Micro-Economics-II (ECB-201) B.

A (IIIrd Semester)

Unit-I
MARKET STRUCTURE -II
Structure
1.0 Introduction
1.1 Unit Objectives
1.2 Monopolistic Competition:
1.2.1 Characteristics
1.3 Short Run Equilibrium of Firm under Monopolistic Competition
1.4 Long Run Equilibrium of Firm under Monopolistic Competition
1.5 Break Even Pricing in Monopolistic Competition
1.6 Selling Costs
1.7 Oligopoly:
1.7.1 Features
1.7.2 Types of Oligopoly
1.8 Cournot’s model
1.9 Kinked Demand Curve Hypothesis
1.10 Cartels
1.11 Price Leadership
1.12 Summary
1.13 Answer to Check Your Progress
1.14 Questions and Exercises

1.0 Introduction
Firms are set up so that they can produce goods and services suitable for
consumption. A market consists of all the consumers and producing firms of a particular
good or service. Market structures are based on the characteristics of a market. Economists
identify a number of characteristics which determine the market structure a firm is said to
operate in.
There are several market structures in which firms can operate. The type of structure
influences the firm‘s behaviour, whether it is efficient, and the level of profits it can generate.

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1.1 Unit Objectives

This is the first part of this course, and it is designed to expose students to the basic
principles of micro economics. This course has the objective of equipping the students in a
rigorous and comprehensive manner with the aspects of market structure especially
monopolistic competition and oligopoly market. The unit enlightens students about the
various aspects and some unique features of monopolistic market and oligopoly market. It
further gives a detailed knowledge of the different types of oligopoly market.
1.2 Monopolistic Competition:
Concept of Monopolistic Competition:
Monopolistic Competition refers to the market situation in which there is a keen
competition, but neither perfect nor pure, among a group of a large number of small
producers or suppliers having some degree of monopoly because of the differentiation of
their products. Thus, we can say that monopolistic competition (or imperfect competition) is
a mixture of competition and a certain degree of monopoly, on the basis of a correct appraisal
of the market situation.
Chamberlin has asserted that monopoly and competition are not mutually exclusive
rather both are frequently blend together. In short, we can say that a market with a blending
of monopoly and competition is called monopolistic competition or imperfect competition.
Definition:
1. Monopolistic Competition refers to competition among a large number of sellers
producing close but not perfect substitutes for each other.
2. According to Prof. Lerner – “The condition of imperfect competition arises when a seller
has to face the falling demand curve.”
3. According to Prof. J. K. Mehta – “It has been more fully realised that every case of
exchange is a case of what may be called partial monopoly and partial monopoly is
looked at from the other said a case of imperfect competition. There is a blending of both
competition element and monopoly element in each situation.”
4. According to Prof. Leftwich – “Monopolistic Competition (or imperfect competition) is
that condition of industrial market in which a particular commodity of one seller creates
an idea of difference from that of the other sellers in the minds of the consumers.”
1.2.1 Characteristics
Important Characteristics or Main Features of Monopolistic competition are as
follows:

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1. Large Number of Sellers:

There are large numbers of firms selling closely related, but not homogeneous
products. Each firm acts independently and has a limited share of the market. So, an
individual firm has limited control over the market price. Large number of firms leads to
competition in the market.
2. Product Differentiation:
Each firm is in a position to exercise some degree of monopoly (in spite of large
number of sellers) through product differentiation. Product differentiation refers to
differentiating the products on the basis of brand, size, colour, shape, etc. The product of a
firm is close, but not perfect substitute of other firm.
Implication of ‘Product differentiation’ is that buyers of a product differentiate
between the same products produced by different firms. Therefore, they are also willing to
pay different prices for the same product produced by different firms. This gives some
monopoly power to an individual firm to influence market price of its product.
Explore More about Product Differentiation:
a) The product of each individual firm is identified and distinguished from the products of
other firms due to product differentiation.
b) To differentiate the products, firms sell their products with different brand names, like
Lux, Dove, Lifebuoy, etc.
c) The differentiation among different competing products may be based on either ‘real’ or
‘imaginary’ differences.
(i) Real Differences may be due to differences in shape, flavour, colour, packing, after
sale service, warranty period, etc.
(ii) Imaginary Differences mean differences which are not really obvious but buyers are
made to believe that such differences exist through selling costs (advertising).
d) Product differentiation creates a monopoly position for a firm.
e) Higher degree of product differentiation (i.e. better brand image) makes demand for the
product less elastic and enables the firm to charge a price higher than its competitor’s
products. For example, Pepsodent is costlier than Babool.
f) Some more examples of Product Differentiation:
i. Toothpaste: Pepsodent, Colgate, Neem, Babool, etc.
ii. Cycles: Atlas, Hero, Avon, etc.
iii. Tea: Brooke Bond, Tata tea, Today tea, etc.
iv. Soaps: Lux, Hamam, Lifebuoy, Pears, etc.

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3. Selling costs:
Under monopolistic competition, products are differentiated and these differences are
made known to the buyers through selling costs. Selling costs refer to the expenses incurred
on marketing, sales promotion and advertisement of the product. Such costs are incurred to
persuade the buyers to buy a particular brand of the product in preference to competitor’s
brand. Due to this reason, selling costs constitute a substantial part of the total cost under
monopolistic competition.
It must be noted that there are no selling costs in perfect competition as there is perfect
knowledge among buyers and sellers. Similarly, under monopoly, selling costs are of small
amount (only for informative purpose) as the firm does not face competition from any other
firm.
4. Freedom of Entry and Exit:
Under monopolistic competition, firms are free to enter into or exit from the industry
at any time they wish. It ensures that there are neither abnormal profits nor any abnormal
losses to a firm in the long run. However, it must be noted that entry under monopolistic
competition is not as easy and free as under perfect competition.
5. Lack of Perfect Knowledge:
Buyers and sellers do not have perfect knowledge about the market conditions.
Selling costs create artificial superiority in the minds of the consumers and it becomes very
difficult for a consumer to evaluate different products available in the market. As a result, a
particular product (although highly priced) is preferred by the consumers even if other less
priced products are of same quality.
6. Pricing Decision:
A firm under monopolistic competition is neither a price- taker nor a price-maker.
However, by producing a unique product or establishing a particular reputation, each firm has
partial control over the price. The extent of power to control price depends upon how strongly
the buyers are attached to his brand.
7. Non-Price Competition:
In addition to price competition, non-price competition also exists under monopolistic
competition. Non-Price Competition refers to competing with other firms by offering free
gifts, making favourable credit terms, etc., without changing prices of their own products.
Firms under monopolistic competition compete in a number of ways to attract
customers. They use both Price Competition (competing with other firms by reducing price of
the product) and Non-Price Competition to promote their sales.

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1.3 Short Run Equilibrium of Firm under Monopolistic Competition

Equilibrium of a firm under monopolistic competition is often couched in terms of
short period and long period. In the short run, Chamberlin’s model of monopolistic
competition comes closer to monopoly.
That is to say, there is virtually no difference between monopolistic competition and
monopoly in the short run. Thus, Chamberlin’s firm may earn supernormal profit, normal
profit, or incur loss in the short run—since entry and exit are not allowed during this time
period.
Figure 1.1: Short Run Equilibrium

In Fig. 1.1, the short run marginal cost curve, SMC, is equal to MR at point E. Thus E
is the equilibrium point. Corresponding to this equilibrium point, the firm produces OQ
output and sells it at a price OP. Thus, the firm earns pure profit to the extent of PARB since
total revenue (OPAQ) exceeds total cost of production (OBRQ).
A firm, in the short run, may earn only normal profit if MC = MR < AR = AC occurs.
A loss may result in the short run if MC = MR < AR < AC happens
1.4 Long Run Equilibrium of Firm under Monopolistic Competition
In the long run, monopolistic competition comes closer to perfect competition because
the freedom of entry and exit allows firms to enjoy only normal profit.
Whenever some firms earn pure profit in the long run some other firms may be attracted to
join this product group, thereby shifting the demand curve or AR curve downward and to the
left. Thus, entry of new firms would cause decline in market share by reducing the demand
for its product.
Consequently, excess profit will be reduced to zero. Further, if the existing firm
experiences losses then the exit of firms will bring about an opposite effect and the process

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will continue until normal profit is earned driving excess profit to zero. Seeing losses for a
long time, losing firms may be induced to leave the product group thereby eliminating losses.
Thus all firms in the long run earn only normal profit.
Figure 1.2: Long Run Equilibrium: Normal Profit

Long run equilibrium is achieved at point E where LMC equals MR (Fig. 1.2). The
equilibrium output thus determined is OQM. At this output, AR equals AC. The firm gets
normal profit by selling OQM output at the price OPM. Note that a monopolistically
competitive firm always operates somewhere to the left of the minimum point of its AC
curve.
In other words, as the demand curve is not perfectly elastic, or, as the demand curve is
negative sloping, the AR curve becomes tangent to the left of the lowest point of the AC
curve (say, point N). Each firm thus produces at a cost higher than the minimum and gets
only normal profit.
Under perfect competition, long run equilibrium is achieved at that point where MC =
MR = AR = AC. Because of the perfectly elastic AR curve, a tangency occurs between AR
and AC at the latter’s lowest point. In Fig. 1.2 the dotted AR = MR curve is the demand curve
faced by a competitive firm.
Equilibrium is attained at point R where LMC = MR = AR = lowest point of LAC.
The competitive output thus determined is OQP which will be sold at the price OPP. So, we
can conclude that monopolistically competitive output (OPM) is less than the perfectly
competitive output (OQP), and monopolistically competitive price (OPM) is larger than
competitive price (OPP).
Thus, the difference in output — QMQP— measures excess capacity or unused
capacity faced by monopolistically competitive firms. Production at a higher cost implies
wastage of resources or underutilization of resources.

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Since production takes place at the lowest point of AC curve under perfect
competition, there does not occur any wastage of resources. Hence a perfectly competitive
market is ‘efficient’ in the sense that resources are allocated efficiently. Society gets larger
output and consumers get output at a low price. Thus, as perfect competition maximizes
social welfare, it is an ideal market.
But as the monopolistically competitive firm operates to the left of the minimum point
of its AC curve, this market is considered as an ‘inefficient’ one. As a result, social welfare is
not maximized under monopolistic competition since society gets lower output compared to
perfectly competitive output and buyers buy the differentiated products at a high price.
1.5 Break Even Pricing in Monopolistic Competition
Meaning of Break-Even Point or Pricing:
The break-even point may be defined as that level of sales in which total revenues
equal total costs and net income is equal to zero and the price that is set at this point is known
as break-even point. This is also known as no-profit no-loss point. This concept has been
proved highly useful to the company executives in profit forecasting and planning and also in
examining the effect of alternative business management decisions.
The break-even point (B.E.P.) of a firm can be found out in two ways. It may be determined
in terms of physical units, i.e., volume of output or it may be determined in terms of money
value, i.e., value of sales.
BEP in terms of Physical Units:
This method is convenient for a firm producing a product. The BEP is the number of
units of a product that should be sold to earn enough revenue just to cover all the expenses of
production, both fixed and variable. The firm does not earn any profit, nor does it incur any
loss. It is the meeting point of total revenue and total cost curve of the firm.
The break-even point is illustrated by means of Table 1.1:
Table 1.1: Total Revenue and Total Cost and BEP

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Some assumptions are made in illustrating the BEP. The price of the commodity is
kept constant at Rs. 4 per unit, i.e., perfect competition is assumed. Therefore, the total
revenue is increasing proportionately to the output. All the units of the output are sold out.
The total fixed cost is kept constant at Rs. 150 at all levels of output.
The total variable cost is assumed to be increasing by a given amount throughout.
From the Table we can see that when the output is zero, the firm incurs only fixed cost. When
the output is 50, the total cost is Rs. 300. The total revenue is Rs. 200.
The firm incurs a loss of Rs. 100. Similarly when the output is 100 the firm incurs a
loss of Rs. 50. At the level of output 150 units, the total revenue is equal to the total cost. At
this level, the firm is working at a point where there is no profit or loss. From the level of
output of 200, the firm is making profit.
Break-Even Chart:
Break-Even charts are being used in recent years by the managerial economists,
company executives and government agencies in order to find out the break-even point.
In the break-even charts, the concepts like total fixed cost, total variable cost, and the total
cost and total revenue are shown separately. The break even chart shows the extent of profit
or loss to the firm at different levels of activity. The following Fig. 1.3 illustrates the typical
break-even chart.
Figure 1.3: Cost, Revenue, Price and Units of Output

In this diagram output is shown on the horizontal axis and costs and revenue on
verti-cal axis. Total revenue (TR) curve is shown as linear, as it is assumed that the price is
con-stant, irrespective of the output. This assump-tion is appropriate only if the firm is
operating under perfectly competitive conditions.
Linearity of the total cost (TC) curve results from the assumption of constant variable
cost. It should also be noted that the TR curve is drawn as a straight line through the origin
(i.e., every unit of the output contributes a constant amount to total revenue), while the TC

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curve is a straight line originating from the vertical axis because total cost comprises
constant/fixed cost plus variable cost which rise linearly. In the figure, B is the break-even
point at OQ level of output.
In the preparation of the break-even chart we have to take the following considerations:
a) Selection of the approach,
b) Output measurement,
c) Total cost curve,
d) Total revenue curve,
e) Break-even point, and
f) Margin of safety.
Determination of Break-Even Point:
The formula for calculating the break-even point is
BEF = Total Fixed Cost/Contribution Margin Per Unit
Contribution margin per unit can be found out by deducting the average variable cost from
the selling price. So the formula will be
BEP = Total Fixed Cost/Selling Price – AVC
Example:
Suppose the fixed cost of a factory in Rs. 10,000, the selling price is Rs. 4 and the average
variable cost is Rs. 2, so the break-even point would be
BEP = 10,000/(4 – 2) = 5,000 units
It means if the company makes the sales of 5,000 units, it would make neither loss nor profit.
This can be seen in the analysis.
Sales = Rs.20,000
Cost of goods sold:
(a) Variable cost at Rs.2 = Rs. 10,000
(b) Fixed costs = Rs. 10,000
Total Cost = Rs. 20,000
Net Profit = Nil
BEP in term of Sales Value:
Multi-product firms are not in a position to measure the break-even point in terms of
any common unit of product. They find it convenient to determine the break-even point in
terms of total rupee sales. Here again the break-even point would be where the contribution
margin (sales value—variable costs) would be equal to fixed costs. The contribution margin,
however, is expressed as a ratio to sales.

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The formula for calculating the break-even point is

BEP = Fixed Cost/Contribution Ratio
Contribution Ratio (CR) = Total Revenue (TR) – Total Variable Cost (TVC)/Total Revenue
(TR)
For example, if TR is Rs. 600 and TVC is Rs. 450, then the contribution ratio is
CR = 600-450/600 = 150/600 = 0.25
The Contribution Ratio is 0.25
BEP = Total Fixed Cost/Contribution Ratio
= 150/0.25 = 600
The firm achieves its BEP when its sales are Rs. 600
Total Revenue = Rs.600
Total Cost = Rs.600
Net Profit/loss = Nil
Types of Break-Even Point:
The above paragraph explains a simple type of break-even point which is based on
cost and revenue i.e., the profit and loss break-even.
There are two other types of break-even and they are:
(i) Cash break-even, and
(ii) Income break-even.
(i) The Cash Break-Even:
An industry requires money for two purposes i.e., to acquire capital assets and to meet
working capital requirements. These requirements can be partly met by his own investment
and partly by loans and advances from financial institutions. The industry requires term loans
to acquire capital assets like land and building, plant and machinery.
In the case of term loans, the financial institutions shall have to find out the
probability of the applicant being able to meet the interest and loan repayment schedule. It
will be more interested in knowing the level of break-even point where not only total costs
are required but also the full debt service.
The level of break-even is called the cash break-even. It is based on revenue and cost
data involving cash flows. The depreciation, investment allowance reserve and other
provision of the cost items should be excluded but at the same time the repayment of
instalments should be added to fixed cost.
Cash Break-Even Point = Fixed Cost + Loan installment – Cash outflow/Contribution per
unit

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(ii) The Income Break-Even:

The various sources from which the industry is proposed to be financed such as the
capital, long term borrowing, deferred payments and other sources. If these sources are
inadequate the industry may approach the bank for under writing its shares. If the share
market does not respond positively, the equity risk falls on the underwriter.
As the share-holder of the bank will expect a certain dividend just to cover the
payment of interest for the term loans. In order to calculate income break-even point the
equity capital cash earnings should be added. The income break-even point can be calculated
in the following manner.
Income Break-Even Point = Fixed Cost + Earnings required for dividend/Contribution per
unit
Multiple-product Firms and Break-Even Point:
The multiple products may differ in models, styles or sizes of their output. In the case
of multi-product firms the break-even point for each product can be calculated if the ‘product
mix’ is known. The product mix is the full list of products offered for sale by a company. It
may range from one or two product lines to a combination of several product lines or groups.
Suppose an industry is engaged in the production of three items, namely X, Y, and Z. The
contribution for items is as follows:
X = Rs. 6 per unit
Y = Rs. 4 per unit
Z = Rs. 2 per unit
The product-mix given by the manufacturer is as follows:
X = 40,000 units
Y = 2,00,000 units
Z = 1,60,000 units.
Then the product-mix proportions are [Link]. We can work out the weighted average
contribution in the following way:

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We will get the break-even output for all the three items by dividing the above figure in
the same proportion:
X = 15,000
Y = 75,000
Z = 60,000
This reveals that the production manager has to ensure that production in the X line
does not go below 15,000 units, in the Y line 75,000 units and in the Z line 60,000 units. If
not, he has to sustain loss. The same method can be applied for computing the BEP in cases
of multiple product industries produc-ing any number of items.
1.6 Selling Costs
Concept
Selling costs play the key role in monopolistic competition and oligopoly. Under
these market forms, the firms have to compete to promote their sale by spending on
advertisements and publicity. Moreover, producer has not to decide about price and output
and he also keeps in view how to maximize the profit.
Thus, cost on advertisement publicity and salesmanship ads to the demand of the
product. We do not find perfect competition or monopoly in the real world but monopolistic
competition or oligopoly. In short, selling costs is a broader concept than the advertisement
expenditures. Advertisement expenditures are part of selling costs.
In selling costs we include the salaries of sales persons, allowances to retailers to
display the products etc. besides the advertisements. Advertisement expenditure includes
costs incurred for advertising in newspapers and magazines, televisions, radio, cinema slides
etc. It was Chamberlin who introduced the analysis of selling costs and distinguished it from
the production costs. The production costs include all those expenses which are spent on the
manufacturing of the commodity, its transportation cost of handling, storing and delivering of
the commodity to actual customers because these add utilities to a commodity.

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On the other hand, all selling costs include all expenditures in order to raise demand for a
commodity. In short, selling costs are those which are made to create the demand for the
product. Transport costs should not be included in selling costs; rather these should be
included in the production costs. Transport costs actually do not increase the demand; it only
helps in meeting the demand of the consumers.
In the same fashion, high rents are not the part of selling costs. High rents are paid so
as to meet the already existing demand of the people. According to Edward H. Chamberlin,
“Those costs which are made to adopt the product to the demand are costs of production;
those made to adopt the demand to product are costs of selling.”
Definitions:
“Selling costs are costs incurred in order to alter the position or shape of the demand
curve for the product.” E.H. Chamberlin.
“Selling costs may be defined as costs necessary to persuade a buyer to buy one
product rather than another or to pay from one seller rather than another.” Meyers
As far as sales promotion is concerned, monopolistic competition differs from perfect
competition. No individual firm under perfect competition has any incentive to advertise its
product since products of all firms are homogeneous or identical in quality.
Gains from advertising by an individual firm have spill-over effects in the sense that
the gains would be distributed across all the cases for monopolistic competition since
different sellers produce slightly different products. It is the product differentiation that
enables a monopolistically competitive seller to exercise some sort of monopoly power.
Under the circumstance, sales promotional activities are undertaken by the sellers to
persuade more buyers to buy their products. Sales promotion, thus, involves selling cost
which is to be distinguished from production cost. As far as monopolistic competition is
concerned, total cost of producing a product is the sum of total production cost and total
selling cost.
It was Chamberlin who first introduced the concept of selling cost. Through various
sales promotion activities and advertising, a firm claims that its product is better than its
rival’s product. Thus selling costs are those costs which are incurred by a firm to influence or
persuade buyers to buy its product instead of others’ products.
According to Chamberlin, selling costs are defined as those costs which are incurred
by monopolistically competitive firm ‘to alter the position or shape of the demand curve for a
product’. The purpose of selling cost is, thus, to capture the saleable markets so as to increase
total revenue and, ultimately, profit.

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Since buyers have imperfect knowledge about the firm, price, quality of the product,
existence of rival sellers, etc., and since there is the possibility of altering wants of buyers
through advertisement and other sales promotional activities, sellers are tempted to incur
selling costs. Thus, selling costs increase and shift the demand curve to the right.
Now we will consider the effect of advertising on price-output decision of monopolistically
competitive seller. Our problem is to find the optimum output, price, and selling costs. In Fig.
1.4 we do this.
Advertisement plays two roles:
i. It increases costs and it shifts the demand curve upwards.
ii. AR curve is the average revenue curve of the firm prior to incurring any selling expenses.
Figure 1.4: Selling Cost and Equilibrium

Selling Cost and Equilibrium

AC is the average production costs that do not take into account selling costs or
advertising cost. For the neatness of the diagram, we have not used MR and MC curves.
However, the profit-maximizing output that has been described here is determined by the
intersection of MR and MC curves.
Our firm maximizes profit by producing OQ output where price OP is determined,
since, at this output, MC and MR curves (not drawn) are equal to each other. Toted profit is
represented by the shaded area (abcP) — the profits earned before any advertisement is made
because AC curve lies below the AR curve.
Let us assume that our firm spends a amount of selling cost. This selling expense
raises both the demand curve to ARα and average cost curve (inclusive of advertisement cost)
to ACα. Consequently, equilibrium output becomes OQα and the optimum price thus

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determined becomes OPα. At this level of output—volume of profit has gone up (def Pα—the
shaded area).
Since profits have increased following advertising expenditure, our firm will be
tempted to spend more on advertisement (β amount). As a result, AR curve will shift to ARβ.
AC curve will now shift to ACβ. Now the equilibrium output is OQβ and equilibrium price is
OPβ. This time, our firm earns some profit but the volume of profit is comparatively less than
when a amount was spent (mnqPβ < def Pα).
It is to be noted here that the firm does not get maximum profit by spending P amount
of money. Therefore, it should choose to produce OQα amount and sell it at price OPα with
the selling expenditure represented by ACα as an optimal advertising expenditure for the firm.
So we can conclude that it will be profitable on the part of the firm to increase additional
selling cost so long as each increment of selling expenditure adds more to revenue than to its
costs. Only when the additional revenue net of production costs generated equals the
additional or marginal amount spent in order to generate such net revenue, profit will be the
largest.
Sales promotion, thus, may not necessarily cause profits to rise. There is an optimal
level of selling cost. However, if advertising campaign does not cause demand curve to shift
to the right, profits are then likely to decline. Particularly, when all firms in the
monopolistically competitive market go for sales promotion excess profit will be eliminated
eventually because of free entry and free exit.
1.7 Oligopoly:
The term ‘Oligopoly’ is coined from two Greek words ‘Oligoi meaning ‘a few’ and
‘pollein means ‘to sell’.
It occurs when an industry is made up of a few firms producing either an identical
product or differentiated product.
In simple words, “Oligopoly is a situation in which there are so few sellers that each
of them is conscious of the results upon the price of the supply which he individually places
upon the market”-The number of sellers is greater than one, yet not big enough to render
negligible the influence of any one upon the market price.
Definition:
The concept of oligopoly can be defined as under:
“Oligopoly is that situation in which a firm bases its markets policy in part on the expected
behaviour of a few close rivals.” – J. Stigier

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“An oligopoly is a market of only a few sellers, offering either homogeneous or differentiated
products. There are so few sellers that they recognize their mutual dependence.” – PC.
Dooley
1.7.1 Features
The main features of oligopoly are elaborated as follows:
1. Few firms:
Under oligopoly, there are few large firms. The exact number of firms is not defined.
Each firm produces a significant portion of the total output. There exists severe competition
among different firms and each firm try to manipulate both prices and volume of production
to outsmart each other. For example, the market for automobiles in India is an oligopolist
structure as there are only few producers of automobiles.
The number of the firms is so small that an action by any one firm is likely to affect
the rival firms. So, every firm keeps a close watch on the activities of rival firms.
2. Interdependence:
Firms under oligopoly are interdependent. Interdependence means that actions of one
firm affect the actions of other firms. A firm considers the action and reaction of the rival
firms while determining its price and output levels. A change in output or price by one firm
evokes reaction from other firms operating in the market.
For example, market for cars in India is dominated by few firms (Maruti, Tata,
Hyundai, Ford, Honda, etc.). A change by any one firm (Tata) in any of its vehicle (Indica)
will induce other firms (Maruti, Hyundai, etc.) to make changes in their respective vehicles.
3. Non-Price Competition:
Under oligopoly, firms are in a position to influence the prices. However, they try to
avoid price competition for the fear of price war. They follow the policy of price rigidity.
Price rigidity refers to a situation in which price tends to stay fixed irrespective of changes in
demand and supply conditions. Firms use other methods like advertising, better services to
customers, etc. to compete with each other.
If a firm tries to reduce the price, the rivals will also react by reducing their prices.
However, if it tries to raise the price, other firms might not do so. It will lead to loss of
customers for the firm, which intended to raise the price. So, firms prefer non- price
competition instead of price competition.

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4. Barriers to Entry of Firms:

The main reason for few firms under oligopoly is the barriers, which prevent entry of
new firms into the industry. Patents, requirement of large capital, control over crucial raw
materials, etc, are some of the reasons, which prevent new firms from entering into industry.
Only those firms enter into the industry which is able to cross these barriers. As a result,
firms can earn abnormal profits in the long run.
5. Role of Selling Costs:
Due to severe competition ‘and interdependence of the firms, various sales promotion
techniques are used to promote sales of the product. Advertisement is in full swing under
oligopoly, and many a times advertisement can become a matter of life-and-death. A firm
under oligopoly relies more on non-price competition.
Selling costs are more important under oligopoly than under monopolistic competition.
6. Group Behaviour:
Under oligopoly, there is complete interdependence among different firms. So, price
and output decisions of a particular firm directly influence the competing firms. Instead of
independent price and output strategy, oligopoly firms prefer group decisions that will protect
the interest of all the firms. Group Behaviour means that firms tend to behave as if they were
a single firm even though individually they retain their independence.
7. Nature of the Product:
The firms under oligopoly may produce homogeneous or differentiated product.
(i) If the firms produce a homogeneous product, like cement or steel, the industry is called a
pure or perfect oligopoly.
(ii) If the firms produce a differentiated product, like automobiles, the industry is called
differentiated or imperfect oligopoly.
8. Indeterminate Demand Curve:
Under oligopoly, the exact behaviour pattern of a producer cannot be determined with
certainty. So, demand curve faced by an oligopolist is indeterminate (uncertain). As firms are
inter-dependent, a firm cannot ignore the reaction of the rival firms. Any change in price by
one firm may lead to change in prices by the competing firms. So, demand curve keeps on
shifting and it is not definite, rather it is indeterminate.

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1.7.2 Types of Oligopoly

Oligopoly is of the following types
(a) Pure or Perfect Oligopoly:
If the firms produce homogeneous products, then it is called pure or perfect oligopoly.
Though, it is rare to find pure oligopoly situation, yet, cement, steel, aluminum and chemicals
producing industries approach pure oligopoly.
(b) Imperfect or Differential Oligopoly:
In such a case a few firms sell similar but not identical products under the same
conditions. For example automobiles, tyres, cigarettes, electrical appliances and soft drinks.
The goods produced by different firms have their own distinguishing characteristics, yet all of
them are close substitutes of each other.
(c) Collusive Oligopoly:
If the firms cooperate with each other in determining price or output or both, it is
called collusive oligopoly or cooperative oligopoly.
(d) Non-collusive Oligopoly:
If firms in an oligopoly market compete with each other, it is called a non-collusive or
non-cooperative oligopoly.
1.8 Cournot’s model
The earliest duopoly model was developed in 1838 by the French economist Augustin
Cournot. The model may be presented in many ways.
The original version is quite limited in that it makes the assumption that the duopolists
have identical products and identical costs.
Actually Cournot illustrated his model with the example of two firms each owning a
spring of mineral water, which is produced at zero costs. We will present briefly this version,
and then we will generalize its presentation by using the reaction curves approach.
Cournot assumed that there are two firms each owning a mineral well, and operating
with zero costs. They sell their output in a market with a straight-line demand curve. Each
firm acts on the assumption that its competitor will not change its output, and decides its own
output so as to maximize profit.
Assume that firm A is the first to start producing and selling mineral water. It will
produce quantity A, at price P where profits are at a maximum (figure 1.5), because at this
point MC — MR = 0. The elasticity of market demand at this level of output is equal to unity
and the total revenue of the firm is a maximum. With zero costs, maximum R implies

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maximum profits, Π. Now firm B assumes that A will keep its output fixed (at 0/1), and
hence considers that its own demand curve is CD’.
Clearly firm B will produce half the quantity AD’, because (under the Cournot
assumption of fixed output of the rival) at this level (AB) of output (and at price F) its
revenue and profit is at a maxi-mum. B produces half of the market which has not been
supplied by A, that is, B’s output is ¼ (= ½. ½) of the total market.
Figure 1.5: Cournot's Duopoly Model

Firm A, faced with this situation, assumes that B will retain his quantity constant in
the next period. So he will produce one-half of the market which is not supplied by B. Since
B covers one-quarter of the market, A will, in the next period, produce ½(1 – ¼) = ½. ¾ = ⅜
of the total market.
Firm B reacts on the Cournot assumption, and will produce one-half of the unsupplied
section of the market, i.e. ½ (1 – ⅜) = 5/16.
In the third period firm A will continue to assume that B will not change its quantity,
and thus will produce one-half of the remainder of the market, i.e. 1/2 (1 – 5/16).
This action-reaction pattern continues, since firms have the naive behaviour of never
learning from past patterns of reaction of their rival. However, eventually an equilibrium will
be reached in which each firm produces one-third of the total market. Together they cover
two-thirds of the total market. Each firm maximises its profit in each period, but the industry
profits are not maximised.
That is, the firms would have higher joint profits if they recognised their
interdependence, after their failure in forecasting the correct reaction of their rival.
Recognition of their interdependence (or open collusion) would lead them to act as ‘a
monopolist,’ producing one-half of the total market output, selling it at the profit-maximising
price P, and sharing the market equally, that is, each producing one-quarter of the total
market (instead of one-third).

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The equilibrium of the Cournot firms may be obtained as follows:

Thus the Cournot solution is stable. Each firm supplies 4 of the market, at a common
price which is lower than the monopoly price, but above the pure competitive price (which is
zero in the Cournot example of costless production). It can be shown that if there are three
firms in the industry, each will produce one-quarter of the market and all of them together
will supply ¾ ( = ¼ . 3) of the entire market OD’.
And, in general, if there are n firms in the industry each will provide n /(n + 1) of the
market, and the industry output will be n/(n + 1) = 1 /(n + 1) . n. Clearly as more firms are
assumed to exist in the industry, the higher the total quantity supplied and hence the lower the
price. The larger the number of firms the closer is output and price to the competitive level.

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Cournot’s model leads to a stable equilibrium. However, his model may be criticized on
several accounts
The behavioural pattern of firms is naive. Firms do not learn from past miscalculations of
competitors’ reactions.
Although the quantity produced by the competitors is at each stage assumed constant,
a quantity competition emerges which drives P down, towards the competitive level.
The model can be extended to any number of firms. However, it is a ‘closed’ model, in that
entry is not allowed: the number of firms that are assumed in the first period remains the
same throughout the adjustment process.
The model does not say how long the adjustment period will be.
The assumption of costless production is unrealistic. However, it can be relaxed
without impairing the validity of the model. This is done in the subsequent presentation of the
model, based on the reaction-curves approach.
The reaction-curves approach is a more powerful method of analysis of oligopolistic
markets, because it allows the relaxation of the assumption of identical costs and identical
demands. This approach is based on Stackelberg’s indifference-curve analysis, which
introduces the concept of isoprofit curves of competitors. We will first establish the shape of
the isoprofit curves for substitute commodities, and from these curves we will subsequently
derive the reaction curves of the Cournot duopolists.
An isoprofit curve for firm A is the locus of points defined by different levels of
output of A and his rival B, which yield to A the same level of profit (figure 1.6).
Figure 1.6 : Isoprofit map of firm A

Similarly, an isoprofit curve for firm B is the locus of points of different levels of
output of the two competitors which yield to B the same level of profit (figure 1.7).

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Figure 1.7: Isoprofit map of firm B

From the above definitions it should be clear that the isoprofit curves are a type of
indifference curves.
There is a whole family of isoprofit curves for each firm which have the following
properties:
1. Isoprofit curves for substitute commodities are concave to the axes along which we
measure the output of the rival firms. For example, an isoprofit curve of firm A is
concave to the horizontal axis QA. This shape shows how A can react to B’s output
decisions so as to retain a given level of profit. For example, consider the isoprofit curve
ΠA1 in figure 1.8.
Suppose that firm B decides to produce the level of output B1. A line parallel to the
horizontal axis through B1 intersects the isoprofit curve ΠA1 at points h and g. This shows that
given the output that B decides to produce, firm A will realise the profit Π A1 if it produces
either of the two levels of output corresponding to points h and g, that is, either Ah or A g.
Assume that firm A decides to react by producing the higher level Ag.
If now firm B increases its output (say at the level B2), firm A must decrease its
output (at Af) if it wants to retain its profit at the same level (ΠA1). If firm A continued to
produce Ag while B increased its production, the total quantity supplied in the market would
depress the price, and hence the profit of firm A would decline. Up to a certain point (e in
figure 1.8) firm A must react to increases in B’s output by reducing its own production,
otherwise the market price would fall and A’s profit would decrease. As firm A reduces its
output, its costs also change, but the net profit (Π = R – C) remains at the same level (ΠA1),
because of market elasticity and/or decreasing costs arising from a better utilisation of A’s
plant.

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Figure 1.8: Isoprofit Curve

Consider now point h. If firm A reacts to B’s initial decision by producing the lower
output Ah, it will clearly earn the same profit ΠA1. If firm B decides to increase its output (at
the levels B2, B3 and so on, up to Be), firm A will react by increasing its output as well y4’s
profit will remain the same despite the resulting fall in the market price, because of market
elasticity and/or decrease in its costs due to a better utilisation of its plant.
2. The farther the isoprofit curves (for substitute commodities) lie from the axes, the lower
is the profit. And vice versa, the closer to the quantity-axis an isoprofit curve lies, the
higher the profitability of the firm is. Consider figure 1.9. If firm B were to increase its
output beyond Be, firm A would not be able to retain its level of profit. Suppose that firm
B decides to produce B4. Firm A can react in three ways: increase, decrease or retain its
output constant (at Ae). If A retains its output constant while B increases its production,
the ensuing fall in the market price will result in a reduction in the revenue and in the
profits of A, given its costs.
Figure 1.9: Profit Increasing Factor

If firm A were to increase output beyond Ae, its profit would fall because of
inelasticity of demand and/or increasing costs. If firm A were to reduce output below Ae, its
profit would fall because of elasticity of demand and/or increasing costs. Thus firm A will
earn a lower level of profit, no matter what its reaction, if B increased its output beyond Be. A
line through B4 parallel to the QA-axis lies above ΠA1, and will intersect (or will be tangent)
to an isoprofit curve which represents a lower profit for firm A.

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In figure 1.9 the isoprofit curve ΠA2 represents a lower profit than ΠA1. To summaries
for any given output that firm B may produce, there will be a unique level of output for firm
A which maximises the latter’s profit. This unique profit-maximizing level of output will be
determined by the point of tangency of the line through the given output of firm B and the
lowest attainable iso-profit curve of firm A. In other words, the profit-maximising output of
A (for any given quantity of B) is established at the highest point on the lowest attainable
isoprofit curve of A.
3. For firm A, the highest points of successive isoprofit curves lie to the left of each other. If
we join the highest points of the isoprofit curves we obtain firm A’s reaction curve. Thus,
the reaction curve of firm A is the locus of points of highest profits that firm A can attain,
given the level of output of rival B. It is called ‘reaction curve’ because it shows how firm
A will determine its output as a reaction to B’s decision to produce a certain level of
output, A’s reaction curve is shown in figure 1.10.
Figure 1.10: Highest Profit Points

B’s isoprofit curves are concave to the QB axis. Their shape and position are
deter­mined by the same factors as the ones underlying firm A’s isoprofit curves. The highest
point of the isoprofit curves of B lie to the right of each other as we move to curves further
away from the QB axis. If we join these highest points we obtain B’s reaction function (figure
1.11). Each point of the reaction curve shows how much output B must produce in order to
maximize its own profit, given the level of output of its rival.

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Figure 1.11: Profit Maximization

Cournot’s equilibrium is determined by the intersection of the two reaction curves. It

is a stable equilibrium, provided that A’s reaction curve is steeper than B’s reaction curve.
(This condition is satisfied by the assumption we made that the highest points of successive
isoprofit curves of A lie to the left of one another, while the highest points of B’s isoprofit
curves lie to the right of each other.) To see that, let us examine the situation arising from A’s
decision to produce quantity A1, lower than the equilibrium quantity Ae (figure 1.12). Firm B
will react by producing B1 given the Cournot assumption that firm A will keep its quantity
fixed at A1.
Figure 1.12: Equilibrium Quantity

However, A reacts by producing a higher quantity, of A2, on the assumption that B

will stay at the level B1. Now firm B, reacts by reducing its quantity at B2. This adjustment
will continue until point e is reached. The same equilibrium would be reached if we started
from a point to the right of e. Thus e is a stable equilibrium.

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Figure 1.13: Edgeworth's Contract Curve

Note that at point e each firm maximises its own profit, but the industry (joint profit)
is not maximized (figure 1.13). This is easily seen by a curve similar to Edge-worth’s
contract curve which traces points of tangency of the two firms’ isoprofit curves. Points on
the contract curve are optimal in the sense that points off this curve imply a lower profit for
one or both firms, that is, less industry profits as compared to points on the curve. Point e is a
suboptimal point, and total industry profits would be higher if firms moved away from it on
any point between a and b on the contract curve at point a firm A would continue to have the
same profit while firm B would have a higher profit (ΠA2 > ΠA3).
At point b firm B would remain on the same isoprofit curve nB3 while firm A would
move to a higher isoprofit curve (ΠA2 > ΠA3). Finally at any inter-mediate point between a
and b, e.g. at c, both firms would realise higher profits. The question arises of why the firms
choose the suboptimal equilibrium e. The answer is that the Cournot pattern of behaviour
implies that the firms do not learn from past experience, each expecting the other to remain at
a given position.
Each firm acts independently, in that it does not know that the other behaves on the
same assumption (behaviourial pattern). We will see in a subsequent section how Stackelberg
modified this model, by assuming that one or both of the duopolists may be sufficiently alert
to recognise that his rival will make the Cournot assumption about his behaviour.

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The first duopolist maximises his profit by assuming X2 constant, irrespective of his
own decisions, while the second duopolist maximises his profit by assuming that X1 will
remain constant.
The first-order condition for maximum profits of each duopolist is

Solving the first equation) for X1 we obtain X1 , as a function of X2, that is, we obtain
the reaction curve of firm A. It expresses the output which A must produce in order to
maximise his profit for any given amount X2 of his rival.
Solving the second equation for X2 we obtain X2 as a function of X1, that is, we obtain
the reaction function of firm B.

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If we solve the two equations simultaneously we obtain the Cournot equilibrium, the
values of X1 and X2 which satisfy both equations; this is the point of intersection of the two
reaction curves.

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1.9 Kinked Demand Curve Hypothesis

It has been observed that many oligopolistic industries exhibit an appreciable degree
of price rigidity or stability. In other words, in many oligopolistic industries prices remain
sticky or inflexible, that is, there is no tendency on the part of the oligopolists to change the
price even if the economic conditions undergo a change.
Many explanations have been given of this price rigidity under oligopoly and most
popular explanation is the so called kinked demand curve hypothesis. The kinked demand
curve hypothesis was put forward independently by Paul M. Sweezy, an American
economist, and by Hall and Hitch, Oxford economists.
It is for explaining price and output under oligopoly with product differentiation, that
economists often use the kinked demand curve hypothesis. This is because when under
oligopoly prod-ucts are differentiated, it is unlikely that when a firm raises its price, all
customers would leave it because some customers are intimately attached to it due to product
differentiation.
As a result, demand curve facing a firm under differentiated oligopoly is not perfectly
elastic. On the other hand, under oligopoly without product differentiation, when a firm raises
its price, all its customers would leave it so that demand curve facing an oligopolist
producing homogeneous product may be per-fectly elastic.

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Further, under oligopoly without product differentiation, there is a greater tendency

on the part of the firms to join together and form a collusion, formal or tacit, and,
alternatively, to accept one of them as their leader in setting their price. No doubt, kinked
demand curve has a special relevance for differentiated oligopoly, but it has also been applied
for explaining price and output under oligopoly without product differentiation.
The demand curve facing an oligopolist, according to the kinked demand curve
hypothesis, has a ‘kink’ at the level of the prevailing price. The kink is formed at the
prevailing price level because the segment of the demand curve above the prevailing price
level is highly elastic and the segment of the demand curve below the prevailing price level is
inelastic.
A kinked demand curve dD with a kink at point K has been shown in Fig. 1.14. The
prevailing price level is OP and the firm is produc-ing and selling the output OM. Now, the
upper segment dK of the demand curve dD is relatively elastic and the: lower segment KD is
relatively inelastic. This difference in elasticities is due to the particular competitive reaction
pattern assumed by the kinked demand curve hypothesis.
The competitive reaction pattern assumed by the kinked demand curve oligopoly theory
is as follows:
Each oligopolist believes that if he lowers the price below the prevailing level, his
competitors will follow him and will accordingly lower their prices, whereas if he raises the
price above the prevailing level, his competitors will not follow his increase in price.
In other words, each oligopolistic firm believes that though its rival firms will not match his
increase in price above the prevailing level, they will indeed match its price cut. These two
different types of reaction of the competitors to the increase in price on the one hand and to
the reduction in price on the other make the portion of the demand curve above the prevailing
price level relatively elastic and the lower portion of the demand curve relatively inelastic.
This is explained below:
(a) Price reduction:
If the oligopolist reduces its price below the prevailing price level OP in order to
increase his sales, the competitors will fear that their customers would go away from them to
buy the product from the former oligopolist which has made a price cut.
Therefore, in order to retain their customers they will be forced quickly to match the price
cut. Because of the competitors quickly following the reduction in price by an oligopolist, he
will gain in sales only very little. (His sales will increase not at the expense of his competitors
but because of the rise in total quantity demanded due to the reduction in price of the good.

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In fact each will gain in sales to the extent of a proportionate share in the increase in total
demand). Very small increase in sales of an oligopolist following his reduction in price below
the prevailing level means that the demand for him is inelastic below the prevailing price.
Thus the segment KD of the demand curve in Fig. 1.14 which lies below the prevailing price
OP is inelastic showing that very little increase in sales can be obtained by a reduction in
price by an oligopolist.
(b) Price increase:
If an oligopolist raises his price above the prevailing level, there will be a substantial
reduction in his sales. This is because as a result of the rise in his price, his customers will
withdraw from him and will go to his competitors who will welcome the new customers and
will gain in sales.
These happy competitors will have therefore no motivation to match the price rise.
The oligopolist who raises his price will be able to retain only those customers who either
have a strong preference for his product (if the products are differentiated) or who cannot
obtain the desired quantity of the product from the competitors because of their limited
productive capacity.
Large reduction in sales following an increase in price above the prevailing level by
an oligopolist means that demand with respect to increases in price above the existing one is
highly elastic. Thus, in Fig. 1.14 the segment dK of the demand curve which lies above the
current price level OP is elastic showing a large fall in sales if a product raises his price.
It is now evident from above that each oligopolist finds himself placed in such a position that
while, on the one hand, he expects his rivals to match his price cuts very quickly, he does not
expect his rivals to match his price increases on the other. Given this expected competitive
reaction pattern, each oligopolist will have a kinked demand curve dKD with the upper
segment dK being relatively elastic and the lower segment KD being relatively inelastic.
Figure 1.14: Kinked Demand Curve under Oligopoly

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Why Price Rigidity under Oligopoly?

From what has been said above, it is easy to see why an oligopolist confronting a
kinked demand curve will have no incentive to raise its price or to lower it. Since the
oligopolist will not gain a large share of the market by reducing his price below the prevailing
level, and will have substantial reduction in sales by increasing his price above the prevailing
level, he will be extremely reluctant to change the prevailing price. In other words, each
oligopolist will adhere to the prevailing price seeing no gain in changing it. Thus, rigid prices
are explained in this way by the kinked demand curve theory.
In Fig. 1.14, the prevailing price is OP at which kink is found in the demand curve
dKD. The price P will tend to remain stable or rigid as every member of the oligopoly will
not see any gain in lowering it or in increasing it. It should be noted that if the prevailing
price OP is greater than average cost, more than normal profits will be made.
Further, it is worth mentioning that the oligopolist confronting a kinked demand curve
will be maximising his profits at the current price level. For finding the profit maximizing
price-output combination, marginal revenue curve MR corresponding to the kinked demand
curve dKD has been drawn. It is worth mentioning that the marginal revenue curve associated
with a kinked demand curve is discontinuous, or in other words, it has a broken vertical
portion.
The length of the discontinuity depends upon the relative elasticities of two segments
dK and KD of the demand curve at point K. The greater the difference in the two elasticities,
the greater the length of the discontinuity. In Fig. 1.15 marginal revenue curve MR
corresponding to the kinked demand curve dKD has been drawn which has a discontinuous
portion or gap HR.
Figure 1.15: Change in Costs within Limits do not Affect the Oligopoly Price

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Now, if the marginal cost curve of the oligopolist is such that it passes anywhere, say
from point E, through the discontinuous portion HR of the marginal revenue curve MR, as
shown in Fig. 1.15, the oligopolist will be maximizing his profits at the prevailing price level
OP, that is, he will be in equilibrium at point E or at the prevailing price OP. Since the
oligopolist is in equilibrium, or in other words, maximising his profits at the prevailing price
level, he will have no incentive to change the price.
Furthermore, even if there are changes in costs, the price will remain stable so long as
the marginal cost curve passes through the gap HR in the marginal revenue curve. In Fig.
1.15 when the marginal cost curve shifts upward from MC to MC’ (dotted) due to the rise in
cost, the equilibrium price and output remain unchanged since the new marginal cost MC’
also passes from point E’ through the gap HR.
Likewise, the kinked demand curve theory explains that even when the demand
conditions change, the price may remain stable. This is illustrated in Fig. 1.16 in which when
the demand for the oligopolist increases from dKD to d’K’D’, the given marginal cost curve
MC also cuts the new marginal revenue curve MR’ within the gap. This means that the same
price OP continues to prevail in the oligopolistic market.
Figure 1.16: Change in Demand do not Affect the Oligopoly Price

However, it is worth mentioning that from the kinked demand curve oligopoly theory
it does not follow that the price always remains the same whenever the costs and demand
conditions undergo a change.
When the price is likely to change and when it is likely to remain inflexible in the face of
changing costs and demand conditions is explained below:

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(1) Decline in Costs:

When the cost of production declines, the price is more likely to remain stable. When
the cost of production falls, then segment of the demand curve above the current price will
become more elastic because with lower costs there is a greater certainty that the increase in
price by an oligopolist will not be followed by his rivals and will thus cause greater loss in
sales.
On the other hand, with lower cost the segment of the demand curve below the current
price will become more inelastic because with the decline in costs, there is then greater
certainty that the reduction in price by an oligopolist will be followed by his rivals.
With the upper segment becoming more elastic and the lower segment becoming
more inelastic than before, the angle dKD will become less obtuse and hence the gap in the
marginal revenue curve will increase.
As a result of the increase in the gap (that is, the length of discontinuity) in the
marginal revenue curve, the lower marginal cost curve is likely to pass through this gap
showing that the price and output remain the same as before.
(2) Rise in Cost:
If there is a rise in the cost of the oligopolistic industry, the price is not likely to stay
rigid. When there is a rise in cost of industry an oligopolist can reasonably expect that his
increase in price will be followed by the others in the industry.
Consequently, the segment of the demand curve above the prevailing price will
become less elastic and thereby make the angle dKD more obtuse and this will narrow down
the gap in the marginal revenue curve.
With the smaller gap in the marginal revenue curve, the higher marginal cost curve is
likely to cut it above the upper point H indicating that the equilibrium price will rise and the
equilibrium output will fall. Thus it follows from the kinked demand curve theory that price
is not likely to remain stable in the event of rise in cost.
(3) Decrease in Demand:
In case of decrease in demand, the price is very likely to remain inflexible and will
not fall. When the demand decreases, it becomes more certain that if one oligopolist initiates
the reduction in price, others will follow with the result that the lower segment of the demand
curve will become more inelastic.
On the other hand, in the face of a decline in demand it is very certain that the
increase in price by one oligopolist will never be followed by others. As a result, the upper

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segment of the demand curve becomes more elastic, that is, it becomes more nearly
horizontal.
With the increase in the elasticity of the upper segment and the decrease in the
elasticity of the lower segment, the gap in the marginal revenue curve becomes wider and
there it is most likely that the given marginal cost curve will cross the marginal revenue curve
inside the gap when the demand curve dKD shifts downward. This indicates that the price
will remain unchanged in the case of decrease in demand.
(4) Increase in Demand:
When the demand increases, the price is unlikely to remain stable, instead the price is
likely to rise. In the event of increase in demand, an oligopolist can expect that if he initiates
the increase in price, his competitors will most probably follow him. Therefore, the upper
segment dKD of the demand curve will become less elastic and the angle dKD will become
more obtuse.
As a result, the gap HR in the marginal revenue curve will decrease and if this gap
decreases much it is very likely that the marginal cost curve crosses the marginal revenue
curve above the upper point H, that is, above the gap, indicating that the price will rise above
OP.
From above, it is clear that the kinked demand curve analysis of oligopoly explains
stability in price in the face of falling costs or declining demand, whereas, price are likely to
rise when either the costs rise or demand increases. M.M. Bober, thus rightly writes:
“The kinky demand curve analysis points to the likelihood of price rigidity in
oligopoly when a price reduction is in order and of price flexibility when conditions warrant a
rise in price. There is hardly any disposition to lower the price when there is decline in
demand or in costs, but the price may be raised in response to increased demand or to rising
cost.”
Critical Appraisal of Kinked Demand Curve Theory:
1. We saw above how the kinked demand curve theory of oligopoly provides an explanation
of price rigidity under oligopoly. But there is a major drawback in the theory. It only
explains why once an oligopoly price has been determined it would remain rigid or stable
it does not explain how the price has been determined.
There is nothing in the kinked demand theory which explains how the price which is
prevailing is determined. In other words, whereas this theory shows why price tends to stay
where it is, it tells us nothing about why the price is where it is.

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In Fig. 1.14 the kink occurs at the price OP because OP happens to be the prevailing or
established price. The theory does not explain how the price got to be equal to OP.
Commenting upon kinked demand curve theory Prof. Silberston rightly writes, “The most
interesting question is not ‘why are prices sticky in the short run?’ (if they are), but who
decides what the price is to be and on what principles.”
However, it may be mentioned that the above criticism applies especially to P.M. Sweezy’s
version of the kinked demand curve analysis. Hall and Hitch’s version of kinked demand
curve analysis also explains the determination of oligopoly price.
Figure 1.17: Full-Cost Pricing and Kinked Demand Curve

According to Hall and Hitch, equilibrium price is determined by average cost

(including normal profits), that is, by the tangency between average cost curve and the
demand curve, as shown in Fig. 1.17. However, Hall and Hitch version runs into difficulty
when the average cost curve of the various firms in an oligopolistic industry is different.
2. Another shortcoming of the kinked-demand oligopoly theory is that it does not apply to
the oligopoly cases of prices leadership and price cartels which account for quite a large
part of the oligopolistic markets. When price leadership and price cartels exist in
oligopolistic markets there is concerted behaviour in regard to the price changes and
hence there is no kink in the demand curve in these cases.
3. Finally, even in the case of pure oligopoly (i.e. oligopoly with homogenous products), the
kinked demand curve theory does not furnish a complete explanation for price rigidity
observed in oligopolistic markets. From the kinked demand curve analysis it follows that
prices are likely to remain stable when demand or cost conditions decrease, whereas
under pure oligopoly prices are likely to rise in the case of increase in cost or demand.
4. Finally, it has been rightly asserted that explanation of price stability by Sweezy’s kinked
demand curve theory applies only to depression periods. In periods of depression, demand

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for the products decreases. As has been explained above, in the context of decreased
demand, price in kinked demand curve theory is likely to remain sticky. But in periods of
boom and inflation when the demand for the product is high and increasing, the price is
likely to rise rather than remaining stable.
We, therefore, conclude that from Sweezy as well as Hall and Hitch’s versions of
kinked demand curve follows that prices are likely to remain stable during depression periods
but not during boom and inflationary periods. Our analysis shows that whether we use kinked
demand curve of the type postulated by Sweezy, or Hall and Hitch prices are unlikely to be
stable during the boom periods.
1.10 Cartels
A cartel is an association of independent firms within the same industry. The cartel
follows common policies relating to prices, outputs, sales and profit maximization and
distribution of products.
Cartels may be voluntary or compulsory and open or secret depending upon the policy
of the government with regard to their formation. They are of many forms and use many
devices in order to follow varied common policies depending upon the type of the cartel.
We saw that, in the absence of collusion, the monopoly solution in the industry (the solution
at which the joint industry profit is maximized) can be achieved under the rare conditions
that;
a) each firm knows the monopoly price, that is, has a correct knowledge of the market
demand and of the costs of all firms,
b) that each firm recognizes its interdependence with the others in the industry,
c) all firms have identical costs and identical demands. (Actually condition (c) implies
condition (a))
We will examine two typical forms of cartels:
(a) Cartels aiming at Joint-Profit Maximization, (i.e., maximization of the industry profit) and
(b) Cartels aiming at the Sharing of the Market.
A. Cartels aiming at Joint-Profit Maximization:
Assumptions:
The analysis of joint profit maximisation cartel is based on the following assumptions:
1. Only two firms A and B are assumed in the oligopolistic industry that form the cartel.
2. Each firm produces and sells a homogeneous product that is a perfect substitute for each
other.

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3. The market demand curve for the product is given and is known to the cartel.
4. The number of buyers is large.
5. The price of the product determines the policy of the cartel.
6. The cost curves of the firm’s are different but are known to the cartel.
7. The cartel aims at joint profit maximisation.
Cartels imply direct (although secret) agreements among the competing oligopolist
with the aim of reducing the uncertainty arising from their mutual interdependence. In this
particular case the aim of the cartel is the maximisation of the industry (joint) profit. The
situation is identical with that of a multiplant monopolist who seeks the maximisation of his
profit. We concentrate on a homogeneous or pure oligopoly, that is, an oligopoly where all
firms produce a homogeneous product. The case of differentiated oligopoly will be examined
in a separate section.
The firms appoint a central agency, to which they delegate the authority to decide not
only the total quantity and the price at which it must be sold so as to attain maximum group
profits, but also the allocation of production among the members of the cartel, and the
distribution of the maximum joint profit among the participating members.
The authority of the central cartel agency is complete. Clearly the central agency will
have access to the cost figures of the individual firms, and for the purposes of the present
theory we unrealistically suppose that it will calculate the market-demand curve and the
corresponding MR curve. From the horizontal summation of the MC curves of individual
firms the market MC curve is derived.
The central agency, acting as a multi- plant monopolist, will set the price defined by
the intersection of the industry MR and MC curves. For simplicity assume that there are only
two firms in the cartel. Their cost structure is shown in figures 1.18 and 1.19. From the
horizontal summation of the MC curves we obtain the market MC curve.
This is implied by the profit-maximisation goal of the cartel each level of industry
output should be produced at the least possible cost. Thus if we add the outputs of A and B
that can be produced at the same MC, clearly the resulting total output is the output that can
be produced at this common lowest cost. Given the market demand DD (in figure 1.18) the
monopoly solution, which maximises joint profits, is determined by the intersection of MC
and MR (point e in figure 1.20).

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Figure 1.18, 1.19 and 1.20: Cartels aiming at Joint-Profit Maximization

Figure: 1.18 Figure: 1.19 Figure: 1.20

The total output is X and it will be sold at price P. Now the central agency allocates
the production among firm A and firm B as a monopolist would do, that is, by equating the
MR to the individual MCs. Thus firm A will produce X1 and firm B will produce X2. Note
that the firm with the lower costs produces a larger amount of output. However, this does not
mean that A will also take the larger share of the attained joint profit. The total industry profit
is the sum of the profits from the output of the two firms, denoted by the shaded areas of
figures 1.18 and 1.19. The distribution of profits is decided by the central agency of the
cartel.

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Although theoretically the monopoly solution is easy to derive, in practice cartels

rarely achieve maximum joint profits. There are several reasons why industry profits cannot
be maximised, even with direct cartel collusion.
It should be obvious that equilibrium with joint profit maximisation will be easier to
attain and will be in general stable if firms have identical costs and identical demands,
conditions that are rarely met in practice. (However, even with identical costs cartels may still
be unstable. See below.) Even in these conditions many factors may mitigate against
achievement of the joint profit-maximisation goal of the cartel. The main reasons why
industry profits may not be maximised may be summarized as follows.
First:
Mistakes in the estimation of market demand. Usually the elasticity of market demand
is underestimated. Each firm believes that the e of its own demand curve is high due to the
existence of perfect (or almost perfect) substitutes made by competitors, while the industry
demand is much less elastic. Clearly, mistakes in the estimation of the market demand lead to
mistakes in the derivation of the MR and hence to a price which is higher than the monopoly
price.
Second:
Mistakes in the estimation of MC. The estimation of the market MC, from the
summation of individual costs, may involve mistakes, due to incomplete knowledge of the
individual MC curves at all levels of output. That is, even if a cartel estimated marginal costs,
which is highly improbable, it would probably get them wrong.
Such errors lead to an equilibrium which differs from the monopoly solution. There is
a strong incentive for the individual members to present low-cost figures to the central

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agency, since the allocation of output and of profit shares is determined, among others, by the
level of costs.
Third:
Slow process of cartel negotiations. Cartel agreements take a long time to negotiate
due to the differences in size, costs, and markets of the individual firms. During the
negotiations each firm is bargaining in order to attain the greatest advantage from the cartel
agreement.
Thus, even if at the beginning of the negotiations costs and market demand were
correctly estimated, by the time agreement is reached market conditions may have changed,
thus rendering the initially denned monopoly price obsolete. Cartel agreements with more
than about twenty partners are difficult to reach, and break down easily once reached.
Fourth:
‘Stickiness’ of the negotiated price. Once the agreement about price is reached, its
level tends to remain unchanged over long periods, even if market conditions are changing.
This price inflexibility (stickiness) is due to the time-consuming process of cartel negotiations
and the difficulties and uncertainties about the bargaining of cartel members.
Fifth:
The ‘bluffing’ attitude of some members during the bargaining process. Some firms
may attempt to reduce price, to expand their selling activities and in general to achieve a
large market share before the final agreement, so as to achieve the maximum advantage from
it. However, such activities have only short-run effects and lead to miscalculations of the real
monopoly equilibrium price and output.
Sixth:
The existence of high-cost firms. If a firm is operating with a cost curve which is
higher than the equilibrium MC, clearly this firm should close down if joint profits are to be
maximised. (Firm C in figure 1.21 should close down.) However, no firm would join the
cartel if it had to close down, even if the other firms agree in allocating to it part of the total
profits, because by closing down the firm loses all its customers, and if subsequently the
cartel members decide to stop sharing their profits with this member, there is little that he can
do about it, since he has to start from scratch in order to attract back his old customers.

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Figure 1.21: High-Cost Firm Reduces Profit Maximisation

Seventh:
Fear of government interference. If the monopoly price yields too high profits the
cartel members may decide not to charge it, for fear of government interference.
Eighth:
The wish to have a good public image. Similarly the members of the cartel may
decide not to charge the profit-maximising price if profits are lucrative, if they wish to have
the ‘good’ reputation of charging a ‘fair price’ and realising ‘fair profits’.
Ninth:
Fear of entry. One major reason for not charging the profit-maximising price if it
yields too high profits is the fear of attracting new firms to the industry. Since there is great
uncertainty regarding the behaviour of the new firm, established firms prefer to sacrifice
some of their profits in order to prevent entry.
Tenth:
Keeping freedom regarding design and selling activities. Even if firms adhere to the
price defined by the central agency, they usually keep their freedom in deciding the style of
their output and their selling activities. Each firm tries to attain higher sales by better service
or intensive selling activities. (This holds in particular for differentiated products. See below.)
This attitude leads to increased costs, and hence to a decrease in the monopoly profits.
It is clear that there are too many exceptions to the theory of joint profit maximisation for it to
be a satisfactory theory of oligopolistic behaviour.
A note on mergers:
The above model of profit-maximising cartel, where output of each member is
decided by the central governing body of the cartel on the basis of marginalistic rules, is also
applicable to mergers of firms producing the same product. A merger involves the decision of
a number of independent firms to form a single corporation. The new firm may act as a cartel
it may decide to change the output quota of each plant so as to maximise the overall profit of
its operations.

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In this process each plant will be allocated a quota defined by the equality of its
marginal cost with the common marginal revenue of the corporation created from merger.
Under these conditions the difference between a cartel and a merger is only a legal one while
overt cartel agreements are illegal in Britain and in the U.S.A., mergers are generally legal.
A merger can be forbidden only if it is proved that its aim is to restrict competition
and earn abnormal monopoly profits. However, mergers are usually rationalised on grounds
of better utilisation of resources and attainment of economies of scale, and thus are allowed to
take place more often than not.
While the above model may be applied to mergers in theory, it is not certain that the
implied reallocation of resources and output will actually take place. The analysis of the
motives of mergers and their actual operation goes beyond the scope of this book.
B. Market-sharing cartels:
This form of collusion is more common in practice because it is more popular. The
firms agree to share the market, but keep a considerable degree of freedom concerning the
style of their output, their selling activities and other decisions.
There are two basic methods for sharing the market non-price competition and determination
of quotas.
Non-price competition agreements:
In this form of ‘loose’ cartel the member firms agree on a common price, at which
each of them can sell any quantity demanded. The price is set by bargaining, with the low-
cost firms pressing for a lower price and the high-cost firms for a high price. The agreed price
must be such as to allow some profits to all members.
The firms agree not to sell at a price below the cartel price, but they are free to vary
the style of their product and/or their selling activities. In other words, the firms compete on a
non-price basis. By keeping their freedom regarding the quality and appearance of their
product, as well as advertising and other selling policies, each firm hopes that it can attain a
higher share of the market.
This form of cartel is indeed loose’, in the sense that it is more unstable than the
complete cartel aiming at joint profit maximisation. If all firms have the same costs, then the
price will be agreed at the monopoly level. However, with cost differences the cartel will be
inherently unstable, because the low-cost firms will have a strong incentive to break away
from the cartel openly and charge a lower price, or to cheat the other members by secret price
concessions to the buyers.

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However, such cheating will soon be discovered by the other members of the cartel,
who will gradually lose their customers. Thus others may split away from the cartel, and a
price war and instability may develop until only the fittest low-cost firms survive. Another
possibility is that the members of the cartel in conjunction may decide to start a price war
until the firm which split off or cheated is driven out of business.
Whether this policy will be successful depends on the cost differential (cost
advantage) of the splitter relative to the other cartel members as well as on the liquidity
position and the ability of obedient members to finance possible losses during the period of
the price war.
In figure 1.22 firm B has lower costs than A, and hence B will have the incentive to
cut the price below the monopoly level, thus driving the high-cost competitor A out of
business.

Figure 1.22: Market-Sharing Cartels

Even with the same cost structure these cartels are inherently unstable, because if one
firm splits away and charges a slightly lower price than the monopoly price PM while the
others remain in the cartel, the splitting firm will attract a considerable number of customers
from the others its demand curve will be much more elastic and its profits will be increased.
All firms will have the same incentive to leave the cartel, which thus becomes inherently
unstable, unless supported by tight legislation. With open collusion being illegal it is not
surprising that cartels are usually short-lived.
Sharing of the market by agreement on quotas:
The second method for sharing the market is the agreement on quotas, that is,
agreement on the quantity that each member may sell at the agreed price (or prices). If all
firms have identical costs, the monopoly solution will emerge, with the market being shared
equally among member firms. For example, if there are only two firms with identical costs,

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each firm will sell at the monopoly price one-half of the total quantity demanded in the
market at that price.
In figure 1.23 the monopoly price is PM and the quotas which will be agreed are X1 =
X2 = ½ XM. However, if costs are different, the quotas and shares of the market will differ.
Allocation of quota-shares on the basis of costs is again unstable. Shares in the case of cost
differentials are decided by bargaining. The final quota of each firm depends on the level of
its costs as well as on its bargaining skill. During the bargaining process two main statistical
criteria are most often adopted quotas are decided on the basis of past levels of sales, and/or
on the basis of ‘productive capacity’. The ‘past-period sales’ and/or the definition of
‘capacity’ of the firm depends largely on their bargaining power and skill.
Figure 1.23: Sharing of the Market by Agreement on Quotas

Another popular method of sharing the market is the definition of the region in which
each firm is allowed to sell. In this case of geographical sharing of the market the price as
well as the style of the product may differ. There are many examples of regional market-
sharing cartels, some operating at international levels.
However, even a regional split of the market is inherently unstable. The regional
agreements are often violated in practice, either by mistake or intentionally, by the low-cost
firms who have always the incentive to expand their output by selling at a lower price openly
defined, or by secret price concessions, or by reaching adjacent markets through advertising.
It should be obvious that the cartel models of collusive oligopoly are ‘closed’ models. If entry
is free, the inherent instability of cartels is intensified: the behaviour of the entrant is not
predictable with certainty. It is not certain that a new firm will join the cartel.
On the contrary, if the profits of the cartel members are lucrative and attract new firms
in the industry, the newcomer has a strong incentive not to join the cartel, because in this way
his demand curve will be more elastic, and by charging a slightly lower price than the cartel
he can secure a considerable share in the market, on the assumption that the cartel members
will stick to their agreement.

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Cartels, being aware of the dangers of entry, will either charge a low price so as to
make entry unattractive, or may threaten a price war on the newcomer. If entry occurs and the
cartel carries out its threat of price war, the newcomer may still survive, depending on his
cost advantage, and his financial strength in withstanding possible losses during the initial
period of his establishment, until he reaches the size which will allow him to reap the full
‘scale economies’ that he has over those enjoyed by existing firms.
1.11 Price Leadership
Price leadership is said to exist when the price at which most or all of the firms in the
industry offer to sell is determined by the leader (one of the firms of the industry).
This method was formulated by the German economist. Prof. Heinrichvon Stackelberg. This
is also known as leadership solution or followership solution.
Here, we shall discuss three important cases of price leadership:
1) Price Leadership by a Low-Cost Firm, and
2) Price Leadership by a Dominant Firm.
3) The Barometric Price Leadership Model
1. The Low-Cost Price Leadership Model:
In the low-cost price leadership model, an oligopolistic firm having lower costs than
the other firms sets a lower price which the other firms have to follow. Thus the low-cost firm
becomes the price leader.
Assumptions:
The low-cost firm model is based on the assumptions of:
1. There are two firms A and B.
2. Their costs differ. A is the low-cost firm and B is the high-cost firm.
3. They have identical demand and MR curves. The demand curve faced by them is 1/2 of
the market demand curve.
4. The number of buyers is large.
5. The market industry demand curve for the product is known to both the firms.
Explanation:
In Figure 1.24, D is the industry demand curve and d/MR is its corresponding
marginal revenue curve which is the demand curve for both the firms and mr is their marginal
revenue curve. The cost curves of the low-cost firm A are ACa and MCa and of the high-cost
firm B are ACb, and MCb.

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Figure 1.24: Industry Demand and its Corresponding Marginal Revenue Curve

If the two firms act independently, the high cost firm B would charge OP price per
unit and sell OQb quantity, as determined by point B where it’s MCb, curve cuts the mr curve.
Similarly, the low- cost firm A would charge OP1 price per unit and sell OQ a quantity, as
determined by point A where its MCa curve cuts the I curve. As there is a tacit agreement
between the two firms, the high-cost fir leader firm A.
It will, therefore, sell OQ quantity, at a lower price OP1 even though it will not be
earning maximum profits. On the other hand, the price leader A will earn much higher profits
at OP1 price by selling OQa quantity.
Since both A and B sell the same quantity OQa the total market demand OQ is equally
divided between the two, OQ = 2 OQa. But if firm B sticks to OP price, its sales will be zero
because the product being homogeneous, all its customers will shift to firm A.
The price-leader firm A can, however, drive firm B out of the market by setting a
lower price than OP1, lower than the average cost ACb, of firm B. Firm A would become a
monopoly firm. But in such, a situation it will have to face legal problems. Therefore, it will
be in its interest to fix OP1 price and tolerate firm B in order to share the market equally and
maximize its profits.
Price leadership model with unequal market Shares. The two firms will have different
demand curves along with their different cost curves. The low-cost firm’s demand curve will
be more elastic than that of the high-cost firm.
The high-cost firm would maximize its profits by selling less at a higher price while
the low-cost firm would sell more at a lower price and maximize its profits. If they enter into
a common price agreement, the high-cost firm will sell more quantity at a lower price set by
the price leader by earning a little less than the maximum profits. But this is only possible so
long as the price set by the leader covers the AC of the high-cost firm.

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The price leadership model with unequal market shares is given in Figure 1.25, where
the market demand curve is not shown to simplify the analysis. In the figure, Da is the
demand curve of the low-cost firm A and MRa is its marginal revenue curve.
Figure 1.25: Price Leadership Model with Unequal Market Shares

The demand curve and MR curve of the high-cost firm B are Db, and MRb, The low-
cost firm A sets the price OP and the quantity OQa when its MCa curve cuts its MRa curve at
point A. The price OP1 and the quantity OQ/, of the high-cost firm B are determined when its
MCb, curve cuts its MRb, curve at point B. Following the price leader firm A, when firm B
accepts the price OP, it sells more quantity OQa1 and earns less than maximum profits.
It will pay the follower firm to sell this quantity at OP price so long as this price
covers its average cost. If it does not follow the leader firm and tries to sell OQ1, quantity at
its profit maximisation price OP1, it will have to close down because its customers will switch
over to the leader firm which charges low price OP.
However, if there is no agreement for sharing the market between the leader and the
follower firms, the follower can adopt the price of the leader (OP) but produce a lower
quantity (less than OQb1) than required to maintain the price in the market, and thus push the
leader to a non-profit maximisation position by producing less output.
2. The Dominant Firm Price Leadership Model:
This is a typical case of price leadership where there is one large dominant firm and a
number of small firms in the industry. The dominant firm fixes the price for the entire
industry and the small firms sell as much product as they like and the remaining market is
filled by the dominant firm itself. It will, therefore, select that price which brings more profits
to itself.

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Assumptions:
This is based on the following assumptions:
1. The oligopolistic industry consists of a large dominant firm and a number of small
firms.
2. The dominant firm sets the market price.
3. All other firms act like pure competitors, which act as price takers. Their demand
curves are perfectly elastic for they sell the product at the dominant firm’s price.
4. The dominant firm alone is capable of estimating the market demand curve for the
product.
5. The dominant firm is in a position to predict the supplies of other firms at price set by it.
Explanation:
Given these assumptions, when each firm sells its product at the price set by the
dominant firm, its demand curve is perfectly elastic at that price. Thus its marginal revenue
curve coincides with the horizontal demand curve.
The firm will produce that output at which its marginal cost equals marginal revenue.
The MC curves of all the small firms combined laterally establish their aggregate supply
curve. All these firms behave competitively while the dominant firm behaves passively. It
fixes the price and allows the small firms to sell all they wish at that price.
The case of price leadership by the dominant firm is explained in Fig. 1.26. DD1 is the
market demand curve. ΣMCS. is the aggregate supply curve of all the small firms.
By subtracting 2MC5 from DD) at each price, we get the demand curve faced by the
dominant firm, PNMBD1 which can be drawn as follows:
Figure 1.26: Dominant Firm Price Leadership Model

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Suppose the dominant firm sets the price OP. At this price, it allows the small firms to
meet the entire market demand by supplying PS quantity. But the dominant firm would
supply nothing at the price OP. Point P is, therefore, the starting point of its demand curve.
Now take a price OP1 less than OP.
The small firms would supply P1 C (= OQs) output at this price OP1 when their SMCs
curve cuts their horizontal demand curve P1R at point C. Since the total quantity demanded at
OP1 price is P1R (= OQ) and the small firms supply P1C quantity, CR (= Qs Q) quantity
would be supplied by the dominant firm. By taking P1N = CR on the horizontal line P1R, the
dominant firm’s supply becomes P1N (= OQd). Thus we derive point N on the dominant
firm’s demand curve by subtracting the horizontal distance from point P1 to N from the
demand curve DD1.
Since the small firms supply nothing at prices below OP2 because their ΣMCs curve
exceeds this price, the dominant firm’s demand curve coincides with the horizontal line P 2B
over the range MB and then with the market demand curve over the segment BD1. Thus the
dominant firm’s demand curve is PNMBD1.
The dominant firm will maximize its profits at that output where its marginal cost
curve MCd cuts its MRd, the marginal revenue curve. It establishes the equilibrium point E at
which the dominant firm sells OQ1 output at OP1 price.
The small firms will sell OQs output at this price for ΣMCs, the marginal cost curve of
the small firms equals the horizontal price line P1R at C. The total output of the industry will
be OQ = OQd + 0Q5. If OP2 price is set by the dominant firm, the small firms would sell P2A
and the dominant firm AB. In case a price below OP2 is set the dominant firm would meet the
entire industry demand and the sales of the small firms would be zero. The above analysis
shows that the price- quantity solution is stable because the small firms behave passively as
price-takers.
3. The Barometric Price Leadership Model:
The barometric price leadership is that in which there is no leader firm as such but one
firm among the oligopolistic firms with the wisest management which announces a price
change first which is followed by other firms in the industry. The barometric price leader may
not be the dominant firm with the lowest cost or even the largest firm in the industry. It is a
firm which acts like a barometer in forecasting changes in cost and demand conditions in the
industry and economic conditions in the economy as a whole.
On the basis of a formal or informal tacit agreement, the other firms in the industry
accept such a firm as the leader and follow it in making price changes for the product.

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The barometric price leadership develops due to the following reasons:

1. As a reaction to the earlier experience of violent price changes and cut-throat
competition among oligopolistic firms, they accept one firm as the price leader.
2. Most firms do not possess the expertise to calculate cost and demand conditions of the
industry. So they leave their estimation to one leader firm which has the ability to do so.
3. Oligopolistic firms accept one among them as the barometric leader firm which
possesses better knowledge and predictive power.
1.12 Summary
The analysis of market structures is of great importance when studying
microeconomics. How the market will behave, depending on the number of buyers or sellers,
its dimensions, the existence of entry and exit barriers, etc. will determine how an
equilibrium is reached.
The main aspects that determine market structures that is the number of agents in the
market, both sellers and buyers; their relative negotiation strength, in terms of ability to set
prices; the degree of concentration among them; the degree of differentiation and uniqueness
of products; and the ease, or not, of entering and exiting the market. The interaction and
differences between these aspects allow for the existence of several market structures.
1.13 Answer to Check Your Progress
Monopolistic Competition: It refers to the market situation in which there is a keen
competition, but neither perfect nor pure, among a group of a large number of small
producers or suppliers having some degree of monopoly because of the differentiation of
their products.
Main Features/ Characteristics of Monopolistic competition:
1. Large Number of Sellers
2. Product Differentiation
3. Selling costs
4. Freedom of Entry and Exit
5. Lack of Perfect Knowledge
6. Pricing Decision
7. Non-Price Competition
Selling costs: Those costs which are made to adopt the product to the demand are costs of
production; those made to adopt the demand to product are costs of selling.

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Oligopoly: It is that situation in which a firm bases its markets policy in part on the expected
behaviour of a few close rivals
Cartel: A cartel is an association of independent firms within the same industry. The cartel
follows common policies relating to prices, outputs, sales and profit maximization and
distribution of products.
1.14 Questions and Exercises
1. Define Monopolistic competition. Explain the features of Monopolistic competition
…………………………………………………………………………………………………
2. With the help of diagrams explain the long run equilibrium of firm under monopolistic
competition.
…………………………………………………………………………………………………
3. What is Monopolistic competition? How does the selling cost make monopolistic
competition unique.
…………………………………………………………………………………………………
4. Define oligopoly competition. Explain the features of oligopoly competition
…………………………………………………………………………………………………
5. Discuss the Kinked Demand Curve Hypothesis of oligopoly market.
…………………………………………………………………………………………………
6. Define Cartel. How does the cartel operate to control the prices under oligopoly
competition?
…………………………………………………………………………………………………

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