MODULE-2

Cost and Revenue, Profit Functions

Cost Concepts, Fixed and variable costs, Total Cost, Average Cost, Marginal Cost, Opportunity
Cost. - Short-run and Long-run Cost Curves Profits
Determinants of Short-Term & Long Term Profits, Measurement of Profit. Break Even
Analysis- Meaning, Assumptions, Determination of BEA, Limitations and Uses of BEA in
Managerial Economics. (Problems on BEP).

Market Structure
Perfect Competition: Features, Determination of Price under Perfect Competition -
Monopoly: Features, Pricing under Monopoly, Price Discrimination - Oligopoly: Features,
Kinked Demand Curve, Cartel, Price Leadership - Monopolistic Competition: Features,
Pricing under Monopolistic Competition, Product Differentiation Pricing - Descriptive
Pricing- Price Skimming, Price Penetration
Contents
Cost Analysis ....................................................................................................................... 3
Break Even Analysis ......................................................................................................... 15
Market Structure .............................................................................................................. 17
Profit Maximization under Perfect Competition ............................................................. 23
Monopoly Market ............................................................................................................. 27
Monopolistic Competition................................................................................................. 32
Oligopoly Market .............................................................................................................. 34
Kinked Demand Curve in oligopoly ................................................................................. 35
 Cost Analysis

Objective of this section

At the end of section, you will be able to understand the concepts like fixed cost, variable cost,
average cost, and marginal cost. The concept of the marginal costing is the contribution of the
20th century. The concept like break even analysis, cost volume profit analysis are the
important tools used to take various managerial decisions. The concept like average revenue
decides the level of output to earn profit. At the same time the concept like marginal cost is the
tool available in the hands of the producers to decide that level of output where MC = AR i.e.,
the equilibrium position of the suppliers and consumers.

Introduction:

A production function tells us how much output a firm can produce with its existing plant and
equipment. The level of output depends on prices and costs. The most desirable rate of output
is the one that maximizes total profit that is the difference between total revenue and total cost.

Entrepreneurs pay for the input factors- Wages for labour, price for raw material, rent for
building hired, interest for borrowed money. All these costs are included in the cost of
production. The economist’s concept of cost of production is different from accounting.

This section helps us to understand the basic cost concepts and the cost output relationship in
the short and long runs. Having looked at input factors in the previous chapter it is now possible
to see how the law of diminishing returns affect short run 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.
 Actual cost/ Outlay cost/ Absolute cost / Accounting cost: The cost or expenditure
which a firm incurs for producing or acquiring a good or service. (Eg. Raw material
cost)
 Opportunity cost: The revenue which could have been earned by employing that good
or service in some other alternative uses. (Eg. A land owned by the firm does not pay
rent. Thus a rent is an income forgone by not letting it out)
 Sunk cost: Are retrospective (past) costs that have already been incurred and cannot be
recovered.
 Historical cost: The price paid for a plant originally at the time of purchase.
 Replacement cost: The price that would have to be paid currently for acquiring the
same plant.
 Incremental cost: Is the addition to costs resulting from a change in the nature of level
of business activity. Change in cost caused by a given managerial decision.
 Explicit cost: Cost actually paid by the firm. If the factors of production are hired or
rented then it is an explicit cost.
 Implicit cost: If the factors of production are owned by a firm then its cost is implicit
cost.
 Book cost: Costs which do not 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 to take tax
advantages.
 Social cost: Total cost incurred by the society on account of production of a good or
service.
 Transaction cost: The cost associated with the exchange of goods and services.
 Controllable cost: Costs which can be controllable by the executives are called as
controllable cost.
 Shut down cost: Cost incurred if the firm temporarily stops its operation. These can be
saved by continuing business.

Economic costs are related to future. They play a vital role in business decisions as the costs
considered in decision - making are usually future costs. They are similar in nature to that of
incremental, imputed explicit and opportunity costs.
Determinants of Short –Run Cost
 Fixed cost: Some inputs are used over a period of time for producing more than one
batch of goods. The costs incurred in these are called fixed cost. For example amount
spent on purchase of equipment, machinery, land and building.
 Variable cost: When output has increased the firm spends more on these items. For
example the money spent on labour wages, raw material and electricity usage. Variable
costs vary according to the output. In the long run all costs become variable.
 Total cost: The market value of all resources used to produce a good or service.
 Total Fixed cost: Cost of production remains constant whatever the level of output.
 Total Variable cost: Cost of production varies with output.
 Average cost: Total cost divided by the level of output. The Average Cost is the per
unit cost of production obtained by dividing the total cost (TC) by the total output (Q).
By per unit cost of production, we mean that all the fixed and variable cost is taken into
the consideration for calculating the average cost. Thus, it is also called as Per Unit
Total Cost.
 Average variable cost: Variable cost divided by the level of output.
 Average fixed cost: Total fixed cost divided by the level of output.
 Marginal cost: Cost of producing an extra unit of output. In economics, marginal
cost is the change in the total cost that arises when the quantity produced is incremented
by one unit; that is, it is the cost of producing one more unit of a good.

Short Run Cost Output Relationship

Fixed cost curve is a horizontal line which is parallel to the ‘X’ axis. This cost is constant with
respect to output in the short run. Fixed cost does not change with output. It must be paid even
if ‘0’ units of output are produced. For example: if you have purchased a building for the
business you have invested capital on building even if there is no production.

Total fixed cost (TFC) consists of various costs incurred on the building, machinery,
land, etc. For example if you have spent Rs. 2 Lakhs and bought machinery and building which
is used to produce more than one batch of commodity, then the same cost of Rs. 2 Lakhs is
fixed cost for all batches. The total variable costs vary according to the output. Whenever the
output increases the firm has to buy more raw materials, use more electricity, labour and other
sources therefore the TVC curve is upward sloping. The total cost consists of fixed (TFC) and
variable costs (TVC). The TFC of Rs. 2 Lakhs is included with the variable cost throughout
the production schedule so the total cost (TC) is above the TVC line.
The above set of graphs indicates clearly that the average variable cost curve looks like a boat.
Average fixed cost curve declines as output increases and it is a hyperbola to the origin. The
Marginal cost curve slopes like a tick mark which declines up to an extent then it starts
increasing along with the output.

Let us see and understand the nature of each and every curve with an example. The table and
graphs shown below indicates the total costs curves and average cost curves at various output
level.
C/A B/A D/A B(1)-B(-1)
A B C D E F G H
Output TC TFC TVC AFC ATC AVC MC AC
0 1200 300 - - - - -
1 1800 300 1500 300 1800 1500 600 1800
2 2000 300 1700 150 1000 850 200 1000
3 2100 300 1800 100 700 600 100 700
4 2250 300 1950 75 562.5 487.5 150 562.5
5 2600 300 2300 60 520 460 350 520
6 3300 300 3000 50 550 500 700 550
Table - Cost Schedule

Some of the calculations are as follows:

Total cost = TFC + TVC for 1 unit TC = 300 + 1500 = 1800.
The marginal cost of producing an extra unit is calculated based on the difference in total cost.
MCn = TCn – TCn-1
MC2 = TC2 – TC2-1 = 2000 – 1800 = 200
MC for 5th unit = TC of 5th unit minus TC of 4th unit, in our example
2600 – 2250 = 350.

AVC = TVC / output = 2600 / 5 = 460

AFC = TFC / output = 300 / 5 = 60.
If we obtain average cost values and graph it we will obtain the following results.

Output AFC ATC MC

0 - - -
1 300 1800 600
2 150 1000 200
3 100 700 100
4 75 562.5 150
5 60 520 350
6 50 550 700

Graph – Average Cost Curves

1900
1800
1700
1600
1500
1400
1300
1200
1100
1000
900
800
700
600
500
400
300
200
100
0
0 1 2 3 4 5 6 7

AFC - ATC - MC -

Graph – Total Cost Curves

3500

3000

2500

2000 TC 1200
TFC 300
1500
TVC -
1000

500

0
0 1 2 3 4 5 6 7
From the above table and set of graphs we can understand that capital is the fixed factor of
production and the total fixed cost will be the same Rs. 300,000. The total variable cost will
increase as more and more goods are produced. So the total variable cost TVC of producing 1
unit is Rs.1500 000, for 2 units 1700 000 and so on.

Relationship between Marginal Cost and Average Cost Curve:

The marginal cost and average cost curves are U shaped because of law of diminishing returns.
The marginal cost curve cuts the average cost curve and average variable cost curves at their
lowest point. Marginal cost curve cuts the average variable cost from below. The AC curve is
above the MC curve when AC is falling. The AC curve is below the MC when AC is increasing.
The intersecting point indicates that AC=MC and that is the minimum average cost with an
optimum output. (No more output can be produced at this average cost without increasing the
fixed cost of production)

2000
1800
1600
1400
1200
1000 MC
800 AC
600
400
200
0
0 1 2 3 4 5 6 7

Graph – Relationship Between Average Cost And Marginal Cost

Optimum Output and Minimum Cost
The MC and AC curves are mirror image of the MP and AP curves. It is presented in the graph
below.

All organizations aim for maximum output

with minimum cost. To achieve this goal
they like to derive the point where optimum
output can be produced with the given
amount of input factors and with a
minimum average cost. In the graph the
MP=AP at maximum average
production. On the other hand MC = AC
at minimum average variable cost.
Therefore this is the optimum output to be
produced to achieve their managerial goals.

The above set of cost curves explain the cost output relationship in the short period but in the
long run there is no fixed cost because all costs vary over a period of time. Therefore in the
long run the firm will have only average cost curve that is called as long run average cost curve
(LAC). Let us see how the average cost curve is derived in the long run. This LAC also slopes
like the short period average cost curve (U shaped) provided the law of diminishing returns
prevails. In case the returns to scale are increasing or constant then the LAC curve will have a
different slope. It will be a horizontal line, which is parallel to the ‘X’ axis.
Cost Output Relationship In The Long Run

In the long run costs fall as output increases due to economies of scale, consequently the
average cost AC of production falls. Some firms experience diseconomies of scale if the
average cost begins to increase. This fall and rise derives a U shaped or boat shaped average
cost curve in the long run which is denoted as LAC. The minimum point of the curve is said to
be the optimum output in the long run. It is explained graphically in the chart given below.

In the long run all factors are variable and the average cost may fall or increase to A, B
respectively but all these costs are above the long run cost average cost. LAC is the lower
envelope of all the short run average cost curves because it contains them all. At point ‘E’ the
SAC1 and SMC1 intersects each other, in case the organization increases its output from OM
to OM1 they have to spend OC1 amount. In case the organization purchases one more machine
(increase in fixed cost) then they will get a new set of cost curves SAC2, and SMC2. But the
new average cost curve reduces the cost of production from OC1 to OC2.That means they can
save the difference of C1C2 which is nothing but AB. Therefore in the long run due to business
expansion a firm can reduce their cost of production. During their business life they will meet
many combinations of optimum production and minimum cost in different short periods. In the
long run due to law of diminishing returns the long run average cost curve LAC also slopes
like boat shape.
Economies of Scale
Economies of scale exist when long run average costs decline as output is increased.
Diseconomies of scale exist when long run average cost rises as output is increased. It is
graphically presented in the following graph.
The economies of scale occur because of
i. Technical economies: the change in production process due to technology adoption.
ii. Managerial economies
iii. Purchasing economies,
iv. Marketing economies and
v. Financial economies.

Economies of scale means a fall in average cost of production due to growth in the size of the
industry within which a firm operates.

Diseconomies of Scale:
Arises due to managerial problems such as, if the size of the business becomes too large, then
it becomes difficult for management to control the organizational activities therefore
diseconomies of scale arise.
Factors Causing Economies of Scale:
There are various factors influencing the economies of scale of an organization. They are
generally classified in to two categories as Internal factors and External factors.

Internal Factors:
1. Labour economies: if the labour force of a firm is specialized in a specific skill then
the organization can achieve economies of scale due to higher labour productivity.
2. Technical economies: with the use of advanced technology they can produce large
quantities with quality which reduces their cost of production.
3. Managerial economies: the managerial skills of an organization will be advantageous
to achieve economies of scale in various business activities.
4. Marketing economies: use of various marketing strategies will help in achieving
economies of scale.
5. Vertical integration: if there is vertical integration then there will be efficient use of
raw material due to internal factor flow.
6. Financial economies: the firm’s financial soundness and past record of financial
transactions will help them to get financial facilities easily.
7. Economies of risk spreading: having variety of products and diversification will help
them to spread their risk and reduce losses.
8. Economies of scale in purchase: when the organization purchases raw material in bulk
reduces the transportation cost and maintains uniform quality.

External Factors:
1. Better repair and maintenance facilities: When the machinery and equipments are
repaired and maintained, then the production process never gets affected.
2. Research and Development: research facilities will provide opportunities to introduce
new products and process methods.
3. Training and Development: continuous training and development of skills in the
managerial, production level will achieve economies of scale.
4. Economies of location: the plant location plays a major role in cutting down the cost
of materials, transport and other expenses.
5. Economies of Information Technology: advanced Information technology provides
timely accurate information for better decision making and for better services.
6. Economies of by-products: Organizations can increase the economies of scale by
minimizing waste and can be environmental responsible by using the by- products of
the organization.
Factors Causing Diseconomies of Scale:
1. Labour union: continuous labour problem and dissatisfaction can lead to diseconomies
of scale.
2. Poor team work: Poor performance of the team leads to diseconomies of scale.
3. Lack of co-ordination: lack of coordination among the work force has a major role to
play in causing diseconomies of scale.
4. Difficulty in fund raising: difficulties in fund raising reduce the scale of operation.
5. Difficulty in decision making: the managerial inability, delay in decision making is
also a factor that determines the economies of scale.
6. Scarcity of Resources: raw material availability determines the purchase and price.
Therefore there is a possibility of facing diseconomies in firms.
7. Increased risk: growing risk factors can cause diseconomies of scale in an
organization. It is essential to reduce the same.

Constant Returns to Scale:

In the long run if the returns to scale are constant then the average cost of production will be
the same. For example : Times of India magazine, started several years ago and it was sold in
the market for 25 paise but now it is still sold at a nominal cost of Rs.15. The price increased
because raw material cost and printing and labour costs have also increased but in the long run
the price of the commodity has not increased much. The constant returns to scale curve is
graphically presented below which indicates that the LRAC is not a boat shaped curve.

From the above graph it is clear that in the long run it is possible to derive a LRAC as a straight
line with constant returns to scale.
Economies of Scope

An economy of scope means that the production of one good reduces the cost of producing
another related good. Economies of scope occur when producing a wider variety of goods or
services in tandem is more cost effective for a firm than producing less of a variety, or
producing each good independently. In such a case, the long-run average and marginal cost of
a company, organization, or economy decreases due to the production of complementary
goods and services.

Thus, producing variety can help in getting cost advantage. In retail business it is commonly
used. Product diversification within the same scale of plant will help them to achieve success.

Lessons for Managers:

 To achieve reasonable return the firm should go for larger plants or expand their plant
for optimum utilization of available resources.
 Build market share to achieve the scale which in turn reduces the cost of production.
 All business activities of the organization lead to economies of scale directly or
indirectly.

Assignment Questions

 What is Marginal cost? State its significance in cost analysis.

 Define opportunity cost and give an example.
 Explain the concepts: AFC, AVC, ATC and MC.
 Explain briefly the various types of costs with suitable examples.
 Discuss the short run cost output relationship with the graph.
 Derive long run total cost curve.
 What is the relationship between AC and MC?
 Give reasons for the U shape of long run AC curve.
 Distinguish between economies of scale and diseconomies of scale with a graph.
 List out the factors that cause economies and diseconomies of scale.
 Break Even Analysis

Break even analysis helps to identify the level of output and sales volume at which the firm
‘breaks even’. It means the revenues are sufficient to cover all costs of production. Various
managerial decisions of firms are taken by the managers based on the break- even point. It is a
study of cost, revenues and sales of a firm and finding out the volume of sales where the firm’s
costs and revenues will be equal. There is no profit and no loss. The total revenue is equal to
the total cost of production. The amount of money which the firm receives by the sale of its
output in the market is known as revenue.

The above graph shows the break- even point of an organization. The total revenue curve (TR)
and total cost curve (TC) is given. When they produce 3000 units the total cost and total revenue
are equal that is $3000(in ‘000s) which is at the intersecting point of the curves. Break even
point always denotes the quantity produced or sold to equalize the revenue and cost.

When the firm produces less than 50 units the revenue earned is less than the cost of production
(TR<TC) therefore in the initial period the firm incurs loss which is shown in the graph.
Through selling more than 50 units the revenue increases more than the cost of production
therefore the difference increases and provides profit to the organization (TR>TC).

Breakeven point can be calculated with the help of the following formula.

TFC
Break even quantity = Selling Price − AVC

TFC + targeted profit

To decide a quantity to achieve a targeted profit = Selling price – AVC
 Sales − BEP
Safety margin = ∗ 100
Sales

Managerial Uses of Break-Even Analysis:

1. Product planning: it helps the firm in planning its new product development. Decisions
regarding removal or addition of new products in their product line.
2. Activity planning: the firm decides the expansion of production capacity.
3. Profit planning: this helps the firm to plan about their profit well in advance and at the
same time it helps to identify the quantity to be sold to achieve the targeted profit.
4. Target capacity: the targeted sales quantity helps to decide the purchase, inventory and
management.
5. Price and cost decision: Decision regarding how much the price of the commodity
should be reduced or increased to cover their cost of production.
6. Safety margin: it helps to understand the extent to which the firm can withstand their
fall in sales.
7. Price decision: the selling price can be fixed based on its expected revenue or profit.
8. Promotional decision: the firm can decide the kind of promotion required and how
much amount could be spent.
9. Distribution decision: Break even analysis helps to improve the distribution system and
for business expansion.
10. Dividend decision: firm can decide the dividend to be fixed for their shareholders.
11. Make or buy decision: break even analysis helps to decide on whether to make or buy
the product. It means outsourcing or in house production.

We can conclude that the break – even analysis is a useful tool for decision making at various
levels of a business firm in the short and long run. Therefore it is an essential tool to be used
by the Managers.
 Market Structure

Objectives of this section

After reading this lesson the reader will understand that the economist meaning of market is
something different from the common understanding of the market. In economics, the market
is the study about the demand for and supply of a particular commodity and its consequent
fixing of prices for instance the market may be a bullion market, stock market, or even food
grains market. The market is broadly divided into two categories like perfect market and
imperfect market. The perfect market is further divided into pure market (which is a myth) and
perfect market. The imperfect market is divided into monopoly market, monopolistic market,
oligopoly market and duopoly market. Based on the nature of competition and on the number
of buyers and sellers operating in the market, the price for the commodity may be settled at the
point where the demand forces and supply forces agree upon.

Market is a place where people can buy and sell commodities. It may be vegetables market,
fish market, financial markets or foreign exchange markets. In economic language market is a
study about the demand for and supply of a particular item and its consequent fixing of prices,
example bullion on market and foreign exchange market or a commodity market like food
grains market etc.

Market is classified into various types based on the characteristic features. They are classified
on the basis as follows:

1. Area: family market, local, regional, national and international

2. Time: very short period, short period, long period, very long period
3. Commodity: produce exchange, bullion market, capital market, stock market
4. Nature of Transaction: spot market, forward market and futures market
5. Volume of business: whole sale market, retail market
6. Importance: primary market, secondary market, territory market
7. Regulation: regulated market, unregulated market
8. Economics: Perfect market and imperfect market

Market In Economic Sense Implies:

1. Presence of buyers and sellers of the commodity
2. Establishment of contact between the buyer and seller
3. Similarity of the product
4. Exchange of commodity for a price
Classification of Market Structure Based on the Nature of Competitor:

1. Perfect market
2. Imperfect market

The imperfect market in turn can be classified as

a. Monopoly market
b. Duopoly market
c. Oligopoly market
d. Monopolistic market/ competition

The number and relative size of firms producing a good vary across industries. Market
structures range from perfect competition to monopoly. Most real-world firms are along the
continuum of imperfect competition. Market structure affects market outcomes, i.e., the price
and quantity of goods supplied.

There are four types of imperfect competition existing in the present market environment. It
is classified based on
a. The number of buyers,
b. The number of sellers and
c. Competitors in the market.

This section explains the price determination and profit maximization methods followed in
these markets. Let us understand the meaning of each competition.

a. Monopoly market: a market with only one seller and a large number of buyers.
b. Monopolistic competition: a market in which firms can enter freely, each producing
its own brand or version of a differentiated product.
c. Oligopoly market: market in which only a few firms compete with one another and
entry by new firms is impeded/restricted.
d. Duopoly: market in which two firms compete with each other.
e. Monopsony: is a market with only one buyer, and a few/large sellers.
Perfect Market

Perfect competition is a market structure characterized by a complete absence of rivalry

among the individual firms. A perfectly competitive firm is one whose output is so small in
relation to market volume that its output decisions have no perceptible impact on price. No
single producer or consumer can have control over the price or quantity of the product.

Characteristic features of perfect market:

1. Large number of buyers and sellers
2. Homogeneous product
3. Perfect knowledge about the market
4. Ruling prices
5. Absence of transport cost
6. Perfect mobility of factors
7. Profit maximization
8. Freedom in decision making

In perfect market, the price of the commodity is determined based on the demand for and
supply of the product in the market. The equilibrium price and output determination is as
shown in the graph.

The demand curve (D) and the supply curve (S) intersect each other at a particular point which
is called the equilibrium point. At the equilibrium point ‘E’ the quantity demanded and the
quantity supplied are equal (that is OQ quantity of commodity is demanded and the same level
is supplied etc). Based on the equilibrium the price of the commodity is fixed as OP. This is
the fundamental pricing strategy followed in the perfect market.
Pricing under Perfect Competition

Demand and supply curves can be used to analyze the equilibrium market price and the
optimum output.
1. If quantity demanded is equal to quantity supplied at a particular price then the market
is in equilibrium
2. If quantity demanded is more than the quantity supplied then market price may not be
stable. i.e., it will rise.
3. If quantity demanded is less than quantity supplied then market price is fixed not in a
equilibrium position.

When the price at which quantity demanded is equal to quantity supplied, buyers as well as
sellers are satisfied. If price is greater than the equilibrium price, some sellers would not be
able to sell the commodity. So they would try to dispose the unsold stock at a lower price. Thus
the price will go on declining till they get equalized (Qd = Qs). The various possible changes in
Demand and supply are expressed in the following graphs to understand the price fluctuations
in the market. When the firm is producing its goods at the maximum level, the unit cost of
production or managerial cost of the last item produced is the lowest. If the firm produces more
than this, the managerial cost will rise. If that firm produces less than that level of output, it is
not taking advantage of the economics of the large scale operation. When the firm produces
largest level of output and sell at the managerial cost, it is said to be in equilibrium position.
There is no temptation to produce more or produce less level of output. Likewise, when all the
firms put together or the industry produces the largest amount of output at the lowest marginal
cost, the industry is also said to be in the equilibrium

Let us look into various scenario’s which would lead to changing responses in
prices/demand/supply:

Let us assume that the demand equal to supply Q d = Qs and the equilibrium point ‘E’ determines
the price as OP. In the short run the demand for the commodity increases but the supply remains
the same. Then the demand curve shifts to the right and the new demand curve D 1 is derived.
The demand has increased from OM quantity to OM1 . The new demand curve intersects the
supply curve at the new equilibrium point ‘E1 ’ and the price of the commodity is increased
from OP to OP1 . Therefore it is clear that when demand increases without any change in
supply this leads to price rise in the market.
SCENARIO-2

Let us assume now that, the demand is equal to supply Q d = Qs and the equilibrium point ‘E’
determines the price as OP. In the short run the supply for the commodity increases but the
demand remains the same

Earlier the equilibrium point was ‘E’ and the price of the commodity was OP. Due to change
in supply the equilibrium point has changed into ‘E1 ’ which in turn reduced the price form OP
to OP0 . Therefore if the firm supplies more than the demand this leads to price fall in the
market.

SCENARIO-3

If the firm changes its supply due to increase in demand then the possible fluctuations in the
price is explained below. Let us assume that the firm increased its supply 10%, the demand has
also increased but not in the same proportion – it increased only 2% ( ΔQd < ΔQs). From the
graph below we can understand that the equilibrium point ‘E’ has changed into ‘E 1’ which
reduced the price of the commodity from OP to OP 1.
SCENARIO-4

On the other hand when there is 10% increase in the demand and the supply has increased only
to 2%, the new demand curve D1 and the new supply curve S1 intersect each other at the new
equilibrium point ‘E1’. The price of the commodity is OP at ‘E’ and it increases from P to P1
and becomes OP1 .i.e. When the demand increases more than the supply ( ΔQd > ΔQs ) the
price of the commodity will increase.

SCENARIO-5

The following graph explains clearly that both the demand for the commodity and the supply
increases in the same proportion (i.e. ΔQD = ΔQS).The shift in supply curve and the shift in
demand curve are in the same level and the new equilibrium point ‘E 1’ determines the same
price OP level. There is no change in the price when the demand and supply are equal.
 Profit Maximization under Perfect Competition

The primary objective of any business is to maximize the profit. Profit can be increased either
by increasing total revenue (TR) or by reducing the total cost (TC). The profit is nothing but
the difference between the revenue and the cost.
The total profit = TR – TC

Let us assume that whatever produced is sold in the market.

TR = Quantity sold x price

To increase the revenue, it is better to either increase the quantity sold or increase the price.
Therefore while increasing the revenue or minimizing the total cost of production over a period
of time with attendant economies of scale will widen the difference to gain more profit.

In perfect market, the firm’s Marginal cost, Average cost, Average revenue, Marginal
revenue are equal to the price of the commodity. The cost is measured as average cost and
marginal cost .When the firm is in equilibrium, producing the maximum output i.e. cost of the
last item produced is known as marginal cost. The total cost divided by the number of goods
produced will give the average cost. When the firm is operating in perfect market MC = AC.

In the same way the revenue available to the firm through selling goods is called as total
revenue. The last item sold is the marginal revenue. The total revenue divided by the number
of items sold is the average revenue and when the firm is working in the perfect market the MR
shall be equal to AR. Therefore the MC = MR = AR = AC = P in the short run. The size of the
plant is fixed only with the variable factors and the price is fixed by the demand and supply.
The demand for the commodity is expressed in the demand curve (D) and the supply (S) curve
is known as S curve. The point of intersection of the D curve and S Curve is the equilibrium
point (E) where the price is determined as OP. (Rs.10) The average revenue per unit is also
Rs.10 expressed in graph (b) along with the marginal cost (MC) and average cost (AC) curves.
The MC and AC intersect at point ‘K’ which is equal to the price OP / AR / MR. Therefore we
can say that P=AR=AC=MR=MC at this level. At this equilibrium point buyers and sellers are
satisfied with their price. The price of the commodity includes the normal profit through the
average cost. The average cost consists of implicit and explicit costs. That means the organizers
knowledge, time, idea and effort is also considered in the cost of production. Let us assume
that in the short run the demand for the commodity increases, then the change in price and
profit are explained in the graph below

From the above graph we can understand that in the short run demand curve DD and the short
period supply curve SPSC intersects at ‘E’ and the price of the commodity is determined as
OP. The right side graph indicates the cost and revenue curves. The average revenue (AR) and
marginal revenue (MR) are equal to the price of the commodity OP. The short period marginal
cost (SMC) and short period average cost (SAC) are also depicted in the graph. The minimum
average cost is selected based on the equilibrium point Q which produces optimum quantity of
OM. The marginal cost curve and average cost curve intersects at the point Q that means QM
amount (rupees) is spent as marginal as well as average cost. The SAC is tangential to AR/MR
at this point therefore we can conclude that the price of the commodity is equal to the average
cost, average revenue, marginal cost and marginal revenue ( P = AR = MR = AC = MC )

If the demand increases in the market then the new demand curve D1 D1 intersects the SPSC at
the new equilibrium point ‘E1’ and the price increases from OP to OP1. Therefore the average
revenue also increases from AR to AR1 . At this situation P1 = AR1 = MR1 but the SMC curve
intersects at Q1 ie., new equilibrium point and the OM quantity has increased from OM to OM1
in the ‘X’ axis. The average cost has increased as M1 R.

The profit = Total Revenue (TR) – Total Cost (TC)

Where,
TR = quantity sold x price
TC = average cost x quantity produced
 TR = OM1 x OP1 = OM1 Q1 P1
TC = M1 R x OM1 = OM1 RS
Profit = OM1 Q1 P1 - OM1 RS = P1 Q1RS

In the above graph, the shaded portion of P1 Q1 RS is the total profit earned by the firm in the
short run but in the long run the organization will increase the production and will supply more
of the commodity. Ultimately both the demand and the supply gets equalized and the short run
abnormal profit becomes normal. Therefore we can conclude that even in the perfect market it
is possible to earn profit in the short period. It indicates clearly that in the short run, in any
perfect market, the increase in demand will increase the profit to the businessmen. The normal
profit will be there until it gets equalized with the demand i.e. new D 1 D1 with the increased
supply of S1 S1.

This economic profit attracts new firms into the industry and the entry of these new firms
increases the industry supply. This increased supply pushes down the price. As price falls, all
firms in the industry adjust their output levels in order to remain in profit maximizing
equilibrium. New firms continue to enter the industry and price continues to fall, and existing
firms continue to adjust their outputs until all economic profits are eliminated. There is no
longer an incentive for the new firms to enter and the owners of all firms in the industry will
earn only what they could make through their best alternatives.

Economic losses motivate some to exit (shut down) from the industry. The exit of these firms
decreases industry supply. The reduction in supply pushes up market price and all the firms
shall adjust their output in order to maximize their profit.

Shut Down Point:

If the market price for the product is below minimum average variable cost, the firm will cease
to produce, if this appears to be not just a temporary phenomenon. When the price is less than
average variable cost it will neither cover fixed cost nor a part of the variable costs. Then the
firm can minimize losses up to total fixed costs only by not producing. It is therefore regarded
as the shut down point.

In the short run, a firm can be in equilibrium at various levels depending upon different cost
and market price conditions. But these are temporary equilibrium points. Thus at this unstable
equilibrium point the firm gets excess profits or normal profit and sometimes incur loss also.

Consequences of Pure Competition:

Perfect competition ensures maximum welfare of the people as a whole. Each firm tends to
attain the most efficient size to expand output and to reduce the average cost of production.
SUMMARY:

1. Important to enter a growing market as far ahead of the competitors as possible. When
there is fall in supply and increase in prices, take advantage before the new entrants.
2. Due to profit new entrants are willing to offer low price, therefore a firm should be
among the lowest cost producer to ensure its survival.
3. Differentiation offers temporary relief for competition pressure.
4. Due to globalization firms enjoy advantage of cheap labour and disadvantage of
technology up gradation.

Assignment Questions:

1. Define the market and market structure.

2. Explain various types of markets with suitable examples.
3. Distinguish between perfect and imperfect market.
4. List out the major characteristic features of a perfect market.
5. Show graphically how an individual firm attains equilibrium under perfect
competition.
6. Explain how the price and output is determined in perfect competition.
7. Is it possible to earn profit in the perfect competition? Justify.
8. What do you mean by shut down point? Explain why a firm suffering from losses.
9. How will each of the following changes in demand and supply affect equilibrium price
and equilibrium price and equilibrium quantity in a competitive market; that is, do price
and quantity rise, fall or remain unchanged or are the answers indeterminate because
they depend on the magnitude of the shift. Use supply and demand diagrams to verify
your answers.
a. Supply increases and Demand is constant
b. Demand increases and Supply is constant
c. Supply increases and Demand is constant
d. Demand increases and Supply increases
e. Demand increases and Supply is constant
f. Supply increases and Demand increases
g. Demand increase and Supply decreases
h. Demand decreases and Supply decreases
 Monopoly Market
Mono means single, poly means seller and hence monopoly is a market structure where only
one sells the goods and many buyers buy the same. Monopoly lies at the opposite extreme from
perfect competition on the market structure continuum. A firm produces the entire supply of a
particular good or service that has no close substitute.

Characteristic Features of the monopoly market are as follows:

1. A single seller in the market
2. There are no close substitutes
3. There is a restriction for the entry and exit for the firms in the market
4. Imperfect dissemination of information

This does not mean that the monopoly firms are large in size. For example a doctor who has a
clinic in a village has no other competitor in the village but in the town there may be more
doctors. Therefore the barrier to the entry is due to economies of scale, economies of scope,
cost complementarities, patents and other legal barriers.

Profit maximization under Monopoly Competition

For monopolist there are two options for maximizing the profit i.e. maximize the output and
the limit the price or limit the production of the goods and services and fix a higher price
(market driven price). In monopoly competition, the demand curve of the firm is identical to
the market demand curve of that product. In monopoly the MR is always less than the price of
the commodity.
VARIOUS SCENARIO’S UNDER MONOPOLY

SCENARIO-1

Profit Maximization Rule: Produce at that rate of output where MR = MC. From the graph
we can understand the profit maximization under monopoly. ‘X’ axis indicates the output and
‘Y’ the price/cost and revenue. The marginal revenue curve is denoted as MR. The average
revenue curve is AR which is also the demand curve. MC is the marginal cost curve, It looks
like a tick mark and average cost curve AC is boat shape.

From the above graph it is seen that the demand curve D and average revenue curve AR are
depicted as a single curve. The marginal revenue curve MR also slopes the same but the MR
curve is below the AR curve. The short run marginal cost curve SMC looks like a tick mark
and the boat shaped average cost curve SAC is also seen in the graph. The profit maximization
criteria of MR=MC is followed in the monopoly market and the equilibrium point ‘E’ is derived
from the intersection of MR and SMC curves in the short run. i.e. MC curve or SMC here
intersects the MR curve from below. Based on the equilibrium point, the output is the optimum
level of production i.e., at OM quantity. The price of the commodity is determined as OP. On
an average the firm receives MQ amount as revenue. The total revenue of selling OM quantity
gives OMQP amount of total revenue (OM quantity x OP price). The firm has spent MR as an
average cost to produce OM quantity and the total cost of production is OMRS (OM quantity
x MR cost per unit)

Profit = TR – TC
= OMQP - OMRS
= PQRS (the shaded portion in the graph)

In the short run the monopoly firm will earn profit continuously even with various returns
SCENARIO-2

From the above graph it can be understood that the cost of production (MC, AC) is increasing
along with the output but even with the increasing scale the firm earns PQRS as profit which
is the shaded portion in the graph

SCENARIO-3

The graph given below explains clearly that the firms cost curves of Marginal cost (MC) and
Average cost (AC) are declining with this slope. The organization earns PQRS profit but the
profit is comparatively lesser than the previous situation.
SCENARIO-4

The Graph below observed provides another situation. It explains that the organizations’
marginal cost and average cost curves are horizontal and parallel to the X axis. Even with the
constant scale, the firms earns profit as PQRS.

Therefore we can conclude by saying that under monopoly market structure the firm will earn
profit even under different cost conditions and profit maximization takes place. They follow
the price determination condition as MC=MR and never incur loss.

Difference between Perfect and Monopoly Market:

1. Perfect market is unrealistic in practical life. But slowly certain commodities are
moving towards it. Monopoly market exists in real time.
2. Under perfect market only homogenous products are sold but on the other hand
monopoly market deals with different products.
3. Under perfect competition, price is determined by demand and supply of the market.
But in monopoly the seller determines the price of the good.
4. Monopolist can control the market price but in perfect competition the sellers have no
control over the market price.
5. There is no advertisement cost in perfect market. In other markets it is essential and it
is included in the cost of production and is reflected in the price.
6. Monopolist sell their products higher than the perfect competitors except when there is
government regulation or adverse public opinion.
Summary of the section

1. The seller has to fix the price based on the marginal revenue and marginal cost instead
of focusing on their profit.
2. It is essential to understand the substitutes and their market competition.
3. Under monopoly for certain products buyer has more market power.
4. Government policies can also change at any time.
5. Monopolist in domestic market may face tough competition from imported products.

Questions from the section

1. Mention the characteristic features of Monopoly market.
2. Distinguish between monopoly and perfect market.
3. Describe graphically the pricing and profit determination under monopoly market.
4. A monopolist aims at maximizing price rather than profits, do you agree with this
statement?
 Monopolistic Competition
The perfect competition and monopoly are the two extreme forms. To bridge the gap the
concept of monopolistic competition was developed by Edward Chamberlin. It has both the
elements like many small sellers and many small buyers. There is product differentiation.
Therefore close substitutes are available and at the same time it is easy to enter and easy to exit
from the market. Therefore it is possible to incur loss in this market. The profit maximization
for each firm, for each product depends upon the differentiation and advertising expenditure.
As every firm is acting as a monopoly the same logic of monopoly is followed. Each and every
firm will have their own set of cost and revenue curves and the price determination is based on
the rule of MR=MC and they incur varied profits according to their market structure. But in
the monopolistic competition number of monopoly competitors will be there in different levels.
They monopolize in a small geographical area or a segment or a model.

The demand curve of a monopolistically competitive firm would be more elastic than that of a
purely monopolistic firm. The cost function of a firm would be that there will not be any
significant difference across different types of structures in the product market. Given the
function, and the corresponding AR and MR curves, and the cost function, and the
corresponding SAC and SMC curves, the price and output determination of a profit –
maximizing monopolistically competitive firm could be as follows.

SCENARIO-1: PROFITS UNDER MONOPOLISTIC COMPETITION

From the above graph we can understand that under monopolistic competition firms incur profit
which is PP1 BB1 the pricing and profit determination are similar to the monopoly market. MR
is marginal revenue curve AR is average revenue and demand curve. At point ‘E’ both MR and
marginal cost curve MC intersects. Based on this equilibrium the product is sold at OP price in
the market. The Average cost curve indicates that the firm has spent QB 1 amount per unit but
it receives QB through its sale. Therefore the difference between the two BB 1 is the profit
margin which should be multiplied with the total quantity sold OQ which gives PP1 BB1
amount of profit.
SCENARIO-2: LOSSES UNDER MONOPOLISTIC COMPETITION

Observe the graph given below. The marginal revenue curve MR and the average revenue curve
AR that is the demand curve is also represented in the graph. The condition for product decision
is MR=MC. The MR and MC intersect at point ‘E’ based on the equilibrium. It is decided to
produce OM quantity and the price of the commodity is fixed at OP in the market. Therefore
the total revenue by selling OM quantity in the market for OP price is equal to OM x OP =
OPRM. But to produce OM quantity the firm has spent MQ as average cost. Therefore the total
cost of production = OM x MQ = OMQS.

Therefore the profit = TR – TC

= ORPM – OMQS
= - PQRS. (Negative)

That means the cost of production per unit is more than the average revenue earned per unit.
Average revenue = MR and the Average cost = MQ which is more than the revenue. Therefore
the difference QR is the loss per unit multiplied with OM quantity. PQRS is the total loss to
the organization.

Summary of the section

1. A firm must concentrate on differentiation and building brand value.

2. The managers must never be complacent with their profit because of new entrants.
3. The market is competing with differentiated products at lowest price.
4. Need not offer at low price always. Through supplying best products he can retain his
price and profit.
 Oligopoly Market

This is a market consisting of a few firms relatively large firms, each with a substantial share
of the market and all recognizing their interdependence. It is a common form of market
structure. The products may be identical or differentiated. The price determination and profit
maximization is based on how the competitors will respond to price or output changes.

There Are Different Types of Oligopoly:

1. Pure and perfect oligopoly: if the firm produced homogeneous products it is perfect
oligopoly. If there is product differentiation then it is called as imperfect or
differentiated oligopoly.
2. Open and closed oligopoly: entry is not possible. When it is closed to the new entrants
then it is closed oligopoly. On the other hand entry is accepted in open oligopoly.
3. Partial and full oligopoly: under partial oligopoly industry is dominated by one large
firm who is a price leader and others follow. In full oligopoly no price leadership.
4. Syndicated and organized oligopoly: where the firms sell their products through a
centralized syndicate. On the other hand firms organize themselves into a central
association for fixing prices, output and quotas.

Characteristic Features of an Oligopoly Market:

1. Few sellers
2. Lack of uniformity in the product
3. Advertisement cost is included
4. No monopoly competition
5. Firms struggle constantly
6. There is interdependency
7. Experience of Group behavior
8. Price rigidity
9. Price leadership
10. Barriers to entry

Price rigidity: the price will be kept unchanged due to fear of retaliation and prices tend to be
strict and inflexible. No firm would indulge in price cutting as it would eventually lead to a
price war with no benefit to anyone.

Reasons for rigidity are: firms know ultimate outcome of price cutting; large firms incur more
expenditure than others; keeping the price low to reduce the new entrants; increased price rise
leads to reduction in number of customers.

The oligopoly prices are indeterminate. The demand function is then an important ingredient
in the price determination mechanism. Several theories of oligopoly prices have been
developed and each one of them is based on a particular assumption about the reactions of the
rival firms and the firms’ actions. The popular models and appropriate classifications are
discussed below
Oligopoly Models:
1. Cournot oligopoly: There are few firms producing differentiated or homogeneous
products and each firm believes that competitors will hold their output constant if it
changes its output.
2. Stackelberg oligopoly: Few firms and differentiated or homogeneous product. The
leader chooses an output and others follow.
3. Bertrand oligopoly: Few firms produce identical product. Firms compete in price and
react optimally to competitor’s prices.
4. Sweezy oligopoly: An industry in which there are few firms serving many consumers.
Firms produce differentiated products and each firm believes competitors will respond
to a price reduction but they will not follow a price increase.

Kinked Demand Curve in oligopoly

When a firm increases its price, the rival firms do not follow it by increasing their prices in turn
this increases its market share. When a firm reduces its price rival firms immediately follows
it by decreasing their prices. If they do not do so, customers go to the firm which is offering at
lower price. This is the fundamental behaviour of the firms in an oligopoly market. Let us
understand the unique characteristic feature of kinked demand curve.

The demand curve in oligopoly has two parts.

(i) Relatively elastic demand curve
(ii) Relatively inelastic demand curve as shown in the graph below.

In oligopoly market firms are reluctant to change prices even if the cost of production (or)
demand changes. Price rigidity is the basis for the kinked demand curve. Each firm faces
demand curve kinked at the currently prevailing price. At higher prices demand is highly
elastic, whereas at lower prices it is inelastic.