MODULE V

MARKET STRUCTURE
Market structure
Market structure refers to how different industries are
classified and differentiated based on their degree and
nature of competition for services and goods
Determinants of market structure
Number and nature of sellers
Number and nature of buyers
Nature of product
Exit and entry conditions
Economies of scale
 Examples
• Foreign exchange markets.
• Agricultural markets
Price Determination aand Firm’s
Equilibrium under perfect competition

• A firm is in equilibrium when it maximizes its profits.

Hence, the output that offers maximum profit to a firm is
the equilibrium output.
• When a firm is in equilibrium, there is no reason to
increase or decrease the output.
• In a competitive market, firms are price-takers.
• Therefore, firms cannot influence the price in their
individual capacities. They have to follow the price
determined by the industry.
• To attain an equilibrium position, a firm must satisfy the following two
conditions:
They must ensure that the marginal revenue is equal to the
marginal cost (MR = MC).
• If MR > MC, the firm has an incentive to expand its production and sell
additional units.
• If MR < MC, the firm must reduce the output since additional units add
more cost than revenue.
• The firm gets maximum profits only when MR = MC.

The MC curve must have a positive slope and cut the MR

curve from below.
• Observe that the curve MC cuts the MR curve at two
points – T and R.
• At point T, the MC curve cuts the MR curve from above
whereas at point R it cuts the MR curve from below.
• Therefore, according to the conditions of equilibrium of a
firm, point R is the point of equilibrium and OQ2 is the
equilibrium level of output.
• From the figure, its clear that the industry price, OP, is
fixed throughout the interaction of demand and supply of
the industry.
• Firms have to accept this price. Hence, they are price-
takers and not price-makers. Hence, they cannot increase
or decrease the price OP.
• Therefore, the line P acts as a demand curve for such
firms. Hence, in perfect competition, the demand curve
of an individual firm is a horizontal line at the level of
the industry-set market price. Firms have to choose the
level of output that yields maximum profit.
• Equilibrium in perfect competition is the point where
market demands will be equal to market supply.
• A firm's price will be determined at this point.
• In the short run, equilibrium will be affected by demand.
• In the long run, both demand and supply of a product
will affect the equilibrium in perfect competition
MONOPOLISTIC COMPETITION
• Monopolistic competition means a situation in market
where, differentiated products are sold in the market by
many firms.
Monopolistic Competition Examples:
• Restaurants
• Hairdressers
• Clothing
• TV programs
Price determination and Firm’s
equilibrium under monopolistic
competition
• Under monopolistic competition, the firm will be in equilibrium
position when marginal revenue is equal to marginal cost.
• So long the marginal revenue is greater than marginal cost, the seller
will find it profitable to expand his output, and
• If the MR is less than MC, it is obvious he will reduce his output
where the MR is equal to MC.
• In short run, therefore, the firm will be in equilibrium when it is
maximizing profits, i.e., when MR = MC.
Short run equilibrium
• In the above diagram, the short run average cost is MT
and short run average revenue is MP.
• Since the AR curve is above the AC curve, therefore, the
profit is shown as PT.
• PT is the supernormal profit per unit of output.
• The firm may also incur losses in the short run if it is
facing AR curve below the AC curve.
• In figure (b) MP is less than MT and TP is the loss per
unit of output.
• (b) Long Run Equilibrium:
• Under monopolistic competition, the supernormal profit
in the long run is disappeared as new firms are entered
into the industry.
• As the new firms are entered into the industry, the
demand curve or AR curve will shift to the left, and
therefore, the supernormal profit will be competed away
and the firms will be earning normal profits.
• If in the short run firms are suffering from losses, then in
the long run some firms will leave the industry so that
remaining firms are earning normal profits.
 Now profits are normal only when AR = AC. It is further
illustrated in the following diagram:
Monopoly
A Firm’s Short-Run Equilibrium in Monopoly
Like in perfect competition, there are three possibilities
for a firm’s Equilibrium in Monopoly. These are:
• The firm earns normal profits – If the average cost = the
average revenue
• It earns super-normal profits – If the average cost < the
average revenue
• It incurs losses – If the average cost > the average
revenue.
• In the short-run, a monopolist firm cannot vary all its
factors of production as its cost curves are similar to a
firm operating in perfect competition.
• Also, in the short-run, a monopolist might incur losses
but will shut down only if the losses exceed its fixed
costs.
• Further, if the demand for his product is high, then the
monopolist can also make super-normal profits
A Firm’s Long-run Equilibrium in Monopoly
• In the long-run, a monopolist can vary all the inputs.
• Due to the non entry of the new firms in the market, the
profit of the monopoly firm is abnormal in the long run.
• There is no loss to monopoly firm, as in the long run, all
the cost are changeable and are to be recovered.
Tools of price discrimination
Coupons- coupons offering discounts to
customers before their expiry dates.
Rebates-some portion of the purchase price is
refunded.
Volume discounts- customers pay less per unit,
if they purchase more.
Segregated market- monopoly segregate the
market and charge a different price in each.
International Price Discrimination-
Dumping
• Certain companies adopt price discrimination at
international level as a business strategy to earn profit.
This is called dumping.

According to Viner’s, “Dumping is price discrimination

between 2 markets in which the monopolist sells a portion
of his produced product at a low price and the remaining
part at high price in the domestic market”
Conditions for dumping
• The industry has be perfectly competitive only if
there is an imperfect competition, and the prices
are set by the firms itself and not taking into
account the market prices.
• The markets must be segmented so that the
domestic residents cannot easily purchase goods
intended for export.
 When a monopolist continuously sells a portion of his
commodity at a high price in the domestic market and the remaining output at
a low price in the foreign market, it is called persistent dumping.
It happens when there is a constant demand for the product in the foreign
market.
• Example,
• Hitachi was accused of following predatory dumping for its EPROM
(electrically programmable read only memory) chips.
• Zenith in USA accused Japanese Television manufacturers of using
predatory dumping. A charge was leveled against Japanese manufacturers
for false billing and secret rebates to set low predatory prices on T.V. sets in
U.S markets. It was argued that they tried to drive U.S firms out of business
in order to gain a monopoly.
Persistent dumping ((Long
period dumping)
• Persistent dumping as the name itself implies is the most
permanent type of dumping.
• It involves consistent selling at lower prices in one
market than in the rest of the market.
• In persistent dumping, the firm may use marginal cost
pricing abroad while using full cost pricing (covering
fixed costs at home) in domestic market.
• Japan, for example, sold consumer electronics at high
prices in its own country. This is because it has no
foreign competition. But it lowered prices in the U.S
market in order to maintain market share.
Reverse dumping
• Reverse dumping is followed in the overseas
markets where the demand is less elastic.
• Such markets tolerate a higher price.
• Thus, dumping is done in the manufacturer’s home
market by selling locally at a lower price.
Advantages of Dumping

• Consumers in the importer’s country can gain

access to products at lower prices.
• Exporters receive subsidies from their
government to sell at lower prices abroad.
• The exporter’s country can generate employment
and become industry leaders.
Disadvantages of Dumping

• The debt of the exporter’s country will increase due to

subsidies provided to sell at lower prices abroad.
• Dumping is expensive, and it will take the exporters
years to sell at a lower price and put competitors out of
business.
• The target company can retaliate and cause a trade war.
ANTI-DUMPING MEASURES
Tariff Duty- to stop dumping, the importing Country imposes tariff
on the dumped commodity. Consequently, the price of the importing
commodity increases and the fear of dumping ends.
Import Quota-A commodity of a specific volume or value is
allowed to be imported into the country.
Import Embargo- its also another measure against dumping.
According to this, the imports of certain, or all types of goods from
the dumping country are banned.
Voluntary Export Restraint- to restrict dumping, developed
countries enter into bilateral agreements with other Countries from
which they fear dumping of commodities.
Such bilateral agreement exist between India and EU countries in
exporting Indian textiles.
OLIGOPOLY
• The term oligopoly is derived from two Greek words:
‘oligi’ means few and ‘polein’ means to sell.
• Oligopoly is a market structure in which there are only a
few sellers (but more than two) of the homogeneous or
differentiated products.
• So, oligopoly lies in between monopolistic competition
and monopoly.
Example of Oligopoly:
• In India, markets for automobiles, cement, steel,
aluminium, etc, are the examples of oligopolistic market
DUOPOLY is a special case of oligopoly, in which there
are exactly two sellers.
Under duopoly, it is assumed that the product sold by the
two firms is homogeneous and there is no substitute for it.
Examples where two companies control a large proportion
of a market are: (i) Pepsi and Coca-Cola in the soft drink
market; (ii) Airbus and Boeing in the commercial large jet
aircraft market; (iii) Intel and AMD in the consumer
desktop computer microprocessor market
Types of Oligopoly:

1. Pure or Perfect Oligopoly:

If the firms produce homogeneous products, then it is called pure or
perfect oligopoly. Though, it is rare to find pure oligopoly situation,
yet, cement, steel, aluminum and chemicals producing industries
approach pure oligopoly.
2. Imperfect or Differentiated Oligopoly
If the firms produce differentiated products, then it is called
differentiated or imperfect oligopoly. For example, passenger cars,
cigarettes or soft drinks.
3. Collusive Oligopoly:
• If the firms cooperate with each other in determining price or output
or both, it is called collusive oligopoly or cooperative oligopoly Eg,
Milk price by supermarkets, Price fixing in air travel,..
4. Non-collusive Oligopoly:
If firms in an oligopoly market compete with each other, it
is called a non-collusive or non-cooperative oligopoly.
Features of Oligopoly:

1. Few firms-there are few large firms- severe competition.

2. Interdependence: Firms under oligopoly are interdependent.
Interdependence means that actions of one firm affect the actions of other
firms.
For example, market for cars in India is dominated by few firms (Maruti,
Tata, Hyundai, Ford, Honda, etc.). A change by any one firm (say, Tata) in
any of its vehicle will induce other firms (say, Maruti, Hyundai, etc.) to
make changes in their respective vehicles.
• 3.Non-Price Competition: Under oligopoly, firms are in a position to
influence the prices. However, they try to avoid price competition for the
fear of price war. They follow the policy of price rigidity. Price rigidity
refers to a situation in which price tends to stay fixed irrespective of
changes in demand and supply conditions.
4. Barriers to Entry of Firms: The main reason for few
firms under oligopoly is the barriers, which prevent entry
of new firms into the industry. Patents, requirement of
large capital, control over crucial raw materials, etc, are
some of the reasons, which prevent new firms from
entering into industry.
5. Role of Selling Costs- Due to severe competition ‘and
interdependence of the firms, various sales promotion
techniques are used to promote sales of the product.
6. Group Behaviour: Under oligopoly, there is complete
interdependence among different firms. So, price and
output decisions of a particular firm directly influence the
competing firms.
s
7. Nature of the Product: The firms under oligopoly may
produce homogeneous or differentiated product.
• If the firms produce a homogeneous product, like cement
or steel, the industry is called a pure or perfect oligopoly.
• . If the firms produce a differentiated product, like
automobiles, the industry is called differentiated or
imperfect oligopoly.
8. Indeterminate Demand Curve: Under oligopoly, the
exact behaviour pattern of a producer cannot be determined
with certainty. So, demand curve faced by an oligopolist is
indeterminate (uncertain)
In an oligopolistic market, firms do not have a fixed
demand curve.
The demand curve changes when the competitors
change the price/quantity of the product.
Yet, the oligopolistic must know their demand curve to
maximize profits.
Economists, thus, have developed many price-output
models to explain the oligopoly market behavior.
The two most popular ones of them are- kinked demand
curve theory and cartel theory
KINKED-DEMAND CURVE
• The kinked‐demand theory of oligopoly describes the
high degree of interdependence that exists among the
firms that form an oligopoly.
• The market demand curve faced by each oligopolistic is
determined by the output and price decisions of the other
firms in the oligopoly.
• kinked demand curves are downward sloping.
• As the name suggests, the kinked demand curves have a
‘kink’. This kink is nothing but a discontinuity at a
concave bend and this kink is what sets it apart from the
traditional demand curves.
• A kinked demand curve occurs when the demand curve is
not a straight line but has a different elasticity for higher
and lower prices.
• This model of oligopoly suggests that prices are rigid and
that firms will face different effects for both increasing
price or decreasing price.
• The kink in the demand curve occurs because rival firms
will behave differently to price cuts and price
increases.
• The logic of the kinked demand curve is based on

A few firms dominate the industry

Firms wish to maximize profitss
ASSUMPTIONS
(i) There are only a few firms in an oligopolistic market.
(ii) The firms are producing close-substitute products.
(iii) The quality of the products remains constant and the
firms do not spend on advertising.
(iv) A set of prices of the product has already been
determined and these prices prevail in the market at present.
(v) Each firm believes that if it reduces the price of its
product, the rival firms would follow suit, but if it increases
the price, then the rivals would not follow it, they would
simply keep their prices unchanged.
 Because of this asymmetric reaction pattern of the rivals,
the demand curve of each firm would have a kink at the
prevailing price of its product.
Impact of price rise

• Ifa firm increases the price, then it becomes more

expensive than rivals and therefore, consumers will
switch to its rivals.
• Therefore for a price rise, there is likely to be a
significant fall in demand. Demand is, therefore, price
elastic.
• In this case, of increasing price firms will lose revenue
because the percentage fall in demand is greater than the
percentage rise in price.
Impact of price cut

• In the short term, if a firm cuts price it would cause a big

increase in demand and therefore would lead to a rise in
revenue. The firm would gain market share.
• However, other firms will not want to see this fall in
market share and so they will respond by also cutting
price to follow the first firm. The net effect is that if all
firms cut price – the individual firm will only see a small
increase in demand.
• Because there is a ‘price war’ demand for a firm is price
inelastic – there is a smaller percentage rise in demand.
Prices stable

If the kinked demand curve is true, the firm has no

incentive to raise price or to cut price
Example of a kinked demand curve in practice
• One possibility is the market for petrol. It is homogenous
and consumers are price sensitive.
• If one petrol station increased the price there would be a
shift to other petrol stations.
• However, if one petrol station cuts price, other firms may
feel obliged to follow suit and also cut price – therefore a
price cut would be self-defeating for the first firm
CRITICISM
• The stability of price may be illusory, because it may not
be based on the actual market behaviour. The
oligopolistic seller may outwardly keep the price stable
but he may reduce the quality or quantity of the product.

• This model analysis holds during the short run when the
reactions of the rival produces can be guessed. But, since
it is difficult to guess rival's reactions correctly, the
theory not applicable in the long run.
• This model is based on the assumption that other firms
will follow a price cut, they will not follow a price rise.
this assumption is not true in an inflationary situation. In
inflationary situation when demand curve increases the
oligopolistic firm will raise price and other firms will
also follow it. In short kinked demand curve analysis is
applicable only under depression.
• Economists Sweezy, Hall and Hitch explain price rigidity
on the basis of the kinked demand curve assumption.
They do not explain the determination of the price itself.
COLLUSIVE OLIGOPOLY
Collusion can be of 2 types;
Perfect collusion / Cartels
Imperfect/ price leadership collusion
Cartels/ Perfect collusion
• A cartelis an explicit agreement that is carried out among
independent firms on various subjects such as output, price, market
share etc.
• There are basically 2 types of cartels
Centralized cartels
Market sharing cartels
In centralized cartels, the output, pricing, distribution and sale of
profits is done by a central cartel association of all the firms.-gain
maximum joint profit.
In case of market sharing cartel, the firm would agree upon the
market share with or without any common understanding on price.
Price leadership/ Imperfect
collusion
• Incertain situations, organizations under oligopoly are not involved
in collusion.
• Thereare a number of oligopolistic organizations in the market, but
one of them is dominant organization, which is called price leader
• Price
leadership takes place when there is only one dominant
organization in the industry, which sets the price and others follow
it.
• Thedominant organization is treated as price leader because of
various reasons, such as large size of the organization, large
economies of scale, and advanced technology etc
• Priceleadership is assumed to stabilize the price and maintain price
discipline.
PRICING ANALYSIS
• Price- amount which a customer pays for the product or
service.
• Pricing- is an analytical process to arrive at price of a product
at a particular time.
Objectives of pricing.
Survival
Expansion of current profits
Market share
Price stabilization
Entry into new markets
Achieving the target
I. Cost-based Pricing

• Cost-based pricing refers to a pricing method in which

some percentage of desired profit margins is added to the
cost of the product to obtain the final price.
• In other words, cost-based pricing can be defined as a
pricing method in which a certain percentage of the total
cost of production is added to the cost of the product to
determine its selling price.
Cost-based pricing can be of two types, namely,
Cost-plus pricing/ Mark up pricing
Break even or BEP pricing
 Cost-plus Pricing/ Mark up pricing
In cost-plus pricing method, a fixed percentage, also
called mark-up percentage, of the total cost (as a profit) is
added to the total cost to set the price.
For example, if a retailer has taken a product from the
wholesaler for Rs. 100, then he/she might add up a
markup of Rs. 20 to gain profit.
Pricing is more common in retailing in which a retailer
sells the product to earn profit.
 BEP pricing/ Break Even Point pricing
The situation at which the total sales revenue and total cost of the
product equalizes or there is no profit or loss for the company, is
termed as Break even point.
This is also called No profit No loss pricing method.
B.E.P = Fixed cost/ Selling price/unit-Variable cost /unit
II. Demand-based Pricing
Demand-based pricing refers to a pricing method in which
the price of a product is finalized according to its demand.
If the demand of a product is more, an organization
prefers to set high prices for products to gain profit;
whereas, if the demand of a product is less, the low prices
are charged to attract the customers.
For instance, airlines during the period of low demand
charge less rates as compared to the period of high
demand.
III. Competition-based Pricing
Competition-based pricing refers to a method in which an
organization considers the prices of competitors’ products
to set the prices of its own products.
The organization may charge higher, lower, or equal prices
as compared to the prices of its competitors.
The aviation industry is the best example of
competition-based pricing where airlines charge the same
or fewer prices for same routes as charged by their
competitors.
In addition, the introductory prices charged by publishing
organizations for textbooks are determined according
to the competitors’ prices
IV. Other Pricing Methods

• Value Pricing
• Target Return Pricing
• Going Rate Pricing
• Transfer Pricing
 Value pricing- Implies a method in which an organization tries to
win loyal customers by charging low prices for their high- quality
products.
Target Return Pricing- Helps in achieving the required rate of
return on investment done for a product. In other words, the price of
a product is fixed on the basis of expected profit.
 Going Rate Pricing- Implies a method in which an organization
sets the price of a product according to the prevailing price trends in
the market.
Transfer Pricing- Involves selling of goods and services within the
departments of the organization. One department of an organization
can sell its products to other departments at low prices
 PRICING
STRATEGIES/PRACTICES
1. Penetration pricing
strategyaims to attract buyers by offering lower prices
on goods and services than competitors.
Penetration pricing can be risky because it can result in
an initial loss of income for the business.
Set a low price to enter a competitive market and raise it
later.
Best for: Small businesses with the main goal of
building brand loyalty and reputation
Food and Beverages , internet providers…
2. Price skimming
• Is a type of dynamic pricing strategy that is designed to help
businesses maximize sales on new products and services. This involves
setting rates high during the initial phase of a product, then gradually
lowering prices as competitor goods appear on the market.
• Electronic products – take the Apple iPhone, for example – often
utilize a price skimming strategy during the initial launch period. Then,
after competitors launch rival products, i.e., the Samsung Galaxy, the
price of the product drops so that the product retains a competitive
advantage.
• Apple, Samsung, Sony,. Automobile industry.
3.Psychological pricing
Itis a strategy that uses pricing to influence a customer's spending
or shopping habits to make more or higher value sales. The goal is
to meet a customer's psychological need for something, whether that's
saving money, investing in the highest quality item, or getting a “good
deal.
Examples of psychological pricing,
Charm pricing-Setting the price of a watch at $199 is likely to
attract more new customers than setting it at $200.
Flash sales- Amazon, flipkart..
BOGOF (Buy one, get one free)
4.Bundle pricing
• With bundle pricing, small businesses sell multiple products for a
lower rate than selling each item individually.
Bundle pricing examples
• An example of bundle pricing occurs at your local fast food
restaurant where it’s cheaper to buy a meal than it is to buy each
item individually.
• Internet service providers will also use this strategy and take
advantage of cable TV packages and bundled mobile plans.
5.Promotional pricing
Promotional pricing is another competitive pricing strategy that
involves offering discounts on a particular product.
These strategies are often run during a holiday, like Memorial Day
weekend.
An example of promotional pricing can apply to a retail store that
implements a “Buy One Get One”
6. Value pricing
• Valuepricing is a way of setting your prices based on your
customer’s perceived value of what you’re offering.
Say a coffee shop, Company A, charges twice as much for a cup of
coffee than their competitor, Company B. Although their prices are
double what others charge for similar products, people are willing to
pay more for coffee from Company A
7.Competitive pricing
• Competitive pricing is when your prices either match or beat those
of similar products that are sold by competitors.
• An example of a company that takes advantage of competitive
pricing is Amazon. Amazon will compare the prices of products sold
on their platform and utilize that information to offer the lowest
price in the market.
8.Cost-plus pricing
• Cost-plus
pricing is a strategy of marking up (adding a fixed
percentage) the cost of services and goods to arrive at your selling
price.
• Grocery stores and supermarkets
 THEORIES OF
FACTOR PRICING
Factors of production
Factors of production can be defined as inputs
used for producing goods or services with the aim to make
economic profit.
In economics, there are four main factors of production, namely
land, labor, capital, and enterprise.
The price that an entrepreneur pays for availing the services
of these factors is called factor pricing.
An entrepreneur pays rent, wages, interest, and profit for
availing the services of land, labor, capital, and enterprise
respectively.
The theory of factor pricing deals with the price determination of
different factors of production.
• The theory of factor pricing is concerned with the
principles according to which the price of each factor
of production is determined and distributed.
• Therefore, the theory of factor pricing is also known
as theory of distribution..
Concept of productivity of a
Factor
• In economics, productivity measures the efficiency of the input
factors to produce the given level of output at a specified period of
time in a day.
Physical productivity- Total Physical productivity
(TPP), Average physical productivity (APP) & Marginal
Physical productivity (MPP)
TPP- total quantity of goods produced from the given
quantity of input.
APP- TPP/No. of unit of factor
MPP- Change in TPP due to change in variable input
factor.
Revenue Productivity- Total Revenue Productivity (TRP),
Average Revenue Productivity (ARP) & Marginal Revenue
Productivity (MRP)
TRP= revenue earned by the sale of total output
TRP= TPPx P
ARP= TRP/No. of units of input
MRP= additional revenue earned by employing additional unit of
factors of production
Theories of factor pricing
Marginal productivity theory of
distribution
Modern theory of distribution
MARGINAL PRODUCTIVITY
THEORY
• Marginal productivity is the additional output that results from
an increase in input factors.
• The marginal productivity theory was developed by John Bates
Clark at the end of the nineteenth century.
• Marginal productivity theory suggests that the amount paid to
each factor in the production process is equal to the value of the
extra output the factor of production produces
• According to this theory, every company will pay for their factors
of production according to the marginal product they bring to
the company.
• Whether it is labour, capital, or land, the firm will pay according
to their additional output..
Marginal productivity of labor first increases, but after certain point
of time, it diminishes.
Keep in mind that it assumes that capital is fixed.
So if you maintain capital fixed and just keep hiring workers, at
some point you won't have even enough room to fit them.
Economists argue that the marginal output of labour begins to fall
due to the Law of Diminishing Returns.
Assumptions
• Factor identical= there should be similarity in all the units of the
factors.
• Factors can be substituted= additional units of labor, or less unit of
land or more unit of labor and less unit of capital can be utilized.
• Perfect mobility of factors
• Application of law of diminishing return
• Perfect competition= under perfect competition and full
employment, the rewards for the factors of production is
determined.
MODERN THEORY OF
DISTRIBUTION
• Modern theory of factor pricing is also called as Demand and
supply theory of Distribution.
• While determining the prices of various factors of production, the
modern theory takes into consideration both the forces of demand
and supply.
• This theory helps to explain the equilibrium prices of the factors by
the forces of demand and supply.
• Demand for factors of production is influenced by many factors-
demand for final product, productivity of the factor, price of the
factor, prices of related factors etc..
• Demand curve will be downward sloping
• Supply of a factor refers to the amount of quantity supplied by the
owners at each level of price with the specified period of time like
land is supplied by land owners, labor is supplied by workers,
capital by investors, and enterprise by entrepreneurs.
• Factors affecting elasticity of supply= quantity and quality of
factors, time period, prevailing pattern of factor price.
• Supply curve is upward sloping from left to right.
INTEREST
• Interest is the price paid for the use of capital in any market, as a
reward for parting with the liquidity.
• “Interest is a payment in money and for money”
Components of interest
Net interest= refers to amount of money paid by the borrower
to the lender
Gross interest= annual rate of interest received by the lender
which the borrower pays in respect of the capital.
Gross interest= Net interest +Reward for risk + Reward for
management+ Reward fro inconvenience.
THEORIES OF INTEREST
1. Classical Theory of Interest
2. Loanable Funds Theory of Interest
3. Liquidity Preference Theory of Interest
4. Modern Theory of Interest
Classical theory of interest
• The theory is also called saving investment theory of interest or
demand and supply theory of interest.
• The theory was propounded and developed by classical economists
Keynes.
• The rate of interest is describes as the factor which is equivalent to
the savings and investment .
• The investment is treated as the demand of investible resources
and saving is the supply of these resources.
Determination of Rate of Interest:
According to the classical theory of interest, the rate of interest will be
determined at the point where the supply schedule (SS) and investment
schedule intersects each other.
The point of equilibrium is at E where the investment is equal to
savings. The rate of interest is OR and the demand for and supply of
capital are equal to OQ.
Loanable Fund theory
• The theory was propounded by Wicksell, Ohlin Robinson and A.C.
Pigou.
• It is an improvement on the classical theory of interest. It is also
called neo-classical theory of interest.
• According to this theory the rate of interest is determined by the
demand for loanable funds and the supply of loanable funds.
• The term loanable funds includes all forms of credit, such as loans,
bonds, or savings deposits.
.
DD is the demand for loanable funds which is shown on OX-axis
while rate of interest is shown on OY-axis. When the rate of interest
is OR the demand for loanable funds is OQ. When the rate of interest
decreases from OR to OR1 the demand increases from OQ to O1. It
means there is inverse relationship between the rate of interest and
demand for loanable funds..
SS is the supply of loanable funds and the rate of interest and the
supply of such funds have direct relationship. It the rate of interest is
OR the supply of loanable funds is OQ. With the increase in the rate
of interest from OR to OR1 the supply of loanable funds increases
from OQ to OQ1
.
• For example, if a person has an income of $20,000, spends
$18,000 on goods and services and puts $2,000 into a savings
account, the supply of loanable funds will increase by $2000. This
$2000 is now available for someone else to borrow. The quantity of
loanable funds supplied increases as the interest rate increases.
Determination of the Rate of Interest:
• The equilibrium rate of interest will be determined at the point
where the demand curve for loanable funds cuts the supply curve of
loanable funds.

• Demand for loanable funds (DD) and supply of loanable funds (SS)
are shown on OX-axis while the rate of interest is shown on OY-
axis. The point of equilibrium is at E where the rate of interest is OR
and the demand for loanable funds is equal to its supply (OQ).
3. Liquidity Preference Theory of Interest:

• J M. Keynes has propounded the theory of interest known as the

liquidity preference theory.
• According to this theory, “Interest is the reward for parting with
liquidity for a specific period.”
• In other words, it can be said that interest is the reward for parting
with liquidity.
• According to liquidity preference theory of interest the rate of
interest is determined by the demand for liquidity and supply of
liquidity.
• The theory is also called the monetary theory of interest.
• According to his proposition, that interest rate is the price paid for
borrowed money, people will rather keep cash with themselves
than invest cash in assets.
• Hence, people have a preference for liquid cash. People also intend
to save a percentage of their income.
• The amount that will be held in the form of cash and the amount
that will be spent depends on liquidity preference.
• People will prefer to hold cash since it is the most liquid asset and
the reward for parting with liquidity is interest, whose rate
according to Keynes' is determined by the economic demand and
supply of money.
Determination of the Rate of Interest:
• According to Keynesian theory of interest, the rate of interest will
be determined at the point where the demand for liquidity (LP)
curve cuts the supply of money (SM) curve.
4. Modern Theory of Interest:

Professor Hanson and Professor Lerner have propounded the

modern theory of interest.
The theory has taken into consideration some of the elements of
classical theory of interest and liquidity preference theory of
interest.
The theory has taken four determinants of the rate of interest,
namely, saving function (S), the investment function (I), the liquidity
preference function (L) and the supply of money function (M).
• The modern theory has evolved two curves, namely, the IS curve
consisting of investment and saving and the LM curve consisting of
liquidity preference and the quantity of money.
• The rate of interest is determined at the point where the IS curve
intersects the LM curve.
• IS curve represents the equilibrium in real sector and LM curve
represents the equilibrium in monetary sector.
Determination of Rate of Interest
• The rate of interest is determined at the point where the IS curve
and LM curve intersects each other.
 THEORIES OF
INVESTMENT DECISION
1. Keynesian theory of investment
• According to the classical theory there are three determinants of
business investment, viz., (i) cost, (ii) return and (iii) expectations.
• According to Keynes investment decisions are taken by comparing
the marginal efficiency of capital (MEC) or the yield with the real
rate of interest (r).
• So long as the MEC is greater than r, new investment in plant,
equipment and machinery will take place.
• However, as more and more capital is used in the production
process, the MEC will fall due to diminishing marginal product of
capital.
• Marginal Efficiency of Capital: The MEC is the rate of return at
which a project is expected to break­even.
• This depends on the immediate profits (cash flows) expected from
operating the project and the rate at which these are expected to
decline through reduction in the price of output, or increases in the
real wages or cost of raw materials and fuel.
• If all possible projects in an economy are arranged in descending
order of their MEC, investors will accept those with MEC higher
than r and reject those whose MEC is lower than r
2. Modern portfolio theory
• The modern portfolio theory (MPT) is a practical method for
selecting investments in order to maximize their overall returns
within an acceptable level of risk.
• A key component of the MPT theory is diversification.
• Most investments are either high risk and high return or low risk
and low return.
• MPT says that if one diversify his portfolio-putting all kinds of eggs
into all kinds of basket-one reduce risk and optimize return.