Question

Name TWO reasons why the way firms make decisions in a perfectly competitive market differs from price and output decisions by firms in an oligopoly market.

Answer 1

1. Price determinations and Output decisions under PERFECT COMPETITION market.

PERFECT COMPETITION

Perfect Competition which may be defined as an ideal market situation in which buyers and sellers are so numerous and informed that each can act as a price taker, able to buy or sell any desired quantity affecting the market price.

ASSUMPTIONS AND FEATURES

It is based on following assumptions and features.

• Large number of buyers and sellers

In perfect competition, there are large number of buyers and sellers in the market. The individual firm as buyer and seller is simply a price taker.

• Product homogeneity:

Another feature of the perfect competition is the product homogeneity. All products are perfectly same in terms of size, shape, taste, color, ingredients, quality, trademarks, etc. It ensures the existence of single price in the market.

• Free entry and exit of the firms:

In the perfect competition, the firms are free to enter or exit in the market. It ensures the existence of normal profit in perfect competition. When profit is more, new firms enter the market and this leads to competition.

• No government restrictions:

In perfect competition, there is no government intervention in the form of taxes, subsidies, licensing policy, control over the supply of raw materials, etc.

PRICE AND OUTPUT DETERMINATION UNDER PERFECT COMPETITION

The market price and output is determined on the basis of consumer demand and market supply under perfect competition. In other words, the firms and industry should be in equilibrium at a price level in which quantity demand is equal to the quantity supplied. They make maximum profit if the firm and industry are in equilibrium.

Price determination has to be shown in the following diagram.

Price of Curd (Rs.)	Quantity Demand (Liter)	Quantity Supplied (Litre)	Conditions
2	90	30	D>S
3	80	40
4	70	50
5	60	60	D=S
6	50	70	D<S
7	40	80
8	30	90

In this above table, we can say that when a price is low, demand is increased. Talking about the part of supply, as price increases, supply is also increased. When the price is low, the competition between the consumers can raise the price and when the price is high, the competition among the sellers reduces the price. So, the price finally comes to be determined at such a place when the demand and supply of a commodity are equal to each other.At Rs. 5, the demand of curd is 60 liter and supply is also 60 liters.

Fig: Price and output determination under perfect competition market

In the given figure, both the demand curve DD and the supply curve SS are intersected at point E. So, the point E is the equilibrium point. The price is fixed at OP. At OP, the demand and supply are equal to OQ. If the price rises from OP to OM, the supply increases. In this price, supply exceeds the demand thus at a higher price OM, the quantity MB is supplied but only the MA quantity is demanded and the quantity AB remains unsold. Due to this the price should be reduced and finally the price comes to remain at OP. If price is decreased form OP to OL than supply decreased upto LT but demand is increased upto LH. Due to this, there is excess demand than supply. So, the demand exceeds the supply the consumer starts to compare them to get the quantities of goods they requires. As a result, price again rises to OP.

Short-Run Equilibrium of Firm and Industry

Whether a firm makes abnormal profit or loss depends on the level of AC in the short run equilibrium. It generally consists of 3 cases i.e abnormal profit, normal profit, and loss.

According to marginal revenue (MR) and marginal cost (MC) approach firm can get equilibrium when it mentioned two conditions which are:

• Marginal revenue (MR) must be equal to marginal cost (MC) i.e. MC = MR
• Slope of MC curve > Slope of MR curve i.e. MC curve cuts MR curve from below.

  

• Fig: Short run equilibrium of firm and industry

From the figure, the industry demand curve DD and supply curve SS intersect each other at point 'E' where the market price is P. Firm A enjoys abnormal profit as AC lies below equilibrium of the AR curve. So, the shaded region PACE1 is the abnormal profit enjoyed by the firm. Likewise, firm B faces normal profit, as AC is tangent to AR at equilibrium. Finally, firm C bears loss and the shaded region PCBE3 is the loss faced by the firm.

Long-Run Equilibrium of Firm and Industry

A firm, in the long run, can adjust their fixed inputs. In the long run, under perfect competition, entry and exit are easy and free. All the firms in the perfect competition can earn only normal profit in the long run.

Under perfect competition, the firms could be in long run equilibrium if they fulfill the following conditions:

Long run marginal revenue (LMR) = Long run marginal cost (LMC) Long run marginal cost (LMC) must cut long run marginal revenue (LMR) from below at equilibrium point. The slope of LMC must be greater than the slope of LMR.

The given figure shows the equillibrium of firm and industry respectively under perfect competition market. An industry demand curve DD1 and supply curve SS1 intersect each other at point E where the market price is P. At point E, industry determine OP price for OQ quantity of product.

Next figure of firm explains long run equilibrium of competitive firm where LMC and LAC represent long run marginal cost and average cost curves where, at point E, P= LAR = LMR = LMC = LAC respectively. OP price is determined for OQ1 level of output and firm making only normal profit.

Fig: Long run equilibrium of firm and industry

2. Price determinations and Output decisions under OLIGOPOLY market.

The ‘tight’ oligopoly situation in which two or three firms dominate the entire market and the ‘loose’ oligopoly situation where six or seven firms occupy the maximum share of the market.

Other firms share the balance. It includes both differentiation and standardization. It encompasses the cases in which firms are acting in collusion and in which they are acting independently. Therefore, the existence of various forms of oligopoly prevents the development of a general theory of price and output. The element of mutual interdependence in oligopolistic market further complicates the determination of price and output.

In-spite of these difficulties, two interrelated characteristics of oligopolistic pricing stand out:

1. Oligopolistic prices tend to be inflexible or Sticky Price change less frequently in Oligopoly than they happen under other competitions like perfect, competition, monopoly and monopolistic competition.

2. When oligopolistic prices change, firms are likely to change their prices together they act in collusion in setting and changing prices.

Keeping these facts in mind, the price and output determination under oligopoly is in the following situations:

1. Price Determination in Non-Collusive Oligopoly:

In this case, each firm follows an independent price and output policy on the basis of its judgment about the reactions of his rivals. If the firms are producing homogeneous products, price war may occur. Each firm has to fix the price at the competitive level. On the contrary, in case of differentiated oligopoly, due to product differentiation, each firm has some monopoly control over the market and therefore charge near monopoly price.

Thus the actual price may fall between the two limits:

(i) The Upper Limit of Monopoly Price and,

(ii) The Linear limit of Competitive Price.

Practically, there is every possibility to determine the exact price within these limits. However there may be the following possibilities:

(i) There may be complete price instability in the market which results in price war.

(ii) The price may settle down at intermediate level due to the working of the market forces.

(iii) The firm may accept the prevailing price and adjust itself according to prevailing price.

So long as the firm earns adequate profits at the prevailing price, it may not try to change it. Any effort to change it may create uncertainties in the market. A firm will stick to that price to avoid uncertainties. Thus the price tends to be rigid where oligopolist takes independent action.

B. Equilibrium under Collusion:

The modern economists are of the view that independent price determination cannot exist for long in oligopoly. It leads to uncertainty and insecurity and to overcome them there is a tendency among oligopolists to act collectively by tacit collusion. In addition, the firms can gain the economics of production. All the firms in oligopoly tend to enlarge their size and lower their costs of production per unit and capture maximum share of the market.

Collusive oligopoly is a situation in which firms in a particular industry decide to join together as a single unit for the purpose of maximising their joint profits and to negotiate among themselves so as to share the market.

The former is known as:

(i) The joint profit maximisation cartel and

(ii) The latter as the market-sharing cartel. There is another type of collusion, known as leadership, which is based on tacit agreements.

Under it, one firm acts as the price leader and fixes the price for the product while other firms follow it.