MODULE 3

MARKET STRUCTURE

Market is a place or a process where the interaction between buyers and sellers takes place in
order to buy or sell a product; this interaction may take place at a particular place, over
telephone or through Internet.
There are different types of market structures in an economy. It depends on nature of
competition, type of product, number of buyers and sellers, freedom of entry and exit from the
market etc. Based on these features, markets are classified into perfect competition, monopoly,
oligopoly, monopolistic competition etc.

Perfect competition
Perfect competition is a market situation in which there are a large number of buyers and
sellers dealing in a homogeneous product with perfect knowledge about the market conditions
and perfect mobility of goods and factors of production. it is a hypothetical market condition
but the study of this market situation is essential to understand other forms of market structures.
The important features of perfect competition are the following
1. Large number of buyers and sellers : the number of buyers and sellers is so large that the
act of a single seller or buyer cannot influence price or output in the market.
2. Homogeneous product: Under perfect competition, all sellers are selling identical product
which is same in appearance, color, quality etc. and hence they are perfect substitutes. All
sellers are selling the same product and so they can charge only the same price.
3.Freedom of entry and exit - there are no restrictions on the entry and exit of firms; if the
existing firms are earning super normal profit, new firms will enter into the market. On the
other hand, if there is loss, some of the sellers will leave the market.
4.Perfect knowledge: buyers and sellers have perfect knowledge about market conditions.
Buyers know about the product and its price. Similarly, sellers will have the knowledge about
the price of the raw materials, technology etc.
5.Perfect mobility of goods and factors of production: Goods and factors of production are
free to move from one place to another place or from one industry to another industry.
6.Absence of transport cost: it is assumed that transport cost is absent in perfect competition
because of the uniformity of prices.
7.Perfectly elastic demand curve – under perfect competition, a firm can sell any amount of
the commodity at the market price and hence demand curve is a horizontal straight line parallel
to the X- axis.

Imperfect competition
If any of the features of perfect competition is absent in a market, that market situation is
known as imperfect competition. In other words, imperfect competition refers to any economic
market that does not meet the rigorous assumptions of a hypothetical perfectly competitive
market.
The important forms of imperfect competition are monopoly, oligopoly, monopolistic
competition etc.

Monopoly
Monopoly is a market situation in which a single seller controls the entire supply of a
commodity.Mono means a single seller; Poly means market .In other words, monopolist has
the full control over price and output. Indian railway is a monopoly of the government.
Features of Monopoly
1.Single seller: Under monopoly there is only a single seller who controls the entire production
and distribution of a commodity. Since there is only one seller, there is no competition and the
seller can charge any price for his product. In monopoly, there is no distinction between firm
and industry because the firm itself is the industry.
2.No close substitutes: The monopolist is selling a product which has no close substitutes.
Close substitute means goods which satisfy the same want.
3.Barriers to entry: Freedom of entry is restricted in monopoly. There are certain barriers in
the form of legal restrictions, exclusive ownership of certain resources, technical know -how.
All these prevent the entry of new firms.
4.Price maker: Since the monopolist is the only seller of the product which has no close
substitutes, there is no competition from other sellers. Hence, he can fix any price for his
product. Therefore, a monopolist is a price maker.
5. Downward sloping demand curve – Even though in monopoly, prices are fixed by the
monopolist, a consumer can decide whether he has to buy the product at that price or not. A
consumer purchases a larger quantity only at a lesser price; that is, a monopolist can sell a larger
quantity at a lesser price and hence the demand curve or AR curve facing a monopolist is
downward sloping. .
6.Price discrimination: A monopolist sells the same commodity at different prices to different
customers; this is known as price discrimination.

Oligopoly
Oligopoly is a market situation in which there are a few sellers selling either a homogenous
or differentiated product. Examples of oligopoly market are firms under aviation industry,
telecommunication industry etc.

Features
1.Few sellers: Under oligopoly, a few sellers dominate the entire industry. The sellers influence
the price of each other.
2.Homogeneous or differentiated product: In certain cases, product may be homogeneous
like product in perfect competition. But in the case of certain other products, it may be
differentiated.
3.Barriers to entry: Even though there are no legal barriers, various economic barriers prevent
the entry of new firms. Economic barriers may be in the form of huge investment requirement,
strong consumer loyalty for existing brands or because of economies of scale enjoyed by the
existing firms.
4.Mutual interdependence: It implies that firms are influenced by each other's decisions. The
quantity sold by one firm depends on its own price and price of its competitors because the
firms are producing either homogeneous products or close substitutes.
5.Existence of price rigidity: It means that firms do not prefer to change the price of their
product because it will not be beneficial for them. If one firm decreases the price, others will
also reduce price. Hence the profitability of the firm will be affected. On the other hand, if the
firm increases the price, others will not increase the price and hence it will lose its customers.
Hence firms resort to non price competition like advertisement and other forms of sales
campaigning.
6.Indeterminate demand curve: This implies that the demand curve is unknown under
oligopoly due to uncertain behavior patterns of firms under Oligopoly. Every organization
keeps an eye on the actions of rivals and makes strategies accordingly. Therefore, the demand
curve under oligopoly is never stable and shifts in response to the actions of rivals.

Monopolistic competition
The term monopolistic competition was given by professor Edward H Chamberlin. It is a
market situation in which there are a large number of buyers and sellers dealing in a
differentiated product. Even though the product produced by each seller is not identical, they
are close substitutes. They may differ in color, shape, taste etc. Different brands of bath soap,
soft drinks etc. are examples. Monopolistic competition is the real world situation.
Since the product is differentiated, the product of each seller has unique features. As there are
large number of buyers and sellers, the competitive element is present. Thus monopolistic
competition is a combination of perfect competition and monopoly.
Features of monopolistic competition
1.Large number of buyers and sellers – Similar to perfect competition, there are large number
of buyers and sellers in monopolistic competition. But the number of sellers is not as large as
in perfect competition.
2.Product differentiation - Product differentiation is the essence of monopolistic competition.
It can be in the form of changes in color, shape, quality, packing etc. Therefore, product of each
producer has a unique feature and this gives him the monopoly power over his product.
3 Selling cost- Each seller is selling a product which are close substitutes. Hence there is acute
competition between sellers and they spend huge amounts on advertisement and other sales
promotion activities. This is called selling cost.
4 Freedom of entry and exit – There are no restrictions on the entry or exit of firms. New
firms can enter into the industry or loss making firms can leave the market at any time.
5 Imperfect knowledge - The information about market conditions like price, quality, cost etc.
is not uniformly available to all buyers and sellers.
Equilibrium of a firm
Under any market situation, a firm is in equilibrium when it gets maximum profit. There are
two approaches to find the profit maximizing level of output.

TC - TR approach
Under this approach, a firm will be in equilibrium when it produces that level of output where
profit or the difference between TR and TC is the maximum.

In the diagram, when the firm produces Q level of output, the difference between TR and TC
is the maximum. Hence it is the equilibrium or profit maximizing output.

MC- MR approach
Under this approach, profit will be maximum when the following two conditions are satisfied.
1.At the equilibrium point, MC=MR ie; Marginal Cost of the firm should be equal to Marginal
Revenue.
2.At the point of equilibrium, MC should be rising.

Price and output determination under perfect competition

Under perfect competition, price of a product is determined for the entire industry by the forces
of market demand and market supply. This price is accepted by each firm in the industry.
Therefore, a seller under perfect competition is called a price taker. A seller can sell any
amount of the commodity at this price. Hence the demand curve facing a seller or a firm under
perfect competition is perfectly elastic; it is a horizontal straight line parallel to the X axis. A
seller can sell any amount at the price prevailing in the market. Whether he sells one unit or
1000 units, price will be the same. Since all units of the commodity are sold at the same price,
under perfect competition, Price, MR & AR will be the same and the Priceline, MR curve and
AR curve will be a horizontal straight line parallel to the X axis. The demand curve or AR curve
facing a seller under perfect competition is shown in the figure.

MC - MR approach under perfect competition.

A firm is in equilibrium when it gets maximum profit. Profit will be the maximum when it
satisfies the two equilibrium conditions that is MC=MR and MC is rising at the point of
equilibrium. MR curve of the firm is a horizontal straight line and MC curve is U shaped. The
following figure shows the equilibrium point with normal profit. When the firm earns normal
profit at the point E, AR curve is tangent to the AC curve and hence AR and AC will be equal.
Since AC includes normal profit, firm gets normal profit when it produces OQ level of output.

Equilibrium Price and Output determination under monopoly.

A monopolist can sell a larger quantity only at a lesser price; hence the MR curve of a
monopolist will be downward sloping. As MR curve is downward sloping, AR curve also will
be downward sloping. But the AR curve will be less price elastic as there are no close substitutes
in the market.
TC-TR approach
In the diagram, profit is the maximum when the gap between TR and TC is the maximum and
it is at that point the profit maximizing output OQ is produced.

MC MR approach
Usually, a monopolist earns supernormal profit because the monopolist has complete control
over the supply of a commodity. Price and Output determination is explained with the help
of the following diagram.

In the diagram, at point E, MC=MR and MC curve intersects MR curve from below. Hence E
is the equilibrium point and OQ is the equilibrium level of output. When the firm produces OQ
level of output, QA is the AR or price; but the average cost QB is less than this. Hence AB is
the profit per unit. The rectangle PABC shows the total profit earned by the monopolist.

Price discrimination
It is the act of selling the same product at different prices to different buyers. For example for
electricity, low rates are charged for domestic consumption and high rates for commercial
consumption.

Dumping
It means a monopolist sells his product at a higher price in the home market and lower price in
the international market. This may be to clear the excess or outdated stock or to increase the
market share or to avoid competitors.

Regulation of monopoly
The following measures are employed to control monopoly.
1 Increasing competition with anti trust laws: Antitrust laws are developed by governments
to protect consumers from monopoly practices and ensure fair competition. In India, there is
the MRTP act (Monopolies and Restrictive Trade Practices act) to control monopolies.
2.Regulation: Through regulation, the government does not allow the companies to charge any
price as they wish. The government agencies regulate the price. For example, water and
electricity charges are regulated by the government authorities.
3.Public Ownership: In this case, instead of regulating monopoly run by a private firm, the
government runs the monopoly itself. That is the government becomes the owner.

Price and output determination under monopolistic competition

AR curve (Demand curve) and MR curve of a firm:

AR curve or demand curve of a firm under Monopolistic Competition is downward sloping.
This is because a seller can sell more only at a lesser price.

When compared to the demand curve of a monopolist, the AR curve of monopolistic

competition is more flat or price elastic. In monopolistic competition products are close
substitutes and hence a small change in price may cause a larger change in demand. MR curve
lies below the AR curve.

Price and output determination

A firm in monopolistic competition is in equilibrium when it maximizes profit. Profit is the
maximum when it produces that level of output where MC is equal to MR and MC is rising at
the equilibrium point. This is shown in the diagram.

In the diagram, at point E, MC= MR and at this point firm is producing OQ level of output.
When production is OQ, Average cost is QB but AR which is QA is greater than AC. Hence
the difference between AC and AR that is, AB, shows profit per unit of output. The rectangle
PABC represents total profit earned by the firm.

Price and output determination under Oligopoly - Kinked demand Curve model
The kinked demand curve model was developed by Paul M Sweezy in 1939. Kinked demand
curve explains price rigidity under oligopoly on the basis of the following assumptions.
1.If a firm increases its price, others will not follow.
2.If a firm decreases its price, others will also do the same.
Usually, in oligopoly firms will not enter into a price war and hence price remains rigid. If one
firm decreases the price, others will also reduce the price and it will affect their profitability.
On the other hand, if the firm increases the price, others will not increase the price and hence it
will lose its customers. Therefore, a firm under oligopoly stick to its price or prices are sticky
under oligopoly; this kind of behavior in Oligopoly is explained by the kinked demand curve.
The lower part of the demand curve is less elastic because a firm cannot gain from a price cut.
The upper part of the demand curve is more elastic because there will be a substantial fall in
demand if there is a
price rise. In the diagram we can see that there is a kink at point K in the demand curve. This
kink in the demand curve or AR curve at point K creates a discontinuity in the MR curve. At
the kink, MR remains unchanged between points S & R.
Marginal Cost curve MC1 intersects MR curve at point S and OQ is the equilibrium level of
output. Suppose cost increases and MC curve shifts upwards as MC2, there will not be any
change in equilibrium price and quantity till MC reaches the point R in the gap.

Collusive Oligopoly
Under oligopoly, firms are interdependent and face cut-throat competition. To avoid price war
and loss, firms enter into an agreement regarding uniform price and output. This agreement is
known as Collusion. According to Samuelson, collusion denotes a situation in which two or
more firms jointly set their prices or output, divide the market among them or make the business
decisions.
Collusion may be formal or tacit in nature. In formal collusion, there will be an explicit
agreement among the firms. On the other hand, in tacit collusion, firms collide in an informal
way.
The most common form of explicit collusion is cartel. Cartel is a formal agreement between
firms. This kind of collusion is possible when there are a few sellers and the product is
homogeneous. OPEC (Organization of Petroleum Exporting Countries) is an example of a
cartel. Under cartel, firms involve in price and output fixation, division of profit, market share
etc. The main objective of cartel is reducing the supply and raising the price. Price and output
under cartel are determined by a central administrative authority. The total profits are
distributed in proportion as decided by the members.

Price leadership
Under collusion sometimes the dominant firm in the industry sets the price and others follow
it. The dominant firm becomes the price leader because of its large size, large economies of
scale or better technology. Barometric price leadership and aggressive price leadership
also exist. Under barometric price leadership, one firm changes the price first and other firms
follow it; but that may not be the dominant firm. In aggressive price leadership, one aggressive
firm sets the price first and others follow it.

Tacit collusion
Governments always take measures against the formation of cartels or formal agreements
among the firms because such agreements are against the interest of the consumers. Therefore
firms enter into tacit collusion. In a tacit or implicit collusion, firms do not form a cartel, but
informally agree to charge the same price.

Non price competition

Under oligopoly, there is very tight competition between firms. If the firms try to increase their
market share through price competition, it may result in a price war and hence the firms will be
the losers. Hence, they follow non price competition to increase sales. Non price competition
refers to competition between companies that focuses on benefits, extra services, product
quality etc.
Non price competition is a marketing strategy that typically includes promotional expenditures
such as sales staff, sales promotions, special orders, free gifts, coupons and advertising. In other
words, it means marketing a firm’s brand and quality of products rather than lowering prices.
There are two main branches of non price competition; they are product differentiation and
promotion or advertising. Product differentiation means differentiating the product with respect
to packing, color, smell, quality etc. This helps to attract more customers and to increase the
market share. Promotion includes advertising, branding, public relations etc.

Examples of non price competition.

Loyalty card – Loyalty cards give rewards or money back to customers who build up points.
Airlines, supermarkets etc. use loyalty cards to encourage customers two repeat.
Subsidized delivery - big firms offer free delivery for their customers with a paid subscription.
This would give incentive to customers to purchase more. This works well with those customers
who are regular online shoppers.
Offering good after sales service - In order to retain customers, firms provide great after -
sales service. for reputation and brand loyalty of the firm.
Advertising/brand loyalty - Firms spend huge expenditure on advertising because repeated
advertisement of famous brands can make customers more likely to buy such brands. High
brand loyalty can also create more purchase by customers.
Cultivation of good reviews - In an online world, good reviews are increasingly important.
Hence firms encourage happy customers to leave reviews.
Coupons and free gifts- Along with their product, some sellers provide coupons and free gifts.
This is to encourage more customers to buy from that seller. In short, non price competition
increases the market share of a product. But it increases selling cost and other promotional
expenses which in turn increases the average cost of production.
Comparison between perfect competition, monopoly, monopolistic competition and
oligopoly

Product pricing
The right price of a product is one which keeps consumers, sellers and shareholders happy. A
firm should decide its pricing strategy after considering the degree of competition in the market,
price of competitors' product, purchasing power or buying capacity of consumers etc. Objective
of the firm also plays an important role in pricing decision because objectives like profit
maximization and sales maximization need different pricing strategies. Another important
factor which is to be considered in price fixation is cost of the product. Whenever there is a
change in cost of production, the price of the product should also be changed. Government
policy regarding taxation and subsidy is another factor which influences pricing policy.

Important pricing strategies

The important pricing strategies are the following:
Cost plus or Markup pricing:
Under this strategy, price is the sum of cost and a profit margin. Usually, average cost is used
for this purpose. Therefore, it is also called Average Cost Pricing or Full Cost Pricing.
Thus, the price will be
Price = AC + m where m is the percentage of markup. Markup is fixed usually at 10%. It may
vary from industry to industry and among the different firms in the same industry. This method
is very simple and convenient but it is not suitable when there is tough competition in the market
or when there is the threat of entry of new firms.

Target Return Pricing:

This method is similar to cost plus pricing. But the main difference is that in cost plus pricing,
the profit margin is decided arbitrarily, whereas under target return pricing, producer rationally
decides the minimum rate of return. The margin of profit is decided depending on the
experience of the firm, consumer’s paying capacity, risk involved and many other factors.

Penetration Pricing:
When a firm wants to enter into a market which is already dominated by existing firms, the
only option is charging a price less than the existing price; this price is called penetration price.
Reliance has adopted this kind of a pricing strategy in the mobile phone industry.

Predatory pricing:
Under predatory pricing, the predator or the dominant firm sets its prices too low for a sufficient
period of time so that its competitors leave the market and others do not enter because the prices
are too low to make a profit. This kind of predation it’s done on the expectation that these
present losses will be compensated by future gains. In other words, the firm is on the expectation
of acquiring exploitable market power after the predatory period, and that profits of this later
part later period will be sufficiently large enough to compensate incurring present losses.

Going Rate Pricing:

This is the strategy of following the prevailing market price instead of a separate pricing
strategy of their own. Usually, in this case price is fixed by a dominant firm and others accept
it. Going rate pricing strategy is adopted when the products sold by the sellers are very close
substitutes. Packaged drinking water is an example. By adopting this pricing strategy, firms can
avoid a price war like situation.
This kind of a pricing strategy is adopted when the product has reached maturity. That is a
buyer ask for a product in general, rather than a particular brand. An example is mineral water.
Price skimming:
It is a strategy in which high price is charged at the time of introduction of the product and a
lower price during maturity. By experience, producers know that a segment of high income
consumers wishes to become the first among those who possess the product. Hence the
producers charge a very high price from such buyers to skim the market and earn a very high
profit. Once the product is established and reached maturity, producers will reduce the profit
margin and charge a lower price to attract the lower income group.

Administered pricing:
The term administered pricing is used to denote the price charged by the monopolists. Since a
monopolist is a price maker, he can charge any price for his product. But in the Indian context,
administered price means prices fixed by the government. Price of cooking gas is an example.