Unit IV Price and Output Decisions

1.Illustrate how price is determined under monopoly

Ans :- Pricing of a product or service refers to the fixation of a selling price to a
product or service provided by the firm.
Monopoly may be defined as that – “Market form in which a single producer
controls the whole supply of a single commodity which has no close
substitutes.”
Price & Output decisions in Monopoly
In monopoly, one organization constitutes the whole industry and the entire
supply is controlled by one firm. The demand curve of the monopolist is
Average Revenue (AR), which slopes downward.
In monopoly, AR curve and Marginal Revenue (MR) curve are different from
each other. However, both of them slope downward.

The negative AR and MR curve depicts the following facts:

• i. When MR is greater than AR, the AR rises
• ii. When MR is equal to AR, then AR remains constant
• iii. When MR is lesser than AR, then AR falls
Here, AR is the price of a product, As we know, AR falls under monopoly; thus,
MR is less than AR.
In such situation, monopolist has to make two decisions: - to determine the
price for product and to determine the equilibrium level of output.
The monopolist will select the profit-maximizing level of output where MR =
MC, and then charge the price for that quantity of output as determined by the
market demand curve. If that price is above average cost, the monopolist earns
positive profits.

Hence monopolist cannot determine both the price and output separately.
Either he can decide a price on the given demand curve and sell the amount
demanded by the buyers in the market. Alternatively he can determine the
level of output and has to set the price as per the demand conditions.

2. Illustrate how price is determined under Perfect competition in the short

run and long run

Ans :- Pricing of a product or service refers to the fixation of a selling price to a

product or service provided by the firm.

Perfect Competition which may be defined as an ideal market situation in

which buyers and sellers are so numerous and informed that each can act as a
price taker, able to buy or sell the homogenous product at any desired quantity
affecting the market price.

PRICE AND OUTPUT DETERMINATION UNDER PERFECT COMPETITION

The market price and output is determined on the basis of consumer demand
and market supply under perfect competition. In other words, the firms and
industry should be in equilibrium (a point at which the demand and supply
curve intersect each other) at a price level in which quantity demand is equal
to the quantity supplied. They make maximum profit if the firm and industry
are in equilibrium.

Price determination under perfect competition can be analysed into three

periods:
i. Very Short Period/ Market Period
• Refers to a time period in which quantity supplied of a product cannot
be increased with increase in its demand
• In very short period of time, the supply of a product is fixed.
• The time span is so short that no firm can increase its output. The total
stock of the commodity in the market is limited. The market period may
be an hour, a day or a few days or even a few weeks depending upon the
nature of the product.
• For example, a baker has 20 units of bread at a particular time. After an
hour, a customer requires 40 loaves of bread. In such a case, the
 confectioner cannot prepare 20 more units in an hour and can only
supply 20. Therefore, the supply is fixed, which 20 is in the given
example. The price determined in very short period is known as market
price.
• If the demand for increases suddenly, shifting the demand curve
upwards to d’d’. Then the equilibrium point also shifts and the price rises
to P’.

• As price is determined solely by the demand condition that is an active

agent.

ii. Short Period:

• Refers to a time period in which the level of supply of a particular
product can be increased, but only as per the production capacity of an
organization.
• However, the time is adequate enough for producers to adjust to some
extent their output to the increase in demand by overworking their fixed
capacity plants. In the short run, therefore, supply curve is elastic
• For example, an organization is producing 30 units per day and can
produce 50 in a day. This is the maximum production capacity of the
organization. However if the demand increases to 150 per day for three
days. In such a scenario, the organization cannot install new machines or
hire more labour in three days to meet the additional demand.
 • In perfect competition, profit is maximized at the following conditions:

i. MR=MC= Price , ii. MC curve must be rising at the point of equilibrium

iii. Equilibrium in Long Run:

• The Long run refers to a period in which organizations can easily change
variable and fixed factors, such as labour machinery and capital, ill the
factors are variable in the long run. In addition, in this period,
organizations can easily enter or exit the industry
• The long run AC and MC curves are relevant for the price and output
decisions. ATC is also the important determinant for equilibrium point in
the long run. In the long period of time, the following two conditions
must be satisfied for attaining equilibrium.
Price = MC, Price = AC Or, Price = MC = AC
• If price is greater than AC, organizations would make supernormal
profits, which would influence new organizations to enter the industry.
More organizations will increase the supply of the product and thus, the
price of the product will fall. This will happen till price reaches AC and all
organizations are earning only normal profits.
• On the other hand, if price is below AC, organizations would incur losses.
Organizations start exiting that leads to fail in supply. This increases the
price to AC. Thus, remaining organizations will start making the normal
profits.
3. Illustrate how price and output decisions are taken under conditions of
Oligopoly

Ans:- An oligopoly is a market form with limited competition in which a few

producers control the majority of the market share and typically produce
similar or homogenous products. Due to the small number of firms and lack of
competition, this market structure often allows for partnerships and collusion.
There is no general theory which can explain pricing and output decisions in all
kinds of oligopoly situations. Thus, it is said that price and output under
oligopoly is indeterminate.
The main reasons for indeterminate price and output under oligopoly:
i. Different Behaviour Patterns of organizations: - For example, under
oligopoly, organizations may cooperate with each other in setting the pricing
policy or they may act as competitors.
ii. Indeterminate Demand Curve:- Demand curve is unknown under oligopoly
due to different behaviour patterns of organizations. Under oligopoly, every
organization keeps an eye on the actions of rivals and makes strategies
accordingly leading to an unstable and continuously shifting demand curve
iii. Non-profit Motive:- Under oligopoly, organizations are not only indulged in
maximizing profit, but also compete with each other for non-profit motive. For
example, organizations use advertising and other tools to promote their sales.
These motives lead to indeterminate price and output under oligopoly

In case of oligopoly, there is interdependence of the firms. Hence the decisions

of a firm will affect the other firms which in turn will react in a way that affects
the initial firm. This causes uncertainty. Thus it is difficult to take decision of
the demand curve of an oligopolist.
In-spite of these difficulties, two interrelated characteristics of oligopolistic
pricing stand out:
1. Oligopolistic prices tend to be inflexible or Sticky. Price change less
frequently in Oligopoly than they happen under other competitions like
perfect, competition, monopoly and monopolistic competition.
2. When oligopolistic prices change, firms are likely to change their prices
together they act in collusion in setting and changing prices.
4. Illustrate how price and output decisions are taken under conditions of
Monopolistic competition.

Ans:- Monopolistic competition is a market structure which combines elements

of monopoly and competitive markets. Essentially a monopolistic competitive
market is one with freedom of entry and exit, but firms can differentiate their
products. Therefore, they have an inelastic demand curve and so they can set
prices.
 In monopolistic competition, profits are maximized at a point where
marginal revenue is equal to marginal cost. The price determined at this
point is known as equilibrium price and the output produced at this point
is called equilibrium output.
 If the marginal revenue of a seller is greater than marginal cost, he/she
may plan to expand his/her output. On the other hand, if marginal revenue
is lesser than marginal cost, it would be profitable for the seller to reduce
his/her output to the level where marginal revenue is equal to marginal
cost.
 Equilibrium in Short Run:- The short-run equilibrium of a monopolistic
competitive organization is the same as that of an organization under
monopoly. In the short run, an organization under monopolistic
competition attains its equilibrium where marginal revenue equals
marginal cost and sets its price according to its demand curve. This
implies that in the short run, profits are maximized when MR=MC.
 Equilibrium in Long Run:- In the long run, there is a gradual decrease in
the profits of organizations. This is because in the long run, several new
organizations enter the market due to freedom of entry and exit under
monopolistic competition.
 When these new organizations start production the supply would
increase and the prices would fall. This would automatically
increase the level of competition in the market. Consequently, AR
curve shifts from right to left and supernormal profits are replaced
with normal profits.
 In the long run, the AR curve is more elastic than that of in the
short run. This is because of an increase in the number of substitute
products in the long- run. The long-run equilibrium of
monopolistically competitive organizations is achieved when
average revenue is equal to average cost. In such a case,
organizations receive normal profits.
5.What is the difference between Perfect Competition and Monopolistic
competition

BASIS FOR PERFECT MONOPOLISTIC

COMPARISON COMPETITION COMPETITION

Meaning A market structure, where Monopolistic Competition is a

there are many sellers market structure, where there
selling similar goods to the are numerous sellers, selling
buyers, is perfect close substitute goods to the
competition. buyers.

Product Standardized/ Differentiated

Homogenous

Price Determined by demand Every firm offer products to

and supply forces, for the customers at its own price.
whole industry.

Entry and Exit No barrier Few barriers

Demand Curve Horizontal, perfectly Downward sloping, relatively

slope elastic. elastic.

Relation between AR = MR AR > MR

AR and MR

Situation Unrealistic Realistic

6. Discuss various types of market structures

Ans :-

1] Perfect Competiton :- In a perfect competition market structure, there are a

large number of buyers and sellers. All the sellers of the market are small
sellers in competition with each other. There is no one big seller with any
significant influence on the market. So all the firms in such a market are price
takers.
There are certain assumptions when discussing the perfect competition. This is
the reason a perfect competition market is pretty much a theoretical concept.
These assumptions are as follows,

 The products on the market are homogeneous, i.e. they are completely
identical
 All firms only have the motive of profit maximization
 There is free entry and exit from the market, i.e. there are no barriers
 And there is no concept of consumer preference

2] Monopolistic Competition :- This is a more realistic scenario that actually

occurs in the real world. In a monopolistic competition, there are still a large
number of buyers as well as sellers. But they all do not sell homogeneous
products. The products are similar but all sellers sell slightly differentiated
products.
Now the consumers have the preference of choosing one product over
another. The sellers can also charge a marginally higher price since they may
enjoy some market power. So the sellers become the price setters to a certain
extent. For example, the market for cereals is a monopolistic competition. The
products are all similar but slightly differentiated in terms of taste and
flavour’s. Another such example is toothpaste.
3] Oligopoly :- In an oligopoly, there are only a few firms in the market. While
there is no clarity about the number of firms, 3-5 dominant firms are
considered the norm. So in the case of an oligopoly, the buyers are far greater
than the sellers.
The firms in this case either compete with another to collaborate together,
They use their market influence to set the prices and in turn maximize their
profits. So the consumers become the price takers. In an oligopoly, there are
various barriers to entry in the market, and new firms find it difficult to
establish themselves.
4] Monopoly :- In a monopoly type of market structure, there is only one seller,
so a single firm will control the entire market. It can set any price it wishes
since it has all the market power. Consumers do not have any alternative and
must pay the price set by the seller.
Monopolies are extremely undesirable. Here the consumer looses all their
power and market forces become irrelevant. However, a pure monopoly is
very rare in reality.

-: Short Notes:-

1.Price discrimination and advantages + conditions for price discrimination:-

 Price discrimination exists when the same product is sold at different

prices to different buyers. -Koutsoyiannis
 It is a fundamental economic principle that the way to maximize profits is
to charge a price that equates to the value of the product to each
consumer, instead of selling at a uniform price to all consumers. This is
the idea behind price discrimination.
 Firms will be able to increase revenue. This will enable firms to stay in
business for example by offering different prices in peak and off peak
periods. Firm will be able to attract more consumers offering lower prices
during off peak period enabling the firm to stay in business.

There are 3 necessary conditions for a firm to be able to price discriminate:

 The firm has the market power to set its own prices. a monopoly has
the power to set its own prices, because of barriers to entry and no
competition allows the firm to have control of what it does.
 The firm must be able to separate the market and prevent resale e.g.
stopping an adult using a Child’s ticket. This is to prevent being bought
for a cheaper price and being resold for a higher/lower price.
 There must be consumers with different elastic of demands. This is
obvious, it all consumers have the same elasticity of demand then it will
be inefficient for the firm to price discriminate since all the consumers
will only pay for one uniform price.

2. Features of Perfect Competition:-

 Both buyers and sellers are price takers: A price taker is a firm or
individual who takes the market price as given. In most markets,
households are price takers – they accept the price offered in stores.
 The number of firm is large: Large means that what one firm does has no
bearing on what other firms do. Any one firm’s output is minuscule when
compared with the total market.
  There are no barriers to entry: Barriers to entry are social, political, or
economic impediments that prevent other firms from entering the market.
 The firm’s product are identical: This requirement means that each firm’s
output is indistinguishable from any competitor’s product.
 There is a complete information: Firms and consumers know all there is
to know about the market – prices, products, and available technology.
Any technological breakthrough would be instantly known to all in the
market.
 Firms are profit maximizers: The goal of all firms in a perfectly
competitive market is profit and only profit. The only compensation firm
owners receive is profit, not salaries

3. Features of Monopolistic competition:- Monopolistic competition is a

market structure which combines elements of monopoly and competitive
markets. Essentially a monopolistic competitive market is one with freedom of
entry and exit, but firms can differentiate their products. A monopolistic
competitive industry has the following features:
•Many firms.
•Freedom of entry and exit.
•Firms produce differentiated products.
•Firms have price inelastic demand; they are price makers because the good is
highly differentiated
•Firms make normal profits in the long run but could make supernormal profits
in the short term
•Firms are allocatively and productively inefficient.

4. Features of Oligopoly :-
 Few firms:- Under oligopoly, there are few large firms. The exact number
of firms is not defined. Each firm produces a significant portion of the
total output. There exists severe competition among different firms and
each firm try to manipulate both prices and volume of production to
outsmart each other.
 Interdependence: Firms under oligopoly are interdependent.
Interdependence means that actions of one firm affect the actions of
other firms.
 Non-Price Competition:- Under oligopoly, firms are in a position to
influence the prices. If a firm tries to reduce the price, the rivals will also
react by reducing their prices. However, if it tries to raise the price, other
 firms might not do so. It will lead to loss of customers for the firm, which
intended to raise the price. So, firms prefer non- price competition
instead of price competition.
 4. Barriers to Entry of Firms: :- The main reason for few firms under
oligopoly is the barriers, which prevent entry of new firms into the
industry.
 6. Group Behaviour:- Under oligopoly, there is complete
interdependence among different firms. So, price and output decisions
of a particular firm directly influence the competing firms. Instead of
independent price and output strategy, oligopoly firms prefer group
decisions that will protect the interest of all the firms
 7. Nature of the Product:- The firms under oligopoly may produce
homogeneous or differentiated product.
 8. Indeterminate Demand Curve:-Under oligopoly, the exact behaviour
pattern of a producer cannot be determined with certainty. So,
demand curve faced by an oligopolist is indeterminate (uncertain).

5. Features of Monopoly :-
1. There is only one seller in the market and the products are homogeneous.
2. The product produced by the monopolist has no close substitutes.
3. The firm is the price-maker and not price taker i.e., the firm can sell more at
lower price and less at higher price.
4. Monopolist is guided by the motive of profit maximisation either by raising
price or by expanding the scale of production. Much would depend on his
business objectives.
5. There are many buyers on the demand side but none is in a position to
influence the price of the product by his individual action. Thus, the price of
the product is given for the consumer.
6. The monopolist treats all consumers alike and charges a uniform price for his
product.
7. The monopoly price is uncontrolled. There are no restrictions on the power
of the monopolist