UNIT 2:

Producers’ equilibrium

As we all know, producers generally strive hard to maximize profit at minimum cost. A
producer can attain equilibrium by applying the least cost combination of factors of
production to attain maximum profit. Therefore, he/she needs to decide the appropriate
combination among different combinations of factors of production to get maximum
profit at least cost.

The producers try to use ratios of factors in such a way so that maximum output can be
obtained, while keeping the cost as low as possible. The decision of a producer
depends on the principal of substitution. Suppose a producer has two factors of
production, A and B. In these factors A can produce more output than B with the same
amount of money spent on them.

This would make the producer to substitute A for B The producer equilibrium would be
attained when the output produced by spending an additional unit of money (marginal
rupee) on A is equal to the output produced by spending an additional unit of money on
B. The producer would keep on substituting one input with the other to get maximum
output till the producer equilibrium is not reached.

A producer may find out his equilibrium condition by the help of isoquant map and a
family of isocost line.

An isoquant represents various combinations of two factor-inputs which yield same level
of output to the producer while an isoquant map is a set of different isoquants, all of
which represents unique level of output.

On the other hand, an isocost is a line formed by combining points which represents
various combinations of two factor-inputs, given the prices of inputs and the total outlay
available to the producer. And, a family of isocost is a set of isocost lines which shows
various combinations of inputs at different level of outlay

Determination of Producer’s Equilibrium:

Producer’s equilibrium can be obtained with the help of isoquant and iso-cost line. An
isoquant enables a producer to get those combinations of factor that yield maximum
output. On the other hand, iso-cost line provides the ratio of prices of factors of
production and the amount that a producer is willing to spend. For attaining equilibrium,
a producer needs to obtain a combination that helps in producing maximum output with
the least price.

Figure- 11 shows the equilibrium position obtained with the help of isoquant and iso-
cost line:
As shown in Figure-11, the producer can produce 60 units of output by using any
combinations that is R, Q, and S, on curve IP’. He/she would select the combination that
would obtain the lowest cost. It can be seen from Figure-11 that Q lies on the lowest
iso- cost line and would yield same profit as on R and S points, at the lowest cost. In
such a case, Q is the point of equilibrium; therefore, it would be selected by the
producer.

Expansion Path:

In case, after attaining equilibrium, if a producer is willing to increase its production, then
he/she needs to determine the combination that is required to reach a new equilibrium
state. Let us consider Figure-11 in which the producer is willing to produce 60 units of
output. Now, the producer wants to produce 80 units of output instead of 60 units.

In such a case, the equilibrium would be achieved at the point Q’, which is shown in
In Figure-12, Q,’ would be the equilibrium point for producing 80 units of output. This is
because at point Q,’ iso-cost line is tangent to isoquant curve of IP’. Similarly, the
equilibrium point for producing 100 and 120 units are Q.” and Q,'”, respectively. When
the points Q, Q’, Q”, and Q.'” are joined, a straight line is obtained, which is called
expansion path or scale line.

This line is termed as scale line because producer needs to adjust its scale of
production according to this line to achieve the output he/she desires. On the other
hand, this line is also termed as expansion path because the producer needs to expand
his/her output by following this path when the prices of factors remain constant.
Producers would prefer to move along the scale line to increase the output to get
maximum output at least cost with fixed factor prices.

Optional Choice of Inputs

A producer may maximize his profit through two ways. They are

1. A producer can either minimize the cost of production for any given level of
output.
2. Or, maximize the output at any given level of outlay.

Let us examine these two options separately:

Let us suppose that an entrepreneur decided to produce 500 units of a commodity. His
desired level of output can be obtained by employing any combination of labor and
capital that the isoquant (Iq) pass through.

In the figure, we have only one isoquant which denotes that the level of output is fixed,
i.e. 500 units. On the other hand, there are three isocost lines (AB, A’B’ and A”B”) which
indicates different level of outlay (cost).

Since the isoquant (Iq) pass through points such as C, D and E, the producer can attain
his desired level of output by employing any of the combinations of labor and capital
that lie at these points. However, C and D being situated on the higher isocost line will
be ignored by the producer as he will require higher level of outlay to purchase these
combinations.

On the other hand, the producer won’t be able to choose any combinations from the
isocost line AB because no combination of labor and capital lying on that line will be
able to produce 500 units of output.

Hence, the producer will be in equilibrium where the isocost line is tangent to the
isoquant, i.e. at point E. In this situation, the slope of isoquant is equal to the slope of
isocost line.

Maximization of Output for a Given Level of Outlay (Cost)

Sometimes, there may be situation where the producer has fixed outlay from which he
has to produce as much output as possible in order to maximize his profit.

How a producer attains equilibrium is such condition is explained by the help of an

isocost line and an isoquant map.

Figure: maximizing output for a given level of outlay

Let us suppose that this time the producer has decided to incur an outlay of Rs. 5000 on
labor and capital. Since the total outlay is fixed, there is single isocost line AB which
represents various combinations of labor and capital that the producer can afford at Rs.
5000.

Similarly, in the figure, we have an isoquant map (three isoquants) Iq 1, Iq2 and Iq3 which
represents various level of outputs, i.e. 300 units, 400 units and 500 units, respectively.

Since the isocost line AB passes through the points C, E and D, the producer can spend
his total outlay on purchasing any combinations of capital and labor lying on these
points to produce outputs. But, as we can see that the points C and D lie on the lower
isoquant, the producer will choose the combination at point E.

It is because, by the property of isoquants,

level of output in Iq3 > level of output in Iq2 > level of output in Iq1

Although the level of output is greater in Iq 3 as compared to Iq2 and Iq1, the producer
cannot choose any combination at Iq3 as it is away from the isocost line.Hence, we can
once again say that the producer will be in equilibrium at the point where the slope of
isoquant is equal to the slope of isocost.

TRADITIONAL THEORY OF COST

Traditional theory distinguishes between the short run and the long run. The short run is
the period during which some factors is fixed; usually capital equipment and
entrepreneurship are considered as fixed in the short run. The long run is the period
over which all factors become variable.
SHORT-RUN TRADITIONAL THEORY OF COST
According to the traditional theory of the costs, the costs are divided into three types:
 Total Cost
 Average Cost
 Marginal Cost

TOTAL COST
Total cost is the total expenditure incurred by a firm during the production process. Total
cost will change with the change in the ratio of output to input. Such changes may be
the result of the changes in the efficiency of conversion process or changes in the
prices of inputs. Total cost is a positively sloped curve.
Total cost to a producer for the various levels of output is the sum of total fixed cost and
total variable cost, i.e.,
TC = TFC + TVC.
TOTAL FIXED COST: Total fixed costs refer to those costs
which are unable to vary. For example: land, buildings,
machinery etc. Even the output is zero fixed costs will be
there. Because, this cannot be variable with respect to the
level of production. So, it is also called invariable cost. Since
fixed costs are fixed or rigid it can be represented through a
curve having horizontal shape to output axis. This can be
shown with the help of following diagram:

TOTAL VARIABLE COST: Variable cost is incurred on the

employment of variable factors like raw materials, direct
labour, power, fuel, transportation, sales commission,
depreciation charges associated with wear and tear of assets,
etc. It varies directly with output.The curve of variable cost can
be shown as follows:

From the curves of fixed cost and variable costs, the total cost can be derived as
follows:
AVERAGE COST
Average total cost is the sum of the average fixed cost and average variable cost.
Alternatively, ATC is computed by dividing total cost by the number of units of output.
Therefore,
ATC or AC = AFC + AVC
=TC/Q
Average cost is also known as unit cost, as it is cost per unit of output produced. It can
be shown as follows:

Average cost is inclusive of Average Fixed Cost and Average Variable Cost.
AVERAGE FIXED COST: AFC is the average of total fixed costs. AFC can be obtaining
by dividing the total fixed cost by total quantity of output each time produced.
Mathematically,
AFC = TFC /quantity
TFC will be always fixed. So AFC will reduce and never reaches zero. Its curve is as
follows:
AVERAGE VARIABLE COST: AVC is the average of total variable cost. It can be find
out by using the following formula.
AVC = TFC / quantity
AVC curve will be a ‘U’ shaped which is showing that when the output is raises the cost
will decline, but after a certain level the cost starts to increases. That is why due to the
variable proportion.

MARGINAL COST
It is the addition to total cost required to produce one additional unit of a commodity. It is
measured by the change in total cost resulting from a unit increase in output. For
example, if the total cost of producing 5 units of a commodity is Rs. 100 and that of 6
units is Rs. 110, then the marginal cost of producing 6 th unit of. Commodity is Rs. 110 –
Rs. 100 = Rs. 10. The formula for marginal cost is
MCn =TCn –TCn-1,
It means that marginal, cost of ‘n’ units of output (MC n) can be obtained by subtracting
the total cost of production of ‘n-l’ units (TC n-1) from the total cost of production of ‘n’
units (TCn). Alternatively, marginal cost can be expressed as
MC=∆TC/∆Q.
Here, ∆TC stands for change in total cost and ∆Q stands for change in total output.
This can be shown as follows:
LONG RUN COSTS OF TRADITIONAL THEORY
In the long run all factors are assumed to become variable. Long-run cost curve is a
planning curve, in the sense that it is a guide to the entrepreneur in his decision to plan
the future expansion of his output. The long-run average-cost curve is derived from
short-run cost curves. The long run costs are categorised as follows:
 Long run total cost
 Long run average cost
 Long run marginal cost
LONG RUN TOTAL COST
Long run Total Cost (LTC) refers to the minimum cost at which given level of output can
be produced. According to Leibhafasky, “the long run total cost of production is the least
possible cost of producing any given level of output when all inputs are variable.” LTC
represents the least cost of different quantities of output. LTC is always less than or
equal to short run total cost, but it is never more than short run cost.
This can be shown as follows:

LONG RUN AVERAGE COST

Long run Average Cost (LAC) is equal to long run total costs divided by the level of
output. The derivation of long run average costs is done from the short run average cost
curves. In the short run, plant is fixed and each short run curve corresponds to a
particular plant. The long run average costs curve is also called planning curve or
envelope curve as it helps in making organizational plans for expanding production and
achieving minimum cost.
LONG RUN MARGINAL COST
Long run Marginal Cost (LMC) is defined as added cost of producing an additional unit
of a commodity when all inputs are variable. This cost is derived from short run marginal
cost. On the graph, the LMC is derived from the points of tangency between LAC and
SAC.

MODERN THEORY OF COST

Modern economists including Stigler, Andrews and Friedman have questioned the
validity of U-shaped cost curves both theoretical as well as on empirical grounds. Also
the long run costs in modern theory are not U- shaped but L- shaped.
The Modern theory suggests the existence of ‘built- in- reserve capacity ‘which imparts
flexibility and enables the plant to produce larger output without adding to the costs.
Built –in- reserve capacity are planned by firms.
The short-run cost curve has a saucer- type shape whereas the long-run Average cost
curve is either L-Shaped or inverse J-shaped.
The Modern theory of cost stresses on the role of economies of scale, which
significantly enables the firm to continue production at the lowest point of average cost
for a considerable period of time. The firm checks dis-economies of scale by planning in
advance and enjoys the gains of production in comparison to the traditional
theory where the average cost rises after the firm reaches the optimal level of output.

TYPES OF COSTS AS PER MODERN THEORY OF COST

SHORT RUN COSTS

AVERAGE FIXED COST: The fixed costs include the costs for:
 The salaries and other expenses of administrative staff.
 The wear and tear of machinery.
 The expenses for maintenance of building.
 The expenses for the maintenance of land on which the plant is installed or
operates.
As in the traditional theory of cost, the average fixed costs in modern microeconomics,
also plots as a rectangular hyperbola. This is shown as follows:

AVERAGE VARIABLE COST

In modern theory, Average variable cost is not U shaped rather it is saucer shaped and
has a flat stretch over a range of output. This flat stretch represents the ‘built in reserve
capacity’ of the firm to meet seasonal and cyclical changes in the demand. The average
variable cost curve is as follows:
MODERN THEORY OF COST
AVERAGE COST
The short-run Average costs consist of the Average fixed costs and Average variable
costs. The short-run average variable cost curve at each level of output. The smooth
and continuous fall in the average cost curve is due to the fact that the AFC curve is a
rectangular hyperbola and the AVC curve first falls and then becomes horizontal within
the range of reserve capacity. Beyond that it starts rising steeply. The curve of average
cost is as follows:

LONG RUN COSTS

LONG RUN AVERAGE COST
Modern economists divide long run costs into production costs and managerial costs/ In
the long run, all costs are variable and they given rise to a long run average cost curve
which is roughly L- shaped. This curve rapidly slopes downwards in the beginning but
later remains flat or slopes gently downwards at its right-hand cost. The long run
average cost curve is as follows:

The Long run average costs curve has two main features:
 It does not rise at every large scale of output.
 It does not envelope the Short run Average Cost but intersects them.
LONG RUN MARGINAL COST
According to modern theory, shape of long-run marginal cost curve corresponds to the
shape of long-run average cost curve. The given figure shows that when LAC is L-
shaped and LAC curve is falling then LMC curve will also be falling and its falling portion
will be below the falling portion of LAC curve.

Economies of scope
Economies of scope is an economic concept that refers to the decrease in the total cost
of production when a range of products are produced together rather than separately.

Economies of scope allow a company to gain efficiency from producing a larger variety
of products. A company is able to sell a greater range of products and also respond to
changes in consumer preferences. It reduces risks for a company by allowing for related
diversification. If a major car producer only produced SUVs, the company would be
vulnerable to market changes (if, for example, oil price spikes and consumers switch to
buying more eco-friendly cars).

How to achieve economies of scope?

1. Flexible Manufacturing

Flexible manufacturing exists if multiple products can be produced using the same
manufacturing systems and inputs – for example, using the same preparation and
storage facilities when making hamburgers and fries, as opposed to using two separate
facilities.

2. Related Diversification

If a company is able to use its operational expertise, resources, and capabilities across
its organization, then it can take advantage of related diversification. For example, hiring
designers and marketers who can use their skills across different product lines allows
for the production of a wide range of products.

3. Mergers

Mergers often enable a company to share research and development expenses to

reduce costs and diversify its product portfolio or knowledge. For example, two
pharmaceutical companies might merge to combine their research and development
expenses to create new products.

Economies of scope can occur because the products are co-produced by the same
process, the production processes are complementary, or the inputs to production are
shared by the products.

Co-Products: Economies of scope can arise from co-production relationships between

final products. In economic terms these goods are called complements in production.
This occurs when the production of one good automatically produces another good as a
byproduct or a kind of side-effect of the production process. Sometimes one product
might be a byproduct of another, but have value for use by the producer or for sale.
Finding a productive use or market for the co-products can reduce both waste and costs
and increase revenues.
For example, dairy farmers separate raw milk from cows into whey and curds, with the
curds going on to become cheese. In the process they also end up with a lot of whey,
which they can then use as a high-protein feed for livestock to reduce their overall feed
costs or sell as a nutritional product to fitness enthusiasts and weightlifters for additional
revenue. Another example of this is the so-called black liquor produced when
processing wood into paper pulp. Instead of being merely a waste product that might be
costly to dispose of, black liquor can be burned as an energy source to fuel and heat the
plant, saving money on other fuels, or can even be processed into more advanced
biofuels for use on-site or for sale. Producing and using the black liquor thus saves
costs on producing the paper.

Complementary Production Processes: Economies of scope can also result from the
direct interaction of two or more production processes. Companion planting in
agriculture is a classic example here, such as the "Three Sisters" crops historically
cultivated by Native Americans. By planting corn, pole beans, and ground trailing
squash together, the Three Sisters method actually increases the yield of each crop,
while also improving the soil. The tall corn stalks provide a structure for the bean vines
to climb up; the beans fertilize the corn and the squash by fixing nitrogen in the soil; and
the squash shades out weeds among the crops with its broad leaves. All three plants
benefit from being produced together, so the farmer can grow more crops at lower cost.

A modern example would be a co-operative training program between an aerospace

manufacturer and an engineering school, where students at the school also work part
time or intern at the business. The manufacturer can reduce its overall costs by
obtaining low cost access to skilled labor, and the engineering school can reduce its
instructional costs by effectively outsourcing some instructional time to the
manufacturer's training managers. The final goods being produced (airplanes and
engineering degrees) might not seem to be direct complements or share many inputs,
but producing them together reduces the cost of both.

Shared Inputs: Because productive inputs (i.e. land, labor, and capital) usually have
more than one use, economies of scope can often come from common inputs to the
production of two or more different goods. For example, a restaurant can produce both
chicken fingers and French fries at a lower average expense than what it would cost two
separate firms to produce each of the goods separately. This is because chicken fingers
and french fries can share use of the same cold storage, fryers, and cooks during
production.

Proctor & Gamble is an excellent example of a company that efficiently realizes

economies of scope from common inputs since it produces hundreds of hygiene-related
products from razors to toothpaste. The company can afford to hire expensive graphic
designers and marketing experts who can use their skills across all of the company's
product lines, adding value to each one. If these team members are salaried, each
additional product they work on increases the company's economies of scope, because
of the average cost per unit decreases.
Unit 3:

What is the Theory of the Firm?

The theory of the firm refers to the microeconomic approach devised in neoclassical
economics that every firm operates in order to make profits. Companies ascertain the
price and demand of the product in the market, and make optimum allocation of
resources for increasing their net profits.

The traditional theory of the firm is based on classical economics and the work of early
economists, such as David Ricardo and Leon Walras. The basic assumptions of the
traditional theory of the firm are
1. Firms seek to maximise profits.
2. Information symmetry. Owners and workers of the firm have access to good
information which enables them to maximise profits.
3. Firms act as an homogenous unit with owners wishing to maximise profits
and these aims being achieved by managers and workers.
4. To maximise profits a firm makes use of marginal analysis. In particular
profit maximisation occurs at an output where marginal revenue = marginal
cost.
5. Firms and managers are rational. With their rational objectives being to
maximise profits.
Profit maximization theory of firm

Profit maximization is the act of achieving the highest revenue or profit. The sales
level
where profits are highest is at the strategic level. It is typically used as a benchmark for
the best situation and for planning purposes. Profit maximization is simply, using a
product in order to generate a desired profit or return on investment.
Profit maximization can be achieved in a variety of ways, but usually requires a high
level
of specialization and knowledge because minimizing costs and maximizing revenues
are
two key concepts that must be addressed for this to occur.
The most common benchmark for profit maximization is called breakeven point, which
means that if a company can increase sales above this point, then they will not just
maximize profits but also create an opportunity to grow in the future.

Profit Maximization Theory

The profit maximization theory is the principle that every firm should operate in order to
make a profit.
Profitable companies can achieve this by selling more by charging higher prices for their
goods or services and reducing production costs. They have the opportunity to do so
because they have better access to more resources that other companies may not
have.
There are many cases where the profit maximization theory has been put into practice
successfully in the workforce and has resulted in people's wages being increased.
In economics, the profit maximization theory asserts that a firm will select the course of
action that results in the maximum profits. Profit maximization is also an economic
principle which states that firms will select the course of action with the lowest costs for
production, even if other alternatives may result in lower total costs or higher total
benefits.
This theory helped economists understand how firms decide on what to produce, how
much they produce, and what prices they charge for their products.
This theory is a cornerstone of microeconomics, and it has been extensively analyzed
by
various economists in terms of its assumptions and implications.
The profit maximization theory assumes that a company's goal is to maximize profits. It
assumes that the decision-making process in a company is rational and efficient, and in
order to maximize profits, the firm will take advantage of market opportunities and use
its
resources efficiently.
Profit Maximization Formula
Marginal cost is the increase in the total cost of production as a result of one more unit
of
output. Marginal revenue is the change in total revenue per one more unit produced.
Marginal revenue equals marginal cost when profit maximization occurs.
In order to determine which factor causes firms to enter or exit markets, it is important to
understand profit maximization. In order for firms to maximize profits, the marginal cost
must equal marginal revenue for all goods or services offered in a marketplace.

Other theories of firm

1. Sales maximization theory of firm:

Say that you're a restaurant owner who recently thought up a new drink to be served in
the restaurant. You know customers will love it, but you need a way to get them to try it.
You can give away free samples, but how much can you afford to give away? You need
a way to get this product out to as many customers as possible without losing money.
This is a great opportunity for you to use sales maximization.
Sales maximization means to make the most sales revenue possible without the
business taking a loss. It's a fairly logical business approach. After all, businesses
generally want to make as much revenue as possible with as little cost as possible,
which can lead to greater profits. In the case of your restaurant, one way to utilize sales
maximization might be to offer your new drink to customers at cost until you've got them
hooked on the new product. Then, you increase the price a little at a time until you make
a profit.
With sales maximization, firms sell at lower prices and seek to increase sales. They
may have a constraint to make a minimum amount of profit to keep owners happy. But
they may go for sales maximization for various reasons. Increase market share and
therefore monopoly power. This can enable long-term profit maximization. Gives a
greater sense of prestige to be at the head of a big company and dominate the market.
Gaining market share gives a sense of success that may be more measurable in the
world than profit. Managerial salaries are likely to increase in a bigger company.

2. Growth maximization:
Growth maximization is similar to sales maximization, but growth implies increasing size
of firm and this may involve the firm taking on risky expansion, borrowing to invest in
new capital. This may make the firm less financially secure, but offers prospect of rapid
growth through investment and acquisition. The traditional theory of the firm underplays
the role of mergers and acquisitions as a way for firms to increase in size and gain more
market share and prestige.

3. Managerial utility maximisation

A limitation of the traditional theory of the firm is that it equates utility maximisation with
profit maximisation, but in the real world it is much more complex and there are many
things that determine a managers utility.

Getting on with workers. A boss doesn’t want to annoy his fellow workers just to make
more profit for owners. The boss may sacrifice some profits to make his fellow workers
happy, for example avoiding job losses.

Fringe benefits. Managers may get a lot of utility from fringe benefits like having fun at
work, lavish offices and taking time off to play golf.

If the direction of firms is governed by managers, there may be a form of profit

satisficing – where managers do enough to keep the owners happy but then pursue
these other objectives.

4. Corporate responsibility and social welfare

The fourth model assumes that firms have a mixture of objectives. Profit may be one,
but the firm may have a mission statement to prioritise environmental welfare or offer
some services to the local community. Therefore, the firm may invest surplus profit in
community schemes which benefit local stakeholders rather than shareholders. For
example, a football club may choose a price lower than market equilibirum to keep
matches affordable to local supporters and it may re-invest profits in community
schemes.

Sometimes corporate responsibility may be masked as clever marketing strategy and

the percentage of profit invested in the community/charity is actually very low.

What is Market Structure?

Market structure, in economics, refers to how different industries are classified and
differentiated based on their degree and nature of competition for goods and services. It
is based on the characteristics that influence the behavior and outcomes of companies
working in a specific market.

Meaning of Market:

Ordinarily, the term “market” refers to a particular place where goods are purchased and
sold. But, in economics, market is used in a wide perspective. In economics, the term
“market” does not mean a particular place but the whole area where the buyers and
sellers of a product are spread.

1. Perfect Competiton
In a perfect competition market structure, there are a large number of buyers and
sellers. All the sellers of the market are small sellers in competition with each other.
There is no one big seller with any significant influence on the market. So all the firms in
such a market are price takers.
Characteristics of Types of Market Structure
a) Under perfect competition, there are a large number of buyers and sellers in the
market.
b) Under competition, the firms have no control over the price. They have to sell the
products at a price predetermined by the industry.
c) Under perfect competition, firms are free to exit and enter the market at any point
in time. This means that there is no obstruction for a new firm to produce a
similar product produced by the existing firms in the market.
d) Under perfect competition, firms can't charge high prices as both sellers and
buyers have perfect knowledge about the goods and their prices.
e) Under perfect competition, the products offered by different firms are
homogeneous. This implies that buyers do not have any basis to prefer the
goods of one seller over the goods of another seller. The goods are similar in
terms of quality, size, packing, etc.

Perfect Competition Examples

a) Foreign exchange markets.
b) Agricultural markets.
c) Internet-related industries.
Equilibrium in a firm
The necessary and sufficient conditions for the equilibrium of a firm are:
a) MC = MR
b) MC curve cuts the MR curve from below
In other words, the MC curve must intersect the MR curve from below and after the
intersection lie above the MR curve. In simpler terms, the firm must keep adding to its
output as long as MR>MC.
This is because additional output adds more revenue than costs and increases its
Profits

The point P (i.e., at output OM) satisfies this second condition also, as the MC curve
cuts the MR curve from below at P. Beyond the point, P, MC is greater than MR, and it
will clearly be not profitable to expand output beyond OM.

There can, however, be cost-revenue situation, which satisfies the first condition of MC
being equal to MR, but does not satisfy the second condition of MC cutting MR curve
from below. This is shown in Fig. 26.4. In this figure, MR is the straight line marginal
revenue curve (as we have already seen, a straight line marginal revenue curve is
actually faced by a firm under perfect competition). MC represents the marginal cost of
the firm. At point T, the two curves intersect and, therefore, the marginal cost equals
marginal revenue. But from the figure it is clear that at T, marginal cost curve.

MC is cutting marginal revenue curve MR from above and, therefore, marginal cost is
less than the marginal revenue beyond the point T. Obviously, T cannot be a position of
equilibrium since after T marginal cost is less than marginal revenue, and it will be
profitable for the firm to expand output. At T or at output ON, the firm instead of making
maximum profit is making maximum losses.

At point P, however, in the same figure marginal cost curve is cutting marginal revenue
curve from below and marginal cost beyond point P is greater than marginal revenue
and, therefore, if the firm expands output beyond P, it will be adding more to cost than
to revenue—clearly an unprofitable move. Hence, in Fig. 26.4, point P, and not point T,
is the profit-maximizing point. In this equilibrium position, the firm is producing
equilibrium output OM.

Short run equilibrium of a firm in prefect competition

In a perfectly competitive market, a firm can earn a normal profit, super-normal profit, or
it can bear a loss. At the equilibrium quantity, if the average cost is equal to the average
revenue, then the firm is earning a normal profit.
On the other hand, if the average cost is greater than the average revenue, then the
firm is bearing a loss. However, if the average cost is less than average revenue, then
the firm is earning super-normal profits.

Short run normal profit in perfect competition

In the diagram, the MC curve is

intersecting the MR curve from
below at equilibrium point A. At the
point ‘A’ the AC curve is also
tangent to the MR curve creating a
situation of AC=MR=AR which is a
condition of NORMAL PROFIT.

Loss situation in perfect competition

In the diagram, the MC curve is

intersecting the MR curve from below
at equilibrium point A. At point A the
ATC or the AC curve lies above the
P=MR=MC=AR which indicates that
the revenue earned is LESSER than
the Cost incurred. Therefore the area
P’PAB is the area of LOSS
Super Normal Profit situation in perfect competition

In the diagram, the MC curve is

intersecting the MR curve from below
at equilibrium point A. At point A the
AC curve lies BELOW the
P=MR=MC=AR which indicates that
In the long run equilibrium, only one case is possible in a perfectly
the revenue competitive
earned is MORE than
firm. the Cost incurred. Therefore, the area
1) Normal Profit P’PAB is the area of SUPER
NORMAL PROFIT.
In the diagram, the LMC curve is
intersecting the MR curve from
below at equilibrium point S. At the
point ‘S’ the LAC curve is also
tangent to the MR curve creating a
situation of AC=MR=AR which is a
condition of NORMAL PROFIT.

Effects of changes in demand and supply of a product in perfect competition.

The following points highlight the three effects of changes in demand and supply of a
product.
The effects are:
 When Supply is Static but Demand Changes
 When Demand is Static and Supply Changes
 When Demand and Supply Both Changes.

Effect of Change # 1. When Supply is Static but Demand Changes:

In the condition when supply is static and there is increase in demand price increases
and in decrease in demand price decreases

In this diagram the supply curve SS is static and it

meets the demand curve DD on point Q and OP
equilibrium price is determined. But when demand
increases then demands curve goes upward
towards right DD1 and meets supply curve SS on
the point Q1 and the price increases from OP to
OP1.
Again, when demand decreases, then demand curve comes downward at D2D2, which
meets supply curve SS to Q2; and price decreases from price OP to OP2 It should be
remembered that when supply is static and when there is increase or decrease in
demand, then the price increases or decreases and the seller increases or decreases
the sales.

Effect of Change # 2. When Demand is Static and Supply Changes:

Changes in supply are due to changes in technical

knowledge and the price factor. Figure given above
shows the effect of changes in supply. Given the
demand, when the supply increases, the supply
curve shifts downward.

As a result the price of the product falls and its

quantity increases. Taking S and D as the supply
and demand curves respectively they intersect at E
and establish OP price and OQ quantity. Given the
demand when the supply increases, the supply
curve S shifts downward as S1 and new equilibrium
is established at E2. As a result the price falls from OP to OP1 and the quantity of the
product increases from OQ to OQ1.

Effect of Change # 3. When Demand and Supply Both Changes:

When there is a combined increase in demand and supply, there is a definite increase
in the quantity of the product but the rise or fall in price is not certain:

(A) Price rises only when the increase in demand is more than the increase in supply.
This is shown in figure (A) where OP and OQ are the equilibrium price and quantity
respectively. If there is a combined increase in demand and supply but the increase in
demand (D1) is more than the increase in supply (S1), the price rises from OP to OP1
and the quantity also increases from OQ to OQ1.

(B) On the other hand, if the increase in supply is more than that in demand, the price
fails. In diagram (B), the increase in supply from S to S1 is greater than the rise in
demand from D to D1. As a result, the new equilibrium point is E1. The new price OP1
is less than the old price OP but the quantity of the product has increased from OQ to
OQ1.

(C) When the increase in demand and supply is uniform, there is no change in price.
This is shown in diagram (C) where the increase in supply by SS1 is exactly equal to
the increase in demand by DD1. The new price E1Q1 equals the old price OP (= EQ)
but the quantity has increased from OQ to OQ1.

Changes in Cost

A firm’s costs change if the costs of its inputs change. They also change if the firm is
able to take advantage of a change in technology. Changes in production cost shift the
ATC curve. If a firm’s variable costs are affected, its marginal cost curves will shift as
well. Any change in marginal cost produces a similar change in industry supply, since it
is found by adding up marginal cost curves for individual firms.

Suppose a reduction in the price of oil reduces the cost of producing oil changes for
automobiles. We shall assume that the oil-change industry is perfectly competitive and
that it is initially in long-run equilibrium at a price of $27 per oil change, as shown in
Panel (a) of Figure 9.13 "A Reduction in the Cost of Producing Oil Changes". Suppose
that the reduction in oil prices reduces the cost of an oil change by $3.
Figure. A Reduction in the Cost of Producing Oil Changes

The initial equilibrium price, $27, and quantity, Q1, of automobile oil changes are
determined by the intersection of market demand, D1, and market supply, S1 in Panel
(a). The industry is in long-run equilibrium; a typical firm, shown in Panel (b), earns zero
economic profit. A reduction in oil prices reduces the marginal and average total costs
of producing an oil change by $3. The firm’s marginal cost curve shifts to MC2, and its
average total cost curve shifts to ATC2. The short-run industry supply curve shifts down
by $3 to S2. The market price falls to $26; the firm increases its output to q2 and earns
an economic profit given by the shaded rectangle. In the long run, the opportunity for
profit shifts the industry supply curve to S3. The price falls to $24, and the firm reduces
its output to the original level, q1. It now earns zero economic profit once again. Industry
output in Panel (a) rises to Q3 because there are more firms; price has fallen by the full
amount of the reduction in production costs.

Effects of imposition of taxes in perfect competition

Governments will choose to implement taxes to either individuals or firms in order to
increase its revenue. When considering taxes to firms, it must be noted that these taxes
will increase the price of goods being produced and sold, which translates into a welfare
loss.

Short and long run analysis:

Taxes - Short run: In the short run, both

consumers and producers will suffer from the
tax imposed. A new tax increases the price of
goods. Let’s say this tax is imposed to firms,
which increase their prices in order to cover
their losses. In this case, as shown in the
adjacent figure, supply will shift to the left,
decreasing the quantity being produced, which
increases its prices since demand remains
unchanged: the new equilibrium price will be
pD (if the tax was to be imposed to
consumers, there would be a shift in demand
instead). A corresponds to the amount of the tax paid by consumers, while B is the
amount paid by producers. Only consumers actually pay more, but producers are
getting less out of the sale. The loss in consumer and producer surplus will depend on
the elasticity of the demand curve, as shown in the figures below. The lower the
elasticity in absolute terms (left figure), the higher the loss in consumer surplus, and the
lower in producer surplus. Higher elasticity (right figure) will have the opposite effect.
In the long run, since the supply curve is completely elastic, the new tax will reduce
only consumer surplus. Producer surplus will remain equal to zero, since there are no
profits to be made.

MONOPOLY

In a monopoly type of market structure, there is only one seller, so a single firm will
control the entire market. It can set any price it wishes since it has all the market power.
Consumers do not have any alternative and must pay the price set by the seller.
Monopolies are extremely undesirable. Here the consumer loose all their power and
market forces become irrelevant. However, a pure monopoly is very rare in reality.

Features of monopoly:

1. Firm itself is the industry

2. Price maker
3. Barrier to entry
4. Downward sloping demand curve
5. No close substitutes
6. Full control over supply
Equilibrium condition In a Monopoly

The conditions for Equilibrium in Monopoly are the same as those under perfect
competition. The marginal cost (MC) is equal to the marginal revenue (MR) and the MC
curve cuts the MR curve from below.

Firm’s Short-Run Equilibrium in Monopoly

Like in perfect competition, there are three possibilities for a firm’s Equilibrium in
Monopoly. These are:
1. The firm earns normal profits – If the average cost = the average revenue
2. It earns super-normal profits – If the average cost < the average revenue
3. It incurs losses – If the average cost > the average revenue

Normal Profits
A firm earns normal profits when the average cost of production is equal to the average
revenue for the corresponding output.

In the diagram, the MC curve is

intersecting the MR curve from
below at equilibrium point E. At the
point ‘E’ the AC curve is also
tangent to the AR curve above at
point, creating a situation of
AC=AR which is a condition of
NORMAL PROFIT.

Super-normal Profits
• A firm earns super-normal profits when the average cost of production is less
than the average revenue for the corresponding output.

In the diagram, the MC curve is

intersecting the MR curve from
below at equilibrium point E. At the
point ‘E’ the AC curve is below the
AR curve, creating a situation of
AC<AR which is a condition of
NORMAL PROFIT. So the area
PP’BA is the region of normal
profit.
E
Losses
A firm earns losses when the average cost of production is higher than the average
revenue for the corresponding output.

In the diagram, the MC curve is

intersecting the MR curve from
below at equilibrium point E. At the
point ‘E’ the AC curve is above the
AR curve, creating a situation of
AC>AR which is a condition of
LOSS. So the area PP’BA is the
region of LOSS
E

Long run monopoly equilibrium

Conditions of equilibrium in the long run:

Super normal profit on Monopoly market:

In a monopoly situation the fir always earn a super normal profit as the monopoly firm
always looks to earn maximum profit and since they are a price maker the monopolist
set the price level always higher than the cost of production. From the above diagram,
the equilibrium point is set a E where all the conditions of equilibrium is satisfied. Also at
the point E, the AC is above LAC and SAC

which creates a situation of supernormal profit. So the area PGDF is the area of
supernormal profit.

Change in demand in Monopoly

Shifts in demand curve can lead to:
1. Changes in Price with no change in Output
2. Change in output with no change in Price
Graphically
• The Demand Curve D1 shifts to D2. And the new marginal revenue curve MR2
intersects marginal cost at the same point as old marginal revenue curve.
Therefore, the Profit maximizing output remains the same although the Price
shifts from P1 to P2(downwards)

• In this case, the marginal revenue MR2 intersects the Marginal cost curve at a
higher output level Q2. But we can also from the curve that the demand is elastic
so the price remains the same.

Effects of cost:
A) At increasing cost
The above diagram depicts a situation where the MC and AC is increasing at an
increasing rate. The equilibrium condition is established at point E where the MC curve
is intersecting the MR curve from below and corresponding to this point the AR curve is
much above the AC curve which lies way below the MC and AR curve. This creates a
situation which leads to the area PHFG which creates a situation of Supernormal profit.

B) With constant cost

The above diagram depicts a situation where the MC and AC is at a constant rate. The
equilibrium condition is established at point E where the MC curve is intersecting the
MR curve from below and corresponding to this point the AR curve is above the AC and
MC curve. This creates a situation which leads to the area PHFG which creates a
situation of Supernormal profit.

c) Decreasing cost

The above diagram depicts a situation where the MC and AC is increasing at an

increasing rate. The equilibrium condition is established at point E where the MC curve
is intersecting the MR curve from below and corresponding to this point the AR curve is
much above the AC curve which lies way below the MC and AR curve. This creates a
situation which leads to the area PHFG which creates a situation of Supernormal profit.

Imposition of taxes
The above diagram demonstrates a situation of imposition of taxes in a monopoly
market. The imposition of taxes increases the cost of production which pushes the MC
curve to the left to MC1. This leads to a reduction of the quantity produced and the price
level increased to P1 from Pm. So the result of imposition of taxes is that it leads to a
reduction in the quantity produced and an increased price level.

Price Discrimination:
In monopoly, there is a single seller of a product called monopolist. The monopolist has
control over pricing, demand, and supply decisions, thus, sets prices in a way, so that
maximum profit can be earned.

The monopolist often charges different prices from different consumers for the same
product. This practice of charging different prices for identical product is called price
discrimination.

According to Robinson, “Price discrimination is charging different prices for the same
product or same price for the differentiated product.”
The different types of price discrimination are explained as follows:

i. Personal: Refers to price discrimination when different prices are charged from
different individuals. The different prices are charged according to the level of income of
consumers as well as their willingness to purchase a product. For example, a doctor
charges different fees from poor and rich patients.

ii. Geographical: Refers to price discrimination when the monopolist charges different
prices at different places for the same product. This type of discrimination is also called
dumping.

iii. On the basis of use: Occurs when different prices are charged according to the use
of a product. For instance, an electricity supply board charges lower rates for domestic
consumption of electricity and higher rates for commercial consumption.

Degrees of Price Discrimination:

Price discrimination has become widespread in almost every market. In economic

jargon, price discrimination is also called monopoly price discrimination or yield
management. The degree of price discrimination vanes in different markets.

i. First-degree Price Discrimination: Refers to a price discrimination in which a

monopolist charges the maximum price that each buyer is willing to pay. This is also
known as perfect price discrimination as it involves maximum exploitation of consumers.
In this, consumers fail to enjoy any consumer surplus. First degree is practiced by
lawyers and doctors.
ii. Second-degree Price Discrimination: Refers to a price discrimination in which
buyers are divided into different groups and different prices are charged from these
groups depending upon what they are willing to pay. Railways and airlines practice this
type of price discrimination.

iii. Third-degree Price Discrimination: Refers to a price discrimination in which the

monopolist divides the entire market into submarkets and different prices are charged in
each submarket. Therefore, third-degree price discrimination is also termed as market
segmentation.

In this type of price discrimination, the monopolist is required to segment market in a

manner, so that products sold in one market cannot be resold in another market.
Moreover, he/she should identify the price elasticity of demand of different submarkets.
The groups are divided according to age, sex, and location. For instance, railways
charge lower fares from senior citizens. Students get discount in cinemas, museums,
and historical monuments.

Multiplant monopoly
A multiplant monopoly is given in monopolistic firms that have their production divided
into more than one production plant, each one having its own cost structure. Different
cost stuctures give place to different marginal costs and hence each production plant
will have to choose the individual production output level following the maximising
principle.

1. Away from the plant with higher marginal cost.

2. Towards the plant with lower marginal cost.

The multiplant monopolist will need to decide whether to produce in both plants or just
in one plant. This decision depends on each plant’s marginal costs. If it has increasing
marginal costs, the multiplant monopoly will produce in either plant, taking into account
the marginal total cost of both firms. If there are decreasing marginal costs, it will
produce only in one plant, the one with the steepest marginal cost curve, provided it has
equal or lower fixed costs than the other plant.
If marginal costs are constant and equal in both plants, the multiplant monopolist can
produce in either plant, as long as capacity allows it (see figure below). If demand can
be reached with only one plant, the others must be shut down.
If marginal costs are constant but different in each plant, production should take place
only in the plant with lowest marginal costs, as long as maximum capacity is not
reached. When this maximum capacity is reached, production will be moved to the other
plant, as shown in the figure below.

Deadweight loss or welfare cost

When a monopolist elects to reduce the output of a good and causes the total surplus of
that product to be lower than it otherwise would be if it were traded in a perfect market,
it creates a loss. This is known as the welfare cost of monopoly.
Monopolistic Competition
This is a more realistic scenario that actually occurs in the real world. In monopolistic
competition, there are still a large number of buyers as well as sellers. But they all do
not sell homogeneous products. The products are similar but all sellers sell slightly
differentiated products.
Now the consumers have the preference of choosing one product over another. The
sellers can also charge a marginally higher price since they may enjoy some market
power. So the sellers become the price setters to a certain extent.
For example, the market for cereals is a monopolistic competition. The products are all
similar but slightly differentiated in terms of taste and flavours. Another such example is
toothpaste.

Features:
1. Large Number of Sellers
2. Product Differentiation
3. Selling costs
4. Freedom of Entry and Exit
5. Lack of Perfect Knowledge
6. Price decision
7. Non price competition

Short run equilibrium in monopolistic competition

The above diagram depicts a situation of super normal profit of the monopolistic
competition. The equilibrium point is the plave where the MC cuts the MR curve from
below. At this situation the ATC is below the AR which creates a situation of super
normal profit

Long run equilibrium in monopolistic competition

In the long run the monopolistic firm earns only normal profit. The above diagram
dispicts a situation of normal profit. The point of equilibrium where MC curve cust the Mr
curve from below and at the same point the ATC is equal to AR, this creates a situation
of NORMAL PROFIT.

Excess capacity
Excess capacity (or unutilized capacity) occurs when a firm operates or is producing
output at less than the optimum level. It can happen when there is a market recession
or increased competition, where demand declines and firms are forced to reduce
capacity to decrease costs.
To increase demand, companies typically decrease prices when there is excess
capacity in the industry. Excess capacity is determined using the minimum long-run
average cost; hence, it is not a short-run occurrence.

Excess capacity is more defined under monopolistic competition due to the nature of the
market structure.
Unlike perfectly competitive markets where the demand curve is horizontal,
monopolistic competitive markets show a downward sloping demand curve. The
demand curve cannot be tangential to the LAC at its minimum point.

Conditions of equilibrium are reached at E, where LMC = LAC at the minimum point of
the latter. Firms in monopolistic competition are likely to see excess capacity, as there is
no incentive to produce optimum output at a higher long-run marginal cost (LMC) that is
greater than marginal revenue (MR).
Firms in monopolistic competition operate below optimum capacity; hence, they are
smaller in size, large in terms of population, and work under conditions of excess
capacity.

Firms under monopolistic competition operate at the equilibrium point E1, where output
OQ1 is produced, and the demand curve is tangent to the LAC at point A. It is the point
where the LMC curve intercepts with the MR curve.

Firms do not operate at equilibrium (E), where the LMC curve intercepts the LAC curve
at its lowest point, and optimum output (OQ) is produced. Beyond OQ1, firms will start
making losses as LMC is greater than MR. Thus, excess capacity is created as
represented by Q1Q.

The graph also reveals that in the long run, output is lower, and price is higher under
monopolistic competition, compared to perfectly competitive markets where output is
higher and price is lower.

Oligopoly

In an oligopoly, there are only a few firms in the market. While there is no clarity about
the number of firms, 3-5 dominant firms are considered the norm. So in the case of an
oligopoly, the buyers are far greater than the sellers.
The firms in this case either compete with another to collaborate together, They use
their market influence to set the prices and in turn maximize their profits. So the
consumers become the price takers. In an oligopoly, there are various barriers to entry
in the market, and new firms find it difficult to establish themselves.

Features:

 Interdependence in decision making. A small number of big companies in an

oligopoly can’t operate independently. For example, the decision of one firm to
launch an extensive advertising campaign will provoke countermoves. Since
firms in an oligopoly offer homogenous products, they all influence the prices and
output and can’t ignore the actions of their competitors.
 Price rigidity. Each company has to stick to the price in this market system. If
one company cuts down the price, competitors will make a more drastic
reduction, leading to a price war and letting no one benefit.
 Conflicting attitudes. In this market structure, you can find two perspectives. In
the first one, companies understand that competition can’t bring them benefits
and try to cooperate to maximize their revenue. In the second one, the idea of
increasing profit leads to conflict and antagonism.
 Monopoly power. A limited number of companies in an oligopoly with a
significant market share enables these firms to control the price and output.
Therefore, this market structure has some monopoly power.
 Advertising. It is a powerful instrument with the help of which a company in an
oligopoly can start an aggressive campaign to capture a big part of the market. In
this scenario, other firms will have to use defensive advertising.

Cournot’s model of oligopoly

A model of oligopoly was 1st put forward by Cournot a French economist in 1838.
Cournot’s model of oligopoly is one of the oldest theories of the behaviour of the
individual firm and relate to non-collusive oligopoly. In the Cournot model it is assumed
that an oligopolist thinks that his rival will keep their output fixed regardless of what he
might do.
Assumptions
1) Cournot takes the case of two identical mineral springs operated by two owners who
are selling the mineral water in the same market. Their waters are identical. Therefore,
his model relates to the duopoly with homogeneous products.
2) It is assumed by Cournot for the sake of simplicity that the owners operate mineral
springs and sell water without incurring any cost of production.
3) The duopolists completely know the market demand for mineral water.
4) Cournot assumes that each duopolist believes that regardless of his actions and their
effect on market price of the product, the rival firm will keep its output constant

Kinked Demand Curve Theory

It has been observed that many oligopolistic industries exhibit an appreciable degree of
price rigidity or stability.
The kinked demand curve theory put forward by Paul M. Sweezy, Hall and Hitch
explains this price rigidity.
According to this theory, the demand curve facing an oligopolist has a KINK at the level
of the prevailing price. the Kinked is formed at the prevailing price level because the
segment of the demand curve above the prevailing price level is highly elastic and the
segment below the prevailing price level is inelastic.

From the figure, we know that

The prevailing price level = P
The firm produces and sells output = OM
Also, the upper segment (dP) of the demand curve (dD) is elastic.
The lower segment (PD) of the demand curve (dD) is relatively inelastic.
This difference in elasticities is due to an assumption of the kinked demand curve
hypothesis.

Assumption:
Each firm in an oligopoly believes the following two things:

If a firm lowers the price below the prevailing level, then the competitors will follow him.
If a firm increases the price above the prevailing level, then the competitors will not
follow him.

There is logical reasoning behind this assumption. When an oligopolist lowers the price
of his product, the competitors feel that if they don’t follow the price cut, then their
customers will leave them and buy from the firm who is offering a lower price.
Therefore, they lower their prices too in order to maintain their customers. Hence, the
lower portion of the curve is inelastic. It implies that if an oligopolist lowers the price, he
can obtain very little sales.

On the other hand, when a firm increases the price of its product, it experiences a
substantial reduction in sales. The reason is simple – consumers will buy the
same/similar product from its competitors.

This increases the competitors’ sales and they will have no motivation to match the
price rise. Therefore, the firm that raises the price suffers a loss and hence refrain from
increasing the price.

This behavior of oligopolists can help us understand the elasticity of the upper portion of
the demand curve (dP). The figure shows that if a firm raises the price of a product, then
it experiences a large fall in sales.

Hence, no firm in an oligopolistic market will try to increase the price and a kink is
formed at the prevailing price. This is how the kinked demand curve hypothesis explains
the rigid or sticky prices.

Dominant price leadership model

In certain situations, organizations under oligopoly are not involved in collusion.

There are a number of oligopolistic organizations in the market, but one of them is
dominant organization, which is called price leader.

Price leadership takes place when there is only one dominant organization in the
industry, which sets the price and others follow it.
Sometimes, an agreement may be developed among organizations to assign a
leadership role to one of them. The dominant organization is treated as price leader
because of various reasons, such as large size of the organization, large economies of
scale, and advanced technology. According to the agreement, there is no formal
restriction that other organizations should follow the price set by the leading
organization. However, sometimes agreement is formal in nature.

Price leadership is assumed to stabilize the price and maintain price discipline.

Types of Price Leadership:

Price leadership helps in stabilizing prices and maintaining price discipline. There are
three major types of price leadership, which are present in industries over a passage of
time.

These three types of price leadership are explained as follows:

i. Dominant Price Leadership: Refers to a type of leadership in which only one

organization dominates the entire industry. Under dominant price leadership, other
organizations in the industry cannot influence prices. The dominant organization uses
its power of monopoly to maximize its profits and other organizations have to adjust
their output with the set price.

The interests of other organizations are ignored by the dominant organization.

Therefore, dominant price leadership is sometimes termed-as partial monopoly. Price
leadership by the leading organization is most commonly seen in the industry.

ii. Barometric Price Leadership: Refers to a leadership in which one organization

declares the change in prices at first and assumes that other organizations would
accept it. The organization does not dominate others and need not to be the leader in
the industry. Such type of organization is known as barometer.

This barometric organization only initiates a reaction to changing market situation, which
other organizations may follow it if they find the decision in their interest. On the
contrary, the leading organization has to be accurate while forecasting demand and cost
conditions, so that the suggested price is accepted by other organizations.

iii. Aggressive Price Leadership: Implies a leadership in which one organization

establishes its supremacy by threatening the organizations to follow its leadership. In
other words, a dominant organization establishes leadership by following aggressive
price policies and forces other/organizations to follow the prices set by it.

Price-Output Determination under Price Leadership:

Price leadership takes place when there is only one dominant organization in the
industry, which sets the price and others follow it. Different economists have developed
different models for determining price and output in price leadership.

Here, we would discuss a simple model for determining price and output in price
leadership, which is shown in Figure-4:

Suppose there are two organizations, A and B producing identical products where
organization A has a lower cost of the production than organization B. Therefore,
consumers are indifferent between these two organizations due to identical products.
This implies that both the organizations would face same demand curve, which further
represents equal market share.

In Figure-4, DD is the demand curve of both the organizations and MR is their marginal
revenue. MCa and MCb are the marginal cost curves of organization A and B
respectively. As stated earlier, the cost of production of organization A is less than B,
thus, MCa is drawn below MCb.

Let us first start the discussion of price leadership with the case of organization A. The
profits of organization A would be maximized at a point where MR intersects MCa. At
this point, the output of organization A would be OQ with the price level OP. On the
other hand, the profits of organization B would be maximized at a point where MR
intersects MCb with output OQ1 and price OP1.

In such a case, the price of organization B is more as compared to organization A.

However, both the organizations have to charge the same price as products are
homogeneous. In this case, organization A is the price leader and organization B is the
follower.

Thus, organization A will dictate the price to organization B. Both the organizations will
follow the same output, OQ and price OP. However, the profits earned by organization
B are less than A, as it has to produce at price OP which is less than its profit
maximizing price, OP1. In addition, the organization B also has high costs of production
that leads to lower profits at price OP1.
Drawbacks of Price Leadership:

The price leadership suffers from various drawbacks.

These are discussed as follows:

i. Makes it difficult for the price leader to assess the reactions of followers.
ii. Leads to malpractices, such as charging lower prices by rival organizations in the
form of rebates, money back guarantees, after delivery free services, and easy
installment facility. The prices charged by rival organizations are comparatively less
than the prices set by the price leader.
iii. Leads to non-price competition by rival organizations in the form of aggressive
promotion strategies.
iv. Influences new organizations to enter into the industry because of price rise. These
new organizations may not follow the leader of the industry.
v. Poses problems if there are differences in cost of price leaders and price followers. In
case, if cost of production of price leader is less, then he/she would fix lower prices.
This will lead to a loss for a price follower if his/her cost of production is more than the
price leader.

Prisoner’s dilemma

The prisoner’s dilemma is a scenario in which the gains from cooperation are larger
than the rewards from pursuing self-interest. It applies well to oligopoly. The story
behind the prisoner’s dilemma goes like this:

Two co-conspiratorial criminals are arrested. When they are taken to the police station,
they refuse to say anything and are put in separate interrogation rooms. Eventually, a
police officer enters the room where Prisoner A is being held and says: “You know
what? Your partner in the other room is confessing. So your partner is going to get a
light prison sentence of just one year, and because you’re remaining silent, the judge is
going to stick you with eight years in prison. Why don’t you get smart? If you confess,
too, we’ll cut your jail time down to five years, and your partner will get five years, also.”
Over in the next room, another police officer is giving exactly the same speech to
Prisoner B. What the police officers do not say is that if both prisoners remain silent, the
evidence against them is not especially strong, and the prisoners will end up with only
two years in jail each.
Oligopoly version of prisoner’s dilemma

The members of an oligopoly can face a prisoner’s dilemma, also. If each of the
oligopolists cooperates in holding down output, then high monopoly profits are possible.
Each oligopolist, however, must worry that while it is holding down output, other firms
are taking advantage of the high price by raising output and earning higher profits.
Table 2 shows the prisoner’s dilemma for a two-firm oligopoly—known as a duopoly. If
Firms A and B both agree to hold down output, they are acting together as a monopoly
and will each earn $1,000 in profits. However, both firms’ dominant strategy is to
increase output, in which case each will earn $400 in profits.

Can the two firms trust each other? Consider the situation of Firm A:

 If A thinks that B will cheat on their agreement and increase output, then A
will increase output, too, because for A the profit of $400 when both firms
increase output (the bottom right-hand choice in Table 2) is better than a
profit of only $200 if A keeps output low and B raises output (the upper
right-hand choice in the table).
 If A thinks that B will cooperate by holding down output, then A may seize
the opportunity to earn higher profits by raising output. After all, if B is going
to hold down output, then A can earn $1,500 in profits by expanding output
(the bottom left-hand choice in the table) compared with only $1,000 by
holding down output as well (the upper left-hand choice in the table).

Thus, firm A will reason that it makes sense to expand output if B holds down output
and that it also makes sense to expand output if B raises output. Again, B faces a
parallel set of decisions.

The result of this prisoner’s dilemma is often that even though A and B could make the
highest combined profits by cooperating in producing a lower level of output and acting
like a monopolist, the two firms may well end up in a situation where they each
increase output and earn only $400 each in profits. The following example discusses
one cartel scandal in particular.

How to Enforce Cooperation

How can parties who find themselves in a prisoner’s dilemma situation avoid the
undesired outcome and cooperate with each other? The way out of a prisoner’s
dilemma is to find a way to penalize those who do not cooperate.

Perhaps the easiest approach for colluding oligopolists, as you might imagine, would be
to sign a contract with each other that they will hold output low and keep prices high. If a
group of U.S. companies signed such a contract, however, it would be illegal. Certain
international organizations, like the nations that are members of the Organization of
Petroleum Exporting Countries (OPEC), have signed international agreements to act
like a monopoly, hold down output, and keep prices high so that all of the countries can
make high profits from oil exports. Such agreements, however, because they fall in a
gray area of international law, are not legally enforceable. If Nigeria, for example,
decides to start cutting prices and selling more oil, Saudi Arabia cannot sue Nigeria in
court and force it to stop
Because oligopolists cannot sign a legally enforceable contract to act like a monopoly,
the firms may instead keep close tabs on what other firms are producing and charging.
Alternatively, oligopolists may choose to act in a way that generates pressure on each
firm to stick to its agreed quantity of output.