Unit IV: Continued.

__________________________________________________________________________________________________

Equilibrium of a perfect competitive firm and industry in long run

Or
Output decision of a perfect competitive firm in long run
How does a perfect competitive firm decide its output in long run?
Or
What are the equilibrium conditions of a perfect competitive firm in long run?
Or
In long run, each perfect competitive firm earns zero economic profit. Discuss.
Answer
In long run a firm is in equilibrium when
LAC=LMC=SMC=SAC=MR=Price
To understand this we consider the following diagram: In the diagram there are two panels (a) and (b). Panel (a) shows
that initially market was in equilibrium at point E 1where the market supply curve S1 intersects the market demand curve.
At E1the equilibrium price is P1 which is accepted by each firm in the market. In panel (b), at P 1 a firm produces q1 output
at plant 1 where the firm makes super normal profit equal to the shaded area. This output q 1is decided as per the marginal
principle i.e. MR = SMC1 (Short run marginal cost curve) and SMC 1 is rising. The super normal profit attracts new firms
and therefore new firms will start to enter the market causing the market supply curve to shift rightward from S 1 to S2.
This entry will be going on unless the super profit disappears. At price P 2, the firm would like to produce at plant 2 with
short run marginal cost and short run average cost curves SMC 2 and SAC2 respectively. For price P2, the profit
maximizing condition is satisfied at point B in panel (b) where output is q 2. Also, there is no super normal profit at point
B, therefore, there is no attraction to new firms to enter the market. In this way, long run equilibrium is established at
point B where LAC = LMC= SMC2=SAC2=MR=P2. Thus, in long run each firm earns zero economic profit.

Price

Price
S1
LMC

S2

E1

SMC1

P1

AR1=MR1

SAC1 SMC2

P2

E2

SAC2

D
0

Output

Panel (a): Market /

Industry

q 1 q2

LAC

Output

Panel (b): Firm

AR2=MR2

__________________________________________________________________________________________________

Derivation of the supply curve of a perfect competitive firm

Derive the supply curve of a perfect competitive firm.
Or
The rising portion of the marginal cost curve is the supply curve of a perfect competitive firm.
Explain.
Or
What is shut down point of a perfect competitive firm?
We know that a perfect competitive firm produces when MR = MC and MC is rising. But in perfect competition MC =
Price. Therefore, the profit maximizing rule can also be defined as Price = MC. In panel (a) of the diagram we have MC,
AC, and AVC curves representing the marginal cost, the average cost and the average variable cost of a firm respectively.
When the price is below P1, then the firm would not like to supply at all i.e. the quantity supplied is zero. This is because
at any price below P1, the firm cannot recover its average variable cost at all. Therefore, the supply curve starts when the
price is P1 because this price is sufficient to recover the average variable cost. Now how much quantity a firm would like
to produce and supply at P1, then it can be found by drawing a line parallel to X-axis starting from P 1 intersecting MC
curve at point A and at this point price = MC, therefore using the profit maximizing rule we get Q 1 output. Thus, we can
say that at price P 1 the quantity supplied is Q 1. This price-quantity combination is shown by point A* in panel (b).
Similarly, we obtain the quantities supplied Q2, Q3 at the prices P2, P3 being represented by points B, C in panel (a) and
B*, C* in panel (c). Joining points A*, B*, C* we get an upward sloping curve which is the required supply curve the
firm. This is very clear that the supply curve of a perfect competitive firm is nothing but the portion of the MC curve with
the condition MC AVC .

Price

Price / Cost
MC

P3

C*
AVC

P2

B*

P1

Supply Curve

AC

Q1Q2 Q3

A*

Output

Q1Q2 Q3

Output

Panel (b)

Panel (a)

Shut down point/rule: Shut down means a situation of closing down business. A firm should shut down when the price is
less than the average variable cost. Symbolically, shut down means
Price < AVC

 :
. .
NEWS . business
business success . B.Com
. .
. ?

, .
.
. .
- , , , ,
.
.
. .
, . .
Learnings from the story
1. .
2. .
3. . .
memory .
.
4. .
5. college .
(Character)
(Commitment)
(firm determination / will power)
(courtesy)
(courage)

Monopoly
Meaning of a monopoly market

The word monopoly is made of two words (i) monos = single and (ii) polein = to sell. Therefore, a monopoly is a market
model in which there is single seller of a product with no close substitutes. New Delhi Power Limited, Coal India Ltd.,
Indian Railways are some public sectors monopoly and De Beers is the classic example of a private sector monopoly.
Features of a monopoly market
1. Single seller
In monopoly there is single seller known as monopolist and he does not face any competition and therefore there
is no difference between the terms market and firm in monopoly.
2. No close substitutes
There are no close substitutes of the product of the monopolist. Absence of close substitutes increases the
monopoly power.
3. Full control on price
In monopoly market the monopolist is the price maker and has full control over it. He charges the price where the
marginal revenue is equal to the marginal cost and the marginal cost is increasing. In monopoly, Price is always
greater than the marginal cost.
4. Price discrimination
There is a good chance of price discrimination in monopoly market. Price discrimination means a practice of
business in which different prices are charged from two different customers for the same output. Due to price
discrimination there is no supply curve of a monopolist.
5. Entry barriers
Entry barriers keep the competition away. Entry barriers include economies of scale, patent right, copyright,
heavy research and development expenditures, licenses etc.
6. Inelastic downward sloping demand curve
Although the monopolist has full control over the price, yet he cannot charge any price and that is why he faces a
downward sloping demand curve as shown in the figure. The demand curve is inelastic.
Revenue

AR
0
Output

7. The slope of the marginal revenue curve is 2 times the slope of the average revenue curve as shown in the figure.
Revenue

MR

AR

Output

Proof:
Let the demand faced a monopolist is

AR=P=abQ
Where AR = average revenue = Price P ; Q = Quantity; a and b are constants and b is the slope of the AR
Then

Total revenue=R=P Q=( abQ ) Q=aQb Q 2

Differentiating R with respect to Q

dR
=a2bQ =MR
dQ
It is clear that the slope of the MR curve is 2b which is two times of b and b is the slope of the AR curve .
Equilibrium of a monopolist / Profit maximization in monopoly / Price-output rule in
monopoly / Determination of price in monopoly

Case I: Equilibrium in case of abnormal profit

There are two conditions of equilibrium of a monopolist:
1. Necessary condition: MR=MC
2. Sufficient condition: MC curve must be rising i.e. the slope of MC curve must be positive.
In order to understand these conditions we consider the following diagram. In the diagram, AR, MR, AC and MC curves
represent the average revenue, marginal revenue, average cost and marginal cost of a monopolist. At point E, the MR
curve intersects the MC curve at point E and therefore at E, MR =MC. At point E, the corresponding output and price are
QM and PM. The monopolist earns super profit or abnormal profit equal to the shaded area. This profit is because AR > AC
by the length AB. To understand the logic of the condition MR= MC, we assume that equilibrium output is Q 1, then the
marginal revenue curve exceeds the marginal cost by the length GF which means that profit (equal to the area GFE) can
be increased by increasing the output. Thus, the profit is not maximized at Q 1. If the equilibrium output were Q2, then the
marginal cost increases the marginal revenue curve by the length CD which means the profit (equal to area CDE) can be
increased by decreasing the output. Thus the profit is not maximized at Q 2. Thus, this is the point E only where the
incentive to increase or decrease the output does not exist because MR = MC.

Revenue /
Cost

PM 0

A
B
EQ1 QMR
M Q2 MC

AR

AC

G
F

C
E
D

Case II: Equilibrium in case of normal profit / Break even

There are two conditions of equilibrium of a monopolist:
1. Necessary condition: MR=MC
2. Sufficient condition: MC curve must be rising i.e. the slope of MC curve must be positive.
In order to understand these conditions we consider the following diagram. In the diagram, AR, MR, AC and MC curves
represent the average revenue, marginal revenue, average cost and marginal cost of a monopolist. At point E, the MR
curve intersects the MC curve at point E and therefore at E, MR =MC. At point E, the corresponding output and price are
QM and PM. But the monopolist does not earn any super profit because the average cost is equal to the average revenue.
Thus, there is break even at point E. To understand the logic of the condition MR= MC, we assume that equilibrium
output is Q1, then the marginal revenue curve exceeds the marginal cost by the length GF which means that profit (equal
to the area GFE) can be increased by increasing the output. Thus, the profit is not maximized at Q 1. If the equilibrium
output were Q2, then the marginal cost increases the marginal revenue curve by the length CD which means the profit
(equal to area CDE) can be increased by decreasing the output. Thus the profit is not maximized at Q 2. Thus, this is the
point E only where the incentive to increase or decrease the output does not exist because MR = MC.
Revenue /
Cost

AC

MC

PM

G
F

C
EE
D

Case III: Equilibrium in case of loss

0

MR
Q Q

Q2

1
M
There are two conditions of equilibrium
of a monopolist:
Output

AR

1. Necessary condition: MR=MC

2. Sufficient condition: MC curve must be rising i.e. the slope of MC curve must be positive.
In order to understand these conditions we consider the following diagram. In the diagram, AR, MR, AC and MC curves
represent the average revenue, marginal revenue, average cost and marginal cost of a monopolist. At point E, the MR
curve intersects the MC curve at point E and therefore at E, MR =MC. At point E, the corresponding output and price are
QM and PM. But the monopolist faces the loss equal to the shaded area. This loss is because the AC > AR by the length AB.
Thus, there is break even at point E. To understand the logic of the condition MR= MC, we assume that equilibrium
output is Q1, then the marginal revenue curve exceeds the marginal cost by the length GF which means that profit (equal
to the area GFE) can be increased by increasing the output. Thus, the profit is not maximized at Q 1. If the equilibrium
output were Q2, then the marginal cost increases the marginal revenue curve by the length CD which means the profit
(equal to area CDE) can be increased by decreasing the output. Thus the profit is not maximized at Q 2. Thus, this is the
point E only where the incentive to increase or decrease the output does not exist because MR = MC.
Revenue /
Cost
AC

B
MC

PM

G
F

C
EE
D
MR

0
Output

AR

Q 1 QM Q2

Note: There is no need to study long run equilibrium of a monopolist.

Deadweight loss / Social cost of a monopoly / Undesirability of a monopoly

Deadweight loss means the decrease in social welfare due to existence of a monopolist. This is also known as the social
cost of a monopoly. To understand this we consider the following diagram. The AR curve is the demand curve faced by a

monopolist. The marginal cost curve MC intersects the AR curve at E which profit maximizing point because MR=MC at
this point and the MC is rising. At E the output is XM while the price charged is PM. If it were a perfect competitive market
instead of a monopoly market, then the firm would have been in equilibrium when the price was equal to the marginal cost
and therefore perfect competitive output should have been X C and price should have been P C. It is obvious that a
monopolist charges higher price with lower output than a perfect competitive firm. In this the society gets lower output at
higher price in a monopoly market. The same thing can be explained using the concepts of consumer surplus and producer
surplus. Let us see.
Consumer surplus in perfect competition = A + B+ C
Consumer surplus in monopoly = A
Change in consumer surplus = A-(A+B+C) = - B-C
Producer surplus in perfect competition = S + D
Producer surplus in monopoly = B+S
Change producer surplus = B+S- (S+D) = B-D
Total change in surpluses = Change in producer surplus + change in consumer surplus
= (B-D) + (-B-C) = - D-C = - (D+C) = Deadweight loss

Revenue /
Cost

Deadweight
loss

PM
B

C
MC

PC
D

S
E

AR

MR
0
Output

Xm

XC

Relationship between the MR, AR and Elasticity of demand

To derive the rule of thumb for pricing we consider the following equation
R=P Q
Where R = Total revenue; P = Price; Q = quantity
Differentiating R with respect to Q

dR
dQ
dP
=P
+Q
dQ
dQ
dQ

MR=P+Q

dP
dQ

Q dP

P dQ

Q dP

..(1)
P dQ

MR=P 1+

MR=P 1+

)
)

Now we know that

ed=

P dQ

Q
dP

Or

1 Q dP
=
.(2)
ed P dQ

From (1) and (2)

MR=P 1

1
..(3)
ed

Since P = AR, therefore

MR=AR 1

1
..(4 )
ed

Equation (4) is the required relationship between MR, AR and ed. The following conclusions can be derived from this
equation.
1. When ed = 1, then MR = 0
2. When ed < 1, then MR < 0
3. When ed > 1, then MR > 0

Price discrimination
Meaning
Price discrimination is a practice of selling a product at different prices. Examples of price discrimination may include:
1. Cinema halls change their charges on the basis of time and age i.e. higher rates in the evening and on weekends
when demand is high and lower rates from children.
2. Railways charge their charges on the basis of age i.e. lower rates from children having age less than 12 years.
3. Airlines charge high fares to travelling executives whose demand for travel is inelastic and offer lower fares to
general people whose demand is elastic.

4. Electric companies charge on the basis purpose of use (domestic purpose or commercial purpose), quantity being
consumed (units of electricity consumed).
5. Brilliant students find their cost of education lower due to scholarship etc. while other students obtain the same
education at higher cost.
Conditions are of price discrimination are as follows:
1. Monopoly power
The seller must have at least some monopoly power. If there is no monopoly power, then price discrimination can
not be successful.
2. Market separation
The seller must be able to separate buyers into distinct classes. Each class has different willingness and ability to
pay. In other words, the elasticity of demand of each class must be different. The market in which there is high
elasticity, the seller charges a lower price and the market in which there is lower elasticity, the seller charges a
higher price.
3. No resale
A buyer from a market must be not able to resell the product. If buyers in the low-price market could easily resell
in the high-price market, monopolys price discrimination policy would face competition in the high-price market
and therefore the chance of failure of discrimination policy would increase.
Types of price discrimination
Eminent economist A.C. Pigou has mentioned three kinds of price discrimination in his book The Welfare These are as
follows:
1. First degree price discrimination
Under this type of price discrimination a producer charges the maximum price which a customer can pay. The
maximum price a consumer is ready to pay is called his/her reservation price. In this discrimination, the
consumer is not allowed to enjoy any consumer surplus. Hence, consumer surplus is found to be zero. However, it
is practically very difficult to know the reservation price and therefore such type of discrimination is practically
rare.
2. Second degree price discrimination
Under this kind of price discrimination the seller prepares various groups/blocks/ranges each consisting of a
certain number of units of the product. The seller charges a uniform price for a particular group/block/range. As
the range changes, then the seller charges a different price.
3. Third degree price discrimination

Under this kind of price discrimination the seller charges different prices in different markets for the same
product. In this discrimination, the seller exhausts a major part of the consumer surplus, yet the consumer may
enjoy some amount of consumer surplus. In the diagram, we have three panels. In panel (a), the demand curve
AR1 faced by a monopolist is inelastic while in panel (b) the demand curve AR 2 is elastic. Panel (c) shows the
total market demand ART which is obtained by taking horizontal summation of AR 1 and AR2. Apart, the panel
shows total the marginal cost curve MC which intersects AR T at point E. At point E, MR T = MC, therefore this is
equilibrium point at which the output is X. By drawing leftward a line parallel to the X-axis intersecting the MR 2
curve and MR1 curve at points A and B respectively we get the outputs X 2 and X1 such that X1 +X2 =X. This
parallel line is nothing but its constant marginal cost and therefore the prices charged in market 1 and market 2 are
P1 and P2 respectively. This is clear that P1 > P2 because the demand curve is inelastic. Thus, higher price is
charged in a market in which there is lower elasticity.
Pric
e

Pric
e

Pric
e

MC
P1
P2
A
MR1
0
X

X1
Output
Panel (a):
Market 1

AR2

AR1

MR2
Output

ART

MRT
X2

Panel (b):
Market 2

Output

Panel (c): Total

Natural monopoly / Regulated monopoly / Pricing of public utilities

A natural monopoly is a firm that is able to produce the entire output of the market at a cost less than what it
would be if there were several firms. Public utilities companies like local water suppliers, gas suppliers,
electricity suppliers etc. are natural monopolies. The biggest feature of a natural monopoly is that it enjoys
heavy economies of scale and that is its average cost curve, AC and marginal cost curve, MC are downward
sloping as shown in the diagram. Natural monopolies are normally subject to regulation.
Let us see how a natural monopoly is regulated. If the natural monopolist were unregulated, then it would have
charged price PM decided by the intersection of the MR and MC curves at point E. At E, the output is X M. Now
suppose that government wants to regulate the monopolist and therefore reduces its price to P MC which is a
competitive price i.e. the price which would have been charged in perfect competition. Such pricing policy is
called marginal cost pricing or socially optimal pricing. This price has been derived when the MC curve
intersects the AR curve at point B. However, at this price AC > P MC, therefore the monopolist will suffer losses
equal to the shaded area and would like to shut the production. Thus, perfect competitive pricing policy of

government will result in efficient allocation of resources but will result losses also to the monopolist. Now
suppose that the price is reduced to P AC such that the price is sufficient to recover the average cost. Such pricing
policy is called average cost pricing or fair return pricing. At this price the monopolist does not earn super
normal profit and just earns normal return. However, the output X1 at this price is less than the output X2 at the
price PMC.
Price / costs

PM

PAC

AC

PMC

0
Output

MC

MR

AR

XM

X1

X2

Comparison of monopoly and perfect competition

S.No.

Basis

Perfect competition

Monopoly

1.

Meaning

Perfect competition is a market model

in which there is large number of
sellers selling homogeneous products
and the entry of new firms or exit of
existing firms is supposed to be free.

Monopoly is a market model in which there is

only one seller selling a product having no close
substitute.

Demand
curve
faced by the firm

The demand curve or the average

revenue curve is parallel to the X-axis.

The demand curve or the average revenue curve

is downward sloping but is supposed to be
inelastic.

Marginal revenue
curve

The marginal revenue curve and the

average revenue curve are the same.

The marginal revenue curve falls under the

average revenue curve in such a way that the
slope of the marginal revenue curve is two times
the slope of the average revenue curve.

Price
and
Marginal cost

Price = Marginal cost

Price > Marginal cost

Price
determination

Price is decided by the market demand

and the market supply curves. Firm is
a price taker only not maker.

A monopolist is the price maker not taker.

Social cost

There is no deadweight loss in perfect

competition.

There is deadweight loss in monopoly.

Free entry or not

There is free entry of new firms.

Entry of new firms is very difficult because of

barriers of entry like patent right, copyright,
government licenses etc.

Existence of the
supply curve

There is a supply curve of a perfect

competitive firm.

There is no supply curve of a monopolist.

Monopolistic Competition

Monopolistic competition is a market model consisting features of perfect competition and pure monopoly. This is a
market lying between perfect competition and pure monopoly. The main features of a monopolistic competition market
are as follows:
1. Relatively large number of sellers
In monopolistic market there is relatively large number of sellers, say, 30, 60, 70 or 80. Monopolistic competition
does not require thousands of firms as in perfect competition. Examples of monopolistic competition are toilet
soap market (Lux, Lifeboy, Godrej, Cinthol, Ponds, Dove, Dettol etc), toothpaste market (Colgate, Pepsodent,
Close-up, Meswak, Babul etc.) in which the number of sellers is relatively large.
2. Differentiated products
In monopolistic competition the product of a seller can be differentiated from the product of other producers on
the basis of storage capacity, color, design, packaging, after sale services, graphics etc. Thus, products are close
substitutes in monopolistic market but can be differentiated. Due to differentiable products the demand curve
faced by a monopolistic firm is relatively elastic.
3. Some control over price
In monopolistic competition there is some is control over price due to product differentiation. Therefore, there is
some monopoly power with a monopolistic firm.
4. Easy entry and exit
In monopolistic competition entry of new firms is easy because the firms are small absolutely and relatively,
capital requirements and economies of scale are low. Exit is also relatively easy. Nothing prevents an existing firm
to quit the market.
5. Non-price competition
Non-price competition means incurring heavy amount on advertisement and putting efforts to make the
consumers aware about the product. It also includes various attractive schemes like buy one get one free, chance
to win a trip to Europe or the US on buying a product, chance to meet a celebrity on buying a product etc.
6. Elastic downward sloping demand curve
Although there is some control over the price, yet the seller cannot charge any price and that is why he faces a
downward sloping demand curve as shown in the figure. The demand curve is elastic.

Revenue

AR
0

Output

7. The slope of the marginal revenue curve is 2 times the slope of the average revenue curve as shown in the figure.
Revenue

AR
MR
0

Output

Equilibrium of a monopolistic firm / Profit maximization of a monopolistic firm / Priceoutput rule in monopolistic market / Determination of price in monopolistic market in
short run

Case I: Equilibrium in case of abnormal profit

There are two conditions of equilibrium of a monopolist:
3. Necessary condition: MR=MC
4. Sufficient condition: MC curve must be rising i.e. the slope of MC curve must be positive.
In order to understand these conditions we consider the following diagram. In the diagram, AR, MR, AC and MC curves
represent the average revenue, marginal revenue, average cost and marginal cost of a monopolistic firm. At point E, the
MR curve intersects the MC curve at point E and therefore at E, MR =MC. At point E, the corresponding output and price
are QM and PM. The firm earns super profit or abnormal profit equal to the shaded area. This profit is because AR > AC by
the length AB. To understand the logic of the condition MR= MC, we assume that equilibrium output is Q 1, then the
marginal revenue curve exceeds the marginal cost by the length GF which means that profit (equal to the area GFE) can be
increased by increasing the output. Thus, the profit is not maximized at Q 1. If the equilibrium output were Q2, then the
marginal cost increases the marginal revenue curve by the length CD which means the profit (equal to area CDE) can be
increased by decreasing the output. Thus the profit is not maximized at Q 2. Thus, this is the point E only where the
incentive to increase or decrease the output does not exist because MR = MC.

Revenue /
Cost

MC

PM

G
F

AC

B
C
EE
D
MR

0
Output

AR

Q 1 QM Q2

Case II: Equilibrium in case of normal profit / Break even

There are two conditions of equilibrium of a monopolist:
3. Necessary condition: MR=MC
4. Sufficient condition: MC curve must be rising i.e. the slope of MC curve must be positive.
In order to understand these conditions we consider the following diagram. In the diagram, AR, MR, AC and MC curves
represent the average revenue, marginal revenue, average cost and marginal cost of a monopolistic firm. At point E, the

MR curve intersects the MC curve at point E and therefore at E, MR =MC. At point E, the corresponding output and price
are QM and PM. But the firm does not earn any super profit because the average cost is equal to the average revenue. Thus,
there is break even at point E. To understand the logic of the condition MR= MC, we assume that equilibrium output is Q 1,
then the marginal revenue curve exceeds the marginal cost by the length GF which means that profit (equal to the area
GFE) can be increased by increasing the output. Thus, the profit is not maximized at Q 1. If the equilibrium output were Q 2,
then the marginal cost increases the marginal revenue curve by the length CD which means the profit (equal to area CDE)
can be increased by decreasing the output. Thus the profit is not maximized at Q 2. Thus, this is the point E only where the
incentive to increase or decrease the output does not exist because MR = MC.
Revenue /
Cost

AC

MC

PM

G
F

C
EE
D
MR

0
Output

AR

Q 1 QM Q2

Case III: Equilibrium in case of loss

There are two conditions of equilibrium of a monopolist:
3. Necessary condition: MR=MC
4. Sufficient condition: MC curve must be rising i.e. the slope of MC curve must be positive.
In order to understand these conditions we consider the following diagram. In the diagram, AR, MR, AC and MC curves
represent the average revenue, marginal revenue, average cost and marginal cost of a monopolistic firm. At point E, the
MR curve intersects the MC curve at point E and therefore at E, MR =MC. At point E, the corresponding output and price
are QM and PM. But the firm faces the loss equal to the shaded area. This loss is because the AC > AR by the length AB.
Thus, there is break even at point E. To understand the logic of the condition MR= MC, we assume that equilibrium output
is Q1, then the marginal revenue curve exceeds the marginal cost by the length GF which means that profit (equal to the
area GFE) can be increased by increasing the output. Thus, the profit is not maximized at Q 1. If the equilibrium output
were Q2, then the marginal cost increases the marginal revenue curve by the length CD which means the profit (equal to
area CDE) can be increased by decreasing the output. Thus the profit is not maximized at Q 2. Thus, this is the point E only
where the incentive to increase or decrease the output does not exist because MR = MC.

Revenue /
Cost
AC

B
MC

PM

G
F

C
EE
D
AR

MR
0
Output

Q 1 QM Q2

Long run equilibrium

The economic profit earned in the short run will attract new firms to enter the industry and eventually eliminating
the economic profit. After such entry or exit (in case of equilibrium in situation of AR < AC), the price will settle at
the level where it just equals average cost at the MR = LMC output. In the diagram given below, such price is P L
and output is QL. economic/super profit equal to the shaded area.
Revenue / Cost

Long run
equilibrium

LMC

LAC

PL

AR

MR
O

QL

Outp
ut

Excess capacity hypothesis

Or
Is monopolistic competitive market inefficient?
Excess capacity means the difference between the ideal output and the profit maximising output. In the form of
equation,

Excess Capacity = Ideal Output at which average cost is minimum

Profit maximising output
Excess capacity is a long run concept. This concept states that to achieve the maximum profit a monopolistic firm
does not produce at the minimum average cost even it could be done. Profit maximising output is achieved earlier
than minimum average cost output. Let us understand the long run equilibrium. In the diagram, we have long run
equilibrium point where AR = AC at E where MR = MC. Therefore, the profit maximising output is Q L. However,
if output Q* is produced, then AC will be at its minimum at the point A. The gap QLQ* is called the excess
capacity. If Q* output was produced, then the price would have been lower and the society would have gotten
higher output. Therefore, the concept of excess capacity signifies that there is inefficiency of monopolistic
competition.
Revenue / Cost

Long run
equilibrium

LM
C

LAC

PL
A

QL

AR

Q*

Excess Capacity MR

Outp
ut

Oligopoly
Meaning of Oligopoly market
Oligopoly market is a market dominated by a few large producers of homogenous or differentiated products. Due to a few
producers there is considerable control of a producer over the price. However, a producer considers the reaction of his
rivals to his pricing policy. Each producer in this market is known as an oligopolist. Some examples of oligopoly markets
in India are Ice-cream, Bread, Motorcycles, Cigarettes, Fruit Juice, Tyres, Passenger cars, infant milk food etc.

Features of an oligopoly market

1. A few large producers
The number of producers in oligopoly market is very less but a concrete number of producers is unknown. It may
be 3, 4 or 6 etc. The size of a producer is large.
2. Homogeneous or Differentiated products
Products being sold in an oligopolist may be homogeneous or differentiated depending on whether the producers
produce standardized products like steel, zinc, cement etc. or differentiated products like electronic equipment,
household appliances etc.
3. Considerable control over price but mutual interdependence
Since there is a few producers, therefore a producer is a price maker and has considerable control over his price.
However, producers are mutually interdependent. Mutual interdependency means a situation in which each
producers profit depends not on its own price and sales policies but on those of his rivals. In India, when Maruti
Udyog announced a price cut of ` 24000 to ` 36000 in early 1999 on its passenger cars, other companies
particularly Hyundai, also cut their price by `18000 to `22000.
4. Entry barriers
Economies of scale, the ownership and control of raw materials, patent rights, copy rights, licenses are some entry
barriers which keep new firms away from the market.
5. Estimation of demand curve faced by a seller is not possible
The features of fewness and interdependence of oligopolists make derivation of the demand curve a difficult task.
However, this is a controversial view in economics. Economists say that in collusive oligopoly derivation of the
demand curve is possible.

Determination of price-output in Oligopoly

Mainly there are three models in this regard.
1. Kinked demand curve / Non collusive oligopoly
2. Price leadership
3. Collusive pricing

Paul Sweezys kinked demand curve model / Price rigidity model

This model was prepared by Paul M. Sweezy. The model is based upon the following assumptions:
1. Oligopolists know about their mutual interdependence but they do not enter into any collusion.
2. Increase in the price is not followed by the rivals but the decease in the price is followed.
In order to understand Sweezys model we consider the following diagram. In the diagram, P is the price. Paul
says that if a producer charges a price above P, then his rivals would not follow him and he will lose his most of
his sales and as a result the demand curve faced by the producer should be elastic one. But if the producer lowers
his price below P, then his rivals would follow him and his sales would increase to the extent that market
demand increases and as a result the demand curve faced by the producer should be inelastic. Thus, the demand
curve is kinked at point K and it causes the marginal revenue curve MR discontinuous at point K i.e. the AB
portion of the MR curve is discontinuous. If marginal cost changes from MC 1 to MC2 to MC3, the firm can still
produce the same output Q at the same price. Thus, from point A to point B there is rigidity in the price i.e. the
price does not change despite the marginal cost may change. Therefore, this model is also known as the price
rigidity model.

Price

MC3
MC2
MC1

D= AR

Output

Q
MR

Disadvantages / criticism of the model

1. The model does not explain how the price P is determined.
2. The model does not tell at what price the kink takes place. In other words, the model is silent about the
height of the kink.

3. The assumption that the increase in the price is not followed by the rivals but the decrease in the price is
followed is not supported by the empirical studies. Such studies show that the rivals follow the increase
in the price as well as the decrease in the price.

Price Leadership Model

Price leadership is a type of implicit understanding by which oligopolists can coordinate prices without engaging collusion.
Formal agreements or contracts and secret meetings are not entered or held, but there is a practice in which the low cost
firm or a dominant firm fixes the price or is responsible for the price change and other firms follow the dominant firm. A
dominant firm is usually the biggest or most efficient firm in the industry. Studies show that cement, copper, glass
containers, steel, beer, fertilizer, cigarettes etc. are following the price leadership model. Price leadership model works
better when the following conditions are satisfied.
1. Number of the firms should be less.
2. Entry of the new firms should be limited.
3. Products should be large and homogenous.
4. The elasticity of the demand should be lower.
There are three types/forms of price leaderships:
1. Dominant Firm Price leadership
A dominant firm is the biggest firm in the industry i.e. it enjoys the largest share of total sales in the industry.
Under dominant firm price leadership, a dominant firm sets its price and the other firms follow this price. Under
such price leadership, other firms are very small relative to the dominant firm and they acknowledge it and
therefore they behave as if they are operating in a perfect competitive environment. Such kind of price leadership
gives a stable solution to the problem of price and output determination provided the small firms faithfully follow
the dominant firm/leader.
2. Low cost firm price leadership
Low cost firm is a firm that has the lowest cost of production in the industry. Such price leadership arises when the
cost curves of the firms are different. Generally, largest firm is the low cost firm because a large firm enjoys
economies of scale due to which its cost is lower compared to other firms.
3. Barometric price leadership
This is another type of price leadership in which a firm starts well-publicized changes in price which are followed
by the other firms. This is not a necessary condition that price leadership comes from the largest firm in the
industry, but it is expected to the largest firm to lead because, generally, the largest firm has sound knowledge of
the current market conditions and the firm is generally able to identify and predict future market conditions. If a
firm has such quality not necessarily be a large firm, then such firm is called as barometer. The price changes by
the barometric firm serve as barometer of changes in demand and supply conditions in the market. Main reasons of
following barometric price leadership are as follows:

i.

Most firms may not want to calculate the cost, demand and supply conditions continuously because of
various reasons like involvement of high cost and time. Therefore, such firms would like to accept the
price set by a barometric firm.

ii.

Kaplan says that barometric price leadership can be adopted as a response to a long lasting economic
warfare in which all the firms are losers.

Here are the tactics/ methods of price leadership:

1. Communications
The dominant firm often communicates the price or price changes to the industry through speeches by major
executives, interviews, journals etc. The firm justifies the changes in the price to get support from the other firms
in the industry.
2. Limit Pricing
Limit pricing means the strategy in which a firm a firm fixes its price which prevents the new firms to enter the
industry.

Collusive Pricing Model

When firms in an industry enter into agreement to determine prices, divide the market or to restrict competition among
themselves, to determine output etc., then this is known as collusion. Collusion results in cartels. A cartel is a group of
producers which typically develops a formal written agreement as to how much each member will produce and charge.
OPEC (Organsation of Petroleum Exporting Countries) is a real world example of a cartel. By controlling price through
collusion, oligopolists can reduce uncertainty, increase profits and even stop the entry of new firms.

Game Theory/Prisoners Dilemma

Prisoners dilemma is a classic example in game theory which explains the problem faced by oligopolistic producers. Let
us see this example. There are two persons, say A and B, who are caught by the police while doing a bank robbery. They
are sent to separate jai cells and they are not allowed to communicate each other. Both are asked to confess their crimes and
they are given the following options by the police.
Option 1: If both confess their crimes, then each will be sent to the jail for 5 years.
Option 2: If A confesses his crime but B does not, then A will be sent to jail for 2 years but B for 10 years.
Option 3: If B confesses his crime but A does not, then B will be sent to jail for 2 years but A for 10 years.
Option 4: If both do not confess their crimes, then each will be sent to the jail for 1 year.
The above options are shown in the following matrix, known as the payoff matrix.

Confession
A No confession

B
Confession
5, 5
10, 2

No confession
2,10
1,1

A thinks that if he confesses, then he will get 5 years of jail but if B did not confess, then I will get 2 years. B also thinks in
the similar manner. Therefore both will select to confess. However, this is the second best option. The first best option is
that each should follow the strategy of no confession. However, if A does not confess but B confesses, then A will get 10
years of jail which the worst and A would not like to take this risk and this risk is due the fact that A does not know about
what B will do. The same thinking will be exercised by B also. Therefore, none of them can take the risk of 10 years of jail,
hence, both will adopt confession. One point should be noted here is that if both were able to contact each other, then there
were no uncertainty about the behavior of each other and both would have adopted not to confess. Thus, if there is no
collusion between then the second best option is adopted but if there is collusion, then the first best option is adopted.
Oligopoly market and Prisoners dilemma: Just as the prisoners were not aware about the behavior of each other, they
were not able to contact each other similarly in real life also oligopolists are not aware the behavior or reaction of their
rivals and they are not able to contact them also due to various reasons.

Difference between Winners and Losers

Winner is always part of the solution
Loser is always part of the problem
Winner always says that I do this work for you.
Loser always says that this is not my work.
Winner says that I have to do.
Loser says that something must be done.
Winner thinks before speaking.
Loser speaks before thinking.
Winner presents some solution for any problem.
Loser presents problem for any solution.
Winner makes a team.
Loser breaks a team.
Winner presents strong arguments using soft words.
Loser presents weak arguments using harsh words.
Winner is like a thermostate.
Loser is like a thermometer.
When a mistake occurs, then a winner says that it was my fault.
When a mistake occurs, then a loser says that it was not my fault.
Winner has always a programme.
Loser has always an excuse.