UNIT - III: Production, Cost, Market Structures & Pricing

Production is the transformation or conversion of resources into commodities over time. Economists
view production as an activity through which utility is created or enhanced for a product. A firm is a
business unit which undertakes the activity of transforming inputs into output of goods and services.

FACTORS OF PRODUCTION

Factors of production is an economic term that describes the inputs that are used in the production of
goods or services in order to make an economic profit. The factors of production include land, labor,
capital and entrepreneurship. These production factors are also known as management, machines,
materials and labor, and knowledge has recently been talked about as a potential new factor of
production.

1. Land

Land is short for all the natural resources available to create supply. It includes raw land and anything
that comes from the land. It can be a non-renewable resource.

That includes commodities such as oil and gold. It can also be a renewable resource, such as timber. Once
man changes it from its original condition, it becomes a capital good. For example, oil is a natural
resource, but gasoline is a capital good. Farmland is a natural resource, but a shopping center is a capital
good.

The income earned by owners of land and other resources is called rent.

2. Labour

Labor is the work done by people. The value of labor depends on workers' education, skills, and
motivation. It also depends on productivity. That measures how much each hour of worker time produces
in output.

The reward or income for labor is wages.

3. Capital

Capital is short for capital goods. These are man-made objects like machinery, equipment, and chemicals,
that are used in production. That's what differentiates them from consumer goods. For example, capital
goods include industrial and commercial buildings, but not private housing. A commercial aircraft is a
capital goodbut a private jet is not.

The income earned by owners of capital goods is called interest.

4. Entrepreneurship

Entrepreneurship is the drive to develop an idea into a business. An entrepreneur combines the other
three factors of production to add to supply. The most successful are innovative risk-takers.

The income entrepreneurs earn is profits.

PRODUCTION FUNCTION

The production function expresses a functional relationship between physical inputs and physical
outputs of a firm at any particular time period. The output is thus a function of inputs. So, production
function is an input – output relationship. Mathematically production function can be written as Q = Output
f = Function of
Q= f (L1,L2 C,O,T) L1 = Land
L2 = Labour
Here output is the function of inputs. Hence output becomes the dependent C = Capital
variable andinputs are the independent variables. O = Organization
T = Technology
Definition :

Samueson defines the production function as “The technical relationship which reveals the
maximumamount of output capable of being produced by each and every set of inputs”

Michael R Baye defines the production function as” That function which defines the maximum
amountof output that can be produced with a given set of inputs.”

Assumptions:

Production function has the following assumptions.

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

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

The law of variable proportions which was earlier called as “Law of diminishing returns
has played a vital role in the modern economics theory. Assume that a firms‟ production function consists
of fixed quantities of all inputs (land, equipment, etc.) except labour which is a variable input. If you go on
adding the variable input, say, labor, the total output in the initial stages will increase at an increasing
rate, and after reaching certain level of output the total output will increase at declining rate. If variable
factor inputs are added further to the fixed factor input, the total output may decline. This law is of
universal nature and it proved to be true in agriculture.

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

1. Only one factor is varied

2. The scale of output is unchanged
3. The technique of production is unchanged
4. All units of factor input varied are homogeneous
Three stages of law:

The behaviour of the Output when the varying quantity of one factor is combined with a
fixed quantity of theother can be divided in to three district stages. The three stages

can be better understood by following the table.

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

We can sum up the above relationship thus when „AP‟ is rising, “MP‟ rises more than “AP; When „AP” is
maximum and constant, „MP‟ becomes equal to „AP‟ when „AP‟ starts falling, „MP‟ falls faster than „AP‟.

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

PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS

Isoquants analyse and compare the different combinations of capital & labour and output. The term
isoquanthas its origin from two words “iso” and “quantus”. „iso‟ is a Greek word meaning „equal‟
and
„quantus‟ is a Latin word meaning „quantity‟. Isoquant therefore, means equal quantity. An isoquant
curve is therefore calledas iso-product curve or equal product curve or production indifference curve.

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

Assumptions:

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

For example:- Now the firm can combine labor and capital in different proportions and can maintain
specified level of output say, 10 units of output of a product X. It may combine alternatively as follows:

In the below table, combination „A‟ represent 1 unit of capital and 10 units of labour and produces „10 ‟
units of a product. All other combinations in the table are assumed to yield the same given output of a
product say „10‟ units by employing any one of the alternative combinations of the two factors labour
and capital. If we plot all these combinations on a paper and join them, we will get a curve called Iso-
quant curve as shown below.
Labour is on the X-axis and capital is on the Y-axis. IQ is the Iso-Quant curve which shows all the alternative
combinations A, B, C, D which can produce 10 units of a product.

Features of an ISOQUANT:

1. Downward sloping:-If one of the inputs is reduced, the other input has to be
increased. There is no question of increase in both the inputs to yield a given output.

2. Don’t touch the axes:- The isoquant touches neither X-axis nor Y-axis, as both
inputs are required to produce a given product.If an isoquant is touching the X-axis,
it means output is possible even by using a factor(Ex: Labor alone without using
capital). But, this is unrealistic.

3. Don’t intersect:- Iso-quants representing different levels of output never intersect or

touch or be tangent to each other. If they intersect to each other, they have a
common point on them which means that the same amount of labor and capital
produce two different levels of output.

4. Convex to origin:-Isoquants are convex to the origin. It is because the inputs factor
are not perfect substitutes. One input factor is substituted by other input factor in a
decreasing marginal rate.The convexity of isoquant suggests that MRTS is
diminishingwhich means that as quantities of one factor-labor is increased , the less
of another factor-capital will be given up, if output level is to be kept constant.

5. Upper isoquants represent higher level of output:- Each isoquant represents a

different quantity of output. Higher isoquants indicate a higher level of output.
 LAW OF RETURNS TO SCALE

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

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

Assumptions

1. Technique of production is unchanged

2. All units of factors are homogeneous
3. Returns are measured in physical terms

When a firm expands, its scale increases all its inputs proportionally, then technically there are three
possibilities.

1. Law of increasing returns to scale:- if a proportionate/percentage

increase in the output is larger than the proportionate/percentage increase in
inputs, thereare increasing returns.

For example: If a 5% increase in inputs, results in 10% increase in

theoutput, a firm is said to attain increased returns.

If PFC > 1, it means increasing returns

to scaleIf PFC = 1, it means constant
returns to scale
If PFC < 1, it means decreasing returns to scale

2. Law of constant returns to scale:- if the proportionate increase in all the

inputs is equal to the proportionate increase in output, then situation of constant
returns to scale occurs.

For Example:- If the inputs are increased at 10% and if the resultant output also
increases a 10% then the organization is said to achieve constant returns to scale.
3. Law of decreasing returns to scale:- if the proportionate increase in output is
less than the proportionate increase in input, then a situation of decreasing
returns to scale occurs.

For Example:- If the inputs are increased by 10% and if the resultant
outputincreases only by 5% then the organization is said to achieve
decreasing returns to

DIFFERENT TYPES OF PRODUCTION FUNCTIONS

1. Cobb-Douglas Production Function

This production function was proposed by C. W. Cobb and P. H. Dougles. This famous statistical
production function is known as Cobb-Douglas production function. Originally the function is applied on
the empirical study of the American manufacturing industry from 1899 to 1922. Cobb – Douglas
production function takes the following
mathematical form.

Q = aLbKC

Q=
1.01L0.75
K0.25
AAssumptions:
It has the following assumptions
1. The function assumes that output is the function of two factors viz. capital and labour.
2. It is a linear homogenous production function of the first degree
3. There are constant returns to scale b+c=1
4. All inputs are homogenous
5. There is perfect
competition TYPES OF COSTS

Profits are the difference between selling price and cost of production. In general the selling price is not
within the control of a firm but many costs are under its control. The firm should therefore aim at
controlling and minimizing cost. The various relevant concepts of cost are:

1. Opportunity costs and Outlay costs:

Opportunity costs refer to the „costs of the next best alternative foregone‟. We have scarce
resources and all these have alternative uses. Where there is an alternative, there is an opportunity to
reinvest the resources. In other words, if there are no alternatives, there are no opportunity costs. It is
necessary that we should always consider the cost of the next best alternative foregone before
committing the funds on a given option. In other words, the benefits from the present option should be
more than the benefits of the next best alternative. Opportunity cost is said to exist when the resources
are scarce and there are alternative uses forthese resources. If there is no alternative, Opportunity cost
is zero.

For example: if a firm owns a land, there is no cost of using the land (i.e., the rent) in firm ‟s
account. Bust the firm has an opportunity cost of using this land, which is equal to the rent foregone by
not letting the land out on (the return of second best alternative is regarded as the cost of first best
alternative) rent.

Out lay costs are as actual costs which are actually incurred by the firm. these are the
payments madefor labour, material, plant, building, machinery traveling, transporting etc., These are all
those expenses appearing in the books of account, hence based on accounting cost concept.

2. Explicit costs and Implicit costs:

Explicit costs are also called as out-of-pocket cost that involve cash payments. These are the
actual or business costs that appear in the books of accounts. These costs include payment of wages and
salaries, payment for raw-materials, interest on borrowed capital funds, rent on hired land, Taxes paid
etc.

Implicit costs are also called as imputed costs which don‟t involve payment of cash as they are
not actually incurred. They would have been incurred had the owner not been in possession of the
facilities. Ex: Interest on own capital, saving in terms of salary due to own supervision and rent of own
building etc.

3. Historical costs and Replacement costs:

Historical cost is the original cost that has been originally spent to acquire the asset. of an asset.
Historical valuation is the basis for financial accounts.

A replacement cost is the price that is to be paid currently to replace the same asset. A
replacement costis a relevant cost concept when financial statements have to be adjusted for inflation.

4. Short – run costs and Long – run costs:

Short-run is a period during which the physical capacity of the firm remains fixed. Any increase
in output during this period is possible only by using the existing physical capacity more extensively. So
short run cost is that which varies with output when the plant and capital equipment are constant.Long
run is defined as a period of adequate length during which a company may alter all factors of production
with high degree of flexibility.

5. Out-of pocket costs and Books costs:

Out-of pocket costs also known as explicit costs are those costs that involve current cash
payment such as purchase of raw material, payment of salary rents payment, interest on loan etc.

Book costs also called implicit costs do not require current cash payments. Depreciation,
unpaidinterest, salary of the owner is examples of back costs.
6. Fixed costs, Variable costs and Semi-variable costs:

Fixed cost is that cost which remains constant for a certain level to output. It is not affected by
the changes in the volume of production but fixed cost per unit decreases, when the production is
increased. Fixed cost includes salaries, Rent, Administrative expenses depreciations etc.

Variable is that which varies directly with the variation in output. An increase in total output
results in an increase in total variable costs and decrease in total output results in a proportionate
deccease in the total variables costs. The variable cost per unit will be constant. Ex: Raw materials, labour,
direct expenses, etc.

Semi-variable costs refer to such costs that are fixed to some extent beyond which they are
variable. Ex:telephone charges, Electricity charges, etc.

7. Past costs and Future costs:

Past costs also called historical costs are the actual cost incurred and recorded in the book of
account these costs are useful only for valuation and not for decision making.

Future costs are costs that are expected to be incurred in the futures. They are not actual costs.
They are the costs forecasted or estimated with rational methods. Future cost estimate is useful for
decision making because decision are meant for future.

8. Controllable costs and Uncontrollable costs:

Controllable costs are ones, which can be regulated by the executive who is in charge of it. Direct
expenses like material, labour etc. are controllable costs.

Some costs are not directly identifiable with a process of product. They are apportioned to
various processes or products in some proportion. These apportioned costs are called uncontrollable
costs.

9. Incremental costs and Sunk costs:

Incremental cost also known as differential cost is the additional cost due to a change in the level
or nature of business activity. The change may be caused by adding a new product, adding new
machinery, replacing a machine by a better one etc.

Sunk costs are those which are not altered by any change – They are the costs incurred in the
past. This cost is the result of past decision, and cannot be changed by future decisions. Investments in
fixed assets are examples of sunk costs. Once an asset is bought, the funds are blocked forever. They
can neither be changednor controlled.
10. Total costs, Average costs and Marginal costs:

Total cost is the total expenditure incurred for the input needed for production. It may be explicit
or implicit. It is the sum total of the fixed and variable costs.

Average cost is the cost per unit of output. It is obtained by dividing the total cost (TC) by the
total quantity produced (Q)

Marginal cost is the additional cost incurred to produce an additional unit of output.

11. Accounting costs and Economic costs:

Accounting costs are the costs recorded for the purpose of preparing the profit & loss account
and balance sheet to meet the legal, financial and tax purpose of the company. The accounting concept is a
historicalconcept and records what has happened in the post.

Economic cost refers to cost of economic resources used in production including opportunity
cost. Economics concept considers future costs and future revenues, which help future planning, and
choice, while the accountant describes what has happened, the economics aims at projecting what will
happen.

MARKET
Market is a place where buyer and seller meet, goods and services are offered for the sale and transfer of
ownership occurs. A market may be also defined as the demand made by a certain group of potential
buyers for a good or service. The former one is a narrow concept and later one is a broader concept.
Economists describe amarket as a collection of buyers and sellers who transact over a particular product
or product class (the housing market, the clothing market, the grain market etc.)
Different Market Structures
Market structure describes the competitive environment in the market for any good or service. A
marketconsists of all firms and individuals who are willing and able to buy or sell a particular product.
This includesfirms and individuals currently engaged in buying and selling a particular product, as well as
potential entrants. The determination of price is affected by the competitive structure of the market.
This is because the firmoperates in a market and not in isolation. In making decisions concerning
economic variables it is affected, asare all institutions in society by its environment.
 PERFECT COMPETITION

Perfect competition refers to a market structure where competition among the sellers and buyers
prevails in its most perfect form. In a perfectly competitive market, a single market price prevails for the
commodity, which isdetermined by the forces of total demand and total supply in the market.
Characteristics Of Perfect Competition
The following features characterize a perfectly competitive market:
a) A large number of buyers and sellers: The number of buyers and sellers is large and the share of
eachone of them in the market is so small that none has any influence on the market price.
b) Homogeneous product: The product of each seller is totally undifferentiated from those of the others.
c) Free entry and exit: Any buyer and seller is free to enter or leave the market of the commodity.
d) Perfect knowledge: All buyers and sellers have perfect knowledge about the market for the
commodity.
e) Indifference: No buyer has a preference to buy from a particular seller and no seller to sell to
aparticular buyer.
f) Non-existence of transport costs: Perfectly competitive market also assumes the non-existence
oftransport costs.
g) Perfect mobility of factors of production: Factors of production must be in a position to move
freelyinto or out of industry and from one firm to the other.
Perfect competition: The individual firm
AR(Average revenue) curve and MR(Marginal Revenue) curve under perfect competition becomes equal
to D(Demand) curve and it would be a horizontal line or parallel to the X-axis. The curve simply implies
that a firm under perfect competition can sell as much quantity as it likes at the given price determined by
the industry
i.e. a perfectly elastic demand curve.

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Perfect competition: The firm and the industry
Price is determined by the market forces, that is, demand and supply for a given product or service. As
discussed above, firms have no control over the prices they charge for their products. The ultimate price
that determines the quantity demanded is equal to the quantity supplied. This price is also called
equilibrium price, as it balances the forces of demand and supply. The figure shows how the price is
determines. DD is the demand curve and SS is the supply curve. Rs. 6 is the price at which DD and SS
intersect each other. At Rs. 6, 60 units are supplied and demanded.
If the price increases to Rs.8, supply will also increase and hence the price is likely to fall
down. If the price decreases to Rs. 4, supply will decrease and hence the price is likely to go
up.

Price-Output Determination Under Perfect Competition

In this market, the price is determined by supply and demand forces. Marshal who propounded the
theory says that the price is determined by the equilibrium between demand and supply.
The pricing of commodity under perfect competition can be
determinedin three periods of time.
a) Very short period (Market Period)
Market period is too short period to increase the supply. The
market period is so short that supply of the commodity is limited to
existing stock. During the market period, say a single day, the supply of a
commodity is perfectly inelastic.
In this figure quantity is represented along X-axis and price is
represented along Y-axis. MS is the very short period supply curve. DD is
demand curve. It intersects supply curve at E. The price is OP. The quantity is OM. D1 D1 represents
increaseddemand. This curve cuts the supply curve at E1. Even at the new equilibrium, supply is OM only.
But price increases to OP1. So, when demand increases, the price will increase but not the supply. If
demand decreases new demand curve will be D2 D2. This curve cuts the supply curve at E2. Even at this
new equilibrium, the supply is OM only. But price falls to OP2. Hence in very short period, given the
supply, it is the change in demand that influences price. The price determined in a very short period is
called Market Price.
b) Short Period
Short period is not too long period to install new capital
equipments. It is also not sufficient period to permit the new firms
to enter the industry to increase the supply of the commodity in
the market. Hence the firm can increase the supply of a commodity
in the short period only by making intensive use of the given
plants and equipments and increasing the units of variable
factors.
As a result of this, the short period supply of a commodity will be
relatively less elastic.

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In the diagram MS is the market period supply curve. DD is the initial demand curve. It intersects MS curve at
C. The price is OP and output OM. Suppose demand increases, the demand curve shifts upwards and becomes
D1D1. In the very short period, supply remains fixed on OM. The new demand curve D1D1 intersects MS at
E1. The price will rise to OP1. This is what happened in the very short-period.
As the price rises from OP to OP1, firms expand output. As firms can vary some factors but not all, the law
of variable proportions operates. This results in new short-run supply curve SS. It interests D1 D1 curve
at E2. Theprice will fall from OP1 to OP2.
c) Long Period
In Long run, the Firm‟s output (supply) can be changed by
both the variable factors and fixed factors i.e. all factors
become variable. There is enough time for new Firms to enter
the Industry. Further, ifthe demand is increased, the supply can
be increased or decreased according to the demand. For Long
run equilibrium, long run marginal cost (LMC) is equal to MR
and LMC curve cut the MR curve from below. In case of long
run equilibrium, all the firms will earn only normal profits.
Take the case when the Firm earn super-normal profit-Then the existing Firm will increase their
production and new Firm will enter the Industry. Consequently, the total supply will increase and price
fall down and further results in normal profit for the firm
On the contrary, if the firm is incurring losses, Then some Firm will leave the Industry which will reduce
the total supply. And due to decrease in supply, price will rise and once again Firm will begin to earn
normal profit.Firm equilibrium is at the minimum point of its LAC and at this point the Firm will get
the normal profits. If AR (price) rises to OP1, then Firm‟s LMC cuts its MR1 at E1 and the firm gets super-
normal profit but again come to OP yielding normal profits as stated before. And at price OP 2, firm incurs
losses but again rise to level OP to maintain the equilibrium at normal profit
Firm‟s equilibrium: MC=MR=AR= min LAC
MONOPOLY
„mono‟ means single and „poly‟ means seller. The term monopoly refers to that market in which a single
firm controls the whole supply of a particular product which has no close substitutes. Monopoly emerges
in firms such as transport, water and electricity supply etc.
Features:
1. Single person or a firm: A single person or a firm controls the total supply of the commodity. There
will be no competition for monopoly firm. The monopolist firm is the only firm in the whole industry.
2. No close substitute: The goods sold by the monopolist shall not have close substitutes. Even if price of
monopoly product increases, people will not go in far substitute. For example: If the price of electric
bulb increases slightly, consumer will not go in for kerosene lamp.
 3. Large number of Buyers: Under monopoly, there may be a large number of buyers in the market who
compete among themselves.
4. Price Maker: Since the monopolist controls the whole supply of a commodity, he is a price-maker,
andthen he can alter the price.
5. Supply and Price: The monopolist can fix either the supply or the price. He cannot fix both. If he
charges a very high price, he can sell a small amount. If he wants to sell more, he has to charge a low
price. He cannot sell as much as he wishes for any price he pleases.
6. Downward Sloping Demand Curve: The demand curve (average revenue curve) of monopolist slopes
downward from left to right. It means that he can sell more only by lowering price.

Monopoly refers to a market situation where there is only one seller. He has complete control over the
supply of a commodity. He is therefore in a position to fix any price. Under monopoly there is no
distinction between a firm and an industry. This is because the entire industry consists of a single firm.
Being the sole producer, the monopolist has complete control over the supply of the commodity. He has
also thepower to influence the market price. He can raise the price by reducing his output and lower the
price by increasing his output. Thus he is a price-maker. He can fix the price to his maximum advantages.
But he cannot fix both the supply and the price, simultaneously. He can do one thing at a time. If he fixes
the price, his output will be determined by the market demand for his commodity. On the other hand, if
he fixes the output to be sold, its market will determine the price for the commodity. Thus his
decision to fix either the price or theoutput is determined by the market demand.
The market demand curve of the monopolist (the average revenue curve) is downward sloping. Its
corresponding marginal revenue curve is also downward sloping. But the marginal revenue curve lies
below theaverage revenue curve as shown in the figure. The monopolist faces the down-sloping demand
curve because to sell more output, he must reduce the price of his product. The firm ‟s demand curve and
industry‟s demand curve are one and the same. The average cost and marginal cost curve are U shaped
curve. Marginal cost falls and rises steeply when compared to average cost.
Under monopoly, demand curve is average revenue curve.

Price-Output Determination Under Monopoly

The monopolistic firm attains equilibrium when its marginal cost
becomes equal to the marginal revenue. The monopolist always desires
to make maximum profits. He makes maximum profits when MC=MR.
He does not increasing his output if his revenue exceeds his costs. But
when the costs exceed the revenue, the monopolist firm incur loses.
Hence the monopolist curtails his production. He produces up to that

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Thus, the point is called equilibrium point. The price output under
monopoly may be explained with the help of a diagram.
In the diagram, the quantity supplied or demanded is shown along X-axis. The cost or revenue is shown
along Y-axis. AC and MC are the average cost and marginal cost curves respectively. AR and MR curves
slope downwards from left to right. AC and MC are U shaped curves. The monopolistic firm attains
equilibrium when its marginal cost is equal to marginal revenue (MC=MR). Under monopoly, the MC
curve may cut theMR curve from below or from a side. In the diagram, the above condition is satisfied at
point E. At point E, MC=MR. The firm is in equilibrium. The equilibrium output is OM. Up to OM output,
MR is greater than MC and beyond OM, MR is less than MC. Therefore, the monopolist is will be in
equilibrium at output OM where MR=MC and profits are maximized.
The above diagram (Average revenue)
= MQ or OPAverage cost = MR
Profit per unit = Average Revenue-Average cost=MQ-
MR=QRTotal Profit = QR x SR=PQRS
If AR > AC; Abnormal or super normal
profits.If AR = AC; Normal Profit
If AR < AC ; Loss

MONOPOLISTIC COMPETITION
Perfect competition and pure monopoly are rare phenomena in the real world. Instead, almost every
market seems to exhibit characteristics of both perfect competition and monopoly. Hence, in the real
world, it is the state of imperfect competition lying between these two extreme limits that work. Edward.
H. Chamberlain developed the theory of monopolistic competition, which presents a more realistic
picture of the actual market structure and the nature of competition.
Features/Characteristics
The important characteristics of monopolistic competition are:
1. Existence of Many firms: Industry consists of a large number of sellers, each one of whom does
not feel dependent upon others. Every firm acts independently without bothering about the
reactions of its rivals. The size is so large that an individual firm has only a relatively small part in
the total market, so that each firm has very limited control over the price of the product. As the
number is relatively large, it is difficult for these firms to determine its price- output policies
without considering the possible reactions of the rival forms. A monopolistically competitive firm
follows an independent price policy

2. Product Differentiation: product differentiation is the essential feature of monopolistic

competition. Products can be differentiated by means of unique facilities, advertising, brand
loyalty, packing, pricing, terms of credit, superior maintenance service, convenient location and
so on. Through heavy advertisement budgets, Pepsi and Coca-Cola make it very expensive for a
third competitor to enter the cola market on such a big scale. The following example illustrate
how the firms differentiate themselves from others in a monopolistic environment.
 In hotel industry, some hotels have spacious swimming pools, gyms, cultural programs
etc. Thecustomers who value these facilities don‟t bother about price changes.
  The colleges who provide best infrastructure and placements in various reputed
companieshave demand from the student community irrespective of an increase in
tuition fee.
 Cell phones which have unique features have demand from the public even price increases.
3. Large Number of Buyers: There are large number of buyers in the market. But the buyers have
their own brand preferences. So, the sellers are able to exercise a certain degree of monopoly
over them. Each seller has to plan various incentive schemes to retain the customers who
patronize his products.
4. Free Entry and Exist of Firms: As in the perfect competition, in the monopolistic competition
too, there is freedom of entry and exit. That is, there is no barrier as found under monopoly.
5. Selling costs: Since the products are close substitutes, much effort is needed to retain the
existing consumers and to create new demand. So, each firm has to spend a lot on selling cost,
which includes cost on advertising and other sale promotion activities.
6. Imperfect Knowledge: Imperfect knowledge about the product leads to monopolistic
competition. If the buyers are fully aware of the quality of the product, they cannot be influenced
much by advertisement or other sales promotion techniques.
7. The Group: Under perfect competition, the term industry refers to all collection of firms
producing a homogenous product. But under monopolistic competition, the products of various
firms are notidentical though they are close substitutes.
Price – Output Determination Under Monopolistic Competition
Under monopolistic competition, Since different firms produce different varieties of products,
different prices for them will be determined in the market depending upon the demand and cost
conditions. Each firm will set the price and output of its own product. Here also the profit will be
maximized when marginal revenueis equal to marginal costMR=MC. The demand curve for the firm in
case of monopolistic competition is just similar to that of monopoly.
The degree of elasticity of demand of a firm in monopolistic competition depends upon the extent
to which the firm can resorts to product differentiation. The greater the ability of the firm to differentiate
the product, the less elastic the demand is. The firm‟s influence to increase the price depends upon the
extent to which it can differentiate the product

a) Short-run
In the short-run, the firm is in equilibrium when marginal Revenue
= Marginal Cost. In the figure, AR is the average revenue curve. MR marginal revenue curve, MC marginal cost curve, AC average cost curve, M
AC, this firm is making abnormal profits in the short-run. The
abnormal profit per unit is QR, i.e., the
difference between AR and AC at equilibrium point and the total supernormal profit is OR x OM. This total
abnormal profits is represented by the rectangle PQRS. The firm may make supernormal profits in the
short-run if it satisfies the following two conditions.
a) MR = MC
b) AR > AC
b Long–runMore and more firms will be entering the market having been attracted by supernormal profits
enjoyed by the existing firms in the industry. As a result, competition become s intensive on one hand, forms will
compete with one another for acquiring scare inputs pushing up the prices of factor inputs. On the other hand, on
the entry of several firms, the supply in the market will increase, pulling down the selling price of the products. In
order to cope with the competition, the firms will have to increase the budget on advertising. The
entry of new firms continue till the supernormal profits of the firms completely eroded and ultimately
firms in the industry will earn only normal profits. Those firms which are not able to earn at least normal
profits will get closed. Thus in the long-run, every firm in the monopolistic competitive industry will earn
only normal profits, which are just sufficient to stay in the business. It is be noted that normal profits are
part of average costs.
In the long-run, in order to achieve equilibrium position, the firm has to fulfill the following conditions:
a) MR = MC
b) AR = AC at the level of equilibrium level of output.
OLIGOPOLY
The term oligopoly is derived from two Greek words, oligos meaning a few, and pollen meaning to sell.
Oligopoly is the form of imperfect competition where there are a few sellers in the market, producing
either a homogeneous product or producing products, which are close but not perfect substitute of each
other.

Features
1. Monopoly Power:
There is a clement of monopoly power in oligopoly. Since there are only a few firms and each
firm has a large share of the market. In its share of the market, it controls the price and
output. Thus anoligopoly has some monopoly power.

2. Interdependence of Firms:
Under oligopoly, there are only a few firms, each producing a homogeneous or slightly
differentiated product. Since the number of firms is small, each firm enjoys a large share of the
market and has a significant influence on the price and output decisions. Thus, there is
interdependence of firms. No firm can ignore the actions and reactions of rival firms under
oligopoly.

3. Conflicting Attitude of Firms:

Under oligopoly, two types of conflicting attitudes are found in the firms. On the one hand, firms
realize the disadvantages of mutual competition and desire to combine to maximize their joint
profits. This tendency leads to the formation of collusion. On the other hand, the desire to
maximize one‟s individual profit may lead to conflict and antagonism; the firms come into
clash with one another onthe question of distribution of profits and allocation of markets. Thus,
 there is an existence of two opposing attitudes among the firms.

4. Few firms. In this market, only few sellers are found:

For example, the market for automobiles in India exhibits oligopolistic structure as there are
only few producers of automobiles. If there are only two firms, it is called „duopoly‟.
5. Nature of product:
If the firms product homogeneous product, it becomes pure oligopoly. The firms with
productdifferentiation constitute impure oligopoly.

6. Interdependence among firms:

In oligopoly market, each firm treats the other as its rival firm. It is for this reason that each firm while
determining price of its product, takes into account the reaction of the other firms to its own action.

7. Large number of consumers:

In this market, there are large numbers of consumers to demand the produc

TYPES OF PRICING
Firms set prices for their products through several alternative means. The important pricing methods
followedin practice are shown in the chart.

A. Cost Based Pricing

1. Full cost pricing:-Under this method, price is just equal to the average cost.
2. Cost plus pricing:- Here, the average cost is ascertained and then a conventional margin added
to the cost to arrive at the price. In other words, find out the product unit ‟s total cost and add a
percentage of profit to arrive at the selling price. It is commonly followed in departmental stores
and other retail shops. This method is simple to be administered. It may be very difficult to find
the selling price in advance due to complexity of the nature of the project.
3. Marginal cost pricingBreak even pricing or Target profit pricing:- In this method, selling
price is fixed in such a way that it covers full variable or marginal cost and contributes towards
recovery of fixed costs. in the stiff competition, marginal cost offers a guidelines as to how far the
selling price can be lowered.
 B. Competition based pricing
Here the price of product is set based on what the competitor charges for a similar product. In other
words, a reduction in the price of products by the competitor will force us to follow suit. In such a case,
how far we can go on reducing the price?. Here the marginal cost concept comes handy. As long as the
price covers the marginal cost, continue to sell. If not, better stop selling. It is because, every unit sold at
less than marginal cost results in loss.
1. Sealed bid pricing:- This method is more popular in tenders and contracts. Each contracting
firm quotes its price in a sealed cover called “tender”. All the tenders are opened on a scheduled
date and theperson who quotes the lowest price is awarded the contract.
2. Going rate pricing:- Here the prevailing market price is charged. Suppose, when one wants to
buy or sell gold, the prevailing market rate at a given point of time is taken as the basis to
determine the price

C. Demand Based Pricing

1. Perceived value pricing:- This method considers the buyer‟s perception of the value of the
product as the basis of pricing. Here the pricing rule is that the firm must develop procedures for
measuring the relative value of the product as perceived by consumers.
2. Price discriminationDifferential pricing:- Price discrimination refers to the practice of
charging different prices to customers for the same good. In involves selling a product or service
for different prices in different market segments. Price differentiation depends on geographical
location of the consumers, type of consumer, purchasing quantity, season, time of the service etc.
E.g. Telephone charges, APSRTC charges.
D. Strategy based pricing
1. Skimming pricing:- The company follows this method when the product is for the first time
introduced in the market. Under this method, the company fixes a very high price for the product.
this strategy is mostly found in case of technology products. When Samsung introduces a new cell
phone model, it fixes a high price because of the uniqueness of the product.
2. Penetration pricing:- This is exactly opposite to the market skimming method. Here, a low
price is fixed for the product in order to catch the attention of consumers, once the product
image and credibility is established, the seller slowly starts jacking up the price to reap good
profits in future. The Rin washing soap perhaps falls into this category. This soap was sold at a
rather low price in the beginning and the firm even distributed free samples. Today, it is quite an
expensive brand and yet it is selling very well.
3. Two-part pricing:- Under this strategy, a firm charges a fixed fee for the right to purchase its
goods, plus a per unit charge for each unit purchased. Entertainment houses such as country
clubs, athletic clubs, etc, usually adopt this strategy. They charge a fixed initiation fee or
membership fee plus a charge, per month or per visit, to use the facilities.
4. Block pricing:- We see block pricing in our day-to-day life very frequently. Four Santhoor soaps
in a single pack with nice looking soap box or five Maggi packets in a single pack with an
attractive bowl indicate this pricing method. The total value of the goods includes consumer ‟s
surplus as the consumer is given soap box and bowl along with the products freely. By selling
certain number of units of a product as one package, the firm earns more than by selling unit
wise.
5. Commodity bundling:- Commodity bundling means the practice of bundling two or more
different products together and selling them at single „bundle price‟. For example tourist companies offer the package that inc
 6. Peak load pricing:- Under this method, high price is charged during the peak times than off-
peak times. RTC increases charges during festivals, Railways charge more fares during tatkal
time. During seasonal period when demand is likely to be higher, a firm may increase profits by
peak load pricing.
6. Cross subsidization:- The process of charging high price for one group of customers in order to
subsidize another group.
7. Transfer pricing:- Transfer pricing means a price at which one process forwards their
outputwork-in- progress to the next process for further processing. It is an internal pricing
technique.

BREAK EVEN ANALYSIS

BEP analysis is also called as CVP analysis. The BEP can be defined as that level of sales at which total
revenues equals total costs and the net income is equal to zero. This is also known as no-profit no-loss
point.

Break-even analysis refers to analysis of costs and their possible impact on revenues and volume of the
firm. Hence, it is also called the cost-volume-profit (CVP) analysis. A firm is said to attain the BEP when its
total revenue is equal to total cost(TR=TC).

The main objective of the Break Even Analysis is not only to spot the BEP but also to develop an
understanding of the relationships of cost, volume and price within a company‟s practical range of
operations.

Assumptions of Break-Even Analysis

1. All cost are divided into fixed and variable

2. Fixed costs remain constant whereas variable costs vary
3. Selling price remains constant
4. There will be no change in the operating efficiency

Key terms used in Break-even Analysis

1. Fixed cost(FC):- Fixed cost remains fixed in the short-run. These costs must be borne by the firm ever there
is no production. Example: Rent, Insurance, Depreciation, permanent employees‟ salaries. Etc. Fixed cost
per units varies.
2. Variable costs(VC):- The costs which vary in direct proportion to the production/sales volume are called as
variable costs. variable cost per unit is fixed. Examples for variable costs: cost of direct material, cost
directlabor, direct expenses, operating supplies such as oil, grease etc.
3. Total cost(TC):- The total of fixed cost and variable costs. TC=FC+VC

4. Total revenue:- The sales amount of goods sold in the market.(Selling Price per unit x No of units sold).

5. Contribution:- The excess of sales revenue over variable cost(C=S-V).

6. P/V Ratio(Profit/Volume Ratio):- The ratio between the contribution and sales:

7. Margin of Safety sales(M/S sales):- The excess of actual total sales over break even sales.

8. Break-even point BEP :- The point where total revenue is just equal to the total cost is called Break-even
point. At break-even point, there is not profit or no loss to the business. Break-even point can be calculated
in units as well as in sales.

 BEP sales, C=F

 Below the BEP sales, C=F-P; C˂F
 In M/S sales, C=P
 M/S sales =Total sales-BEP sales
 BEP sales=Total sales-M/S sales
 Total sales=BEP sales+M/S sales

We understood from the above BEP graph that:

 In the above figure, units of products/sales are shown on the horizontal axis OX and costs and
revenuesare shown on vertical axis OY.
 The variable cost line is drawn first. It increases along with volume of production and sales.
 The total cost line is parallel to variable cost line. It is derived by adding total fixed costs line to
thetotal variable cost line.
 The total revenue line (TR) starts from point (0) and increases along with volume of production or
salesintersecting total cost line at point BEP.
 To the right of the BEP is profit zone and to the left of the BEP is the loss zone.
 A perpendicular from the BEP to the horizontal axis at point „M‟ shows „OM‟ is the quantity
producedat „ OP‟ the cost at BEP.
 The angle formed by the point of intersection of total revenue and total cost line at BEP is called angle
of incidence. The greater the angle of incidence, the higher is the magnitude of profit once the fixed
costs are observed.
 Margin of safety refers to the excess of production or sales over and above the BEP. The margin of
safety „MN‟ is the difference between ON and OM (ON-OM=MN). The sales value at ON is OQ.

SIGNIFICANCE OF BREAK-EVEN ANALYSIS

1) To ascertain the profit on a particular level of sales volume or a given capacity of production.
2) To calculate sales required to earn a particular desired level of profit.
3) To compare the product lines, sales area, method of sale for individual company.
4) To compare the efficiency of the different firms.
5) To decide whether to add a particular product to the existing product line or drop one from it.
6) To decide to „make or buy‟ a given component or spare part.
7) To decide what promotion mix will yield optimum sales.
8) To assess the impact of changes in fixed cost, variable cost or selling price on BEP and profits during
agiven period.

LIMITATIONS OF BREAK-EVEN ANALYSIS

1) Break-even point is based on fixed cost, variable cost and total revenue. A change in one variable
isgoing to affect the BEP.
2) All costs cannot be classified into fixed and variable costs. we have semi-variable costs also.
3) In case of multi-product firm, a single chart cannot be of any use. Series of charts have to be made
useof .
4) It is based on fixed cost concept and hence-holds good only in the short-run.
5) Total cost and total revenue lines are not always straight as shown in the figure. The quantity and
pricediscounts are the usual phenomena affecting the total revenue line.
6) Where the business conditions are volatile, BEP cannot give stable results.
 PROBLEMS AND SOLUTIONS:

1. A firm has a fixed cost of Rs. 10,000, selling price per unit is Rs.5 and variable cost per unit is Rs. 3.
a. Determine break-even point in terms of volume and also sales value.
b. Calculate the margin of safety considering that the actual production is 8000 units.

𝐹
Solution:
𝒂. 𝐵𝐸𝑃 (𝑖𝑛 𝑢𝑛𝑖𝑡𝑠) =
𝐶 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

Note: BEP in units can be calculated only when unit sales price and unit variable cost are given.
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = 𝑆 − 𝑉 = 5 − 3 = 2

𝐹
𝐵𝐸𝑃 (𝑖𝑛 𝑢𝑛𝑖𝑡𝑠) = = 5000 𝑢𝑛𝑖𝑡𝑠
10000
= 2
𝐶 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

𝐵𝐸𝑃 (𝑖𝑛 𝑠𝑎𝑙𝑒𝑠) = 𝐹

𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜

𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜 =𝐶2 𝑋 100 = 40%

𝑋 100 =
𝑆5

𝐵𝐸𝑃 (𝑖𝑛 𝑠𝑎𝑙𝑒𝑠) =𝐹10000

𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜 =40% = 𝑅𝑠. 25000

(or)

𝐵𝐸𝑃 (𝑖𝑛 𝑠𝑎𝑙𝑒𝑠) = 𝐵𝐸𝑃 𝑢𝑛𝑖𝑡𝑠 𝑥 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = 5000 𝑥 5 = 25000
 𝑃
𝒃. 𝑀𝑎𝑟𝑔𝑖𝑛 𝑜𝑓 𝑠𝑎𝑓𝑒𝑡𝑦
𝒔𝒂𝒍𝒆𝒔 = 𝑃/𝑉
𝑟𝑎𝑡𝑖𝑜
Profit = Total Sales – (Total Variable cost +
Fixed cost)Profit = Contribution – Fixed cost
Contribution = Sales – Variable cost
Total Sales = Total Units sold x Selling price per unit = 8000 x 5 = Rs.
40000Total variable cost x Variable cost per unit = 8000 x 3 = Rs.
24000
Profit = Total Sales – (Total Variable cost + Fixed cost) = 40000 – (24000+10000) = Rs. 6000

𝑃
𝑀𝑎𝑟𝑔𝑖𝑛 𝑜𝑓 𝑠𝑎𝑓𝑒𝑡𝑦 𝑠𝑎𝑙𝑒𝑠 = = = 𝑅𝑠. 15000
6000
𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜 40%
(or)
Margin of safety sales = Margin of safety units x Selling price per unit
Margin of safety unit = Total units – BEP units = 8000 – 5000 = 3000
Margin of safety sales = Margin of safety units x Selling price per unit = 3000 x 5 = Rs.15000

2. A high-tech rail can carry a maximum of 36,000 passengers per annum at a fare of Rs. 400. The variable cost
per passenger is Rs. 150 while the fixed costs are Rs.25,00,000 per year. Find the break-even point in terms
of number of passengers and also in terms of fare collections.
Solution:
𝐹
𝒂. 𝐵𝐸𝑃 (𝑖𝑛 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓
𝑝𝑎𝑠𝑠𝑒𝑛𝑔𝑒𝑟𝑠) =
𝐶 𝑝𝑒𝑟
𝑢𝑛𝑖𝑡
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑝𝑎𝑠𝑠𝑒𝑛𝑔𝑒𝑟 = 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑝𝑎𝑠𝑠𝑒𝑛𝑔𝑒𝑟 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟
𝑝𝑎𝑠𝑠𝑒𝑛𝑔𝑒𝑟
= 𝑆 − 𝑉 = 400 − 150 = 250

𝐹
𝐵𝐸𝑃 (𝑖𝑛 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑎𝑠𝑠𝑒𝑛𝑔𝑒𝑟𝑠) =
𝐶 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = = 10000 𝑝𝑎𝑠𝑠𝑒𝑛𝑔𝑒𝑟𝑠
2500000
250
𝐹
𝒃. 𝐵𝐸𝑃 (𝑖𝑛 𝐹𝑎𝑟𝑒
𝑐𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛) =
𝑃/𝑉
𝐶
𝑟𝑎𝑡𝑖𝑜

𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜 = 𝑋 100 = 𝑋 100 = 62.50%

250
𝑆
400

𝐹
𝐵𝐸𝑃 (𝑖𝑛 𝐹𝑎𝑟𝑒 𝑐𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛) =
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜 =
2500000
= Rs. 4000000

62.50