Economics Unit 3 PDF

Unit 3 market structures and factor market MARKET STRUCTURE – PERFECT COMPETETION MEANING OF MARKET The word ‘Market’ is generally understood to mean a particular place or locality where goods are sold and purchased. However, in economics, the term ‘market’ do not mean any partic...

Unit 3 market structures and factor market MARKET STRUCTURE – PERFECT COMPETETION MEANING OF MARKET The word ‘Market’ is generally understood to mean a particular place or locality where goods are sold and purchased. However, in economics, the term ‘market’ do not mean any particular place or locality where transactions take place. What is required for a market is the existence of contract between sellers and buyers so that transactions take place at an agreed price between them. The seller and buyer may be spread over a whole region, sometimes in different countries, but they contact and communicate and sell and buy commodities. In the words of Augustine Cournot, a French economist “Economists understand by the term market not a particular market place in which things are bought and sold, but the whole of any region in which buyers and sellers are in such free intercourse with one another that the price of the same goods tend to equality easily and quickly’. The essentials of a market are : 1. A commodity to deal with. 2. The existence of buyers and sellers. 3. A place, it may be a particular place, a region or the whole country or the entire world. 4. The facilitites for free interaction between sellers and buyers. Based on the territorial spread of the area, markets may be classified in to local market, regional market, national market or international market. On the basis of the degree of competition, i.e., on the basis of the number of sellers and buyers and the various practices adopted in the market, markets are classified into: 1. Perfectly competitive markets. 2. Monopolistically competitive market, 3. Monopoly market. 4. Oliogophy markets. All the above markets, except the first one, is broadly referred to as imperfectly Competitive markets. I. Perfect Competition Market Feature of a Perfectly Competitive Market a. Large No of buyer and sellers. In a perfectly competitive market there should be a large number of buyers and sellers in the market. The action of individual buyers or sellers do not influence market price. b. Homogenous Product. Perfectly competitive market condition assumes that the producers produce identical products. Products of all producers are similar to one another. c. Uniform market price. Because of the identical nature of the product and other unique features, it is assured that a uniform market price prevail-All sellers sell their  products at the same price. d. Freedom of entry and exit. Perfect competition assumes an open market without barriers for the entry and exit of new firms. e. Perfect Knowledge on the part of buyers about the product and seller about the market and market conditions. f. No Transport cost. It is assured that in a perfectly competition market, there is no transport cost. g. Free mobility of factors of production also is assumed in a perfectly competition market. EQUILIBRIUM OF FIRM INDUSTRY UNDER PERFECT COMPETITION The traditional theory of perfect competition is based on the assumption of profit maximization. Individual firms try to maximize their profit by producing and selling an output where MR = MC. The firm will expand output and sales till the point of equality between MC and MR is reached. The individual firms may be getting abnormal profit, normal profit or even loosing in the short run depending upon the market price, at this point of equilibrium. In other words, in the short period, under perfectly competitive market conditions individual firms may be in equilibrium with abnormal profit, normal profit or even with loss. But the industry as a whole will be not be in equilibrium if individual firms are getting abnormal profit or incurring losses. Industry equilibrium means no change in the level of output and no change in the size of industry (No change in the number of firms). If there is abnormal profit, new firm will enter the industry thereby increasing the number of firms and level of output. This will depress the price level, leading to a general fall in the level of profit. On the otherhand, if firms are incurring losses with the ruling market price, some marginal firms will exit from the industry. It will lead to a fall in output and a revival in price level. SHORT PERIOD EQUILIBRIUM OF FIRM AND INDUSTRY Short period is defined as a time period which is not enough for individual firm to enter into or exit from the market. The market supply curve is given or inelastic. Under perfect competition price determined by industry supply and demand curves. This price is accepted by individual firms for the sale of their product. If the price so determined is high, the firms get abnormal profit which will attract new firms in to the market. On the otherhand, if the prices so determined is low, individual firms will be getting less profit or incurring losses, compelling the existing firms to leave the market. The market operation and behavior and response of individual firms to this in terms of output can be explained with the help of the following diagram.  Firm Industry Y S2 Y MC AC S Q Price S1 Cost P2 AR =MR Q1 AR = MR P T S1 P1 Price s S1 S S1 D O M1 M M2 X O X Suppy & Demand Output  In the above diagram, the industry demand and supply curve determining market price is shown on the right hand side. Individual firms output adjustment is shown on the left side. Suppose, to start with, the original supply (SS) and demand DD determine ‘OP’ price. This is the price at which all firms have to sell their product. The AR and MR of firm will be at a height equal to the market price. Confronted with the price situation, individual firms will produce a profit maximizing output of OM where marginal cost (MC) is equal to MR. At this level of output, the firm is getting normal profit because Average Revenue (AR) is equal to Average Cost (AC). Take another price ‘OP 1’ determined by the market demand curve and a supply curve showing larger quantity supplied (S 1). At this price, the existing firms produce OM 1 output where, MC = MR, to maximize profit. But the firm is incurring losses at this low price level because the AR is less than average cost. The loss suffering firms will have a tendency to reduce output or leave the industry. This will gradually reduce supply and revive the market price. If the market price is ‘OP2’ as determined by market demand (DD) and supply (SS), the individual firm will be getting abnormal profit. The price is very high and profitable to the producers. Average cost (AC) of production is much lower than Average Revenue (AR). The abnormal profit will attract new firms to the industry. It will gradually increase the volume of output and will shift the position of supply curve and lower the market price. LONG PERIOD EQUILIBRIUM FIRM AND INDUSTRY Under perfect competition the industry will be in equilibrium when the individual firms are in equilibrium, getting normal profit. When the ruling market price gives only normal profit to its firms there is no incentive for new firms to enter into the industry or existing firm to leave the industry. The number of firms and the volume of production (supply) remain constant. A market price determined by industry supply and demand forces and which ensure normal profit to firms assure industry equilibrium but only in the long period. Graphic Illustration Firm Industry MC Y Y AC D S P S AR = MR AR = MR = Price P E S D O N X O M X Output Suppy x Demand  In the above diagram the right hand portion shows the market supply and demand curves. OP is the long period equilibrium price determined by market supply demand forces. Since uniform price prevail in the market all individual firms have to accept and sell their products at this price. The average and marginal revenue of individual firms will be equal to the market price. The AR and MR of a firm under perfect competition is represented in the left hand of the diagram by horizondal AR = MR curve. This itself is the perfectly elastic demand curve of the firm. The firm, motivated to maximize profit, produces and sells output ON, where MR = MC. The firms is getting maximum profit at this level of output and hence it is in equilibrium. At equilibrium level of output, both Average Cost and Average revenue are also equal (NS). So the firm is getting normal profit. If all the firms have identified cost conditions then all the firms will be getting normal profit. All the firm getting normal profit is the condition for industry equilibrium under perfect competition. Under such a situation there is no inducement for the existing firms to go out of the market or outside firms to enter into the market. The industry output and the number and size of firms will remains constant. This industry equilibrium will occur only in long period when all the firms are getting normal profit. PRICE DETERMINATION In a competitive market ‘price’ is determined by the forces of supply and demand. The equilibrium price is determined at the point of equality between supply and demand. The following diagram explain determination of market price. Y D S Excess supply P1 S T P Q P2 S2 Excess T2 demand S D O X Market Supply x Demand Equilibrium price is ‘OP’ where supply is equal to demand. If the market price is high at ‘OP1’ there will be excess of supply over demand which will reduce the price level. Similarly if price is very low at ‘OP 2’, there will be excess demand over supply, which will push the price level up. Ultimately the equilibrium market price ‘OP’ will be established in the long period. Role of ‘time period’ in price determination Time period plays an important role in the determination of price in a competitive market. It was Alfred Marshall who brought into notice the role of time period in the theory of product pricing. Marshall classified, time period in to market period, short period and long period. A. Market period (Very short period) The market period refers to the period of time in which the supply of a commodity is perfectly fixed. Each firm has a fixed stock of commodity in hand and the total stock of the commodity in the market also is fixed. The time at the disposal of firms is extremely short that there is no way to increase the supply of the commodity in the market. Therefore in the market period, the supply curve is supposed to be perfectly inelastic (vertical). This vertical supply curve interact with the market demand curve to determine prices. The demand curve plays a more important role than the supply curve in the determination of price in the market period. Price Determination in the Market Period Y D S1 P Q Inelastic Supply curve Price S1 D O X Quantity SS & DD B. Short Period It refers to the time period in which the quantities of some factors of production(variable factors like labour, raw materials etc)can be changed. Fixed factors of production like machinery, equipment, plant etc, remain constant. But using more and more quantities of variable factors, the fixed factors of production can be used more intensively and effectively to produce more output. Similarly, if required time is enough to reduce output by reducing the volume of variable factors of production used by firms. So in the short period the supply curve is slightly elastic. This elastic supply curve has a more powerful role in price determination than in the market period. Price Determination in the Short Period Y D S2 P Q Less elastic Supply curve Price S2 D O M X Quantity DD & SS C. Long period Long period refers to time period which is long enough to allow changes in all factors of production to change the volume of output by a firm. Dirung this time period, a firm can increase output not only by using larger quandities of variable factor (more intensive use of fixed factors) but also by enlarging the size of the plant itself. In the long period the supply curve is more elastic than the supply curve in the short period. This elastic supply curve plays a relatively more important role in the determination of market price than the demand curve. Price Determination in the Long Period Y D S3 P (Elastic Supply curve) Price S3 D O M X Quantity SS & DD Optimum Output and Resource Allocation Perfect competition is regarded as an ideal market structure under which firm can achieve maximum efficiency; economic efficiency and allocation efficiency. A firm is said to be an optimum firm having maximum economic efficiency which produces a given output at the minimum average cost of production. In the long period equilibrium of industry, the firm under perfect competition get only normal profit. When firm get normal profit they will be producing an output at the lowest point of their average cost curve. Price (P) will be equal not only to Marginal Cost (MC) and Marginal Revenue (MR) but also to Average Cost (AC) and Average Revenue (AR). MC Y AC Price P T AR = MR O M X [Optimum Output]  In the above, diagram the firm is in equilibrium by producing and selling an output ‘OM’ where MC = MR. At this level of output the average cost of production is minimum (MT). The price of the commodity (AR) is equal to the minimum Average Cost of production (AC). Under perfect competition. The market mechanism also leads to optimal allocation of productive resources. Optimum allocation of productive resources. Optimum allocation of productive resources assumes the following things. 1. Full Employment Economy. All the Producture resources are fully employed. The plants are operating at their full capacity. 2. Marginal rate of Technical substitution (MRTSxy) in production is equal to Marginal rate of substitution (MRS xy) in consumption. 3. MRTS xy = MRSxy = Px/Py. Both MRTs in production and MRs in consumption are equal to the price ration between the two commodities ‘x’ and ‘y’ produced Y Px P Commodity ‘y’ N 1C3 1C2 Py 1C1 P O M X Commodity ‘x’ Under perfect competition, in the long run all resources are optimally allocated in the economy as a whole. To simplify the matter let’s assume that only two commodities (‘x’ and ‘y’) are produced in the economy. Then the optimum allocation of resources between the production of them can be explained with the help of the diagram given above. Both the commodities are represented along OX and OY axis respectively. PP is the production possibility curve showing the maximum amount of different combinations of these two commodities which can be produced under the given situation. The production possibility curve shows the Marginal Rate of technical substitution between two commodities (MRT xy) At point ‘E’ a market indifference curve IC2 is tangent to the production possibility curve. An in difference curve Represent MRS xy. At the point ‘E’ the slope of both the curves are equal to the slope of the Budget line Px Py which represent the price ratio between the two commodities. Thus, Point ‘E’ represent optimum resources allocation in the industry.  IMPERFECT COMPETITION –MONOPOLY Price and output under monopoly – sources of monopoly – Types of monopoly – market demand curve under monopoly – short run and long run equilibrium of the monopolist – (MC - MR approach) – social cost of monopoly –Degrees of price discrimination – Equilibrium of discriminating monopolist – dumping – regulation of monopoly – A comparison of perfect competition and monopoly. Nature of Monopoly Literally monopoly means one seller. ‘Mono’ means one and ‘poly’ means seller. Monopoly is said to exist when one firm is the sole producer or seller of a product which has no close substitutes. Thus monopoly is negation of competition. The following are important features of monopoly. 1. There is a single producer or seller of the product. Entire supply of the product comes from this single seller. There is no distinction between a firm and an industry in a monopoly. The firm and industry are identical in monopoly. 2. There is no close substitute for the product. If there are some other firms which are producing close substitutes for the product in question there will be competition between them. In the presence of competition a firm cannot be said to have monopoly. Monopoly implies absence of all competition. 3. There is no freedom of entry. The monopolist erects strong barriers to prevent the entry of new firms. The barriers which prevent the firms to enter the industry may be economic or institutional or artificial in nature. In the case of monopoly, the barriers are so strong that prevent entry of all firms except the one which is already in the field. 4. The monopolist is a price maker. But in order to sell more a monopolist had to reduce the price. He cannot sell more units at the existing price. 5. The monopolist aims at maximisation of his profit Source and Types of Monopoly The most important reason the economists generally find the source of monopoly is barriers to entry. Barriers to entry are legal or technical conditions that make it impossible or prohibitively costly for a new firm to enter a given market. The following five types of entry barriers have historically been associated with the presence of monopoly.  1) Control of inputs Some firms acquire monopoly power from their overtime control over certain scarce inputs or raw materials that are essential for the production of certain other goods, e.g. bauxite, graphite, diamonds etc. such monopolies are often called ram material monopolies. The monopolies of this kind may also emerge because of monopoly over certain specific technical knowledge or technique of production. 2) Economies of scale The technology of production for a product may be such that one large producer can supply the entire market at a lower per-unit cost than can several firms sharing the same market. In other words, the long run average cost curve for a single firm slopes downwards over the entire range of market output. Consequently to have more than one firm operating in such a market would be wasteful since production costs are lowest if one firm supplies the entire output. In this situation the industry is natural monopoly. 3) Patents Another source of monopoly power is the patent rights of the firm for a product or the production process. The exclusive right to use the productive technique or to produce a certain product granted by the government is called patents. Patents are granted to the inventor for a technique or product, and they amount to the legal right to a temporary monopoly. Such monopolies are called patent monopolies 4) Legal Restrictions Some monopolies are created by law in public interests. Most of the state monopolies in the public utility sector, including postal, telegraph, generation and distribution of electricity, railways etc are public monopolies. The state may create monopolies in the private sector through license or patents. Such monopolies are called franchise monopolies. 5) Entry Lags The time needed to enter the market can act temporarily to shield an existing producer from competition. Thus, the first firm to market some product will usually enjoy some monopoly position. If the product turns out to profitable, entry is likely to occur as rapidly as technological conditions permit. Market Demand and Revenue Curves under Monopoly A monopoly firm faces the market demand curve for the product it produces since it is the only seller of the product. Thus the monopolist demand curve will slope downwards. This situation is different from the horizontal demand curve facing the competitive firm. While the competitive firm is the price taker, monopoly firm is the price maker. The monopoly firm supplies the total market and can set any price it wants. Since the monopoly firm faces a downward slopping market demand curve, if it raises price, the amount it cal sell will fall. Much of the analysis of monopoly and the differences in output and pricing decisions between a monopoly and competitive industry stems from this difference in the demand curves.  It is important to note that, given the demand curve, a monopoly firm has the option to choose between the price to be charged or output to be sold. Once it chooses the price, the demand for its output is fixed. Similarly, if the firm decides to sell a certain quantity of output, then its price is fixed- it cannot charge any other price inconsistent with the demand curve. Since the monopoly firm faces a downward slopping market demand curve, in order to sell more units of the commodity, the monopoly firm must lower the price. As a result, the marginal revenue is smaller than the price and the monopolist marginal revenue curve lies below his demand curve. This is shown in the following table Units Price TR AR MR Sold 1 10 10 10 10 2 9 18 9 8 3 8 245 8 6 4 7 28 7 4 5 6 30 6 2 6 5 30 5 0 7 4 28 4 -2 It can be noted that the monopolist faces a downward sloping AR curve (demand curve) and MR is less than AR. The implication of MR is less than AR (or price) is that when the monopolist sells more the price of the product falls. The demand curve and MR curve facing the monopolist is shown below. Price D=AR 0 M Output short run Equilibrium of the Monopolist The monopolist aims at profit maximisation. He will maximize his profit when his MC is equal to the MR and MC must be rising at the point of intersection. In other words, the slope of MC must be greater than slope of MR at the point of intersection This is shown below. Cost and revenue P A MC AC C B E AR 0 MR Q* Output  School of Distance Education The monopolist will go on producing additional units of output so long as MR exceeds MC. His profit will be maximum and he will attain equilibrium at the level of output at which MR equals MC. MC intersects MR at point E and equilibrium output is OQ*. The price charged by the monopolist is shown by the point on the demand curve directly above point E and the price charged by the monopolist is OP. to identify the amount of profit explicitly we dram the average cost curve (AR). The difference between price (average revenue per unit) and average cost at 0Q* is the average profit of sales. The total profit earned by the firm is equal to the area ABCP. Long run Equilibrium of the Monopolist In long run the monopolist has the time to expand his plant or to use his existing plant at any level which will maximize his profit. With entry is blocked, it is not necessary for the monopolist to reach an optimum scale of output, that is, to nail up hid plant until he reach the minimum point of long run average cost (LAC). Neither is there is any guarantee that he will use his plant at optimum capacity. What is certain is that the monopolist will not stay in business if he makes loss. He will most probably continue to earn supernormal profit even in the long run, given that the entry is barred. In the long run, the monopolist will be in equilibrium at the level of output where given the marginal revue curve cuts the long run marginal cost curve. In long run, marginal revenue is also equal to short rum marginal cost. That is, in long run MR=LMC=SMC. The following figure depicts the long run equilibrium of the monopolist. Cost and revenue P A LMC SMC1 LAC SAC1 C B L AR E 0 Q* Output MR The monopolist is in equilibrium at the output 0Q* at which the long run marginal cost (LMC) intersects the marginal revenue curve (MR). given the level of demand as indicated by the position of AR and MR curves, the monopolist would choose the plant size whose short run average and marginal cost curves are SAC 1 and SMC1. The monopolist will be charging price equal to 0P and will be making profit equal to the area of rectangle ABCP. Micro Economics II Page 13  School of Distance Education It can be noted that the firm is operating at sub optimal size. That is, monopolist is not producing at the minimum point of his long run average cost curve (point L) and there is excess capacity. Social Costs of Monopoly Perfect competition is a market structure which ensures efficient allocation of resources, prevents redistribution of income and keeps pressure on producers to keep production costs down. In contrast, monopoly results in restriction of output, redistribution of income in favour of monopolist, higher production costs and unproductive expenses which a monopolist often incurs to ensure continuation of his monopoly power. Economists generally measure welfare costs of monopoly in terms of higher prices and restriction of output which results in loss of consumer’s surplus often referred to as dead weight loss. That is, if both monopoly and competitive industries are faced with identical cost conditions, the output under perfect competitive conditions is higher than under monopoly and price in the competitive industry is lower than in monopoly. Thus it is argued that monopoly firm is less efficient than perfectly competitive firms. Monopoly causes loss of social welfare and distortions in resource allocation. The suboptimal allocation of resources and loss of social welfare are illustrated below Micro Economics II Page 14  School of Distance Education A Cost and Revenue M P2 Deadweight Loss L P1 LAC=LMC K AR M 0 Ql Q2 Output Assuming a constant cost industry which has LAC=LMC, the revenue conditions are shown by AR and MR curves. Given the cost and revenue conditions, a perfectly competitive firm will produce OQ2 at which LAC=LMC=AR. Its price will be OP 1. On the other hand, the monopoly firm produces an output equalizes its LMC and MR. thus the monopoly firm produces OQ1 and charges OP2 price. The loss of social welfare is measured in terms of loss of consumer surplus. The total consumer surplus equals the difference between the total utility which a society derives from the consumption of a commodity and the price that it pays for that commodity. If an industry is perfectly competitive, the total output available to the society will be OQ 2. The price which the society pays for OQ2 is given by the area OP 1LQ2. The total utility which the society gains from the output is given by the area OALQ 2. Thus the consumer surplus will be OALQ 2- OP1LQ2, which is the area ALP 1. If the industry is monopolized, the equilibrium output is set at OQ1 and the price is OP 2. This leads to a loss of a part of consumer surplus, which will be ALP1-AMP2=P2MLP 1. Of this loss of consumer surplus, P2MKP1 goes to the monopolist as profit. The remainder MKL goes to none, therefore it is termed as dead weight loss to the society. Price Discrimination Sometimes, a monopoly firm might charge different prices to different groups of buyers. This pricing technique is called price discrimination. The price discrimination exists when the same product is sold at different prices to different buyers. A monopolist, simply by virtue of its monopoly position, is capable of charging different prices from different consumers or different groups of consumers.The product is basically same, but it may have slight differences (slightly differentiated). Thus, price discrimination is the practice of charging different prices to different buyers for similar goods. When a monopolist sells similar products at different prices to different buyers, it is called a discriminating monopoly. The pricing technique is called price discrimination as the differing prices do not correspond to different costs associated with serving the various groups of buyers. Micro Economics II Page 15  According to Stigler “price discrimination is the sale of technically similar products at prices which are not proportional to marginal cost”. In the words of Joan Robinson “the act of selling the same article, produced under single control at different prices to different buyers is known as price discrimination”. Price discrimination is possible when the monopolist sells in different markets in such a way that it is not possible to transfer any unit of the commodity from the cheap market to the dearer market. Although price discrimination is a common practice under monopoly, it should not mean that this practice exists only under monopoly. Price discrimination is quite common also in other kinds of market structures, particularly when market imperfections exist. Most business firms discriminate between their customers on the basis of personal relationship, quantity purchased, duration of their association with the firm as buyers and so on. However, price discrimination is not possible under perfect competition. Since market demand in each market is perfectly elastic, every seller would try to sell in that market in which he could get the highest price. Competition would make the price equal in both the markets. Thus price discrimination is possible only when markets are imperfect. Conditions for Price Discrimination There are three conditions that must be satisfied before price discrimination is to be expected. Firstly, the seller of the product must possess some degree of monopoly power. In the absence of monopoly power, a seller is not able to charge some customers higher prices than others. The seller must possess some monopoly power over the supply of the product to be able to distinguish between different classes of customers and to charge different prices. Under competitive conditions, a single price tends to prevail regardless of whether some sellers wish to charge a higher price to individuals or groups. To practice price discrimination, therefore, seller must have some degree of monopoly power. Secondly, the seller must be able to separate buyers into two or more groups or markets and prevent resale of the product amoung the groups. That is, the markets are so separated that resale is not profitable. The market for different classes of consumers are so separated that buyers of low- priced market do no find it profitable to resell the commodity in high-priced market. This can be because of factors like geographical distance involving high cost of transportation, exclusive use of the commodity, lack of distribution channels etc. if resale of the product is easy, price discrimination can’t be very effective. Thirdly, the price elasticity of demand must differ amoung the different groups of buyers or sub markets. That is, if the market is divided into different sub markets, the elasticity of demand must be different in each sub market. It is the difference in price elasticities that provides opportunity for price discrimination. Low price are charged when demand is more elastic and high price in the market with a less elastic demand. If the price elasticities are the same, price discrimination would not be gainful. The first two conditions are necessary conditions which must be fulfilled for the implementation of price discrimination. The third condition is necessary condition to make price discrimination profitable. Degrees of Price Discrimination Prof. A C Pigou has distinguished between three forms of price discrimination, namely 1. First degree price discrimination 2. Second degree price discrimination 3. Third degree price discrimination First degree price discrimination is the limiting case in which the monopoly firm charges a different price to each of its customers. It charges each customer the maximum price the customer is willing to pay for each unit bought rather than go without it. It is take it or leave it price discrimination. Thus, ‘perfect’ first degree price discrimination involves maximum possible exploitation of each customer in the interest of seller’s profit. The monopolist would be able to extract the entire consumer’s surplus from consumers. First degree price discrimination is possible only when the monopolist is in a position to know the price each buyer is willing to pay. That is, he must know the exact shape of each consumer’s demand curve and be able to charge the highest price that each and every consumer would pay for each unit of the commodity. Even if it is possible, it would be probable be prohibitively expensive to carry out. Thus first degree price discrimination is not very common in the real world. More practical and common is second degree price discrimination. In the second degree price discrimination, the monopoly firm discriminate its customers according to quantities consumed. It works by charging different prices for different quantities of the same commodity or service.It is a situation of the firm charges customers’ different prices according to how much they purchase. Thus, the second degree price discrimination is the practice of charging different prices per unit of the different quantities of the same good or service. By doing so, the monopolist will be able to extract part, but not all, of the consumer’s surplus. The second degree price discrimination is also called ‘block pricing system’. Third degree price discrimination is the practice of dividing customers into two or more groups and charging different prices to each group. Monopolist divides his customers into two more independent submarkets or groups and the price charged in each submarket depend upon the output sold in that market and demand conditions of that market. For simplicity assume that there are only two markets. To maximize profits, the monopolist must produce the best level of output and sell that output in the two markets in such a way that marginal revenue of the last unit sold in each market is the same. This will require the monopolist to sell the commodity at a higher price in the market with the less elastic demand. Third degree price discrimination is the most common. Some of the examples are the lower fees that doctors charge low-income people than high-income for basically identical services, lower prices that airlines, trains, buses usually charge children and the elderly than other adults, the lower prices that producers usually charge abroad than at home for the same commodity, and so on. Equilibrium of Discriminating Monopolist Under simple monopoly, a single price is charged for the whole output, but under price discrimination the monopolist will charge different prices in different sub markets. Therefore, the monopolist has to divide his total market in to various sub markets on the basis of differences in the price elasticity of demand in them. Whenever the monopolist finds that it is not only possible to separate markets for his product, but also the elasticity of demand in these markets are different, he indulges in price discrimination. For the sake of convenience, les us explain the case when the total market is divided into two sub markets. In order to reach the equilibrium position, the discriminating monopolist has to take two decisions. Firstly how much total output should be produced and secondly, how the total output should be distributed between the two submarkets and what prices he should charge in two submarkets. The same marginal principle will guide the decision of the discriminating monopolist to produce to produce total output as that which guides a perfect competitor or a simple monopolist. Thus, if the monopolist is able to sell his product in two separate markets, the condition for equilibrium implies that marginal revenue in the first and second market, that is, MR 1 and MR2 should each be equal to the marginal cost (MR1=MR2=MC). The general condition of equilibrium will also be satisfied in this case as aggregate marginal revenue (AMR) will be equal to marginal cost. AMR is obtained by summing up laterally the marginal revenue curves of the sub markets. Consider the following figure. Price MC P2 P1 AR2 E1 E2 E AR1 AD MR2 MR1 AMR 0 Q1 0 Q2 0 Q Output The discriminating monopolist will maximize his profits by producing the level of output at which the marginal cost (MC) curve intersects the aggregate marginal revenue (AMR) curve. Profit maximizing output is 0Q where AMR equal to MC. The discriminating monopolist will distribute the total output 0Q in such a way that the marginal revenues in the two submarkets are same to maximize his profit. Again, to be in equilibrium it is essential not only that marginal revenues in the two sub markets are same but that they should also be equal to the marginal cost of the whole output. International Price Discrimination: The Concept of Dumping Price discrimination can also be practiced between the domestic and the foreign market. International price discrimination is called dumping. This refers to the charging of a lower price abroad than at home for the same commodity because of the greater price elasticity of demand in the foreign market. By doing so the monopolist earns higher profits than by selling the best level of output at the same price in the both markets. The price elasticity of demand for the monopolist’s product abroad is higher than at home because of the competition from producers from other countries in the foreign market, foreign competition is usually restricted at home by import tariffs or other trade barriers. These import restrictions serve to segment the market, that is, keep the domestic market separate from foreign market and prevent the re-export of the commodity back to the monopolist’s home country, which would undermine the monopolist’s ability to sell the commodity at higher price at home than abroad. Dumping is classified as persistent, predatory and sporadic. Persistent dumping is the continuous tendency of a domestic monopolist to maximize total profit by selling the commodity at a higher price in the domestic market than internationally, where it meet competition of foreign producers (international price discrimination). Predatory dumping is the temporary sale of the commodity at below cost or at the lower price abroad in order to drive foreign producers out of business, after which prices are raised to take advantage of newly acquired monopoly power abroad. Sporadic dumping is the occasional sale of a commodity at below cost or at lower price abroad than domestically in order to unload an unforeseen and temporary surplus of a commodity without having to reduce domestic prices. Trade restrictions to counteract predatory dumping are justified and allowed to protect domestic industries from unfair competition from abroad. These restrictions usually take the form of antidumping duties to offset price differentials. However, it is often difficult to determine the type of dumping, and domestic producers invariably demand protection against any form of dumping. Persistent and sporadic dumping benefit domestic consumers by allowing them to purchase the commodity at lower price and these benefits may exceed the possible losses of domestic producers. Regulation of Monopoly The regulation of monopoly is an important subject in theoretical and applied economic analysis. There are some undesirable aspects of the monopoly market which pave the way for its regulation. We already found that monopolist restrict output and raise price of their products. In this way the monopolist not only able to make supernormal profit and increase inequalities in distribution of income but also cause inefficiency in the allocation of resources of the society. The arguments which go against a private monopoly and hence its regulation are as follows. a) Private monopolization of industries means concentration of economic power which is against the spirit of equity and equality in the society. Concentration of economic power is a source of feudalism and political dictatorship. So from the point of creation and distribution of wealth, a private monopoly is certainly evil.  b) A private monopoly often charges discriminatory prices and this way extracts major portion of consumer surplus from the consumers and thus reduces their welfare c) A private monopolist pursues the objective of profit maximisation. For this, he charges high price for his products and produces less output as compared to a competitive producer. There is wastage of economic resources from the social point of view by not utilizing the production capacity fully. d) Monopoly is inefficient type of market structure. There is a deadweight loss and transfer of consumer surplus from consumers to the monopolist. Due to this, monopoly market is inefficient from the point of view of society as a whole. e) Monopoly firm may not bother for improvement of the technology and hence in the productivity. Even if it does so the benefits of such changes will not be passed to the consumers. On account of all the above reasons, a private monopoly is an undesirable economic entity and hence should be regulated. There are several measures; some of which are listed below. i. Regulation of prices and output levels by the government ii. Creating antimonopoly legislations iii. Putting taxes on monopolies iv. Through nationalization of monopoly firms Suppose in order to improve the allocation of resources or distribution of income, the government decides to regulate the price charges by the monopolist. The government can impose a price ceiling at a level below the profit maximizing price. There are two types of pricing rules often proposed for price regulation of monopoly. Firstly, monopolist can be asked to operate a level of output for which marginal cost is equal to the price. This is known as Marginal cost pricing. But the problem with marginal cost pricing is that the monopolist may still earn abnormal profit if his average revenue exceeds average cost of production. Secondly, those who want to regulate the monopoly to improve the distribution of income or to ensure that lowest possible price be charged from the consumers, they propose to adopt average cost pricing principle. According to average cost pricing, the maximum price should be fixed at which AR curve cuts AC curve. Thus the monopolist will be just covering his average cost of production. It should be noted that average cost includes normal profit or fair return on monopolist’s capital investment. Monopolies can also be regulated by using the instrument of taxation… if lump sum tax is imposed; it leads to an increase in fixed cost. But MC curve of the monopolist does not change. Hence the output and price remains unchanged. At the same time equilibrium level of profit of the monopolist will fall with the imposition of lump sum tax. The case of per unit tax is different. This causes an upward shift in the MC curve by an amount equal to the tax. The effect is that quantity produced declines and price increases. Monopoly and Perfect Competition: A Comparison When comparing any two market structures, one has to analyse the following aspects: A. Goals of the firm B. Assumptions C. Behavioral rules of the firm D. Comparison of long run equilibrium E. Comparison of predictions Comparison of perfect competition and monopoly in the light of above method is summarised below. A. Goals of the firm In both market structures, the firm has a single goal, that of profit maximisation. The firm is rational when its behavior aims at the maximisation of profit. B. Assumptions The product is homogeneous in perfect competition. In monopoly, the product may or may not be homogeneous. The main feature of monopoly is that the total supply of the product is concentrated in a single firm. In perfect competition, there are a large number of sellers, so that each one cannot affect the market price by changing the supply. In monopoly, there is a single seller in the market. In perfect competition, entry and exit is free in the sense that there are no barriers to entry. In monopoly, entry is blockaded by definition. In both markets, cost conditions are such as to give rise to U shaped cost curves, both in the short run and in the long run. Perfect knowledge is assumed in both the markets. C. Behavioral rules of the firm The demand curve in perfect competition is perfectly elastic, showing that the firm is a price taker. In monopoly, the demand of the firm is also the demand of the industry and hence is negatively sloping. The only decision and policy variable of the firm in perfect competition is the determination of its output. There is no room for selling activities, since the firm can sell any amount it can produce. The monopolist can determine either his output or his price, but not both, since once one of these policy variables is decided, the other is simultaneously determined. The monopolist may change the style of his product and/or indulge in research and development activities. In both the market, the firm takes its decisions which will maximize its profit, applying the marginalistic rule MC=MR. D. Comparison of long run equilibrium Given the cost conditions, in monopoly, the level of output will be generally be lower and price higher as compared with perfect competition. This is due to the fact that in perfect competition, the firm produces at the minimum cost (minimum point of LAC curve) and earns just normal profit, while the monopolist usually earns abnormal profits even in the long run. Under such conditions, price will be higher in monopoly as compared with perfect competition. In monopoly abnormal profits are usually earned both in the short run and in the long run. E. Comparison of Predictions In perfect competition, an increase in market demand will lead to an increase in price and in output in the short run. In the long run, the output will be larger, but price may return to the initial level, remains above the original level or fall below the original level. A shift in demand above the original level in monopoly will result in an increase in output, which may be sold at the same or a higher or lower price, depending on the extent of the shift in the demand and the change in elasticity. The imposition of lump sum tax in perfect comp etition will not lead to a change in output and price in long run, but output will decline and price will rise in the long run. In monopoly a lump sum tax will not affect the market equilibrium in the short run or in the long run, so long as the monopolist continues to earn some abnormal profit. The effects of a profit tax are the same in both the markets as in the case of the imposition of the lump sum tax.  MONOPOLISTIC COMPETITION Competition and monopoly lie at opposite ends of the market spectrum. Perfect Monopolistic competition price and output determination – short run and long run –Product differentiation – selling cost – non-price competition – Chamberline’s group equilibrium and the concept of excess capacity. competition and monopoly are rarely found in the real world and thus they do not represent the actual market situation. Still for many years economist believed that either the competitive or the monopoly model could be used to analyse most markets. In 1933 Edward Chamberlin challenged this belief when he published The Theory of Monopolistic Competition. Because his model of monopolistic competition seemed to describe many real world markets better than the competitive model did, it was enthusiastically received by most economists. The Nature of Monopolistic Competition As the name implies, monopolistic competition contains the element of both pure competition and monopoly. The competitive element arises from the fact that there are many sellers of the differentiated product, each of which is too small to affect other sellers. Firms can also enter and leave the monopolistically competitive industry rather easily in the long run. The monopolistic element arises from product differentiation. That is, since the product of each seller is similar but not identical, each seller has a monopoly power over the specific product it sales. Thus, monopolistic competition may be defined as a market structure where there are many sellers who sell differentiated products which are close substitutes of one another. Each producer under monopolistic competition enjoys some degree of monopoly and at the same time faces competition. The following are important features of monopolistic competition. 1. Large number of sellers The market consists of relatively large number of sellers or firms each satisfying a small share of the market demand for the commodity. Unlike perfect competition, these large numbers of firms do not produce homogeneous products. Instead they produce and sell differentiated products which are close substitutes of each other. Thus there is stiff competition between them. Under perfect competition, the number of sellers is so large that a firm becomes a price taker. In contrast under monopolistic competition, the number of firms is only so large that a firm retains its power to be a price maker.  2. Product Differentiation Product differentiation is a key feature of monopolistic competition. Product differentiation is a situation in which firms use number of devices to distinguish their products from those of other firms in the same industry. Products produced by the firms are close substitutes of each other. Products are not identical but are slightly different from each other. In case of monopoly, there is only one product and only one seller, and under perfect competition, a large number of sellers sell homogeneous product. But under monopolistic competition, the firms can differentiate their products from one another in respect of their shape, size, color, design, packaging, etc. Product differentiation may be real or it may be based on perceived differences by consumers. 3. Non price competition: Selling cost Firms incur considerable expenditure on advertisement and other selling costs to promote the sales of their products. Promoting sales of their products through advertisement is an important example of non-price competition. The expenditure incurred on advertisement is prominent amoung the various types of selling costs. But Chamberlin defines selling costs as “cost incurred in order to alter the position or the shape of the demand curve for a product”. Thus his concept of selling cost is not exactly the same as advertisement cost. Selling cost is the advertisement cost plus expenditure on sales promotion schemes, salary and commission paid to sales personal, allowance to retailers for displays and cost of after-sale-services. 4. Freedom of entry and exit In a monopolistically competitive industry, it is easy for new firms to enter and the existing firms to leave it. As in the case of perfect competition, there is no barrier on the entry of new firms and exit of old ones from the industry. Firms will enter in to the industry attracted by super normal profit of existing firms and existing firms will leave industry if they are making losses. Entry of new firms reduces the market share of of the existing ones and exit of firms does the opposite. These consequences of free entry and exit lead to intensive competition amoung the firms for both retaining and increasing their market share. However entry may not be as easy as in perfect competition because of the need to differentiate one’s product in a monopolistically competitive market. 5. There is absence of perfect knowledge. That is buyers and sellers do not have perfect knowledge about market conditions 6. There is no uniform price. Different producers charge different prices for their products because products are differentiated in some way. Short Run Equilibrium of the Firm A firm under monopolistic competition enjoys some control over price of its product since its product is somewhat differentiated from others. Yet, if the firm wants to increase the sales of its product, it must lower the price. Thus the AR curve of the monopolistically competitive firm slopes downward and MR curve lies below it (MR w. For example, the monopsonist can hire one worker at the wage rate Rs 10 for a total cost of Rs 10. To hire the second worker, the monopsonist must increase the wage rate from Rs 10 to Rs 20 and incur a total expenditure of Rs.40. Thus to hire more and more workers, the monopsonist will have to increase the wage rate and hence the total expenditure. The graphical representation of the first two columns (units of workers employed and the wage rate) gives the supply curve of labour (SL). Similarly, the MEL curve which shows the relationship between MEL and various units of labour hired is everywhere above the SL curve. That is; The above figure represents a Monopsonist’s Supply and Marginal Expenditure on Labour Curves.SL is positively sloped market supply curve of labour faced by the monopsonist and ME L is the marginal expenditure of labour curve which is everywhere above the SL curve. Pricing and Employment of One Variable Input A firm using only one variable input maximizes profit by hiring more units of the input until the extra revenue from the sale of the commodity equals the extra expenditure on hiring the input. This is the general marginal condition and applies whether the firm is perfect or imperfect competitor in the product and/or input markets. If the variable input is labour and the firm is a monopsonist in the labour market, the monopsonist maximizes its total profits by hiring labour until the MRP L equals the ME L. That is;  MRPL = MEL MPL. MR = MEL The wage rate (the price of the labour) paid by the monopsonist is given by the corresponding point on the market supply curve of labour (SL). This is shown in the following figure.. In the figure, the S L and ME L curves represents supply curve of labour and marginal expenditure on labour respectively. With the firm’s MRP L curve, the monopsonist maximizes profits by hiring 3 workers (given by point E, at which the MRP L curve intersects MEL curve and MRP L = MEL = Rs 60). To prove this, consider that the second worker adds Rs.80 (point A) to the monopsonist’s total revenue but only Rs.40 (point A’) to its total expenditure. Thus the monopsonist’s profit rise (by AA” = RS.40) by hiring the second worker. On the other hand, the monopsonist would not hire the 4 th worker because he or she would add more to total expenditure (Rs.80, given by point B) than to total revenue (Rs.40 given by point B’), so that the monopsonist’s total profits would fall by Rs.40 (BB” in figure). Only at L = 3, MRP L = MEL = Rs.60 (point E) and the monopsonist maximizes total profits. The figure above also shows that to hire 3 workers, the monopsonist must pay the wage of Rs.30. This is given by the point E’ on the S L curve at L = 3. Thus the intersection of the MRP L and MEL curves give only the profit maximizing number of workers that the firm should hire. The wage rate is given by the amount that the firm must pay each worker, and this is given by the point on the market supply curve of labour at the level of employment. Note that MRPL = Rs 60 (point E) exceeds w = Rs.30 (point E’) at L = 3. Monopsony Pricing and Employment of Several Variable Inputs When the monopsonist employs more variable inputs he or she will maximize profits by hiring each input until the MRP of the input equals the ME on hiring it. With labour and capital as variable inputs, the monopsonist should hire labour and capital until the following equations hold.  MPL.MR = ME L MPK. MR = MEK Dividing both sides of the two equations by MPL and MP K respectively, and combining the results we get; ME L/MPL = MEK/MPK = MC = MR This is the optimal input combination. If the ME L/MP L is smaller than ME K/MP K, the monopsonist would not be minimizing production costs. The monopsonist can reduce the cost of producing any level of output by substituting labour for capital in production at the margin. As the monopsonist hires more labour, MEL rises and MP L declines, so that MEL/MP L rises. As the monopsonist hires less capital MEK falls and MP K rises, so that MEK/MPK falls. To minimize the cost of producing any level of output, the monopsonist should continue to substitute labour for capital in production until the following equation holds. That is; ME L/MPL = MEK/MPK = MC = MR Reference: Microeconomics-Theory and Applications – Dominick Salvatore Advanced Economic Theory- H.L Ahuja