Course Title: ECONOMICS FOR DECISION MAKING

Module-3(09 Hours)
Cost Analysis & Production Analysis:
Concepts of Production, production function with one variable input - Law of
Variable Proportion, Laws of returns to scale, Indifference Curves, ISO-Quants
& ISO-Cost line, Economies of scale, Diseconomies of scale. Types of cost, Cost
curves, Cost – Output Relationship in the short run and in the long run, Long-
Run Average Cost (LAC) curve
Break Even Analysis:Meaning, Assumptions, Determination of BEA,
Limitations, Margin of safety, Uses of BEA In Managerial decisions (Theory and
simple problems).

Concepts of Production
The concept of production in economics and business refers to the process of
transforming inputs into outputs, typically goods and services, that are useful for
meeting human needs and wants. It is central to all forms of economic activity,
whether on the individual, corporate, or national level.

 Production refers to the process of combining inputs (labor, capital, raw

materials) to create goods and services that can be sold in the market.
 Factors of Production include land, labor, capital, and entrepreneurship.
These inputs are combined in different proportions to produce output.

Various concepts of production help to understand the complexity of this process.

Here are some of the most important ones:
Factors of Production

These are the essential inputs required to produce goods and services:

 Land: Natural resources used in production, such as minerals, water, and

agricultural land.
 Labor: Human effort, skills, and time used in the production process.
 Capital: Physical tools, machinery, buildings, and technology that aid
production.
 Entrepreneurship: The risk-taking and innovation ability to combine the
other factors to produce goods and services.
A production function with one variable input expresses the relationship
between the quantity of output produced and the amount of a single input used in
the production process. In the simplest case, the production function can be written
as:

Q=f(L)Q = f(L)Q=f(L)

where:

 QQQ is the output (quantity of goods or services produced),

 LLL is the variable input (typically labor or capital),
 f(L)f(L)f(L) is the production function, which describes how output changes
as the amount of the input changes.

General Form of a Production Function

The specific form of the production function can vary depending on the context
and the nature of the relationship between input and output. A commonly used
functional form is the Cobb-Douglas production function, which is often written
as:

Q=ALαQ = A L^\alphaQ=ALα

where:

 AAA is a constant representing the level of technology or total factor

productivity,
 LLL is the variable input (e.g., labor),
 α\alphaα is a parameter between 0 and 1 that represents the elasticity of
output with respect to the input LLL.

In this case:

 If α=1\alpha = 1α=1, output increases at the same rate as the input,

 If α<1\alpha < 1α<1, there are diminishing returns to the input,
 If α>1\alpha > 1α>1, there are increasing returns to the input.
Law of Diminishing Marginal Returns

A key feature of many production functions with one variable input is the law of
diminishing marginal returns, which states that as the amount of input (e.g.,
labor) increases, while other factors remain constant, the additional output
(marginal product) produced by an additional unit of input eventually decreases.
Mathematically, the marginal product of labor is the derivative of the production
function with respect to LLL:

MPL=dQdLMP_L = \frac{dQ}{dL}MPL=dLdQ

In the case of the Cobb-Douglas production function:

MPL=AαLα−1MP_L = A \alpha L^{\alpha - 1}MPL=AαLα−1

As LLL increases, MPLMP_LMPL tends to decrease (assuming 0<α<10 < \alpha

< 10<α<1).

Example

Let's consider a simple Cobb-Douglas production function:

Q=10L0.5Q = 10 L^{0.5}Q=10L0.5

In this case:

 A=10A = 10A=10,
 α=0.5\alpha = 0.5α=0.5.

The marginal product of labor would be:

MPL=dQdL=10×0.5L−0.5=5LMP_L = \frac{dQ}{dL} = 10 \times 0.5 L^{-0.5}

= \frac{5}{\sqrt{L}}MPL=dLdQ=10×0.5L−0.5=L5

As LLL increases, MPLMP_LMPL decreases, showing diminishing marginal

returns.

Conclusion
A production function with one variable input describes how output changes as a
single input changes, and it can exhibit different behaviors depending on the
functional form and the returns to the input. A common example is the Cobb-
Douglas function, which shows diminishing returns when the exponent α\alphaα is
between 0 and 1.

The Law of Variable Proportion (also known as the Law of Diminishing

Returns) is an important concept in microeconomics, particularly in production
theory. It explains how the output of a production process changes as the quantity
of one input is varied while other inputs remain constant.

Explanation:

The law states that if the quantity of one factor of production (like labor or capital)
is increased while all other factors remain fixed, the resulting increase in output
will initially increase at an increasing rate, but after a certain point, the output will
increase at a decreasing rate. Eventually, further increases in the variable input will
result in a decrease in output.

This law is typically observed in the short run, where at least one factor (such as
capital or land) is fixed, and only the quantity of the variable input (such as labor)
can be changed.

Assumptions of Law of Variable Proportion

Law of variable proportion holds good under certain circumstances, which will be
discussed in the following lines.

1. Constant state of Technology: It is assumed that the state of technology will

be constant and with improvements in the technology, the production will
improve.
2. Variable Factor Proportions: This assumes that factors of production are
variable. The law is not valid, if factors of production are fixed.
3. Homogeneous factor units: This assumes that all the units produced are
identical in quality, quantity and price. In other words, the units are
homogeneous in nature.
4. Short Run: This assumes that this law is applicable for those systems that are
operating for a short term, where it is not possible to alter all factor inputs.
Stages of the Law of Variable Proportion:

1. Stage I – Increasing Returns to the Variable Input:

In the initial phase, as more units of the variable input (e.g., labor) are added,
the total output increases at an increasing rate. This happens because the
fixed inputs (such as machinery or land) are being utilized more effectively,
and there are more workers to complement them.
2. Stage II – Diminishing Returns to the Variable Input:
After a certain point, the total output continues to increase, but at a
diminishing rate. In this stage, while additional labor still contributes to
higher output, each additional unit of labor adds less to the total production.
This is due to the fact that the fixed factors are being fully utilized, and
adding more workers results in overcrowding, inefficiency, or less effective
use of resources.
3. Stage III – Negative Returns:
If more units of the variable input are added beyond this point, total output
may begin to decline. This happens because the fixed inputs become
overcrowded, and workers may start to get in each other’s way, leading to a
reduction in overall productivity.

Key Points:

 Diminishing Returns: The core idea behind the Law of Variable Proportion
is that beyond a certain level, additional units of the variable input lead to
smaller and smaller increases in output, and eventually may even reduce
total output.
 Short-Run Analysis: This law applies primarily in the short run, when at
least one factor is fixed and cannot be changed.
 Real-World Examples: A common example would be a factory where the
amount of machinery is fixed, and additional workers are hired. Initially,
more workers will result in higher productivity, but eventually, the factory
space and equipment will be fully utilized, and adding more workers will
lead to overcrowding and inefficiency.
Graphical Representation:

The law can be graphically represented by plotting total output against the quantity
of the variable input:

 The total product curve initially rises at an increasing rate, then at a

decreasing rate, and eventually starts to decline.
 The marginal product curve (change in output from adding an additional
unit of the variable input) first rises, then falls, and can eventually become
negative.

Importance:

Understanding the Law of Variable Proportion helps firms in deciding how much
of a variable input to use and when it might be inefficient to add more resources. It
is a crucial concept for businesses to optimize production in the short run.

Law of Variable Proportions Explained

Let’s understand this law with the help of another example:

In this example, the land is the fixed factor and labour is the variable factor. The table
shows the different amounts of output when you apply different units of labour to one
acre of land which needs fixing.
 The following diagram explains the law of variable proportions. In order to make a
simple presentation, we draw a Total Physical Product (TPP) curve and a Marginal
Physical Product (MPP) curve as smooth curves against the variable input (labour).

The law of Return to Scale in Production Functions

Changes in output when all factors change in the same proportion are referred to as
the law of return to scale. This law applies only in the long run when no factor is
fixed, and all factors are increased in the same proportion to boost production.

There are three stages in all.

 Increasing the scale’s return

 Constant scale returns
 Decrease in Returns on the scale
The laws of returns to scale describe how the output of a production process
changes as all inputs are increased proportionally. These laws help analyze the
relationship between input quantities and output in the long run, when all factors of
production can be varied.

1. Increasing Returns to Scale (IRS)

 Definition: Increasing returns to scale occur when an increase in all inputs

by a certain proportion leads to a more-than-proportional increase in output.
 Example: If a firm doubles its inputs (e.g., labor, capital) and the output
more than doubles, this is an example of increasing returns to scale.
 Implication: Firms experience economies of scale as they expand, meaning
their average cost of production decreases as they increase output.

Mathematical condition: If inputs (K and L) are increased by a factor of ttt, and

output increases by a factor greater than ttt, then:

f(tK,tL)>t⋅f(K,L)f(tK, tL) > t \cdot f(K, L)f(tK,tL)>t⋅f(K,L)

where f(K,L)f(K, L)f(K,L) is the production function.

2. Constant Returns to Scale (CRS)

 Definition: Constant returns to scale occur when an increase in all inputs by

a certain proportion results in an exactly proportional increase in output.
 Example: If a firm doubles its inputs (e.g., labor and capital) and the output
exactly doubles, this represents constant returns to scale.
 Implication: Firms experience no economies or diseconomies of scale.
Doubling inputs leads to a doubling of output, and average cost remains
constant as the firm expands.

Mathematical condition: If inputs are increased by a factor ttt, and output

increases by exactly ttt, then:

f(tK,tL)=t⋅f(K,L)f(tK, tL) = t \cdot f(K, L)f(tK,tL)=t⋅f(K,L)

3. Decreasing Returns to Scale (DRS)

 Definition: Decreasing returns to scale occur when an increase in all inputs

by a certain proportion leads to a less-than-proportional increase in output.
 Example: If a firm doubles its inputs and the output increases by less than
double, this is an example of decreasing returns to scale.
 Implication: Firms experience diseconomies of scale, meaning the cost per
unit of output increases as the firm grows. This often happens due to
inefficiencies that arise when firms become too large.

Mathematical condition: If inputs are increased by a factor ttt, and output

increases by less than ttt, then:

f(tK,tL)<t⋅f(K,L)f(tK, tL) < t \cdot f(K, L)f(tK,tL)<t⋅f(K,L)

Summary of the Laws of Returns to Scale:

 Increasing Returns to Scale (IRS): Output increases more than

proportionally to input increases.
 Constant Returns to Scale (CRS): Output increases proportionally to input
increases.
 Decreasing Returns to Scale (DRS): Output increases less than
proportionally to input increases.

These laws are essential for understanding cost structures and optimal production
scales in economics and business. They also explain why firms and industries
might either benefit or suffer from growth in size.
 Unit of Unit of % increase in Total % increase in Stages
Labour capital labour and capital production TP

1 3 – 10 – increasing

2 6 100% 30 200%

3 9 50% 60 100%

4 12 33% 80 33% constant

5 15 25% 100 25%

6 18 20% 110 10% diminishing

7 21 16.6% 120 8.3%

Increasing returns to scale

It describes a condition in which all of the factors of production are raised,

resulting in a higher rate of output. For example, if inputs are raised by 10%, the
output will be increased by 20%.

Reasons

 Due to the economy of scale

 Specialisation through better division of labour
 Constant returns to scale

It describes a condition in which all of the factors of production are increased at the
same time, resulting in a steady growth in output. For example, if inputs are raised
by 10%, the output is also increased by 10%.

Reasons

As the firm’s production grows, it reaches a point where all of the economy’s
resources have been fully utilised, and output equals input.

Diminishing returns to scale

When all of the production factors are increased simultaneously, output grows at a
slower rate. For example, if inputs are raised by 10%, the output will be increased
by 5%.

Reasons

 The major cause of diminishing returns to scale is large-scale economies,

diseconomies of scale occur when a company has grown to such a size that it is
difficult to manage
 Lack of coordination

Assumptions of Return to scale

The following are the returns to scale assumptions: Capital and labour are the only
two variables of production used by the company. In a fixed proportion, labour and
capital are integrated. Factor prices do not fluctuate, and the State of technology
remains the same
Indifference curves are a key concept in microeconomics that represent the
different combinations of two goods or services that give a consumer the same
level of satisfaction or utility. Essentially, they show the trade-offs a consumer is
willing to make between two goods while maintaining the same level of overall
happiness.

Here’s a breakdown of the concept:

Key Features of Indifference Curves:

1. Downward Sloping: Indifference curves typically slope downward from left

to right. This implies that if you want more of one good (say Good X), you
must give up some of the other good (say Good Y) to maintain the same
level of utility.
2. Convex to the Origin: Indifference curves are usually convex to the origin,
reflecting diminishing marginal rates of substitution (MRS). This means as
you move along the curve and give up more of one good for the other, you
need increasingly more of the second good to be indifferent to the first.
3. Higher Curves Represent Higher Utility: Indifference curves farther from
the origin represent higher levels of utility. Consumers prefer higher utility,
so they will generally choose bundles on higher indifference curves,
assuming they have the budget to afford them.
4. Non-Intersecting: Indifference curves cannot intersect because it would
imply that the consumer could be equally satisfied with two different levels
of utility, which is inconsistent with the notion of indifference.
5. Infinite Number of Curves: There are an infinite number of indifference
curves because a consumer can be indifferent between an endless variety of
bundles, each representing different combinations of goods.
The Marginal Rate of Substitution (MRS):

The slope of an indifference curve at any given point is known as the Marginal
Rate of Substitution (MRS), which represents how much of one good the
consumer is willing to give up in exchange for one more unit of the other good,
without changing the level of satisfaction.

 MRS = ΔY / ΔX, where Y is the quantity of one good and X is the quantity
of the other good.
 As you move down the curve, MRS typically decreases, reflecting
diminishing marginal utility—the more of one good you have, the less you're
willing to give up of the other good to get even more of it.

Examples:

 Perfect Substitutes: If two goods are perfect substitutes (e.g., two brands of
identical bottled water), the indifference curve would be a straight line with
a constant slope because the consumer is always willing to trade one good
for the other at a fixed rate.
 Perfect Complements: If two goods are perfect complements (e.g., left and
right shoes), the indifference curve would be a right-angle shape. The
consumer needs the goods in fixed proportions, and increasing one good
without increasing the other does not improve utility.
Applications:

 Consumer Choice Theory: Indifference curves are used in conjunction with

budget constraints to determine the optimal consumption bundle for a
consumer. The point where an indifference curve is tangent to the budget
line represents the consumer's equilibrium—where they maximize utility
given their income and prices of goods.
 Welfare Economics: Indifference curves can also be used to evaluate
changes in economic welfare, such as the effects of a price change or income
change on a consumer's well-being.

In summary, indifference curves help economists understand consumer preferences

and behavior by illustrating how consumers trade off between different goods
while maintaining the same level of satisfaction.

In microeconomics, isoquants and iso-cost lines are crucial concepts for

understanding production and cost minimization in the context of firms' decision-
making. Here's a breakdown of each:
1. ISO-QUANT

An isoquant (short for "iso-product curve") represents all the combinations of two
inputs (typically labor and capital) that result in the same level of output for a firm.
In other words, it shows different ways a firm can combine inputs to produce a
fixed quantity of output.

Key points about isoquants:

 Shape: Isoquants are typically downward sloping and convex to the origin.
This reflects the principle of diminishing marginal returns to input
substitution: as more of one input is used (holding the other input constant),
the additional output produced by each additional unit of the input decreases.
 Substitution between Inputs: The rate at which one input can be
substituted for another while maintaining the same output level is called the
marginal rate of technical substitution (MRTS).
 Example: An isoquant might show combinations of labor (L) and capital
(K) that result in producing 100 units of output, like (L=5, K=3) or (L=3,
K=6), etc.

Characteristics of isoquants:

 Higher isoquants represent higher levels of output. So, if a firm moves

from one isoquant to another further away from the origin, it indicates an
increase in output.
 Isoquants never cross because each isoquant corresponds to a different
level of output.

2. ISO-COST LINE

An iso-cost line represents all the combinations of two inputs (typically labor and
capital) that can be purchased for a given total cost. This line shows the different
combinations of inputs a firm can afford given its budget or cost constraint.

The iso-cost line is derived from the firm's total cost and the prices of the two
inputs:
C=wL+rKC = wL + rKC=wL+rK

where:

 CCC is the total cost,

 www is the price of labor,
 rrr is the price of capital,
 LLL is the quantity of labor, and
 KKK is the quantity of capital.

Rearranging to get the equation of the iso-cost line:

K=Cr−wrLK = \frac{C}{r} - \frac{w}{r} LK=rC−rwL

This equation is a straight line with a slope of −wr-\frac{w}{r}−rw, indicating the

trade-off between labor and capital given the cost constraint.

Key points about iso-cost lines:

 Slope: The slope of the iso-cost line, −wr-\frac{w}{r}−rw, represents the

rate at which the firm can trade labor for capital while maintaining the
same total cost. If labor is more expensive than capital, the slope will be
steeper.
 Budget constraint: An iso-cost line is based on the firm's budget, and it
shifts when the total cost changes or when the prices of labor or capital
change.

Relationship Between Isoquants and Iso-Cost Lines

The point at which an isoquant is tangent to an iso-cost line represents the optimal
combination of inputs (labor and capital) that minimizes cost for a given level of
output. At this point, the firm is said to be cost-efficient, as it is using its resources
in the most economical way.

This tangency condition can be expressed in terms of the marginal rate of technical
substitution (MRTS) and the ratio of input prices:

MRTS=wrMRTS = \frac{w}{r}MRTS=rw
where:

 MRTS is the rate at which the firm can substitute labor for capital while
maintaining the same output.
 wr\frac{w}{r}rw is the rate at which labor can be traded for capital in the
market based on their prices.

Thus, at the optimal point of production:

MRTS=wr\text{MRTS} = \frac{w}{r}MRTS=rw

This ensures that the firm is minimizing its costs while producing a given level of
output.

Summary:

 Isoquants show combinations of inputs that result in the same output.

 Iso-cost lines show combinations of inputs that result in the same total cost.
 The optimal combination of inputs is found where an isoquant is tangent to
an iso-cost line, indicating the cost-minimizing choice of inputs for a given
level of output.

Economies of scale refer to the cost advantages that a business obtains due to the
expansion of its production. As the scale of production increases, the average cost
per unit of output typically decreases. This happens because fixed costs are spread
over a larger number of goods or services, and operational efficiencies can be
achieved as production volume rises.

There are several types of economies of scale:

1. Internal Economies of Scale

These are cost reductions that occur within the company as it grows larger. Key
factors include:
  Technical Economies: Larger firms can invest in more advanced and
efficient machinery or technology, which lowers production costs.
 Managerial Economies: As a company grows, it can afford to hire
specialists, leading to more efficient management and operations.
 Financial Economies: Bigger companies often have easier access to capital
and can secure financing at lower interest rates due to their reduced risk.
 Marketing Economies: Larger firms can spread advertising and promotion
costs over a greater volume of sales, reducing the per-unit cost of marketing
efforts.
 Purchasing Economies: Companies that buy raw materials in bulk can
often negotiate lower prices from suppliers due to their larger order volumes.

2. External Economies of Scale

These arise from factors outside the firm, typically as the industry or market grows.
For example:

 Infrastructure Improvements: If an industry grows in a particular region,

the government or private investors may improve infrastructure (roads,
utilities, etc.), benefiting all businesses in the area.
 Labor Pool Expansion: As a sector develops, a larger, more skilled
workforce may become available, helping businesses to find employees with
the right skills at competitive wages.
 Supplier Specialization: As demand grows, suppliers in the region may
specialize in particular components or services, reducing costs for businesses
that source from them.

3. Diseconomies of Scale

While economies of scale reduce per-unit costs with expansion, there are also
diseconomies of scale, which occur when a company becomes too large and
inefficiencies begin to arise. These can include:

 Coordination Problems: Larger organizations can become harder to

manage and coordinate, leading to inefficiencies and slower decision-
making.
 Employee Morale: As a company grows, employees might feel less valued
or disconnected, which can reduce productivity.
 Increased Bureaucracy: Larger firms may face increased levels of
bureaucracy and administrative overhead, leading to higher operational
costs.
Summary

Economies of scale allow companies to reduce their costs as they expand, making
them more competitive in the market. However, companies need to carefully
balance growth, as excessive expansion could lead to diseconomies of scale, where
the cost per unit starts to rise due to inefficiencies.

Costs in business and economics can be classified in various ways depending on

factors such as the behavior of costs, their relevance to decision-making, and how
they relate to production and output. Below are some of the primary types of costs:

1. Fixed Costs

These are costs that do not change with the level of output or production. They
remain constant regardless of how much or little a company produces.

 Examples: Rent, salaries of permanent staff, insurance premiums.

2. Variable Costs

These costs vary directly with the level of production or business activity. The
more you produce, the higher the cost.

 Examples: Raw materials, direct labor, utilities used in production (like

electricity for machinery).

3. Total Cost (TC)

The sum of all the costs incurred in the production process, including both fixed
and variable costs.

 Formula: TC=Fixed Costs+Variable CostsTC = \text{Fixed Costs} + \

text{Variable Costs}TC=Fixed Costs+Variable Costs

4. Marginal Cost (MC)

The additional cost incurred from producing one more unit of output. This is
important for decision-making as it helps determine pricing and production levels.

 Formula: MC=ΔTotal CostΔQuantity ProducedMC = \frac{\Delta \

text{Total Cost}}{\Delta \text{Quantity
Produced}}MC=ΔQuantity ProducedΔTotal Cost
5. Average Cost (AC) or Unit Cost

The total cost per unit of output. It is calculated by dividing total cost by the
number of units produced.

 Formula: AC=Total CostQuantity ProducedAC = \frac{\text{Total Cost}}

{\text{Quantity Produced}}AC=Quantity ProducedTotal Cost

6. Semi-Variable (Mixed) Costs

Costs that have both fixed and variable components. A part of the cost is fixed, and
the rest varies with production levels.

 Examples: A phone bill with a fixed monthly charge plus usage-based fees.

7. Opportunity Cost

The cost of forgoing the next best alternative when making a decision. It represents
the benefits that could have been obtained from choosing the next best alternative.

 Examples: Choosing to invest in stock market assets instead of buying a

house.

8. Explicit Costs

Direct, out-of-pocket expenses that are paid in cash, such as wages, rent, and
materials. These are actual costs that are easy to measure.

 Examples: Payment for raw materials, employee salaries.

9. Implicit Costs

Indirect costs that represent the opportunity costs of using resources that the
company already owns or controls, rather than renting or selling them. These costs
do not involve direct cash payments.

 Examples: The income the business owner could have earned if they
worked elsewhere, or the rent they could have earned by leasing property
owned by the business.
10. Sunk Costs

Costs that have already been incurred and cannot be recovered. These should not
affect future decisions because they cannot be changed, but they are often
emotionally difficult to ignore.

 Examples: Money spent on research and development or on machinery that

can no longer be sold.

11. Controllable Costs

Costs that can be influenced or controlled by management within a certain time

frame. This includes discretionary spending like advertising or hiring additional
staff.

 Examples: Advertising expenses, employee overtime.

12. Uncontrollable Costs

Costs that cannot be influenced by the management's decisions, usually arising

from external factors.

 Examples: Taxes, regulatory fees, interest rates.

13. Direct Costs

Costs that are directly attributable to the production of goods or services. These are
incurred as a result of manufacturing a product or providing a service.

 Examples: Raw materials, direct labor costs (wages of workers involved in

production).

14. Indirect Costs (Overhead Costs)

Costs that are not directly linked to the production of goods or services but are
necessary for the business to operate. These include administrative, marketing, and
maintenance costs.

 Examples: Utilities, office supplies, rent for office space.

15. Break-even Cost

The point at which total revenue equals total cost, resulting in neither profit nor
loss. It’s the minimum sales level required to cover all fixed and variable costs.

 Formula: Break-
even point (units)=Fixed CostsSelling Price per Unit−Variable Cost per Unit
\text{Break-even point (units)} = \frac{\text{Fixed Costs}}{\text{Selling
Price per Unit} - \text{Variable Cost per Unit}}Break-
even point (units)=Selling Price per Unit−Variable Cost per UnitFixed Costs

16. Relevant Costs

Costs that will be affected by a specific decision and therefore should be

considered in decision-making.

 Examples: Future costs that will be incurred if a product is discontinued or a

new product is introduced.

17. Avoidable Costs

Costs that can be eliminated if a particular decision is made. These are usually
variable costs or some portion of fixed costs that can be avoided.

 Examples: A specific contract or project that can be cancelled to save

money.

18. Uneconomic Costs

Costs that should not be incurred because they exceed the potential benefits of the
activity.

 Example: Continuing a product line that consistently loses money.

These cost classifications help businesses make strategic decisions, manage

budgets, and analyze profitability, ultimately guiding pricing, investment, and
operational choices.

Cost curves are graphical representations of the costs incurred by a firm as they
produce goods or services. They are essential tools in microeconomics and help
analyze a firm's production efficiency, profitability, and pricing strategies. Below
are the primary types of cost curves:

1. Total Cost Curves

 Total Fixed Cost (TFC): Represents costs that do not change with output,
such as rent or salaries of permanent staff. The curve is a horizontal line.
 Total Variable Cost (TVC): Varies with output level, such as costs of raw
materials. This curve usually starts at the origin and increases as output rises.
 Total Cost (TC): Sum of TFC and TVC (TC=TFC+TVCTC = TFC +
TVCTC=TFC+TVC). It starts at the level of TFC and increases with TVC.

2. Average Cost Curves

 Average Fixed Cost (AFC): Fixed cost per unit of output

(AFC=TFC/QAFC = TFC/QAFC=TFC/Q). This curve decreases as output
increases, forming a downward-sloping curve.
 Average Variable Cost (AVC): Variable cost per unit of output
(AVC=TVC/QAVC = TVC/QAVC=TVC/Q). It typically has a U-shape due
to economies and diseconomies of scale.
 Average Total Cost (ATC): Total cost per unit of output (ATC=TC/QATC
= TC/QATC=TC/Q). The ATC curve is also U-shaped and lies above the
AVC curve.

3. Marginal Cost Curve (MC)

 Marginal cost represents the additional cost of producing one more unit of
output (MC=ΔTC/ΔQMC = \Delta TC / \Delta QMC=ΔTC/ΔQ).
 The MC curve typically has a U-shape because of initial efficiency gains
followed by diminishing marginal returns.

Key Relationships Between Cost Curves

  MC and AVC: The MC curve intersects the AVC curve at its minimum
point.
 MC and ATC: The MC curve also intersects the ATC curve at its minimum
point.
 AVC and ATC: The distance between these two curves equals AFC, which
decreases as output increases.

The cost-output relationship describes how production costs change with output
levels. This relationship is analyzed differently in the short run and the long run
due to differences in the flexibility of inputs.

Short-Run Cost-Output Relationship

In the short run, at least one factor of production (typically capital) is fixed. This
creates a distinction between fixed costs and variable costs. The relationship
between cost and output is influenced by the law of diminishing returns:

1. Fixed Costs (FC):

 Fixed costs remain constant regardless of output level (e.g., rent, salaries of
permanent staff).
 Average Fixed Cost (AFC) decreases as output increases, spreading the
fixed cost over more units.

2. Variable Costs (VC):

 Variable costs change with output levels (e.g., raw materials, energy).
 Initially, variable costs increase at a decreasing rate (due to increasing
returns to the variable factor), but beyond a certain point, they rise at an
increasing rate (due to diminishing returns).

3. Total Costs (TC):

 TC=FC+VCTC = FC + VCTC=FC+VC
 The shape of the TC curve reflects the diminishing returns in the short run.

4. Marginal Cost (MC):

 The cost of producing one additional unit of output.

  MC initially decreases due to efficiency but eventually rises as diminishing
returns set in.

5. Average Costs (AC):

 Average Total Cost (ATC): ATC=TC/QATC = TC / QATC=TC/Q

 Average Variable Cost (AVC): AVC=VC/QAVC = VC / QAVC=VC/Q
 Both ATC and AVC are U-shaped due to the interplay of fixed and variable
costs.

Long-Run Cost-Output Relationship

In the long run, all factors of production are variable, and firms can choose the
optimal scale of production. The cost-output relationship is determined by returns
to scale and economies of scale.

1. Economies of Scale:

 As output increases, average cost (AC) decreases due to factors like

specialization, bulk purchasing, and better utilization of resources.
 Economies of scale lead to the downward-sloping portion of the long-run
average cost (LRAC) curve.

2. Diseconomies of Scale:

 Beyond a certain output level, average costs may rise due to coordination
issues, bureaucracy, and resource constraints, leading to an upward-sloping
LRAC curve.

3. Long-Run Average Cost Curve (LRAC):

 The LRAC curve is typically U-shaped and is an envelope of all possible

short-run average cost curves.
 The LRAC curve shows the lowest possible cost of production for any level
of output when all inputs are variable.

4. Returns to Scale:

 Increasing Returns to Scale: Output increases more than proportionately to

inputs, reducing average cost.
  Constant Returns to Scale: Output increases proportionately to inputs,
average cost remains constant.
 Decreasing Returns to Scale: Output increases less than proportionately to
inputs, increasing average cost.

Key Differences Between Short-Run and Long-Run Costs:

Aspect Short Run Long Run

Flexibility At least one factor is fixed. All factors are variable.
FC + VC; influenced by No fixed costs; influenced by
Cost Structure
diminishing returns. returns to scale.
Cost Curves U-shaped AC and MC curves. U-shaped LRAC curve.
Decision-
Limited by fixed inputs. Optimal input mix can be chosen.
Making

Understanding these relationships helps firms optimize production and cost

efficiency over different time horizons.

The Long-Run Average Cost (LAC) curve represents the lowest average cost at
which a firm can produce any given level of output when all inputs are variable. It
is a crucial concept in economics and reflects the firm's cost structure when it has
the flexibility to adjust all production factors, such as labor, capital, and
technology.

Key Features of the LAC Curve:

1. Envelope of Short-Run Average Cost (SAC) Curves:

 oThe LAC curve is derived from multiple Short-Run Average Cost
(SAC) curves.
o Each SAC curve corresponds to a specific plant size or level of fixed
inputs.
o The LAC curve is the lower boundary (envelope) of all these SAC
curves, showing the minimum achievable cost at any output level.
2. U-Shaped Curve:
o The LAC curve is typically U-shaped, reflecting economies and
diseconomies of scale:
 Economies of Scale: In the initial phase, increasing production
reduces the average cost due to efficiencies gained in factors
like bulk purchasing or specialization.
 Constant Returns to Scale: There is a range where the LAC
remains flat, indicating that increasing output does not affect
the average cost.
 Diseconomies of Scale: Beyond a certain output level, the
average cost begins to rise due to inefficiencies such as
management complexity or resource limitations.
3. Planning Curve:
o The LAC curve is sometimes referred to as the planning curve
because it helps firms decide the optimal scale of operation for a given
level of demand.
4. No Fixed Costs:
o In the long run, all costs are variable, so the LAC curve does not
include fixed costs as in the short run.

Components of the LAC Curve

 Leftward Slope: Reflects economies of scale (falling average cost with

increasing output).
 Flat Section: Reflects constant returns to scale (output increases
proportionately with cost).
 Rightward Slope: Reflects diseconomies of scale (rising average cost with
increasing output).

Graphical Representation:
Imagine the LAC curve as a smooth U-shaped line, with several smaller U-shaped
SAC curves tangent to it from below. Each tangent point represents the most
efficient level of output for that specific scale of operation.

Importance in Decision-Making:

 Determining Optimal Plant Size: Helps firms choose the most cost-
efficient level of production.
 Long-Term Planning: Guides investment decisions in capacity expansion
or technology adoption.
 Market Competition: Firms with lower LACs are better positioned to
compete by offering lower prices.

Break-Even Analysis (BEA)

Meaning

Break-even analysis is a financial calculation used to determine the point at which

total revenue equals total costs, resulting in neither profit nor loss. This point is
called the break-even point (BEP). It helps organizations understand the level of
sales needed to cover costs, providing a critical insight into profitability.

Assumptions of BEA

1. Costs are categorized into fixed and variable costs.

2. Selling price per unit remains constant at all levels of sales.
3. Variable cost per unit is constant.
4. Fixed costs remain unchanged over the relevant range of activity.
5. All units produced are sold (no inventory changes).
6. The production and sales mix remains constant if multiple products are
involved.
7. The analysis applies to a specific time period.

Determination of BEA

The break-even point can be determined using the following methods:

 1. Formula Approach:
o In Units:
BEP(Units)=Fixed CostsSelling Price per Unit−Variable Cost per Uni
tBEP (\text{Units}) = \frac{\text{Fixed Costs}}{\text{Selling Price
per Unit} - \text{Variable Cost per
Unit}}BEP(Units)=Selling Price per Unit−Variable Cost per UnitFixe
d Costs
o In Sales Value:
BEP(Sales Value)=Fixed CostsContribution Margin RatioBEP (\
text{Sales Value}) = \frac{\text{Fixed Costs}}{\text{Contribution
Margin
Ratio}}BEP(Sales Value)=Contribution Margin RatioFixed Costs
where Contribution Margin Ratio =
Selling Price per Unit−Variable Cost per UnitSelling Price per Unit\
frac{\text{Selling Price per Unit} - \text{Variable Cost per Unit}}{\
text{Selling Price per
Unit}}Selling Price per UnitSelling Price per Unit−Variable Cost per
Unit

2. Graphical Approach: A break-even chart plots:

o Total revenue line.
o Total cost line (fixed + variable). The intersection of these two lines
indicates the break-even point.

Limitations of BEA

1. Unrealistic assumptions (e.g., constant selling price and costs).

2. Ignores changes in market conditions and economies of scale.
3. Doesn't account for semi-variable costs.
4. Assumes linear relationships between costs, sales, and profits.
5. Limited to short-term decisions as fixed costs can change in the long term.

Margin of Safety (MOS)

The margin of safety represents the extent to which sales can drop before the
company reaches the break-even point. It is calculated as:

MOS=Actual Sales−Break-Even SalesActual Sales×100MOS = \frac{\text{Actual

Sales} - \text{Break-Even Sales}}{\text{Actual Sales}} \times
100MOS=Actual SalesActual Sales−Break-Even Sales×100
A higher margin of safety indicates lower business risk.

Uses of BEA in Managerial Decisions

1. Pricing Decisions: Determine the minimum price required to cover costs.

2. Cost Control: Helps in identifying the impact of cost variations on
profitability.
3. Capacity Planning: Evaluate the impact of changes in production capacity
on profitability.
4. Profit Planning: Set sales targets to achieve desired profit levels.
5. Product Mix Decisions: Analyze contribution margins of different products
to decide the optimal mix.
6. Risk Assessment: Quantify the risk associated with different business
strategies.

Simple Problem

Problem:
A company has the following information:

 Fixed costs: ₹50,000

 Selling price per unit: ₹100
 Variable cost per unit: ₹60

1. Calculate the BEP in units and sales value.

2. Calculate the MOS if actual sales are ₹1,00,000.

Solution:

1. BEP (Units):

BEP(Units)=Fixed CostsSelling Price per Unit−Variable Cost per Unit=50,000100

−60=1,250 unitsBEP (\text{Units}) = \frac{\text{Fixed Costs}}{\text{Selling
Price per Unit} - \text{Variable Cost per Unit}} = \frac{50,000}{100 - 60} =
1,250 \
text{ units}BEP(Units)=Selling Price per Unit−Variable Cost per UnitFixed Costs
=100−6050,000=1,250 units

BEP (Sales Value):

BEP(Sales Value)=BEP (Units)×Selling Price per Unit=1,250×100=₹1,25,000BEP

(\text{Sales Value}) = \text{BEP (Units)} \times \text{Selling Price per Unit} =
1,250 \times 100 =
₹1,25,000BEP(Sales Value)=BEP (Units)×Selling Price per Unit=1,250×100=₹1,
25,000

2. Margin of Safety:

MOS=Actual Sales−Break-Even SalesActual Sales×100=1,00,000−1,25,0001,00,0

00×100=−25%MOS = \frac{\text{Actual Sales} - \text{Break-Even Sales}}{\
text{Actual Sales}} \times 100 = \frac{1,00,000 - 1,25,000}{1,00,000} \times 100
= -25\%MOS=Actual SalesActual Sales−Break-Even Sales
×100=1,00,0001,00,000−1,25,000×100=−25%

In this case, the company is operating below its break-even point, indicating a loss.

Module-4
Module-4(09 Hours)
Market Structure Analysis and Pricing Practices: Market Structure
Analysis:

Perfect Competition: Features, Determination of price under perfect

competition,

Monopolistic Competition: Features, Pricing Under monopolistic

competition, Product differentiation.

Oligopoly: Features, Kinked demand Curve, Cartels, Price leadership.

Monopoly: Features, Pricing under monopoly, Price Discrimination.

Pricing Practices:

Descriptive Pricing Approaches: Loss leader pricing, Peak Load pricing,

Transfer pricing.

Price determination is one of the most crucial aspects in economics. Business

managers are expected to make perfect decisions based on their knowledge and
judgment. Since every economic activity in the market is measured as per price, it
is important to know the concepts and theories related to pricing. Pricing discusses
the rationale and assumptions behind pricing decisions. It analyzes unique market
needs and discusses how business managers reach upon final pricing decisions.

It explains the equilibrium of a firm and is the interaction of the demand faced by
the firm and its supply curve. The equilibrium condition differs under perfect
competition, monopoly, monopolistic competition, and oligopoly. Time element is
of great relevance in the theory of pricing since one of the two determinants of
price, namely supply depends on the time allowed to it for adjustment.

Market Structure

A market is the area where buyers and sellers contact each other and exchange
goods and services. Market structure is said to be the characteristics of the market.
Market structures are basically the number of firms in the market that produce
identical goods and services. Market structure influences the behavior of firms to a
great extent. The market structure affects the supply of different commodities in
the market.

When the competition is high there is a high supply of commodity as different

companies try to dominate the markets and it also creates barriers to entry for the
companies that intend to join that market. A monopoly market has the biggest level
of barriers to entry while the perfectly competitive market has zero percent level of
barriers to entry. Firms are more efficient in a competitive market than in a
monopoly structure.

Perfect Competition

Perfect competition is a situation prevailing in a market in which buyers and sellers

are so numerous and well informed that all elements of monopoly are absent and
the market price of a commodity is beyond the control of individual buyers and
sellers

With many firms and a homogeneous product under perfect competition no

individual firm is in a position to influence the price of the product that means
price elasticity of demand for a single firm will be infinite.

Pricing Decisions

Determinants of Price Under Perfect Competition

Market price is determined by the equilibrium between demand and supply in a

market period or very short run. The market period is a period in which the
maximum that can be supplied is limited by the existing stock. The market period
is so short that more cannot be produced in response to increased demand. The
firms can sell only what they have already produced. This market period may be an
hour, a day or a few days or even a few weeks depending upon the nature of the
product.

Market Price of a Perishable Commodity

In the case of perishable commodity like fish, the supply is limited by the available
quantity on that day. It cannot be stored for the next market period and therefore
the whole of it must be sold away on the same day whatever the price may be.

Market Price of Non-Perishable and Reproducible Goods

In case of non-perishable but reproducible goods, some of the goods can be

preserved or kept back from the market and carried over to the next market period.
There will then be two critical price levels.

The first, if price is very high the seller will be prepared to sell the whole stock.
The second level is set by a low price at which the seller would not sell any amount
in the present market period, but will hold back the whole stock for some better
time. The price below which the seller will refuse to sell is called the Reserve
Price.

Monopolistic Competition

Monopolistic competition is a form of market structure in which a large number of

independent firms are supplying products that are slightly differentiated from the
point of view of buyers. Thus, the products of the competing firms are close but
not perfect substitutes because buyers do not regard them as identical. This
situation arises when the same commodity is being sold under different brand
names, each brand being slightly different from the others.

For example − Lux, Liril, Dove, etc.

Each firm is therefore the sole producer of a particular brand or “product”. It is

monopolist as far as a particular brand is concerned. However, since the various
brands are close substitutes, a large number of “monopoly” producers of these
brands are involved in a keen competition with one another. This type of market
structure, where there is competition among a large number of “monopolists” is
called monopolistic competition.

In addition to product differentiation, the other three basic characteristics of

monopolistic competition are −

 There are large number of independent sellers and buyers in the market.
 The relative market shares of all sellers are insignificant and more or less
equal. That is, seller-concentration in the market is almost non-existent.
 There are neither any legal nor any economic barriers against the entry of
new firms into the market. New firms are free to enter the market and
existing firms are free to leave the market.
 In other words, product differentiation is the only characteristic that
distinguishes monopolistic competition from perfect competition.

Product differentiation is a marketing and economics strategy that involves

distinguishing a product or service from its competitors to make it more appealing
to a target market. It can help a business develop a competitive advantage, increase
sales, and build brand loyalty.
 Some ways to differentiate a product include:
 Quality: Emphasizing that a product is more reliable, usable, and performs better
than competitors
 Features: Highlighting unique features, benefits, or attributes
 Customization: Offering customization options that competitors don't
 Customer service: Providing customer support account managers that competitors
don't
 Branding: Developing a brand perception that customers can associate with the
product
There are three types of product differentiation:
 Vertical: Customers rank products based on a measurable factor, such as price or
quality
 Horizontal: Customers choose between products based on personal preference
 Mixed: A combination of vertical and horizontal differentiation

Monopoly

Monopoly is said to exist when one firm is the sole producer or seller of a product
which has no close substitutes. According to this definition, there must be a single
producer or seller of a product. If there are many producers producing a product,
either perfect competition or monopolistic competition will prevail depending upon
whether the product is homogeneous or differentiated.

On the other hand, when there are few producers, oligopoly is said to exist. A
second condition which is essential for a firm to be called monopolist is that no
close substitutes for the product of that firm should be available.

From above it follows that for the monopoly to exist, following things are essential

 One and only one firm produces and sells a particular commodity or a
service.
 There are no rivals or direct competitors of the firm.
  No other seller can enter the market for whatever reasons legal, technical, or
economic.
 Monopolist is a price maker. He tries to take the best of whatever demand
and cost conditions exist without the fear of new firms entering to compete
away his profits.

The concept of market power applies to an individual enterprise or to a group of

enterprises acting collectively. For the individual firm, it expresses the extent to
which the firm has discretion over the price that it charges. The baseline of zero
market power is set by the individual firm that produces and sells a homogeneous
product alongside many other similar firms that all sell the same product.

Since all of the firms sell the identical product, the individual sellers are not
distinctive. Buyers care solely about finding the seller with the lowest price.

In this context of “perfect competition”, all firms sell at an identical price that is
equal to their marginal costs and no individual firm possess any market power. If
any firm were to raise its price slightly above the market-determined price, it
would lose all of its customers and if a firm were to reduce its price slightly below
the market price, it would be swamped with customers who switch from the other
firms.

Accordingly, the standard definition for market power is to define it as the

divergence between price and marginal cost, expressed relative to price. In
Mathematical terms we may define it as −

L =(P − MC) / P

Monopoly: Overview

A monopoly is a market structure where a single firm dominates the entire market
for a particular good or service. It has no direct competition, giving it significant
market power. Monopolies can arise due to factors such as government regulation,
natural barriers to entry, or exclusive control over resources.
Key Features of Monopoly

1. Single Seller: There is only one producer or seller in the market.

2. No Close Substitutes: The product offered by the monopolist has no close
substitutes.
3. High Barriers to Entry: Entry into the market is restricted due to legal,
technical, or economic barriers.
4. Price Maker: The monopolist has control over the price of the product due
to the absence of competition.
5. Downward-Sloping Demand Curve: The monopolist faces the entire
market demand and must lower the price to sell more units.
6. Profit Maximization: The monopolist sets output and price to maximize
profit, producing where marginal cost (MC) equals marginal revenue (MR).

Pricing under Monopoly

Monopolists determine price and output levels differently than firms in competitive
markets due to their market power.

1. Profit Maximization:
o The monopolist produces where MC = MR.
o The price is then set based on the demand curve at the profit-
maximizing quantity.

2. Inefficiency:
o Allocative inefficiency: Monopolists often produce less than socially
optimal levels, leading to higher prices (P > MC).
o Productive inefficiency: The monopolist may not produce at the
lowest possible cost.

3. Price Determination:
o The monopolist assesses demand elasticity. If demand is inelastic, the
firm can charge higher prices without significantly reducing sales
volume.
Price Discrimination in Monopoly

Price discrimination occurs when a monopolist charges different prices to different

customers for the same product, not based on cost differences but on willingness to
pay.

Types of Price Discrimination:

1. First-Degree (Perfect) Price Discrimination:

o The monopolist charges each customer the maximum price they are
willing to pay.
o Captures all consumer surplus as profit.
o Example: Auctions, personalized pricing.

2. Second-Degree Price Discrimination:

o Prices vary based on the quantity purchased or version of the product.
o Example: Bulk discounts, premium vs. standard versions of software.

3. Third-Degree Price Discrimination:

o Different prices are charged to distinct groups based on their price
elasticity of demand.
o Example: Student discounts, senior citizen pricing, or regional
pricing.

Conditions for Price Discrimination:

1. The monopolist must have some degree of market power.

2. There must be different consumer groups with varying willingness to pay.
3. The monopolist must prevent resale between consumer groups.
Advantages and Disadvantages of Monopoly

Advantages:

 Economies of scale due to large-scale production.

 Potential for innovation due to higher profits and R&D investments.

Disadvantages:

 Higher prices and restricted output reduce consumer welfare.

 Potential for inefficiency and lack of innovation due to absence of
competitive pressure.
 Can lead to income inequality and exploitation of consumers.

Monopolies are often regulated by governments to mitigate their negative effects

through antitrust laws, price controls, and competition promotion.

Oligopoly

In an oligopolistic market there are small number of firms so that sellers are
conscious of their interdependence. The competition is not perfect, yet the rivalry
among firms is high. Given that there are large number of possible reactions of
competitors, the behavior of firms may assume various forms. Thus there are
various models of oligopolistic behavior, each based on different reactions patterns
of rivals.

Oligopoly is a situation in which only a few firms are competing in the market for
a particular commodity. The distinguishing characteristics of oligopoly are such
that neither the theory of monopolistic competition nor the theory of monopoly can
explain the behavior of an oligopolistic firm.

Two of the main characteristics of Oligopoly are briefly explained below −

 Under oligopoly the number of competing firms being small, each firm
controls an important proportion of the total supply. Consequently, the effect
of a change in the price or output of one firm upon the sales of its rival firms
 is noticeable and not insignificant. When any firm takes an action its rivals
will in all probability react to it. The behavior of oligopolistic firms is
interdependent and not independent or atomistic as is the case under perfect
or monopolistic competition.
 Under oligopoly new entry is difficult. It is neither free nor barred. Hence
the condition of entry becomes an important factor determining the price or
output decisions of oligopolistic firms and preventing or limiting entry of an
important objective.
For Example − Aircraft manufacturing, in some countries: wireless
communication, media, and banking.

An oligopoly is a market structure characterized by a small number of firms

dominating the industry. These firms are interdependent, meaning the actions of
one firm affect the others, leading to strategic decision-making.

Features of Oligopoly

1. Few Large Firms: A small number of firms control a significant portion of

the market share.
2. Interdependence: Each firm’s pricing and output decisions impact
competitors.
3. Barriers to Entry: High barriers (e.g., high startup costs, economies of
scale) prevent new competitors.
4. Product Differentiation: Products may be either homogeneous (e.g., steel)
or differentiated (e.g., cars).
5. Non-Price Competition: Firms often compete through advertising, quality,
and branding rather than price.
6. Price Rigidity: Prices tend to be stable due to mutual interdependence and
fear of price wars.
7. Collusion and Cooperation: Firms may collude to set prices or output,
leading to cartel formation.
Kinked Demand Curve

The kinked demand curve model, developed by Paul Sweezy, explains price
rigidity in oligopolies.

Key Points:

1. Price Above the Kink: If a firm increases its price, competitors will not
follow, leading to a significant loss in market share. This results in a more
elastic demand above the kink.
2. Price Below the Kink: If a firm lowers its price, competitors will follow to
maintain their market share. This results in a less elastic demand below the
kink.
3. Kink at the Current Price: The curve creates a kink at the current price
level, making firms reluctant to change prices as marginal costs may vary
without affecting the equilibrium price.

Diagram:

 The demand curve has a kink, with a steeper slope below the kink and a
flatter slope above it.
 The marginal revenue (MR) curve has a discontinuity below the kink.

Cartels

A cartel is a formal agreement between firms in an oligopoly to collude on prices,

production, or other competitive factors.

Features:

1. Price Fixing: Members agree on prices to avoid competition.

2. Production Quotas: Firms set limits on production to maintain high prices.
3. Market Division: Firms may divide the market geographically or by
customer segment.
4. Illegal in Many Countries: Cartels often violate antitrust laws due to their
anti-competitive nature.

Example: The Organization of Petroleum Exporting Countries (OPEC) acts as a

cartel to control oil prices and production.
Price Leadership

Price leadership is a form of implicit collusion where one firm (the leader) sets
the price, and other firms follow.

Types of Price Leadership:

1. Dominant Price Leadership: A dominant firm sets the price, and smaller
firms follow.
2. Barometric Price Leadership: A firm perceived as an industry leader
adjusts prices based on market conditions, and others follow.
3. Collusive Price Leadership: Firms agree (implicitly or explicitly) to let one
firm lead.

Advantages:

 Simplifies pricing decisions.

 Reduces price wars.
 Promotes industry stability.

Disadvantages:

 Limits competition.
 May lead to inefficiency.

These features, along with strategic interactions like cartels and price leadership,
make oligopoly a complex and dynamic market structure.

Skimming Price

Skimming price is known as short period device for pricing. Here, companies tend
to charge higher price in initial stages. Initial high helps to “Skim the Cream” of
the market as the demand for new product is likely to be less price elastic in the
early stages.

Penetration Price

Penetration price is also referred as stay out price policy since it prevents
competition to a great extent. In penetration pricing lowest price for the new
product is charged. This helps in prompt sales and keeping the competitors away
from the market. It is a long term pricing strategy and should be adopted with great
caution.

Multiple Products

As the name indicates multiple products signifies production of more than one
product. The traditional theory of price determination assumes that a firm produces
a single homogenous product. But firms in reality usually produce more than one
product and then there exists interrelationships between those products. Such
products are joint products or multi–products. In joint products the inputs are
common in the production process and in multi-products the inputs are
independent but have common overhead expenses. Following are the pricing
methods followed −

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Full Cost Pricing Method

Full cost plus pricing is a price-setting method under which you add together the
direct material cost, direct labor cost, selling and administrative cost, and overhead
costs for a product and add to it a markup percentage in order to derive the price of
the product. The pricing formula is −

Pricing formula =
Total production costs − Selling and administration costs − Markup / Number
of units expected to sell

This method is most commonly used in situations where products and services are
provided based on the specific requirements of the customer. Thus, there is
reduced competitive pressure and no standardized product being provided. The
method may also be used to set long-term prices that are sufficiently high to ensure
a profit after all costs have been incurred.

Marginal Cost Pricing Method

The practice of setting the price of a product to equal the extra cost of producing an
extra unit of output is called marginal pricing in economics. By this policy, a
producer charges for each product unit sold, only the addition to total cost resulting
from materials and direct labor. Businesses often set prices close to marginal cost
during periods of poor sales.

For example, an item has a marginal cost of $2.00 and a normal selling price is
$3.00, the firm selling the item might wish to lower the price to $2.10 if demand
has waned. The business would choose this approach because the incremental
profit of 10 cents from the transaction is better than no sale at all.

Transfer Pricing

Transfer Pricing relates to international transactions performed between related

parties and covers all sorts of transactions.

The most common being distributorship, R&D, marketing, manufacturing, loans,

management fees, and IP licensing.

All intercompany transactions must be regulated in accordance with applicable law

and comply with the "arm's length" principle which requires holding an updated
transfer pricing study and an intercompany agreement based upon the study.

Some corporations perform their intercompany transactions based upon previously

issued studies or an ill advice they have received, to work at a “cost plus X%”.
This is not sufficient, such a decision has to be supported in terms of methodology
and the amount of overhead by a proper transfer pricing study and it has to be
updated each financial year.

Dual Pricing

In simple words, different prices offered for the same product in different markets
is dual pricing. Different prices for same product are basically known as dual
pricing. The objective of dual pricing is to enter different markets or a new market
with one product offering lower prices in foreign county.

There are industry specific laws or norms which are needed to be followed for dual
pricing. Dual pricing strategy does not involve arbitrage. It is quite commonly
followed in developing countries where local citizens are offered the same
products at a lower price for which foreigners are paid more.
Airline Industry could be considered as a prime example of Dual Pricing.
Companies offer lower prices if tickets are booked well in advance. The demand of
this category of customers is elastic and varies inversely with price.

As the time passes the flight fares start increasing to get high prices from the
customers whose demands are inelastic. This is how companies charge different
fare for the same flight tickets. The differentiating factor here is the time of
booking and not nationality.

Price Effect

Price effect is the change in demand in accordance to the change in price, other
things remaining constant. Other things include − Taste and preference of the
consumer, income of the consumer, price of other goods which are assumed to be
constant. Following is the formula for price effect −

Price Effect =
Proportionate change in quantity demanded of X / Proportionate change in
price of X

Price effect is the summation of two effects, substitution effect and income effect

Price effect = Substitution effect − Income effect

Substitution Effect

In this effect the consumer is compelled to choose a product that is less expensive
so that his satisfaction is maximized, as the normal income of the consumer is
fixed. It can be explained with the below examples −

 Consumers will buy less expensive foods such as vegetables over meat.
 Consumers could buy less amount of meat to keep expenses in control.
Income Effect

Change in demand of goods based on the change in consumer’s discretionary

income. Income effect comprises of two types of commodities or products −

Normal goods − If there is a price fall, demand increases as real income increases
and vice versa.
Inferior goods − In case of inferior goods, demand increases due to an increase in
the real income.

Descriptive pricing approaches

1. Loss Leader Pricing

 Definition: A pricing strategy where a product is sold at a price below its

market cost (or at minimal profit) to attract customers to the store or
platform.
 Purpose: The goal is to encourage customers to buy other products that are
more profitable while they're shopping.
 Common Usage: Retailers often use loss leader pricing on popular or
essential items to increase store traffic.
 Example: A supermarket offering milk or eggs at an extremely low price to
bring customers into the store, hoping they will purchase higher-margin
products like snacks or beverages.

2. Peak Load Pricing

 Definition: A dynamic pricing strategy that adjusts prices based on demand

fluctuations during different times or seasons.
 Purpose: To manage demand and optimize resource utilization during peak
times while encouraging usage during off-peak times.
 Common Usage: Utilities (like electricity), transportation (like ride-
sharing), and entertainment industries often use peak load pricing.
 Example: Surge pricing in ride-hailing services like Uber during rush hours
or higher electricity rates during peak energy usage hours in the summer.

3. Transfer Pricing

 Definition: The pricing of goods, services, or intellectual property

exchanged between divisions or subsidiaries within the same company.
 Purpose: Transfer pricing is used for accounting and tax purposes, often to
allocate profits and reduce overall tax liability.
 Common Usage: Multinational corporations use transfer pricing to
distribute costs and profits across their operations in different countries.
  Example: A subsidiary in a low-tax country charges a high price for
components sold to a subsidiary in a high-tax country, shifting profits to the
low-tax jurisdiction.

Each of these pricing strategies serves different purposes, from customer

acquisition to demand management and tax optimization, making them valuable
tools in various business contexts.