UNIT –III

PRODUCTION, COST, MARKET STRUCTURES & PRICING

Introduction:

Production is an important economic activity which satisfies the wants and needs of the people.
Production function brings out the relationship between inputs used and the resulting output. A
firm is an entity that combines and processes resources in order to produce output that will
satisfy the consumer’s needs. The firm has to decide as to how much to produce and how much
input factors (labour and capital) to employ to produce efficiently. This chapter helps to
understand the set of conditions for efficient production of an organization.

Factors of production:

Factors of production include resource inputs used to produce goods and services. Economist
categories input factors into four major categories such as land, labour, capital and organization.

Land: Land is heterogeneous in nature. The supply of land is fixed and it is a permanent factor
of production but it is productive only with the application of capital and labour.

Labour: The supply of labour is inelastic in nature but it differs in productivity and efficiency
and it can be improved.

Capital: is a man made factor and is mobile but the supply is elastic.

Organization: the organization plans, , supervises, organizes and controls the business activity
and also takes risks.

Production Function:

Production function indicates the maximum amount of commodity ‘X’ to be produced from
various combinations of input factors. It decides on the maximum output to be produced from a
given level of input, and how much minimum input can be used to get the desired level of output.
The production function assumes that the state of technology is fixed. If there is a change in
technology then there would be change in production function.

Q = f (Land, Labour, Capital, Organization)

Q = f (L, L, C, O)

The production manager’s responsibility is that of identifying the right combination of inputs for
the decided quantity of output. As a manager, he has to know the price of the input factors and
the budget allocation of the organization. The major objective of any business organization is
maximizing the output with minimum cost. To achieve the maximum output the firm has to
utilize the input factors efficiently. In the long run, without increasing the fixed factors it is not
possible to achieve the goal. Therefore it is necessary to understand the relationship between the
input and output in any production process in the short and long run.

Cobb Douglas Production Function:

This is a function that defines the maximum amount of output that can be produced with a given
level of inputs. Let us assume that all input factors of production can be grouped into two
categories such as labour (L) and capital (K).The general equilibrium for the production function
is Q = f (K, L)

There are various functional forms available to describe production. In general Cobb-Douglas
production function (Quadratic equation) is widely used Q = A Kα Lβ

Q = the maximum rate of output for a given rate of capital (K) and labour (L).

Short Run Production Function:

In the short run, some inputs (land, capital) are fixed in quantity. The output depends on how
much of other variable inputs are used. For example if we change the variable input namely
(labour) the production function shows how much output changes when more labour is used.
In the short run producers are faced with the problem that some input factors are fixed. The firms
can make the workers work for longer hours and also can buy more raw materials. In that case,
labour and raw material are considered as variable input factors.

Long Run Production Function:

In the long run all input factors are variable. The producer can appoint more workers, purchase
more machines and use more raw materials. Initially output per worker will increase up to an
extent. This is known as the Law of Diminishing Returns or the Law of Variable Proportion. To
understand the law of diminishing returns it is essential to know the basic concepts of
production.

MEASURES OF PRODUCTIVITY:

Total production (TP): the maximum level of output that can be produced with a given amount
of input.

Average Production (AP): output produced per unit of input AP = Q/L

Marginal Production (MP): the change in total output produced by the last unit of an input

Marginal production of labour = Δ Q / Δ L (i.e. change in the quantity produced to a given

change in the labour)

Marginal production of capital = Δ Q / Δ K (i.e. change in the quantity produced to a given

change in the capital)

PRODUCTION FUNCTION:

A production function, like any other function can be expressed and analyzed by any one or
more of the three tools namely table, graph and equation. The maximum amounts of output
attainable from various alternative combinations of input factors are given in the table.

The production function expressed in tabular form is as follows.

 Table - Production Schedule

LABOUR TP AP MP

1 20 20 0

2 54 27 34

3 81 27 27

4 104 26 23

5 125 25 21

6 138 23 13

7 147 21 9

8 152 19 5

9 153 17 1

10 150 15 -3

The firm has a set of fixed variables. As long with that it increases the labour force from 1 unit to
10 units. The increase in input factor leads to increase in the output up to an extent. After that it
start declining. Marginal production increases in the initial period and then it starts declining and
it become negative. The firm should stop increasing labour force if the marginal production is
zero- that is the maximum output that can be derived with the available fixed factors. The 9th
labour does not contribute to any output. In case the firm wants to increase the output beyond
153 units it has to improve its fixed variable. That means purchase of new machinery or building
is essential. Therefore the firm understands that the maximum output is 153 units with the given
set of input factors.

The graphical representations of the production function are as shown in the following graph.
GRAPH-PRODUCTION CURVES

The graphical presentations of the values are shown in the graph. The ‘X” axis denotes the
labour and the ‘Y’ axis indicates the total production (TP), average production (AP) and
marginal production (MP). From the given table and graph we can understand all the three
curves in the graph increased in the beginning and the marginal product (MP) first fell, then the
average product (AP) finally total production (TP). The marginal production curve MP cuts the
AP at its highest point. Total production TP falls when marginal production curve cuts the ‘X’
axis. The law of diminishing returns states that if increasing quantity of a variable input are
combined with fixed, eventually the marginal product and then average product will decline.
When the production function is expressed as an equation it shall be as follows:

Q = f (Ld, L, K, M, T )

It can be expressed as Q = f1, f2, f3, f4, f5 > 0

Where,

Q = Output in physical units of good X

Ld = Land units employed in the production of Q

L = Labour units employed in the production of Q

K = Capital units employed in the production of Q

M = Managerial Units employed in the production of Q

T = Technology employed in the production of Q

f = Unspecified function

fi = Partial derivative of Q with respect to ith input.

This equation assumes that output is an increasing function of all inputs.

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.

Isoquants 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’, is 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

A 1 10 50

B 2 7 50

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.

THE LAW OF DIMINISHING MARGINAL RETURNS:

In the combination of input factors when one particular factor is increased continuously without
changing other factors the output will increase in a diminishing manner. Let us assume that a
person preparing for an examination continuously prepares without any break. The output or the
understanding and the coverage of the syllabus will be more in the beginning rather than in the
later stages. There is a limit to the extent to which one factor of production can be substituted for
another. The total production increases up to an extent and it gets saturated or there won’t be any
change in the output due to the addition of the input factor and further it leads to negative impact
on the output. That means the marginal production declines up to an extent and it reaches zero
and becomes negative. The point at which the MP becomes zero is the maximum output of the
firm with the given set of input factors. This law is applicable in all human activities and
business activities.
For example with two sewing machines and two tailors, a firm can produce a maximum of 14
pairs of curtains per day. The machines are used only from 9 AM to 5 PM and the machines lie
idle from 5 pm onwards. Therefore the firm appoints 2 more tailors for the second shift and the
production goes up to 28 units. Then adding two more labour to assist these people will increase
the output to 30 units. When the firm appoints two more people, then there won’t be any change
in their production because their Marginal productivity is zero. There is no addition in the total
production. That means there is no use of appointing two more tailors. Therefore, there is a limit
for output from a fixed input factors but in the long run purchase of one more sewing machine
alone will help the firm to increase the production more than 30 units.

Production Function with One Variable Input:

The laws of returns states that when at least one factor of production is fixed or factor input is
fixed and when all other factors are varied, the total output in the initial stages will increase at an
increasing rate, and after reaching certain level or output the total output will increase at
declining rate. If variable factor inputs are added further to the fixed factor input, the total output
may decline. This law is of universal nature and it proved to be true in agriculture and industry
also. The law of returns is also called the law of variable proportions or the law of diminishing
returns.

Definition According to G. Stigler

“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”.

According to F. Benham

“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”.
 Marginal
Units of Total Average product
Stages
labour Production(TP) product(M (AP)
P)

0 0 0 0

1 10 10 10 Stages 1

2 22 12 11

3 33 11 11

4 40 7 10 Stages 2

5 45 5 9

6 48 3 8

7 48 0 6.85 Stages 3

8 45 -3 5.62
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 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.

Production Function With Two Variable Inputs And Laws Returns

Production process that requires two inputs, capital© and labour (L) to produce a given
output(Q). There could be more than two inputs in a real life situation, but for a simple
analysis, we restrict the number of inputs to two only. In other words, the production
function based on two inputs can be expressed as

Q = f( C,L)

Where c= capital , L = labour,

Normally, both capital and labour are required to produce a product. To some
extent, these two inputs can be substituted for each other. Hence the producer may choose
any combination of labour and capital that gives him the required number of units of
output, for any one combination of labour and capital out of several such combinations.
The alternative combinations of labour and capital yielding a given level of output are
such that if the use of one factor input is increased , that of another will decrease and vice
versa. However, the units of an input foregone to get one unit of the other input changes,
depends upon the degree of substitutability between the two input factors, based on the
techniques or technology used, the degree of substitutability may vary.
LAW OF RETURNS TO SCALE

There are three laws of returns governing production function. They are

1. Law of increasing returns to scale

This law states that the volume of output keeps on increasing with every increase in the inputs.
Where a given increase in inputs leads to a more than proportionate increase in the output, the
law of increasing returns to scale is said to operate. We can introduce division of labour and
other technological means to increase production. Hence, the total product increases at an
increasing rate.

2. Law of constant returns to scale:

When the scope for division of labour gets restricted, the rate of increase in the total output
remains constant, the law of constant returns to scale is said to operate, this law states that the
rate of increase/decrease in volume of output is same to that of rate of increase/decrease in
inputs.

3. Law of decreasing returns to scale

Where the proportionate increase in the inputs does not lead to equivalent increase in output, the
output increases at a decreasing rate, the law of decreasing returns to scale is said to operate.
This results in higher average cost per unit.

These laws can be illustrated with an example of agricultural land. Take one acre of land. If you
till the land well with adequate bags of fertilizers and sow good quality seeds, the volume of
output increases the following table illustrates further

Capital Labor % of Output(i % of Law applicable

 (in ( in increase in n units) increase
units) units) both inputs in output

1 3 --- --- --- ---

2 6 100 120 140 Law of increase returns to scale

4 12 100 240 100 Law of constant returns to scale

8 24 100 360 50 Law of decrease returns to scale

INTERNAL AND EXTERNAL ECONOMIES OF SCALE

INTERNAL ECONOMIES refer to the economies introduction costs which accrue to the firm
alone when it expands its output. The internal economies occur as a result of increase in the scale
of production.

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 its 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 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 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.

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 DETERMINANTS

The cost of production of goods and services depends on various input factors used by the
organization and it differs from firm to firm. The major cost determinants are:

1. Level of output: The cost of production varies according to the quantum of output. If the size
of production is large then the cost of production will also be more.

2. Price of input factors: A rise in the cost of input factors will increase the total cost of
production.

3. Productivities of factors of production: When the productivity of the input factors is high
then the cost of production will fall.

4. Size of plant: The cost of production will be low in large plants due to mass production with
mechanization.
5. Output stability: The overall cost of production is low when the output is stable over a period
of time.

6. Lot size: Larger the size of production per batch then the cost of production will come down
because the organizations enjoy economies of scale.

7. Laws of returns: The cost of production will increase if the law of diminishing returns
applies in the firm.

8. Levels of capacity utilization: Higher the capacity utilization, lower the cost of production

9. Time period: In the long run cost of production will be stable.

10. Technology: When the organization follows advanced technology in their process then the
cost of production will be low.

11. Experience: over a period of time the experience in production process will help the firm to
reduce cost of production.

12. Process of range of products: Higher the range of products produced, lower the cost of
production.

13. Supply chain and logistics: Better the logistics and supply chain, lower the cost of
production.

14. Government incentives: If the government provides incentives on input factors then the cost
of production will be low.

TYPES OF COSTS

There are various classifications of costs based on the nature and the purpose of calculation. But
in economics and for accounting purpose the following are the important cost concepts.

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 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.

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. Past 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.

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)

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:

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.

AC=TC/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 cost MC
Q cost cost TVC (TFC + cost (TVC / (TFC / Q) (TC/Q)
TFC TVC) Q) AVC AFC AC
TC

0 60 - 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

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 drop 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.

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’

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.

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.

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 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 marketing 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:

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
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

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.

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 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

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)

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.
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.

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.

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.

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.

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 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

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 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.

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.

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.
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 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 adveJising 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.
 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.
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 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 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.