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Market Structure and Pricing

Practices in Monopoly
Learning Outcome

• What is monopoly
• Features of Monopoly
• Real Indian and Global examples of Monopoly.
• Analysis of monopoly power through case study.
• Price Determination under Monopoly in short run
and long run
What is Monopoly?

Monopoly is market situation where there is only


one provider of a product or service.
Examples of Monopoly in the real world in India
• Indian Railways has monopoly in rail road transportation.

• Punjab State Power Corporation Ltd. has monopoly over


generation and distribution of electricity in the Punjab state.

• Coal India has the single monopoly in production and


marketing of coal

• Hindustan Aeronautical Ltd has monopoly over production of


aircraft.
Global Examples

• Gillette-the only significant brand in shaving


products specially in Mach3.
• Apple and iOS
• Alcoa-Aluminium Company of America (50 years
monopoly)
• Alcoa-Aluminium Company of America (50 years
monopoly).
• The monopoly was created in late nineteenth
century when Alcoa acquired a patent to remove
oxygen from bauxite to obtain aluminum
How can we identify the monopoly situation ???

1. Single seller and many buyers


2. No close substitutes for product
3. Price maker
4. Entry Barrier
5. Independent decision making
6. AR>MR
Entry Barrier

a) Significant barriers to resource mobility


b) Control of an essential input
c) Patents or copyrights
d) Economies of scale
e) Regional Monopoly--Geographical or territorial
aspects also help in creation of monopolies.
PRICE DISCRIMINATION

Necessary Conditions
– Existence of monopoly power – price discrimination can
occur only if monopoly power exists and there are no
competitors in the market
– Existence of different degree of elasticity of demand –
monopolist can charge higher price for inelastic market and
lower price for elastic market
– No resale – product purchased in the low-priced market
should not be resold in the high-priced market
– Legal sanction – government allows the public utility firms
such as electricity to charge different prices from different
consumers
Demand and MR Curves

 The demand curve of the


Revenue, monopolist is highly price
Cost
inelastic because there is no
close substitute and
consumers have no or very
little choice.
 Hence it faces a normal
downward sloping demand (AR)
AR curve.
MR
O  MR curve corresponds.
Quantity

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Indian Railway: The best example of
monopoly in India
• The development of railway had its roots in the
1800’s.
• State owned railway company of India
• First introduced in 1853 in India.
• Recently railway started advertising and
promotional schemes to attract the passengers.
Railways reduces travel insurance to
just one paisa from 92 paise
• In a "Diwali bonanza" ahead
of the festival, rail
passengers can now avail
travel insurance scheme at
just one paisa.
Price Determination under Monopoly

Monopoly

Short Period Long Period

Supernormal profits Normal profits Losses Supernormalprofits


Price Discrimination
 Discrimination among buyers on the basis of the price charged for the same
good (or service).

 Objective is to maximise sales

Preconditions of Price Discrimination


 Market control

 Division of market

 Different price elasticity of demand in different markets

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Bases of Price Discrimination
 Personal
 Geographical
 Time
 Purpose of use

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MCQ

1. The following are key features of a monopoly EXCEPT


A) diseconomies of scale. B) no close substitutes.
C) influence over price. D) barriers to entry.

2. Which of the following statements about a monopoly is FALSE?


A) A monopoly is the only supplier of the good.
B) Monopolies have no barriers to entry or exit.
C) The good produced by a monopoly has no close substitutes.
D) None of the above; that is, all of the above answers are true statements
about a monopoly.
3. Patents create monopolies by restricting
A) prices B) profit C) entry D) demand
4. A defining characteristic of a natural monopoly is that
A) it exists because of legal barriers to entry.
B) it has no close substitutes.
C) its average total cost curve slopes downward as it intersects the demand
curve.
D) its demand curve slopes downward.
5. All of the following are examples of price discrimination EXCEPT
A) lower ticket prices for matinee performances.
B) buy-one-get-one-free offers.
C) "early bird specials" at a restaurant.
D) "buy now, pay later" payment options.
6. For a monopoly, the industry demand curve is the firm's
A) profit function. B) marginal revenue curve.
C) supply curve. D) average revenue curve.
Monopolistic Competition
• Imperfect competition refers to those market

structures that fall between perfect competition

and pure monopoly.


MONOPOLISTIC COMPETITION

– Market structure in which there are many numbers

of sellers selling differentiated products but these

are close substitute products and have easy entry

into and exit from the market.


Characteristics of Monopolistic
Competition
1. Many Sellers
– There are many firms competing for the same group of
customers.
• Product examples include books, CDs, restaurants, cookies,
etc.
2. Product Differentiation
– Each firm produces a product that is at least slightly
different from those of other firms.
Toothpaste Industry

• Colgate-All round dental protection


• Promise-The first to highlight the advantages of
clove oil
• Close up-First get toothpaste and offers the
goodness of milk calcium
• Meswak-Promises ayurvedic content
• Babool-Natural toothpaste contaning ayurvedic and
medical benefits of the babool tree.
• Dabur Red- A paste for Teeth and Gums
Apparels Industry

• Van Heusen: Workwear


• John Millers: Cool pant rage of trousers to keep you
cool
• Raymonds: Formal is not boring
• Allen Solly: Light colors and eco friendly
• Arrow: Professioanl power dressing
And the list goes on………………………..
Product Differentiation
• Quality
• Color
• Packaging
• Brand name
• After sales services
• Design
• Trade mark
• Location of selling
• Advertising
Benefits of Product
Differentiation???
Benefits of Product Differentiation

• Unique product (Real or Imaginary)


• Higher price
• Customer loyalty
3. Downward Sloping Demand Curve Rather than being a
price taker, each firm faces a downward-sloping demand
curve.
MONOPOLISTIC COMPETITION (cont.)

The demand curve for monopolistic competitive firm is


downward sloping due to product differentiation.
Price

Demand curve for monopolistic


competitive firm is more elastic
than demand curve for
monopolist firm because in
monopolistic competition there
AR=P are many firms and many
substitutes.

MR

Quantity
4. Free Entry or Exit
• Firms can enter or exit the market without
restriction.
5. Role of non-price competition is significant – various
methods used to attract the customers to buy a particular brand.
(Attractive packaging , higher commission to distributors, sales
promotion, advertisement etc.)

6. Selling cost –expenditure on advertisement would incur


additional cost .
Price Determination under
Monopolistic Competition
Monopolistic
Competition

Short Period Long Period

Abnormal Normal Normal


Losses
profits profits profits
PROFIT MAXIMIZATION IN SHORT RUN
Monopolistic competitive firm earns economic profit
At this output, the firm earns
Economic profit or economic profit or supernormal The profit maximization
supernormal profit profit equal to the shaded area. level occurs where MR
is the profit earned curve and MC curve
Price (RM) MC
by a monopolist intersects at Point A.
competitive firm
when TR > TC. ATC
To find the price, we use the
same vertical line with
output up to the demand
curve. The profit maximizing
P* price and output is
PROFIT
AC P* and Q*.
A
DD = AR

MR

Quantity
Q*
PROFIT MAXIMIZATION IN SHORT RUN (cont.)
Monopolistic competitive firm at break-even
Normal profit or break-even is The profit maximization
earned when TR = TC. level occurs where MR
curve and MC curve
Price (RM) At this output, monopolistic
MC
intersects at Point A.
competitive firm is at the break-
even or earns normal profit. ATC

The profit maximizing price


and output is P* and Q*.

AC/ P*

DD = AR

MR

Quantity
Q*
PROFIT MAXIMIZATION IN SHORT RUN (cont.)
Monopolistic competitive firm suffers economic losses
Economic losses or subnormal At this output, monopolist suffers economic losses
profit is the losses incurred by a or subnormal profit equal to the shaded area.
monopolistic competitive firm when
Price (RM) ATC
MC
TR < TC.

The profit maximization level


occurs where MR curve and
AC MC curve intersect at Point
LOSSES A.
P*
The profit maximizing price
A and output is P* and Q*.

DD = AR

MR

Quantity
Q*
PROFIT MAXIMIZATION IN LONG RUN
Monopolistic competitive firm earns normal profit in long run

A monopolistic competitive
firm earns normal profit in
Price (RM) the long run due to free LRMC
entry and exit.

LRATC

P*

DD = LRAR

LRMR

Q*
Quantity
MCQ

1. The following are key features of a monopoly EXCEPT


A) diseconomies of scale. B) no close substitutes.
C) influence over price. D) barriers to entry.

2. Which of the following statements about a monopoly is FALSE?


A) A monopoly is the only supplier of the good.
B) Monopolies have no barriers to entry or exit.
C) The good produced by a monopoly has no close substitutes.
D) None of the above; that is, all of the above answers are true statements
about a monopoly.
OLIGOPOLY

– Market structure in which there are only a few firms selling


either standardized or differentiated products and it restricts the
entry into and exit from the market.
World Scientific, 2007
Characteristics

– Few numbers of firms

– Homogeneous or differentiated product

– Barriers to entry

– Price War

– Non-pricing strategies

– Interdependence
Reliance Jio entry may hit top telcos’
earnings

• Reliance Jio Infocomm’s


entry is set to partly affect
the earnings of India’s
largest three telcos —Bharti
Airtel, Vodafone India and
Idea Cellular
OLIGOPOLY

• Price Rigidity and Kinked Demand Curve


– Since there is mutual interdependence between oligopoly firms,
the prices in the market are more stable. This is called price
rigidity in oligopoly market.

– The price rigidity explains the behaviour of an oligopoly firm that


has no incentive to increase or decrease the price.
OLIGOPOLY

– The theory of the kinked demand curve is based on two


assumptions.

1. First assumption: If an oligopolist reduces its price, its rivals will follow and
cut their prices to prevent losing the customers.

2. Second assumption: If an oligopolist increases its price, its rivals do not


increase the price and keep their prices the same, thereby they gain
customers from the firm that increases the price.
OLIGOPOLY (cont.)
Because of this According to the assumption, An oligopoly firm faces
assumption, an when the firm increases the two demand curve,
oligopolist faces kinked price (P*), no other firms will individual demand
Price (RM) demand curve. follow. Above P*, the firm will curve (dd) and industry
follow the dd curve. demand curve (DD).
If the firm decreases the price,
other firms will follow. Below
P*, the firm follow the DD
curve.

P*

dd

DD

Q* Quantity
OLIGOPOLY (cont.)

This shows the price rigidity At this range of MR, any The kinked demand
in the oligopoly market. change in the MC does not curve below Point E
reflect changes in the profit creates a gap in the
Price (RM)
maximizing price and output. MR, which is indicated
by the dotted line ab.

MC1
MC2
E
P*

b DD

Q*
MR Quantity
Duopoly

• Duopoly is that type of oligopoly in which only two players


operate (or dominate) in the market.
• Used by many economists like Cournot, Stackelberg, Sweezy, to
explain the equilibrium of oligopoly firm, as it simplifies the
analysis.
Price and Output Decisions
• No single model can explain the determination of equilibrium
price and output
– Difficult to determine the demand curve and hence the revenue curve of
the firm
– Tendency of the firm to influence market conditions by various activities
like advertisement, and fear of price war resulting in price rigidity.
Cournot’s Model

• Augustin Cournot illustrated with an example of two firms


engaged in the production and sale of mineral water.
• Each firm owns a spring of mineral water, which is available free
from nature.
Assumptions
• Each firm maximizes profit.
• Cost of production is nil because the springs are available free from
nature, i.e. MC=0.
• Market demand is linear; hence the demand curve is a downward sloping
straight line.
• Each firm decides on its price assuming that the other firm’s output is
given (i.e. the other firm will continue to produce and sell the same
amount of output in next period).
• Firms sell their entire profit maximizing output at the price determined
Cournot’s Model
Period 1: Firm A: ½ (1) = ½
Firm B: ½ (1/2)= 1/4
Period 2: Firm A: ½ (1-1/4)= 3/8
Firm B: ½ (1-3/8) =5/16
Period 3: Firm A: ½ (1-5/16)=11/32
Firm B: ½ (1-11/32)= 21/64
Period 4: Firm A: ½ (1-21/64) = 43/128
Firm B: ½ (1-43/128)=85/256 ………
Period N: Firm A: ½ (1-1/3) =1/3
Firm B: ½ (1-1/3) = 1/3

Thus A’s output is declining progressively (with ratio=1/4), whereas B’s output
Cournot’s Model
• Firm A produces profit maximising
Price, output (OQA) at MR=MC=0 and
Reven D sells half of the total market
ue,
Cost demand (Half of OD*).
• Point A is the mid point of market
A demand DD*.
P
• Firm B assumes A will continue to
A
B produce OQA ,so considers QAD*
P as the market available to it and
B AD* as its demand curve. Its MR
O D*=A curve will be MRB.
Q Q Quan
M M R • B maximizes profit and produces
RB tity
A B
RA QAQB.
• Thus A and B together supply to
three fourths of the total market,
while one fourth remains
unattended.
Collusive Oligopoly
• Rival firms enter into an agreement in mutual interest on various
accounts such as price, market share, etc.
• Explicit collusion: When a number of producers (or sellers) enter into
a formal agreement.
• Tacit collusion/Implicit: A collusion which is not formally declared.
• Cartel
• Agreement price and output.
• Small number of sellers with homogeneous product.
• Price fixation, total industry output, market share, allocation of
customers, allocation of territories, establishment of common sales
agencies, division of profits, or any combination of these.
Types of Cartels
• Two types:
• centralized cartels
• market sharing cartels.
Centralized Cartels
• Assuming the case of a cartel with
two firms facing same MR and AR
Price,
Cost,
MCB
∑MC • MCA = Firm A’s marginal cost
Revenue
MCA • MCB = Firm B’s marginal cost
• ∑MC = industry marginal cost
P
• OQ = profit maximizing output
because (MR=∑MC).
• OQA = A’ output
• OQB = B’s output
AR=D
MR • OQ=OQA + OQB; OQA > OQ B
• OP = price at which both firms can
O sell their output. Price will be
Quantity
QB QA Q determined by summation of all
firms’ costs and demand.
• In a cartel an individual firm is just
a price taker.
Market Sharing Cartels
Price, • Firms decide to divide the
Cost, market share among them and
Revenue fix the price independently.
MC AC
• All firms have the same cost
PA functions because they are
producing a homogenous
PB product but have different
demand functions.
ARA • Due to different demand
MRA functions, at equilibrium total
ARB
MRB output = OQA+ OQB, where
OQA> OQB.
O
Q B QA Quantity • The quantity of output produced
and sold would depend upon
the terms of agreement among
the firms in the cartel.
Factors Influencing Cartels

• Number of firms in the industry

• Nature of product

• Cost structure

• Characteristics of sales
Product Pricing
Take –away of today’s lecture
Introduction

• Price denotes two aspects:


• It is revenue to the seller and
• It is the perceived value of the good (or service) to the
buyer.

• Firms take pricing decisions when


– a new product is to be launched.
– a product is modified (or improved)
– entering a new market or a new market segment,
– change in cost of production
Cost Based Pricing

Cost Plus or Mark up Pricing

• Price of the product is the sum of cost plus a profit margin.


• Price arrived at would thus be:
Price = AC+ m, where m is the percentage of markup.
• Determinates of mark up:
• target rate of return
• degree of competition
• price elasticity and
• availability of substitutes.
Marginal Cost Pricing
(incremental cost pricing)
• Useful when demand is slack and market is highly
competitive.
• Full cost pricing may not be right choice, an alternate in such
a situation is to fix the price on the basis of variable cost.
Competition Based Pricing

Penetration Pricing
• When a new firm plans to enter a market dominated by existing players, it
charges a low price, even lower than the ongoing price.
• Principles of marginal costing are used in this case.
Entry Deterring Pricing

• If the prevailing price is already very low, new entrants with high fixed cost
will not enter the market at a price lower than the prevailing price.
• Existing small players may not survive due to higher average cost.
• Also known as Limit Pricing.

• Real Life Example of Limit Pricing: Aloca


Competition Based Pricing
Going Rate Pricing
• Adopted when most of the players do not indulge in separate pricing but
prefer to follow the prevailing market price.
• Normally the price is fixed by the dominant firm and other firms accept its
leadership and follow that price.
• Products sold by the players are very close substitutes
Product Life Cycle Based Pricing

Price Skimming
• A complete pricing package suitable for different life cycle
stages of a product, i.e. high price at the time of introduction
and lower price during maturity. (e.g. movie tickets, cars,
mobile handsets)
• During introduction stage producers charge a very high price
to skim the market and earn supernormal margins.
• During growth and maturity, sellers reduce their profit
margin and charge lower price to attract larger number of
consumers who have lower paying capacity.

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Informal and Tacit Collusion

• Formed when firms do not declare a cartel, but informally


agree to charge the same price and compete on non price
aspects.
Models of Oligopoly

1. Classical Models of Oligopoly


a. Cournot Model
b. Bertrand Model
2. Price Leadership Model
a. Price Leadership by Low-Cost Firm
b. Price Leadership by a Dominant Firm
c. Barometric Price Leadership
Cartels in the cement Industry

• India ranks second in the world in cement production. The cement


industry is highly fragmented as its faces tremendous pressure on price
realization. The demand for cement is price –elastic. Any imbalance in the
demand and supply leads to a disproportionate increase in the price.
Based on the season, the price is determined by the supply. When the
cement manufacturers increase their capacities, the enhanced capacity
leads to excess supply. As the supply is more than demand, cement prices
fall and demand picks up, leading to an increase in price.
• Since cement production is highly capital-intensive, profit margins are
low. The declining profit margins have prompted cement companies to
form cartels. For example, five big players in the industry cut production
by 10% and managed to increase profit by 50%.
• There are two important factors affecting cement production, namely,
sales tax benefits, and the direct cost incurred in production. Sales tax
incentive varies from state to state. Tamil Nadu offers sales tax
exemption for seven years and the payment can be deferred up to 14th
year. Gujarat offers exemption from sales tax for seven years. Based on
the cost structure and the freight and packing charges, the firm arrives at
its profit or loss. The price and supply of cement in a particular state is
fixed by local cartel. Profit margin depends upon incentives, direct costs,
and decisions of the cartel. The cartel decides the floor price and the sales
volume for individual members in a region. Normally, cement cartels do
not last into the long run; cartelization is more of a short-run
phenomenon.
• What are the reasons for the formation of cartels in the cement industry?

• Why cartels do exists only in the short run?

• What if cartels were not illegal?


• Suppose there are two fast food outlets in Jalandhar. Experience tells that

they have tried to engage in price war to win more customers but have not

gained substantially in terms of profits. Can these outlets collude to

increase profits? Defend your answer with justification.


• What is the role of non-price strategies in
oligopoly?
MCQ’S

1. Which of the following characterizes monopolistic competition?


A) Many interdependent firms sell a homogeneous product.
B) A few firms produce a particular type of product.
C) Many firms produce a particular type of product, but each maintains
some independent control over its own price.
D) A few firms produce all of the market supply of a good.
2. In monopolistic competition, a firm:
A) Has no market power.
B) Captures significant economies of scale
C) Has a downward-sloping demand curve.
D) Has a homogenous product that all firms produce.
if there are many firms in an industry producing goods that are similar but
3.

slightly different, this is an example of:


A) Perfect competition.
B) Monopolistic competition.
C) Oligopoly.
D) Monopoly.
4. Which of the following market structures is composed of many firms
producing close substitutes that are differentiated according to consumers?
A) Perfect competition.
B) Monopolistic competition.
C) Oligopoly.
D) Monopoly.
5. Which of the following is characteristic of monopolistic competition?
A) Many firms in an industry. C) market power.
B) High concentration ratios. D) All of the above
6. A major difference between monopoly and monopolistic competition is:
A) One maximizes profits by setting MR equal to MC, and the other does
not.
B) B) The number of firms in the market.
C) One type of firm has market power, and the other does not.
D) One has a downward-sloping demand curve, and the other does not.
7. One of the main differences between oligopoly and monopolistic
competition is:
A) Monopolistic competition faces a horizontal demand curve; oligopoly
does not.
B) The degree of interdependence among firms.
C) The amount of non-price competition that occurs.
D) All of the above.
8. Entry into a market characterized by monopolistic competition is
generally: A) Entirely blocked by existing firms.
B) Very easy because few barriers exist.
C) As difficult as in oligopoly.
D) More difficult than entry into monopolized markets.
9.Which of the following characterizes monopolistic competition?
A) Price leadership. B) Product differentiation. C) Price discrimination.
D) Economies of scale.
10. Product differentiation occurs when:
A) A completely new process is used to produce a familiar product.
B) One firm produces many varieties of a product.
C) Buyers, though not necessarily sellers, perceive differences in the
products of several companies.
D) Sellers, though not necessarily buyers, perceive differences in the
products of several companies.
11. Which of the following is an example of product differentiation?
A) Two bars of soap differ only in their label, but consumers pay $0.20 more
for the label they recognize.
B) Sugar can be made from sugar beets or sugar cane which consumers
cannot differentiate when looking at sugar.
C) Consumers substitute vans in place of cars because vans accommodate
more passengers.
D) Some sawmills specialize in producing softwood and others specialize in
producing hardwood, but the two types of wood are used for very different
purposes
11. Perfect competition and monopolistic competition are best distinguished
by:
A) The degree of product differentiation.
B) The long-run economic profits that are expected.
C) The number of firms in the market.
D) The ease of entry and exit.

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