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UNIT - III

PRODUCTION, COST, MARKET STRUCTURES & PRICING

Introduction: The production function expresses a functional relationship between

physical inputs and physical outputs of a firm at any particular time period. The output
is thus a function of inputs. Mathematically production function can be written as

Q= f (A, B, C, D)

Where “Q” stands for the quantity of output and A, B, C, D are various input factors
such as land, labour, capital and organization. Here output is the function of inputs.
Hence output becomes the dependent variable and inputs are the independent
variables.

The above function does not state by how much the output of “Q” changes as a
consequence of change of variable inputs. In order to express the quantitative
relationship between inputs and output, Production function has been expressed in a
precise mathematical equation i.e.

Y= a+b(x)

Which shows that there is a constant relationship between applications of input (the
only factor input ‘X’ in this case) and the amount of output (y) produced.

Importance:

1. When inputs are specified in physical units, production function helps to

estimate the level of production.
2. It becomes is equates when different combinations of inputs yield the same
level of output.
3. It indicates the manner in which the firm can substitute on input for another
without altering the total output.
4. When price is taken into consideration, the production function helps to select
the least combination of inputs for the desired output.
5. It considers two types’ input-output relationships namely ‘law of variable
proportions’ and ‘law of returns to scale’. Law of variable propositions explains
the pattern of output in the short-run as the units of variable inputs are
increased to increase the output. On the other hand law of returns to scale
explains the pattern of output in the long run as all the units of inputs are
increased.

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6. The production function explains the maximum quantity of output, which can
be produced, from any chosen quantities of various inputs or the minimum
quantities of various inputs that are required to produce a given quantity of
output.

Production function can be fitted the particular firm or industry or for the economy as
whole. Production function will change with an improvement in technology.

Assumptions:

Production function has the following assumptions.

1. The production function is related to a particular period of time.

2. There is no change in technology.
3. The producer is using the best techniques available.
4. The factors of production are divisible.
5. Production function can be fitted to a short run or to long run.

Cobb-Douglas production function:

Production function of the linear homogenous type is invested by Junt wicksell and
first tested by C. W. Cobb and P. H. Dougles in 1928. This famous statistical production
function is known as Cobb-Douglas production function. Originally the function is
applied on the empirical study of the American manufacturing industry. Cabb –
Douglas production function takes the following mathematical form.

Y= (AKX L1-x)
Where Y=output
K=Capital
L=Labour
A, ∞=positive constant

Assumptions:

It has the following assumptions

1. The function assumes that output is the function of two factors viz. capital
and labour.
2. It is a linear homogenous production function of the first degree
3. The function assumes that the logarithm of the total output of the economy is
a linear function of the logarithms of the labour force and capital stock.
4. There are constant returns to scale

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5. All inputs are homogenous

6. There is perfect competition
7. There is no change in technology

ISOQUANTS:

The term Isoquants is derived from the words ‘iso’ and ‘quant’ – ‘Iso’ means equal
and ‘quent’ implies quantity. Isoquant therefore, means equal quantity. A family of
iso-product curves or isoquants or production difference curves can represent a
production function with two variable inputs, which are substitutable for one another
within limits.

Iqoquants are the curves, which represent the different combinations of inputs
producing a particular quantity of output. Any combination on the isoquant represents
the some level of output.

For a given output level firm’s production become,

Q= f (L, K)

Where ‘Q’, the units of output is a function of the quantity of two inputs ‘L’ and ‘K’.

Thus an isoquant shows all possible combinations of two inputs, which are capable of
producing equal or a given level of output. Since each combination yields same output,
the producer becomes indifferent towards these combinations.

Assumptions:

1. There are only two factors of production, viz. labour and capital.
2. The two factors can substitute each other up to certain limit
3. The shape of the isoquant depends upon the extent of substitutability of the
two inputs.
4. The technology is given over a period.

An isoquant may be explained with the help of an arithmetical example.

Combinations Labour (units) Capital (Units) Output (quintals)

A 1 10 50
B 2 7 50

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C 3 4 50
D 4 4 50
E 5 1 50

Combination ‘A’ represent 1 unit of labour and 10 units of capital and produces ‘50’
quintals of a product all other combinations in the table are assumed to yield the same
given output of a product say ‘50’ quintals by employing any one of the alternative
combinations of the two factors labour and capital. If we plot all these combinations
on a paper and join them, we will get continues and smooth curve called Iso-product
curve as shown below.

Labour is on the X-axis and capital is on the Y-axis. IQ is the ISO-Product curve which
shows all the alternative combinations A, B, C, D, E which can produce 50 quintals of
a product.

Producer’s Equilibrium:

The tem producer’s equilibrium is the counter part of consumer’s equilibrium. Just as
the consumer is in equilibrium when be secures maximum satisfaction, in the same
manner, the producer is in equilibrium when he secures maximum output, with the
least cost combination of factors of production.

The optimum position of the producer can be found with the help of iso-product curve.
The Iso-product curve or equal product curve or production indifference curve shows

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different combinations of two factors of production, which yield the same output. This
is illustrated as follows.

Let us suppose. The producer can produces the given output of paddy say 100 quintals
by employing any one of the following alternative combinations of the two factors
labour and capital computation of least cost combination of two inputs.

L K Q L&LP (3Rs.) KXKP(4Rs.) Total cost

Units Units Output Cost of cost of
labour capital
10 45 100 30 180 210
20 28 100 60 112 172
30 16 100 90 64 154
40 12 100 120 48 168
50 8 100 150 32 182

It is clear from the above that 10 units of ‘L’ combined with 45 units of ‘K’ would cost
the producer Rs. 20/-. But if 17 units reduce ‘K’ and 10 units increase ‘L’, the resulting
cost would be Rs. 172/-. Substituting 10 more units of ‘L’ for 12 units of ‘K’ further
reduces cost pf Rs. 154/-/ However, it will not be profitable to continue this
substitution process further at the existing prices since the rate of substitution is
diminishing rapidly. In the above table the least cost combination is 30 units of ‘L’
used with 16 units of ‘K’ when the cost would be minimum at Rs. 154/-. So this is they
stage “the producer is in equilibrium”.

LAW OF PRODUCTION:

Production analysis in economics theory considers two types of input-output

relationships.

1. When quantities of certain inputs, are fixed and others are variable and
2. When all inputs are variable.

These two types of relationships have been explained in the form of laws.

i) Law of variable proportions

ii) Law of returns to scale

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I. Law of variable proportions:

The law of variable proportions which is a new name given to old classical concept of
“Law of diminishing returns has played a vital role in the modern economics theory.
Assume that a firms production function consists of fixed quantities of all inputs (land,
equipment, etc.) except labour which is a variable input when the firm expands output
by employing more and more labour it alters the proportion between fixed and the
variable inputs. The law can be stated as follows:

“When total output or production of a commodity is increased by adding units of a

variable input while the quantities of other inputs are held constant, the increase in
total production becomes after some point, smaller and smaller”.

“If equal increments of one input are added, the inputs of other production services
being held constant, beyond a certain point the resulting increments of product will
decrease i.e. the marginal product will diminish”. (G. Stigler)

“As the proportion of one factor in a combination of factors is increased, after a point,
first the marginal and then the average product of that factor will diminish”. (F.
Benham)

The law of variable proportions refers to the behaviour of output as the quantity of
one Factor is increased Keeping the quantity of other factors fixed and further it states
that the marginal product and average product will eventually do cline. This law states
three types of productivity an input factor – Total, average and marginal physical
productivity.

Assumptions of the Law: The law is based upon the following assumptions:

i) The state of technology remains constant. If there is any improvement in

technology, the average and marginal out put will not decrease but
increase.
ii) Only one factor of input is made variable and other factors are kept
constant. This law does not apply to those cases where the factors must be
used in rigidly fixed proportions.
iii) All units of the variable factors are homogenous.

Three stages of law:

The behaviors of the Output when the varying quantity of one factor is combines with
a fixed quantity of the other can be divided in to three district stages. The three stages
can be better understood by following the table.

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Fixed factor Variable factor Total product Average Marginal

(Labour) Product Product
1 1 100 100 - Stage
1 2 220 120 120 I
1 3 270 90 50
1 4 300 75 30 Stage
1 5 320 64 20 II
1 6 330 55 10
1 7 330 47 0 Stage
1 8 320 40 -10 III

Above table reveals that both average product and marginal product increase in the
beginning and then decline of the two marginal products drops of faster than average
product. Total product is maximum when the farmer employs 6 th worker, nothing is
produced by the 7th worker and its marginal productivity is zero, whereas marginal
product of 8th worker is ‘-10’, by just creating credits 8th worker not only fails to make
a positive contribution but leads to a fall in the total output.

Production function with one variable input and the remaining fixed inputs is illustrated
as below

From the above graph the law of variable proportions operates in three stages. In the
first stage, total product increases at an increasing rate. The marginal product in this
stage increases at an increasing rate resulting in a greater increase in total product.
The average product also increases. This stage continues up to the point where
average product is equal to marginal product. The law of increasing returns is in

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operation at this stage. The law of diminishing returns starts operating from the
second stage awards. At the second stage total product increases only at a diminishing
rate. The average product also declines. The second stage comes to an end where
total product becomes maximum and marginal product becomes zero. The marginal
product becomes negative in the third stage. So the total product also declines. The
average product continues to decline.

We can sum up the above relationship thus when ‘A.P.’ is rising, “M. P.’ rises more
than “ A. P; When ‘A. P.” is maximum and constant, ‘M. P.’ becomes equal to ‘A. P.’
when ‘A. P.’ starts falling, ‘M. P.’ falls faster than ‘ A. P.’.

Thus, the total product, marginal product and average product pass through three
phases, viz., increasing diminishing and negative returns stage. The law of variable
proportion is nothing but the combination of the law of increasing and demising
returns.

II. Law of Returns of Scale:

The law of returns to scale explains the behavior of the total output in response to
change in the scale of the firm, i.e., in response to a simultaneous to changes in the
scale of the firm, i.e., in response to a simultaneous and proportional increase in all
the inputs. More precisely, the Law of returns to scale explains how a simultaneous
and proportionate increase in all the inputs affects the total output at its various levels.

The concept of variable proportions is a short-run phenomenon as in these period

fixed factors can not be changed and all factors cannot be changed. On the other hand
in the long-term all factors can be changed as made variable. When we study the
changes in output when all factors or inputs are changed, we study returns to scale.
An increase in the scale means that all inputs or factors are increased in the same
proportion. In variable proportions, the cooperating factors may be increased or
decreased and one faster (Ex. Land in agriculture (or) machinery in industry) remains
constant so that the changes in proportion among the factors result in certain changes
in output. In returns to scale all the necessary factors or production are increased or
decreased to the same extent so that whatever the scale of production, the proportion
among the factors remains the same.

When a firm expands, its scale increases all its inputs proportionally, then technically
there are three possibilities. (i) The total output may increase proportionately (ii) The

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total output may increase more than proportionately and (iii) The total output may
increase less than proportionately. If increase in the total output is proportional to the
increase in input, it means constant returns to scale. If increase in the output is
greater than the proportional increase in the inputs, it means increasing return to
scale. If increase in the output is less than proportional increase in the inputs, it
means diminishing returns to scale.

Let us now explain the laws of returns to scale with the help of isoquants for a two-
input and single output production system.

ECONOMIES OF SCALE

Production may be carried on a small scale or o a large scale by a firm. When a firm
expands its size of production by increasing all the factors, it secures certain
advantages known as economies of production. Marshall has classified these
economies of large-scale production into internal economies and external economies.

Internal economies are those, which are opened to a single factory or a single firm
independently of the action of other firms. They result from an increase in the scale
of output of a firm and cannot be achieved unless output increases. Hence internal
economies depend solely upon the size of the firm and are different for different firms.

External economies are those benefits, which are shared in by a number of firms or
industries when the scale of production in an industry or groups of industries
increases. Hence external economies benefit all firms within the industry as the size
of the industry expands.

Causes of internal economies:

Internal economies are generally caused by two factors
1. Indivisibilities 2. Specialization.

1. Indivisibilities
Many fixed factors of production are indivisible in the sense that they must be used in
a fixed minimum size. For instance, if a worker works half the time, he may be paid
half the salary. But he cannot be chopped into half and asked to produce half the
current output. Thus as output increases the indivisible factors which were being used
below capacity can be utilized to their full capacity thereby reducing costs. Such
indivisibilities arise in the case of labour, machines, marketing, finance and research.

2. Specialization.

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Division of labour, which leads to specialization, is another cause of internal

economies. Specialization refers to the limitation of activities within a particular field
of production. Specialization may be in labour, capital, machinery and place. For
example, the production process may be split into four departments relation to
manufacturing, assembling, packing and marketing under the charge of separate
managers who may work under the overall charge of the general manger and
coordinate the activities of the for departments. Thus specialization will lead to greater
productive efficiency and to reduction in costs.

Internal Economies:

Internal economies may be of the following types.

A). Technical Economies.

Technical economies arise to a firm from the use of better machines and superior
techniques of production. As a result, production increases and per unit cost of
production falls. A large firm, which employs costly and superior plant and equipment,
enjoys a technical superiority over a small firm. Another technical economy lies in the
mechanical advantage of using large machines. The cost of operating large machines
is less than that of operating mall machine. More over a larger firm is able to reduce
it’s per unit cost of production by linking the various processes of production. Technical
economies may also be associated when the large firm is able to utilize all its waste
materials for the development of by-products industry. Scope for specialization is also
available in a large firm. This increases the productive capacity of the firm and reduces
the unit cost of production.

B). Managerial Economies:

These economies arise due to better and more elaborate management, which only the
large size firms can afford. There may be a separate head for manufacturing,
assembling, packing, marketing, general administration etc. Each department is under
the charge of an expert. Hence the appointment of experts, division of administration
into several departments, functional specialization and scientific co-ordination of
various works make the management of the firm most efficient.

C). Marketing Economies:

The large firm reaps marketing or commercial economies in buying its requirements
and in selling its final products. The large firm generally has a separate marketing
department. It can buy and sell on behalf of the firm, when the market trends are
more favorable. In the matter of buying they could enjoy advantages like preferential

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treatment, transport concessions, cheap credit, prompt delivery and fine relation with
dealers. Similarly it sells its products more effectively for a higher margin of profit.

D). Financial Economies:

The large firm is able to secure the necessary finances either for block capital purposes
or for working capital needs more easily and cheaply. It can barrow from the public,
banks and other financial institutions at relatively cheaper rates. It is in this way that
a large firm reaps financial economies.

E). Risk bearing Economies:

The large firm produces many commodities and serves wider areas. It is, therefore,
able to absorb any shock for its existence. For example, during business depression,
the prices fall for every firm. There is also a possibility for market fluctuations in a
particular product of the firm. Under such circumstances the risk-bearing economies
or survival economies help the bigger firm to survive business crisis.

F). Economies of Research:

A large firm possesses larger resources and can establish it’s own research laboratory
and employ trained research workers. The firm may even invent new production
techniques for increasing its output and reducing cost.

G). Economies of welfare:

A large firm can provide better working conditions in-and out-side the factory.
Facilities like subsidized canteens, crèches for the infants, recreation room, cheap
houses, educational and medical facilities tend to increase the productive efficiency of
the workers, which helps in raising production and reducing costs.

External Economies.

Business firm enjoys a number of external economies, which are discussed below:

A). Economies of Concentration:

When an industry is concentrated in a particular area, all the member firms reap some
common economies like skilled labour, improved means of transport and
communications, banking and financial services, supply of power and benefits from

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subsidiaries. All these facilities tend to lower the unit cost of production of all the firms
in the industry.

B). Economies of Information

The industry can set up an information centre which may publish a journal and pass
on information regarding the availability of raw materials, modern machines, export
potentialities and provide other information needed by the firms. It will benefit all
firms and reduction in their costs.

C). Economies of Welfare:

An industry is in a better position to provide welfare facilities to the workers. It may

get land at concessional rates and procure special facilities from the local bodies for
setting up housing colonies for the workers. It may also establish public health care
units, educational institutions both general and technical so that a continuous supply
of skilled labour is available to the industry. This will help the efficiency of the workers.

D). Economies of Disintegration:

The firms in an industry may also reap the economies of specialization. When an
industry expands, it becomes possible to spilt up some of the processes which are
taken over by specialist firms. For example, in the cotton textile industry, some firms
may specialize in manufacturing thread, others in printing, still others in dyeing, some
in long cloth, some in dhotis, some in shirting etc. As a result the efficiency of the
firms specializing in different fields increases and the unit cost of production falls.

Thus internal economies depend upon the size of the firm and external economies
depend upon the size of the industry.

DISECONOMIES OF LARGE SCALE PRODUCTION

Internal and external diseconomies are the limits to large-scale production. It is

possible that expansion of a firm’s output may lead to rise in costs and thus result
diseconomies instead of economies. When a firm expands beyond proper limits, it is
beyond the capacity of the manager to manage it efficiently. This is an example of an
internal diseconomy. In the same manner, the expansion of an industry may result in
diseconomies, which may be called external diseconomies. Employment of additional
factors of production becomes less efficient and they are obtained at a higher cost. It
is in this way that external diseconomies result as an industry expands.

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The major diseconomies of large-scale production are discussed below:

Internal Diseconomies:

A). Financial Diseconomies:

For expanding business, the entrepreneur needs finance. But finance may not be
easily available in the required amount at the appropriate time. Lack of finance retards
the production plans thereby increasing costs of the firm.

B). Managerial diseconomies:

There are difficulties of large-scale management. Supervision becomes a difficult job.

Workers do not work efficiently, wastages arise, decision-making becomes difficult,
coordination between workers and management disappears and production costs
increase.

C). Marketing Diseconomies:

As business is expanded, prices of the factors of production will rise. The cost will
therefore rise. Raw materials may not be available in sufficient quantities due to their
scarcities. Additional output may depress the price in the market. The demand for the
products may fall as a result of changes in tastes and preferences of the people. Hence
cost will exceed the revenue.

D). Technical Diseconomies:

There is a limit to the division of labour and splitting down of production p0rocesses.
The firm may fail to operate its plant to its maximum capacity. As a result cost per
unit increases. Internal diseconomies follow.

E). Diseconomies of Risk-taking:

As the scale of production of a firm expands risks also increase with it. Wrong decision
by the management may adversely affect production. In large firms are affected by
any disaster, natural or human, the economy will be put to strains.

External Diseconomies:

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When many firm get located at a particular place, the costs of transportation increases
due to congestion. The firms have to face considerable delays in getting raw materials
and sending finished products to the marketing centers. The localization of industries
may lead to scarcity of raw material, shortage of various factors of production like
labour and capital, shortage of power, finance and equipments. All such external
diseconomies tend to raise cost per unit.

QUESTIONS

1. Why does the law of diminishing returns operate? Explain with the help of a
diagram.
2. Explain the nature and uses of production function.
3. Explain and illustrate lows of returns to scale.
4. a. Explain how production function can be mode use of to reduce cost of
Production.
b. Explain low of constant returns? Illustrate.
5. Explain the following (i) Internal Economics (ii) External Economics (or)
Explain Economics of scale. Explain the factor, which causes increasing
returns to scale.
6. Explain the following with reference to production functions
(a) MRTS
(b) Variable proportion of factor
7. Define production function, explain is equate and is cost curves.
8. Explain the importance and uses of production function in break-even
analysis.
9. Discuss the equilibrium of a firm with isoquants.
10. (a) What are isocost curves and iso quants? Do they interest each other
(b) Explain Cobb-Douglas Production function.

QUIZ

1. How many types of input-output relations discussed by the

Law of production. (
)
(a) Five (b) Four
(c) Two (d) Three
2. How many stages are there in ‘Law of Variable Proportions’? (
)
(a) Five (b) Two
(c) Three (d) Four

3. Congregation of body of persons assembling together to work at a certain

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Time and place is called as (

)
(a) Firm (b) Industry
(c) Plant (d) Size

4. When a firm expands its Size of production by increasing all factors,

It secures certain advantages, known as (
)
(a) Optimum Size (b) Diseconomies of Scale
(c) Economies of Scale (d) None

5. When producer secures maximum output with the least cost combination
Of factors of production, it is known as_______ (
)
(a) Consumer’s Equilibrium (b) Price Equilibrium
(c) Producer’s Equilibrium (d) Firm’s Equilibrium

6. The ‘Law of Variable Proportions’ is also called as ____________. (

)
(a) Law of fixed proportions (b) Law of returns to scale
(c) Law of variable proportions (d) None

7. _________ Is a ‘group of firms producing the same are slightly

Different products for the same market or using same raw material’. (
)
(a) Plant (b) Firm
(c) Industry (d) Size

8. When proportionate increase in all inputs results in an equal

Proportionate increase in output, then we call____________. (
)
(a) Increasing Returns to Scale (b) Decreasing Returns to Scale
(c) Constant Returns to Scale (d) None

9. When different combinations of inputs yield the same level of output

Known as ___________. (
)
(a) Different Quants (b) Output differentiation
(c) Isoquants (d) Production differentiation

10. Conversion of inputs in to output is called as _________________. (

)
(a) Sales (b) Income
(c) Production (d) Expenditure

11. When Proportionate increase in all inputs results in more than equal
Proportionate increase in output, then we call _____________. (
)
(a) Decreasing Returns to Scale (b) Constant Returns to Scale
(c) Increasing Returns to Scale (d) None

12. When Proportionate increase in all inputs results in less than Equal

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Proportionate increase in output, then we call _____________. (

)
(a) Increasing Returns to Scale (b) Constant Returns to Scale
(c) Decreasing Returns to Scale (d) None

13. A curve showing equal amount of outlay with varying Proportions of

Two inputs are called ________________. (
)
(a) Total Cost Curve (b) Variable Cost Curve
(c) Isocost Curve (d) Marginal Cost Curve

Note: Answer is “C” for all the above questions.

COST ANALYSIS

Profit is the ultimate aim of any business and the long-run prosperity of a firm depends
upon its ability to earn sustained profits. Profits are the difference between selling
price and cost of production. In general the selling price is not within the control of a
firm but many costs are under its control. The firm should therefore aim at controlling
and minimizing cost. Since every business decision involves cost consideration, it is
necessary to understand the meaning of various concepts for clear business thinking
and application of right kind of costs.

COST CONCEPTS:

A managerial economist must have a clear understanding of the different cost

concepts for clear business thinking and proper application. The several alternative
bases of classifying cost and the relevance of each for different kinds of problems are
to be studied. The various relevant concepts of cost are:

1. Opportunity costs and outlay costs:

Out lay cost also known as actual costs obsolete costs are those expends which are
actually incurred by the firm these are the payments made for labour, material, plant,
building, machinery traveling, transporting etc., These are all those expense item
appearing in the books of account, hence based on accounting cost concept.

On the other hand opportunity cost implies the earnings foregone on the next best
alternative, has the present option is undertaken. This cost is often measured by
assessing the alternative, which has to be scarified if the particular line is followed.

The opportunity cost concept is made use for long-run decisions. This concept is very
important in capital expenditure budgeting. This concept is very important in capital

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expenditure budgeting. The concept is also useful for taking short-run decisions
opportunity cost is the cost concept to use when the supply of inputs is strictly limited
and when there is an alternative. If there is no alternative, Opportunity cost is zero.
The opportunity cost of any action is therefore measured by the value of the most
favorable alternative course, which had to be foregoing if that action is taken.

2. Explicit and implicit costs:

Explicit costs are those expenses that involve cash payments. These are the actual or
business costs that appear in the books of accounts. These costs include payment of
wages and salaries, payment for raw-materials, interest on borrowed capital funds,
rent on hired land, Taxes paid etc.

Implicit costs are the costs of the factor units that are owned by the employer himself.
These costs are not actually incurred but would have been incurred in the absence of
employment of self – owned factors. The two normal implicit costs are depreciation,
interest on capital etc. A decision maker must consider implicit costs too to find out
appropriate profitability of alternatives.

3. Historical and Replacement costs:

Historical cost is the original cost of an asset. Historical cost valuation shows the cost
of an asset as the original price paid for the asset acquired in the past. Historical
valuation is the basis for financial accounts.

A replacement cost is the price that would have to be paid currently to replace the
same asset. During periods of substantial change in the price level, historical valuation
gives a poor projection of the future cost intended for managerial decision. A
replacement cost is a relevant cost concept when financial statements have to be
adjusted for inflation.

4. Short – run and long – run costs:

Short-run is a period during which the physical capacity of the firm remains fixed. Any
increase in output during this period is possible only by using the existing physical
capacity more extensively. So short run cost is that which varies with output when
the plant and capital equipment in constant.

Long run costs are those, which vary with output when all inputs are variable including
plant and capital equipment. Long-run cost analysis helps to take investment
decisions.

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5. Out-of pocket and books costs:

Out-of pocket costs also known as explicit costs are those costs that involve current
cash payment. Book costs also called implicit costs do not require current cash
payments. Depreciation, unpaid interest, salary of the owner is examples of back
costs.

But the book costs are taken into account in determining the level dividend payable
during a period. Both book costs and out-of-pocket costs are considered for all
decisions. Book cost is the cost of self-owned factors of production.

6. Fixed and variable costs:

Fixed cost is that cost which remains constant for a certain level to output. It is not
affected by the changes in the volume of production. But fixed cost per unit decrease,
when the production is increased. Fixed cost includes salaries, Rent, Administrative
expenses depreciations etc.

Variable is that which varies directly with the variation is output. An increase in total
output results in an increase in total variable costs and decrease in total output results
in a proportionate decline in the total variables costs. The variable cost per unit will
be constant. Ex: Raw materials, labour, direct expenses, etc.

7. Post and Future costs:

Post costs also called historical costs are the actual cost incurred and recorded in the
book of account these costs are useful only for valuation and not for decision making.

Future costs are costs that are expected to be incurred in the futures. They are not
actual costs. They are the costs forecasted or estimated with rational methods. Future
cost estimate is useful for decision making because decision are meant for future.

8. Traceable and common costs:

Traceable costs otherwise called direct cost, is one, which can be identified with a
products process or product. Raw material, labour involved in production is examples
of traceable cost.

Common costs are the ones that common are attributed to a particular process or
product. They are incurred collectively for different processes or different types of
products. It cannot be directly identified with any particular process or type of product.

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9. Avoidable and unavoidable costs:

Avoidable costs are the costs, which can be reduced if the business activities of a
concern are curtailed. For example, if some workers can be retrenched with a drop in
a product – line, or volume or production the wages of the retrenched workers are
escapable costs.

The unavoidable costs are otherwise called sunk costs. There will not be any reduction
in this cost even if reduction in business activity is made. For example cost of the ideal
machine capacity is unavoidable cost.

10. Controllable and uncontrollable costs:

Controllable costs are ones, which can be regulated by the executive who is in change
of it. The concept of controllability of cost varies with levels of management. Direct
expenses like material, labour etc. are controllable costs.

Some costs are not directly identifiable with a process of product. They are appointed
to various processes or products in some proportion. This cost varies with the variation
in the basis of allocation and is independent of the actions of the executive of that
department. These apportioned costs are called uncontrollable costs.

11. Incremental and sunk costs:

Incremental cost also known as different cost is the additional cost due to a change in
the level or nature of business activity. The change may be caused by adding a new
product, adding new machinery, replacing a machine by a better one etc.

Sunk costs are those which are not altered by any change – They are the costs
incurred in the past. This cost is the result of past decision, and cannot be changed
by future decisions. Investments in fixed assets are examples of sunk costs.

12. Total, average and marginal costs:

Total cost is the total cash payment made for the input needed for production. It may
be explicit or implicit. It is the sum total of the fixed and variable costs. Average cost
is the cost per unit of output. If is obtained by dividing the total cost (TC) by the total
quantity produced (Q)
TC
Average cost = ------
Q

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Marginal cost is the additional cost incurred to produce and additional unit of output
or it is the cost of the marginal unit produced.

13. Accounting and Economics costs:

Accounting costs are the costs recorded for the purpose of preparing the balance sheet
and profit and ton statements to meet the legal, financial and tax purpose of the
company. The accounting concept is a historical concept and records what has
happened in the post.

Economics concept considers future costs and future revenues, which help future
planning, and choice, while the accountant describes what has happened, the
economics aims at projecting what will happen.

COST-OUTPUT RELATIONSHIP

A proper understanding of the nature and behavior of costs is a must for regulation
and control of cost of production. The cost of production depends on money forces
and an understanding of the functional relationship of cost to various forces will help
us to take various decisions. Output is an important factor, which influences the cost.
The cost-output relationship plays an important role in determining the optimum level
of production. Knowledge of the cost-output relation helps the manager in cost control,
profit prediction, pricing, promotion etc. The relation between cost and its
determinants is technically described as the cost function.

C= f (S, O, P, T ….)

Where;
C= Cost (Unit or total cost)
S= Size of plant/scale of production
O= Output level
P= Prices of inputs
T= Technology

Considering the period the cost function can be classified as (a) short-run cost function
and (b) long-run cost function. In economics theory, the short-run is defined as that
period during which the physical capacity of the firm is fixed and the output can be
increased only by using the existing capacity allows to bring changes in output by
physical capacity of the firm.

(a) Cost-Output Relation in the short-run:

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The cost concepts made use of in the cost behavior are total cost, Average cost, and
marginal cost.

Total cost is the actual money spent to produce a particular quantity of output. Total
cost is the summation of fixed and variable costs.

TC=TFC+TVC

Up to a certain level of production total fixed cost i.e., the cost of plant, building,
equipment etc, remains fixed. But the total variable cost i.e., the cost of labour, raw
materials etc., Vary with the variation in output. Average cost is the total cost per
unit. It can be found out as follows.

TC
AC=
Q
Q
The total of average fixed cost (TFC/Q) keep coming down as the production is
increased and average variable cost (TVC/Q) will remain constant at any level of
output.

Marginal cost is the addition to the total cost due to the production of an additional
unit of product. It can be arrived at by dividing the change in total cost by the change
in total output.

In the short-run there will not be any change in total fixed cost. Hence change in
total cost implies change in total variable cost only.

Cost – output relations

Units of Total Total Total Average Average Average Marginal

Output fixed variable cost variable fixed cost cost
Q cost cost (TFC + cost cost (TC/Q) MC
TFC TVC TVC) TC (TVC / (TFC / AC
Q) AVC Q) AFC
0 - - 60 - - - -
1 60 20 80 20 60 80 20
2 60 36 96 18 30 48 16
3 60 48 108 16 20 36 12
4 60 64 124 16 15 31 16
5 60 90 150 18 12 30 26
6 60 132 192 22 10 32 42

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The above table represents the cost-output relation. The table is prepared on the basis
of the law of diminishing marginal returns. The fixed cost Rs. 60 May include rent of
factory building, interest on capital, salaries of permanently employed staff, insurance
etc. The table shows that fixed cost is same at all levels of output but the average
fixed cost, i.e., the fixed cost per unit, falls continuously as the output increases. The
expenditure on the variable factors (TVC) is at different rate. If more and more units
are produced with a given physical capacity the AVC will fall initially, as per the table
declining up to 3rd unit, and being constant up to 4th unit and then rising. It implies
that variable factors produce more efficiently near a firm’s optimum capacity than at
any other levels of output.

And later rises. But the rise in AC is felt only after the start rising. In the table ‘AVC’
starts rising from the 5th unit onwards whereas the ‘AC’ starts rising from the 6th unit
only so long as ‘AVC’ declines ‘AC’ also will decline. ‘AFC’ continues to fall with an
increase in Output. When the rise in ‘AVC’ is more than the decline in ‘AFC’, the total
cost again begin to rise. Thus there will be a stage where the ‘AVC’, the total cost
again begin to rise thus there will be a stage where the ‘AVC’ may have started rising,
yet the ‘AC’ is still declining because the rise in ‘AVC’ is less than the droop in ‘AFC’.

Thus the table shows an increasing returns or diminishing cost in the first stage and
diminishing returns or diminishing cost in the second stage and followed by
diminishing returns or increasing cost in the third stage.

The short-run cost-output relationship can be shown graphically as follows.

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In the above graph the “AFC’ curve continues to fall as output rises an account of its
spread over more and more units Output. But AVC curve (i.e. variable cost per unit)
first falls and than rises due to the operation of the law of variable proportions. The
behavior of “ATC’ curve depends upon the behavior of ‘AVC’ curve and ‘AFC’ curve. In
the initial stage of production both ‘AVC’ and ‘AFC’ decline and hence ‘ATC’ also
decline. But after a certain point ‘AVC’ starts rising. If the rise in variable cost is less
than the decline in fixed cost, ATC will still continue to decline otherwise AC begins to
rise. Thus the lower end of ‘ATC’ curve thus turns up and gives it a U-shape. That is
why ‘ATC’ curve are U-shaped. The lowest point in ‘ATC’ curve indicates the least-cost
combination of inputs. Where the total average cost is the minimum and where the
“MC’ curve intersects ‘AC’ curve, It is not be the maximum output level rather it is the
point where per unit cost of production will be at its lowest.
The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up as follows:

1. If both AFC and ‘AVC’ fall, ‘ATC’ will also fall.

2. When ‘AFC’ falls and ‘AVC’ rises
a. ‘ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.
b. ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
c. ‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’

b. Cost-output Relationship in the long-run:

Long run is a period, during which all inputs are variable including the one, which are
fixes in the short-run. In the long run a firm can change its output according to its
demand. Over a long period, the size of the plant can be changed, unwanted buildings
can be sold staff can be increased or reduced. The long run enables the firms to expand
and scale of their operation by bringing or purchasing larger quantities of all the
inputs. Thus in the long run all factors become variable.

The long-run cost-output relations therefore imply the relationship between the total
cost and the total output. In the long-run cost-output relationship is influenced by the
law of returns to scale.

In the long run a firm has a number of alternatives in regards to the scale of
operations. For each scale of production or plant size, the firm has an appropriate
short-run average cost curves. The short-run average cost (SAC) curve applies to only
one plant whereas the long-run average cost (LAC) curve takes in to consideration
many plants.

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The long-run cost-output relationship is shown graphically with the help of “LCA’
curve.

To draw on ‘LAC’ curve we have to start with a number of ‘SAC’ curves. In the above
figure it is assumed that technologically there are only three sizes of plants – small,
medium and large, ‘SAC’, for the small size, ‘SAC2’ for the medium size plant and
‘SAC3’ for the large size plant. If the firm wants to produce ‘OP’ units of output, it will
choose the smallest plant. For an output beyond ‘OQ’ the firm wills optimum for
medium size plant. It does not mean that the OQ production is not possible with small
plant. Rather it implies that cost of production will be more with small plant compared
to the medium plant.

For an output ‘OR’ the firm will choose the largest plant as the cost of production will
be more with medium plant. Thus the firm has a series of ‘SAC’ curves. The ‘LCA’
curve drawn will be tangential to the entire family of ‘SAC’ curves i.e. the ‘LAC’ curve
touches each ‘SAC’ curve at one point, and thus it is known as envelope curve. It is
also known as planning curve as it serves as guide to the entrepreneur in his planning
to expand the production in future. With the help of ‘LAC’ the firm determines the size
of plant which yields the lowest average cost of producing a given volume of output it
anticipates.

BREAKEVEN ANALYSIS

The study of cost-volume-profit relationship is often referred as BEA. The term BEA is
interpreted in two senses. In its narrow sense, it is concerned with finding out BEP;
BEP is the point at which total revenue is equal to total cost. It is the point of no profit,
no loss. In its broad determine the probable profit at any level of production.

Assumptions:

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1. All costs are classified into two – fixed and variable.

2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change in
the volume of production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
8. Volume of sales and volume of production are equal. Hence there is no unsold
stock.
9. There is only one product or in the case of multiple products. Sales mix
remains constant.

Merits:

1. Information provided by the Break Even Chart can be understood more easily
then those contained in the profit and Loss Account and the cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit.
It reveals how changes in profit. So, it helps management in decision-making.
3. It is very useful for forecasting costs and profits long term planning and
growth
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
7. Analytical Break-even chart present the different elements, in the costs –
direct material, direct labour, fixed and variable overheads.

Demerits:

1. Break-even chart presents only cost volume profits. It ignores other

considerations such as capital amount, marketing aspects and effect of
government policy etc., which are necessary in decision making.
2. It is assumed that sales, total cost and fixed cost can be represented as
straight lines. In actual practice, this may not be so.
3. It assumes that profit is a function of output. This is not always true. The firm
may increase the profit without increasing its output.
4. A major draw back of BEC is its inability to handle production and sale of
multiple products.
5. It is difficult to handle selling costs such as advertisement and sale promotion
in BEC.
6. It ignores economics of scale in production.

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7. Fixed costs do not remain constant in the long run.

8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because generally
there may be opening stock.
10. When production increases variable cost per unit may not remain constant but
may reduce on account of bulk buying etc.
11. The assumption of static nature of business and economic activities is a well-
known defect of BEC.

1. Fixed cost
2. Variable cost
3. Contribution
4. Margin of safety
5. Angle of incidence
6. Profit volume ratio
7. Break-Even-Point

1. Fixed cost: Expenses that do not vary with the volume of production are known
as fixed expenses. Eg. Manager’s salary, rent and taxes, insurance etc. It should
be noted that fixed changes are fixed only within a certain range of plant capacity.
The concept of fixed overhead is most useful in formulating a price fixing policy.
Fixed cost per unit is not fixed.
2. Variable Cost: Expenses that vary almost in direct proportion to the volume of
production of sales are called variable expenses. Eg. Electric power and fuel,
packing materials consumable stores. It should be noted that variable cost per unit
is fixed.
3. Contribution: Contribution is the difference between sales and variable costs and
it contributed towards fixed costs and profit. It helps in sales and pricing policies
and measuring the profitability of different proposals. Contribution is a sure test to
decide whether a product is worthwhile to be continued among different products.

Contribution = Sales – Variable cost

Contribution = Fixed Cost + Profit.

4. Margin of safety: Margin of safety is the excess of sales over the break even
sales. It can be expressed in absolute sales amount or in percentage. It indicates
the extent to which the sales can be reduced without resulting in loss. A large
margin of safety indicates the soundness of the business. The formula for the
margin of safety is:
Profit
Present sales – Break even sales or
P. V. ratio

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Margin of safety can be improved by taking the following steps.

1. Increasing production
2. Increasing selling price
3. Reducing the fixed or the variable costs or both
4. Substituting unprofitable product with profitable one.

5. Angle of incidence: This is the angle between sales line and total cost line at the
Break-even point. It indicates the profit earning capacity of the concern. Large
angle of incidence indicates a high rate of profit; a small angle indicates a low rate
of earnings. To improve this angle, contribution should be increased either by
raising the selling price and/or by reducing variable cost. It also indicates as to
what extent the output and sales price can be changed to attain a desired amount
of profit.

6. Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful ratios
for studying the profitability of business. The ratio of contribution to sales is the
P/V ratio. It may be expressed in percentage. Therefore, every organization tries
to improve the P. V. ratio of each product by reducing the variable cost per unit or
by increasing the selling price per unit. The concept of P. V. ratio helps in
determining break even-point, a desired amount of profit etc.

Contributi on
The formula is, X 100
Sales

7. Break – Even- Point: If we divide the term into three words, then it does not
require further explanation.
Break-divide
Even-equal
Point-place or position
Break Even Point refers to the point where total cost is equal to total revenue.
It is a point of no profit, no loss. This is also a minimum point of no profit, no
loss. This is also a minimum point of production where total costs are
recovered. If sales go up beyond the Break Even Point, organization makes a
profit. If they come down, a loss is incurred.

Fixed Expenses
1. Break Even point (Units) =
Contributi on per unit
Fixed expenses
2. Break Even point (In Rupees) = X sales
Contributi on

QUESTIONS

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1. What cost concepts are mainly used for management decision making?
Illustrate.

2. The PV ratio of matrix books Ltd Rs. 40% and the margin of safety Rs. 30.
You are required to work out the BEP and Net Profit. If the sales volume is Rs.
14000/-

3. A Company reported the following results for two period

Period Sales Profit

I Rs. 20,00,000 Rs. 2,00,000
II Rs. 25,00,000 Rs. 3,00,000
Ascertain the BEP, PV ratio, fixes cost and Margin of Safety.

4. Write short notes on the following

a) Profit – Volume ratio
b) Margin of Safety

5. Write short notes on: (i) Suck costs (ii) Abandonment costs

6. The information about Raj & Co are given below:

PV ratio : 20%
Fixed Cost : Rs. 36,000/-
Selling Price Per Unit: Rs. 150/-
Calculate (i) BEP in rupees (ii) BEP in Units
(iii) Variable cost per unit
(iv) Contribution per unit

7. Define opportunity cost. List out its assumptions & Limitation.

8. (a) Explain the utility of BEA in managerial decision making

(b) How do you explain break even chart? Explain.

9. Write short motes on:

(i) Fixed cost & variable cost
(ii) Out of pocket costs & imputed costs
(iii) Explicit & implicit Costs
(iv) Short rum cost

10. Write short note on the following:

(a) PV ratio
(b) Margin of Safety
(c) Angle of incidence
(d)
11. Explain Cost/Output relationship in the short run.

12. Appraise the usefulness of BEA for a multi product organization

13. Describe the BEP with the help of a diagram and its uses in business decision
making.

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14. If sales in 10000 units and selling price Rs. 20/- per unit. Variable cost is Rs.
10/- per unit and fixed cost is Rs. 80000. Find out BEP in Units and sales
revenue what is profit earned? What should be the sales for earning a profit
of Rs. 60000/-

15. How do you determine BEP in terms of physical units and sales value? Explain
the concepts of margin of safety & angle of incidence.

16. Sales are 1,10,000 producing a profit of Rs. 4000/- in period I, sales are
150000 producing a profit of Rs. 12000/- in period II. Determine BEP & fixed
expenses.

17. When a Mc change does Ac changed (a) at the same rate (b) at a higher rate
or (c) at a lower rate? Illustrate your answer with a diagram.

18. Explain the relationship between MC, AC and TC assuming a short run non-
linear cost function.

19. Sale of a product amounts to 20 units per months at Rs. 10/- per unit. Fixed
overheads is Rs. 400/- per month and variable cost is Rs. 6/- per unit. There
is a proposal to reduce prices by 107. Calculate present and future P-V ratio.
How many units must be sold to earn a target profit of present level?

QUIZ

1. The cost of best alternative forgone is_______________ (

)
(a) Outlay cost (b) Past cost
(c) Opportunity cost (d) Future cost

2. If we add up total fixed cost (TFC) and total variable cost (TVC),
we get__ (
)
(a) Average cost (b) Marginal cost
(c) Total cost (d) Future cost

3. ________ costs are theoretical costs, which are not recognized by the
Accounting system. (
)
(a) Past (b) Explicit
(c) Implicit (d) Historical

4. _____cost is the additional cost to produce an additional unit of output. (

)
(a) Incremental (b) Sunk
(c) Marginal (d) Total

5. _______ costs are the costs, which are varies with the level of output. (
)
(a) Fixed (b) Past
(c) Variable (d) Historical

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6. _________________ costs are those business costs, which do not

Involve any cash payment. (
)
(a) Past (b) Historical
(c) Implicit (d) Explicit

7. The opposite of Past cost is ________________________. (

)
(a) Historical (b) Fixed cost
(c) Future cost (d) Variable cost

8. _____ is a period during which the existing physical capacity of the

Firm can be changed. (
)
(a) Market period (b) Short period
(c) Long period (d) Medium period

9. What is the formula for Profit-Volume Ratio? (

)
Sales Variable cost
(a) --------------- X 100 (b) ----------------- X 100
Contribution Sales

Contribution Fixed cost

(c) --------------- X 100 (b) ----------------- X 100
Sales Sales

10. _______ is a point of sales at which there is neither profit nor loss. (
)
(a) Maximum sales (b) Minimum sales
(c) Break-Even sales (d) Average sales

11. What is the formula for Margin of Safety? (

)
(a) Break Even sales – Actual sales (b) Maximum sales – Actual sales
(c) Actual sales – Break Even sales (d) Actual sales – Minimum sales

12. What is the formula for Break-Even Point in Units? (

)
(a) __Contribution_____ (b) __Variable cost____
Selling Price per unit Contribution per unit
(c) _ _Fixed cost _____ (d) __Variable cost____
Contribution per unit Selling Price per unit

13. What is the Other Name of Profit Volume Ratio? (

)
(a) Cost-Volume-Profit Ratio (b) Margin of safety Ratio
(c) Marginal Ratio (d) None

14. What is the break-even sales amount, when selling price per unit
is 10/- , Variable cost per unit is 6/- and fixed cost is 40,000/-. (
)
(a) Rs. 4, 00,000/- (b) Rs. 3, 00,000/-

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(c) Rs. 1, 00,000/- (d) Rs. 2, 00,000/-

15. ‘Contribution” is the excess amount of Actual Sales over ______. (

)
(a) Fixed cost (b) Sales
(c) Variable cost (d) Total cost

Note: Answer is “C” for all the above questions.

Pricing

Introduction

Pricing is an important, if not the most important function of all enterprises. Since
every enterprise is engaged in the production of some goods or/and service. Incurring
some expenditure, it must set a price for the same to sell it in the market. It is only
in extreme cases that the firm has no say in pricing its product; because there is
severe or rather perfect competition in the market of the good happens to be of such
public significance that its price is decided by the government. In an overwhelmingly
large number of cases, the individual producer plays the role in pricing its product.

It is said that if a firm were good in setting its product price it would certainly flourish
in the market. This is because the price is such a parameter that it exerts a direct
influence on the products demand as well as on its supply, leading to firm’s turnover
(sales) and profit. Every manager endeavors to find the price, which would best meet
with his firm’s objective. If the price is set too high the seller may not find enough
customers to buy his product. On the other hand, if the price is set too low the seller
may not be able to recover his costs. There is a need for the right price further, since
demand and supply conditions are variable over time what is a right price today may
not be so tomorrow hence, pricing decision must be reviewed and reformulated from
time to time.

Price

Price denotes the exchange value of a unit of good expressed in terms of money. Thus
the current price of a maruti car around Rs. 2,00,000, the price of a hair cut is Rs. 25

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the price of a economics book is Rs. 150 and so on. Nevertheless, if one gives a little,
if one gives a little thought to this subject, one would realize that there is nothing like
a unique price for any good. Instead, there are multiple prices.

Price concepts

Price of a well-defined product varies over the types of the buyers, place it is received,
credit sale or cash sale, time taken between final production and sale, etc.

It should be obvious to the readers, that the price difference on account of the above
four factors are more significant. The multiple prices is more serious in the case of
items like cars refrigerators, coal, furniture and bricks and is of little significance for
items like shaving blade, soaps, tooth pastes, creams and stationeries. Differences in
various prices of any good are due to differences in transport cost, storage cost
accessories, interest cost, intermediaries’ profits etc. Once can still conceive of a basic
price, which would be exclusive of all these items of cost and then rationalize other
prices by adding the cost of special items attached to the particular transaction, in
what follows we shall explain the determination of this basis price alone and thus
resolve the problem of multiple prices.

Price determinants – Demand and supply

The price of a product is determined by the demand for and supply of that product.
According to Marshall the role of these two determinants is like that of a pair of scissors
in cutting cloth. It is possible that at times, while one pair is held fixed, the other is
moving to cut the cloth. Similarly, it is conceivable that there could be situations under
which either demand or supply is playing a passive role, and the other, which is active,
alone appear to be determining the price. However, just as one pair of scissors alone
can never cut a cloth, demand or supply alone is insufficient to determine the price.

Equilibrium Price

The price at which demand and supply of a commodity is equal known as equilibrium
price. The demand and supply schedules of a good are shown in the table below.

Demand supply schedule

Price Demand Supply

50 100 200
40 120 180
30 150 150
20 200 110

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10 300 50

Of the five possible prices in the above example, price Rs.30 would be the market-
clearing price. No other price could prevail in the market. If price is Rs. 50 supply
would exceed demand and consequently the producers of this good would not find
enough customers for their demand, thereby they would accumulate unwanted
inventories of output, which, in turn, would lead to competition among the producers,
forcing price to Rs.30. Similarly if price were Rs.10, there would be excess demand,
which would give rise to competition among the buyers of good, forcing price to Rs.30.
At price Rs.30, demand equals supply and thus both producers and consumers are
satisfied. The economist calls such a price as equilibrium price.

It was seen in unit 1 that the demand for a good depends on, a number of factors and
thus, every factor, which influences either demand or supply is in fact a determinant
of price. Accordingly, a change in demand or/and supply causes price change.

MARKET

Market is a place where buyer and seller meet, goods and services are offered for the
sale and transfer of ownership occurs. A market may be also defined as the demand
made by a certain group of potential buyers for a good or service. The former one is
a narrow concept and later one, a broader concept. Economists describe a market as
a collection of buyers and sellers who transact over a particular product or product
class (the housing market, the clothing market, the grain market etc.). For business
purpose we define a market as people or organizations with wants (needs) to satisfy,
money to spend, and the willingness to spend it. Broadly, market represents the

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structure and nature of buyers and sellers for a commodity/service and the process
by which the price of the commodity or service is established. In this sense, we are
referring to the structure of competition and the process of price determination for a
commodity or service. The determination of price for a commodity or service depends
upon the structure of the market for that commodity or service (i.e., competitive
structure of the market). Hence the understanding on the market structure and the
nature of competition are a pre-requisite in price determination.

Different Market Structures

Market structure describes the competitive environment in the market for any good
or service. A market consists of all firms and individuals who are willing and able to
buy or sell a particular product. This includes firms and individuals currently engaged
in buying and selling a particular product, as well as potential entrants.

The determination of price is affected by the competitive structure of the market. This
is because the firm operates in a market and not in isolation. In marking decisions
concerning economic variables it is affected, as are all institutions in society by its
environment.

Perfect Competition

Perfect competition refers to a market structure where competition among the sellers
and buyers prevails in its most perfect form. In a perfectly competitive market, a
single market price prevails for the commodity, which is determined by the forces of
total demand and total supply in the market.

Characteristics of Perfect Competition

The following features characterize a perfectly competitive market:

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1. A large number of buyers and sellers: The number of buyers and sellers is
large and the share of each one of them in the market is so small that none
has any influence on the market price.
2. Homogeneous product: The product of each seller is totally undifferentiated
from those of the others.
3. Free entry and exit: Any buyer and seller is free to enter or leave the market
of the commodity.
4. Perfect knowledge: All buyers and sellers have perfect knowledge about the
market for the commodity.
5. Indifference: No buyer has a preference to buy from a particular seller and no
seller to sell to a particular buyer.
6. Non-existence of transport costs: Perfectly competitive market also assumes
the non-existence of transport costs.
7. Perfect mobility of factors of production: Factors of production must be in a
position to move freely into or out of industry and from one firm to the other.

Under such a market no single buyer or seller plays a significant role in price
determination. One the other hand all of them jointly determine the price. The price
is determined in the industry, which is composed of all the buyers and seller for the
commodity. The demand curve facing the industry is the sum of all consumers’
demands at various prices. The industry supply curve is the sum of all sellers’ supplies
at various prices.

Pure competition and perfect competition

The term perfect competition is used in a wider sense. Pure competition has only
limited assumptions. When the assumptions, that large number of buyers and sellers,
homogeneous products, free entry and exit are satisfied, there exists pure
competition. Competition becomes perfect only when all the assumptions (features)
are satisfied. Generally pure competition can be seen in agricultural products.

Equilibrium of a firm and industry under perfect competition

Equilibrium is a position where the firm has no incentive either to expand or contrast
its output. The firm is said to be in equilibrium when it earn maximum profit. There
are two conditions for attaining equilibrium by a firm. They are:

Marginal cost is an additional cost incurred by a firm for producing and additional unit
of output. Marginal revenue is the additional revenue accrued to a firm when it sells
one additional unit of output. A firm increases its output so long as its marginal cost
becomes equal to marginal revenue. When marginal cost is more than marginal

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revenue, the firm reduces output as its costs exceed the revenue. It is only at the
point where marginal cost is equal to marginal revenue, and then the firm attains
equilibrium. Secondly, the marginal cost curve must cut the marginal revenue curve
from below. If marginal cost curve cuts the marginal revenue curve from above, the
firm is having the scope to increase its output as the marginal cost curve slopes
downwards. It is only with the upward sloping marginal cost curve, there the firm
attains equilibrium. The reason is that the marginal cost curve when rising cuts the
marginal revenue curve from below.

The equilibrium of a perfectly competitive firm may be explained with the help of the
fig. 6.2.

In the given fig. PL and MC represent the Price line and Marginal cost curve. PL also
represents Marginal revenue, Average revenue and demand. As Marginal revenue,
Average revenue and demand are the same in perfect competition, all are equal to
the price line. Marginal cost curve is U- shaped curve cutting MR curve at R and T. At
point R marginal cost becomes equal to marginal revenue. But MC curve cuts the MR
curve fro above. So this is not the equilibrium position. The downward sloping
marginal cost curve indicates that the firm can reduce its cost of production by
increasing output. As the firm expands its output, it will reach equilibrium at point T.
At this point, on price line PL; the two conditions of equilibrium are satisfied. Here the
marginal cost and marginal revenue of the firm remain equal. The firm is producing
maximum output and is in equilibrium at this stage. If the firm continues its output
beyond this stage, its marginal cost exceeds marginal revenue resulting in losses. As
the firm has no idea of expanding or contracting its size of out, the firm is said to be
in equilibrium at point T.

Pricing under perfect competition

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The price or value of a commodity under perfect competition is determined by the

demand for and the supply of that commodity.

Under perfect competition there is large number of sellers trading in a homogeneous

product. Each firm supplies only very small portion of the market demand. No single
buyer or seller is powerful enough to influence the price. The demand of all consumers
and the supply of all firms together determine the price. The individual seller is only
a price taker and not a price maker. An individual firm has no price policy of it’s own.
Thus, the main problem of a firm in a perfectly competitive market is not to determine
the price of its product but to adjust its output to the given price, So that the profit is
maximum. Marshall however gives great importance to the time element for the
determination of price. He divided the time periods on the basis of supply and ignored
the forces of demand. He classified the time into four periods to determine the price
as follows.

1. Very short period or Market period

2. Short period
3. Long period
4. Very long period or secular period

Very short period: It is the period in which the supply is more or less fixed because
the time available to the firm to adjust the supply of the commodity to its changed
demand is extremely short; say a single day or a few days. The price determined in
this period is known as Market Price.

Short Period: In this period, the time available to firms to adjust the supply of the
commodity to its changed demand is, of course, greater than that in the market
period. In this period altering the variable factors like raw materials, labour, etc can
change supply. During this period new firms cannot enter into the industry.

Long period: In this period, a sufficiently long time is available to the firms to adjust
the supply of the commodity fully to the changed demand. In this period not only
variable factors of production but also fixed factors of production can be changed. In
this period new firms can also enter the industry. The price determined in this period
is known as long run normal price.

Secular Period: In this period, a very long time is available to adjust the supply fully
to change in demand. This is very long period consisting of a number of decades. As
the period is very long it is difficult to lay down principles determining the price.

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Price Determination in the market period

The price determined in very short period is known as Market price. Market price is
determined by the equilibrium between demand and supply in a market period. The
nature of the commodity determines the nature of supply curve in a market period.
Under this period goods are classified in to (a) Perishable goods and (b) Non-
perishable goods.

Perishable Goods: In the very short period, the supply of perishable goods like fish,
milk vegetables etc. cannot be increased. And it cannot be decreased also. As a result
the supply curve under very short period will be parallel to the Y-axis or Vertical to X-
axis. Supply is perfectly inelastic. The price determination of perishable goods in very
short period may be shown with the help of the following fig. 6.5

In this figure quantity is represented along X-axis and price is represented along Y-
axis. MS is the very short period supply curve of perishable goods. DD is demand
curve. It intersects supply curve at E. The price is OP. The quantity exchanged is OM.
D1 D1 represents increased demand. This curve cuts the supply curve at E1. Even at
the new equilibrium, supply is OM only. But price increases to OP1. So, when demand
increases, the price will increase but not the supply. If demand decreases new demand
curve will be D2 D2. This curve cuts the supply curve at E2. Even at this new
equilibrium, the supply is OM only. But price falls to OP2. Hence in very short period,
given the supply, it is the change in demand that influences price. The price
determined in a very short period is called Market Price.

Non-perishable goods: In the very short period, the supply of non-perishable goods
like cloth, pen, watches etc. cannot be increased. But if price falls, preserving some
stock can decrease their supply. If price falls too much, the whole stock will be held

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back from the market and carried over to the next market period. The price below,
which the seller will refuse to sell, is called Reserve Price.

The Price determination of non-perishable goods in very short period may be shown
with the help of the following fig 6.6.

In the given figure quantity is shown on X-axis and the price on Y-axis. SES is the
supply curve. It slopes upward up to the point E. From E it becomes a vertical straight
line. This is because the quantity existing with sellers is OM, the maximum amount
they have is thus OM. Till OM quantity (i.e., point E) the supply curve sloped upward.
At the point S, nothing is offered for sale.

It means that the seller with hold the entire stock if the price is OS. OS is thus the
reserve price. As the price rises, supply increases up to point E. At OP price (Point E),
the entire stock is offered for sale.

Suppose demand increases, the DD curve shift upward. It becomes D1D1 price raises
to OP1. If demand decreases, the demand curve becomes D2D2. It intersects the
supply curve at E3. The price will fall to OP3. We find that at OS price, supply is zero.
It is the reserve price.

Price Determination in the short period

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Short period is a period in which supply can be increased by altering the variable
factors. In this period fixed costs will remain constant. The supply is increased when
price rises and vice versa. So the supply curve slopes upwards from left to right.

The price in short period may be explained with the help of a diagram.

In the given diagram MPS is the market period supply curve. DD is the initial demand
curve. It intersects MPS curve at E. The price is OP and out put OM. Suppose demand
increases, the demand curve shifts upwards and becomes D1D1. In the very short
period, supply remains fixed on OM. The new demand curve D1D1 intersects MPS at
E1. The price will rise to OP1. This is what happen in the very short-period.

As the price rises from OP to OP1, firms expand output. As firms can vary some factors
but not all, the law of variable proportions operates. This results in new short-run
supply curve SPS. It interests D1 D1 curve at E4. The price will fall from OP1 to OP4.

It the demand decreases, DD curve shifts downward and becomes D2D2. It interests
MPS curve at E2. The price will fall to OP2. This is what happens in market period. In
the short period, the supply curve is SPS. D2D2 curve interests SPS curve at E3. The
short period price is higher than the market period price.

Price determination in the long period (Normal Price)

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Market price may fluctuate due to a sudden change either on the supply side or on
the demand side. A big arrival of milk may decrease the price of that production in
the market period. Similarly, a sudden cold wave may raise the price of woolen
garments. This type of temporary change in supply and demand may cause changes
in market price. In the absence of such disturbing causes, the price tends to come
back to a certain level. Marshall called this level is normal price level. In the words of
Marshall Normal value (Price) of a commodity is that which economics force would
tend to bring about in the long period.

In order to describe how long run normal price is determined, it is useful to refer to
the market period as short period also. The market period is so short that no
adjustment in the output can be made. Here cost of production has no influence on
price. A short period is sufficient only to allow the firms to make only limited output
adjustment. In the long period, supply conditions are fully sufficient to meet the
changes in demand. In the long period, all factors are alterable and the new firms
may enter into or old firms leave the; industry.

In the long period all costs are variable costs. So supply will be increased only when
price is equal to average cost.

Hence, in long period normal price will be equal to minimum average cost of the
industry. Will this price be more or less than the short period normal price? The answer
depends on the stage of returns to which the industry is subject. There are three
stages of return on the stage of returns to which the industry is subject. There are
three stages of returns.

1. Increasing returns or decreasing costs.

2. Constant Returns or Constant costs.
3. Diminishing returns or increasing costs.

1. Determination of long period normal price in decreasing cost industry:

At this stage, average cost falls due to an increase in the output. So, the supply
curve at this stage will slope downwards from left to right. The long period Normal
price determination at this stage can be explained with the help of a diagram.

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In the diagram, MPS represents market period supply curve. DD is demand

curve. DD cuts LPS, SPS and MPS at point E. At point E the supply is OM and the
price is OP. If demand increases from DD to D1D1 market price increases to OP1.
In the short period it is OP2. In the long period supply increases considerably to
OM3. So price has fallen to OP3, which is less than the price of market period.

2. Determination of Long Period Normal Price in Constant Cost Industry:

In this case average cost does not change even though the output
increases. Hence long period supply curve is horizontal to X-axis. The
determination of long period normal price can be explained with the help of the
diagram. In the fig. 6.9, LPS is horizontal to X-axis. MPS represents market
period supply curve, and SPS represents short period supply curve. At point ‘E’
the output is OM and price is OP. If demand increases from DD to D1D1 market
price increases to OP1. In the short period, supply increases and hence the price
will be OP2. In the long run supply is adjusted fully to meet increased demand.
The price remains constant at OP because costs are constant at OP and market
is perfect market.

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3. Determination of long period normal price in increase cost industry:

If the industry is subject to increasing costs (diminishing returns) the supply curve
slopes upwards from left to right like an ordinary supply curve. The determination of
long period normal price in increasing cost industry can be explained with the help of
the following diagram. In the diagram LPS represents long period supply curve. The
industry is subject to diminishing return or increasing costs. So, LPS slopes upwards
from left to right. SPS is short period supply curve and MPS is market period supply
curve. DD is demand curve. It cuts all the supply curves at E. Here the price is OP and
output is OM. If demand increases from DD to D1D1 in the market period, supply will
not change but the price increases to OP1. In the short period, price increase but the
price increases to OP1. In the short period, price increases to OP2 as the supply
increased from OM to OM2. In the long period supply increases to OM3 and price
increases to OP3. But this increase in price is less than the price increase in a market
period or short period.

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Monopoly

The word monopoly is made up of two syllables, Mono and poly. Mono means single
while poly implies selling. Thus monopoly is a form of market organization in which
there is only one seller of the commodity. There are no close substitutes for the
commodity sold by the seller. Pure monopoly is a market situation in which a single
firm sells a product for which there is no good substitute.

Features of monopoly

The following are the features of monopoly.

1. Single person or a firm: A single person or a firm controls the total supply of
the commodity. There will be no competition for monopoly firm. The monopolist
firm is the only firm in the whole industry.
2. No close substitute: The goods sold by the monopolist shall not have closely
competition substitutes. Even if price of monopoly product increase people will
not go in far substitute. For example: If the price of electric bulb increase
slightly, consumer will not go in for kerosene lamp.
3. Large number of Buyers: Under monopoly, there may be a large number of
buyers in the market who compete among themselves.
4. Price Maker: Since the monopolist controls the whole supply of a commodity,
he is a price-maker, and then he can alter the price.

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5. Supply and Price: The monopolist can fix either the supply or the price. He
cannot fix both. If he charges a very high price, he can sell a small amount. If
he wants to sell more, he has to charge a low price. He cannot sell as much as
he wishes for any price he pleases.
6. Downward Sloping Demand Curve: The demand curve (average revenue
curve) of monopolist slopes downward from left to right. It means that he can
sell more only by lowering price.

Types of Monopoly

Monopoly may be classified into various types. The different types of monopolies are
explained below:

1. Legal Monopoly: If monopoly arises on account of legal support or as a matter

of legal privilege, it is called Legal Monopoly. Ex. Patent rights, special brands,
trade means, copyright etc.
2. Voluntary Monopoly: To get the advantages of monopoly some private firms
come together voluntarily to control the supply of a commodity. These are
called voluntary monopolies. Generally, these monopolies arise with industrial
combinations. These voluntary monopolies are of three kinds (a) cartel (b) trust
(c) holding company. It may be called artificial monopoly.
3. Government Monopoly: Sometimes the government will take the
responsibility of supplying a commodity and avoid private interference. Ex.
Water, electricity. These monopolies, created to satisfy social wants, are
formed on social considerations. These are also called Social Monopolies.
4. Private Monopoly: If the total supply of a good is produced by a single private
person or firm, it is called private monopoly. Hindustan Lever Ltd. Is having the
monopoly power to produce Lux Soap.
5. Limited Monopoly: if the monopolist is having limited power in fixing the price
of his product, it is called as ‘Limited Monopoly’. It may be due to the fear of
distant substitutes or government intervention or the entry of rivals firms.
6. Unlimited Monopoly: If the monopolist is having unlimited power in fixing the
price of his good or service, it is called unlimited monopoly. Ex. A doctor in a
village.
7. Single Price Monopoly: When the monopolist charges same price for all units
of his product, it is called single price monopoly. Ex. Tata Company charges the
same price to all the Tata Indiaca Cars of the same model.
8. Discriminating Monopoly: When a Monopolist charges different prices to
different consumers for the same product, it is called discriminating monopoly.
A doctor may take Rs.20 from a rich man and only Rs.2 from a poor man for
the same treatment.

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9. Natural Monopoly: Sometimes monopoly may arise due to scarcity of natural

resources. Nature provides raw materials only in some places. The owner of
the place will become monopolist. For Ex. Diamond mine in South Africa.

Pricing under Monopoly

Monopoly refers to a market situation where there is only one seller. He has complete
control over the supply of a commodity. He is therefore in a position to fix any price.
Under monopoly there is no distinction between a firm and an industry. This is because
the entire industry consists of a single firm.

Being the sole producer, the monopolist has complete control over the supply of the
commodity. He has also the power to influence the market price. He can raise the
price by reducing his output and lower the price by increasing his output. Thus he is
a price-maker. He can fix the price to his maximum advantages. But he cannot fix
both the supply and the price, simultaneously. He can do one thing at a time. If the
fixes the price, his output will be determined by the market demand for his commodity.
On the other hand, if he fixes the output to be sold, its market will determine the price
for the commodity. Thus his decision to fix either the price or the output is determined
by the market demand.

The market demand curve of the monopolist (the average revenue curve) is downward
sloping. Its corresponding marginal revenue curve is also downward sloping. But the
marginal revenue curve lies below the average revenue curve as shown in the figure.
The monopolist faces the down-sloping demand curve because to sell more output, he
must reduce the price of his product. The firm’s demand curve and industry’s demand

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curve are one and the same. The average cost and marginal cost curve are U shaped
curve. Marginal cost falls and rises steeply when compared to average cost.

Price output determination (Equilibrium Point)

The monopolistic firm attains equilibrium when its marginal cost becomes equal to the
marginal revenue. The monopolist always desires to make maximum profits. He
makes maximum profits when MC=MR. He does not increasing his output if his
revenue exceeds his costs. But when the costs exceed the revenue, the monopolist
firm incur loses. Hence the monopolist curtails his production. He produces up to that
point where additional cost is equal to the additional revenue (MR=MC). Thus point is
called equilibrium point. The price output determination under monopoly may be
explained with the help of a diagram.

In the diagram 6.12 the quantity supplied or demanded is shown along X-axis. The
cost or revenue is shown along Y-axis. AC and MC are the average cost and marginal
cost curves respectively. AR and MR curves slope downwards from left to right. AC
and MC and U shaped curves. The monopolistic firm attains equilibrium when its
marginal cost is equal to marginal revenue (MC=MR). Under monopoly, the MC curve
may cut the MR curve from below or from a side. In the diagram, the above condition
is satisfied at point E. At point E, MC=MR. The firm is in equilibrium. The equilibrium
output is OM.

The above diagram (Average revenue) = MQ or OP

Average cost = MR
Profit per unit = Average Revenue-Average cost=MQ-MR=QR
Total Profit = QRXSR=PQRS

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The area PQRS resents the maximum profit earned by the monopoly firm.

But it is not always possible for a monopolist to earn super-normal profits. If the
demand and cost situations are not favorable, the monopolist may realize short run
losses.

Through the monopolist is a price marker, due to weak demand and high costs; he
suffers a loss equal to PABC.

If AR > AC -> Abnormal or super normal profits.

If AR = AC -> Normal Profit
If AR < AC -> Loss

In the long run the firm has time to adjust his plant size or to use existing plant so as
to maximize profits.

Monopolistic competition

Perfect competition and pure monopoly are rate phenomena in the real world. Instead,
almost every market seems to exhibit characteristics of both perfect competition and
monopoly. Hence in the real world it is the state of imperfect competition lying
between these two extreme limits that work. Edward. H. Chamberlain developed the

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theory of monopolistic competition, which presents a more realistic picture of the

actual market structure and the nature of competition.

Characteristics of Monopolistic Competition

The important characteristics of monopolistic competition are:

1. Existence of Many firms: Industry consists of a large number of sellers, each

one of whom does not feel dependent upon others. Every firm acts
independently without bothering about the reactions of its rivals. The size is so
large that an individual firm has only a relatively small part in the total market,
so that each firm has very limited control over the price of the product. As the
number is relatively large it is difficult for these firms to determine its price-
output policies without considering the possible reactions of the rival forms. A
monopolistically competitive firm follows an independent price policy.

2. Product Differentiation: Product differentiation means that products are

different in some ways, but not altogether so. The products are not identical
but the same time they will not be entirely different from each other. IT really
means that there are various monopolist firms competing with each other. An
example of monopolistic competition and product differentiation is the
toothpaste produced by various firms. The product of each firm is different from
that of its rivals in one or more respects. Different toothpastes like Colgate,
Close-up, Forehans, Cibaca, etc., provide an example of monopolistic
competition. These products are relatively close substitute for each other but
not perfect substitutes. Consumers have definite preferences for the particular
verities or brands of products offered for sale by various sellers. Advertisement,
packing, trademarks, brand names etc. help differentiation of products even if
they are physically identical.
3. Large Number of Buyers: There are large number buyers in the market. But
the buyers have their own brand preferences. So the sellers are able to exercise
a certain degree of monopoly over them. Each seller has to plan various
incentive schemes to retain the customers who patronize his products.
4. Free Entry and Exist of Firms: As in the perfect competition, in the
monopolistic competition too, there is freedom of entry and exit. That is, there
is no barrier as found under monopoly.
5. Selling costs: Since the products are close substitute much effort is needed
to retain the existing consumers and to create new demand. So each firm has
to spend a lot on selling cost, which includes cost on advertising and other sale
promotion activities.

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6. Imperfect Knowledge: Imperfect knowledge about the product leads to

monopolistic competition. If the buyers are fully aware of the quality of the
product they cannot be influenced much by advertisement or other sales
promotion techniques. But in the business world we can see that thought the
quality of certain products is the same, effective advertisement and sales
promotion techniques make certain brands monopolistic. For examples,
effective dealer service backed by advertisement-helped popularization of
some brands through the quality of almost all the cement available in the
market remains the same.
7. The Group: Under perfect competition the term industry refers to all collection
of firms producing a homogenous product. But under monopolistic competition
the products of various firms are not identical through they are close
substitutes. Prof. Chamberlin called the collection of firms producing close
substitute products as a group.

Price – Output Determination under Monopolistic Competition

Since under monopolistic competition different firms produce different varieties of

products, different prices for them will be determined in the market depending upon
the demand and cost conditions. Each firm will set the price and output of its own
product. Here also the profit will be maximized when marginal revenue is equal to
marginal cost.

Short-run equilibrium of the firm:

In the short-run the firm is in equilibrium when marginal Revenue = Marginal Cost. In
Fig 6.15 AR is the average revenue curve. NMR marginal revenue curve, SMC short-
run marginal cost curve, SAC short-run average cost curve, MR and SMC interest at
point E where output in OM and price MQ (i.e. OP). Thus the equilibrium output or the
maximum profit output is OM and the price MQ or OP. When the price (average
revenue) is above average cost a firm will be making supernormal profit. From the
figure it can be seen that AR is above AC in the equilibrium point. As AR is above AC,
this firm is making abnormal profits in the short-run. The abnormal profit per unit is
QR, i.e., the difference between AR and AC at equilibrium point and the total
supernormal profit is OR X OM. This total abnormal profits is represented by the
rectangle PQRS. As the demand curve here is highly elastic, the excess price over
marginal cost is rather low. But in monopoly the demand curve is inelastic. So the gap
between price and marginal cost will be rather large.

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If the demand and cost conditions are less favorable the monopolistically competitive
firm may incur loss in the short-run fig 6.16 Illustrates this. A firm incurs loss when
the price is less than the average cost of production. MQ is the average cost and OS
(i.e. MR) is the price per unit at equilibrium output OM. QR is the loss per unit. The
total loss at an output OM is OR X OM. The rectangle PQRS represents the total loses
in the short run.

Long – Run Equilibrium of

the Firm:

A monopolistically competitive firm will be long – run equilibrium at the output level
where marginal cost equal to marginal revenue. Monopolistically competitive firm in
the long run attains equilibrium where MC=MR and AC=AR Fig 6.17 shows this
trend.

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Oligopoly

The term oligopoly is derived from two Greek words, oligos meaning a few, and pollen
meaning to sell. Oligopoly is the form of imperfect competition where there are a few
firms in the market, producing either a homogeneous product or producing products,
which are close but not perfect substitute of each other.

Characteristics of Oligopoly

The main features of oligopoly are:

1. Few Firms: There are only a few firms in the industry. Each firm contributes a
sizeable share of the total market. Any decision taken by one firm influence the
actions of other firms in the industry. The various firms in the industry compete
with each other.
2. Interdependence: As there are only very few firms, any steps taken by one
firm to increase sales, by reducing price or by changing product design or by
increasing advertisement expenditure will naturally affect the sales of other
firms in the industry. An immediate retaliatory action can be anticipated from
the other firms in the industry every time when one firm takes such a decision.
He has to take this into account when he takes decisions. So the decisions of
all the firms in the industry are interdependent.
3. Indeterminate Demand Curve: The interdependence of the firms makes
their demand curve indeterminate. When one firm reduces price other firms
also will make a cut in their prices. So he firm cannot be certain about the
demand for its product. Thus the demand curve facing an oligopolistic firm loses

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its definiteness and thus is indeterminate as it constantly changes due to the

reactions of the rival firms.
4. Advertising and selling costs: Advertising plays a greater role in the
oligopoly market when compared to other market systems. According to Prof.
William J. Banumol “it is only oligopoly that advertising comes fully into its
own”. A huge expenditure on advertising and sales promotion techniques is
needed both to retain the present market share and to increase it. So Banumol
concludes “under oligopoly, advertising can become a life-and-death matter
where a firm which fails to keep up with the advertising budget of its
competitors may find its customers drifting off to rival products.”
5. Price Rigidity: In the oligopoly market price remain rigid. If one firm reduced
price it is with the intention of attracting the customers of other firms in the
industry. In order to retain their consumers they will also reduce price. Thus
the pricing decision of one firm results in a loss to all the firms in the industry.
If one firm increases price. Other firms will remain silent there by allowing that
firm to lost its customers. Hence, no firm will be ready to change the prevailing
price. It causes price rigidity in the oligopoly market.

OTHER MARKET STRUCTURES

Duopoly

Duopoly refers to a market situation in which there are only two sellers. As there are
only two sellers any decision taken by one seller will have reaction from the other Eg.
Coca-Cola and Pepsi. Usually these two sellers may agree to co-operate each other
and share the market equally between them, So that they can avoid harmful
competition.

The duopoly price, in the long run, may be a monopoly price or competitive price, or
it may settle at any level between the monopoly price and competitive price. In the
short period, duopoly price may even fall below the level competitive price with the
both the firms earning less than even the normal price.

Monopsony

Mrs. Joan Robinson was the first writer to use the term monopsony to refer to market,
which there is a single buyer. Monoposony is a single buyer or a purchasing agency,
which buys the show, or nearly whole of a commodity or service produced. It may be
created when all consumers of a commodity are organized together and/or when only
one consumer requires that commodity which no one else requires.

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Bilateral Monopoly

A bilateral monopoly is a market situation in which a single seller (Monopoly) faces a

single buyer (Monoposony). It is a market of monopoly-monoposy.

Oligopsony

Oligopsony is a market situation in which there will be a few buyers and many sellers.
As the sellers are more and buyers are few, the price of product will be comparatively
low but not as low as under monopoly.

PRICING METHODS

The micro – economic principle of profit maximization suggests pricing by the marginal
analysis. That is by equating MR to MC. However the pricing methods followed by the
firms in practice around the world rarely follow this procedure. This is for two reasons;
uncertainty with regard to demand and cost function and the deviation from the
objective of short run profit maximization.

It was seen that there is no unique theory of firm behavior. While profit certainly on
important variable for which every firm cares. Maximization of short – run profit is not
a popular objective of a firm today. At the most firms seek maximum profit in the long
run. If so the problem is dynamic and its solution requires accurate knowledge of
demand and cost conditions over time. Which is impossible to come by?

In view of these problems economic prices are a rare phenomenon. Instead, firms set
prices for their products through several alternative means. The important pricing
methods followed in practice are shown in the chart.

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Cost Based Pricing

There are three versions of the cost – based pricing. Full – cost or break even pricing,
cost plus pricing and the marginal cost pricing. Under the first version, price just
equals the average (total) cost. In the second version, some mark-up is added to the
average cost in arriving at the price. In the last version, price is set equal to the
marginal cost. While all these methods appear to be easy and straight forward, they
are in fact associated with a number of difficulties. Even through difficulties are there,
the cost- oriented pricing is quite popular today.

The cost – based pricing has several strengths as well as limitations. The advantages
are its simplicity, acceptability and consistency with the target rate of return on
investment and the price stability in general. The limitations are difficulties in getting
accurate estimates of cost (particularly of the future cost rather than the historic cost)
Volatile nature of the variable cost and its ignoring of the demand side of the market
etc.

Competition based pricing

Some commodities are priced according to the competition in their markets. Thus we
have the going rate method of price and the sealed bid pricing technique. Under the
former a firm prices its new product according to the prevailing prices of comparable
products in the market. If the product is new in the country, then its import cost –
inclusive of the costs of certificates, insurance, and freight and customs duty, is used
as the basis for pricing, Incidentally, the price is not necessarily equal to the import

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cost, but to the firm is either new in the country, or is a close substitute or
complimentary to some other products, the prices of hitherto existing bands or / and
of the related goods are taken in to a account while deciding its price. Thus, when
television was first manufactures in India, its import cost must have been a guiding
force in its price determination. Similarly, when

maruti car was first manufactured in India, it must have taken into account the prices
of existing cars, price of petrol, price of car accessories, etc. Needless to say, the
going rate price could be below or above the average cost and it could even be an
economic price.

The sealed bid pricing method is quite popular in the case of construction activities
and in the disposition of used produces. In this method the prospective seller (buyers)
are asked to quote their prices through a sealed cover, all the offers are opened at a
preannounce time in the presence of all the competitors, and the one who quoted the
least is awarded the contract (purchase / sale deed). As it sound, this method is totally
competition based and if the competitors unit by any change, the buyers (seller) may
have to pay (receive) an exorbitantly high (too low) price, thus there is a great degree
of risk attached to this method of pricing.

Demand Based Pricing

The demand – based pricing and strategy – based pricing are quite related. The seller
knows rather well that the demand for its product is a decreasing function of the price
its sets for product. Thus if seller wishes to sell more he must reduce the price of his
product, and if he wants a good price for his product, he could sell only a limited
quantity of his good. Demand oriented pricing rules imply establishment of prices in
accordance with consumer preference and perceptions and the intensity of demand.

Two general types demand oriented pricing rules can be identified.

i. Perceived value pricing and

ii. Differential pricing

Perceived value pricing considers the buyer’s perception of the value of the product
ad the basis of pricing. Here the pricing rule is that the firm must develop procedures
for measuring the relative value of the product as perceived by consumers. Differential
pricing is nothing but price discrimination. In involves selling a product or service for
different prices in different market segments. Price differentiation depends on

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geographical location of the consumers, type of consumer, purchasing quantity,

season, time of the service etc. E.g. Telephone charges, APSRTC charges.

Strategy based pricing (new product pricing)

A firm which products a new product, if it is also new to industry, can earn very good
profits it if handles marketing carefully, because of the uniqueness of the product. The
price fixed for the new product must keep the competitors away. Earn good profits for
the firm over the life of the product and must help to get the product accepted. The
company can select either skimming pricing or penetration pricing.

While there are some firms, which follow the strategy of price penetration, there are
some others who opt for price – skimming. Under the former, firms sell their new
product at a low price in the beginning in order to catch the attention of consumers,
once the product image and credibility is established, the seller slowly starts jacking
up the price to reap good profits in future. Under this strategy, a firm might well sell
its product below the cost of production and thus runs into losses to start with but
eventually it recovers all its losses and even makes good overall profits. The Rin
washing soap perhaps falls into this category. This soap was sold at a rather low price
in the beginning and the firm even distributed free samples. Today, it is quite an
expensive brand and yet it is selling very well. Under the price – skimming strategy,
the new product is priced high in the beginning, and its price is reduced gradually as
it faces a dearth of buyers such a strategy may be beneficial for products, which are
fancy, but of poor quality and / or of insignificant use over a period of time.

A prudent producer follows a good mix of the various pricing methods rather than
adapting any once of them. This is because no method is perfect and every method
has certain good features further a firm might adopt one method at one time and
another method at some other accession.

QUESTIONS

1. Explain how a firm attains equilibrium in the short run and in the long run
under conditions of perfect competition.
2. Explain the following with the help of the table and diagram under perfect
competition and monopoly

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(a) Total Revenue

(b) Marginal Revenue
(c) Average Revenue
3. Define monopoly. How is price under monopoly determined?
4. Explain the role of time factor in the determination of price. Also explain
price-O/P determination in case of perfect competition.
5. (a) Distinguish between perfect & imperfect markets (b) What are the
different market situations in imperfect competition.
6. “Perfect competition results in larger O/P with lower price than a monopoly”
Discuss.
7. Compare between monopoly and perfect competition.
8. What is price discrimination? Explain essential conditions for price
discrimination.
9. Explain the following (a) Monopoly (B) Duopoly (c) Oligopoly (d) imperfect
competition.
10. What is a market? Explain, in brief, the different market structures.
11. Monopoly is disappearing from markets. Do you agree with this statement?
Do you advocate for monopoly to continue in market situations.

QUIZ

1. Exchange value of a unit of good expressed in terms of money

is called ( )
(a) Cost (b) Capital
(c) Price (d) Expenditure

2. The price of a product is determined by the ______of that product ( )

(a) Place and time (b) Production and sales
(c) Demand and supply (d) Cost and income

3. The price at which demand and supply of a commodity equal is ( )

Known as
(a) High price (b) Low price
(c) Equilibrium price (d) Marginal price

4. A market where large number of buyers and sellers dealing in ( )

Homogeneous product with perfect knowledge is called
(a) Imperfect competition (b) Monopoly
(c) Perfect competition (d) Monopolistic competition

5. In which market, single market price prevails for the commodity ( )

(a) Monopoly market (b) Oligopoly market
(c) Perfect competition market (d) Duopoly market

6. The Price determined in the very short period is known as_____. ( )

(a) Secular price (b) Normal price
(c) Market price (d) Short run price

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7. In which period, the supply of commodity is fixed ( )

(a) Short period (b) Long period
(c) Very short period (d) Very long period

8. Charging very high price in the beginning and reducing it gradually

is called ( )
(a) Differential pricing (b) Sealed bid pricing
(c) Skimming pricing (d) Penetration pricing

9. If monopoly arises on account of legal support or as a matter

of legal Privilege, it is called as ( )
(a) Private monopoly (b) Government monopoly
(c) Legal monopoly (d) Single price monopoly

10. Under which pricing method, price just equals the total cost ( )
(a) Marginal cost pricing (b) Cost plus pricing
(c) Full cost pricing (d) Going rate pricing

11. ______ is a place in which goods and services are bought and sold. ( )
(a) Factory (b) Workshop
(c) Market (d) Warehouse

12. ___________________ is the example for perishable goods. ( )

(a) Pens (b) Belts
(c) Vegetables (d) Cloths

13. ____________________is a form of market organization in which

There is only one seller of the commodity. ( )
(a) Perfect Competition (b) Duopoly
(c) Monopoly (d) Oligopoly

14. If average Revenue is greater than the Average cost, monopolist

Earns __ . ( )
(a) Loss (b) No loss No profit
(c) Profit (d) None

15. The firm is said to be in equilibrium, when it’s Marginal Cost (MC)
Equals to___ . ( )
(a) Total cost (b) Total revenue
(c) Marginal Revenue (d) Average Revenue

16. ___________ is a position where the firm has no incentive either

to expand or contrast its output. ( )
(a) Maximum output (b) Minimum output
(c) Equilibrium (d) None

17. Marginal revenue, Average revenue and Demand are the same
in ________ Market Environment ( )

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(a) Monopoly (b) Duopoly

(c) Perfect Competition (d) Imperfect Competition

18. _________ is a period in which supply can be increased by altering

the Variable factors and fixed costs will remain constant. ( )
(a) Long – run (b) Mid – term
(c) Short – run (d) Market period

19. The total supply of a good is produced by a single private person or

Firm is called as________. ( )
(a) Government Monopoly (b) Legal Monopoly
(c) Private Monopoly (d) Natural Monopoly

20. In perfect competition market, seller is the _________. ( )

(a) Price – Maker (b) Price changer
(c) Price – Taker (d) Price Dictator

21. Charging Very Low price in the beginning and increasing it gradually
is called ________ ( )
(a) Differential pricing (b) Sealed bid Pricing
(c) Penetration Pricing (d) Skimming Pricing

22. If Average Revenue is less than the Average Cost, Monopoly

secures __. ( )
(a) Profits (b) Abnormal Profits
(c) Losses (d) Super Profits

23. In Monopoly market environment, seller is the __________. ( )

(a) Price - Taker (b) Price - Accepter
(c) Price - Maker (d) None

Note: Answer is “C” for all the above questions.

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