Theory of The Firms

Unit 6 – Theory of the Firms
• Meaning of Perfect Competition

• Characteristics of Perfect Competition
• Supply Curve of Perfect Competition
• Demand Curve of Perfect Competition
• Short-run Equilibrium of Perfect Competition Firm
• Shut Down Position of Perfect Competition
• Price and Output Determination under Perfect Competition in the Long Run
of a Firm
• Price and Output Determination under Perfect Competition in the Short-Run
of an Industry
• Price and Output Determination under Perfect Competition in the Long-Run
of an Industry
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Unit 6 – Theory of the Firms
• Meaning of Monopoly
• Characteristics of Monopoly
• Causes of Monopoly
• Demand and Revenue Curves under Monopoly
• Price Output Determination under Monopoly or Short run Equilibrium of
Monopoly
• Long Run Equilibrium under Monopoly
• Comparison between Perfect Competition and Monopoly
• Meaning of Price Discriminating Monopoly
• Types and Degrees of Price Discriminating Monopoly
• Conditions of Price Discrimination
• Conditions making Price Discrimination Possible and Profitable
• Price Output Determination under Price Discriminating Monopoly
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Introduction
• The theory of the firm is a foundational concept in economics that explores the
behavior and decision-making of businesses (firms) in various market
environments. It seeks to answer fundamental questions about how firms operate,
why they exist, and how they make choices to maximize their objectives, typically
profit. Firms aim to maximize their objectives, which is most commonly profit.
Profit is the difference between total revenue (the income generated from selling
goods or services) and total cost (the expenses incurred in producing those goods
or services).Production: Firms use inputs, such as labor, capital, and raw materials,
to produce outputs, which are the goods or services they offer to consumers. The
production process is analyzed through production functions, which show how
inputs are transformed into outputs. The behavior of firms depends on the market
structure in which they operate. Different market structures, such as perfect
competition (many firms, identical products), monopoly (one firm dominates),
oligopoly (few large firms), and monopolistic competition (many firms with
differentiated products), influence pricing, competition, and firm behavior.
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Introduction
• Perfect competition is a foundational concept in economics that represents an
idealized market structure characterized by specific conditions and behaviors. In a
perfectly competitive market, there are many buyers and sellers, homogeneous or
identical products, perfect information, and no barriers to entry or exit. Perfect
competition serves as a theoretical benchmark for understanding how markets
operate under conditions of extreme competition and transparency. While it is
rarely found in real-world markets, it provides valuable insights into pricing,
production, and resource allocation in competitive industries.
• A monopoly is a market structure that represents the extreme opposite of perfect
competition. In a monopoly, there is a single seller or producer that dominates the
entire market and has significant control over prices and supply. Monopolies are
relatively rare in the real world due to their potential for abuse and negative effects
on consumer welfare. However, when they do exist, they have a significant impact
on pricing, consumer choice, and market dynamics. Understanding monopolies is
crucial for both economic analysis and public policy discussions regarding market
competition and regulation.
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Introduction
• A discriminating monopoly, also known as price-discriminating
monopoly, is a type of monopoly that charges different prices for the
same product or service to different groups of consumers. Unlike a
standard monopoly, which charges a uniform price to all consumers, a
discriminating monopoly engages in price discrimination to maximize
its profits.
• Price discrimination is a common strategy employed by many firms in
various industries, such as airlines, entertainment, and software. While
it can lead to increased profits for the monopolist, it also raises ethical
and regulatory questions related to fairness and consumer protection.
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Objectives of Unit 6
• Meaning of Perfect Competition
• Discuss the Characteristics of Perfect Competition
• Draw the Supply Curve of Perfect Competition
• Draw the Demand Curve of Perfect Competition
• Explain the Price Output determination of Perfect Competition Firm
• Briefly explain the Shut Down Position of Perfect Competition
• Price and Output Determination under Perfect Competition in the
Long Run of a Firm
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Short-Run of an Industry
Long-Run of an Industry
• Meaning of Monopoly
• Discuss the Characteristics of Monopoly
• Causes of Monopoly
• Draw the Demand and Revenue Curves under Monopoly
• Price Output Determination under Monopoly or Short run Equilibrium
of Monopoly
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• Long Run Equilibrium under Monopoly
• Comparison between Perfect Competition and Monopoly
• Meaning of Price Discriminating Monopoly
• Types and Degrees of Price Discriminating Monopoly
• Conditions of Price Discrimination
• Conditions making Price Discrimination Possible and Profitable
• Price Output Determination under Price Discriminating Monopoly
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Perfect Competition - Meaning
• The concept of perfect competition was first introduced by Adam Smith in
his book "Wealth of Nations". Later on, it was improved by Edgeworth.
However, it received its complete formation in Frank Kight's book "Risk,
Uncertainty and Profit" (1921).
• Leftwitch has defined market competition in the following words:
• "Prefect competition is a market in which there are many firms selling
identical products with no firm large enough, relative to the entire market,
to be able to influence market price".
• According to Bllas:
• "The perfect competition is characterized by the presence of many firms.
They sell identically the same product. The seller is a price taker".
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Perfect Competition - Meaning
• Perfect competition describes a market structure in which many sellers and
buyers exchange a homogeneous good and no individual can influence the
market price, i.e., buyers and sellers are price takers. In this market,
consumers have full or perfect knowledge about the product that is on sale.
They know what firm charges what price for a specific product. There is a
perfect mobility in terms of resources including labor, and there are no
barriers to entry and exit involved for such firms. In a perfectly competitive
market total welfare (that is, the sum of consumer and producer surplus) is
maximal. As there is no deadweight loss, the equilibrium allocation in
perfect competition usually serves as a benchmark to measure the welfare
loss associated with market structures that are not perfectly competitive
(e.g. because one side of the market has market power).
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Characteristics of Perfect Competition
• 1. A Large Number of Buyers and Sellers:
• Under perfect competition there are a large number of buyers and
sellers of a commodity. The numbers of buyers are so many that a
single buyer buys a very small part of the market supply. Similarly, a
single seller supplies a very small part of the total output. For this
reason, the size of a competitive firm becomes very small in relation to
the industry to which it belongs.
• 2. An Identical or a Homogeneous Product:
• All the sellers in a perfectly competitive market supply an identical
product. In other words, the products of all the competitive firms are
the same.
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• 3. No Individual Control over the Market Supply and Price:
• As many sellers are selling an identical product, a single firm supplies a
negligible or an insignificant portion of the industry. For this reason, it has
no control over market supply and market price. In other words, a single
firm cannot bring about an appreciable change in total supply through the
variation in its own supply. As a result it cannot influence the market price
through its own independent action.
• For this reason, a competitive firm is described as “a price-taker, not a
price-maker”, and it has to sell all the units of its own output at the
prevailing market price. From this it follows that the demand curve or the
average revenue curve of a competitive firm becomes a horizontal line. As
the price remains the same for all units of output, its marginal revenue curve
becomes identical with the average revenue curve.
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• 4. No Buyers’ Preferences:
• In a perfectly competitive market there is no preference of buyers for the
product of any particular seller. As the products of all the sellers are
identical, buyers can buy the product from any of them.
• 5. Perfect Knowledge:
• Again, both buyers and sellers have a perfect or full knowledge relating to
the price prevailing in the market. For this reason, there can exist only one
price in a perfectly competitive product market.
• 6. Perfect Mobility of Factors:
• The factors of production like labour or capital can freely move into the
industry or freely go out of the industry. This is necessary to keep a proper
balance between demand and supply of a commodity.
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• 7. Free Entry and Free Exit of Firms:
• In this type of market new firm can freely enter the industry or an existing
firm can freely leave the industry in the long run.
• 8. Absence of Transport Cost and a Close Contact between Buyers and
Sellers:
• A market becomes perfectly competitive when both buyers and sellers stay
at the same place so that there is a close contact between them. Because of
this, neither buyers nor sellers have to bear any transport cost. If the same
price is to prevail in all parts of the market, it is necessary that there is no
transport cost. In the presence of any transport cost, prices will differ in the
different segments of the same market.
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Supply Curve of Perfect Competition
• A perfectly competitive firm’s supply curve shows how the firm’s
profit-maximizing output varies as the market price varies, other
things remaining the same.
• Because the firm produces the output at which marginal cost equals
marginal revenue, and because marginal revenue equals price, the
firm’s supply curve is linked to its marginal cost curve.
• But at a price below the shutdown point, the firm produces nothing.
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• The following figure shows how the
firm’s supply curve is constructed.
• If price equals minimum AVC, $17 in
this example, the firm is indifferent
between producing nothing and
producing at the shutdown point, T.
• If the price is $25, the firm produces 9
sweaters a day, the quantity at which P
= MC.
• If the price is $31, the firm produces
10 sweaters a day, the quantity at
which P = MC.
• The blue curve in part (b) traces the
firm’s short-run supply curve.
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Demand Curve of Perfect Competition
• No individual firm can affect the market price
• Demand curve facing each firm is perfectly elastic
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Short-run Equilibrium of Perfect Competition Firm
• Short period is the span of time so short that existing plants cannot be
extended and new plants cannot be erected to meet increased demand.
However, the time is adequate enough for producers to adjust to some
extent their output to the increase in demand by overworking their
fixed capacity plants. In the short run, therefore, supply curve is
elastic. The average and marginal cost curves of the firm together with
its demand curve. Demand curve, in a perfectly competitive market, is
also the average revenue curve and the marginal revenue curve of the
firm. The marginal cost intersects the average cost at its minimum
point. The U-shape of both the cost curves reflects the law of variable
proportions operative in the short run during which the size of the
plant remains fixed.
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Short-run Equilibrium of Perfect Competition Firm-Conditions
of Equilibrium
• Two conditions must be satisfied-
• 1.) A marginal income must be at least equal to the marginal cost, that is,
MR=MC. If MR is higher than MC, there is always a reason for the company to
increase production even more and profit after selling extra costs instead of
reducing output, as the additional unit is more to the cost than revenue. Profits are
maximum only at the point where MR=MC, which is first order condition.
However, this condition is not sufficient, since it may be fulfilled and yet the firm
may not be in equilibrium. The following figure shows that marginal cost is equal
to marginal revenue at point T, the firm is not in equilibrium at OQ1 output,
because output OQ2 is greater than OQ1 which is at point R. So, we need to
second order condition.
• (b) The second order and necessary condition for equilibrium requires that the
marginal cost curve cuts the marginal revenue curve from below i.e. the marginal
cost curve be rising at the point of intersection with the marginal revenue curve.
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Short-run Equilibrium of Perfect Competition Firm-Conditions of
Equilibrium
• Thus, a perfectly competitive firm will adjust its output at the point
where its marginal cost is equal to marginal revenue or price, and
marginal cost curve cuts the marginal revenue curve from below.
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Short-run Equilibrium of Perfect Competition
Firm-Assumptions of Equilibrium
• 1. Large Number of Buyers and Sellers
• 2. Homogeneous Products
• 3. No Discrimination
• 4. Perfect Knowledge
• 5. Free Entry or Exit of Firms
• 6. Perfect Mobility
• 7. No Selling Cost
• 8. No Transport Costs
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Short-run Equilibrium of Perfect Competition
Firm-Analysis of Equilibrium
• There are three possible cases in the short run.
• 1. If AR>AC, it implies firm obtains Abnormal Profit or Supernormal
Profit or excess profit
• 2. If AR=AC, it implies firm obtains normal profit
• 3. If AR<AC, it implies firm incurs losses.
• The following figure shows the measurement of price and output of
the firm in the short run.
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Equilibrium of the Firm in the Short Run - Abnormal
Profit or Supernormal Profit or excess profit
• A business may make unusual profits at
the equilibrium level of output when its
average earnings exceed the cost of
production by an average. In diagram
6.7, the firm’s equilibrium is at point E
when the MC curve meets with the MR
curve. When the firm is at OP prices, the
company generates OQ output. The
company’s average income (AR) equals
EQ when it produces OQ output. Its
average cost (AC) will be BQ because AR
is higher than AC. Firms get abnormal
profits. In the end, companies experience
per unit abnormal profits (EB). So, the
total profits equal to (PABE), the per-unit
profit EB multiply by total output OQ.
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Equilibrium of the Firm in the Short Run - Losses
• In the event of an equilibrium

output, firms can suffer losses. A
seller might not recoup a portion of
fixed costs in the short term.
Despite these losses, the company
may choose to produce to cover its
average variable costs. In figure
6.8, the equilibrium value and, at
this point, AR=EQ while AC=BQ
as BQ is greater than EQ. The firm
earns BE per unit loss, and the total
loss is the amount of ABEP.
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Equilibrium of the Firm in the Short Run -
Normal profits or Break-Even
• If the company only covers its
total costs, it makes normal
profits, here AR = ATC=EQ.
Figure 6.9 illustrates at E
MR=MC, the final output of the
equilibrium is called OQ. Since
AR=ATC=EQ, per unit profit is
EQ, the total revenue and total
cost is equal, so, the company
gets normal profits.
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Shut Down Position of Perfect Competition
• The shut down price are the conditions and price where a firm will decide to
stop producing. It occurs where AR <AVC
• The shut down price is said to occur, where price (average revenue AR) is
less than average variable costs (AVC).
• At this price (AR<AVC), the firm is making an operating loss. The total
revenue is less than operating (variable) costs.
• A firm can keep producing, even if AR < ATC (average total costs) because
they are making a contribution towards fixed costs which have been paid
anyway.
• The shutdown price is P1 or less.
• Between P1 and P2, the firm is making an economic loss but will continue
in the short term.
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Shut Down Position of Perfect Competition
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Evaluation of shut-down price
• In the real world, there are circumstances where firms will continue to
produce – even if AR < AVC.
• For example, if there is a temporary fall in demand, due to a recession, a
firm may prefer to keep producing – so they don’t lose long-term
customers.
• If a firm can gain access to credit (loan) or if it has high savings, it can
afford to run an operating loss for a short time.
• If a firm sees AR<AVC, they may respond – not by shutting down, but
trying to cut costs and/or increase the prices.
• It is possible, a firm will shut down, even if the price is greater than average
variable costs. For example, the firm may be pessimistic about the growth
of this particular market and feel there is a high opportunity cost to staying
in a declining industry.
• In the real world, it may take time for a firm to realize they are making an
operating loss.
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Price and Output Determination under Perfect
Competition in the Long Run of a Firm
• The ability to enter or leave firms is not a problem in a highly
competitive market. The firms that are inefficient are then able to lose
money and close the business or improve their effectiveness. New
companies attract profit-driven firms to establish because of the
entrance of new producers, the quantity of the commodity rises, and
the cost of the commodity falls.
• All firms are at break-even because of the loss of profits. It results
from the long-term equilibrium between the industry and firm in a
perfect market. Also, price and output determination under perfect
competition, whereas all firms break even and make regular profits in
the long term. Firms operate in a zero-loss-no-profit scenario where
AR=AC is graphically plots in Figure 6.10.
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Competition in the Long Run of a Firm
• In figure 6.10, in this output stage,
the price and output determination
under perfect competition is as the
average revenue and average cost
are the same as QS, while OQ
represents the equilibrium value.
Because of this, the firm will only
earn regular profits. In this case, as
the average cost is low, the average
and marginal costs will remain the
same, so the long-term equilibrium
conditions for a business will be:
MR=LMC=LAC= Price.
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Price and Output Determination under Perfect Competition in
the Short-Run of an Industry
• When the total output is constant and shows no sign of expansion or
decrease in output, the industry is considered to be in equilibrium for
the short term. Thus, the business is in equilibrium when the entire
industry is at equilibrium. It implies that the equilibrium is complete
for the business in the short-term when all companies realize the
average profit. The prerequisite for this is SMC=MR=AR=SAC. The
market’s equilibrium is an unexpected and accidental event because, in
the short term, some firms may earn more than average profits or
experience losses.
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Competition in the Short-Run of an Industry
• Even then, the business is in short
equilibrium, at the price at which it
can clear the market, where the
demand of quantity is greater than the
quantity supply. In figure 6.11 the
figure shows that in panel (1), the
industry is at equilibrium at the point
E that its demand curve and its supply
curve S intersect. At the current price
OP, some companies have been able to
earn extraordinary profits PE1ST, as
shown in Panel (2). Other firms are
suffering FGE2P affections, as
illustrated in Panel (3) of Figure 6.11.
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Price and Output Determination under Perfect Competition in
the Long-Run of an Industry
• These are the primary conditions for price and output determination under perfect competition that
establish the equilibrium of a higher market.
• 1.) In the long run, there is an long run marginal cost equal to the industry’s losses, producing an
output level equal to the equilibrium that equals the marginal revenue from the long run (LMC=
LMR). The total production of the industry consists of the output total of these companies
• 2.) There must be a set amount of firms within the field, and the entry of new firms is not
allowable. In these cases, each firm should be earning average profits to the point at which either
price or LAR=LAC is the same for all the companies. The business will not reach a steady
equilibrium over the long term unless all companies make normal profits. If the same companies
make an excessive profit, new participants will encourage to join, results in changes in supply and
market prices over the long term. Therefore, for an industry to achieve equilibrium, it is helpful for
all companies to earn regular profits over the long run.
• 3.) A long equilibrium value is resolute to achieve equality between all quantities of goods and
services supplied over the long term in market liquidation. The equilibrium in the market’s long run
is shown in figure 6.12.
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Competition in the Long-Run of an Industry
• Figure 6.12 The long-run price and
output determination under perfect
competition, OP determines the price
by the intersection of the Supply
curve, S, and Demand curve D. At this
rate, the equilibrium for the firm is in
calculation through the consumption
of LMR = LMC. This means that OM
is the output at the firm’s equilibrium
over the long term. There is a
complete equilibrium position.
Price=LAR=LMR=LAC=LMC. In
this way, the firm has normal earnings.
Long-run equilibrium, Price
LAR=LAC=LMR=LMC.
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Price and Output Determination Under Perfect
Competition in the Long-Run of an Industry
• In other words, the number is stable when all firms are at equilibrium, making
normal profits. The market supply position remains stable in the long term and
with the specified demand D in (Figure 6.12 Panel 1). The long-run price and
output determination under perfect competition and equilibrium value (OP) is set,
placing the industries within the longer-run equilibrium. Firms operating under
homogeneity conditions have identical cost functions and should be operating at
the minimum level that LAC can reach (figure 6.12 Panel 2).
• Some companies are quitting the business over time because they’re not efficient
when it comes to higher-level cost functions, i.e., LAC price. Inability to make
normal profits and unable to keep losses in check. In the end, firms’ and
industries’ long-term equilibrium conditions are Long-Run Equilibrium
Price=LAR=LAC=LMR=LMC. In the long run, price and output determination
under perfect competition and the equilibrium conditions for firms include Long
Run Equilibrium Price = LAR = LAC LMR = LMC.
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Meaning of Monopoly
• The word monopoly has been derived from the combination of two words
i.e., ‘Mono’ and ‘Poly’. Mono refers to a single entity and poly to control.
In this way, monopoly refers to a market situation in which there is only one
seller of a commodity.
• There are no close substitutes for the commodity that monopoly firm
produces and there are barriers to entry. The single producer may be in the
form of individual owner or a simple partnership or a joint stock company.
In other words, under monopoly there is no difference between firm and
industry.
• Monopolist has full control over the supply of commodity. Having control
over the supply of the commodity, it exercises the market power to set the
price. Thus, as a single seller or producer monopolist may be a king without
a crown. If there is to be an effective monopoly, the cross elasticity of
demand between the product of the monopolist and the product of any other
seller must be very small.
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Definitions of Monopoly
• “Pure monopoly is represented by a market situation in which there is
a single seller of a product for which there are no substitutes; this
single seller is unaffected by and does not affect the prices and outputs
of other products sold in the economy.” -Bilas
• “Monopoly is a market situation in which there is a single seller. There
are no close substitutes of the commodity it produces, and there are
barriers to entry”. -Koutsoyiannis
• “Under pure monopoly there is a single seller in the market. The
monopolist’s demand is market demand. The monopolist is a price-
maker. Pure monopoly suggests no substitute situation”. -A. J. Braff
• “A pure monopoly exists when there is only one producer in the
market. There are no dire competitors.” -Ferguson
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Characteristics of Monopoly
• 1) Single Seller: There is only one seller; he can control supply of his product.
But he cannot control demand for the product, as there are many buyers.
• 2) No close Substitutes: There are no close substitutes for the product. Either they
have to buy the product or go without it.
• 3) Control over price: The monopolist has control over the supply and thereby on
price. Sometimes he may adopt price discrimination. He may fix different prices
for different sets of consumers. A monopolist can either fix the price or quantity of
output; but he cannot do both, at the same time.
• 4) No Entry: There is no freedom to other producers to enter the market as the
monopolist is enjoying monopoly power. Barriers for new firms to enter are
strong. There are legal, technological, economic and natural obstacles, which may
block the entry of new producers.
• 5) No difference between Firm and Industry: Under monopoly, there is no
difference between a firm and an industry. As there is only one firm, that single
firm constitutes the whole industry.
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Causes of Monopoly
• 1) Natural: A monopoly may arise on account of some natural causes. Some minerals are available
only in certain regions. For example, South Africa has the monopoly of diamonds; nickel in the
world is mostly available in Canada and oil in Middle East. This monopoly is caused by natural
availability of resources.
• 2) Technical: Monopoly power may be enjoyed due to technical reasons. A firm may have control
over raw materials, technical knowledge, special know-how, scientific secrets and formula that
enable a monopolist to produce a commodity, e.g., Coco Cola.
• 3) Legal: Monopoly power is achieved through patent rights, copyrights and trademarks by the
producers. This is called legal monopoly.
• 4) Large Amount of Capital: The manufacture of some goods requires a large amount of capital
or lumpiness of capital. All firms cannot enter the field because they cannot afford to invest such a
large amount of capital. This may give rise to monopoly. For example, iron and steel industry,
railways, etc.
• 5) State: Government will have the sole right of producing and selling some goods. They are State
monopolies. For example, in India we have public utilities like electricity, railways, water supply.
These public utilities are generally run by the State.
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Demand and Revenue Curves under
Monopoly
• An individual firm under perfect competition does not face a downward-
sloping demand curve. But in the case of monopoly one firm constitutes the
whole industry. Therefore, the entire demand of the consumers for a product
faces the monopolist. Since the demand curve of the consumers for a
product slopes downward, the monopolist faces a downward sloping
demand curve.
• Consider Figure, DD is the demand curve facing a monopolist. At price OP
the quantity demanded is OM, therefore he would be able to sell OM
quantity at price OP. If he wants to sell a greater quantity ON, then he has to
price it OL. If he restricts his quantity to OG, the price will rise to OH.
• Thus, every quantity change by him entails a change in price at which the
product can be sold. The problem faced by a monopolist is to choose a price
quantity combination which is optimum for him, that is, which yields him
maximum possible profits.
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Monopoly
• Demand curve facing the
monopolist will be his average
revenue curve. Thus, the average
revenue curve of the monopolist
slopes downward throughout its
length. Since average revenue
curve slopes downward, marginal
revenue curve will lie below it.
This follows from usual average-
marginal relationship. The
implication of marginal revenue
curve lying below average revenue
curve is that the marginal revenue
will be less than the price or
average revenue.
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Monopoly
• When monopolist sells more, the
price of his product falls;
marginal revenue therefore must
be less than the price. In the
Figure, AR is the average
revenue curve of the monopolist
and slopes downward. MR is the
marginal revenue curve and lies
below AR curve. At quantity
OM, average revenue (or price)
is MP and marginal revenue is
MQ which is less than MP.
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Price Output Determination under Monopoly
or Short run Equilibrium of Monopoly
• Under monopoly, for the equilibrium and price determination, two
different conditions need to be satisfied:
• 1) Marginal revenue must be equal to marginal cost.
• 2) MC must cut MR from below.
• However, there are two approaches to determine equilibrium price
under monopoly viz.;
• 1) Total Revenue and Total Cost Approach.
• 2) Marginal Revenue and Marginal Cost Approach.
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Short run Equilibrium of Monopoly
• According to marginal revenue and marginal cost approach, a monopolist
will be in equilibrium when two conditions are fulfilled i.e.,
• 1) Marginal revenue must be equal to marginal cost, i.e., MC = MR and
• 2) MC must cut MR from below.
• Short period refers to that period in which the monopolist has to work with
a given existing plant. In other words, the monopolist cannot change the
fixed factors like, plant, machinery etc. in the short period. Monopolist can
increase his output by changing the variable factors. In this period, the
monopolist can enjoy super-normal profits, normal profits and sustain
losses.
• These three possibilities are described as follows:
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• Super Normal Profits
• If the price determined by the monopolist in more
than AC, he will get super normal profits. The
monopolist will produce up to the level where
MC=MR. This limit will indicate equilibrium
output. In the figure, the output is measured on X-
axis and price on Y-axis. SAC and SMC are the
short run average cost and marginal cost curves
respectively while AR and MR are the average
revenue and marginal revenue curves respectively.
• The monopolist is in equilibrium at point E because
at point E both the conditions of equilibrium are
fulfilled i.e., MR = MC and MC intersects the MR
curve from below. At this level of equilibrium the
monopolist will produce OQ1 level of output and
sells it at CQ1 price which is more than average
cost DQ1 by CD per unit. Therefore, in this case
total profits of the monopolist will be equal to
shaded area ABDC.
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• Normal Profits
• A monopolist in the short run would enjoy
normal profits when average revenue is just
equal to average cost. We know that average
cost of production is inclusive of normal
profits. This situation can be illustrated with
the help of the following figure.
• In the figure, above the firm is in
equilibrium at point E. Here marginal cost is
equal to marginal revenue. The firm is
producing OM level of output. At OM level
of output average cost curve touches the
average revenue curve at point P. Therefore,
at point ‘P’ price MR is equal to average
cost of the total product. In this way,
monopoly firm enjoys the normal profits.
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• Minimum Losses
• In the short run, the monopolist may have
to incur losses. This situation occurs if in
the short run price falls below the variable
cost. In other words, if price falls due to
depression and fall in demand, the
monopolist will continue to produce as
long as price covers the average variable
cost. Once the price falls below the
average variable cost, monopolist will
stop production. Thus, a monopolist in the
short run equilibrium may bear the
minimum loss, equal to fixed costs.
Therefore, equilibrium price will be equal
to average variable cost. This situation
can also be explained with the help of the
following figure.
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• In the following figure, above monopolist is in equilibrium at point E.
At point E marginal cost is equal to marginal revenue and he produces
OM level of output. At OM level of output, equilibrium price fixed by
the monopolist is OP1. At OP1 price, AVC touches the AR curve at
point A.
• It signifies that the firm will cover only average variable cost from the
prevailing price. At OP1 price, firm will bear loss of fixed cost i.e., A
per unit. The firm will bear the total loss equal to the shaded area PP1
AN. Now if the price falls below OP1, the monopolist will stop
production. It is so, because, if he continues production, he will have
to bear the loss of variable costs along with fixed costs.
49
Long Run Equilibrium under Monopoly
• Long-run is the period in which output can be
changed by changing the factors of production.
In other words, all variable factors can be
changed and monopolist would choose that plant
size which is most appropriate for specific level
of demand. Here, equilibrium would be attained
at that level of output where the long-run
marginal cost cuts marginal revenue curve from
below. This can be shown with the help of the
following figure.
• In following figure, above monopolist is in
equilibrium at OM level of output. At OM level
of output marginal revenue is equal to long run
marginal cost and the monopolist fixes OP price.
HM is the long run average cost. Price OP being
more than LAC i.e., HM which fetch the
monopolist super normal profits. Accordingly,
the monopolist earns JM – HM = JH super
normal profit per unit. His total super normal
profits will be equal to shaded area PJHP1.
50
Comparison between Perfect Competition and Monopoly
• Following points make clear difference between both the monopoly and perfect
competition:
• 1) Output and Price
• Under perfect competition, price is equal to average cost which is equal to marginal cost
at the equilibrium output. Under monopoly, the price is always greater than marginal cost,
it may be less than, equal to or greater than average cost.
• 2) Equilibrium
• Both under perfect competition and monopoly equilibrium is possible only when MR =
MC and MC cuts the MR curve from below.
• 3) Entry and Exit
• Under perfect competition, there exists no restrictions on the entry or exit of firms into the
industry. Under simple monopoly, there are strong barriers on the entry and exit of firms.
• 4) Discrimination
• Under monopoly, a monopolist can charge different prices from the different groups of
buyers. But, in the perfectly competitive market, it is absent by definition.
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• 5) Profits
• The difference between price and average cost under monopoly results in super-
normal profits to the monopolist. Under perfect competition, a firm in the long run
enjoys only normal profits.
• 6) Supply Curve of Firm
• Under perfect competition, supply curve can be known. It is so because all firms
can sell desired quantity at the prevailing price. Moreover, there is no price
discrimination. Under monopoly, supply curve cannot be known. MC curve is not
the supply curve of the monopolist.
• 7) Slope of Demand Curve
• Under perfect competition, demand curve is perfectly elastic. It is due to the
existence of large number of firms. Price of the product is determined by the
industry and each firm has to accept that price. On the other hand, under
monopoly, average revenue curve slopes downward. AR and MR curves are
separate from each other. Price is determined by the monopolist.
52
53
• 8) Goals of Firms
• Under perfect competition and monopoly the firm aims at to maximise
its profits. The firm which aims at to maximise its profits is known as
rational firm.
• 9) Comparison of Price
• Monopoly price is higher than perfect competition price. In long
period, under perfect competition, price is equal to average cost. In
monopoly, price is higher as is shown in figure below. The perfect
competition price is OP1, whereas monopoly price is OP. In
equilibrium, monopoly sells ON output at OP price but a perfectly
competitive firm sells higher output ON1 at lower price OP1.
54
• 10) Comparison of Output

• Perfect competition output is higher
than monopoly output. Under
perfect competition the firm is in
equilibrium at point M1 where AR
= MR = AC = MC are equal. The
equilibrium output is ON1. On the
other hand monopoly firm is in
equilibrium at point M where
MC=MR. The equilibrium output is
ON. The monopoly output is lower
than perfectly competitive firm
output.
55
Comparison between Perfect Competition and Monopoly -
Summary of Comparison
Features Perfect Competition Monopoly
Description A fair, direct competition between buyers Extreme market situation, where there is
and buyers, seller and sellers, and finally only one seller. He has no competition
between buyers and sellers. and so controls supply and price.
Buyers and Large number of buyers and sellers. Only one seller and practically all buyers
Sellers Hence no sellers or buyers can alter the depend on him. Hence he has absolute
price in the market. control over the market.
Supply i) Supply comes from large number of Supply from only one seller, hence
sellers absolute control over the supply.
ii) Individual supply is negligible,
compared to market supply.
Demand Demand is perfectly elastic. Demand Demand is not perfectly. Demand curve
curve faced by a seller is a horizontal slopes downward.
straight line.
Product Homogeneous product. No close substitutes in the market.
56
Comparison between Perfect Competition and Monopoly -
Summary of Comparison
Features Perfect Competition Monopoly
Nature ofPure and perfect competition in No competition at all. No price or
Competition price. product competition.
Price Normal Price P = MR = MC Higher price, higher than all
competitive price. P > MR = MC
Output Large output fixed by MR = MC Small output fixed by the sole
seller.
Profit Normal profit realized by price Excess profit monopoly gain.
competition.
Application Pure competition is rare but Pure Monopoly is rare but elements
monopolistic competition is of monopoly are there in markets.
available.
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Price Discriminating Monopoly-Meaning
• 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.”
• Price Discrimination refers strictly to the practice by a seller to charging
different prices from different buyers for the same good - J.S.Bains
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Price Discriminating Monopoly-Types and Degrees
• Types of Price Discriminating Monopoly

• Price discrimination is a common pricing strategy used by a monopolist
having discretionary pricing power. This strategy is practiced by the
monopolist to gain market advantage or to capture market position.
• There are three types of price discrimination:
• i) Personal
• Personal price discrimination refers to a situation 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.
59
• ii) Geographical
• This type of price discrimination occurs when the monopolist charges
different prices at different places for the same product. This type of
discrimination is possible if those who buy at lower price cannot sell to
those being charged a higher price by the firm.
• iii) On the basis of use
• This kind of price discrimination 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. Similar discrimination occurs when buyers
are charged different prices at different hours of the day – it is referred to as
peak load pricing.
60
• Degrees of Price Discriminating Monopoly
• 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 price discrimination, 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.
61
• 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.
62
Conditions of Price Discrimination
• Some monopolists used product differentiation for price discrimination by means
of special labels, wrappers, packing, etc. For example, the perfume manufacturers
discriminate prices of the same fragrance by packing it with different labels or
brands.
• Conditions of Price-Discrimination: There are three main types of situation:
• (a) When consumers have certain preferences : Certain consumers usually
have the irrational feeling that they are paying higher prices for a good because it
is of a better quality, although actually it may be of the same quality. Sometimes,
the price differences may be so small that consumers do not consider it worthwhile
to bother about such differences.
• (b) When the nature of the good is such as makes it possible for the monopolist
to charge different prices. This happens particularly when the good in question is a
direct service.
• (c) When consumers are separated by distance or tariff barriers : A good may
be sold in one town for Tk.1 and in another town for Tk 2. Similarly, the
monopolist can charge higher prices in a city with greater distance or a country
levying heavy import duty.
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Conditions making Price Discrimination Possible
and Profitable
• Conditions making Price Discrimination Possible and Profitable: The
following conditions are essential to make price discrimination possible and
profitable:
• (a) The elasticities of demand in different markets must be different : The
market is divided into sub-markets. The sub-market will be arranged in ascending
order of their elasticities, the higher price being charged in the least elastic market
and vice versa.
• (b) The costs incurred in dividing the market into sub-markets and keeping
them separate should not be so large as to neutralize the difference in demand
elasticities.
• (c) There should be complete agreement among the sellers otherwise the
competitors will gain by selling in the dear market.
• (d) When goods are sold on special orders because then the purchaser cannot
know what is being charged from others.
64
Price Output Determination under Price
Discriminating Monopoly
• Conditions of Equilibrium
1. Monopolist must get same marginal revenue in both markets:
The marginal revenue of both the markets must be the same i.e.
MR1=MR2
2. Equality between MR and MC:
Condition of maximum profit or equilibrium is that marginal
revenue earned in each market should be equal to the marginal cost
of the total output
MR1 = MR2 = MC
65
• The aim of monopolist is to increase total revenue and profit. Under price
discrimination, the monopolist will charge different prices in different sub-
markets. Each discriminating monopolist, in order to maximize his profit,
will produce up to that level where his marginal revenue is equal to
marginal cost.
• Suppose, the monopolist has two different markets having different
elasticity of demand.
• He has to take following three decisions in order to maximize his
profits:
• 1. How much output should be produced?
• 2. How to divide total output between two different markets?
• 3. What price should be charged in each market?
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• Now, let us examine these decisions in details
• 1. How much Total Output should be produced?
• Since it is assumed that the product is homogeneous, the monopolist must
consider his marginal cost (MC) for the whole output irrespective of which market
it is sold in. He equates this marginal cost (MC) with the composite (combined)
marginal revenue curve (ZMR) from both markets-market-I and market-II. The
composite (combined) marginal revenue curve (ZMR) is found by adding the
marginal revenue curves of Market-I and Market-II, horizontally.
• The composite marginal revenue curve (combined marginal revenue curve) is
represented as 2MR or CMR. Thus total output is fixed at the point where MC =
CMR (or ZMR). Thus, in the diagram 12, the monopolist will produce OM
amount of output. At this output, the addition to his cost of producing the last unit
is just equal to the addition to his revenues from selling that unit in either market.
67
68
• 2. How to Divide Total Output between Two Markets:
• The monopolist will maximize his profits by equating the MC of the whole output
with the MR in Market I (MR1) and MC of the whole output with the MR in
Market II (MR2). In other words, the total output (OM) is divided between two
markets in such a way that marginal revenue in each is equal to the marginal cost
for the whole output which is also equal to the composite (combined) marginal
revenue at OR.
• This means he will sell OM1 output in market-I and OM2 output in market-II and
the combined output at price OR is obtained by adding the output in market-I and
market-II at OR. MR must be the same in both the markets – (i.e., MR1 = MR2)
for it has to be equated with the same MC (i.e., the marginal cost for the whole
output) which is also equal to OR. In any case, if it were not the same, the
monopolist could increase profits by transferring output from where marginal
revenue was lower to where it was higher.
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• 3. What Price should be charged in Each Market?
• Since the elasticity’s of demand are different in each market, the monopolist
will charge different prices in both the markets to maximize his profits. The
price in market-I with less elastic demand will be higher than the price in
market-II with more elastic demand.
• An output OM1 will be sold at OP1 price in market-1; an output OM2 will be
sold at OP2 price in market- II. The prices are different in both the markets,
since the demand is less elastic in market-I than in market II; hence, a
smaller quantity can be sold at higher price in market-I than the market-II.
• The monopolist will be in equilibrium, where MR1 = MR2 = CMR = MC
(for the whole output). It is this distribution where the monopolist
maximizes his profits or it is this point where the monopolist earns
maximum profits. The monopolist is said to be in equilibrium.
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Theory of The Firms

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Theory of The Firms

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Unit 6 – Theory of the Firms

• Meaning of Perfect Competition

• In the event of an equilibrium

• 10) Comparison of Output

• Types of Price Discriminating Monopoly

• iii. Third-degree Price Discrimination

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