Unit IV
Q.1: Differentiate between perfect competition and monopoly.
Ans: Perfect competition:
Infinite buyers and sellers – Infinite consumers with the willingness and ability to buy the
product at a certain price, and infinite producers with the willingness and ability to supply the
product at a certain price.
Homogeneous products – The products sold by perfectly competitive firms are so identical that
the buyers are not able to distinguish the product of one firm from that of another firm.
Zero entry and exit barriers – It is relatively easy for a business to enter or exit in a perfectly
competitive market.
Perfect information - Prices and quality of products are assumed to be known to all consumers
and producers.
Perfect factor mobility - In the long run factors of production are perfectly mobile allowing free
long term adjustments to changing market conditions.
Zero transaction costs - Buyers and sellers incur no costs in making an exchange (perfect
mobility).
Profit maximization - Firms aim to sell where marginal costs meet marginal revenue, where
they generate the most profit.
Monopoly:
(i) Single Producer: There must be only one producer who may be an individual, a partnership
firm or a joint stock company. Thus single firm constitutes the industry. The distinction between
firm and industry disappears under conditions of monopoly.
(ii) Close Substitute: The commodity produced by the producer must have no closely
competing substitutes, if he is to be called a monopolist. This ensures that there is no rival of the
monopolist. Therefore, the cross elasticity of demand between the product of the monopolist and
the product of any other producer must be very low
Q2: Why does a firm has no control over the price of a product under perfect competition?
Ans: In prefect competition, price is determined by the market forces of demand and supply. All
buyers and sellers are price takers and not price makers. Buyer represents demand side in the
market. Every rational buyer aims at maximizing his satisfaction by purchasing more at lower
price and lower at higher price. This is called demand behaviour of buyer i.e. Law of Demand
Seller represents supply side in the market. Every rational seller aims at maximizing his profits
by selling more at higher price and lesser at lower price. This is called supply behaviour of seller
i.e. Law of supply.
But at a common price, buyer is ready to demand a particular quantity of goods and seller is also
ready to supply exactly the same quantity of goods to buyer, such common price is called
'Equilibrium Price' and such quantity is called 'Equilibrium Quantity'
Q3: Explain the features of monopolistic competition.
Ans: The following are the features or characteristics of monopolistic competition:-
1. Large Number of Sellers
2. Product Differentiation
3. Freedom of Entry and Exit
4. Selling Cost
5. Absence of Interdependence
6. Two Dimensional Competition
Monopolistic competition has two types of competition aspects viz. Price competition i.e. firms
compete with each other on the basis of price. Non price competition i.e. firms compete on the
basis of brand, product quality advertisement.
7. Concept of Group
8. Falling Demand Curve
Q4: Define perfect competition. Draw average and marginal curves of a firm under perfect
competition market.
Or
Q5:Briefly explain the features of a perfectly competitive market. What type of demand
curve does a firm have under perfect competition?
Ans: PERFECT COMPETITION
In economic theory, perfect competition describes markets such that no participants are large
enough to have the market power to set the price of a homogeneous product. Because the
conditions for perfect competition are strict, there are few if any perfectly competitive markets.
Still, buyers and sellers in some auction-type markets say for commodities or some financial
assets may approximate the concept. Perfect competition serves as a benchmark against which to
measure real-life and imperfectly competitive markets.
Features:
Infinite buyers and sellers – Infinite consumers with the willingness and ability to buy the
product at a certain price, and infinite producers with the willingness and ability to supply the
product at a certain price.
Homogeneous products – The products sold by perfectly competitive firms are so identical that
the buyers are not able to distinguish the product of one firm from that of another firm.
Zero entry and exit barriers – It is relatively easy for a business to enter or exit in a perfectly
competitive market.
Perfect information - Prices and quality of products are assumed to be known to all consumers
and producers.
Perfect factor mobility - In the long run factors of production are perfectly mobile allowing free
long term adjustments to changing market conditions.
Zero transaction costs - Buyers and sellers incur no costs in making an exchange (perfect
mobility).
Profit maximization - Firms aim to sell where marginal costs meet marginal revenue, where
they generate the most profit.
Average and Marginal Curves of a Firm under Perfect Competition
Q6: How a seller under perfect competition is a price taker? What is the relevance of the
characteristics that there are a large number of sellers in this context?
Ans: In prefect competition, price is determined by the market forces of demand and supply. All
buyers and sellers are price takers and not price makers. Buyer represents demand side in the
market. Every rational buyer aims at maximizing his satisfaction by purchasing more at lower
price and lower at higher price. This is called demand behavior of buyer i.e. Law of Demand
Seller represents supply side in the market. Every rational seller aims at maximizing his profits
by selling more at higher price and lesser at lower price. This is called supply behavior of seller
i.e. Law of supply.
But at a common price, buyer is ready to demand a particular quantity of goods and seller is also
ready to supply exactly the same quantity of goods to buyer, such common price is called
'Equilibrium Price' and such quantity is called 'Equilibrium Quantity'
Q7: What are the features of a monopoly? Can a monopolist sell more of a commodity at a
higher price? Explain.
Ans: MONOPOLY
Monopoly is that market form in which a single producer controls the whole supply of a single
commodity which has no close substitute.
From this definition there are two points that must be noted:
(i) Single Producer: There must be only one producer who may be an individual, a partnership
firm or a joint stock company. Thus single firm constitutes the industry. The distinction between
firm and industry disappears under conditions of monopoly.
(ii) Close Substitute: The commodity produced by the producer must have no closely competing
substitutes, if he is to be called a monopolist. This ensures that there is no rival of the
monopolist. Therefore, the cross elasticity of demand between the product of the monopolist and
the product of any other producer must be very low.
PRICE DETERMINATION UNDER MONOPOLY
A firm under monopoly faces a downward sloping demand curve or average revenue curve.
Further, in monopoly, since average revenue falls as more units of output are sold, the marginal
revenue is less than the average revenue. In other words, under monopoly the MR curve lies
below the AR curve.
The Equilibrium level in monopoly is that level of output in which marginal revenue equals
marginal cost. The producer will continue producer as long as marginal revenue exceeds the
marginal cost. At the point where MR is equal to MC the profit will be maximum and beyond
this point the producer will stop producing.
It can be seen from the diagram that up till OM output, marginal revenue is greater than marginal
cost, but beyond OM the marginal revenue is less than marginal cost. Therefore, the monopolist
will be in equilibrium at output OM where marginal revenue is equal to marginal cost and the
profits are the greatest. The corresponding price in the diagram is MP’ or OP. It can be seen from
the diagram at output OM, while MP’ is the average revenue, ML is the average cost, therefore,
P’L is the profit per unit. Now the total profit is equal to P’L (profit per unit) multiply by OM
(total output).
In the short run, the monopolist has to keep an eye on the variable cost, otherwise he will stop
producing. In the long run, the monopolist can change the size of plant in response to a change in
demand. In the long run, he will make adjustment in the amount of the factors, fixed and
variable, so that MR equals not only to short run MC but also long run MC.
Price Discrimination in Monopoly:
Price discrimination may be (a) personal, (b) local, or (c) according to trade or use:
(a) Personal: It is personal when different prices are charged for different persons.
(b) Local: It is local when the price varies according to locality.
(c) According to Trade or Use: It is according to trade or use when different prices are charged
for different uses to which the commodity is put, for example, electricity is supplied at cheaper
rates for domestic than for commercial purposes.
Some monopolists used product differentiation for price discrimination by means of special
labels, wrappers, packing, etc. For example, the perfume manufacturers discriminate prices of
the same fragrance by packing it with different labels or brands.
A firm under monopoly faces a downward sloping demand curve or average revenue curve.
Further, in monopoly, since average revenue falls as more units of output are sold, the marginal
revenue is less than the average revenue. In other words, under monopoly the MR curve lies
below the AR curve.
The Equilibrium level in monopoly is that level of output in which marginal revenue equals
marginal cost. The producer will continue producer as long as marginal revenue exceeds the
marginal cost. At the point where MR is equal to MC the profit will be maximum and beyond
this point the producer will stop producing.
Q8: Differentiate between perfect competition and pure competition. State the condition
for a firm’s equilibrium under perfect competition.
Ans: PERFECT COMPETITION
In economic theory, perfect competition describes markets such that no participants are large
enough to have the market power to set the price of a homogeneous product. Because the
conditions for perfect competition are strict, there are few if any perfectly competitive markets.
Still, buyers and sellers in some auction-type markets, say for commodities or some financial
assets, may approximate the concept. Perfect competition serves as a benchmark against which
to measure real-life and imperfectly competitive markets.
BASIC STRUCTURAL CHARACTERISTICS
Generally, a perfectly competitive market exists when every participant is a "price taker", and no
participant influences the price of the product it buys or sells. Specific characteristics may
include:
Infinite buyers and sellers – Infinite consumers with the willingness and ability to buy the
product at a certain price, and infinite producers with the willingness and ability to supply the
product at a certain price.
Zero entry and exit barriers – It is relatively easy for a business to enter or exit in a perfectly
competitive market.
Perfect factor mobility - In the long run factors of production are perfectly mobile allowing free
long term adjustments to changing market conditions.
Perfect information - Prices and quality of products are assumed to be known to all consumers
and producers.
Zero transaction costs - Buyers and sellers incur no costs in making an exchange (perfect
mobility).
Profit maximization - Firms aim to sell where marginal costs meet marginal revenue, where they
generate the most profit.
Homogeneous products – The characteristics of any given market good or service do not vary
across suppliers.
Non-increasing returns to scale - Non-increasing returns to scale ensure that there are sufficient
firms in the industry.
In the above graphical diagram, the following points have been observed :On X axis, quantity demand and supplied per week has been given and on Y axis, price has been
given.
Buyers are purchasing more at lower price and vice versa. This negative relationship is shown by
downward sloping DD curve.
Sellers are selling more at higher price and vice versa. This positive relationship is shown by
upward sloping SS curve.
Rs. 30 is that price at which demand equates supply (300 units). So, Rs. 30 is an equilibrium
price and 300 units is an equilibrium quantity.
Suppose, price fails to Rs. 20/-, So this results into increase in demand (as per Law of Demand)
and decrease in supply (as per Law of Supply). Since DD > SS, i.e. because of low supply,
sellers will be dominant and competition will be among buyers, this leads to rise in price level.
(i.e. from Rs. 20 to Rs. 30) Again price will come back at original level i.e. equilibrium price
(Rs. 30).
Suppose, supply exceeds demand (DD < SS) now buyers become dominant and competition will
be among sellers. This leads to downfall in price. (i.e. from Rs. 40 to Rs.30). Again price will
come back to original level. i.e. equilibrium price (Rs. 30).
Such automatic adjustment by demand and supply forces will keep single price in market.
Q9: Define Oligopoly and explain classification of Oligopoly.
Ans: OLIGOPOLY
Oligopoly is that market situation in which the number of firms is small but each firm in the
industry takes into consideration the reaction of the rival firms in the formulation of price policy.
The number of firms in the industry may be two or more than two but not more than 20.
Oligopoly differs from monopoly and monopolistic competition in this that in monopoly, there is
a single seller; in monopolistic competition, there is quite a larger number of them; and in
oligopoly, there are only a small number of sellers.
Classification of Oligopoly:
The oligopolistic industries are classified in a number of ways:
(a) Duopoly: If there are two giant firms in an industry it is called duopoly. Duopoly is further
classified as below:
(i) Perfect or Pure Duopoly: If the duopolists in an industry are producing identical products it
is called perfect or pure duopoly.
(ii) Imperfect or Impure Duopoly: If the duopolists in an industry are producing differentiated
products it is called imperfect or impure duopoly.
(b) Oligopoly: If there are more than two firms in an industry and each firm takes consideration
the reactions of the rival firms in formulating its own price policy it is called oligopoly.
Oligopoly is further classified as below:
(i) Perfect or Pure Oligopoly: If the oligopolists in an industry are producing identical products
it is called perfect or pure oligopoly.
(ii) Imperfect or Impure Oligopoly: If the oligopolists in an industry are producing
differentiated products it is called imperfect or impure oligopoly.
Causes of Oligopoly:
Economies of Scale: The firms in the industry, with heavy investment, using improved
technology and reaping economies of scale in production, sales, promotion, etc, will compete
and stay in the market.
Barrier to Entry: In many industries, the new firms cannot enter the industry as the big firms
have ownership of patents or control of essential raw material used in the production of an
output. The heavy expenditure on advertising by the oligopolistic industries may also be a
financial barrier for the new firms to enter the industry.
Merger: If the few firms in the industry smell the danger of entry of new firms, they then
immediately merge and formulate a joint policy in the pricing and production of the products.
The joint action of the few big firms discourages the entry of new firms into the industry.
Mutual Interdependence: As the number of firms is small in an oligopolistic industry,
therefore, they keep a strict watch of the price charged by rival firms in the industry. The firms
generally avoid price ware and try to create conditions of mutual interdependence.
Q9: Explain price determination under oligopoly.
Ans: PRICE DETERMINATION UNDER OLIGOPOLY
Effects of Oligopoly:
Small output and high prices: As compared with perfect competition, oligopolist sets the prices
at higher level and output at low level.
Restriction on the entry: Like monopoly, there is a restriction on the entry of new firms in an
oligopolistic industry.
Prices exceed Average Cost: Under oligopoly, the firms fixed the prices at the level higher than
the AC. The consumers have to pay more than it is necessary to retain the resources in the
industry. In other words, the economy’s productive capacity is not utilized in conformity with the
consumers’ preferences.
Lower efficiency: Some economists argued that there is a low level of production efficiency in
oligopoly. There is no tendency for the oligopolists to build optimum scales of plant and operate
them at the optimum rates of output. However, the Schumpeterian hypothesis states that there is
high tendency of innovation and technological advancement in oligopolistic industries. As a
result, the product cost decreases with production capacity enhancement. It will offset the loss of
consumer surplus from too high prices.
Selling Costs: In order to snatch markets from their rivals, the oligopolistic firms may engage in
aggressive and extensive sales promotion effort by means of advertisement and by changing the
design and improving the quality of their products.
Wider range of products: As compared with pure monopoly or pure competition, differentiated
oligopoly places at the consumers’ disposal a wider variety of commodities.
Welfare Effect: Under oligopoly, vide sums of money are poured into sales promotion to create
quality and design differentiations. Hence, from the point of view of economic welfare,
oligopoly fares fairly badly. The oligopolists push non-price competition beyond socially
desirable limits.
Q10: Explain price determination under price discrimination
Ans: Price Determination under Price Discrimination:
First of all, the monopolist divides his total market into sub-markets. In the following diagrams,
the monopolist has divided his total market into two sub-markets, i.e., A and B:
(ii) The monopolist has now to decide at what level of output he should produce. To achieve
maximum profit, hence, he will be in equilibrium at output at which MR=MC, and MC curve
cuts the MR curve from below. In the above diagram (c) it is shown that the equilibrium of the
discriminating monopolist is established at output OM at which MC cuts CMR. The output OM
is distributed between two markets in such a way that marginal revenue in each is equal to ME.
Therefore, he will sell output OM1 in Market A, because only at this output marginal revenue
MR’ in Market A is equal to ME (M1E’ = ME). The same condition is applied in Market B
where MR” is equal to ME (M2E” = ME). In the above diagram, it is also shown that in Market
B in which elasticity of demand is greater, the price charged is lower than that in Market B
where the elasticity of demand is less.
Q.11: Explain Price determination models of oligopoly.
Ans: Price Determination Models of Oligopoly:
1. Kinky Demand Curve: The kinky demand curve model tries to explain that in non-collusive
oligopolistic industries there are not frequent changes in the market prices of the products. The
demand curve is drawn on the assumption that the kink in the curve is always at the ruling price.
The reason is that a firm in the market supplies a significant share of the product and has a
powerful influence in the prevailing price of the commodity. Under oligopoly, a firm has two
choices:
(a) The first choice is that the firm increases the price of the product. Each firm in the industry
is fully aware of the fact that if it increases the price of the product, it will lose most of its
customers to its rival. In such a case, the upper part of demand curve is more elastic than the part
of the curve lying below the kink.
(b) The second option for the firm is to decrease the price. In case the firm lowers the price, its
total sales will increase, but it cannot push up its sales very much because the rival firms also
follow suit with a price cut. If the rival firms make larger price cut than the one which initiated it,
the firm which first started the price cut will suffer a lot and may finish up with decreased sales.
The oligopolists, therefore avoid cutting price, and try to sell their products at the prevailing
market price. These firms, however, compete with one another on the basis of quality, product
design, after-sales services, advertising, discounts, gifts, warrantees, special offers, etc.
In the above diagram, we shall notice that there
is a discontinuity in the marginal revenue curve just below the point corresponding to the kink.
During this discontinuity the marginal cost curve is drawn. This is because of the fact that the
firm is in equilibrium at output ON where the MC curve is intersecting the MR curve from
below. The kinky demand curve is further explained in the following diagram:
In the above diagram, the demand curve is made up of two segments DB and BD’. The demand
curve is kinked at point B. When the price is Rs. 10 per unit, a firm sells 120 units of output. If a
firm decides to charge Rs. 12 per unit, it loses a large part of the market and its sales come down
to 40 units with a loss of 80 units. In case, the producer lowers the price to Rs. 4 per unit, its
competitors in the industry will match the price cut. Its sales with a big price cut of Rs. 6
increases the sale by only 40 units. The firm does not gain as its total revenue decreases with the
price