UNIT-IV

MANAGEMENT ECONOMICS
MAM-SEM-III
PRICING ANALYSIS
Q1) Explain the characteristics of perfect competition.
ANS: There are four types of markets in which a seller can its products and services. Therefore, it is very
necessary to classify them and understand its characteristics. The four types of markets are as under:
Perfect competition
Perfect monopoly
Monopolistic competition
Oligopoly
It is necessary to know that perfect competition and perfect monopoly cannot exist in real life situation. It
is just a myth but the real life case like monopolistic competition and oligopoly is based on this unrealistic
cases. Actually, it is the mixture of the two unrealistic cases. We will first look at the characteristics of
perfect competition.
1. Perfect competition:
The term Perfect competition refers to set of conditions prevailing in the market. It is
characterized by many sellers and many buyers. In this case, the firm is a price taker and not a price maker.
This means that the firms have to accept the price determined by the market forces of demand and supply.
Each seller supplies a very small fraction of the total supply. No single seller is powerful enough to
influence the market price. If the firm fixes the price above the ruling market price then it will loose its
revenue and customers will buy the product from the competitors. Where as if it fixes a price lower than
the ruling market price, it will not be able to cover the average cost of production and therefore will make
loss. This can be explained by the following characteristics:
a. Large number of sellers and buyers:
Existence of large number of buyers and sellers is one of the important features of perfect competition
market. As there are millions of buyers and sellers, the share of each seller or buyer is not in apposition to
influence the market price. The price is determined by the forces of total demand and supply. The price
that prevails in the perfect competition is uniform throughout the market. All the sellers and buyers will
take the price as given that is why they are called price takers and not price makers.
b. Homogenous Products: The product, which is sold in perfect competitive market, is homogenous in
character. All the firms will produce and sell the same product, which is identical in al respects such as size,
color, design, taste etc. In other words, they are perfect substitutes to each other as a result no firm will
resort to product differentiation.
c. Free entry and exit for firms:
Perfect competition is characterized by freedom of entry and exists for the firms that are the existing firms
can leave the industry whenever they desire so and new firms can enter the industry whenever they wish
so. If the firm faces losses, they may quit. New firms will join the industry if the existing firms enjoy super
normal profits.
d. Perfect knowledge on the part of buyers: The buyers and sellers possess perfect knowledge regarding
market conditions. The buyer knows the ruling market conditions. The buyers know the ruling market price
and hence they will not offer a higher price. On the other hand, the sellers are aware of the prevailing
market price. Hence, they will not change a lower price. As buyers and sellers possess perfect knowledge of
the market there is no necessity for the seller to go for advertisement and publicity.
e. Perfect mobility of factors of production: There is perfect mobility on the part of factors is free to move
into any industry or any use where they find the reward attractive and profitable. They are free to leave
the industry if they find the reward unprofitable.
f. Absence of transport cost: The next feature of perfect competition is that there is no transportation cost
i.e. there will be no difference in the price of two similar products due to transport cost. If at all exists it is
assumed to be constant.
g. Full and perfect competition: The competition in the market is full and perfect. Sellers compete with
themselves. There is no possibility of sellers coming together to raise the price. Similarly all the buyers
compete themselves in the buying the product and there is no possibility of buyers coming together to
bring down the prices.
h. No interference of government: It is assumed that there is no interference of the government with the
economic activities of the buyers and sellers. The government interference is in the form of tariffs,
subsidies, price control, rationing etc. which affects the free mechanism of market force and there by
makes the market imperfect. Hence, there is no interference of the government.
Thus, the main problem of a firm in a perfectly competitive market is maximize profit by adjusting
the output level to the prices. The firm does not have to bother about the price fixation as it is already
fixed by the market forces.
i. A firm is a price taker and not a price maker: The demand curve for a perfectly competitive firm is
perfectly elastic. The firm has to accept the price given by the market. It is unprofitable for the firm to
increase or decrease the market equilibrium price. The following diagram explain how the firm is a price
taker and not a price maker.

Q2). Explain the equilibrium of a firm under perfect competition for short run as well as
long run.

ANS: In perfect competition there are many buyers and many sellers. They have to accept the price
which is determined jointly by total demand and total supply. Thus, a firm under perfect competition is a
price taker and not the price maker. As the result in perfect competition, average revenue is always equal
to marginal revenue and is also equal to price. If we plot the graph, its position will be parallel to X-Axis and
perpendicular to Y-Axis. This can be explained with the help of a table as well as the diagram.

Units of X Price TR AR MR
PXQ=TR AR = TR MR =
Q TR
Q
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
 Y

PRICE AR

P=AR=MR

0 Quantity sold X

EQUILIBRIUM OF THE FIRM AND INDUSTRY UNDER PERFECT COMPETITION

Conditions of equilibrium for the firm

A firm is in equilibrium when the following conditions are satisfied:

1. MC =MR
2. MC must cut MR from below.

Conditions of equilibrium for the Industry

An industry is in equilibrium when the following conditions are fulfilled:

1. When there is no tendency for the firm either to enter or leave the industry.
2. When all the firms are in equilibrium.

In short at the point of equilibrium:

1. MC=MR

2. AC=AR

Since AR=MR, AC=MC.

Short Period Equilibrium of the Firm and Industry

The short run is a period in which the number and plant size of the firms are fixed. In this period the firm
can produce more only with the help of variable inputs along with the given fixed factors.

In the short run market price is determined by the interaction of the market forces of demand and supply.
This price is given to the firms. The firm in a perfectly competitive market is a price taker and a quantity
adjuster. The firm can sell any amount it wants to sell at that price. The equilibrium position of a firm can
be analysed with the help of marginal analysis as well as with the help of the marginal analysis as well as
with the total cost- total revenue analysis. We shall first discuss the marginal analysis under identical cost
conditions and under different cost conditions.

It is clear from the above discussion that in the short run, each firm may be making either supernormal
profits or normal profits or incurs losses depending upon the price of the product.

Thus in the short run:

 1. If price < the minimum AVC, the firm will not produce anything.
2. If price=minimum AVC, then the firm will produce in the short-run. And it will maximise its profit by
producing an output where P=MC.
3. The firm will make a profit only if P exceeds minimum AC.

The industry as a whole is in equilibrium when all the firms are in equilibrium. This indicates a situation
when MC=MR=AR=AC. In such a situation all firms will earn only normal profits. In the words of D.S.
Watson An industry is in equilibrium in the short run when the output of the industry holds steady , there
being no force acting to expand output or to contact it. If all the firms are in equilibrium, then so the
industry.

The following diagrams will illustrate the point more clearly.

Super Normal Profit

Category 1

Profit=TR-TC

= AR X Total Output AC X Total Output

= OP X OQ OP1 X OQ
= OPEQ OP1E1Q
= PP1E1E

Thus firms in Category 1 will earn super normal profits equal to PP1E1E.

Loss
Thus firms in category 2 will incur a loss equal to PP1EE1.

Normal Profit

Category 3

Firms in the category 3 cover only their SAC which includes normal profit.

Long run Equilibrium of the Firm and Industry.

In the long run, the dichotomy between fixed cost and variable cost disappears. All factors are variable. In
the long run the firm can pick from the full menu of choices. In the long run existing firms will make
adjustments in their output and costs. If after these adjustments a firm is still unable to cover its total
costs, it will leave the industry. If existing firms earn economic profits in an industry, these profits will lure
additional firms. When economic profits in the industry become zero, there will be no incentive either to
enter or leave. The number of firms in the industry will remain stable. As the average cost of production
includes the normal profit, this will occur when price is equal to minimum Long Run Average Cost (LRAC
min).

The long run competitive equilibrium can also be analysed under identical and different cost conditions.In
case the entrepreneurs are heterogeneous, some firms will be able to produce the same output at lower
costs than others. This means that some firms will be able to earn super normal profits. The firms which
earn supernormal profits are the intra- marginal firms as distinct from the marginal firms, which just
earns a normal profit. These two cases are shown in following figure:

Let us assume that there are two firms A and B. Firm A has a more efficient entrepreneur, and therefore
enjoys lower costs than firm B. At the price OP, firm A is earning supernormal profits of PBCE even in the
long run. But firm B is earning only normal profits. Therefore firm A is the intra-marginal firm and firm B is
the marginal firm. Unless the influx of very efficient producers are able to compete more effectively with
firm. A than with firms like B, firm A will continue to earn supernormal profits even in the long run.

Q3) Explain the characteristics of monopoly market.

ANS:

Characteristics of monopoly
The term monopoly indicates that the seller has the absolute power and to produce and sell a product. As
the product sold by the monopolist has no close substitute, the cross elasticity of the product is zero or
negative. Monopoly is a market where a single seller controls the supply of a commodity. He faces no
competition, as there is no close substitute for his commodity. Following are the important features of
monopoly.
a. Existence of single firm: The term monopoly is the combination of two terms mono and poly,
which means single seller. There is a single seller in the market who controls the supply of the entire
market. He has no rivals and he faces no competition.
b. No close substitute: The commodity supplied by the monopoly producers does have close
substitutes. However, it may have remote substitutes for e.g. there is no absolute substitute for electricity.
However, things like kerosene, oil, and gas act as a remote substitute for electricity. As there are no close
substitutes, the monopolist faces no serious competition.
c. Barriers to entry: The entry of other firms is strictly restricted under monopoly. A firm can exist as
long as it is a single seller. Entry of other firms destroys the very existence of monopoly market. Barriers to
entry can be due to the legal restriction or availability of scarce resources. For e.g. electricity services is the
monopoly of the government in India. OPEC-oil producing and exporting countries have a monopoly on
petroleum products.
d. A monopolist cannot fix a price as well as the output to be sold: under the monopoly, the seller is
the price maker and not a price taker. However, it does not mean that he can decide the price as well as
the output on his own. He can fix either a price or output. In case if he fixes a price at a higher level, the
output or supply will be determined on the basis of the response of the consumers. Change in price may
affect the purchasing power, which influences the demand and supply of the good in concern. Thus, the
monopolist cannot fix a price as well as output.
e. Firm and Industry are same: under monopoly, the firm itself is the industry. As the entry of other
firms is strictly prohibited. The firm itself develops into an industry under monopoly.
f. Large number of buyers: Under monopoly, there are large numbers of buyers in market who
compete with one another.

Q4) Explain the equilibrium of a firm under monopoly for short run as well as the long
run.

Where as imperfect competition, is a situation where perfect competition is absent. Monopoly, duopoly,
oligopoly, monopolistic competitions are examples of imperfect competitions. Under imperfect
competition, as seller has to reduce the price so as to sell more. The total revenue increases but at a
decreasing rate. In this type of market average revenue is equal to price and average revenue is greater
than marginal revenue.

1. AR = P
2. MR <AR
This can be explained with the help of a table and a diagram

Units of X Price of X TR AR MR
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
7 4 28 4 -2
8 3 24 3 -4
From the above diagram we notice that AR and MR curves are downward sloping curve and AR is greater
than MR.
 PRICE
AR MR

AR

MR

QUANTITY

Conditions of equilibrium for the firm

A firm is in equilibrium when the following conditions are satisfied:

1. MC =MR
2. MC must cut MR from below.

Graphically it can be explained below.

MC

PRICE
AR MR
E

AR

MR

0 Q OUTPUT

The figure shows that MC curve cuts MR from below at point E. This means at E, equilibrium price is OP
and equilibrium output is OQ. In order to know whether the monopolist makes profits or losses in the short
run, we need to introduce the average total cost curve. The following figure shows how the firm makes
profits or losses in the short run.

Short Period Equilibrium of the Firm and Industry

The condition for super normal profit is

AR>AC

The following figure explains super-normal or abnormal profits earned by the firm under monopoly in the
short run.
 MC

AC
PRICE A
AR MR
B E

AR

MR

0 Q OUTPUT
In the above diagram we see that the equilibrium of the firm is at point E and the equilibrium price is OP.
The firm makes super normal or abnormal profit as the vertical distance AQ>EQ. In other words the
average revenue is greater that average cost i.e. AR>AC. This indicates that the firm is making super normal
profit. The shaded area PABC indicates the supernormal profit. AB is the per unit profit where as the total
supernormal profit is the area PABC.

The condition for loss is

AR<AC

One misconception is that the monopolist always makes profits. But one must know that the monopoly
firm can make losses too. It all depends upon the cost conditions. If the firm faces very low demand and
the total cost is very high i.e. AC>AR then the firm is bound to make losses. The figure below explains the
same.
MC
AC

P A
PRICE C
B
AR MR
E

AR

MR

0 Q OUTPUT
In the above figure MC cuts MR from below. The equilibrium point is at E and the total revenue earned by
the firm is BQ where as the total cost incurred by the firm is AQ. In the figure it is clear that per unit loss
incurred is AB and the total loss area is equal to PABC which is the shaded area. Thus the monopoly firm
earns losses if it is unable to meet the average variable cost in the short run.

Long Run equilibrium for Firm

Long run is a period long enough to allow the monopolist to adjust his plant size or use his existing plant at
any level that maximizes his profit. In the long run if there is absence of competition, then monopolist need
not produce at optimal level. He can produce at sub-optimal scale. In other words, he need not reach the
minimum of LAC curve; he can stop at any place where profits are maximum. The figure on the next page
indicates that the total supernormal profit in the long run is the area PACB. He will continue to make super
normal profit as long as entry of outside firms is blocked.

Long run Super-normal profit for a monopoly firm

LMC

PRICE
A LAC
AR MR P

B C

E
LAR

LMR

0 Q OUTPUT

Q1. Explain the characteristics of Monopolistic competitive market.

ANS: Generally, we do not see perfect competition or perfect monopoly in the real life situation but in
the real world, we find only monopolistic competition or imperfect competition. In this type of market,
there is non-price competition as price cuts would lead to price wars and therefore sellers to maximize
their profits would resort to product innovation, advertisement, better after sales service, discounts,
expensive displays, packaging etc. This market is said to be imperfect because some of the buyers or sellers
or both are not fully aware of the prices at which the transactions take place.

Characteristics or features of monopolistic competition

The following are the features of the monopolistic competitive market.

Large number of firms: The number of firms constitutes an industry is fairly large. Individual firms have not
to bother about the reactions of rival firms. It can follow its independent price and output policy.
Large number of buyers: There are large numbers of buyers in a monopolistic competitive market. Each
buyer enjoys their specific preferences over a particular brand and chooses to buy from a particular seller.
Thus, the buyers purchase goods by choice and not by chance.
Product differentiation: Product differentiation is the most important feature of monopolistic
competition. Since all the sellers sell the product which are substitutes for each other. They go for product
differentiation. Every seller makes efforts to show that his product is superior to other product. Product
differentiation is practiced in many firms like advertisements, brands, trademarks, designs, packaging,
colour etc. thus the products are not homogenous under perfect competition. For e.g.
 Automobile industry

Small Luxurious 9-seater

family cars cars cars

Maruti-800 Esteem
Zen Mercedes Sumo
Matiz Accent Qualis
Santro Opel Bolero
WagonR Lancer Maruti-Van
Alto Honda-city Voyager
Indica Tata-estate
Uno Versa

From the above table it is clear that in the monopolistic competition all the products in the industry are
different from one other. Automobile industry can be divided into three small car segment, luxurious car
segment and 9-seater segment. However, all the cars under small car segment are different from one
another and similarly the cars in the luxurious and 9-seater segment are different from one other. This
explains that in real life all the products have different features from one another.
Selling cost: One of the unique features of monopolistic competition is its selling cost. Selling cost is the
cost incurred by the sellers in a monopolistic market to promote sales. The sellers make efforts through
advertisement, window display, salesman service etc. to promote sales. The cost involved in such sales
promotion efforts is called selling cost. Selling cost enables the seller to persuade buyers to buy their
products from other sellers.
Free entry and exit: There is a free entry and exit of firms under monopolistic competition. There are no
barriers for the firms to enter the market since each firm produces a product, which is slightly different
from others. In addition, any firm who wants to live the market can easily do so.

Q2. Explain the equilibrium of a firm under monopolistic competition in short run as well
as the long run with the help of figures.

ANS: In monopolistic competitive market the product is differentiated and therefore each firm do not
face perfectly elastic market for its products. Each firm is a price maker and is in a position to determine
price of its own product. As such the firm is faced by downward sloping demand curve for its product. But
it has to be noted that the AR and MR curves are downward sloping from left to right but they are flatter.
In this type of market average revenue is equal to price and average revenue is greater than marginal
revenue.

1. AR = P
2. AR>MR
Conditions of equilibrium for the firm

A firm is in equilibrium when the following conditions are satisfied:

 1. MC =MR
2. MC must cut MR from below.

Graphically it can be explained below.

MC

PRICE
AR MR
E

AR

MR

0 Q OUTPUT

The figure shows that MC curve cuts MR from below at point E. This means at E, equilibrium price is OP
and equilibrium output is OQ. In order to know whether the monopolistic competitive firm makes profits
or losses in the short run, we need to introduce the average total cost curve. The following figure shows
how the firm makes profits or losses in the short run.

Short Period Equilibrium of the Firm and Industry

The condition for super normal profit is

AR>AC

The following figure explains super-normal or abnormal profits earned by the firm under monopoly in the
short run.
MC

AC
PRICE A
AR MR
B E

AR

MR

0 Q OUTPUT

In the above diagram we see that the equilibrium of the firm is at point E and the equilibrium price is OP.
The firm makes super normal or abnormal profit as the vertical distance AQ>EQ. In other words the
average revenue is greater that average cost i.e. AR>AC. This indicates that the firm is making super normal
profit. The shaded area PABC indicates the supernormal profit. AB is the per unit profit where as the total
supernormal profit is the area PABC.

The condition for loss is

AR<AC

In monopolistic competitive market the firm can make supernormal profit in the short run or losses. The
supernormal profits occur because the entrepreneur takes the risk of introducing new innovations in the
market and thus earns abnormal profit for time being or the short run. But one must know that the
monopolistic competitive firm can make losses too. It all depends upon the cost conditions. If the firm
faces very low demand and the total cost is very high i.e. AC>AR then the firm is bound to make losses. The
figure below explains the same.
MC
AC

P A
PRICE
C B
AR MR
E

AR

MR

0 Q OUTPUT

In the above figure MC cuts MR from below. The equilibrium point is at E and the total revenue earned by
the firm is BQ where as the total cost incurred by the firm is AQ. In the figure it is clear that per unit loss
incurred is AB and the total loss area is equal to PABC which is the shaded area. Thus the monopoly firm
earns losses if it is unable to meet the average variable cost in the short run.

Long run equilibrium of a firm under monopolistic competition

In the long run the firm in monopolistic competitive market makes normal profit. The condition for making
normal profit is

AR=AC

This happens because the firm if it made losses would have to exit the market where as if it was making
supernormal profit in the short-run then, it would invite new competition in the market. In addition to that
the product may be imitated by the existing firms and the profits may decline to just normal profit in the
long run. Also it has to be noted that there is always under-utilized capacity in the firm. That means the
entrepreneur or the firm does not produce the product at the optimal level. This is explained with the help
of the diagram below.
 LATC MC

PRICE X
AR MR R
E

AR

MR

0 Q Q1
OUTPUT
It is seen in the figure that the firm is having excess capacity. The firm produces OQ which is the
equilibrium quantity. But this level of output is less than the optimal level of output that is at OQ1 where
the average cost AC is at its minimum point. It implies that monopolistic competitive firms are not of
optimum size and there exist excess capacity of production with each firm.

Q) Explain the relationship between average revenue, marginal revenue and

elasticity of demand.

ANS: There are different concepts of revenue of a firm. This should be clearly explained
as the average revenue, marginal revenue and elasticity of demand are closely related. In
this context, we will study the following three concepts.

a. Total Revenue: Total revenue can be obtained by multiplying the price of the
goods with the total units sold. For example if the price is Rs. 9 per unit and the
quantity sold is 10 units then total revenue is
TR = P Q

TR = 9 10
TR =Rs. 90
b. Average Revenue: Average revenue is the income obtained by dividing the total
revenue by quantity sold. For example if the total revenue is Rs.16 and quantity
sold are 2 units then average revenue is
TR
AR =
Q

16
AR =
2
= Rs. 8
c. Marginal Revenue: Marginal Revenue means the additional revenue earned by
the firm by selling one more unit of output. The formula for marginal revenue is
TR
MR =
Q
Where TR = Change in total revenue, Q= Change in total output.

The inter-relationship among various concepts of revenue of the firm can be explained
with the help of the following table:

TR TR
Price Quantity sold TR = P Q AR = MR =
Q Q
(Rs.) (Units)
9 1 9 9 -
8 2 16 8 7
7 3 21 7 5
6 4 24 6 3
5 5 25 5 1
4 6 24 4 -1
3 7 21 3 -3

On the basis of the above table some conclusions can be drawn:

1. When average revenue decreases, marginal revenue is less than average revenue.
2. Average revenue decreases more rapidly than marginal revenue.
3. Till marginal revenue is positive, total revenue continues to increase.
4. When marginal revenue turns negative, total revenue begins to decrease.
5. When marginal revenue is zero, total revenue is maximum.

AR/MR

AR/D

0 Quantity sold

MR

Inter-relationship between Elasticity of demand, Marginal Revenue and total

revenue

1. When elasticity of demand is more than 1, the marginal revenue is positive and
when price decreases total revenue increases.

2. When elasticity of demand is less than one 1, marginal revenue is negative and
when price decreases total revenue decreases.
3. When elasticity of demand is equal to 1 marginal revenue is zero and changes in
price will not bring any change in total revenue.
Inter-relation between average revenue, marginal revenue and elasticity of demand

Mrs. Joan Robinson has given the following equation to explain the relationship
between average revenue, marginal revenue and elasticity of demand.
AR
AR =
AR MR
To find out AR the following equation can be used.
E
AR = MR ( )
E1
To find out the marginal revenue, we can use the following equation.
E1
MR = AR ( )
E

Change in Price E>1 E<1 E=1

Price Increases TR decreases TR increases TR remains same
Price Decreases TR increases TR decreases TR remains same

Q) Difference between Perfect competition and Monopoly.

Number of Firms: Perfect competition is an industry comprised of a large number of small firms, each of
which is a price taker with no market control. Monopoly is an industry comprised of a single firm, which is
a price maker with total market control.

Available Substitutes: Every firm in a perfectly competitive industry produces exactly the same product as
every other firm. An infinite number of perfect substitutes are available. A monopoly firm produces a
unique product that has no close substitutes and is unlike any other product.

Resource Mobility: Perfectly competitive firms have complete freedom to enter the industry or exit the
industry. There are no barriers. A monopoly firm often achieves monopoly status because the entry of
potential competitors is prevented.

Information: Each firm in a perfectly competitive industry possesses the same information about prices
and production techniques as every other firm. A monopoly firm, in contrast, often has information
unknown to others.

Demand curve: The demand curve for a perfectly competitive firm is perfectly elastic and the demand
curve for a monopoly firm is THE market demand, which is negatively-sloped according to the law of
demand. A perfectly competitive firm is thus a price taker and a monopoly is a price maker.
Perfect Competition v/s Monopoly