Industries that commonly use price discrimination include the travel industry,
pharmaceutical industry, and textbook publishers.
 Examples of forms of price discrimination include coupons, age discounts,
occupational discounts, retail incentives, gender based pricing, financial aid, and
haggling.

Key Terms
 surplus: That which remains when use or need is satisfied, or when a limit is
reached; excess; overplus.
 revenue: The total income received from a given source.
 price discrimination: The practice of selling identical goods or services at different
prices from the same provider.

Price Discrimination

Price discrimination occurs when identical goods or services are sold at different prices
from the same provider. There are three types of price discrimination:
 First degree – the seller must know the absolute maximum price that every
consumer is willing to pay.
 Second degree – the price of the good or service varies according to quantity
demanded.
  Third degree – the price of the good or service varies by attributes such as location,
age, sex, and economic status.

The purpose of price discrimination is to capture the market’s consumer surplus. Price
discrimination allows the seller to generate the most revenue possible for a good or
service.

Price discrimination: These graphs show multiple market price discrimination. Instead
of supplying one price and taking the profit (labelled “(old profit)”), the total market is
broken down into two sub-markets, and these are priced separately to maximize profit.
The graph shows how a seller wants to generate the most revenue possible for a good or
service. The elasticity of a market influences the profit.

Examples of Price Discrimination

There are industries that conduct a substantial portion of their business using price
discrimination:
 Travel industry: airlines and other travel companies use differentiated pricing
often. Travel products and services are marketed to specific social segments. Airlines
usually assign specific capacity to various booking classes. Also, prices fluctuate
based on time of travel (time of day, day of the week, time of year). Prices fluctuate
between companies as well as within each company.
 Pharmaceutical industry: price discrimination is common in the pharmaceutical
industry. Drug-makers charge more for drugs in wealthier countries. For example,
drug prices in the United States are some of the highest in the world. Europeans, on
average, pay only 56% of what Americans pay for the same prescription drugs.
 Textbooks (physical ones, not your Boundless one!): price discrimination is also
prevalent within the publishing industry. Textbooks are much higher in the United
States despite the fact that they are produced in the country. Copyright protection
laws increase the price of textbooks. Also, textbooks are mandatory in the United
States while schools in other countries see them as study aids.

Price discrimination is prevalent in varying degrees throughout most markets. Methods of

price discrimination include:
 Coupons: coupons are used to distinguish consumers by their reserve price.
Companies increase the price of a good and individuals who are not price sensitive
will pay the higher price. Coupons allow price sensitive consumers to receive a
discount. At the same time the seller is still making increased revenue.
 Age discounts: age discounts are a form of price discrimination where the price of a
good or admission to an event is based on age. Age discounts are usually broken
down by child, student, adult, and senior. In some cases, children under a certain age
are given free admission or eat for free. Examples of places where age discounts are
given include restaurants, movies, and other forms of entertainment.
  Occupational discounts: price discrimination is present when individuals receive
certain discounts based on their occupation. An example is when active military
members receive discounts.
 Retail incentives: this includes rebates, discount coupons, bulk and quantity
pricing, seasonal discounts, and frequent buyer discounts.
 Gender based prices: in certain markets prices are set based on gender. For
example, a Ladies Night at a bar is a form of price discrimination.

Q.4. Note on “Price-Output-Profit” decision in monopolistic competition.

Ans: In a model of collusive oligopoly, we discuss the economics of agreement between
the firms in an undifferentiated oligopolistic industry. When these firms get together and
agree to set prices and outputs so as to maximise total industry profits, they are known as
a cartel.
Assumptions of the Cartel Model:
For the sake of simplicity, we shall make here the following assumptions:
(i) There are only two firms in the oligopolistic industry, i.e., here we have a case of
duopoly.

(ii) Each firm produces and sells a product that is a perfect substitute for that of the other.

(iii) The product is perishable.

(iv) There are many knowledgeable buyers of the product.

(v) Each firm knows the market demand for the product.

(vi) The two firms have different cost curves.

(vii) Both the firms have the same expectations about the prices and productivities of the
inputs which they use.

(viii) The price of the product is the sole parameter of action of each firm.

(ix) The two firms are contemplating whether or not to form a cartel and agree upon a
price that will promise the maximum maximorum of profits per period to both of them
jointly.
Analysis of the Cartel Model:
Let us discuss the choice of this price [mentioned in assumption (ix)] and its implications
with the help of Fig. 14.16. Here, in part (a), the average and marginal cost curves of
duopolist A are given to be ACA and MCA, and those of duopolist B are given to be ACB and
MCB in part (b).
As is seen in these figures in 14.6, the cost levels of A have been assumed here to be lower
than those of B. The curve DD in part (c) of the figure is the market demand curve for the
product produced by the duopolists.
Here the dupolists A and B are exploring the possibility of jointly producing and selling the
product and earning the maximum maximorum of profits. Henceforth, we shall call the
duopoly firms A and B that have come under collusion, the firms A + B (the “plus” sign
indicates collusion).
In our attempt to analyse the price-output-profit policy of the firms A + B, we shall first
see how the firms would distribute the production of any particular quantity (q) of their
product between the plants of A and B, so that the cost may be minimum. We may call the
plants of the two firms plant A and plant B.

Now, the total cost (C) of producing any particular quantity of output, q is

c = CA(qA) + CB(qB) = C(qA, qB)                                       (14.72)

subject to

q = qA + QB = constant                                                      (14.73)

where qA = quantity of output to be produced in plant A,
and qB = quantity of output to be produced in plant B,
CA = cost of production in plant A
and CB = cost of production in plant B
Given these, the first-order conditions (FOCs) of producing the output quantity, q, in the
two plants at minimum cost, i.e., the FOCs for minimising C, are

Conditions (14.75) and (14.76) give us that two (or more) oligopoly firms under collusion
(here firms A + B) would distribute the production of any particular quantity of output
between their plants in such a way that the marginal cost (MC) in each plant may become
the same.
We may easily understand the economic significance of this condition. Instead of
MCA being equal to MCB, if we have MCA > MCB (in the two-firm case), then the firms A + B
would reduce the quantity of production in the higher cost plant A and increase the
quantity in the lower cost plant B, total output remaining the same.
The firms would do this because then they would be able to produce the same quantity of
total output (q) at a lower cost.

Now, as we know, for the sake of profit maximisation, and, therefore, for the sake of
efficient production, firms A + B would operate along the upward sloping segments of the
MC curves of plants A and B that correspond to the second stage of production. That is
why, as the firms decrease and increase qB, MCa will fall and MCB will rise, and ultimately,
at some distribution, MCA will become equal to MCB.
This distribution is the cost-minimising distribution of the output quantity, q, between the
two plants. For if MCA = MCB, then it will not be possible for the firms to reduce the cost
further by transferring output production from plant A to plant B, or, the other way round.
On the other hand, if MCA < MCB, the firms A + B will reduce output in plant B and increase
it in plant A, till MCA rises and MCB falls to become equal to each other.
Thus, we come to the conclusion that the duopoly firms under collusion (i.e., firms A + B)
will distribute the production of any particular quantity of output over the two plants in
such a way that the MC in each plant may become the same; only then it would be able to
produce the said quantity at the minimum cost.
Therefore, that at each quantity of output, q, there is a problem of cost- minimisation, or,
profit-maximisation (the price, p, and, therefore, total revenue, p x q, being given by the
demand curve). Here equilibrium will be obtained at that quantity, q*, at which profit is
maximum among the maximums, or, maximum.
We may now proceed to explain how the equilibrium output, q*, of the firms A + B with
maximum of profit is obtained. It follows from (14.75) or (14.76) that, at any output, q =
qA + qB, the condition MCA = MCB ensures cost-minimising of profit-maximising distribution
of q between the two plants.
Now, at any q = qA + qB, the MC of firms A + B is MCA = MCB. This is because, here the qAth
unit of output is either the qAth unit of output in plant A or the qBth unit of output in plant
B, and the additional cost of producing that unit is either MC A or MCB, and MCA = MCB.
On the revenue side, the firms A + B sell any quantity, q, of their product at the price given
by the demand curve, DD. Now, if at any q, the firms A + B have MC = MC A = MCB < MR
(marginal revenue), then they would be able to earn a positive profit on the margin, and
so, they would increase the output to push up the maximum maximorum of profit.
But as q increases the MR, being a decreasing function of q, would diminish, and MC (=
MCA = MCB) would increase, since in the relevant range, both MCA and MCB are increasing
functions of q. Therefore q, while increasing, would eventually assume a value (say, q*) at
which we would have MR = MC (= MCA = MCB).
At this q = q*, the firm would acquire the maximum maximorum of profit. For, now its
profit on the margin is zero, and so it will not be able to increase its profit by increasing q.
On the other hand, if at some q, the firms have MC = MCA = MCB > MR, then it would suffer
losses on the margin and would now want to shed the loss-earning marginal units, i.e., it
would now want to decrease q to maximise its profit. But as q decreases, the firm’s MC (=
MCA = MCB) would also decrease, and its MR would increase.
Eventually, at q = q*, the firm would have MR = MC (= MC A = MCB), and this q = q* would be
its q with maximum of profit. For, now the firms’ losses on the margin are zero, and so it is
no longer required of the firms to decrease their output in order to maximise profit.
It follows from the above analysis that the necessary or the first order condition (FOC) for
profit maximisation under collusive oligopoly (here duopoly) is

MR = MCA = MCB                                   (14.77)

However, condition (14.77) is not the sufficient condition or the second order condition
(SOC) of profit maximisation. For, if at the MR = MCA = MCB point, the firms A + B find that
a further increase in output would result in MC (= MCA = MCB) being less than MR, (which
can of course happen in an inefficient stage of production), then the firms would not settle
at this point, rather they would go on increasing the output quantity, for, by doing that,
they would be able to increase the profit level.
Therefore, the SOC for profit maximisation states that at the point where the FOC is
satisfied, i.e., at the MR = MCA = MCB point, further increase in output should result in MC =
MCA = MCB being greater than MR. In that case, there would be a loss on the margin and so
the firms A + B would not venture beyond the point (where the FOC is satisfied).
In other words, the SOC for profit maximisation under collusive oligopoly states that, at
the point of intersection between the MC curve and the MR curve, where the FOC has been
satisfied, the slope of the MC curve viz., the MCA + B curve in Fig. 14.16(c), which, as we shall
see, is the lateral summation of the MCA and MCB curves, should be greater than that of the
MR curve.
It may be noted that, since the firms operate in the stage of efficient production, they
would operate along the positively sloped portion of their respective MC curves, and,
therefore, along the positively sloped portion of the MCA + B curve. Here the SOC for profit
maximisation would be automatically satisfied, for the MR curve of the firms A + B is
negatively sloped, by definition.
We may now illustrate the profit-maximising equilibrium of the collusive oligopoly under
discussion with the help of Fig. 14.16. The MCA+B curve in Fig. 14.16(c) is the MC curve of
firms A + B. It is obtained by laterally adding together the MC A and MCB curves given in
Figs. 14.16(a) and 14.16(b). The curve MCA+B shows us what would be the total output of
the firms A + B at any particular amount of MC in both the plants.
Thus, if the MC in both the plants is to be OC, (MCA = MCB = OC), plant A should produce
OMA of output and plant B should produce OMB. The combined output in this case would
be OMA + OMB = OM (in Fig. 14.16).
Conversely, we would also know from the curve MCA+B what would be the MC = MCA =
MCB at any particular output. For example, at q = OM, the MC = MC A = MCB would be OC,
provided the distribution of this q between the two plants is q A = OMA and qB = OMB.
Now, the total output for which the firms A+ B would be jointly earning the maximum
maximorum of profits is obtained at the point of intersection, E, of the MR and MC A +
B curves in Fig. 14.16 (c). For at the point E, or at the total output of OM, the FOC for profit
maximisation, viz., MR = MCA = MCb (- OC), has been satisfied.
Also, the SOC for maximum profit has been satisfied at point E, for here the MR curve is
negatively sloped and the MCA + B curve is positively sloped.
It is obtained from the AR curve in Fig. 14.16(c) that the output OM of firms A + B can be
sold at the price OR The output OM and the price OP are called, respectively, the monopoly
output and price, for they would form the equilibrium price-output combination if the
firms A and B merged into a single monopolistic firm.
The duopolists in this collusive oligopoly model will plan to sell OM units of their product
at a price of OP per unit and firm A will produce and sell OM A units per period and firm B,
OMB per period. The distribution of the ‘monopoly’ output of OM between the two firms
implies a distribution of the maximum joint profits.
In the solution given in Fig. 14.16, firm A may expect to earn LMNP of profits per period
and firm B may expect to earn RSTP of profit per period. The sum of LMNP and RSTP will
be the maximum maximorum of profits that the two firms will be able to earn jointly.
Mathematical Derivation of the Condition for Maximum Profit:
We may also derive the conditions for maximum maximorum of profit under collusive
oligopoly with the help of calculus.
The profit (π) function of the firms A + B is:
(14.83) and (14.84) give us the SOCs for maximum maximorum of profit under collusive
oligopoly. These conditions state that at the MR = MCA = MCB point, i.e., at the point of
intersection of the MR and MCA + B curves in Fig. 14.16 (where the FOC has been satisfied),
the slope of the MR curve of firms A + B should be less than the slopes of both MC A and
MCB curves.
This implies, as we have already asserted, that the slope of the MR curve should be less
than the slope of the MCA+B curve. We have also mentioned the significance of these
conditions. Like the FOC, the SOCs are also perfectly general.
That is, if the number of collusive firms is n, then these conditions give us that, at the point
where the FOC is satisfied, the slope of the MR curve should be less than the slope of the
MC curve of each of then firms.

Comparison between the Collusion Solution and the Quasi-competitive solution:

We may now obtain the collusion solution for the example given in (14.5) and compare it
with the quasi-competitive solution given in (14.8).

The profit of the two firms taken together, or, the industry profit, is given by

Solving (14.86) for qA and qB and substituting in equations (14.5), (14.85) and (14.86), we
have the following collusive solution:
qA = 90 (units), qB = 5 (units), p = 52.5 (Rs), πA = 4,275 (Rs), πB = 250 (Rs.).                      
(14.87)
Comparing (14.87) with (14.8), we find that, under collusion, total output is much lower
(95 < 190), price is much higher (52.5 > 5) and profits are much higher (4,275, 250 > 0,
12.5).
Cartel Instability:
The problem with agreeing to form a cartel in the real world is that there is always a
temptation for the participating firms to act contrary to the agreement, i.e., to cheat. We
may elaborate the problem as follows. Let us rewrite the profit function (14.78) as

That is, if firm A believes that firm B will keep its output fixed, then it will also believe that
it can increase profits (πA) by increasing its own production (qA). It may be shown in a
similar way that the firm B will also believe accordingly.
And herein lies the temptation for a member of the cartel to increase his own profits by
unilaterally expanding his output beyond the output level that maximises joint profits. The
situation becomes grave for the existence of the cartel if each firm comes to know that the
other firm is not going to keep its output at the agreed level.

Therefore, in order to make the cartel effective and operational, its members must be able
to detect and punish cheating. Otherwise, temptation to cheat would break the cartel.

In order to renew our understanding of the cartel solution, let us assume that the costs of
production are zero and the demand curve for the product is linear which is the same as
(14.9).

Then the total revenue (R) function of the cartel will be

R = (a – bq)q = aq – bq2 = R(q) where q = qA + qB

And here the MR = MC condition, or the FOC for maximum profit, will be

a – 2bq = 0

⇒ a – 2b(qA +qB) = 0
⇒ qA + qB = a/2b
Since marginal costs are zero here, the division of output between the two firms does not
matter. All that is important here is the total industry output which is This solution is
shown in Fig. 14.17. In this figure, qA is measured along the horizontal axis and qB along
the vertical axis.
Since qA + qB = a/2b, here we have qA = a/2b, given qB = 0 and qB = a/2b, given qA = 0, or
here we would have any other combination of positive values of both q A and qB provided it
lies on the straight line joining the points L (a/2b, 0) on the horizontal axis and M (0,
a/2b) on the vertical axis.
Now, at any point on this line, the industry’s profit is maximum, i.e., the profit of A is
maximum given the profit of B and the profit of B is maximum given the profit of A, i.e., the
iso-profit curve of A is the lowest, given the iso-profit curve of B and the iso-profit curve of
B is the lowest, given the iso-profit curve of A, i.e., at any point on the line LM, the iso-
profit curves of the two firms are tangent to each other.

Hence, the (qA, qB) combinations that maximise total industry profits and give us the
alternative cartel solutions are those that lie on the line LM in Fig. 14.17.
Fig. 14.17 also helps us to understand how the temptation to cheat is present at the cartel
solution. Let us consider, for example, the point N at the midpoint of the line segment LM.

At this point, the two firms share the market equally between themselves, each producing
and selling half of the total quantity sold in the market. Let us now suppose that firm A
decides to increase its output believing that B would keep its output unchanged.
Consequently, A would now move towards right of the point N along a horizontal straight
line and would reach a lower iso-profit curve which implies that he would now be on a
higher level of profit.

Similarly, if firm B decides to increase its output at the point N, believing that A would
keep its output constant, it would move upward from N along a vertical straight line and
reach a lower iso-profit curve or a higher level of profit. Thus both the duopolists are in
temptation to increase their respective outputs in violation of the cartel agreement.

Punishment Strategies:
We have seen above that a cartel is fundamentally unstable for its members are always
tempted to increase their output quantities beyond their maximising levels. If the cartel is
to continue its operations successfully, the behaviour of its members must conform to the
agreement made by them. One way to ensure this is for the firms to threaten to punish
each other for violating the cartel agreement.

This is known as a punishment strategy. For example, let us consider a duopoly with two
identical firms. If the firms come to an understanding and produce the monopoly output,
then the share of each firm will be half the monopoly output (= 1/2 x 1/2 a/b = 1/4 a/b)
and the total profit of the duopolists will be maximised.

Let us suppose that the profit accruing to each firm, now, is πm. In an effort to make this
position stable, one of the firms, say, firm A, may threaten firm B that if it violated the
output agreement, then it would punish firm B by producing the Cournot level of output
forever.
Now, since the optimal response to Cournot behaviour is Cournot behaviour, both the
firms now would operate at the Cournot equilibrium point which is the point of
intersection, I, of the reaction functions of the two firms (not shown in Fig. 14.17). In other
words, the point of operation of the firms would shift from the point N to the point I.

Consequently, both the firms would move to a higher iso-profit curve, i.e., both of them
would move to a lower level of profit. It may be noted also that in the cartel solution, total
amount of output produced by the duopolists was 1/2 of competitive output and each of
them had an equal share which was 1/4 of the competitive output.

Now, in the Cournot solution, total amount of output is larger being equal to 2/3 of
competitive output and each firm had an equal share, equal to 1/3 of competitive output.
Therefore, as the cartel breaks down, the firms now produce a larger quantity of output
and sell at a lower price, since the demand curve for the product is negatively sloped, and
earn a lower level of profit.

The economics here is very simple. Let us suppose that the two firms have agreed to
produce an equal share of the collusive, monopoly level of output. Now, if one of the firms
produces more output than its quota, it makes profit, say, πd where πd > πm.
That is, here the two firms agree to enter into a cartel. They agree to restrict production.
Consequently, the price goes up. Now one of them decides to produce more output to take
advantage of the high price. This is the standard temptation that a cartel member is easily
susceptible to.

Let us now look at the benefits and costs of cheating as opposed to those of normal cartel
behaviour. If each firm produces the cartel amount, then it gets a steady stream of payoffs
of Tin,. The present value (PV) of this stream is given by PV of Cartel behaviour = π m +
πm/r.
On the other hand, if the firm produces more than the cartel amount, it gets a one-time
benefit of profits πd, but then the cartel breaks up, and it would have to revert to the
Cournot behaviour to get a stream of payoffs of πc. Therefore, we have
PV of cheating = πd + πc/r
Obviously, the PV of cartel amount would be greater than the PV of cheating if
The above inequality implies that so long as the interest rate (r) is sufficiently small, the
expected return from cheating (i.e., the LHS of the inequality) is smaller than the expected
return of cartel over the Cournot return (i.e., the RHS of the inequality), and therefore, if
the above inequality is satisfied, the tendency to violate the provisions of the cartel
agreement would be eliminated. That is, the firms would now stick to their cartel quotas.

4 Key Benefits of AR and MR Curves

Key Benefit # 1.  Profit Determination:
The AR curve is the price line for the producer in all market situations. By relating the AR
curve to the AC curve of a firm, it can be found out whether it is earning supernormal or
normal profits or incurring losses. If the AR curve is tangent to the AC curve at the point of
equilibrium, the firm earns normal profits.

If the AR curve is above AC curve, it makes supernormal profits. In case the AR curve is
below the AC curve at the equilibrium point, the firm incurs losses.

Key Benefit # 2. Determination of Full Capacity:

It can also be known from their relationship whether the firm is producing at its full
capacity or under capacity. If the AR curve is tangent to the AC curve at its minimum point,
(as under perfect competition) the firm produces at its full capacity. Where it is not so (as
under monopoly or monopolistic competition), the firm possesses idle capacity.

Key Benefit # 3. Equilibrium Determination:

The MR curve when intersected by the MC curve determines the equilibrium position of
the firm under all market situations. Their point of intersection in fact determines price,
output, profit or loss of a firm.

Key Benefit # 4. Factor-Pricing Determination:

The use of the average-marginal revenue helps in determining factor prices. In factor-
pricing, they are inverted U-shaped and the average and marginal revenue curves become
the average revenue productivity and marginal revenue productivity curves (ARP and
MRP) and are useful tools in explaining the equilibrium of the firm under different market
conditions.
Q.5. Oligopoly market.
Ans: Done before

Q.6. What is Price War and what do you mean by Price Leadership? Who and Under
What circumstances price leadership is a helpful exercise for firms in oligopoly.
Ans: What Is a Price War?
A price war is a competitive exchange among rival companies who lower the price points
on their products, in a strategic attempt to undercut one another and capture greater
market share. A price war may be used to increase revenue in the short term, or it may be
employed as a longer-term strategy.

Price wars can be prevented through strategic price management, that relies on non-
aggressive pricing, a thorough understanding of the competition, and even robust
communication with competitors.

 
Price wars should be entered into cautiously because pricing most significantly impacts a
company income statement's bottom line; a 1% price drop can slash profits by more than
10%.
Understanding Price Wars
When a company seeks to increase market share, the easiest way typically is to reduce
prices, which subsequently increases product sales. The competition may be forced to
follow suit if it sells similar products. And as prices drop, the quantity of sales increases,
which consequently benefits customers.

Eventually, a price point is reached that only one company can afford to offer, while still
remaining profitable. Some companies will even sell at a loss in an attempt to eliminate
the competition completely.

Price wars are often short-lived and intense periods when competing businesses lower
their prices in a bid to win extra market share, generate improved cash-flow and perhaps
increase total revenues.

Price wars are common in industries where – perhaps after a period of relative price
stability – one firm decides to make an aggressive move on rivals and undercut
prices. Game theory can be used to help explain why it might be in the rational self-
interest of each business to set low prices given that they expect their rivals to do the
same.

Recent examples of price wars

Recent examples include a price war between the supermarkets in the UK petrol retail
industry involving Asda, Morrisons and Tesco. Read more about this here.
Another example of a price war is in the low-cost airline market caused in part by over-
capacity on some routes. Read more about this here.

The leading supermarkets often engage in extensive price-cutting for staple products after
Christmas when budgets are tight, and many families are even more price-sensitive than
usual. Read more about this here.

We can find examples of price wars in many other markets including price discounting in
cinemas, the UK funeral industry, the mortgage market and the online film streaming
industry (Hulu v Netflix)

Market share of petrol station outlets in the United Kingdom in 2017, by brand

Advantages of price wars

Prices fall for consumers which leads to an increase in their real incomes (their disposable
incomes stretch further each month) and an increase in consumer surplus
Price wars can help bring down the annual rate of consumer price inflation

Price wars on staple / essential products might have a bigger impact on larger and
relatively low-income families. In this sense, aggressive price wars can have a progressive
effect on the distribution of real income and consumption

Disadvantages of price wars

Price wars are nearly always bad news for the majority of businesses that get locked into
them. Deep discounts on prices doesn’t necessarily increase revenues as this depends on
the coefficient of price elasticity of demand and also that rival firms will have also lowered
their prices in response.

Price cutting erodes profit margins and, in some cases, can lead to firms making losses and
at risk of leaving the market. Lower profits mean fewer resources are available to fund
capital investment. Consider for example a price war in broadband services. Ultimately
service providers need to make sufficient profit not only to meet the expectations of their
shareholders but also because the industry needs to invest huge amounts in increasing the
capacity and efficiency of telecoms infrastructure.

A balance might need to be struck between the short-term needs of customers to get the
best deal on their phones and the medium-term challenge of expanding the supply-side
capacity of the industry.

If some smaller firms with less backing eventually go out of business, then competition in
a market can be stifled and this might lead to higher prices for consumers in the long run.
Customers might then be left with less choice. Price wars squeeze out marginal firms and
can make a market less contestable than it once was.

Typically it is the bigger firms with deep pockets who can withstand a price war which –
for example – might lead to price reductions of 10 to 20 percent over a six month period.

Price wars which lower profits can also cause a decline in direct tax revenues to the
government from corporation tax which makes it harder for the state to achieve fiscal
balance.

PRICE LEADERSHIP
What Is Price Leadership?
Price leadership occurs when a pre-eminent firm (the price leader) sets the price of goods
or services in its market. This control can leave the leading firm's rivals with little choice
but to follow its lead and match the prices if they are to hold on to their market
share. Price leadership is common in oligopolies, such as the airline industry, in which a
dominant company sets the prices and other airlines feel compelled to adjust their prices
to match.
More About Price Leadership
Price leadership has a greater impact on goods or services that offer
little differentiation from one producer to another. Price leadership is also apparent
where levels of consumer demand make a particular price selected by the market leader
viable because consumers are drawn from competing products. Price leadership is
assumed to stabilize prices and maintain pricing discipline. In general, effective price
leadership works when

 The number of companies involved is small

 Entry to the industry is restricted
 Products are homogeneous
 Demand is inelastic, or less elastic
 Organizations have a similar long-run average total cost (LRATC)

LRATC, an economics metric, is the minimum or lowest average total cost at which a firm
can produce any given level of output in the long run, when all inputs are variable.

Types of Price Leadership

In business economics, there are three primary models of price leadership: barometric,
collusive, and dominant.

Barometric
The barometric model occurs when a particular firm is more adept than others at
identifying shifts in applicable market forces—like a change in production costs—which in
turn allows it to respond most efficiently—by initiating a price change, for instance. It is
possible for a firm with a small market share to act as a barometric leader if it is a good
producer, and attuned to trends in its market. Other producers follow its lead, assuming
that the price leader is aware of something that they have yet to realize. However, because
a barometric leader has very little power to impose its decisions on other firms in the
industry, its leadership might be short-lived.

Collusive
The collusive price-leadership model may emerge in an oligopoly as a result of an explicit
or implicit agreement among a handful of dominant firms to keep their prices in mutual
alignment. The smaller firms follow the price change initiated by the dominant firms. This
practice is most common in industries where the cost of entry is high, and the costs of
production are known. Such agreements can be illegal if the effort is designed to defraud
the public. There is a fine line between actual collusion, which is unlawful, and price
leadership—especially if the price changes are not related to changes in operating costs.

Dominant
The dominant model occurs when one firm controls the vast majority of market share in
its industry. The leading firm is flanked by small firms that provide the same products or
services, but which cannot influence prices. Often the dominant company ignores the
interests of the smaller companies. Therefore, dominant price leadership is sometimes
referred to as a partial monopoly. A drawback of this model is that the leader might
engage in predatory pricing by lowering its prices to levels that smaller firms cannot
sustain. Such practices that are aimed at hurting smaller companies are illegal in most
countries.

Further Considerations of Price Leadership

Potential advantages

 Increased profitability. If companies in a particular market follow a price leader by

setting higher prices, then all producers in that market stand to profit, as long as
demand remains steady.
 Fewer price wars. If companies of similar size comprise a particular market, then
without price leadership, price wars could ensue as each competitor tries to
increase its share of the market.
 Better-quality products. Increased profits often mean more revenue for companies
to invest in research and development (R&D) to design new products and deliver
more value to customers.
 Interdependence instead of rivalry. When firms in the same market choose a
parallel pricing structure instead of undercutting each other, it fosters a positive
environment conducive to growth for all companies.

Potential disadvantages

 Unfair to smaller firms. Small firms who attempt to match a leader's prices may not
have the same economies of scale as the leaders, which could make it hard for them
to sustain consistent price declines, and even to survive in business.
 High prices for customers. In any price-leadership model, it is the sellers who will
benefit from increased revenues, not the consumers. Customers will need to pay
more for items that they were used to getting for less before the sellers conspired to
raise prices.
 Could lead to malpractices. Rival organizations might not follow the leader's prices
—choosing instead to engage in aggressive promotion strategies such as rebates,
money-back guarantees, free delivery services, and installment payment plans.
 A discrepancy in benefits. If it costs the leader less capital to produce the same
product than it costs a follower, then the leader would set lower prices, which would
result in a loss for the follower.

Real World Example—Southwest Airlines

Price leadership is a common strategy to boost revenues and profits among large
corporations.
Southwest Airlines Co.
Southwest Airlines (LUV) is a definite price leader. Since its inception, the company's
mission has been to offer the most competitively priced flights on the market, and it has
not deviated from that goal. Through the end of 2017, the company posted 45 consecutive
years of profitability.

How does Southwest maintain its role as price leader?

Because the airline industry is fiercely competitive, volatile, and economically sensitive, it
is difficult to become a price leader in that arena. In addition to being consistently
profitable, Southwest has even garnered market share from its competitors. Southwest
offers the lowest prices possible by being more efficient in its operations.

Low costs

 Buying the same brand of an airframe (Boeing) helps Southwest to keep its
maintenance and training costs low.
 The average age of Southwest's fleet is around 12 years. So, the company can retrofit
its planes effectively, and save money by not needing to purchase new ones as often.
 Southwest has always been a no-frills airline. They have never sold food or offered
other amenities. The carrier passes these savings on to customers in the form of
more low-priced solutions. 
 Rather than trying to be all things to all people, Southwest has focused on catering
to consumers who want cheap, quick, and painless fight plans.

Efficiency

 Southwest's flight crews begin cleaning a plane even before the passengers have
finished disembarking. This speed helps to ensure quick turnarounds at the gate,
which in turn means more revenues for the company.
 The company also has escalated its boarding process because Southwest
understands that they only make money when their planes are in the air.
 Southwest offers only nonstop, point-to-point service. Because airports with more
point-to-point flights typically have less air traffic than others, Southwest can
schedule more trips, which minimizes downtime, and maximizes employee
productivity.
 Instead of trying to fly everywhere at the expense of efficiency, Southwest Airlines
concentrates on becoming excellent in the cities it does serve.

What is a Price Leader?

A price leader is a company that exercises control in determining the price of goods and
services in a market. The price leader’s actions leave the other competitors with few or no
options other than to adjust their prices to match the price set by the price leader.
 

Price leaders are usually large firms in the industry that incur the lowest production
costs and, therefore, are in a position to undercut the prices charged by their competitors.
Other players who are not comfortable with the price leader’s prices may still charge
higher prices, but it will result in a reduced market share for their goods or services.

Types of price leadership

Price leadership comprises three types, which include:

Barometric model
In the barometric model, a small but efficient company positions itself as a leader in
identifying and adapting to changing market conditions better than other firms in the
market. Once a company establishes itself as the first to spot market changes, competitors
will follow its lead rather than wait to discover the anticipated market changes on their
own. They will follow the agile company with the assumption that the firm knows
something about the market that the other competitors are yet to realize.

Dominant firm
A dominant firm is a company that controls a significant proportion of the market share
within an industry. It is surrounded by other small firms that provide the same products
or services as the dominant firm. As the firm changes its prices according to the forces of
supply and demand, the smaller firms must adjust their prices as well in order to retain
the small market share that they control.

However, the dominant company may engage in predatory pricing by lowering their
prices to levels that are unsustainable to smaller firms. Such practices that are aimed at
hurting the smaller companies are illegal in most countries.

Collusive model
The collusive model is prevalent in oligopoly markets, where a group of market leaders
colludes to set prices for products or services. Smaller firms must adjust their prices to
match those of the large firms. Collusive models are considered illegal if their purpose is to
defraud the public.

 
Conditions under which price leadership occurs

Several factors contribute to price leadership, including:

Large market share

Large companies often have a large capacity and the ability to serve a substantial number
of customers in various locations. They give the company the ability to set prices for the
market since it has considerable control over its competitors. The smaller firms will have
no choice other than to match their products with those of the price leader if they want to
continue enjoying the small market share that they currently hold.

Trend knowledge
Some companies excel in identifying industry trends that are likely to affect their
profitability. They implement preventive measures by adjusting prices to reflect the
expected changes in the market. Other industry players that do not have the capacity to
identify important trends may choose to match the price leader’s prices rather than invest
a lot of money and time to gain the same level of knowledge.

Technology
Ownership of a patented technology may influence a company’s decision to charge a
premium price for its products or services. The company may want to establish itself as a
producer of high-quality products or services that people can trust and buy. Other firms
that do not have the technology may lower their prices to prevent the risk of losing market
share, even as they try to acquire the technology.

Superior execution
A company may be popular for its better execution methods than its competitors, giving it
an opportunity to charge a higher price per unit. The practice is often applicable in
industries that bill an hourly rate or on a per contract basis. Customers prefer working
with companies that are productive and that deliver quality output on the contracted
work, even at a premium price.

Advantages of price leadership

A price leader enjoys the following benefits:

 
Profitability
Where the price leader sets high product prices and competitors implement the price
changes, then the company and the other players will enjoy high profits as long as
consumer demand remains steady. Also, where the competitors replicate the price
leader’s actions, it ensures that the price leader does not lose the significant market share
it enjoys to the competitors.

Reduces price wars

Where the market comprises companies of the same size, there is likely to be price wars
as each competitor tries to increase its market share. However, when one company
establishes itself as the market leader, there is likely to be fewer price wars as the small
competitors try to safeguard their market share. Instead, they will adjust the prices of
their products and services to correspond to the prices set by the price leader.

Better quality products

When a company establishes itself as a price leader, it increases its annual revenues, some
of which are used to design new products and improve product quality. Customers want
to pay a premium price for a premium product, and the company can only deliver it when
its activities are profitable. Profits earned from its current products can be re-invested in
research and development to find new ideas that will help the company deliver value to its
customers.

Disadvantages of price leadership

A price leader faces the undesirable consequences below:

Unfair competition
Price leaders may use operating synergies to mark down their products to levels that are
unmanageable by small competitors. Since the small competitors do not enjoy the same
operating synergies as the price leaders, they will attempt to lower their prices in a bid to
retain their market share. However, where the small firms maintain the low prices over an
extended period, they will become unprofitable and eventually fold up.

 
High product/service prices
When a price leader increases the price of its products or services, the competitors will
follow the lead or collude to increase prices. However, the effect of such increases is that
sellers will benefit from increased revenues whereas consumers will be compelled to pay
more for products and services that they acquired cheaply before the sellers conspired to
raise prices.

Additional resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst
(FMVA)™ certification program, designed to help anyone become a world-class financial
analyst. To keep advancing your career, the additional resources below will be useful:

 Absolute Advantage
 Capitalism
 Market Economy
 Natural Monopoly

Price Leadership (With 3 Forms and Diagrams)

Another form of collusion is price leadership. In this form of coordinated behaviour of
oligopolists one firm sets the price and the others follow it because it is advantageous to
them or because they prefer to avoid uncertainty about their competitors’ reactions even
if this implies departure of the followers from their profit-maximizing position.

Price leadership is widespread in the business world. It may be practiced either by explicit
agreement or informally. In nearly all cases price leadership is tacit since open collusive
agreements are illegal in most countries.

Price leadership is more widespread than cartels, because it allows the members complete
freedom regarding their product and selling activities and thus is more acceptable to the
followers than a complete cartel, which requires the surrendering of all freedom of action
to the central agency. If the product is homogeneous and the firms are highly concentrated
in a location the price will be identical. However, if the product is differentiated prices will
differ, but the direction of their change will be the same, while the same price differentials
will broadly be kept.

There are various forms of price leadership.

The most common types of leadership are:

(a) Price leadership by a low-cost firm.

(b) Price leadership by a large (dominant) firm.

(c) Barometric price leadership.

These are the form of price leadership examined by the traditional theory of leadership as
developed by Fellner and others. The characteristic of the traditional price leader is that
he sets his price on marginalistic rules, that is, at the level defined by the intersection of
his MC and MR curves. For the leader the behavioural rule is MC = MR. The other firms are
price-takers who will not normally maximise their profit by adopting the price of the
leader. If they do, it will be by accident rather than by their own independent decision.

A. The Model of the Low-cost Price Leader:

We will illustrate this model with an example of duopoly. It is assumed that there are two
firms which produce a homogeneous product at different costs, which clearly must be sold
at the same price. The firms may have equal markets (or they may come to an agreement
to share the market equally) as in figure 10.7, or they may have unequal markets (or agree
to share the market with unequal shares), as in figure 10.8. The important condition for
this model is that the firms have unequal costs.
The firm with the lowest cost will charge a lower price (P A) and this price will be followed
by the high-cost firm, although at this price firm B (the follower) does not maximize its
profits. The follower would obtain a higher profit by producing a lower output (X Be) and
selling it at a higher price (PB). However, it prefers to follow the leader, sacrificing some of
its profits in order to avoid a price war, which would eliminate it if price fell sufficiently
low as not to cover its LAC. It should be stressed that for the leader to maximize his profit
price must be retained at the level PA and he should sell XA. This implies that the follower
must supply a quantity (0XB in figure 10.8, or OX1 = OX2 in figure 10.7) sufficient to
maintain the price set by the leader.
Although the price- leadership model stresses the fact that the leader sets the price and
the follower adopts it, it is clear that the firms must also enter a share-of-the-market
agreement, formally or informally, otherwise the follower could adopt the price of the
leader but produce a lower quantity than the level required to maintain the price (set by
the leader) in the market, and thus push (indirectly, by not producing enough output) the
leader to a non-profit-maximising position.

In this respect the price follower is not completely passive he may be coerced to adopt the
leader’s price, but, unless tied by a quota-share agreement (formal or informal) he can
push the leader to a non-maximising position.

B. The model of the Dominant-firm Price Leader:

In this model it is assumed that there is a large dominant firm which has a considerable
share of the total market, and some smaller firms, each of them having a small market
share. The market demand (DD in figure 10.9) is assumed known to the dominant firm.
It is also assumed that the dominant leader knows the MC curves of the smaller firms,
which he can add horizontally and find the total supply by the small firms at each price; or
at best that he has a fair estimate, from past experience, of the likely total output from this
source at various prices. With this knowledge the leader can obtain his own demand curve
as follows.

At each price the larger firm will be able to supply the section of the total market not
supplied by the smaller firms. That is, at each price the demand for the product of the
leader will be the difference between total D (at that price) and the total S 1. For example,
at price P1 the demand for the product of the leader will be zero, because the total quantity
demanded (D1) is supplied by the smaller firms.
As price falls below P1 the demand for the leader’s product increases. At P2 the total
demand is D2; the part P2 A is supplied by the small firms and the remaining AD2 is
supplied by the leader. At P3 total demand is D3 and the total quantity is supplied by the
leader since at that price the small firms do not supply any quantity. Below P 3 the market
demand coincides with the leader’s demand curve.
Having derived his demand curve (dL in figure 10.10) and given his MC curve, the
dominant firm will set the price P at which his MR = MC and his output is 0x. At price P the
total market demand is PC, and the part PB is supplied by the small firms followers while
quantity BC = 0x is supplied by the leader.
The dominant firm leader maximises his profit by equating his MC to his MR, while the
smaller firms are price-takers, and may or may not maximise their profit, depending on
their cost structure. It is assumed that the small firms cannot sell more (at each price)
than the quantity denoted by S1. However, if the leader is to maximise his profit, he must
make sure that the small firms will not only follow his price, but that they will also
produce the right quantity (PB, at price P). Thus, if there is no tight sharing-the- market
agreement, the small firms may produce less output than PB and thus force the leader to a
non-maximising position.
C. Barometric Price Leadership:
In this model it is formally or informally agreed that all firms will follow (exactly or
approximately) the changes of the price of a firm which is considered to have a good
knowledge of the prevailing conditions in the market and can forecast better than the
others the future developments in the market. In short, the firm chosen as the leader is
considered as a barometer, reflecting the changes in economic environment.

The barometric firm may be neither a low-cost nor a large firm. Usually it is a firm which
from past behaviour has established the reputation of a good forecaster of economic
changes. A firm belonging to another industry may also be chosen as the barometric
leader. For example, a firm in the steel industry may be agreed as the (barometric) leader
for price changes in the motor-car industry. Barometric price leadership may be
established for various reasons.

Firstly, rivalry between several large firms in an industry may make it impossible to
accept one among them as the leader. Secondly, followers avoid the continuous
recalculation of costs, as economic conditions change. Thirdly, the barometric firm usually
has proved itself as a ‘reasonably’ good forecaster of changes in cost and demand
conditions in the particular industry and the economy as a whole, and by following it the
other firms can be ‘reasonably’ sure that they choose the correct price policy.
Price Leadership under Oligopoly (With Diagram)
Price Leadership under Oligopoly: Types, Price-Output Determination and Feedback!
In certain situations, organizations under oligopoly are not involved in collusion.

There are a number of oligopolistic organizations in the market, but one of them is
dominant organization, which is called price leader.
Price leadership takes place when there is only one dominant organization in the industry,
which sets the price and others follow it.

Sometimes, an agreement may be developed among organizations to assign a leadership

role to one of them. The dominant organization is treated as price leader because of
various reasons, such as large size of the organization, large economies of scale, and
advanced technology. According to the agreement, there is no formal restriction that other
organizations should follow the price set by the leading organization. However, sometimes
agreement is formal in nature.

Price leadership is assumed to stabilize the price and maintain price discipline.

This also helps in attaining effective price leadership, which works under the
following conditions:
i. When the number of organizations is small

ii. Entry to the industry is restricted

iii. Products are homogeneous

iv. Demand is inelastic or less elastic

v. Organizations have similar cost curves

Types of Price Leadership:

Price leadership helps in stabilizing prices and maintaining price discipline. There are
three major types of price leadership, which are present in industries over a passage of
time.

These three types of price leadership are explained as follows:

i. Dominant Price Leadership:
Refers to a type of leadership in which only one organization dominates the entire
industry. Under dominant price leadership, other organizations in the industry cannot
influence prices. The dominant organization uses its power of monopoly to maximize its
profits and other organizations have to adjust their output with the set price.

The interests of other organizations are ignored by the dominant organization. Therefore,
dominant price leadership is sometimes termed-as partial monopoly. Price leadership by
the leading organization is most commonly seen in the industry.

ii. Barometric Price Leadership:

Refers to a leadership in which one organization declares the change in prices at first and
assumes that other organizations would accept it. The organization does not dominate
others and need not to be the leader in the industry. Such type of organization is known as
barometer.
This barometric organization only initiates a reaction to changing market situation, which
other organizations may follow it if they find the decision in their interest. On the
contrary, the leading organization has to be accurate while forecasting demand and cost
conditions, so that the suggested price is accepted by other organizations.

Barometric price leadership takes place due to the following reasons:

a. Lack of capacity and desire of organizations to estimate appropriate supply and demand
conditions. This influences organizations to follow price changes made by the barometric
organization, which has a proven ability to make correct forecasts.

b. Rivalry among the organizations may make a leader, which can be unacceptable by
other organizations. Thus, most of the organizations prefer barometric price leadership.

iii. Aggressive Price Leadership:

Implies a leadership in which one organization establishes its supremacy by threatening
the organizations to follow its leadership. In other words, a dominant organization
establishes leadership by following aggressive price policies and forces
other/organizations to follow the prices set by it.

Price-Output Determination under Price Leadership:

Price leadership takes place when there is only one dominant organization in the industry,
which sets the price and others follow it. Different economists have developed different
models for determining price and output in price leadership.

Here, we would discuss a simple model for determining price and output in price
leadership, which is shown in Figure-4:

Suppose there are two organizations, A and B producing identical products where
organization A has a lower cost of the production than organization B. Therefore,
consumers are indifferent between these two organizations due to identical products. This
implies that both the organizations would face same demand curve, which further
represents equal market share.

In Figure-4, DD is the demand curve of both the organizations and MR is their marginal
revenue. MCa and MCb are the marginal cost curves of organization A and B respectively.
As stated earlier, the cost of production of organization A is less than B, thus, MC a is drawn
below MCb.
Let us first start the discussion of price leadership with the case of organization A. The
profits of organization A would be maximized at a point where MR intersects MC a. At this
point, the output of organization A would be OQ with the price level OP. On the other hand,
the profits of organization B would be maximized at a point where MR intersects MC b with
output OQ1 and price OP1.
In such a case, the price of organization B is more as compared to organization A.
However, both the organizations have to charge the same price as products are
homogeneous. In this case, organization A is the price leader and organization B is the
follower.

Thus, organization A will dictate the price to organization B. Both the organizations will
follow the same output, OQ and price OP. However, the profits earned by organization B
are less than A, as it has to produce at price OP which is less than its profit maximizing
price, OP1. In addition, the organization B also has high costs of production that leads to
lower profits at price OP1.
Drawbacks of Price Leadership:
The price leadership suffers from various drawbacks.

These are discussed as follows:

i. Makes it difficult for the price leader to assess the reactions of followers.

ii. Leads to malpractices, such as charging lower prices by rival organizations in the form
of rebates, money back guarantees, after delivery free services, and easy installment
facility. The prices charged by rival organizations are comparatively less than the prices
set by the price leader.

iii. Leads to non-price competition by rival organizations in the form of aggressive

promotion strategies.

iv. Influences new organizations to enter into the industry because of price rise. These
new organizations may not follow the leader of the industry.

v. Poses problems if there are differences in cost of price leaders and price followers. In
case, if cost of production of price leader is less, then he/she would fix lower prices. This
will lead to a loss for a price follower if his/her cost of production is more than the price
leader.