Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

Figure 2.1 
2.2.2. Leadership by the dominant firm: 
 
In oligopoly market, large and small firms exist side by 
side. When the oligopoly is composed of a large firm and many 
small firms, the large firm becomes the dominant firm and acts as 
the price-leader. The dominant firm sets the price for the industry 
and allows the small firms to sell all that they want to sell at that 
price. The rest of the market demand for the product is met by the 
dominant firm. For the small firms, the price is given and fixed and 
they can behave as if it were perfect competition for them. It is 
clear that each small firm is faced with a perfectly elastic demand 
curve (horizontal straight line). This demand curve is situated at 
the level of the price fixed by the dominant firm. It means that 
each firm behaves as if it were functioning in atmosphere of 
perfect competition. The only difference is that in a competitive 
market, the industry sets the price, but in this case, the price is 
fixed by the dominant firm. Since for every small firm, the demand 
curve is horizontal straight line, its marginal revenue curve 
coincides with it. In other words, for a small firm, AR = MR. The 
small firm's AR curve (demand curve) is also its MR curve. Thus, 
in order to earn maximum profits, the small firm should produce 
that output at which its marginal cost is equal to its marginal 
revenue i.e. the price fixed by the dominant firm. By horizontal 
summation of the marginal cost curves of the small firms, we 
obtain the supply curve for all the small firms. In Fig. 2.2, CMC is 
such a supply curve for the small firms. This supply curve shows 
the amounts of the product which all the small firms taken together 
will place in the market at different prices. DD indicates the market 
demand curve. It shows what amounts of the product the 

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consumers will purchase at each possible price. We can now 
derive the demand curve faced by the dominant firm. The 
horizontal difference between the market demand curve DD and 
the supply curve of the small firms CMC at different prices 
indicates how much the dominant firm would be able to supply at 
different prices. The demand curve for the dominant firm is 
obtained by horizontally substracting the CMC curve from the DD 
curve. Let us see how it is done. Suppose the dominant firm fixes 
OP as the price. At this price, the small firms will be able to meet 
the entire market demand because opposite OP price, DD = CmC 
i.e. the market demand is equal to the supply of all the small firms 
taken together. Therefore, the dominant firm will have no sales to 
make. Let us now consider a lower price OP
1
. At this price, the 
small firms will supply P
1
A
1
output although the market demand at 
this price is P
1
B
1
.