Unit-4: Market morphology

Dr. Saileja Mohanty

(Ph.D. in Economics from NIT, rourkela)

Assistant Professor, School of Business

MIT World Peace University, Pune
Email id- saileja.Mohanty@gmail.com
 Unit-4: Market morphology

➢Chapter-1: Concept of market

➢Chapter-2: Perfect competition- Features and price determination under short-run

and long run

➢Chapter-3: Monopoly- Features and price determination, Sources of monopoly and

price discrimination

➢Chapter-4: Monopolistic competition- Features and overview

➢Chapter-5: Oligopoly- Features and types of oligopoly competition

 Chapter-1: Concept of Market
&
Chapter-2: Perfect competition- Features and price
determination under short-run and long run
Market
• Market is. defined as the institutional relationship between buyers and sellers; it refers to the interaction
between buyers and sellers of a good (or service) at a mutually agreed upon price. Such interaction may be ata
particular place, or may be over telephone, or even through the Internet.
• Sellers and buyers may meet each other personally, or may not ever see each other, as in E-commerce. In a
nutshell, a market may be a place, or a function, or even a process.
Features of Market
• Nature of Competition This refers to the number, size and distribution of sellers in any market. There can be a
market in which a very large number of sellers exist and size of an individual seller is very small, whereas there
can be another market with only ore very large player, without any competitor.
• Nature of Product This refers to whether the product is homogeneous or differentiated (even if slightly). The
market we face may have sellers producing (and selling) the same products which are almost identical. Typical
examples may be vegetables, minerals, precious metals and jewels
• Number and Size of Buyers : We know that any market has two players, a buyer and a seller. As we can
categorise markets on the basis of number and size of sellers, so also can be done on the basis of number and
size of buyers.
• Freedom to Enter into or Exit from the Market Some markets may be very difficult to enter, there may be
financial restrictions, legal compulsions and technological constraints on entry.
 Perfect Competition
• Among the various market forms, perfect competition is the most basic. It appears
to be theoretical and hypothetical, but at the same time it deserves a discussion here
because it is the most ideal form of market.
• Its understanding facilitates the comprehension of all other forms of markets.
• Before a discussion on demand and supply curves of perfectly competitive firms
and their state of equilibrium output and price in the short run and long run, let us
see the main characteristics of perfect competition.
Features of Perfect Competition

Presence of Large Number of Buyers and Sellers

Homogeneous Product

Freedom of Entry and Exit

Perfect Knowledge

Perfectly Elastic Demand

Perfect Mobility of Factors of Production

No Governmental Intervention Another very interesting aspect of perfect.

Firm is a Price Taker

A Case Study in Perfect Competition:

The U.S. Bicycle Industry U.S. bicycle industry has been cited as a classic
state of perfect competition, featuring component manufacturers in haste to
get the latest designs and functionality to market in time and bicycle suppliers
struggling to design bicycle products that have more value than the
competition. Retailers are anxious about how much to commit for and what to
bring to market, whether to become a concept store or operate independently,
and which suppliers to do business with. Alongside, it has also been observed
that each buyer or seller in this industry has a negligible impact on the market
price and that everybody is a price taker, earning the bare minimum profit
necessary to stay in business.
DEMAND AND REVENUE OF A FIRM
• Let us now understand the concepts of revenue and cost of a firm under perfect
competition.
• You would recall that following the assumption of rationality, all firms would aim at
maximisation of profit. Since firms in a competitive market are price takers, they can only
adjust quantity at a fixed price. Hence, TR depends on quantity only. Following the
concept of MR, we have:

Total Revenue (TR) is the

multiplicative product of the price and
the quantity sold. TR=P*Q

In PC based on price takers and can supply as

much as they want at the existing price in the
market, we may say: AR =MR =P
 • In order to determine just how much each firm wants to sell, or how much each firm is willing to offer at the
prevailing market price, we have to use the concept of costs.
• In Figure 10.1, TR is the Total Revenue curve, sloping upward; TC is the Total Cost curve in the short run,
drawn on the basis of the law of variable proportions. Profit is derived as the difference between Total
Revenue and Total Cost.

As you can see from Figure 10.1, the profit curve begins from the negative axis.
implying that in order to produce an output less than OQ, the firm actually incurs
losses.

This is because the total cost of producing any output less than OQ, is more than
the revenue earned by selling it. To produce output OQ,, the firm actually incurs
losses equal to zero; this corresponds to the point 4, where the total revenue and
total cost curves intersect each other for the first time from the left.

The firm starts earning profits when it produces an output greater than OQ, and
earns maximum profit at output OQ*. Beyond OQ*, any extra production will
lead to reduction in profits.

At point B, the TR and TC curves intersect again; this is the point where the
falling profit level is equal to zero, corresponding to output OQ,. Thus, any
rational producer must produce an output OQ*, in order to maximise profit.
MARKET DEMAND CURVE AND FIRM’S DEMAND CURVE

• The market demand curve for the whole industry is a standard downward sloping curve, which
shows alternative combinations of price and output available to the buyers, such that an individual
buyer is able to get the maximum amount of output at each existing price, at a given time.
• Definitely, the buyer would demand more of the product at lower prices, and less at higher prices,
other things remaining equal. The market demand curve is the horizontal summation of individual
demand curves. The demand curve for an individual firm is a horizontal straight line showing that
the firm can sell infinite volume of output at the same price.

• The market supply curve is upward sloping, giving various combinations of price and output; it
shows the maximum output any firm is willing to produce and supply at each specified price, at a
given time.
• Firms definitely are willing to sell larger quantities of output at higher prices, and lower quantities
at lower prices, other things remaining constant. The market supply curve is the horizontal
summation of all the individual supply curves of the firms.
In Figure 10.2 market equilibrium is reached at the point of
intersection of the market demand and market supply curves, i.c., at
E; equilibrium output for the industry is given at O*.

Each perfectly competitive firm, being a price taker, takes the

equilibrium price from the market as given at P*.

Since a firm can sell all it wants at this price, it faces an infinitely
elastic demand curve for its product. Such a shape of the demand
curve also implies that the firm can sell not even a single unit of its
product at even a slightly higher price.

It is not worthwhile for the firm to offer any quantity at a lower

price either, since it can sell as much as it wants at the prevailing
market price.

This would imply that Total Revenue of a firm would increase at a

constant rate, i.e., Marginal Revenue would be constant. In other
words, Average Revenue will be equal to Marginal Revenue (refer to
equation (2)).
Hence, the demand curve of the firm will be a straight horizontal
line, showing perfect elasticity of demand, and this infinitely elastic
demand curve, drawn at market price, coincides with the AR and
MR curves.
SHORT RUN EQUILIBRIUM
➢Case of Supernormal Profit
• In the short run, an individual firm under perfect competition may either earn supernormal profit, or
normal profit, or can incur losses.
• This depends on the positions of the short run cost curves. These three possibilities are shown by the
three short run equilibrium positions of a competitive firm.
• Let us begin this section with the assumption that in each case, the point of market equilibrium is
attained by the intersection of market demand curve and market supply curve, at point E.
• An individual firm takes the equilibrium price P* as given, and faces an infinitely elastic demand
curve given by P = AR = MR, as shown in Figure 10.2.
• In the short run a perfectly competitive firm can earn supernormal | n the short run, a perfectly
competitive profits (when revenue exceeds cost). The AC and MC curves are the usual short run
cost curves.
• As the firm maximizes profits at the point where MR is equal to MC and also where MC cuts MR
from below, the point of equilibrium of the in Figure 10.3 is at point £; output at this price is OQ*.
• So, by selling OQ* equilibrium output at
equilibrium price P*, the total revenue
earned by the firm is given by the
rectangular area OP*EQ* (area below the
AR curve, since TR = AR.Q).
• To produce this output, the total cost
incurred by the firm is given by the
rectangular area OABQ* (area below the
AC curve, since TC = AC.Q).
• Therefore, profit earned by the firm is
given by the rectangular region AP*EB.
• This is the supernormal profit made firm in
the short run, because the ruling market
price P* is greater than average cost.
➢ Case of Normal Profit
• Not all firms earn supernormal profits in the short run; some of them may also earn normal profits (when revenue is
equal to cost).
• As in the previous case, equilibrium of the firm is shown at E in Figure 10.4, the output that maximises profit is O0*.
• Total revenue earned by the firm by selling O0* is the rectangular area OP*EQ*. Similarly, the total cost of producing
OQ* is also given by the area OP*EQ*.
• Profit is thereby nil, in other words, the firm makes normal profit, and actually ends up producing at the break-even
level of output.
• This situation occurs because the average cost curve is tangent to the average revenue line.
➢ Case of Loss
• In Figure 10.5, point E determines the equilibrium level of output O0* to be produced by the firm. Total
revenue is given by the rectangular area OP*EQ* (as in the earlier cases) and the cost of producing OQ* level
of output is given by the rectangular area O4BQ*.
• Thus, the total cost of producing OQ* is more than the revenue earned by selling OQ*. The amount of loss
incurred by the firm is given by the area P*ABE.
• The firm incurs loss or subnormal profit in the short run because the average cost of producing this output is
more than the ruling market price.
➢Special Case:
• Exit or Shut Down Point You might be wondering as to what a firm would do, if it incurs losses in
the short run. Will it decide to withdraw immediately?
• No. It will actually prefer to wait and find out whether market conditions improve in the long run.
• If, however, it continues to make losses in the long run, the firm will ultimately have to leave the
industry. So how does a firm decide on whether to continue production in spite of incurring losses, or
to shut down operations?
• If the prevailing price in the market is more than the average variable cost (AVC) of production, the
Sfirm would continue production. But if AVC exceeds AR, the firm would shut down. rom the
market
 Market Supply Curve and Firm’s Supply Curve
As you have seen in the previous section, the
perfectly competitive firm produces above the
minimum point of its AVC and discontinues
production if price falls short of minimum of
AVC.

This can be summed up with the following

conditions: Condition I: If Price < minimum AVC,
then shut down. Condition II: If Price = minimum
AVC, then choose any output that would
maximise profit.

The supply curve of the firm would be identical

to the short run marginal cost curve above the
minimum point of the AVC curve.
Long Run Equilibrium
In the long run, perfectly competitive firms earn only
normal profits. This is due to the unrestricted entry into
and exit of firms from the industry in the long run.

Let us explain this with two extreme possibilities: first,

when existing firms enjoy supernormal profits in the short
run; and next, when the existing firms incur losses in the
short run.

If some of the existing firms earn supernormal profits, this

attracts new firms to the industry to gain profits. With the
entry of new firms, the supply of the commodity in the
market increases.
The point of equilibrium in the long run is where each firm
Assuming no change in the demand side, this lowers the would be operating at the minimum points of both its short
price level. This process of adjustment continues till the run and long run average cost curves, thus, attaining full
price becomes equal to the long run average cost (AR = AC economies of scale.
= MR = MC).
Point E, in the figure represents the long run equilibrium point
at which 7 = LAC = SAC = SMC= MR = AR.
As such, supernormal profits of the existing firms are
squeezed until all the firms in the industry earn normal
profit.
 ASSIGMENTS

Perfect Competition: Existence in Real World

 MONOPOLY
• You have learnt about perfect competition in the previous chapter and you know that it is one extreme
case in market morphology. The other extreme is of monopoly, i.e., no competition. Now what does
monopoly mean?
• A monopoly (from the Greek word “mono” meaning single and “polo” meaning to sell) is that form of
market in which a single seller sells a product (good or service) which has no substitute.
• A monopolist (or a monopoly firm) is a firm that is the only seller of a product (good or service) that
has no close substitute.
• Economists often distinguish between pure monopoly and monopoly. Pure monopoly is that market
situation in which there is absolutely no substitute of the product, and the entire market is under
control of a single firm.
• As we can see, this is more or less a hypothetical situation, because there will be some substitute to
every good (or service) but such substitutes would vary in terms of their ability to satisfy a particular
human want.
• Other alternatives may not satisfy the same want with the same efficiency and at the same (or similar)
price as the particular good in question. Take the example of common salt; you may say that it has no
substitute as such.
• We would, however, like to remind you of rock salt that can be used as an alternative to common salt. So
there is an alternative to common salt, but in terms of availability and price, there is a wide difference
between the two.
• Hence, common salt appears to be a monopolies product and if there was only a single seller of salt, it would
become a case of monopoly!
• Therefore, we agree to say that a monopoly exists when there is no close substitute to the product and also
when there is a single producer and seller of the product, like Indian Railways, as mentioned above.

➢FEATURES OF MONOPOLY

• Single Seller – One firm controls production, distribution and sales of the product; no competition
• Single Product – No (close) substitutes
• No difference between firm and industry – Only one firm constitutes the entire industry
• Independent Decision-Making – Undivided market power allows for unanimous decision making; price
maker
• Restricted Entry – existence of barriers leads to monopoly
Sources of Monopoly
• Restriction by Law – Majority of State Electricity Boards are examples.
• Control over key raw materials – strategic raw material control; nuclear weapons in India.
• Specialised Know How – Patented technologies (entry barriers) like IBM mainframe.
• Economies of Scale – If a firm’s long run minimum average cost coincides with the size of market,
monopoly is warranted at maximum scale to provide the product at economical price.
• Small Markets – will remove the scope for multiple firms to exist.

➢Types of monopoly
• Legal Monopoly – When govt. decides to restrict other players to keep total control of the product
• Economic Monopoly – when competition is removed due to inefficiency of other players or
superior efficiency of the particular monopolist
• Natural Monopoly – when the size of the market is small and allows for only one player to
produce
• Regional Monopolies – protection of intellectual property rights emerging from possession of a
natural resource specific to a region.
 Demand and Marginal Revenue Curves for a Monopoly Firm

• The main reason behind the negative slope is that

although a monopoly firm is in total control of the market
price, yet it can sell more only when it reduces the price
of its product.
• Therein is the trade off for the monopolist, it can increase
its sales if and only if it chooses to lower the price of the
product; conversely, sales would go down if price is
increased.
• The demand curve of the monopolist is highly price
inelastic because there is no close substitute and
consumers have no or very little choice.
• Hence, if consumers want to consume the product, they
would have to buy it at the price charged by the
monopolist.
• So, monopolist can set price or quantity but not both.
Price and output decisions in short run
• We assume here that in order to maximise profit a monopoly firm follows the rule of MR=MC when
MC is rising.
• Similar to the case of perfect competition, a monopoly firm may earn supernormal profit or normal
profit or even subnormal profit in the short run.
 DEMAND AND MARGINAL REVENUE CURVES FOR A MONOROLY FIRM
➢ Supernormal Profit First of all we shall explain the
occurrence of supernormal profit, because that appears to be
the most acceptable position for a monopolist.
➢ Following the conditions of profit maximisation, the point of
equilibrium is and the equilibrium output is shown as OQ, in
Figure 11.2.
➢ Since this equilibrium price (or AR) is more than AC, the firm
earns supernormal profit. The total revenue carned by the firm
by selling OQ, at OP, is given by the rectangular area OP BQ,
(the area below the AR curve), whereas the total cost incurred
is given by the rectangular area OAEQ, (the area below the
AC curve, since TC = AC.Q).
➢ Therefore, the total profit (supernormal) earned by the firm is
given by the rectangular region AP, BE.
➢ This is technically possible, because in the early years of
operations the firm may be producing at high costs and
may be is just able to manage normal profit.
➢ In the chapter on perfect competition you have seen that
normal profit is earned when average cost is equal to
average revenue. Graphically, it can be shown when the
AC curve is tangent to the AR (or demand) curve, as
given in Figure 11.3, equilibrium here occurs at point E,
where the two conditions of profit maximisation are
satisfied.
➢ At E, the output that maximises profitis OQ, and
equilibrium price (at which total output OQ, is sold) is
OP,. The total revenue earned by the firm by selling OQ,
is the rectangular area OP,BQ, and the total cost of
producing OQ, is also given by the same area OP BQ,
showing that TR is equal to TC and AR is equal to AC.
➢ Profit being the difference between total revenue and total
cost is thereby nil. The firm in this case makes neither
profit, nor loss; in other words, it makes normal profit.
The case of loss is shown in Figure 11.4, in which the
equilibrium is at point E, equilibrium level ofoutput is
OQ, and price is OP.

The firm earns total revenue given by the rectangular

area OP,CQ, (as in the earlier case).

But the cost of producing OQ, level of output is given

by the rectangular area O4BQ,.

Thus, the O Quantity total cost of producing OQ, is

more than the revenue earned by selling it.

The amount of loss incurred by the firm is given by the

area PABC.
Supply CURVE of A monopoly firm

• From our previous discussion on demand and supply you must recollect that a supply curve tells us
the quantity that a firm chooses to supply (or produce) at a particular price.
• In perfect competition, firms equate price of the product with their individual marginal costs of
production and thus, determine the supply curve in the short run.
• But a monopolist is a price maker, the firm itself sets the price of the product it sells, instead of
taking the price as given.
• Thus, it does equate MC with MR for profit maximisation, but unlike perfect competition, it
cannot equate its price to MR. Supply of the good by the monopolist at a given price would be
determinee.
• Thus, P=AR =MR = MC
Price Discrimination.
• You must be aware of the different concessions offered to its
passengers by the Indian Railways.
• Let us quickly list some of them: concession to students, research
scholars, teachers, senior citizens, physically challenged, sports
persons and even to unemployed youth travelling for interview.
• This illustration has been used here to introduce you to the concept
and practice of price discrimination.
 Price Discrimination
• First-Degree Price Discrimination (Perfect Price Discrimination):
• In this type, the monopolist charges each consumer the maximum price they are willing to pay. This
results in capturing the entire consumer surplus and maximizing the monopolist's profit.
• However, perfect price discrimination is challenging to implement in reality because it requires detailed
information about each consumer's willingness to pay, and such information is often not available.

Second-Degree Price Discrimination:

1. In this form of price discrimination, the monopolist sets different prices based on the quantity
consumed or the characteristics of the consumer.
2. For example, a monopoly may offer quantity discounts or tiered pricing. This allows the monopolist
to capture more consumer surplus by offering lower prices to consumers who are more price-
sensitive or willing to buy larger quantities.
Third-Degree Price Discrimination:
1. This is the most common form of price discrimination. In third-degree price discrimination, the
monopolist divides the market into different segments based on observable characteristics such as
age, income, location, or other demographic factors.
2. The monopolist then charges different prices to each segment based on their price elasticity of
demand. For example, if the monopolist knows that one segment of consumers is more price-
sensitive than another, it may charge a lower price to the more price-sensitive segment.

• Price discrimination can have both positive and negative effects. On the positive side, it can increase
overall output and consumer surplus by allowing the monopolist to sell more units at a lower price to
some consumers. On the negative side, it can lead to a redistribution of wealth among consumers, as
those who are less able to pay end up paying higher prices.
 Monopolistic Competition

▪ The term “imperfect competition” has been derived from the realistic features of markets, a
large number of sellers sell heterogeneous products and buyers have preferences for specific
of producers offer similar but not identical sellers.
▪ The market can also be termed as “monopolistic” because each of these sellers makes the
product unique by some differentiation and has control over the small section of market, just
like a monopolist.
▪ This market form was seen to have characteristics of both perfect competition (for example,
many sellers) and of monopoly (for example, control over market).
Features of monopolistic competition
• Large Number of Buyers and Sellers – but not as many as perfect competition; products
are fairly close substitutes to each other.
• Heterogenous Product - A product is said to be differentiated if there are even minor
changes in the same generic product, such as in colour, or packaging, or brand name. Eg:
different toothpastes. A differentiated product enjoys some degree of uniqueness in the
mindset of customers, be it real, or imaginary.
• Selling Costs – Expenditure beyond production costs spent on packaging and promotions
• Independent Decision-making – Each firm decides its own output and prices based on
demand and cost (no price collusion)
• Imperfect Knowledge - (monopolistic market) is characterised by distortion of market
conditions by the sellers
• Unrestricted Entry and Exit – Mobility of resources is unrestricted, hence, new firms can
easily imitate the existing products and enter the market, whereas a loss making firm can
leave the industry in the long run.
Demand and marginal revenue curves for a monopoly firm
• Normal demand curve for a firm under monopolistic competition.
• Negative slope due to selling heterogeneous products that are close
substitutes. Substitution effect leads to the negative slope.
• Firms under monopolistic competition can independently determine price and
output.
• Unlike perfect competition, they have flexibility in setting the optimal
combination of price and output.
• Demand curve is highly price elastic.
• Small price changes result in gaining or losing some customers.
• Larger price reductions can attract more customers from rivals.
• AR (Average Revenue) and MR (Marginal Revenue) curves are similar to
those in monopoly.
• Departure: Demand is highly elastic in monopolistic competition, whereas it is
highly inelastic in monopoly.
• The slope of the demand curve for monopolistic competition is flatter
compared to a monopolist.
• The AR and MR curves in monopolistic competition resemble those in
monopoly.
Price and Output decisions in short run
• We assume here that firm follows the rule of MR=MC when MC is rising.
• Like monopoly, there can be three possible cases of profits of a firm under
monopolistic competition in the short run.
 Case of Super normal profits
• In the short run, the monopolistically competitive firm
can earn supernormal profit. As the firm maximises
profit at a point where (i) MR = MC and (ii) MC cuts
MR from below, the point of equilibrium in Figure 12.2
is at point E, with the equilibrium price at OP; and
output at OQy. So the total revenue earned by the firm
by selling OQj at OP;; is given by the rectangular area
OP;BQ; (the area below the AR curve). To produce this
equilibrium output OQ, the total cost incurred by the
firm is given by the rectangular area OAEQ;; (the arca
below the AC curve). Therefore, the total profit
(supernormal) earned by the firm is given by the
rectangular region 4 EBP;;, because price Py is greater
than average cost.
 Case of normal profits
• Not all firms in the market can earn supernormal profits
in the short run; some firms may also earn normal
profits. This situation occurs when the average cost is
just equal to average revenue and the AC curve is
tangent to the AR (demand) curve, given in Figure 12.3.
Equilibrium here occurs at point £ where the conditions
of profit maximisation are satisfied. At E, the output that
maximises profit is OQ; and price is OP;;. The total
revenue earned by the firm by selling OQ; is the
rectangular area OQBP. Similarly, the total cost of
producing OQy is also given by the area OQ;BPy. Profit
being the difference between total revenue and total cost
is thereby nil. The firm in this case neither makes
economic profit nor loss, in other words, it makes
normal profit.
 Case of Loss
• In the shortrun, a monopolistically competitive firm can
also incur loss, i.e., when average B revenue is less than
average cost, or when the e T, AC curve is over and
above the price line.
• As shown in Figure 12.4, the equilibrium point in this
case is at point £, with equilibrium level of output at
OQy and price OPy.
• Now, the firm earns total revenue given by the
rectangular area OP;CQy (as in the carlier cases).
• But the cost of producing OQ, level of output is given
by the rectangular area OABQ;.
• Thus, the total cost of producing OQ is more than the o
revenue earned by selling OQg. The amount of loss
incurred by the firm is given by the Fig.12.4 Loss in
Short Run area ABCP.
 Price and output decisions in longrun
• In the long run, the same situation would exist for
monopolistic competition as in perfect competition,
in other words, all the firms would earn normal
profits.
• If any firm is earning supernormal profit, this would
attract new firms to enter the industry in the long
run.
• This is nothing but added competition, and would
result in a shift in the original demand curve and
MR curve of the firm downwards, signifying a
decrease in market share of the original firm (i.e.,
decrease in demand for its product). For the sake of
simplicity, we assume here that aggregate market
demand remains the same.
• This shift will continue till all the firms in the market earn only normal
profits. Consider the opposite situation, in which some of the existing
firms are making losses. Due to freedom to exit the industry, some firms
would leave the industry in the long run, causing the demand curve to
shift upwards to the right. This shift will continue till the firms in the
market earn only normal profits. As such, with relatively free entry and
exit, AC and demand curves of a firm will be driven towards tangency, as
at point B in Figure 12.5. The equilibrium is at E, with price Py and quantity
Q.
 Oligopolistic
• The word oligopoly is derived from the Greek word “oligo” meaning few and “polo”
meaning to sell; it means a market with a few sellers. Oligopoly consists of characteristics
of various other markets; let us see how.
• Normally, there are a small number of sellers (or producers) in such a market; however
there can be many sellers (just like in monopolistic competition) as well, with a few very
large sellers dominating the market.
• The products sold in an oligopoly may be homogenous or identical (like in perfect
competition), or may be differentiated (like in monopolistic competition).
• In a nutshell, it can be said that oligopoly is a kind of market where a few dominant
sellers (oligopolists) sell differentiated or homogenous products under continuous
consciousness of rivals’ actions.
• When there is product differentiation among the sellers, the market is called
differentiated oligopoly or oligopoly with product differentiation and in case of identical
products, the market is called pure oligopoly or oligopoly without product differentiation.
• Let us now look at the main characteristics of this market.
• Features of Oligopoly
• Few Sellers Few Buyers.
• The word “oligopoly” itself implies a market dominated by a few sellers, although the term few’ is
ambiguous and does not specify any particular number of players.
• Product The product under oligopoly may be differentiated (like cars, motorbikes, televisions,
washing machines, and soft drinks) or homogenous
• Entry Barriers There are no legal barriers as such to enter the market under oligopoly. However, at
the same time there are various economic barriers which restrict the number of firms in the market.
us (like petrol, cement, steel and aluminum).
• Interdependent Decision-Making As has been pointed out earlier, the single most distinctive feature
of oligopoly is that, one firm cannot take any decision independent of other firms.
• There are few firms in the industry and each is selling a product which is either a perfect substitute
(homogenous) or a very close substitute (differentiated).
 Types of Oligopoly
• Duopoly a special case of oligopoly with only two players in the market.
• Pepsi and Coca Cola have converted the soft drink market in a duopoly through mergers and acquisitions.
Before establishment of Maruti Udyog Ltd. (MUL), the Indian auto industry too was a duopoly with
Premier and Hindustan Motors as the only two players.
• In Delhi, Times of India and Hindustan Times have created a duopoly like situation due to their dominance
among newspaper readers.
• Cournot’s Model
• Augustin Cournot has illustrated the market situation under oligopoly with an example of two firms
engaged in the production and sale of mineral water. Each firm owns a spring of mineral water, which is
available free from nature.
• The crux of this model is a situation in which the firms ignore interdependence and take decisions as if
they are operating independently in the market.
• One firm enters the market first and the other firm follows. Cournot has made a few assumptions to build
this model which, in modern context, may appear very simplistic, but it sets a precursor to more advanced
models on oligopoly.
• Assumptions of Cournot’s Model (i) Each firm aims at maximizing profit, i.e., equilibrium will be at MC =
MR.
• (ii) Cost of production is nil because the springs are available free from nature, i.e., MC = 0.
• (iii) Market demand is linear; hence the demand curve is a downward sloping straight line.
• (iv) Each firm decides on its price assuming that the other firm’s output is given (i.e., the other firm will
continue to produce and sell the same amount of output in next period).
• (v) Firms sell their entire profit maximising output at the price determined by their demand curves.

Firm 4 is the first entrant to the market of mineral water. Being rational,
this firm would try to maximize its output and would produce till MR =
MC. Its demand curve is given as DD* and MR is its marginal revenue
curve. To maximize profit, firm 4 will produce where MC = MR; since MC
= 0, therefore, at equilibrium MR = MC = 0. Hence, it will produce OQ ,
output and charge OP, price which is governed by the demand (AR) curve.
You will note that the firm is able to sell to half of the total market
demand. Note further that point 4 is the mid point of DD* .
• A is supplying to one half of the total market. It assumes that A will continue to produce OQ,, and
hence, decides to consider O ,D* as the market available to it and AD* as its demand curve.
• Thus, its MR curve will be MR 5. Now B too will try to maximise its profit and will produce till its
MC = MR, i.e., O, because at this point its cost of production is nil (MR = MC = 0).
• In this way, firm B will produce O, output and sell at price OPg. As an outcome of this process, 4
supplies to half of the total market and B supplies to half of the remaining half.
• In other words, 4 and B together supply to three-fourth of the total market, while one-fourth remains
unattended.
Stackelberg’s Model
• Stackelberg’s Model German Economist H.V. Stackelberg developed his model,
popularly known as the Leader Follower Model, as an extension of the model of
Cournot.
• He assumes that one of the players is sufficiently sophisticated to recognize that the
rival firm acts according to Cournot’s assumption.
• As is obvious, the naive firm will act as follower, like the one in Cournot’s model.
• Figure 13.4 illustrates the reaction functions of oligopoly firms in Stackelberg’s
model.
• Point E shows Cournot’s equilibrium, where both firms are producing equal output
and selling at the same price.
• As per Stackelberg’s model, if firm A is the sophisticated firm, it will operate within
the area R𝐴 ER, and will try to produce that output at which it can maximise its profit,
shown at point a in the figure.
• Here A will produce OX𝐴 , and B will be contended with OX𝐵 .
• In this case, firm B will act as a follower and accept the leadership of 4 and act
accordingly.
➢ On the other hand, if firm B is the sophisticated firm, it will
produce within RzER; and will be at equilibrium at point b,
producing Ox.
➢ In this case, firm A will act as the follower and accept B’s
leadership, will produce only OX.
➢ What if both firms are sophisticated? In that case, there will be a
price war like situation and will either result in a cartel or in the
final emergence of one firm as the leader.
➢ In the figure, R,R curve is the reaction function of firm 4 and
RzRp, is the reaction function of firm B.
➢ E is the point of equilibrium at which firm 4 is producing X,
amount of output and firm B is producing Xj amount of output.

➢ Note that at this point, both the firms are in equilibrium because
they are maximising their profits and have no tendency to change
the output.
➢ However, this point is reached when each firm is able to assess
the other’s output correctly, and this is achieved after a series of
changes in output by each firm in anticipation of the other’s
output remaining unchanged, as discussed above.
Kinked Demand
• Thus, an oligopolist faces an indeterminate curve, as you have seen in earlier sections.
• Taking this to be the most distinct characteristic of oligopoly, Sweezy developed a model which is still
considered to be the most suitable explanation of the behaviour of a firm in an oligopoly market.
• According to him, such firms do not prefer to enter into a price war like situation; therefore they stick to the
current price and resort to non-price competition strategies like advertisement and sales promotion, and
product differentiation.
• The demand curve is more elastic above the kink and less elastic below the kink.
• This is further explained by the above mentioned behavioral assumptions that if one firm reduces its price,
other firms will also reduce their price, simply because the products are very close substitutes and other firms
will fear that by reducing price the first firm will capture larger market share.
• As a result, the firm which had initially reduced its price does not get the expected advantage of price
reduction and thus, faces a highly elastic demand curve.
• No firm will follow in this case and hence, the firm will lose large number of its customers to rivals due to
substitution effect.
• Thus, a firm under oligopoly has no option but to stick to its current price. Hence, at current price a kink is
developed in the demand curve.
• Have a close look at the demand curve of an oligopoly firm
in Figure 13.5, with the kink at point K.
• The curve is more elastic above the kink (current price) and
less elastic below the kink.
• OP is the current price at which the oligopolist can sell OQ
output.
• DK shows the highly elastic portion of the demand curve
due to no reaction by rivals in the event of increase in
price; KD, shows the less elastic portion, when rival firms
react with a price reduction.
• This discontinuity in the demand curve (AR) creates
discontinuity in the MR curve as well, as is shown in the
figure. At the kink, MR is constant between point 4 and B.
• Hence, the producer will produce the same amount of
output (OQ), whether it is operating on MC, or MC, since
the profit maximising conditions are being fulfilled at
points S as well as 7.
• If the marginal cost fluctuates between points 4 and B, the
firm will neither change its output nor its price.
• It will change its output and price only if MC moves above
4 or below B.
Case Study

‘Nickel’ Coke The price of a 6.5 oz Coke was 5 (one nickel) starting on 29 May 1886, the day it
was first introduced to the public in Atlanta, until about 1959, thus creating a history of a
nominal price rigidity that lasted more than 70 years.
The case of Coca Cola is particularly interesting because during the 70-year period there were
major events like the two World Wars and the Great Depression, along with substantial changes
in the structure of the soft drink market, as well as numerous regulatory interventions, which
led to substantial changes in the demand and supply conditions.

Yet the company insisted that the price of Coke be held at 5.

In addition, the incredibly long period of the Coca Cola price rigidity was accompanied by
equally long lasting Coca Cola quality rigidity.
Case Study

Differentiation in Air With the entry of a new competitor in the premium air services space, Vistara, a
joint venture between Tata Sons and Singapore Airlines, the war between Indian full-service airlines is
being fought through their loyalty programmes. The prominent loyalty programmes for flyers in India
are: Flying Returns by Air India, Jet Privilege by Jet Airways and Club Vistara by Vistara. Flying
Rectums by the state-owned Air India brings the advantage of being a Star Alliance Partner. Jet Privilege
has the advantages of multiple ways to accrue points, in addition to similar benefits on 150+ programme
partners across industries. Club Vistara has changed the rules of the game as far as the structure of
rewards programmes is concerned, by being the first to introduce accumulation of points on the basis of
ticket prices, i.e., more points for flights with higher fares. Vistara has also done away with the concept of
a physical loyalty card and has introduced an online account which would help in marginally reduced
costs. Jet Airways has retaliated by introducing a new scheme whereby customers can upgrade to a higher
tier of the loyalty programme based on the value of ticket as well as the distance and frequency of travel.
Earlier accumulation of points was only linked to the miles travelled, irrespective of ticket price. Jet has
also doubled and tripled the number of miles its passengers earn on routes on which Vistara operates.
Needless to say in this new kind of war of differentiation, passengers shall gain immensely.
Thank You