Eae 408

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KENYATTA UNIVERSITY
Digital School of Virtual and Open Learning
EAE 408: ECONOMICS OF INDUSTRY
MODULE
Dianah M Muchai (PhD) and Joseph Muchai (PhD)
DEPARTMENT OF APPLIED ECONOMICS
Rodgers Wesonga - 0723 063 404

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TABLE OF CONTENT
LESSON ONE: INTRODUCTION TO INDUSTRIAL ECONOMICS........................... 3
LESSON TWO: CONCEPTS USED IN INDUSTRIAL ECONOMICS......................... 7
LESSON THREE: THEORY OF THE FIRM (NEOCLASSICAL AND
TRANSACTION COST THEORIES) ............................................................................. 15
LESSON FOUR: THEORY OF THE FIRM (PRINCIPAL-AGENT AND PROPERTY
RIGHTS THEORIES) ...................................................................................................... 25
LESSON FIVE: MARKET STRUCTURE DETERMINATION................................... 32
LESSON SIX: MARKET STRUCTURE (MONOPOLY) ............................................. 39
LESSON SEVEN: MARKET STRUCTURE (MONOPOLISTIC COMPETITION) ... 52
LESSON EIGHT: MARKET STRUCTURE (OLIGOPOLY) ...................................... 60
LESSON NINE: MARKET STRUCTURE, CONDUCT AND PERFORMANCE....... 65
LESSON TEN: ELEMENTS OF MARKET STRUCTURE (DIVERSIFICATION AND
INTEGRATION).............................................................................................................. 70
LESSON ELEVEN: ELEMENTS OF MARKET STRUCTURE (MERGER) ............. 77
LESSON TWELVE: MEASUREMENT APPROACHES TO THE ELEMENTS OF
MARKET STRUCTURE ................................................................................................. 81
LESSON THIRTEEN: INDUSTRIAL EFFICIENCY .................................................. 94

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LESSON ONE
INTRODUCTION TO INDUSTRIAL ECONOMICS
In this lesson our focus will be concentrated on understanding what industrial economics
is and differentiate it from other related disciplines.
Objectives

Industrial economics deals with the economic problems of firms and industries and their
relationship with the society. In economic literature, it is also referred to as economics of
industry, industry and trade, industrial organization and policy, commerce and business
economics etc.
Industrial economics can either be:
(a) Descriptive
Introduction
By the end of this lesson you should be able to:
 Define industrial economics
 Distinguish between the descriptive and analytical arms
of industrial economics
 Differentiate industrial economics from other related
disciplines
WHAT IS INDUSTRIAL ECONOMICS?
Courtesy of Rodgers Wesonga

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This is aimed at providing businessmen with a survey of the industrial and
commercial organization of their own country and of other countries which they
might come into contact with. It gives information concerning /regarding natural
resources, industrial climate in the country, situation of the infrastructure including
links of traffic, supplies of production factors, trade and commercial policies of the
government, and the degree of competition in the business in which he operates. In
short, it deals with information about the competitors’ natural resources and factors of
production and government rules and regulations related to the concerned industry
(b) Analytical
The analytical part deals with aspects such as market analysis, pricing, choice of
techniques, location of plant, investment planning, hiring and firing labour, financial
decisions, product diversification, etc.
Economic problem arises due to scarcity of resources and their alternative uses in relation
to the needs of an individual or a group or a society as a whole. For example:
(a) Income (resources) of a consumer is limited implying that he has to adopt some
criterion to achieve maximum gain from his limited income hence the utility
maximization problem.
(b) Production resources like land, labour and capital are scarce thus the producer has to
take decisions about production and distribution; for example, the type of technology to
adopt, where to produce his goods, size of factory, etc
All such decisions explain the producers’ behaviour in the different market situations
which are also studied hence industrial economics is regarded as being an elaboration of,
and developed from the traditional theory of the firm taught under micro economics.
HOW DOES DECISION MAKING ARISE IN INDUSTRIES?

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Microeconomics Industrial Economics
Formal, deductive, and abstract :- arrive at
conclusion by subtraction
Less formal, more inductive in nature :-
draw conclusions from instances
Assumes that the goal of firms is profit
maximization
Searches firms goal from revealed facts
Maximizes profit subject to constraints Concentrates on the constraints to goal
achievement and tries to remove them
Passive in nature Active in nature
Does not go into operational details of the
production, distribution and other aspects
of firms and industries
Goes into depth of such details
Conclusions from microeconomics may not
be testable empirically hence one may not
access their predictive efficiency
Emphasizes on empiricism and takes care
of policy implications
NOTE
Even with the marked differences, both disciplines are concerned with economic aspects
of firms and industries; seeking to analyze their behavior and draw normative
implications.
REVIEW QUESTIONS
ACTIVITY
INDUSTRIAL ECONOMICS AND MICROECONOMICS RELATIONS
1. How is analytical industrial economics different from descriptive
industrial economics?
2. Highlight two similarities for microeconomics and industrial
economics.

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ACTIVITY
SUMMARY
FURTHER READINGS
As an economist, is it sufficient to acquire knowledge in
microeconomics and avoid industrial economics knowledge?
In this lesson we have looked at what industrial economics. We
have also distinguished between the descriptive and analytical
arms of industrial economics. Finally, we looked at the
difference between industrial economics and microeconomics.
1. Barthwal, R.R., (1988), Industrial Economics: An Introductory
Text Book, New Delhi, Wiley Eastern Limited.
2. Shepherd, W., (1985), The Economics of Industrial
Organization, Prentice-Hall, USA

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LESSON TWO
CONCEPTS USED IN INDUSTRIAL ECONOMICS
In lesson one, we defined industrial economics. In this lesson our focus will be drawn to
understanding the major concepts that are used in industrial economics.
Objective
The Firm
This is an organization owned by one or jointly by a few or many individuals which is
engaged in a productive activity of any kind for the sake of profit or some other well
defined aim.
The Industry
This is a group of firms producing a single homogeneous product and selling it in a
common market. However, most firms produce many outputs which may or may not be
Introduction
 Define and explain the concepts used in industrial
economics.
CONCEPTS IN INDUSTRIAL ECONOMICS

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substitutable for each other. This industry can be defined as a group of sellers /of close
substitute outputs who supply to a common group of buyers.
 In monopolistic competition, we talk about the ‘product group’ as a substitute
word for industry. The competition among firms as well as their products is
implicit here.
 Not all substitutes can come from the same industry. For instance-woolen
blankets and electric room heaters are used for removing cold but come from
different industries. Similarly a firm producing two different unsubstitutable
goods may be classified under both industries. In this case, classifying industry
under their products is rather arbitrary.
NOTE


The Market
This is a closely interrelated group of sellers and buyers for a commodity. It is where
buyers and sellers transact business for the exchange of particular goods and services and
where the prices for these goods and services tend towards equality. The quantity of
goods and services demanded and supplied must be equal at a given price for the market
to clear. Some markets take place in a physical location e.g. a street market, whereas
others may be virtual markets e.g. when people buy and sell through the medium of the
Internet. Markets may be local, regional, national or international depending on the
location of buyers and sellers at the geographic market, and do not necessarily require
buyers and sellers to meet or communicate directly with each other.
The definition depends more or less on the purpose of the industry.
However, a clear demarcation is needed since ‘industry’ is the primary
focus of the competitive forces. Its structure constrains the conduct and
performance of the firms within it. Public policies are also designed to
regulate industries.

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There are different types of markets, for example:
 Business-to-Business (B2B) markets in which a business’ customers are other
businesses.
 Business to Consumer (B2C) markets in which businesses sell to individual
consumers.
The size of the market can be calculated in terms of:
-the number of customers that make up the market,
- the value of sales in the market.
A business can then calculate its market share in terms of:
-the number of customers its sells to,
- the total value of its sales.
Note that it is very important for a business to be able to define its market:
i) So that it can estimate the size of the market
ii) So that it can forecast the growth of the market
iii) To identify the competitors in the market
iv) To break the market down into relevant segments
v) To create an appropriate marketing mix to appeal to customers in the market.
The market may be sub-divided into separate segments each of which can be considered
to be a separate market in its own right. Primary segmentation is between customers
buying entirely different products. For example, an oil company manufactures a wide
range of fuels and lubricants for road, rail, water and air transport and for industry, all of
them for different groups of customers.

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Further segmentation can be based on demographic and psychographic factors.
Demographics segment people by clearly ascertainable facts, their sex, their age, size of
family, etc.
Psychographics segment people by something less clearly ascertainable and often
disputable: their 'life-style'. A person's lifestyle is built upon his or her attitudes, beliefs,
interests and habits.
Market Structure
Structure implies the pattern/form/manner in which the constituent parts of a particular
body are arranged together.
Taking market as a complex body, we can examine how its different constituents, that is,
buyers and sellers are linked together. This we can specify in terms of the original
characteristics which determine the relations:
(a) Of sellers in the market to each other
(b) Of buyers in the market to each other
(c) Of sellers to the buyers
(d) Of sellers established in the market that seems to exercise a strategic influence on
the nature of competition and pricing within the market
Features of the market structure as suggested by Bain:
a) The degree of seller concentration. This is the number and size distribution of
firms producing a particular commodity in the market
b) The degree of buyer concentration: This shows the number and size distribution
of buyers for particular commodity in the market

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c) The degree of product differentiation: This shows the difference in the products of
different firms in the market
d) The condition of entry to the market: This shows the relative ease with which new
firms can join the category of sellers (that is firms) in the market.
Market Power
This is the ability of a firm (or a group of firms) to raise and maintain price above the
level that would prevail under competition. It denotes the degree of monopoly arising out
of the various elements of the market structure. The exercise of market power leads to
reduced output and loss of economic welfare. With a high degree of market power, the
firm will be an active entity in the business while in situation of competition, the market
power will be negligible.
Market power can be measure via:
(a) Lerner Index, that is, the extent to which price exceeds marginal cost.
However, since marginal cost is not easy to measure empirically, an alternative
measure is to substitute average variable cost
(b) Price elasticity of demand facing an individual firm since it is related to the
firms price-cost (profit) margin and its ability to increase price. This measure is
however difficult to compute.
Product Differentiation
Products are considered to be differentiated when there are physical differences or
attributes which may be real or perceived by buyers so that the product is preferred over
that of a rival firm. Products are differentiated by firms in order to obtain higher prices
and/or increased sales.
 Differentiation may occur in terms of physical appearance, quality, durability,
ancillary services (e.g. warranties, post-sales services and information), image and
geographic location.

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 Firms will frequently engage in advertising and sales promotion activities to
differentiate their products.
 Product differentiation can give rise to barriers to entry but then it may also
facilitate entry into and penetration of markets by firms with products which buyers
may prefer over existing ones.
 Differentiated products should not be confused with heterogeneous products. The
latter heterogeneous generally refers to products which are different and not easily
substitutable whereas among differentiated products there is some degree of
substitutability.
Market Conduct
This is the behavior that firms follow in adopting or adjusting to the market in which they
operate to achieve a well defined goal.
The entire process of reacting to the market situation in pursuit of the desired goal is
called market conduct.
Given the market conditions and goals to be pursued, the firm will be acting alone or
jointly to decide about the price level for the products, the types of products and their
quantities, product design and quality standards, advertisement etc. Moreover, the firms
under such conditions have to device ways for interactions, cross-adaptation and
coordination among the competing group of sellers in the market (all these are elements
of market conduct). For example: Duopoly structure: both firms aim at maximizing
profits, how should they conduct their businesses? Given such conditions, one needs to
now examine how the firms will be taking decision about the prices and quantity of
outputs in the market. They may ignore each other and pursue their objectives
independently, they may join together and share the total profits in a mutually arrived
agreement, or involve themselves in games of competing with each other such as
indiscriminate price cuts, bribing government officials etc. There may be more tactics

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such as product diversification, effective advertisement and sales campaigns. All the
activities reflect the conduct of the firm in the market.
The choice of tactics or strategies reflects the behavior of the firm which is an important
aspect in the firms organization.
Market Performance
This is the end result of the activities undertaken by the firms in pursuit of their goals.
Note that performance of individual firms can be judged on the basis of high profitability,
high rate of growth, increase in sales, increase in the capital turn over and employment
among others depending on the goals of the firm.
For the society as a whole, performance can be judged on the basis of its contribution to
increasing the market welfare.
REVIEW QUESTIONS
ACTIVITY
ACTIVITY
1. List the features of market structure.
2. Differentiate between market conduct and market performance
3. Explain the various channels through which products can be
differentiated.
You are an industrialist operating in an oligopolistic market. How
can you ensure that you attain the maximum market power?

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SUMMARY
FURTHER READINGS
In this lesson we have looked at the concepts used in the field
of industrial economics. The concepts discussed were the firm,
the industry, the market, market structure, market power,
differentiation, market conduct and market performance.
2. Shepherd, W., (1985), The Economics of Industrial
Organization, Prentice-Hall, USA

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LESSON THREE
THEORY OF THE FIRM
(NEOCLASSICAL AND TRANSACTION COST THEORIES)
In the previous lesson, we defined ‘the firm’ as one of the concepts used in industrial
economics. In this lesson, we will introduce the theory of the firm and look at two
traditional theories of the firm; the neoclassical and the transaction cost theories. Other
theories will be discussed in lesson four.
Objectives
The theory of the firm goes along with the theory of the consumer, which states that
consumers seek to maximize their overall utility. The theory of the firm is always being
re-analyzed and adapted to suit changing economies and markets.
Early economic analysis focused on broad industries, but as the nineteenth century
progressed, more economists began to look at the firm level to answer basic questions
Introduction
 Explain the neoclassical theory of the firm
 Explain the transaction cost theory of the firm.
TRADITIONAL THEORIES OF THE FIRM

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about why companies produce what they do, and what motivates their choices when
allocating capital and labor.
The traditional theories of the firm include:
 The neoclassical theory
 The transaction cost theory
 The princiapl-agent theory
 The property rights theory


This theory captures the production view of the firm.
In neoclassical economics, the value of the products and the allocation of resources are
determined by the costs of production and the tastes and preferences of consumers.
It relies on marginal analysis in which the quantity of a product that is purchased or sold
is based on the additional utility, revenue, or cost associated with the last unit.
Firms are characterized by technological transformations.
The theory does not, however, engage in detailed inquiry as to the role of knowledge in
the firms’ organization.
The neoclassical theory posits that:
 All firms have the same knowledge, know-how or capacity to produce.
 All firms in an industry are assumed to have the same production function in the
long-run but note that capabilities and organizational knowledge may vary even
among firms that produce in the same industry and rely on similar technologies
THE NEOCLASSICAL THEORY OF THE FIRM

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 In this theory, the behavior of the firm is not dependent on its internal structure or
its ownership structure, infact ownership and institutions neither affect the
objective of the firm nor its knowledge base, technology or cost efficiency
 In conclusion, a basic neoclassical view has a little room for examining
comparative issues of economic organization, such as the existence of the firms in
a market economy, essentially because market-contracting perfectly solves all
incentive and coordination issues


The transaction cost theory of the firm was proposed by Ronald Coase. Coase noted that
the distinguishing feature of the firm is the allocation of resources by the entrepreneur,
rather than the price mechanism.
He pointed out the supersession of price mechanism by pointing out that there are costs
to using the price mechanism.
These costs are transaction costs associated with establishing a price, and negotiating and
concluding contracts separately for each allocation decision.
Transaction cost refers to the cost of providing for some good or service through the
market rather than having it provided from within the firm.
Coase urgued that production takes place in the firm whenever transaction costs involved
in the firm are lower than the transaction costs would be for that same type of production
in the market.
In order to carry out a market transaction it is necessary to discover who it is that one
wishes to deal with, to conduct negotiations leading up to a bargain, to draw up the
contract, to undertake the inspection needed to make sure that the terms of the contract
are being observed, and so on. For example, in order to produce a coat in the market, one
would have to seek out and contract separately with a tailor, a cloth supplier, a supplier of
THE TRANSACTION COST THEORY OF THE FIRM

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buttons, and so forth. Each transaction involves transaction costs in the form of
information costs, negotiating costs, monitoring and enforcement mechanisms.
More succinctly transaction costs are:
 Search and information costs
 Bargaining and decision costs
 Policing and enforcement costs
By vertically integrating these activities, a firm can economize on transaction costs and
produce more efficiently
Transaction costs could be avoided by negotiating long term contracts with employees,
the fewer contracts signed over a given period of time the lower the transaction costs.
The unsuitability of short term contracts arises from the costs of collecting information
and the costs of negotiating contracts.
Coase thus explained how the organization of production within the firm reduces
transaction costs that would otherwise occur in the market, but his explanation relied on a
narrow understanding of the firm organization, as one based on fiat control of the
entrepreneur (master-servant relationship), not recognizing the emergence of salaried
managers, who were both employees (non-owners) and decision makers, bringing the
separation of ownership from management
Such fiat control however rarely takes place in other organizational forms. For instance
high technology firms are characterized by shared decision making among highly
specialized employees, who exercise considerable control over their work agendas and
project development. These employees would not engage in productive cooperation if
their reasoned judgments and thoughtful approaches to problem solving were supplanted
regularly by appeals of authority. Coase theory does not supply a universal account of
firm structure, although it may account for the organization of a particular type.

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One limitation of Coase theorem
1. is that it consists of too general accounts of transaction costs, thus it fails to
sufficiently provide the nature of transaction costs it propagates making any
variable to be invoked as a determinant of firm boundaries, as long as it is defined
as a transaction cost
The Coase Theorem says that even in the presence of externalities (although he doesn't
use that term), if there are no transactions costs to creating private agreements the levels
of productions of goods will be the same no matter which party (to an externality) has
legal right to compensation.
This means that the intervention of the government in the case of an externality doesn't
affect production if there are no transaction costs, but affects the distribution of income
in such cases.
Illustration of Coase Theorem
Suppose there is a railway that runs coal-burning steam locomotives through a farming
area and caused fires in the crop fields at harvest time. The crop damage from each train
run is $200. Suppose the costs of running trains on a line next to a farming area are as
follows:
Number of Trains per Day Private Costs ($) Crop Damage ($) Social Cost ($)
1 100 200 300
2 200 400 600
3 400 600 1,000
4 700 800 1,500
5 1,100 1,000 2,100
6 1,600 1,200 2,800
If the revenue from a train run is $350 how many runs would the
railways run if no compensation is required for crop damage?

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This question can be answered by comparing the revenue to the private costs and finding
the number of runs which give the maximum difference between revenue and private
costs; i.e.,
Number of Trains per Day Revenue ($) Private Costs ($) Profit ($)
1 350 100 250
2 700 200 500
3 1,050 400 650
4 1,400 700 700
5 1,750 1,100 650
6 2,100 1,600 500
As can be seen from the table, maximum profit is achieved by running 4 trains.
On the other hand if the crop damage costs are imposed upon the railway company then
the costs to the railway company are increased by the amount of the damage. The profit
picture for the railway changes to the following.
Number of Trains per
Day
Revenue
($)
Private Costs + Damage
Costs($)
Profit ($)
1 350 300 50
2 700 600 100
3 1,050 1,000 50
4 1,400 1,500 -100
5 1,750 2,100 -350
6 2,100 2,800 -700
As the above table shows the maximum profit for the railway company is achieved with 2
runs per day. The profit of the railway company corresponds to the net social benefit of
running the trains. In this case it makes a great deal of difference (in terms of the number
ANSWER

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of train runs) as to whether the railway company is liable for the crop damage or not.
Two trains per day is the socially optimal number of train runs, but four trains seem to be
what would occur in the absence of legal liability concerning the crop damage.
What Ronald Coase did was to examine what alternatives there might be to government-
enforced legal liability to deal with the externality problem. Coase suggested that the
farmers could pay the railway not to run trains. To keep matters simple suppose the
farmers told the railway that they would be willing to pay the railway $1200 not to run
any trains and deduct $200 from this payment for every train run. The revenue to the
railway would consist of the revenue made from operating the trains plus the payment
received from the farmers. The profitability picture for the railway would be as follows:
Number of Trains
per Day
Revenue ($) Private
Costs
Payment from
Farmers
Profit ($)
0 0 0 1,200 1,200
1 350 100 1,000 1,250
2 700 200 800 1,300
3 1,050 400 600 1,250
4 1,400 700 400 1,100
5 1,750 1,100 200 850
6 2,100 1,600 0 500
As can be seen from the table above the railway achieves its maximum profit with two
train runs per day, which is the socially optimal number of train runs.
This is the essence of Coase's Theorem: The same levels of production are achieved
whether the perpetrator of the negative externalities is legally liable for the externality
costs or the victims of the negative externalities make a payment to the perpetrator that is

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reduced by the amounts of the externalities. Note that the level of production of crops is
determined as well as the number of trains run per day.
The second part of Coase's Theorem is that the levels of production achieved under either
legal liability or the payment scheme is socially optimal. Of course the profits of the
farmers and the railway are drastically different depending upon whether the railway is
legally liable for crop damage or not.
The illustration above made use of the total revenues and total costs, both private and
external. The quicker method to determine the number of train runs that would be most
profitable uses the marginal revenues and marginal costs. These marginal quantities are
shown below:
Number of
Trains per Day
Marginal
Revenue
($)
Marginal
Private Costs
($)
Marginal Crop
Damage
($)
Marginal
Social Cost
($)
1 350 100 200 300
2 350 200 200 400
3 350 300 200 500
4 350 400 200 600
5 350 500 200 700
6 350 600 200 800
Rule of Thumb
If the marginal revenue at n runs per day is greater than the marginal costs at n,
then the total profit is higher at n+1 runs than it is at n runs.
On the other hand, if the marginal revenue at n runs per day is less than the
marginal costs at n then the total profit is higher at n-1 runs than it is at n runs.

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In the above example, at 3 runs the marginal revenue is $350 but the marginal private
cost is $300 so, in the absence of legal liability for crop damage or a payment from
farmers, the railway company's profit is higher at 4 runs than at 3. But at 4 runs the
marginal revenue of $350 is less than the marginal runs the marginal private cost of $400
so the profit is higher at 4 runs than it is at 5. Therefore the maximum profit occurs at 4
runs per day. Finding the maximum profit level of production is a matter in this case of
finding a level at which the marginal cost switches from being less than marginal
revenue to being more than marginal revenue.
When the marginal costs of crop damage are included the marginal cost at 3 runs is $500
which is greater than the marginal revenue of $350 therefore 3 per day is a more
profitable level of operation than 4. However in this case the marginal revenue of $350 at
2 runs is less than the marginal cost of $400 therefore 2 runs is more profitable than 3
runs. The marginal cost at 1 run per day $300 is less than the marginal revenue of $350
therefore 2 runs per day is more profitable than 1 run per day.
REVIEW QUESTIONS
ACTIVITY
ACTIVITY
1. Discuss the main tenets of the neoclassical theory of the firm and
highlight its limitations
2. Under Coase theorem, the same level of production is achieved
whether the perpetrator of the negative externality is legally liable
for the externality costs or the victims of the negative externality
make a payment to the perpetrator to reduce the amount of the
externality. Prove this hypothesis using a hypothetical example
Using an industry of your choice prove the neoclassical theory of the
firm

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SUMMARY
FURTHER READINGS
In this lesson we have looked at the neoclassical theory of the
firm and the transaction cost theory of the firm. Coase theory
has been given an elaborate coverage as it forms the core
principal behind the transaction cost theory.
2. Pepall L., Richards D., Norman G. (2002), Industrial
Organization: Contemporary Theory and Practice. 2d. ed. South-
Western.
3. Phlip L. (1998), Applied Industrial Economics, Cambridge
University Press, United Kingdom:

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LESSON FOUR
THEORY OF THE FIRM
(PRINCIPAL-AGENT AND PROPERTY RIGHTS THEORIES)
In the previous lesson, we looked at the neoclassical and transaction cost theories of the
firm. In this lesson, we will turn to two more traditional theories of the firm; the
principal-agent and property rights theories.
Objectives
The theory deals with a relationship between the principal (owner) and agent (manager)
who work in a well defined task although the model can be generalized to encompass
many agents (hierarchical layers, for instance middle manager who is both agent and
principal). The assumption is that some information asymmetry exists between the two,
so that the principal cannot directly observe the activities of the agent or the agent knows
some other aspect of the situation unknown to the principal
Introduction
 Explain the principal-agent theory of the firm
 Explain the property rights theory of the firm.
PRINCIPAL-AGENT THEORY

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It is a class of representations of a situation in which an informed party trades with an
uninformed party and where the private information sometime may concern what the
agent does (sometimes called hidden action) or what the characteristics are (sometimes
called hidden information)
Some Concepts in the Principal-Agent Theory
i) Agency costs: these are the transaction costs of contracting that result from the
irreducible difference of interest between the principal(s) and the agent(s).
Agency costs can be reduced through monitoring (and enforcement) mechanisms.
The monitoring costs themselves, however, would not have been incurred, were it
not for the need to limit the agent’s pursuit of his own interest to the detriment of
principal’s interest. The agent incurs costs that only arise out of the inability of
the principal to fully control her agent. The agent must bond herself in order for
the principal to entrust her with her interests. Thus, monitoring, bonding, and
residual costs are defined as agency costs and are used to explain the
organizational structure of the firm.
ii) Models are classified according to the timing of the moves in the corresponding
games (that is, who moves first, the informed or the uninformed party?)
iii) Adverse selection models: this is where uninformed party is imperfectly informed
of the characteristics of the informed party
iv) Signaling models: parties have the same informational structure, but the informed
moves first
v) Moral hazard models: These are models in which the uninformed party moves
first, but is imperfectly informed of the actions of the informed party
A Look at the Model
The agency problem (in its moral hazard manifestation) stems from a conflict between
insurance and incentives. On one hand the theory of optimal insurance demonstrates that
optimal division of a pie of a random size (the profit) between a risk neutral party (the
shareholders) and risk averse one (the manager), has the risk neutral party bear all the

27
risk if the incentive issues are left aside. In the principal bilateral setting, the principal
cannot propose a first-best contract to the agent because the agent’s action is assumed not
to be verifiable, hence cannot be written into the contract
 Suppose there is a pie of random size  to be divided between two parties, and
that this random variable is not affected by the parties’ actions. Let  take the
value in a discreet set 1 <….< i <…< n , with probabilities 1p …. ip … np ,
where ip > 0 and 


n
i
ip
1
1
 Let )(  w and )( w denote the allocations of the risk neutral party and the
risk averse party when the realization is  . The parties expected utilities are:
))((  wE =  


n
i
iii wp
1
; and
))(( wEu =

n
i
ii wup
1
)(
respectively where )( ii ww 
An efficient (or pareto optimal) contract maximizes the utility of one party given
the level of utility of another party. It satisfies:
  0
11
UwuptswpMax
n
i
ii
n
i
iii
wi
 

)(. , where 0U is a constant.
The langrangian for this program is:
  





 

0
11
UwupwpL
n
i
ii
n
i
iii )(
Taking the derivatives with respect to iw , one gets for all i, /)( 1 iwu .

28
The implication is that iw is independent of i if the manager is strictly averse ( 0u  ).
Thus the risk averse party should take all the insurance. This is where the issue of
incentives arises.
This theory assumes that the ownership of non-human assets explains firm boundaries:- a
firm consists of those assets that it owns, over which it has control.
This theory therefore, does not distinguish between ownership and control, but defines
ownership as the capacity to exercise control. Furthermore it posits that control is
achieved through the ownership of physical assets.
The theory assumes that ownership gives the owner the rights to dispose of physical asset
that the owner hasn’t given away, or that the government hasn’t taken by force.
PROPERTY RIGHTS THEORY

29
This theory has several limitations:
i) The theory fails to perceive that, as we know from law, ownership does not
necessarily give the legal control to dispose property, as property law tells us
that ownership consists of a bundle of rights.
ii) The theory focuses on physical assets which cannot operate independently of
expertise. For instance, an entrepreneur owning a chemical laboratory without
the knowledge required cannot operate it.
iii) The theory argues that control over physical assets can lead to control of human
assets that are embedded in the organization capital. This is a shortcoming in
that there are many cases when employees themselves are the most important
assets for firm production. If employees are the most important assets like in
law firms, or high tech firms, the physical assets are simply not key if the
employee leaves, he can potentially take with him the main important asset for
the development of certain products or services.

30
REVIEW QUESTIONS
ACTIVITY
ACTIVITY
SUMMARY
1. Discuss the main assumptions of the property rights theory of the
firm.
2. Demonstrate that the optimal division of a pie ( ) of a random
size (the profit) between a risk neutral party (the shareholders) and
a risk averse one (the manager), has the risk neutral party bear all
the risk if the incentive issues are not taken into consideration
Think of a hypothetical manufacturing firm and show how the
principal-agent theory can be applied in the firm.
In this lesson we have looked at the principal-agent theory of
the firm and the property rights theory. In the principal-agent
theory, we looked at the owner-worker relationship and how
the incentive structure is implemented. In the property rights
theory, it is assumed that control is achieved through the
ownership of physical assets.

31
FURTHER READINGS
1. Tirole, J., (1988), The Theory of Industrial Organization, MIT
Press, USA
Western.
3. Phlip L. (1998), Applied Industrial Economics, Cambridge
University Press, United Kingdom:

32
LESSON FIVE
MARKET STRUCTURE DETERMINATION
Every industry has a prevailing market structure. It could be perfect competition,
monopolistic competition, monopoly or oligopoly. How do firms and industries attain
these structures? This lesson will delve into answering this question and move further to
define the structure for perfect competion.
Objectives
Market structure refers to the specific social organization that exists between buyers
and sellers in a given market. That is, market structures are models of markets that
describe a specific social organization between buyers and sellers.
Introduction
 Define market structure
 Highlight the characteristics that specify a given market
structure.
 Explain the characteristics and implications of the perfect
competition structure.
WHAT IS MARKET STRUCTURE?

33
The information below gives us some of the important characteristics that describe a
market and enable us to form some predictions about the behaviour and strategies that
might be observed in theses markets.
Characteristics of market structures.
 Number of firms: This will affect firms’ strategy in a number of ways. First, it
will determine whether the firm will need to consider how its own output
decisions will affect the market price for its product. A large number of firms
means that a single firm can assume that its production decisions will not have
any impact on the market price. However, if it is one or a few firms, then its
output decisions will affect the market price and this needs to be considered in its
decisions. Second, since a single firm among a large number of firms will have no
impact on the market price, the firm need not worry about how other firms
respond to any changes in the price of its product or its output. With a few firms,
then firms must consider, when choosing output or prices, what the response will
be from their competitors.
 Similar or differentiated products: if we have similar products, any attempt to
increase price will lead to a dramatic decrease in sales. The demand curve is
horizontal. However, if products are not identical among firms in an industry, a
firm can raise price without losing all its sales. The firm has a downward sloping
demand curve.
 Cost of Information: The lower the cost of information, the fewer the
opportunities for having pricing policies or quality distinctions among firms. Cost
of information also plays a major role in determining when collusion or
competition is likely to occur in oligopolistic industries
 Barriers to entry: This determines whether economic profits (profits above the
normal rate of return) will exist in the long run. If there are low barriers to entry
with positive economic profits, we expect the entry of firms to increase supply
and reduce price until all firms in the industry are earning only normal returns in
their investments (economic profits will eventually be zero)
 IMPORTANCE OF MARKET STRUCTURES

34
 It is important that households and firms know the markets in which they
participate in as buyers of goods and services. Markets are dynamic and keep on
changing and as such are always changing their structures and hence need to be
studied to understand their new structures. For instance, a monopolist market may
change to an oligopolistic market if for instance one or two firms succeed to enter
the market as competitors
Market Structure Forms
There are various forms of market structure as outlined below.
 Perfectly competitive market structure
 Monopolistic competition
 Monopolist
 Oligopolist
2.
3.
These are markets in which the competitive market forces of supply and demand
determine market prices and output levels of goods and services produced by firms in
an industry.
Characteristics
 There are many buyers and sellers
 Homogeneous product (identical)
 No barriers to entry and exit
 Buyers and sellers are price takers, that is they are too small to influence the
market price as individual buyers and sellers
 Perfect information regarding prices and product quality
 Perfect substitutability of the products
PERFECTLY COMPETITIVE MARKETS

35
 Transportation costs tend to be zero in these markets
 Market demand curve of perfectly competitive markets is horizontally sloped, that
is P=AR=MR=D.
 The first three conditions are for pure competition
Implications of Market Structure
 P=MR or horizontal demand curve. Why? There are many sellers, identical
products, no information costs, each seller must charge the same price. The sellers
can sell as much as they could without affecting the commodity price given that
each seller has a small share of the market.
 Long run economic profits equal zero and price is equal to average (total) cost in
the long run. Because there are no barriers to entry, price must equal average total
cost and profits are zero in the long run. If there are profits then firms will enter,
increasing supply and reducing price.
How will the Firm Behave Under Perfect Competition?(QUIZ: How will the firm
behave under perfect competition)
 We begin from a short-run static situation where the productive capacity of the
firm is constrained by existence of fixed inputs. The firm here is small, almost a
negligible entity in the market. Its products are not different from the others while
there’s no collusion between firms; the market power conditions are negligible. It
will not influence the price of the product and its market quantity, and instead will
be a price taker.
 The individual firms will accept these prices as given and adjust their level of
output to the maximum profit situation
 The figure below shows the equilibrium position for the firm having positive
profits in the short run under perfect conditions.
0 Q2 Q1 M1 M2
P1
Ac
P2
P1
P2
X
Y
MC AC
S1
S2
D2
D1
E2
E1

36
At P1 is the equilibrium market price determined by supply and demand forces. At point
E1, firms take prices as given; implying a straight line demand curve parallel to the x-axis
for the firm
Point X is the optimum profit position where P1 =M1, OQ1 is the optimum output for the
firm. The firm will be content with optimum profit given by the area P1,X,Y,AC; that is;
OQ1,*XY. XY segment on Q1X shows the profit margin over the average cost. If AC is
above P1,X, then there is a negative profit at P=MC situation.
The profit shown is pure economic profits and will attract new firms to the industry (no
entry barriers). Number of suppliers increase, supply increases, supply curve shifts
rightwards showing a decrease in price of the product with a fixed demand curve.
Decrease in price implies a decrease in profit margin for the firms. However, the process
of entry of potential firms in the market continues till complete disappearance of the
profit margin P=MC=AC=LR (P is the equilibrium price under perfect condition).
In the figure, P2 is the longrun price of the firm given by interaction of longrun demand
(D2) and supply (S2) curves. Because of the greater number of firms in the longrun, the
supply curve of the market will be flatter. Longrun equilibrium is at the lowest point of
the AC curve.
If there are negative profits in the short run, the equilibrium process will act in the reverse
direction. That is, some firms leave the market making the supply curve to shift left thus
increasing the market price, this will come again to stop at the lowest point of the average
cost curve.
Deductions
The market structure under perfect competition limits the firms conduct such that it
cannot do anything except to adjust its output level consistent with the market price in the
light of its objective

37
 There will be no profit at all in the market except in the short run but that will be a
temporary situation
 A zero profit situation implies that the firm will survive only on the basis of the
normal profit which constitutes part of the production cost. It will try to maintain
its profit in the longrun. If they are not there, the firm will close down
 Equilibrium will persist unless some external force shifts firms’ cost curves or
the market demand curve
REVIEW QUESTIONS
ACTIVITY
ACTIVITY
SUMMARY
1. Explain the factors that define a given market structure.
2. Using appropriate figures explain the behaviour of firms operating
under perfect competition that lead to zero profits eventually.
Which industries in Kenya operate under the perfect competion
structure?
In this lesson we have defined ‘market structure’ and explained
the characteristics that specify a given market structure. We
have also explained the characteristics and implications of the
perfect competition structure.

38
FURTHER READINGS
Press, USA
2. Scherer, F. M., and Ross, D., (1990). Industrial Market Structure
and Economic Performance, Houghton-Mifflin, 3rd ed.
Western.

39
LESSON SIX
MARKET STRUCTURE (MONOPOLY)
In the previous lesson, we looked at what market structure is and how it is determined.
We also looked at the characteristics and implications of the perfect competion market
structure. In this lesson we will look at the characteristics and implications of a
monopoly.
Objectives
Monopoly markets structure is defined by the fact that there is a single firm. There is no
competition in these markets and the single firm sets its own profit maximizing price and
output where its marginal cost is equal to its marginal revenue, that is, MC=MR. This
type of monopoly market is referred to as a pure monopolist or a single firm industry.
Introduction
 Highlight the characteristics of a monopoly
 Explain the pricing behaviour of a monolpoly
 Explain price discrimination in relation to a monopoly
THE MARKET STRUCTURE OF A MONOPOLY

40
Monopolized markets have the following market characteristics
 One firm
 Unique product/no substitutes
 Barriers to entry (Cost, technological, managerial barriers): These would
include economies of scale, capital requirements, quality and cost advantages,
product differentiation niches, patents and copy rights, strategic barriers,
control of resources etc
 Imperfect information regarding price, product quality btwn the monopolist
and the customers
 Price maker : How the monopolist fixes the price for its product and what will
be the output level depends on the goal of the firm and the demand schedule
putting the constraint on its conducts
 The demand schedule for a monopolist is downward sloping: this represents
relatively inelastic demand because there are no close substitutes for the
product being bought and sold in these markets. That is P=AR=D>MR of a
monopolist firm
When a monopolist produces and sells an extra unit of output, it must move down the
market demand curve, In so moving, it suffers price reduction on output it previously sold
at a higher price. Price reduction as a result of output increases, leads to the concept of
marginal revenue (MR)
TR=P*Q
MR=
Q
TR


= 0
Q
PQ
P
Q
PQ
Q
QP








.
Note that negativeQP ,/ 0 .
MR< P, because the sale of an additional unit of output requires a move down the
demand curve and hence a reduction in price and a loss in revenue and units that might
have been sold at a higher price

41
The profit maximization point MR=MC is at point E1. OQ1=Optimum output;
OP1=Optimum price; XY-Profit margin per unit output. ZYXP1=shaded area gives
optimum profit. The firm will continue to operate at this point so long as there is no threat
for its market from any potential rival in the industry
If there is an effective threat, the firm may reduce its price; increase output and this way
keep the industry away from potential competitors or do something else to block their
entry.
In a monopolistic market, there is unutilized production capacity to the extent shown by
Q1Q3 distance. This is a major consequence of monopoly market structure. If the goal is
sales maximization, the equilibrium situation is shown by the condition MR=0, at Q2,
Output = OQ2 > OQ1, Price = OP2 < OP1, Total Profit = Z’Y’X’P2 area < ZYXP1 area.
To maintain E1, the firm will engage in some activities to block the entry of the rivals in
the business.
MC AC
AR
MR
E2
E1
OutputQ1 Q2 Q30
P1
P2
Z
Z’
P3
X
X’
Y
Y’

42
Factors that create monopolies include:
 Economies of scale production - A single firm may supply the entire
market at a lower cost than its potential/actual rivals and thus keep them
out of the market
 Barriers of entry caused by permits, licenses and other legal/institutional
rights, patent rights etc
 The firm controlling supply of all strategic raw material sources for an
industry

A monopolist will select the profit level that makes its MR=MC
MR= MC
Q
PQ
P 



MR = 








Q
P
P
Q
P 1
MR =


















pp e
P
e
P
1
1
1
1
pe is the demand elasticity for the monopoly price.
Note that
Q
P
P
Q


 is the reciprocal of price elasticity of demand =
P
Q
Q
P


 .
The degree of market power can be measured by the extent to which the monopolist can
hold the price above the MC
The proportional excess of price over MC is from MR =









pe
P
1
1 = MC
PRICING BEHAVIOUR

43
peP
MCP 1


This equation indicates that the ratio between the profit margin (price minus marginal
cost) and the price, also called the Lerner index is inversely proportional to demand
elasticity.
The degree to which a monopolist can raise price above MC depends on sensitivity of
demand to price. As pe → ∞,
pe
1
= 0. Therefore the maximizing profit will be close to
MC, when pe is small, the monopolist has more leeway to raise the price.
The price distortion is larger when consumers, facing a price increase, reduce their
demand only slightly. The intuition is of course that the monopolist is more wary of the
perverse effect of a high price on consumption when consumers react to a price increase
by greatly reducing their demand.
Using a well labeled diagram explain the inefficiency of the monopoly
(5mks)
A competitive firm will operate at a point where Price = MC, while a monopolized
industry operates where Price > MC. Thus price will be higher and the output lower if a
firm behaves monopolistically rather than competitively implying pareto inefficiency (See
the figure below).
MC
P(q)=dd=AR
MR
Pm
Pc
C
B
D
Qm Qc
F
G
E
A

44
Given monopoly inefficiency, it is good to know the total loss in efficiency (inefficiency)
due to the monopolist

peP
MCP 1


presents a quantification of price distortion although
the appropriate measure of distortion is the loss of social welfare.
To measure the latter, we compare the total surplus at the monopoly price with that of
competitive (marginal-cost) price. The total surplus is equal to the sum of consumer
surplus and the producer surplus (or profit), or to the difference between the total
consumer utility and production costs (see Figure below)
From the figure, the total surplus is represented by the area DGAD under marginal cost
pricing and by the area DEFAD under monopoly pricing. The net consumer surplus is
Welfare
Loss
Net consumer
surplus
MC
P(q)=dd=AR
MR
Pm
Pc
C
B
D
Qm Qc
F
G
E
A
THE DEAD WEIGHT LOSS OF A MONOPOLY

45
given by the triangle CDE. A profit maximizing monopolist will equate MC=MR
restricting output to Qm
which is less than Qc
. Under monopoly, output is restricted by:
∆Q = Qc
- Qm
. The monopolist’s profit is equal to the total revenue Pm
Qm
, minus the
integral of the marginal cost equal to the area of the trapezoid ACEF.
For consumers willing to pay at least the cost of production of these units are unwilling to
pay the monopoly price. They withdraw from the monopolized market and spend their
income on other products, which become more attractive because the price of the product
is artificially inflated by the monopolist. The quantity demanded of the monopolized
product falls and quantity demanded of other groups increases. Corresponding inputs are
also allocated away from the monopolized product and towards other industries. This
reduction of quantity demanded creates a misallocation of resources among industries
The resource misallocation produces the welfare reducing and income redistributing
effect of market power. Thus the dead-weight welfare loss is equal to the area of the
triangle EFG. It provides a measure of how much worse off people are paying the
monopolist price than paying the competitive price.
Measurement of Dead Weight Loss
Dead weight loss resulting from market power measures the aggregate welfare loss to
producers and consumers due to monopolist output restriction. Suppose the figure is as
follows:
P(q)=dd=AR
Pm
Pc
∆P
D
F
E
A
MC=AC
∆Q
G
DEFINITION
The deadweight loss due to monopoly measures the value of the lost output by
valuing each unit of lost output at the price that people are willing to pay for that unit

46
∆P = Pm
– Pc
∆Q = Qc
- Qm
Data on Qc
and Pc
is hard to get. What is observed is sales revenue (Pm
Qm
) and a measure
of accounting ∏ = ( Pm
– Mc
) Qm
Pm
Qm
= TR
MC Qm
= TC
∏ = TC - TR
Since we compare price under market power with price under competition:
∆P = Pm
– Pc
= Pm
– Mc.
∆WL = ½(∆p×∆Q)
=½( Pm
– Mc) ∆Q
=½(Pm
– Mc)2
∆Q/∆p (squaring what is inside and dividing by ∆p does not
make any difference)
= ½ mm
m
m
m
m
QP
P
Q
Q
P
P
MCP





2
2
)(
)(
(dividing and multiplying by Pm
squared; and again dividing and multiplying Qm
)
=½ QP
mm
m
m
eQP
P
MCP


2
2
)(
)(
MR

47
This is an alternative expression of dead weight loss, an expression that doesn’t depend
on an arbitrary assumption about elasticity. Using index of the degree of market power a
profit maximizing monopolist will pick an output that makes MC=MR.
Thus,
pq
m
m
eP
MCP 1


is the lerner index
Dead weight loss is thus:
=½ QP
mm
m
m
eQP
P
MCP


2
2
)(
)(
=½
MCP
P
QP
P
MCP
m
m
mm
m
m



2
2
)(
)(
=½ mm
m
m
QP
P
MCP


)(
)(
= ½ mm QMCP  )(
= ½ )( mmm MCQQP 
This equation simply estimates the dead weight loss as half of monopoly profit.
Price Discrimination
This is where the monopolist sells different units of output at different prices. There are
two kinds of price discrimination.
i) The possibility of price discrimination is linked to possibility of arbitrage. The
first type of arbitrage is associated with transferability of the commodity. It is
clear that if the transaction (arbitrage costs) are low, any attempt to sell a given
good to two consumers at different prices runs into the problem that the low
priced consumer buys goods and resells to the high-price one.
ii) The second type of arbitrage is associated with transferability of the demand
between different packages or bundles offered to the consumers. Here there is no

48
physical transfer of goods between consumers. The consumer simply chooses
between the different options offered. Eg. Traveling in a plane-first and second
class. Note that if tastes differ, the producer generally wants to target a specific
package for each consumer and should ensure that each consumer chooses the
package designed for him and not for the other one.
In terms of consequences of price discrimination, the two types of arbitrages are
different. Transferability of the commodity tends to prevent discrimination while
transferability of the demand induces discrimination.
There are three types of price discrimination:
 First degree price discrimination; This is also referred to as perfect price
discrimination. The monopolist sells different units of output for different prices, and
these prices may differ from person to person. This occurs when consumers have unit
demands and the producer knows each consumers preservation price and can prevent
arbitrage between consumers. This is rarely in practice probably due to arbitrage or
incomplete information about consumer preferences.
 Second degree price discrimination; Also known as non-linear pricing. Here the
monopolist sells different units of output at different prices, but every individual who
buys the same amount of the good pays the same price. Thus prices differ across the
units of good, but not across people. For example; public utilities like electricity'
where the price per unit of electricity often depends on how much is bought.
 Third degree price discrimination; This occurs when the monopolist sells different
outputs to different people for different prices, but every unit of output sold to a given
person sells for the same price. For example; student discounts at food courts.
Conditions for third degree price discrimination (QUIZ: Discuss conditions for 3rd
degree price discrimination-2mks)
1) There must be two or more markets which can be separated and can be kept
separate, otherwise some people would purchase at low priced market and resell

49
2) The coefficients of price elasticity of demand must be different in these markets. If
coefficients are same then it is good to sell similar prices.
Using the standard elasticity formula and writing the profit maximization problem as:
)(
)(
)( 21
11
11
1
1 yyMC
y
yp 










)(
)(
)( 21
22
22
1
1 yyMC
y
yp 










where )( 11 y and )( 22 y represent the elasticities of demand in the respective markets
evaluated at the profit –maximizing choices of output. If 1p > 2p , then
)( 11
1
1
y
 >
)( 22
1
1
y
 which in turn implies that:
)( 11
1
y
>
)( 22
1
y
= )( 11 y > )( 22 y
Thus the market with higher price must have the lower elasticity of demand. An elastic
demand is a price-sensitive demand and hence a firm will set a low price for the price-
sensitive group and viceversa.
SELF TEST QUESTION
ACTIVITY
Suppose a monopolist faces two markets with demand curves give by:
111 100 ppD )(
222 2100 ppD )(
Assume MC = 20,
i) If it can price discriminate, what price should it charge in each
market in order to maximize profits?
ii) What if it can’t price discriminate, what price should it charge?
Add the two direct demands and solve the same way.

50
ANSWER TO SELF TEST QUESTION
ACTIVITY
ACTIVITY
SUMMARY
This is the solution for question (i)
First calculate the inverse demand functions:
111 100 yyp )(
2
50 2
22
yyp )(
MR = MC in each market, then:
1210020 y and,
25020 y
Solving for 401 *y , 302 *y
Substituting back to the inverse demand functions gives the
prices: ,60*1 p 352 *p
Which industries in Kenya operate under the monopoly structure?
In this lesson we have highlighted the characteristics of a
monopoly structure. We have also discussed the pricing
behaviour of a monolpoly and its implication on profits and
welfare We have also looked at price discrimination in relation

51
FURTHER READINGS
Press, USA
Western.

52
LESSON SEVEN
MARKET STRUCTURE (MONOPOLISTIC COMPETITION)
In the previous two lessons we looked at the characteristics and implications of the
perfect competion market structure and monopoly. In this lesson we will look at the
characteristics and implications of a monopolistic competition structure.
Objectives
Monopolistic competitive markets refer to those markets that are a hybrid between two
other extremes of market structures; namely perfectly competitive markets on the one
hand and monopoly markets on the other. Here the number of sellers is large enough to
create competitive conditions but at the same time the products will not be identical
though close substitutes for each other which gives them some monopoly power. There is
product differentiation making it different from perfect competition.
Introduction
 Highlight the characteristics and implications of a
monopolistic competion market structure.
 Explain product differentition and its relationship to
monopolistic competion market structure
MONOPOLISTIC COMPETITIVE MARKETS

53
Characteristics
i) Many buyers and sellers
ii) Products are slightly differentiated (heterogeneous)
iii) Firms are price makers - they have more market power over the product they sell
since each product is slightly differentiated
iv) Freedom of exit and entry of both buyers and sellers
v) The firms in these markets incur advertising costs to market their slightly
differentiated products and to incalculate brand loyalty among their clients
vi) There is imperfect information among buyers and sellers because of product
differentiation, price differential and product quality
vii)The products are substitutes since they are slightly differentiated, they serve the
same function, example bathing soap with different colors, shapes and odor
viii) The market demand curve is negatively sloped and flat because of the
availability of slightly differentiated products i.e P=AR=D>MR.
ix) Each firms makes no profit
x) A price change by one firm has only a negligible effect on the demand of any
other firm
Implications on Market Structure
 MR<P:- Differences in products means an in increase price does not lead
to quantity being equal zero
 In the Long-run profits equal zero; this is because of low barriers to entry
 Inefficient Output (too little) – we maximize profit by equating price and
marginal cost but since P > MR=MC and therefore P > MC, the value of the
good at P is greater than the cost of the good MC, also Q will not minimize the
average total cost.

54
Diagrammatically:
The firm continues to get profits (dotted area) in the short-run by charging Ps
and
producing Qs
so long as rival firms do not revise their decisions. Other firms will revise
their decisions in order to maintain their market share. There is free entry and so new
firms will join the market due to the existence of positive profits. This results in a
competitive advantage process in the market which stops at the point when the profit
margin completely vanishes from the market for every firm. This implies that at the long-
run equilibrium point, the demand curve touches the AC curve showing no profit, no loss
situation. The tangency point showing long run equilibrium will be before the minimum
of AC curve because the demand curve is downward sloping though elastic in nature. It
can’t be tangent to the rising portion of AC curve.
The limiting case for the long run equilibrium is that of perfect competition when
P=AC=MC=MR for monopolistic firm MR=MC and P=AC. This means just below x
point on the second figure above.
MC AC
AR
MR
ps
Qs
Output
Pr, AC,
MC
x
S/R
QL
PL
Pr, AC,
MC
Output
L/R
x
LMC
LAC

55
This refers to a situation in which consumers perceive two or more goods as close, but
not perfect substitutes. One product can be made distinguishable from others by using
various marketing instruments (i.e. price) by offering different sets of product attributes
(ingredients, taste, texture) or by protecting different product images and personalities
There are real and unreal causes for product differentiation:
1.Real causes of differentiation emanate from:
(a) Technological composition- chemical composition, product design, colour e.t.c
(b) Quality of service offered by the sellers- delivery service, favorable terms of
credit, courtesy
2.Unreal causes of differentiation are based on:
(a) Advertising and other selling devices - carpeting of floors, air conditioning of
shops, general decoration
(b) type of packaging, brand name etc,
(c) personal considerations- friendship, religious affinity, regional bias
Because of the causes, a buyer will be able to maintain identity (monopoly power) over
its product in the short run but won’t be able to maintain it a very long period of time
since other goods are close substitutes. The moment a firm charges a high price, buyers
will leave it and move to another product.
Types of product differentiation
Vertical Differentiation
Refers to a set of products ordered according to their attributes, over which consumers
share common preferences - most agree that high quality is more preferable. For instance,
two identical products with different qualities are considered to be vertically
differentiated (inferior Vs superior products eg. Brand name Vs. generic products). -
PRODUCT DIFFENTIATION

56
Nokia: 3310 and 2630 - However more consumers may still purchase the former. The
consumers’ income and the prices of the phone and of repairing them may determine the
consumers’ ultimate choice
Horizontal Differentiation:
This implies that on the extreme case, each consumer has their own valuation of the
product’s characteristics e.g. Pepsi and Coke. Tastes vary in the population; e.g colors –
Kambas and Westerners; Location - some people would prefer goods available at their
own place compared to the same goods physically available elsewhere. Similarly
consumers would prefer to go to a supermarket nearby. Consumers’ choices depend on
product prices and their preferences are revealed by transportation costs or desirable
product properties
Advertising and Informational product differentiation
Views of advertising
Partial view
 This sees advertising as providing information to consumers and thus enabling
them to make rational choices
 Advertising announces the existence of a product, quotes its price, informs
consumers about its retail location, and describes products quality
 It reduces consumers search for costs and helps them choose between brands
 It reduces product differentiation associated with a lack of information about
some products and fosters competition
 Similarly, it facilitates entry of new firms, who can capture the demand of
established firms
 It also encourages production of high quality goods
 High quality firms have an incentive to reveal their quality through advertising,
which puts low quality firms at a disadvantage

57
 The medium is newspaper- containing information about the price, attributes and
retail location. Products include eye glasses, prescription drugs, food
Adverse view
 This claims that advertising is meant to pursue and fool consumers
 It creates differentiation that is not real, rather than reducing real informational
differentiation. Thus it reduces product competition; it also increases barriers to
entry
 The medium is network television- which is image oriented, and conveys little
information beyond the existence of the product. Eg. Cigarretes, beer etc
Each of these views has some merit. The relevance seems to depend on the product, the
nature of consumer demand, and the advertising medium.
REVIEW QUESTIONS
ACTIVITY
ACTIVITY
1. Explain the difference between perfect competition and
monopolistic competition
2. Discuss the link between monopolistic competition and horizontal
differentiation.
If you were to introduce a new toothpaste brand in your country, how
would you go about entering the market?

58
SUMMARY
FURTHER READINGS
In this lesson we have highlighted the characteristics and
implications of monopolistic competion market structures. We
have also looked at product differentition and its relationship to
monopolistic competion market structure
Press, USA
Western.

60
LESSON EIGHT
MARKET STRUCTURE (OLIGOPOLY)
In the previous lesson we looked at monopolistic competitive markets. In this lesson we
will look at the last market structure which is oligopoly.
Objectives
This refers to those market structures in which a few firms, large or small dominate a
particular market or industry and there is limited competition and often collusion on the
part of these firms to dominate a market or industry. These firms also collude explicitly
or implicitly to limit or prevent rival firms from entering these markets or industries by
erecting barriers to their entry
Characteristics
 An oligopolistic market contains a small number of sellers, sufficiently
small so that actions of any one seller have a perceptible influence upon his rivals.
Introduction
 Highlight the characteristics and implications of an
oligopolistic market structure.
 Highlight the main models explaining the behavior of
oligopolists
OLIGOPOLY

61
The limiting case of oligopoly is duopoly when only two sellers operate in the
market.
 Oligopolist firms are price makers, that is they set their own prices
 The reaction function of firms in an oligopolist market or industry is
interdependent, that is, policy action of one firm affects the action of another firm
regarding a change in price, output, advertising etc. Take an example of a three
firm oligopoly market. If one firm reduces the price in order to increase its market
share and earn more profit, the other two firms will react to protect their interest
by following suit. This way the three firms will be interdependent in the market.
The reactions of the rival firms will reflect their conduct/behaviour.
 The firms in oligopolistic markets tend to collude to set prices for their
output.
 The collusion of oligopolistic firms leads to the creation of cartels - which
is a group of producers or consumers that determines the price and quantity of
output to be produced or consumed. For example OPEC is a global oil producing
cartel.
 Oligopolists tend to compete on non-price criteria such as advertising,
warranties, gift certificates, because they know they are counterproductive (see
Kinked Demand Curve Model)
 There are costs and technological barriers to the potential entry of rival
competitors in oligopolistic markets
 There is imperfect information between buyers and sellers in these
markets
 There are two types of oligopolist:
o Pure oligopoly - referring to those oligopolists selling products that are
homogenous like cooking gas or gasoline and,
o Differentiated oligopoly – referring to those oligopolists selling products
that are slightly differentiated-eg breakfast cereals or airline services.
 Oligopolists incur advertising costs to incalculate brand loyalty among their
clients particularly in differentiated oligopoly markets

62
What are the main models explaining the behavior of oligopolists?
There are several models
 The kinked demand curve
 The cartel model
 The leader follower model
 The cournot model
 The chamberlain model
 The edgeworth model

Kinked demand curve solution assumes that rival sellers follow a price cut policy but
not a price rise one i.e whenever a seller reduces the price, all others will do so. It tries to
explain price rigidity observed in oligopolistic markets.
dd’ represent the anticipated demand curve for a representative seller under oligopoly.
This shows the product quantity relationship when all other firms keep their prices
constant. DD’ is the market share curve for the seller. Let the seller be at point X where
she gets maximum profit. If the seller wants to increase the price of its product, it will
Pr
P
D MC1
MC2
D’
d’
d
Q
R
S
Y T Output
X
O
OLIGOPOLY KINKED DEMAND EQUILIBRIUM

63
move on the Xd segment of the anticipated demand curve. Other firms follow so as not to
face the inelastic segment of the DD’ curve.
If a seller reduces price, all the others will follow. This implies that the seller now moves
on the XD’ segment of the market share curve. The seller (firm) follows dxD’ demand
curve which has a kink at point X.
Corresponding to this demand curve QRST will be MR curve. It is continuous with a
vertical gap under X point shown by the RS segment. Between this segment whatever be
the MC, the price and quantity solution for the oligopolistic firms remains unchanged.
Such price rigidity is an important feature of the oligopoly market.
Another solution for oligopoly is that there is one dominant firm in the market which sets
the price through maximization of its own profit. The other firms just accept its price and
adjust their output for maximizing its profits. Though this doesn’t give an explanation for
oligopoly behaviour
REVIEW QUESTIONS
ACTIVITY
ACTIVITY
1. Explain the main features of an oligopolistic market structure
2. Why is the kinked demand curve applicable in the oligopolistic
market structure?
In most countries, the mobile phone service providers’ market is
oligopolistic. Establish whether this is true for your country.

64
SUMMARY
FURTHER READINGS
In this lesson we have highlighted the characteristics and
implications of an oligopolistic market structure. We have also
looked at the main models explaining the behavior of
oligopolists where the kinked demand equilibrium model was
elaborated.
Press, USA
Western.

65
LESSON NINE
MARKET STRUCTURE, CONDUCT AND PERFORMANCE
In lesson two, while defining concepts in undustrial economics, we defined market
structure, conduct and performance. In this lesson we will look at the relations between
these concepts in a framework of ‘Market Structure – Conduct – Performance’ as used in
industrial in industrial economics.
Objectives
The market structure of an industry determines/strongly influences the crucial aspects of
its market conduct which in turn directly or indirectly determine certain important
dimensions of its performance. This link need not be unidirectional running from the
Introduction
 Explain how market structure affects the conduct of
firms in an industry, and in turn, how the conduct affects
performance.
THE MARKET STRUCTURE – CONDUCT – PERFORMANCE
FRAMEWORK

66
structure to the performance but may operate in some situation in the reverse way. It may
be segmented showing cross links between any two of the three aspects- structure,
conduct and performance as shown below.
Consider a monopoly; there is one seller in the market with zero or negligible cross
elasticity of demand for its products. The seller will have full market power over the price
and quantity decisions and will manipulate the decisions. The existing profits can be
maintained at the highest level. This indicates there is a straight forward line between the
structure, conduct and performance.
BASIC CONDITIONS
Supply
Raw materials,
technology,product
durability, business
attitudes, unionization
Demand
Price elasticity, rate of
growth, substitutes,
marketing type,
purchase method,
MARKET STRUCTURE
Number of sellers and buyers, product
differentiation, barriers to entry, cost structures,
vertical integration etc
CONDUCT
Pricing behaviour, pricing strategy, research and
innovation, advertising, legal tactics
MARKET PERFORMANCE
Productive and Allocative efficiency, progress,
full employment, equity

67
From diagram, at the top, there are a set of variables that influence the market structure
directly. The two way possible linkages between the blocks are shown with different
lines, thick and broken. The task of industrial economics is to find how strong these
linkages are, and then the next step would be to use them independently or jointly in a
model form for policy purposes.
Interactions:
 Structure and conduct are both determined in part by underlying conditions and
technology. The higher the elasticity of demand the more firms become profit
takers.
 Structure affects conduct but conduct (strategic behaviour) also affects structure.
STRUCTURE
Strategy
CONDUCT
Progressiveness
Profitability
PERFORMANCE
Technology
Demand
Sales Effort
1
2
3
4
5
6

68
 Structure and conduct interact to determine performance.
 Sales effort (element of conduct) also feed back and affects demand.
 Performance in turn feeds back on the technology and structure. Progressive (of
technological progress) moulds the available technology.
 Profitability which determines how attractive it is to the market has a dynamic
effect on market structure.
REVIEW QUESTIONS
ACTIVITY
ACTIVITY
SUMMARY
FURTHER READINGS
1. Explain the market structure-conduct-performance framework of
industrial economics.
2. Are there situations where the market structure has a direct
influence on performance without influencing conduct? Explain.
Pick an industry of your choice in Kenya and explain the validity of
the Structure-Conduct-Performance framework.
In this lesson we have discussed how the market structure of an
industry determines the crucial aspects of its market conduct
which in turn directly or indirectly determines certain important
dimensions of its performance.
Press, USA

70
LESSON TEN
ELEMENTS OF MARKET STRUCTURE
(DIVERSIFICATION AND INTEGRATION)
In the previous lesson, we looked at the Structure – Conduct – Performance framework of
industrial economics. In this lesson we will look at two specific elements of this
framework, that is, diversification and integration.
Objectives
Diversification refers to the expansion of an existing firm into another product line or
market. Note that if the firm adds one more variety of the product, then this is
differentiation but if a firm produces a totally different product which is a substitute for
the products in the market then it is called diversification.
Diversification may be related or unrelated
Introduction
 Explain what diversification is and highlight its motives
 Explain the concept of vertical diversification
DIVERSIFICATION

71
 Related diversification occurs when a firm expands into similar product
lines. For example, Automobile may engage in production of passenger vehicles
and light trucks.
 Unrelated diversification takes place when products are very different
from each other. E.g. a firm producing margarine starts producing soap for
example comes under diversification. If a leather firm starts manufacturing blue
band and other leather goods this is diversification because here the products are
different as a result of which the market area for the firm expands from one class
of consumers to another.
A firm is said to diversify if without entirely abandoning its old product lines embarks
upon them, producing new products including intermediate products which are
sufficiently different from the other products it produces to imply some significant
difference in the firms production and distribution programmes. In the process of
diversification a firm makes significant changes in its areas of operation, related
technological base, market areas and productive activities in which it has acquired
experience or knowledge in the past.
There are four different possibilities of diversification
 Where there are additional products within the firm’s existing technological
places bases and existing market areas.
 Where there are products involving the existing technological bases but destined
to new market areas.
 When there are products which involve altogether new technological bases for the
existing markets.
 When there are new products within new technological bases for new market
areas.
Diversification, apart from changes in the products only, implies changes in the
technological base and market areas.

72
Diversification may arise due to a variety of reasons:
 To take advantage of complementarities in production and existing technology
 To exploit economies of scale
 To reduce exposure risk
 To stabilize earnings and overcome cyclical business conditions
Motives for diversification (QUIZ: Explain the main motives of product
differentiation-8maks)
The motives depend on its types
a) Lateral diversification
This occurs when a firm produces different goods which diverge from the same process
or source or which are used as materials for the same process or market e.g. a leather
tuning firm starts making boots and shoes, leather garments and suit cases itself because
such business diverge from leather tannin business.
Reasons for this:
 When the production of one commodity involves production of another. For
instance, the by-products from a firm’s production would form a natural scope for
lateral diversification in order to avoid wastages and enhance gains in the business
(Mutton and wool).
 When market demand for the existing products is decreasing or stagnant.
 Better utilization of existing facilities via managerial talents, research and
development activities.
 Market complementarily or interlocking pattern in seasonal demands e.g. one may
produce colours and sprayers together for festive
 Effective barrier to entry to reduce potential competition.

73
b) Conglomerate diversification
It has some features related to lateral diversification but products will be unrelated (see
merger later)
Motives for Conglomerate diversification:
 Helps in extension of market power of the firm.
 Brings stability in earnings through cross subsidization i.e. loss of one product is
covered by the gain from the other.
 Causes an increase in barriers to entry.
 Provides more options for risk taking for the sake of profits.
 Maintains the process of growth.
 Gives gains to the firm.
 Provides better utilization of some facilities.
c) Vertical diversification (see vertical integration)
It involves diversification into the process of manufacturing or distribution which
precedes or succeeds those in which the firm already engages in. A firm moves nearer to
the final market for its product and carries out a function which was previously
undertaken by its customers via a shoemaking firm may start its own distribution or
selling shops like Bata shoe company.
d) Diagonal diversification or integration.
Consists of the provision within the same organization of auxiliary goods and services
required for the several main processes or lines of production of the organization e.g. a
firm may have its own power house to generate electricity.
Reasons for this:
 Mopping up excess capacity.
 Reduction of the risks.

74
Motives for all Diversification Types
Profitability: This implies fuller utilization of resources at the firm’s disposal.
Stability: Implies reduction of risks and uncertainties through assured supplies of
resources and markets for main production line.
Growth: Implies expansion of productive capacities without being charged for
monopolizing production in the face of market limitations.
Market power is assured through increase in barriers to entry.
This refers to operations by a firm in two or more industries representing successive
stages in the flow of materials or products from an earlier to a later stage of production
and vice versa. It describes ownership or control by a firm of different stages of the
production process, e.g. petroleum refining firms owning ‘downstream’ the terminal
storage and retail gasoline distribution facilities and ‘upstream’ the crude oil fields wells
and transportation pipelines.
 Forward integration refers to the production to distribution stages
whereas;
 Backward integration refers to the production to raw materials stages of
production.
Vertical integration may be achieved through new investment and/or vertical mergers
and acquisition of existing firms at different stages of production. An important motive
for vertical integration is efficiencies and minimization of transaction costs.
VERTICAL INTEGRATION

75
Reasons for Vertical Integration
 Provides security to the firm via integrating backwards to have assured sources of
raw materials
 Provides economies of linked processes and thus the efficiency of the firm goes
up due to improvements in capacity utilization.
 There will be economies in marketing such as saving of transportation,
advertisements e.t.c.
 There may be saving by eliminating middle men.
 Firm gets more market power through its size or absolute cost
advantages/pecuniary gains through vertical integration.
 Backwards integration is aimed at controlling factor supplies which makes the
owners of merged firms to dictate over their competitors in buying of factor
inputs. Forward integration involves acquisition of retail outlets which can have
the effect of foreclosing substantial portions of retail markets for competitors.
REVIEW QUESTIONS
ACTIVITY
ACTIVITY
SUMMARY
1. What are the main economic motives for diversification?
2. Why would a firm opt to indulge in vertical integration?
If you are a milk processing company, explain how you would
indulge in vertical integration.
In this lesson we have looked at what diversification is and
highlighted its motives. We also looked at the concept of
vertical diversification and its operational rational for an

76
FURTHER READINGS
Press, USA

77
LESSON ELEVEN
ELEMENTS OF MARKET STRUCTURE (MERGER)
In the previous lesson, we looked at two elements of the Structure – Conduct -
Performance framework, that is, diversification and integration. In this lesson we will
consider the third element of the framework which is merging.
Objectives
A merger refers to an amalgamation or integration of two or more firms to form one firm.
The resultant firm may be existing or can be a new firm. Firms under different ownership
and management controls come under a unified one through a merger. This is a method
by which firms can increase their size and expand into existing or new economic
activities and markets. The terms acquisition and take over are also used for merger;
which implies that a firm acquires assets or stocks in part or full of other firm(s) to get
operational control over them.
Introduction
 Explain what a merger is
 Explain the different types of mergers
 Explain the economic motivation for firms to merge
MERGER

78
A variety of motives may exist for mergers:
 to increase economic efficiency,
 to acquire market power, to diversify,
 to expand into different geographic markets
 to pursue financial and R&D synergies
There are three different situations for a merger;
 Horizontal merger: Firms that produce and sell the same products, that is,
between competing firms. Products are viewed by buyers as identical; that is their
products have a high cross elasticity of demand and supply. These mergers if
significant in size may reduce competition in a market and are often reviewed by
competition authorities. Horizontal mergers can be viewed as horizontal
integration of firms in a market or across firms
 Vertical mergers: These are mergers between firms operating at different stages
of production. It occurs in firms where there is a successive functional link
between their products, that is, the output of one firm is input for the output of
another firm at a higher stage of production. There may be such integration
between a marketing and a producing firm for the same commodity(s). An
example would be a steel manufacturer merging with an iron ore producer.
Vertical mergers often increase economic efficiency although they may
sometimes have anticompetitive effects.
 A conglomerate merger: This is a merger between firms operating at different
stages of production. It occurs between firms which are producing altogether
different products (i.e. which are not substitutes for each other (zero cross
elasticity of demand and supply) such as merging of a cloth making firm and a
drug manufacturing one. The amalgamated firm in this situation will be a market
diversified firm. Diversification is also implied in the situation of vertical merger.

79
Motives (Reasons) for Mergers
Increase in Profitability: May be possible either through increased degree of
diversification of the combined firm or through other consequences of merger such as
increased efficiency and market power.
Stability in Earnings: When firms merge, there is little variation in their combined profit
rate. However they get stability in earnings due to increased market power.
Stock market gains: Firms would like to merge if there is a difference in the earning price
ration or market price for their shares in the stock market.
Valuation discrepancies: Discrepancies exist when circumstances make firm A to be
willing to pay a higher price for firm B which is greater than the price firm B expects for
itself. In this situation, there will be sale of firm B to firm A which implies a merger.
Why such discrepancy?
This occurs due to the stock market effect, expected changes in
technology, price management, succession, market structure, differences
in tax rates, accounting practices, existing risks e.t.c.
Efficiency motives: Stronger in horizontal other than vertical mergers. As a result of such
integration one can expect economies of scale in a variety of ways such as reduction in
inventory requirements, transportation and distribution costs, duplicate research and
development activities, cheaper raw materials due to increased size of purchases, better
management e.t.c.
Market power motive: Market power is a command over pricing and output decisions by
the firm.
Note

80
How much market power the firms would get after their merger is difficult to say.
This can be explained through synergy concept. Synergy results from
complementary activities or from the carrying over of managerial capabilities. For
instance-one firm may be efficient in production while the other in marketing,
when both of them come together the best of their individual capabilities make a
new balance in the operations resulting in higher effectiveness.
Growth motive: A firm will grow or expand in the market by acquiring some firm. the
combined firm will acquire more assets, more sales and more market power.
REVIEW QUESTIONS
ACTIVITY
ACTIVITY
SUMMARY
1. What are the different situations for a merger?
2. Explain the economic motives for a merger.
List the different mergers that have taken place in the banking
industry in Kenya and explain their motives.
In this lesson we have looked at what a merger is and explained
the different types of mergers. We have also explained the
economic motivation for firms to merge

81
FURTHER READINGS
LESSON TWELVE
MEASUREMENT APPROACHES TO THE ELEMENTS OF
MARKET STRUCTURE
In the previous two lessons, we looked at the elements of the Structure – Conduct -
Performance framework, that is, diversification, integration and merging. In this lesson
we will consider the measurement approaches to these elements.
Objectives
Press, USA
Introduction
By the end of this lesson you should be able to measure the
following elements using different approaches:
 Diversification
 Vertical Integration
 Merger
DIVERSIFICATION

82
a) Counting the number industries in which the firm operates. This method is simple and
crude, gives undue weight to many activities which account for only a small proportion
of the firm’s total business.
b) Government index. This is the ratio of a firm’s sales within the firm’s primary industry
to the firms’ total sales. A high ratio reflects less diversification and vice versa. This
method doesn’t give any idea of the number of industries in which the firm operates.
c) Berry’s index: 


n
i
iH pD
1
21 )(
 DH- is the degree of diversification, Pi- ratio of firms output (or sales) in the ith
industry to the firms total output (or sales) in n industries.
 For a single product firm; this index will have a zero value. It increases with
increase in diversification.


a) Ratio of value added to sales:




 n
i
i
n
i
i
i
s
AV
Cv
1
1
.
, i = Product
b) Ratio of inventory values to sales:




 n
i
i
n
i
i
i
s
I
Cv
1
1
, Ii = value of stocks of product i;
Si- sales in value of product i.
MERGER
VERTICAL INTEGRATION

83
a) Market Concentration: Market concentration is a situation in which an industry or
market is controlled by a small number of leading producers who are exclusively or at
least very largely engaged in that industry.
Two variables that are important in determining such a situation are:
 The number of firms in the industry.
 Their relative size distribution.
Some theoretical deductions
 Market concentration is a feature of the imperfect competition where one or few
firms dominate the entire industry.
 Assume there are few large firms along with many smaller firms selling a
homogenous product at a uniform single price. This is what is called homogenous
oligopoly. The large firms will be having interdependence among themselves in
the sense that variations in the price or supply of any one of them will have
significant effect on the market supply, equilibrium market price and revenue of
all other firms.
 It can be made explicitly known with the help of the following mathematical
derivation.
Let the total market supply for the product be specified as Q units and let the
demand function be:
)......()( ni QQQQFQFP  21 (1)
Where P is product price, Qi is output of the i-th firm. Revenue for firm i is given
as:
ii PQR  (2)
Differentiating with respect to Qi, the MR of the i-th firm:

84
ii
i
i
i
Q
Q
Q
P
QP
Q
R







; But
iQ
Q


= 1 (3)
Since an increase in one unit of output by the i-th firm means one unit increase in
the total market supply, this equation can be written as;
)(
i
i
i
i
Q
P
P
Q
Q
Q
P
Q
R





1 ; (4)
Where
Q
Qi
is the market share of the ith firm.
 We have assumed a uniform price for the industry which changes if output of any
big firm changes.
 Let us define the market quantity elasticity of demand ( qe ) as the percentage
change in market price with a marginal percent change in the market quantity
supplied.
qe =
iQ
P
P
Q


(5)
 Substituting equation (5) into (4) we get:
)( q
i
i
i
e
Q
Q
P
Q
R



1 , i=1..n (6)
 This equation shows that MR for the ith firm depends on the product price,
market share in output for the firm and quantity elasticity of price. If the firms are
of uneven sizes, then the average MR for the firm in the industry will be written
as:
Q
Q
MR
Q
Q
MR
Q
Q
MRMR n
n ...2
2
1
1 (7)
 Market shares of the firms are being taken as weights to compute the average MR.

85
 Making the substitution for MR1,MR2…MRn from (7) and simplifying we get;
)( q
n
i
i
e
Q
Q
PMR 








1
2
1 = )( qHeP 1 ,
 Where H = 






n
i
i
Q
Q
1
2
is the Hirshman-Herfindal index of concentration.
Assuming
Q
Qi
= Si, then H =  

n
i
iS
1
2
.
Note
The market share of each firm is defined by its own market share. The larger the
firm, the higher it will be in the index.
 The equation means the average MR depends on product price (p), concentration
index (H) and the elasticity coefficient (Eq). If all n firms are of equal size then
H=1/n which tends to be zero as n becomes greater and greater as in a competitive
situation. If so MR will almost be equal to price.
 To decide which industry is more concentrated than the other, select one with the
highest H-value. The maximum value for the index is 1 where only one firm
occupies the whole market. If Qi=Q and iS =1; then this is the case of monopoly.
The opposite should hold true as the number of firms in the industry increases
infinitely. It will approach zero - the case of price competition.
 So 0<H<1 where there are n firms holding identical market share output of each
firm (Qi)=Q/n. Therefore the market share for each firm will be;
iS =
Q
Qi
=
Q
nQ
=
n
1
, thus H = 






n
i n1
2
1
=
2n
n
=
n
1
.
 If there are 4 firms with identical market shares:

86
H = 






n
i 1
2
4
1
=
24
1
+
24
1
+
24
1
+
24
1
=
24
4
=
4
1
 H decreases as n increases.
 The H index gives greater weights to bigger market shares when they are 2)( iS
making the H index of such firms greater than the one of the industry with firms
having smaller market shares.
 Merger of firms based on this index will increase the degree of concentration.
Example:
Firm iS (%) 2)( iS (%)
1 4 16 0.0016
2 8 64 0.0064
3 17 0.0289
4 21 0.0004
5 10 0.0100
6 13 0.0169
7 21 0.0441
8 25 0.0625
H=0.1708 = 17.08%
b) Concentration Ratio
It measures the total share of the market for some of firms normally considered largest
firms in each industry to total production in the industry. Usually 4 firms are considered.
Market share may be taken either in production or sales or any magnitude of the market.
Ratio C=

m
i
iP
1
, M = 4, 8, 10….., Pi is the market share of the i-th firm in descending
order
Illustration;
Market share computation for an 8 firm industry

Eae 408

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