UNIT - II

PRODUCTION FUNCTION

Introduction: The production function expresses a functional relationship between

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

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

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

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

Y= a+b(x)

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

Importance:

1. When inputs are specified in physical units, production function helps to estimate
the level of production.
2. It becomes is equates when different combinations of inputs yield the same level of
output.
3. It indicates the manner in which the firm can substitute on input for another
without altering the total output.
4. When price is taken into consideration, the production function helps to select the
least combination of inputs for the desired output.
5. It considers two types’ input-output relationships namely ‘law of variable
proportions’ and ‘law of returns to scale’. Law of variable propositions explains the
pattern of output in the short-run as the units of variable inputs are increased to
increase the output. On the other hand law of returns to scale explains the pattern
of output in the long run as all the units of inputs are increased.
6. The production function explains the maximum quantity of output, which can be
produced, from any chosen quantities of various inputs or the minimum quantities
of various inputs that are required to produce a given quantity of output.

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

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

Assumptions:

Production function has the following assumptions.

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

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

Cobb-Douglas production function:

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

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

Assumptions:

It has the following assumptions

1. The function assumes that output is the function of two factors viz. capital and
labour.
2. It is a linear homogenous production function of the first degree
3. The function assumes that the logarithm of the total output of the economy is a
linear function of the logarithms of the labour force and capital stock.
4. There are constant returns to scale
5. All inputs are homogenous
6. There is perfect competition
7. There is no change in technology

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

 ISOQUANTS:

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

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

For a given output level firm’s production become,

Q= f (L, K)

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

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

Assumptions:

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

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

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

A 1 10 50
B 2 7 50
C 3 4 50
D 4 4 50
E 5 1 50

Combination ‘A’ represent 1 unit of labour and 10 units of capital and produces ‘50’
quintals of a product all other combinations in the table are assumed to yield the same

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

given output of a product say ‘50’ quintals by employing any one of the alternative
combinations of the two factors labour and capital. If we plot all these combinations on a
paper and join them, we will get continues and smooth curve called Iso-product curve as
shown below.

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

Producer’s Equilibrium:

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

The optimum position of the producer can be found with the help of iso-product curve. The
Iso-product curve or equal product curve or production indifference curve shows different
combinations of two factors of production, which yield the same output. This is illustrated
as follows.

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

 L K Q L&LP (3Rs.) KXKP(4Rs.) Total cost
Units Units Output Cost of cost of
labour capital
10 45 100 30 180 210
20 28 100 60 112 172
30 16 100 90 64 154
40 12 100 120 48 168
50 8 100 150 32 182

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

LAW OF PRODUCTION:

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

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

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

i) Law of variable proportions

ii) Law of returns to scale

I. Law of variable proportions:

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

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

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

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

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

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

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

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

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

Three stages of law:

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

Fixed factor Variable factor Total product Average Marginal

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

Above table reveals that both average product and marginal product increase in the
beginning and then decline of the two marginal products drops of faster than average
product. Total product is maximum when the farmer employs 6 th worker, nothing is
produced by the 7th worker and its marginal productivity is zero, whereas marginal

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

product of 8th worker is ‘-10’, by just creating credits 8th worker not only fails to make a
positive contribution but leads to a fall in the total output.

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

From the above graph the law of variable proportions operates in three stages. In the first
stage, total product increases at an increasing rate. The marginal product in this stage
increases at an increasing rate resulting in a greater increase in total product. The
average product also increases. This stage continues up to the point where average
product is equal to marginal product. The law of increasing returns is in operation at this
stage. The law of diminishing returns starts operating from the second stage awards. At
the second stage total product increases only at a diminishing rate. The average product
also declines. The second stage comes to an end where total product becomes maximum
and marginal product becomes zero. The marginal product becomes negative in the third
stage. So the total product also declines. The average product continues to decline.

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

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

II. Law of Returns of Scale:

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

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

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

When a firm expands, its scale increases all its inputs proportionally, then technically
there are three possibilities. (i) The total output may increase proportionately (ii) The total
output may increase more than proportionately and (iii) The total output may increase
less than proportionately. If increase in the total output is proportional to the increase in
input, it means constant returns to scale. If increase in the output is greater than the
proportional increase in the inputs, it means increasing return to scale. If increase in the
output is less than proportional increase in the inputs, it means diminishing returns to
scale.

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

ECONOMIES OF SCALE

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

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

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

Causes of internal economies:

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

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

2. Specialization.

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

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

Internal Economies:

Internal economies may be of the following types.

A). Technical Economies.

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

firm. This increases the productive capacity of the firm and reduces the unit cost of
production.

B). Managerial Economies:

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

C). Marketing Economies:

The large firm reaps marketing or commercial economies in buying its requirements and in
selling its final products. The large firm generally has a separate marketing department. It
can buy and sell on behalf of the firm, when the market trends are more favorable. In the
matter of buying they could enjoy advantages like preferential treatment, transport
concessions, cheap credit, prompt delivery and fine relation with dealers. Similarly it sells
its products more effectively for a higher margin of profit.

D). Financial Economies:

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

E). Risk bearing Economies:

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

F). Economies of Research:

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

G). Economies of welfare:

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

External Economies.

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

A). Economies of Concentration:

When an industry is concentrated in a particular area, all the member firms reap some
common economies like skilled labour, improved means of transport and communications,
banking and financial services, supply of power and benefits from subsidiaries. All these
facilities tend to lower the unit cost of production of all the firms in the industry.

B). Economies of Information

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

C). Economies of Welfare:

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

D). Economies of Disintegration:

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

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

DISECONOMIES OF LARGE SCALE PRODUCTION

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

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

Internal Diseconomies:

A). Financial Diseconomies:

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

B). Managerial diseconomies:

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

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

C). Marketing Diseconomies:

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

D). Technical Diseconomies:

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

E). Diseconomies of Risk-taking:

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

External Diseconomies:

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

 INTRODUCTION TO MARKET AND PRICING STRATEGIES

Pricing

Introduction

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

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

Price

Price denotes the exchange value of a unit of good expressed in terms of money. Thus the
current price of a maruti car around Rs. 2,00,000, the price of a hair cut is Rs. 25 the
price of a economics book is Rs. 150 and so on. Nevertheless, if one gives a little, if one
gives a little thought to this subject, one would realize that there is nothing like a unique
price for any good. Instead, there are multiple prices.

Price concepts

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

It should be obvious to the readers, that the price difference on account of the above four
factors are more significant. The multiple prices is more serious in the case of items like
cars refrigerators, coal, furniture and bricks and is of little significance for items like
shaving blade, soaps, tooth pastes, creams and stationeries. Differences in various prices

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

of any good are due to differences in transport cost, storage cost accessories, interest
cost, intermediaries’ profits etc. Once can still conceive of a basic price, which would be
exclusive of all these items of cost and then rationalize other prices by adding the cost of
special items attached to the particular transaction, in what follows we shall explain the
determination of this basis price alone and thus resolve the problem of multiple prices.

Price determinants – Demand and supply

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

Equilibrium Price

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

Demand supply schedule

Price Demand Supply

50 100 200
40 120 180
30 150 150
20 200 110
10 300 50

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

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

MARKET

Market is a place where buyer and seller meet, goods and services are offered for the sale
and transfer of ownership occurs. A market may be also defined as the demand made by a
certain group of potential buyers for a good or service. The former one is a narrow
concept and later one, a broader concept. Economists describe a market as a collection of
buyers and sellers who transact over a particular product or product class (the housing
market, the clothing market, the grain market etc.). For business purpose we define a
market as people or organizations with wants (needs) to satisfy, money to spend, and the
willingness to spend it. Broadly, market represents the structure and nature of buyers and
sellers for a commodity/service and the process by which the price of the commodity or
service is established. In this sense, we are referring to the structure of competition and
the process of price determination for a commodity or service. The determination of price
for a commodity or service depends upon the structure of the market for that commodity
or service (i.e., competitive structure of the market). Hence the understanding on the
market structure and the nature of competition are a pre-requisite in price determination.

Different Market Structures

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

The determination of price is affected by the competitive structure of the market. This is
because the firm operates in a market and not in isolation. In marking decisions

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

concerning economic variables it is affected, as are all institutions in society by its
environment.

Perfect Competition

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

Characteristics of Perfect Competition

The following features characterize a perfectly competitive market:

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

Under such a market no single buyer or seller plays a significant role in price
determination. One the other hand all of them jointly determine the price. The price is

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

determined in the industry, which is composed of all the buyers and seller for the
commodity. The demand curve facing the industry is the sum of all consumers’ demands
at various prices. The industry supply curve is the sum of all sellers’ supplies at various
prices.

Pure competition and perfect competition

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

Equilibrium of a firm and industry under perfect competition

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

Marginal cost is an additional cost incurred by a firm for producing and additional unit of
output. Marginal revenue is the additional revenue accrued to a firm when it sells one
additional unit of output. A firm increases its output so long as its marginal cost becomes
equal to marginal revenue. When marginal cost is more than marginal revenue, the firm
reduces output as its costs exceed the revenue. It is only at the point where marginal cost
is equal to marginal revenue, and then the firm attains equilibrium. Secondly, the
marginal cost curve must cut the marginal revenue curve from below. If marginal cost
curve cuts the marginal revenue curve from above, the firm is having the scope to
increase its output as the marginal cost curve slopes downwards. It is only with the
upward sloping marginal cost curve, there the firm attains equilibrium. The reason is that
the marginal cost curve when rising cuts the marginal revenue curve from below.

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

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

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

Pricing under perfect competition

The price or value of a commodity under perfect competition is determined by the demand
for and the supply of that commodity.

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

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

1. Very short period or Market period

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

Very short period: It is the period in which the supply is more or less fixed because the
time available to the firm to adjust the supply of the commodity to its changed demand is

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

extremely short; say a single day or a few days. The price determined in this period is
known as Market Price.

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

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

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

Price Determination in the market period

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

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

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

Non-perishable goods: In the very short period, the supply of non-perishable goods like
cloth, pen, watches etc. cannot be increased. But if price falls, preserving some stock can
decrease their supply. If price falls too much, the whole stock will be held back from the
market and carried over to the next market period. The price below, which the seller will
refuse to sell, is called Reserve Price.

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

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

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

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

Price Determination in the short period

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

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

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

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

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

Price determination in the long period (Normal Price)

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

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

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

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

1. Increasing returns or decreasing costs.

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

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

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

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

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

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

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

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

 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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

 sell more, he has to charge a low price. He cannot sell as much as he wishes for
any price he pleases.
6. Downward Sloping Demand Curve: The demand curve (average revenue curve)
of monopolist slopes downward from left to right. It means that he can sell more
only by lowering price.

Types of Monopoly

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

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

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

 Pricing under Monopoly

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

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

The market demand curve of the monopolist (the average revenue curve) is downward
sloping. Its corresponding marginal revenue curve is also downward sloping. But the
marginal revenue curve lies below the average revenue curve as shown in the figure. The
monopolist faces the down-sloping demand curve because to sell more output, he must
reduce the price of his product. The firm’s demand curve and industry’s demand curve are
one and the same. The average cost and marginal cost curve are U shaped curve.
Marginal cost falls and rises steeply when compared to average cost.

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

Price output determination (Equilibrium Point)

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

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

The above diagram (Average revenue) = MQ or OP

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

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

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

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

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

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

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

Monopolistic competition

Perfect competition and pure monopoly are rate phenomena in the real world. Instead,
almost every market seems to exhibit characteristics of both perfect competition and
monopoly. Hence in the real world it is the state of imperfect competition lying between
these two extreme limits that work. Edward. H. Chamberlain developed the theory of
monopolistic competition, which presents a more realistic picture of the actual market
structure and the nature of competition.

Characteristics of Monopolistic Competition

The important characteristics of monopolistic competition are:

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

2. Product Differentiation: Product differentiation means that products are different

in some ways, but not altogether so. The products are not identical but the same
time they will not be entirely different from each other. IT really means that there
are various monopolist firms competing with each other. An example of
monopolistic competition and product differentiation is the toothpaste produced by
various firms. The product of each firm is different from that of its rivals in one or
more respects. Different toothpastes like Colgate, Close-up, Forehans, Cibaca, etc.,

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

 provide an example of monopolistic competition. These products are relatively close
substitute for each other but not perfect substitutes. Consumers have definite
preferences for the particular verities or brands of products offered for sale by
various sellers. Advertisement, packing, trademarks, brand names etc. help
differentiation of products even if they are physically identical.
3. Large Number of Buyers: There are large number buyers in the market. But the
buyers have their own brand preferences. So the sellers are able to exercise a
certain degree of monopoly over them. Each seller has to plan various incentive
schemes to retain the customers who patronize his products.
4. Free Entry and Exist of Firms: As in the perfect competition, in the monopolistic
competition too, there is freedom of entry and exit. That is, there is no barrier as
found under monopoly.
5. Selling costs: Since the products are close substitute much effort is needed to
retain the existing consumers and to create new demand. So each firm has to
spend a lot on selling cost, which includes cost on advertising and other sale
promotion activities.
6. Imperfect Knowledge: Imperfect knowledge about the product leads to
monopolistic competition. If the buyers are fully aware of the quality of the product
they cannot be influenced much by advertisement or other sales promotion
techniques. But in the business world we can see that thought the quality of certain
products is the same, effective advertisement and sales promotion techniques
make certain brands monopolistic. For examples, effective dealer service backed by
advertisement-helped popularization of some brands through the quality of almost
all the cement available in the market remains the same.
7. The Group: Under perfect competition the term industry refers to all collection of
firms producing a homogenous product. But under monopolistic competition the
products of various firms are not identical through they are close substitutes. Prof.
Chamberlin called the collection of firms producing close substitute products as a
group.

Price – Output Determination under Monopolistic Competition

Since under monopolistic competition different firms produce different varieties of

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

Short-run equilibrium of the firm:

In the short-run the firm is in equilibrium when marginal Revenue = Marginal Cost. In Fig
6.15 AR is the average revenue curve. NMR marginal revenue curve, SMC short-run
marginal cost curve, SAC short-run average cost curve, MR and SMC interest at point E

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

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

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

Long – Run Equilibrium of the Firm:

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

Oligopoly

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

Characteristics of Oligopoly

The main features of oligopoly are:

1. Few Firms: There are only a few firms in the industry. Each firm contributes a
sizeable share of the total market. Any decision taken by one firm influence the
actions of other firms in the industry. The various firms in the industry compete
with each other.
2. Interdependence: As there are only very few firms, any steps taken by one firm
to increase sales, by reducing price or by changing product design or by increasing
advertisement expenditure will naturally affect the sales of other firms in the
industry. An immediate retaliatory action can be anticipated from the other firms in
the industry every time when one firm takes such a decision. He has to take this
into account when he takes decisions. So the decisions of all the firms in the
industry are interdependent.

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

 3. Indeterminate Demand Curve: The interdependence of the firms makes their
demand curve indeterminate. When one firm reduces price other firms also will
make a cut in their prices. So he firm cannot be certain about the demand for its
product. Thus the demand curve facing an oligopolistic firm loses its definiteness
and thus is indeterminate as it constantly changes due to the reactions of the rival
firms.
4. Advertising and selling costs: Advertising plays a greater role in the oligopoly
market when compared to other market systems. According to Prof. William J.
Banumol “it is only oligopoly that advertising comes fully into its own”. A huge
expenditure on advertising and sales promotion techniques is needed both to retain
the present market share and to increase it. So Banumol concludes “under
oligopoly, advertising can become a life-and-death matter where a firm which fails
to keep up with the advertising budget of its competitors may find its customers
drifting off to rival products.”
5. Price Rigidity: In the oligopoly market price remain rigid. If one firm reduced price
it is with the intention of attracting the customers of other firms in the industry. In
order to retain their consumers they will also reduce price. Thus the pricing decision
of one firm results in a loss to all the firms in the industry. If one firm increases
price. Other firms will remain silent there by allowing that firm to lost its
customers. Hence, no firm will be ready to change the prevailing price. It causes
price rigidity in the oligopoly market.

OTHER MARKET STRUCTURES

Duopoly

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

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

Monopsony

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

Bilateral Monopoly

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

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

Oligopsony

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

PRICING METHODS

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

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

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

Cost Based Pricing

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

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

Competition based pricing

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

a account while deciding its price. Thus, when television was first manufactures in India,
its import cost must have been a guiding force in its price determination. Similarly, when

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

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

Demand Based Pricing

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

Two general types demand oriented pricing rules can be identified.

i. Perceived value pricing and

ii. Differential pricing

Perceived value pricing considers the buyer’s perception of the value of the product ad the
basis of pricing. Here the pricing rule is that the firm must develop procedures for
measuring the relative value of the product as perceived by consumers. Differential pricing
is nothing but price discrimination. In involves selling a product or service for different
prices in different market segments. Price differentiation depends on geographical location
of the consumers, type of consumer, purchasing quantity, season, time of the service etc.
E.g. Telephone charges, APSRTC charges.

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

Strategy based pricing (new product pricing)

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

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

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

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS