Unit4: Cost Revenue Analysis, Pricing Policies and Degree of Competition

Cost of Production- Private cost and social cost, Accounting Costs and Economic costs,
Short run cost -- TFC, TVC, TC, AFC, AVC, ATC, MC.

Cost of Production- Private cost and social cost

• Private Cost: Private costs are the actual expenses incurred by a business or
individual to produce a good or service. These include costs like wages, rent,
materials, and other out-of-pocket expenses borne directly by the producer.
Private costs only consider the direct expenses that affect the producer.

• Social Cost: Social costs include both the private costs and any additional costs
imposed on society due to production. These can be environmental costs, health
impacts, or other negative effects that aren’t accounted for in private costs but are
borne by society. For example, a factory producing chemicals might incur private
costs for raw materials and labor but also create pollution, imposing a social cost
on the surrounding community.

Accounting Costs vs. Economic Costs

• Accounting Costs: These are the explicit, out-of-pocket costs recorded in a

company’s financial statements, like rent, salaries, and utilities. They are
concrete, direct expenses that can be easily calculated.

• Economic Costs: Economic costs include both accounting costs (explicit costs)
and implicit costs. Implicit costs represent the opportunity costs of using
resources in their current way rather than in the next best alternative. For example,
if a business owner uses their own building instead of renting it out, the foregone
rental income is an implicit cost. Economic cost provides a more complete view
of the true cost of production, factoring in both explicit and implicit costs.

Short-Run Costs

In the short run, some production inputs are fixed (like capital), while others are variable
(like labor and raw materials). This results in different cost categories:

• Total Fixed Cost (TFC): Fixed costs that do not change with the level of output.
These are costs for inputs that cannot be easily altered in the short run, such as
rent, insurance, or salaries of permanent staff. Even if output is zero, TFC remains
constant.

• Total Variable Cost (TVC): Variable costs that change with the level of output, like
costs for raw materials, electricity, and hourly wages. As output increases, TVC
also increases.
 • Total Cost (TC): The sum of Total Fixed Cost and Total Variable Cost at each level
of output.

TC=TFC+TVCTC = TFC + TVCTC=TFC+TVC

• Average Fixed Cost (AFC): Fixed cost per unit of output, calculated by dividing
TFC by the quantity of output (Q).

As output increases, AFC decreases because the fixed cost is spread over a larger
number of units.

• Average Variable Cost (AVC): Variable cost per unit of output, calculated by
dividing TVC by the quantity of output.

AVC typically decreases initially due to increasing efficiency, then increases after a
certain point as diminishing returns set in.

• Average Total Cost (ATC): Total cost per unit of output, calculated by dividing TC
by the quantity of output.

ATC is the sum of AFC and AVC.

• Marginal Cost (MC): The additional cost incurred by producing one more unit of
output. It is the change in Total Cost when output is increased by one unit.

MC plays a crucial role in production decisions, as firms compare the marginal cost of
producing an additional unit to the marginal revenue it generates.

These cost measures are essential for understanding how businesses make production
decisions, particularly when determining the optimal level of output to minimize costs or
maximize profits.

Nature of Short-Run Average Cost (SRAC)

 • In the short run, some inputs are fixed, and firms face constraints on expanding
capacity. As a result, the SRAC curve is typically U-shaped.

• The U-shape of the SRAC curve reflects the principle of diminishing returns:

o Initially, as production increases, SRAC decreases due to increasing

returns to the variable inputs and better utilization of fixed resources.

o After a certain point, as more units are produced, SRAC starts to rise due
to diminishing marginal returns from over-utilization of fixed inputs.

Relation between Average Cost (AC) and Marginal Cost (MC)

• When MC < AC: If the cost of producing an additional unit (MC) is less than the
average cost, the average cost will decrease. This typically happens in the initial
stages of production.

• When MC > AC: If the marginal cost of producing one more unit is higher than the
average cost, AC will start to increase. This generally happens after reaching an
optimal production level.

• When MC = AC: The marginal cost curve intersects the average cost curve at its
lowest point. At this point, the average cost is minimized, representing the most
efficient scale of production in the short run.

Long-Run Cost Curve (LAC)

• In the long run, all inputs are variable, and firms can adjust their production scale
fully.

• The long-run average cost (LAC) curve is derived by combining the minimum
points of various short-run average cost curves for different scales of production.

• The LAC curve is also typically U-shaped but is flatter than the SRAC curve. It
represents the lowest possible cost per unit at each level of output when the firm
can adjust all inputs.

Nature of the Long-Run Average Cost Curve (LAC)

• The LAC curve is often referred to as an “envelope curve” since it “envelops” all
possible SRAC curves.

• In the initial downward-sloping section, economies of scale allow cost savings,

so LAC decreases as output increases.

• At the minimum point of the LAC curve, the firm achieves the optimal production
scale, known as the minimum efficient scale (MES).
 • Beyond this point, the LAC curve may start to slope upward due to diseconomies
of scale, leading to higher costs as output continues to grow.

Economies of Scale and Diseconomies of Scale

• Economies of Scale: When a firm increases production, it may benefit from lower
average costs per unit due to factors like bulk purchasing, specialization, and
more efficient use of technology. These benefits can be internal (within the firm,
such as specialization of labor) or external (outside the firm, like improved
infrastructure or industry developments). Economies of scale contribute to the
downward slope of the LAC curve.

• Diseconomies of Scale: As a firm expands beyond a certain point, it may face

increased per-unit costs. These higher costs can stem from challenges in
coordination, inefficiencies in communication, or overcrowding of resources.
Diseconomies of scale cause the LAC curve to slope upward beyond the optimal
production level.

In summary, economies and diseconomies of scale determine the shape of the long-run
average cost curve, reflecting the impact of expansion on production efficiency. The LAC
curve is U-shaped due to the balance between economies of scale (cost-saving) at lower
production levels and diseconomies of scale (cost-increasing) at higher production
levels.

Revenue: Meaning and Types

Revenue is the total income generated by a business from selling goods or services. It’s
calculated by multiplying the quantity of goods sold by their price. Revenue is critical
because it reflects a company’s ability to cover its costs and generate profit.

There are three main types of revenue:

1. Total Revenue (TR): The overall income from selling a particular quantity of goods.
Mathematically, it’s:

TR=Price×Quantity

2. Average Revenue (AR): The revenue earned per unit sold, which is typically equal
to the price in many cases. It’s calculated as:
3. Marginal Revenue (MR): The additional revenue gained from selling one extra unit
of a product. It reflects the change in total revenue with each additional unit sold:

Relationship between TR, AR, and MR

• Total Revenue (TR) is the aggregate revenue at different levels of quantity sold,
and it increases with each additional unit sold.
• Average Revenue (AR) is simply TR divided by quantity, showing the revenue per
unit. In a perfectly competitive market, AR equals price since all units are sold at
the same rate.
• Marginal Revenue (MR) tells us how much extra revenue is generated by selling
one more unit. The relationship between MR and AR depends on market structure:
o If MR > AR, TR increases at an increasing rate.
o If MR = AR, TR increases linearly (constant rate).
o If MR < AR, TR increases but at a decreasing rate, and if MR becomes
negative, TR starts to decline.
In perfect competition, MR equals AR and price, as firms are price-takers.
However, in imperfect competition, MR falls below AR as additional units are sold
at a lower price.
Revenue Curves in Different Market Structures
1. Perfect Competition:
o TR Curve: The TR curve is a straight line sloping upwards since revenue
increases at a constant rate (price stays the same).
o AR and MR Curves: AR and MR are horizontal lines at the market price
level, reflecting that each additional unit sold yields the same revenue. AR
= MR = Price.
2. Monopoly (and Monopolistic Competition):
o TR Curve: TR initially increases but at a decreasing rate, eventually
reaching a peak and then declining as more units are sold (due to lower
MR).
o AR and MR Curves: The AR curve is downward-sloping, as the firm must
reduce prices to sell additional units. MR is also downward-sloping and lies
below the AR curve due to diminishing returns with each additional unit
sold. In monopoly, MR is less than AR because selling extra units requires
lowering the price for all units.
3. Oligopoly:
o Oligopolistic firms’ revenue curves depend on interdependent pricing
strategies and whether they are engaging in competitive or cooperative
behaviors.
 o Kinked Demand Curve: A kinked demand curve in oligopoly suggests that
firms might face two different demand curves — elastic above the kink (as
they fear losing customers if they raise prices) and inelastic below it (as
rivals would match price cuts). The MR curve reflects this kink, causing
discontinuity, which can stabilize prices.

Degree of Competition
The Degree of Competition in a market refers to the level of rivalry between
businesses selling similar or substitute goods and services. This concept is vital
as it determines how prices are set, how much control individual firms have, and
how resources are allocated within the market. Economists classify markets
based on their degree of competition, which varies from highly competitive (many
firms with little control over price) to non-competitive (one firm with complete
control over price).
Here’s an overview of the main market structures based on competition:
1. Perfect Competition: Characterized by a large number of small firms selling
identical products. Firms are price-takers, meaning they have no control over
price and must accept the market price. There are no barriers to entry or exit, and
buyers and sellers have perfect information.
2. Monopolistic Competition: Many firms sell similar but differentiated products,
giving each firm some control over its prices. There’s freedom of entry and exit,
and firms compete on product quality, branding, and other non-price factors.
3. Oligopoly: A few large firms dominate the market, selling identical or
differentiated products. Firms have significant control over prices but are
interdependent; each firm’s decisions affect and are affected by the actions of
others, leading to potential collusion or competition.
4. Monopoly: A single firm controls the entire market for a product with no close
substitutes. The firm has complete control over the price and output, facing high
barriers to entry that prevent other firms from entering the market.

Pricing and Equilibrium in Different Market Structures

1. Perfect Competition
• Pricing: Since firms are price-takers, they sell goods at the market-determined
price. The price is set at the intersection of the market's supply and demand
curves. A firm’s Marginal Cost (MC) curve also acts as its supply curve.
• Equilibrium: Short-Run Equilibrium occurs when a firm’s Marginal Cost (MC)
equals Marginal Revenue (MR), which is also equal to the price (P). Firms may
make abnormal profits or losses in the short run. Long-Run Equilibrium is
reached when firms make only normal profit (break-even), as free entry and exit
adjust supply until Price = Average Total Cost (ATC).
2. Monopoly
• Pricing: A monopolist sets prices by determining the output level where Marginal
Revenue (MR) equals Marginal Cost (MC), then charging the highest price
consumers are willing to pay at that output (as shown by the demand curve). This
price will be above the marginal cost, leading to economic profits.
• Equilibrium: The Monopoly Equilibrium is achieved where MR = MC. Unlike in
perfect competition, monopolies can sustain long-term profits due to high
barriers to entry. This typically results in higher prices and lower quantities than
would exist in a more competitive market, often leading to a deadweight loss for
society.
3. Monopolistic Competition
• Pricing: Firms in monopolistic competition set prices based on their own demand
curve, which is downward-sloping due to product differentiation. They have some
price-setting power and typically charge a price higher than marginal cost.
• Equilibrium: Short-Run Equilibrium is achieved where MR = MC, allowing firms
to earn abnormal profits if they have strong product differentiation. However,
Long-Run Equilibrium is achieved when new firms enter the market, attracted by
these profits, which shifts each firm’s demand curve leftward until firms only
make normal profits (P = ATC). At this point, firms operate with excess capacity as
they do not produce at the minimum point of the ATC curve.
4. Oligopoly
• Pricing: Pricing in an oligopoly depends heavily on the interdependence between
firms. They may either compete or collude. In a competitive oligopoly, firms may
adopt aggressive pricing to gain market share (price wars). In a collusive oligopoly
(such as a cartel), firms coordinate to set prices above marginal cost, similar to
monopoly pricing.
• Equilibrium: There are multiple models to explain oligopoly equilibrium, but two
common ones are:
o Kinked Demand Curve Model: Suggests price rigidity where firms face a
demand curve that’s more elastic for price increases (risking loss of
customers) and less elastic for price decreases (rivals match cuts). This
creates a discontinuous MR curve, causing firms to maintain prices even if
costs fluctuate slightly.
 o Cournot and Bertrand Models: In Cournot, firms choose output levels
simultaneously, leading to equilibrium where no firm can benefit by
changing its output. In Bertrand, firms set prices, potentially leading to
competitive outcomes if products are identical (prices can approach
marginal cost).

1. Perfect Competition – Agricultural Market (e.g., Wheat Farming)

Case Summary: Consider a regional wheat market where numerous small
farmers produce identical wheat products. No single farmer can influence the
market price, and they sell their product at the going market rate determined by
overall supply and demand.
• Pricing: Since all wheat is identical, each farmer is a price-taker and must accept
the market price. If they try to sell at a higher price, buyers will simply purchase
from other farmers at the market rate.
• Equilibrium: Short-Run – Individual farmers may earn profits or losses based on
weather, productivity, and other factors. Long-Run – In the long run, new farmers
can enter the market if profits exist, and underperforming farms exit, driving the
price to a point where only normal profits (break-even) are made.
Impact: In perfect competition, equilibrium pricing is efficient as it reflects the
true marginal cost of production, with firms producing the quantity where Price =
MC. Consumers benefit from lower prices and abundant supply.

2. Monopoly – Utility Provider (e.g., Electricity Company)

Case Summary: Imagine a regional electric utility company, "PowerGrid Co.," that
is the sole provider of electricity in a city. High fixed costs (infrastructure) and
government licensing prevent other firms from entering the market, giving
PowerGrid Co. monopoly power.
• Pricing: PowerGrid Co. maximizes profit by setting a price where Marginal
Revenue (MR) equals Marginal Cost (MC). Since it’s the only provider, it charges a
 price higher than MC, creating a profit margin. Consumers face higher prices than
in a competitive market, but electricity is a necessity.
• Equilibrium: Long-Run – PowerGrid Co. can sustain economic profits as there are
no competitors. If the government doesn’t regulate prices, PowerGrid may restrict
output to keep prices high, causing inefficiency.
Impact: Monopoly pricing leads to higher prices and potentially lower output,
creating a deadweight loss as the market isn’t perfectly efficient. Governments
often regulate monopolies, requiring fair pricing to protect consumers, as seen
with public utility commissions.

3. Monopolistic Competition – Restaurant Industry

Case Summary: In a metropolitan area, multiple restaurants offer distinct dining
experiences, cuisines, and atmospheres, appealing to different customer tastes.
Each restaurant differentiates its offerings (e.g., Italian, vegan, fusion), allowing
some control over pricing.
• Pricing: Each restaurant has some pricing power due to its unique offerings,
setting prices above marginal cost. They attract customers based on brand loyalty,
quality, and uniqueness. However, if prices are too high, consumers may switch
to other restaurants.
• Equilibrium: Short-Run – Successful restaurants may earn profits by attracting a
loyal customer base. Long-Run – In the long run, new restaurants enter if profits
are high, increasing competition and shifting demand for each existing restaurant
leftward until they earn only normal profit. Excess capacity occurs as restaurants
don’t operate at the lowest point of their Average Cost curve.
Impact: Monopolistic competition creates a market where firms compete based
on differentiation. Consumers benefit from variety, though prices are slightly
higher than in perfect competition due to product uniqueness and brand
differentiation.

4. Oligopoly – Automobile Industry

Case Summary: A handful of large automobile manufacturers (e.g., Toyota, Ford,
Volkswagen) dominate the global car market, each producing similar but
differentiated vehicles. Significant barriers to entry, such as high capital
requirements, restrict new firms from entering the market.
• Pricing: The interdependence among firms means that one company’s pricing
and production decisions affect all others. For instance, if Toyota reduces its car
prices, other manufacturers may respond to avoid losing market share, potentially
leading to a price war.
• Equilibrium: Kinked Demand Curve – Companies may avoid changing prices
significantly, especially increases, as competitors are likely to undercut them,
maintaining a relatively stable price range. Alternatively, companies may tacitly
collude to maintain prices at a higher level, though this is illegal in many countries.
Cournot Equilibrium – Each company may choose output levels assuming the
outputs of its rivals are fixed, leading to a stable equilibrium where no firm can
increase profit by altering output independently.
Impact: Oligopolies often lead to stable prices but can result in higher-than-
competitive prices if firms collude or avoid competition. Consumers may face
less variety and higher prices, though quality and innovation can improve as firms
differentiate themselves to compete.
Revenue Curves under Different Markets

(i) Revenue Curve under Perfect competition:

Perfect competition is the term applied to a situation in which the individual buyer or
seller (firm) represent such a small share of the total business transacted in the market
that he exerts no perceptible influence on the price of the commodity in which he deals.

Thus, in perfect competition an individual firm is price taker, because the price is
determined by the collective forces of market demand and supply which are not
influenced by the individual. When price is the same for all units of a commodity,
naturally AR (Price) will be equal to MR i.e., AR = MR. The revenue schedule for a
competitive firm is shown in the table 5.

as
output increases, AR remains the same i.e. Rs. 5. Total revenue increases but at a
constant rate. Marginal revenue is also constant i.e. Rs. 5 and is equal to AR.

Thus

TR = AR x Q

Also TR = MR x Q [Since AR = MR]

on the X-axis, we take quantity whereas on Y-axis, we take revenue. At price OP, the seller
can sell any amount of the commodity. In this case the average revenue curve is the
horizontal line. The Marginal Revenue curve coincides with the Average Revenue.

It is because additional units are sold at the same price as before. In that case AR = MR.
A noteworthy point is that OP price is determined by demand and supply of industry.
(ii) Revenue Curves under Monopoly:

Monopoly is opposite to perfect competition. Under monopoly both AR and MR curves

slope downward. It indicates that to sell more units of a commodity, the monopolist will
have to lower the price. This can be shown with the help of table

In case of pure monopoly, AR curve can be rectangular hyperbola as has been shown in
Fig. 9. In this situation, a producer is so powerful that by selling his output at different
prices, he can make the consumer spend his income on the concerned commodity. In
this case AR curve is rectangular hyperbola. It implies that TR of the monopolist will
remain same whatever may be the price. Area below each point of AR curve will be equal
to each other. When TR is constant MR curve will be represented by OX-axis

(iii) Revenue Curve under Imperfect Competition:

When a firm is working under conditions of monopoly or imperfect competition, its

demand curve or AR curve is less than perfectly elastic, the exact degree of elasticity
being different in different market situations depending upon the number of sellers and
the nature of product.

In other words, the demand/AR curve has a negative slope and the MR curve lies below
it. This is because the monopolist seller ordinarily has to accept a lower price for his
product, as he increases his sales.
Under imperfect competition conditions, total revenue increases at a diminishing rate. It
becomes maximum and then begins to decline.

2 units can be sold at a unit price of Rs. 5, bringing in total revenue of Rs. 10. When 3 units
are sold, the price per unit is lowered to Rs. 4 to make it possible for larger quantity to be
sold. The total revenue in this case is Rs. 12.

The marginal unit is not bringing in Rs. 4 which is its price, but only Rs. 2. This is because
the additional one unit is sold at Re. one less and the first 2 units which could have been
sold for Rs. 5 are also sold at Rs. 4. i.e., Re. one less.

A shows that as additional units are sold when price comes down not only for the
marginal units but also for other previous units. As a result, marginal units do not bring
revenue equal to its price. In fig. 10 B. TR increases at a diminishing rate, becomes
maximum at point N and then begins to decline. This has been represented by the curve
TR. AR at any point on the TR curve is given by the slope of straight line joining the point
to the origin. For instance, AR at any point N on TR curve is given by the slope of line

(iv) Revenue Curves under Oligopoly:

Under oligopoly market situation the number of sellers is small. The price reduction or
extension by one firm affects the other firms. If a seller raises the price of his product,
others will not follow him. They know that by following the same price, they can earn more
profits. That producer, who has raised the price, is likely to suffer losses because demand
of his product will fall.
In this case, the AR curve becomes highly elastic after K whereas it was less elastic before
K. MR, corresponding to AR curve rises discontinuously from b. After that it again takes
its course at a new higher level.

(b) If a firm has a kinked demand curve i.e. when it expects that other firms will follow,
then it will cut the price. In that case MR curve will be discontinuous at the point of the
kink.

If under oligopoly, a seller reduces the price of his product; his rivals also follow him in
reducing the price of their product. If it is done so, he may not be in a position to raise his
sales. Thus AR curve becomes less elastic from K onwards and correspondingly MR curve
falls vertically from a to b and then slopes at a lower level.

Thus, from the above analysis we can conclude that:

1. Under perfect competition, average revenue curve is a straight horizontal line and is
equal to MR.

2. In pure monopoly, AR curve is a rectangular hyperbola and MR curve coincides with

the horizontal axis.
3. In all other markets, AR curve slopes downwards and MR curve lies below it. In
oligopoly, however, AR curve cannot be drawn with definiteness but the practice is to
draw downward sloping AR and MR curves.

Equilibrium
• Equilibrium refers to a state of market in which quantity demanded of a
commodity equals the quantity supplied of the commodity.
• The equality of demand and supply produces an equilibrium price.

Pricing and Equilibrium under perfect competition-

• A large number of firms compete against each other for selling their product.
• Only a single price is ruling the market and firm is price taker.
• Price is determined by the market forces of demand and supply and a firm has to
accept the price determined by the market forces.
• If a firm uses its discretion to fix the price of its product above or below its market
level, it loses its revenue and profit in either case.
• Equilibrium price of a commodity in a free market is determined by the market
forces of demand and supply.
 Pricing and Equilibrium under Perfect Competition-
In short Run
• If market price< Short Run Average Total Cost, there will be loss at all these
output level (AR=AVC). In short run business will continue if it is able to recover
at least variable cost.
 • If market price = Short Run Average Total Cost, there will be break even point.
(Price=AR=AC and TR=TC)
• If market price > Short Run Average Total Cost, there will be excess profit
(MR=MC and AR>AC)
• If market price < AVC, it is considered shut down point.
In Long Run
• Firm will adjust its output and scale to level where,
Long Run Price=LMR=LAR =LMC=LAC

Short Run Equilibrium

SMC=SMR, SAC curve cuts SAR curve from below

Long Run Equilibrium

• LMC=LMR
• Price=LAR, so only normal profit
 Pricing and Equilibrium under Oligopoly-

Pricing and Equilibrium under Monopoly-

• If the price determined by the monopolist in more than AC, he will get super
normal profits.
• MR = MC and MC intersects the MR curve from below.
A monopolist in the short run would enjoy normal profits when average revenue is just
equal to average cost.

Pricing and Equilibrium under Monopoly-

• In the short run, the monopolist may have to incur losses. This situation occurs if
in the short run price falls below the variable cost.
• Once the price falls below the average variable cost, monopolist will stop
production.
 Long Run Equilibrium under Monopoly-
• Equilibrium would be attained at that level of output where the long-run marginal
cost cuts marginal revenue curve from below.