Theory of production

 Theory of production, in economics, is an effort to explain the principles by which a business firm decides how much of
each commodity that it sells (its “outputs” or “products”) it will produce, and how much of each kind of labour, raw material,
fixed capital good, etc., that it employs (its “inputs” or “factors of production”) it will use.

 The theory involves some of the most fundamental principles of economics.

 These include the relationship between the prices of commodities and the prices (or wages or rents) of the productive factors
used to produce them and also the relationships between the prices of commodities and productive factors, on the one hand,
and the quantities of these commodities and productive factors that are produced or used, on the other.
Production function has to be expressed in a precise mathematical equation i.e. Y = a +bx
Assumptions:

 The production function is related to a particular period of time

 The level of technology remains constant
 The producer is using the best and most technique available
 The factors of production are divisible (inputs can be adjusted to the Output)
 Production can be fitted to a short run or to long run.
 Utilization of inputs at maximum level of efficiency.

Importance of production function:

 When inputs are specified in physical units, production function helps to estimate the level of production
 With the help of iso-quants, production function explains the different combinations of inputs which will yield the same
level of output.
 Production function indicates the manner in which the firm can substitute one input for another without altering the total
output
 When prices are taken into consideration, the production function helps to select the least combination of inputs for
desired output
 It considers two types of input- output relationship namely 1. Law of variable proportion and 2. Law of returns to scale
 It helps us to understand the laws of returns in production
COBB- DOUGLAS PRODUCTION FUNCTION

 Production function of the linear homogenous type is invented by Jnut Wicksell and first tested by C.W. Cobb and
P.H. Douglas 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.

 Cobb-Douglas production function takes the following mathematical form

Where, Y= Output K= Capital L= Labour A, α = Positive Constant or elasticity of production

Assumptions:

 It assumes that output is the function of two factors, i.e. capital and labour
 There are constant returns to scale
 All inputs are homogenous
 There is perfect competition
 There is no change in technology
Production Function with One Variable Inputs and Laws Of Returns

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”.
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.
 Fixed factor Variable factor (Labour) Total product Average Product Marginal Product
(Capital)

1 1 100 100 - Stage I

1 2 220 120 120

1 3 270 90 50

1 4 300 75 30 Stage II

1 5 320 64 20

1 6 330 55 10

1 7 330 47 0 Stage III

1 8 320 40 -10

 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.
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 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
STAGES TP MP AP
1 Increase at an increasing rate Increase reaches Increase and reaches
the maximum
the maximum

2 Increase at Diminishing rate Till it Diminish equal to Starts to Diminish

reaches Maximum zero

3 Start declining Becomes Continues to decline

negative
Production Function with Two Variable Inputs and Laws of Returns

Let us consider a production process that requires two inputs, capital(c) 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)

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 entrepreneur may choose any combination of labour and capital that gives him the required number of units of
output.

For any given level of output, a producer may hire both capital and labour, but he is free to choose 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.
 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 indifference 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.
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.
Combinations Labour (units) Capital (Units) Output (quintals)

A 1 10 50
B 2 7 50
C 3 4 50
D 4 4 50
E 5 1 50
FEATURES OF AN ISOQUANT

1) Downward Sloping
2) Convex to The Origin
3) Do not intersect
4) Do not Touch Axis
(1) DOWNWARD SLOPING:-Isoquants are downward sloping curves because, if one input increases, the other one reduces.
There is no question of increase in both the inputs to yield a given output.
A degree of substitution is assumed between the factors of production. In other words, an isoquant cannot be increasing, as
increase in both the inputs does not yield same level of output. If it is constant, it means that the output remains constant
though the use of one of the factors is increasing, which is not true, isoquants slope from left to right.

(2)CONVEX TO ORIGIN:-Isoquants are convex to the origin. It is because the input factors are not perfect substitutes. One
input factors were perfect substituted by other input factor in a 'diminishing marginal rate'. If the input factors were perfect
substitutes, the isoquant would be a falling straight line. When the inputs are used in fixed proportion, and substitution of one
input for the other cannot take place, the isoquant will be L shaped.

(3)DO NOT INTERSECT:-Two iso products do not intersect with each other. It is because, each of these denote a particular
level of output. If the manufacturer wants to operate at a higher level of output, he has to switch over to another isoquant with
a higher level of output and vice versa.

(4)DO NOT TOUCH AXES:-The isoquant touches neither x-axis nor y-axis, as both inputs are required to produce a given
product.
 Iso Quant for Perfect Substitutes Iso Quant for Non-Substitutes

No two Isoquants intersect with each other

 Marginal rate of technical substitution

where MP1 and MP2 are the marginal products of input 1 and input 2, respectively, and MRTS(x1,x2) is Marginal Rate of
Technical Substitution of the input x1 for x2.

Along an isoquant, the MRTS shows the rate at which one input (e.g. capital or labor) may be substituted for another,
while maintaining the same level of output. The MRTS can also be seen as the slope of an isoquant at the point in
question.
Combinations Labour (units) Capital (Units) Output (quintals) MRTS

A 20 1 50
B 15 2 50 5:1
C 11 3 50 4:1
D 8 4 50 3:1
E 6 5 50 2:1
F 5 6 50 1:1
ISO COST

Definition:
A firm can produce a given level of output using efficiently different combinations of two inputs. For choosing efficient
combination of the inputs, the producer selects that combination of factors which has the lower cost of production. The
information about the cost can be obtained from the iso cost lines.

Explanation:
An iso cost line is also called outlay line or price line or factor cost line. An iso cost line shows all the combinations of labor
and capital that are available for a given total cost to-the producer..

In economics, the iso cost is the set of combinations of goods that have the same total cost; this can be represented by a curve
on a graph.

In economics an `iso cost` line shows all combinations of inputs which cost the same total amount
Iso cost Curve
Least cost combination of inputs
Laws of Returns to Scale

 The law of returns to scale explains the proportional change in output with respect to proportional change in
inputs.

 In other words, the law of returns to scale states when there is a proportionate change in the amounts of inputs,
the behavior of output also changes.

 The degree of change in output varies with change in the amount of inputs.

 For example, an output may change by a large proportion, same proportion, or small proportion with respect to
change in input.

On the basis of these possibilities, law of returns can be classified into three categories:

i. Increasing returns to scale

ii. Constant returns to scale
iii. Diminishing returns to scale
1. Increasing Returns to Scale:
If the proportional change in the output of an organization is greater than the proportional change in inputs, the
production is said to reflect increasing returns to scale.

For example, to produce a particular product, if the quantity of inputs is doubled and the increase in output is more
than double, it is said to be an increasing returns to scale.

When there is an increase in the scale of production, the average cost per unit produced is lower. This is because at
this stage an organization enjoys high economies of scale.
2. Constant Returns to Scale:
The production is said to generate constant returns to scale when the proportionate change in input is equal to
the proportionate change in output. For example, when inputs are doubled, so output should also be doubled,
then it is a case of constant returns to scale.
 In Figure-14, when there is a movement from a to b, it indicates that input is doubled. Now, when the
combination of inputs has reached to 2K+2L from IK+IL, then the output has increased from 10 to 20.

Similarly, when input changes from 2Kt2L to 3K + 3L, then output changes from 20 to 30, which is equal to the
change in input. This shows constant returns to scale. In constant returns to scale, inputs are divisible and
production function is homogeneous.

3. Diminishing Returns to Scale:

Diminishing returns to scale refers to a situation when the proportionate change in output is less than the
proportionate change in input.

For example, when capital and labor is doubled but the output generated is less than doubled, the returns to
scale would be termed as diminishing returns to scale.
Fig:15- Diminishing Returns to Scale
In Figure-15, when the combination of labor and capital moves from point a to point b, it indicates that input
is doubled. At point a, the combination of input is 1k+1L and at point b, the combination becomes 2K+2L.

However, the output has increased from 10 to 18, which is less than change in the amount of input. Similarly,
when input changes from 2K+2L to 3K + 3L, then output changes from 18 to 24, which is less than change in
input. This shows the diminishing returns to scale.
Capital (Units) Labour (units) % increase in both Output (quintals) % increase in both Law applications
inputs output

1 3 50

A2 6 100 120 140 increase

4 12 100 240 100 constant

8 24 100 360 50 decrease

 ECONOMIES OF SCALE
The economics of scale result because of increase in the scale of production. Marshal divides the economies of scale
into two groups:
Internal economies
External economies
Internal economies:
It refers to the economies in production cost which accrue to the firm alone when it expands it output. the internal
economies occur as results of increase in the scale of production.
The internal economies divide into following type:
1. Managerial economies :
As the firm expands the firm need qualified managerial personnel to handle each of its functions such as marketing,
finace, ect functional specilisational ensure minimum wastage and lower the cost of productions in the long run.
2. Commercial economies
The transactions of buying and selling raw material and other operating supplies such as spares and so on. There
could be cheaper saving in the procurement, transportation and storage costs. This will leads to lower cost and
increase profits.
3.Financial economies
There could be cheaper credit facility from the financial institution to meet the capital expenditure or working capital
requirement .a large firm to give security to financial institution
4.Technical economies
Increase in the scale of production follows when there is sophisticated technology available and the firm is in a position to hire
qualified technology manpower to make use of it.
5. Marketing economies
As the firm grow lager and lager it can afford to maintain a full fledged marketing department independently to handle the
issues related to design of customer ,promotion ,marketing staff.
6. Risk bearing economies
As there is growth in size of firm there is increase in the risk also. Sharing in the risk with the insurance companies is the first
priority for any firm. The firm insures its machinery and other assets against the fire theft ect.
The lager firm can spread their risk so that they do not keep all their eggs in one basket.
7. Economies of research and development
Large organizations such as Dr.Reddy labs, HCL, etc. bring out several innovative products.
External economies
It refers to the entire firms in the industry, because of growth of the on industry as a whole or because of growth of
industry.

1. Economies of concentration
Because all firms are located at one place ,it is likely that there is better infrastructure in terms of approach roads, teans
portation etc
2. Economies of R&D
The entire firms can pool resource together to finance research and development activity and thus share benefits of
research.
3. Economies of welfare
There could be common facility such as canteen, industry housing, community halls,ect which can be used in common by
the employees in the whole industry.
Cost concepts:

(a)Actual Cost

Actual cost is defined as the cost or expenditure which a firm incurs for producing or acquiring a good or service. The actual costs
or expenditures are recorded in the books of accounts of a business unit.
Actual costs are also called as "Outlay Costs" or "Absolute Costs” or "Acquisition Costs".
Examples: Cost of raw materials, Wage Bill etc.

(b) Opportunity Cost

Opportunity cost is concerned with the cost of forgone opportunities/alternatives. In other words, it is the return from the
second best use of the firms resources which the firms forgoes in order to avail of the return from the best use of the resources.
It can also be said as the comparison between the policy that was chosen and the policy that was rejected.
Opportunity cost is also called as "Alternative Cost".
Ex: A Firm decides to use its land for the purpose of business instead of giving the land for rent.

(c) What is sunk costs

Sunk costs are all those costs which have been incurred by the company in the past time with no chance of its recovery in the
future and the example of which includes research and development expenses incurred by the company before starting of the
project etc.
Example #1 – Research and Development

Almost all industries will have Research and development expenses in their books, and companies will be spending massive
money on research and development purposes for their product.
A drug manufacturing company A invests Rs 2,50,000/- for many years for the R&D on a new drug for hair growth. When
the company launched this product in the market, due to some side effects faced by many patients, doctors stopped
recommended that pill to their patients. This issue forced the company to stop the production of that pill. In this case, Rs
2,50,000/- has become a sunk cost, so it should not be considered in any decision for this product in the future.

Example #2 – Marketing Expenses

Let’s consider the example of Company A, which is into two-wheeler manufacturing and have a vast product line in their
portfolio. Recently, the Company has launched one new two-wheeler model, and the board has decided to spend Rs 5,00,000
on marketing and advertisement to promote its new product. Although they have not succeeded in this marketing campaign
as the product efficiency was not up to the mark.

The company has already spent Rs 5,00,000 on this failed marketing campaign. Still, they should not consider this expense
in any future decision making for the same product or any other product of the company. This amount will be regarded as a
Sunk cost.
(d) Incremental Cost
An incremental cost is the difference in total costs as the result of a change in some
activity. Incremental costs are also referred to as the differential costs and they may be
the relevant costs for certain short run decisions involving two alternatives.

Example of Incremental Cost

Let's assume that a company has the following experience:

•Total cost of manufacturing 8,000 units of Product X is Rs.3,20,000, or rs.40 per unit
•Total cost of manufacturing 10,000 units of Product X is Rs.3,60,000, or rs.36 per unit

From the above information, we see that the incremental cost of manufacturing the
additional 2,000 units (10,000 vs. 8,000) is Rs.40,000 (Rs.360,000 vs. rs.320,000). Therefore,
for these 2,000 additional units, the incremental manufacturing cost per unit of product will be an average of Rs.20 ($40,000
divided by 2,000 units).
(e) Explicit costs

Explicit costs are out-of-pocket costs, that is, actual payments. They are recorded in the Accounting Books.

Ex: Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs.

(f) Implicit costs

Implicit costs are related to the opportunity cost of one course of action that leads to lower income (e.g. a shop which
offers space for a charity to collect money will have lower sales) Implicit costs are not usually recorded.

Implicit costs are the perceived or estimated loss in revenue from undertaking an action, but they do not have an
actual transfer of money and are not recorded in accounting balance sheets. An example of an implicit cost is having to
deal with a fire alarm, which causes a factory to shut down for two hours. There is no observable increase in costs,
however by stopping production, it leads to lower output and so there is a loss of sales and income – even if it will not
be recorded.
(g) Book Costs

Book costs are those business costs which don't involve any cash payments but a provision is made in the books of accounts
in order to include them in the profit and loss account and take tax advantages.

Ex: like provision for depreciation and for unpaid amount of the interest on the owners capital.

(h) 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 Cost 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.

Cost-Output Relationship

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

(1) short-run cost function and

(2) (2) 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.
1. Cost-Output Relationship 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 Costs
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 labor, 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.
­
Units of Total fixed Total variable Total cost Average Average fixed Average cost Marginal cost
Output Q cost TFC cost TVC (TFC + TVC) variable cost cost (TFC / Q) (TC/Q) AC MC
TC (TVC / Q) AVC 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
The above table represents the cost-output relationship. 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 AVC starts 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.

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’.

So at some stage , the AC will start rising when the rise in ‘AVC’ is more than the droop in ‘AFC’.
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 on 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 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

 ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.
 ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
 ‘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 will
opt 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.
INTRODUCTION TO MARKETS

Price
Price denotes the exchange value of a unit of good expressed in terms of money.
Price determinants – Demand and supply (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.

Price Demand Supply

50 100 200
40 120 180
30 150 150
20 200 110
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. 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.
BASIC FACTORS IN PRICING
Factors considered while pricing:

1. Price of raw materials: Price of any item primarily depends upon the raw material availability and the cost spent on
purchasing the raw martial. If prices of raw materials are high, price of the finished product will also be high and vice
versa. If availability of raw materials is less, the price will get increased else it will be minimum.

2. Production costs: Next factor deterring the price of the product is the production costs. Higher the production costs,
higher will be the price of finished goods. It includes cost of machinery, hiring people, transportation costs, and
distribution costs etc.

3. Profit expectation: Profit expectation influences the price a lot. If the organization has higher profit expectations, the
price of the product becomes high and vice versa.

4. Price of the complementary goods: The organization needs to have an eye on the Complementary goods price. If the
complimentary goods price is high, the organization has to reduce its price otherwise both the products will lose the
demand. But the firm can price the item high if the price of complimentary good is less.

5. Number of substitutes: If the number of substitutes for the product is high, the organization should be very careful
while pricing the item. Because of perfect competition, there is a chance of losing the customer base. If the number of
substitutes is less, the organization can price the item according to their wish.
6. Intervention of government: One of the most important factors in the necessary products is the government intervention.
In the some product category, Government will fix some price ceiling and the organization has to price their items according
to that only.

7. Demand for the product: The most common factor that has to be considered while pricing is demand. Higher the
demand, higher the price can be charged.
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.

Narrow 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
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.
Perfect competition

It 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.

Monopoly

If there is only one seller, monopoly market is said to exist. An extreme version of imperfect market is monopoly.

Here a single seller completely controls the entire industry. It is only firm producing the given product in its industry. In case of
monopoly, there is very little difference between the firm and industry. The firm is called monopolist or monopoly firm. Indian
Railways is a Classical example of Monopoly.

Monopolistic Competition

When large number of sellers produces differentiated products, monopolistic competition is said to exist. A product is said to be
differentiated when its important features vary. It may be differentiated based on real or perceived differences.

Ex: Restaurants, Clothing

Duopoly

If there are two sellers, duopoly is said to exist. If Pepsi and coke are the two companies in soft drinks, this market is called
duopoly.

Oligopoly

Another variety of imperfect competition is oligopoly. If there is competition among a few sellers, oligopoly is said to exist.

The examples are the car manufacturing companies (such as Maruti suzuki, Ford, Toyota and so on), newspapers (such as The
Hindu, Indian Express, times of india, Economic Times and so on).

In oligopoly, each individual seller or firm can affect the market price
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. Under perfect
competition, the product offered for sale by all the seller must be identical in every respect. The goods offered for sale are
perfect substitutes of one another. Buyers have no special preference for the product of a particular seller. No seller can raise
the price above the prevailing price or lower the price below the prevailing price.

3. Free entry and exit: Any buyer and seller is free to enter or leave the market of the commodity. Under perfect competition,
there will be no restriction on the entry and exit of both buyers and sellers. If the existing sellers start making abnormal
profits, new sellers should be able to enter the market freely. This will bring down the abnormal profits to the normal level.
Similarly, when losses will occur existing sellers may leave the market. However, such free entry or free exit is possible
only in the long run, but not in the short-run.

4. Perfect knowledge: All buyers and sellers have perfect knowledge about the market for the commodity. Perfect competition
implies perfect knowledge on the part of buyers and sellers regarding the market conditions. As a results, no buyer will be
prepared to pay a price higher than the prevailing price. Sellers will not charge a price higher or lower than the prevailing
price. In this market, advertisement has no scope.
5. Indifference (No attachment): No buyer has a preference to buy from a particular seller and no seller to sell to a
particular buyer. There is no attachment between the buyers and sellers under perfect competition. Since products of
all sellers are identical and their prices are the same a buyer is free to buy the commodity from any seller he likes. He
has no special inclination for the product of any seller as in case of monopolistic competition or oligopoly.
Theoretically, perfect competition is irrelevant. In reality, it does not exist.

6. 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. The second perfection mobility of factors of production from one use to another use.
This feature ensures that all sellers or firms get equal advantages so far as services of factors of production are concerned.
This is essential to enable the firms and industry to achieve equilibrium.

PRICE-OUTPUT DETERMINATION IN CASE OF PERFECT COMPETITION

The Price-output Determination in Case of Perfect Competition can be studied under two time periods.

(i) Short run

(ii) Long run

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.
 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.

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 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 are 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.

According to this analysis, a monopolist will be in equilibrium when two conditions are fulfilled:
(i) MC =MR and
(ii) MC curve cuts MR curve from below.
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

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 its plant size or to use existing plant so as to maximize profits.
Monopolistic competition

Perfect competition and pure monopoly are rare 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. These products are relatively close substitute for each other but not perfect substitutes. Consumers have definite
preferences for the particular varieties 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 though 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.
Chamberlain called the collection of firms producing close substitute products as a group.
8. Non-price competition: In monopolistic competition, sellers compete on factors other than price. These factors include
aggressive advertising, product development, better distribution, after sale services, etc. Sellers don’t cut the price of their
products but incur high costs for the promotion of their goods. If the firms indulge in price-wars, which is the possibility under
perfect competition, some firms might get thrown out of the market.

Price-output determination under Monopolistic Competition: Equilibrium of a firm

Fig. 1 above depicts a firm facing a downward sloping, but flat demand curve. It also has a U-shaped short-run cost curve.

Conditions for the Equilibrium of an individual firm

The conditions for price-output determination and equilibrium of an individual firm are as follows:
1.MC = MR
2.The MC curve cuts the MR curve from below.

In Fig. 1, we can see that the MC curve cuts the MR curve at point E. At this point,
•Equilibrium price = OP and
•Equilibrium output = OQ
Now, since the per unit cost is BQ, we have
•Per unit super-normal profit (price-cost) = AB or PC.
•Total super-normal profit = APCB
The following figure depicts a firm earning losses in the short-run.

From Fig. 2, we can see that the per unit cost is higher than the price of the firm. Therefore,
•AQ > OP (or BQ)
•Loss per unit = AQ – BQ = AB
•Total losses = ACPB
Long-run equilibrium
If firms in a monopolistic competition earn super-normal profits in the short-run, then new firms will have an incentive to
enter the industry. As these firms enter, the profits per firm decrease as the total demand gets shared between a larger number
of firms. This continues until all firms earn only normal profits. Therefore, in the long-run, firms, in such a market, earn only
normal profits.
As we can see in Fig. 3 above, the average revenue (AR) curve touches the average cost (ATC) curve at point X. This
corresponds to quantity Q1 and price P1. Now, at equilibrium (MC = MR), all super-normal profits are zero since the average
revenue = average costs. Therefore, all firms earn zero super-normal profits or earn only normal profits.

It is important to note that in the long-run, a firm is in an equilibrium position having excess capacity. In simple words, it
produces a lower quantity than its full capacity.

From Fig. 3 above, we can see that the firm can increase its output from Q1 to Q2 and reduce average costs. However, it does
not do so because it reduces the average revenue more than the average costs.

Hence, we can conclude that in monopolistic competition, firms do not operate optimally. There always exists an excess
capacity of production with each firm.

In case of losses in the short-run, the firms making a loss will exit from the market. This continues until the remaining firms
make normal profits only.
Break-Even Analysis
The study of cost-volume profit analysis is often referred to as ‘break-even analysis’ and the two terms are used
interchangeably by many.

This is so, because break-even analysis is the most widely known form of cost-volume-profit analysis. The term
“break-even analysis” is used in two senses—narrow sense and broad sense.

In its broad sense, break-even analysis refers to the study of relationship between costs, volume and” profit at
different levels of sales or production.

In its narrow sense, it refers to a technique of determining that level of operations where total revenues equal total
expenses, i.e., the point of no profit, no loss.
Assumptions of Break-Even Analysis:

(i) All elements of cost, i.e., production, administration and selling and distribution can be segregated into fixed
and variable components.
(ii) Variable cost remains constant per unit of output irrespective of the level of output and thus fluctuates directly
in proportion to changes in the volume of output.
(iii) Fixed cost remains constant at all volumes of output.
(iv) Selling price per unit remains unchanged or constant at all levels of output.
(v) Volume of production is the only factor that influences cost.
(vi) There will be no change in the general price-level.
(vii) There is only one product or in case of multi-products, the sales mix remains unchanged.
(viii) There is synchronization between production and sales.
Break-even Point
The break-even point may be defined as that point of sales volume at which total revenue is equal to total cost. It is
a point of no profit, no loss.

A business is said to break-even when its total sales are equal to its total costs. The break-even point refers to that
level of output which evenly breaks the costs and revenues and hence the name.

At this point, contribution, i.e., sales minus marginal cost, equals the fixed costs and hence this point is often called
as ‘Critical Point’ or ‘Equilibrium Point’ or ‘Balancing Point’ or no profit, no loss.

If production/sales is increased beyond this level, there shall be profit to the organization and if it is decrease from
this level, there shall be loss to the organization.
Computation of the Break-Even Point:
The break-even point can be computed in terms of:
(a) Units of sales volume.
(b) Budget total or in terms of money value.

(a)Break-Even Point in Units:

As the break-even point is the point of no profit no loss, it is that level of output at which the total contribution
equals the total fixed costs, It can be calculated with the help of following formula:
(b) Break-even Point in terms of budget-total or money value:
Profit-volume ratio indicates the relationship between contribution and sales and is usually expressed in percentage. The ratio
shows the amount of contribution per rupee of sales.

The Profit/volume ratio, which is also called the ‘contribution ratio’ or ‘marginal ratio’, expresses the relation of
contribution to sales and can be expressed as under:
P/V Ratio = Contribution/Sales
Since Contribution = Sales – Variable Cost P/V ratio can also be expressed as:
P/V Ratio = Sales – Variable cost/Sales i.e. S – V/S

This ratio can also be shown in the form of percentage by multiplying by 100. Thus, if selling price of a product is Rs. 20 and
variable cost is Rs. 15 per unit, then
P/V Ratio = 20 – 15/20 × 100 = 5/20 × 100 = 25%

The P/V ratio, which establishes the relationship between contribution and sales, is of vital importance for studying the
profitability of operations of a business. It reveals the effect on profit of changes in the volume.

In the above example, for every Rs. 100 sales, Contribution of Rs. 25 is made towards meeting the fixed expenses and then the
profit comparison for P/V ratios can be made to find out which product, department or process is more profitable. Higher the
P/V ratio, more will be the profit and lower the P/V ratio, lesser will be the profit. Thus, every management aims at increasing
the P/V ratio.
Illustration 1:
From the following information, calculate the break-even point in units and in sales value:
Output = 3,000 units
Selling price per unit = Rs. 30
Variable cost per unit =Rs. 20
Total fixed cost = Rs. 20,000
Solution:
From the following particulars, calculate:
(i) Break-even point in terms of sales value and in units.
(ii) (ii) Number of units that must be sold to earn a profit of Rs. 90,000.
Solution:
Question
A company makes a product with a selling price of Rs.20 per unit and variable costs of Rs.12
per unit. The fixed costs for the period are Rs.40,000. What is the required output level to make
a target profit of Rs.10,000?

Question 2
A company has fixed costs of Rs. 3,00,000 and produces one product with a selling price of Rs.
72.00 and a variable cost of Rs. 42.00 per unit. The company has produced and sold 15,000
units. Calculate BEP and determine margin of safety.

How much profit will they make:

1.at the present level of operation?
2.if sales increase to the maximum that the factory can supply? (Maximum capacity to produce
and supply is 20,000 Units)
From the following data, you are required to calculate:
(a) P/V ratio
(b) Break-even sales with the help of P/V ratio.
(c) Sales required to earn a profit of Rs. 4,50,000

Fixed Expenses = Rs. 90,000

Variable Cost per unit:
Direct Material = Rs. 5
Direct Labour = Rs. 2
Direct Overheads = 100% of Direct Labour
Selling Price per unit = Rs. 12.
Solution:
 Q. From the following information find out:
a. P/V Ratio
b. Sales &
c. Margin of Safety

Fixed Cost = Rs.40, 000

Profit = Rs. 20,000
B.E.P. = Rs. 80,000

Sales = Contribution/P/V Ratio

Contribution = Sales – Variable Cost (or) Fixed Costs +
Profit
P/V Ratio = Fixed Expenses / Breakeven Sales

P/V Ratio = Rs. 40,000 / Rs. 80,000

=½
= 50 %

Sales = Contribution/P/V Ratio

Contribution = Sales – Variable Cost (or) Fixed Costs + Profit

Sales = Fixed Costs + Profit / P/V Ratio

= Rs. 40,000 + rs. 20,000 / 50/100
= Rs. 1,20,000

Margin of Safety = Sales – B.E.P Sales

So, MOS = 1, 20,000 – 80,000

MOS = Rs.40, 000