MANAGERIAL ECONOMICS

CHAPTER – IV

Presented By
Dr. G.VIJAYAKRISHNA
MBA,MHRM, PG D(IR&PM), Ph.D
Associate Professor
Department of Management
Bule Hora University
 PRICE AND OUTPUT DECISIONS UNDER
DIFFERENT MARKET STRUCTURES
• The Theory of the Firm
• The basic assumptions of the theory of the firm are:
• The objective of the firm is to maximize net revenue in the face
of given prices and a technologically determined production
function
• The theory of the firm deals with the role of business firms in
the resource allocation process. It uses aggregation as a tactic
and attempts to specify total market supply and demand curves.
• The firm operates with perfect knowledge of all relevant
variables involved in making a decision and it acts rationally
while doing so.
• Originally, the theory assumed that the firm is operating within
a perfectly competitive market. But it has now been extended to
Dr.G.Vijayakrishna, Associate Professor
cover other market situations.
• From the viewpoint of price analysis, it is very important for
business management to gain a proper understanding of the
nature and process of competition in the modern industrial
society.
• First, the management should understand the rationale of the
free enterprise system within which its own business decisions
have to be made, aims and limitations of that system.
• Secondly, it must have full knowledge of the markets and
market situations in which its own business operates and of the
policies appropriate to those market situations.
• Thirdly, it is in the process – price, product innovation and
promotional activity – may be manipulated in enlarging the
firm’s market share.
• Fourthly, the firms having monopoly power should be familiar
with the nature and the purpose of the law relating to monopoly
and restrictive practices.
Dr.G.Vijayakrishna, Associate Professor
• What is more important, the management must also
be alert and recognize when market conditions
change.
• An understanding of the nature of competition can
provide an insight into the probable behavior
patterns of the competitors.
• It will be useful to distinguish the following types of
market situations to study how prices are determined:
• Perfect competition
• Imperfect competition
– Monopoly and Monopsony
• Monopolistic competition, and
– Oligopoly and oligopsony.
Dr.G.Vijayakrishna, Associate Professor
 Perfect competition
Main Features:
• There are a large number of undifferentiated buyers
and sellers.
• Each seller must be small and the quantity supplied
by any one of the sellers must be so insignificant that
no increase or decrease in his output can appreciably
affect the total supply and the market price.
• Each competitor offers or seeks exactly a similar
thing as do the others. There is nothing to distinguish
one from the other so that one could be substituted for
the other if the price is lower.
Dr.G.Vijayakrishna, Associate Professor
• The market in which the commodity is bought and sold must
be well organized, trading must be continuous and buyers
and sellers must be so well informed that every unit bought
or sold at any particular time will sell at the same price.
• There are many competitors (whether buyers or sellers),
each acting independently. There must be no restraint upon
the independence of any seller or buyer, either by custom,
contract, collusion, and fear of reprisals by the competitors,
or by the imposition of government control.
• The market price must be flexible over a period of time,
constantly rising or falling in response to the changing
conditions of supply and demand.
• There should be no obstacle to the entry and to the
withdrawal of the firms in the industry concerned.
Dr.G.Vijayakrishna, Associate Professor
• All firms have equal access to production
technologies and techniques. There are no patents,
proprietary designs or special skills that allow an
individual firm to do the job better than its
competitors. Firms also have equal access to all their
inputs which are available on similar terms.
• In the case pure competition is said to exist
where only two conditions are fulfilled., viz.
(1) there must be a large number of firms in the
industry. And (2) the products of the firms must be
homogeneous.

Dr.G.Vijayakrishna, Associate Professor

Determination of Price
As is popularly known, prices under perfect competition are determined by
the forces of supply and demand. Prices will be fixed at a point where the supply and
demand are at equilibrium. The equilibrium will change by changes in the forces of
demand and supply.

Dr.G.Vijayakrishna, Associate Professor

• Price and Quantity Variability
• Responses to a change in demand or to a change in supply may
be primarily in price or primarily in quantity.
• If the demand is highly elastic, consumers will respond readily to
price changes by dropping out of the market when prices are
raised a little and by coming in and increasing purchases when
prices are lowered a little.
• As a result, most of the adjustments to changes in supply (an
increase leading to a reduction in price and a decrease leading to
an increase in price) will be adjustments in quantity purchased if
the demand is highly elastic.
• If the demand is inelastic, the adjustment will take place
primarily in price. Similarly, if sellers respond readily by greatly
increasing their offerings on slight increases in price, or by heavy
withdrawals on slight price drops, the adjustments to changes in
demand will be largely in quantity exchanged.
Dr.G.Vijayakrishna, Associate Professor
• Consequences of Pure Competition
• If the market price is below the cost of production of a
particular producer, he can do nothing but to take a loss (in
the short run).
• If the price remains below his cost of production for a
sufficiently long period, he has no alternative but to go out
of business.
• A firm can increase its profits by selling more units.
• Products subjects to a competitive market situation, face a
greater degree of price instability than is the case with
differentiated products.
• No useful purpose is served by advertising. When products
sold by individual sellers are identical, advertizing by any
one seller would have a negligible effect on the demand for
his product. Dr.G.Vijayakrishna, Associate Professor
Key lessons of Perfect Competition for Managers
The key lessons of perfect competition for
managers in highly competitive market
environment are as under:
• It is important to enter a growing market as far
ahead of the competitors as possible. Smart
managers should take advantage of the market
when supply is low and price is high well before
the competitors enter the market. This requires
entrepreneurial skill to take a risk.

Dr.G.Vijayakrishna, Associate Professor

• Managers may try to escape the pressures that a
perfectly competitive market exerts on the cost
structure by differentiating their products. Very
often, however, differentiation offers a company
only a temporary relief from competitive
pressures on cost.
• With growing globalization of world economy,
new competitive cost pressures are being felt by
companies around the world. In this regard, the
companies enjoy the advantage of cheap, low-cost
labor but disadvantage of technology lag.

Dr.G.Vijayakrishna, Associate Professor

 Monopoly
• Any condition which gives individual sellers, or groups
of sellers acting as a unit, some measure of direct
control over price is to some degree monopolistic.
• And any such control on the part of buyers is
monopsonistic. The type of monopolistic and
monopsonistic situations may be distinguished
according to the nature and extent of the deviation
from the conditions of perfect competition. A useful
classification can be:
• Monopoly and monopsony
• Monopolistic competition and
• Oligopoly and Oligopsony.
Dr.G.Vijayakrishna, Associate Professor
Main features of Monopoly
• There is only one seller of a particular good or service
• Rivalry from the producers of substitutes is so remote as to be
insignificant. This implies that the cross-elasticity of demand between
the monopolist’s product and any other product is low.
• As a result, the monopolist is in a position to set the price himself. In
fact, monopoly implies market power.
• The strength of a monopolist lies in his power raise his prices without
frightening away all his customers.
• How much he can raise them depends on the elasticity of demand for
his particular product. This in turn depends on the extent to which
substitutes for his products are available. Even exclusive monopolies
like railways or telephones must take account of potential competition
by alternative services.
• In fact, two conditions are necessary to make a monopolist strong: (i)
A gap in the chain of substitutes, and (ii) Possibility of securing
control over all the close substitutes.
Dr.G.Vijayakrishna, Associate Professor
Causes of Monopoly
• Monopoly may arise due to the following causes:
• The government may grant a license to any particular
person or persons for operating public utilities like an
electricity undertaking. Again, the government may
reserve the right of foreign trade in any commodity for
itself, or may give this right to any other person. In all
these cases, the statutory grant of special privileges by the
State creates monopoly condition.
• A producer may possess certain scarce raw materials,
patent right, secret methods of production, or specialized
skill which might give him monopoly power. Example:
Drugs.
• Ignorance, laziness and prejudice of the buyers may
Dr.G.Vijayakrishna, Associate Professor
create monopoly in favor of a particular producer.
Disadvantages of Monopoly
• When a monopolist exercises the market power by restricting supplies,
he will become richer than he would have been if he had no market
power. And he will do so at the expense of those who consume his
product.
• Consumer choice is restricted. Indeed consumer will depend on the
monopolist’s decisions not only as regards price, but also on such
matters as the amount and direction of research and development in the
industry, the services offered and the continuity of supply.
• The absence of competition means that there will be no pressure on the
monopolist firms to be as economical as feasible. i.e., to keep down
cost. Wasteful costs tend to be reflected in higher prices.
• The exercise of monopoly power causes resources to be misallocated
from society’s point of view. As the monopolist restricts output, his
output is too small. He employs too little of society’s resources. As a
result, too much of these resources may go into the production of goods
with low consumer preferences. Thus resources are misallocated.
• A firm enjoying monopoly position in a strategic sector may provide
too big a risk for the economy.
Dr.G.Vijayakrishna, Associate Professor
 Monopsony

Main Features of Monopsony

• There is only one buyer of the goods or services.

• Rivalry from buyers who offer substitutive outlets is
so remote as to be insignificant.
• As a result, the buyer is in a position to determine
the price he pays for the goods or services he buys.

Dr.G.Vijayakrishna, Associate Professor

 Monopolistic Competition
• Monopolistic competition is a market situation in which there are
many sellers of a particular product, but the product of each seller is
in some way differentiated in the minds of consumers from the
product of every other seller.
• Product differentiation is the basic condition giving rise to
monopolistic competition.
• Under monopolistic competition, sellers are numerous but no one of
them is in a position to control a major part of the supply of the
common commodity which all of them are offering for sale.
• But each seller so differentiates his portion of the supply of that
commodity from the portions sold by others that buyers hesitate to
shift their purchases from his product to that of another in response to
price differences.
• At times, one manufacturer may differentiate his own products. For
example, a blade manufacturer manufactures some 26 brands of
Dr.G.Vijayakrishna, Associate Professor
blades.
• A wide range of consumer goods like toothpastes, soaps,
cigarettes, radios, TVs, scooters, commercial vehicles,
electronic goods etc., are subject to a large degree of
product differentiation as means of attracting customers.
• So long as a consumer has an impression that the product
brand is different and superior to others, he will be willing
to pay more for that brand than for any other brand of the
same commodity.
• The differences, real or illusory, may be built up in his
mind by (a) recommendation of friends, (b) publicity
campaigns and the claims of the advertisers, and (c) his
own experience and observation.
• The producer gains and retains his customers by (a)
competitive advertising and sales promotion, (b) the use of
the brand names quite as much as (c) by price competition.
Dr.G.Vijayakrishna, Associate Professor
Options under Monopolistic Competition
A firm in monopolistic competition has
three options open to it to promote its sales:
• It can change its price and indulge in price
competition,
• It can intensify the differentiation of its products,
and
• Increase its advertisement and sales promotion
efforts.

Dr.G.Vijayakrishna, Associate Professor

• Product differentiation takes various forms. It may
be based upon certain characteristics of the product
itself; patented features, trade marks, trade names,
peculiarities of the package or container, if any or
singularity in quality, design, color or style.
• Differentiation may also be based on conditions
surrounding the sales of the product, such as
convenience of the seller’s location, reputation and
goodwill and various other links which attach the
customer to the seller.
• Benefits of product differentiation – Supply side: it
allows firms to minimize competition and earn
higher profits. Demand side: it provides consumers
with a greater variety of goods and services.
Dr.G.Vijayakrishna, Associate Professor
Differences between Perfect Competition and
Monopolistic Competition
• While perfect competition is a myth, monopolistic
competition is fact of life.
• Under perfect competition, product are homogeneous;
in monopolistic competition, products are
differentiated.
• Under perfect competition, the price prevailing in the
market is the same for all producers; under
monopolistic competition, there are different prices
for differentiated products.
• Advertisement does not help in perfect competition; it
is rather necessary to sustain monopolistic
competition. Dr.G.Vijayakrishna, Associate Professor
Key lessons of Monopolistic Competition for Managers
• A firm must try to be first into a market through differentiation;
brand names, packaging, advertising, location and ‘service with
a smile’, all help the manager in this regard.
• The managers of the early entrant firms must never be
complacent because new entrants are always looking around
the corner, waiting to seize the economic profits of those
already on the market.
• The manager must realize that a monopolistically completed
market offers the opportunity for firms to compete not only by
trying to be the lowest cost producer but also by effectively
differentiating their products.
• A manager in a monopolistically competitive market need not
have to lower prices in the face of competition as long as he
successfully makes the customers believe that he is supplying
the best product out ofDr.G.Vijayakrishna,
all competitors. Associate Professor
 Oligopoly
The term Oligopoly has a Greek base and means few sellers. Oligopoly,
as such, refers to markets with small number of large firms.
It means , an economic condition in which a small number of Sellers
exert control over the market price of a commodity.

Main Features of Oligopoly

• Sellers are few in number
• Any of them is of such a size that an increase and decrease in his output will
appreciably affect the market price.
• Each seller knows his competitors individually in each market.
• Each oligopolist realizes that any change in his price and advertising policy
may lead rivals to change their policies.
• Hence, an individual firm must consider the possible reactions of the other
firms to its own policies.
• The smaller the number of firms, the more interdependent are their policies.
The reactions of rivals will generally be immediate and strong, and tendencies
to close collaboration in price determination
Dr.G.Vijayakrishna, are apt to appear.
Associate Professor
Oligopoly Pricing – Some General Principles
To conclude, the problem of oligopoly pricing is complex and
indeterminate. A few general principles of oligopoly pricing may,
however, be indicated here:
• If a rival cuts his price, it is better to match the cut than to undercut
his price.
• The fact that each seller knows that a price cut will be met promptly
usually destroys the effect of overt price-cuts as a means of enlarging
market share. It may be safer to engage in secret price concessions for
selected customers than to reduce prices openly with the possibility of
retaliation.
• Price reductions, once made, are not easily reversible.
• Open price competition in oligopoly usually generates into an open
price war.
• Many oligopoly firms believe that their demand curve is kinked, that
is inelastic for price-cuts but elastic for price changes as their
competitive weapon. Dr.G.Vijayakrishna, Associate Professor
 Oligopsony
Main Features of Oligopsony
• Buyers in a particular market are few in number.
• It means , an economic condition in which a small
number of buyers exert control over the market price
of a commodity.
• Each one of them is of such a size that an increase or
decrease in his demand will considerably affect the
price.
• No single buyer can afford to ignore the reactions of
his rivals to policies he might initiate.
• Eg. The offer of a lower price. This is the basic
feature of Oligopsony.
Dr.G.Vijayakrishna, Associate Professor
 Profit Policies
Profit Maximization
• It is generally accepted that a business firm aims at making profits.
Moreover, the volume of profit made by it is regarded as a primary
measure of its success.
• However, in economic theory a basic assumption is that the firm aims
at maximizing profits. This assumption does not always hold true
since, in practice, firms do not always try to maximize profits. This is
so for a number of reasons:
• Attainment of Industry Leadership
• Firms often aim at becoming leader in their respective industries even
if it means higher costs and lower profit. In such firms, the goal of
profit maximization is subordinated to the goal of industry leadership.
• Industry leadership may involve either the achievement of the
maximum sales volume or the manufacture of the maximum product
line. “Instead of maximum profit level consistent with a certain share
of the market or a certainDr.G.Vijayakrishna,
level of sales.” Associate Professor
Preventing Government’s Intervention
• The government’s attitude towards profit may differ sharply
from that of businessmen. High profits are often considered as
an index of monopoly power.
• They may create an impression that the firm is exploiting the
consumers. As a result, there may be a demand on the part of
the public for nationalization of the enterprise or investigation
into its profits or some sort of regulation of prices, profits and
dividends. Hence, firms may decide to aim at less than the
maximum profits.
Maintaining Consumer Goodwill
• Customer is the foundation of any business. A policy of profit
restraint may be followed in order to maintain goodwill of the
customers. In fact, consumer goodwill is valued so much these
days that firms often make organized efforts to impress upon
the public, quite often through public advertisements, that they
are making a very low margin of
Dr.G.Vijayakrishna, profit.
Associate Professor
Restraining Demand for Wage Increases
• Higher profits may be taken as an evidence of he
ability to pay higher wages.
• In fact, organized labor may advance the existence
of high profits as an argument in support of their
demand for higher wages. (Wages here mean not
only basic wages but include dearness allowance,
bonus, etc.).
• This is particularly applicable in industries having
strong trade unions. Companies take a long-term
view of wage increases. As wages tend to be sticky,
it may not be possible for a company to continue
paying high wages during recessionary periods.
Dr.G.Vijayakrishna, Associate Professor
• Avoiding Risk
• Profit maximization may involve an element of risk. Very
often, a managerial decision involving the setting up of a
new venture has to operate in the midst of a number of
uncertainties. Due to inherent uncertainties, a project
which appears to be profitable at the outset may turn out
to be unprofitable.
• Conservative managements very often avoid the
possibility of any risk all by deciding not to have a
project which promises maximum profits though hedged
in by a number of uncertainties.
• Business executives may dislike taking such risks
because in case of failure they run the risk of losing their
job, status and image.
Dr.G.Vijayakrishna, Associate Professor
Alternative Profit Policies
Different economists have suggested a variety of profit
policies which business firms may purse as an alternative to
profit maximization. These alternative profit policies are
enumerated below:
• K. Rothschild has suggested that the primary motive of an
enterprise is long-run survival. Decisions, therefore, aim at
maximizing the security of the organization. The desire for a
secure profit is a dominant motive in oligopolistic industries.
• M. Reder has argued that an entrepreneur may have two
objectives:
– To maximize profits, and
– To maintain financial control or the firm.
Under the circumstances, he may not maximize profits
in order to achieve the second objective, say, by financing
firm’s expansion with own funds or retained earnings.
Dr.G.Vijayakrishna, Associate Professor
• Donaldson and Lorsch found that “career managers
preferred policies that favored the long-term stability
and growth of their enterprises to those that maximized
current profits. To assure survival, self-sufficiency and
success, these top managers strive continuously to
conserve and augment corporate wealth…… Top
managers seek the maximization of wealth: the more
the wealth, the greater the assurance of the means of
surviaval.”
• W. Fellner has similarly argued that firms are interested
in ‘safety margins’.
• W. W. Cooper has introduced another variable, viz.,
liquidity. Businesses attempt to maintain liquidity
enough to ensure the firm’s financial position and
retention of control.
Dr.G.Vijayakrishna, Associate Professor
 Profit Planning
Naturally, the firm will have to plan for profits. In this respect, a
thorough understanding of the relationship of costs, price and volume is
extremely helpful to business executives. The most important method of
determining the cost-volume-profit relationship is that of Break – Even
Analysis, also known as Cost-Volume-Profit (C-V-P) analysis.
Break – Even Analysis
• Break-even analysis involves the study of revenues and costs of a firm in
relation to its volume of sales and specifically the determination of that
volume at which the firm’s costs and revenues will be equal.
• The Break-even Point (BEP) may be defined as that level of sales at which
total revenues equal total costs and the net income is equal to zero. This is
also known as no-profit no-loss point.
• The main objective of the break-even analysis is not simply to spot the BEP,
but to develop an understanding of the relationship of cost, price, and volume
within a company’s practical range of operations.
• The break-even chart is an “excellent instrument panel for your guidance in
controlling your business.”Dr.G.Vijayakrishna, Associate Professor
Determination of the Break – Even Point
• It may be determined either in terms of physical units or in money
terms, i.e. sales value in amount.
Break – Even Point in terms of Physical units
• This method is convenient for the single-produce firm. The break-even
volume is the number of units of the product which must be sold to
earn enough revenue just to cover all expenses – both fixed and
variable.
• The selling price of a unit covers not only its variable cost but also
leaves a margin to contribute towards the fixed costs. The break-even
point is reached when sufficient number of units have been sold so
that the total contribution margin of the units sold is equal to the fixed
costs.
• The formula:

• Where the contribution margin is: Selling Price – Variable costs per
unit. Dr.G.Vijayakrishna, Associate Professor
Break – Even Point in terms of Sales Value
• Multi-product firms are not in a position to measure
the break-even point in terms of any common unit of
product. They find it convenient to determine their
break-even point in terms of total Birr sales.
• Here, again, the break-even point would be the point
where the contribution margin (Sales value –
Variable costs) would equal the fixed costs. The
contribution margin, however, is expressed as a ratio
to sales.
• For example, if the sales are Br. 200 and the variable
costs of these sales is Br. 140, the contribution
margin ratio is (200 - 140)/200. i.e. 0.3.
• The formula for calculating the
Dr.G.Vijayakrishna, Associate break-even point is:
Professor
Break – Even Charts
• Break – even analysis is very commonly presented by
means of break-even charts, also known as profit-
graphs.
• A break-even chart prepared on the basis of example 1
in the following figure. Units of product are shown on
the horizontal axis OX and revenues and costs are
shown on the vertical axis OY. The fixed costs of Br.
10000 are represented by a straight line parallel to the
horizontal axis. Variable costs are then plotted over and
above the fixed cost. The resultant line is the total cost
line, combining both variable and fixed cost. There is
no variable cost line in the graph: variable costs are
represented by the vertical distance between the fixed
cost and the total cost lines.
Dr.G.Vijayakrishna, Associate Professor
• The total cost at any point is the sum of Br. 10000 plus Br. 2
per unit of variable cost multiplied by the number of units
sold at that point. Total revenue at any point is the unit price
of Br. 4 multiplied by the number of units sold. The break-
even point corresponds to the point of intersection of the total
revenue and the total cost lines. Projecting a perpendicular
from the BEP to the horizontal axis shows the break-even
point in units of the product. Dropping a perpendicular from
BEP to the vertical axis shows the break-even sales value in
rupees. Below the BEP (or to the left of it), total costs are
more than total revenue and the firm would suffer a loss.
Above the BEP (to its right), total revenue exceeds total cost
and the firm would be making profits. Since profits or loss
occurs between costs and revenue lines, the space between
them is known as the profit zone (to the right of the BEP) and
the loss zone (to the left of the BEP).
Dr.G.Vijayakrishna, Associate Professor
Dr.G.Vijayakrishna, Associate Professor
Dr.G.Vijayakrishna, Associate Professor
• Where the BEP is measured in terms of sales
value rather than in physical units, the break-even
chart remains basically the same as in Fig. 1. The
only difference is that the volume on the X-axis is
measured in terms of sales value. In that case, a
perpendicular from the point BEP to either axis
would show the break-even amount sales value.
The same type of chart can be used to depict the
BEP in relation to full capacity; in this case, the
horizontal axis would represent the percentage of
full capacity, instead of physical units or the sale
value.

Dr.G.Vijayakrishna, Associate Professor

 Profit Forecasting
• Profit planning cannot be done without proper
profit forecasting.
• Profit forecasting means projection of future
earnings taking into consideration all the factors
affecting the size of business profits. Eg., firm’s
pricing policies, costing policies, depreciation
policy, and so on.
• A thorough study including proper estimation of
both economic and non-economic variables may
be necessary for a firm to project its sales volume,
costs and consequently the profits in future.
Dr.G.Vijayakrishna, Associate Professor
 Joel Dean has pointed out three approaches to
profit forecasting:
Spot Projection
• Projection the entire profit and loss statement for a
specified future period by forecasting each important
element separately: forecasts are made about sales
volume and prices and costs of producing the
anticipated sales.
• Since, profits are residual resulting from the forces that
shape demand for the company’s products and govern
the behavior of its costs, their prediction is subject to
wide margins of error, from cumulating of errors in
forecasting revenues and costs, and from the inter-
relation of the various components of the income
statement. Dr.G.Vijayakrishna, Associate Professor
Break – Even Analysis
• Analysis identifying functional relations of both
revenues and costs to output rate, with profits
related to output as residual; or alternatively,
relating profits to output directly by the usual data
used in break-even analysis.
Environmental Analysis
• Analysis relating the company’s profits to key
variables in the economic environment, such as
the general business activity and the general price
level. These variables are external to the company.

Dr.G.Vijayakrishna, Associate Professor

• In fact, factors that control profits have a tendency to
move in regular and related patterns; rate of output,
prices, wages, material costs and efficiency are all inter-
related by their connections with the national markets
and by their interactions in aggregate business activity.
• In practice, these three approaches need not be mutually
exclusive, but can be used jointly for maximum
information. In projecting the profit and loss statement,
use can be made of the functional relations of cost to
output and to its other determinants.
• Similarly, direct measurement of the impact of outside
economic forces upon the company’s profits can
facilitate good spot guesses and can also enhance the
accuracy of break-even analysis.
Dr.G.Vijayakrishna, Associate Professor
Thank you

Dr.G.Vijayakrishna, Associate Professor