PERFECT COMPETITION

Assumptions of the model

Perfect competition is considered as the ideal or the standard against which everything is judged. Perfect competition is characterised as having:

Many buyers and sellers. Nobody has power over the market. Perfect knowledge by all parties. Customers are aware of all the products on offer and their prices. Firms can sell as much as they want, but only at the price ruling. Thus sellers have no control over market price. They are price takers, not price makers. All firms produce the same product, and all products are perfect substitutes for each other i.e. goods produced are homogenous. There is no advertising. There is freedom of entry and exit from the market. Sunk costs are few, if any. Firms can, and will come and go as they wish. Companies in perfect competition in the long-run are both productively and allocatively efficient.

Equilibrium under perfect competition

In perfect competition, the market is the sum of all of the individual firms. The market is modelled by the standard market diagram (demand and supply) and the firm is modelled by the cost model (standard average and marginal cost curves). The firm as a price taker simply 'takes' and charges the market price (P* in figure 1 below). This price represents their average and marginal revenue curve. Onto this we superimpose the marginal and average cost curves and this gives us the equilibrium of the firm.

Figure 1 Equilibrium of the firm and industry in perfect competition Firms in equilibrium in perfect competition will make just normal profit. This level of profit is just enough to keep them in the industry and since profits are adequate they have no incentive to leave.

Normal profits
Normal profit is the level of profit that is required for a firm to keep the resources they are using in their current use. In other words it is enough profit to keep them in the industry. Anything in excess of normal profits is called abnormal or supernormal profits. Any profit above normal profit is a 'bonus' for the firms, as it is more than they need to keep them in the industry. We call this supernormal (or abnormal) profit. However, this supernormal profit will be a signal to other firms and will attract more firms into the industry. If firms are making consistently below normal profits then they will choose to leave the industry. What does this mean for prices and competition? Consider the following case. A firm enters a perfectly competitive market with a product. It sells Q1 units of its product at price P1. It is able to make supernormal profits at this stage. It sells at P1 but has a cost of only C. It makes SNP's of P1 to C per unit sold. This is shown below.

Figure 2 Firm in perfect competition making supernormal profit Competition is perfect. New firms enter the market. Supply increases (the supply curve shifts to the right - S2 in figure 3 below) and prices fall. The original firm has to lower its price or it will sell nothing. It charges P2 (the same as the market price) and so now sells Q2. The market size expands from Q1 to Q2. Look at the modified diagram below.

Figure 3 The impact on a market of supernormal profit The presence of SNP's has attracted more firms to the market and this has led to the price falling. The supernormal profits were competed away and equilibrium was reached where only normal profit was earned. Each of the firms will now be in long run equilibrium earning only normal profit. The long run equilibrium is where MC = MR = AC = AR. This can be seen in figure 4 below.

Figure 4 Long run equilibrium in perfect competition The falling prices put pressure on the less efficient firms. They may be forced to close and transfer their assets elsewhere. Short-run losses A firm with high costs may face a short-term loss-making situation. It is not at risk in the short-run provided price at least covers its variable cost. i.e. its day-to-day running costs, so that a contribution is made towards the fixed costs. This is shown below. The price, P*, covers variable costs and some fixed costs. A loss of C - P* is made.

Figure 5 Short-run losses

The firm will have to become more efficient. If it does not, it will be forced to leave the industry. As a number of firms leave the industry, the market supply curve will shift to the left, and price will rise until losses are eliminated and normal profits are again being made. The long run equilibrium will occur where no firms are making losses and no firms are making SNP's. It will be in equilibrium, as shown earlier. Look at the diagram again, you must know it and be able to explain its development.

Figure 6 Long-run equilibrium of firm and industry in perfect competition So, perfect competition is a model of an efficient form of competition. Efficient firms face well informed consumers. Only normal profits are made, so prices are not excessive. Resources are used effectively and efficiently. Sounds too good to be true.

Shut down price, break-even price

The break-even price in perfect competition is where normal profits are made and AR = P = ATC = MC = MR. This is shown in figure 7 below.

Figure 7 Perfect competition - break-even price Shut down price A firm may make a loss in the short run, providing AVC is being covered and some contribution is being made to the fixed costs. If a firm is at least unable to cover its

AVC's i.e. its day-to-day running costs, it will shut down immediately. This is illustrated in figure 8 below.

Figure 8 Shut down point Here output is OQ*, where MC = MR. A loss of PBCE is being made, as ATC is greater than AR. The fixed costs are given by the area ABCD. Thus if the firm receives a price of OP it will not cover all its costs but will contribute the area APED towards its fixed costs which have to be met even if output is zero. It will therefore be worth remaining in the business at least in the short run. However, if the price were to fall to OP1 (the lowest point on the AVC curve, where AVC = MC), the firm would shut down immediately as it would be covering neither its fixed nor its variable costs. Do perfectly competitively industries exist? No 'perfect' perfectly competitive industries exist. Ironically, one of the closest today is probably the market for shares. However, as we mentioned before it is still an important model as it provides a benchmark against which other markets can be judged. It can help in formulating appropriate policies to improve uncompetitive markets.

Efficient allocation of resources

Economists are concerned about the efficiency of markets, and ensuring that resources are allocated efficiently. Perfect competition is considered to be efficient because:

Supernormal profits are not made by any firm in perfect competition in the long-run.

MC = price, so both parties, suppliers and customers, get exactly what they want. No wasteful advertising. Firms are allocatively and productively efficient.

The major assumption behind this analysis and evaluation is that firms cannot produce products cheaper if they were bigger. It assumes that there are no economies of scale available in the market. Allocative efficiency Allocative efficiency occurs when the value consumers put on the good or service equals the cost of producing the product or service. In other words, when price = marginal cost. Productive efficiency Productive efficiency occurs when output is achieved at the minimum average cost. This can apply to the short-run and long-run. The lowest AC possible on the LRAC curve corresponds to the minimum efficient scale (MES). We can see from figure 1 below that when it is in long-run equilibrium, perfect competition achieves allocative and productive efficiency as MC = MR = AC = AR. This means that they are maximising profits (MC = MR) but only making normal profit (AC = AR).

Figure 1 Long-run equilibrium - perfect competition

So, perfect competition looks good, but is it always so? Problems with perfect competition are:

There are no reasons to do anything better, or research new products. As soon as you do, everybody else would step in and copy. Wait and let somebody else do it.

Consumer has no choice. There is just one unbranded product on the market.

Some economies of scale always exist. Perfect competition is not competitive in the fullest sense of the word! Barriers to entry will always exist.

Look at economies of scale. Some are always likely to exist. Financial economies apply the better your reputation the cheaper the loans, bulk-buying economies are there as well. Economies of scale are there, like gravity. It is up to the firm to take advantage of them. Competition encourages their application and exploitation. Perfect competition may well operate efficiently, as far as economists are concerned. The consumer, however, may get an ordinary product or service at a high price. Is it worth it?

MONOPOLY AND OLIGOPOLY INTRODUCTION

Concentrated markets, ones where there are only a limited number of suppliers, behave differently to competitive markets. You are required to know about monopoly and oligopoly. Monopoly One or occasionally a few firms dominate the market. The others have to accept the market as established by the others. A perfect monopoly is when there is a single supplier. However, a firm gets monopoly powers as its market share edges above 25%. Some industries are natural monopolies, such as water supply and basic power generation. Oligopoly Oligopoly is when a few suppliers who provide the same product dominate a market. Petrol companies and the soap and detergent industry are good examples. Each firm has to be concerned about what the others in the industry will do. Governments are concerned about both of these types of competition. Economic theory suggests that as markets become more concentrated (the number of firms in the industry falls) they become controlled by the suppliers at the expense of the consumer. As we shall see, this is not always the case. They try to regulate, or control these industries. As was seen earlier, the very size of the firms makes it difficult for others to enter the industry (the size of the firms acts as a barrier to entry). Sunk costs are high so potential losses are high. There is no great encouragement to enter the market, however good a product the firm has.

Why do some markets become concentrated and others do not?

The simple answer is growth and economies of scale. Some firms are more efficient than others, and in some industries there are much greater economies of scale than others. This has led to the formation of a number of highly concentrated industries. Examples are the oil and petrochemical industry, the aircraft manufacturing industry, airlines, soft drinks and banking to name just a few. Follow the links below to see how each industry fits the characteristics of monopoly and oligopoly.

Oil and petrochemicals Aircraft manufacture Airlines Soft drinks Banking

All the above are examples of oligopoly. Examples of monopoly are few and far between. Many natural monopolies, often state owned, have been broken up (privatised) and artificial competition (usually with regulators to control the market) introduced. Examples are electrical power, gas and the telephone service.
It is worth being aware of recent examples of monopoly and oligopoly and government policy towards them. The best bet is probably to do a search in the Biz/ed In the News archive. You can do this in the window below: Try searching on terms like:

Monopoly Oligopoly Competition

Growth and power

Why do firms want to grow?
As they get larger they get stronger. They start to eliminate competition, and start to gain control of the market. They move from being a 'price taker' in a situation of perfect competition towards being a 'price setter' (or price maker) in a monopoly situation. Price taker A price taker is a firm who cannot influence the price of the product on the market. If it puts its price above the one ruling in the market it sells little or none. Firms in perfect competition are price takers.

Price setter A price setter (or price maker) is a firm that can determine or fix the price of the product on the market. It sets the price, but the quantity sold is determined by the demand curve. Firms start to develop monopoly power as they grow and increase their market share. Monopoly power The power, or ability to influence a market, influence the survival of others, and establish the price. It enables it to increase profits.

Sources of monopoly power

One of the features of monopoly is that, unlike perfect competition, supernormal profits may be made in the long run. If there were free entry to the market this could not of course happen as the arrival of new firms would have the effect of shifting the market supply curve to the right and lowering the market price until the supernormal profits were eliminated. The existence of long run supernormal profits therefore implies the presence of barriers which prevent the entry of new firms into the industry. Indeed the basis of monopoly power is the ability to prevent entry of new firms. So what are the barriers to entry that exist? They may include:

Legal restrictions Capital costs Limited sources of supply Agreements between producers to limit competition Non-price competition as a barrier to entry Tariffs and quotas

It is worth being aware of recent examples of monopoly and oligopoly and government policy towards them. The best bet is probably to do a search in the Biz/ed In the News archive.

THE MODEL OF MONOPOLY

Monopoly, as a market form, is at the opposite end of the spectrum to perfect competition. In the literal sense, a monopoly exists when one single firm or a small group of firms acting together controls the entire market supply of a good or service for which there are no close substitutes. This is a situation of pure monopoly, which like the case of perfect competition, is rarely easy to identify in reality. Moreover, whether an industry can be classed as a monopoly will depend on how narrowly the industry is defined; for example, a city underground often has a monopoly on the supply of underground travel

within the city, but does not have a monopoly on all forms of public transport within the city: people can also travel by bus or overground trains. Thus in practice, less stringent definitions than 'single producer' tend to be used and economists focus instead on the degree of monopoly power which exists rather than absolute monopoly power. A firm may be regarded as being a monopolist if it controls 25 per cent or more of the total market supply of a particular good or service. A market concentration ratio is used to measure the degree of concentration within a particular industry or group of industries. A commonly used ratio is the five firm concentration ratio which indicates the proportion of the industry's output produced by the five largest firms.

Theory of monopoly
The monopolist's demand curve
In our analysis of perfect competition, we showed how there is a distinction between the demand curve of the individual firm and that of the market as a whole - the existence of many firms each competing against each other means that each one has no influence over price, and has to take the price that is determined in the market through the intersection of the demand and supply curves. The demand curve for each firm is therefore horizontal: an infinite amount is demanded at one price, with nothing at all being demanded at a higher price and with the charging of a lower price being inconsistent with the goal of profit maximisation. However, under monopoly there is only one firm in the industry; thus there is no difference between the demand curve for the industryand the demand curve for the firm. As the monopolist is subject to the normal law of demand, the monopolist's demand curve will be downward sloping so that to sell more, price would have to be lowered (see figure 1). In comparison to other types of market, the monopolist's demand curve is likely to be relatively inelastic as close substitutes may not be available if price is raised. Indeed, the availability or non-availability of close substitutes is one of the key factors determining the monopolist's power in the market.

Figure 1 Monopolist's demand curve

The demand curve shown in figure 1 presents the monopolist with a choice. The monopolist can either choose to make the price or the quantity, but cannot do

both; for example, if the monopolist chooses to set a price of OP1, the market dictates that only a quantity of OQ1 could be sold; however, if the monopolist chooses to set a quantity of OQ2 to be sold, clearly the demand curve tells us that this could only be achieved at a price of OP2.

Marginal revenue and average revenue under monopoly

The table below assumes that the monopolist faces a normal demand schedule, and from this the revenue curves are derived. Try calculating the figures for total, average and marginal revenue and once you have had a go, follow the link to check your answers. Output 1 2 3 4 Price 20 18 16 14 Total revenue 20 36 48 56 Marginal revenue 20 16 12 8 Average revenue 20 18 16 14

From the table two points can be seen: a) As price has to be lowered to increase sales, marginal revenue is not equal to price as in perfect competition: the additional revenue gained from each extra sale is always less than price or average revenue, and thus the MR curve will always be below the AR curve in monopoly. b) As price is identical to average revenue, the demand curve is also the curve relating average revenue to the quantity produced. The information in this table can now be shown in diagrammatic form to show the relationship between the average and marginal revenue curves (figure 2).

Figure 2 Marginal and average revenue curves

Monopoly equilibrium
Like the firm in perfect competition, the monopolist will maximise profits where marginal cost = marginal revenue (MC=MR). This indicates the best or profit maximising level of output. When the average cost and average revenue curves are related to each other, they indicate the level of profit.

Figure 3 Equating MC with MR in monopoly

Figure 3 shows that there is no level of output better than OQ for the monopolist; for example, if the monopolist decides to stop producing at OQ1, then MR would be greater than MC by the distance AB, and output could be expanded with more being added to revenue than to cost; if the monopolist decides to produce beyond OQ, say to OQ2, then MC would be greater than MR by the distance CD, with more being added to cost than to revenue, and clearly this would not be worthwhile. The best output would therefore be where MC=MR. In figure 4 we add the average cost and average revenue curves to the previous diagram to show the monopolist's best output and level of profit at that output.

Figure 4 Monopoly equilibrium

As in figure 3, the best level of output is at OQ where MC=MR. To find the price or average revenue, a vertical line is taken from OQ to the demand curve (the monopolist

'charges what the market will bear'), and a horizontal line is drawn across to the revenue/cost axis. The price is therefore OP or QR. The level of profit is indicated by the amount by which AR exceeds AC: AR=QR; AC=QS; so RS is the profit per unit of output, and the total supernormal profit is given by the area CPRS. Under perfect competition, supernormal profits can only exist in the short run, as in the long run new firms are attracted into the industry and the abnormal profits are competed away as the market supply curve shifts to the right and the market price falls. However, under monopoly new firms are unable to enter the market as there are various barriers to entry which are the very source of monopoly power. Thus a single firm may remain the only supplier, and supernormal profits may persist in both the short and long run; in monopoly, there is therefore no distinction between short and long run equilibrium. Although the existence of such long run abnormal profits implies a considerable degree of market power, the fact that the monopolist cannot control both the supply of the good and its demand means that complete control does not exist. Corporations devote an enormous amount of time, money and effort trying to mould our demand to fit in with their long term corporate plans: a situation which might be described as producer sovereignty; however, providing the demand curve is not completely inelastic, some element of consumer sovereignty will still remain. You should note that a monopolist will always produce at a point where demand is elastic, and will achieve this by restricting output to keep price in the upper price ranges (the elasticity of demand on a straight line demand curve varies from infinity at the top left section of the curve to nought at its bottom right section).Figure 4 shows that the marginal revenue curve falls continuously as price falls, eventually becoming negative. It can be seen, however, that although the marginal cost curve falls and rises, it is always positive as there will always be some cost involved in producing any economic good. It would therefore follow that where MC=MR and the firm is in profit maximising equilibrium, MR will be positive, and where this occurs demand is always elastic.

MONOPOLY V. PERFECT COMPETITION

Monopoly compared with perfect competition
In the discussion that follows, we shall draw extensively upon several concepts that have been introduced earlier; that is, the perfect competition model and the various types of economic efficiency, static, dynamic, productive and allocative. If you are unsure about the meaning of any of these concepts, it would be advisable at this stage to refer to the relevant sections before proceeding.

Consumer and producer sovereignty

Because of the conditions of perfect competition - many buyers and sellers, perfect knowledge and freedom of entry - firms would be forced to produce those goods and services which consumers most wanted. Any firm or even group of firms not behaving in this way would be unable to survive for very long as the competitive pressures from those firms who were responding to consumers' wishes would soon drive them into extinction. From this point of view it could be argued that consumers are sovereign in as much that it is they who 'call all the shots'. However, as described previously, monopoly

producers may well decide on which types of goods they are going to supply and at what prices, and then set about manipulating and moulding consumers' tastes, via their marketing activities, to match their pre-determined output plans - a situation in which the producer and not the consumer is sovereign. Under monopoly price is likely to be higher and output lower as compared with perfect competition. Figure 1 can be used to predict the effect of a monopoly taking over a perfectly competitive industry, making the assumption that costs would be unchanged in the process of monopolisation.

Figure 1 Perfect competition compared with monopoly

Arm(Dp) is the monopolist's demand curve and the market demand curve under perfect competition. MC is the combined marginal cost curve of all the firms in the perfectly competitive industry. As the competitive firm's marginal cost curve is also its supply curve, this combined marginal cost curve must also represent the industry's supply curve. Equilibrium occurs where demand equals supply, and therefore in perfect competition OPc would be the equilibrium price and OQc the equilibrium output of the industry. If the industry is monopolised and costs are unchanged the monopolist would produce where MC=MR, giving an equilibrium price of OPm, higher than OPc, and an equilibrium quantity of OQm, lower than OQc. However, if monopolisation of a perfectly competitive industry leads to the reaping of economies of scale, as may well be the case when several small producers are replaced by one large producer, then lower prices and a greater output might result _ the opposite of what we originally predicted. In this case, it is possible to predict a social gain from monopolisation. In figure 1, the gaining of economies of scale is indicated by a downward shift of the marginal cost curve from MC to MC1, and where MC1 intersects with the marginal revenue curve a new and greater equilibrium output is obtained at OQ1, with a price of OP1, which is lower than the perfectly competitive price of OPc. However, the monopolist has still not achieved full allocative efficiency as price is still above marginal cost; neither has it achieved full productive efficiency as it will not be operating on the bottom point of its new average cost curve.

ECONOMIC EFFICIENCY IN PC AND MONOPOLY

Productive efficiency
Productive efficiency refers to a situation in which output is being produced at the lowest possible cost, i.e. where the firm is producing on the bottom point of its average total cost curve. Since the marginal cost curve always passes through the lowest point of the average cost curve, it follows that productive efficiency is achieved where MC= AC.

Figure 1 Equilibrium in perfect competition and monopoly

The diagrams in figure 1 show the long run equilibrium positions of the firm in perfect competition and the monopolist. We can clearly see that for the perfectly competitive firm, productive efficiency automatically arises as in long run equilibrium MC=AC at point X. However, in the case of monopoly, the firm is not operating on the lowest point of its AC curve (point X ) but is instead operating on some higher point (point S). We can therefore conclude that in contrast to perfect competition, and assuming an absence of economies of scale, the monopolist will be productively inefficient.

Allocative efficiency
Allocative efficiency occurs where price equals marginal cost in all parts of the economy. Again, with reference to figure 1, it can be seen that in perfect competition, MR = MC, and MR = price. MC therefore equals price (at point Y), and allocative efficiency occurs. However, the monopolist produces where MC = MR, but price does not equal MR. It can be seen that at the equilibrium output of OQ, price is greater than MC by the distance RZ, and the monopolist could thus be said to be allocatively inefficient.

Dynamic efficiency
Both productive and allocative efficiency are examples of static efficiency in that they are concerned with how well resources are being used at a particular point in time. However, it is also important to consider how efficiently resources are being allocated over a period of time, when, for example, there may be technological advances, and this is the concern of dynamic efficiency.

Monopoly has been justified on the grounds that it may lead to dynamic efficiency. This is because the supernormal profits made will not only enable the monopolist to finance expensive research and development programmes but may also provide the necessary inducement to undertake such programmes in the first place. In contrast to this, firms operating in a perfectly competitive environment may lack the incentive to finance expensive research and development programmes, as open access to the market would mean that their competitors would immediately be able to share in the fruits of any success. The greater certainty of being able to earn supernormal profits in the long run also explains why levels of investment in capital projects may be greater in more monopolistic markets. So can you now summarise the advantages and disadvantages of monopoly? Have a think about them, jot them down and then follow the link to compare your notes with ours.

Efficiency and market structure

We are concerned here with concentrated (monopoly and oligopoly) and competitive markets. Competitive markets are considered to be statically efficient - both allocatively and productively. Dynamic efficiency is another matter. Because firms are all small, no one firm can afford R&D; it would have to be done on a collective or industrial basis. This has been done, but a number of problems arise over funding levies and charges. Concentrated markets, on the other hand, are considered to be inefficient in the shortrun. They are statically inefficient, even though their AC may be significantly lower than their smaller 'perfectly competitive' equivalent. The profit motive makes them strive to be more efficient, so they may invest in R&D and may be dynamically efficient

ANSWER: Advantages and disadvantages of monopoly

Disadvantages Producer as opposed to consumer sovereignty A higher price and lower output as compared with perfect competition Productive inefficiency Allocative inefficiency Advantages Large scale production may result in economies of scale, offering the possibility of lower prices Avoids the wasteful duplication of distribution costs in the case of utilities Dynamic efficiency Abnormal profits may be used to consumers' advantage in providing funds for research and development

MONOPOLISTIC COMPETITION
Monopolistic competition An industry in monopolistic competition is one made up of a large number of small firms who produce goods which are only slightly different from that of all other sellers. It is similar to perfect competition with freedom of entry and exit for firms and any supernormal profits earned in the short-run will be competed away in the long-run as new firms enter the industry and compete away the profits.

Assumptions of monopolistic competition

In monopolistic competition, as with perfect competition, we make a number of assumptions. However, don't get muddled by the word monopolistic in the title. As a form of competition, this is closest to perfect competition and nowhere near the monopoly end of the scale. The reason for the name is that in monopolistic competition we drop the assumption from perfect competition of homogeneity of products and so each firm can develop their own 'brand' of product. This means that each firm has a 'monopoly' over their brand, but there is still a large number of firms. The main assumptions are:

Large number of firms - each firm has an insignificantly small share of the market. Independence - as a result of a large number of firms in the market, each firm is unlikely to affect its rivals to any great extent. In making decisions it does not have to think about how its rival will react.

Freedom of entry - any firm can set up business in this market. Product differentiation - each firm produces a different product or service different from its rivals. Therefore each firm faces a downward sloping demand curve. This is the key difference from perfect competition. Product differentiation involves creating difference between products, either real or imagined, in consumers minds and is likely to involve various forms of non-price competition such as branding and advertising.

Examples of monopolistic competition

Petrol stations, restaurants, hairdressers and builders are all examples of monopolistic competition. Monopolistic competition is a common form of competition in many areas. A typical feature is that there is only one firm in a particular location. There may be many chip shops in town but only one in a particular street. People may be prepared to pay higher prices than go elsewhere, or they may simply prefer this 'brand' of fish and chips.

Monopolistic competition in the short-run

As with other market structures, profits are maximized in monopolistic competition where MC = MR. The AR and MR curves are more elastic than for a monopolist as there are more substitutes available. The profits depend on the strength of demand, the position and elasticity of the demand curve. In the short run therefore firms may be able to make supernormal profits. This situation is shown in the diagram below.

Figure 1 Equilibrium in monopolistic competition in the short-run

Monopolistic competition in the long run

In the long run firms will enter the industry attracted by the supernormal profits. This will mean that demand for the product of each firm will fall and the AR (demand curve) will shift to the left. Long run equilibrium occurs where only normal profits are being made as new firms will keep entering as long as there are supernormal profits to be made. At equilibrium the demand curve (AR) will be tangential to the firm's long run average cost curve as shown in the diagram below.

Figure 2 Equilibrium in monopolistic competition in the long run

We can see this change between the short-run and long run clearly if we combine figures 1 and 2 together. Figure 3 shows the changes taking place as new firms enter the market.

Figure 3 Changes in equilibrium in monopolistic competition short-run to long run

Limitations of model
The monopolistic competition model has various limitations and these include:

Imperfect information Difficulties in deriving the demand curve for the industry as a whole Size and cost structure mean that normal and supernormal profits can be made in the long run by firms in the same industry The simple model concentrates on price and output, however in practice the firm will need to decide the variety of the product and advertising

Efficiency in monopolistic competition

Monopolistically competitive firms may have higher costs than perfectly competitive firms, but consumers gain from greater diversity Monopolistically competitive firms may have fewer economies of scale and conduct less research and development, but competition may keep prices lower than under monopoly

Neither productive nor allocative efficiency is achieved. AC is not at its minimum in the long run (productive inefficiency) and price is greater than marginal cost (allocative efficiency).

OLIGOPOLY
The nature of oligopoly / assumptions of the model
Oligopoly is a market form in which there are only a few firms in the industry with many buyers; so market supply will be concentrated in the hands of relatively few producers, although an industry might still be said to be oligopolistic where several smaller firms existed alongside the few large firms that dominate; the wholesale petrol market provides a suitable example of the latter. The markets for cigarettes, records, confectionery, motor vehicles, fizzy drinks, high street banks, airline carriers, domestic appliances, soap powders and supermarket chains all provide good examples of oligopoly in the UK and elsewhere. Where the few firms produce an identical product, this is known as perfect oligopoly, and where, more commonly, the products are differentiated, this is referred to as imperfect oligopoly. The case of duopoly, where there are only two firms in the industry, is a special case of oligopoly. However, the absolute number of firms in the market is less significant than the way in which they behave and the relationship between the firms that comprise the industry. In the case of the monopolist, for example, independent price and output decisions can be made, with the only consideration being the customer's reaction to the change in price. However, in oligopoly, where there is competition amongst the relatively few, each firm has to also try to assess the reaction of its rivals to a change in price, as each firm will occupy a sufficiently important position within the industry for its particular price and output decisions to have a significant impact on its competitors. Thus if an oligopolist is thinking of raising the price of its product, it has to assess whether its rivals will do likewise or keep price down in order to gain more custom. Oligopoly is therefore characterised by interdependence between the firms that comprise the industry, and by reactivemarket behaviour. Oligopoly has emerged as the most prevalent market form in the industrialised world. This can partly be explained by the existence of economies of scale, especially in manufacturing, encouraging the growth of large scale production; inevitably, as firms grow in size, the number of firms supplying the market falls, and hence the tendency towards oligopoly power. Moreover, once established, this power may be sustained by various barriers to entry, similar to those that exist under monopoly.

The importance of non-price competition

As we shall see from our forthcoming discussion of oligopoly, an important feature of oligopolistic markets i.e. ones dominated by a few large firms, is the tendency towards relative price stability. Lack of price movement will occur most obviously where firms collude with each other to collectively fix their prices, but it may also occur in a situation of, what is known as, non-collusive oligopoly, where no such price agreements exist; inderdependent firms may well come to the conclusion that there is no point in 'cutting each others throats' by engaging in price warfare in the longer term as this could be disastrous for all the combatants, although there may be a tendency towards occasional short bursts of price cutting. However, this absence of price competition does not necessarily mean an absence of competition: oligopolistic firms are likely to compete in a variety of non-price forms.

Non- price competition occurs where firms attempt to win a competitive advantage over their rivals by strategies other than reducing prices. Non-price competition inevitably involves product differentiation.Here, oligopolistic competitors try to carve out separate markets in which they can command consumer loyalty through the creation of actual or imagined differences in the goods or services they offer, which are essentially the same as their rivals. This is in contrast to perfect competition where the good on offer, perhaps an agricultural one, is homogeneous, and product differentiation is difficult e.g. one carrot is pretty much the same as another. Product differentiation is extremely widespread amongst the whole variety of consumer goods and services that we buy e.g. washing machines, television sets, home computers, motor cars, washing powders, soft drinks, packaged holidays and financial services, to name but a few. These are all differentiated one from another in a variety of ways, including shape, size, quality and image. Non-price competition may take a variety of forms, including:

Advertising Branding Product innovation Packaging The provision of after sales services e.g. product guarantees Free samples and gift offers.

We shall examine the first three of the above i.e. advertising, branding and product innovation in greater detail.

2.3.9.1 Advertising
Advertisements are usually classified according to whether they are informative or persuasive.

Informative advertising
As the name implies, this type of advertising is concerned with the dissemination of information about products or services e.g. as regards availability, price or performance, and such information would be of a factual type. For instance, an advertisement for a car could focus on such things as its fuel consumption, its safety features, the time it takes to reach certain speeds, its price, the names and addresses of main dealers etc.

Persuasive advertising
The main feature of persuasive advertising is that it provides consumers with little, if any, meaningful information about the products being advertised; rather it seeks to persuade consumers to buy one particular brand of a product rather than another through a combination of 'catchy' jingles and appealing images.

If the advertising is successful, the images and jingles register into our consciousness and create strong brand loyalty e.g. the lines, 'A Mars a day helps you work, rest and play', and 'Coke, the real thing' are extremely widely known, but provide consumers with absolutely no information on the sugar, fat and chemical contents of the products in question.

Often the images are sexual and are intended to lead consumers to believe that their relative attractiveness to the opposite sex will be enhanced by the consumption of the good. Many advertisements for such things as cigarettes, alcohol, cosmetics, sports cars and even ice-cream fall into this category.
The following table provides a summary of the potential advantages and disadvantages of advertising to consumers, firms and the economy as a whole, although its overall impact on such factors as prices, costs, competition and resource allocation is, as with many aspects of economics, very much a matter of judgement. Advantages For consumers Acts as a medium of communication between buyers and sellers, provides information on product availability and facilitates wider choice May lead to lower prices if (a) larger sales and production levels result in economies of scale and lower unit costs (b) the advertising is based on price competition Disadvantages Persuasive advertising may render consumer choice irrational and destroy consumer sovereignty

Through its portrayal of a fantasy, largely affluent world, it creates unnecessary wants by generating feelings of inadequacy and greed

May lead to higher prices because (a) there may be higher costs, particularly if economies of scale are not achieved (b) advertising may act as a barrier to entry of new firms and thus increase monopoly power, particularly where established firms engage in saturation advertising which cannot be matched by smaller firms For firms If successful, advertising will (a) shift the demand curve to the right and (b) make the demand curve more inelastic. It may enable firms to maintain their monopoly power through the creation of brand loyalty and barriers to entry Greater profits may be earned if higher sales and output levels lead to economies of scale and lower costs Lower profits if costs of production are increased without raising sufficient extra revenue, or without shifting the demand curve making demand more inelastic

For the A greater level of employment if economy as a the level of sales and production whole increase

Advertising may lead to a misallocation of society's scarce resources as the pattern of production may reflect the skill of the advertisers in manipulating consumers' tastes, rather than what consumers actually want / need. The generation of negative externalities through tasteless or unsightly advertising

Certain sectors of the economy only survive because of the revenue which advertising earns e.g. commercial radio, newspapers and magazines

Branding
The creation of consumer loyalty to particular brands is mainly achieved through advertising, and it is in oligopolistic markets where branding, backed by extensive product promotion, is most prevalent. The markets for soap-powders, cereals, cars, confectionery and cosmetics provide a few notable examples. The main aim of branding is to make particular goods, produced by particular firms, appear as if they have unique features which the products of competing firms do not possess. On occasions these features may be real e.g. the distinctive quality of a BMW car or a Sony camcorder. However, often the 'uniqueness' may only exist in consumers' minds, but a difference, real or imagined, in how consumers perceive branded products, may be sufficient to allow goods to be sold at very different prices e.g. well known brands of soft drinks, sports-wear, bars of soap and shaving creams are all sold at higher prices than their 'own brand', or lesser-known, equivalents. Thus, if successful, branding will reduce the degree of substitutability for the good, make its demand more inelastic, allow for higher prices and profits to be earned and enable the brand to become unassailable. Moreover, the practice of multiple branding serves as a very effective barrier to entry of new firms e.g. go to any supermarket and you will see several brands of soap powders on the shelves, but these are mainly produced by just two firms, Unilever and Procter and Gamble - the costs of breaking into such a market would be formidable as any new entrant would have to compete against numerous brands of soap powder, requiring an enormous outlay on advertising; obviously if Unilever and Procter and Gamble only produced one brand each, the task of contesting the market would be made considerably easier.

Product innovation
Non-price competition in oligopoly may also take the form of product innovation whereby rival firms attempt to gain a larger slice of the market by constantly seeking to improve the quality and/or style of their existing products, or by developing entirely new products. This innovation usually has to be backed by extensive research and development (R&D), and has the effect of causing rapid obsolescence of consumer durable goods, a renewable source of demand and certain decline for those firms unwilling or unable to engage in such innovation. Most car manufacturers, for example, are constantly in the

process of changing the design and other features of particular models so as to generate new demand, and the few large firms that dominate the pharmaceuticals industry are locked into a perpetual struggle to develop new and better drugs. This process fits well with the writings of Joseph Schumpeter (1883-1950) who took a long-run, dynamic view of monopoly to argue that over time it would be far more efficient than perfect competition. He argued that the static method i.e. taking a point in time approach, of comparing perfect competition with monopoly, overlooked the likelihood of technical advances which may lower costs and prices as output expands. Although Schumpeter's analysis relates specifically to monopoly, it is appropriate to apply it to contemporary oligopolistic markets. Schumpeter identified two main reasons why monopolies would be more innovative than competitive industries: firstly, because of the earning of long term supernormal profits, the monopolist would have greater access to the funds necessary to finance inevitably expensive research and development programmes which are the basis of most innovation; and secondly, the monopolist would have a far greater inducement to undertake R&D in the first place - in highly competitive markets, any technical advantage gained by one firm would only permit the earning of high profits to be made for a relatively short period of time, as new entrants and existing firms copy the innovation and bid any abnormal profits away; the monopolist however would be the sole beneficiary of technical advance and would thus be able to reap the benefits of lower costs and higher profits indefinitely. However, empirical evidence on the subject suggests that whilst smaller firms i.e. those not possessing substantial monopoly power, tend to undertake little R&D, no clear, positive relationship between the amount of R&D spending and company size exists beyond a certain minimum size of enterprise.

THEORIES OF OLIGOPOLY
A central aim of market theory is to formulate predictions about firms' price and output decisions in different situations, and, under such market forms as perfect competition and monopoly, economists can be fairly certain about likely outcomes: in the case of the former, price is set in the market through the free interaction of demand and supply, and individual firms passively take this price and equate marginal cost with marginal revenue to determine the best output; in the case of the latter, the firm will still equate MC with MR, but can restrict output and raise price in so doing. However, under oligopoly no such certainty exists - where the number of firms in the industry is small and much interdependence exists between these firms, there will be a whole variety of ways in which individual oligopolists may respond to rivals' price and output decisions. Consequently, several different models of oligopoly have been developed, underpinned by different analytical approaches and assumptions about the nature of oligopolistic, reactive market behaviour. Unfortunately, therefore, for students of economics, there is no single, general and allembracing theory of oligopoly to explain the nature of the business world around us! Particular theories of price and output determination under oligopoly should therefore be seen as illustrative of what might happen under certain sets of assumptions about the reactions of rival oligopolists.

The various models of oligopoly can be classified under two main headings: non-collusive or competitive oligopoly and collusive oligopoly. We shall consider each in turn:

Non-collusive or competitive oligopoly

In this case, each firm will embark upon a particular strategy without colluding with its rivals, although there will of course still exist a state of interdependence, as possible reactions of rivals will have to be considered. There are three broad approaches that might be adopted by firms in a situation of competitive oligopoly:

Observe the behaviour of rival firms but make no attempt to predict their possible strategies on the basis that they will not develop counter strategies. This was the essence of the earliest model of oligopoly developed by Cournot as far back as 1838: each firm acts independently on the assumption that its decision will not provoke any response from rivals; this is not generally accepted nowadays as providing a useful framework in which to analyse contemporary oligopoly behaviour.

Make the assumption that a given strategy will provoke a response from competitor firms, and assess the nature of the response using past experience. This is the basis of the kinked demand curve model, described below, in which it is assumed that any price cut by one oligopolist will induce all others to do likewise, whilst a similar price increase would not be matched.

Formulate a strategy and try to anticipate how rivals are most likely to react, and be prepared with suitable counter measures.

This is the basis of game theory in which competition under oligopoly is seen as being similar to a game of chess in which every potential move must be regarded as a strategy, and possible reactive moves by opponents and subsequent counter-moves must all be carefully considered. The application of the theory of games to economics was first introduced in 1944 by J. von Neuman and O. Morgenstern. Games theory involves the study of optimal strategies to maximise payoffs, taking into account the risks involved in estimating reactions of opponents, and also the conditions under which there is a unique solution, such that an optimum strategy for two opponents is feasible and not inconsistent. A zero-sum game is one in which one player's gain is another's loss, and a non-zero-sum game is one in which a decision adopted by one player may be to the benefit of all. In this discussion of non-collusive oligopoly, we shall focus our attention on the second of the three broad approaches identified above.

The kinked demand curve theory

This theory of oligopoly was first developed in 1939 by Paul Sweezy in the U.S.A, and by R. Hall and C. Hitch in the U.K, to explain why oligopolistic markets would be characterised by relatively rigid prices, even when costs increase.

As mentioned previously, the kinked demand curve model makes the assumption of an asymmetrical reaction to a change in price by one firm: a decrease in price by one firm will cause a similar reduction of price by other firms eager to protect their market share, whilst a price increase by one firm will not be matched and its market share will be eroded. This is shown in figure 1 below.

Figure 1 Kinked demand curve

Price is initially set at OP1, at the kink of the demand curve, and the oligopolist sells an output of OQ1. If the firm tries to reduce price to OP2 in order to sell more, other firms would match this reduction so that sales would increase only slightly, or more technically, by a less than proportionate amount, to OQ2. The demand curve would be inelastic and the reduction in price would not represent a sound strategy as total sales revenue, and probably profit levels, would both fall; clearly the area OP1 x OQ1, representing initial revenue, is greater than OP2 x OQ2, the producer's revenue after the reduction in price. The alternative ploy of raising price to OP3 would also be unsound as none of the other oligopolists would follow suit, and a large or more than proportionate fall in demand would follow. Here, the demand curve would be elastic and the change in price would again cause total revenue to fall - OP3 x OQ3 is smaller than OP x OQ. The logical conclusion from this analysis would therefore be that oligopolists would benefit from keeping prices stable so long as all could enjoy reasonable profits at the established price. The kinked demand curve theory also has other implications. A normal demand curve becomes less elastic as price falls, but the oligopolist's demand curve becomes less elastic suddenly at the kink. Mathematically, this causes the MR curve to suddenly change to a different position, as can be seen in figure 2, so that a discontinuity exists along the vertical line YZ above output OQ1.

Figure 2 The oligopolist's absorption of a rise in costs

This implies that the MC curve can increase or decrease between this discontiuity, without necessitating a change in the profit maximising output OQ1 or price OP1 - the oligopolist will absorb the higher costs. According to normal demand and supply analysis, an increase in costs would cause a fall in output and an increase in price. An example of cost absorption in practice is when the price of crude oil rises and petrol companies wish to increase price, but do not as no company wants to be the first to do so.

Criticisms of the kinked demand curve theory

The theory assumes that oligoplists perceive a kink at the current market price i.e. at point X, but it does not explain how or why the original price was chosen. As a theory, it is therefore incomplete as it does not deal with price determination.

Price stickiness or rigidity in oligopolistic markets might, in practice, be more apparent than real; for example, in the market for new cars, published catalogue prices may remain constant over relatively long periods, but the common practices of offering discounts, and items such as free insurance, cash- back deals and interest -free credit all amount to ways of reducing price. In fact, the theory takes no account of the various forms of non-price competition which characterise most oligopolistic markets.

There is little empirical evidence from firms operating in oligopolistic markets to substantiate the kinked demand curve hypothesis that a change in price by one firm will always evoke a predictable and uniform response from its rivals. In practice, a very wide range of possible reactions is probable.

Any perceived stability in prices in oligopolistic markets may not be due to the existence of a kinked demand curve, but may occur for other reasons such as the administrative expense and inconvenience of altering prices too regularly.

Cut-price competition (predatory pricing)

Although oligopolistic markets tend to be characterised by relative price stability in the longer term, occasionally short bursts of price warfare break out. This typically occurs when the dominant players attempt to defend and/or raise their market shares because the total level of demand in the market is insufficient to enable all to achieve their intended level of sales, and overcapacity results. The price cutting has the effect of reducing the profits of all the combatants in the short run, with consumers gaining the temporary benefit of lower prices. However, the likely outcome is that the weakest firms i.e. those with the highest costs, will be driven into bankruptcy, with a new era of relative price stability eventually emerging. If too many casualties are caused, consumers are likely to face greater monopoly power and possibly higher prices. There have been numerous examples of price wars in recent years with the most notable battles occurring on the petrol forecourts and in the retail grocery and travel businesses.

Collusive oligopoly
A central feature of competitive or non-collusive oligopoly is the existence of uncertainty amongst the interdependent firms. Although these firms may utilise informed guesswork and calculation to cope with such uncertainty, they can never be entirely sure as to how their competitors will react to any given marketing strategy. Thus instead of living with uncertainty, firms may adopt a policy of reducing, or even eliminating, it by some form of central co-ordination, co-operation or collusion. Such collusion may occur where firms attempt to maximise their joint profits, by reaching agreement on their price, output and other policies, or where firms seek to prevent the entry of new firms into the industry so as to protect their longer run profits.

Forms of collusion
Formal collusion
The most common type of formal collusion is through the cartel; where a small number of rival firms, selling a similar product, come to the conclusion that it is in their joint interests to formally collude rather than compete, they may establish a cartel arrangement in which they agree to set an industry price and output which enables them to achieve a common objective. This is likely to involve the setting of agreed output quotas for each member in order to maintain the agreed price. A successful cartel arrangement, from the point of view of the participating firms, would be one in which the cartel acts like a single monopolist to maximise profits of individual members. This is illustrated in figure 1 below.

Figure 1 Profit maximisation for the cartel

This is the familiar monopoly diagram, with each curve representing the aggregated situation for all the firms in the cartel. In order to maximise profits, MC is equated with MR and a price of OP is set, with an output of OQ, which represents the potential level of sales. The allocation of this market quota between members could be decided by such criteria as geography, productive capacity or pre-cartel market share, or cartel members, having set a price of OP, could engage in non-price competition to each gain as large a slice of OQ as they can. In practice, cartels may tend to be rather fragile and may not last for very long. This is because individual members may have an incentive to renege on the agreement by secretly undercutting the cartel price. The almost inevitable necessity to limit output to keep price high will tend to leave individual firms with spare productive capacity, and provide the temptation to increase profits by expanding output. Such an expansion would not only generate profit on the additional sales, but would also increase the profits on existing sales, as average fixed costs would fall as output expanded. As the end result of successful collusion will be to create a situation similar to monopoly, with its consequent drawbacks and loss of economic efficiency, cartels are illegal in many countries, including the UK and the USA. Various cartels do, however, operate internationally, the most famous of which is OPEC. Another example of an international cartel is IATA (The International Air Transport Association) which has sought to set prices for international airline routes. However, the experience of both these cartels has been one of price cutting amongst its members, particularly during periods of declining product demand and competition from non-members.

Informal or tacit collusion

The most usual method of tacit collusion is priceleadership which occurs where one firm sets a price which is subsequently accepted as the market price by the other producers. There need be no formal or written agreement for this to happen; it is sufficient that firms believe this to be the best way of maintaining or increasing their profits. Price leadership may take various forms:

Dominant firm price leadership

This type of price leadership occurs where a firm, probably by virtue of its size comes to dominate an industry in terms of its power to influence market supply. The dominant firm sets a price to suit its own needs and the smaller firms then adjust their planned output

in line with the market price that has been set for them. An example of such price leadership is provided by Ford Motor Company, who have often been the first to raise prices in the car industry.

Barometric price leadership

A barometric price leader need not necessarily be the dominant firm in the industry; rather it will be a firm, possibly small in size, which is acknowledged by others in the industry as having an informed insight into current market conditions, perhaps because it employs the best team of accountants and market analysts. The firm's reputation will therefore enable it to act as a 'barometer' to others in the industry, and its price movements will be closely followed.

Collusive price leadership

This involves a form of tacit group collusion in which prices within an industry change almost simultaneously and is linked to price parallelism where there are identical prices and price movements in a given market. In practice collusive price leadership might be difficult to distinguish from dominant firm leadership, especially in circumstances where the price leader is quickly followed. Tacit collusion may also occur where firms in the industry follow a set of 'rules of thumb' instead of a price leader. Such rules may be designed to prevent destructive competition and thus maintain longer term profitability, although some short run profitability may be sacrificed as the rules do not require MC and MR to be equated. One such rule of thumb is cost-plus pricing.

Cost-plus pricing
This is also known as average cost pricing, mark-up pricing and full-cost pricing, and empirical evidence suggests that it is the most common pricing procedure adopted by firms. It involves firms setting price by adding a standard percentage profit margin to average costs, so that: Price = AFC+ AVC + profit margin Cost-plus pricing is consistent with the idea of relatively stable oligopoly prices as, providing costs are stable, prices will also remain stable in the short run, even though demand might be changing. Conversely, if costs rise on average by 5%, then prices in the industry will also be rising by a similar percentage.

Contestable markets
This theory was first developed by the American economist W.J.Baumol in the early 1980s. The theory argues that what really matters in determining an industry's price and output is not, in reality, whether the industry is perfectly competitive or a monopoly, but the potential of new firms to enter or leave the market. The theory is based on the idea that a firm may enjoy a monopoly position within a market, but if there existed the real threat of competition from other firms, this would force the firm to behave as if it actually faced competition; that is, the firm would not pursue a policy of charging exorbitant prices to make excessive profits.

What is a contestable market?

The term 'contestability' has nothing to do with the number of firms currently in the industry, but refers instead to the ease with which firms are able to enter or leave a market; a perfectly contestable market is one in which there are no barriers or costs to entry or exit: the greater these are, the less contestable is the market, and thus the greater is the monopoly power of existing firms; so for a market to be contestable, a barrier to entry, such as a patent protecting technical knowledge, must be absent. We previously discussed the various restrictions to entry, the idea of barriers to exit needs further explanation. A firm will incur substantial costs of leaving an industry of its capital equipment cannot be transferred to other uses. In this case these costs are known as sunk costs or irrecoverable costs, and are costs which cannot be recovered in the event of exit from the market. For example, the air travel industry is often cited as an example of a contestable market as an established airline operating on a particular route would easily be able to gain entry to another route, and, just as importantly, would be able to withdraw from that route if it so desired. Should operations on the new route prove unprofitable, the airline could transfer its operations without incurring high sunk costs because aircraft can easily be switched from one particular route which is loss making to another which is more profitable. Thus, so long as a firm is able to redeploy its capital or sell it when it wishes to leave a market, then the sunk costs would be low and relatively costless exit would be ensured. One feature of markets which are contestable, that is where entry and exit costs are low, is that it may encourage hit-and-run competition - because entry to the industry is easy, firms may enter that industry to share in the fruits of temporarily high profits, and then withdraw as soon as the abnormal profits have been whittled away. However, the threat of such competition may be sufficient to force firms to price as competitively as possible.

Implications of the theory

The theory implies that, given easy entry to and exit from an industry, monopoly or oligopoly firms will behave as if they actually existed in perfect competition; that is they will:

Equate MC with MR to maximise profits Only earn normal profits (AR = ATC) in the long run, because if supernormal profits were made, new firms would enter the industry increasing supply and driving down price to a level where only normal profits are made; and if losses are made, some firms will be forced to leave the industry, causing supply to fall and price to rise back to a level consistent with the making of normal profits.

Operate with productive efficiency on the lowest point of the ATC curve where AC = MC; if this were not the case, new firms could enter the industry, produce at the most efficient level, price their goods more competitively and force existing firms out.

Operate with allocative efficiency where P = MC; this will occur because the earning of long run normal profits requires that AR or price should equal AC, and as AC = MC (see above point), the MC should equal the price.

It would appear from the theory that the 'best of both worlds' can be enjoyed; that is, so long as there exists the threat of entry into an industry, consumers will be protected from the worst abuses of monopoly power, whilst at the same time firms will be able to reap the advantages of large scale production in the form of greater economies of scale, and will operate in accordance with the criteria for economic efficiency. The theory has been 'taken to heart' by right-wing politicians and economists who argue the case for non-intervention by the government and a policy of deregulation. The theory, it is argued, implies that providing there is sufficient potential for competition, there is no need for the government to interfere with the pricing and output policies of firms, but should instead confine itself to ensuring contestability through the use of deregulatory policies designed to remove barriers to entry and exit. Such policies have had a major influence on government's monopoly policies in recent years. It has been argued that the theory represents an improvement on the simple perfect competition and monopoly models: Like perfect competition, the perfectly contestable market may exist only rarely in practice and could be said to represent a model or abstraction of the real world rather than the real world itself. However, advocates of the theory of contestable markets argue that it is a more useful model than that of perfect competition as it provides a more effective means of making predictions about firms' price and output behaviour than does the number of sellers in a market. The theory of monopoly only considers the markets in terms of the number of firms operating in it or in terms of concentration ratios, but does not make any allowance for the impact that potential competition might have.

Criticisms of the theory

The extent to which the theory of contestable markets may be applied in practice is limited. Two pre-requisites may not be met: 1. Firstly, firms' sunk costs must be low so that they can easily leave the market. However, in reality sunk costs may be extremely high, even when capital is transferable. For example, if the Ford Motor Company decided to switch its operations from Dagenham (UK) to Delhi (India), it could not do so without substantial costs, despite the possibility of taking much fixed capital to India with it. 2. Secondly, the specific technical knowledge necessary to operate in the industry must be freely available. However, sole possession of technical knowledge, often protected by patent, is a common and powerful barrier to entry to monopolistic markets where production is of a highly sophisticated nature, and is underpinned by extensive R&D - for example, the case of the drugs industry. The theory ignores the possible aggressive actions of existing firms to potential entrants. In a market where cost barriers to entry and exit are low, existing firms may behave like monopolists by charging high prices and making supernormal profits, but might frighten

off potential entrants by making it quite clear that any firm attempting to enter their 'patch' would face 'big trouble' in the form of all-out, to-the-death competition. Those on the political right view the theory in terms of a justification of free markets and non-government intervention as both consumers and producers appear to benefit. However, this standpoint may be criticised on the grounds that even if perfect contestability exists, which is in itself by no means common in practice, government intervention in the free market may be warranted for a whole variety of other reasons.

Price discrimination
Price discrimination Price discrimination is the practice of charging different prices for the same or similar product/service to different consumers where the price differences do not reflect the differences in cost of supply.

Reasons for price discrimination

Price discrimination is carried out primarily to increase the profits of the discriminating firms. It occurs where different consumers are charged different prices in different markets for the same product or service, or where the same consumer is charged different prices for the same product, where the different prices are not due to differences in supply costs.

Necessary conditions for price discrimination

Condition 1
There must be some imperfection of the market. If there were perfect competition, price discrimination would be impossible since the individual producer could have no influence on price. At least some degree of monopoly power is therefore necessary so that producers have some ability to make rather than take the market price.

Condition 2
The discriminating supplier must be able to split the market into separate sections and keep them separate, such that it is difficult to transfer the seller's product from one sector to another i.e. there must be no 'seepage' between markets in the sense that goods can be bought in the cheaper market and re-sold in the dearer. Barriers between markets may be:

Geographical in that customers are separated by distance e.g. the international dumping of cheap goods, where goods are sold overseas at prices below those in the home market, and often below the cost of production e.g. the East European Communist block countries used to sell their exports to the West at lower prices than those prevailing in domestic markets to earn hard foreign currency.

Temporal in that customers are separated by time e.g. it may be cheaper to travel by train after 9.30am than before 9.30 am, and the two markets can be kept separate as ticket office staff will not sell the cheaper tickets until after this time

According to customer type so that customers are separated according to some easily identified feature of the customers themselves e.g. age, sex, income or occupation; examples of this would include cheaper theatre tickets for children, old age pensioners and the unemployed, reduced price rail travel for students and higher private physician consultation fees for those who are perceived as being able to pay more.

The two conditions discussed so far would make price discrimination possible, but for it to also be profitable a third condition must also be satisfied:

Condition 3
Price elasticity of demand in each market must be different; if this were the case , the discriminating supplier would increase price in the market with an inelastic demand curve, and reduce price where demand is elastic in order to increase total revenue and profits. If the elasticity of demand in each market was the same at each and every price, a common price would be charged in both markets as this price would represent the profit maximising price in each market where MC = MR. You might wish to refer back at this stage to where we discussed the relationship between price elasticity of demand and total revenue.

Equilibrium of the discriminating monopolist

Figure 1 Equilibrium of the discriminating monopolist The profit gain from price discrimination is (x + y) - z

In figure 1 there are two distinct markets, Market A and Market B. A third market, Market C, which is the combined market, is obtained by the horizontal summation of the individual AR and MR curves from A and B. Market A has an inelastic demand curve, whilst Market B has a more elastic demand curve. The gradient of the combined market demand curve will lie between that of A and B.

In the combined market, MC is equated with MR to give a single profit maximising price of OPc with an output of OQc, and a total profit equal to the shaded area z is earned. With a single price, this is the maximum profit that could be earned as the charging of a higher price would reduce demand and the area of profit, z. However, total profits can be increased through price discrimination, with the total output OQc being sold at different prices in markets A and B. Price will always be higher in the market with a more inelastic demand as consumers will be less responsive to price changes. As price discrimination only occurs where the differences in price are not associated with any cost differences, the combined market MC curve will also apply to markets A and B, and the output of each sub-market is therefore determined by equating MR in each market with the marginal cost of producing OQc units of output. Thus in figure 1, it can be seen that the marginal cost of production, OM, is projected back from the combined market as a horizontal line to enable the monopolist to find the equilibrium points Ea and Eb where MC = MR in each of the individual markets, A and B. Similarly the average cost of production, OC, is projected back from the combined market to determine the area of profit in markets A and B. As the level of profit is denoted by the amount by which AR exceeds AC, the areas x and y will represent the total profit for A and B respectively. From the producer's standpoint, price discrimination will be a success if total profits increase as a result. In the diagram, it can be seen that Area x + Area y is greater than Area z, so the producer has succeeded.

Advantages and disadvantages of price discrimination

Disadvantages
The main disadvantage will be experienced by consumers, particularly those having to pay the higher prices who may object to the discrimination against them e.g. users of peak time public transport. It could be argued that price discrimination represents a transfer of welfare from consumers to producers and is a way in which producers gain at the expense of consumers through the extraction of consumer surplus. In the extreme case of perfect or first degree price discrimination, no consumer receives any consumer surplus at all. In more general terms, the higher profits earned through price discrimination could be viewed as an unjustifiable redistribution of income in favour of profit takers with higher prices reducing consumers' real incomes.

Advantages

Producers of course benefit from the higher profits as previously shown. It could also be argued that if such profits are re-invested, consumers might derive long run benefits in terms of increased efficiency and lower costs and prices.

Those consumers paying the lower price may be able to obtain a good or service that they might not otherwise have been able to afford e.g. half price tickets for children at football matches.

Consumer and producer alike may gain if a loss making firm is turned into a profitable one. This is illustrated in figure 2 below.

Figure 2 Profits and losses (a) without and (b) with discrimination

In figure 2, the producer's best output, where MC = MR is at OQe, but the price of OPe does not cover the average cost of OC, and a loss, equivalent to the rectangular area x, is made. However, a loss can be transformed into a profit by charging those consumers who are prepared to pay, a higher price of OPe1. The shaded area y shows the additional revenue that accrues to the firm from charging a two-part tariff. As area y exceeds that of x, the loss making firm is now able to make a profit at the current output level. In the absence of price discrimination, this good would probably not be supplied in the long run, which would particularly represent a loss to society if it were one which generated positive externalities e.g. a doctor in a remote area charging wealthier patients more than the less affluent ones.