SYBCOM SEM III ECONOMICS NOTES NEP 2024-2025 PDF

Advanced Micro Economics S.Y.B. Com Semester – III Academic Year – 2024-25 Programme code - 223001 Course code: Category - Major...

Advanced Micro Economics S.Y.B. Com Semester – III Academic Year – 2024-25 Programme code - 223001 Course code: Category - Major Number of hours - 60 Course objective "Students will learn Advanced level of Micro Economics and its application." Department of Business Economics 1. Dr. B.G. Shetty, Associate Professor. 2. Ankur O. Nigam, Assistant Professor. 1  SYLLABUS NO. OF WEIGHTAGE LECTURES OF MARKS UNIT COURSE UNITS AT A GLANCE / HOURS NO. 1. Market structure: Perfect Competition and Monopoly 1.1 Perfect competition: Features, Conditions of equilibrium, the competitive firm’s supply curve Price, output and profit determination of firm and industry in the short and long run under perfect competition 15 1.2 Monopoly: Features, sources of monopoly power, Price discrimination 1.3 Price, output and Profit Determination under monopoly Price, output, and profit determination of firm in the short and long run under simple and discriminating monopoly 2. Market structure: Monopolistic competition and Oligopoly 2.1 Monopolistic Competition: Features, Comparison between perfect competition and monopolistic competition, Product 15 differentiation, Selling cost, Price, output and profit determination of a firm in the short and long run under monopolistic competition 2.2 Oligopoly: Features, Collusive (price leadership, and cartels) Equal and non-collusive oligopoly (kinked demand curve) (with practical Weightage examples) case study 2.3 Price, output, and Profit determination under Oligopoly: Price, output, and profit determination under Collusive and Non- Collusive Oligopoly 3. Pricing Practices and Capital Budgeting 3.1 Cost-Plus, Marginal Cost, and Mark-Up Pricing: Meaning, concept; advantages and disadvantages, applications, and 15 limitations. 3.2 Multiple-Product and Transfer Pricing: Meaning, Concept; Strategies for digital products and services, Regulatory and tax considerations. 3.3 Capital budgeting and Investment appraisal: Meaning and importance of capital budgeting- steps in capital budgeting- Techniques of Investment appraisal: payback period method, net present value method, and internal rate of return method (with numerical examples) 2 4. Theories of Factor Pricing 4.1 Theory of Distribution and Rent: Marginal productivity theory of Distribution - Theories of rent: Ricardian, Quasi rent and Modern theory. 4.2 Theories of Wages and Interest: Meaning and Types of Wages, Backward Bending Supply Curve of Labour, Role of Collective Bargaining in Wage Determination. Modern theory of wages. Interest: Meaning, Loanable Fund Theory, Liquidity 15 Preference Theory 4.3 The Theory of Profits: Meaning, Risk, and Uncertainty Theory of Profit, Dynamic Theory of Profit, Innovation Theory of Profit TOTAL HOURS/ LECTURES 60 ESSENTIAL READINGS  Salvatore, D.: Managerial Economics in a global economy (Thomson South Western Singapore, 2001)  Gregory Mankiw., Principles of Economics, Thomson South western (2002 reprint)  Samuelson & Nordhas.: Economics (Tata McGraw Hills, New Delhi, 2002)  Koutsyiannis, A., Modern Microeconomics, Macmillan Press Ltd (1998 Reprint). Varian, Micro-Economic Analysis (ed. 3), Norton, 1992.  Ahuja H.L. Advanced Economic Theory: Microeconomic Analysis  Mehta, P.L.: Managerial Economics – Analysis, Problem and Cases (S. Chand & Sons, N. Delhi, 2000)  Dean, Joel: Managerial Economics (Prentice Hall of India, N. Delhi, 2002)  Gupta, G.S.: Managerial Economics (Tata McGraw Hill, N. Delhi, 1997) Principles of Macroeconomics Paperback - N. Gregory Mankiw Examination Pattern Continuous Assessment Tests (CAT) (Best Of Two) 40 Marks& Semester End Examination (See) 60 Marks, Total 100 Marks NATURE OF ASSESSMENT MARKS METHODOLOGY CAT 1 20 Assignment/ project CAT 2 20 Internal Class Test CAT 3 20 Presentation/ VIVA/Group discussion SEE 60 External Examination 3  Pattern of Question paper – Internal Class Test (CAT) Maximum marks: 20 Duration:40 Mins. Q. No Nature of assessment Marks 1 Objective questions (MCQ, True or False or Fill in the blanks) 10 Students should answer 10 sub-questions out of 12 sub-questions 2 Concept-based short questions (Meaning or definitions) 04 Students should answer 04 sub-questions out of 05 sub-questions 3 Short notes 06 Students should answer 01 sub-questions out of 03 sub-questions Pattern of Question paper – External Maximum marks: 60 Duration:2 Hours Question No Module Particulars Marks 1 I, II, III, IV a) MCQ, True or False or Fill in the 06 blanks Students should answer 6 sub-questions out of 8 sub-questions b) Answer in One/Two sentences 06 Students should answer 3 sub-questions out of 4 sub-questions 2 I, Attempt any 2 questions out of 3 12 3 II, Attempt any 2 questions out of 3 12 4 III, Attempt any 2 questions out of 3 12 5 IV Attempt any 2 questions out of 3 12 Passing criteria: Minimum 40% in Internal (16 out of 40) and 40% in External (24 out of 60) are required to pass in the subject. 4  UNIT 1: MARKET STRUCTURE: PERFECT COMPETITION AND MONOPOLY 1.1 PERFECT COMPETITION Meaning of Market: Market is defined as the interaction between buyers and sellers in connection with the respective demand and supply or exchange of goods and services. Market Structure: The market can be classified based on various parameters based on location it is classified as local market, regional, national, international, and global. Based on the period, it is classified as short-term, medium-term, and long-term, based on the nature of the product it will be classified as food market, vegetable market commodity market, etc. Based on competition, it will be classified as perfect competition and imperfect competition. A. Meaning and Features of Perfect Competition Perfect competition refers to a market structure with many small firms, all producing homogenous goods. It is an ideal market situation in which buyers and sellers are so numerous and well-informed that each can act as a price–taker, able to buy or sell any desired quantity without affecting the market price. FEATURES: Perfect competition, as is generally understood, is said to prevail when the following conditions are found in the market. 1. Large number of buyers and sellers: - The first condition of perfect competition is that there must be numerous firms in the industry and many buyers. This condition is necessary so that the position of a buyer or seller in the market is like a drop in the ocean. As a result, no individual buyer or seller can influence the price of the product by changing the output demanded or supplied. 2. Homogenous Products: - This means that the products of various firms are indistinguishable from each other i.e. they are perfect substitutes for one another. In other words, cross elasticity between the products of the firms is infinite. In this case, trademarks, patents, special brand labels, etc. do not exist since these things make the products differentiate. 3. Perfect information about the prevailing price: -Sellers and buyers must have complete knowledge of the conditions of the market. If any seller tries to charge a higher price than that ruling in the market, the buyers will shift to some other sellers to buy at a lower price. Similarly, no seller can charge a price lower than the ruling price since they know the prevailing market conditions. 4. Free Entry and exit: - It requires that there must be complete freedom for the entry of new firms and the exit of existing firms from the industry in the long run. Since in the short run, firms can neither change the size of their plants nor new firms can enter or old firms can leave 5 the industry. The condition of free entry and free exit therefore applies only to the long–run equilibrium under perfect competition. 5. Firms aim to maximize profit: -The goal of firms under perfect competition is to maximize profit. They aim to sell where marginal costs meet marginal revenue, where they generate the most profit. 6. Transactions are costless: - Buyers and sellers incur no costs in making an exchange. 7. Perfectly elastic demand curve: - The assumption of large number of buyers and sellers and that of product homogeneity implies that the individual firm is a price taker. Its demand curve is perfectly elastic indicating that the firm can sell any amount of output at the prevailing market price but with any increase in market price, buyers do not buy anything from that firm that increased the price. 8. No government intervention: Since the market has been controlled by the forces of demand and supply, there is no government intervention. B. CONDITIONS OF EQUILIBRIUM AND PROFIT MAXIMIZATION A firm is in equilibrium when profit is maximum. The maximum profit point of the firm will be decided either based on the totality approach or through the Marginality approach. According to the totality approach firm will be in equilibrium at the point where the Difference between Total revenue and Total cost is the highest and total revenue is greater than Total cost. According to the marginality approach, a firm will be in equilibrium and will maximize its profits when it produces at the point where its marginal cost of production is equal to its marginal revenue (MR = MC). Further, this maximizes profits because any time the last unit produced brings more additional revenue (MR) than it incurs in additional cost (MC), the firm can increase its profits by producing that unit On the other hand, if the last unit produced incurs more additional cost (MC) than it brings in additional revenue, then the firm's profits will decline if it produces that unit. Thus, When MR>MC is at the margin, the firm will profit by producing more. When MC>MR at the margin, the firm will profit more by producing less. Only when MC=MR is the firm doing the best it possibly can. The equality between marginal revenue and marginal cost is considered a necessary condition of equilibrium but not a sufficient condition. The sufficient condition of equilibrium of the firm states that at the point of equilibrium Marginal cost curve must intersect the marginal revenue curve from below. In other words, at the point of equilibrium, marginal revenue must be rising. 6 In the above diagram in which price OP is prevailing in the market. PL would then be the demand curve or the average and marginal revenue curve of the firm. It will be seen from the diagram that marginal cost curve cuts average and marginal revenue curve at two different points, F and E. F cannot be the position of equilibrium, since at F second order condition of the firm’s equilibrium, namely, the marginal cost curve must cut marginal revenue curve from below at the point of equilibrium, is not satisfied. The firm will be increasing its profits by increasing production beyond F because marginal revenue is greater than marginal cost. The firm will be in equilibrium at point E or output OM since at E marginal cost equals marginal revenue (or price) as well as marginal cost curve is cutting the marginal revenue curve from below. Under perfect competition marginal revenue curve is a horizontal straight line, the marginal cost curve must be rising to cut the marginal revenue curve from below. Therefore, in case of perfect competition, the second-order condition of a firm’s equilibrium requires that the marginal cost curve must rise at the point of equilibrium. Hence the twin conditions of a firm’s equilibrium under perfect competition are: (1) MC=MR = Price (2) The MC curve must be rising at the point of equilibrium. But the fulfilment of the above two conditions does not guarantee that the profits will be earned by the firm. To know whether the firm is making profits or losses and how much of them, the average cost curve must be introduced in the figure. C. THE COMPETITIVE FIRM’S SUPPLY CURVE Under perfect competition, the Marginal cost curve is the supply curve of a firm. However, the entire marginal cost curve is not the supply curve of a firm. The Short-Run Supply Curve of the Perfectly Competitive Firm: 7 As is known, the short-run is a period in which more quantity of the good is produced by working the given capital equipment or plant more intensively by employing more amounts of the variable factors. We know that the firm under perfect competition produces that amount of the good at which marginal cost equals price. Since the price for a perfectly competitive firm is given and constant for it, price line will be a horizontal straight line. The horizontal coordinate of a point on the rising marginal cost curve measures the quantity of the good that the firm will produce at that price. The short-run mar- ginal cost curve of the firm therefore indicates the quantities which the firm will produce in the short run at different prices. Short run supply curve under perfect competition: In the above diagram at price OP, the firm will produce and offer for sale OM quantity of the good, because at OM quantity of the good, price OP equals marginal cost. Similarly, at price OU the quantity produced or supplied will be ON, since price OU equals marginal cost at output ON. Likewise, at price OS, the firm will produce and supply OL quantity of the product. It is thus clear that short-run marginal cost curve of the firm ii in fact the short-run supply curve of the firm. The firm will not produce any output at a price below OD, since it will not be fully recovering its variable costs. Thus, only the part of the short run marginal cost curve which lies above the average variable cost forms the short-run supply curve of the firm. In the diagram, the thick portion of the short-run marginal cost curve SMC represents the short- run supply curve of the firm. Since under perfect competition marginal cost must be rising at the equilibrium output, the short-run supply curve of the firm must always slope upward to the right. 8 Long run supply curve under perfect competition: Long Run Supply Curve of a firm is that portion of its marginal cost curve that lies above the minimum point of the average cost curve.In the diagram, the marginal cost curve above point E is the supply curve of a firm under perfect competition inn the long run. D. SHORT-RUN EQUILIBRIUM OF THE FIRM UNDER PERFECT COMPETITION WITH HOMOGENEOUS COST CONDITIONS In a perfectly competitive market, a firm’s demand curve is perfectly elastic. Profit maximization requires that marginal cost (MC) must be equal to marginal revenue (MR). And, at the point of equilibrium, the MC curve must intersect MR. curve from below These two conditions are the necessary and sufficient conditions for profit maximization. Under homogeneous cost conditions, all firms in the industry face equal cost conditions and since under perfect competition, uniform prices for all firms, they will experience similar profit conditions. A firm being in equilibrium does not necessarily earn a profit. It only means the firm observes the equilibrium rules to determine its output and sells it at the prevailing price. By doing so the firm may earn excess profit, normal profit or even may incur loss. Equilibrium of the firm under perfect completion in the short run with homogeneous cost conditions can be shown with the help of following diagram. P5 9 The above diagram shows short-run equilibrium of the firm under homogeneous cost conditions. When the price is OP5 firm is in equilibrium at point e and the equilibrium output is OQ5 At the OQ5 level of output average revenue is greater than the average cost. Since average revenue is greater than average cost firm is enjoying super normal profit. When the price is OP4 firm is in equilibrium at point d and the equilibrium output is OQ4. At the OQ4 level of output average revenue is equal to average cost. Since average revenue is equal to average cost firm is experiencing normal profit. When the price is OP3 firm is in equilibrium at point c and the equilibrium output is OQ3. At the OQ3 level of output average revenue is less than average cost but more than average variable cost and the firm recovers fixed cost and part of the variable cost and the firm incurs minimum loss. When the price is OP2 firm is in equilibrium at point b and the equilibrium output is OQ2. At the OQ2 level of output average revenue is equal to the average variable cost and the loss is equal to the fixed cost. When loss is equal to fixed cost, then that loss is considered as maximum loss. The firm reaches its shutdown point when the average revenue is equal to the average variable cost. In the diagram, point b is the shutdown point of the firm. If price is OP1, which 10 is less than average variable cost the loss is more than fixed cost then firm will close down its production. Thus, under perfect competition in the short run under homogeneous cost conditions firm may earn excess profit, normal profit, or even incur a loss. Under perfect competition, a firm can incur loss and can continue to produce and remain in the market provided if the firm can recover its variable cost. If it fails to recover the variable cost of production it will shut down its production. E. SHORT-RUN EQUILIBRIUM OF THE FIRM UNDER PERFECT COMPETITION WITH HETEROGENEOUS OR DIFFERENTIAL COST CONDITIONS In reality, firms do not operate with homogeneous cost conditions. Each firm experiences different cost conditions depending on its efficiency. Most efficient firms may operate with low cost and high profitability. The least efficient firm may operate with high cost and low profitability. Equilibrium of the firm under perfect completion in the short run with differential cost conditions can be shown with the help of following diagram. In Fig ‘a’ firm is in equilibrium at point E and the equilibrium output is OQ At OQ output A A. A average revenue (E Q ) is greater than average cost (DQ ) and firm is making super normal A A A profit. The super normal profit of the firm is equal to area P E DC. A A 11 In Fig ‘a’ firm is in equilibrium at point E and the equilibrium output is OQ At OQ output B B. B average revenue (E Q ) is equal to average cost (E Q ) and the firm is making just normal B B B B profit. In Fig ‘c’ firm is in equilibrium at point E and the equilibrium output is OQ At OQ output C C. C average revenue (E Q ) is less than average cost (NQ ) and the firm is incurring losses. The C C C loss of the firm is equal to area P E NM. C C In our discussion of differential cost conditions, firm A is the most efficient firm operates with the lowest cost, and makes super normal profit. Firm B is the next efficient firm that makes just normal profit and Firm C is the least efficient firm with the highest cost incurring losses. F. LONG-RUN EQUILIBRIUM OF THE FIRM UNDER PERFECT COMPETITION The long-run equilibrium of the firms under perfect competition is also called as stable equilibrium. If firms are enjoying super normal profit in the short run, it will attract new firms into the industry. This will increase the supply of the product reduce the price on one hand and increase the cost of production on the other. Due to this excess profit of the firm will disappear and the firm will end up with just normal profit in the long run. If firms are incurring losses in the short run, loss-making firms will exit from the industry. This will reduce the supply of the product increase the price on one hand and reduce the cost of production on the other. Due to this lose firms in the industry will end up with just normal profit in the long run. In the long run, the firm will be in equilibrium when LMR=LMC=SMC=LAC= SAC=AR Fig A shows the long-run equilibrium of the industry and Fig B shows the long-run equilibrium of the firm. 12  OP is the price and the firm is making supernormal profits by working with the plant whose cost is SAC1. Therefore, the firm has an incentive to build new capacity and move along its LAC. Simultaneously, the excess profits attract new firms to the industry. This leads to an increase in the quantity supplied, shifting the supply curve to the left and a fall in the price, until it reaches the point OP1. At OP1, the firms and the industry are in long-run equilibrium. In the long-run, we have: SMC = LMC = SAC = LAC = P = MR=AR In the long run equilibrium, firms enjoy market efficiencies, which leads to scarce resources not being wasted. Productive efficiency: When the firm produces at the lowest short-run average cost. When productive efficiency is achieved, price equals minimum average total costs. Therefore, any firm that cannot produce at the minimum Average Total Cost will be forced to leave the industry. Technical efficiency: When the firm produces at maximum average product. This is also a consequence of productive efficiency. Allocative/Pareto efficiency: When the price is equal to marginal cost. The greatest allocative efficiency has been achieved when there is no other combination of goods and services that would be more desired by society. In the long run, firm will be in equilibrium when LMR=LMC=SMC=LAC= SAC=AR The following diagram shows the long run equilibrium of the firm under perfect competition with normal profit. G. SHORT-RUN EQUILIBRIUM OF THE INDUSTRY UNDER PERFECT COMPETITION 13  In the short run, Industry is in Equilibrium when Demand is equal to Supply. The equality between demand and supply will decide the equilibrium price. Being price takers, firms will decide their output based on the price decided by the industry. In the short run profitability of the firms will be decided based on their efficiency. Most efficient firms will have the lowest cost and enjoy super-normal profits. Least efficient firms may incur losses. And mediocre firms can earn just normal profit. Therefore, in the short run, when the industry is in equilibrium firms operating in the industry can make either super- normal profits, Normal profits, or Losses. The short-run equilibrium of the Industry along with firms can be shown with the help of the following diagram. In the above diagram, Fig(a) shows the short equilibrium of the industry. Fig(b) Fig(c) and Fig(d) show the equilibrium of the firms. In Fig (a) industry is in equilibrium at point E and the equilibrium price is OP. At the given price OP Firm A is in equilibrium at point E1 with super normal profit as shown in Fig (b). Fig(c) shows the equilibrium of Firm B. Firm B is in equilibrium at point E2 with just normal profit. Fig(d) shows the equilibrium of Firm C. Firm C is in equilibrium at point E 3 with loss. Thus, in the short run, when the industry is in equilibrium firms operating in the industry can make either super-normal profits, Normal profits, or Losses. 14  H. LONG-RUN EQUILIBRIUM OF THE INDUSTRY UNDER PERFECT COMPETITION In the long run, Industry is in equilibrium when demand is equal to supply. When the industry is in equilibrium all the firms operating in the industry are also in equilibrium but with just normal profit. The industry is in equilibrium in the long run when all firms earn normal profits. There is no incentive for firms to leave the industry or for new firms to enter it. With all factors homogeneous and given their prices and the same technology, each firm and industry as a whole are in full equilibrium where LMC = MR = AR (-P) = LAC at its minimum. Such an equilibrium position is attained when the long-run price for the industry is determined by the equality of total demand and supply of the industry The long-run equilibrium of the industry is illustrated in the above Figure where the long-run price OP is determined by the intersection of the demand curve D and the supply curve S at point E and the industry is producing OM output. At this price OP, the firms are in equilibrium at point A in Panel (B) at the OQ level of output where LMC = SMC = MR =P ( = AR) = SAC = LAC at its minimum. At this level, the firms are earning normal profits and have no incentive to enter or leave the industry. It follows that when the industry is in long-run equilibrium, each firm in the industry is also in long-run equilibrium. If both the industry and the firms are in long-run equilibrium, they are also in short-run equilibrium. 15  1.2 MONOPOLY A monopoly is a market structure where a single seller controls the entire supply of a good or service, allowing them significant control over the market price. This lack of competition often leads to higher prices and reduced output compared to competitive markets. Monopolies typically arise due to high barriers to entry, unique products with no close substitutes, and sometimes government regulations or patents. Monopoly is said to exist when one firm is the sole producer or seller of a product that has no close substitutes. Three points are worth nothing in this definition; first, there must be a single producer or seller of a product if there is to be a monopoly. This single producer may be in the form of an individual owner or a single partnership or a joint stock company. Secondly, there are no close substitutes for the product of that firm because monopoly implies an absence of competition. Thirdly, there must be a strong barrier to the entry of new firms wherever one firm has sole control over the production of a commodity. A. CHARACTERISTICS OR FEATURES OF MONOPOLY The important features of monopoly are given below: 1. There is a single seller (i.e. one firm) and the firm is the industry. The firm is the only firm producing such a good or service and since no other firm produces such a good or service, the firm is also the industry. 2. There are no close substitutes for the commodity produced under a monopoly. 3. There are barriers to entry which means that other firms cannot produce the same commodity either because they are not allowed or because of monopolistic conditions that make entry into the industry difficult. 4. It is faced with a negatively downward-sloped demand curve. This means that the monopolist is a price setter, that is, the monopolist sets price but the quantity demanded is dictated by the buyers (consumers). Under this, the demand curve of the monopolist is not equal to its marginal revenue. 5. Monopoly is a one-firm industry. In other words, there is no difference between the firm and industry. 6. A monopolist is a price maker but he can’t decide the price and output at the same time. 7. Monopolists can practice price discrimination. This is possible because a monopolist has control over the market. 8. Being a single seller, a monopolist tries to exploit the buyers or the suppliers of factors of production. 16  B. DIFFERENCE BETWEEN PERFECT COMPETITION AND MONOPOLY The following points make a clear difference between both the competitions: 1. Output and Price: Under perfect competition, price is equal to marginal cost at the equilibrium output. While under monopoly, the price is greater than the average cost. 2. Equilibrium: Under perfect competition, equilibrium is possible only when MR = MC and MC cut the MR curve from below. However, under a simple monopoly, equilibrium can be realized whether the marginal cost is rising, constant, or falling. 3. Entry: Under perfect competition, there exist no restrictions on the entry or exit of firms into the industry. Under a simple monopoly, there are strong barriers to the entry and exit of firms. 4. Discrimination: Under a simple monopoly, a monopolist can charge different prices from the different groups of buyers. But, in a perfectly competitive market, it is absent. 5. Profits: The difference between price and marginal cost under a monopoly results in super- normal profits to the monopolist. Under perfect competition, a firm in the long run enjoys only normal profits. 6. Supply Curve of Firm: Under perfect competition, the supply curve can be known. This is so because all firms can sell the desired quantity at the prevailing price. Moreover, there is no price discrimination. Under a monopoly, the supply curve cannot be known. MC curve is not the supply curve of the monopolist. 7. Slope of Demand Curve: Under perfect competition, demand curve is perfectly elastic. It is due to the existence of large number of firms. Price of the product is determined by the industry and each firm must accept that price. On the other hand, under monopoly, average revenue curve slopes downward. AR and MR curves are separate from each other. Price is determined by the monopolist 8. Goals of Firms: Under perfect competition and monopoly the firm aims at to maximize its profits. The firm which aims at to maximize its profits is known as rational firm. 9. Comparison of Price: Monopoly price is higher than perfect competition price. In long period, under perfect competition, price is equal to average cost. In monopoly, price is higher 10. Comparison of Output: Perfect competition output is higher than monopoly C. CAUSES OR SOURCES OF MONOPOLY There are five major reasons or sources of monopoly. These sources relate to the factors, which prevent the entry of new firms in an industry. These major sources are: 1. Patents or copyright: The first important source of monopoly is that a firm may possess a patent or copyright that prevents others from producing the same product or using a particular production process. When a firm introduces a new product, it gets a patent right from the Government so that others cannot produce it. This patent right will be granted for a certain period. 17  2. Control over the essential raw material or natural resources: - If a firm gains control over an essential raw material or input used in the production of a commodity, it gains monopoly power. It is just denying others the use of the material (s) thus becoming a monopoly. 3. Grant of Franchise by the Government: - A firm may be granted exclusive legal right to produce a given product or service in a particular area or region. The government on its part keeps the right to regulate its price and quality. 4.Advertising and Brand Loyalties of the established firms: -Huge advertising campaigns and customer service programmes are often undertaken to enhance the market power of the producer and prevent the entry of potential competitors. Besides, if well-established firms are expecting new potential competitors, they cut prices of their products so that potential competitors find it unprofitable to enter the industry. 5. Technology: Technology developed by the business firms give them a monopoly rights over such goods or services. 6. Cartel formation: If a product is produced by few producers and these producers come together and form a cartel to establish a monopoly. 7. Price policy: A firm may follow a price policy to restrict the entry of new firms in to the market and enjoy monopoly power. 8. Narrow size of the market: Market size is so narrow that, which will not allow more than one seller in the market and hence only single seller will remain in the market and enjoy the monopoly power. D. PRICE DISCRIMINATION Meaning and definition: Price Discrimination refers to charging different prices for different consumers for a homogeneous commodity. It is the act of the seller selling the same product at different price to different customers or buyers. According to Prof.Stigler, Price Discrimination is the sale of technically similar products at price which are not proportional to marginal costs. This definition means that the seller charges different prices for different units of the same product. The price charged by the seller has no relation with marginal costs. Seller practices price discrimination when it is both possible and profitable for him to do so. Types of Price Discrimination: 1. Personal Discrimination: It is based on economic status of buyers. Different price will be charged from different buyers. This type of discrimination is followed by Doctors. Lawyers, teachers etc. They charge different fees from rich and poor people. 2. Age Discrimination: This is practiced by railways, buses etc. Children are given concessions and adults are charged full fares. 3. Sex Discrimination: Girls are entitled for fee education where as boys have to pay full fees. 4. Location Discrimination: When a seller sells at a lower price in one market and higher price in another market. For e.g. Dumping. 5. Use Discrimination: Different prices are charged according to the use of the products. For e.g. Electricity is given at a cheaper rate for industrial use and at a higher rate for households. 6. Size Discrimination: Discrimination may be based on the size or quantity of the product. For e.g. party pack Ice-cream is sold at a lower price and family pack is sold at a higher price 7. Time Discrimination: Here price discrimination is based on time of service. BSNL charges rates at different time, the STD charges are full during the day and quarter at the night time Degrees of price discrimination. 18 Prof.Pigou distinguished Price discrimination into three degrees. They are as follows. 1. First Degree Price Discrimination It is also called as perfect price discrimination. It happens when monopolist is able to sell each and every unit of a product at different prices. The buyer is compelled to pay maximum price that he is willing to pay rather than go without the product. The seller leaves no consumer surplus with the buyers. The First Degree Price Discrimination involves maximum exploitation of the buyers. 2. Second Degree Price Discrimination: Under Second Degree Price Discrimination the discriminating monopolist divides the buyers into different groups. For each groups separate price is charged. Therefore, expect the marginal buyers, other buyers get some consumer 3. Third Degree Price Discrimination: This price discrimination happens when the seller divides the market into different sub-markets and charge different prices in different sub- markets. The price set in each sub-market depends upon the elasticity of demand in that sub-market. In third degree price discrimination majority of consumers get consumer surplus and least exploitation of buyers is observed. Factors influencing price discrimination (conditions of price discrimination) Under monopoly the price discrimination is possible under following conditions: 1. Non-transferability: It should be impossible to transfer the commodity from cheaper market to the dearer market (costly market). It should not be possible for the buyers in a dealer market to transfer themselves into cheaper market. 2. Geographical distance: If markets are located at long distance then, transfer of goods may not be economical. For example : If discrimination is practiced Bombay and Pune markets and difference in prices is Rs. 25 per unit then transfer of goods from one market to another market is not economical. Therefore, should be no possibility of reselling commodities in different markets i.e. buying is a market which charges a low price and selling it in a market which charges high price. 3. Political Barriers: Political boundaries can prevent people from moving from one place / market to another. For example: Calcutta and Dhaka. Since trade is allowed between both the countries a monopolist can charge different price for the same commodities. 4. Peculiarities of Buyers or consumers:  Ignorance: Price Discrimination can be practiced when consumers in one part of the market are unaware of market price prevailing in another part of market.  Too small difference price discrimination is possible when price differences are too small and the consumer can ignore it.  Irrational: Price discrimination when consumer have a feeling that they are paying higher price for a better product through product may not be rally better. 5. Legal protection: price discrimination can be practiced when the seller has obtained a legal protection to practice price discrimination. For example: Electricity service providers and education institutions. 6. Differentiated Products: price discrimination can be practiced when the products are differentiated. 19  1.3 PRICE, OUTPUT AND PROFIT DETERMINATION UNDER MONOPOLY A. SHORT-RUN EQUILIBRIUM OF THE FIRM UNDER MONOPOLY A monopolist, being a rational producer, aims at maximization of profit. Under monopoly firm will be in equilibrium when profit is maximum. The condition of equilibrium under monopoly is the same as perfect competition. i.e., the firm will be in equilibrium when marginal cost (MC) is equal to marginal revenue (MR). And, at the point of equilibrium, the MC curve most intersect MR. curve from below These two conditions are the necessary and sufficient conditions of profit maximization. In the short run a monopoly firm can be equilibrium with either super normal profit or normal profit or loss Monopoly firm with super normal profit: Monopoly equilibrium with super normal profit can be shown with the help of following diagram. Fig A: Monopoly equilibrium with super normal profit Fig A shows the super normal profit of the firm under monopoly. When price is OP firm is in equilibrium at point MR=MC and the equilibrium output is OQ. At the OQ level of output average revenue AQ is greater than average cost BQ. Since average revenue is greater than average cost firm is enjoying super normal profit. Monopoly firm with normal profit: Monopoly equilibrium with normal profit can be shown with the help of following diagram 20  Fig B : Monopoly equilibrium with normal profit Fig B shows the normal profit of the firm under monopoly. When the price is OP firm is in equilibrium at point MR=MC and the output is OQ. At OQ level of output average revenue is equal to average cost. Since average revenue is equal to average cost firm is experiencing normal profit. Monopoly firm with losses: Monopoly equilibrium with loss can be shown with the help of the following diagram. Fig C: Monopoly equilibrium with Loss Fig c shows the loss of the firm under monopoly. In the diagram, the firm is in equilibrium at point MR=MC. At the equilibrium level of output average revenue is less than the average cost. Since average revenue is less than the average cost firm incurs loss. In the diagram, the loss is equal to area PP1BA 21  B. LONG-RUN EQUILIBRIUM OF THE FIRM UNDER MONOPOLY In the long run, the monopolist will adjust its plant to achieve even larger profits. In the long monopoly, the firm is in equilibrium at the point where LMC=MR. In the long run, a loss-making firm will shut down its production. Only firms with super normal profit and normal profit will survive in the long run. Monopoly firm with super normal profit: Monopoly equilibrium with super normal profit can be shown with the help of the following diagram. Fig A: Monopoly equilibrium with super normal profit Fig A shows the super normal profit of the firm under monopoly. When price is OP firm is in equilibrium at point E1 and the equilibrium output is OXd. At OXd level of output average revenue AXd is greater than average cost E1Xd. Since average revenue is greater than average cost firm is enjoying super normal profit C. PRICE AND OUTPUT DETERMINATION UNDER DISCRIMINATING MONOPOLY. Simple monopolist charges a single price but a discriminating monopolist charges different prices from different customers. A simple monopolist reaches equilibrium when marginal revenue is equal to marginal cost. A discriminating monopolist divides the market into sub- markets and charges different prices for the same products in different sub-markets. A discriminating monopolist has to decide: 1. Total output that has to be produced. 2. Quantitative distribution of output among sub-market A and sub-market B Conditions of Equilibrium: A. Aggregate Marginal Revenue (AMR) = MC 22 B. MC Curve intersects the AMR Curve from below. Equilibrium of a Discriminating Monopolist can be explained with the help of following diagram: Diagram: In figure (a), AR (1) and MR (1) are average revenue and marginal revenue curves of Market I. In figure (b), AR (2) and MR (2) are average revenue and marginal revenue curves of market II. In figure (c), AMR is the aggregate marginal revenue curve. Aggregate Marginal Revenue curve is obtained by adding the marginal revenue curves of both market I and market II. MC is the Marginal Cost Curve of the entire market. Discriminating Monopolist is in equilibrium at point E. At this point both the conditions of equilibrium are satisfied i.e. AMR is equal to MC and MC curve cuts AMR curve from below. The equilibrium level of output is OQ. This output is to be distributed between the two markets I and II. Discriminating Monopolist will distribute his total output in such a way that the Marginal Revenue in the sub-markets is equal to that profits are maximized. Moreover, the marginal revenues in the two markets should be equal to marginal cost of the whole output. This will make sure that the amount sold in the two markets will be equal to the total output. It can be seen from the above diagram, that AMR = MC will give total output OQ in the Total Market. The Marginal Revenue of Market A is equal to ME1 = NE2 = QE. Thus, Marginal Revenue in the sub-markets are equal with the AMR. At equilibrium seller distributed OQ1 quantity in Market (I) and OQ2 quantity in Market (II) such that OQ1 + OQ2 = OQ. The discriminating monopolist charges OP 1 price in Market (I) and OP2 price in Market (II). The price charged in Market (I) is greater than the price charged in Market (II). Conclusion: Thus a monopolist charges different prices in different markets to practice price Discrimination. 23  D. DUMPING Dumping is a special type of price discrimination where a monopolist selling the same product at a higher price in the domestic market and at a lower price in the Foreign market. Monopolist enjoys monopoly in the home market and faces perfect competition in the foreign market. Assumptions: 1. The monopolist is selling the same product in domestic market and foreign market. 2. There is large number of buyers. 3. Both the markets have different elasticity of demand, so that price discrimination is profitable. 4. The monopolist will equate combined marginal revenue of the two markets with the marginal cost (CMR=MC). Price output determination under dumping Given the above assumption the Price output determination under dumping can be explained with the help of following diagram. In the above diagram AR(H) and MR(H) are the respective average and marginal revenue curves for the home market. As perfect competition exists in the foreign market, the monopolist faces a horizontal straight line demand or average revenue curve which coincides with the marginal revenue. Therefore, P(F) = AR(F) = MR(F) for the foreign market. The marginal cost curve of the total output is represented by MC. To decide the price and output" monopolist has to find out the equilibrium point, where MC equals the combined marginal revenue (CMR = MC). The combined marginal revenue curve is obtained by adding MR(H) and MR (F). In the diagram NRD is the combined marginal revenue curve which intersects MC curve at point E. At this point, equilibrium level of output is OQ. 24 The firm distributes the OQ output between the home market and foreign market in such a way that MR (H) = MR (F) = MC. At point R, MR (H) = MR (F), Where OM output is supplied and OP (H) Price charged in the home market. Practice Questions 1. What is perfect competition? Explain its features. 2. Discuss the conditions of equilibrium under perfect competition. 3. Explain the short run equilibrium of a firm under perfect competition under homogeneous cost conditions. 4. Discuss the short run equilibrium of a firm under perfect competition under differential cost conditions. 5. Discuss long-run equilibrium of a firm under perfect competition. 6. Write a note on supply curve of a competitive firm. 7. what is monopoly? Discuss the important features of monopoly. 8. Discuss the difference between perfect competition and monopoly. 9. What are the sources of monopoly? Discuss. 10. What is Price discrimination? Discuss the different types of Price discrimination. 11. Explain the conditions of price discrimination. 12. Explain the short-run equilibrium of a firm under monopoly. 13. Write a note on the long-run equilibrium of the firm under monopoly. 14. What is perfect competition? How it is different from monopoly? Discuss. 15. Explain price output determination under discriminating monopoly. 16. Write notes on Dumping. xxxxxxxxx 25  UNIT II: MARKET STRUCTURE: MONOPOLISTIC COMPETITION AND OLIGOPOLY 2.1 MONOPOLISTIC COMPETITION A. Meaning and features of Monopolistic Competition Monopolistic competition is a market structure where many competing producers sell products that are differentiated from one another (i.e. the products are substitutes but are not exactly alike Chamberlin’s concept of monopolistic competition is a blending of competition and monopoly. He says, “Monopolistic competition is a challenge to the traditional viewpoint of economics that competition and monopoly are alternatives. Monopolistic Competition refers to a market situation in which there are large numbers of firms that sell closely related but differentiated products. Markets of products like soap, toothpaste AC, etc. are examples of monopolistic competition. Monopoly + Competition = Monopolistic Competition. Under monopolistic competition, each firm is the sole producer of a particular brand or product. t enjoys a ‘monopoly position’ as far as a particular brand is concerned. However, since the various brands are close substitutes, its monopoly position is influenced due to stiff ‘competition’ from other firms. So, monopolistic competition is a market structure, where there is competition among a large number of monopolists. Example of Monopolistic Competition: Toothpaste Market: When you walk into a departmental store to buy toothpaste, you will find several brands, like Pepsodent, Colgate, Neem, Babool, etc. i. On one hand, the toothpaste market seems to be full of competition, with thousands of competing brands and freedom of entry. ii. On the other hand, its market seems to be monopolistic, due to the uniqueness of each toothpaste and the power to charge different prices. Such a toothpaste market is a monopolistic competitive market. Features: Let us discuss some of the important features of monopolistic competition. 1. Large Number of Sellers: There are large numbers of firms selling closely related, but not homogeneous products. Each firm acts independently and has a limited share of the market. So, an individual firm has limited control over the market price. Large number of firms leads to competition in the market. Each firm is in a position to exercise some degree of monopoly (in spite of large number of sellers) through product differentiation. Product differentiation refers to differentiating the 26 products on the basis of brand, size, colour, shape, etc. The product of a firm is close, but not perfect substitute of another firm. Implication of ‘Product differentiation’ is that buyers of a product differentiate between the same products produced by different firms. Therefore, they are also willing to pay different prices for the same product produced by different firms. This gives some monopoly power to an individual firm to influence market price of its product. 3. Selling costs: Under monopolistic competition, products are differentiated and these differences are made known to the buyers through selling costs. Selling costs refer to the expenses incurred on marketing, sales promotion and advertisement of the product. Such costs are incurred to persuade the buyers to buy a particular brand of the product in preference to competitor’s brand. Due to this reason, selling costs constitute a substantial part of the total cost under monopolistic competition. It must be noted that there are no selling costs in perfect competition as there is perfect knowledge among buyers and sellers. Similarly, under monopoly, selling costs are of small amount (only for informative purpose) as the firm does not face competition from any other firm. 4. Freedom of Entry and Exit: Under monopolistic competition, firms are free to enter into or exit from the industry at any time they wish. It ensures that there are neither abnormal profits nor any abnormal losses to a firm in the long run. However, it must be noted that entry under monopolistic competition is not as easy and free as under perfect competition. 5. Lack of Perfect Knowledge: Buyers and sellers do not have perfect knowledge about the market conditions. Selling costs create artificial superiority in the minds of the consumers and it becomes very difficult for a consumer to evaluate different products available in the market. As a result, a particular product (although highly priced) is preferred by the consumers even if other less priced products are of same quality. 6. Pricing Decision: A firm under monopolistic competition is neither a price- taker nor a price-maker. However, by producing a unique product or establishing a particular reputation, each firm has partial control over the price. The extent of power to control price depends upon how strongly the buyers are attached to his brand. 7. Non-Price Competition: In addition to price competition, non-price competition also exists under monopolistic competition. Non-Price Competition refers to competing with other firms by offering free gifts, making favourable credit terms, etc., without changing prices of their own products. Firms under monopolistic competition compete in a number of ways to attract customers. They use both Price Competition (competing with other firms by reducing price of the product) and Non-Price Competition to promote their sales. 8. Demand Curve under Monopolistic Competition: Under monopolistic competition, large number of firms selling closely related but differentiated products makes the demand curve downward sloping. It implies that a firm can sell more output only by reducing the price of its product. At first glance, the demand curve of monopolistic competition looks exactly like the demand curve under monopoly as both faces downward sloping demand curves. However, demand curve under monopolistic competition is more elastic as compared to demand curve under 27 monopoly. This happens because differentiated products under monopolistic competition have close substitutes, whereas there are no close substitutes in case of monopoly. 9. MR < AR under Monopolistic Competition: Like monopoly, MR is also less than AR under monopolistic competition due to negatively sloped demand curve 10. Product Group: Chamberlin used the term ‘group’ rather than industry. An industry is a set of firms that produces homogeneous goods. But under monopolistic competition, goods are heterogeneous or slightly differentiated. Thus, the term ‘industry’ cannot be applied here. That is why Chamberlin used ‘product group’ which is defined as a collection of firms producing almost similar goods, but not identical goods. 11. Brand loyalty: Every product is unique to the buyers. So every seller enjoys some degree of monopoly of his own product over other sellers. However since these goods are close substitutes, sellers face competition. Because of the brand loyalty of buyers, sellers exercise some monopoly power. B. COMPARISON BETWEEN PERFECT COMPETITION AND MONOPOLISTIC COMPETITION The basic differences between perfect competition and monopolistic competition are indicated in the following points: i. A market structure, where many sellers are selling similar goods to the buyers, is perfect competition. A market structure, where there are numerous sellers, selling close substitute goods to the buyers, is monopolistic competition. ii. In perfect competition, the product offered is standardized whereas in monopolistic competition product differentiation is there. iii. In perfect competition, the demand and supply forces determine the price for the whole industry and every firm sells its product at that price. In monopolistic competition, every firm offers products at its price. iv. Entry and Exit are comparatively easier in perfect competition than in monopolistic competition. v. The slope of the demand curve is horizontal, which shows perfectly elastic demand. On the other hand, in monopolistic competition, the demand curve is downward sloping which represents the relatively elastic demand. vi. Average revenue (AR) and marginal revenue (MR) curve coincide with each other in perfect competition. Conversely, in monopolistic competition, average revenue is greater than the marginal revenue, i.e. to increase sales the firm has to lower down its price. vii. Perfect competition is an imaginary situation which does not exist in reality. Unlike, monopolistic competition, that exists practically. 28  C. CONCEPT OF PRODUCT DIFFERENTIATION Product differentiation refers to differentiating the products based on brand, size, colour, shape, etc. The product of a firm is close, but not a perfect substitute for another firm. The implication of ‘Product differentiation’ is that buyers of a product differentiate between the same products produced by different firms. Therefore, they are also willing to pay different prices for the same product produced by different firms. This gives some monopoly power to an individual firm to influence the market price of its product. 1. The product of each individual firm is identified and distinguished from the products of other firms due to product differentiation. 2. To differentiate the products, firms sell their products with different brand names, like Lux, Dove, Lifebuoy, etc. 3. The differentiation among different competing products may be based on either ‘real’ or ‘imaginary’ differences. i. Real Differences may be due to differences in shape, flavor, colour, packing, after-sale service, warranty period, etc. ii. Imaginary Differences mean differences that are not really obvious but buyers are made to believe that such differences exist through selling costs (advertising). 4. Product differentiation creates a monopoly position for a firm. 5. A higher degree of product differentiation (i.e. better brand image) makes demand for the product less elastic and enables the firm to charge a price higher than its competitor’s products. For example, Pepsodent is costlier than Babool. 6. Some more examples of Product Differentiation: (i) Toothpaste: Pepsodent, Colgate, Neem, Babool, etc. (ii) Cycles: Atlas, Hero, Avon, etc. (iii) Tea: Brooke Bond, Tata tea, Today tea, etc. (iv) Soaps: Lux, Hamam, Lifebuoy, Pears, etc. D. CONCEPT OF SELLING COST Selling costs play a key role in monopolistic competition and oligopoly. Under these market forms, the firms have to compete to promote their sale by spending on advertisements and publicity. Moreover, the producer does not have to decide about price and output and he also keeps in view how to maximize the profit. Definitions: Selling costs are costs incurred to alter the position or shape of the demand curve for the product.” E.H. Chamberlin “Selling costs may be defined as costs necessary to persuade a buyer to buy one product rather than another or to pay from one seller rather than another.” Meyers 29 Assumptions: Basically, the concept of selling cost is based on the following two assumptions: 1. Buyers do not have any perfect knowledge about the different types of products. 2. Buyers demand and tastes can be changed. Explanation: Selling costs are a broader concept than advertisement expenditures. Advertisement expenditures are part of selling costs. In selling costs, we include the salaries of salespersons, allowances to retailers to display the products, etc. besides the advertisements. Advertisement expenditure includes costs incurred for advertising in newspapers and magazines, televisions, radio, cinema slides, etc. It was Chamberlin who introduced the analysis of selling costs and distinguished it from the production costs. The production costs include all those expenses that are spent on the manufacturing of the commodity, its transportation cost of handling, storing, and delivering the commodity to actual customers because these add utilities to a commodity. On the other hand, all selling costs include all expenditures to raise demand for a commodity. In short, selling costs are those which are made to create the demand for the product. Transport costs should not be included in selling costs; rather these should be included in the production costs. Transport costs do not increase the demand; they only help in meeting the demand of the consumers. In the same fashion, high rents are not part of selling costs. High rents are paid to meet the already existing demand of the people. According to Edward H. Chamberlin, “Those costs which are made to adopt the product to the demand are costs of production; those made to adopt the demand to the product are costs of selling.” Difference between Selling cost and Production cost: We cannot make a clear-cut distinction between the selling cost and production cost. In fact, both costs are interrelated throughout the price system, so that at no point it can be said that one has ended and the other is to begin. However, the following fundamental differences between selling costs and production costs can be observed..  Production cost includes all the expenses incurred in making particular product and transporting it to the consumers. They include, outlays incurred on services engaged in the manufacturing of the product like land, labour and capital etc. On the other hand, selling costs include all the costs incurred to change the consumer’s preference from one product to another. These are generally intended to raise the demand of one product at any given price.  According to E.H. Chamberlin, “Production costs create utilities in order that demands may be satisfied while selling costs create and shift the demand curves themselves.”  Production cost shifts the supply curve whereas; selling cost shifts the demand curve.  Production cost creates utilities whereas, selling cost will not create any utility but creates demand.  Production cost is a mandatory cost. while, selling cost is not mandatory, 30  E. SHORT-RUN EQUILIBRIUM OF THE FIRM UNDER MONOPOLISTIC COMPETITION Monopolistic competition refers to the market organization where there are a fairly large number of firms which sell somewhat differentiated products. If a firm reduces price, it can expect a considerable increase in its sales. If the firm raises its price, it will not lose all its customers. This is because of the fact that the product is differentiated from competing firms due to price and non-price factors. The demand curve (AR curve) of the monopolistic firm is therefore, highly elastic and is downward sloping. As regards the marginal revenue curve, it slopes downward and lies below the demand curve because price is lowered of all the units to sell more output in the market. Firm's Equilibrium Price and Output: In the short-run, the number of firms in the 'product group' remains the same. The size of the plant of each firm remains unaltered. In order to achieve the objective of profit maximization firms under monopolistic competition goes on producing a commodity so long as the marginal revenue is greater than marginal cost. When MR = MC, it is then in equilibrium and produces the best level of output. If a firm produces less than or more than the MR = MC output, it will then not be making maximum of profits. At the point of equilibrium where, MR=MC, MC curve must intersect MR curve from below. In the short-run, a monopolistically competitive firm may be realizing abnormal profits or suffering losses. If it is earning profits, no new firms can enter the industry in the short-run. In case, it is suffering, losses but covering full variable cost, the firm will continue operating so that the losses are minimized. If the full variable cost is not met, the firm will close down in the short-run. The short-run equilibrium with profits and short run equilibrium with losses of a monopolistically competitive firm are explained with the help of two separate diagrams as under. Diagram: Monopolistic competition with super normal profit In the figure the downward sloping demand curve (AR curve) is quite elastic. The MR curve lies below the average curve except at point N. The SMC curve which includes advertising and sales promotional costs is drawn in the usual fashion. The SMC curve cuts the MR curve from below at point Z. The firm produces and sells an output OK, as at this level of output MR = MC. The firm sells output OK at OE/KM per unit price. The total revenue of the firm is equal 31 to the area OEMK, whereas the total cost of producing output OK is OFLK. The total profits of the firm are equal to the shaded rectangle FEML. The firm earns abnormal profits in the short run. If the demand and cost situations are not favorable in the market, a monopolistically competitive firm may incur losses in the short-run. The short-run equilibrium of the firm with losses is explained with the help of a diagram. Diagram: Monopolistic competition with Losses In the Figure marginal cost (SMC) equates marginal revenue MR curve from below at point Z. The firm produces output OK and sells at OF/KT per unit-price. The total receipt of the firm is OFTK. The total cost of producing output OK is equal to OEMK. The firm suffers a net loss equal to the area FEMT on the sale of OK output. F. LONG RUN EQUILIBRIUM OF THE FIRM UNDER MONOPOLISTIC COMPETITION In the long run, under monopolistic competition, there is a gradual decrease in the profits of organizations. This is because in the long run, several new organizations enter the market due to freedom of entry and exit under monopolistic competition. When these new organizations start production the supply would increase and the prices would fall. This would automatically increase the level of competition in the market. Consequently, AR curve shifts from right to left and supernormal profits are replaced with normal profits. In the long run, the AR curve is more elastic than that of in the short run. This is because of an increase in the number of substitute products in the long- run. In the following Figure, P is the point at which AR curve touches the average cost curve (LAC) as a tangent. At this point the price level is MP (which is also equal to OF) and output is OM. Since price (average revenue) is equal to average cost firm is experiencing just normal profit. 32 Long-run equilibrium position under monopolistic competition: Thus, in the long-run, equilibrium of monopolistically competitive organizations is achieved when average revenue is equal to average cost. In such a case, organizations receive normal profits. OLIGOPOLY An oligopoly is one of the major imperfect market structures where very few firms try to sell their homogeneous differentiated products. Oligopoly is also referred to as competition among the few. Oligopoly is a situation where few firms are producing a product, the word Oligopoly originated from the Greek word 'oligous' means few, and Latin word 'polis' which means seller. Therefore, Oligopoly is a market situation where there are few sellers in the market, selling homogeneous or differentiated products. According to Stigler, 'Oligopoly' is a situation in which a firm bases its market policy in part on the expected behavior of close rivals. 33 FEATURES: A few important features of oligopoly are given below: 1. Few Sellers: Under Oligopoly there are very few firms. It is difficult to pinpoint the exact number of firms. These few firms naturally influence the interest of their rival firms. 2. Large number of buyers: An Oligopoly is an imperfect market where a large number of buyers interact with a few sellers. These buyers are aware of the number of products available in the market. 3. Interdependence: The sellers in an oligopolistic market depend on each other. Any change in the price, output or product of one firm will have a direct effect on the rivals. The rival firms will retaliate by changing their own prices, output or product. The reactions of the rival firms may be difficult to guess hence price indeterminate under Oligopoly. 4. High cross elasticities: The cross elasticity of demand for the products of Oligopoly firms is very high. Hence, each firm is conscious of the possible actions & reactions of competitors while making any change in price or output. 5. Importance of advertising and selling cost: A direct effect of the interdependence of the oligopolistic firms is that they have to apply various aggressive and defensive marketing weapons to gain a greater share in the market or to maintain their share. Hence, the firms have to spend huge amounts of money on advertisement and sales promotion activities. 6. Lack of uniformity in size: It is an important feature of the Oligopoly market that there is no uniformity in the size of firms. Some firms may be very small while others may be too big. 7. Competition: In an oligopolistic market, there exist competition among the sellers. There are few sellers and a single move by one seller immediately affects the rivals. Therefore, every seller is always conscious and keeps watch over any move of its rival firm in order to counter that. 8. Group behaviour: The theory of Oligopoly is the theory of group behaviour. Under Oligopoly, profit maximization, policy is not that much valid. The firms are interdependent and they may decide their policies based on the policies adopted by the other sellers in the market. 9. Uncertainty: The interdependence on other firms for the determination of price and output will create an atmosphere of uncertainty under Oligopoly. 10. Price rigidity: In an Oligopoly market each firm sticks to its own price to avoid a possible price war. The price remains rigid because of constant fear of retaliation by rivals. 34 11. Kinky or kinked demand curve: The interdependence of the firms and the inability of a particular firm to predict the behaviour of other firms make the demand curve of an Oligopolistic firm indeterminate. Hence, there is a kinky demand curve under oligopoly. This can be shown with the help of the following diagram. In the diagram DKD is the demand, DK portion of the demand curve is relatively elastic and KD, portion is relatively in elastic. At point K there is a kink in the demand curve and therefore price becomes rigid at op level. COLLUSIVE AND NON-COLLUSIVE OLIGOPOLY MARKET In oligopolistic market situations, organizations are indulged in high competition with each other, which may lead to price wars. To avoid such type of problems, organizations agree to uniform price-output policy. This agreement is known as collusion, which is opposite to competition. Under collusion, organizations are involved in collaboration with each other to take combined actions to keep their bargaining power stronger against consumers. Definitions of collusion : According to Samuelson, “Collusion denotes a situation in which two or more firms jointly set that prices or output, divide the market among them, or make other business decisions.” In the words of Thomas J. Webster, “Collusion represents a formal agreement among firms in an oligopolistic industry to restrict competition to increase industry profits.” Benefits of collusion: i. Helps organizations to increase their performance ii. Helps organizations in preventing uncertainties iii. Provides opportunities to prevent the entry of new organizations Nature of Collusion: The agreement of collusion formed may be tacit or formal in nature. A formal agreement formed among competing organizations is known as a cartel. In other words, a cartel can be defined as a group of organizations that together make pricing and output decisions. A vigorous price competition may result in uncertainty. The question that arises now is: how do oligopoly firms remove uncertainty? Firms enter into pricing agreements with each other instead of adopting competition or price war with each other. Such agreement—both explicitly (or formal) and implicit (or informal)—may be called collusion. Always, every firm has the inclination to achieve more strength and power over the rival firms. As a result, in the oligopolist industry, one finds the emergence of a few powerful competitors who cannot be eliminated easily by other powerful firms.Under the circumstance, some of these firms act together or collude with each other to reap maximum advantage. In fact, in oligopolist industry, 35 there is a natural tendency for collusion. The most important forms of collusion are: price leadership cartel and merger and acquisition. When a formal collusive agreement becomes difficult to launch, oligopolists sometimes operate on informal tacit collusive agreements. One of the most common forms of informal collusion is price leadership. Price leadership arises when one firm—which may be a large as well as dominant firm—initiates price changes while other firms follow. Non-collusive Oligopoly: If different firms in the oligopolistic structures do not cooperate is known as a non-collusive oligopoly. In this case, collusion breaks down because the incentive to cheat is very high. This can arise, for instance, in a situation where there is a lure of very high profits so that individual firms cheat on their quota and try to increase output and profits. But this causes everyone else to do the same and therefore supply soars and prices tumble producing in effect a non-collusive oligopoly. The incentive to collude becomes strong for members of a non-collusive oligopoly when firms are not making good profits. Thus oligopolies usually oscillate between collusive and non- collusive equilibria. CARTELS According to Leftwitch, “the firms jointly establish a cartel organization to make price and output decisions, to establish production quotas for each firm, and to supervise market activities of the firms in the industry.” According to Webster, “A cartel is a formal agreement among firms in an oligopolistic industry to allocate market share and/or industry profit.” Under cartels, the price and output determination is done by the common administrative authority, which aims at equal profit distribution among all member organizations under cartel. The total profits are distributed in proportion as decided among member organizations. The most famous example of cartel is Organization of the Petroleum Exporting Countries (OPEC), which has shared control of petroleum markets. Practical example of cartel: 36 Perhaps the most globally recognizable and effective cartel is OPEC, the Organization of Petroleum Exporting Countries. In 1973 members of OPEC reduced their production of oil. Because crude oil from the Middle East was known to have few substitutes, OPEC member's profits skyrocketed. From 1973 to 1979, the price of oil increased by $70 per barrel, an unprecedented number at the time. In the mid-1980s, however, OPEC started to weaken. Discovery of new oil fields in Alaska and Canada introduced new alternatives to Middle Eastern oil, causing OPEC's prices and profits to fall. Around the same time OPEC members also started cheating to increase their individual. PRICE LEADERSHIP When a formal collusive agreement becomes difficult to launch, oligopolists sometimes operate on informal tacit collusive agreements. One of the most common form of informal collusion is price leadership. Price leadership arises when one firm—may be a large as well as dominant firm—initiates price changes while other firms follow. Types of Price Leadership: There are several types of price leadership. The following are the principal types: (a) Price leadership of a dominant firm, i.e., the firm which produces the bulk of the product of the industry. It sets the price and rest of the firms simply accepts this price. (b) Barometric price leadership, i.e., in the case of price leadership of a dominant firm the price leadership of an old, experienced and the largest firm assumes the role of a leader, but undertakes also to protect the interest of all firms instead of promoting its own interests(Dewett,2001). (c) Exploitative or Aggressive price leadership, i.e., one big firm built its supremacy in the market by following aggressive price leadership. It compels other firms to follow it and accept the price fixed by it. In case the other firms show any independence, this firm threatens them and coerces them to follow its leadership. PRICE RIGIDITY (KINKED DEMAND CURVE) It implies a stable, constant price of a product over some time despite the change in demand and cost conductions. It is common experience in the case of durable consumer goods that their wholesale prices remain fixed or stable for the entire year or season. Price rigidity thus, indicates the absence of price movement upward or downward. The following are major factors responsible for price rigidity: 1.Preference of Oligopolistic producer stability with a desire to avoid destructive price war. 2.Price rigidity provides a solution to common in determinant demand and price rigidity overcomes the instability and uncertainty in an Oligopolistic situation. 3.Sticking to existing price may prevent the entry of new rivals in the industry. 4.Preference may be given to non-price competitors like sales promotion drives over the competitive price reduction by rival firms. 37 5.A firm may not like to raise the price and deprive itself of the customers after so much amount spent on advertising. 6.A price change unnecessarily raises the expenditure on printing stationery, communication etc. 7.The rigid price may be the result of negotiations, conflict etc. Diagrammatic explanation of price rigidity through Kinky demand curve. In the diagram DKD, is the demand, DK portion of the demand curve is relatively elastic and KD, the portion is relatively in elastic. At point K there is a kink in the demand curve and therefore price becomes rigid at OP level. Review Questions: 1. Discuss the short-run equilibrium of a firm under Monopolistic competition. 2. What is Oligopoly? Discuss its features. 3. What is Oligopoly? Discuss the differences between Collusive and non-collusive Oligopoly. 4. What is monopolistic competition? Discuss its features. 5. What is Price leadership? Explain different types of price leadership 6. Write a note on product differentiation. 7. Write a note on Price rigidity. 8. Discuss the long-run equilibrium of a firm under Monopolistic competition. 9. Distinguish between monopolistic competition and perfect competition. 10. Discuss the merits and demerits of Advertisement. 11. Write a note on Cartels. xxxxx UNIT III: PRICING PRACTICES AND CAPITAL BUDGETING 38  COST –PLUS (FULL COST)/ MARK-UP PRICING Under Full cost pricing, the price is set equal to the average total cost. The price is set to cover all costs both fixed and variable and a pre-determined percentage of profits. The percentage differs among industries, member firms, and even among the products of the same firm. It depends on the intensity of competition, differences in costs, risk, and rate of turnover. It implies a just profit i.e. a normal profit. The profit margins are fixed and they may be rigid due to the following reasons: 1. Due to common practice. 2. Mark-ups may be determined by associations through price lists. 3. Profit margins sanctioned under price control may remain the same even after the price control is discontinued. These margins are considered ethical and reasonable... 4. Profit margins under full-cost pricing are so set that even the least efficient firm would survive. Thus, the margin of profits may be higher than what would be possible under competitive conditions. Advantages of Full Cost Pricing: 1. Full cost pricing helps to find fair prices with ease and speed irrespective of the number of products handled by the firm. 2. Prices fixed under full cost pricing are justifiable on moral grounds. 3. Firms with uncertain knowledge about the market and preferring stability use full cost pricing. 4. Firms which are uncertain about their demand. Curve and do not want to take risks adopt full-cost pricing.. 5. Some firms feel that if fixed costs are not covered in the short run, they cannot be covered in the long-run also. Hence full-cost pricing is justified.. 6. The reaction of rivals is unknown and this is a major uncertainty while setting a price. Cost- plus pricing offers competitive stability, yielding acceptable profit. 7. Under full-cost pricing, management tends to know more about product costs than other factors relevant to pricing.. 8. Cost plus pricing is especially useful in the following cases: a) Public-Utility pricing... b) Product-tailoring - i.e. determining the product design when selling price is determined. c) Pricing products that are designed to the specification of single buyer. d) Monopsony, where the buyers know a great deal about supplier's costs. The full-cost method is the most commonly used method of pricing. This method is widely used in India as it has the approval of the government. Limitations: 1) The full-cost pricing ignores demand. 2) It fails to reflect the forces of competition. 3) Allocating the cost of overheads. is arbitrary & unrealistic & it is not a suitable base for price fixing. 4) It is difficult to identify the costs & it is not a logical approach to pricing. 5) It is difficult to decide the markup to cover overheads to the unknown future volume of sales. 6) It ignores marginal or incremental costs & instead uses average costs. 7) This price policy is highly imprudent during the depression 39  MARGINAL COST PRICING Under marginal cast pricing, the price is set equal to the marginal cost. The fixed costs are ignored & prices are determined based on the marginal cast. This implies that the firm considers only the variable costs i.e. the costs that are directly attributable to the output of a specific product.. The pricing decision is based on future planning dealing with anticipated expenses & outlays. Under marginal cast pricing, the firm fixes its price in such a way that its contribution to fixed costs & profit is maximized. This objective can be achieved by considering each product in isolation. The firms follow MC pricing when they enter into a new market, the firm has unutilized capacity and there is a high degree of competition. Advantages:.... 1. Since fixed costs are not covered under marginal cast pricing, prices seem to look competitive. 2. Marginal cost pricing reflects future changes in costs. 3. Marginal cost pricing permits the manufacturer to develop a more aggressive pricing policy which may lead to higher sales. 4. Marginal cost pricing is more useful for pricing over the lifecycle of a product. 5. It is useful in the short-run period. 6. It is useful for multi-product, multi-process, and multi-market firms. Limitations: 1. It is useful in the short run and does not provide a long-run stable price policy. 2. This does not guarantee that the firm will operate at a break-even point. 3. During the recession, firms using marginal cost pricing may lower prices to maintain business. This may cause other firms to reduce their prices, leading to cut-throat competition. Hence no one would be earning sufficient to cover the fixed costs. 4. Under increasing cost conditions, it may lead to a higher price, and under decreasing cost conditions; it may lead to a lower price.. MULTIPLE – PRODUCT PRICING In practice, all firms produce more than one product. Even the most specialized firms produce different sizes, models & styles of products, The product is differentiated in such a manner that consumer considers them to be separate products, Some firms may produce related products & some other firms may produce unrelated products. The firms dealing with multi-products should consider the following factors while determining prices: 1] Demand relations: - Whether the products are complementary or substitutes & the cross elasticity for the products. 2] Production relation: - Whether the production functions are fixed proportion or variable proportion. 3] Capacity relationship: -Whether ideal or unutilized capacity exists in the firm. 40 Factors influencing multi-product pricing: Pricing in a multi-product firm is very complicated. Yet the following factors play a vital role in pricing of these products: - 1] A firm may be producing a number of products, which are totally independent. In such a case, pricing is like single product pricing. It is based on cost function & demand function. 2] When a firm is engaged in production of joint product, the pricing principle is that TC must be covered by pricing of main & byproduct taken together.' 3] When Production is made by using some common facilities, pricing is based on the contribution of each product to the fixed cost. 4] When a firm is producing substitutes, market is separated based on the degree of elasticity of demand. Pricing may be mark-up pricing or the size of margin for profits may be varied based on cost level. 5] A multi-product firm behaves like a discriminating monopolist & tries to maximize its revenue from each product. Different prices are charged based on relative elasticity of demand. TRANSFER PRICING Transfer pricing refers to the determination of the price of the intermediate products sold by one semi-autonomous division of the same firm. The optimum output of each division & the firm as a whole has to be determined to evaluate the divisional performance & determine divisional rewards. 1) For an intermediate product. for which there is no external market, the correct transfer price is the marginal cost of production. , 2) For an intermediate product for which a perfectly competitive external market exists, the transfer price is determined by the external competitive price for the intermediate products. 3) For an intermediate product that can be sold in 'an imperfectly competitive market, the transfer price is given at the point where the net marginal revenue is equal to' the marginal cost of production of the intermediate product. Transfer price pertains to the price to be put on goods or services transferred by one department to another i.e. the intermediate goods or services. The transfer price must satisfy the following two criteria. 1) It should help to establish the profitability of each division or department. 2) It should permit & encourage maximization of profits of the company as a whole rather than individual divisions & departments. There are three alternative methods of computing transfer price. 1) Market price basis 2) Cost basis and 3) Cost-plus basis 1) Market price basis: The prices are determined based on market conditions. It is possible to find out the price of a good or service had it been done by an outside firm, keeping in mind the quality, service & promptness of work. This method avoids the possibility of passing the inefficiencies of one division or department 41  to another. In some cases, it may be difficult to ascertain the price of a good at each stage of production. 2) Cost Basis: The prices of goods or services transferred to the transferee department are fixed based on actual costs incurred. The drawback in this method is that the efficiency or inefficiency of the department cannot be established. This method is useful when the market price cannot be determined. 3) Cost-plus Basis: The price of goods or services rendered by the transferring department is based on the actual cost plus a profit margin. In case of severe competition or depression, the prices may be fixed very high which would affect the sales. The' transferring department may increase the costs so that the amount of profit margin would be higher. There could be wastage & losses which may be passed on to the other department. In such a case, the loss should be computed by omitting all abnormal losses or abnormal idle capacity. Advantages:.... 1. This method avoids the possibility of passing the inefficiencies of one division or department to another. 2. This method of pricing may improve the overall efficiency of the firm by encouraging inter- departmental competition 3. Generally this method solves the problem of overpricing or under pricing since each department is involved in the pricing decision. 4. It helps in identifying useful departments in the organization. 5. I t is useful for multi- departmental firms. 6. This method is useful when the market price cannot be determined. Limitations: 1. It is useful in the short run and does not provide a long-run stable price policy. 2. The drawback in this method is that the efficiency or inefficiency of the department cannot be established. 3. In case of severe competition or depression, the prices may be fixed very high which would affect the sales. 4. In some cases, it may be difficult to ascertain the price of a good at each stage of production. PRICING STRATEGIES FOR DIGITAL PRODUCTS AND SERVICES Pricing strategies for digital products and services require a nuanced approach that considers the unique aspects of the digital market, including low marginal costs, scalability, and varying 42 customer segments. Below are detailed pricing strategies specifically tailored for digital products and services: 1. Freemium Model Description: The freemium model offers a basic version of a product or service for free, while charging for premium features or functionalities. Advantages:  Attracts a large user base quickly.  Encourages users to upgrade to premium versions.  Generates revenue through a combination of free and paid users. Example: Dropbox offers a free basic plan with limited storage and charges for additional storage and features. 2. Subscription Pricing Description: Customers pay a recurring fee (monthly, quarterly, annually) to access a product or service. Advantages:  Provides a steady and predictable revenue stream.  Enhances customer retention through continuous engagement.  Allows for easier upselling and cross-selling. Example: Netflix charges a monthly subscription fee for access to its streaming content library. 3. Value-Based Pricing Description: Prices are set based on the perceived value to the customer rather than the cost of production. Advantages:  Aligns pricing with customer willingness to pay.  Can result in higher profit margins.  Encourages a focus on delivering high-value features. Example: Adobe Creative Cloud prices its suite of tools based on the value it provides to creative professionals. 4. Tiered Pricing Description: Offering multiple pricing tiers based on different levels of service, features, or usage. Advantages:  Targets multiple customer segments with different needs and budgets. 43   Increases customer lifetime value by encouraging upgrades.  Provides a clear path for customers to scale their usage. Example: Slack offers free, standard, plus, and enterprise grid plans with varying features and support levels. 5. Pay-Per-Use Pricing Description: Customers pay based on their actual usage of the product or service. Advantages:  Aligns cost with usage, making it attractive to customers.  Can lead to higher overall revenue from heavy users.  Reduces barriers to entry for new users. Example: Amazon Web Services (AWS) charges based on the computing resources consumed by the user. 6. Dynamic Pricing Description: Prices are adjusted in real time based on demand, competition, or other factors. Advantages:  Maximizes revenue by capturing the highest possible price customers are willing to pay.  Responds to market changes and competitor pricing.  Can drive sales during low-demand periods through discounts. Example: Uber uses dynamic pricing to adjust fares based on current demand and supply conditions. 7. Bundling and Unbundling Description: Bundling involves selling multiple products or services together at a discounted rate. Unbundling involves selling products or services individually. Advantages:  Increases perceived value and sales volume through bundles.  Allows for higher prices on individual components in unbundling.  Appeals to different customer preferences. Example: Microsoft Office 365 offers a suite of applications (Word, Excel, PowerPoint) at a bundled price, while also selling individual applications separately. 8. Psychological Pricing Description: Pricing strategies that consider the psychological impact of pricing on consumers, such as setting prices slightly below a round number (e.g., $9.99 instead of $10). Advantages:  Can make prices appear more attractive to customers. 44   Encourages impulse purchases.  Creates a perception of value. Example: Many app stores price digital products at $0.99, $1.99, or $4.99 to make them seem more affordable. 9. Penetration Pricing Description: Setting a low initial price to attract customers and gain market share quickly, with plans to increase the price later. Advantages:  Quickly builds a large user base.  Can deter competitors from entering the market.  Creates initial brand loyalty. Example: Spotify initially offered significant discounts on its premium subscription to attract users before gradually raising prices. 10. Price Discrimination Description: Charging different prices to different customer segments based on their willingness to pay. Advantages:  Maximizes revenue by capturing consumer surplus.  Tailors pricing to different customer needs and budgets.  Enhances mark