UNIT-4

THEORY OF PRODUCTION, COST, PRICE & MARKETS

Definition: According to Michael R Baye defines production function as “that function
which defines the maximum amount of output that can be produced with a given set of inputs

Production is the result of the combinations of factors for the creation of values and utility to
the corresponding commodities. The factors of production are namely Land, Labour, Capital,
Organization and Technology.

Production Function:

The function for the production is stated as:

Q = f {L1, L2, C, O, T}

Where Q = Quantity of Production. F = Relation between Inputs and Outputs,

L1 = land, L2= Labour, C = Capital, O = Organization, T = Technology.

The level of output of a firm can be increases in to two ways:

1. By increasing only one factor and keeping the other factors constant.

2. By increasing all factors of Production.

COST ANALYSIS:

Introduction:

The Managerial economist is concerned with making Managerial decisions. Different

business proposals are evaluates of their costs and revenues.

Concept and Nature of Cost: Cost refers to the expenditure incurred to produce a particular
product or service. All costs involve a sacrifice of some kind or other or acquire some
benefits.

Eg: I want to eat food; I should be prepared to sacrifice Money. Costs may be monetary or
non monetary, tangible or intangible, determined subjectively or objectively. Social costs
such as pollution, noise or traffic congestion to the cost concept.
 The cost of production normally includes the cost of raw materials, labour and other
expenses. These are called Total cost (TC). This is compared with the total revenues (TR)
realized on the sale of the products manufactured. The difference between total revenues and
total cost is known as Profit (P)

Profit (p) = TR-TC

In decision making Cost refers needs to be analyzed and understood in a wider perspective.
Though the data for studying the costs is obtained from the financial records, these need to be
supplemented by specific details. The costs as reported by financial accounts are more suited
to the legal and financial purpose for which they are designs. But financial records cannot
provide all the necessary information about costs.

An understanding of the meaning of various cost concepts is essential for clear business
thinking. They facilitate clear understanding of the management problem and also of the
concept of cost that is relevant to it.

OPPORTUNITY COST: Opportunity cost refers to the earning / profits that are foregone
from alternatives ventures by using given limited facilities for a particular purpose. They
represent only the sacrificed alternatives. So they are never recorded in the books of accounts.
These costs must be considered for decision making. Opportunity cost refers to the “cost for
the next best alternatives foregone”. We have scarce resources and all these have alternative
uses. Where there is an alternative, there is an opportunity to reinvest the resources. In other
words if there are no alternatives there are no opportunity costs.

Eg: If the firm owns land there is no cost of using the land (i.e rent) in the firms account. But
the firm has an opportunity cost of using this land, which is equivalent to the rent foregone by
not letting the land out on rent.

ACTUAL COST or OUTLAY COST: Actual cost is defined as the cost or expenditure which a
firm incurs for producing or acquiring a good or service and they are recorded in the books of
accounts of a business unit.

Example: cost of raw material, rent, interest, wages, etc.

EXPLICIT vs IMPLICIT COSTS: The costs of using resources in production involve both
implicit & explicit costs. It is also called as out-of-Pocket cost and other non cash costs called
Implicit costs entered in the books of accounts. Explicit costs involve payment of cash. The
rent for the land lord, wages for the laborer, interest paid are the explicit cost. Other examples
of explicit costs are:

Cost of raw material, Salaries, Power charges, Rent of business, insurance premium

IMPLICIT COSTS: These are also called imputed costs do not involve payment of cash as
they are not actually incurred. They do not take the form of cash outlays, nor outlays, nor
they do not appear in the accounting system. Eg: wages of labour rendered by the
entrepreneur himself, Interest on capital supplied by him.

HISTORICAL AND REPLACEMENT COSTS:

Historical cost is the original cost of an asset. Historical cost valuation shows the cost of an
asset as the original price paid for the asset acquired in the past. Historical valuation is the
basis for financial accounts.

A replacement cost is the price that would have to be paid currently to replace the same
asset. During periods of substantial change in the price level, historical valuation gives a poor
projection of the future cost intended for managerial decision. A replacement cost is a
relevant cost concept when financial statements have to be adjusted for inflation.

SHORT – RUN & LONG – RUN COSTS:

Short-run is a period during which the physical capacity of the firm remains fixed. Any
increase in output during this period is possible only by using the existing physical capacity
more extensively. So short run cost is that which varies with output when the plant and
capital equipment in constant.

Long run costs are those, which vary with output when all inputs are variable including plant
and capital equipment. Long-run cost analysis helps to take investment decisions.

OUT-OF-POCKET COSTS: The costs that involve an immediate outflow of cash. These
are spent in the day- to-day life of the business, such as purchase of raw material, payment of
salaries interest on loans and so on. Out of pocket costs are also called explicit costs because
they are incurred in reality.

BOOK COST: Book costs are taken into account in determining the level dividend payable
during a period. Both book costs and out-of-pocket costs are considered for all decisions.
Book cost is the cost of self-owned factors of production.
FIXED COST VS VARIABLE COST: Economists often divide costs into two main groups
they are fixed cost and Variable cost. Fixed costs are that part of the total cost of the firm
which does not vary with output. Eg: Expenditure depreciation rent of land and building,
property taxes etc. If the period under consideration is long enough to allow the necessary
adjustments in the capacity of the firm. The fixed costs no longer remain fixed.

Variable Costs: It directly dependent on the volume of output or service variable costs
increase but not necessarily in the same proportion as the increase in output. The degree of
proportionality between the variable cost and output depends up on the utilization of fixed
facilities and resources during the process of production.

IMPUTED/ BOOK COST: Sometimes book costs is also known as imputed cost. Book costs
are those business costs which don’t involve any cash payment but a provision is made in the
books of accounts. Books costs are imputed costs or the payments made by the firm itself.

Example: Cost of using owners money, depreciation of fully-written-off-property, the firm own
capital equipment etc.

COST-OUTPUT RELATIONSHIP

The cost and output are related. The cost of production depends upon several factors such as
volume of production; relationship between the costs and output; prices and productivity of
the inputs such as land, labour, capital and so forth, and the time scale.

The cost-output relationship significantly differs in the short run and in the long-run. It is
because, in the short run, the cost can be classified into fixed costs and variable costs. The
cost-output relationship in the short-run is governed by certain restrictions in terms of fixed
costs. Where in the long-run, the cost-output relationship studies the effect of varying the size
of plants upon its cost.

The cost-output relationship plays an important role in determining the optimum level of
production. Knowledge of the cost-output relation helps the manager in cost control, profit
prediction, pricing, promotion etc. The relation between cost and its determinants is
technically described as the cost function.

C= f (S, O, P, T ….)

Where;

C= Cost (Unit or total cost)

S= Size of plant/scale of production

O= Output level

P= Prices of inputs

T= Technology

1. Cost-Output Relationship in the Short-Run

The cost concepts made use of in the cost behavior are Total cost, Average cost,
and Marginal cost.

Total cost is the actual money spent to produce a particular quantity of output. Total Cost is
the summation of Fixed Costs and Variable Costs.

TC=TFC+TVC

Up to a certain level of production Total Fixed Cost i.e., the cost of plant, building,
equipment etc, remains fixed. But the Total Variable Cost i.e., the cost of labor, raw materials
etc., vary with the variation in output. Average cost is the total cost per unit. It can be found
out as follows.

AC=TC/Q

The total of Average Fixed Cost (TFC/Q) keep coming down as the production is increased
and Average Variable Cost (TVC/Q) will remain constant at any level of output.

Marginal Cost is the addition to the total cost due to the production of an additional unit of
product. It can be arrived at by dividing the change in total cost by the change in total output.

In the short-run there will not be any change in Total Fixed Cost. Hence change in total cost
implies change in Total Variable Cost only.

Units of Total Total Total cost Average Average Average Marginal

Output Q fixed cost variable (TFC + variable cost fixed cost cost cost MC
TFC cost (TVC / Q) (TFC / Q)
 TVC TVC) TC AVC AFC (TC/Q) AC

0 – – 60 – – – –

1 60 20 80 20 60 80 20

2 60 36 96 18 30 48 16

3 60 48 108 16 20 36 12

4 60 64 124 16 15 31 16

5 60 90 150 18 12 30 26

6 60 132 192 22 10 32 42

The above table represents the cost-output relationship. The table is prepared on the basis of
the law of diminishing marginal returns. The fixed cost Rs. 60 May include rent of factory
building, interest on capital, salaries of permanently employed staff, insurance etc. The table
shows that fixed cost is same at all levels of output but the average fixed cost, i.e., the fixed
cost per unit, falls continuously as the output increases. The expenditure on the variable
factors (TVC) is at different rate. If more and more units are produced with a given physical
capacity the AVC will fall initially, as per the table declining up to 3rd unit, and being
constant up to 4th unit and then rising. It implies that variable factors produce more
efficiently near a firm’s optimum capacity than at any other levels of output and later rises.
But the rise in AC is felt only after the start rising. In the table ‘AVC’ starts rising from the
5th unit onwards whereas the ‘AC’ starts rising from the 6th unit only so long as ‘AVC’
declines ‘AC’ also will decline. ‘AFC’ continues to fall with an increase in Output. When the
rise in ‘AVC’ is more than the decline in ‘AFC’, the total cost again begin to rise. Thus there
will be a stage where the ‘AVC’, the total cost again begin to rise thus there will be a stage
where the ‘AVC’ may have started rising, yet the ‘AC’ is still declining because the rise in
‘AVC’ is less than the droop in ‘AFC’.
Thus the table shows an increasing returns or diminishing cost in the first stage and
diminishing returns or diminishing cost in the second stage and followed by diminishing
returns or increasing cost in the third stage.

The short-run cost-output relationship can be shown graphically as follows.

In the above graph the “AFC’ curve continues to fall as output rises an account of its spread
over more and more units Output. But AVC curve (i.e. variable cost per unit) first falls and
than rises due to the operation of the law of variable proportions. The behavior of “ATC’
curve depends upon the behavior of ‘AVC’ curve and ‘AFC’ curve. In the initial stage of
production both ‘AVC’ and ‘AFC’ decline and hence ‘ATC’ also decline. But after a certain
point ‘AVC’ starts rising. If the rise in variable cost is less than the decline in fixed cost, ATC
will still continue to decline otherwise AC begins to rise. Thus the lower end of ‘ATC’ curve
thus turns up and gives it a U-shape. That is why ‘ATC’ curve are U-shaped. The lowest
point in ‘ATC’ curve indicates the least-cost combination of inputs. Where the total average
cost is the minimum and where the “MC’ curve intersects ‘AC’ curve, It is not be the
maximum output level rather it is the point where per unit cost of production will be at its
lowest.

The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up as follows:

If both ‘AFC’ and ‘AVC’ fall, ‘ATC’ will also fall.

When ‘AFC’ falls and ‘AVC’ rises

ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.

‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’

‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’

2. Cost-output Relationship in the Long-Run

Long run is a period, during which all inputs are variable including the one, which are
fixes in the short-run. In the long run a firm can change its output according to its demand.
Over a long period, the size of the plant can be changed, unwanted buildings can be sold staff
can be increased or reduced. The long run enables the firms to expand and scale of their
operation by bringing or purchasing larger quantities of all the inputs. Thus in the long run all
factors become variable.

The long-run cost-output relations therefore imply the relationship between the total cost and
the total output. In the long-run cost-output relationship is influenced by the law of returns to
scale.

In the long run a firm has a number of alternatives in regards to the scale of operations. For
each scale of production or plant size, the firm has an appropriate short-run average cost
curves. The short-run average cost (SAC) curve applies to only one plant whereas the long-
run average cost (LAC) curve takes in to consideration many plants.

The long-run cost-output relationship is shown graphically with the help of “LCA’ curve.

To draw on ‘LAC’ curve we have to start with a number of ‘SAC’ curves. In the above figure
it is assumed that technologically there are only three sizes of plants – small, medium and
large, ‘SAC’, for the small size, ‘SAC2’ for the medium size plant and ‘SAC3’ for the large
size plant. If the firm wants to produce ‘OP’ units of output, it will choose the smallest plant.
For an output beyond ‘OQ’ the firm wills optimum for medium size plant. It does not mean
that the OQ production is not possible with small plant. Rather it implies that cost of
production will be more with small plant compared to the medium plant.

For an output ‘OR’ the firm will choose the largest plant as the cost of production will be
more with medium plant. Thus the firm has a series of ‘SAC’ curves. The ‘LCA’ curve drawn
will be tangential to the entire family of ‘SAC’ curves i.e. the ‘LAC’ curve touches each
‘SAC’ curve at one point, and thus it is known as envelope curve. It is also known as
planning curve as it serves as guide to the entrepreneur in his planning to expand the
production in future. With the help of ‘LAC’ the firm determines the size of plant which
yields the lowest average cost of producing a given volume of output it anticipates.

BREAK EVEN ANALYSIS (BEP)/ COST VOLUME PROFIT ANALYSIS (CVP)

Introduction: Break even analysis refers to analysis of the breakeven point. The BEP is
defined as a no profit or no loss point. It is necessary to determine the BEP when there is
neither profit nor loss. It is important because it denoted the minimum volume of production
to be undertaken to avoid losses.

In other words BEP refers to the point where total cost is equal to total revenues

BEP equal to TC=TR. It is points of no profit no loss. Break even analysis is defined of costs
and their possible impact on revenues and volume of the firm. Hence it is also called the
Cost-Volume-Profit Analysis. A firm is said to attain the BEP when its total revenue is equal
to total cost (TR=TC).

Total cost comprises fixed cost and variable cost. The significant variables on which the
BEP is based are fixed cost, variable cost and Total Revenues.
Break Even Chart: The graphical representation of breakeven point in a breakeven chart is
Output is shown on Horizontal axis and Revenues on Vertical axis.

 TC =
Total variable cost (TVC) + Total Fixed Cost (TFC).
 The variable cost line is drawn first. It varies proportionately with volume of production
and sales.
 The total cost line is derived by adding total fixed cost line to the total variable cost line.
The total cost line is parallel to variable cost line.
 The total revenue line starts from zero point and increase along with the volume of sales
intersecting total cost line at point BEP.
 The zone below BEP is loss zone and above is BEP profit zone.
 OP is the quantity produced/ sold at OC. The cost/price at BEP.
 The angle formed at BEP that is the point of intersection of total revenues and total cost is
called “Angle of Incidence”.
 The larger the angle of incidence, the higher is the quantum of profit. Once the fixed costs
are absorbed.

Applications of Breakeven Analysis:

 Make or Buy Decision: The manager is confronted with “Make or Buy” decision. The
necessary components or spare parts, where the consumption is larger making may be
economical.
 Choosing a product mix when there is a limiting factor: It is very likely that the
company may be dealing in more than one product and company wants to know, in view
of the limited plant capacity.
 Drop or Add Decision: It is common that the firm keep on adding new products to their
product range, while dropping the old ones to keep space with the changing demand. In
this process we proposed to be dropped, saves the firm from the losses then |Break even
analysis helps in such decisions.

Assumptions of Break Even Analysis:

1. All costs are classified into two – fixed and variable.

2. Fixed costs remain constant at all levels of output.

3. Variable costs vary proportionally with the volume of output.

4. Selling price per unit remains constant in spite of competition or change in the volume of
production.

5. There will be no change in operating efficiency.

6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
8. Volume of sales and volume of production are equal. Hence there is no unsold stock.
9. There is only one product or in the case of multiple products. Sales mix remains constant.

Significance of Break Even Analysis:

 To ascertain the profit on a particular level of sales volume or a given capacity of

production.
 To calculate sales required to earn a particular desired level of profit.
 To compare the product line, sales area, method of sale for individual company.
 To compare the efficiency of the different firms.
 To decide whether to add a particular product to the existing product line or drop one from
it.
 To decide to “Make or Buy” a given component or spare part.
 To decide what promotion mix will yield optimum sales.

Merits:
1. Information provided by the Break Even Chart can be understood more easily then
those contained in the profit and Loss Account and the cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit. It reveals
how changes in profit. So, it helps management indecision-making.
3. It is very useful for forecasting costs and profits long term planning and growth
4. The chart discloses profits at various levels of production.
 5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
7. Analytical Break-even chart present the different elements, in the costs – direct
material, direct labour, fixed and variable over heads.

Limitations of BEA:

1. Break-even chart presents only cost volume profits. It ignores other considerations such as
capital amount, marketing aspects and effect of government policy etc., which are necessary
in decision making.
2. It is assumed that sales, total cost and fixed cost can be represented as straight lines. In
actual practice, this may not be so.
3. It assumes that profit is a function of output. This is not always true. The firm may
increase the profit without increasing its output.
4. A major drawback of BEC is its inability to handle production and sale of multiple
products.
5. It is difficult to handle selling costs such as advertisement and sale promotion in BEC.
6. It ignores economics of scale in production.
7. Fixed costs do not remain constant in the long run.
8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because generally there may be
opening stock.
10. When production increases variable cost per unit may not remain constant but may reduce
on account of bulk buying etc.
11. The assumption of static nature of business and economic activities is a well-known
defect of BEC.

Some important terms used in Break-Even-Analysis:

1. Fixed cost
2. Variable cost
3. Contribution
4. Margin of safety
5. Angle of incidence
6. Profit volume ratio
7. Break-Even-Point

1. Fixed cost: Expenses that do not vary with the volume of production are known as fixed
expenses. Eg. Manager’s salary, rent and taxes, insurance etc. It should be noted that fixed
changes are fixed only within a certain range of plant capacity. The concept of fixed overhead
is most useful in formulating a price fixing policy. Fixed cost per unit is not fixed.
2. Variable Cost: Expenses that vary almost in direct proportion to the volume of production
of sales are called variable expenses. E.g. Electric power and fuel, packing materials
consumable stores. It should be noted that variable cost per unit is fixed.
3. Contribution: Contribution is the difference between sales and variable costs and it
contributed towards fixed costs and profit. It helps in sales and pricing policies and
measuring the profitability of different proposals. Contribution is a sure test to decide
whether a product is worthwhile to be continued among different products.
4. Margin of safety: Margin of safety is the excess of sales over the break even sales. It can
be expressed in absolute sales amount or in percentage. It indicates the extent to which the

sales can be reduced without resulting in loss. A large margin of safety indicates the
soundness of the business.

Margin of safety can be improved by taking the following steps.

1. Increasing production
2. Increasing selling price
3. Reducing the fixed or the variable costs or both
4. Substituting unprofitable product with profitable one.

5. Angle of incidence: This is the angle between sales line and total cost line at the Break-
even point. It indicates the profit earning capacity of the concern. Large angle of incidence
indicates a high rate of profit; a small angle indicates a low rate of earnings. To improve this
angle, contribution should be increased either by raising the selling price and/or by reducing
variable cost. It also indicates as to what extent the output and sales price can be changed to
attain a desired amount of profit.

6. Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful ratios for
studying the profitability of business. The ratio of contribution to sales is the P/V ratio. It may
be expressed in percentage. Therefore, every organization tries to improve the P. V. ratio of
each product by reducing the variable cost per unit or by increasing the selling price per unit.
The concept of P. V. ratio helps in determining break even-point, a desired amount of profit
etc.
7. Break – Even- Point: If we divide the term into three words, then it does not require
further explanation.

Break-divide Even-equal
Point-place or position
Break Even Point refers to the point where total cost is equal to total revenue. It is a point of
no profit, no loss. This is also a minimum point of no profit, no loss. This is also a minimum
point of production where total costs are recovered. If sales go up beyond the Break Even
Point, organization makes a profit. If they come down, a loss is incurred.
 CONCEPT OF PRICING

Introduction: Pricing is the process whereby a business sets the price at which it will sell its
products and services, and may be part of the business's marketing plan. In setting prices, the
business will take into account the price at which it could acquire the goods,
the manufacturing cost, the market place, competition, market condition, brand, and quality
of product.

Definition: Price is the value that is put to a product or service and is the result of a complex set of
calculations, research and understanding and risk taking ability. A pricing strategy takes into account
segments, ability to pay, market conditions, competitor actions, trade margins and input costs,
amongst others.

OBJECTIVES OF PRICING:

A. Maximum Current Profit

B. Sales Growth
C. Increase in Market Share
D. To Face Competition
E. To Remove Competitors from the Market
F. To Satisfy Customers
PRICING METHODS: Fixation of the price for the product is very important. Most often
discounts, concessions offered at the time of purchase. Sometimes certain schemes are
introduced.

In consideration of pricing “Under-pricing will result in losses and over pricing will make
the customer run away. So, in order to determine the pricing, objectives, methods, policies
and procedures are implemented.

Pricing objectives: It refers to the general and specific objectives. The various objectives are:

 To maximize profits.
 To increase sales.
 To increase market share.
 To satisfy customers and to meet the competition.

Pricing Methods:

 Cost based pricing methods.

 Competition oriented pricing.
  Strategy based pricing.
 Demand oriented pricing.

1. Cost Based Pricing: These are two types

A. Cost Plus pricing: This is also called as “Mark up” pricing. The average cost at
normal capacity of output is ascertained and then a conventional margin of profits is
added to the cost to arrive at the price. This method is suitable where the costs keep
fluctuating from time to time. It is commonly followed in departmental stores and
other retail shops.
B. Marginal Cost pricing: In Marginal Cost pricing, selling pricing is fixed in such a
way that it covers fully the variables or marginal cost and contributes towards
recovery of fixed costs fully or partly depending up on the market situations. In stiff
competition, marginal cost offers a guide line or boundary line, how the selling prices
are lowered. This is also called Break- Even Pricing or Target profit pricing.
2. Competition Oriented Pricing: The pricing is a very complex task. The price of a product is
set based on the competition charges for a similar product. These are various types mainly:
A. Sealed Bid Pricing: This method is more popular in tenders and contracts. Each
contracting firm quotes its price in a sealed cover called “Tender”. All the tenders are
opened on a scheduled date and the person, who quotes the lowest price, is awarded
the contract. Any price quoted less than the marginal price results in loss.
B. Going rate pricing: The price charged by the firm is in tune with the price charged in
the industry as a whole. When one wants to buy and sell gold, the prevailing market
rate at a given point of time is taken as the basis to determine the price. Normally the
market leaders keep announcing the prevailing prices at a given point of time based
on demand and supply positions.
3. Demand based pricing methods: Demand-based pricing, also known as customer-based
pricing, is any pricing method that uses consumer demand - based on perceived value - as the
central element. These include:

Price discrimination: Price discrimination is the practice of charging a different price for the
same good or service. It is also called as differential pricing. Customer may be differ in their
profile in terms of their education, quality of life, and so forth.
4. Strategy Based Pricing: The various types of pricing are
A. Market Skimming: when the product is introduced for the first time in the market, the
company follows this method. Under this method the company fixes High price for the
 product. The main idea is to change the customer maximum possible. This strategy is
mostly found in case of technological products. Eg: when Sony introduces a particular TV
model, it fixes a very high price.
B. Penetration price: This is exactly opposite to the market skimming method. The price of
the product is fixed at low price that the company can increase its market share. The
company attains profits with increasing volumes and increase in market share. The
companies believe that it is necessary to dominate the market in the long run than making
profits in the short run.
C. Two-Part Pricing: The firms with market power can enhance profits by the strategy of
two part pricing. Under this strategy, a firm charges a fixed fee for the right to purchase its
goods, plus a per unit charges for each unit purchased.
D. Peak Load pricing: During seasonal period when demand is likely to be higher a firm may
enhance profits by peak load pricing. The firm’s philosophy is to charge a higher price
during peak times.
LIMIT PRICING: limit pricing refers to the pricing by incubent firms to deter or inhibit
the entry or the expansion or the fringe firms.
Limit pricing implies that firms sacrifice current profits in order to deter entry of new firms
and earn future profits.

INTERNET PRICING MODELS:

The traditional pricing scheme of putting a postage stamp on every letter does not work
with internet. The internet pricing models are described as follows:
FLAT RATE PRICING:
The internet user is required to pay a fee to connect for a fixed period during which one is
not charged on the basis of bits sent or received each time.
USAGE SENSITIVE PRICING: This model looks like a two part tariff. That utilities
have a part of the bill is for the connection and the other part is a price per unit of bit sent or
received.
We would have the peak user paying both parts and off peak user paying only one part.
The variable part could be based on connection time speed of connection etc.
TRANSACTION BASED PRICING: This model is a variant of the usage sensitive
pricing.
In this model the pricing is transaction based and not usage based. In this we cannot
distinguish between different qualities of service.
 PRIORITY PRICING:
In this model the users pay according to the quality of service chosen by them. This comes
close to the price discrimination model.
Ex: Electricity pricing where the user pays a fixed amount for the first block of units, a
higher amount for the next block and so on.

TRANSFER PRICING: Transfer pricing is an internal pricing technique. It refers to a price

at which inputs are transferred to another to maximise the overall profits of the company.
In case of a company having multiple processes, the output of one process is the output of the
next process. Till the production reaches the last stage, the output of each process is termed as
work in progress.
Ex: the engine department Honda Activa makes the scooter engines and forward these to the
assembly department. The assembly department in turn assembles the scooter. Here the price
at which the engine department forwards each engine affects the price of the scooter.

Equilibrium Price
The price at which demand and supply of a commodity is equal known as equilibrium price.
The demand and supply schedules of a good are shown in the table below.

Demand supply schedule

Price Demand Supply

50 100 200

40 120 180

30 150 150

20 200 110

10 300 50

Of the five possible prices in the above example, price Rs.30 would be the market-clearing
price. No other price could prevail in the market. If price is Rs. 50 supply would exceed
demand and consequently the producers of this good would not find enough customers for
their demand, thereby they would accumulate unwanted inventories of output, which, in turn,
would lead to competition among the producers, forcing price to Rs.30. Similarly if price
were Rs.10, there would be excess demand, which would give rise to competition among the
buyers of good, forcing price to Rs.30. At price Rs.30, demand equals supply and thus both
producers and consumers are satisfied. The economist calls such a price as equilibrium price.

INTRODUCTION OF MARKET:

Market constitutes an important phase in the economic activity. All the goods and
services that are produced need to be sold to the consumer for a price. Market primarily
provides possession utility for the goods and services. In other words “the sellers sell the
goods to the buyer and thus transfer the ownership of the goods.

Definition: It is defined as it is a place or point at which buyer and sellers negotiate their
exchange of well defined products or services. It was referred to as a public place in a village
or town where provisions and other objects where brought for sale. Based on the locations,
markets are classified as rural, urban, national or world markets.

Nature of the market

1. It has the boundaries

2. Different organizations are their
 3. Different products are available
4. Different prices
5. Competition

Market Structure: Market structure refers to the characteristics of a market that influence
the behavior and performance of firms that sell in that market.

The structure of market is based on its following features:

 The degree of seller Concentration: This refers to the number of sellers and their market
share for a given product or service in the market.
 The degree of buyer concentration: This refers to the number of buyers and their extent
of purchases of a given product or service in the market.
 The degree of product differentiation: This refers to the extent by which the product of
each trader is differentiated from that of the other. Product differentiation can take several
forms as varieties, brands all of which are sufficiently similar to distinguish them as a
group, from other products eg: cars
 The conditions of entry into the market: There could be certain restrictions to enter or
exit from the markets. The degree with which one can enter the market or exit from the
markets also determines the market structure.

Types of Competition: Based on the degree of competition, the market can be divided into

1. Perfect market Competition

2. Imperfect market Competition
 PERFECT MARKET COMPETITION

A market in which all firms in an industry are price takers and in which there is freedom of
entry into and exit from the industry. The business motive of the entire firm under perfect
competition is profit maximization. Each firm seeks to maximize its profit. The market with
perfect conditions is known as perfect market.

IMPERFECT MARKET COMPETITION

A Competition is said to be imperfect when it is not perfect. In other words when any or most
of the above conditions do not exist in a given market. It is referred to as imperfect market.
Based on the number of buyers and sellers, the imperfect markets are classified as explained
below. The structure of market varies as below.

THE VARIOUS IMPERFECT COMPETITIONS ARE:

 Monopoly
 Monopolistic Competition
 Oligopoly
 Duopoly
 MONOPOLY

Monopoly refers to a situation where a single firm is in a position to control either supply or
price of a particular product/services. In monopoly the seller have rights to fix the price as he
like.

Monopoly can be interpreted in to two ways. When there is a sole supplier it is a case
of a pure monopoly. In this case, the firm and the industry are one and the same. E.g.: RBI is
the sole supplier of currency notes in India. Another way is the firm supplying a half of the
total market may have a greater market power, if the rest of the market is shared by a number
of small firms, when the remaining firms are equally big it may face competition from the
other firms.

MONOPOLISTIC COMPETITION

When large number of seller produces differentiated products, monopolistic is said to exist.
A product is said to be differentiated when its important features vary.

Eg: For “cameras”, the important features include Zoom lenses, focal length, memory, size of
the camera, flash, safety, digital day and so on. The products with better features are
differentiated from the others and they can be sold at higher prices. NIKON, KODAK,
YASHICA and so on are the leading players among the many in market.

OLIGOPOLY:

Oligopoly is a situation where a few large firms compete against each other and there is an
element of interdependence in the decision making of these firms. Another variety of
imperfect competition is oligopoly. If there is competition among a few sellers. Oligopoly is
said to exist.

Eg: 1.Car manufacturing companies such as Maruthi Suzuki, Hindustan Motors, and Toyota
so on. 2. News papers (such as The Hindu, Indian Express, and Times of India).

OLIGOPSONY: Oligopoly was defined at that form of market organized, where there are
few sellers of a homogenous or differentiated product or oligopoly.

Two or more firms existing in an industry each with a significant market share can be called
oligopoly.
DUOPOLY

If there are two sellers, then duopoly is said to exist. If Pepsi and Coke are the two
companies in soft drinks this market is called Duopoly.

PERFECT COMPETETION:

A market in which all firms in an industry are price takers and in which there is freedom of
entry into and exit from the industry. The business motive of the entire firm under perfect
competition is profit maximization. Each firm seeks to maximize its profit. The market with
perfect conditions is known as perfect market.

Features: The following are features of perfect competition. In other words these are the
assumptions underlying perfect markets:

 Large number of buyers and sellers: There should be significantly large number of
buyers and sellers in the market. The number should be so large that it should not make any
difference in terms of price or quantity supplied even if one enters the market or one leaves
the market.
 Homogenous products or services: The products and services of each seller should be
homogeneous. They cannot be differentiated from that of one another. It makes no
difference to the buyer whether he buys from firm X or firm Z.
 Freedom to enter or exit the market: There is no restriction on the part of the buyer and
sellers to enter the market or leave the market. There should not be any barriers. The buyer
can enter the market or leave the market whenever they want.
 Perfect information available to the buyer and sellers: Each buyer and seller has total
knowledge of the prices prevailing in the market at every given point of time, quantity
supplied, costs, demand, nature of product and other relevant information. There is no need
for any advertisement expenditure as the buyer and sellers are fully informed.
 Each firm is a price taker: An individual firm can alter its rate of production or sales
without significantly affecting the market price of the product. A firm in a perfect market
cannot influence the market through its own individual actions.
 Perfect Mobility of factors of production: There should not be any restrictions on the
utilization of factors of production such as Land, Labour, and Capital so on. In other words
whenever capital or labour is required it should instantly be made available.
PRICE OUTPUT DETERMINATION INCASE OF PERFECT COMPETETION

SHORT RUN: - The price and output of the firm are determined under perfect competition,
based on the industry price and its own costs.

The firms demand curve is horizontal at the price determined in the industry
(MR=AR=Price).

The demand curve is also known as average revenue curve. This is because if all units are
sold at the same price, on an average, the revenue to the firm equals its price.

When the average revenue is constant, it will coincide with the marginal revenue curve, thus
CC is the demand curve representing the price.

The firm satisfies both conditions.

a) MR=MC
b) MC curve must cut the MR curve from below the firm attain equilibrium point D
where MR=MC

Here, OC=QD, Which is the price

OF=QE, which is the average cost

OQ=FE, which is the equilibrium output.

Here DE is the average profit and the areas CDEF is the total profit which constitute the
supernormal profits (or) abnormal profits.
PRICE OUTPUT DETERMINATION IN LONG RUN:-

Having been attracted by supernormal profit, more and more firms enter the industry,
with the result, there will be a scramble for scarce inputs among the competing firms pushing
the input prices. Hence the average cost increases. The entry of more and more firms will
expand the supply pulling down the market price. As a result the supernormal profits neither
enjoyed by the firms get eroded.

In long run, the firms will be in a position to enjoy only normal profits but not
supernormal profits.

It shows the long run equilibrium position of the firm under perfect competition. Two
conditions are to be fulfilled in large in the long run.

a) MR=MC
b) AR=AC, and AC must tangential to AR at its lowest price.

QE is the price and also the long run average cost (LAC). Long run marginal cost (LMC)
Curve passes through the minimum point of the average cost curve (AC) at E,

E is only equilibrium point of the firm

OQ units of output.
 MONOPOLY

Monopoly refers to a situation where a single firm is in a position to control either supply or
price of an particular product or service. It cannot control both the price and supply.

Feature of monopoly:

FEATURES OF MONOPOLY

 Single seller and large number of buyers

 There is no close substitute goods
 Price maker
 In monopoly there is no difference between company and industry
 In monopoly restrictions are more
 Demand is inelastic
 In monopoly the seller control both price and supply

PRICE OUTPUT DETERMINATION IN MONOPOLY: - Under monopoly the average

revenue curve for a firm is downward sloping one. It is because if the monopolistic reduces
the price of his products the quantity demand increases and vice versa.

In case of monopoly the marginal revenue (MR) is always less than the average revenue (AR)
because of quantitative discounts or concessions.

In other words the marginal revenue curve lies below the average revenue curve.

He can continue to sell as long as the marginal revenue exceeds marginal cost. At point F,
where MR=MC, profits will be maximized profits will diminished if the production is
continued beyond its profit.

OQ is the equilibrium output

OA is the equilibrium Price

QC is the average cost.

BC is the average profit.

The monopolist will be in equilibrium at output OQ where MR=MC and profits are
maximum.
 MONOPOLISTIC COMPETITION

Monopolist competition is said to exist when there are many firms and each one produces
such goods and services that are close substitutes to each other. They are sustain but not
identical.

Ex: In the hotel industry some hotels have long and spacious pools, attached gymnasium,
beauty parlors, separate restaurants for vegetarians and non-vegetarians cultural programmed
and so on.

FEATURES OF MONOPOLISTIC COMPETITION:

 Large Number of Buyers and Sellers.

 Product Differentiation.
 Selling Cost.
 Lack of Perfect Knowledge.
 Less Mobility.
 More Elastic Demand.
Price output determination in monopolistic competition: the products are differentiated the
demand curve has a downward slope. In other words each firm’s has limited control over
price.

SHORT-RUN:

In the short run, firms may experience supernormal or normal profits or even losses. When
there is fall in costs or increases in demand. The firms may enjoy supernormal profits. In
other words if the firm satisfies the following two conditions, it may make supernormal
profits.

(a) Where marginal cost is equal to marginal revenue (MC=MR)

(b) Where average revenue is less than average cost (AR<AC)

It reveals that the demand curve is a downward sloping curve because of product
differentiation.

At F marginal cost (MC) is equal to marginal revenue (MR).

OQ= Equilibrium output

OA=QB=Equilibrium price.
QC=Average cost
BC=Average profit.
ABCD represents the supernormal profits earned by a firm under monopolistic competition
short run.

LONG RUN: More and more firms will be entering the market having been attracted by
supernorz mal profits enjoyed by the existing firms in the industry. As a result,
competition becomes intensive on one hand. Firms will compete with one another for
acquiring scarce inputs pushing up the prices of factor inputs.

The entry of new firms continue till the supernormal profits of the firms completely get
eroded and ultimately firms in the industry will earn only normal profits. Thus in the long run
every firm in the monopolists competitive industry will earn only normal profits, which are
just sufficient to stay in the business.

In the long run in order the achieve equilibrium position the firm has to fulfill the following
two conditions.

a) MR=MC
b) AR=AC at equilibrium level of output.

OLIGOPOLY:

Oligopoly was defined at that form of market organized, where there are few sellers of a
homogenous or differentiated product or oligopoly.

Two or more firms existing in an industry each with a significant market share can be called
oligopoly.

Oligopoly is of two kinds (a) Homogeneous oligopoly

(b)Differentiated oligopoly
Why we do not have the price output determination oligopoly: The reason of
Interdependence of firms led uncertainty always exists in the market. In such a situation, it
becomes difficult to determine the equilibrium price and output for an oligopolistic firm. An
oligopolist cannot assume that its competitors will not change their price and/or output if it
changes.

Homogenous oligopoly:

A perfect Oligopoly is that situation in which all firms in an industry produce homogenous
products. It is also known as Pure Oligopoly.
It consists of mostly agricultural products, such as oil & wheat, a few wholesale oil
merchants may control the entire supply of oil. Homogeneous oligopoly is also called Pure
oligopoly.

Differentiated oligopoly :- On the other hand, an Imperfect Oligopoly is a market situation

in which all firms produce differentiated products but close substitutes. Therefore, it is also
known as a Differentiated Oligopoly.
Ex: the automobile industry, throughout the world as well as in India, paper & pulp,
refrigerators, soaps and detergents.

THE FOLLOWING ARE SOME OF THE CHARACTERISTICS FEATURES OF AN

OLIGOPOLY:

Only a few sellers: the number of sellers in an oligopoly industry in only few.

Inter-dependence: in this each firm closely watches the moves of the other firm and reacts
carefully to their moves. The firms may frequently anticipate the moves of the rival and out
accordingly.

Price rigidity: Generally prices once established in an oligopoly industry, remain relatively
stable unlike in the case of perfect competition. Prices are more or less rigid and a firm in an
oligopoly may change their price upward and downwards.

Price leadership: one of the firms in the industry has the highest market share and therefore
is called dominant price leadership.

Advertising and selling cost: firms in an oligopoly market in incur heavy expenditure on
advertising and other promotional activities. Advertising is one way which existing firms try
to prevent the entry of new firms.
Innovations: oligopoly firms continually innovate and improve the quantity of the product,
reduce the cost of production and improve the brand image customer care etc.

Non-Price competition: Because price competition is easy to imitate and leads to price wars
oligopoly firms indulge in non-price competition.

KINKED DEMAND THEORY OF OLIGOPOLY: Many economists observed that prices

in an oligopoly industry are surprisingly stable or rigid. paul sweezy explained very
convincingly the reasons for price rigidity in any oligopoly industry through his kinked
demand curve model.

The model is based on two assumptions:

a) If an oligopoly firm increases the prices, its rivals will not increase the price because
they believe that they can gain more customers by keeping status quo.
b) In an oligopoly firm reduces the prices with an intention of increasing the volume of
sales, other rival firms also follows the same strategy.

The demand curve of oligopoly firms will slope downwards. It actually consists of two
parts, one is below the kink and another above the kink.

The firm somehow fixed the price originally and once the price is fixed, it remains stable or
rigid at that level. The upper part of the demand curve is relatively elastic demand
indicating that any small increases in price will result in more than a proportionate fall in
sales revenue.