CONTENTS
Unit No. Title Page No.
SEMESTER II
UNIT - I
1. Perfect Competition 01
1A. Monopoly 14
UNIT - II
2. Monopolistic Competition 21
2A. Oligopolistic Market 35
UNIT - III
3. Pricing Methods 47
3A. Price Discrimination 56
UNIT - IV
4. Capital Budgeting 66
4A. Techniques of Investment Appraisal 72
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UNIT -I
Unit -1
PERFECT COMPETITION
Unit Structure :
1.0 Objectives
1.1 Meaning
1.2 Features of perfect competition
1.3 Profit Maximisation
1.4 Perfect Competition in the Short Run
1.5 Long run equilibrium of a firm
1.6 Equilibrium of a firm an d industry under perfect competition
1.7 Summary
1.8 Questions
1.0 OBJECTIVES
To understand the meaning and features of perfectly
competitive market.
To study the concept of profit maximisation of firm under perfect
competition.
To understand the short run and long run equilibrium of a firm .
To understand the equilibrium of a firm and industry under
perfect competition .
1.1 MEANING
The theory of perfect competition has origin ated in the late -
19th century. The first laborious definition of perfect comp etition
and resultant some of its main results was given by Léon Walras.
Then later in the 1950s, the theory was further redefined by
Kenneth Arrow and Gérard Debreu. But in reality, markets are
never perfect.
A perfectly competitive market is a hypothet ical in nature. In
this market p roducers are large in number; however, they may face
many competitor firms selling highly similar types of goods, in which
case they often act as price takers. Agricultural markets are
commonly used as an example.munotes.in
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A perfectl y competitive firm is also known as a price taker
because the pressure of competing firms in the market forces other
firms to accept the price prevailing in the market. If a firm in a
perfectly competitive market try to raise the price of its product in
the market it will lose all of its share s in the market . The market
price in the perfect competition is determined by the market supply
andmarket demand in the entire market and not by the individual
firm or seller in the market .Further in this chapter we will try to
discuss the price determination and equilibrium of the firm and
industry under perfect competition.
1.2 FEATURES OF PERFECT COMPETITION
Perfect competition can be generally understood by its
following important features:
1.Large number of b uyers and seller s:The very first important
feature of perfect competition is its number of participants i.e.
number of buyers and sellers. Both buyers and sellers are large
in number under perfect competition . The existence of these
large number of buyers and sellers makes no influence over
price of the product. Therefore, the individual firm under perfect
competition is a price taker because he has no influence over
the price. Whatever price the market demand and market supply
collectively decide every fi rm is expected to follow the same.
2.Homogeneous or Similar products: The second important
feature of perfect competition is the commodity which is being
sold in the market. It means that the product or commodity
which is sold in perfect competition is simi lar or identical in
nature . As the product are identical or similar in nature the firm
has no control over the price of the product because products
are perfect substitute for one another. No firm can try to charge
different price to consumer then the mark et price due to
homogeneous factor of product.
3.Free entry and exit of firm: There are no restriction to the
entry and exit of firm in the market. The condition of free entry
and free exit of a firm applies only in the long run, in short run
firms can nei ther change the size of their plant s, nor new firms
can enter or old firm can leave the market. If the existing old firm
earns super normal profit in the short run will attract the new
firm to enter in the market in the long run.
4.Complete market informat ion: It is assumed that there is a
perfect knowledge about the market situation to both buyers and
seller in the perfect competition. A perfect knowledge or
complete information about the market demand and market
supply, price etc. This allows the firms an d buyer to take
appropriate decision to influence the market demand and supply
collectively.munotes.in
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5.Prefect mobility of factors of production: Under perfect
competition the factors of production are assumed to be freely
mobile. Factors of production such as labo ur and capital are
assumed to be mobile. The mobility of factors helps the firm to
adjust the market demand with the change in market supply.
6.No transportation cost: It is assumed that there is no
transportation cost under perfect competition. It applies when
the production area and sales market take place in a small
geographical area or in the same area. For example, agriculture
products are sold in the same village or town which requires no
transportation cost.
Check your Progress :
1)Why uniform pric e exist in perfect competition?
2)Why we don’t consider transportation cost?
1.3 PROFIT MAXIMISATION
Profit is the main objective of any firm into business. Each
and every firm tries to makes maximum possible profit into the
business. Firm e arns profit when Total revenue which has earned
subtracted from the Total cost which he has bare for the production.
To state
Where Profit, TR = Total Revenue, TC = Total Cost.
Total revenue (TR) is the total revenue firm earned after the sale of
his product .To state
TR = P × Q
Where ,TR is Total Revenue, P = Price per unit, Q = Quantity per
unit sold.
Total Cost (TC) is the total cost which a firm spend to produce the
product . We obtain it by multiplying t he quantity of output produce
by the average cost.
TC = Q ×AC
Average revenue (AR) is the revenue generated by selling per unit
of output.
AR = TR
Qmunotes.in
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Where AR is the Average Revenue.
Hence if, P × Q = TR= AR
Q
Therefore, we can say that,
P = AR
Therefore, we say that the price under perfect competition is
equal to the average revenue which a firm earns in a market.
A firm in a perfectly competitive market tries to maximize his
profits. In the short -run, it is po ssible for a firm to earn profits which
can be positive, negative, or zero. Economic profits which the firm
earns will be zero in the long -run.
In the short -run, if a firm earns negative economic profit, it is
said that he should continue to operate his b usiness if its price
exceeds its average variable cost and he should shut down if its
price is below its average variable cost.
The marginal revenue (MR) is the change in total revenue
from an additional unit of output sold in the market for which the
firm bares Marginal cost .
MR =ΔTR
ΔQ
Marginal Cost (MC) is the additional cost which a firm spends to
produce the additional unit of output.
MC =Δ TC
ΔQ
In order to maximize theprofits in a perfectly competitive
market, thefirms set the price where the marginal revenue equal to
marginal cost (MR=MC). TheMRcurve is the slope of the revenue
curve, which is also equal to the demand curve (D D),price (P) and
the Marginal and Average Revenue curve .Therefore, In the short -
term, it is possible for a firm to ear neconomic profits to be positive,
zero, or negative. When price is greater than average total cost, the
firm is making a profit. When price is less than average total cost,
the firm is making a loss in the market .munotes.in
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Diagram 1.1
Perfect Competition in t he Short Run: In the short run, it is
possible for an individual firm to make an economic profit. This
state is shown in th e above Diagram 9.1, as the price or average
revenue, denoted by P, is above the average cost denoted by AR.
Inthe long -run, if fir mstry to earning positive economic profits,
more and firms will enter into perfectly competitive market are,
which will shift the supply curve to the right of the original place . As
the supply curve shifts to the right, the equilibrium price of the firm
will go down. As the price goes down, theeconomic profits will
decrease until they become zero.
When theprice is less than theaverage total cost of the production ,
at that time the firms are making a loss. Inthe long -run, if firms in a
perfectly compet itive market are earning negative economic profits,
then more firms will leave the market andwhich in turn will shift the
supply curve left of the diagram . As the supply curve shifts to the
left, the price wil l rise . As the price rises ,theeconomic profi ts will
increase until they become zero.
Inthe long -run, companies that are engaged in a perfectly
competitive market will earn zero economic profits. The long -run
equilibrium point for a perfectly competitive market occurs where
the demand curve ( price)( P)intersects the marginal cost (MC)
curve a tthe minimum point of the average cost (AC) curve.munotes.in
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Diagram 1.2
Perfect Competition in the Long Run: In the long -run, economic
profit cannot be constant . The entry of new firms in the market will
cause the de mand curve of each individual firm to shift the demand
curve downward, bringing down the price, the average revenue
(AR) and marginal revenue curve (MR) . In the long -run, the firm will
make zero economic profit. Its horizontal demand curve will touch
its average total cost curve at its lowest point (E).
The firm is at equilibrium at the point (E) where Marginal revenue
(MR) is tangent to Marginal cost (MC) .
1.4 SHORT -RUN EQUILIBRIUM OF A FIRM UNDER
PERFECT COMPETITION
The short run is a period of time within which the firms can
change their level of output only by increasing or decreasing the
amounts of variable factors such as labour and raw material, while
fixed factors like capital equipment, machinery, etc. remains
unchanged.
In other words, short run is the conceptual time period where
at least one factor of production is fixed in amount while other
factors are variable.munotes.in
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A firm in short run is in equilibrium at a point where Marginal
Revenue (MR) is equal Marginal Cost (MC) i.e. MR=MC and where
MCis increasing at the point or MC is cutting MR from below.
The firm under perfect competition operates under the U -
shaped cost curve. Since marginal revenue is the same as price or
average revenue under perfect competition, the firm will equalise
margina l cost with price to attain the equilibrium level of output.
A firm under perfect competition in short run being in
equilibrium does not necessarily earn profit. The firm determines
the equilibrium level of output and price and tries to earn excess
profit, normal profit or may even i ncur loss. The Diagram 9.3 which
is given below will explain the firm’s equilibrium situation in the
short run.
Diagram 1.3
In the above fig Level of output is determined on the X axis
and price on the Y axis.
The firm may face excess profit, normal profit or even loss
can be understood by the given fig above.
1.Excess Profit: OP is the price at which the firm sell its OQ level
of output. Where, E is the is the equilibrium point wheremunotes.in
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Marginal Cost is equal to Marginal Re venue (MR=MC) and
where MC is increasing which fulfils the condition.
Now to determine the firm’s level of profit we calculate:
Profit = TR -TC
Where, TR = P ×Q
Where, TR is the total revenue which a firm earns by selling the
output, P, is the price per unit sold and Q is the quantity sold.
So, in the above fig,
TR = OP × OQ = OQEP.
TC = Q × Revenue/ Cost.
Where, TC is the total cost
TC = OQ × OQRS
Therefore,
Profit = TR –TC
= OQEP –OQRS
=SREP
Thus, the firm in the short run wh en the price is OP is at the
equilibrium and earns SREP amount of profit which is the excess
profit which is also called as super normal profit.
2.Normal Profit: the perfect competitive firm may also earn
normal profit in the short run if he fails to earn the super normal
profit. In the above fig 9.3 if the firm is in equilibrium at the point
E1 where OP1 is the price and OQ1 is the level of output. The
firm is at the position where he earns normal profit.
Profit = TR –TC
Where, TR = P ×Q
=OP1 ×OQ1
= OQ1E1P1
TC = Q × Revenue/ Cost
= OQ1 × E1P1
=OQ1E1P1
Therefore,
Profit = TR –TC
= OQ1E1P1 -OQ1E1P1
= Normal Profit.
Thus, the firm at price OP1 earns Normal profit.
Normal profit is the profi t which a firm must get to survive
into the business where he can produce the same level of output in
future with the amount of revenue he earns. It is a situation of no
profit no loss. If the firm unable to make a normal profit he may go
into loss.
3.Loss or Sub -normal profit: when a firm fails to earn even
normal profit and still continue to operate his business by
incurring into loss. Such situation can be explained as flow:munotes.in
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The firm is equilibrium at the point E2 where OP2 is the market
price and OQ2 is the level of output.
Profit = TR –TC
Where, TR = P ×Q
= OP2 × OQ2
= OQ2E2P2
TC = Q × Revenue/ Cost
= OQ2 × US
=OQ2US
Loss = P2E2US
4.Shut down point: Whenthe firm not even able to earn variable
cost he better tries to shut down his business or stops operating
for that particular time.
Diagram 1.4
In the above Diagram 9.4 when the price is OP, the firm
produces the equilibrium level of output which is O Q at that price
and at that volume of output the firm total revenue (TR) is OQRP
and his Total Variable Cost (TVC) is OQSN so the loss which firm
gets in terms of variable cost is PRSN. His total loss is PRUT of
which PRSN is variable cost and NSUT is the fixed cost. At this
time, it is better for a firm to either shut down his business or to wait
for a time when the price goes up for his commodity where at least
he can cover up his Total Variable Cost. It is because that variable
cost enables the firm to o perate in his business.munotes.in
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Check your Progress :
1)What do you mean by shut down point of firm?
2)What is normal profit?
3)What is super normal profit?
4)What is subnormal profit?
1.5 LONG RUN EQUILIBRIUM OF A FIRM
The long run is a peri od of time which is sufficiently long to
allow the firms to make changes in all factors of production.
Therefore, it is said that in the long run, all factors of production are
variable and no factors are fixed. So in the long run the firms, can
increase o r decrease their output by changing their capital
equipment; they may expand or contract their old plants or replace
the old lower -capacity plants by the new higher -capacity plants or
add new plants in the business or the firms can contract their output
level by reducing their capital equipment; they may allow a part of
the existing capital equipment to wear out without replacement or
sell out a part of the capital equipment
Besides, in the long run, new firms can enter the industry to
compete the existin g firms. Moreover, the firms can leave the
industry in the long run. The long -run equilibrium then refers to the
situation when free and full adjustment in the capital equipment as
well as in the number of firms has been allowed to take place. It is
there fore long -run average and marginal cost curve which are
relevant for deciding about equilibrium output in the long run.
Moreover, in the long run, it is the average total cost which is of
determining importance, since all costs are variable and none fixed.
As explained above, a firm is in equilibrium under perfect
competition when marginal cost is equal to price i.e. MC = P . But
for the firm to be in long -run equilibrium, besides marginal cost
being equal to price, the price must also be equal to average c ost
(P = MC) .
For, if the price is greater or less than the average cost,
there will be tendency for the firms to enter or leave the industry. If
the price is greater than the average cost, the firms will try to earn
more than normal profits. These supern ormal profits will attract s the
new firms to enter into the industry.munotes.in
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With the entry of new firms in the industry, the price of the
product will go down as a result of the increase in supply of output
and also the cost will go up as a result of more intens ive
competition for factors of production will be generated . The firms
will continue entering the industry until the price is equal to average
cost so that all firms are earning only normal profits.
These can be explained with the help of the following
Diagram 9.5 given below:
Diagram 1.5
Diagram 1.5represents the equilibrium condition of firm
under perfect competition. The firm in the long -run equilibrium is at
a price OP and quantity of output is OQ where the equilibrium point
is E. at the equilibr ium point MR = MC. As said the firm earns
normal profit in the long run so,
Profit = TR -TC
= OQEP –OQEP
Therefore, the firm earns normal profit in the long run where,
P= AR= MR= AC= MC.munotes.in
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1.6 EQUILIBRIUM OF A FIRM AND INDUSTRY UNDER
PERFECT CO MPETITION
As we have already studied the equilibrium conditions of
both firm and industry. A firm is in equilibrium when it has no
tendency to change its level of output. It needs neither expansion
nor contraction. It wants to earn maximum profits in by e quating its
marginal cost with its marginal revenue, i.e. MC = MR. An industry
is in equilibrium only in the long run. The following Diagram 9.6 will
explain the condition of the equilibrium of a firm and industry.
The MC curve must equal the MR curve (MC=MR) . This is
the first order and necessary condition. But this is not a sufficient
condition which may be fulfilled yet that the firm may not be in
equilibrium. The second order condition says that under perfect
competition, The MC curve must cut the MR c urve from below and
after the point of equilibrium it must be above the MR. the MR curve
of a firm coincides with the AR curve. The MR curve is horizontal to
the X -axis. Therefore, the firm is in equilibrium when MC=MR=AR
(Price).
Diagram 1.6
InDiagram 9.6 (A), the MC curve cuts the MR curve first at
point A. It satisfies the condition of MC = MR, but it is not a point of
maximum profits because after point A, the MC curve is below the
MR curve. It does not pay the firm to produce the minimum output
OM when it can earn larger profits by producing beyond OM.
Point В is of maximum profits where both the conditions are
satisfied. Between points A and B., it pays the firm to expand its
output because it’s MR > MC. It will, however, stop further
productio n when it reaches the OM1 level of output where the firm
satisfies both the conditions of equilibrium.
If it has any plans to produce more than OM1 it will be
incurring losses, for its marginal cost exceeds its marginal revenuemunotes.in
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beyond the equilibrium poin t B. The same conclusions hold good in
the case of a straight -line MC curve as shown in Diagram 9.6. (B)
1.7SUMMARY
In this unit we have discussed the perfect competition
market in detail. The theory of perfect competition has originated in
the late -19th century. The first laborious definition of perfect
competition and resultant some of its main results was given by
Léon Walras. Then later in the 1950s, the theory was further
redefined by Kenneth Arrow and Gérard Debreu. But in reality,
markets are neve r perfect. A perfectly competitive firm is also
known as a price taker because the pressure of competing firms in
the market forces other firms to accept the price prevailing in the
market. If a firm in a perfectly competitive market try to raise the
price of its product in the market it will lose all of its shares in the
market. It has also discussed the features of perfect competition
market in detail. The current unit also study the equilibrium of the
firm under short run and long run market conditions.
1.8QUESTIONS
1.What is perfect competition? Explain the features of it in detail.
2. Explain how a firm gets profit maximisation under perfect
competition.
3. Explain the short run equilibrium of the firm under perfect
competition.
4.Discuss the lo ng run equilibrium of the firm under perfect
competition.
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Unit -1A
MONOPOLY
Unit Structure :
1A.0Objectives
1A.1Meaning of monopoly
1A.2Features of monopoly
1A.3Sources of monopoly power
1A.4Equilibrium of a monopoly firm
1A.5Summary
1A.6Questions
1A.0 OBJECTIVES
To understand the meaning and features of monopoly market.
To study the sources of monopoly power.
To understand the equilibrium of a firm under monopoly market.
1A.1 MEANING
The word monopoly has been derived from the combination
of two words i.e., ‘Mono’ and ‘Poly’. Mono refers to a single and
poly to control. Monopoly market is said to exist when one firm or a
single firm is a sole producer or seller of a product in a market
which has no close substitutes.
Prof. Bober rightly remarks, “The privilege of being the only
seller of a product does not by itself make one a monopolist in the
sense of possessing the power to set the price. As the one seller,
he may be a king without crown”
According to Koutsoyiannis “Monopoly is a market situation
in which there is a single seller. There are no close substitutes of
the commodity it produces, there are barriers to entry”. -
A seller in a monopoly market is known as monopolist. A
monopolist is a price maker not a pric e taker in the market where
he is the only or a sole seller in the market, where he has control
over it. A monopolist can control both the price as well as the
supply of a commodity to earn profit. But it is said that if a firm is a
rational monopolist, he will control only one at a time.munotes.in
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1A.2 FEATURES OF MONOPOLY
The following are some features of monopoly market:
1.Single Seller and Large Number of Buyers: As said above
monopoly market is run by a single seller known as monopolist.
The monopolist’s firm is the only firm in the market; it is an
industry as well. But the number of buyers is assumed to be
large.
2.No Close Substitutes: Another important feature of monopoly
market is that there shall not be any close substitutes for the
product sold by the mon opolist in the market. The cross
elasticity of demand between the product of the monopolist and
others must be negligible or zero.
3.Difficulty of Entry of New Firms: There are either natural or
artificial restrictions on the entry of firms into the monopoly
market.
4.Price Maker: Under the monopoly market, the monopolist has
the full control over the supply of the commodity. But due to
large number of buyers, demand of any one buyer constitutes
an infinitely small part of the total demand. Therefore, buyers
have to pay the fixed amount of price fixed by the monopolist.
5.No distinction between the firm and industry: Under
monopoly market firm being the single seller is the firm as well
as industry. So there is no need to understand the firm and
industry separate ly.
1A.3 SOURCES OF MONOPOLY POWER
The monopoly has numerous factors which gives monopoly
power to the monopolist.
1.Natural monopoly power :Some monopolist gets monopoly
power naturally by the product they produce which is naturally
available to them. A natural monopoly is a type of monopoly that
exists due to the high start -up costs of conducting a business in a
specific industry. A company with a natural monopoly might be the
only provider or a product or service in an industry or geographic
location in the whole market which gives him the monopoly power
naturally. Natural monopolies are allowed when a single company
can supply a product or service at a lower cost than any potential
competitor in the market.
2.Product differentiation: The product which is being sold in the
monopoly market is differentiated product which has no close
substitute in the market. In a perfectly competitive market, every
product is perfectly homogeneous and a perfect substitute for any
other product in the market . With a monopol y, there is great tomunotes.in
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absolute product differentiation in the sense that there is no
available substitute for a monopolized good. The monopolist is the
sole supplier of the commodity in the market.
3.Legal protection: Legal is an artificial power which a fir m has
to protect this product from various market competition and make a
product unique or different. Legal protection is in the form of copy
rights, patent rights, trade marks etc. which gives the firm the
monopoly power and make his product different fro m the other
product in the market.
4.Barriers to Entry: Barriers to entry are factors and
circumstances that prevent entry into market by would -be
competitors and limit new companies from operating and expanding
within the market. Monopolies have relatively high barriers to entry
due to its natural and artificial barriers. The barriers must be strong
enough to prevent or discourage any potential competitor from
entering into the market.
5.Control over the resources: As the firm is the only seller in the
marke t, he has sole control over the resources which is use for
production of the product. The source of control comes either from
the natural or legal power.
1A.4 EQUILIBRIUM OF A MONOPOLY FIRM
The Equilibrium condition of a firm under Monopoly is the
same as those under perfect competition. Where the marginal cost
(MC) is equal to the marginal revenue (MR) and the MC curve cuts
the MR curve from below. We will understand Equilibrium of
Monopolies in short run and in long run in detail.
Short run equilibriu m condition: There are two possibilities for a
firm’s Equilibrium in Monopoly. These are:
The firm earns normal profits or excess profit –If the total
cost < the total revenue
It incurs losses –If the total cost > the total revenue
Normal Profits or E xcess Profit: At Excess profit the firm is in
equilibrium at the point E where the Marginal Cost is equal to
Marginal Revenue (MR = MC). At this equilibrium point OP is the
Price and OQ is the level of Output. Firms profit is determined
when,munotes.in
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Diagra m1A.1
Profit = TR –TC
Where, TR = P ×Q
=OP × OQ
= OQRP
TC = Q × AC
= OQ × QT
= OQTS
Therefore, Profit = OQRP –OQTS
= STPR
Thus, the firm earns the exc ess profit. TR > TC
Loss condition: A firm under monopoly may also face a problem
of getting loss. As in perfect competition even in monopoly the cost
of the firm is divided into fixed cost and variable cost. It is essential
for a firm to receive at least the variable cost to function in the
market. The loss condition of a monopoly firm can be explained
below with the help of the fig 1A.2.munotes.in
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Diagram 1A.2
Profit = TR –TC
Where, TR = P × Q
= OP × OQ
= OQRP
TC = Q × AC
= OQ × VU
= OQ VU
Therefore, Loss = OQRP –OQVU
=PRVU
Thus, the firm earns the excess profit. TR
contrast all the inputs. Therefore, to determine the equilibrium of
the firm, we need only two cost curves –the AC and the MC.
Further, since the monopolist exits the market if he is operating at a
loss, the demand curve must be tangent to the AC curve or l ie to
the right and intersect.
A monopolist usually earns excess profit in the long run. This
can be understood by the following fig 1A.3.munotes.in
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Diagram 1A.3
Profit = TR –TC
Where, TR = P × Q
= OP × OQ
= OQ TP
TC = Q × AC
= OQ × Q S
= OQS N
Therefore, Profit = OQ TP–OQS N
=NSTP
Thus, the firm earns the excess profit. TR > TC in the long run.
Check your Progress :
1)Define Monopoly.
2)List out the sources of monopoly power.
3)List out the important features of monopoly market.munotes.in
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1A.5SUMMARY
This unit studies the monopoly market in detail. The word
monopoly has been derived from the combination of two words i.e.,
‘Mono’ and ‘Poly’. Mono refers to a single and poly to control.
Monopoly market is said to exist when one firm or a single firm is a
sole producer or seller of a product in a market which has no close
substitutes. The unit has also discussed the features and sources
of monopoly. The unit has also discussed the equilibrium of
monopoly firm during short run and long run.
1A.6QUESTIONS
1.What is monopoly? Explain the features of monopoly in detail.
2. Define monopoly. Discuss the various sources of monopoly
power.
3.Explain the short run and klong run equilibrium of a monopoly
firm in detail.
munotes.in
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UNIT -II
Unit -2
MONOPOLISTIC COMPETITION
Unit Structure :
2.0 Objectives
2.1 Features of monopolistic competition
2.2 Equilibrium of a firm under monopolistic competition in the
short run and in the long run
2.3 Production and selling cost
2.4 Role of advertising (real life examples)
2.5 Excess capacity and inefficiency
2.6 Summary
2.7 Questions
2.0 OBJECTIVES
•To understand the characteristics features of monopolistic
competition and study determination of price and output in the
short run and in the long run
•To study the differences between perfect competition and
monopolistic competition
•To understand the difference between selling and production
cost and also to understand the importance of selling cost and
its effects
•To understand how excess capa city is created under
monopolistic competition
•To study the role of advertising along with advantages and
disadvantages with real life examples
2.1FEATURES OF MONOPOLISTIC COMPETITION
Perfectly competitive market and monopoly market are
extreme and the refore not easy to find in real world.
In the real world the market that we find either have many
sellers selling variety of products (such as toothpaste, textile or
cloth market) called monopolistic competition. Or few sellers having
dominant position in the market (such as airlines, mineral water)
called oligopoly market.munotes.in
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Monopolistically competitive market is the market which has
some characteristics of perfect competition and some of monopoly.
Even though there are many sellers under monopolistic
compe tition, each seller has its monopoly but still there is a
competition due to product differentiation. Prof. Edward Chamberlin
introduced the concept of monopolistic competition in his book
Theory of Monopolistic Competition.
Features of monopolistic compe tition
•Fairly large number of sellers -In monopolistic competition
there are many sellers. Therefore an individual seller cannot
influence the market. Every seller to a certain extent follow an
independent policy in price and output.
•Fairly large number o f buyers -There are fairly large number
of buyers in a monopolistically competitive market.
•Close substitute products -Under monopolistic competition
sellers sold products which are close substitutes of each other.
For eg. Soaps, pens etc.
•Free entry and exit-There are no restrictions on entry and exit
of the firm under monopolistic competition. If existing firms are
making supernormal profit, new firms can enter in to the market
but they have to enter with a close substitute product. Similarly
firms who are making loss can leave the market. Therefore in
the long run firm who remains in the market will make only
normal profit.
•Selling cost -As close substitute products are available in
monopolistic competition, firms have to spend money for
increasing sale of their product in the market. This cost is called
as selling cost. It includes all expenditures of the firm which can
increase their sale. It is in the form of T.V, newspaper
advertisement, hoardings, exhibitions, distribution of free
samples, discounts offered on products etc.
•Product differentiation -As goods are close substitutes ofeach
other, it is necessary to have an independent identity of each
product. Variety of factors on which goods can be differentiated
are brand name, design, size, color, p acking, taste,
advertisement policy, after sales services etc. Due to product
differentiation, firm can have some degree of monopoly.
•Nature of demand curve -The demand curve of a
monopolistically competitive firm is more elastic. ie demand
curve is flatte r than it is under monopoly. This is because of the
availability of close substitute products, where an increase in
price of one commodity reduces its sale by a greater amount.
Following diagram explains the shape of demand curve under
monopolistic competi tion.munotes.in
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Diagram 2.1
•Concept of group -Prof. E. Chamberlin introduced the concept
of group under monopolistic competition. Group includes those
products which are close substitutes in economic and technical
sense. The group will be in equilibrium in the l ong run when all
firms in the group make normal profit.
Product differentiation
Product differentiation is one of the characteristics of
monopolistic competition. Products are close substitutes of each
other due to small differences in them. In case of pr oducts like
soaps, garments, tooth paste etc. variety of products are available
but each product is different from another due to following factors.
•Brand name -Brand name develops loyalty of public towards
the product. Firms name itself is the name of it s product.
Raymond cloth, LG TV, Colgate toothpastes are some of the
examples of branded products. Brand name helps to
differentiate between the products.
•Design -On the basis of design products can be differentiated.
Fridge, cars, furniture are some of the products which are
purchased on the basis of design.
•Size-Firm produces their product in different sizes so that
consumers can consume their most preferred size. Various
sizes of product include economy size, family size, extra -large
etc.
•Color -Custo mers would like to purchase various products on
the basis of their color. Products like fridge, cupboard, tooth
brush etc. are consumed on the basis of their color.
•Taste and perfume -Products like soaps, toothpaste, face
powder, shampoo etc. are purchased on the basis of their taste
and perfume.munotes.in
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•Salesmanship -People prefer products of a particular company
because of the positive attitude of the salesman, their good
behavior, their cooperation etc.
•After sales services -Customers consider after sales servic es
while consuming a product. This is because products like TV,
fridge, water purifier have a warranty period during which
company provide free services to their customers. Thus the
quality of after sales services is very important.
Due to above factors c onsumers have some loyalty to their
products. Loyalty towards product gives some degree of monopoly
to the firm. Product differentiation allows firms to charge different
prices for their products. Under monopolistic competition it is
necessary for the firm to maintain monopoly power over loyal
customers.
2.2 EQUILIBRIUM OF A FIRM UNDER MONOPOLISTIC
COMPETITION IN THE SHORT RUN AND IN THE
LONG RUN
Short run equilibrium of a firm under monopolistic
competition:
Monopolistically competitive firm can operate with
supernormal profit, normal profit or loss in the short run. Following
diagrams explains all the three cases.
•Excess profit
Given the demand curve and cost curves of a firm, firm
would produce profit maximizing level of output at that point where
MR=M C. This is the equilibrium level of output for the firm.
Diagram 2.2munotes.in
25
On the X axis we measure output and on the Y axis we
measure cost and revenue. AR and MR are the average and
marginal revenue curves which are more elastic or flatter. SAC and
SMC are the short run average and marginal cost curves. Firms
equilibrium point is E and equilibrium level of output is OQ. Thus
the price determined is OP or QM.
In the above diagram with price OP and output OQ, TR= OQMP,
TC=OQ ER. As TR>TC, Excess profit = R EMP(OQMP -OQER)
•Normal profit
Condition for normal profit is very rare. Due to change in
demand and cost conditions, sometimes it is possible for the firm to
just cover its cost of production ie the case of normal profit.
Diagram 2.3
With given revenue and cost curves firm is in equilibrium at
point E1, with the intersection of MR and MC curves. Output= OQ1,
Price= OP1, TR= OQ 1R1P1
TC= OQ 1R1P1. As TR=TC, the firm will make normal profit.
•Loss
Due to demand and cost conditions it is also possible that
firm may operate with loss. With the help of following diagram we
can explain the case of loss.munotes.in
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Diagram 2.4
With given revenue and cost curves, firm is in equilibrium at
point at point E2, where MR and MC curves intersects.
Equilibrium output= OQ 2 and equilibrium price = OP2. TR=
OQ 2L2P2, TC=OQ 2N2M2. As TC>TR, firm will make loss. Loss=
P2L2N2M2
In the short run when the firm incurs loss, it has to decide
whether to continue with the business or not. As long as the firm is
able to cover its total variable cost, it will continue with the business
and when TR
competition:
In the long run it is possible for the firm to make all
necessary changes in its fixed fac tors of production. As all costs
are variable, firm cannot continue to operate with loss. As there is
free ent ryand free exit, due to supernormal profits earned by the
existing firms, more firms will enter the market and firms which
cannot cover the cost of production will leave the market. More
firms who are entering the market reduces the share of existing
firms and therefore in the long run all firms will make only normal
profit. The case of normal profit can be discussed with the help of
following diag ram.munotes.in
27
Diagram 2.5
With given revenue and cost curves, equilibrium point is E
where MR and MC curves intersects. Equilibrium output= OQ,
price= OP TR= OQRP TC= OQRP. As TR=TC, there is a normal
profit.
2.3 PRODUCTION COST AND SELLING COST
Production cost includes all those expenditures incurred by
the firm to produce a commodity and to reach to shops. It includes
rent on land, wages and salaries paid to workers, interest on
capital. Depreciation charges, taxes etc. The objective of
production cost is to produce a commodity.
On the other hand the purpose of selling cost is to increase
the sale of its product in the market. Due to the availability of
substitutes, selling cost is very important for the firm under
monopolistic competition. Throug h selling cost firms try to spread
the message regarding how their product is better than the other
products available in the market.
Selling costs are incurred in various forms like T.V
advertisement, newspaper advertisement, pamphlets, hoardings,
distribution of free samples, gifts, discounts offered on products,
exhibitions ,after sales services etc.
The concept of production and selling cost can be explained
with the help of following diagram.munotes.in
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Diagram 2.6
As shown in the diagram, the differenc e between Average
Cost (AC) and Average Production Cost (APC) is the Average
Selling Cost (ASC).
Selling cost:
Selling cost is one of the important features of monopolistic
competition. Under perfect competition, as there are homogeneous
goods there is no need for selling cost. Similarly under monopoly
due to the absence of substitute products, selling cost is not
required. But in case of monopolistic competition as close
substitute products are available, firm has to incur selling cost.
Thus the cost incu rred by the firm to promote their product in the
market or to increase the demand for the product in the market is
called the selling cost. Various forms of incurring selling cost are as
follows -
•Advertising -this is the main form of selling cost. Through
advertisement the firm is trying to show how their product is
superior to other products that are available in the market.
Advertisement can be through T.V, radio, newspaper,
hoardings, distribution of pamphlets etc.
•Exhibitions -exhibitions can be held a t local, state, national and
an international level. The purpose of exhibition is to increase
the sale of the product.
•Window dressing -various products like garments, electronic
items, and other consumer durables are displayed to the
consumers to provide some idea about the product and also to
attract the consumers.
•Free samples -in case of goods like soaps, tea, biscuits, oil,
hand wash etc. Companies distribute free samples to attract the
large number of customers.munotes.in
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•Gifts -various gifts are offered by t he companies on purchase of
a specific amount.
•Discounts -another way of attracting large number of
customers is to offer them large discounts. Once the market for
the product is established, the discount may be withdrawn.
•After sales services -good after sales services play an
important role in gaining goodwill of the customers. Along with
better after sales services, warranty period, relation with
customers etc. are also important to have greater sale of their
product in the market.
Effects of selling co st
Selling cost affects the consumers demand. It makes people
aware of the existing commodity and also inform them how their
product is better than substitutes available in the market. Effect of
selling cost on demand can be explained with the help of fol lowing
diagram s.
Diagram 2.7
In the above diagrams X axis measures quantity demanded
and Y axis measures price. In the first diagram DD is the initial
demand curve with price OP and output OQ. Due to selling cost
demand curve shifts to the right to D 1D1and further to D 2D2. The
producer is able to sell more quantity OQ 1and OQ 2at the same
price OP.
Second diagram shows that DD is the original demand curve
without selling cost with price OP and quantity OQ. If selling cost is
incurred, demand curve wi ll become more elastic. ie D1D1. If firm
reduces price to OP1, its demand will increase to OQ2. But at the
same time firm incurs the selling cost, it will be able to sell more i.e.
OQ 1at price OP 1.munotes.in
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Effect of selling cost on profit
Effect of selling cos t on profit can be explained with the help
of following diagram
Diagram 2.8
In the above diagram X axis represents output and Y axis
represents cost and revenue. If we consider a case without selling
cost, AR and MR are the downward sloping curves star ting at a
lower side of Y axis. APC and MPC are the average and marginal
production curves. Initial equilibrium point is E where MPC curve
and MR curves intersect. Equilibrium output= OQ and price = OP,
TR = OQRP, TC = OQNM as TR>TC, profit = MNRP.
If the firm incur selling cost, demand for goods will increase
and therefore AR curve shifts upward to AR 1. Correspondingly MR
curve will also shift to MR 1. Adding selling cost in production cost
we have the average and marginal cost curves. New equilibrium
point is E1. Output = OQ 1, price = OP 1, TR = OQ 1R1P1, TC =
OQ 1N1M1. TR>TC, therefore profit = M 1N1R1P1.
This shows that due to selling cost demand for commodity
increases from OQ to OQ1. An increase in demand raises the price
from OP to OP1. And therefore pro fit after selling cost is also
greater than the level of profit before selling cost.1 1 1 1 MNRP M N R P
2.4. ROLE OF ADVERTISEMENT
Due to the availability of close substitute products,
advertisement or selling cost plays an important role under
monopolistic competition. These advertisements are undertakenmunotes.in
31
through exhibitions, T.V, hoardings, discounts, distribution of free
samples etc. The purpose of selling cost is to increase the sale of
commodity in the market. It also encourages competition a mong
the firms producing close substitute products.
There are many advertisements which gives an information
about the availability of various products in the market and also
inform them about quality and uses of the product. Advertisement
also specifies the benefits of using a particular product. Such
advertisements are called informative or educative advertisement.
On the other hand there are some advertisements who distort
consumer’s preferences by misleading them to purchase certain
commodities. Such a dvertisements are called manipulative or
competitive advertisement.
There are debates over its role which is discussed as
follows -
Arguments for advertisement or benefits of advertisement:
•Advertisement creates awareness amongst the consumers
about the a vailability of various products, their advantages and
disadvantages, price of the product etc.
•Advertisement generally increases the demand for the product
and thereby increases the level of investment and employment.
•Successful advertisement which leads t o increase in demand
will lead to increase in production of the firm and thereby greater
benefits of economies of scale.
•Advertisement directly provides information to the consumers
and thus eliminates middlemen.
•If the advertisement is genuine and peopl e are happy with the
quality of the product, firms will succeed in building a brand
loyalty among the consumers.
Arguments against advertisement or disadvantages of
advertisement:
•Advertisement creates temptation to spend money on those
goods which are so metimes not required.
•In order to attract consumers, sometimes producer explains
false qualities of their product where the consumers do not have
any source of verifying. In this way advertisement misleads the
consumers.
•Advertising costs are added to the production cost of the firm
and therefore price of the product will also be high.
•Advertising cost leads to psychological dissatisfaction to many
poor people for whom it is not affordable to consume advertised
product.munotes.in
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•If an advertisement is not successf ul in increasing demand for a
product, advertisement expenditure will be considered as
wastage.
•Posters on wall for advertisement spoils the beauty of specific
areas.
•Due to attractive advertisement many people consume food
items (junk food) in large qua ntity.
•Advertisements by the financial institutions offering loans at a
concessional rate for consumption of specific goods divert
peoples mind to consume such goods. But at the time of
repayment of loan if they face some problem, it leads to stress,
famil y problems etc.
•In most of the advertisements female models are shown. In
some cases there is an exploitation of these models.
Check your Progress :
1)Suppose there are fairly large numbers of a firm producing
detergent powder. Each firm spends huge am ount of money on
advertisement to increase the sale of their product in the
market. Identify the market structure for the detergent powder.
2)Explain the role of advertisement.
3)If you want to sale of your product under the monopolistically
competitiv e market, there is a need of selling cost. Justify your
answer.
2.5 WASTAGES UNDER MONOPOLISTIC
COMPETITION
There are different types of wastages under monopolistic
competition. These are discussed below.
1.Excess capacity -Excess capacity is created under
monopolistic competition the equilibrium of a firm under
monopolistic competition is attained at a less than optimum level
of output. This means that the resources are not fully utilized
and therefore this underutilization of existing capacit y leads to
excess capacity. Following diagram explains the case of excess
capacity.munotes.in
33
Diagram 2.9
In the above diagram horizontal AR and MR curve indicates
perfect competition and downward sloping AR and MR curves
indicates monopolistic competition. It is clear from the diagram that
equilibrium under perfect competition is attained at point E with
price OP and output OQ. Whereas equilibrium under monopolistic
competition is attained at point E1, with price OP1 and output OQ1.
This shoes that firm under per fect competition produces optimum
level of output (OQ) with minimum cost and thus charges lower
price (OP). On the other hand under monopolistic competition
produces less than optimum level of output (OQ1) and sells at a
higher price (OP1). As firm produce s less than optimum level of
output, Q1Q capacity of the form is unused. This is the excess
capacity of the firm under monopolistic competition.
•As there is underutilization of a capacity, it leads to the problem
of unemployment.
•If the firm is not succes sful in increasing demand for their
product in the market, all firms expenditure in the form of selling
cost will be a wastage.
•Heavy expenditure on advertisement will increase the prices of
goods and services and therefore there is an exploitation of the
consumers.
2.Unemployment -as the production capacity of a firm is not fully
utilized under monopolistic competition, the problem of
unemployment occurs in case of monopolistic competition.
3.Exploitation of the consumer -Due to product differentiation,
firm has to incur selling cost under monopolistic competition.
Therefore the consumers have to pay higher price for the
product and this leads to exploitation of the consumers.munotes.in
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4.Selling cost -Under monopolistic competition firm undertakes
huge expenditure on ad vertising their product in order to
increase the sale of their product in the market. If the firm is not
successful in increasing the sale of their product in the market,
this expenditure is considered as the wasteful expenditure.
5.Lack of specialization -as there are many firms, producing
close substitute products, there is a very little scope for
specialization. Thus the advantages of large scale production
are not possible.
2.6SUMMARY
This unit studies the monopolistically competitive market . It
includes the features of monopolistic competition. The concept of
monopolistic competition was introduced by professor chambertin.
Monopolistic competition is a more realistic market structure in
which we live. This unit discusses the equilibrium of a firm in t he
short run and in the long run. It concentrates on product
differentiation and also explains the factors that leads to product
differentiation.
This unit explains selling cost as an important feature of
monopolistic competition. It shows the effects of selling cost on
demand for a commodity and profit of the firm with the help of
diagrams. It also explains excess capacity and wastages under
monopolistic competition.
2.7QUESTIONS
1. Discuss the features of monopolistic competition.
2. Write a note on product differentiation.
3. Explain the short run equilibrium of a firm under monopolistic
competition.
4. Discuss the long run equilibrium of a firm under monopolistic
competition.
5. Bring out distinguish between production cost and selling cost.
6. What are the various forms of selling cost.
7. Explain with the help of diagram effects of selling cost.
8. Discuss the effect of selling cost on profit.
9. Discuss the role of advertising.
10. What are the arguments for and against advertising.
11. Write a note on wastages under monopolistic competition.
munotes.in
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Unit -2A
OLIGOPOLISTIC MARKET
Unit Structure :
2A.0Objectives
2A.1Features of oligopoly
2A.2Collusive and non -collusive oligopoly
2A.3Summary
2A.4Questions
2A.0 OBJECTIVES
•To unders tand thefeatures of oligopoly
•To understand the difference between collusive and non -
collusive oligopoly models
•To understand the types of collusions
•To understand theprice leadership ,its types and limitations.
2A.1 OLIGOPOLY MARKET CAN BE WELL
UNDERS TOOD WITH THE HELP OF FOLLOWING
CHARACTERISTICS -
•Few sellers -In case of oligopoly market there are few sellers.
The number of sellers is not more than 10. In case if there are
more than ten sellers, few sellers are dominant and others are
insignificant.
•Homogeneous or differentiated products -goods which are
sold under oligopoly are either homogeneous or differentiated.
Differentiation is in the form of brand name, design, color etc.
•Entry is possible but difficult -In case of oligopoly a new firm
can en ter the market but in reality, it is difficult because of the
technological, financial and other barriers
•Interdependence -as there are few firms under oligopoly, a
single firm is not in a position to take any decision about price
and output independently. Any decision taken by one firm has
the reactions from the rival firms or competitive firms. Different
firms will have different decisions. Thus the firms are
interdependent. Therefore it is necessary for the firm to take in
to consideration the possible r eactions of the rival firms.
•Uncertainty -as the firms are interdependent for deciding the
price and output, it creates the atmosphere of uncertainty. If onemunotes.in
36
seller increases his output to capture large share of the market,
others will react in the same w ay. If one seller increases the
price of his product, others will not follow him due to the fear of
losing the market. On the other hand if one seller reduces the
price, others will also reduce their prices. But how much price
reduction they will do is unc ertain. This means that an
oligopolist is uncertain about the reactions of the competitive
firms.
•Indeterminateness of the demand curve -in case of perfect
competition price is determined in the market with demand and
supply factors and the firm is a pri ce taker therefore demand
curve of the firm is perfectly elastic (parallel to x axis). In case of
monopoly a single seller decides the price for his commodity
and accordingly sells his output. Thus the demand curve of the
monopolist slopes downward. And th e demand curve is steeper
as the substitute products are not available. Under monopolistic
competition as close substitute products are available, demand
curve is downward sloping and more elastic or flatter. This
means that under perfect competition, mono poly and
monopolistic competition there is a definite shape of the
demand curve.
In case of oligopoly due to interdependence of firms and the
uncertainty aspect
Demand curve do not have a definite shape. It loses its
determinateness.
The demand curve under oligopoly is kinky as shown in the
following diagram.
Diagram 2A.1munotes.in
37
Check your Progress :
1)Suppose there are two firms which are interdependent on each
other for taking any decision related to price and output. There
isalso and uncertainty in the market. Identify the market
structure.
2)Give few examples of firms operating under Oligopoly.
2A.2 COLLUSIVE AND NON -COLLUSIVE OLIGOPOLY
The oligopoly market faces the problem of price
determination because of the continuous reactions of the rival firms.
Due to differentiate products, competition in the oligopoly market is
also high. An oligopoly can be collusive or non -collusive.
Non collusive oligopoly
In case of non -collusive oligopoly, firms behave
independently, even though they are interdependent.
interdependence of the firm leads to stiff competition among the
rivals. In this case the behavior of the Seller depends on how he
thinks his competitors will react to his decision making. In case of
non-collusive oligopoly firm while deciding price for its product
assumes that rival firms will keep their price and output constant
and will not react to any change in price and output introduced by
the firm. A very good example of non -collusive oligopoly is
sweezy’s kinked demand curve model.
Collusive oligopoly -collusive oligopoly prevails when the firms
working under oligopoly market enter into an agreement regarding
uniform price and output policy to avoid uncertainty arising due to
interdependence of t he firm and to avoid high level of competition.
The agreement may be either formal (open) or tacit (secret).
As the open agreement to form monopolies are illegal in most of
the countries agreements between the oligopolists are tacit.
Collusions are of tw o types:
•a. Cartel and b. price leadership
In case of collusive oligopoly, price fixing takes place when
all firms in the market try to control supply, to achieve a monopolymunotes.in
38
like situation. In this type of oligopoly, firms aim at maximizing
collective pro fit rather than individual profit.
Collusive and non -collusive models are discussed below.
Price rigidity -kinked demand curve model (non -collusive
oligopoly model)
Kinky demand curve model or kinked demand curve
hypothesis was given by an American ec onomist Paul M. Sweezy
and Oxford economist Hall and Hitch.
Interdependence and uncertainty aspect of oligopoly leads to
indeterminateness of the demand curve. In case of oligopoly price
is rigid or inflexible because oligopolists are not interested in
changing their price even though economic conditions undergo a
change.
In order to explain price and output determination under
oligopoly with product differentiation economists often used kinked
demand curve model. This model is explained by taking an
exam ple of extremely limited case of oligopoly i.e. Duopoly, where
there are only two firms. Therefore there are two demand curves as
shown in the following diagram.
Diagram 2A.2
As shown in Diagram 2A.2above there are two demand
curves DD of firm A and D1D1 of firm B. Demand curve DD is
more elastic where as demand curve D 1D1is less elastic. These
two demand curves intersect at point K. Thus the prevailing price is
OP and quantity is OQ. As shown in the diagram the demand
curve faced by an oligopolis t is DKD 1. This demand curve has a
kink at point K because the upper segment of demand curve
(segment DK is more elastic) and the lower segment of the demandmunotes.in
39
curve (segment KD 1) is less elastic. This difference in elasticities is
because of the reactions o f the competitive firms.
An oligopolists believes that if he reduces the price below
prevailing price, his competitors will also reduce their prices and if
he increases the price above prevailing price, his competitors will
not increase their prices.
•Increase in price -If an oligopolistic increases the price above
prevailing price his competitors will not increase their price.
Therefore ,demand for his goods will fall substantially. This is
because due to increase in price his customers will go to his
competitors who have not increased their prices. Due to this the
demand curve abo veprevailing price is more elastic.
•Reduction in price -If an oligopolistic reduces the price below
prevailing price, his competitors will follow him and also reduce
their prices due to the fear of losing their customers. Due to
quick reactions of the oligopolists, whoever reduces the price,
demand for his goods increases by a very little amount.
Therefore the demand curve below prevailing price is less
elastic.
Therefore D KD1is the kinked demand curve under oligopoly.
Due to differences in elast icity, a demand curve has a kink at point
K. Thus the demand curve under oligopoly is called kinky demand
curve.
Rigid price -With an increase in price, there is a fear of losing the
market and there is a very little benefit by reducing the price.
There fore an oligopolist is not interested in changing their price.
Thus price remains rigid or sticky under oligopoly.
Equilibrium of a firm
Equilibrium of a firm occurs when MR= MC. In case of oligopoly the
demand curve or the average revenue curve has a kin kat a
particular prevailing price. Therefore the MR curve of the firm has a
discontinuous portion as shown in the following diagram.munotes.in
40
Diagram 2A.3
In the above diagram DKD 1isthe kinked demand curve
under oligopoly. The demand curve has the kin kat point K.
There fore MR curve which lies half way between AR curve and Y -
axis has a discontinuous portion RS. MR curve is discontinuous
because of the Kink to the demand curve. Discon tinuous portion of
the MR curve depends on the difference in elasticities. Larger is the
difference in elasticities, longer will be the discontinuous portion of
the MR curve. MC is the marginal cost curve which passes through
discontinuous portion of the M R curve. Equilibrium of the oligopoly
form is achieved at a point where MR=MC. Therefore equilibrium
output is OQ and price is QK or OP. If MC increases or decreases,
there will be upward or downward Movement in the marginal cost
curve over the discontinu ous portion of the MR curve. This will keep
price and output level constant at OP and OQ respectively.
Therefore the price remains rigid. If an oligopolistic increases
price over DK portion of the kinked demand curve, the Rivals will
not follow due to th e fear of losing the market. Due to this
oligopolists will not increase price above OP. Similarly, no
oligopolist is interested in reducing the price because in this case
due to the continuous reactions of the rivals, demand increases by
a very small amoun t. Thus the demand curve is inelastic.
Collusive oligopoly models:
In case of oligopoly there is interdependence of the firms
and there is also, uncertainty. In order to avoid uncertainty arising
out of interdependence, firms generally enter into an agree ment to
follow a uniform price and output policy. This type of agreementmunotes.in
41
helps firms to avoid price wars and also stiff competition. The
agreement may be either formal (open) or tacit (secret). Open
agreements are illegal in most of the countries. Thus, th e
agreements to form monopolies are in the form of tacit agreements.
This type of oligopoly is called collusive oligopoly. OPEC
(Organization of Petroleum Exporting Countries) is the best
example of this type of oligopoly. There are two types of collusions .
They are -a.cartel and b. price leadership Cartel -Cartel is an
agreement among the competitive firms to earn higher profits.
Cartels are formed in oligopoly market where the number of sellers
is few and they are selling homogeneous or differentiated pr oducts.
In this agreement, the member firms may agree on price fixing,
market share division of profits etc. The cartels are of two types -
centralized cartel and market sharing cartel. In case of centralized
cartel there is a common Sales Agency which alo neundertakes the
selling operations for all the forms who are party to the agreement.
Here the Central Administrative agency decides the product price,
distribution of output, profit sharing for all the firms. All firms agree
tosurrender their rights to Central Administrative Agency for
earning maximum joint profits. This is known as perfect cartel.
Agreement under centralized cartel can be discussed with the help
of following diagram.
Diagram 2A.4
In the about figure first two diagrams shows the case of two
firms A and Band third diagram explains the case of industry.
Formation of cartel leads to Monopoly power and therefore AR and
MR of industry are downward sloping. As shown in figure 3,
summation MC is the marginal cost curve for an industry, which is
being derived by adding horizontally the marginal cost of curves of
two f irms MC1 and MC2. Total industries output is produced at a
point where summation MC= MR. Therefore, total output is OM and
the market price is OP. This is the price set by the cen tralized
authority.
Firm A sells OM 1output and Firm B cells OM 2output.
OM1+OM2=OM. Market price is charged by both the firms.munotes.in
42
therefore, price of firm A is OP1 and price of firm B is OP 2. Profit
for firm A is S 1K1M1P1and profit for firm B is S 2K2M2P2.This shows
that firm Aproduces and sells greater quantity as compared to firm
Band thus makes higher profits.
A type of cartel discussed above is very rare. In the real
world we generally have loose type of cartel. Here we have two
types of market sharing. They are -
a. Market sharing by non -price competition and
b. Market sharing by output quota
a. Market sharing by non -price competition -In case of
oligopoly ,due to interdependence of firms and uncertainty, price is
rigid i.e. firms follow a par ticular price and there is no tendency
either to increase or to reduce the price. At a uniform price firms are
free to produce and sell that level of output which will maximize
their profits. Here even though the firms are following same price
they are fre e to change the style of their product, style of
advertising the product, additional facilities or discounts may be
given. If all member firms have identical cost, they will be agreeing
to uniform monopoly price and this price will maximize their joint
profits. But if their costs are different, cartel price will be decided by
the bargaining between the firms. If low cost firms are interested in
charging lower price cartel may break away.
b. Market sharing buy output quota -In this case an oligopoly firm
enters in to an agreement regarding quota of output to be produced
and sold by each of the firm at a particular agreed price.
If the cost of production is same for all the firms and firms
areproducing homogeneous product, a monopoly element will exist
andall firms will share the market equally and charge the maximum
possible price. On the other hand, if the cost of production is
different for different firms, market share of the firms will differ.
These differences are dependent on the bargaining power of the
firms. The Quota of output shared by the firm depends on the past
records and negotiation skills.
Another method for market sharing quota is to divide the
markets region wise. In this case firms are free to decide the price
and to bring changes in the ir product. When there are cost
differences between the firms all types of cartels are unstable.
Price leadership:
Price leadership is one way of avoiding unnecessary
competition. In case of price leadership one firm decides the price
and the other follow it.Firms who decides the price will be the
leader and the others are followers.munotes.in
43
There are different types of price leadership. They are
discussed below:
1) Price leadership by a low -cost firm -In this case a firm with
lower cost of production becomes th e leader. Here a firm with low
cost sets a price and the other firms with higher cost of production
accept the price. While deciding price, low cost firm has to ensure
that this price brings some profits to the high cost firms.
2) Price leadership by a do minant firm -In this case one of the
firms in the oligopoly market may be producing a large portion of
the total output. Such a firm will become dominant, who can
influence other firms in the market. As other firms are small they
cannot have impact on the market. The dominant firm fixes a price
which maximizes its own profit. Thus, the other firms will follow the
price set by the dominant firm and accordingly adjust their output.
3) Barometric price leadership -In this type of price leadership an
oldexperienced and most respected firm in the market becomes
the leader. This firm study the changes in market conditions like
demand for the product, cost conditions, level of competition etc.
and decides such a price which protects the interest of all. A leade r
firm decides the price which is beneficial to all and other firms
Follow the Leader.
4) Exploitative or aggressive price leadership -Here a large and
dominant firm establishes its leadership through aggressive price
policy and forces the other firms to follow the price set by him. If the
firm's do not agree with the price, aggressive firms may threaten
the other firms to keep them out of the market.
Price leadership by a dominant firm In case of price
leadership by a dominant firm, one of the large and dominant firm in
the industry sets the price and the other small firms follow the price
set by the dominant firm. Following diagram explains the price
leadership by a dominant firm.munotes.in
44
Diagram 2A.5
In the above diagram DD is the demand curve of a marke t at
and DL is the demand curve of a dominant firm, MR Lis the
marginal revenue curve and MC Listhe marginal cost of the
dominant firm. The dominant firm will maximize their profit when
MR L= MC L. Therefore, the price set by the dominant firm is Pd and
the output of the dominant firm is Qd. As the small firms in the
market are price takers, they follow price Pd which is set by the
dominant firm. for the small firms, price set by the dominant firm
becomes their marginal revenue, Pd =MRs. The small firms or
followers will maximize their profit when MRs = summation MCs.
Thus, the output of small firms is Qs. Thus, in the market
consumers pay price Pd and consume quantity Q. Out of this total
quantity Q the share of dominant firm is Qd and the share of small
firms is Qs. Whether the price leadership is successful or not
depends on various factors. It is expected that the leader or
dominant firm is fully aware of the reactions of the small firms. If the
leader firm takes the decision with incomplete information, firms’
leadership may not be successful. Some of the limitations of the
price leadership are as follows -
1) Non price competition -There is a possibility that even though
the small firms are following the price set by dominant firm, they
may also follow various non -price competition methods, which are
in the form of discounts ,after sales services etc. In this case non
price competition may lead to reduction in prices to protect their
own market share.
2) Product differentiation -In case of oligopoly, i f the firms are
selling differentiated products, it is difficult to have the leadership.
This is because each firm will incur selling cost in order to attract
more customers. Selling cost is in the form of TV on newspapermunotes.in
45
advertising, giving free samples, discount, etc. This situation forces
the leader firm to enter into the competition and protect its market
share.
3) Difference in the cost of production -Cost of production for
each of the firm is different. In case of price leadership if the low
cost fi rm becomes leader and sets the price, which other forms in
the industry have to follow. In this case for a dominant firm it is
difficult to follow the price set by low cost firm. If the firms with a
lower cost enter into non price competition it may lead t o open
competition by all the firms. On the other hand, if high cost firm
becomes the leader for setting the price it has to set high price for
its product in order to cover the cost firms who are not ready to
accept this high price may try to enter into non-price competition to
enlarge their market.
2A.3SUMMARY
This unit explains the characteristics of oligopoly market. It
explains two types of oligopoly models that is collusive oligopoly
and non -collusive oligopoly.
Non collusive oligopoly model is discussed with the help of
Paul sweezy's kinky demand curve. It explains why price remain
rigid under oligopoly. Equilibrium of a firm under oligopoly market is
also explained wit h the help of intersection of discontinuous
marginal revenue curve under olig opoly and marginal cost curve.
Collusive oligopoly is discussed with the help of cartels and
price leadership.
Two types of cartels are discussed that is centralised cartels
and market sharing cartels.
Two types of market sharing are
1)Market sharing by non -price competition and
2)Market sharing bye quota.
Four types of price leaderships are explained in this unit. They are
1) Price leadership by high cost firm
2) Price leadership by low cost firm
3) Barometric price leadership
4) Aggressive or exp loitative price leadershipmunotes.in
46
2A.4QUESTIONS
1. Discuss the features of oligopoly market.
2. What is oligopoly? Explain its characteristics.
3. Explain why price is rigid under oligopoly?
4. Discuss kinky demand curve under oligopoly.
5. Explain the collusive oligopoly models
6. Write a note on cartel.
7. What is price leadership? Explain its various types.
8. Discuss the price leadership by a dominant firm.
9. Discuss price leadership along with limitations.
10. Explain non -collusive oligopoly model.
munotes.in
47
UNIT -III
Unit -3
PRICING METHODS
Unit Structure :
3.0 Objectives
3.1 Cost –Plus (Full Cost)/Mark -Up Pricing Method
3.2 Marginal Cost Pricing Method
3.3 Multiple –Product Pricing Method
3.4 Summary
3.5 Questions
3.0 OBJECTIVES
1)To study the concept of Cost plus pricing.
2)To study the concept of marginal cost pricing.
3)To study the concept of multiple –product pricing.
3.1 COST –PLUS PRICING / FULL COST PRICING /
MARKUP PRICING
Cost-plus pricing is also called as full cost pricing or mark -up
pricing. Two famous economist of Oxford University Hall and Hitch
developed this concept of pricing. This is the most commonly
adopted method of pricing. It is used by a company or firm to
determine the selling price of their product. Cost -plus pricing is a
very si mple method for setting the prices of goods and services.
According to this method price of a commodity is determined
by taking into consideration Average Fixed Cost (AFC), Average
Variable Cost (AVC) and Normal Profit Margin (NPM) or markup
percentage. This markup percentage is nothing but profit. In other
words price is determined by adding a fixed mark -up to the cost of
producing the product. This method is generally used by
manufacturing firms. Thus, it is imperative to have an accurate
information of average costs.
P = AFC + AVC + NPM
Example :
If variable cost of a product is `100, average fixed cost is
`200 and desired markup is 50% on cost. The price will be
calculated as follows:
P = 100 + 200 + (0.5 × 300)
= 300 + 150
=`450munotes.in
48
Advantages /Merits
1]This method is simple and easy for the firms to implement, no
matter how many products the firm produces.
2]It promises fair returns to both producers and consumers.
3]It is less time consuming as it requires less data for calculation
i.e.(AFC and AVC).
4]It is easy to apply.
5]This method guarantees stability in prices when cost of
production remains stable.
6]This method provides a logical reasoning for increase in prices
because prices increase as a result of increase in costs.
7]It lessens the cost of decision making as price can be calculated
just by using one formula.
Disadvantages / Demerits
1]This method concentrates only on cost of production and profit
margin, and completely overlooks demand and preferences by
consumer.
2]It disregards the role of competition in the market.
3]It makes use of historical data rather than replacement value.
4]It isvery difficult to estimate precisely the average variable cost
and average total cost and distribute it between the vario us
products produced by the firm.
5]Few economist are of the opinion that pricing should be based
on marginal cost rather than average costs.
Despite of all the demerits, in reality many firms use this method
because of following reasons.
1]Ifthe pr ice is more than the average cost, firms would make
supernormal profits and this will interest the competitor’s to
enter in to the market.
2]It difficult to get correct information about MR and MC and
therefore many firms use full cost pricing method.
Case Studies –Pricing Methods
1]Suppose the firm has capacity to produce 1000 units. It uses
70% of its capacity and is considered as the standard output.
The total variable cost incurred is `1400 and the overhead cost
is`700. The mark up decided by the firm is 25%.
Estimate the price per unit.
Standard output is = 700 units
i.e. 70% of its capacitymunotes.in
49
Total Variable Cost = `1400
Average Variable cost =`1400 / 700 = 2
Overhead Cost = `700
Average Fi xed Cost =`700/700 = `1
Average Cost = AVC +AFC
= 2+1 = `3
Now P = C (1+m)
3 (1+0.25)
3 (1.25)
=`3.75
2] A firm produces 5000 units of commodity X at the t otal fixed cost
of`2,00,000& total variable cost of `3,00,000. Find the price which
the firm would charge to its customers if it wants to make profit
margin of 15% on cost. The firm uses cost plus pricing method.
Output of the firm = 5000 units
TFC = `200000
TVC = `300000
Average Fixed Cost (AFC) =
=`40
Average Variable Cost (AVC) =
=`60
Average Total Cost = AFC + AVC
=`40 +`60
=`100
Net profit margin is 15% of total cost
Price of Commodity = `100 + `15
=`115
3] If total cost of producing a commodity A is `5,00,000 and markup
fixed by the firm is
`1,00,000. Total Output to be sold is `6000 units. Calculate the
price per unit.
Price
= `100munotes.in
50
4] If th e cost of product is `500 per unit and the market expects
10% profit on costs.
Calculate selling price
Selling Price = AC + markup
=
= 500 + 50
=`550
5] ABC International expects to incur the following c osts in its
business in the upcoming year.
Total production cost = `250000
Total Sales and administration cost = `100000
Company wants to make profit of `200000
And ABC expects to sell 20000 units of its product.
On the basis of above information, calcula te full cost price.
Full Cost Price =
=
=
Full Cost Price = `27.5 per unit
3.2 MARGINAL COST PRICING
According to marginal cost pricing method price is
determined on the basis of the marginal cost of production.
Marginal cost means cost of producing an extra unit of output. Here
the price is charged on the basis of cost of additional unit of output
which the firm produces. The price is determined in such a way that
it must cover the marginal cost.
In the long run both average / full cost pricing method and
marginal cost pricing method will give same price under perfect
competition. This is because under perfect competition in the long
run P = AR = MR = L .This is shown in the following
diagram.munotes.in
51
FIG3.1
Above diagram s hows that at profit maximizing condition i.e.
MR=MC, Average/ Full Cost Price method and Marginal Cost Price
Method gives same price i.e. OP.
But in case of monopoly, pricing with each of the method will
give different result. This can be discussed with t he help of
following diagram.
Fig3.2
In the above diagram on the basis of profit maximizing condition i.e.
MR=MC, equilibrium price is OP & equilibrium quantity is OQ.
On the basis of Average / Full Cost Pricing Method equilibrium
price is OP 1and qu antity is OQ 1. This price is considered to be fair
for both consumers & producers.
On the basis of Marginal Cost Pricing Method (P = MC) price is OP 2
and quantity is OQ 2.
Here TR = OQ 2SP2and TC = OQ 2NM
Profit = MNSP 2.munotes.in
52
If price charged by using Marg inal Cost Method (i.e. OP 2) is
greater than the price charged by using full cost pricing rule (i.e.
OP 1) firm will make profit (i.e. excess profit).
But if price charged by using Marginal Cost Pricing Method
is less than price charged by using average cos t pricing method,
firm will make loss.
Advantages
1] This method helps in solving short run problems therefore it is
more effective than full cost pricing method.
2] Firms will be able to increase sales as prices tend to be
competitive.
Disadvantages
1]It is very difficult to calculate MR and MC accurately for every
additional unit of output produced.
2] This method is not advantageous in the long run.
3] During recession, firms using marginal cost pricing encourage
severe competition. The firm may lower prices to increase the
sales. Due to this other firms also reduce their prices and hence
no firm would be earning sufficient to cover the fixed cost.
Check your Progress :
1)Suppose the firm has capacity to produce 2000 units. It uses
50% of its capaci ty and is considered as the standard output.
The total variable cost incurred is `2000 and the overhead cost
is`4,000. The mark up decided by the firm is 25%.
2)A firm produces 4000 units of commodity X at the total fixed
cost of `12,00,000 & total varia ble cost of `4,00,000. Find the
price which the firm would charge to its customers if it wants to
make profit margin of 20% on cost. The firm uses cost plus
pricing method.
3)What do you mean byfullcost pricing ?
4)What do you mean by Marginal cost pric ing?munotes.in
53
3.3 MULTIPLE –PRODUCT PRICING
Most of the companies today produce more than one
product and sell them in more than one markets. They produce
variety of products instead of specializing in one product. They do
this in order to make op timum utilization of their production
capacities. The goods sold by them may be substitutes or
complementary goods. An automobile firm like Maruti Suzuki
produces wide range of cars. So each product will have an
independent demand curve and hence a separat e price.
Few more Examples:
Samsung producing variety of products viz mobile phones,
tablets, laptops etc.
Cadbury producing variety of chocolates viz dairy milk, 5 star
etc.
Pricing of variety of goods produced by a single firm is called
multiple produ ct pricing. It is also known as multi -product pricing or
product line. In this type of pricing firms needs to be very vigilant
about the repercussions of change in prices of one product on
another.
Marginal revenue functions helps to explain the relation ships
between two products. These functions are: -
Suppose A & B are two products
MR A=
MR B=
Marginal revenue of a product A has two components i.e. change in
total revenue of A product due to change in sale of A product and
change in total revenue of B product due to change in sale of A
product. Similarly we have equation for marginal product of B. Here
also there are two components i.e. change in total revenue of B
product due to change in sale of B product and change in total
revenue of A product due to change in sale of B product.
If the second term on the right hand side is positive, commodities’
are complementary and if second term is negative, goods are
substitutes.
Multiple product pricing can be explained with the help of
following diagra m.munotes.in
54
Fig3.3
In the above diagram D A, D B& D Care the demand curves of
products A, B and C sold by the firm and MR A, MR Band MR Care
the corresponding marginal revenue curves.
The firm maximizes its profit when MR A= MR B= MR C= MC
i.e. [Marginal Reven ue of each product should be equal to each
other and that should be equal to Marginal Cost]
This is shown by points E A, E B, & E Cwhere the equal
marginal revenue or combined marginal revenue (CMR) curve is
equal to marginal cost.
Therefore output of prod uct A is OQ1and price is P AQ1, for
product B output is Q 1Q2& price is P BQ2, for product C output is
Q2Q3and price is P CQ3.
This shows that as demand curve becomes more flatter
(relatively elastic), price goes on declining.
Check your Progress :
1)What do you mean by Multiple product pricing?
2)Give few examples of firms using multiple product pricing.
3.4 SUMMARY
In this unit we have seen three pricing methods i.e. Full cost
pricing, Marginal cost pricing and multiple product pricing.
According to Full cost pricing, price of a commodity is determined
by taking into consideration Average Fixed Cost (AFC), Average
Variable Cost (AVC) and Normal Profit Margin (NPM) or mark -upmunotes.in
55
percentage. Marginal cost pricing focus on marginal costs for
determining price. Pricing of variety of goods produced by a single
firm is called multiple product pricing. It is also known as multi -
product pricing or product line. In this type of pricing firms needs to
be very vigilant about the repercussions of change in prices of one
product on another.
3.5QUESTIONS
1)Discuss the concept of full cost pricing with advantages and
disadvantages.
2)Explain marginal cost pricing method in detail.
3)Write short note on multiple product pricing.
4)Suppose the firm has capacity to produce 5000 units. It uses
80% of its capacity and is considered as the standard output.
The total variable cost incurred is `16000 and the overhead cost
is`8000. The mark up decided by the firm is 50%. Estimate the
price per unit with the help of mark -up pricing.
5)A firm produces 100 units of commodity X at the total fixed cost
of`2000 & total variable cost of `3000. Find the price which the
firm would charge to its customers if it wants to make profit
margin of 25% on cost. The firm uses cost plus prici ng method.
6)If total cost of producing a commodity A is `5000 and mark -up
fixed by the firm is `2000. Total Output to be sold is `700 units.
Calculate the price per unit.
7)If the cost of product is `1500 per unit and the market expects
30% profit on costs. Calculate selling price.
8)XYZ International expects to incur the following costs in its
business in the upcoming year.
Total production cost = `300000
Total Sales and administration cost = `200000
Company wants to make profit of `300000
And ABC expects to sell 4000 units of its product.
On the basis of above information, calculate full cost price.
munotes.in
56
Unit -3A
PRICE DISCRIMINATION
Unit Structure :
3A.0Objectives
3A.1Meaning of Price Discrimination
3A.2Condition for Price Discrimination
3A.3Equilibrium of price discriminating monopolist
3A.4Dumping
3A.5Transfer Pricing
3A.6Summary
3A.7Questions
3A.0 OBJECTIVES
1)To study the concept of Discriminating pricing / Price
Discrimination.
2)To understand Condition for Price Discrimination.
3)To understand equilibrium of price discriminating monopolist.
4)To study the concept of international Price Discrimination /
Dumping.
5)To study the concept of transfer pricing.
3A.1 MEANING OF PRICE DISCRIMINATION
Price discrimination refers to the chargi ng of different prices
by the monopolist for the same product.
Few Definitions:
“Price discrimination exists when the same product is sold at
different prices to different buyers.” –Koutsoyiannis
“Price discrimination refers to the sale of technically si milar
products at prices which are not proportional to their marginal cost.”
-Stigler
“Price discrimination is the act of selling the same article produced
under single control at a different price to the different buyers.” -
Mrs. Joan Robinson
“Price dis crimination refers strictly to the practice by a seller of
charging different prices from different buyers for the same good.” -
J.S. Bainmunotes.in
57
Price discrimination refers to the act of selling the same article,
produced under single control at different prices to different buyers.
Price discrimination generally takes place in case of
monopoly. Following are the types of price discrimination.
1] Personal price discrimination -In this type different prices are
charged to different consumers for the same product or service.
Example: Doctors, Lawyers, Tuition Teachers etc. Charges
different prices for different individuals. It is similar to first degree
price discrimination.
2] Group Price Discrimination –Here entire population or area is
divided into different groups and different prices are charged for
different groups of people.
Example: Railways charges lower ticket to children and senior
citizens and more for others. Industrial areas are charged more
electricity charges as compared to residential areas. Thi s is same
as second degree price discrimination.
3] Market Price Discrimination –This means charging different
prices for the same product in different markets.
3A.2 CONDITION FOR PRICE DISCRIMINATION
1] Non -Transferability of goods –A monopolist can charge
different prices for the same good provided that the consumers are
not in a position to transfer the goods from one to other. This could
happened only if consumers either do not meet each other or in
case they meet, will not be able to exchange the goods.
2] Geographical Distance –If markets are situated at sufficiently
long distances then the transfer of goods may not be economical.
Example: IF we consider Mumbai and Kolhapur market and price
difference is of `50 per unit, the transfer of goods fr om one buyer to
other between the markets is not at all economical.
3] Political Hurdles –If political boundaries prevent the movement
of people from one market to other market, a monopolist who
operates in both markets can change different prices for th e same
commodity.
4] Lack of awareness –When the consumers are ignorant of the
price difference, they will not mind paying higher prices than what
the others are paying.munotes.in
58
5] Insignificant price difference –When the price difference is
very small, the co nsumers would not bother about negligible price
difference. Therefore it is possible for the monopolist to have price
discrimination.
6]Link between Price and Quality –When consumers, due to
irrationality or any other reason consider higher price as an
indicator of better quality, then it is possible for the monopolist to
change higher price for such consumers.
7] Location –Goods sold in sophisticated or rich localities or sold
in departmental stores may be charged higher prices than the same
goods sold in poor localities.
8] Tariff Barriers –If home market is protected through tariffs, a
monopolist may charge a higher price in the protected home market
and lower price in competitive world market.
9] Government Sanctions –Government due to welfare so cial or
political reasons may change different prices for the same goods &
services.
10] If monopolist can bring about some product differentiation like
changing packaging sale, promoting after sales services etc. then
price discrimination is possible.
11] Differences in Elasticity –If elasticity of demand is different in
different markets, it is possible for the monopolist to have price
discrimination.
Check your progress :
1)What do you mean by price discrimination?
2)What are the types of price di scrimination?
3)Discuss any two conditions for price discrimination.
3A.3 EQUILIBRIUM OF PRICE DISCRIMINATING
MONOPOLIST
For explaining equilibrium of price discriminating monopolist
we make following assumptions: -munotes.in
59
1] Monopolist operates i n two different markets, i.e. market A &
market B
2] Two markets differ in elasticities.
3] Production is undertaken at one place and it is at equal distance
between the two markets so that there is no scope for price
differences on the basis of transport cost.
Equilibrium of a price discriminating monopolist can be
discussed with the help of following diagram.
Fig3A.1
Above diagram shows that in (Figure -A) & (Figure -B),there are two
markets -Market A & Market B. Market A is relatively inelastic an d
Market B is relatively elastic. As Market A is relatively inelastic, AR
& MR, of Market A are steeper and as Market B is relatively elastic,
AR2& MR 2of market B are flatter.
[AR & MR are the Average & Marginal revenue Curves of the two
markets.] (Figu re-C) explains the production.
CMR is the Combined Marginal Revenue Curve in (Figure -C) which
is derived from horizontal summation of MR 1and MR 2.
In figure -C Marginal Cost Curve (MC) intersects the combined
marginal revenue curve at point R. Therefore t otal output is OQ.
This output is distributed between market A & B in such a way that
MR 1= MR 2= MC. In order to show this equality we have drawn
horizontal line RL from point R in (Figure -C) to Y axis of (Figure -A).
Accordingly OQ 1output is sold in ma rket A at price OP 1and
OQ 2output is sold in market B at price OP 2.
[Price in relatively inelastic market is greater than price in relatively
elastic market.]
Profit of the monopolist = TR –TC
OQRDA –OQRB
= BRDAmunotes.in
60
Therefore Price Discr imination monopolist will be in equilibrium
when: -
1] Different markets differ in price elasticities enabling him to
charge different price.
2] Total output is distributed in all the markets in such a way that
marginal revenue in all the markets is equal.
3] Marginal Revenue in all markets which are equal must also be
equal to marginal cost at equilibrium output.
3A.4 DUMPING
The practice of discriminatory monopoly pricing in the area
of foreign trade is described as dumping. It implies different prices
in the domestic and foreign markets.
Dumping refers to the situation in which producer enjoys a
monopoly power in the domestic market, charges a high price to
the domestic buyers and sell the same commodity at low
competitive price in the world market or foreign markets. This type
of dumping which results in international price discrimination is
called persistent Dumping.
The rationale behind dumping is that it enables the
exporter’s to compete in the it enables exporters to compete in the
foreign mark et and capture the market by selling at a low price,
even sometimes below cost and make up the deficiency in sales
revenue by charging high prices to the domestic buyers.
The success of international price discrimination depends on
following conditions.
1] The producer must possess a degree of monopoly power at least
in the home market.
2] The markets should be widely separated.
3] It should not be possible for the buyers to re -sell the goods from
a cheaper market to the costly market.
4] Elasticity of d emand should be different in different markets.
A situation of dumping can be discussed with the help of following
diagram.munotes.in
61
Fig3A.2
In the above diagram AR Hand MR Hare the average and
marginal revenue curves of the home market. As the seller is
monop olist in the home market, they are downward sloping.
ARW= MR Wis the average and marginal revenue curve of
the world market. It is perfectly elastic i.e. parallel to X -axis.
ARTD is the combined marginal revenue curve of the home
market and of the wor ld market. Equilibrium output is determined at
the point where combined marginal revenue curve equals the
marginal cost curve. In the above diagram equilibrium point is T
and equilibrium output is OM.
This total output is distributed between two markets in such
a way that marginal revenue of two markets are equal and that will
be equal to marginal cost i.e. (MR H= MR W= MC)
Accordingly OL output is sold in the home market at price
OP Hand LM output is sold in the world market at price OP W.
Total outp ut OM = OL + LM.
Price charged in the domestic market (OP H) is greater than price
charged in the world market i.e. (OP W).
Total profit of price discriminating monopolist is given by
TR = OMTRA & TC = OMTS
Profit = Area STRA
This is the maximum profit earned by two markets.munotes.in
62
3A.5 TRANSFER PRICING
Transfer prices are intern alprices at which intermediate
goods from upstream divisions are sold to downstream divisions.
[Upstream divisions are those which are producing intermediate
product & down stream divisions are those that are producing
finished product.
In the present day industrial system, vertical integration is
common. [A firm is considered to be vertically integrated when it
contains several divisions, with some divisions producing part s and
components which other divisions use to produce the finished
product.]
In such a company it is not easy for top management to be
familiar with all stages of production process. This leaves scope for
the emergence of bureaucratic style of functionin g.
In a vertically integrated firm it is not easy to determine the
amount of profit that should be credited to a division producing
intermediate good in such a way that firm’s total profit is maximized.
For this management has to determine appropriate tr ansfer price of
intermediate goal.
In our case of determining transfer price we assume that
there are only two stages of production.
1] In the first stage cloth is produced as an intermediate product
and
2] In the second stage cloth is used for manufac turing shirts.
We discuss transfer pricing under 2 conditions
1] An External Market Exists for Cloth.
This means that cloth producing divisions can sell cloth to
outside firm and divisions requiring cloth to make shirts can borrow
from external sources.
As external market is perfectly competitive, there will be a
market determined price at which cloth manufacturing division will
sell its product to cloth using division. This can be explained with
the help of following diagrammunotes.in
63
Fig3A.3
Here cloth m anufacturing division faces horizontal demand curve.
For maximizing profit cloth manufacturing division will expand their
output up to the point where (MR=MC) or (P=MC).
Accordingly OP is the market determined price of cloth.
If cloth manufacturing unit tries to set a price in excess of
market price, shift making division purchase cloth from outside
suppliers. Similarly if shift making unit refuses to pay a market
determined price, the cloth producing division will sell their cloth to
other buyers in open market.
Where an external market exists, the output of intermediate
good producing division may not necessarily be equal to input
demand of final good producing unit. If there is excess supply of
cloth, it can be sold to other users. And if supply of cl oth is
insufficient, shift making division can buy cloth from other markets.
2] No External Market
When external market do not exist, cloth can be bought and
sold only between two divisions of the firm. Here conflict may
develop regarding the price to be charged for the cloth by its cloth
manufacturing division. Here cloth manufacturing unit wants to set
a high price but shirt making unit will benefit from lower price.
Therefore management has to determine such a price for cloth that
maximizes the overall profit of the firm. Following diagram explains
the determination of price for intermediate and finance product.munotes.in
64
Fig3A.4
In the diagram D Sand MR Sare the demand (average) & marginal
revenue curves for shirt.
The marginal cost of producing clot to ma ke shirt is MC Aand the
marginal cost of transforming cloth into shirt is MC B.
Marginal cost of each additional shirt is MC A+ MC B= MC S.
For a firm combining cloth manufacturing and shift making division,
profit maximizing out is at a point where MR S= MC S. Thus output
per period is Q S. The transfer price determined for cloth must be
such that it compels the managers of shirt making unit to produce
OQ Squantity of shirts.
Top management of the integrated firm would solve this
problem by advising th e cloth division to change a price that is
equal to the marginal cost of producing cloth.
For shirt making division profit maximizing quantity is OQ S&
price is OP Sand for cloth unit price is OP Aat which cloth unit will
supply the exact amount of cloth that is necessary for producing
OQ Samount of shirts.
Check your progress :
1)Define Dumping.
2)What do you mean by transfer pricing?munotes.in
65
3A.6SUMMARY
Price discrimination refers to the charging of different prices
by the monopolist for th e same product. In this unit we have seen
concept of price discrimination along with conditions of price
discrimination such as Non -Transferability of goods, Geographical
Distance, Political Hurdles, Lack of awareness, insignificant price
difference, Link between Price and Quality, Location, Tariff Barriers,
Government Sanctions and Differences in Elasticity. We have also
seen equilibrium of price discriminating monopolist. Price
Discrimination monopolist will be in equilibrium when: -
1]Different markets differ in price elasticities enabling him to
charge different price.
2]Total output is distributed in all the markets in such a way that
marginal revenue in all the markets is equal.
3]Marginal Revenue in all markets which are equal must also be
equal to marginal cost at equilibrium output.
Unit also discusses concept of international price
discrimination i.e. dumping and Transfer pricing. Dumping refers to
the situation in which producer enjoys a monopoly power in the
domestic market, charges a high price to the domestic buyers and
sell the same commodity at low competitive price in the world
market or foreign markets. Transfer prices are internal prices at
which intermediate goods from upstream divisions are sold to
downstream divisions.
3A.7QUESTI ONS
1)Explain the concept of Price Discrimination.
2)Discuss condition required for Price Discrimination.
3)Explain equilibrium of price discriminating monopolist.
4)Write short note on Dumping.
5)Write short note on transfer pricing.
munotes.in
66
UNIT -IV
Unit -4
CAPITAL BUDGETING
Unit Structure :
4.0 Objectives
4.1 Introduction / Meaning of Capital Budgeting
4.2 Objectives of Capital Budgeting
4.3 Features of Capital Budgeting
4.4 Importance of Capital Budgeting
4.5 Steps involved in Capit al Budgeting
4.6 Advantages and Disadvantages of Capital Budgeting
4.7 Summary
4.8 Questions
4.0 OBJECTIVES
1)To study Meaning, importance, features and objectives of
capital budgeting.
2)To comprehend steps involved in capital budgeting.
4.1 INTRODUCTIO N / MEANING OF CAPITAL
BUDGETING
Capital budgeting or investment appraisal is an official
procedure used by firms for assessing and evaluating possible
expenses or investments. It is a process of planning of expenditure
which involves current expenditure on fixed/durable assets in return
for estimated flow of benefits in the long run.
Investment appraisal is the procedure which involves
planning for determining whether firm’s long term investments such
as heavy machinery, new plant, research and developm ent projects
are worth the funding or not.
Charles T. Horn green defines Capital budgeting as a long term
planning for making and financing proposed capital outlays.
Peterson defines capital budgeting as the process of planning
capital projects, raising funds and efficiently allocating resources to
capital projects.munotes.in
67
Thus capital budgeting is the decision of the firms which
leads to most efficient long term investment in the production
process with the positive expectations regarding future flow of
return s. A sound capital budget is the one which is not only done at
the right time but is also of right quality and quantity. Success or
failure of firms is based on soundness of capital budgeting.
4.2 OBJECTIVES OF CAPITAL BUDGETING
1)To identify whether the r eplacement of any of the existing fixed
assets gives more profit than earlier.
2)To identify the cost -effective and profit oriented capital
expenditure.
3)To decide and execute correct method of investment appraisal.
4)To evaluate the merits and demerits of each prospective
projects to decide the best one.
5)To elect most suitable project for the firm.
6)To identify and make provisions for the volume of finance
required for the capital expenditure.
4.3 FEATURES OF CAPITAL BUDGETING
1)Capital budgeting decisions influ ences rate and direction of
growth.
2)Capital budgeting comprises of the investment in present for
getting benefits in the future.
3)Usually, the forthcoming benefits arising out of investments are
spread over several years.
4)The investments made by firm in pre sent will determine its
financial condition in future.
5)Here each investment includes huge volume of funds.
6)Investment decisions taken here are irreversible.
7)It helps to avoid and reduce unnecessary expenditures.
8)It helps to replace current old equipment by modern and more
efficient equipment.
9)There is a high degree of risk involved in capital budgeting.munotes.in
68
4.4 IMPORTANCE OF CAPITAL BUDGETING
1)Helps to determine the future of the firm:
It helps firms to take long term investment decisions.
Benefits arising out of investments are spread over several years.
As a result capital budgeting decision has its effect over a long time
span and certain lyit affects the firm’s future growth and
development. A wrong decision taken in present can prove terrible
for the h ealth of the firm in future. So the capital budgeting helps to
determine the future of the firm.
2)Involvement of large amount of funds:
Capital budgeting decisions involve significant amount of
investment. Therefore there is a need for judicious and accura te
decisions, as an inappropriate decision would not only result in
heavy losses but also affects the growth of the firm.
3)Decisions are Irreversible:
Capital budgeting decisions are irreversible because such
decisions cannot be taken back without any subs tantial loss. These
decisions involve bulky investments such as heavy machinery, new
plant, buying land, construction of building, research and
development projects so on so forth. And it is difficult to find a
market for such second hand or used assets. T herefore capital
budgeting decisions are irreversible.
4.Covers Risk and uncertainty:
There is a high degree of risk and uncertainty involved in
capital budgeting decision. Investment done in present will give
returns in future. The future is indefinite an d full of risks. Longer the
period of project, more may be the risk and uncertainty involved in
it. Apt and sound capital budgeting will help to cover these risks
and uncertainties.
5.Helps to estimate and forecast future cash flows:
Capital budgeting help sfirm to select a best project and
estimate its future cash flows, which in turn helps to determine
whether a project should be accepted or rejected.
6.Helps to monitor and Control of expenditures:
A good project can become bad one if expenditures aren't
judiciously controlled or monitored. A sound capital budgeting helps
to monitor and control of expenditures.
7.Helps to maximise shareholder’s worth
Capital budgeting protects the interests of the shareholders
because it avoids over -investment and under -investment in fixedmunotes.in
69
assets. By selecting the most rewarding projects, the management
enables the maximization of shareholder’s worth.
8.Long term Effect on Profitability:
Profitability of firm depends upon the extent of Capital
expenditures. If the expenditures are incurred after making capital
budget accurately, then p rofitability of the firm will be high.
9.National Significance:
The selection of any project through capital budgeting will ultimately
results in the creation of more employment opportunities, increase
in national income, economic growth and development.
4.5 STEPS INVOLVED IN CAPITAL BUDGETING
Capital budgeting is a procedure in which multiple steps are
involved. Firms use Capital budgeting to determine worth of a
project or investment. The capital budgeting process involves five
steps.
Step 1. Identifica tion of various Investment Proposals:
The first step in capital budgeting is to identify various investment
proposals. Identifications of investment proposals will give firm an
idea about options available and then it will be easy for a firm to
select the best possible investment proposals. The proposal
regarding potential investment opportunities may come from
workers of any department, management or from any officer of the
firm.
Step2. Screening, Evaluation and selection of the Proposals:
After identific ation of prospective investment proposal it is very
important to screen and evaluate these proposals on the basis of
certain parameters such as practicality, feasibility, risk and
uncertainty involved and most important profitability. There are
many method s by which this screening and evaluation can be done
such as payback period method, net present value method, internal
rate of return method etc. After this entire exercise it becomes
imperative for firm to select best suited investment proposal.
Step3. Preparation of Capital Expenditure Budget:
After selection of investment project, preparation of capital
expenditure budget is must. The estimated amount of expenditure
to be incurred on fixed assets during the given period is specified
by capital expendit ure budget.
Step4. Implementing and monitoring of the Proposal:
After selection of investment proposal and preparation of budget it
is imperative to implement the project. While executing the project,munotes.in
70
it is better to allocate roles and responsibilities to staff for
completing the project within the given time and cost structure so
as to avoid unnecessary delays and losses. Investor should monitor
both quality and quantity associated with production process. Along
with this close monitoring with regard to d evelopment of market for
the product and repayment of dividends to stakeholders is also
important.
Step5. Evaluation of the proposal:
Evaluation of the performance is the last stage in the process of
capital budgeting. The evaluation can be done by compa rison of
projected and actual expenditures, and also by comparing the
anticipated and actual return from the investment.
Check you progress :
1)Define Capital Budgeting.
2)Why Capital Budgeting is important?
3)List out important steps involved in Cap ital Budgeting.
4.6 Advantages and Disadvantages of Capital
Budgeting
Advantages of Capital Budgeting:
1)Capital budgeting helps firm to understand and manage risk and
uncertainty associated with investment decisions.
2)It helps firm to select be st possible and cost effective investment
proposal for maximising profit.
3)It helps firm to make long -term investment decisions.
4)It helps to avoid and reduce unnecessary expenditures and
offers adequate control over entire outlay.
5)It helps firm to take an informed decision about an investment
project taking into consideration merits and demerits of each
project.
6)It helps firm to curb over investing and under -investing.
7)All methods of capital budgeting aims at maximising
shareholders worth.
Disadvantages of Capital Budgeting:
1)Capital budgeting decisions are of long -term in nature.
2)Almost all Capital budgeting decisions are irreversible in nature.munotes.in
71
3)Capital budgeting comprises of the investment in present for
getting benefits in the future. Future is always unc ertain.
Therefore there is a possibility that calculations of the firm may
go wrong.
4)Risk and the discounting factor remains subjective therefore
there is a possibility that they may affect actual profit.
Check you progress :
1)List out advantages of Ca pital Budgeting.
2)List out disadvantages of Capital Budgeting.
4.7SUMMARY
Capital budgeting or investment appraisal is an official
procedure used by firm for assessing and evaluating possible
expenses or investments. It is a process of p lanning of expenditure
which involves current expenditure on fixed/durable assets in return
for estimated flow of benefits in the long run. In this unit we have
seen meaning, objectives, features and importance of capital
budgeting. Identification of vari ous Investment Proposals,
Screening, Evaluation and selection of the Proposals, Preparation
of Capital Expenditure Budget, Implementing and monitoring of the
Proposal and Evaluation of the proposal are important steps
involved in capital budgeting. Unit al so focuses on some
advantages and disadvantages of capital budgeting.
4.8QUESTIONS
1)Discuss meaning and importance of capital budgeting.
2)What are the objectives of capital budgeting?
3)Elucidate features of capital budgeting.
4)Explain advantages and disadva ntages of capital budgeting.
5)What are the steps involved in capital budgeting?
munotes.in
72
Unit -4A
TECHNIQUES OF INVESTMENT
APPRAISAL
Unit Structure:
4A.0Objectives
4A.1Payback Period Method
4A.2Net Present Value (NPV) Method
4A.3Internal rate of return (IRR) method
4A.4Summary
4A.5Questions
4A.0 OBJECTIVES
1)To study and understand the payback period method of
investment appraisal.
2)To study and understand the net present value method of
investment appraisal.
3)To study and understand the interna l rate of return method of
investment appraisal.
4A.1 PAYBACK PERIOD METHOD
It is one of the simplest method of investment appraisal. It
helps to calculate period within which initial investment or entire
cost of project would be completely recovered. It is also known as
pay-off or pay out method. It gives total number of years in which
the total investment in particular capital project pays back itself. As
per this method there will be no profit till the payback period is over.
Selection criteria : Accord ing to payback period criteria, project
with lowest payback period should be selected.
Following methods are used to calculate Payback period.
Type I
If the firm is generating constant cash flows every year, then
following formula will be used.
Payback Period =munotes.in
73
Example 1
Calculate Payback period for the following data and find
most suitable project.
Projects Initial Investment (In
Rupees)Net annual Cash
Inflows
A 30000 5000
B 30000 6000
C 30000 2000
D 30000 3000
Solution:
Projects Initial
InvestmentNet
annual
Cash
InflowsPayback Period
Payback Period =Ranks
A 30000 5000= 6 years2
B 30000 6000= 5 years1
C 30000 2000= 15 years4
D 30000 3000= 10 years3
On the basis of payback period project B should be selected.
Type II
If firm is generating uneven or different cash flows in different
years, then we have to calculate cumulative cash flows. The year in
which cumulative cash flow is equal to initial investment, that year
will be considered as payback period.
Example 1
Suppose an initial investment in a project is Rs. 50000 and
following are the annual cash flows. Calculate payback period.
Year Annual Cash flows
First 10000
Second 15000
Third 25000
Forth 40000
Fifth 60000munotes.in
74
Solution:
Year Annual Cash flows Cumul ative cash flows
First 10000 10000
Second 15000 25000
Third 25000 50000
Forth 40000 90000
Fifth 60000 150000
As initial investment is recovered in third year, payback period is 3
years.
Example 2
Suppose there are two projects A and B, with an init ial
investment of Rs. 100000 each. Cash flows of both the projects are
given below. Calculate payback period and find most suitable
project.
Year Annual Cash flows
For Project AAnnual Cash flows
For Project B
First 20000 40000
Second 30000 60000
Third 50000 70000
Forth 70000 90000
Fifth 90000 95000
Solution:
For project A
Year Annual Cash flows Cumulative cash flows
First 20000 20000
Second 30000 50000
Third 50000 100000
Forth 70000 170000
Fifth 90000 260000munotes.in
75
For project B
Year Annual Cash flows Cumulative cash flows
First 40000 40000
Second 60000 100000
Third 70000 170000
Forth 90000 260000
Fifth 95000 355000
For project A, initial investment is recovered in third year.
Therefore payback period is 3 years. For project B, initial
investment is recovered in second year. Therefore payback period
is 2 years. On the basis of payback period criteria, project B should
be selected.
Type III
After calculating cumulative cash flows, if we are not getting
cumulative cash flows exactly equa l to initial investment, then we
use following formula to calculate payback period.
Payback period = E +
Where,
E = Preceding year of final recovery
B = Balance amount to be recovered
C = Cash flow during the year of final recovery
Example 1
Suppose a n initial investment in a project is Rs. 20000 and annual
cash flows are as follows. Calculate payback period.
Year Annual Cash flows
First 4000
Second 6000
Third 9000
Forth 10000
Fifth 14000munotes.in
76
Solution:
Step 1:
Year Annual Cash flows Cumulat ive cash flows
First 4000 4000
Second 6000 10000
Third 9000 19000
Forth 10000 29000
Fifth 14000 43000
Step 2:
It can be seen from the above table that out of initial investment of
Rs. 20000, Rs. 19000 are recovered in third year and Rs. 29000
are re covered in the fourth year. Therefore payback period lies
between third and fourth year. The balance amount still to be
recovered is Rs. 1000. (i.e. 20000 –19000 = 1000)
Step 3:
Payback period = E +
Where,
E = Preceding year of final recovery = 3 year s.
B = Balance amount to be recovered = Rs. 1000
C = Cash flow during the year of final recovery = 10000
Therefore, Payback period = 3 + = 3 + 0.1 = 3.1 years .
Merits of Payback period Method
1)This method is simple to calculate and easy to understand.
2)This method is more realistic because psychology of any
investor is that he/she would like to get back initial investment
as soon as possible.
3)This method is relatively safe because it avoids risk in long run.
4)This method help us to rank various projects an d select best out
of them.
5)This method gives importance to the speedy recovery of initial
investment.
Demerits of Payback Period Method
1)It stresses only on the recovery of initial investment and
completely ignores the annual cash inflow after the payback
period
2)This method oversee the interest i.e. costs of capital which is an
important part of making sound investment decisions.
3)This method ignores time value of money.munotes.in
77
Check your progress :
1)Calculate Payback period for the following data and find most
suitable project.
Projects Initial Investment
(In Rupees)Net annual Cash Inflows
A 20000 5000
B 20000 4000
C 20000 2000
D 20000 10000
2)Suppose an initial investment in a project is Rs. 25000 and
following are the annual cash flows. Calculate payback period.
Year Annual Cash flows
First 4000
Second 8000
Third 13000
Forth 20000
Fifth 30000
3)Suppose there are two projects A and B, with an initial
investment of Rs. 20000 each. Cash flows of both the projects are
given below. Calculate payback perio d and find most suitable
project.
Year Annual Cash flows
For Project AAnnual Cash flows
For Project B
First 4000 3000
Second 5000 4000
Third 11000 6000
Forth 15000 7000
Fifth 18000 10000munotes.in
78
4A.2 NET PRESENT VALUE (NPV) METHOD
Investment in project generates series of income (cash
inflows) over a number of years. It is also known as discounted
cash flow technique. NPV method considers the time value of
money. To find out whether investment is worthwhile or not, the
present value of this se ries of income (cash inflows) is calculated at
a given rate of discount. This gives us Gross Present Value (GPV).
If we deduct initial cost (investment) of project from GPV we get Net
Present Value i.e. NPV.
Investment should be made if present value of t he expected future
cash inflows from project is larger than the cost of the investment.
In simple terms if NPV > 0 then accept the project and if NPV < 0,
then reject the project. In case of more than one project, project
with higher NPV should be preferre d by the firm.
NPV = GPV –Initial Cost.
If R 1, R2, R3, ……. R nare yields of assets after first, second, third,
………nthyear and r is the rate of discount then,
NPV =
Example1
If an initial investment is Rs. 20000 in a project. The project
gener ates annual cash inflows of Rs. 6000, Rs. 10000 and Rs.
15000 for 3 years respectively. If rate of discount is 12 % p.a. then
calculate NPV and find out whether project should be accepted or
rejected.
Solution:
NPV =
NPV =
NPV =
NPV =
NPV =
NPV =
NPV =
As NPV is positive, project should be selected.
Example2
If an initial investment is Rs. 30000 in a project. The project
generates annual cash inflows of Rs. 10000, Rs. 12000 and Rs.munotes.in
79
15000 for 3 years respectively. If rate of discount is 12 % p.a. then
calculate NPV and find out whether project should be accepted or
rejected.
Solution:
NPV =
NPV =
NPV =
NPV =
NPV =
NPV =
NPV =
As NPV is negative, project should be rejected.
Merits of NPV Method
1)This method takes into account the time value of money.
2)This method takes into account entire series of cash inflows that
are generated.
3)This method is simple to understand, here we simply accept or
reject the project on the basis of NPV.
4)This method help us to take corre ct decision if we are looking
for maximum profits.
Demerits of NPV method
1)This method involves good amount of calculations and it is little
complicated method.
2)If we want to use this method, knowledge of discount rate is
must. If we are not aware of disco unting rate then we cannot
use this method.
3)The use of this method needs forecasting of future cash inflows
and the discount rate. Thus correctness of Net Present Value
depends on accurate estimation future cash inflows and the
discount rate. This may not be possible in reality.
Check your Progress :
1)If an initial investment is Rs. 60000 in a project. The project
generates annual cash inflows of Rs. 1 0000, Rs. 12000 and
Rs.15000 for 3 years respectively. If rate of discount is 1 5%
p.a. then calculate NP V and find out whether project should be
accepted or rejected.
2)If an initial investment is Rs. 2 5000 in a project. The project
generates annual cash inflows of Rs. 8000, Rs. 9000, Rs.
10000 and Rs. 1 1000 for 4 years respectively. If rate ofmunotes.in
80
discount is 1 0% p.a. then calculate NPV and find out whether
project should be accepted or rejected.
4A.3 INTERNAL RATE OF RETURN (IRR) METHOD
Internal rate of return method like NPV also considers time
value of money by discounting annual cash inflows. Thi s method is
also known as time adjusted rate of return method. In this method
we find out that rate of return which will equate the present value of
future cash inflows to the present cost of the project. It is generally
the rate of return that project ea rns. It is the discount rate (r) which
equates aggregate present value of the net cash inflows with
aggregate present value of cash outflows of a project. In simple
terms it is the rate which makes NPV of a project equals to zero. In
case of multiple proje cts, project with higher IRR should be
selected.
Following formula is used for calculating IRR.
I =
Where,
I = Initial Investment
R = Cash flows
r = Rate of return
Example 1
If a sum of Rs. 800 is invested in a project, it will earn Rs. 1000 at
the en d of one year. Calculate IRR.
I =
Where,
I = Initial Investment = Rs. 800
R = Cash inflows = Rs 1000
r = Rate of return = ?
800 =
800 (1+ r) =1000
800 + 800 r = 1000
800 r = 1000 –800
800 r = 200munotes.in
81
r =
r = 0.25
or
r = 25 %
Example 2
If a sum of R s. 20000 is invested in a project, it will earn Rs.
120000 at the end of one year. Calculate IRR.
I =
Where,
I = Initial Investment = Rs. 20000
R = Cash inflows = Rs 120000
r = Rate of return = ?
20000 =
20000 (1+ r) =120000
20000 + 20000 r = 120000
20000 r = 120000 –20000
20000 r = 100000
r =
r = 5
or
r = 5 %
Merits of IRR Method
1)Like NPV, this method also takes into account the time value of
money.
2)This method provides meaningful consideration to the
entrepreneurs in their decision making proce ss.
3)This method is more realistic as it deals with the entire range of
annual cash inflows earned during lifetime of the project.
Demerits of IRR method
1)This method is difficult to understand and tedious to calculate.
2)It does not consider the size of th e project while comparing
projects. Here cash inflows are compared with the volume of
capital expenditure. So it is unsuitable method for ranking the
projects.
Check your Progress :
1)If a sum of Rs. 2000 is invested in a project, it will earn Rs. 1500
atthe end of one year. Calculate IRR.
2)If a sum of Rs. 5000 is invested in a project, it will earn Rs. 2500
at the end of one year. Calculate IRR.munotes.in
82
3)If a sum of Rs. 20000 is invested in a project, it will earn Rs.
200000 at the end of one year. Calculate IRR.
4A.4SUMMARY
Capital budgeting or investment appraisal is an official
procedure used by firm for assessing and evaluating possible
expenses or investments. It is a process of planning of expenditure
which involves current expenditure on fixed/d urable assets in return
for estimated flow of benefits in the long run. In this unit we have
discussed three important methods of investment appraisal with
multiple examples viz. Pay Back period method, net present value
method and internal rate of return method. Payback Period Method
is one of the simplest method of investment appraisal. It helps to
calculate period within which initial investment or entire cost of
project would be completely recovered. According to payback
period criteria, project with lo west payback period should be
selected. NPV method considers the time value of money. To find
out whether investment is worthwhile or not, the present value of
this series of income (cash inflows) is calculated at a given rate of
discount. This gives us G ross Present Value (GPV). If we deduct
initial cost (investment) of project from GPV we get Net Present
Value i.e. NPV. Investment should be made if present value of the
expected future cash inflows from project is larger than the cost of
the investment. In simple terms if NPV > 0 then accept the project
and if NPV < 0, then reject the project. In case of more than one
project, project with higher NPV should be preferred by the firm.
Internal rate of return method like NPV also considers time value of
money by discounting annual cash inflows. This method is also
known as time adjusted rate of return method. In this method we
find out that rate of return which will equate the present value of
future cash inflows to the present cost of the project. It is g enerally
the rate of return that project earns. It is the discount rate ( r ) which
equates aggregate present value of the net cash inflows with
aggregate present value of cash outflows of a project. In simple
terms it is the rate which makes NPV of a proj ect equals to zero. In
case of multiple projects, project with higher IRR should be
selected.munotes.in
83
4A.5QUESTIONS
1)Discuss in detail payback period method of investment
appraisal.
2)What are the merits and demerits of payback period method?
3)Discuss in detail net present value method of investment
appraisal.
4)What are the merits and demerits of net present value method?
5)Discuss in detail internal rate of return method of investment
appraisal.
6)What are the merits and demerits of internal rate of return
method?
7)Calculate Payback period for the following data and find most
suitable project.
Projects Initial Investment
(In Rupees)Net annual Cash Inflows
A 10000 5000
B 10000 4000
C 10000 2000
D 10000 3000
8)Suppose an initial investment in a project is Rs. 5000 and
following are the annual cash flows. Calculate payback period.
Year Annual Cash flows
First 1000
Second 1500
Third 2500
Forth 4000
Fifth 6000
9)Suppose there are two projects A and B, with an initial
investment of Rs. 50000 each. Cash flows of bo th the projects
are given below. Calculate payback period and find most
suitable project.munotes.in
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Year Annual Cash flows
For Project AAnnual Cash flows
For Project B
First 20000 10000
Second 30000 20000
Third 50000 30000
Forth 70000 50000
Fifth 90000 6000 0
10)Suppose an initial investment in a project is Rs. 30000 and
annual cash flows are as follows. Calculate payback period.
Year Annual Cash flows
First 6000
Second 9000
Third 13000
Forth 18000
Fifth 25000
11)If an initial investment is Rs. 50000 in a project. The project
generates annual cash inflows of Rs. 15000, Rs. 20000 and Rs.
25000 for 3 years respectively. If rate of discount is 10 % p.a.
then calculate NPV and find out whether project should be
accepted or rejected.
12)If an initial investment is Rs. 22000 in a project. The project
generates annual cash inflows of Rs. 7000, Rs. 9000, Rs.
12000 and Rs. 15000 for 4 years respectively. If rate of discount
is 12 % p.a. then calculate NPV and find out whether project
should be accepted or rejected.
13)Ifa sum of Rs. 1000 is invested in a project, it will earn Rs. 1500
at the end of one year. Calculate IRR.
14)If a sum of Rs. 3000 is invested in a project, it will earn Rs. 3500
at the end of one year. Calculate IRR.
15)If a sum of Rs. 20000 is invested in a proj ect, it will earn Rs.
100000 at the end of one year. Calculate IRR.
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