UNIT 5
Imperfect competition
Monopolistic competition
In Monopolistic competition there are large numbers of buyers and sellers which do not sell homogenous product unlike perfect competition. This is more realistic in the real world. Monopolistic competition occurs when an industry in which many firms selling products that are similar but not identical.
Monopolistic competitions try to differentiate its product. Thus it is closely related to business strategy of brand differentiation. In monopolistic competition heavy advertising and marketing is common among firms.
Monopolistic competition combines element of both monopoly and perfect competition. All firms in monopolistic competition relatively have low market power and they are all market makers.
Monopolistic competitive market
- The firm offer highly differentiated product
- Free entry and exit in the market ie no barriers
- Firm can make decision independently
- Customers have the preference of choosing products
- Seller becomes price setter
- Seller can charge marginally high price to enjoy some degree of market power
Characteristics
- Product differentiation – monopolistic competition includes firms that offer similar product but are not identical. The products are differentiated not on the basis of price but the difference includes physical aspects of the product, location from where it sells and intangible aspects of the product. The product and services performs the basic function but have difference ion quality such as type, colour, appearance, reputation, location that distinguish the product from each other. For ex, motor vehicles are same to move people from one point to another. But there are many types of motor vehicles such as car, bike, scootor.
2. Many firms – there are many firms in each product group. A product group is a "collection of similar products". Under monopolistic market, each firms has a small market share. This gives each firm a freedom to set price and each firm action have negligible impact on the market. A firm can cut the price to increase sale without any fear. As its action will not prompt retaliatory responses from competitors.
3. Freedom of entry and exit - Like perfect competition, under monopolistic competition the firms can freely enter or exit. When the existing firms makes super-normal profits, then new firms will enter. The entry of new firms leads to increase the supply of goods and services and this would reduce the price and thus the existing firms will be left only with normal profits. Similarly, if the existing firms are incurring losses, some of the firms will exit. This will reduce the supply which result decrease in price and the existing firms will be left only with normal profit.
4. Independent decision making – under monopolistic market, each firm can independently sets the terms and conditions of exchange for its product. The firm does not consider how their decision will have impact on competitors. In other words, each firm feels free to set prices and prompting heightened competition.
5. Market power – under monopolistic competition, the firms have low degree of market power. Market power means that the firm has control over the terms and conditions of exchange for its product. All firms under monopolistic competition are price makers. A firm can raise the prices of products and services without losing all its customers base. The firm can also lower prices without any effect on the competitors. Since the firm have relatively low market power, there is no barrier to entry.
Duopoly and oligopoly
Duopoly is a limiting case of oligopoly, in the sense that it has all the characteristics of oligopoly except the number of sellers which are only two increase of duopoly as against a few in oligopoly. The main distinguishing feature of duopoly (and also of oligopoly) from other market situating is that the sellers’ decisions are not independent of each other. A change in price and output by our seller affect the former, and now the former may have to react. This process of action- reaction of the sellers may continue. This when a duopolist (or an oligopolist) takes any policy decision he also takes into account the reactions of his rivals. That is, such a market situation is characteristics by the mutual interdependence in policy-making.
Thus, Oligopoly is a situation where a few large firms complete against each other and there is an element of interdependence in the decision making of these firms. Each firm in the oligopoly recognizes this interdependence. Any decision one firm makes (be it on price, product or promotion) will affect the trade of the competitors and so results in countermoves.
In order to differentiate oligopoly situation from perfect and monopoly situations, it is essential to understand the following main features of oligopoly:
- Small number of large sellers.
- Interdependence.
- Presence of monopoly element—so long products are differentiated, the firms enjoy some monopoly power, as each product will have some loyal customers.
- Existence of price rigidity.
- Advertising—Given high Gross elasticity demand for products and price rigidity in oligopoly the only way open to oligopolist is to raise his sales volume by either advertising or improving the quality. Advertisement expenditure is aimed primarily at shifting the demand in favour of the product.
Examples
Duopoly is a special case of oligopoly, in which there are exactly two sellers. Under duopoly, it is assumed that the product sold by the two firms is homogeneous and there is no substitute for it. Examples where two companies control a large proportion of a market are: (i) Pepsi and Coca-Cola in the soft drink market; (ii) Airbus and Boeing in the commercial large jet aircraft market; (iii) Intel and AMD in the consumer desktop computer microprocessor market.
Monopolistic competition price and output decision-equilibrium
Under monopolistic competition a firm can some extent independently control the supply and price of the product. The demand curve is stable and slightly downward slope
A monopolistic competitor creates output at which the marginal cost is equal to marginal revenue. The price is greater than marginal cost.
short run
In short run, the firm attains its equilibrium where marginal revenue equals marginal cost and the price is set according to its demand curve. Thus when MR=MC, profits are maximized
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In the above fig,
AR is the average revenue curve,
MR represents the marginal revenue curve,
SAC curve represents the short run average cost curve,
SMC signifies the short run marginal cost.
In the above figure we can see that at output OM, MR intersects SMC. Here price is OP’ (which is equal to MP). Thus P is the point on AR curve, which is price. PT is the supper normal profit per unit output, is the difference between the average revenue and average cost.
Long run
In the long run due to the possibility of new firms entering the industry the price under monopolistic competition becomes equal to long-run average cost giving only normal profits. So, no firm under monopolistic competition can make excess profit or loss in the long run.
When the new firm start supplying , the price would fall. Thus the AR curve shifts from right to left and supernormal profits are replaced with normal profits. The long run equilibrium is achieved when average revenue is equal to average cost.
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In the above fig we can see that, at pointP, AR curve touches the average cost curve (LAC) as a tangent. P is the equilibrium at price MP and output OM.
At MP average cost is equal to average revenue. Therefore, in long run, the profit is normal. The conditions (MR=MC and AR=AC) result in attaining equilibrium in long run.
Key takeaways –
- Monopolistic competition combines element of both monopoly and perfect competition
- A monopolistic competitor creates output at which the marginal cost is equal to marginal revenue. The price is greater than marginal cost.
- Duopoly is a limiting case of oligopoly, in the sense that it has all the characteristics of oligopoly except the number of sellers which are only two increase of duopoly as against a few in oligopoly.
Perfect competition ensures maximum possible social welfare and is said to be the ideal market form. In partial equilibrium analysis welfare is measured by the consumer surplus gained by the consumers and producer surplus earned by the producers.
Under perfect competition, the maximum possible sum of consumer surplus and producer surplus is achieved given the demand and cost conditions so that social welfare is maximised. Also, under perfect competition in the long run firms operate at the minimum point of the long-run average cost curve which ensures maximum efficiency in the use of resources.
According to this, plant is operated at its optimum or full capacity, that is, at the minimum point of short-run average cost curve of the plant.
On the other hand, firms operating in monopolistic competitive environment in their long-run equilibrium earn zero economic profits but they operate with two types of inefficiencies.
First, firms operate in the long run with excess capacity which implies inefficiency or waste in the use of resources and delay the achievement of maximum social welfare.
In long-run equilibrium under monopolistic competition, firms operate at less than the scale of output at which long-run average cost is minimum. In this long-run equilibrium situation, neither the optimum scale of plant is set up, nor the plant actually set up is operated at its optimum capacity (i.e., at minimum point of short-run average cost).
This implies higher cost and price as well as lower output than if production had been done at minimum point of LAC. Thus, the existence of excess capacity under monopolistic competition causes inefficiency in the use of resources and loss of consumer welfare.
Key takeaways
- firms operating in monopolistic competitive environment in their long-run equilibrium earn zero economic profits
- Perfect competition ensures maximum possible social welfare
- Cournot’s Duopoly model
- a French economist Augustin Cournot was the first to develop a formal duopoly model in 1838.
- This model is implied when firm produces homogenous goods, they compete simultaneously on market share and output, they expect any changes the firm make, in response the rivals not to change their output.
- Cournot uses the example of mineral spring water. Both the firm operates at zero marginal cost. The demand curve face constant negative slope. Each seller acts on the assumption that his competitor will not react to his decision to change his and price.
- The model conclude that each firm supplies one-third of the market and charges the same price. While one-third of the market remains unsupplied.
- The model is criticised that the assumption zero cost of production is totally unrealistic
2. Chamberlin’s duopoly model
- Chambrilin states that the firm takes into account the reaction of other firms to the firms output and price decision.
- His model is based on assumption of homogeneous products, firms of equal size with identical costs, no entry by new firms and full knowledge of demand.
- The single oligopolistic takes into account both the direct as well as the indirect effects of his decisions.
- Each oligopolist must be aware of the marginal costs of other firms.
- According to chamberlin, the recognition of reaction to an oligopolistic firms price and output decision would avert harmful competition and would result in a stable industry equilibrium with the monopoly price and monopoly output.
3. Bertrand’s Duopoly Model
- A French Mathematician Bertrand, developed his own model of duopoly in 1883.
- On the basis of behavioural assumption Bertrand’s model differs from Cournot’s model
- Cournot assumes rival output remains constant. While under Bertrand’s model seller determines his price on the assumption that rivals price remains constant.
- This model focuses on price competition
- The firm thinks by marginally cutting the price with others price remain same, it can capture the entire market
- The other firm also respond and price war flares up
- The process of cutting the price to capture the market goes on as long as the price exceeds the marginal cost of the firm at its current sales.
4. Stakelberg’s duopoly
- Under this model, each seller from his experience becomes aware of this rival reaction to his sales plan
- The firm then estimates his rival’s reaction curve and then make his own calculation to choose a profit maximising output.
- A firm allows his rival’s reaction in its decision making is called a leader by Stackelberg
5. Sweezy’s Kinked Demand Model:
- American economist Sweezy in 1939 came up with the kinked demand curve to explain the behaviour of oligopolistic organizations.
- A kinked demand curve occurs when the demand curve is not a straight line but due to higher and lower prices, it has a different elasticity ie elastic and inelastic.
Key takeaways –
- Duopoly is a special case in the sense that it is limiting case of oligopoly as there must be at least two sellers to make the market oligopolistic in nature.
- Four types of model are The Cournot's Duopoly Model. The Chamberlin Duopoly Model. The Bertrand's Duopoly Model. The Edgeworth Duopoly Model.
Oligopoly and interdependence
The term oligopoly has been derived from Greek words, ‘oligoi’ means few and ‘poly’ means control. Oligopoly refers to a market structure in which few sellers control the market. These sellers deal with either homogenous or differentiated products.
Oligopoly is also called ‘competition among the few’. Under oligopoly, the industry are dominated by few sellers in the market, every seller influence the behavior of other firm.
In oligopoly there are small numbers of firms in the market. As per the norms, oligopoly consist of 3 -5 dominant firms. The firms can compete with each other or collaborate to earn more profits. Here the buyers are more than the sellers. Some of the examples are automobiles, cement, steel, aluminum, etc.
Characteristics
- Few firms – under oligopoly, there are few firms and the exact number of firms is not defined. Each firm produces a significant portion of the total output, so there is severe competition.
- Barriers to entry – under oligopoly there are barrier to entry and thus the firm can earn super normal profits in the long run. Barriers to entry are patents, licenses, control over crucial raw materials, etc. The entry of new firms is prevented by these barriers.
- Non price competition - due to the fear of price wars in Oligopoly, firms try to avoid price competition. They are dependent on non price methods such as advertising, after sales services, warranties, etc.
- Interdependence - each firm is affected by the price and output decisions of rival firms since each firms hold a significant share in the total output of the industry. While determining the price and output levels, the firm takes into consideration the action and reaction of its rival firms.
- Nature of product – the firm products are homogeneous or differentiated under oligopoly.
- Selling cost – for large market share selling costs are highly important for competing against rival firms
- No unique pattern of pricing behaviour - The firms can cooperate with each other in setting the pricing policy or they may act as competitors. The pricing behaviour depends on the firm motives. The firms can compete or cooperate with other firm which leads to different pricing situations.
- Indeterminateness of the Demand Curve - Unlike other market structures, it is not possible to determine the demand curve of a firm, under Oligopoly. Under oligopoly, the demand curve is not stable and changes as per the action of rivals
The main reasons for indeterminate price and output under oligopoly are as follows:
- Different behaviour patterns – the behaviour patterns differ from organisation to organisation under oligopoly. The firms can cooperate with each other in setting the pricing policy or they may act as competitors. According to Baumol, “under the circumstances a very wide variety of behaviour patterns becomes possible. Rivals may decide to get together and co-operate in the pursuit of their objectives so far as the law allows, or at the other extreme they may try to fight each other to the death.” Thus price and output of an organisation under oligopoly differ in different behaviour patterns.
2. Intermediate demand curve - due to different behaviour patterns of organizations, the demand curve is unknown under oligopoly. Every firm observe the action of the rivals and make strategies accordingly. Under oligopoly, the demand curve is not stable and changes as per the action of rivals. According to Baumol, “the firm’s attempts to outguess one another are then likely to lead to interplay of anticipated strategies and counter strategies which is tangled beyond hope of direct analysis.”
3. Non profit motive – non profit motive implies, organisation not only aims at maximising profit, it also competes for non profit motive. Under oligopoly, these motives lead to indeterminate price and output. For ex, to promote sales firm uses advertisement and other tools.
Kinked demand model
In oligopolistic market, the competitors change the prices/quantity of output and thus firm cannot have a fixed demand curve. The price remain inflexible for a long time. American economist Sweezy in 1939 came up with the kinked demand curve to explain the behaviour of oligopolistic organizations.
A kinked demand curve occurs when the demand curve is not a straight line but due to higher and lower prices, it has a different elasticity ie elastic and inelastic.
Assumption of kinked demand curve model
- All firms in the industry are quite developed with or without product differentiation
- All firms are selling goods on satisfactory prices
- If one organisation reduces the price, then other organisation will cut the price means demand is inelastic
- If one organisation increase the price and other organisation will not increase the price, then customer will shift to low priced firm . it means demand is elastic
- There is always a prevailing price
The following figure shows a kinked demand curve dD with a kink at point P.
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From the above fig, we can see that at price P, the firm produces and sell output at OM. the upper segment dP of the demand curve dD is elastic as the price rises the demand falls. The lower segment PD of the demand curve dD is relatively inelastic as the price falls, demand for the product increases.
This model suggest that price are rigid and with the increase or decrease in price the firm will face different affects. The kink in the demand curve is due to the behaviour of rival firms to the increase or decrease in price
Impact of price rise
- The increase in price by a firm will make the product expensive and consumer will switch to the rivals.
- Increase in price will result in fall in demand. Thus it refers to price elastic
- The firm will loose revenue with increase in price because the percentage fall in demand is greater than the percentage rise in price.
Impact of price cut
- The cut in price by the firm will increase the demand for the goods and would lead to rise in revenue. The firm would gain market share
- Other firms will not see fall in their market share. They will also cut the price to follow the first one. Thus the firm will only see small increase in demand.
- If demand is inelastic and price falls, then revenue will fall.
Example of kinked demand curve
The market of petrol is homogenous and consumers are price sensitive. If one petrol pump increases the price, consumer will shift to other petrol station. If one petrol station will cut the price, the other station will also follow and cut the price.
Collusive oligopoly – price-leadership model
Collusion occurs when the rival firms agree to work together. They together set high price in order to make greater profits. Collusion refers to making higher profit in the expense of the consumer and reduces the competition in the market. Collusion is an agreement to seek higher price.
Definition
According to Samuelson, “Collusion denotes a situation in which two or more firms jointly set that prices or output, divide the market among them, or make other business decisions.”
In the words of Thomas J. Webster, “Collusion represents a formal agreement among firms in an oligopolistic industry to restrict competition to increase industry profits.”
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In the above figure we can see that when the industry is competitive quantity Q is given at price P1. As the firm collude, the price increase to P2 and quantity reduced to Q2. Thus the firm earns super normal profit.
Types of collusion
- Formal collusion – a formal agreement made between the firms to stick to high prices. This involves the creation of a cartel. The most famous cartel agreement is OPEC. OPEC control over the world petroleum market. It is also referred as two or more firms within the same industry formally agree to control the market. Such formal agreement is kept highly secret.
2. Tacit collusion – it is also referred as implicit collusion. This happens when two or more firms within the same industry informally agree to control the market.
3. Price leadership - Price leadership occurs when a firm leading in a given industry and can effectively determines the price of goods and services for the entire market. This type of firm is referred as price leaders. Price leadership is “situation in which a market leader sets the price of a product or services and competitors feel compelled to match that price”
Problems of collusion
Collusion is regulated by the government as it is seen bad for consumers and economic welfare. Collusion can lead to
- High price to consumer which result in decline in consumer surplus and allocative inefficiency
- It act as a barrier to entry. New firms are discouraged to enter the market.
- Collusion leads to easy profit which can make the firm lazy and avoid innovation to increase productivity.
Price leadership
Price leadership occurs when a firm leading in a given industry and can effectively determines the price of goods and services for the entire market. This type of firm is referred as price leaders.
Price leadership is “situation in which a market leader sets the price of a product or services and competitors feel compelled to match that price”
A dominant company sets the price and other firms with little choice have to follow its leads and adjust the price to match the price of the leading firm to hold their market share. Large firms commonly use price leadership as a strategy.
Effective leadership works under following conditions
- When the number of companies are small
- Entry to the industry are restricted
- Products are homogeneous
- Demand is inelastic or less elastic
Types of price leadership
There are three types of price leadership which includes barometric, collusive, and dominant.
- Dominant –
- In dominant price leadership, only one organisation dominates the entire industry
- It is also referred as partial monopoly.
- Under this the leading firm sets the prices and the smaller firms providing same products and services adjust and match the price of the leading firm
- The dominant firm use its monopoly power to maximise the profits
- The dominant firm ignores the interest of other organisation
- The price leader follows predatory pricing, which refers to lowering prices to levels so that smaller, competing firms find difficulty to remain in business.
2. Barometric –
- Under barometric, one organisation at first declares the change in the price and assumes that other organisation will accept it.
- The organisation need not to be leader of the firm and does not dominate others.
- Barometric leader have less power to impose its decision on the other firms
- Organisation which lacks capacity to estimate appropriate supply and demand conditions they follow the price changes made by barometric leaders
- Barometric leader is preferred as one organisation is not the only leader.
3. Collusive
- Collusive leadership is an agreement between the dominant firms to keep their prices in mutual alignment.
- This type of leadership is used in industry where the entry cost is high and cost of production is known.
- Smaller firms follow the price change effectively.
- It is done to avoid competition
- This involves illegal agreement to disrupt the market equilibrium and gain unfair market advantage.
- The firm collude to avoid uncertainties and maximise the joint profit.
Advantages
- It can secure high profit margin for the company
- Pricing strategies improves the market share of the company for a specific products and services
- The price leaders control the price of the goods and services, which makes difficult for other rivals to enter the market as disruptors
- Leads to price stability avoiding price wars to an extent
- Small firms lack sufficient knowledge into the principle of costing. They can utilize the big firm’s costing department by being price followers
Disadvantages
- The price leaders find difficulty to assess the reactions of followers.
- Leads to malpractices like the rival firm charging lower prices as compared to the price set by the price leaders
- Rival firm follow non price competition in the form of aggressive promotion strategies.
- Problem arises if there are differences in cost of price leaders and price followers. Price leader will fix lower price if cost of production is less. This will result in loss of price follower if his cost of production is more.
Key takeaways –
- Price leadership occurs when a firm leading in a given industry and can effectively determines the price of goods and services for the entire market.
- Collusion refers to making higher profit in the expense of the consumer and reduces the competition in the market.
- A kinked demand curve occurs when the demand curve is not a straight line but due to higher and lower prices, it has a different elasticity
Sources
1. Lipsey, R.G. and K.A. Chrystal, Economics, Oxford Printing Press
2. Bilas, Richard A. Microeconomic Theory: A Graphical Analysis, McGraw Hill book Co.
Kogakusha co. Ltd.
3. Amit Sachdeva, Micro Economics, Kusum Lata Publishers.
4. Chopra, P.N. Micro Economics
5. Seth, M.L. Micro Economics
