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INTRODUCTION
In the preceding unit, you have been introduced to the concept of market structure and the impact it has on the competitive behaviour of firms. You must have noted that the number and size of the firms is an important determinant of the structure of the industry and/or market. In this unit, we shall analyse the behaviour of a firm under two different market structures, namely, pure/perfect competition and monopoly. The crucial parameter is the size of the constituent firms in relation to the total industry’s output. Throughout this unit, we go by the assumption that the firms are guided by profit maximisation.
CHARACTERISTICS OF PERFECT COMPETITION
Perfect competition is a form of market in which there are a large number of buyers and sellers competing with each other in the purchase and sale of goods, respectively and no individual buyer or seller has any influence over the price. Thus perfect competition is an ideal form of market structure in which there is the greatest degree of competition.
A perfectly competitive market has the following characteristics:
1. There are a large number of independent, relatively small sellers and buyers as compared to the market as a whole. That is why none of them is capable of influencing the market price. Further, buyers/sellers should not have any kind of association or union to arrive at an understanding with regard to market demand/price or sales.
2. The products sold by different sellers are homogenous and identical. There should not be any differentiation of products by sellers by way of quality, variety, colour, design, packaging or other selling conditions of the product. That is, from the point of view of buyers, the products of competing sellers are completely substitutable.
3. There is absolutely no restriction on entry of new firms into the industry and the existing firms are free to leave the industry. This ensures that even in the long run the number of firms would continue to remain large and the relative share of each firm would continue to remain insignificant.
4. Both buyers and sellers in the market have perfect knowledge about the conditions in which they are operating. Buyers know the prices being charged by different competing sellers and sellers know the prices that different buyers are offering.
5. The distance between the location of competing sellers is not significant and therefore the price of the product is not affected by the cost of transportation of goods. Buyers do not have to incur noticeable transport costs if they want to switch over from one seller to another.The characteristics of perfect competition are summarised in Table
In the preceding unit, you have been introduced to the concept of market structure and the impact it has on the competitive behaviour of firms. You must have noted that the number and size of the firms is an important determinant of the structure of the industry and/or market. In this unit, we shall analyse the behaviour of a firm under two different market structures, namely, pure/perfect competition and monopoly. The crucial parameter is the size of the constituent firms in relation to the total industry’s output. Throughout this unit, we go by the assumption that the firms are guided by profit maximisation.
CHARACTERISTICS OF PERFECT COMPETITION
Perfect competition is a form of market in which there are a large number of buyers and sellers competing with each other in the purchase and sale of goods, respectively and no individual buyer or seller has any influence over the price. Thus perfect competition is an ideal form of market structure in which there is the greatest degree of competition.
A perfectly competitive market has the following characteristics:
1. There are a large number of independent, relatively small sellers and buyers as compared to the market as a whole. That is why none of them is capable of influencing the market price. Further, buyers/sellers should not have any kind of association or union to arrive at an understanding with regard to market demand/price or sales.
2. The products sold by different sellers are homogenous and identical. There should not be any differentiation of products by sellers by way of quality, variety, colour, design, packaging or other selling conditions of the product. That is, from the point of view of buyers, the products of competing sellers are completely substitutable.
3. There is absolutely no restriction on entry of new firms into the industry and the existing firms are free to leave the industry. This ensures that even in the long run the number of firms would continue to remain large and the relative share of each firm would continue to remain insignificant.
4. Both buyers and sellers in the market have perfect knowledge about the conditions in which they are operating. Buyers know the prices being charged by different competing sellers and sellers know the prices that different buyers are offering.
5. The distance between the location of competing sellers is not significant and therefore the price of the product is not affected by the cost of transportation of goods. Buyers do not have to incur noticeable transport costs if they want to switch over from one seller to another.The characteristics of perfect competition are summarised in Table
As mentioned in the previous unit, it is difficult to find a market that satisfies all the text book conditions of perfect competition. There are markets that come close to fulfilling these stringent conditions, but none that completely is in synchronisation with all of them. You might well ask the rationale for studying this market structure if it does not exist in the real world. The answer is that perfect competition is the ideal market, and serves as a benchmark. We can use the outcomes of other markets to compare with outcomes that would have been achieved under perfect competition. For instance, if the market is competitive, prices would be lower and closer to costs, while if the market is monopolised then prices are likely to be
higher.
Another useful comparison relates to the concept of consumer’s surplus. Intuitively, consumer’s surplus can be thought of as the difference between the maximum amount the consumer is willing to pay for a product and the amount he actually pays. Think about your purchase of a big ticket item such as a camera. You have a price in mind that is the maximum you are willing to pay. The difference between this and the price actually paid is the consumer’s surplus.In perfectly competitive markets, consumer’s surplus is the maximum, while in monopoly markets it is low. In fact, it is the endeavour of monopolies to capture as much of the consumer’s surplus as possible. When a perfectly competitive industry gets monopolised there is a transfer of surplus from the consumer to the producer. Or stated differently, the producer is able to increase his surplus (or profit) at the expense of the consumer. On the other hand, when a monopolised industry becomes competitive, there is transfer from producers to the consumers; i.e. consumers become better off when there is increased competition. An illustration of this can be gauged from the conduct of the automobile industry in India since it was deregulated in 1991. The consumers have benefited from competition in the sector and one can definitely assert that producer margins (or surplus) have
declined to the benefit of the consumers.
PROFIT-MAXIMISING OUTPUT IN THE SHORTRUN
Having examined the rationale for studying perfectly competitive markets, let us analyse the profit-maximising output of a profitable competitive firm in the short run. As you already know, the short run is defined as a period of time in which at least one input is fixed. Often the firm’s capital stock is viewed as the fixed input. Accordingly, this analysis assumes that the number of production facilities in the industry and the size of each facility do not change because the period being considered is too short to allow firms to enter or leave the industry or to make any changes in their operations.
Under perfect competition, since an individual firm cannot influence the market price by raising or lowering its output, the firm faces a horizontal demand curve, that is, the demand curve of any single firm is perfectly elastic – its elasticity is equal to infinity at all levels of output. If a firm charges a price slightly higher than the prevailing market price, demand for that firm will fall to zero because there are many other sellers selling exactly the same product. On the other hand, if a firm reduces its price slightly, its demand will increase to infinity and thus other firms will match the low price.
A firm under perfect competition is a price-taker and not a price-maker. Because an individual firm’s demand or Average Revenue (AR) curve is horizontal underperfect competition, the Marginal Revenue (MR) curve of the firm is also horizontal and coincides with the AR curve. In other words, AR and MR are
constant and equal at all levels of output. You should satisfy yourself that if price (i.e. average revenue) is constant, marginal revenue will be equal to price.2 The price-output determination and equilibrium of the firm under perfect competition may be explained through a numerical example. Suppose the demand and supply conditions of a product are represented by the following equations: Aggregate Demand: Q = 25 – 0.5 P Aggregate Supply: Q = 10 + 1.0 P
The equilibrium price would be at a point where aggregate demand equals aggregate supply: 25 – 0.5 P = 10 + 1.0 P or P = 10
Industry output at P = 10 is obtained by substituting this price into either the demand or supply function: Q = 10 + 1.0 (10)= 20
Therefore equilibrium price, P = 10 and equilibrium output, Q = 20. Figure shows that when the market price is at P1, demand and marginal revenue facing the firm are D1 and MR1. The optimal output for the firm to
higher.
Another useful comparison relates to the concept of consumer’s surplus. Intuitively, consumer’s surplus can be thought of as the difference between the maximum amount the consumer is willing to pay for a product and the amount he actually pays. Think about your purchase of a big ticket item such as a camera. You have a price in mind that is the maximum you are willing to pay. The difference between this and the price actually paid is the consumer’s surplus.In perfectly competitive markets, consumer’s surplus is the maximum, while in monopoly markets it is low. In fact, it is the endeavour of monopolies to capture as much of the consumer’s surplus as possible. When a perfectly competitive industry gets monopolised there is a transfer of surplus from the consumer to the producer. Or stated differently, the producer is able to increase his surplus (or profit) at the expense of the consumer. On the other hand, when a monopolised industry becomes competitive, there is transfer from producers to the consumers; i.e. consumers become better off when there is increased competition. An illustration of this can be gauged from the conduct of the automobile industry in India since it was deregulated in 1991. The consumers have benefited from competition in the sector and one can definitely assert that producer margins (or surplus) have
declined to the benefit of the consumers.
PROFIT-MAXIMISING OUTPUT IN THE SHORTRUN
Having examined the rationale for studying perfectly competitive markets, let us analyse the profit-maximising output of a profitable competitive firm in the short run. As you already know, the short run is defined as a period of time in which at least one input is fixed. Often the firm’s capital stock is viewed as the fixed input. Accordingly, this analysis assumes that the number of production facilities in the industry and the size of each facility do not change because the period being considered is too short to allow firms to enter or leave the industry or to make any changes in their operations.
Under perfect competition, since an individual firm cannot influence the market price by raising or lowering its output, the firm faces a horizontal demand curve, that is, the demand curve of any single firm is perfectly elastic – its elasticity is equal to infinity at all levels of output. If a firm charges a price slightly higher than the prevailing market price, demand for that firm will fall to zero because there are many other sellers selling exactly the same product. On the other hand, if a firm reduces its price slightly, its demand will increase to infinity and thus other firms will match the low price.
A firm under perfect competition is a price-taker and not a price-maker. Because an individual firm’s demand or Average Revenue (AR) curve is horizontal underperfect competition, the Marginal Revenue (MR) curve of the firm is also horizontal and coincides with the AR curve. In other words, AR and MR are
constant and equal at all levels of output. You should satisfy yourself that if price (i.e. average revenue) is constant, marginal revenue will be equal to price.2 The price-output determination and equilibrium of the firm under perfect competition may be explained through a numerical example. Suppose the demand and supply conditions of a product are represented by the following equations: Aggregate Demand: Q = 25 – 0.5 P Aggregate Supply: Q = 10 + 1.0 P
The equilibrium price would be at a point where aggregate demand equals aggregate supply: 25 – 0.5 P = 10 + 1.0 P or P = 10
Industry output at P = 10 is obtained by substituting this price into either the demand or supply function: Q = 10 + 1.0 (10)= 20
Therefore equilibrium price, P = 10 and equilibrium output, Q = 20. Figure shows that when the market price is at P1, demand and marginal revenue facing the firm are D1 and MR1. The optimal output for the firm to
produce is at point A, where Marginal Cost (MC) = P1, and the firm will produce Q1 units of output. At Q1 level of output, the Average Total Cost (ATC) is less than the price and the firm makes an economic profit. Suppose the market price falls to P2, price equals MC at point C. Because at this level of output (Q2) average total cost is greater than price, total cost is greater than total revenue, and the firm suffers losses. The amount of loss is the loss per
unit (CR) times the number of units produced (Q2). At price level P2, demand is D2 = MR2, there is no way that the firm can earn a profit. This is because at every output level average total cost exceeds price (ATC > P). The firm will continue to produce only if it loses less by producing than by closing its operations entirely. When the firm produced zero output, total revenue would also be zero and the total cost would be the total fixed cost. The loss would
thus be equal to total fixed cost. If the firm produces at MC = MR2 (point C), total revenue is greater than total variable cost, because P2 > AVC at Q2 units of output. The firm will be in a position to cover all its variable costs and still has CD times the number of units produced (Q2) left over to pay part of its fixed cost. This way the firm suffers a smaller loss when it continues production than it shut down its operations.
At market price P3, demand is given by D3 = MR3. The equilibrium output Q3 would be at T where MC = P3. At this output level, since the average variable cost of production exceeds price, the firm not only loses all its fixed costs but would also lose Rs. ST per unit on its variable costs as well. The firm could improve its earnings situation by producing zero output and losing only fixed costs. In other words, when price is below average variable cost at every level of output, the short-run loss-minimizing output is zero. To reiterate, the profit maximising output for a perfectly competitive firm in the
short run is to set P = MC. Since P = MR, this is equivalent to setting MR = MC. In the short run, as the above discussion shows, it is possible for the firm to make above normal or economic profit. On the other hand, it is also possible for the firm to make losses, as long as those losses are less than its total fixed costs. In other words, the firm will continue to produce as long as P>AVC in the short run, because this is a better strategy than shutting down. The firm will shut down only if P< AVC.
PROFIT-MAXIMISING OUTPUT IN THE LONGRUN
Now let us analyse the profit maximising output decision by perfectly competitivefirms in the long run when all inputs and therefore costs are variable. In the longrun, a manager can choose to employ any plant size required to produce the efficient level of output that will maximise profit. The plant size or scale ofoperation is fixed in the short run but in the long run it can be altered to suit theeconomic conditions.In the long run, the firm attempts to maximise profits in the same manner as in the short run, except that there are no fixed costs. All costs are variable in the longrun. Here again the firm takes the market price as given and this market price isthe firm’s marginal revenue. The firm would increase output as long as the marginal revenue from each additional unit is greater than the marginal cost of thatunit. It would decrease output when marginal cost exceeds marginal revenue. Thisway the firm maximises profit by equating marginal cost and marginal revenue(MR = MC; as discussed above).
unit (CR) times the number of units produced (Q2). At price level P2, demand is D2 = MR2, there is no way that the firm can earn a profit. This is because at every output level average total cost exceeds price (ATC > P). The firm will continue to produce only if it loses less by producing than by closing its operations entirely. When the firm produced zero output, total revenue would also be zero and the total cost would be the total fixed cost. The loss would
thus be equal to total fixed cost. If the firm produces at MC = MR2 (point C), total revenue is greater than total variable cost, because P2 > AVC at Q2 units of output. The firm will be in a position to cover all its variable costs and still has CD times the number of units produced (Q2) left over to pay part of its fixed cost. This way the firm suffers a smaller loss when it continues production than it shut down its operations.
At market price P3, demand is given by D3 = MR3. The equilibrium output Q3 would be at T where MC = P3. At this output level, since the average variable cost of production exceeds price, the firm not only loses all its fixed costs but would also lose Rs. ST per unit on its variable costs as well. The firm could improve its earnings situation by producing zero output and losing only fixed costs. In other words, when price is below average variable cost at every level of output, the short-run loss-minimizing output is zero. To reiterate, the profit maximising output for a perfectly competitive firm in the
short run is to set P = MC. Since P = MR, this is equivalent to setting MR = MC. In the short run, as the above discussion shows, it is possible for the firm to make above normal or economic profit. On the other hand, it is also possible for the firm to make losses, as long as those losses are less than its total fixed costs. In other words, the firm will continue to produce as long as P>AVC in the short run, because this is a better strategy than shutting down. The firm will shut down only if P< AVC.
PROFIT-MAXIMISING OUTPUT IN THE LONGRUN
Now let us analyse the profit maximising output decision by perfectly competitivefirms in the long run when all inputs and therefore costs are variable. In the longrun, a manager can choose to employ any plant size required to produce the efficient level of output that will maximise profit. The plant size or scale ofoperation is fixed in the short run but in the long run it can be altered to suit theeconomic conditions.In the long run, the firm attempts to maximise profits in the same manner as in the short run, except that there are no fixed costs. All costs are variable in the longrun. Here again the firm takes the market price as given and this market price isthe firm’s marginal revenue. The firm would increase output as long as the marginal revenue from each additional unit is greater than the marginal cost of thatunit. It would decrease output when marginal cost exceeds marginal revenue. Thisway the firm maximises profit by equating marginal cost and marginal revenue(MR = MC; as discussed above).
The firm’s long run average cost (LAC) and marginal cost (LMC) curves are shown in Figure. The firm faces a perfectly elastic demand indicating theequilibrium price (Rs. 17) which is the same as marginal revenue ( i.e., D = MR = P). You may observe that as long as price is greater than LAC, the firm can make a profit. Therefore, any output ranging from 20 – 290 units yields some economic profit to the firm. In figure, B and B1 are the breakeven points, at which price equals LAC, economic profit is zero, and the firm can earn only a normal profit. The firm, however, earns the maximum profit at output level 240 units (point S). At this point marginal revenue equals LMC and the firm would ideally select the plant size to produce 240 units of output. Note that in this situation the firm would not produce 140 units of output at point M, which is the minimum point of LAC. At this point marginal revenue exceeds marginal cost, so the firm can gain by producing more output. As shown in figure , at point S total revenue (price times quantity) at 240 units of output is equal to Rs. 4080 (= Rs. 17 * 240), which is the area of the rectangle OTSV. The total cost (average cost times quantity) is equal to Rs. 2,880 (= Rs. 12 * 240) which is the area of the rectangle OURV. The total profit is Rs. 1,200 = (Rs. 17 – Rs. 12) * 240, which is the area of the rectangle UTSR.Thus, the firm would operate at a scale such that long run marginal cost equals price. This would be the most profitable situation for an individual firm (illustrated in figure). Therefore, if the price is Rs. 17.00 per unit, the firm will produce 240 units of output, generating a profit of Rs. 1,200.00. This profit is variously known as above normal, super normal or economic profit. The crucial question that one needs to ask is whether this is a sustainable situation in a perfectly competitive market i.e. whether a firm in a perfectly competitive industry can continue to make positive economic profits even in the long run? The answer is unambiguously no. This result derives from the assumption that in a perfectly competitive market there are no barriers to entry. Recall that in a market economy, profit is a signal that guides investment and therefore resource allocation decisions. In this case, the situation will change with other prospective entrants in the industry. The economic force that attracts new firms to enter into or drives out of an industry is the existence of economic profits or economic losses respectively. Economic profits attract new firms into the industry whose entry increases industry supply. As a result, the prices would fall and the firms in the industry adjust their output levels in order to remain at profit maximisation level. This process continues until all economic profits are eliminated. There is no longer any attraction for new firms to enter since they can only earn normal profits. By observing figure you should try to work out the price that will prevail in this market in the long run when all firms are earning normal profit.
Analogous to economic profit serves as a signal to attract investment, economic losses drive some existing firms out of the industry. The industry supply declines due to exit of these firms which pushes the market prices up. As the prices have risen, all the firms in the industry adjust their output levels in order to remain at a profit maximisation level. Firms continue to exit until economic losses are eliminated and economic profit becomes zero, that is, firms earn only a normal rate of profit.
CHARACTERISTICS OF MONOPOLY
Monopoly can be described as a market situation where a single firm controls theentire supply of a product which has no close substitutes.
The market structurecharacteristics of monopoly are listed below:
Though perfect competition and monopoly are the two extreme cases of market structure, they both have one thing in common – they do not have to compete withother individual participants in the market. Sellers in perfect competition are sos mall that they can ignore each other. At the other extreme, the monopolist is theonly seller in the market and has no competitors.
The market or industry demand curve and that of the individual firm are the same under monopoly since theindustry consists of only one firm.Pricing Decisions8Managers of firms in a perfectly competitive market facing a horizontal demandcurve would have no control over the price and they simply choose the profitmaximising output. However, the monopoly firm, facing a downward-slopingdemand curve (see Figure ) has power to control the price of its product.
If thedemand for the product remains unchanged, the monopoly firm can raise the priceas much as it wishes by reducing its output. On the other hand, if the monopoly firmwishes to sell a larger quantity of its product it must lower the price because totalsupply in the market will increase to the extent that its output increases. While anindividual firm under perfect competition is a price-taker, a monopolist firm is aprice-maker. It may, however, be noted that to have price setting power a monopolymust not only be the sole seller of the product but also sell a product which does nothave close substitutes.
PROFIT MAXIMISING OUTPUT OF A MONOPOLY FIRM
Often students are tempted into thinking that since a monopolist is the only producerin the market, he will be able to charge any price for the product. While amonopolist will certainly charge a high price, it must also ensure that it ismaximising profit. Our earlier discussion proves that a profit maximising monopolyfirm determines its output at that level where its marginal cost (MC) curveintersects its downward sloping marginal revenue (MR) from below. Since the MRcurve of the monopoly firm is below its average revenue or demand curve at alllevels of output, and at the equilibrium output level marginal revenue is equal tomarginal cost, the profit maximising monopoly price is greater than marginal cost.You may recall, the profit maximising price under perfect competition is equal tomarginal cost. Since the demand curve of the monopoly firm is above the firm’saverage cost curve, the price at equilibrium output is also greater than average cost.Therefore, super-normal profits are a distinguishing feature of equilibrium under
Analogous to economic profit serves as a signal to attract investment, economic losses drive some existing firms out of the industry. The industry supply declines due to exit of these firms which pushes the market prices up. As the prices have risen, all the firms in the industry adjust their output levels in order to remain at a profit maximisation level. Firms continue to exit until economic losses are eliminated and economic profit becomes zero, that is, firms earn only a normal rate of profit.
CHARACTERISTICS OF MONOPOLY
Monopoly can be described as a market situation where a single firm controls theentire supply of a product which has no close substitutes.
The market structurecharacteristics of monopoly are listed below:
- Number and size of distribution of sellers Single seller
- Number and size of distribution of buyers Unspecified
- Product differentiation No close substitutes
- Conditions of entry and exit Prohibited or difficult entry
Though perfect competition and monopoly are the two extreme cases of market structure, they both have one thing in common – they do not have to compete withother individual participants in the market. Sellers in perfect competition are sos mall that they can ignore each other. At the other extreme, the monopolist is theonly seller in the market and has no competitors.
The market or industry demand curve and that of the individual firm are the same under monopoly since theindustry consists of only one firm.Pricing Decisions8Managers of firms in a perfectly competitive market facing a horizontal demandcurve would have no control over the price and they simply choose the profitmaximising output. However, the monopoly firm, facing a downward-slopingdemand curve (see Figure ) has power to control the price of its product.
If thedemand for the product remains unchanged, the monopoly firm can raise the priceas much as it wishes by reducing its output. On the other hand, if the monopoly firmwishes to sell a larger quantity of its product it must lower the price because totalsupply in the market will increase to the extent that its output increases. While anindividual firm under perfect competition is a price-taker, a monopolist firm is aprice-maker. It may, however, be noted that to have price setting power a monopolymust not only be the sole seller of the product but also sell a product which does nothave close substitutes.
PROFIT MAXIMISING OUTPUT OF A MONOPOLY FIRM
Often students are tempted into thinking that since a monopolist is the only producerin the market, he will be able to charge any price for the product. While amonopolist will certainly charge a high price, it must also ensure that it ismaximising profit. Our earlier discussion proves that a profit maximising monopolyfirm determines its output at that level where its marginal cost (MC) curveintersects its downward sloping marginal revenue (MR) from below. Since the MRcurve of the monopoly firm is below its average revenue or demand curve at alllevels of output, and at the equilibrium output level marginal revenue is equal tomarginal cost, the profit maximising monopoly price is greater than marginal cost.You may recall, the profit maximising price under perfect competition is equal tomarginal cost. Since the demand curve of the monopoly firm is above the firm’saverage cost curve, the price at equilibrium output is also greater than average cost.Therefore, super-normal profits are a distinguishing feature of equilibrium under
monopoly. The firm would enjoy such super normal profits even in the long run because it is very difficult for new firms to enter in a monopolised market.
The determination of profit maximising equilibrium output and price under monopoly is shown in figure . DD and MR are the downward sloping demand (or
average revenue curve) and marginal revenue curves respectively of the monopoly firm. AC and MC are its average cost and marginal cost curves. At point E, MC intersects MR from below. Corresponding to E, the profit maximising equilibrium output is OQ. At OQ output, the price is OP = QR; and average cost is OC = QK. The monopoly profits are equal to price minus average cost multiplied by output i.e., (OP – OC) * OQ = PC *CK = PCKR. The rectangle area PCKR represents the super normal profits of the monopoly firm.
Monopoly Power
The above analysis shows that whereas under perfect competition, price is equal to marginal cost and profits are normal in the long run; under monopoly, price is greater than marginal cost and profits are above normal even in the long run.Therefore, the monopolist has power to charge a price which is higher than marginal cost and earn super normal profits. The extent of monopoly power of a firm can be calculated in terms of how much price is greater than marginal cost. Recall that a perfectly competitive firm sets P = MC. Thus the greater the difference, the greater is the monopoly power. Economist A.P. Lerner devised such an index to measure the degree of monopoly power and which has come to be known as the Lerner index. According to this index, the monopoly power of a firm is — μ = (P – MC)/P where
P = Price of the firm’s product
MC = Firm’s marginal cost
We know that at equilibrium output MC = MR and MR = P(1 – 1/e) where e is the price elasticity of demand.
μ = (P – MC)/P
μ = (P – MR )/P = 1 – (MR/P)
But (MR/P) = (1-1/e)
μ = 1 – (1 – 1/e)
μ = 1/e
The monopoly power of a firm is inversely related to elasticity of demand for its product. The less elastic the demand for its product, the greater would be its monopoly power, and vice versa. As we have discussed in Block 2, elasticity of demand depends on the number and closeness of the substitutes available for a product. In the real world we find some essential goods and services like life saving medicines, petroleum, cooking gas, railways etc. enjoy a high degree monopoly power because the demand for these products is highly inelastic. Left to itself the monopoly could price such inelastic products at rates that do not meet the social objectives of the government and policy makers. Thus we often witness government intervention in monopolies. For example, Railway ticket prices are fixed by the government and electricity tariffs are set by a regulatory authority. The reason why monopolies need to be regulated is discussed in the next section.Besides, an evaluation of monopoly is also done.
EVALUATION OF MONOPOLY
Pricing Decisions10scale and barriers to entry. On the other hand, production processes like foodprocessing, textiles, garments, wood and furniture, it is relatively easy to enter themarket as a supplier – for example, capital requirements are low and sunk costs arealso low. Many service industries like travel agencies fall into this category. In suchindustries, competition ensures that prices are set ‘right’ and moreover the threat ofentry ensures that prices never exceed long-run average cost (for example, marginalcompanies in the industry cannot persistently earn above average profits). Moreover,competition also ensures that price equals long-run marginal cost. Hence the priceof a good accurately reflects the opportunity cost of manufacturing it.Problems arise from leaving everything to the market, however when a situation ofmonopoly occurs. In economists’ jargon, there are economies of scale to beexploited when one company meets market demand. There are typically also majorbarriers to entry in such industries. Most public utilities – electricity generation,water supply, gas supply and perhaps national telecommunications systems – havetechnologies of this sort. There are several special problems for these industries.First, their size and capital intensity often puts particular strain on private capitalmarkets in satisfying their investment needs. In India, in the 1990s strain was feltinstead on the public coffers, and this was a major factor behind the move towardsdisinvestment and privatisation. Hence, while for example automobile or chemicalsmanufacture are also characterised by huge scale economies, governments haverarely seen it as their role to regulate companies in these industries. The questionfor policy makers is what to do about natural monopolies like power and watersupply. Left to themselves, they will charge monopoly prices and restrict output.The absence of any competitive threat will also probably leave such organisationswasteful, inefficient and sluggish. Since all costs can be passed on to the consumers,there will be little incentive for managers to keep them under control. Experiencefrom, for example, the railways suggests that it will not be long before the absenceof competitive pressures may damage the motives for innovation and change, socrucial in such capital-intensive sectors. Thus in some cases a regulator isappointed who must fix the natural monopolist’s price. In India, privatisation ofpower and telecommunications has been accompanied by the creation of a regulator,while there is no such institution for cement, automobile or chemical industry.The above discussion can also be illustrated with the help of Figure 12.4. Assumea perfectly competitive industry. We know that price would be Pc and quantity
The determination of profit maximising equilibrium output and price under monopoly is shown in figure . DD and MR are the downward sloping demand (or
average revenue curve) and marginal revenue curves respectively of the monopoly firm. AC and MC are its average cost and marginal cost curves. At point E, MC intersects MR from below. Corresponding to E, the profit maximising equilibrium output is OQ. At OQ output, the price is OP = QR; and average cost is OC = QK. The monopoly profits are equal to price minus average cost multiplied by output i.e., (OP – OC) * OQ = PC *CK = PCKR. The rectangle area PCKR represents the super normal profits of the monopoly firm.
Monopoly Power
The above analysis shows that whereas under perfect competition, price is equal to marginal cost and profits are normal in the long run; under monopoly, price is greater than marginal cost and profits are above normal even in the long run.Therefore, the monopolist has power to charge a price which is higher than marginal cost and earn super normal profits. The extent of monopoly power of a firm can be calculated in terms of how much price is greater than marginal cost. Recall that a perfectly competitive firm sets P = MC. Thus the greater the difference, the greater is the monopoly power. Economist A.P. Lerner devised such an index to measure the degree of monopoly power and which has come to be known as the Lerner index. According to this index, the monopoly power of a firm is — μ = (P – MC)/P where
P = Price of the firm’s product
MC = Firm’s marginal cost
We know that at equilibrium output MC = MR and MR = P(1 – 1/e) where e is the price elasticity of demand.
μ = (P – MC)/P
μ = (P – MR )/P = 1 – (MR/P)
But (MR/P) = (1-1/e)
μ = 1 – (1 – 1/e)
μ = 1/e
The monopoly power of a firm is inversely related to elasticity of demand for its product. The less elastic the demand for its product, the greater would be its monopoly power, and vice versa. As we have discussed in Block 2, elasticity of demand depends on the number and closeness of the substitutes available for a product. In the real world we find some essential goods and services like life saving medicines, petroleum, cooking gas, railways etc. enjoy a high degree monopoly power because the demand for these products is highly inelastic. Left to itself the monopoly could price such inelastic products at rates that do not meet the social objectives of the government and policy makers. Thus we often witness government intervention in monopolies. For example, Railway ticket prices are fixed by the government and electricity tariffs are set by a regulatory authority. The reason why monopolies need to be regulated is discussed in the next section.Besides, an evaluation of monopoly is also done.
EVALUATION OF MONOPOLY
Pricing Decisions10scale and barriers to entry. On the other hand, production processes like foodprocessing, textiles, garments, wood and furniture, it is relatively easy to enter themarket as a supplier – for example, capital requirements are low and sunk costs arealso low. Many service industries like travel agencies fall into this category. In suchindustries, competition ensures that prices are set ‘right’ and moreover the threat ofentry ensures that prices never exceed long-run average cost (for example, marginalcompanies in the industry cannot persistently earn above average profits). Moreover,competition also ensures that price equals long-run marginal cost. Hence the priceof a good accurately reflects the opportunity cost of manufacturing it.Problems arise from leaving everything to the market, however when a situation ofmonopoly occurs. In economists’ jargon, there are economies of scale to beexploited when one company meets market demand. There are typically also majorbarriers to entry in such industries. Most public utilities – electricity generation,water supply, gas supply and perhaps national telecommunications systems – havetechnologies of this sort. There are several special problems for these industries.First, their size and capital intensity often puts particular strain on private capitalmarkets in satisfying their investment needs. In India, in the 1990s strain was feltinstead on the public coffers, and this was a major factor behind the move towardsdisinvestment and privatisation. Hence, while for example automobile or chemicalsmanufacture are also characterised by huge scale economies, governments haverarely seen it as their role to regulate companies in these industries. The questionfor policy makers is what to do about natural monopolies like power and watersupply. Left to themselves, they will charge monopoly prices and restrict output.The absence of any competitive threat will also probably leave such organisationswasteful, inefficient and sluggish. Since all costs can be passed on to the consumers,there will be little incentive for managers to keep them under control. Experiencefrom, for example, the railways suggests that it will not be long before the absenceof competitive pressures may damage the motives for innovation and change, socrucial in such capital-intensive sectors. Thus in some cases a regulator isappointed who must fix the natural monopolist’s price. In India, privatisation ofpower and telecommunications has been accompanied by the creation of a regulator,while there is no such institution for cement, automobile or chemical industry.The above discussion can also be illustrated with the help of Figure 12.4. Assumea perfectly competitive industry. We know that price would be Pc and quantity
supplied Qc. The consumer’s surplus will be the area Pc AD. Now consider output and price of the profit maximising monopolist. As indicated in the figure, price would be Pm and quantity would be Qm . Notice that the monopolist will charge a higher price and produce a lower quantity as expected. The consumer surplus is reduced to PmAB. The rectangle Pc Pm BC that was part of consumer surplus under competition is now economic profit for the monopolist. This economic profit represents income redistribution from consumers to producers. Further, there is also a dead weight loss to society represented by the area BCD that represents loss of consumer surplus that accrued under competition, but is lost to society because of lower production levels under monopoly. If we now consider the reverse case i.e. a monopoly being broken to foster competition, the result will be transfer of income from producers to consumers and elimination of deadweight loss. Herein lies the economic basis for regulation of monopoly firms. It is to generate the outcomes of competitive markets and pass these benefits to consumers in the form of lower prices. If competition exists in markets then arguably, that is the best regulation. If it does not, and the industry is envisaged to play a social role, regulation of monopoly becomes an important policy objective.
RELEVANCE OF PERFECT COMPETITION AND MONOPOLY
The assumptions underlying perfect competition market are very restrictive. Fewmarkets are found with characteristics of many small sellers, easy entry and exit,and an undifferentiated product. Normally, a majority of modern industries operateunder conditions of oligopoly or monopolistic competition. You will study these twomarket structures in detail in Unit 13.Perfect competition and monopoly are the two extreme market conditions whichwe rarely come across in the real world of business. Then the question arises as towhy study them? It is useful to think of perfect competition and pure monopoly asextremes with other market structures placed in between. There are manyindustries that have most of the characteristics of perfect competition or monopoly.The two extreme models therefore serve as benchmarks and provide guidance inmaking decisions.Consider the following case. In 1931, the Pepsi-Cola Company was in bankruptcyfor the second time in 12 years. The president of Pepsi, Charles G. Guth, eventried to sell the company to Coca-Cola, but Coke wanted no part of the deal. Inorder to reduce costs, Guth purchased a large supply of recycled 12-ounce beerbottles. At that time, both Pepsi and Coke were sold in six ounce bottles.
Initially,Pepsi priced the bottles at 10 cents, twice the amount of the original six ouncebottles, but with little success. Then, however, Guth had the brilliant idea of sellingthe 12 ounce bottles of Pepsi at the same price as the six ounce bottles of Coke.Pricing Decisions12Sales took off, and by 1934, Pepsi was out of bankruptcy and soon making a verynice profit.Pepsi’s pricing decision in 1931 was clearly crucial to the life of the firm. Theprimary background necessary for understanding the pricing decision is a goodunderstanding of the law of demand – i.e. as price goes up, demand goes down –and some understanding of the amount by which a price increase effects a quantitydecrease – i.e. the price elasticity of demand. We will start by examining the polarcases of pricing under perfect competition and pricing under monopoly, and thenmove on to examining Pepsi and Coke’s situation.Alfred Marshall, a famous 19th Century economist, used a fish market as anexample of perfect competition.
For the sake of argument, consider a fishmongerselling cod. How would he price his product? First, he would look around and findout at what price his numerous competitors were selling cod. He certainly couldnot price above the competitors; since cod is pretty much identical and consumersshould not care from whom they purchase. Furthermore, in fish markets, it is quiteeasy for consumers to compare prices. So, if he priced above his competitors, hewould not sell any fish. Suppose he decided to price below his competitors. All ofthe customers would certainly purchase from him. However, if he were stillmaking a profit, the other competitors would also be making a profit at the lowerprice and would march the price cut in order to retain their customers.
They mayeven consider lowering price more, if they could still make a profit and capturefurther customers.This reasoning, along with the ease of entry for new fish mongers, if there is aprofit to be made (which prevents collusion among fish mongers already in themarket), ensures that the price being charged is equal to the cost of supplying anadditional fish, or the marginal cost. A fishmonger will be a price-taker, setting hisprice identically to his competitors’ prices. A firm is a monopoly if it has exclusivecontrol over the supply of a product or service. Therefore, a monopolist, in hispricing decisions, cannot consider the pricing decision of rival firms. So, what doeshe consider?The smart monopolist considers the incremental effect of his decision, i.e. what isthe revenue to be received from selling one additional unit of a product and whatare the costs of selling one additional unit of a product. Certainly, if the costs ofselling one additional unit of a product exceed the revenues, the monopolist wouldcertainly not want to sell that additional product.
The law of demand says that hecould raise the price of his product and thus sell less. Alternatively, if the revenuesof selling an additional unit of a product exceed the costs of selling that unit, themonopolist should want to sell more units. The law of demand says that he couldsell more by lowering his price.Thus, by setting the price correctly, the monopolist can sell the exact number ofunits such that the costs of selling one additional unit exactly equals the revenues ofselling the additional unit, which, by the above reasoning, is the only optimal price.However, there is an additional complication: the costs of selling one additional unitdo not include any part of the salary of the CEO or the rental costs of the plant,both which must be paid whether or not the additional unit is sold. Thus, in the longrun, if a monopolist cannot cover his overhead by pricing in the optimal manner, heshould shut down.The situation in 1931 involving Pepsi and Coke clearly differs from either of theabove scenarios, but what can we learn from the polar cases? First, Pepsi clearlysaw that Coke was pricing the six-ounce bottles at 5 cents. By pricing the 12-ounce bottles at 5 cent also, Pepsi made the bet that Coke would not cut its price.Coke did not see the need to cut price because its product was different from Pepsi’s and it did not fear losing many of its customers. Whether the gain inrevenues resulting from increased demand would offset the loss in revenue from the lower price depends on the price elasticity of demand. The price elasticity of demand faced by Pepsi depends on Coke’s response to the price cut and the consumer’s responses. As we saw above, Pepsi made the assumption that Coke would not cut price. In the Great Depression, Pepsi counted on a highly elastic consumer response, that is the percentage change in quantity purchased by the consumer due to the lower price, and therefore profits would accrue to Pepsi. What other concerns you think played a part in the Pepsi’s decision?
RELEVANCE OF PERFECT COMPETITION AND MONOPOLY
The assumptions underlying perfect competition market are very restrictive. Fewmarkets are found with characteristics of many small sellers, easy entry and exit,and an undifferentiated product. Normally, a majority of modern industries operateunder conditions of oligopoly or monopolistic competition. You will study these twomarket structures in detail in Unit 13.Perfect competition and monopoly are the two extreme market conditions whichwe rarely come across in the real world of business. Then the question arises as towhy study them? It is useful to think of perfect competition and pure monopoly asextremes with other market structures placed in between. There are manyindustries that have most of the characteristics of perfect competition or monopoly.The two extreme models therefore serve as benchmarks and provide guidance inmaking decisions.Consider the following case. In 1931, the Pepsi-Cola Company was in bankruptcyfor the second time in 12 years. The president of Pepsi, Charles G. Guth, eventried to sell the company to Coca-Cola, but Coke wanted no part of the deal. Inorder to reduce costs, Guth purchased a large supply of recycled 12-ounce beerbottles. At that time, both Pepsi and Coke were sold in six ounce bottles.
Initially,Pepsi priced the bottles at 10 cents, twice the amount of the original six ouncebottles, but with little success. Then, however, Guth had the brilliant idea of sellingthe 12 ounce bottles of Pepsi at the same price as the six ounce bottles of Coke.Pricing Decisions12Sales took off, and by 1934, Pepsi was out of bankruptcy and soon making a verynice profit.Pepsi’s pricing decision in 1931 was clearly crucial to the life of the firm. Theprimary background necessary for understanding the pricing decision is a goodunderstanding of the law of demand – i.e. as price goes up, demand goes down –and some understanding of the amount by which a price increase effects a quantitydecrease – i.e. the price elasticity of demand. We will start by examining the polarcases of pricing under perfect competition and pricing under monopoly, and thenmove on to examining Pepsi and Coke’s situation.Alfred Marshall, a famous 19th Century economist, used a fish market as anexample of perfect competition.
For the sake of argument, consider a fishmongerselling cod. How would he price his product? First, he would look around and findout at what price his numerous competitors were selling cod. He certainly couldnot price above the competitors; since cod is pretty much identical and consumersshould not care from whom they purchase. Furthermore, in fish markets, it is quiteeasy for consumers to compare prices. So, if he priced above his competitors, hewould not sell any fish. Suppose he decided to price below his competitors. All ofthe customers would certainly purchase from him. However, if he were stillmaking a profit, the other competitors would also be making a profit at the lowerprice and would march the price cut in order to retain their customers.
They mayeven consider lowering price more, if they could still make a profit and capturefurther customers.This reasoning, along with the ease of entry for new fish mongers, if there is aprofit to be made (which prevents collusion among fish mongers already in themarket), ensures that the price being charged is equal to the cost of supplying anadditional fish, or the marginal cost. A fishmonger will be a price-taker, setting hisprice identically to his competitors’ prices. A firm is a monopoly if it has exclusivecontrol over the supply of a product or service. Therefore, a monopolist, in hispricing decisions, cannot consider the pricing decision of rival firms. So, what doeshe consider?The smart monopolist considers the incremental effect of his decision, i.e. what isthe revenue to be received from selling one additional unit of a product and whatare the costs of selling one additional unit of a product. Certainly, if the costs ofselling one additional unit of a product exceed the revenues, the monopolist wouldcertainly not want to sell that additional product.
The law of demand says that hecould raise the price of his product and thus sell less. Alternatively, if the revenuesof selling an additional unit of a product exceed the costs of selling that unit, themonopolist should want to sell more units. The law of demand says that he couldsell more by lowering his price.Thus, by setting the price correctly, the monopolist can sell the exact number ofunits such that the costs of selling one additional unit exactly equals the revenues ofselling the additional unit, which, by the above reasoning, is the only optimal price.However, there is an additional complication: the costs of selling one additional unitdo not include any part of the salary of the CEO or the rental costs of the plant,both which must be paid whether or not the additional unit is sold. Thus, in the longrun, if a monopolist cannot cover his overhead by pricing in the optimal manner, heshould shut down.The situation in 1931 involving Pepsi and Coke clearly differs from either of theabove scenarios, but what can we learn from the polar cases? First, Pepsi clearlysaw that Coke was pricing the six-ounce bottles at 5 cents. By pricing the 12-ounce bottles at 5 cent also, Pepsi made the bet that Coke would not cut its price.Coke did not see the need to cut price because its product was different from Pepsi’s and it did not fear losing many of its customers. Whether the gain inrevenues resulting from increased demand would offset the loss in revenue from the lower price depends on the price elasticity of demand. The price elasticity of demand faced by Pepsi depends on Coke’s response to the price cut and the consumer’s responses. As we saw above, Pepsi made the assumption that Coke would not cut price. In the Great Depression, Pepsi counted on a highly elastic consumer response, that is the percentage change in quantity purchased by the consumer due to the lower price, and therefore profits would accrue to Pepsi. What other concerns you think played a part in the Pepsi’s decision?
