NCERT Class 12 Microeconomics Chapter 6: Non-Competitive Markets

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Perfect Competition

  • There exist a very large number of firms and consumers of the commodity, such that the output sold by each firm is negligibly small compared to the total output of all the firms combined, and similarly, the amount purchased by each consumer is extremely small in comparison to the quantity purchased by all consumers together;
  • Firms are free to start producing the commodity or to stop production, i.e.. , entry and exit is free
  • Output produced by each firm in the industry is indistinguishable from the others and the output of any other industry cannot substitute this output
  • Consumers and firms have perfect knowledge of the output, inputs and their prices.

Market Structure

Includes all the features which affect the behavior/performance of the firms in a market.

Features of market structure include:

  • Number and size of sellers (concentration ratio) ,
  • Ability of one firm՚s actions to influence another firm,
  • Degree of product differentiation,
  • Degree of freedom of entry (including gov ′ t regulation) .

The greater the ability of an individual firm to influence the market in which it sells its product, the less competitive the market structure.

Types of market structures:

  • Perfect competition
  • Monopoly
  • Monopolistic competition; and
  • Oligopoly

Perfectly competitive market structure:

  • each firm has zero market power,
  • the actions of any individual firm will have no influence, whatsoever, in the market in which it sells its product.
  • If assumption of free entry and exit dropped then monopoly. If monopoly, then large number of firms cannot exist
  • If output is not indistinguishable from others, then monopolistic competition

Monopoly

  • Competitive Behaviour versus Competitive Structure
  • A market structure in which there is a single seller
  • A monopoly market structure requires that there be a single producer of a particular commodity; no other commodity works as a substitute for this commodity In particular,

we need,

1. All the consumers are price takers; and

2. that the markets of the inputs used in the production of this commodity are perfectly competitive both from the supply and demand side.

  • A perfectly competitive market has been defined as one where an individual firm is unable to influence the price at which the product is sold in the market. Since price remains the same for any level of output of the individual firm, such a firm is able to sell any quantity that it wishes to sell at the given market price. It, therefore, does not need to compete with other firms to obtain a market for its produce. This is clearly the opposite of the meaning of what is commonly understood by competition or competitive Behaviour.
  • Coke and Pepsi compete with each other in a variety of ways to achieve a higher level of sales or a greater share of the market. Conversely, we do not find individual farmers competing among themselves to sell a larger amount of crop. This is because both Coke and Pepsi possess the power to influence the market price of soft drinks, while the individual farmer does not. Thus, competitive Behaviour and competitive market structure are, in general, inversely related; the more competitive the market structure, less competitive is the Behaviour of the firms

Market Demand Curve is the Average Revenue Curve

Market Demand Curve
  • Average revenue (AR) of a firm is the total revenue per unit of output (for a price-taking firm, average revenue equals the market price)
  • Marginal revenue (MR) of a firm is the increase in total revenue for a unit increase in the firm՚s output or
  • For the perfectly competitive firm,
  • The monopoly firm՚s decision to sell a larger quantity is possible only at a lower price. Conversely, if the monopoly firm brings a smaller quantity of the commodity into the market for sale it will be able to sell at a higher price. Thus, for the monopoly firm, the price depends on the quantity of the commodity sold.
  • monopoly firm faces the market demand curve, which is downward sloping.
  • Marginal revenue, MR, equals the derivative of total revenue taken with respect to quantity

p = a-bq

p = 10 - 0.5q

q = 20 - 2p

Market Demand Curve

q = 20 – 2p,

p = 10 – 0.5q

Now,

TR = p × q

= (10 – 0.5q) × q

= 10q – 0.5q2 (TR is represented as a function of the quantity sold)

  • It is a quadratic equation in which the squared term has a negative coefficient. Such an equation represents an inverted vertical parabola. TR increases to ₹ 50 when output becomes 10 units, and after this level of output, total revenue starts declining.
  • AR = TR/q = pq/q = p (revenue received by the firm per unit of commodity sold is called the Average Revenue – AR)
  • The AR curve will therefore lie exactly on the market demand curve. This is expressed by the statement that the market demand curve is the average revenue curve for the monopoly firm
  • (Graphically - average revenue at any level of output is given by the slope of the line joining the origin and the point on the total revenue curve corresponding to the output level under consideration)

TR, MR, AR

TR, MR, and AR
  • TR does not increase by the same amount for every unit increase in quantity. Sale of the first unit leads to a change in TR from ₹ 0 when quantity is of 0 unit to ₹ 9.50 when quantity is 1 unit, i.e.. , a rise of ₹ 9.50. As the quantity increases further, the rise in TR is smaller. For example, for the 5th unit of the commodity, the rise in TR is ₹ 5.50. After the quantity reaches 10 units, MR has negative values.
  • TR is horizontal, i.e.. its slope is zero.
  • At point ‘d’ on the TR curve, where the tangent is negatively sloped, the MR takes a negative value
  • When TR rises, MR is positive
  • When TR falls, MR is negative
  • If the AR curve is less steep, the vertical distance between the AR and MR curves is smaller.
  • Price elasticity of demand is more than 1 when the MR has a positive value, and becomes less than the unity when MR has a negative value

Elasticity of Demand

inelastic at a point where the price elasticity is less than unity and unitary elastic when price elasticity is equal to 1.

Elasticity of Demand

Short Run Equilibrium of Monopoly Firm

Short Run Equilibrium of Monopoly Firm

Case of zero cost - only one well to get water in village monopolist bearing zero costs to determine the amount of water sold and the price at which it is sold. The profit received by the firm equals the revenue received by the firm minus the cost incurred, that is, Profit = TR TC. Since in this case TC is zero, profit is maximum when TR is maximum total revenue is given by the product of AR and the quantity sold, i.e.. ₹ 5 × 10 units = ₹ 50 (shaded rectangle)

Compare with Perfect Competition

  • Infinite Wells – each charge different some ₹ 5/bucket others ₹ . 2/bucket
  • In fact, competition among well-owners will drive the price down to zero. At this price 20 buckets of water will be sold larger quantity being sold at a lower price

Long Run

with free entry and exit, perfectly competitive firms obtain zero profits. That was due to the fact that if profits earned by firms were positive, more firms would enter the market and the increase in output would bring the price down, thereby decreasing the earnings of the existing firms. Similarly, if firms were facing losses, some firms would close down and the reduction in output would raise prices and increase the earnings of the remaining firms. The same is not the case with monopoly firms. Since other firms are prevented from entering the market, the profits earned by monopoly firms do not go away in the long run.

Perfect Competition: Long Run

Profit – when TR > TC and distance b/w TR & TC is maximum

TC > TR – loss and profit is negative

  • Below q0 when MR > MC - This means that the increase in total revenue from selling an extra unit of the commodity is greater than the increase in total cost for producing the additional unit. This implies that an additional unit of output would create additional profits -
  • MR curve lies above the MC curve, the reasoning provided above would apply and thus the firm would increase its output when the firm reaches an output level of q0 since at this level MR equals MC and increasing output provides no increase in profits.

Problems of Monopoly

  • Substitutes will come – cannot exist
  • pure monopoly situation is never without competition. This is because the economy is never stationary – new technologies will come
  • Since monopoly firms earn large profits, they possess sufficient funds to take up research and development work, something which the small perfectly competitive firm is unable to do.
  • Monopolies make supernormal profits; they may benefit consumers by lowering costs
  • Higher prices: Firms with monopoly power can set higher prices than in a competitive market
  • Allocative inefficiency: A monopoly is allocatively inefficient because in monopoly at price is greater than MC. (P > MC) . In a competitive market, the price would be lower, and more consumers would benefit from buying the good. A monopoly results in dead-weight welfare loss indicated by the blue triangle. (this is net loss of producer and consumer surplus)
  • Productive inefficiency: A monopoly is productively inefficient because the output does not occur at the lowest point on the AC curve.
  • Cost – Inefficiency: It is argued that a monopoly has less incentive to cut costs because it doesn՚t face competition from other firms. Therefore, the AC curve is higher than it should be.
  • Supernormal Profit: A monopolist makes Supernormal Profit leading to an unequal distribution of income in society.
  • Higher prices to suppliers: A monopoly may use its market power (monopsony power) and pay lower prices to its suppliers. E. g. supermarkets have been criticized for paying low prices to farmers. This is because farmers have little alternative but to supply supermarkets who have dominant buying power.
  • Diseconomies of scale: It is possible that if a monopoly gets too big it may experience diseconomies of scale – higher average costs because it gets too big and difficult to coordinate.
  • Lack of incentives: A monopoly faces a lack of competition, and therefore, it may have less incentive to work at product innovation and develop better products.
  • Lack of choice: Consumers in a monopoly market face a lack of choice. In some markets – clothing, choice is as important as price

How Monopolies Can Develop

  • Horizontal Integration: Where two firms join at the same stage of production, e. g. two banks such as TSB and Lloyds
  • Vertical Integration: Where a firm gains market power by controlling different stages of the production process. A good example is the oil industry, where the leading firms produce, refine and sell oil.
  • Legal Monopoly: E. g. Royal Mail or Patents for producing a drug.
  • Internal Expansion of a firm: Firms can increase market share by increasing their sales and possibly benefiting from economies of scale. For example, Google became a monopoly through dominating the search engine market.
  • Being the first firm: e. g. Microsoft has created monopoly power by being the first firm.

Monopolistic Competition

Monopolistic Competition

Restaurants, Clothing Stores, Supermarkets – Heavy Marketing

  • where the number of firms is large, there is free entry and exit of firms, but the goods produced by them are not homogeneous. Such a market structure is called monopolistic competition – coming to same example of biscuits in product differentiation
  • A consumers՚ preference for a brand will often vary in depth, so the change in price required for the consumer to change her brand may vary. Therefore, if price of a particular brand is lowered, some consumers will shift to consuming that brand. Lowering of the price further will lead to more consumers shifting to the brand with the lower price.
  • In the case of monopolistic competition, the firm expects increases in demand if it lowers the price. Recall that the demand curve of a firm is also its AR curve. This firm, therefore, has downward sloping AR curve. The marginal revenue is less than the average revenue, and also downward sloping. The firm increases its output whenever MR > MC
  • The monopolistic competitive firm is also a profit maximizer. So, it will increase production as long as the addition to its TR > addition to TC
  • firm under monopolistic competition will produce less than the perfectly competitive firm. Given lower output, the price of the commodity becomes higher than the price under perfect competition.
  • market structure of monopolistic competition allows for new firms to enter the market. If the firms in the industry are receiving supernormal profit in the short run, this will attract new firms. As new firms enter, some customers shift from existing firms to these new firms – prices will fall, and profits will fall – demand curve shifts leftwards Conversely, if firms in the industry are facing losses in the short run, some firms would stop producing (exit from the market) . The demand curve for existing firms would shift rightward. This would lead to a higher price, and profit.
  • Entry or exit would halt once supernormal profits become zero and this would serve as the long run equilibrium

A monopolistic competitive industry has the following features:

  • Many firms.
  • Freedom of entry and exit.
  • Firms produce differentiated products.
  • Firms have price inelastic demand; they are price makers because the good is highly differentiated
  • Firms make normal profits in the long run but could make supernormal profits in the short term
  • Firms are allocatively and productively inefficient.

Efficiency of firms in monopolistic competition Allocative inefficient. The above diagrams show a price set above marginal cost Productive inefficiency. The above diagram shows a firm not producing on the lowest point of AC curve Dynamic efficiency. This is possible as firms have profit to invest in research and development Cost-efficiency. This is possible as the firm does face competitive pressures to cut cost and provide better products.

Examples of Monopolistic Competition

Restaurants – restaurants compete on quality of food as much as price. Product differentiation is a key element of the business. There are relatively low barriers to entry in setting up a new restaurant.

Limitations of the Model of Monopolistic Competition

  • Some firms will be better at brand differentiation and therefore, in the real world, they will be able to make supernormal profit.
  • New firms will not be seen as a close substitute.
  • There is considerable overlap with oligopoly – except the model of monopolistic competition assumes no barriers to entry. In the real world, there are likely to be at least some barriers to entry.
  • If a firm has strong brand loyalty and product differentiation – this itself becomes a barrier to entry. A new firm can՚t easily capture the brand loyalty.
  • Many industries, we may describe as monopolistically competitive are very profitable, so the assumption of normal profits is too simplistic.

Oligopoly

  • Interdependence of firms
  • 5 firm concentration ratio > 50 %
  • Product differentiation
  • Possibility of collusion
  • Some barriers to entry
  • Car industry – economies of scale have cause mergers so big multinationals dominate the market. The biggest car firms include Toyota, Hyundai, Ford, General Motors, VW.
  • number of sellers is few, the market structure is termed oligopoly exactly two sellers is termed duopoly.
  • In analyzing this market structure, we assume that the product sold by the two firms is homogeneous and there is no substitute for the product, produced by any other firm there are a few firms, each firm is relatively large when compared to the size of the market. As a result, each firm is in a position to affect the total supply in the market, and thus influence the market price. For example, if the two firms in a duopoly are equal in size, and one of them decides to double its output, the total supply in the market will increase substantially, causing the price to fall. This fall in price affects the profits of all firms in the industry. Other firms will respond to such a move in order to protect their own profits, by taking fresh decisions regarding how much to produce.
  • Case I: firms could decide to ‘collude’ with each other to maximize collective profits. In this case, the firms form a ‘cartel’ that acts as a monopoly. The quantity supplied collectively by the industry and the price charged are the same as a single monopolist would have done.
  • Case II: firms could decide to compete with each other. For example, a firm may lower its price a little below the other firms, in order to attract away their customers. Obviously, the other firms would retaliate by doing the same. So, the market price keeps falling as long as firms keep undercutting each other՚s prices. If the process continues to its logical conclusion, the price will have fallen till the marginal cost. (No firm will supply at a lower price than the marginal cost) .
  • Oligopolistic equilibrium is likely to lie somewhere between the two extremes of monopoly and perfect competition.

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