UNIT – IV

(Pricing)
MODULE –1: MARKET STRUCTURES - PERFECT
COMPETITION.

CONTENTS
1.0: Introduction
1.1: Objectives
1.2: Perfect competition –Meaning
1.3: Characteristics of perfect competition
1.4: Determination of equilibrium price
1.5: Conditions for determination of equilibrium output.
1.6: Determination of equilibrium output.
1.7: Summary
1.8: References
1.9: Self Assessment Test.

1.0: Introduction:
The process by which price and output are determined in the real
world is strongly affected by the structure of the market. A market
consists of all the actual and potential buyers and sellers of a
particular product. Market structure refers to the competitive
environment in which buyers and sellers of the product operate.
Four different types of markets are usually identified. These are
perfect competition, pure monopoly, monopolistic competition and
oligopoly. These different types of market structures are
distinguished from one another in terms of number of buyers and
sellers for a product, the type of product bought and sold i.e
homogeneous or differentiated, the degree of mobility of resources,
The degree of knowledge that economic agents have of prices &
costs and demand and supply conditions.

1.01: Objectives:
The objective of this module is to discuss the pricing under perfect
competition. After reading this module, you will be able to
understand the:

Meaning of perfect competition

Characteristics of perfect competition
Equilibrium conditions of firm
Determination of equilibrium price in the short run & long run
Determination of equilibrium output in the short run & long run

1.02: Perfect Competition -Meaning:

Perfect competition is an ideal market structure. It is a market
structure characterized by the complete absence of rivalry among
individual business firms. It always takes care of consumer welfare
through efficient utilization of resources. Consumer welfare is the
maximum under perfect competition. Price of the product will
remain same under perfect competition irrespective of geographic
location.

1.03: Characteristics of perfect competition:

Presence of large number of buyers and sellers: There exist
millions of buyers and sellers for a product. Buyers represent the
demand side where as sellers represent the supply side. In such a
market forces of demand and supply determine the equilibrium
price. As a result, neither a buyer nor a seller can influence price.
Under perfect competition, a firm has no role in the determination
of price and hence a firm is a price taker.

Homogeneous Product: All firms under perfect competition

produce homogeneous product.

Perfect mobility of factors of production: Factors of production

can move from one place to other, wherever they expect higher
reward.
Free Entry and Exit: There are no restrictions on the entry and
exit of business firms. Business firms enjoy complete freedom with
respect to entry and exit. This is true only in the long run.

Information availability: Market information regarding demand,

supply and price is available to buyers and sellers.

Absence of transport cost: Business firms under perfect

competition ignore transport cost. This is so because, the business
firms maintain uniform price throughout the market.

ACTIVITY-1
1. Spell out the features of perfectly competitive market.

1.04: Determination of equilibrium price:

In perfect competition price remains the same irrespective of the
quantity that the individual business firms produce. Hence AR
(average revenue ) and MR ( marginal revenue)curves are one and
the same and parallel to horizontal axis. AR represents the demand
for individual firm’s product. The price under perfect competition
is determined by the industry through the equality between demand
and supply and passed on to the individual firms.
GRAPH-1

Y
Y INDUSTRY
P FIRM
AR
D S MR
E
P
P
Price

D
S

Demand &Supply X 0 Quantity

0

In the above graph, at point E, the demand is equal to supply and

hence the equilibrium price is determined as OP. Since price
remains constant, AR and MR lines are same and parallel to
horizontal axis.

In the long run the price of a product depends on cost of

production. The cost conditions experienced by the business firm
determine the level of price. If the industry experiences increasing
cost conditions, the long run price will be more than the market
period price and the long run supply curve slopes upward from left
to right. If the industry experiences constant cost conditions, the
long run price will be equal to the market period price and the long
run supply curve would be a horizontal straight line. If the industry
experiences decreasing cost conditions, the long run price will be
less than the market period price and the long run supply curve
slopes downward from left to right.

ACTIVITY-2
1. Why the shape of AR and MR is parallel to horizontal axis?

1.05: Conditions for determination of Equilibrium output:

The basic conditions required for equilibrium under perfect

competition are:

1. Marginal cost (MC) should be equal to Marginal Revenue

(MR).
2. MC curve should cut MR from below i.e at the point of
intersection MC should increase. This we can understand with the
help of following graph.
GRAPH-2

MC
Revenue S S1
Cost AR
Price

0 Q0 Q1
Quantity

In the above graph, MC is equal to MR at point S corresponding to

QO level of output. But at point S, MC is falling i.e cutting MR
from above. This indicates that by expanding quantity, firm can
reduce MC. Business firm expand quantity to OQ1. Corresponding
to OQ1 quantity at point S1, MC is not only equal to MR but it is
cutting MR curve from below. Hence business firm attain
equilibrium at point S1 by producing OQ1 quantity.

ACTIVITY-3
1. Explain the conditions of equilibrium output determination by a
firm under perfect competition.
1.06: Determination of equilibrium output:
In the short run firms have to operate under constraints and hence
whether they earn profit or incur loss depends on existing
economic conditions. If there is boom where the economy look
upwards, firms can earn maximum profits. On the other hand, if
there is downward tendency of economic activity, firms’ continue
production by earning normal profits. If there is economic
depression, firms may continue production operations by incurring
loss.

Equilibrium Output with Maximum profit:

A firm can earn maximum profit, if the price set by the industry is
more than the average cost. Under perfect competition price is
determined in the industry and passed on to the individual firms.
By accepting the price set by the industry, individual firms can
decide their equilibrium level of output.
GRAPH-3

Y
MC AC

S1
Revenue
Cost P
Price
In the above graph, firm established its equilibrium at point S1 and
decided to produce OQ1 quantity. At OQ1 level of output, Price or
Average Revenue (AR) is Q1S1. Where as average cost (AC) is
Q1S. Profit per unit is SSI. The total profit earned by firm is equal
to the area of rectangle P0PS1S. These profits are known as
maximum profits.

Equilibrium Output with normal profit:

If the price set by the industry is just equal to the AC of firm, then
the firm earns normal profits. It is the excess of total revenue over
and above rent, wages and interest. After making payments to land,
labour and capital, the left over income if it is just equal to the
reward of entrepreneur, it is called normal profit.
GRAPH-4

Y SAC
SMC

Revenue
Cost S1
Price
P1

X
0 Q1
Quantity

In the above graph, firm established its equilibrium at point S1 and

decided to produce OQ1 quantity. At OQ1 level of output, AR is
Q1S1 and AC is Q1S1. Since AR = AC, it is a situation of normal
profits.

Equilibrium Output with loss:

In the short run, if the price set by the industry is less than the AC
of firm, then the firm incurs loss. If the loss is just equal to or less
than the fixed cost, firms continue production operations. On the
other hand, if the loss is more than the fixed cost, firms close down
production operations. In the short run firms can not avoid fixed
costs and hence they are ready to bear these fixed costs as loss. The
point where price is equal to average variable cost is known as
shut-down point.

GRAPH-5

SAC

SMC
Y SA

Revenue
Cost
Price P
E

Q1
0
Quantity

In the above graph, price set by the industry is OP which is just

equal to average variable cost (AVC) at point E. Therefore point E
is called the shut down point. If the price is less than OP, then the
firm cannot recover even the AVC and hence, it close down
production operations. If price is equal to AVC, firm establishes
equilibrium with OQ1 quantity even by incurring loss which is
equal to fixed cost. If price moves beyond OP, it can reduce loss
i.e. minimizes loss. The portion of MC above AVC is known as
short run supply curve of firm.

Equilibrium output in the long run:

Long run is a time period in which new firms can enter and
existing firms can leave the industry. Due to free entry and exit, in
the long run individual firms and the industry as a whole earns
normal profits only. In the long run, the price set by the industry is
just equal to the AC of firms. The changes in total demand and
supply ultimately equate price with AC.

GRAPH-6

Y LM
SMC C SAC L

Revenue S1
Cost
Price P

Q1
0 Quantity
In the above graph, equilibrium is established at point S1, and each
firm decides to produce OQ1 quantity. At OQ1 level of output,
Long run average cost (LAC) is Q1S1 and AR is Q1S1. Further at
the point of equilibrium LAC =LMC = AR = Price =SMC =SAC.

ACTIVITY-4
1. Explain the meaning of maximum profit, normal profit and shut-
down point.

1.07: Summary:
Perfect competition is a market structure characterized by the
absence of rivalry among individual business firms. In this market
there exist large number of buyers and sellers for the product. The
price is determined by the forces of demand and supply. In the
long run the price is determined by the cost of production. A firm
is a price taker. But it can decide the level of output. Firms decide
equilibrium level of output at a point where MC =MR and rising
portion of MC. In the short run, firms operating under perfect
competition may earn maximum profit or normal profit or incur
loss. In the long run due to presence of free entry and exit,
individual firms and industry as a whole earns normal profits.

1.08: References:
1. P.L.Mehta : Managerial Economics- Analysis,Problems and
Cases.
2. Dominick Salvatore: Managerial Economics in a global
economy
3. R.L Varshney and Maheswari : Managerial Economics.
4. H.Craig Petersen and Cris Lewis: Managerial Economics
5. Koutsoyiannis: Modern Micro Economics

1.09: Self Assessment Test:

1. Discuss the process of equilibrium output determination under
perfect competition.
2. Analyse the characteristics of perfect competition.
 UNIT-IV
(Pricing)
MODULE- 3: MONOPOLISTIC COMPETITION

CONTENTS

3.0: Objectives
3.01: Meaning of monopolistic competition
3.02: Characteristics of monopolistic competition
3.03: Nature of demand curves
3.04: Determination of equilibrium price and output in the
short run
3.05: Determination of equilibrium price and output in the
long run
3.06: Wastes of monopolistic competition
3.07: Summary
3.08: Self Assessment Test
3.09: References

3.0: Objectives:
The aim of this module is to explain the basic features of
monopolistic competition. After reading this unit you will be able
to understand:
Meaning of monopolistic competition
Characteristics of monopolistic competition
Nature of demand curves
Equilibrium under monopolistic competition

3.01: Meaning of monopolistic competition:

Monopolistic competition owes its origin to Prof.E.H.Chamberlin.
In his famous work “The theory of monopolistic competition” he
explained the features of this form of market. Monopolistic
competition consists of the elements of monopoly and perfect
competition. It reflects the actual features of modern day
commodity markets. In this form of market Individual firms have
the power to fix price on their own. At the same time, firms face
competition, as all firms produce close substitute product

3.02: Characteristics of monopolistic competition:

Presence of relatively large number of sellers: In monopolistic
competition, large number of business firms produce same product
but not identical product. Ex: television sets, bath soaps,
detergents etc.
Product differentiation: Business firms produce a differentiated
product. Product differentiation may be in the form of unique
package, colour, physical appearance, post- sale service,
installment credit etc. Through product differentiation, firms under
monopolistic competition try to create uniqueness in the minds of
consumers regarding their product.

Substitutes: Though all firms produce a differentiated product, yet

they are close substitutes. Consumers could substitute the product
of a business firm to the other for same purpose.

Selling expenses: Due to the existence of product differentiation

and close substitutability of products, firms under monopolistic
competition resort to intensive selling campaign. Through selling
expenses firms tries to convey the unique qualities of their product
and pursue customers to buy their product. According to
Chamberlin, costs that shift the demand curve upwards are known
as selling costs.

Profit maximization: Each firm aims at profit maximization.

Firms determine their output corresponding to the equality between
marginal cost and marginal revenue.
Free entry and exit: Firms enjoy complete freedom regarding
entry and exit. New firms could enter the market or can exit based
on their expectation of market conditions.

Identical demand and cost curves: Chamberlin assumed that the

demand and cost curves of all firms are identical. This is known as
chamberlin’s heroic aggregation.

ACTIVITY-1
1. List out the characteristics of monopolistic competition.

3.03: Nature of demand curves:

In monopolistic competition, we come across two types of demand
curves. They are denoted as dd (lower case letter d) and DD (upper
case letter D). dd curve represents firm’s demand ( it is also the
average revenue curve) or expected sales curve of a firm. If a firm
changes its price and other firms keep their prices constant, the
likely sales of this firm is indicated by each point on dd curve. DD
represents actual sales of a firm. If a firm changes its price and
other firms also change the price of their product, not as a reaction,
the actual sales of each firm is indicated by points on DD curve.
DD curve is also known as market share curve. DD and dd slopes
downward from left to right as shown in the diagram.

GRAPH-1

Y
D
d

d
Price

x
0
Quantity

ACTIVITY-2
1. Define dd and DD curves.

3.04: Determination of Equilibrium price and output in the

short run:
In monopolistic competition, in the short run, firms attain
equilibrium by equating marginal cost with marginal revenue.
Each firm produces quantity corresponding to the equality between
MC and MR. In the short run, at the point of equilibrium whether
the firms’ earn profit or incur loss depends on prevailing economic
conditions. We can examine the equilibrium output determination
in the short run with the help of following diagram.

GRAPH-2

Y SMC

SAC

R
Revenue, Cost & Price

P1
R1
Po
AR or dd
E

X
0 Q1

Quantity

In the above graph, quantity is measured on horizontal axis and

revenue & cost is measured on vertical axis. At point E marginal
cost is equal to marginal revenue and hence firm attains
equilibrium by producing OQ1 quantity. At OQ1 level of output,
average revenue is Q1R and average cost is Q1R1. Profit per unit
is R1R. At OQ1 quantity, total revenue is OQ1RP1 and total cost is
OQ1R1P0. Total profit is P0R1RP1.If the existing economic
conditions are favorable; each firm could earn maximum profit to
the extent of P0R1RP1.

3.05: Determination of Equilibrium price and output in the

long run:
In the long run all firms can adjust their production capacities by
taking in to consideration, changes in technology, demand patterns
and cost conditions. Since there are no restrictions on the entry and
exit of firms, in the long run, at the point of equilibrium all firms
earn normal profit.

Equilibrium in the long run :

In the short run, if the existing firms earn abnormal profit, attracted
by the presence of profit, new firms could enter the market in the
long run. As long as there is profit i.e the price or average revenue
is more than average cost, there is scope for entry of new firms in
to the market. The entry will come to an end when all firms’ in the
group earn normal profit. We can examine equilibrium with free
entry with the help of following diagram.

GRAPH-3

Y
Attracted by the presence of profits, new firms enter the market in
the long run. Due to entry of new firms, the expected sales of each
firm decreases and hence AR curve or expected sales curve of
individual firms’ shifts downward. The entry will come to an end
when expected sales curve will become tangent to long run average
cost curve. In the long run all business firms attain equilibrium at
point R, where AR is tangent to LAC and there by earn normal
profits by producing OQ1 quantity.
The business firms in monopolistic competition also attain
equilibrium with price competition. Under this, each firm will
reduce its price, with an expectation to reach optimum sales. But
all firms reduce their prices independently and never produce
optimum level of output. They attain equilibrium before reaching
optimum level.

3.06: Wastes of monopolistic competition:

In monopolistic competition all firms in the group attain long run
equilibrium at less than optimum level of output. Even though,
there is scope for expanding output up to optimum level, they
produce at less than optimum level and there by operate with
excess unutilized capacity. Excess capacity is the difference
between optimum output and actual output. Critiques argued that,
the presence of excess capacity is nothing but wastage of
resources. We can understand the presence of excess capacity or
wastes of monopolistic competition with the help of graph.

GRAPH- 4

LMC
Y

E1
E2
P2
, Cost & Price

P1

AR
E
In the above graph, OQ4 is the optimum output i.e. the output
corresponding to minimum point of LAC. Where as OQ2 is the
actual output. Excess capacity is Q2Q4. If they produce at
optimum level, they can charge P1 price but instead by producing
at less than optimum level they charge price more than P1. For
example at Q2 level of output, they charge P2 price. But
Chamberlin disagreed with this and argued that Q2Q4 is the social
cost of offering differentiated product.

ACTVITY-3
1. Define excess capacity under monopolistic competition.

3.07: Summary:
Monopolistic competition is a market consists of relatively large
number of business firms which produces differentiated product.
Yet the product of all business firms is perfect substitute. In order
to attract customers by explaining them the unique qualities of
their product, business firms take up intensive selling campaign. In
the short run the business firms aim at profit maximization. In
monopolistic competition there are two demand curves denoted as
DD and dd. The DD represents market share or actual sales of
each firm where as dd represents expected sales of each firm. In
monopolistic competition, in the long run business firms compete
with each other through free entry and price competition. Since the
business firms suffer from myopia, they never learn from their past
mistakes. In the long run, though each firm is expected to reach
optimum level and to maximize profit, group as a whole attain
equilibrium with less than optimum level and normal profit. The
equilibrium at less than optimum level indicates the presence of
excess capacity with business firms.

3.08: Self Assessment Test:

1. Discuss the features of monopolistic competition
2. Explain equilibrium with price competition under monopolistic
competition.
3. Explain group equilibrium under monopolistic competition.
3.09: References:
1. Koutsoyiannis : Modern Micro Economics

2. H.L.Ahuja: Advanced Economic Theory

3. K.N.Verma: Micro Economic Theory

4. Dominick Salvatore: Managerial Economics in a Global

Economy
 UNIT-IV
(Pricing)
MODULE- 4: OLIGOPOLY (NON-COLLUSIVE
OLIGOPOLY)

CONTENTS
4.0: Objectives
4.01: Meaning of Oligopoly
4.02: Features of Oligopoly
4.03: Concept of Kinky demand curve
4.04: Duopoly Models
A. Cournot’s model of duopoly
B. Bertrands model of duopoly
C. Stackleberg model of duopoly
D. Edgeworth model of duopoly
4.05: Summary
4.06: References
4.07: Self Assessment Test

4.0: OBJECTIVES:
The basic aim of this module is to explain the main features of
oligopoly and the behavior of business firms in non –collusive
oligopoly. After reading this module you will be able to understand
the:

Meaning of oligopoly
Features of oligopoly
Concept of kinky demand curve
The extreme case of oligopoly:i.e.Duopoly.

4.01: Meaning of Oligopoly:

Oligopoly is a market structure characterized by the presence of
few sellers or firms producing either homogeneous or
differentiated product. The best examples of differentiated
oligopoly are Automobiles, iron and steel, telephone services, air
transport, cable T.V. services. In oligopoly there exists severe
competition among few business firms. If there is no secret
understanding or agreement among business firms regarding price
fixation, it is called non collusive oligopoly. In such a situation
each firm will take its pricing decision on its own. This leads to
cut- throat competition among business firms.

4.02: FEATURES OF OLIGOPOLY:

1. Interdependence: Interdependency is the main feature of
oligopoly. In oligopoly since there exist few business firms, the
decisions of each firm are influenced by the reactions of rival
business firms. Though each will arrive at the pricing or output
decision independently, no business firm ignores the reactions of
other rival firms. Business firms in oligopoly arrive at final
decisions after fully incorporating the expected reactions of other
rival firms. It is a fact that, firms in oligopoly must take into
account not only the market demand but also the reactions of rival
firms in the group.

2. Selling campaign: In differentiated oligopoly, basically, though

all firms produce same product, but at the same time, the product
of each firm is differentiated in terms of physical appearance,
colour, fragrance brand loyalty, trade mark, post-sale service,
packaging etc. The presence of product differentiation and close
substitutability of products requires intensive advertising activity.
Each firm will undertake intensive selling campaign, to pursue the
customer to purchase its product in preference to those of others.

3. Indeterminate demand curve: In non collusive oligopoly, it is

not possible to derive a smooth downward sloping demand curve
due to the peculiar behavior of business firms.
4. Price Rigidity: Due to the peculiar behavior of business firms,
the initial price remains constant under oligopoly.

ACTIVITY -1
1. Spell out the features of oligopoly.

4.03: CONCEPT OF KINKY DEMAND CURVE:

Paul Sweezy used the kinky demand curve to explain price rigidity
in oligopoly. Kinky demand curve consists of two segments i.e a
segment of expected sales curve and the other segment of actual
sales curve. According to Sweezy’s observation, the peculiar
behavior of business firms in non collusive oligopoly was the basic
reason for kink in the demand curve. In non collusive oligopoly, if
any firm raises the price beyond initial equilibrium price, other
firms in the group will not react. All firms are fully aware of this
fact, and hence no firm will raise the price above the initial
equilibrium price. On the other hand, if any firm reduce the price,
below the initial equilibrium price, other firms in the group will
react immediately and reduce the price to the same extent. In such
a situation, though the market demand may expand in absolute
terms but the share of each firm will remain constant. Since the
firms are aware that even after reducing the price, the market share
remains constant, they do not reduce price. As a result, initial
equilibrium price and quantity will not move either side. This leads
to price rigidity in oligopoly. We can understand price rigidity in
oligopoly with the help of kinky demand curve.

GRAPH-1

d
MC
K
Revenue, cost & Price

A
D
B
X
0 Q
Quantity

MR

In the above graph, quantity is measured on X axis and price,

revenue & cost on Y axis. dKD is the kinky demand curve. d K
is the segment of expected sales curve.. The price elasticity of
demand on dK is more than one and hence no firm will raise the
price above OP, since it has to forego sales rapidly as other firms
do not raise their price. K D is the segment of actual sales curve or
market share curve. The price elasticity of demand on KD is less
than unity and hence even if firms reduce their price below OP, the
market share of firms will not improve. As a result, no firm will
reduce price below OP. There is discontinuity in marginal revenue
curve between A & B points. According to Paul Sweezy, if the
marginal cost curve passes through the discontinuity region,
business firms satisfy the equilibrium condition and attain
equilibrium. Corresponding to point K the equilibrium price is
determined as OP and quantity as OQ which remains rigid.

ACTIVITY-2
1. Draw the kinky demand curve and identify elasticity on dK and
KD segments.

4.04: Duopoly models:

The limiting case of oligopoly is called as Duopoly. Duopoly is a
market structure consists of two business firms which basically
produce identical product. Now we try to understand, how the
business firms under duopoly arrive at equilibrium through action
and reaction.

A. Augustin Cournot’s model:

The earliest model of duopoly was presented by Cournot. The
basic assumptions of Cournot model:
1. There exist two business firms.
2. They produce homogeneous product.
3. They aim at profit maximization
4. Each firm expects that the conjectural variations with respect to
rival firms output are zero. This implies that both firms assume that
rival firms do not react to production decisions of other competitor.
Though the expected reaction does not in fact materialize, they
continue to assume the same and hence both firms suffer from
naïve behavior i.e. never learn from their past experience.
5. Production is free of cost.
6. Firms are aware of total demand for their product.

Based on these assumptions, Cournot explained the working of

business firms in duopoly. To understand the working of duopoly,
we assume that there are two firms A & B. firm A is the first to
start production. In order to maximize profit, A will produce one –
half of the total market. B will produce one –half of the total
market left out by A to maximize its profit. The action and reaction
pattern will continue till they produce same level of output. This
we can understand with the help of following numerical example.
We assume that total demand is 100 units.
A’s production B’s
production

A- First time B-First

time

100 x 1/ 2 = 50 100- 50 =
50 x 1/ 2 = 25

A second time B second

time

100 –25 = 75 x 1/ 2 = 37.5 100 –

37.5 = 62.5 x 1 /2 = 31.25

A third time B third

time

100 – 31.25 = 68.75 x ½ =34.38 100 –

34.38 =65.62 x 1 /2 =32.81
With the help of above numerical example we can observe that,
A’s output is decreasing and B’s output is increasing. Their output
level becomes equal if each produce 1/3 of the total market. If they
produce same level of output, the action and reaction will come to
an end. Both firms attain equilibrium by producing 2/3 of the total
market and maximize their individual profits.

This model of duopoly was criticized by many economists on the

ground that the assumption of production is free of cost is totally
unrealistic. Cournot relaxed this assumption and explained stable
equilibrium induopoly with the help of iso-profit curves and
reaction curves.

Iso-profit curve:
Iso profit curve is a locus of different combinations of output of
firm A and firm B which yield same level of profit to either of the
firms. For example: Isoprofit curve of A is the locus of different
levels of output of A & B which yield A the same level of profit. In
the same way, the isoprofit curve of B is the locus of different
levels of output of A & B which yield B the same level of profit.
Isoprofit curves for substitute products are concave to the axis
where we measure output of respective firms on that axis. The
shape of isoprofit curves of A & B is shown below.
GRAPH-2

Y
E1

Quantity of B
e πA

0 Quantity of A

The above graph represents isoprofit curves of firm A which are

concave to it’s quantity axis i.e X axis. All points on isoprofit
curves of firm A,indicates that different combinations of output of
firm A and B which yield same level of profit to firm A. Farther
the isoprofit curve from quantity axis, lower the level of profit it
represents. The maximum points on successive isoprofit curves of
firm A lies left to each other. By joining together the maximum
points on successive isoprofit curves we can derive the reaction
curve of firm A, as shown below
GRAPH- 3

Quantity of B
Reaction Curve of A

X
0
Quantity of A

GRAPH-4

Y πB1 πB2

e
Quantity of B

E1

X
0
Quantity of A
In the above graph the isoprofit curve of firm B is concave to the
quantity axis of B. All points on isoprofit curves of firm B
indicates that different combinations of output of firm A and B
which yield same level of profit to firm B. Farther the isoprofit
curve from quantity axis, lower the level of profit it represents. The
maximum points on successive isoprofit curves of B lie right to
each other. By joining together the maximum points we can derive
the reaction curve of B as shown in below

GRAPH-5
Y
Quantity of B

Reaction curve of B

X
0 Quantity of A

The reaction curve of A indicates the reaction pattern of A to the

production decisions of B. In the same way, the reaction curve of B
indicates the reaction pattern of B to the production decisions of A.
Intersecting point of two reaction curves establishes the stable
equilibrium in duopoly.
GRAPH-6
Y

Reaction curve of A

Quantity of B
B3

Reaction curve of

X
0
A3 Quantity of A

In the above graph, point E indicates stable equilibrium in duopoly.

At point E, the action and reaction pattern will come to an end and
both firms produce the same level of output by maximizing their
individual profits.

B. Bertrand model of duopoly

Bertrand also explained the stable equilibrium in duopoly with the
help of isoprofit curves and reaction curves. Bertrand assumed
that, conjectural variations in prices of rival firm’s product are
zero. It implies that, by deciding its price each firm assumes that
the price of rival firm’s product will remain constant. In Bertrand’s
model, the isoprofit curve of each firm is convex to its price axis
i.e. isoprofit curve of A is convex to its price axis and B is convex
to its price axis as shown
GRAPH-7
Y

Reaction Curve of A
π

Price of firm B
π

X
0
Price of firm A

In the above graph isoprofit curves of A are convex to X axis

where we have measured price of A. The minimum points on
successive isoprofit curves of A lie right to each other. Farther the
isoprofit curve from price axis, the higher the level of profit it
represents.

GRAPH-8
πB1 πB2
Y
Reaction Curve of B
Price of B
Isoprofit curves of B are convex to Y axis where we have
measured price of B. Farther the isoprofit curve from price axis,
the higher the profit it represents. Minimum points on B’s
isoprofit curves lie left to each other. By joining together the
minimum points on successive isoprofit curves of A and B, we can
derive the reaction curve of firm A and B. The intersecting point of
two reaction curves represents stable equilibrium in duopoly.

GRAPH-9
Y
Reaction cu

Rea

E
Price of B

Price of A
In the above graph, Point E represents equilibrium at which the
action and reaction pattern comes to an end and both firms
maximize their individual profits.

C. Stackleberg model of duopoly:

Cournot and Bertrand assumed naïve behavior on the part of both
the business firms. Stackleberg relaxed the assumption of naïve
behavior and assumed that one of the duopolist’s is sophisticated
enough to accurately expect the reaction of other rival firm. The
sophisticated business firm by fully incorporating the reaction of
other rival firm decides its level of output in such a way to
maximize its profit. The sophisticated business firm decides its
level of output corresponding to the tangency point of its isoprofit
curve to the reaction curve of other rival firm as shown below.

GRAPH- 10

Reaction Curve of A

S
Quantity of B

B1
πA2
πA1
X
A4
0
Quantity of A
According to above graph, If A is the sophisticated duopolist, A
produces OA4 quantity corresponding to tangency point ( S )of its
isoprofit curve with the reaction curve of B.

GRAPH-11 Y

Reaction C

B4 S

Quantity of B
πB1
πB2

0
A1

According to above graph, if B is the sophisticated duopolist, B

produces OB4 quantity corresponding to point S1, where its
isoprofit curve is tangent to the reaction curve of A. In both cases,
the sophisticated duopolist produces rfelatively large quantity.
D. Edgeworth model
Edgeworth has shown successfully that there is indeterminacy
regarding equilibrium in duopoly. He also incorporated the same
assumptions of other duopoly models. In addition, he assumed that
the business firms operate with limited production capacity. We
can understand the Edgeworth model with the help of following
diagram.

GRAPH-12 Y

P4

P3

P
2

P0

B B1 B0 0 A1
A0

According to above graph, YA is the demand curve for firm A’s

product. YB is the demand curve for firm B’s product. OA1 is the
production capacity of firm A and OB1 is the production capacity
of firm B. At P0 price, both firms can fully utilize their limited
production capacity OA0 and OB0 respectively. If they charge P4
price, they can not utilize full production capacity. At P4 price, the
unutilized production capacity of firm A is A0A and B is B0B. By
reducing price from P4 to P3, A is expected to utilize its full
capacity OA1. As a reaction B will reduce its price from P4 to P2,
to fully utilize its production capacity OB1, assuming that A will
keep its price constant. But A will react and further reduce its price
its price to P0, to fully utilize its production capacity, on the
assumption, B will keep its price constant. But as a retaliatory
measure B will reduce its price to P0. A also reduce its price to P0.
Now either of the firms raises its price from P0 assuming that other
rival firm will keep its price constant and operate at full capacity.
Under these conditions whatever the demand is there in excess of
the full capacity of rival firm, it assumes that, it is the demand for
its product, at price above P0. Through action and reaction other
firm also raises the price and finally price will reach to P4.
According to Edgeworth, price will move from P4 to P0and P0to
P4. Since the price moves up and down in the range of P0 & P4,
and hence it is not possible to have stable equilibrium in duopoly.

ACTIVITY- 3
1. What is iso-profit curve?
2. What is reaction curve?
3. What is stable equilibrium?

4.05: SUMMARY:
Oligopoly is a market structure consists of few business firms
competing with each other intensively. In differentiated oligopoly,
each firm produces a differentiated product. Though the business
firms produce differentiated product, there exists interdependency
among business firms regarding production and pricing decisions.
According to Paul Sweezy, There is price rigidity in non- collusive
oligopoly. The behavior of business firms in non –collusive
oligopoly results in price rigidity, which he explained with the help
of kinky demand curve. The limiting case of oligopoly is called
duopoly. Duopoly is a market structure consists of two firms which
produces identical product. In duopoly business firms suffers from
naïve behavior i.e.they never learn from their past experience.
With the help of isoprofit curves and reaction curves, Cournot,
Bertrand, Stackleberg established stable equilibrium in duopoly.
According to them, though the business firms maximize individual
profits by attaining equilibrium, group profit can not be
maximised. According to Edgewoth there is indeterminacy
regarding equilibrium in duopoly.
4.06: Self Assessment Questions:
1. Discuss the features and working of non-collusive oligopoly.
2. Distinguish between Cournot and Bertrand model of
duopoly.
3. Explain in detail Stackleberg and Edgeworth model of
duopoly.

4.07: References:
1. Koutsoyiannis : Modern Micro Economics
2. Dominick Salvatore: Managerial Economics in a Global
Economy
3. H. Craig Petersen : Managerial Economics
And W. Cris Lewis
 UNIT-IV
(Pricing)
MODULE- 5: COLLUSIVE OLIGOPOLY

CONTENTS
5.0: Objectives
5.01: Meaning of collusive oligopoly
5.02: Forms of collusive oligopoly
5.03: Working of cartel
5.04: Price leadership
(a) Price leadership by a low cost firm
(b) Price leadership by a dominant firm
(c) Price leadership by a barometric firm
5.05: Summary
5.06: References
5.07: Self assessment test

5.0: Objectives:
The basic objective of this module is to explain the working of
collusive oligopoly. After reading this module you should be able
to understand the:

* The meaning of collusive oligopoly

* Different forms of collusive oligopoly.

5.01: Meaning of collusive oligopoly:

To overcome the problems of non-collusive oligopoly i.e the price
war due to cut throat competition, business firms arrive at secret
agreements regarding price fixation. The reason for secret
agreement is that governments’ never allow open agreements.
Since these secret agreements cause harm to consumers. Under
collusive oligopoly the business firms form into a group and take
price and out put decisions collectively and there by strive for
mutual benefit.

5.02: Forms of collusive oligopoly:

Basically there are two different forms of collusive oligopoly.
They are (1) Cartel formation (2) Price leadership.

5.03: Working of cartel:

Cartel implies group of firms. To avoid severe competition among
them selves, business firms form in to a group in order to gain
mutual benefit. In cartel, there is a central agency that acts as
highest decision making body. Central agency consists of
representatives from all member firms in the group. These
representatives sit together and arrive at final decisions regarding:

Price to be charged
Total supply of the commodity
Allocation of total supply among business firms
The share of each firm in total profit

Central agency is fully aware of the cost structure of each member

firm. While allocating output quotas, central agency takes in to
account cost structure of each firm. It follows the principle; lower
the cost of production higher the quota a business firm gets.
Regarding profit, whatever the profit business firms earn, they can
not enjoy on their own. They have to surrender the profit to the
central agency. After pooling together the profit from all member
firms, central agency will decide the share of each firm in total
profit. Regarding price fixation also, central agency take stock of
demand and supply and there by decide the price to be charged by
member firms. All firms must follow the decisions of central
agency. If any business firm ignores the decisions of central
agency and follows its own decisions, it leads to the collapse of
cartel. In way cartel works as a monopolist. Organisation of
Petroleum Exporting Countries (OPEC) is a classic example of a
cartel successfully operating international level since its inception
in early nineteen seventies. We can understand the working of
cartel with help of following graph.

GRAPH-1

FIRM - A
MCA ACA FIRM-B MCB Y
Y

ACB
R1 P4 P4
R
P4
P2
R
P1
Revenue, Cost,Price

0 Q2 X 0 Q1 X 0

Quantity Quantity
In the above graph, for analytical simplicity, we have shown the
working of cartel with the help of two business firms i.e firm A
and firm B having formed into cartel. In the cartel equilibrium
output is determined by the central agency as OQ3, corresponding
to the equality between MC and MR at point E. The central agency
of the cartel distributed OQ3 quantity between firm A and B. OQ2
is allocated to firm A and OQ1 is allocated to firm B. The position
of cost curves shows that, the cost of production of A is relatively
less than that of B and hence A was allocated large quantity
compare to the quantity allocated to B. The total profit of A is
P1RR1P4 where as the total profit of B is P2RR1P4. The area of
profit of A is more than the same of B. Business firms A and B can
not enjoy the entire amount of profit on their own. They have to
hand over their profit to the central agency. The central agency will
decide the share of each firm in total profit. In reality, the share of
firm B will be more than what it has earned while the share of A
will be less than the profit it has earned.

ACTIVITY-1
1. Spell out the meaning of collusive oligopoly.
2. Write few lines about OPEC.
3. Spell out the decisions generally arrived at by the central
agency.
5.04: Price leadership:
Price leadership is another form of collusive oligopoly. In this
form, any one firm in the group will decide the price and acts as
leader, where as other firms in the group acts as followers. Price
leadership is of three different forms. They are (1) Price leadership
by a low cost firm (2) Price leadership by a dominant firm (3)
Price leadership by barometric firm. Now we will discuss these
different forms of price leadership.

Price leadership by a low cost firm:

In this form of price leadership, the low cost firm i.e. the firm
which produces at relatively lower cost of production, will fix the
price and acts as price leader where as high cost firms in the group
acts as followers. For example the average cost of production of A,
B, C, D, firms is as follows.

Firms A B C
D

Average cost Rs 10 Rs 12 Rs 9
Rs 11
According to the above example, C is the low cost firm and hence
C will fix the price and acts as price leader. Other high cost firms
i.e. A, B, D acts as followers. In order to keep the group intact, C
must fix the price more than Rs 11. What ever the price C decides,
at that price it must ensure a reasonable amount of profit to other
firms in the group. If it fixes a very low price, keeping in mind its
own profit, other firms may not earn a reasonable amount of profit
and hence they may not continue in the group. If they move out of
the group, the actions i.e price and output decisions of this group of
firms may adversely affect the low cost firm. Hence C i.e the low
cost firm is afraid of collective actions of high cost firms. The high
cost firms always afraid of the actions of low cost firm. If the high
cost firms fail to accept the price fixed by C, then C may fix a very
low price at which they cannot survive in the market. Hence high
cost firms can not take independent decisions. They always follow
low cost firm and earn a reasonable amount of profit. We will
examine price leadership by low cost firm with the help of graph.

GRAPH-2

MCB ACB

R3 MCC ACC
venue,Cost,Price

R2 R ARC
E
ARB
In the above graph ARC and MRC are average revenue and
marginal revenue curves of firm C respectively. ARB and MRB are
average revenue and marginal revenue curves of firm B
respectively. The position of cost curves indicates that firm C is the
low cost firm and firm B is the high cost firm. By equating
marginal cost with marginal revenue at point E, firm C determined
the price as OP. Since B is a high cost firm, B decided to follow
the price fixed by firm A. Firm A produces OQ1 quantity, where
as firm B produces OQ0 quantity. The share of firm C is more
than the share of firm B. Profit per unit of C is RR1 and same for
firm B is R2R3. Above graph represents equilibrium with unequal
market shares. Business firms can also attain equilibrium with
equal market share.

Price leadership by a dominant firm:

In this form of collusive oligopoly, the dominant firm determines
equilibrium price and acts as leader, where as other small firms in
the group acts as followers. The business firm having maximum
share in market is called as dominant firm. For example the market
share of A, B, C, D firms is shown below.

Firm A B C
D

Share (per cent) 15 12 13

60

According to above example, firm D is the dominant firm since it

is enjoying 60% of the market share. Dominant firm will fix the
price in such a manner so as to ensure a reasonable amount of
market share to other small firms in the group. Dominant firm is
assumed to have perfect knowledge regarding cost structure and
the supply of small firms together at different prices. We can
understand the price leadership by dominant firm with the help of
graph.

GRAPH-3
 Panel -1
S
D Panel - 2
Y
Y
E
P4

A A P3 R
P3

B
S R
Price

E1

Q4 X Q1
Quantity
Demand & supply

In the above graph, panel-1 represents total demand and supply

position of small firms at different prices. SS is the supply curve of
small firms. If the dominant firm decide price as OP4, total
demand is OQ4. At OP4 price, supply of small firms is OQ4. This
implies that at OP4 price total demand is met by small firms and
hence the left out demand in the market for dominant firm is zero.
Hence the dominant firm never fix price as OP4. If the price is
OP3, total demand is P3A1 where as the supply of small firms is
P3A. The left out demand for dominant firm is AA1. If the price is
OS, the total demand in the market is SB and the supply of small
firms is zero. At very low price small firms cannot survive in the
market. At very low price the entire demand is for dominant firm’s
product. The dominant firm never ignores the interest of other
small firms in the group and hence it determines price at a level
where all other small firms can have a reasonable amount of
market share. The gap between supply and demand curves below
point E indicates leader’s (dominant firm’s) supply. Panel-2
represents equilibrium price determination by the dominant firm.
Dominant firm determined price as P3 corresponding to the
equality between marginal cost and marginal revenue at point E1.
At P3 price the share of small firms is P3A where as the share of
dominant firm is AA1 or OQ1. The profit per unit of dominant
firm is RR1.

Price leadership by a barometric firm:

Barometric firm is neither a low cost firm nor a dominant firm. For
example: In price leadership by a low cost firm, firm C is the low
cost firm where as under dominant firm price leadership, firm D is
dominant firm. Barometric firm is neither firm C nor firm D. It
may be firm B or firm A. Other firms in the group follow the
decisions of this barometric firm because of the confidence they
have in the decision making abilities of barometric firm.
ACTIVITY-2
1. Explain the meaning of price leadership.
2. What are the types of price leadership?
3. What is barometric price leadership?
4. How do you identify a dominant among given number of firms?

5.05: Summary
If the business firms under oligopoly have secret agreements
among them selves and take price or output decision collectively, it
is called collusive oligopoly. Basically, collusive oligopoly is a
part of homogeneous oligopoly. There are two forms of collusive
oligopoly (1) Cartel formation (2) Price leadership. Under cartel
formation central agency will play an important role as highest
decision making body. Central agency will take the decisions
related to price, output and share of each firm in total profit.
Central agency acts as a monopolist. There are three forms of price
leadership. They are price leadership by a low cost firm, price
leadership by a dominant firm and barometric price leadership.
While taking the pricing decision, either the low cost firm are the
dominant firm never ignore the interest of other firms in the group.

5.06: References:
1. Koutsoyiannis : Modern Micro Economics
2. Dominick Salvatore: Managerial Economics in a Global
Economy
3. H. Craig Petersen : Managerial Economics
And W. Cris Lewis

5.07: Self assessment questions:

1. Explain the working of a cartel with the help of suitable
diagram.
2. Discuss different forms of price leadership.
 UNIT-IV
(Pricing)
MODULE – 6: LIMIT PRICE

CONTENTS

6.0: Objectives
6.01: Meaning of Limit Price
6.02: Bain’s Limit Pricing Model
6.03: Sylos-Labini Model of Limit Pricing
6.04: Modigliani Model of Limit Pricing
6.05: Factors that determine the level of Limit Price
6.06: Summary
6.07: References
6.08: Self Assessment Test

6.0: Objectives:
The objective of this module is to explain how the business firms
operating under collusive oligopoly set the limit price, the factors
that determine the level of limit price. After reading this module
you shall be able to understand the:

Meaning of limit price

Bain’s theory of limit price
Sylos-Labini model of limit price
Modigliani model of Limit price
Factors that determine the level of limit price

6.01: Meaning of Limit Price:

It is the price that the established business firms can charge
without attracting entry of new firms into the market. Under
collusive oligopoly, the objective of established firms is to
maximize profit in the long-run. So that in the short run, they set
the price at a level to effectively prevent the entry of new firms in
to the market. Limit price is also called as entry preventing price.

6.02: Bain’s Limit Pricing Model:

Bain formulated his limit pricing theory in his article Barriers to
New Competition published in 1956. Bain stated that in the long
run the price always more than long average cost because of the
existence of barriers to entry i.e high level of initial investment,
patents acquired by firms, research and development facilities and
high switch over costs. According to Bain, “the highest price
which the established business firms believe they can charge
without inducing entry” is the limit price.

Assumptions:
1. There is a determinate ling run demand curve for industry
output, which is unaffected by price adjustments of sellers or by
entry. The long –run industry demand curve shows the expected
sales at different prices maintained over long period.
2. There is effective collusion among the established oligopoly
firms.
3. The established firms can compute a limit price below which the
entry will not occur. The level of limit price depends on the
average cost of the potential entrant, size of the market, elasticity
of demand for the product, the shape and level of LAC and number
of firms in the group.
4. Above the limit price entry is attracted and there is considerable
uncertainty regarding the market share of established firms.
5. The established firms aim at maximization of their long run
profit.

Determination of Limit Price:

GRAPH-1

Uncertainty region
D

Pm R
R1
P
E=1
Revenue, Cost, Price

S
Po
E E1

0
Q1 Q2
Quantity

MR

In the above graph, DD is the demand curve of the established

business firms. MR is the marginal revenue curve. It is assumed
that in the long run, the average cost remains constant. So that the
LAC curve of potential entrant and established firms is parallel to
horizontal axis. LACPE is the long average cost curve of potential
entrant where as LACEF is the long run average cost of established
firms. When AC remains constant and so the marginal cost (MC).
The business firms in oligopoly follow the marginal rule to set the
price. At point E, MC =MR and hence firms fixed the price as
OPM. This OPM price is much higher than the average cost of the
potential entrant (OP) and hence it induces entry of new firms into
the market. Any price above OP indicates uncertainty region
regarding the market share of established business firms. If the
established business firms fix the price just equal to the average
cost of potential entrant such as OP, it can effectively prevent the
entry of new firms into the market. At this price, any new firm
enters the market, the supply increases and hence given the
demand, price will fall below the AC of potential entrant. Potential
entrants are fully aware of this fact. As a result, at OP price new
firms cannot think in terms of entering the market. Therefore OP
price serves as limit price. Bain stated that even by setting the price
corresponding to a point on the demand curve say for example
point S, where the elasticity is less than one, the firms in collusive
oligopoly can effectively prevent the entry of new firms and also
maximize their profits in the long run.

ACTIVITY-1
1. Define limit price.
2. Spell out the assumptions of Bain’s model.

6.03: Sylos- Labini model of Limit Pricing:

Sylos-Labini model of limit pricing is based on economies of scale
barrier.

Assumptions:
1. The demand for the product of the group is unitary elastic in
nature. The product is homogeneous and firms sell at unique
equilibrium price.
2. The technology consists of three types. Small plat with capacity
of 100 units output: a medium plant with capacity of 1000 units
output: a large size plant with capacity of 8000 units output. Each
firm can expand by multiples of its initial capacity. That is a small
firm can expand by setting another small plant and medium size
plant can expand by setting another medium size plant and large
firm can expand by setting another 8000 units capacity plant.
There are economies of scale: cost decreases as the size of the
plant increases. But the fact is that, with this rigid technology, we
can not derive a smooth average cost curve. The shape of the cost
curves with three types of technologies is shown below.

GRAPH-2
 Y

15

12

Average Cost
10

0
100 1000 8000

Output in units

In the above graph, ACS is the average cost of small plant size,
ACM is the average cost of medium size plat and ACL is the
average cost of large plant size.

3. The price is set by the price leader, who is the large-sized firm,
with a lowest cost at a level to prevent entry. The smaller firms are
price takers. Each one individually can not affect the price.
However, collectively they may put pressure on the leader by
regulating their output. Thus the large plant sized firm does not
have unlimited discretion in setting the price. Large plant sized
firm must set a price that is acceptable to all the firms in the
industry as well as preventing entry.
Let us say the AC small plant Rs 15, AC of medium plat Rs 12
and the AC of large plant Rs 10. Then the large plant sized firm
has to fix the price above Rs 15 in such a way to ensure normal
rate of profit to small plant sized firm. The large firm should fix
the price in such a way that Pi = AC i ( 1 + r ).
Pi is the price acceptable to ith firm i.e small plant sized firm. AC i
is the average cost of ith firm and r is the normal rate of profit.
4. There is normal rate of profit in each industry. According to
Sylos –Labini the normal rate of profit assumed to be 5%.
5. The leader is assumed to know the cost structure of all plant
sizes and the market demand.
6. The entrant is assumed enter the industry with the smallest plant
size.

Determination Limit Price:

GRAPH-3

P5
e Cost

P4 ACs
In the above graph DD is the demand curve of the industry’s
product. ACS is the average cost of small plant size, ACM is the
average cost of medium size plat and ACL is the average cost of
large plant size. OP4 is the price acceptable to the smallest plant
size. At P4 price the total demand is 1000 units. If the large plant
sized firm fixes the price as P5, the total demand for the product is
910 units. The gap between the demand at P4 and P5 price is 90
units which is less than minimum plant size. At P5 price any new
firm enter the market; it can use its full plant capacity of 100 units
since the left over demand in the market is less than the capacity of
minimum plant size. Therefore P5 price serves as limit price. The
established business firms can charge P5 price without attracting
the entry of new firms in to the market.
1. Explain the meaning of ‘Economies of Scale Barrier’.
2. Spell out the types of technology according to Sylos-Labini.

6.04: Modigliani model of limit pricing:

Modigliani model is a generalization of Sylos-Labini model of
Limit pricing. This model also based on economies of scale barrier.

Assumptions:
1. Technology is the same for all firms in the industry. There is a
minimal optimal plant size at which economies of scale are fully
reaped. Once the minimum optimum scale is reached the LAC
curve becomes a straight line.

GRAPH-4

A
Average Cost

100
Output
In the above graph 100 units is the optimum capacity. Right to
point A, the LAC curve is parallel to the horizontal axis. Any
business firm think in terms of entering the market must produce
minimum of 100 units output. Then only they can minimise the
cost of production.

2. Entry occurs with the minimum plant size.

3. The product is homogeneous and the market demand is known.
The point of intersection of the given demand curve with a line
drawn at the level of the flat section of LAC determines the
competitive output QC and competitive price PC.

GRAPH-5

D
Price

E
Average cost

P
c

0 x 0 Qc
Output
4. The price is set by the largest firm in the industry, at such a level
as to prevent entry.

Determination of Limit Price:

GRAPH- 6 Y

D
Price and demand

P4 Entry premium

Pc

920 1000

Output

In the above graph, DD is the demand curve. PC is the competitive

price. At competitive price, the demand for the product is 1000
units. If the large firm set the price as P4, the demand at P4 price
is 920 units. The left over demand in the market at P4 price is 80
units which is less than optimal plant size. Therefore no new firm
can enter the market. P4 price serves as limit price. The difference
between the competitive price and the limit price P4 is the entry
premium.

ACTVITY-3
1. Define optimum plant capacity.

6.05: Factors that determine the level of limit price:

There are four factors that determine the limit price. They are:

1. The absolute market size: There is inverse relationship between

the absolute size of the market and the limit price. The larger the
market size the lower the limit price.
2. The elasticity of market demand: There is inverse relationship
between elasticity of demand and the absolute market size. If the
demand is relatively elastic, the large firm set the limit price at a
low level.
3. The technology: The technology determines the minimum viable
plant size. The larger the minimum viable plant size, the higher the
higher will be the limit price.
4. The prices of factors of production: There is direct relation
between factor prices and the limit price.
ACTIVITY-4
1. Identify the factors that determine the level of Limit Price.
2.
6.06: Summary:
The price that the established business firms can charge without
attracting the entry of new firms in to the market is called limit
price. Bain stated that if the established firms fix the price by
following the marginal principle, the price may be very high and
induces the entry of new firms. The established firms should fix
the limit price in such a way that the post entry price must fall
below the average cost of the new entrant. According to Sylos-
Labini, the entry gap should be less than the small plant sized firm.
According to Modigliani, the entry gap should be less than
optimum size plant. The level of limit price depends on size of the
market, elasticity of demand, optimum plant size and the factor
prices.

6.07: References:
1. Koutsoyiannis : Modern Micro Economics
2. Dominick Salvatore: Managerial Economics in a Global
Economy
3. H. Craig Petersen : Managerial Economics
 And W. Cris Lewis
4. R.L Varshney and K.L. Maheswari : Managerial Economics
5. D.N.Dwivedi : Managerial Economics

6.08: Self Assessment Test:

1. Define limit price and explain Bain’s model of limit pricing.
2. Discuss the limit pricing models of Sylos-Labini and
Modigliani.
 UNIT-IV
(Pricing)
MODULE- 7: PRICING PROBLEMS AND
TECHNIQUES

CONTENTS
7.0: Objectives
7.01: Pricing problems
Multiple product pricing
Pricing in life-cycle of a product
7.02: Pricing techniques
Skimming price policy
Penetration pricing
Marginal cost pricing
Target return pricing
Cost-plus pricing
Loss leader pricing
Basing point pricing
Administered prices
Pricing by public firms
7.03: Discount structure
7.04: Types of discounts
7.05: Summary
7.06: References
7.07: Self Assessment test.

7.0: Objectives:
The objective of this module is to discuss different pricing
strategies adopted by private and public sector firms. After reading
this module, you should be able to understand the:

Multiple product pricing

Pricing in life cycle of a product
Skimming price policy
Penetration price policy
Cost plus pricing
Loss leader pricing
Discount Structure
Administered prices
Pricing policy adopted by public firms.

7.01: Pricing problems:

Pricing is one of the crucial decisions that a management executive
has to arrive at. Managers generally face problems while setting
prices of products produced in a product line. In the same way, it is
not easy to fix the price of a product on the basis of product life-
cycle. Now we shall try to discuss and understand the specific
pricing problems of business firms.

Multiple product pricing:

The price theory is based on the assumption that a firm produces a
single, homogeneous product. In actual practice, production of a
single homogeneous product is an exception. Almost all firms have
more than one product in their line of production. Many firms
produce a commodity in multiple models, sizes, each so much
differentiated from the other that every model or size of the
product may be considered a different product. For example: the
various models of refrigerators, television sets, washing machines,
cell phones etc, produced by same company may be treated as
different products for at least pricing purpose. The various models
are so differentiated that consumers view them as different
products. It is therefore not surprising that each model has different
average revenue (AR) and marginal revenue (MR) and that one
product of the firm competes against the other product. The pricing
under these conditions is known as multi-product pricing or
product line pricing.
The major problem in pricing multiple products is that each
product has a separate demand curve. But since all products are
produced under one establishment by interchangeable production
facilities, they have only one joint and inseparable marginal cost
curve. That is while revenue curves i.e. AR and MR are separate
for each product; cost curves i.e. AC and MC are inseparable.
Therefore the marginal rule of pricing cannot be applied to fix the
price of each product separately. Under these conditions the price
is fixed in such way to equate marginal revenue from each product
is equal to combined marginal cost (CMC). Suppose if a firm
produces three different sizes i.e. A, B, C, of same product in its
product line, based on price elasticity of demand for different size
groups, then it fix the price by following the condition CMC=
MRA=MRB=MRC .

GRAPH-1

Y Y Y

A B C
Revenue,Price

E3 E2 E1
ARA ARB

MRA MR MR
B
0 0 0
Output Output Output
Pricing in life-cycle of a product:

The life-cycle of a product is generally divided in to five stages.

These stages are (1) Introduction (2) Growth (3) Maturity (4)
Saturation (5) Decline. The pricing strategy varies from stage to
stage over the life-cycle of the product.

The pricing policy in respect of a new product depends on whether

or not close substitutes are available. Depending on this, generally
two kinds of pricing strategies are adopted in pricing a new
product. These are (A) Skimming price policy (B) Penetration
price policy.

GRAPH=2
Y
Sales

Saturati Decline
Maturit
Growth on-on
Introd y
uction
7.02: Pricing techniques:
Business firms generally adopt various pricing techniques
depending up on the nature of the product, elasticity of demand,
availability of substitutes, the income level of consumers, the
pressure on its production capacity and the objectives. Now we
shall try to discuss and understand various pricing techniques
adopted by business firms.

Skimming price policy:

This price policy is adopted where close substitutes of a new
product are not available. This pricing strategy is intended to skim
the cream i.e consumer’s surplus off the market by setting a high
initial price and subsequent lowering of price in a series of
reductions especially incase of consumer durables. The initial high
price is generally be accompanied by intensive selling campaign.
GRAPH-3

Price
Price

0
Time

Penetration price policy:

This pricing policy is generally adopted in the case of new
products for which substitutes are available. This policy requires
fixing a lower initial price designed to penetrate the market as
quickly as possible and is intended to maximize the profits in the
long run.. Therefore, the firms pursuing the penetration price
policy set a low price of the product in the initial stage. As there is
rise in demand in due course of time, price is gradually increased.

GRAPH-4
 Y
Price

Price

X
0
Time

Marginal cost pricing:

Under this method business firms always fix the price
corresponding to the equality between marginal cost (MC) and
marginal revenue (MR).

Target -return pricing:

Under this method business fix its target rate of return either on
fixed capital or on total capital. Let us say that a business firm
aimed at 10% profit. Now the firm has to specify clearly whether
its aim is to earn 10% on fixed capital or total capital. Based on
this it has to fix the price in such a way to realize expected rate of
return.
Cost-plus pricing:
This is also known as Mark-up pricing or average cost pricing or
full-cost pricing. The cost-plus pricing is the most common method
of pricing used by the manufacturing business firms. The general
practice under this method is to add a fair percentage of profit
margins to the average variable cost (AVC). The formula for fixing
the price under this method is shown below.

P = AVC + GPM

The AVC is assumed known to the firm with certainty. GPM will
cover the average fixed cost (AFC) and yield a normal profit. Thus
GPM =AFC + NPM. Therefore P = AVC+ AFC+ GPM. Here
NPM is the net profit margin. The net profit margin is assumed to
be known to the business firms. It should yield a fair return on
capital and cover all risks peculiar to the product.

Example: A firm produced 100 units of output. Its total fixed cost
is Rs 6000 and Total variable cost is Rs 30,000. Its aim is to earn
20% profit. Profit margin is always fixed on price which is
unknown. Let us assume price is Rs X. In this example AVC = Rs
300 and AFC =Rs 60. Therefore AC = Rs 360. Based on this
information, we can find out the price that a business firm has to
set, to earn 20% profit margin.

X – 360 =. 20 X
X - . 20 X = 360
X (1- . 20) = 360
X (. 80) = 360

360
X = ------ = Rs 450.
. 80

Given the cost conditions, the firm has to set the price as Rs 450 to
realize 20% profit margin.

Loss leader pricing:

A firm producing jointly demanded products can adopt this type of
pricing strategy. A firm producing Xerox machines and toners can
price the Xerox machine average cost if it is confident of selling
large quantity of toners. The firm incurs loss on Xerox machines
but more than makes it up through the sale of toners. This strategy
is appropriate in case of complementary products where one time
purchase of a high value low volume product i.e. Xerox machine,
leads to repeat purchase of low value but high volume product i.e
toner.

For example: The average cost of Xerox machine is Rs 80,000.

The sale price of Xerox machine is Rs 70,000. Business firm is
incurring loss of Rs 10,000 on the sale of each Xerox machine. The
average cost of toner is Rs 400. The sale price of toner is Rs 600.
Business firm is earning profit to the extent of Rs 200, on the sale
of each toner. It is a fact that toner is a repeat purchase item and
hence the business firm can compensate loss from the sale of
Xerox machines through the profits from the sale of toners and
finally smell the net profit.

Basing point pricing:

The business firms operating under collusive oligopoly generally
follow this pricing policy. Under this, the price quoted by each is
the sum of production cost and the transportation cost from the
basing point. Under this system the delivered price may be
computed by using either single basing point or multiple basing
points. Under the single basing point system, all suppliers quote
the delivered prices which are the sum production cost and
transportation cost from the basing point. Thus the delivered prices
quoted by all firms for a given point of delivery are uniform
regardless of the point from which the delivery is made. Under the
multiple points pricing system, two or more producing centers are
selected as basing points. This pricing system has been in use by
the business firms producing steel in America.

GRAPH-5

In the above graph, P1P is the production cost line which is

parallel to horizontal axis. The horizontal cost line indicates that
the cost of production is identical across firms. PT is the
transportation cost from location A. Business firms decided to
consider location A as the basing point. Business firms will set the
price based on their production cost and transportation cost from
basing point. Firm A, to place commodity in its location, will quote
the price as AP. Where as to place commodity in location B, it will
quote the price as BN and in location C it will quote CQ, location
D, it will quote DH and in location E, it will quote ET price. In the
same other business firms quote their price.

Administered prices:
Administered prices are the prices fixed by the government. The
prices of petroleum products, kerosene, coal, aluminium, fertilisers
and the commodities supplied through public distribution system.
The objective of administered prices is to control the prices of
essential commodities and to arrest price escalation and protect the
welfare of consumers.

Pricing by public firms:

The pricing policy of public sector enterprises is generally
governed by social objectives rather profit considerations alone.
Keeping the social responsibility of supplying commodities the
public sector undertakings follow different pricing strategies
pertaining to nature of the commodity and its users. Public sector
undertakings may follow break-even pricing or profit as the basis
or loss as the basis for its pricing policy.

7.03: Discount structure:

Distributors’ discounts are price discounts that systematically
make the net price vary according to buyers’ position in the chain
of distribution. They are so called because these discounts are
given to various distributors in the trade channel namely dealers,
wholesalers and retailers. For the same reason they are also called
trade channel discounts. As these discounts create differential
prices for different customers on the basis of marketing functions
performed by them example: whether they are wholesaler or
retailer. These discounts also called as functional discounts.
Special discounts are also given to persons other than distributors.

7.04: Types of discounts:

Quantity discounts:
These are price reductions related to the quantities purchased.
Quantity discounts may take several forms. Quantity discounts
may be related to the size of the order being measured in terms of
physical units of a particular product. This method is practicable
where the commodities are homogeneous in nature and may be
measured in terms of truck loads. The important objective of
quantity discounts is to reduce the number of small orders and
there by avoid the high cost servicing them.

Cash discounts:
Cash discounts are price reductions based on promptness of
payment. An example is: 10% discount if paid in 10 days, full
invoice price in 20 days. In practice the size of cash discount may
vary widely. Cash discount is a convenient device to over come
bad credit risks. With respect to the sale of certain commodities
credit risk is high. So that business firm offers maximum discount.

Time differentials:
Charging different prices on the basis of time is another kind of
price discount. Here the objective of the seller is to take advantage
of the fact that buyers’ demand elasticity’s vary over time. The
discounts based on time are: (1) clock-time discounts (2) calendar
time discounts.

Clock-time discounts: When different prices are charged for the

same service or commodity at different times within a 24 hour
period, the price differentials are known as clock time differentials.
The common example of these is the differences between the day
and night rate on trunk calls. This is also the case of peak-load
pricing. Business firms generally charge high price when there is
huge demand i.e peak-load, for given services i.e. the line capacity,
to divert some customers to use their services during off-peak
period. Therefore the firms fix low price during off-peak period.

Calendar time discounts:

Under this method the price differences are based on period longer
than 24 hours. For example: seasonal price variations in the case
woolen clothes, hotel accommodation at hill stations and tourist
places.

7.05: Summary:
Pricing policy of a business firm determines its future growth. It is
the most difficult decision that a management executive or CEO of
a business has to arrive at after giving due importance to various
factors. If a business firm adds a product line, it has to face
problems while setting the price. In the same way, it is very
difficult to price of products based on product life-cycle. Different
pricing techniques are generally adopted by business firms taking
into account the nature of the product, elasticity of demand,
availability of substitutes and the objectives. The government
generally fixes the prices of coal, petrol, kerosene, fertilizers. The
prices fixed by government are called as administered prices. The
public sector under takings also fix the prices products supplied by
them keeping in mind the social responsibility. Business firms also
offer quantity and cash discounts and also implement price
variation policy based on peak and off-peak demand.

7.06: References:
1. Koutsoyiannis : Modern Micro Economics

2. Dominick Salvatore: Managerial Economics in a Global

Economy

3. H. Craig Petersen : Managerial Economics

 And W. Cris Lewis
4. R.L Varshney and K.L. Maheswari : Managerial Economics
5. D.N.Dwivedi : Managerial Economics

7.07: Self Assessment Test:

1. Discuss the pricing problems of business firms.
2. Discuss different pricing techniques adopted by business firms.