Business Economics-III 2024-25 PDF

BUSINESS ECONOMICS-III REFERENCE MATERIAL 2024-25 (For Private Circulation Only) 2 Factor Markets A. Introduction to Factor Markets: Definition and classification of factors of production; Distinction between factor markets and product markets. B. Supply and Demand in Factor Markets: Determinants of labour supply and demand; determinants of capital supply and demand; Equilibrium in factor markets. C. Wage and Rent Determination: Marginal productivity theory of wages, Factors influencing wage differentials, role of labour unions in wage determination; Economic rent and its determination; Factors affecting land rent, differential rent and land use. Textbook reference: Ahuja. H.L.; Principles of Economics; S Chand and Company Ltd; 22nd edition; 2019 Chapter 32, 33, 34 - Page No- 739- 830 A. Koutsoyiannis; Modern Microeconomics; Macmillan Publishers India Ltd.; 2nd edition; 2009 Chapter 21- Page No- 437- 450 Pindyck.S. Robert & Rubinfeld. L Daniel; Microeconomics; 8th Edition;2013 Chapter 14- Page No- 529- 556 3 Information, Market Failure & Role of Government A. Market failure - Market Power and inefficiency, incomplete information, externalities and inefficient allocation of resources. B. Common Property Resources- Tragedy of the commons, Overexploitation of common resources, Sustainable resource management. C. Information asymmetry in markets, adverse selection and moral hazard, market consequences of asymmetric information, principal-agent problem. Textbook reference: Ahuja. H.L.; Principles of Economics; S Chand and Company Ltd; 22nd edition; 2019 Chapter 40 - Page No- 898- 914 Chapter- 43- Page No- 931- 946 N. Gregory Mankiw; Principles of Microeconomics; Cengage Learning; 8th edition; 2020 Chapter 10 & 11- Page No- 187- 224 Pindyck.S. Robert & Rubinfeld. L Daniel; Microeconomics; 8th Edition;2013 Chapter 16, 17 & 18 - Page No- 595- 697 Evaluation Pattern: I. Continuous Assessment (C.A.) - 40 Marks (i) C.A.-I: Test – (Objective type of questions)- 20 Marks (ii) C.A.-II: Case Studies/Assignments- 20 Marks II. Semester End Examination (S.E.E.)- 60 Marks QUESTION PAPER PATTERN OF SEE Maximum Marks: 60 Marks Time: 2 Hours Note: 1) All four questions are compulsory 2) All Questions carry equal marks 3) Attempt any two questions out of three in each question Question No Particulars Marks A) Full Length Question Q-1 (from Module 1) B) Full Length Question 15 Marks C) Application based Question A) Full Length Question Q-2 (from Module 2) B) Full Length Question 15 Marks C) Application based Question A) Full Length Question Q-3 (from Module 3) B) Full Length Question 15 Marks C) Application based Question Short Notes (Any three out of six) A. Unit-1 B. Unit-1 Q-4 (from Modules 1-3) C. Unit-2 15 Marks D. Unit-2 E. Unit-3 F. Unit-3 Reference books: Essential Reading: 1. Ahuja. H.L.; Principles of Economics; S Chand and Company Ltd; 22nd edition; 2019 2. A. Koutsoyiannis; Modern Microeconomics; Macmillan Publishers India Ltd.; 2nd edition; 2009 3. Dominick Salvatore; Microeconomics: Theory and Applications; Oxford University Press; 5th edition; 2015 4. N. Gregory Mankiw; Principles of Microeconomics; Cengage Learning; 8th edition; 2020 5. Pindyck. S. Robert & Rubinfeld. L Daniel; Microeconomics; 8th Edition; 2013 Advanced Reading: 1. Paul Krugman and Robin Wells; Microeconomics; Worth Publishers; 5th edition; 2019 2. Paul Samuelson and William Nordhaus; Economics: Principles, Problems, and Policies; Tata McGraw-Hill Education; 19th edition; 2010 3. Robert H. Frank, Ben S. Bernanke, Kate Antonovics, and Ori Heffetz; Principles of Microeconomics; Tata McGraw-Hill Education; 7th edition; 2018 4. Varian Hal. R.; Intermediate Microeconomics- a modern approach; W.W. Norton; 8th edition; 2014 MODULE I Class: SYBCom Semester-III Subject: B. Economics-III Perfect Competition Table of Contents: I. Assumptions 1 II. Short-run Equilibrium 3 A. Equilibrium of the Firm in the Short Run 3 B. The supply curve of the firm and the industry 7 C. Short-run equilibrium of the industry 9 III. Long-run Equilibrium 9 A. Equilibrium of the firm in the long run 9 B. Equilibrium of the industry in the long run 11 C. Long Run Supply Curve 12 Constant-cost industry 12 Increasing-cost industry 12 Decreasing-cost industry 14 Perfect competition is a market structure characterized by a complete absence of rivalry among the individual firms. Thus, perfect competition in economic theory has a meaning diametrically opposite to the everyday use of this term. In practice businessmen use the word competition as synonymous to rivalry. In theory, perfect competition implies no rivalry among firms. I. Assumptions The model of perfect competition is based on the following assumptions. 1. Large numbers of sellers and buyers The industry or market includes a large number of firms (and buyers), so that each individual firm, however large, supplies only a small part of the total quantity offered in the market. The buyers are also numerous so that no monopsonistic power can affect the working of the market. Under these conditions each firm alone cannot affect the price in the market by changing its output. Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 1 Class: SYBCom Semester-III Subject: B. Economics-III 2. Product homogeneity The industry is defined as a group of firms producing a homogeneous product. The technical characteristics of the product as well as the services associated with its sale and delivery are identical. There is no way in which a buyer could differentiate among the products of different firms. If the product were differentiated the firm would have some discretion in setting its price. This is ruled out ex hypothesi in perfect competition. The assumptions of large numbers of sellers and of product homogeneity imply that the individual firm in pure competition is a price-taker: its demand curve is infinitely elastic, indicating that the firm can sell any amount of output at the prevailing market price (figure below). The demand curve of the individual firm is also its average revenue and its marginal revenue curve. 3. Free entry and exit of firms There is no barrier to entry or exit from the industry. Entry or exit may take time, but firms have freedom of movement in and out of the industry. This assumption is supplementary to the assumption of large numbers. If barriers exist the number of firms in the industry may be reduced so that each one of them may acquire power to affect the price in the market. 4. Profit maximisation The goal of all firms is profit maximisation. No other goals are pursued. 5. No government regulation There is no government intervention in the market (tariffs, subsidies, rationing of production or demand and so on are ruled out). The above assumptions are sufficient for the firm to be a pricetaker and have an infinitely elastic demand curve. The market structure in which the above assumptions are fulfilled is called pure competition. It is different from perfect competition, which requires the fulfilment of the following additional assumptions. Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 2 Class: SYBCom Semester-III Subject: B. Economics-III 6. Perfect mobility of factors of production The factors of production are free to move from one firm to another throughout the economy. It is also assumed that workers can move between different jobs, which implies that skills can be learned easily. Finally, raw materials and other factors are not monopolised and labour is not unionised. In short, there is perfect competition in the markets of factors of production. 7. Perfect knowledge It is assumed that all sellers and buyers have complete knowledge of the conditions of the market. This knowledge refers not only to the prevailing conditions in the current period but in all future periods as well. Information is free and costless. Under these conditions, uncertainty about future developments in the market is ruled out. Under the above assumptions we will examine the equilibrium of the firm and the industry in the short run and in the long run. II. Short-run Equilibrium In order to determine the equilibrium of the industry we need to derive the market supply. This requires the determination of the supply of the individual firms, since the market supply is the sum of the supply of all the firms in the industry. A. Equilibrium of the Firm in the Short Run The firm is in equilibrium when it maximises its profits (∏), defined as the difference between total cost and total revenue:∏ = TR- TC Given that the normal rate of profit is included in the cost items of the firm, n is the profit above the normal rate of return on capital and the remuneration for the risk bearing function of the entrepreneur. The firm is in equilibrium when it produces the output that maximises the difference between total receipts and total costs. The equilibrium of the firm may be shown graphically in two ways. Either by using the TR and TC curves, or the MR and MC curves. In the figure below, we show the average- and marginal-cost curves of the firm together with its demand curve. We said that the demand curve is also the average revenue curve and the marginal revenue curve of the firm in a perfectly competitive market. The marginal cost cuts the SATC at Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 3 Class: SYBCom Semester-III Subject: B. Economics-III its minimum point. Both curves are U-shaped, reflecting the law of variable proportions which is operative in the short run during which the plant is constant. The firm is in equilibrium (maximises its profit) at the level of output defined by the intersection of the MC and the MR curves (point e in figure below). To the left of e, profit has not reached its maximum level because each unit of output to the left of Xe brings to the firm a revenue which is greater than its marginal cost. To the right of Xe each additional unit of output costs more than the revenue earned by its sale, so that a loss is made and total profit is reduced. In summary: (a) If MC < MR total profit has not been maximised and it pays the firm to expand its output. (b) If MC > MR the level of total profit is being reduced and it pays the firm to cut its production. (c) If MC = MR short-run profits are maximised. Thus, the first condition for the equilibrium of the firm is that marginal cost be equal to marginal revenue. However, this condition is not sufficient, since it may be fulfilled and yet the firm may not be in equilibrium. In the figure below, we observe that the condition MC = MR is satisfied at point e', yet clearly the firm is not in equilibrium, since profit is maximized at Xe > Xe’. The second condition for equilibrium requires that the MC be rising at the point of its intersection with the MR Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 4 Class: SYBCom Semester-III Subject: B. Economics-III curve. This means that the MC must cut the MR curve from below, i.e. the slope of the MC must be steeper than the slope of the MR curve. In figure above, the slope of MC is positive at e, while the slope of the MR curve is zero at all levels of output. Thus, at e, both conditions for equilibrium are satisfied (i) MC = MR (ii) (slope of MC) > (slope of MR). It should be noted that the MC is always positive, because the firm must spend some money in order to produce an additional unit of output. Thus, at equilibrium the MR is also positive. The fact that a firm is in (short-run) equilibrium does not necessarily mean that it makes excess profits. Whether the firm makes excess profits or losses depends on the level of the ATC at the short-run equilibrium. If the ATC is below the price at equilibrium (figure below) the firm earns excess profits (equal to the area PABe). Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 5 Class: SYBCom Semester-III Subject: B. Economics-III If, however, the ATC is above the price (figure below) the firm makes a loss (equal to the area FPeC). In the latter case the firm will continue to produce only if it covers its variable costs. Otherwise it will close down, since by discontinuing its operations the firm is better off: it minimizes its losses. The point at which the firm covers its variable costs is called 'the closingdown point.' Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 6 Class: SYBCom Semester-III Subject: B. Economics-III In the figure below, the closing-down point of the firm is denoted by point w. If price falls below Pw the firm does not cover its variable costs and is better off if it closes down. B. The supply curve of the firm and the industry The supply curve of the firm may be derived by the points of intersection of its MC curve with successive demand curves. Assume that the market price increases gradually. This causes an upward shift of the demand curve of the firm. Given the positive slope of the MC curve, each higher demand curve cuts the (given) MC curve to a point which lies to the right of the previous intersection. This implies that the quantity supplied by the firm increases as price rises. The firm, given its cost structure, will not supply any quantity (will close down) if the price falls below Pw because at a lower price the firm does not cover its variable costs (figure below). Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 7 Class: SYBCom Semester-III Subject: B. Economics-III If we plot the successive points of intersection of MC and the demand curves on a separate graph we observe that the supply curve of the individual firm is identical to its MC curve to the right of the closing-down point w. Below Pw the quantity supplied by the firm is zero. As price rises above Pw the quantity supplied increases. The supply curve of the firm is shown in the figure below Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 8 Class: SYBCom Semester-III Subject: B. Economics-III The industry-supply curve is the horizontal summation of the supply curves of the individual firms. It is assumed that the factor prices and the technology are given and that the number of firms is very large. Under these conditions the total quantity supplied in the market at each price is the sum of the quantities supplied by all firms at that price. C. Short-run equilibrium of the industry Given the market demand and the market supply the industry is in equilibrium at that price which clears the market, that is at the price at which the quantity demanded is equal to the quantity supplied. In figure A the industry is in equilibrium at price P, at which the quantity demanded and supplied is Q. However, this will be a short-run equilibrium, if at the prevailing price firms are making excess profits (figure B) or losses (figure C). In the long run, firms that make losses and cannot readjust their plant will close down. Those that make excess profits will expand their capacity, while excess profits will also attract new firms into the industry. Entry, exit and readjustment of the remaining firms in the industry will lead to a long-run equilibrium in which firms will just be earning normal profits and there will be no entry or exit from the industry. A B C III. Long-run Equilibrium A. Equilibrium of the firm in the long run Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 9 Class: SYBCom Semester-III Subject: B. Economics-III In the long run firms are in equilibrium when they have adjusted their plant so as to produce at the minimum point of their long-run AC curve, which is tangent (at this point) to the demand curve defined by the market price. In the long run the firms will be earning just normal profits, which are included in the LAC. If they are making excess profits new firms will be attracted in the industry; this will lead to a fall in price (a downward shift in the individual demand curves) and an upward shift of the cost curves due to the increase of the prices of factors as the industry expands. These changes will continue until the LAC is tangent to the demand curve defined by the market price. If the firms make losses in the long run they will leave the industry, price will rise and costs may fall as the industry contracts, until the remaining firms in the industry cover their total costs inclusive of the normal rate of profit. In the figure below we show how firms adjust to their longrun equilibrium position. If the price is P, the firm is making excess profits working with the plant whose cost is denoted by SAC1. It will therefore have an incentive to build new capacity and it will move along its LAC. At the same time new firms will be entering the industry attracted by the excess profits. As the quantity supplied in the market increases (by the increased production of expanding old firms and by the newly established ones) the supply curve in the market will shift to the right and price will fall until it reaches the level of P1 (in left figure) at which the firms and the industry are in long-run equilibrium. The LAC in the right figure is the final-cost curve including any increase in the prices of factors that may have taken place as the industry expanded. The condition for the long-run equilibrium of the firm is that the marginal cost be equal to the price and to the long-run average cost LMC =LAC= P The firm adjusts its plant size so as to produce that level of output at which the LAC is the minimum possible, given the technology and the prices of factors of production. At equilibrium the short-run marginal cost is equal to the long-run marginal cost and the short-run average cost is equal to the long-run average cost. Thus, given the above equilibrium condition, we have SMC = LMC = LAC = LMC = P = MR This implies that at the minimum point of the LAC the corresponding (short-run) plant is worked at its optimal capacity, so that the minima of the LAC and SAC coincide. On the other hand, the LMC cuts the Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 10 Class: SYBCom Semester-III Subject: B. Economics-III LAC at its minimum point and the SMC cuts the SAC at its minimum point. Thus at the minimum point of the LAC the above equality between short-run and long-run costs is satisfied. B. Equilibrium of the industry in the long run The industry is in long-run equilibrium when a price is reached at which all firms are in equilibrium (producing at the minimum point of their LAC curve and making just normal profits). Under these conditions there is no further entry or exit of firms in the industry, given the technology ; and factor prices. The long-run equilibrium of the industry is shown in the figure above. At the market price, P, the firms produce at their minimum cost, earning just normal profits. The firm is in equilibrium because at the level of output X LMC = SMC = P = MR This equality ensures that the firm maximises its profit. At the price P the. industry is in equilibrium because profits are normal and all costs are covered so that there is no incentive for entry or exit. That the firms earn just normal profit (neither excess profits nor losses) is shown by the equality LAC= SAC= P which is observed at the minimum point of the LAC curve. With all firms in the industry being in equilibrium and with no entry or exit, the industry supply remains stable, and, given the market demand (DD' in the figure above), the price P is a long-run equilibrium price. Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 11 Class: SYBCom Semester-III Subject: B. Economics-III C. Long Run Supply Curve Constant-cost industry In the figure below, we show the case of long-run equilibrium of an industry which grows with constant costs. We start from an initial long-run equilibrium situation where the demand-curve price line of the firm is tangent to the long-run and the short-run average- total-cost curves at their minimum points. Assume that the market demand shifts from DD' to D1D'1. In the short run price increases to P' and the existing firms increase their output, operating their plant above full capacity. The increased quantity is shown by a movement along the market supply SS'. This situation, however, cannot persist in the long run because the excess profits attract entry. The resulting increase in the demand of factors of production is assumed not to raise their price, so that the LAC curve does not shift upwards. The new firms will produce under the same LAC conditions as the already established firms. Entry will continue until the new supply curve S1S'1 intersects the shifted-demand curve at the initial price P. If the market continues to grow, the industry-demand curve will shift further to the right (D2D2') and the whole process will repeat itself. New firms will enter the industry and the supply curve will shift to the right until it cuts the new demand curve at the initial price. The long-run industry supply is a straight line (abc in the figure below) parallel to the quantity-axis at the initial price level. Increasing-cost industry An industry is said to be an increasing-cost industry if its long-run supply curve has a positive slope, indicating that the prices of factors increase as the industry output expands. Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 12 Class: SYBCom Semester-III Subject: B. Economics-III The process of adjustment of the industry supply to the growing market demand under conditions of increasing costs is shown in the figure below. As the market demand shifts from its initial equilibrium DD' to the new level D1D'1 price will increase in the short run (to P1): an increase in the quantity supplied is forthcoming by existing firms working their plant beyond its optimal capacity. Excess profits will attract new firms in the industry. Now, however, we assume that the prices of factors increase as their demand expands. The LAC of all firms (existing as well as new) shifts upwards, while the LMC shifts to the left with the increasing factor prices. This will tend to shift the industry supply to the left. However, at the same time, the quantity supplied increases as new firms enter the industry and thus the market supply will tend to shift to the right. The latter shift more than offsets the first, so that on balance the supply curve shifts outwards as price increases (otherwise the new firms would work by bidding away resources from the established firms, and industry output would be impossible to expand as required by the increase in the market price). The shift of the supply curve will lead to a fall in price (as compared with the short-run level P1} if the increase in factor prices permits it. If, however, the increase in factor costs is substantial the new equilibrium price might stay at the short-run level despite the shift in supply. In any case the new market price will be higher than the original level and the long-run supply curve (efg in the figure below) will be upwards-sloping. In an increasing-cost industry output can expand in the long run only at an increasing supply price. Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 13 Class: SYBCom Semester-III Subject: B. Economics-III Decreasing-cost industry An industry is said to be a decreasing-cost industry if its long-run supply curve has a negative slope, indicating that the prices of factors fall as the industry output expands. The process of adjustment of the industry supply to the expanding market demand is shown in the figure below. As the market demand shifts to the right (from D to D1) price increases in the short run and entry is attracted. The ensuing increased demand for factors encourages their suppliers to innovate or improve their skills, so that factor costs become in fact lower per unit of output. In these circumstances we speak of external (to the industry and to the firm) economies (figure below). The decline in factor prices shifts the cost curves of individual firms downward (figure below). The industry supply shifts so far to the right that price in the long run falls below the initial level. The long-run supply curve is the line hlm in the figure below, which has a negative slope. This implies that if there are strong external economies the industry supply can expand in the long run at a decreasing price. ***************************** Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 14 Class: SYBCom Semester-III Subject: B. Economics-III Monopoly Table of contents: Features...................................................................................................................................... 1 Causes leading to Monopoly...................................................................................................... 1 Price-output determination under monopoly............................................................................ 2 Long run equilibrium................................................................................................................ 3 Supply Curve of the monopolist................................................................................................ 6 The Deadweight Loss................................................................................................................. 7 Monopoly is that market form in which a single producer controls the entire supply of a single commodity which has no close substitutes. There must be only one seller or producer. The commodity produced by the producer must have no close substitutes. Monopoly can exist only when there are strong barriers to entry. The barriers which prevent the entry may be economic, institutional or artificial in nature. Features 1. There is a single producer or seller of the product. 2. There are no close substitutes for the product. If there is a substitute, then the monopoly power is lost. 3. No freedom to enter as there exists strong barriers to entry. 4. The monopolist may use his monopolistic power in any manner to get maximum revenue. He may also adopt price discrimination. Causes leading to Monopoly The main causes that lead to monopoly are the following: Firstly, ownership of strategic raw materials, or exclusive knowledge of production techniques. Secondly, patent rights for a product or for a production process. Thirdly, government licensing or the imposition of foreign trade barriers to exclude foreign competitors. Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 1 Class: SYBCom Semester-III Subject: B. Economics-III Fourthly, the size of the market may be such as not to support more than one plant of optimal size. The technology may be such as to exhibit substantial economies of scale, which require only a single plant, if they are to be fully reaped. For example, in transport, electricity, communications, there are substantial economies which can be realised only at large scales of output. The size of the market may not allow the existence of more than a single large plant. In these conditions it is said that the market creates a 'natural' monopoly, and it is usually the case that the government undertakes the production of the commodity or of the service so as to avoid exploitation of the consumers. This is the case of the public utilities. Fifthly, the existing firm adopts a limit-pricing policy, that is, a pricing policy aiming at the prevention of new entry. Such a pricing policy may be combined with other policies such as heavy advertising or continuous product differentiation, which render entry unattractive. This is the case of monopoly established by creating barriers to new competition. Price-output determination under monopoly The aim of the monopolist is to maximise profits. Therefore, he will produce that level of output and charge a price which gives him the maximum profits. He will be in equilibrium at that price and output at which his profits are maximum. In order words, he will be in equilibrium position at that level of output at which marginal revenue equals marginal cost. The monopolist, to be in equilibrium should satisfy two conditions : 1. Marginal cost should be equal to marginal revenue. 2. The marginal cost curve should cut the marginal revenue curve from below. The short run equilibrium of the monopolist is shown in the figure below: Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 2 Class: SYBCom Semester-III Subject: B. Economics-III AR is the average revenue curve, MR is the marginal revenue curve, AC is the average cost curve and MC is the marginal cost curve. Up to OQ level of output marginal revenue is greater than marginal cost but beyond OQ the marginal revenue is less than marginal cost. Therefore, the monopolist will be in equilibrium where MC = MR. Thus, a monopolist is in equilibrium at OQ level of output and at OP price. He earns abnormal profit equal to PRST. But it is not always possible for a monopolist to earn super- normal profits. If the demand and cost situations are not favourable, the monopolist may realise short run losses. Though the monopolist is a price maker, due to weak demand and high costs, he suffers a loss equal to PABC. Long run equilibrium In the long run the monopolist has the time to expand his plant, or to use his existing plant at any level which will maximise his profit. With entry blocked, however, it is not necessary for the monopolist to reach an optimal scale (that is, to build up his plant until he reaches the minimum point of the LAC). Neither is there any guarantee that he will use his existing plant at optimum capacity. What is certain is that the monopolist will not stay in business if he makes losses in the long run. He will most probably continue to earn supernormal profits even in the long run, given that entry is barred. However, the size of his plant and the degree of utilisation of any given plant size depend entirely on the market demand. Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 3 Class: SYBCom Semester-III Subject: B. Economics-III He may reach the optimal scale (minimum point of LAC) or remain at suboptimal scale (falling part of his LAC) or surpass the optimal scale (expand beyond the minimum LAC) depending on the market conditions. In the figure below, we depict the case in which the market size does not permit the monopolist to expand to the minimum point of LAC. In this case not only is his plant of suboptimal size (in the sense that the full economies of scale are not exhausted) but also the existing plant is under- utilised. This is because to the left of the minimum point of the LAC the SRAC is tangent to the LAC at its falling part, and also because the short-run MC must be equal to the LRMC. This occurs at e, while the minimum LAC is at band the optimal use of the existing plant is at a. Since it is utilised at the level e', there is excess capacity. In the figure below, we depict the case where the size of the market is so large that the monopolist, in order to maximise his output, must build a plant larger than the optimal and over utilise it. This is because to the right of the minimum point of the LAC the SRAC Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 4 Class: SYBCom Semester-III Subject: B. Economics-III and the LAC are tangent at a point of their positive slope, and also because the SRMC must be equal to the LAC. Thus, the plant that maximises the monopolist's profits leads to higher costs for two reasons: firstly because it is larger than the optimal size, and secondly because it is over utilised. This is often the case with public utility companies operating at national level. Finally, in the figure below we show the case in which the market size is just large enough to permit the monopolist to build the optimal plant and use it at full capacity. Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 5 Class: SYBCom Semester-III Subject: B. Economics-III Supply Curve of the monopolist We may now examine the statement that there is no unique supply curve for the monopolist derived from his MC. Given his MC, the same quantity may be offered at different prices depending on the price elasticity of demand. Graphically this is shown in the figure below. The quantity X will be sold at price P1 if demand is D1 while the same quantity X will be sold at price P2 if demand is D2. Thus, there is no unique relationship between price and quantity. Similarly, given the MC of the monopolist, various quantities may be supplied at any one price, depending on the market demand and the corresponding MR curve. In the figure below, we depict such a situation. The cost conditions are represented by the MC curve. Given the costs of the monopolist, he would supply OX1, if the market demand is D1, while at the same price, P, he would supply only OX2 if the market demand is D2. Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 6 Class: SYBCom Semester-III Subject: B. Economics-III Allocation inefficiency and dead-weight loss in monopoly In a competitive market, price equals marginal cost. Monopoly power, on the other hand, implies that price exceeds marginal cost. Because monopoly power results in higher prices and lower quantities produced, we would expect it to make consumers worse off and the firm better off. A monopoly, in contrast to a competitive firm, charges a price above marginal cost. From the standpoint of consumers, this high price makes monopoly undesirable. At the same time, however, the monopoly is earning profit from charging this high price. From the standpoint of the owners of the firm, the high price makes monopoly very desirable. The equilibrium of supply and demand in a competitive market is not only a natural outcome but a desirable one. The invisible hand of the market leads to an allocation of resources that makes total surplus as large as it can be. Because a monopoly leads to an allocation of resources different from that in a competitive market, the outcome must, in some way, fail to maximize total economic well-being The Deadweight Loss The fact that the market outcome under monopoly is different to that under conditions of perfect competition means there is a deadweight loss associated with monopoly. Total surplus equals the value of the good to consumers minus the costs of making the good incurred by the monopoly producer. In the figure below, the demand curve reflects the value of the good to consumers, as measured by their willingness to pay for it. The marginal cost curve reflects the costs of the monopolist. Thus, the socially efficient quantity is found where the demand curve and the marginal cost curve intersect. Below this quantity, the value to consumers exceeds the marginal cost of Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 7 Class: SYBCom Semester-III Subject: B. Economics-III providing the good, so increasing output would raise the total surplus. Above this quantity, the marginal cost exceeds the value to consumers, so decreasing output would raise total surplus. The efficient outcome would be where the demand curve intersects the marginal cost curve where P = MC. Because this price would give consumers an accurate signal about the cost of producing the good, consumers would buy the efficient quantity. We can evaluate the welfare effects of monopoly by comparing the level of output that the monopolist chooses to the socially efficient output where P = MC. The monopolist chooses the profit maximizing output where the marginal revenue and marginal cost curves intersect but this is not the same as the socially efficient output where the demand and marginal cost curves intersect. The figure above shows the comparison. The monopolist produces less than the socially efficient quantity of output. We can also view the inefficiency of monopoly in terms of the monopolist’s price. Because the market demand curve describes a negative relationship between the price and quantity of the good, a quantity that is inefficiently low is equivalent to a price that is inefficiently high. When a monopolist charges a price above marginal cost, some potential consumers value the good at more than its marginal cost but less than the monopolist’s price. These consumers do not end up buying the good. Because the value these consumers place on the good is greater than the cost of providing Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 8 Class: SYBCom Semester-III Subject: B. Economics-III it to them, this result is inefficient. Thus, monopoly pricing prevents some mutually beneficial trades from taking place. The figure below shows the deadweight loss. Recall that the demand curve reflects the value to consumers and the marginal cost curve reflects the costs to the monopoly producer. Thus, the area of the deadweight loss triangle between the demand curve and the marginal cost curve equals the total surplus lost because of monopoly pricing. Discriminating Pricing Price discrimination refers to the act of selling the same article, produced under single control at different prices to different buyers. Price discrimination generally takes place in case of monopoly. Following are the types of price discrimination. 1] Personal price discrimination- In this type different prices are charged to different consumers for the same product or service. Example: Doctors, Lawyers, Tuition Teachers etc. Charges different prices for different individuals. It is similar to first degree price discrimination. 2] Group Price Discrimination – Here entire population or area is divided into different groups and different prices are charged for different groups of people. Example: Railways charges lower ticket to children and senior citizens and more for others. Industrial areas are charged more electricity charges as compared to residential areas. This is same as second degree price discrimination. 3] Market Price Discrimination – This means charging different prices for the same product in different markets. Condition for Price Discrimination 1] Non-Transferability of goods – A monopolist can charge different prices for the same good provided that the consumers are not in a position to transfer the goods from one to other. This Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 9 Class: SYBCom Semester-III Subject: B. Economics-III could happen only if consumers either do not meet each other or in case they meet, will not be able to exchange the goods. 2] Geographical Distance – If markets are situated at sufficiently long distances then the transfer of goods may not be economical. Example: If we consider Mumbai and Kolhapur market and price difference is `50 per unit, the transfer of goods from one buyer to other between the markets is not at all economical. 3] Political Hurdles – If political boundaries prevent the movement of people from one market to other market, a monopolist who operates in both markets can change different prices for the same commodity. 4] Lack of awareness – When the consumers are ignorant of the price difference, they will not mind paying higher prices than what the others are paying. 5] Insignificant price difference – When the price difference is very small, the consumers would not bother about negligible price difference. Therefore it is possible for the monopolist to have price discrimination. 6] Link between Price and Quality– When consumers, due to irrationality or any other reason consider higher price as an indicator of better quality, then it is possible for the monopolist to change higher price for such consumers. 7] Location – Goods sold in sophisticated or rich localities or sold in departmental stores may be charged higher prices than the same goods sold in poor localities. 8] Tariff Barriers – If home market is protected through tariffs, a monopolist may charge a higher price in the protected home market and lower price in competitive world market. 9] Government Sanctions – Government due to welfare social or political reasons may change different prices for the same goods & services. 10] If monopolist can bring about some product differentiation like changing packaging sale, promoting after sales services etc. then price discrimination is possible. 11] Differences in Elasticity – If elasticity of demand is different in different markets, it is possible for the monopolist to have price discrimination. Types of Price Discrimination There are three types of price discrimination: first-degree or perfect price discrimination, seconddegree, and third-degree. These degrees of price discrimination are also known as personalized pricing (1st-degree pricing), product versioning or menu pricing (2nd-degree pricing), and group pricing (3rd-degree pricing). First-degree Price Discrimination First-degree discrimination, or perfect price discrimination, occurs when a business charges the maximum possible price for each unit consumed. Because prices vary among units, the firm captures all available consumer surplus for itself, or the economic surplus. Many industries involving client services practice first-degree price discrimination, where a company charges a different price for every good or service sold. Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 10 Class: SYBCom Semester-III Subject: B. Economics-III Second-degree Price Discrimination Second-degree price discrimination occurs when a company charges a different price for different quantities consumed, such as quantity discounts on bulk purchases. Third-degree Price Discrimination Third-degree price discrimination occurs when a company charges a different price to different consumer groups. For example, a theatre may divide moviegoers into seniors, adults, and children, each paying a different price when seeing the same movie. This discrimination is the most common. Discriminating pricing can be explained with the help of a diagram. We start with a case of a monopolist who sells his product at two different prices. It is assumed that the monopolist will sell his product in two segregated markets, each of them having a demand curve with different elasticity. In the figure below the demand curve D1 has a higher price elasticity than D2 at any given price. The total-demand curve D is found by the horizontal summation of D1 and D2. The aggregate marginal revenue (MR) is the horizontal summation of the marginal-revenue curves MR1 and MR2. The marginal-cost curve is depicted by the curve MC. The price-discriminating monopolist has to decide (a) The total output that he must produce (b) How much to sell in each market and at what price, so as to maximise his profits. The total quantity to be produced is defined by the point of intersection of the MC and the aggregate MR curves of the monopolist. In the figure below the two curves intersect at point e, thus defining a total output OX which must be produced. If the monopolist were to charge a uniform price this would be P, and his total revenue would be OXAP. Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 11 Class: SYBCom Semester-III Subject: B. Economics-III His profit would be the difference between this revenue and the cost for producing OX. However, the monopolist can achieve a higher profit by charging different prices in the two markets. The price and the quantity in each market is defined in such a way as to maximise profit in each market. Thus in each market he must equate the marginal revenue with the MC. However, the marginal cost is the same for the whole quantity produced, irrespective of the market in which it is going to be sold. The marginal revenue in each market differs due to the difference in the elasticity of the two demand curves. The profit in each market is maximised by equating MC to the corresponding MR: In the first market, profit is maximised when MR1 =MC In the second market profit is maximised when MR2 =MC Clearly the total profit is maximised when the monopolist equates the common MC to the individual revenues MC = MR1 = MR2 If MR in one market were larger, the monopolist would sell more in that market and less in the other, until the above condition was fulfilled. Graphically the determination of the prices and quantities in the two markets is defined as follows. From the equilibrium point e we draw a line perpendicular to the price axis. This line cuts the marginal revenue MR1 at point e1 and the marginal revenue MR2 at point e2. Clearly at these points we have the required equality MC = MR1 = MR2 Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 12 Class: SYBCom Semester-III Subject: B. Economics-III From e1 and e2 we drop vertical lines to the quantity axis, and we extend them upwards until they meet the demand curves D1 and D2 respectively. These vertical lines define the output and price in each market. Thus, in the first market the monopolist will sell OX1 at a price P1 and in the second market the monopolist will sell OX2 at the price P2. Clearly OX1 +OX2 = OX. From the figure above it is obvious that the total revenue from price discrimination is larger than the revenue OXAP which would be received by charging a uniform price P. With price discrimination the total revenue is (P1)(OX1) + (P2) (0X2) = OP1FX1 +OP2EX2 Comparing this revenue with the revenue from the unique price P we find the following: Revenue from P: R1 =OXAP=OX2DP+X2XBC+CBAD ……………….. (1) Revenue from P1 and P2: R2= OX1FP1+ OX2EP2 But OX1FP1 =X2XBC and OX2EP2 = OX2DP + PDEP2 Therefore, R2= X2XBC + OX2DP + PDEP2 …………………….. (2) Subtracting (1) from (2) we get, R2 - R1 = [X2XBC + OX2DP + PDEP2] - [OX2DP+X2XBC+CBAD] = PDEP2-CBAD Since CBAD< PDEP2 it is obvious that R2>R1 Note that PDEP2 is the additional revenue from selling OX2 at price P2 which is higher than P, while CBAD is the loss in revenue from selling OX1 at price P1 which is lower than P. The additional revenue from selling OX2 at a higher price more than offsets the loss of revenue from selling OX1 at a lower price, so that total revenue from price discrimination is larger. Since the cost of producing OX is the same irrespective of the price at which it will be sold, the profits from price discrimination are larger as compared with those that would be obtained from selling all the output at the uniform price P. ****************** Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 13 Class: SYBCom Semester-III Subject: B. Economics-III Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 14 Class: SYBCom Semester-III Subject: B. Economics-III Monopolistic competition Table of Contents: Features...................................................................................................................................................................... 1 Assumptions of Monopolistic Competition.................................................................................................. 2 Short run Equilibrium........................................................................................................................................... 3 Long Run Equilibrium........................................................................................................................................... 3 Excess Capacity........................................................................................................................................................ 6 Monopolistic competition is more realistic than either pure competition or monopoly. It is a blending of competition and monopoly. "There is competition which is keen though not perfect, between many firms making very similar products". Thus, monopolistic competition refers to competition among a large number of sellers producing close but not perfect substitutes. Features 1. Large number of sellers: In monopolistic competition the number of sellers is large. No one controls a major portion of the total output. Hence each firm has a very limited control over the price of the product. Each firm decides its own price-output policy without considering the reactions of rival firms. Thus, there is no interdependence between firms and each seller pursues an independent course of action. 2. Product differentiation: One of the most important features of monopolistic competition is product differentiation. Product differentiation implies that products are different in some ways from each other. They are heterogeneous rather than homogeneous. There is slight difference between one product and others in the same category. Products are close substitutes but not perfect substitutes. Product differentiation may be due to differences in the quality of the product. Product may be differentiated in order to suit the tastes and preferences of the consumers. The products are differentiated on the basis of materials used, workmanship, durability, size, shape, design, colour, fragrance, packing etc. Products are differentiated in order to promote sales by influencing the demand for the products. This can be achieved through propaganda and advertisement. Advertisement brings a psychological reaction in the minds of the buyers and thus influences the demand. In addition, location of the shop, its general appearance, counter service, credit and other facilities increase sales. Patent rights and trademarks also promote product differentiation. Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 1 Class: SYBCom Semester-III Subject: B. Economics-III Kodak and Coca Cola are the examples of patent rights. Trade marks like Hamam, Rexona, Lux etc. help the consumers to differentiate one product over others. 3. Free entry and exit of firms: Another feature of monopolistic competition is the freedom of entry and exit of firms. Firms under monopolistic competition are small in size and they are capable of producing close substitutes. Hence, they are free to enter or leave the industry in the long run. Product differentiation increases entry of new firms in the group because each firm produces a different product from the others. 4. Selling cost: It is an important feature of monopolistic competition. As there is keen competition among the firms, they advertise their products in order to attract the customers and sell more. Thus, selling cost has a bearing on price determination under monopolistic competition. 5. Group equilibrium: Chamberlin introduced the concept of group in the place of industry. Industry refers to a number of firms producing homogeneous products. But, firms under monopolistic competition produce similar but not identical products. Therefore, Chamberlin uses, the concept of group to include firms producing goods which are close substitutes. 6. Nature of demand curve: Under monopolistic competition, a single firm can control only a small portion of the total output. Though there is product differentiation, as products are close substitutes, a reduction in price leads to increase in sales and vice-versa. But it will have little effect on the price-output conditions of other firms. Hence each will lose only few customers, due to an increase in price. Similarly, a reduction in price will increase sales. Therefore, the demand curve of a firm under monopolistic competition slopes downwards to the right. It is highly elastic but not perfectly elastic. In other words, under monopolistic competition, the demand curve faced by the firm is highly elastic. It means that it has some control over price due to product differentiation and there are price differentials between the firms. Assumptions of Monopolistic Competition 1. The number of sellers is large and they act independently of each other. 2. The product is differentiated. 3. The firm has a demand curve which is elastic. 4. The supply of factor services is perfectly elastic. 5. The short run cost curves of each firm differ from each other. 6. No new firms enter the industry. Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 2 Class: SYBCom Semester-III Subject: B. Economics-III Short run Equilibrium Each firm in a monopolistically competitive market is, in many ways, like a monopoly. Because its product is different from those offered by other firms, it faces a downward-sloping demand curve. (By contrast, a perfectly competitive firm faces a horizontal demand curve at the market price.) Thus, the monopolistically competitive firm follows a monopolist’s rule for profit maximization: It chooses to produce the quantity at which marginal revenue equals marginal cost and then uses its demand curve to find the price at which it can sell that quantity. The figure below shows the cost, demand, and marginal-revenue curves for two typical firms, each in a different monopolistically competitive industry. In both panels of this figure, the profitmaximizing quantity is found at the intersection of the marginal-revenue and marginal-cost curves. The two panels in this figure show different outcomes for the firm’s profit. In panel (a), price exceeds average total cost, so the firm makes a profit. In panel (b), price is below average total cost. In this case, the firm is unable to make a positive profit, so the best the firm can do is to minimize its losses. All this should seem familiar. A monopolistically competitive firm chooses its quantity and price just as a monopoly does. In the short run, these two types of market structure are similar. Long Run Equilibrium When firms are making profits, new firms have an incentive to enter the market. This entry increases the number of products from which customers can choose and, therefore, reduces the Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 3 Class: SYBCom Semester-III Subject: B. Economics-III demand faced by each firm already in the market. In other words, profit encourages entry, and entry shifts the demand curves faced by the incumbent firms to the left. As the demand for incumbent firms’ products falls, these firms experience declining profit. Conversely, when firms are making losses, firms in the market have an incentive to exit. As firms exit, customers have fewer products from which to choose. This decrease in the number of firms expands the demand faced by those firms that stay in the market. In other words, losses encourage exit, and exit shifts the demand curves of the remaining firms to the right. As the demand for the remaining firms’ products rises, these firms experience rising profit (that is, declining losses). This process of entry and exit continues until the firms in the market are making exactly zero economic profit. The figure below depicts the long-run equilibrium. Once the market reaches this equilibrium, new firms have no incentive to enter, and existing firms have no incentive to exit. Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 4 Class: SYBCom Semester-III Subject: B. Economics-III Notice that the demand curve in this figure just barely touches the average- total-cost curve. Mathematically, we say the two curves are tangent to each other. These two curves must be tangent once entry and exit have driven profit to zero. Because profit per unit sold is the difference between price (found on the demand curve) and average total cost, the maximum profit is zero only if these two curves touch each other without crossing. Also note that this point of tangency occurs at the same quantity where marginal revenue equals marginal cost. That these two points line up is not a coincidence: It is required because this particular quantity maximizes profit and the maximum profit is exactly zero in the long run. To sum up, two characteristics describe the long-run equilibrium in a monopolistically competitive market: As in a monopoly market, price exceeds marginal cost. This conclusion arises because profit maximization requires marginal revenue to equal marginal cost and because the downward-sloping demand curve makes marginal revenue less than the price. As in a competitive market, price equals average total cost. This conclusion arises because free entry and exit drive economic profit to zero. The second characteristic shows how monopolistic competition differs from monopoly. Because a monopoly is the sole seller of a product without close substitutes, it can earn positive economic profit, even in the long run. By contrast, because there is free entry into a monopolistically competitive market, the economic profit of a firm in this type of market is driven to zero. The figure below compares the long-run equilibrium under monopolistic competition to the longrun equilibrium under perfect competition. There are two noteworthy differences between monopolistic and perfect competition: excess capacity and the markup. Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 5 Class: SYBCom Semester-III Subject: B. Economics-III Excess Capacity Entry and exit drive each firm in a monopolistically competitive market to a point of tangency between its demand and average-total-cost curves. Panel (a) of the figure above shows that the quantity of output at this point is smaller than the quantity that minimizes average total cost. Thus, under monopolistic competition, firms produce on the downward-sloping portion of their averagetotal-cost curves. In this way, monopolistic competition contrasts starkly with perfect competition. As panel (b) shows, free entry in competitive markets drives firms to produce at the minimum of average total cost. The quantity that minimizes average total cost is called the efficient scale of the firm. In the long run, perfectly competitive firms produce at the efficient scale, whereas monopolistically competitive firms produce below this level. Firms are said to have excess capacity under monopolistic competition. In other words, a monopolistically competitive firm, unlike a perfectly competitive firm, could increase the quantity it produces and lower the average total cost of production. The firm forgoes this opportunity because it would need to cut its price to sell the additional output. It is more profitable for a monopolistic competitor to continue operating with excess capacity. ****************** Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 6 Class: SYBCom Semester-III Subject: B. Economics-III Department of Economics and Foundation Course, R.A.P.C.C.E. (Autonomous) 7 Class: SYBCom Semester-III Subject: B. Economics-III Oligopoly Table of Contents: Definition 2 Features 2 1. Few sellers 2 3. Interdependence 3 4. Advertising 3 6. Existence of Price Rigidity 4 7. No Unique Pattern of Pricing Behaviour: 4 8. Indeterminateness of Demand Curve: 5 Sweezy’s Kinked Demand Curve Model 5 Assumptions 6 Collusive Oligopoly 10 Price Leadership 11 The Model of the Dominant-firm Price Leader 12 A critique of the traditional price leadership model 13 Cooperative vs. Non-Cooperative Games 17 Zero-Sum vs. Non-Zero-Sum Games 17 Simultaneous Move vs. Sequential Move Games 18 One Shot vs. Repeated Games 18 Maximax 19 Maximin 19 Understanding the Prisoner's Dilemma 19 Department of Economics, R.A.P.C.C.E. (Autonomous) 1 Class: SYBCom Semester-III Subject: B. Economics-III Definition Oligopoly is a market structure in which there are a few firms producing a product. Examples of oligopoly include the auto industry, cable television, and commercial air travel. Oligopoly arises when a small number of large firms have all or most of the sales in an industry. Oligopolies are typically characterized by mutual interdependence where various decisions such as output, price, advertising, and so on, depend on the decisions of the other firm(s). Under oligopoly, prices and output are indeterminate. Moreover, organizations are mutually dependent on each other in setting the pricing policy. If oligopolists compete hard, they may end up acting very much like perfect competitors, driving down costs and leading to zero profits for all. If oligopolists collude with each other, they may effectively act like a monopoly and succeed in pushing up prices and earning consistently high levels of profit. As a result, price will be higher than the market-clearing price, and output is likely to be lower. Features 1. Few sellers There are just several sellers who control all or most of the sales in the industry. 2. Barriers to entry It is difficult to enter an oligopoly industry and compete as a small start-up company. Oligopoly firms are large and benefit from economies of scale. It takes considerable know-how and capital to compete in this industry. A few barriers to entry which tend to restrain new firms from entering the industry are as follows: (a) Economics of scale enjoyed by a few large firms; Department of Economics, R.A.P.C.C.E. (Autonomous) 2 Class: SYBCom Semester-III Subject: B. Economics-III (b) Control over essential and specialized inputs; (c) High capital requirements due to plant costs, advertising costs, etc. (d) Exclusive patents; and licenses; and (e) The existence of unused capacity which makes the industry unattractive. When entry is restricted or blocked by such natural and artificial barriers the oligopolistic industry can earn long-run supernormal profits. 3. Interdependence The foremost characteristic of oligopoly is interdependence of the various firms in the decision making. This fact is recognized by all the firms in an oligopolistic industry. If a small number of sizeable firms constitute an industry and one of these firms starts advertising campaign on a big scale or designs a new model of the product which immediately captures the market, it will surely provoke countermoves on the part of rival firms in the industry. Thus different firms are closely interdependent on each other. 4. Advertising Under oligopoly a major policy change on the part of a firm is likely to have immediate effects on other firms in the industry. Therefore, the rival firms remain all the time vigilant about the moves of the firm which takes initiative and makes policy changes. Thus, advertising is a powerful instrument in the hands of an oligopolist. A firm under oligopoly can start an aggressive advertising campaign with the intention of capturing a large part of the market. Other firms in the industry will obviously resist its defensive advertising. Department of Economics, R.A.P.C.C.E. (Autonomous) 3 Class: SYBCom Semester-III Subject: B. Economics-III Under perfect competition advertising is unnecessary while a monopolist may find some advertising to be profitable when his product is new or when there exist a large number of potential consumers who have never tried his product earlier. But according to Prof. Baumol, “under oligopoly, advertising can become a life-and-death matter where a firm which fails to keep up with the advertising budget of its competitors may find its customers drifting off to rival products.” 5. Group Behaviour In oligopoly, the most relevant aspect is the behaviour of the group. There can be two firms in the group, or three or five or even fifteen, but not a few hundred. Whatever the number, it is quite small so that each firm knows that its actions will have some effect on other firms in the group. 6. Existence of Price Rigidity In an oligopoly situation, each firm has to stick to its price. If any firm tries to reduce its price, the rival firms will retaliate by a higher reduction in their prices. This will lead to a situation of price war which benefits none. On the other hand, if any firm increases its price with a view to increase its profits; the other rival firms will not follow the same. Hence, no firm would like to reduce the price or to increase the price. The price rigidity will take place. 7. No Unique Pattern of Pricing Behaviour: The rivalry arising from interdependence among the oligopolists leads to two conflicting motives. Each wants to remain independent and to get the maxmium possible profit. Towards this end, they act and react on the price-output movements of one another which are a continuous element of uncertainty. Department of Economics, R.A.P.C.C.E. (Autonomous) 4 Class: SYBCom Semester-III Subject: B. Economics-III 8. Indeterminateness of Demand Curve: In market structures other than oligopolistic, demand curve faced by a firm is determinate. The interdependence of the oligopolists, however, makes it impossible to draw a demand curve for such sellers except for the situations where the form of interdependence is well defined. In real business operations, the demand curve remains indeterminate. Under oligopoly a firm can expect at least three different reactions of the other sellers when it lowers its prices: (i) It is possible that others maintain the prices they had before. In this case, an oligopolist can hope that its demand would increase substantially as the prices are lowered, (ii) When an oligopolist reduces his price, the other sellers also lower their prices by an equivalent amount. In this situation although demand of the oligopolist making the first move will increase as he lowers his price, the increase itself would be much smaller than in the first case. (iii) When a firm reduces its price, the other sellers reduce their prices far more. Under the circumstances the demand for the product of the oligopolistic firm which makes the first move may decrease. Thus, uncertainty under oligopoly is inevitable, and as a result, the demand curve faced by each firm belonging to the group is necessarily indeterminate. Sweezy’s Kinked Demand Curve Model The kinked demand curve of oligopoly was developed by Paul M. Sweezy in 1939. Instead of laying emphasis on price-output determination, the model explains the behavior of oligopolistic organizations. The model advocates that the behavior of oligopolistic organizations remain stable when the price and output are determined. This implies that an oligopolistic market is characterized by a certain degree of price rigidity or stability, especially when there is a change in prices in downward direction. For example, if an Department of Economics, R.A.P.C.C.E. (Autonomous) 5 Class: SYBCom Semester-III Subject: B. Economics-III organization under oligopoly reduces price of products, the competitor organizations would also follow it and neutralize the expected gain from the price reduction. On the other hand, if the organization increases the price, the competitor organizations would also cut down their prices. In such a case, the organization that has raised its prices would lose some part of its market share. The kinked demand curve model seeks to explain the reason of price rigidity under oligopolistic market situations. Therefore, to understand the kinked demand curve model, it is important to note the reactions of rival organizations on the price changes made by respective oligopolistic organizations. There can be two possible reactions of rival organizations when there are changes in the price of a particular oligopolistic organization. The rival organizations would either follow price cuts, but not price hikes or they may not follow changes in prices at all. A kinked demand curve represents the behavior pattern of oligopolistic organizations in which rival organizations lower down the prices to secure their market share, but restrict an increase in the prices. Assumptions i. Assumes that if one oligopolistic organization reduces the prices, then other organizations would also cut their prices ii. Assumes that if one oligopolistic organization increases the prices, then other organizations would not follow increase in prices iii. Assumes that there is always a prevailing price Department of Economics, R.A.P.C.C.E. (Autonomous) 6 Class: SYBCom Semester-III Subject: B. Economics-III The demand curve of the oligopolist has a kink (at point E in the figure above), reflecting the following behavioural pattern. If the entrepreneur reduces his price he expects that his competitors will follow suit, matching the price cut, so that, although the demand in the market increases, the shares of competitors remain unchanged. Thus, for price reductions below P (which corresponds to the point of the kink) the share-of-the- market-demand curve is the relevant curve for decisionmaking. However, the entrepreneur expects that his competitors will not follow him if he increases his price, so that he will lose a considerable part of his custom. Thus, for price increases above P, the relevant demand curve is the section dE of the dd' curve. The upper section of the kinked-demand curve has a higher price elasticity than the lower part. Due to the kink in the demand curve of the oligopolist, his MR curve is discontinuous at the level of output corresponding to the kink. The MR has two segments: segment dA corresponds to the upper part of the demand curve, while the segment from point B corresponds to the lower part of the kinked-demand curve. Department of Economics, R.A.P.C.C.E. (Autonomous) 7 Class: SYBCom Semester-III Subject: B. Economics-III The equilibrium of the firm is defined by the point of the kink because at any point to the left of the kink MC is below the MR, while to the right of the kink the MC is larger than the MR. Thus, total profit is maximised at the point of the kink. However, this equilibrium is not necessarily defined by the intersection of the MC and the MR curve. Indeed in general the MC passes somewhere through the discontinuous segment AB, and in that sense one might argue that, although marginalistic calculations are behind the 'kink-equilibrium,' the kinked-demand curve is a manifestation of the break- down of the basic marginalistic rule according to which the price and output level that maximise profit are defined by equating MC with MR. Intersection of the MC with the MR segments requires abnormally high or abnormally low costs, which are rather rare in practice. The discontinuity (between A and B) of the MR curve implies that there is a range within which costs may change without affecting the equilibrium P and X of the firm. In the figure above, so long as MC passes through the segment AB, the firm maximises its profits by producing P and X. This level of price and output is compatible with a wide range of costs. Thus, the kink can explain why price and output will not change despite changes in costs (within the range AB defined by the discontinuity of the MR curve). The greater the difference of elasticities of the upper and lower parts of the kinked-demand curve, the wider the discontinuity in the M R curve, and hence the wider the range of cost conditions compatible with the equilibrium price P and output X. There is only one case in which a rise in cost will most certainly induce the firm to increase its price when costs rise, despite the fact that the higher costs pass through the discontinuity of the MR curve. This occurs when the rise in costs is general (for example, imposition of a sales tax) and affects all firms equally. Under these circumstances the firm will increase its price with the certainty that the others in the industry will follow, since their costs are similarly affected. The point of the kink shifts upwards to the left, and equilibrium is established at a higher price and a lower output (figure below). The firms, via independent action, move closer to the point of joint profit maximisation. Department of Economics, R.A.P.C.C.E. (Autonomous) 8 Class: SYBCom Semester-III Subject: B. Economics-III Prima facie the kinked-demand hypothesis appears attractive. The behavioural pattern implied by the kink seems quite realistic in the highly competitive business world which is dominated by strongly competing oligopolists. However, this model does not explain the price and output decisions of the firms. It does not define the level at which price will be set in order to maximise profits. The kinked-demand curve can explain the 'stickiness' of prices in a situation of changing costs and of high rivalry. The kink is the consequence (manifestation) of the uncertainty of the oligopolists and of their expectations that competitors will match price cuts, but not price increases. However, it does not explain the level of the price at which the kink will occur. In the figure below, we depict two kinked-demand curves, with the kink occurring at a different price level. Sweezy's 'theory' cannot define which of the two kinks (that is, which one of the two prices) will materialise. The kinked-demand hypothesis does not explain the height of the kink. Hence, it is not a theory of pricing, but rather a tool for explaining why the price, once determined in one way or another, will tend to remain fixed. Department of Economics, R.A.P.C.C.E. (Autonomous) 9 Class: SYBCom Semester-III Subject: B. Economics-III Collusive Oligopoly One way of avoiding the uncertainty arising from oligopolistic interdependence is to enter into collusive agreements. There are two main types of collusion, cartels and price leadership. Both forms generally imply tacit (secret) agreements, since open collusive action is commonly illegal in most countries at present. Although direct agreements among the oligopolists are the most obvious examples of collusion, in the modern business world trade associations, professional organisations and similar institutions usually perform many of the activities and achieve in a legal or indirect way the goals of direct Department of Economics, R.A.P.C.C.E. (Autonomous) 10 Class: SYBCom Semester-III Subject: B. Economics-III collusive agreements. For example, trade associations issue various periodicals with information concerning actual or planned action of members. In this official way firms get the message and act accordingly. There are two formal types of collusion, cartels and price leadership. Price Leadership One form of collusion is price leadership. In this form of coordinated behaviour of oligopolists one firm sets the price and the others follow it because it is advantageous to them or because they prefer to avoid uncertainty about their competitors' reactions even if this implies departure of the followers from their profit-maximising position. Price leadership is widespread in the business world. It may be practiced either by explicit agreement or informally. In nearly all cases price leadership is tacit since open collusive agreements are illegal in most countries. Price leadership is more widespread than cartels, because it allows the members complete freedom regarding their product and selling activities and thus is more acceptable to the followers than a complete cartel, which requires the surrendering of all freedom of action to the central agency. If the product is homogeneous and the firms are highly concentrated in a location the price will be identical. However, if the product is differentiated prices will differ, but the direction of their change will be the same, while the same price differentials will broadly be kept. There are various forms of price leadership. The most common types of leadership are: (a) Price leadership by a low-cost firm. (b) Price leadership by a large (dominant) firm. (c) Barometric price leadership. Department of Economics, R.A.P.C.C.E. (Autonomous) 11 Class: SYBCom Semester-III Subject: B. Economics-III These are the form of price leadership examined by the traditional theory of leadership as developed by Fellner and others. The characteristic of the traditional price leader is that he sets his price on marginalistic rules, that is, at the level defined by the intersection of his MC and MR curves. For the leader the behavioural rule is MC = MR. The other firms are price-takers who will not normally maximise their profit by adopting the price of the leader. If they do, it will be by accident rather than by their own in- dependent decision. The Model of the Dominant-firm Price Leader In this model it is assumed that there is a large dominant firm which has a considerable share of the total market, and some smaller firms, each of them having a small market share. The market demand (DD in figure below) is assumed known to the dominant firm. It is also assumed that the dominant leader knows the MC curves of the smaller firms, which he can add horizontally and find the total supply by the small firms at each price; or at best that he has a fair estimate, from past experience, of the likely total output from this source at various prices. With this knowledge the leader can obtain his own demand curve as follows. At each price the larger firm will be able to supply the section of the total market not supplied by the smaller firms. That is, at each price the demand for the product of the leader will be the difference between Department of Economics, R.A.P.C.C.E. (Autonomous) 12 Class: SYBCom Semester-III Subject: B. Economics-III total D (at that price) and the total S1. For example, at price P1 the demand for the product of the leader will be zero, because the total quantity demanded (D1) is supplied by the smaller firms. As price falls below P1 the demand for the leader's product increases. At P2 the total demand is D2 ; the part P2 A is supplied by the small firms and the remaining AD2 is supplied by the leader. At P3 total demand is D3 and the total quantity is supplied by the leader since at that price the small firms do not supply any quantity. Below P3 the market demand coincides with the leader's demand curve. Having derived his demand curve (dL in the figure above) and given his MC curve, the dominant firm will set the price Pat which his MR = MC and his output is Ox. At price P the total market demand is PC, and the part PB is supplied by the small firms followers while quantity BC = Ox is supplied by the leader. The dominant firm leader maximises his profit by equating his MC to his MR, while the smaller firms are price-takers, and may or may not maximise their profit, depending on their cost structure. It is assumed that the small firms cannot sell more (at each price) than the quantity denoted by S1. However, if the leader is to maximise his profit, he must make sure that the small firms will not only follow his price, but that they will also produce the right quantity (PB, at price P). Thus, if there is no tight sharing-the- market agreement, the small firms may produce less output than PB and thus force the leader to a non maximising position. A critique of the traditional price leadership model The price-leadership model will lead to a stable equilibrium if the leader has the power to make the other firms in the industry follow his price increases or price decreases, and provided that there is some agreement (or other means) for sharing the market, so that the followers produce the 'right' quantity, that is, the quantity which is required to maintain the price set by the leader, with him Department of Economics, R.A.P.C.C.E. (Autonomous) 13 Class: SYBCom Semester-III Subject: B. Economics-III producing as much as is compatible with this profit-maximising policy (the quantity Ox at which MC = MR). In order to have the power to impose his price the leader must be both a low-cost and a large firm. Although two models were developed, one for a low-cost leader and another for a dominant-firm leader, in practice the power of the leader depends both on his costs and his size. If a firm has low costs but is very small compared with the leader, it may not find it possible to survive a price, or advertising or product-design war that the dominant firm may start. On the other hand, if the dominant firm loses its cost advantage, it loses also its power to impose an increase in price, since the smaller firms, having lower costs, will normally not follow it in price increases. Unless the leader is both a low-cost and a large firm, his demand curve will be kinked: there will be an asymmetry in his power in setting the price. His power will be larger in lowering the price than in increasing it. A common argument is that in the real world there are many cases in which the initiative for a price change does not come from a large firm, nor from a low-cost firm. There is a frequent case in recessions where a firm depletes its liquid assets faster than his rivals, and starts cutting its price in an attempt to have some 'quick cash'. Thus, the argument runs, the leader loses his initiative in price-setting. I think that this argument plays with semantics: it implies that the leader is the firm that initiates the price change. This definition is only partial. A leader is a firm that not only initiates the price change but is able to enforce it in the long run and survive at the price it sets. A 'desperate' firm which wants some cash and cuts its price to achieve this result quickly, surely cannot be said to be the price leader unless its price cut is justified by some cost advantage and can be maintained in the long run. The price-cutting is the manifestation of the desperate position of the firm rather than an expression of power, which would establish the initiating firm as the leader. Department of Economics, R.A.P.C.C.E. (Autonomous) 14 Class: SYBCom Semester-III Subject: B. Economics-III A more valid argument is that the leader will lose its position of leadership if it loses its cost advantage or loses a considerable part of its share of the market for whatever reason. In fact leadership changes frequently in the real world. There is a frequent 'passing to-and-fro' of leadership among the competing oligopolists as a consequence of innovation in their product or processes. In many cases where there are several firms of similar costs and similar size, it may be difficult to agree who will be the leader, if prestige counts among the competitors. Under such circumstances the leader may be decided by common consent, and may be neither a low-cost nor among the largest firms in the industry. We may then have a case of barometric price leadership, the leader being a firm whose price changes are followed by the others for convenience. Game Theory Introduction The interdependence of firms in oligopolistic markets and the inherent uncertainty about competitors' reactions to any course of action adopted by a firm cannot be analyzed effectively by the traditional tools of economic theory. Economists have developed collusive models, limitpricing models, managerial models, and behavioral models, but these do not provide a general theory of oligopoly in the sense that none of these models could fully explain the decision-making process of oligopolists. A different approach to the study of the oligopoly problem is provided by the theory of games. The first systematic attempt in this field is von Neumann and Morgenstern's Theory of Games and Economic Behavior, published in 1944. Since that time numerous economists have developed models of oligopolistic behavior based on the theory of games. Perhaps the most prominent proponent of the games-theory approach is Martin Shubik, who seems to believe that the only hope for the development of a general theory of oligopoly is the games theory. Despite such enthusiasts the games theory approach has not yet provided results which could lead to a general theory of oligopoly. The main contribution of this approach is that it can use highspeed computers to conduct experiments of oligopolistic behavior. Such controlled experiments cannot be conducted in the real business world. Thus, the computerized study of oligopolistic behavior is Department of Economics, R.A.P.C.C.E. (Autonomous) 15 Class: SYBCom Semester-III Subject: B. Economics-III an extremely useful tool which might lead to generalizations about the decision-making process of oligopolists in real world situations, and thus provide the basis for a theory of oligopoly. This development, however, is still in its infancy, and has not as yet gained much acclaim by the majority of economists. Game Theory meaning Game theory is a theoretical framework for conceiving social situations among competing players. In some respects, game theory is the science of strategy, or at least the optimal decision-making of independent and competing actors in a strategic setting. The focus of game theory is the game, which serves as a model of an interactive situation among rational players. The key to game theory is that one player's payoff is contingent on the strategy implemented by the other player. The game identifies the players' identities, preferences, and available strategies and how these strategies affect the outcome. Depending on the model, various other requirements or assumptions may be necessary. Assumptions 1. There are finite numbers of competitors (players). 2. The players act reasonably. 3. Every player strives to maximize gains and minimize losses. 4. Each player has a finite number of possible courses of action. 5. The choices are assumed to be made simultaneously, so that no player knows his opponent's choice until he has decided his own course of action. 6. The pay-off is fixed and predetermined. 7. The pay-offs must represent utilities. Important Terms Game: Any set of circumstances that has a result dependent on the actions of two or more decisionmakers (players) Department of Economics, R.A.P.C.C.E. (Autonomous) 16 Class: SYBCom Semester-III Subject: B. Economics-III Players: A strategic decision-maker within the context of the game Strategy: A complete plan of action a player will take given the set of circumstances that might arise within the game Payoff: The payout a player receives from arriving at a particular outcome (The payout can be in any quantifiable form, from dollars to utility.) Information set: The information available at a given point in the game (The term information set is most usually applied when the game has a sequential component.) Equilibrium: The point in a game where both players have made their decisions and an outcome is reached Types of Game Theories Cooperative vs. Non-Cooperative Games Although there are many types (e.g., symmetric/asymmetric, simultaneous/sequential, etc.) of game theories, cooperative and non-cooperative game theories are the most common. Cooperative game theory deals with how coalitions, or cooperative groups, interact when only the payoffs are known. It is a game between coalitions of players rather than between individuals, and it questions how groups form and how they allocate the payoff among players. Non-cooperative game theory deals with how rational economic agents deal with each other to achieve their own goals. The most common non-cooperative game is the strategic game, in which only the available strategies and the outcomes that result from a combination of choices are listed. A simplistic example of a real-world non-cooperative game is rock-paper-scissors. Zero-Sum vs. Non-Zero-Sum Games When there is a direct conflict between multiple parties striving for the same outcome, this type of game is often a zero-sum game. This means that for every winner, there is a loser. Alternatively, Department of Economics, R.A.P.C.C.E. (Autonomous) 17 Class: SYBCom Semester-III Subject: B. Economics-III it means that the collective net benefit received is equal to the collective net benefit lost. Almost every sporting event is a zero-sum game in which one team wins and one team loses. A non-zero-sum game is one in which all participants can win or lose at the same time. Consider business partnerships that are mutually beneficial and foster value for both entities. Instead of competing and attempting to "win", both parties’ benefit. Investing and trading stocks is sometimes considered a zero-sum game. After all, one market participant will buy a stock and another participant will sell that same stock for the same price. However, because different investors have different risk appetites and investing goals, it may be mutually beneficial for both parties to transact. Simultaneous Move vs. Sequential Move Games Many times in life, game theory presents itself in simultaneous move situations. This means each participant must continually make decisions at the same time their opponent is making decisions. As companies devise their marketing, product development, and operational plans, competing companies are also doing the same thing at the same time. In some cases, there is intentional staggering of decision-making steps in which one party is able to see the other party's moves before making their own decisions. This is usually always present in negotiations; one party lists their demands, then the other party has a designated amount of time to respond and list their own. One Shot vs. Repeated Games Last, game theory can begin and end in a single instance. Like much of life, the underlying competition starts, progresses, ends, and cannot be redone. This is often the case with equity traders that must wisely choose their entry point and exit point as their decision may not easily be undone or retried. On the other hand, some repeated games continue on and seamlessly never end. These types of games often contain the same participants each time, and each party has the knowledge of what occurred last time. For example, consider rival companies trying to price their goods. Whenever Department of Economics, R.A.P.C.C.E. (Autonomous) 18 Class: SYBCom Semester-III Subject: B. Economics-III one makes a price adjustment, so may the other. This circular competition repeats itself across product cycles or sale seasonality. Maximax and maximin strategies Maximax A maximax strategy is a strategy in game theory where a player, facing uncertainty, makes a decision that yields the ‘best of the best’ outcome. All decisions will have costs and benefits, and a maximax strategy is one that seeks out where the greatest benefit can be found. The maximax theorem was first formulated in 1928 by John von Neumann. It is often referred to as an aggressive or optimistic strategy. Maximin A maximin strategy is a strategy in game theory where a player makes a decision that yields the ‘best of the worst’ outcome. All decisions will have costs and benefits, and a maximin strategy is one that seeks out the decision that yields the smallest loss. It is also referred to as a pessimistic or conservative strategy. Understanding the Prisoner's Dilemma The typical prisoner's dilemma is set up in such a way that both parties choose to protect themselves at the expense of the other participant. As

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