Market Structures, Competitive and Non-competitive

Equilibria, and their Efficiency Properties

Equilibrium of the firm and industry under perfect competition
 Perfect competition, as is generally understood, is said to prevail when
the following conditions are found in the market:
 There are a large number of firms producing and selling a product.
 The product of all firms is homogeneous.
 Both the sellers and buyers have perfect information about the prevailing
price in the market.
 Entry into and exit from the industry is free for the firms
We shall discuss below in detail the above four conditions of perfect
competition.
A large Number of Firms
 The first condition of perfect competition is that there are a large number
of firms in the industry. The position of a single firm in the industry
containing numerous firms is just like a drop in the ocean.
 The existence of a large number of firms producing and selling the
product ensures that an individual firm exercises no influence over the
price of the product.
 The output of an individual firm constitutes a very small fraction of the
total output of the whole industry so that any increase or decrease in
output by an individual firm has a negligible effect on the total supply of
products of the industry.
 As a result, a single firm is not in a position to influence the price of the
product by increasing or reducing its output.
 The individual firm under perfect competition, therefore, takes the price
of the product as a given datum and adjusts its output to earn maximum
profits. In other words, a firm under perfect competition is a price-taker
and output-adjuster.
Homogeneous Products
 The second condition of perfect competition is that the products produced
by all firms in the industry are fully homogeneous and identical.
 It means that the products of various firms are indistinguishable from
each other; they are perfect substitutes for one another. In other words,
cross elasticity between the products of the firms is infinite.
  In the case of homogeneous products, trademarks, patents, special brand
labels, etc. do not exist since these things make the products
differentiated. It should be noted that if there are many firms, but they are
producing differentiated products, each one of them will influence the
price of the variety of the product.
 The control over price is eliminated only when all firms are producing
homogeneous products.
Perfect Information about the Prevailing Price
 Another condition for perfect competition to prevail is that both the
buyers and sellers are fully aware of the ruling price in the market.
 Because only when all buyers know fully the current price of the product
in the market, sellers cannot charge more than the prevailing price.
 If any seller tries to charge a higher price than that ruling in the market,
then the buyers will shift to some other sellers and buy the good at the
ruling price since they know what the ruling price in the market is.
 Similarly, all sellers are also aware of the prevailing price in the market
and no one will charge less price than this.
Free Entry and Exit
 Lastly, perfect competition requires that there must be complete freedom
for the entry of new firms or the exit of the existing firms from the
industry in the long run.
 There must be no barriers to the entry of firms. Since, in the short run,
firms can neither change the size of their plants, nor new firms can enter
or old ones can leave the industry, the condition of free entry and free
exit, therefore, applies only to the long-run equilibrium under perfect
competition.
 If the existing firms are making super-normal profits in the short run, then
this condition requires that in the long run new firms will enter the
industry to compete away the profits. If,
 on the other hand, firms are making losses in the short run, some of the
existing firms will leave the industry in the long run with the result that
the price of the product will go up and the firms left in the industry will
be earning at least normal profits.
The Demand Curve of a Product Facing a Perfectly Competitive
Firm
 The first three conditions ensure that a single price must prevail under
perfect competition and the demand curve or average revenue curve faced
by an individual firm under perfect competition is perfectly elastic at the
ruling price in the market.
 A perfectly elastic demand curve signifies that the firm does not exercise
any control over the price of the product but can sell any amount of the
product as it likes at the ruling price.
 If the firm raises its price slightly above the ruling price, it will lose all
its customers to its rivals.
 Because it can sell as much as it likes at the prevailing price it has no
incentive to lower it. Without being able to raise the price and having no
incentive to lower it, the firm is content to accept the ruling price in the
market.
 Once the price in the market is established, a firm accepts as a given
datum and adjusts its output at the level which gives it maximum profits.
 Consider Fig.1. To begin with, demand curve DD and supply curve SS
intersect at point E and determine price OP.
 Now, the firm, not influence the price, will take the price OP as given and
therefore average-marginal revenue curve facing it will be a horizontal
straight line at the level of OP.
 When the demand increases and as a result the price rises to OP, the
firm will now confront the average-marginal revenue curve at the level of
OP. And if the demand decreases and price falls to OP the firm’s
average-marginal revenue curve will shift below the level of OP

Figure 1
  The fourth condition, namely, free entry and free exit, ensures that the firm
will make only normal profits in the long run.
 On the one hand, super-normal profits will disappear by the entry of new
firms in the industry and, on the other, losses will disappear as a result of
some firms leaving the industry.
EQUILIBRIUM OF THE FIRM UNDER PERFECT COMPETITION
 The short-run means a period within which the firms can alter their level
of output only by increasing or decreasing the amounts of variable factors
such as labour and raw materials, while fixed factors like capital
equipment, machinery, etc. remain unchanged. Moreover, in the short
run, new firms can neither enter the industry, nor the existing firms can
leave it.
Short-run Equilibrium of the Firm
 As explained earlier, under perfect competition, an individual firm is a
price taker, that is, it has to accept the pre- vailing price as a given datum.
It can- not influence the price by its action.
 As a result, the demand curve or average revenue curve of the firm is a
horizontal straight line (i.e., perfectly elastic) at the level of the
prevailing price. Since a perfectly competitive firm sells additional units
of output at the same price, the marginal revenue curve coincides with
the average revenue curve.
 The marginal cost curve, as usual, is U-shaped. Now, to decide about its
equilibrium output, the firm will compare the marginal cost with marginal
revenue.
 It will be in equilibrium at the level of output at which marginal cost
equals marginal revenue and marginal cost curve is cutting marginal
revenue curve from below. At this level, it will be maximizing its profits.
 Since marginal revenue is the same as price (or average revenue) under
perfect competition, the firm will equalize marginal cost with a price to
attain equilibrium output.
 Consider Fig. 2 in which price OP is prevailing in the market. PL would
then be the demand curve or the average and marginal revenue curve of
the firm.
 It will be seen from Fig. 2 that the marginal cost curve cuts average and
marginal revenue curve at two different points, F and E. F cannot be the
position of equilibrium, since, at F second-order condition of firm’s
 equilibrium, namely, that marginal cost curve must cut marginal revenue
curve from below at the point of equilibrium, is not satisfied.

Figure 2

 The firm will be increasing its profits by increasing production beyond F

because marginal revenue is greater than marginal cost. The firm will be
in equilibrium at point E or output OM since at E marginal cost equals
marginal revenue (or price), as well as marginal cost curve, is cutting
marginal revenue curve from below
 As under perfect competition, the marginal revenue curve is a horizontal
straight line, the marginal cost curve must be rising to cut the marginal
revenue curve from below. Therefore, in the case of perfect competition,
the second-order condition of a firm’s equilibrium requires that the
marginal cost curve must be rising at the point of equilibrium. Hence the
twin conditions of a firm’s equilibrium under perfect competition are:
I. MC = MR = Price
II. MC curve must be rising at the point of equilibrium.
 But the fulfilment of the above two conditions does not guarantee that the
profits will be earned by the firm. To know whether the firm is making
profits or losses and how much of them, the average cost curve must be
introduced in figure 3
 Figure 3

 SMC curves are short-run average cost and marginal cost curves
receptively
 Profit per unit of output is the difference between average revenue (price)
and average cost.
 In fig 3 at the equilibrium output OM. Average revenue is ME and the
average cost is MF therefore profit per unit of output is EF, the difference
between ME and MF
 The total profits earned by the firm will be equal to EF (profit per unit
multiplier by OM or HF) total output
 Thus, the total profits will be equal to area HFEP. Because normal profits
are included in average cost, the area HFEP is supernormal profit.
 Since we are assuming that all firms in the industry are working under the
same cost conditions and also for all of the prices is OP, all will be
earning super-normal profits equal to the area HFEP.
 Thus, while all firms in the industry will be in short-run equilibrium, but
the industry will not be in equilibrium since there will be a tendency for
the new firms to enter the industry to complete away from the super-
normal profits.
 But the short run is not a period long enough for new firms to enter the
industry the existing firms will therefore continue earning supernormal
profit equal to HEFP in the short period.
 It is evident that in the situation depicted in Fig. 3 all firms will be in
equilibrium at E and each will be producing OM output, but the tendency
for the new firms to enter the industry will be present, though they cannot
enter during the short period.
 Now suppose that the prevailing market price of the product is such that
the price line or average and marginal revenue curve lies below-average
cost curve throughout.
 This case is illustrated in Fig.4 where the ruling price is OP’ which is
taken as given by the firm. P’L’ is the price line that lies below the AC
curve at all levels of output.
 The firm will be in equilibrium at point E’ at which marginal cost is equal
to price (or marginal revenue) and marginal cost curve is rising.
 The firm would be producing OM’ output but would be making losses,
since average revenue (or price) which is equal to M’E’is less than
average cost which is equal to M’F’
 The loss per unit of output is equal to E’F’ and the total loss will be equal
to P’E’F ‘Which is the minimum loss that a firm can make under the
given price-cost situation.
 Since all the firms are working under the same cost conditions, all would
be in equilibrium at point E’ or output OM’ and everyone will be
making losses equal to P’E’F’H.
 As a result, the firms will tend to quit the industry to search for earning at
least normal profits elsewhere. We thus see that at price OP’ the firms
will be in equilibrium at E’but there will be a tendency for firms to leave
it through they cannot do so in the short period.
Deciding to Shut Down
 In the analysis of a firm's decision to continue operating or to shut down
in the short run, the difference between variable costs and fixed costs is
important.
 It will be remembered that variable costs are costs incurred on factors
such as labour, raw materials, fuel, or electricity which can be easily
varied in the short run.
 When a firm shuts down in the short run and stops producing the
commodity, the variable costs also fall to zero.
 On the other hand, a firm cannot escape from fixed costs even if it ceases
production in the short run. It should be noted that fixed costs are costs
incurred on those factors which cannot be varied in the short run.
 Thus, rent of factory building, costs on machinery purchased, wages of a
certain minimum managerial staff are some examples of fixed costs.
 When a firm stops production, that is, shuts down in the short run, it
will have to bear losses equal to the fixed costs.
 Therefore, it will be wise to continue operating in the short run when the
firm's total revenue exceeds total fixed costs because in that case firm’s
losses will be less than the fixed costs.
To make our analysis simple, we examine the question in two parts.
 The situation when a firm decides to continue operating in the short run
even when incurring losses.
 The situation when a firm decides to shut down in the short run.
The situation when a firm decides to continue operating when incurring
losses.
 A firm working under conditions of perfect competition has no control
over the price of the product. It takes the prevailing price in the market as
given and decides what level of output it should produce.
 When the price in the market falls below the average total cost, it will
suffer losses.
 To avoid losses if it shuts down and stops producing the commodity in
the short run its total revenue, as well as variable costs, will fall to zero.
 But it will have to bear losses equal to the total fixed costs.
 Therefore, it is prudent on the part of the firm to continue producing in
this situation when losses are less than total fixed costs.
 That is, it is quite rational for a firm to continue producing the commodity
in the short run if it is recovering its variable costs fully plus a part of the
fixed costs.
 But it will minimize losses by producing a level of output at which price
equals marginal cost (P = MC). This situation is illustrated in Fig. 5(a)
where the various short-run cost curves SAC, AVC, and SMC are shown.
The price of the product prevailing in the product is OP which is taken as
given by the firm.
 The firm is in equilibrium at point E where it produces OQ output at
which the given price OP is equal to the marginal cost of production
(SMC). It will be seen from Fig. 5(a) that at the equilibrium output OQ, the
average variable cost is QL, which is less than the price OP (=QE) or
Price > AVC.
 This means a firm is recovering variable cost plus a part of fixed cost
 The total revenue earned by producing output OQ is equal to area OPEQ,
while the total cost is equal to area ORTQ

Figure 5(a)

 Losses made equal to the area RTEP are less than the total fixed cost
equal to the shaded area RTLK. If a firm shuts down in the short run and
ceases to produce the product, its losses will be equal to the total fixed
cost RTLK. It will therefore be a rational decision on the part of the firm
to continue operating as shutting down in this situation will mean greater
losses equal to the entire total fixed cost.
 To conclude, the firm will continue operating in the short run at a loss
when total revenue exceeds total variable costs. This enables the firm to
earn revenue to recover a part of the fixed costs.
  We state below the condition when it is rational for
the firm to continue production in the short run
even when it is incurring losses:
TR > TVC
TR = P.Q, and TVC = AVC.Q
P.Q > AVC.Q
P > AVC
The situation when a firm decides to shut down in the short run.
 This situation is depicted in Fig. .5(b) where it will be seen that the price
has fallen to the level OP1. With price OP1, equilibrium is attained at
point D corresponding to output OQ1 at which price is equal to both
marginal cost (MC) and minimum average variable cost.
 By producing OQ1 output and selling it at price OP1, the firm earns total
revenue equal to the area OQ1 DP1. The total cost of producing OQ1
output is equal to the area OQ1 HB.
 Thus, with price OP1 the firm is incurring losses equal to the area P1
DHB. It should be noted that the average fixed cost is DH at OQ1 output,
that is, the vertical distance between SAC and AVC. The total fixed cost is
then given by the area P1 DHB.
 Thus, when the price falls to OP1, the firm’s losses are equal to the total
fixed cost. Even when the firm closes down, its losses will be equal to the
total fixed cost.
 Therefore, if the price falls below OP1 which is equal to the minimum
possible average variable cost (AVC), the losses will become greater than
the fixed costs and the firm will shut down.
 Point D which indicates the minimum possible average variable cost
represents the shut-down point.
 The situation when the firm shuts down when the price falls below
average variable cost is explained below.
 Figure 5(b)

The situation when the firm shuts down and does not operate.
 When the price of the commodity falls below the minimum possible
average variable cost, the losses would exceed the total fixed cost at the
output for which price equals marginal cost. This means that the firm will
not fully recover even variable costs which can be avoided by stopping
operations.
Long-run Equilibrium of the Firm under Perfect Competition
 The long-run is a period that is sufficiently long to allow the firms to
make changes in all factors of production. In the long run, all factors are
variable and none fixed.
 The firms, in the long run, can increase their output by changing their
capital equipment; they may expand their old plants or replace the old
lower-capacity plants with the new higher-capacity plants or add new
plants.
 Besides, in the long run, new firms can enter the industry to compete with
the existing firms
 the firms can leave the industry in the long run.
 The long-run equilibrium then refers to the situation when a free and full
adjustment in the capital equip meant as well as in the number of firms
has been allowed to take place.
 It is therefore long-run average and marginal cost curves which are
relevant for deciding about equilibrium output in the long run.
 Moreover, in the long run, it is the average total cost that is of
determining importance, since all costs are variable and none fixed
 As explained above, a firm is in equilibrium under perfect competition
when marginal cost is equal to price. But for the firm to be in long-run
equilibrium, besides marginal cost is equal to price, the price must also be
equal to average cost.
 For, if the price is greater or less than the average cost, there will be a
tendency for the firms to enter or leave the industry.
 If the price is greater than the average cost, the firms will earn more than
normal profits.
 These supernormal profits will attract other firms into the industry.
 With the entry of new firms in the industry, the price of the product will
go down as a result of the increase in the supply of output, and also the
cost will go up as a result of more intensive competition for factors of
production.
 The firms will continue entering the industry until the price is equal to the
average cost so that all firms are earning only normal profits.
 On the contrary, if the price is lower than the average cost, the firms
would make losses. These losses will induce some of the firms to quit the
industry.
 As a result, the output of the industry will fall which will raise the price.
 On the other hand, with some firms going out of the industry, the cost
may go down as a result of a fall in the demand for certain specialized
factors of production.
 The firms will continue leaving the industry until the price is equal to the
average cost so that the firms remaining in the field are making only
normal profits. It, therefore, follows that for a perfectly competitive firm
to be in long-run equilibrium, the following two conditions must be
fulfilled.
 Price = Marginal Cost
 Price = Average Cost
 If price is equal to both marginal cost and average cost, then we have a
double condition of long-run perfectly competitive equilibrium:
Price = Marginal Cost = Average Cost
 But from the relationship between marginal cost and average cost, we
know that marginal cost is equal to average cost only at the minimum
point of the average cost curve. Therefore, the condition for the long-run
equilibrium of the firm can be written as:
Price = Marginal Cost = Minimum Average Cost
 Fig. 6 represents the long-run equilibrium of the firm under perfect
competition. The firm cannot be in the long-run equilibrium at a price
greater than OP in Fig 6.
 This is because if the price is greater than OP, then the price line (demand
curve) would lie somewhere above the minimum point of the average
cost curve so that marginal cost and price will be equal where the firm is
earning abnormal profits.
 Since there will be a tendency for new firms to enter and compete away
these abnormal profits, the firm cannot be in long-run equilibrium at any
price higher than OP.
 Likewise, the firm cannot be in long-run equilibrium at a price lower than
OP in Fig. 6 under perfect competition.
 If the price is lower than OP, the average and marginal revenue curve will
lie below the average cost curve so that the marginal cost and price will
be equal at the point where the firm is making losses.
 Therefore, there will be a tendency for some of the firms in the industry
to go out with the result that price will rise and the firms left in the
industry make normal profits.
 We, therefore, conclude that the firm can be in long-run equilibrium under
perfect competition only when the price is at such a level that the
horizontal demand curve (that is, AR curve) is tangent to the average cost
curve so that price equals average cost and firm makes only normal
profits.
 It is clear from above that the long-run equilibrium of the firm under
perfect competition is established at the minimum point of the long-run
average cost curve. Working at the minimum point of the long-run
average cost curve signifies that the firm is producing with the plant of
optimum scale, that is, with the lowest possible level of the short-run
average cost curve.
 Figure 6

Price and output under monopoly

 Monopoly is said to exist when one firm is the sole producer or seller of
a product which has no close substitutes. Three points are worth noting
in this definition.
 First, there must be a single producer or seller of a product if there is to be
a monopoly. This single producer may be in the form of an individual
owner or a single partnership or a joint-stock company.
 If many producers are producing a product, either perfect competition or
monopolistic competition will prevail depending upon whether the
product is homogeneous or differential.
 On the other hand, when there are few producers or sellers of a product,
oligopoly is said to exist. If then there is to be monopoly, there must be
one firm in the industry. Even literally monopoly means one seller.
‘Mono’ means one and ‘poly’ means the seller. Thus, monopoly means
one seller or one producer.
 A second condition that is essential for a firm to be called monopolistic is
that no close substitutes for the product of that monopolistic firm
should be available in the market
 The fact that there is one firm under monopoly means that other firms for
one reason or other are prohibited to enter the monopolistic industry. In
other words, strong barriers to the entry of firms exist wherever there is
one firm having sole control over the production of a commodity.
The nature of demand and marginal revenue curves under
monopoly
 It is important to understand the nature of the demand curve facing a
monopolist.
 The demand curve facing an industrial firm under perfect competition, as
explained in a previous chapter, is a horizontal straight line, but the
demand curve facing the whole industry under perfect competition is
sloping downward.
 This is so because the demand is by the consumers and the demand curve
of consumers for a product usually slopes downward. The downward-
sloping demand curve of the consumers faces the whole competitive
industry
 In the case of monopoly one firm constitutes the whole industry.
 Therefore, the entire de- mand of the consumers for a product faces the
monopolist. Since the demand curve of the consumers for a product slope
downward, the monopolist faces a downward-sloping demand curve.
 If he wants to increase the sale of his good, he must lower the price. He
can raise the price if he is prepared to sacrifice some sales.
 Consider Fig.7.1 DD is the demand curve facing a monopolist.
 At price OP the quantity demanded is OM, therefore he would be able to
sell OM quantity at price OP. If he wants to sell a greater quantity ON,
then price the to OL. If would he restricts his quantity to OG, the falling
price will rise to OH.
 Thus, every quantity change by him entails a change in price at which the
product can be sold. Thus the problem faced by a monopolist is to choose
a price-quantity combination that is optimum for him, that is, which
yields him maximum possible profits.
 The demand curve facing the monopolist will be his average revenue
curve. Thus, the average revenue curve of the monopolist slopes
downward throughout its length. Since the average revenue curve slopes
downward, the marginal revenue curve will lie below it.
 Figure 7.1
and 7.2

 This follows from the usual average-marginal relationship. The

implication of marginal revenue curve lying below-average revenue curve
is that the marginal revenue will be less than the price or average revenue
 When a monopolist sells more, the price of his product falls; marginal
revenue therefore must be less than the price. In Fig. 7.2 AR is the
average revenue curve of the monopolist and slopes downward. MR is the
marginal revenue curve and lies below the AR curve.
 At quantity OM, average revenue (or price) is MP and marginal revenue
is MQ which is less than MP. In an earlier chapter we have explained that
average and marginal revenue at a quantity is related to each other
through price elasticity of demand and in this connection, we derived the
following formula:

Price–output equilibrium under monopoly

 Monopoly equilibrium is depicted in Fig.8 The monopolist will go on
producing additional units of output so long as marginal revenue
exceeds marginal cost.
 This is because it is profitable to produce an additional unit if it adds
more to revenue than to cost.
 His profits will be maximum and he will attain equilibrium at the level of
output at which marginal revenue equals marginal cost.
 If he stops short of the level of output at which MR equals MC, he will be
unnecessarily forgoing some profits which otherwise he could make.
 In Fig.8, marginal revenue is equal to marginal cost at OM level of
output.
 The firm will be earning maximum profits and will therefore be in
equilibrium when it is producing and selling the OM quantity of the
product.
 If he increases his output beyond OM, marginal revenue will be less
than marginal cost, that is, additional units beyond OM will add more to
cost than to revenue. Therefore, the monopolist will be incurring a loss on
the additional units beyond OM and will thus be reducing his total profits
by producing more than OM.
 Thus he is in equilibrium at the OM level of output at which marginal
cost equals marginal revenue (MC =MR)

Figure 8

 It will be seen from the AR curve in Fig. 3 that he will be getting the price
MS or OP by selling OM quantity of output.
 The total profits earned by him are equal to the area HTSP. There is here
a significant difference between monopoly and perfect competition.
 The price under perfect competition is equal to marginal cost, but
under monopoly price is greater than marginal cost. Therefore, in
monopoly equilibrium when marginal cost is equal to marginal revenue,
it is less than price (or average revenue).
 From Fig.8 it will be noticed that at equilibrium output OM, marginal
cost and marginal revenue are equal and both are here equal to ME, while
 the price fixed by a monopolist is MS or OP. It thus follows that price
under monopoly is greater than marginal cost.

Long-run equilibrium under monopoly

 In the long run, the monopolist would adjust the size of his plant.
 The long-run average cost curve and its corresponding long-run marginal
cost curve portray the alternative plants, i.e., various plant sizes from
which the firm has to choose for operation in the long run.
 The monopolist would choose the plant size which is most appropriate for
a particular level of demand. In the short run, the monopolist adjusts the
level of output while working with a given existing plant.
 His profit-maximizing output in the short run will be where only the
short-run marginal cost curve (i.e., marginal cost curve with the existing
plant) is equal to marginal revenue. But in the long run, he can further
increase his profits by adjusting the size of the plant.
 So in equilibrium, he will be at the output where given marginal revenue
cuts the long-run marginal cost curve
 the firm will operate at a point on the long-run average cost curve
(LAC) at which the short-run average cost is tangent to it.
 This is because it is only at such a tangency point that the short-run
marginal cost (SMC) of a plant equals the long-run marginal cost (LMC).
 Figure 9 portrays the long-run equilibrium of the monopolist. He is in
equilibrium at OL output at which long-run marginal curve LMC
intersects marginal revenue curve MR.

Figure 9

 Given the level of demand as indicated by positions of AR and MR

curves, he would choose the plant size whose short-run average and
 marginal cost curves are SAC and SMC. He will be charging a price equal
to LQ or OP and will be making profits equal to the area of rectangle
THQP.
 It, therefore, follows that for the monopolist to maximize profits in the
long run, the following conditions must be fulfilled
 MR = LMC = SMC
 SAC = LAC
 P > LAC
 The last condition implies that in a long-run monopoly equilibrium price
of the product should be either greater than the long-run average cost or at
least equal to it.
 The price cannot fall below long-run average cost because in the long
run, the monopolist will quit the industry if it is not even able to make
normal profits

MONOPOLISTIC COMPETITION
 Perfect competition and monopoly are rarely found in the real world and
thus they do not represent, for the most part, the actual market situations.
Therefore, the conclusions which follow from the theories of pure
competition were found to be inapplicable to the behaviour of business
firms in the actual world.
 The monopolistic competition theory of Prof. Chamberlin and the
imperfect competition theory of Joan Robinson, though similar in various
ways differ in some important respects.
 The nutshell of these theories, especially of the theory of monopolistic
competition, is that pure competition and pure monopoly are the two
opposite limiting cases, lying between which is a series of intermediate
causes, which differ from each other in relative strengths of monopoly
and competitive elements, or other words, in degrees of imperfection.
Important features of monopolistic competition
 It is important to understand the important characteristics of monopolistic
competition. The knowledge of these features will enable the students to
know how this form of market structure is different from perfect
competition and oligopoly. We explain below its important features.
A large number of firms.
  The first important feature of monopolistic competition is that under it
there are a relatively large number of firms each satisfying a small share
of the market demand for the product.
 Because there is a large number of firms under monopolistic competition,
there exists stiff competition between them. Unlike perfect competition,
these large numbers of firms do not produce identical products. Instead,
they produce and sell differentiated products which are close substitutes
for each other.
 This makes the competition among firms real and tough.
 Further, the fact that there is a large number of firms under monopolistic
competition, the size of each firm will be relatively small. This is unlike
oligopoly where there are a few firms of big size.
Product differentiation.
 The second important feature of monopolistic competition is that the
products produced by various firms are not identical but are slightly
different from each other.
 Though different firms make their products slightly different from others,
they remain close substitutes for each other. In other words, the products
of various firms working under monopolistic competition are not the same
but are similar.
 Therefore, their prices cannot be very much different from each other. It
is because their products are similar and close substitutes of each other
that the various firms under monopolistic competition compete with each
other.
Some influence over the price.
 Each firm under monopolistic competition produces a product variety that
is a close substitute for others.
 Therefore, if a firm lowers the price of its product variety, some
customers of other product varieties will switch over to it. This means as
it lowers the price of its product variety, the quantity demanded of it will
increase.
 On the other hand, if it raises the price of its product, some of its
customers will leave it and buy similar products from its competing
firms. This implies that the demand curve facing a firm working under
monopolistic competition slopes downward and the marginal revenue
curve lies below it.
 This means that under monopolistic competition an individual firm is not
a price taker but will have some influence over the price of its product. If
 it fixes a higher price, it will be able to sell a relatively smaller quantity of
output. And if it fixes a lower price, it will be able to sell more. Thus
under monopolistic competition, a firm has to choose a price-output
combination that will maximize its profits.
Non-price competition: Expenditure on the advertisement and other selling
costs.
 An important feature of monopolistic competition is that firms incur a
considerable expenditure on advertisements and other selling costs to
promote the sales of their products.
 Promoting sales of their products through advertisement is an important
example of non-price competition. The expenditure incurred on
advertisement is prominent among the various types of selling costs.
 The advertisement and other selling outlay by a firm change the demand
for its product as well as its costs. Like the adjustments of price and
product, a seller under monopolistic competition will also adjust the
amount of his advertisement expenditure to maximize his profits.
 This problem of adjusting one’s selling outlay is unique to monopolistic
competition because the firm under perfect competition has not to incur
any expenditure on the advertisement.
 The advertisement expenditure by a purely competitive firm will be
without purpose since it can sell as much amount as it pleases at the
going market price without any advertisement expenditure.
 The rival firms under monopolistic competition keenly compete with
each other through advertisement by which they change the consumers’
wants for their products and attract more customers.
Product variation.
 Another form of non-price competition which a firm under monopolistic
competition has to face is the variation in products by various firms.
 The variation of the product may refer to a change in the quality of the
product itself, technical changes, a new design, better materials, and it
may mean only a new package or container. It may also mean more
prompt or courteous service and a different way of doing business.
 The amount of the product which a firm will be able to sell in the market
depends in part upon how its product differs from others.
 Where the possibility of product differentiation exists, sales depend upon
the skill with which a product is distinguished from others and made to
appeal to a particular group of buyers.
  The profit maximization principle applies to the choice of the nature of
the product as to its price. In other words, a firm will choose the nature of
the product, given its price, which gives it maximum profits.
Freedom of entry and exit.
 This is another important feature of monopolistic competition. In a
monopolistically competitive industry, it is easy for the new firms to
enter and the existing firms to leave it.
 Free entry means that when in the industry existing firms are making
super-normal profits, the new firms enter the industry which leads to the
expansion of output.
 under monopolistic competition, the new firms can produce only new
brands or product varieties which may initially find it difficult to compete
with the already well-established brands and product varieties.
Price-output equilibrium under monopolistic competition
 under monopolistic competition, an individual firm’s market is isolated to
a certain degree from those of its rivals with the result that its sales are
limited and depend upon
( 1 ) its price, (2) the nature of its product, and (3) the advertising outlay
it makes.
 Thus, the firm under monopolistic competition has to confront a more
complicated problem than the perfectly competitive firm
Individual Firm’s Equilibrium under Monopolistic Competition
 The demand curve for the product of an individual firm, as noted above,
is downward sloping. Since the various firms under monopolistic
competition produce products that are close substitutes of each other, the
position and elasticity of the demand curve for the product of any of them
depend upon the availability of the competiting substitutes and their
prices.
 Therefore, the equilibrium adjustment of an individual firm cannot be
defined in isolation from the general field of which it is a part.
 However, for the sake of simplicity in analysis, conditions regarding the
availability of substitute products produced by the rival firms and prices
charged for them are held constant while the equilibrium adjustment of an
individual firm is considered in isolation.
 Since close substitutes for its product are available in the market, the
demand curve for the product of an individual firm working under
conditions of monopolistic competition is fairly elastic.
 Thus, although a firm un- der monopolistic competition has monopolistic
control over its variety of the product its control is tempered by the fact
that there are close substitutes available in the market and that if it sets too
high a price for its product, many of its customers will shift to the rival
products.
 Assuming the conditions concerning all substitutes such as their nature
and prices being constant, the demand curve for the product of a firm will
be given.
 We further suppose that the product of the firm constant, only variables
are price and out-put in respect of which equilibrium adjustment is to be
made. The individual equilibrium under monopolistic competition is
graphically shown in Fig.10. DD is the demand curve for the product
of an individual firm, the nature and prices of all substitutes being given

Figure 10

 This demand curve DD is also the average revenue (AR) curve of the
firm. AC represents the average cost curve of the firm, while MC is the
marginal cost curve corresponding to it. It may be recalled that the
average cost curve first falls due to internal economies and then rises
due to internal diseconomies.
 Given these demand and cost conditions, a firm will adjust its price and
output at the level which gives it maximum total profits.
 The theory of value under monopolistic competition is also based upon
the profit maximization principle, as is the theory of value under perfect
competition.
 Thus, a firm to maximize profits will equate marginal cost with marginal
revenue. In Fig.10 the firm will fix its level of output at OM, for at OM
output marginal cost is equal to marginal revenue.
 The demand curve DD facing the firm in question indicates that output
OM can be sold at price MQ = OP.
 Therefore, the determined price will be MQ or OP. In this equilibrium
position, by fixing its price at OP and output at OM, the firm is making
profits equal to the area RSQP which is maximum.
 It may be recalled that profits RSQP are more than normal profits
because the normal profits which represent the minimum profits
necessary to secure the entrepreneur’s services are included in the
average cost curve AC.
 Thus, the area RSQP indicates the amount of supernormal or economic
profits made by the firm.
 In the short run, the firm, in equilibrium, may make supernormal profits,
as shown in Fig. 11 above, but it may make losses too if the demand
conditions for its product are not so favorable relative to cost conditions.
 Fig. 11 depicts the case of a firm whose demand or average revenue curve
DD for the product lies below the average cost curve throughout
indicating thereby that no output of the product can be produced at
positive profits.
 However, the firm is in equilibrium at output ON and setting price NK or
OT, for by adjusting price at OT and output at ON, it is rendering the
losses to the minimum. In such an unfavorable situation there is no
alternative for the firm except to make the best of the bad bargain.
 We thus see that a firm in equilibrium under monopolistic competition, as
under pure or perfect competition, maybe making supernormal profits or
losses depending upon the position of the demand curve relative to the
position of the average cost curve.
 Further, a firm may be making only normal profits even in the short run
if the demand curve happens to be tangent to the average cost curve.
 It should be carefully noted that in the individual equilibrium of the firm
both in Fig. 10 and Fig. 11, the firm having once adjusted price at OP and
OT respectively will not tend to vary the price anymore.
 If it varies its price upward, the loss due to the fall in quantity demanded
will be more than made up by the higher price.
 If it cuts down its price, the gain due to the increase in quantity demanded
will be less than the loss due to the lower price. Hence, the price will
remain stable at OP and OT in the two cases respectively.
 Figure 11

Excess capacity under monopolistic or imperfect competition

 Theories of Chamberlin’s monopolistic competition and Joan Robinson’s
imperfect competition have revealed that a firm under monopolistic
competition or imperfect competition in long-run equilibrium produces an
output that is less than socially optimum or ideal output. \
 This means that firms operate at the point on the falling portion of the
long-run average cost curve, that is, they do not produce the level of
output at which long-run average cost is minimum.
 The amount by which the actual long-run output of the firm under
monopolistic competition falls short of the socially ideal output is a
measure of excess capacity which means unutilized capacity
 The existence of excess capacity under imperfect or monopolistic
competition can be understood from Figures 12.1 and 12-2 depicts the
long-run position of a perfectly competitive firm that is in long-run
equilibrium at the level of output ON corresponding to which long-run
average cost is minimum.
 It is at output ON that the double condition of long-run equilibrium,
namely P= MC = AC is fulfilled.
 Figure 12.1 and 12.2

 It is thus clear that firms under perfect competition produce socially ideal
output. On the other hand, a firm under monopolistic competition depicted
in Fig. 12.1 is in long-run equilibrium at output OM at which its marginal
revenue is equal to marginal cost and price is equal to average cost
(Average revenue curve AR is tangential to average cost curve LAC at
point F corresponding to output OM).
 It will be noticed that at output OM long-run average cost is still falling
and goes on falling up to output ON.
 This means that the firm can expand its production up to ON and reduce
its long-run average cost to the minimum. Ideal output is the output at
which the long-run average cost is minimum.
 Therefore, the firm is producing MN less than the ideal output. Thus,
MN output represents the excess capacity that emerges under
monopolistic competition. It is worth noting that the concept of excess
capacity refers only to the long run.
 This is because in the short run under any type of market structure
(including perfect competition) there can be all sorts of departures from
the ideal reflecting incomplete adjustment to the existing market
conditions.

OLIGOPOLY MARKET
 Oligopoly refers to the presence of few sellers in the market selling
homogeneous or differentiated products. In other words, the Oligopoly
market structure lies between the pure monopoly and monopolistic
competition, where few sellers dominate the market and have control
over the price of the product
  Under the Oligopoly market, a firm either produces homogeneous or
heterogeneous products:
 Homogeneous Product: The firms producing the homogeneous products
are called Pure or Perfect Oligopoly. It is found in the case of industrial
products such as aluminium, copper, steel, zinc, iron, etc
 Heterogeneous Product: The firms producing the heterogeneous
products are called Imperfect or Differentiated Oligopoly. Such a type of
Oligopoly is found in the production of consumer goods such as
automobiles, soaps, detergents, television, refrigerators, etc.
Features of Oligopoly Market
I. Few Sellers:
 Under the Oligopoly market, the sellers are few, and the customers
are many. Few firms dominating the market enjoy considerable
control over the price of the product.
II. Interdependence:
 It is one of the most important features of an Oligopoly market,
wherein, the seller has to be cautious concerning any action taken
by the competing firms. Since there are few sellers in the market, if
any firm makes a change in the price or promotional scheme, all
other firms in the industry have to comply with it to remain in the
competition.
 Thus, every firm remains alert to the actions of others and plans its
counterattack to escape the turmoil. Hence, there is a complete
interdependence among the sellers concerning their price-output
policies.
III. Advertising:
 Under the Oligopoly market, every firm advertises its products
frequently to reach more and more customers and increase its
customer base.
 This advertising makes the competition intense. If any firm does a
lot of advertisement while the other remained silent, then you will
observe that its customers are going to the firm which is
continuously promoting its product. Thus, to be in the race, each
firm spends lots of money on advertisement activities.
IV. Competition:
 It is genuine that with a few players in the market, there will be
intense competition among the sellers. Any move by one firm will
have a considerable impact on its rivals. Thus, every seller keeps
an eye over its rivals and be ready with the counterattack.

V. Entry and Exit Barriers:

  The firms can easily exit the industry whenever they want but have
to face certain barriers to enter into it.
 These barriers could be Government licenses, Patents, large firms’
economies of scale, high capital requirement, complex technology,
etc. Also, sometimes the government regulations favor the existing
large firms, thereby acting as a barrier for the new entrants.

VI. Lack of Uniformity:

 There is a lack of uniformity among the firms in terms of their size,
some are big, and some are small.
 Since there are a smaller number of firms, any action taken by one
firm has a considerable effect on the other. Thus, every firm must
keep a close eye on its counterpart and plan the promotional
activities accordingly.

Paul Sweezy Model: Kinked Demand Curve Analysis

 This model was developed independently by Prof. Paul M. Sweezy on the

one hand and Profs. R. C. Hall and C. J. Hitch on the other hand.

The assumptions of this model are:

i) There are only a few firms in an oligopolistic market.

ii) The firms are producing close-substitute products.
iii) The quality of the products remains constant and the firms do not spend on
advertising.
iv) A set of prices of the product has already been determined and these prices
prevail in the market at present.
v) Each firm believes that if it reduces the price of its product, the rival firms
would follow suit, but if it increases the price, the rivals would not follow it.
They would simply keep their prices unchanged.

We shall see presently that, because of this asymmetric pattern of reaction of the
rivals, the demand curve of each firm would have a kink at the prevailing price
of its product.

Why the Kink in the Demand Curve?

 In the figure, we have drawn two negatively sloped straight-line demand

curves, viz., dd' and DD'. Of these two curves, dd' is flatter than DD'.
 Now, when one particular firm in the industry changes the price of its
product, all other firms keeping their prices constant, the firm’s demand
curve will be relatively flattered like dd', i.e., the magnitude of the change
in the demand for its product as its price changes would be relatively
larger.

Figure 14

 This is because, as the firm reduces or increases the price of its product,
the prices of the products of other firms remaining constant, the product
of the firm becomes relatively cheaper or dearer, respectively, than those
of the other firms. This will make the demand curve flatter for this firm.
 On the other hand, if a firm increases its price, the office firms will not
follow the suit.
 So, there will be an asymmetry in the responses of the rivals. If one firm
reduces price, all others follow the suit otherwise they run the risk of
losing their customers to this firm.
 If one raises the price, others do not as they expect to win some
customers from this firm. Together, these responses create a kink in the
demand curve.
 Let us suppose that initially the price of the product of the firm is p1 or
Op1 and the demand for the product is q1 or Oq1 If the firm now
increases its price from p1, the rival firms would keep their prices
unchanged according to assumption (v) of this model.
 In this case, the firm’s demand would decrease along the segment Rd of
the relatively more elastic demand curve dd'.
 On the other hand, if it goes on decreasing its price from p1, its rivals
also would be decreasing their prices according to assumption (v). In this
case, the quantity demanded of the firm’s product will increase along the
segment RD' of the relatively steeper demand curve DD'.
 Therefore, at the price p1, the firm’s demand curve would be dRD'.
Obviously, because of assumption (v), the segment dR of this demand
curve would be flatter or more elastic than the segment RD' (and the
segment RD' would be steeper or less elastic than the segment dR).
 As a result, there would be a kink at the prevailing price p1, or, at the
point R on the firm’s demand curve d RD', i.e., the demand curve in this
model would be kinked.