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Monopoly and Price discrimination
Definition and Meaning of Monopoly:
“Monopoly” means absence of competition.
It is an extreme situation in imperfect
competition. It denotes a single seller or producer having the control over the market. A
monopoly may be defined as a condition of production in which a single person or a
number of persons acting in combination, having the power to fix the price of the
commodity.
The commodity produced by the monopolist has no substitutes.
It is a
situation where there exists single control over the market producing a commodity having
no substitutes and no possibility for anyone to enter the industry and compete. Single
control may mean a single producer or a joint stock organization or any organization,
governmental or Quasi governmental.
Monopolistic firm should have certain features to be identified as such. They are;
1) It has single seller.
2) The commodity produced should not have any close substitutes.
3) No freedom to other entrepreneurs to enter and compete with the existing seller.
4) The monopolist may use his monopolistic power in any manner in order to realise
maximum revenue. He may adopt price discrimination.
Since there is only one seller the distinction between the firm and industry disappears in
monopoly. The firm becomes the industry itself.
Kinds of monopoly:
Monopoly may be of different types.
It may be private monopoly, public or state
monopoly, simple monopoly, discriminating monopoly, absolute and limited monopolies.
Private and public monopolies:
When monopolistic control exists in private sector, we call it as private monopoly.
If the state controls the production and pricing of the commodity it is public or state
monopoly. Many of the public sector undertakings come under this category.
Pure monopoly:
It is a phenomenon which exists only in public sector. Production of a particular
commodity will be the exclusive privilege of the state or state sponsored undertaking.
Simple monopoly
There are larger possibilities of simple monopoly in the real world. It is a situation
where the single producer produces a commodity having only a remote substitute. In
pure monopoly there are no substitute commodities for the product produced by the
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monopoly firm.
substitute.
But in simple monopoly the producer of the firm may have some
But in economic theory and analysis we assume that the monopoly firm
produces a commodity having no close substitutes.
Discrimination monopoly
The monopolist may charge different prices for different customers or markets.
He has not only the power to fix the price of the commodity but also charge different
prices for different customers.
The monopolist will be discrimination between the
markets.
Determination of price in monopoly
It would be a mistake to suppose that the monopolist will always push up his prices
higher and higher. If he does so, he must consider the effect of such a procedure on
demand which will shrink as price rise. The monopolist cannot compel the consumer to
buy at higher prices. A very important point to be borne in mind is that unlike competitive
firm, a monopolist firm will have a downward sloping demand curve and his average
revenue will
fall as the output is increased, because the buyers will take up larger
quantities only at lower. The monopolist can charge a higher, but he will sell less. If he
wants to sell more, he has to lower his price.
D
Price
Y
K2
R2
R
K
D
O
M2
M
X
Output
In the diagram, DD is the demand curve.
According to this diagram, the
monopolist cannot for example fix his output at one and expect to be able to sell at OK2
price per unit. If he decides to fix the price at OK2 the output has to be automatically
fixed by him at OM2, because at OK2 price he can sell only OM2 units. Out of any
number of possible prices, the monopolist endeavors to choose that price which yields
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here the highest net monopoly revenue. Net monopoly revenue is the profit realized by
the monopolist by selling the commodity at a particular price.
Price determination under monopoly depends on two factors. The nature of
demand for the commodity produced by the monopolist and the cost of production of the
commodity. If the demand for the commodity is inelastic the prices may be raised without
the demand being appreciably curtailed in consequence.
If the demand for the
commodity is very elastic and increased price will lead to decrease in sales and the
revenue will be less. On the cost side, if the monopolist is producing under increasing
returns or decreasing costs he can produce larger amount of commodity at lower cost and
sell it at lower price. If the commodity has elastic demand and it is produced under
diminishing cost, the interest of the monopolist will be better served if he fixes the price at
a low level. If on the other hand, the commodity has inelastic demand and it is produced
under increasing cost or diminishing returns, the price can be fixed at a higher level, by
doing so, the sales will not diminish much even if it reduces a little, the output at that
reduced level will cost here less.
In the case of commodities subject to the law of
constant returns or cost, the monopolist can exclusively concentrate his attention on the
demand side, since there are no changes on cost which indicates only the lower limit to
the price to be fixed according to the elasticity or inelasticity of demand. If the demand is
elastic, price will be low, if inelastic, prices will be high. Thus in all cases of monopoly
prices, the monopolist carefully weigh two main considerations nature of demand or
average revenue realized and the expenses of production or cost of production per unit.
But in all cases, the price will be fixed in such a way that the net monopoly revenue is
maximum. We can illustrate the fixation of monopoly price with the help of a sample
schedule.
Total
Net
Revenue in
Monopoly
Rs
revenue
30
30000
25000
14000
25
50000
36000
10
40000
20
80000
40000
15
120000
16
128000
8000
Output in
Cost per
Total Cost
units
units in Rs
in Rs.
1000
5
5000
2000
7
4000
8000
Price / Unit
3
4
The maximum profit or the net monopoly revenue will be realized when the output
is 4000 units at this level the net monopoly revenue is maximum, that is, Rs 40000.
Price – Output determination or monopoly equilibrium
In monopoly the average revenue curve will slope downwards. Further the
marginal revenue per will also be falling and it will be steeper occupying a low level than
the AR curve. The reason is since the AR is falling the extra units sold will be fetch less
and lesser revenue in the market. In the case of perfect competition, both AR and MR is
the same horizontal line parallel to X access and equal to the price. But in monopoly, this
is not so. The AR curve will be at a higher level sloping down, the MR curve will be at a
lower level sloping down.
The principle of profit maximization is the same as that of perfect competition. The
monopolist will maximize his net monopoly revenue by keeping the marginal cost and the
marginal revenue at the same level. The following diagram illustrate monopoly equilibrium
and price fixation.
Y
MC
P
S
Q
Profit
AC
R
E
AR
MR
O
M
X
Output
Where,
AR = Average Revenue
OM = Equilibrium Output
MR = Marginal Revenue
OP = Price
AC = Average Cost
E
MC = Marginal Cost
PQRS = Net Monopoly Revenue
= Equilibrium point where MR = MC
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With the AR curve falling and MR curve falling below it and cost curve, the Monopolist comes to
the equilibrium at the point E where MR = MC and produces OM units of the commodity fixing the price
at OP. at this price an output the monopolist realizes the maximum profit shown by the shaded area
PQRS. In the diagram at OM output the Marginal revenue is greater than the marginal cost, but beyond
OM, Marginal revenue is less than marginal cost. So equilibrium output is OM. This output OM can be
sold in the market at a price OP according to the demand curve (AR curve). At this level of out put the
difference between average cost and average revenue is QR. The total profit is PQRS.
The monopolist firm has come to equilibrium and it is earning maximum profit. The equilibrium fall
a short period is also for a long period under monopoly as there will not be any competitor entering the
field.
Price discrimination
Price discrimination means the practice of selling the same commodity at different prices to
different buyers. Under monopoly the producer usually restricts output and sells it at a higher price,
thereby making maximum profit. If the monopolist charges different prices from different customers for
the same commodity, it is called price discrimination or discriminating monopoly. The idea is to get from
each customer whatever profits could be squeezed out of him depending on his ability to pay and
intensity of demand. When a seller charges Rs.20 for a commodity from a customer A and Rs.22 for the
same commodity from customer B, he is practicing price discrimination. Joan Robinson defines price
discrimination as, “the act of selling the same article produce under a single control at different prices”.
Price discrimination may also be defined as, “the sale of technically similar products at prices which are
not proportional to marginal cost”.
Types of price discrimination
There are different types of price discrimination. They are
1.
Personal discrimination: in personal discrimination, the monopolist will charge different prices
from different customers on the basis of their ability to pay. Rich customers will be asked to pay more and
poor customers to pay less. This is possible in specialized personal services of doctors and lawyers. If it is
a commodity the discrimination will not be done openly but in a disguised manner. For e.g. the book of a
famous Author can be sold in the market at different prices to different class of customers – deluxe edition
is higher than the popular edition at a considerably lower price. Though the cost of producing deluxe
edition is higher than the popular edition, the price fixed for the former will be very high than the price fixed
for the latter. The content of the book is the same for which different customers pay the different prices.
The deluxe edition will command a market among the richer class and it will have prestige value. Thus
personal discrimination can be mad by making some superficial changes.
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Similar principle of personal discrimination adopted in railways or transport organization. The upper class
passengers pay more than the lower class for the same services rendered.
2.
Place discrimination: monopolist having different markets in different regions may charge
different prices for the same commodity in the different regions or localities. The locality in which his
market is situated will be the criteria in fixing up the price. Suppose a monopolist has a shop in an
aristocratic locality and also in a slum. He will charge higher prices in the former shop and lesser price in
the slum shop on the understanding that aristocrats will not go for shopping in the slum. Generally the
extra price charge in an aristocratic locality will not be felt by the customers as this shop would cater to
their extra needs such as ‘drive - in‘ facility, ‘door - delivery’ etc. sometimes the monopolist may charge
lower prices in a foreign country than in the home market. This is also place discrimination. This method
is adopted for “dumping” the goods in the foreign markets
3. Trade discrimination: this can also be called ‘use discrimination’. By this method, the monopolist
will charge different price for the same commodity for different types of users to which the
commodity is put to. For instance, electricity will be sold at cheaper rates for industrial
establishments and charged at a higher rate for domestic consumption. Similarly accessories like
small springs, bolts, nuts, etc will be charged at a higher price for automobiles and a lower price
when the same material is used for bicycles and for domestic purposes.
Degrees of price discrimination:
Prof. A.C. Pigou has distinguished between three types of price discrimination on the basis of
the degree or extent of price discrimination. Under price discrimination of the first degree, the
producer exploits the consumer to the maximum possible extent by asking him to pay the maximum
he is prepared to pay rather than go without the commodity. This type of price discrimination is called
perfect discrimination
In the price discrimination of the second degree, the markets are divided on the basis in each
market the lowest price, which the poorest member of the group are prepared to pay will be charged
in that market for all consumers.
It is price discrimination of the third degree which has been commonly practiced by monopolist. In this
case the markets are divided into many submarkets and in each submarket, the price charged will not
be the minimum price but the price depending on the output and demand of that market. With the
quantum output on hand which is fixed the monopolist will fix the prices in each submarket on the
basis of the demand curve in each. This is illustrated in the following diagram.
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The market demand curve is
demand
sub
for
three
markets
up
monopolist
control. Assuming that the
monopolist
selling in each market the
OM, he will charge a price
represented by demand curve
P3
same
D3 Mkt - III
P2
D2 Mkt - II
P1
D1 Mkt - I
market II will be OP2 and in
as shown in the diagram.
undertakes
“dumping”
and
into
separate markets
under
Price
or
curves
broken
Y
is
quantity
OP, in market I
D1.The
price
the market III OP3
When a producer
O
M
Quantity
X
charges
for
the
same commodity one price in
one country and
different
country, it is also a
price
in
another
case of price discrimination of the third degree.
Pricing under discriminating monopoly:
Under simple monopoly the producer will charge the equilibrium price on the basis of total output
and the marginal revenue and marginal cost will decide the equilibrium of the monopoly firm. In order to
discrimination prices, the entire market will be divided into sub-markets on the basis of the elasticity of
demand for the product. Only if the elasticity of demand is different, price discrimination will be profitable.
After dividing the market, the producer has to decide the supply for each submarket. Here the decision of
out put for each sub – market depends on the equilibrium condition of each sub-market with the total cost
condition and the revenue curves of the sub-market. The monopolist should decide two things on the
basis of his cost and revenue curves.
1. how much the total output should produce
2. How the total output should be shared between the sub-markets and what prices should be
charged in each of his sub-market.
For sake of simplicity, we shall take that a monopolist device his market, into sub-markets A and B and
finds the AR curve different in these two. The following diagram illustrates the revenue curves of the two
sub-markets A and B and the aggregate situation in the entire market under his control.
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Sub Market - A
Sub Market - B
Y
Y
Price
P1
P
E2
E
X
Quantity
O
M2
Quantity
AAR
AMR
AR2
MR2
MR1
on
the
extreme left AR,
2
AR1
M1
given
MC
Y
E1
O
The sub-market A
Total Market
is
the
curve
demand
or
the
average revenue
X
O
M
Quantity
X
curve
of
the
market.
In
sub-
market B it is the
demand curve or the average revenue curve of the market. Note that the elasticity of demand in these
two sub-market are different. In sub-market A the demand curve show inelastic in nature and in submarket B the curve shows the elastic in nature. The two sub-markets respective marginal revenue curves
are shown as MR1 and MR2 .which lie below the average revenue curve of the respective sub-market.
The figure on the extreme rite shows the total market where the aggregate conditions of the revenue
curves are shown. The total average revenue curves of the two sub-markets have been shown in the
total market as AAR. Similarly, the aggregate of the two marginal revenue curves of the sub-markets has
been shown as AMR. According to the figure AR1 + AR2 = AAR. MR1+MR2=AMR combined at various
levels of output. Since the output is under single control the marginal cost curve in the aggregate figure.
MC in the total market shows the marginal cost for the entire production. The level of production is
determine at the point where MR=MC. In the total market the aggregate MR curve cuts the MC curve at
E and the total output is determine at OM for the two sub-markets. How much of OM goes to each of
these markets is found out by drawing from E a line parallel to X-axis. This line indicating marginal cost
of output cuts the marginal revenue curves of the sub-markets at E2 and E1. at the point E1 the marginal
revenue of the sub-market A and the marginal cost of production are equal. So the equilibrium condition
in sub-market A lies at E1 where the quantity of commodity should be OM1. Similarly the equilibrium point
in sub-market B lies at the point E2 where the marginal cost level meets the marginal revenue level of
that sub-market. The corresponding quantity of the commodity in sub-market B is OM2.
Therefore quantity OM will be sold in sub-market A and quantity OM2 in the sub-market B. At the
equilibrium point E1 in sub-market A the price of the commodity will be P1M1 as at the level of equilibrium
output the average revenue is P1M1. In submarket B, at the equilibrium output the average revenue P 2
M2. So, the price of the commodity in that sub-market will be P2M2.
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Thus the monopolist producing OM quantities in sub-market A at a price
P1M1.
He will sell OM2
quantity in sub-market B at a price P2M2. in the figure price is higher in sub-market A and lower in B. It
has discriminated the two and charges different prices for the same commodity.
Price discrimination under dumping.
The monopolist producer having monopoly power in the domestic market may not have it in the
world market, where he has face lot of competition approximately to perfect competition. So, a
monopolist has to discriminate between the domestic market and the world market. In the world market
the producer has to keep the prices decided on the basis of perfect competition. While he can keep the
price at a higher level in the home market. If the producer charges a lower price in the world market than
in the home market, he said to be dumping in the world market.
How will the monopolist discriminate between the home market and the world market and decide
price output equilibrium. In the home market he will face falling revenue curve or demand curve. In the
world market since it is perfect competition the revenue or demand curve will be straight line parallel to
X-axis. In the home market, demand is inelastic while in the world market it is elastic. The condition of
equilibrium and price discrimination is illustrated in the diagram
Price and Cost
Y
B
PH
MC
E
1
PW
E
D
ARW= MRW
ARH
MRH
O
M1
M
X
Output
NC=Marginal Cost Curve
ARW=Average Revenue Curve of the World market
MRW=Marginal Revenue Curve of the World market
ARH/MRH=Average Revenue and Marginal Revenue of Home market.
The average revenue curve for the world market and the marginal revenue market curve are the
same. We have to find out equilibrium output where the Marginal Cost Curve cuts the aggregate
marginal revenue curve of the world market and home market. The marginal revenue for world market is
MRW: for the home market it is MRH in the figure. The aggregate position of the aggregate MR curve is
represented by the curve BKED which is the summation of MRW and MRH. This aggregate MR curves
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cut the MC at E. which is equilibrium position where the output is OM unit. Now how much of this quantity
goes to home market? The equilibrium E where extended to MRH meets at E 1 showing the equilibrium
point for the home market. At this point the output is OM 1. So the monopolist will produce OM units of the
commodity and sells OM1 units in the home market and sells M1M units in the world market. At the
equilibrium point position of output the price of the home market is OPH and the equilibrium point
position of output the price in the world market is OPW.
Thus the monopolist sells OM quantity at the price OPH in the home and sells M 1M in the world
market at a price OPW, which is less than the price charge at home. This practice is called dumping.
Monopolistic Competition
Perfect competition is the extreme of perfection on the nature of competition while monopoly is the
other extreme where there will not be any competition at all in production and selling by rival firms.
There are two different extreme can be concerned only in theory. But in practical world we cannot meet
a situation of either perfect competition or complete monopoly, the market forms will be really between
the two extremes exhibition both monopoly and perfect competition.
Monopolistic competition is a term which is used interchangeably with perfect competition, as it describes
a condition of imperfection.
Assumption and features of monopolistic competition
Monopolistic competition, as the name itself implies, is a blend of monopoly and perfect
competition. It refers to the market situation in which many producers produce goods which are close
substitutes of one another. But there will be some differentiation to identify it with the firms, and that
particular brand of consumers. In this respect each firm will have some monopoly at the same time the
firm has to compete in the market will other firms as they produce close substitutes. The essential
feature of monopolistic competition is produce differentiation and existence of many firms supplying the
market.
The main features of monopolistic competition are;
1.
Existence of large number of firms:
Under monopolistic competition the number of firms producing a commodity will be very large.
The term very large denotes that the total demand of the product is small.
Each will be acting
independently on the basis of product differentiation and each firm determines its price output policies.
Under these conditions the firms are bound to be small sized. Any acting of the individual firm in
increasing or decreasing the output will have little or no effect on other firms.
2.
Product differentiation:
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Product differentiation is the essence of monopolistic competition. Many firms popularize their
products stressing on the special features of their products and the customers are made to feel that there
are differences. In the production of soaps, cigarettes, cosmetics etc. different firms producing the same
commodity differentiate their product for instance, many firms produce toilet soaps. Any toilet soap is a
substitute for the toilet soap produced by different firms. But by popularising a particular brand with
specific aroma, size, shape, colour, the firm captures a portion of the market and the consumer will
become used to that brand.
In this way the producer exhibits monopolistic power over his loyal
customers. Greater the product differentiation, greater will be the element of monopoly for the firm.
Product differentiation can be brought about in various ways. It may be by using different quality
of the raw material, different chemicals and mixtures used in the product.
Difference in workshop,
durability and strength will also make product differentiation. Product differentiation may also be effected
by offering customers some benefits with the sale of the product facilities like free servicing home
delivery, acceptance of returned goods, etc would make the customers demand that particular brand of
product. Product differentiation through effective advertisement is another method. This is known as
sale promotion.
By frequently advertising the brand of the product through press, film, radio and
television, the consumers are made to feel that the brand produced by the firm in question is superior to
that of other brands sold by other firms. Thus, product differentiation is attempted through
a) physical difference
b) quality difference
c) imaginary difference
d) purchase benefit difference
The ultimate aim in product differentiation in product differentiation is to capture a large number of
customers to the firm’s product and advance monopolistic interest in the midst of large number of firms
competing
3.
Selling costs:
Because of product differentiation we can infer that the producer under monopolistic competition
has to incur expenses to popularize his brand. This expenditure involved in selling the product is called
“Selling Cost”. Most important form of selling cost is advertisement. Sales promotion by advertisement
is called non-price competition.
4.
Freedom of entry and exit of firms:
Another important feature is the freedom for any firm to enter into the field and produce the
commodity under his own brand name and any firm can go out of the field if it so chooses. Monopolistic
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competition presupposes that customers have definite preferences for particular varieties or brand of
products. Hence pricing is not the problem but product differentiation is the problem and competition is
not prices on products.
Thus in monopolistic competition the features of monopoly and perfect competition are partially present.
Price determination under monopolistic competition
Price-output determination under monopolistic competition is governed by the cost and revenue
curves of the firm. The cost curves are governed by laws of production. The revenue curves of the firm
will not be very elastic, to be parallel to x-axis as in monopoly. The average revenue curve of the firm
under monopolistic competition will be a sloping down curve, the sloping being neither too steep nor too
flat. It will not be flat or parallel straight line because the firm may not have very elastic demand for its
product. The product is not homogenous but slightly different from that of other firms. The firm cannot
sell unlimited quantities at the established prices as the products of other firms are close substitutes if not
perfect substitutes. The curve will not be too steep because the demand under monopolistic condition
will be much more sensitive to small changes in price as any fall in price could ensure more customers
using the substitute product of other firms, similarly any rise in price will drive out many customers from
the firm to go demanding other firms product. Thus under monopolistic competition the AR curve will be
fairly a sloping down curve and MR curve will be below it.
Equilibrium of the individual firm:
The monopolistic competitive firm will come to equilibrium on the same principle of equalizing MR
and MC. Each firm will choose that price that price and output where it will be maximizing its profit. The
following diagram shows the equilibrium of the individual firm in short period.
Y
Profit
SMC
Price
SAC
P
S
curves are shown as SMC and SAC. The sloping
down average revenue and marginal revenue curves
Q
R
are shown as AR and MR. The equilibrium point is
AR
E where MR equals MC. The equilibrium output is
MR
O
The short period marginal cost and average cost
M
Output
OM and the price is fixed OP.
X
The difference
between average cost and average revenue is RQ.
The output is OM. So, the supernormal profit for the
firm is shown by the rectangle PQRS. The firm by
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producing OM units of its commodity and selling it at a price of OP per unit realizes the maximum profit in
the short run.
Firms may also incur loss also which can be indicated in the following diagram.
Price and Cost
Y
With the revenue curves and cost curves the firm
SMC
SAC
Loss
P1
S1
1
Q
1
R
comes to equilibrium at E1 where MR equals MC. At
this point the firm is making the minimum loss
P1Q1R1S1 shown by the shaded rectangle. The price
1
E
is P1.
MR
AR
O
Output
X
The firm incurs loss in the short run because
average cost is high than average revenue.
The different firms in monopolistic competition
may be making either abnormal profits or losses in
the short period depending on their costs and revenue curves. The price of the commodity of the
different firms will be different because the firm adopt individual price policy.
Based on consumer
preferences of the product of the firm and the cost of production each firm will be fixing its price which
may be different from the price of other firms. Old and long standing firms with established customers
and goodwill will find high price advantageous. The technique of production due to long experience may
result in the cost position very comfortable. So, established firms will be making abnormal profits in the
short period.
Newly started firms may have to fix the price at a lower possible level to establish
themselves. The profit may not be very high. It may even result in loss at the initial stages. Thus in
monopolistic competition firms may be making abnormal profit, normal profit or loss in the short period.
Firms making losses will keep the loss out at minimum and try to cover the average variable cost.
Group equilibrium in the long period
Group equilibrium means price-output adjustment of a number of firms, instead of an individual
firm, whose products are close substitutes. The different firms in a group adopt independent price-output
policies because of their monopolistic position with reference to the peculiarity of the product. Where it
should be remembered that product is a close substitute of other firms. In the short run when firms make
huge profit, the tendency will be for the new producers to enter the field. But the difficulty of finding out
the group equilibrium arises out of diversity of conditions of various firms constituting the group. Each
firm in its own way carters the specific tastes and preferences of the group consumers. So, each firm will
have different demand curves and cost curves depending on their efficiency
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Chamberlin solved the difficulty by making some heroic assumption of uniformity to arrive at the
long run equilibrium of the group.
1. The firms competing in the group are producing more or less similar products
2. The firms competing have equal share of the market demand which means that the shape
of the AR curve will be the same for all
3. All firms have equal efficiency in production and therefore the cost curve are similar and
4. The numbers of firms are fairly large and each firm regards itself as independent in the
group. This assumption of chamberlain actually boils down to the conditions of the perfect
competition with minor differences.
The abnormal profit earn in short period will attract new comers to the group. The new comers will
fix lower prices than the prices charged by the existing firms. This will compel the existing firms to reduce
the prices. As a result of such a keen competition, price will fall. Consequently the AR curve will shift to a
lower position. The AC curve will shift to a higher position due to increased demand on factors of
production. This distance between AR and AC will be narrowed down and the abnormal profits will be
removed. Ultimately the firms will earn only normal profits. The group equilibrium in the long run under
monopolistic competition is shown below.
Price and Cost
Y
P
LPMC
K
E
O
LPAC
LPAR
LPMR
M
Output
X
LPAR and LPMR indicate the long period average and marginal revenues. LPMC and LP AC
show the long period marginal and average cost curves. The point E is the equilibrium where marginal
revenue equals marginal cost and the output is OM. At the equilibrium output the average revenue or the
price of the price is OP. the figure shows that the firm produces OM units and sells it at a price of OP per
unit making only normal profit. The figure shows that the average curve just touches the AC curve at the
point of equilibrium output. So average cost equals average revenue. The firm is not making any
abnormal profit but only normal profit. Over a long period of time, under monopolistic competition, every
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firm will earn only normal profit. This situation is exactly similar to the perfect competition, long run
equilibrium. The main difference is that in perfect competition the AR is horizontal touching to the
average cost curve at the lowest point showing that the average cost is the minimum cost and the prices
also minimum. But in monopolistic competition the average revenue curve is sloping down. It touches the
average cost curve not at the minim point but at the falling side (point K in the figure). So long as the
shape of the average cost curve is ‘U’ shaped, the long period equilibrium of a firm producing under
monopolistic competition will necessarily result in smaller output than in the perfect competition.
Since all the firms are producing on no-profit no-loss condition (Normal Profit) there will be no
tendency for the new firms to enter nor existing firms to go out. The group has come to equilibrium.
Thus by Chamberlin’s method we can arrive at the group equilibrium in the long run in the
monopolistic competition. But Stigler and Kaldor have criticized this method and they have questioned
the assumption made by Chamberlin. The uniformity assumption is criticized grossly unrealistic. How can
differentiated products of different firms have uniform demand and costs? If the cost, demands and
prices of the products of various firms are assumed to be uniformed then the demand curve of the each
firm would become perfectly elastic as the situation becomes perfect competition. The condition seized to
be monopolistic competition with downward sloping demand curve. Further the assumption of “perfect
freedom of entry” when interpreted properly means freedom to enter and produce completely identical
product of those of any other producer in the market. If this be so, the free entry strikes at the very root of
monopolistic competition and makes it perfect competition. When this was pointed out to chamberlain, he
agreed and put a restriction on the interpretation of freedom of entry by saying that with respect to the
particular product by any individual firm under monopolistic competition there can be no freedom of entry
whatever chamberlain thus revised the view of freedom of entry to interpret in a narrow sense of entering
to produce only close substitute and not identical substitute.
Selling costs and monopolistic competition
Definition and meaning of selling cost:Selling cost literally means the cost of selling a product in the market. It denotes the expenses
incurred in connection with salesmanship, propaganda advertisement in order to push up the sales of a
product. It refers to the expenditure incurred by the firm to canvass or persuade the buyers to buy its
product rather than the product of any other firm. It is an attempt to net large number of buyers to
become the customers of the firm.
Selling cost has been defined as, “cost incurred in order to alter the position or shape of the
demand curve for a product”. Selling cost may be incurred on various items like advertisement, salaries,
allowances given to salesman, display and demonstration. Free supply of samples to prospective buyers,
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entertaining there are costs connected with selling. A large portion of the selling cost will be incurred on
advertisement. But Watson is of the opinion that the term selling cost is wider than the cost of
advertisement. Selling cost, in short, is the cost involved in sales promotion.
Differences between selling cost and production cost:A distribution is made between selling cost and production cost. The cost incurred in raw
materials, wages to the workers, fuel, packing, transport to the market as classified as production cost.
This is defined as those costs which are incurred by a firm in the production of a given variety of a
product. Production is not complete unless it is placed in the market for consumers. So production costs
include the transport costs. On the other hand, the cost of changing consumers wants are selling costs.
This is done through “sales promotion programme”. The distinction may not be clear cut always. For
instance, an attractive packing may result in increased sales. The cost of packing can be taken as
production cost and because of the result it can taken as sales cost. But it cannot be taken in both.
Similarly, when the product of the firm is sold by a mobile demonstration team for publicity, the expenses
may be take under selling cost or as production cost. Professor Watson therefore, points out that it is
difficult to differentiate between selling cost and production cost though Chamberlin has given a distinct
place for selling cost.
Significance of selling costs:Selling cost has special place and significance tin the theory of pricing as it is exclusively
associated with imperfect competition. Under perfect competition the consumer have full knowledge of
the market and price of the commodity. Hence there is no need for publicity and advertisement and the
firms incur only production costs. But in monopolistic competition market has to be created by making the
people know about the product and price. Further, there is difference in quality and variety of the product
unlike perfect competition. So, the firms have to necessarily incur expenditure in selling the commodity
through various methods. The people should be made known of the commodity produced by the firm.
Then the consumers of the product should be advised or educated to that particular variety produced by
the firm. For this advertisement plays a vital part in monopolistic competition. In perfect competition and
monopoly there is no need for advertisement as in the former people know the product and in the latter
the firm does not have nay rival. Product difference and rivalry by the other firms make advertisement as
integral programme of modern production in monopolistic competition.
Selling costs are incurred to promote sales. But, it is not possible to establish a direct relationship
between selling costs incurred and the volume of business done by the firm. The anticipated result of
advertisement and publicity may not be forthcoming. The selling cost may even prove utterly barren.
Further the advertisement of one form will evoke counter advertisement. So, selling cost will get inflated
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by counter advertisement as it may eventually lead to advertisement war. Ultimately, the firms advertising
may not get any extra profit, but the available profits will be eaten away due to inflated selling costs.
Hence this cost is significant and producers have to be very cautious and choosy. Further, the benefits
from selling cost may also accrue to rival firms as the advertisement made may create a potential
demand and not necessarily the benefits should go the firm advertising the consumer would go in for the
variety of other firms.
Selling costs are incurred on the assumption that a large number of customers will be prepared to
change their preference on advertisement and publicity. This may not be so as the consumer gets
resistance from his habits. The firm cannot asses the extent of new customers won by advertisement ad
the increased demand due to advertisement may be from existing customers as well as new customers.
If new customers are won by advertisement holds on the existing customers, then the selling costs is
fixed cost.
OLIGOPOLY
Meaning and definition of Oligopoly.
“Oligopoly” is a term derived from two Greek words “Oligos” meaning a few “pollein” meaning to
sell. Thus Oligopoly refers to that form of imperfect competition where there will be only a few sellers
producing either a homogenous product which are close substitutes but not perfect substitutes .Oligopoly
is also referred to as “competition among the few” as a few big firms will be producing and competing in
the market. The simplest case of Oligopoly is duopoly which prevails when there are only two producers
in the market.
Professor Sligter defines Oligopoly as that “selication in which a firm bases its market policy in
part on the expected behavior of a few close rivals”. According to professor Leftwich, “An Oligopolistic
industry is one in which the number of sellers is small enough for the activities of a single seller to affect
other firms and for the activities of other firms to affect him”.
Classification of Oligopoly
There are different types of Oligopoly .They are:
1.Pure or perfect Oligopoly and differentiated or imperfect Oligopoly:Oligopoly is said to be pure or perfect based on the product. If firms competing produce
homogenous product it is perfect Oligopoly. If there is product differentiation where the products of a
few competing firms are only close substitutes but not perfect substitutes, it is called imperfect or
differentiated Oligopoly. Production of cement, Aluminum industry can be taken as the exampled of
the former type, while production of talcum powder or aspirin tablets may be taken as the example of
the latter.
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2. Open and closed Oligopoly:In the former the new firms can enter the market and compete with the existing firms. But in
closed Oligopoly entry into the industry is not possible.
3. Collusive and competitive Oligopoly:When the few firms of the Oligopolistic market come to a common understanding or act in
collusion with each other I fixing price and out put, it is collusive Oligopoly. A non-collusive Oligopoly
denotes lack of understanding between the firms and they maybe competing making the market
competitive Oligopoly.
4. Partial and full Oligopoly:Oligopoly is partial when the industry is dominated by one large firm which is considered or
looked upon as the leader of the group. The dominating firm will be the price leader. The rest of the
smaller firms would follow the leader in fixing prices of their products. In full Oligopoly, the market will
be conspicuous by the absence of price leadership.
5. Syndicated and Organized Oligopoly:The extent and degree of coordination between the firms will decide this type of classification.
Syndicated Oligopoly refers to that situation where the firms sell their product through a centralized
indicate. Organized Oligopoly refers to the situation where the firms organize themselves into a
central association for fixing prices, out put, quotas. Etc
On the basis of these different situations of Oligopoly market a few characteristics features can
be enumerated. These special features are not found in other market forms.
Characteristics of Oligopoly.
1. Interdependence.
The most striking feature of Oligopoly market is the interdependence of the firms operating. The
price and out put decisions of one will affect the other firms and any decision can be arrived at only after
deep consideration of the possible reaction of the rival firms or firms in the group. As the number of firms
is few, a change in price and out put by a firm will directly affect the fortunes of its rivals which will
retaliate by changing their own price and output policies. Decision making is closely connected with price
output policies of other firms. Hence in Oligopolistic market a firm cannot act independently in fixing the
price. This interdependence between the firms is a special feature of Oligopoly. Imperfect competition
each firm is a price taker and each firm has elastic demand curve and as such they follow independent
output policies and firms are on no way inter dependent. In monopoly the question of dependence does
not arrives as there are no rival and the firm is a price maker. In monopolistic competition because of the
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large number of firms in the groups, the price and out put decision will not affect other firms in a larger
measure due to product differentiation. But in Oligopoly, firms are interdependent.
2. Indeterminate Demand curve.
This feature is a natural outcome of the first feature. No firm in Oligopoly can forecast with fair
degree of certainty about the nature and position of its demand curve whenever a change in price output
policy is contemplated. The firm cannot make an estimate of sales of its product if it were to cut the price
by a certain percentage. Hence the demand curve or the revenue curve of the firm is indeterminate.
When a firm decides a course of action and implements it, there will be quick and equal reaction, if not
more, from the rivals. In this process the firms would try to outguess each other and a state of uncertainty
would prevail and the firm cannot anticipate with definiteness the quality that can be sold in the market.
This indeterminate demand condition is a singularly important feature when contrasted with other types
of market. In perfect competition, the demand curve is given as a horizontal line. The firm has elastic
demand. In monopoly the fixation of price depends on the shape of the demand curve. In monopolistic
competition each firm anticipates their demand and fixed the price on the basis of demand curve. But in
the case of Oligopoly, since demand is indeterminate the curve cannot be arrived at easily.
3.Importance of selling cost.
Indeterminate demand leads to the condition of aggressive advertisement to bring more
customers in to the fold of the firm. A direct effect of interdependence and indeterminateness of demand
of various firms in Oligopoly is the enormous selling cost incurred by the competing firms. To make the
average revenue curve, decisive and also favorable each firm will be employing various advertisement
techniques and consequently the selling cost will be very high. In perfect competition, advertising by a
firm is unnecessary as the firm can sell any amount at the market price. In monopoly advertisement plays
a very insignificant role. It will be used only for the, introduction of a product and not for competition. In
monopolistic competition the advertisement plays a significant role due to producer differentiation. But
advertisement plays a bigger role in Oligopoly “leader Oligopoly, advertisement can become a life and
death matter, where a firm which fails to keep up with the advertising budget of its competitors may tend
its customers drifting off to rival products”. Thus selling cost occupies a very significant part in Oligopoly
market.
4.Group behavior.
Another peculiarity in Oligopoly is the conflicting attitudes of the firms in the group. The firms are
interdependent in the market and they also realize the importance of mutual co-operation to their best
advantage. When such desire to further their common interest arises, the group will have a tendency of
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collision. At other items, the desire of each firm to earn maximum profit may initiate antagonism and
competitive spirit, which causes uncertainty.
5. Element of monopoly:In Oligopolistic market, where there are only a few firms, monopoly element may be present if
there is product differentiation. Each firm controls a large share of the market and markets a
differentiated product. So, each firm becomes a petty monopolist. The monopoly power will be all the
more conspicuous if the customers are deeply attached to the product of a particular firm in Oligopolistic
market. In that case the firm will have more independence.
6. Price rigidity:Another important feature of oligopoly with product differentiation is price rigidity. The price will be
kept unchanged due to be sticky and inflexible. Even for years together the price may remain rigid. No fir
would indulge in price cutting as it would eventually lead to a price war with no benefit to anyone. The
price may be kept constant even without any collusion or agreement. The season for price rigidity are:a) The firms know the ultimate out come of price cutting.
b) Large firms will have to incur unnecessary expenditure in bringing out revised prices. Revised
schedule of rates, catalogue and negotiation with customers on new terms would mean extra
expenditure. Further it would even irritate the longstanding customers.
c) The firms would like to keep the price fairly at lower level to discourage any new firm entering into
the field of production of that product.
d) Price rise by a firm would result in losing the customers; a fall in price will result in counter
measures. In both ways the firm would face difficulties. When firms get a fair and reasonable profit
the change of price will not be attempted. Instead of price cutting, the firms will intensify sales
through effective advertisement.
Pricing under oligopoly
Kinked demand curve
Price rigidity under oligopoly is better explained by kinked demand curve. The kinked demand
model represents a condition in which the firm has no incentive either to increase the price or to
decrease the price but keep the price rigid at a particular level. The firm believes that the rival firms will
not follow suit if it raises the price. But if it cuts down the price the rival firms will follow suit. Adding on
this belief the firm maintains the present price. If it increases the price sales will be decreased
automatically and that will prove advantages to the rivals who have not increased the price. If price
reduction is restored, the rivals also would not improve appreciably. Hence to stick on to the present
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price is very expedient. Only in the event of any drastic changes in demand and cost conditions the firm
could think of changing the price.
Under such a condition the demand curve of the firm, as anticipated by the firm would be kinked. This
means that the curve will have a kink at the present price. The following diagram shows kinked demand
curve.
y
D
Price and cost
MR
P
K
B
L
x
In the figure the demand curves with a kink point P has been shown. P is the price at which the
firm is selling the product by producing ON units. Above the price P the demand curve as anticipated by
the firm is DP. The curve is elastic. Below the price P the anticipated demand will be PB which is
inelastic. This shows that when the firm increases the price above P and if all other firms maintain the old
price, then the demand for the firms product would fall off. So the demand curve is highly elastic above P
[DP portion]. The total revenue and profits of the firm would be reduced. The corresponding portion of
marginal revenue curve is also shown in the figure [MR]. If the firm decreases the price the demand
curve becomes much less [PB]. PB curve is inelastic because, the reduction in price will be followed by
other firms and the sales may not increases appreciably, than what it is at the price P. as this level the
marginal revenue curve is shown as MR, when the demand curve is positive. When the demand curve is
PB the marginal revenue becomes negative. When there is no scope of better profit in either way, why
should the firm think of changing the price from what it is. (P) so the price PN as shown in the diagram
becomes rigid.
The peculiarity of this figure is that there is gap or discontinuity in MR curve below the point of
kink. KL shows the gap or extent of discontinuity between MR and MR1. This gap will depend on the
elasticity of demand above and below the kink.
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The gap will be larger if the elasticity is greater above the kink and elasticity is also greater below the
kink, price will not change oligopoly unless there is drastic change in demand and cost conditions.
The kinked demand curve theory of oligopoly explains the price rigidity but it does not explain how
the price under oligopoly is determined. Moreover this theory has little application to oligopoly with
product differentiation. This method is not useful in case of price leadership or collusive oligopoly.
Because of this complexities and variations and uncertainties a general theory of pricing under oligopoly
is not possible.
Equilibrium under oligopoly without product differentiation
As a result of competition and price war, let us imagine that the firms have settled down to a price
OP. at this price the firm sells an output OM earning just normal profit. This OM output is the optimum
output as it is produced at the lower average cost. If the firm increases the price beyond OP it will lose all
its customers because the product is not differentiated. It is assumed that other firms will not increase the
price. The firm cannot reduce the price as it will go out of business without normal profits.
y
AC
AC: Average Cost
AR: Average Revenue
AR
P
Price
Output
M
x
Equilibrium with product differentiation
Let us imagine that after price war the price has settled at OP and the firm is producing ON output.
The firm is earning just the normal profit. The equilibrium in the case of product differentiation under
oligopoly is similar to monopolistic competition. The firm is earning normal profit but it is producing less
than the optimum output.
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y
AC
P
Price
AR
Output
N
x
Final price under oligopoly with product differentiation will lie between monopoly price and competitive
price and it will vary from case t case depending on market conditions.
Marginal productivity theory of distribution.
The marginal productivity theory states that remuneration of each factor of production tends to be
equal to its marginal productivity. Marginal productivity is the addition to the total production by using one
extra unit of the factor. In order to find out the marginal productivity of a factor we have to change the
quantity of a factor concerned by one unit while keeping quantity of others factors constant and see the
difference in the total production for example, if 10 machines and 100 labourers produce 1000 units of
cloth, the same 10 machines are worked with 101 labourers, the total production increases 1006 units of
cloth. It is evident that the marginal labourer has contributed towards 6 units of cloth. So, marginal
productivity of labour is 6 units of cloth. This is called marginal physical product. This means the exact
physical quantity of the product produced by the marginal unit of factor. When this marginal physical
product is expressed in terms of market value, it is called marginal value product. The value of marginal
product is found out by multiplying of the commodity by its price in the market. In our example if 6 units of
marginal product is valued at the rate of Rs. 3 per unit in the market, the total value of the marginal
product is 18 (6 x 3 = 18).
So long as the marginal cost is less than the marginal productivity, the entrepreneur will go on
employing more and more units of the factors. He will stop giving further employment as soon as the
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marginal productivity of the factor is equal to marginal cost. Now obvious no entrepreneur will pay a
factor anything more than what it is worth. The worth of a factor is what it could fetch in the market for the
entrepreneur in the selling of the marginal product produced by it. So each factor is paid accordingly to
its production at he market.
The marginal productivity theory is based on the principle of law of diminishing return. As the
producer employs more and more of a factor in the production of a commodity the marginal productivity
of that factor diminishes. He shall employ a factor so long as its productivity exceeds its remuneration
otherwise when returns diminish and costs go up, the producer will meet loses. As such the producer has
to substitute and combine the different factors of production in such a way that the factor –price and
marginal productivity are equal. The producer stops at the point when marginal revenue product is equal
to the price of the factor. At this point he makes maximum profit and beyond this point he will loose if he
employs more units of a factor of production.
Assumption of the theory
1) the marginal productivity theory assumes perfect competition. Through perfect competition the
price of factors throughout the market is assumed to be uniform and each factor receives the
same remuneration at different places in the same market. Only on this conclusion the marginal
productivity shall be equal and factor prices be uniform.
2) All the factor of production are assumed to be perfectly mobile as between different uses and
regions. This assumption is essential as will not be possible to have equi marginal returns from
different factors of production through the principle of substitution without perfect mobility of
factors.
3) The different units of a factor of production are alike and homogeneous in all respects. It means
that one unit is as efficient as that of the other units. Without this assumption substitution of
factors cannot be worked out to increaser production.
4) The employer is interested in getting maximum amount of profit. This basic assumption is
essential in economic analysis. Only in the context of maximum profits, the producer uses the
factor units in such away that the cost of the last unit employed is equal to the product of the last
worker.
5) All factor units are employed and no factor unit is prepared to come for work for any remuneration
which is less than the market remuneration. In other words the full market condition is assumed.
6) Although the scale and proportions of factors for production changeable, the technique of
production is assumed to remain constant.
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7) The theory is assumed to be applicable in the long period to prove that the remuneration of factor
will be equal to both average and marginal productivity.
Based on these assumptions, the marginal productivity theory of distribution states that :
i) The price or remuneration of a factor will depend upon productivity or contribution that it
makes to production.
ii) The price of a factor is determined by the marginal productivity of that factor unit and it is
equal to marginal productivity.
iii) In the long period, the price of remuneration of factor unit will be equal to average product
also.
From the above analysis and assumptions, there is a market for factors of production. This market
has its buyers and sellers and these forces – demand and supply determine the price of the commodity.
On the side of demand the producer is willing to pay a maximum price equal to the marginal productivity.
On the supply side of the demand, the producer is willing to pay the maximum price equal to the marginal
productivity. On the supply side the factors of production will be willing to charge a minimum price equal
to its marginal productivity and this maximum price almost unlimited. Taking these two forces, the
equilibrium point where the supply will be equal to demand and at this point it is equivalent to marginal
productivity. Thus the price of factor of production is equal to marginal, a price at which both buyers and
sellers are willing to buy and sell the factor. This is illustrated in this diagram.
D
S
P
D
S
No. of factor units
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X- Axis we measure number of factor units and so on the y – axis price for factor. SS is the supply and
DD demand curve. They intersect at P. the price is equal to PM which is equal to marginal productivity.
Criticism of Marginal Productivity Theory
Marginal productivity theory has been criticized by a large number of economists notably Taussig,
Davenport, Maurice, Dobb, Keynes and others. The main point of criticism is as follows.
1) the theory is based on two realistic assumptions: prevalence of perfect competition and state of
full employment condition. In the real world there is neither full employment nor perfect
competition. Under imperfect and monopolistic conditions there will be exploitation of factor of
production and they are paid much below their marginal productivity.
2) The assumption of perfect mobility of factors between different employment and regions is also
another unrealistic assumption in practical side there are many obstacles to free movement of
factors. In these days of increasing speculation the mobility of a factor gets restricted and it may
not be paid equal to its marginal productivity.
3) Assumption of homogeneity of factors is far from reality. The factors are neither identical nor
homogeneous or equal in all respects so that the principle of substitution would not work perfectly
well. In reality factors of production are heterogeneous and they differ widely in efficiencies. This
difference is productivity accounts for differential rents in factors which marginal productivity
theory has ignored. Similarly the assumption of divisibility of factors into small quantities is also
unreal for instance it’s not possible to divide an entrepreneur.
4) Taussig and Davenport are of the view that production of a commodity cannot be attributed to any
one factor of production. Production is the result of factors working in cooperation with one
another. The additional product which attribute to the additional unit of factor, cannot be solely
caused by the additional unit. The marginal production or the extra production due to extra unit of
the factor is the result of extra unit working in cooperation with existing factors and as such the
extra output cannot be solely attributed to the extra factor. So it is not possible in production to
make any one unit of output as specific to particular unit of factor used.
5) Variations in proportions of factors of production are not easy. It is not done purely from the point
of view of increasing production nor could it be done with ………………………… Hobson points
out that the proportion in which factors are used is determined by technical condition of business
and not by any arbitrary decisions of the producer. It may, therefore, not be possible to vary the
use of factor without making a corresponding variation in the use of other factors.
6) The theory does not carry with it any ethical justification. The reward of a factor of production
which tends to equal to the marginal net product bears no necessary relation to with the social
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service. The theory should not be constructed as a apology for perpetuating the existing
inequalities of income.
In spite of its draw backs and defects the marginal productivity theory of distribution offers a
reasonable understanding of factor pricing.
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