Market Structures: Perfect and

Imperfect Market Structures
Market Structure

Market structure is best defined as the organizational and other characteristics

of a market. We focus on those characteristics which affect the nature of
competition and pricing – but it is important not to place too much emphasis
simply on the market share of the existing firms in an industry.

Traditionally, the most important features of market structure are:

1. The number of firms (including the scale and extent of foreign

competition)
2. The market share of the largest firms (measured by the concentration
ratio – see below)
3. The nature of costs (including the potential for firms to exploit
economies of scale and also the presence of sunk costs which affects market
contestability in the long term)
4. The degree to which the industry is vertically integrated – vertical
integration explains the process by which different stages in production and
distribution of a product are under the ownership and control of a single
enterprise. A good example of vertical integration is the oil industry, where the
major oil companies own the rights to extract from oilfields, they run a fleet of
tankers, operate refineries and have control of sales at their own filling
stations.
5. The extent of product differentiation (which affects cross-price elasticity
of demand)
6. The structure of buyers in the industry (including the possibility of
monopsony power).
7. The turnover of customers (sometimes known as “market churn”) – i.e.
how many customers are prepared to switch their supplier over a given time
period when market conditions change. The rate of customer churn is affected
by the degree of consumer or brand loyalty and the influence of persuasive
advertising and marketing.
Perfect Market Structure

The Perfect Competition is a market structure where a large number of buyers

and sellers are present, and all are engaged in the buying and selling of the
homogeneous products at a single price prevailing in the market.

In other words, perfect competition also referred to as a pure competition,

exists when there is no direct competition between the rivals and all sell
identically the same products at a single price.
 Features of Perfect Competition

1. Large number of buyers and sellers

In perfect competition, the buyers and sellers are large enough, that no
individual can influence the price and the output of the industry. An individual
customer cannot influence the price of the product, as he is too small in
relation to the whole market. Similarly, a single seller cannot influence the
levels of output, which is too small in relation to the gamut of sellers operating
in the market.

2. Homogeneous Product

Each competing firm offers the homogeneous product, such that no individual
has a preference for a particular seller over the others. Salt, wheat, coal, etc.
are some of the homogeneous products for which customers are indifferent
and buy these from the one who charges a less price. Thus, an increase in
the price would let the customer go to some other supplier.

3. Free Entry and Exit

 Under the perfect competition, the firms are free to enter or exit the industry.
This implies, If a firm suffers from a huge loss due to the intense competition
in the industry, then it is free to leave that industry and begin its business
operations in any of the industry, it wants. Thus, there is no restriction on the
mobility of sellers.

4. Perfect knowledge of prices and technology

This implies that both the buyers and sellers have complete knowledge of the
market conditions such as the prices of products and the latest technology
being used to produce it. Hence, they can buy or sell the products anywhere
and anytime they want.

5. No transportation cost

There is an absence of transportation cost, i.e. incurred in carrying the goods

from one market to another. This is an essential condition of the perfect
competition since the homogeneous product should have the same price
across the market and if the transportation cost is added to it, then the prices
may differ.

6. Absence of Government and Artificial Restrictions

Under the perfect competition, both the buyers and sellers are free to buy and
sell the goods and services. This means any customer can buy from any
seller and any seller can sell to any buyer. Thus, no restriction is imposed on
either party. Also, the prices are liable to change freely as per the demand-
supply conditions. In such a situation, no big producer and the government
can intervene and control the demand, supply or price of the goods and
services.

Thus, under the perfect competition, a seller is the price taker and cannot
influence the market price.

IMPERFECT MARKET STRUCTURE

An imperfect market refers to any economic market that does not meet the
rigorous standards of a hypothetical perfectly or purely competitive market, as
established by Marshellian partial equilibrium models.
 An imperfect market is one in which individual buyers and sellers can
influence prices and production, where there is no full disclosure of
information about products and prices, and where there are high barriers to
entry or exit in the market. It’s the opposite of a perfect market, which is
characterized by perfect competition, market equilibrium, and an unlimited
number of buyers and sellers.

Imperfect markets are found in the real world and are used by businesses and
other sellers to earn profits.

Understanding Imperfect Markets

All real-world markets are theoretically imperfect, and the study of real
markets is always complicated by various imperfections. They include the
following:

 Competition for market share

 High barriers to entry and exit
 Different products and services
 Prices set by price makers rather than by supply and demand
 Imperfect or incomplete information about products and prices
 A small number of buyers and sellers

For example, traders in the financial market do not possess perfect or even
identical knowledge about financial products. The traders and assets in a
financial market are not perfectly homogeneous. New information is not
instantaneously transmitted, and there is a limited velocity of reactions.
Economists only use perfect competition models to think through the
implications of economic activity.

The term imperfect market is somewhat misleading. Most people will assume
an imperfect market is deeply flawed or undesirable, but this is not always the
case. The range of market imperfections is as wide as the range of all real-
world markets—some are much more or much less efficient than others.
 Perfect Competition- Features,
Determination of price under
Perfect Competition
Features of Perfect Competition

There are various market forms like perfect competition, monopoly,

monopolistic competition, and oligopoly. Suppliers provide commodities based
on the market demand, their cost and revenue functions. Each market
structure leads to a different demand and revenue function. In this article, we
will look at the features of perfect competition.

An essential aspect of perfect competition is the absence of any monopolistic

element. These are the three essential features of perfect competition:

1. The number of buyers and sellers in the market is very large. These
buyers and sellers compete among themselves. Due to the large number, no
buyer or seller influences the demand or supply in the market.
2. The commodity sold or bought is homogeneous. In other words, goods
produced by different firms are identical in nature.
3. Firms can enter or exit the market freely.

Additional Features of Perfect Competition

(i) Buyers and Sellers have a perfect knowledge of:

 The quantities of stock of goods in the market

 The conditions of the market
 Prices at which transactions of sale or purchase are happening.

(ii) There are facilities that help the movement of goods from one center to
another.

(iii) Buyers have no preference between different sellers.

(iv) Also, buyers have no preference between different units of the commodity
offered for sale.

(v) Sellers have no preference between different buyers.

(vi) At any given point in time, the goods are bought or sold at a uniform price.
In other words, all firms must accept the price determined by the market
forces to total demand and supply.

DETERMINATION OF PRICE UNDER PERFECT COMPETITION

Perfect competition is defined as a market situation where there are a large

number of sellers of a homogeneous product. An individual firm supplies a
very small portion of the total output and is not powerful enough to exert an
influence on the market price.

A single buyer, however large, is not in a position to influence the market

price. Market price in a perfectly competitive market is determined by the
interaction of the forces of market demand and market supply. Market
demand means the sum of the quantity demanded by individual buyers at
different prices.

Similarly, market supply is the sum of quantity supplied by the individual firms
in the industry. Each seller and buyer takes the price as determined.
Therefore, in a perfectly competitive market, the main problem for a profit-
maximizing firm is not to determine the price of its product but to adjust its
output to the market price so that profit is maximized.

Price determination under perfect competition is analyzed under three

different time periods:

(a) Market Period

(b) Short Run

(c) Long Run

(a) Market Period

In a market period, the time span is so short that no firm can increase its
output. The total stock of the commodity in the market is limited. The market
period may be an hour, a day or a few days or even a few weeks depending
upon the nature of the product.

For example, in the case of perishable commodities like vegetables, fish,

eggs, the period may be a day. Since the supply of perishable commodities is
limited by the quantity available or stock in day that neither can be increased
nor can be withdrawn for the next period, the whole of it must be sold away on
the same day, whatever may be the price.

Fig. 1 shows that the supply curve of perishable commodities like fish is
perfectly inelastic and assumes the form of a vertical straight line SS. Let us
suppose that the demand curve for fish is given by dd. Demand curve and
supply curve intersect each other at point R, determining the price OP. If the
demand for fish increases suddenly, shifting the demand curve upwards to
d’d’.

The equilibrium point shift from R to R” and the price rises to OP’. In this
situation, price is determined solely by the demand condition that is an active
agent.
Similarly, if the demand for a product is given, as shown in demand curve SS
in figure 2. If the supply of the product decreases suddenly from SS to S’S’,
the price increases from P to P’. In this case price is determined by supply,
the supply being an active agent.

In this case supply curve shifts leftward causing increase in price of the
reduced supply goods. Given the demand curve dd and supply curve SS, the
price is determined at OP. Demand curve remaining the same, the decrease
in supply shifts the supply curve to its left to S’S’. Consequently, the price
rises from OP to OP’.

The supply curve of non-perishable but reproducible goods will not be a

vertical straight line throughout its length. This is for certain goods can be
withdrawn from the market if the price is too low as the seller would not sell
any amount of the commodity in the present market period and would like to
hold back the whole stock.

The price below which the seller declines to offer for any amount of his
product is known as ‘reserve price’. Thus, the seller faces two extreme price-
levels; at one he is ready to sell the whole stock and the other he refuses to
sell any. The amount he offers for sale will vary with price.

The seller will be ready to supply more at a higher price rather than at a lower
one will depend upon his anticipations of future price and intensity of his need
for cash. The supply curve of a seller will, therefore, slope upwards to the right
up to the price at which he is ready to sell the whole stock. Beyond this point,
the supply curve will become a vertical straight line whatever the price.
(b) Pricing in the Short Run- Equilibrium of the Firm

Short period is the span of time so short that existing plants cannot be
extended and new plants cannot be erected to meet increased demand.
However, the time is adequate enough for producers to adjust to some extent
their output to the increase in demand by overworking their fixed capacity
plants. In the short run, therefore, supply curve is elastic.

Figure 3 shows the average and marginal cost curves of the firm together with
its demand curve. Demand curve, in a perfectly competitive market, is also the
average revenue curve and the marginal revenue curve of the firm. The
marginal cost intersects the average cost at its minimum point. The U-shape
of both the cost curves reflects the law of variable proportions operative in the
short run during which the size of the plant remains fixed.

The firm is in equilibrium at the point B where the marginal cost curve
intersects the marginal revenue curve from below:

The firm supplies OQ output. The QC is the average cost and the firm earns
total profit equal to the area shown by ABCD. The firm maximizes its profit.
Earlier to the point of equilibrium, the firm does not attain the maximum profit
as each additional unit of output brings more revenue that its cost. Any level of
output greater than OQ brings less marginal revenue than marginal cost.

For the equilibrium of a firm the two conditions must be fulfilled:

(a) The marginal cost must be equal to the marginal revenue. However, this
condition is not sufficient, since it may be fulfilled and yet the firm may not be
in equilibrium. Figure 4 shows that marginal cost is equal to marginal revenue
at point e’, yet the firm is not in equilibrium as Oq output is greater than Oq’.

(b) The second and necessary condition for equilibrium requires that the
marginal cost curve cuts the marginal revenue curve from below i.e. the
marginal cost curve be rising at the point of intersection with the marginal
revenue curve.

Thus, a perfectly competitive firm will adjust its output at the point where its
marginal cost is equal to marginal revenue or price, and marginal cost curve
cuts the marginal revenue curve from below.

The fact that a firm is in equilibrium does not imply that it necessarily earns
supernormal profits. In the short-run equilibrium firms may earn supernormal
profits, normal profits or may incur losses.
Whether the firm makes supernormal profits, normal profits or incurs losses
depends on the level of the average cost at the short run equilibrium. If the
average cost is below the average revenue, the firm earns supernormal
profits. Figure 5 illustrates that the average cost QC is less than average
revenue QB, and the firm earns profits equal to the area ABCD.

If the average cost is above the average revenue the firm makes a loss.
Figure 6 shows that the Average cost QF is higher than QG average revenue
and the firm is incurring loss equal to the shaded area EFGH. In this case the
firm will continue to produce only if it is able to cover its variable costs.

Otherwise it will close down, since by discontinuing its operations the firm is
better off; it minimizes its losses. The point at which the firm covers its
variable costs is called ‘the closing-down point’. If the price falls below or
average costs rise, the firm does not cover its variable costs and is better off if
it closes down. Figure 7 explains shut- down point.
Equilibrium of the Industry

An industry is in equilibrium at that price at which the quantity demand is

equal to the quantity supplied.

Figure 8 explains that DD is the industry demand and SS the industry supply.
The point E at which industry demand and industry supply equalizes, the price
OP is determined. OQ is the quantity demanded and quantity supplied. This,
however, is a short run equilibrium where at the market-determined price
some firms may be making supernormal profits, normal profits or making
losses. In the long run the firms may not continue incurring losses. Loss
making firms that cannot adjust their plant will close down.
Firms that are making supernormal profits will expand their capacity.
Simultaneously new firms will be attracted into the industry. Free movement of
firms in and outside the industry and readjustment of the existing firms in the
industry will establish a long run equilibrium in which firms will just be earning
normal profits and there will be no tendency of entry or exit from the industry.

(c) Pricing in the Long Run

The long run is a period of time long enough to permit changes in the variable
as well as in the fixed factors. In the long run, accordingly, all factors are
variable and non- fixed. Thus, in the long run, firms can change their output by
increasing their fixed equipment. They can enlarge the old plants or replace
them by new plants or add new plants.

Moreover, in the long run, new firms can also enter the industry. On the
contrary, if the situation so demands, in the long run, firms can diminish their
fixed equipments by allowing them to wear out without replacement and the
existing firm can leave the industry.

Thus, the long run equilibrium will refer to a situation where free and full scope
for adjustment has been allowed to economic forces. In the long run, it is the
long run average and marginal cost curves, which are relevant for making
output decisions. Further, in the long run, average variable cost is of no
particular relevance. The average total cost is of determining importance,
since in the long run all costs are variable and none fixed.

In the short run a firm under perfect competition is in equilibrium at that output
at which marginal cost equals price or Marginal Revenue. This is equally valid
in the long run. But, in the long run for a perfectly competition firm to be in
equilibrium, besides marginal cost being equal to price, price must also be
equal to average cost. If the price is greater than the average cost, the firms
will be making supernormal profits.

Lured by these supernormal profits, new firms will enter the industry and these
extra profits will be competed away. When the new firms enter the industry,
the supply or output of the industry will increase and hence the price of the
output will be forced down. The new firms will keep coming into the industry
until the price is depressed down to average cost, and all firms are earning
only normal profits.
On the other hand, if the price happens to be below the average cost, the
firms will be incurring loses. Some of the existing firms will quit the industry.
As a result, the output of the industry will decrease and the price will rise to
equal the average cost so that the firms remaining in the industry are making
normal profits. Hence, in the long run, firms need not be forced to produce at
a loss since they can leave the industry, if they are having losses. Thus, for a
perfectly competitive firm to be in equilibrium in the long run, price must equal
marginal and average cost.

Now when average cost curve is falling, marginal cost curve is below it, and
when average cost curve is rising, marginal cost curve must be above it.
Hence, marginal cost can be equal to the average cost only at the point where
average cost curve is neither falling nor rising, i.e. at the minimum point of
average cost curve. Therefore, it is at the point of minimum average cost
curve, and the two are equal there.

Thus, the conditions for long run equilibrium of perfectly competitive

firm can be written as:

Price = Marginal Cost = Minimum Average Cost.

The conditions for the long run equilibrium of the firm under perfect
competition can be easily understood from the Fig. 4.9, where LAC is the long
run average cost curve and LMC in the long run marginal cost curve. The firm
under perfect competition cannot be in long run equilibrium at price OP’,
because though the price OP’ equals MC at G (i.e., at output OQ) but it is
greater than the average cost at this output and, therefore, the firm will be
earning supernormal profits.

Since all the firms are assumed to be identical, all would be earning
supernormal profits. Hence, there will be attraction for the new firms to enter
the industry. As a result, the price will be forced down to the level Op at which
price, the firm is in equilibrium at F and is producing OQ” output.

At point F or equilibrium output OQ”, the price is equal to average cost, and
hence the firm will be earning only normal profits. Therefore, at price OP,
there will be no tendency for the outside firms to enter the industry. Hence, the
firm will be in equilibrium at OP price and OQ output.

On the contrary, a firm under perfect competition cannot be in the long run
equilibrium at price OP”. Though price OP” is equal to marginal cost at point
E, or at output OQ” but price OP” is lower than the average cost at this point
and thus the firm will be incurring losses.

Since all the firms in the industry are identical in respect of cost curves, all
would be incurring losses. To avoid these losses, some of the firm will leave
the industry. As a result, the price will rise to OP, where again all firms are
making normal profits. When the price OP is reached, the firms would have no
further tendency to quit.

Thus, to conclude that at price OP, the firm under perfect competition is
in equilibrium in the long run when:

Price = MC = Minimum AC

Now, at price OP, besides all firms being in equilibrium at output OQ, the
industry will also be in equilibrium, since there will be no tendency for new
firms to enter or the existing firms to leave the industry, because all will be
earning normal profits. Thus, at OP price, full equilibrium, i.e. equilibrium of all
the individual firms and also of the industry, as a whole, is achieved in the
long run under perfect competition.
 Monopoly: Feature, Pricing
under Monopoly
The word monopoly has been derived from the combination of two words i.e.,
‘Mono’ and ‘Poly’. Mono refers to a single and poly to control.

In this way, monopoly refers to a market situation in which there is only one
seller of a commodity.

“Pure monopoly is represented by a market situation in which there is a single

seller of a product for which there are no substitutes; this single seller is
unaffected by and does not affect the prices and outputs of other products
sold in the economy.” Bilas

“Monopoly is a market situation in which there is a single seller. There are no

close substitutes of the commodity it produces, there are barriers to entry”.
-Koutsoyiannis

“Under pure monopoly there is a single seller in the market. The monopolist
demand is market demand. The monopolist is a price-maker. Pure monopoly
suggests no substitute situation”. -A. J. Braff

“A pure monopoly exists when there is only one producer in the market. There
are no dire competitions.” -Ferguson

“Pure or absolute monopoly exists when a single firm is the sole producer for
a product for which there are no close substitutes.” -McConnel

Features of Monopoly

We may state the features of monopoly as:

1. One Seller and Large Number of Buyers

The monopolist’s firm is the only firm; it is an industry. But the number of
buyers is assumed to be large.
2. No Close Substitutes

There shall not be any close substitutes for the product sold by the
monopolist. The cross elasticity of demand between the product of the
monopolist and others must be negligible or zero.

3. Difficulty of Entry of New Firms

There are either natural or artificial restrictions on the entry of firms into the
industry, even when the firm is making abnormal profits.

4. Monopoly is also an Industry

Under monopoly there is only one firm which constitutes the industry.
Difference between firm and industry comes to an end.

5. Price Maker

Under monopoly, monopolist has full control over the supply of the
commodity. But due to large number of buyers, demand of any one buyer
constitutes an infinitely small part of the total demand. Therefore, buyers have
to pay the price fixed by the monopolist.

Price Determination under Monopoly Market

A monopolist is the sole seller of a commodity. The aim of a monopolist is to

get maximum profits. Of course, everyone who enters business aims at
getting maximum profit. But there is no scope for getting abnormal profit under
competition for there are several number of sellers. But the monopolist is the
sole seller of a commodity. So he will take advantage of the situation and try
to get maximum profits. For, all those who want the good should buy it only
from him. They have no other way. So in determining the price of a
commodity, he will be guided by only one motive, that is, to maximize his
profits.

We know in a market, price is determined by the interaction of supply and

demand. Under monopoly too, the price of a good is determined by the
interaction of supply and demand, but in a different way. Under perfect
competition, there will be several number of sellers. But under monopoly, the
monopolist is the sole seller of a commodity. So he can control the supply of
his good. But he cannot control demand for there are several number of
buyers as in the case of competition.

The aim of a monopolist is to maximize his profits. For that, he can do one of
the following two things. He can fix the price for his good and leave the market
to decide what output will be required. Or he can fix the output and leave the
price to be determined by the interaction of supply and demand. In other
words, he can fix the price or the output; he cannot do both. The amounts he
can sell at any given price depend upon the conditions of demand for his
good.

Just because the monopolist is the sole seller of the commodity, we should
not think he can fix whatever price he likes. Of course, he can do it but he will
not make profits. Benham has put it will in the following lines: “The fortunate
monopolist can fix what price he chooses, but if he cannot sell enough, he
doesn’t gain; he loses.” The monopolist, therefore, has to study the conditions
of supply and demand. He must carefully estimate the demand for his goods.
He has to see first whether his commodity has got elastic demand or inelastic
demand. If the demand for the commodity is elastic, the monopolist cannot fix
a very high price because a rise in price may result in a fall of demand. So he
cannot sell much and he may not get large profits. In such a case, the
monopolist will fix a low price. If the good in question has inelastic demand,
the monopolist may fix a high price. It is so because even if the price is high,
there will not be a fall in demand. Then the monopolist will get maximum
profits by fixing a high price.

The monopolist should also study the conditions of supply. He must estimate
the cost of production for different quantities of his goods. If his firm is
producing under the conditions of the Law of Diminishing costs, cost of
production per unit will fall as output increases. Then the monopolist will try to
fix a low price and sell more units. Thereby he will try to get maximum profits.
On the other hand, if his firm is working under conditions of increasing costs,
cost of production per unit will rise as output increases. Under such
circumstances, the monopolist will generally restrict his output and sell his
goods at a high price. Thereby he will try to get maximum profits. Suppose his
firm is working under conditions of constant costs, the price he fixes will
depend largely on the conditions of demand for his goods.

The monopolist will get maximum profit at the output at which his marginal
cost and marginal revenue are equal to one another.
In the earlier stages of production, marginal cost may be much less than the
marginal revenue and the monopolist may make huge profits. But after a
certain stage is reached the marginal cost will rise and it may tend to be
higher than the marginal revenue. The monopolist will stop producing
additional units at that point. So price is fixed by the monopolist at that point
where his marginal costs and marginal revenue are equal to one another.
There is one more thing we should note. Under perfect competition too,
marginal revenue = marginal cost = price. In other words, marginal revenue is
equal to price. Under monopoly, it is true that marginal cost is equal to
marginal revenue. But marginal revenue is not equal to price. Marginal
revenue is always less than price. This is so because in order to expand his
sales, the monopolist must reduce his price. This will result in a fall in his
marginal revenue. So marginal revenue is less than price. Since marginal cost
is equal to marginal revenue, marginal cost is also less than price. In other
words, price is higher than marginal cost. We may summarize it as follows:

Under monopoly, marginal cost = marginal revenue; but marginal revenue is

less than price, therefore marginal cost is less than price. In other words, price
is greater than marginal cost.

Price Discrimination
Price discrimination is a selling strategy that charges customers different
prices for the same product or service, based on what the seller thinks they
can get the customer to agree to. In pure price discrimination, the seller
charges each customer the maximum price he or she will pay. In more
common forms of price discrimination, the seller places customers in groups
based on certain attributes and charges each group a different price.

Price discrimination is most valuable when the profit that is earned as a result
of separating the markets is greater than the profit that is earned as a result of
keeping the markets combined. Whether price discrimination works and for
how long the various groups are willing to pay different prices for the same
product depends on the relative elasticities of demand in the sub-markets.
Consumers in a relatively inelastic submarket pay a higher price, while those
in a relatively elastic sub-market pay a lower price.

[Important: Price discrimination charges customers different prices for the

same products based on a bias toward groups of people with certain
characteristics—such as educators versus the general public, domestic users
versus international users, or adults versus senior citizens.]

How Price Discrimination Works?

With price discrimination, the company looking to make the sales identifies
different market segments, such as domestic and industrial users, with
different price elasticities. Markets must be kept separate by time, physical
distance, and nature of use.

For example, Microsoft Office Schools edition is available for a lower price to
educational institutions than to other users. The markets cannot overlap so
that consumers who purchase at a lower price in the elastic sub-market could
resell at a higher price in the inelastic sub-market. The company must also
have monopoly power to make price discrimination more effective.

Types of Price Discrimination

First-degree discrimination: or perfect price discrimination, occurs when a

company charges the maximum possible price for each unit consumed.
Because prices vary among units, the firm captures all available consumer
surplus for itself. Many industries involving client services practice first-degree
price discrimination, where a company charges a different price for every
good or service sold.

Second-degree price discrimination occurs when a company charges a

different price for different quantities consumed, such as quantity discounts on
bulk purchases.

Third-degree price discrimination occurs when a company charges a

different price to different consumer groups. For example, a theater may
divide moviegoers into seniors, adults, and children, each paying a different
price when seeing the same movie.

Examples of Price Discrimination

One example of price discrimination can be seen in the airline industry.

Consumers buying airline tickets several months in advance typically pay less
 than consumers purchasing at the last minute. When demand for a particular
flight is high, airlines raise ticket prices in response.

By contrast, when tickets for a flight are not selling well, the airline reduces the
cost of available tickets to try to generate sales. Because many passengers
prefer flying home late on Sunday, those flights tend to be more expensive
than flights leaving early Sunday morning. Airline passengers typically pay
more for additional legroom too.

 With price discrimination, a seller charges customers a different fee for

the same product or service.
 With first-degree discrimination, the company charges the maximum
possible price for each unit consumed.
 Second-degree discrimination involves discounts for products or
services bought in bulk, while third-degree discrimination reflects different
prices for different consumer groups.

Monopolistic: Features, Pricing

under Monopolistic Competition
Under, the Monopolistic Competition, there are a large number of firms that
produce differentiated products which are close substitutes for each other. In
other words, large sellers selling the products that are similar, but not identical
and compete with each other on other factors besides price.

Important Points

 Monopolistic competition occurs when an industry has many firms

offering products that are similar but not identical.
 Unlike a monopoly, these firms have little power to set curtail supply or
raise prices to increase profits.
 Firms in monopolistic competition typically try to differentiate their
product in order to achieve in order to capture above market returns.
 Heavy advertising and marketing is common among firms in
monopolistic competition and some economists criticize this as wastefull.
 Features of Monopolistic Competition

1. Product Differentiation

This is one of the major features of the firms operating under the monopolistic
competition, that produces the product which is not identical but is slightly
different from each other. The products being slightly different from each other
remain close substitutes of each other and hence cannot be priced very
differently from each other.

2. Large number of firms

A large number of firms operate under the monopolistic competition, and there
is a stiff competition between the existing firms. Unlike the perfect competition,
the firms produce the differentiated products which are substitutes for each
other, thus make the competition among the firms a real and a tough one.

3. Free Entry and Exit

With an intense competition among the firms, the entity incurring the loss can
move out of the industry at any time it wants. Similarly, the new firms can
enter into the industry freely, provided it comes up with the unique feature and
 different variety of products to outstand in the market and meet with the
competition already existing in the industry.

4. Some control over price

Since, the products are close substitutes for each other, if a firm lowers the
price of its product, then the customers of other products will switch over to it.
Conversely, with the increase in the price of the product, it will lose its
customers to others. Thus, under the monopolistic competition, an individual
firm is not a price taker but has some influence over the price of its product.

5. Heavy expenditure on Advertisement and other Selling Costs

Under the monopolistic competition, the firms incur a huge cost on

advertisements and other selling costs to promote the sale of their products.
Since the products are different and are close substitutes for each other; the
firms need to undertake the promotional activities to capture a larger market
share.

6. Product Variation

Under the monopolistic competition, there is a variation in the products offered

by several firms. To meet the needs of the customers, each firm tries to adjust
its product accordingly. The changes could be in the form of new design,
better quality, new packages or container, better materials, etc. Thus, the
amount of product a firm is selling in the market depends on the uniqueness
of its product and the extent to which it differs from the other products.

The monopolistic competition is also called as imperfect competition because

this market structure lies between the pure monopoly and the pure
competition.

PRICING UNDER MONOPOLISTIC COMPETITION

Price determination under Monopolistic Competition: Equilibrium of a firm

In monopolistic competition, since the product is differentiated between firms,
each firm does not have a perfectly elastic demand for its products. In such a
market, all firms determine the price of their own products. Therefore, it faces
a downward sloping demand curve. Overall, we can say that the elasticity of
demand increases as the differentiation between products decreases.
 Fig. above depicts a firm facing a downward sloping, but flat demand curve. It
also has a U-shaped short-run cost curve.

Conditions for the Equilibrium of an individual firm

The conditions for price-output determination and equilibrium of an individual

firm are as follows:

(a) MC = MR

(b) The MC curve cuts the MR curve from below.

In Fig., we can see that the MC curve cuts the MR curve at point E. At this
point,

 Equilibrium price = OP and

 Equilibrium output = OQ

Now, since the per unit cost is BQ, we have

 Per unit super-normal profit (price-cost) = AB or PC.

 Total super-normal profit = APCB
 The following figure depicts a firm earning losses in the short-run.

From Fig., we can see that the per unit cost is higher than the price of the firm.
Therefore,

 AQ > OP (or BQ)

 Loss per unit = AQ – BQ = AB
 Total losses = ACPB

Long-run equilibrium

If firms in a monopolistic competition earn super-normal profits in the short-

run, then new firms will have an incentive to enter the industry. As these firms
enter, the profits per firm decrease as the total demand gets shared between
a larger number of firms. This continues until all firms earn only normal profits.
Therefore, in the long-run, firms, in such a market, earn only normal profits.
As we can see in Fig. above, the average revenue (AR) curve touches the
average cost (ATC) curve at point X. This corresponds to quantity Q1 and
price P1. Now, at equilibrium (MC = MR), all super-normal profits are zero
since the average revenue = average costs. Therefore, all firms earn zero
super-normal profits or earn only normal profits.

It is important to note that in the long-run, a firm is in an equilibrium position

having excess capacity. In simple words, it produces a lower quantity than its
full capacity. From Fig. above, we can see that the firm can increase its output
from Q1 to Q2 and reduce average costs. However, it does not do so because
it reduces the average revenue more than the average costs. Hence, we can
conclude that in monopolistic competition, firms do not operate optimally.
There always exists an excess capacity of production with each firm.

In case of losses in the short-run, the firms making a loss will exit from the
market. This continues until the remaining firms make normal profits only.

Product Differentiation
An important part of the marketing of the product is through product
differentiation.

This means making the product different from its competitors.

 Product differentiation can be achieved through:

 Distinctive design– e.g. Dyson; Apple iPod

 Branding – e.g. Nike, Reebok
 Performance – e.g. Mercedes, BMW

A key term to remember is USP, which is the acronym for Unique Selling
Point.

A Unique Selling Point is a feature or benefit that separates a product from its
competitors.

A USP could be a lower price, a smaller version of the product, offering extra
functions, or even simply producing a standard product in a range of colours
or designs.

A business needs to look at its unique selling points compared to competitors.

If it doesn’t have any, the business will probably struggle to make the product
seem attractive to customers (the remaining option is usually to compete
solely on price).

If a business finds that its customers are switching to competitors or buying

purely on price, it should be asked whether the business has identified the
USPs for its products and services. If it has, then the question is whether it is
communicating USPs clearly to customers?

The Advantages of a Product Differentiation Strategy

Product differentiation is a marketing strategy that businesses use to

distinguish a product from similar offerings on the market. For small
businesses, a product differentiation strategy may provide a competitive
advantage in a market dominated by larger companies. The differentiation
strategy the business uses must target a segment of the market and deliver
the message that the product is positively different from all other similar
products available.

Creates Value
When a company uses a differentiation strategy that focuses on the cost value
of the product versus other similar products on the market, it creates a
perceived value among consumers and potential customers. A strategy that
focuses on value highlights the cost savings or durability of a product in
comparison to other products.

Non-Price Competition

The product differentiation strategy also allows business to compete in areas

other than price. For example, a candy business may differentiate its candy
from other brands in terms of taste and quality. A car manufacturer may
differentiate its line of cars as an image enhancer or status symbol while other
companies focus on cost savings. Small businesses can focus the
differentiation strategy on the quality and design of their products and gain a
competitive advantage in the market without decreasing their price.

Brand Loyalty

A successful product differentiation strategy creates brand loyalty among

customers. The same strategy that gains market share through perceived
quality or cost savings may create loyalty from consumers. The company
must continue to deliver quality or value to consumers to maintain customer
loyalty. In a competitive market, when a product doesn’t maintain quality,
customers may turn to a competitor.

No Perceived Substitute

A product differentiation strategy that focuses on the quality and design of the
product may create the perception that there’s no substitute available on the
market. Although competitors may have a similar product, the differentiation
strategy focuses on the quality or design differences that other products don’t
have. The business gains an advantage in the market, as customers view the
product as unique.
 Oligopoly: Features
The Oligopoly Market characterized by few sellers, selling the 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

1. Homogeneous Product

The firms producing the homogeneous products are called as Pure or Perfect
Oligopoly. It is found in the producers of industrial products such as aluminum,
copper, steel, zinc, iron, etc.

2. Heterogeneous Product

The firms producing the heterogeneous products are called as Imperfect or

Differentiated Oligopoly. Such type of Oligopoly is found in the producers 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 enjoys a 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 with respect to any action taken by the competing
firms. Since there are few sellers in the market, if any firm makes the 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 plan their
counterattack beforehand, to escape the turmoil. Hence, there is a complete
interdependence among the sellers with respect to their price-output policies.

(iii) Advertising

Under Oligopoly market, every firm advertises their products on a frequent

basis, with the intention to reach more and more customers and increase their
customer base. This is due to the advertising that makes the competition
intense.
If any firm does a lot of advertisement while the other remained silent, then he
will observe that his customers are going to that firm who is continuously
promoting its product. Thus, in order 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 an intense
competition among the sellers. Any move taken by the firm will have a
considerable impact on its rivals. Thus, every seller keeps an eye over its rival
and be ready with the counterattack.

(v) Entry and Exit Barriers

The firms can easily exit the industry whenever it wants, but has to face
certain barriers to entering into it. These barriers could be Government
license, Patent, large firm’s 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 less 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.

Kinked Demand Curve

In an oligopolistic market, firms cannot have a fixed demand curve since it

keeps changing as competitors change the prices/quantity of output. Since an
oligopolist is not aware of the demand curve, economists have designed
various price-output models based on the behavior pattern of other firms in
the industry.

In many oligopolist markets, it has been observed that prices tend to remain
inflexible for a very long time. Even in the face of declining costs, they tend to
 change infrequently. American economist Sweezy came up with the kinked
demand curve hypothesis to explain the reason behind this price rigidity under
oligopoly.

According to the kinked demand curve hypothesis, the demand curve facing
an oligopolist has a kink at the level of the prevailing price. This kink exists
because of two reasons:

1. The segment above the prevailing price level is highly elastic.

2. The segment below the prevailing price level is inelastic.

The following figure shows a kinked demand curve dD with a kink at point P.

From the figure, we know that

(i) The prevailing price level = P

(ii) The firm produces and sells output = OM

(iii) Also, the upper segment (dP) of the demand curve (dD) is elastic.

(iv) The lower segment (PD) of the demand curve (dD) is relatively inelastic.
This difference in elasticities is due to an assumption of the kinked demand
curve hypothesis.

Assumption:

Each firm in an oligopoly believes the following two things:

(a) If a firm lowers the price below the prevailing level, then the competitors
will follow him.

(b) If a firm increases the price above the prevailing level, then the
competitors will not follow him.

There is logical reasoning behind this assumption. When an oligopolist lowers

the price of his product, the competitors feel that if they don’t follow the price
cut, then their customers will leave them and buy from the firm who is offering
a lower price.

Therefore, they lower their prices too in order to maintain their customers.
Hence, the lower portion of the curve is inelastic. It implies that if an oligopolist
lowers the price, he can obtain very little sales.

On the other hand, when a firm increases the price of its product, it
experiences a substantial reduction in sales. The reason is simple –
consumers will buy the same/similar product from its competitors.

This increases the competitors’ sales and they will have no motivation to
match the price rise. Therefore, the firm that raises the price suffers a loss and
hence refrain from increasing the price.

This behavior of oligopolists can help us understand the elasticity of the upper
portion of the demand curve (dP). The figure shows that if a firm raises the
price of a product, then it experiences a large fall in sales.

Cartels
A cartel is a grouping of producers that work together to protect their
interests. Cartels are created when a few large producers decide to co-
operate with respect to aspects of their market. Once formed, cartels can fix
prices for members, so that competition on price is avoided. In this case
cartels are also called price rings. They can also restrict output released onto
the market, such as with OPEC and oil production quotas, and set rules
governing other aspects of the behaviour of members. Setting rules is
especially important in oligopolistic markets, as predicted in game theory. A
significant attraction of cartels to producers is that they set rules that members
follow, thus reducing risks that would exist without the cartel.

The negative effects on consumers include:

(i) Higher Prices

Cartel members can all raise prices together, which reduces the elasticity of
demand for any single member.

(ii) Lack of Transparency

Members may agree to hide prices or withhold information, such as the

hidden charges in credit card transactions.

(iii) Restricted Output

Members may agree to limit output onto the market, as with OPEC and its oil
quotas.

(iv) Carving up a market

Cartel members may collectively agree to break up a market into regions or

territories and not compete in each other’s territory.

The World’s Biggest Cartel

The Organization of Petroleum Exporting Countries (OPEC) is the world’s

largest cartel. It is a grouping of 14 oil-producing countries whose mission is to
coordinate and unify the petroleum policies of its member countries and
 ensure the stabilization of oil markets. OPEC’s activities are legal because
U.S. foreign trade laws protect it.

Amid controversy in the mid-2000s, concerns over retaliation and potential

negative effects on U.S. businesses led to the blocking of the U.S. Congress
attempt to penalize OPEC as an illegal cartel. Despite the fact that OPEC is
considered by most to be a cartel, members of OPEC have maintained it is
not a cartel at all but rather an international organization with a legal,
permanent and necessary mission.

Price Leadership
Price leadership occurs when a pre-eminent firm (the price leader) sets the
price of goods or services in its market. This control can leave the leading
firm’s rivals with little choice but to follow its lead and match the prices if they
are to hold on to their market share. Price leadership is common in
oligopolies, such as the airline industry, in which a dominant company sets the
prices and other airlines feel compelled to adjust their prices to match.

Price leadership has a greater impact on goods or services that offer little
differentiation from one producer to another. Price leadership is also apparent
where levels of consumer demand make a particular price selected by the
market leader viable because consumers are drawn from competing products.
Price leadership is assumed to stabilize prices and maintain pricing discipline.
In general, effective price leadership works when

 The number of companies involved is small

 Entry to the industry is restricted
 Products are homogeneous
 Demand is inelastic, or less elastic
 Organizations have a similar long-run average total cost (LRATC)
 LRATC, an economics metric, is the minimum or lowest average total cost at
which a firm can produce any given level of output in the long run, when all
inputs are variable.

TAKEAWAYS

 Price leadership is when a pre-eminent company sets the price of goods

or services, and the other firms in its market follow suit.
 There are three primary models of price leadership: barometric,
collusive, and dominant.
 Price leadership is commonly used as a strategy among large
corporations.

Types of Price Leadership

In business economics, there are three primary models of price leadership:

barometric, collusive, and dominant.

1. Barometric

The barometric model occurs when a particular firm is more adept than others
at identifying shifts in applicable market forces—like a change in production
costs—which in turn allows it to respond most efficiently—by initiating a price
change, for instance. It is possible for a firm with a small market share to act
as a barometric leader if it is a good producer, and attuned to trends in its
market. Other producers follow its lead, assuming that the price leader is
aware of something that they have yet to realize. However, because a
barometric leader has very little power to impose its decisions on other firms
in the industry, its leadership might be short-lived.

2. Collusive

The collusive price-leadership model may emerge in an oligopoly as a result

of an explicit or implicit agreement among a handful of dominant firms to keep
their prices in mutual alignment. The smaller firms follow the price change
initiated by the dominant firms. This practice is most common in industries
where the cost of entry is high, and the costs of production are known. Such
agreements can be illegal if the effort is designed to defraud the public. There
is a fine line between actual collusion, which is unlawful, and price leadership
—especially if the price changes are not related to changes in operating costs.
3. Dominant

The dominant model occurs when one firm controls the vast majority of
market share in its industry. The leading firm is flanked by small firms that
provide the same products or services, but which cannot influence prices.
Often the dominant company ignores the interests of the smaller companies.
Therefore, dominant price leadership is sometimes referred to as a partial
monopoly. A drawback of this model is that the leader might engage in
predatory pricing by lowering its prices to levels that smaller firms cannot
sustain. Such practices that are aimed at hurting smaller companies are illegal
in most countries.