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INTRODUCTION TO BUSINESS
ECONOMICS
Unit Structure:
1.0 Objectives
1.1 Scope and Importance of Business Economics
1.2 Basic tools - Opportunity Cost principle - Incremental and Marginal
Concepts and Use of Marginal analysis in decision making
1.3 Basic eco nomic relations - functional relations: equations
1.4 Total, Average and Marginal relations
1.5 Summary
1.6 Questions
1.0 OBJECTIVES
• To understand Scope and Importance of Business Economics.
• To study the basic tools of Economics.
• To explore Basic eco nomic and functional relations.
• To understand use of Marginal analysis in decision making.
1.1 MEANING, SCOPE AND IMPORTANCE OF
BUSINESS ECONOMICS
1.1.1 MEANING
Business Economics is also called as Managerial Economics. It involves
application of econ omic theory and practice to business. In business,
decision making is very important. Decision making is a process of
selecting one course of action out of available alternatives. Thus business
economics serves as a link between economic theory and decisio n-making
in the context of business. Following are few definitions of Business
Economics.
Spencer and Siegelman:
It is “the integration of economic theory with business practice for the
purpose of facilitating decision making and forward planning by
manage ment.”
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2 Henry and Hayne:
“Business Economics is economics applied in decision making. It is a
special branch of economics. That bridges the gap between abstract theory
and managerial practice.”
Salvatore:
“Business Economics refers to the application of ec onomic theory and the
tools of analysis of decision science to examine how an organisation can
achieve its objectives most effectively.”
1.1.2 SCOPE OF BUSINESS ECONOMICS
Scope is nothing but the subject matter of business economics. Scope of
Business Econ omics is very wide.
1) Market Demand and Supply
In economics both demand and supply are the important forces through
which market economy functions. Individual demand for a product is
based on an individual’s choice / Preferences among different products,
price of the product, income etc. Individual demand is nothing but desire
backed by individual’s ability and willingness to pay. By summing up the
demand of all the consumers or individuals for the product we get market
demand for that particular product. Individual Supply is the amount of a
product that producer is willing to sell at given prices. By summing up the
supply of all the producers for the product we get market supply for that
particular product. The market price where the quantity of goods sup plied
is equal to the quantity of goods demanded is called as equilibrium price.
Existence, growth and future of business or firm depends on what price
market determines for its product.
2) Production and Cost Analysis
Knowledge of business economics help s manager to do production and
cost analysis. Production analysis helps to understand process of
production and to make optimum utilisation of available resources. Cost
analysis on the other hand helps firm to identify various costs and plan
budget accordi ngly. Both production and cost analysis will help firm to
maximize profit.
3) Market structure and Pricing Techniques
Markets are very important in business economics. Study of markets such
as perfect completion, monopoly, oligopoly, monopolistic market et c. is
very significant for producers. It is very imperative for manager or
producer to identify type of market that will be there for their products.
Knowledge of markets and competition will help them to take better
decision regarding pricing of the produ ct, marketing strategies etc. Pricing
techniques, on the other hand, helps the firms to decide best remunerative
price at different kinds of markets. munotes.in
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Introduction to Business
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3 4) Forecasting and coverage of risk and uncertainty.
Knowledge of business economics helps manager to for ecast future. For
example Demand forecasting. It means estimation of demand for the
product for a future period. Demand forecasting enables an organization to
take various decisions in business, such as planning about production
process, purchasing of raw materials, managing funds in the business, and
determining the price of the commodity. Likewise forecasting future helps
firm to take important decisions and cover risk and uncertainty associated
with those decisions.
5) Inventory Management
Knowledge of b usiness economics will help producer to reduce costs
associated with maintenance of inventory such as raw materials, finished
goods etc.
6) Allocation of resources
Business Economics provides advanced tools such as linear programming
which helps to achieve optimal utilisation of available resources.
7) 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 w hich 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 development projects are worth the
funding or not. Knowledge of business economics helps producer to take
appropriate investment decisions with the help of capital budgeting.
1.1.3 IMPORTANCE OF BUSINESS ECONOMICS
1. Knowledge of b usiness economics helps business organization to take
important decisions as it deals with application of economics in real
life situation.
2. It helps manager or owner of firm to design policies suitable for their
firm or business.
3. Business economics i s useful in planning future course of action.
4. It helps to control cost and monitor profit by doing cost benefit
analysis.
5. It helps in forecasting future for taking important decisions in present.
6. It helps to set appropriate prices for various prod ucts by using
available pricing techniques. munotes.in
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Business Economics -I
4 7. It helps to analyse effects of various government policies on business
and take appropriate decision.
8. It helps to degree of efficiency of firms by using various economic
tools.
1.2 BASIC TOOLS IN BUSINESS E CONOMICS
Opportunity cost :
Individuals face Trade -offs in day to day life. It is a conflicting situation
where people have to make decision or make choices among available
alternatives. The moment selection takes place, the counterpart becomes
opportunity cost. Opportunity lost is nothing but opportunity cost. If you
decide to attend lecture, then you have to sacrifice on time that you could
have spent otherwise. If you plant potatoes in your field, you must forego
the chance of planting another crop beca use your resources are limited.
Opportunity cost plays very important role in decision making. Doing one
thing excludes doing something else. In other words, when we select
something, we pay a cost, which is the cost of not being able to do the next
best t hing.
Marginalism :
Rational decision makers will always think in terms of marginal
quantities. One should compare the cost of an additional chocolate with
the benefits of an extra chocolate in order to decide whether to have it or
not. If the additional r evenue that the producer is going to get by
producing one more car is greater than the cost of producing the extra car,
only then the seller will produce an extra car.
Let us take one example, an additional car sells for Rs. 10 lacks while it
costs only R s. 8 lakhs to produce the additional car. Clearly, a rational
producer will decide to produce the car because he will make profit of Rs.
2 lakhs per car. On the other hand, if the price of car falls to Rs.7 lakhs
while the cost of producing it remains Rs. 8 lakh, it will not make sense to
produce the additional car since the cost surpasses the revenue to be
earned from it. The cost of producing the extra car is called as marginal
cost while the revenue obtained from selling an extra car is called as
margina l revenue. If marginal revenue exceeds marginal cost, it obviously
makes sense to produce the extra car. If the marginal revenue is less than
marginal cost, it not advisable to produce the extra car.
Let us take another example from your day to day life. Suppose you may
score 10 additional marks in economics by studying for entire night.
Getting the additional 10 marks is important because it makes you feel
happy and proud. But suppose staying up for entire night makes you feel
really sleepy in the mornin g hence makes you feel dull and unhappy. In
this case, whether you should study for entire night depends upon whether
the happiness that you get from the 10 additional marks in economics
overshadows the unhappiness caused by the additional sleeplessness. In munotes.in
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Introduction to Business
Economics
5 this way individuals can make use of marginalism principal in their day to
day life for making appropriate decisions.
Incrementalism :
Marginalism represents small unit change in the concerned variables. But
many times in real life situations changes ta kes place in chunks or batches.
For example firm producing car will not generally increase its production
by one unit, but by a batch of additional units. Here we use concept of
incrementalism instead of marginalism and decision will be taken by
comparing incremental cost and incremental revenue.
Check your progress :
1) What do you mean by Business Economics?
2) Why knowledge of Business Economics is important?
3) Define opportunity cost.
4) Distinguish between Marginalism & Incrementalism.
1.3 BASIC ECON OMIC RELATIONS - FUNCTIONAL
RELATIONS: EQUATIONS - TOTAL, AVERAGE
AND MARGINAL RELATIONS
The Relationship between Total, Average and Marginal can be explained
with the help of concepts like utility, cost, revenue etc. Here we will take
example of revenue co ncepts.
Where, P = Price & Q = Quantity
TR = Total Revenue
AR = Average Revenue
MR = Marginal Revenue
Quantity Price TR AR MR
1 30 30 30 30
2 28 56 28 26
3 26 78 26 22
4 24 96 24 18
5 22 110 22 14
6 20 120 20 10
7 18 126 18 6
8 16 128 16 2
9 14 126 14 -2
10 12 120 12 -6
Tabel 1
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6 Total revenue is calculated by multiplying price and quantity. As quantity
increases TR increases initially then it decreases. AR is same as price. MR
decreases constantly and becomes negative eventually.
Important conce pts
1. Variables
A variable is magnitude of interest that can be measured. Variables can be
endogenous and exogenous variables. Variables can be independent and
dependent.
2. Functions
Function shows existence of relationship between two or more variable s.
It indicates how the value of one variable depends on the value of another
one. It does not give any direction of relation.
3. Equations
An equation specifies the relationship between the dependent and
independent variables. It specifies the direction of relation.
4. Graph
Graph is a geometric tool used to express the relationship between
variables. It is a pictorial representation of data which shows how two or
more sets of data or variables are related to one another.
5. Curves
The functional relati onship between the variables specified in the form of
equations can be shown by drawing line or outline which gradually
deviates from being straight for some or all of its length in the graph.
6. Slopes
Slopes show how fast or at what rate, the dependant variable is changing
in response to a change in the independent variable.
1.4 SUMMARY
In this unit we have seen meaning, scope and importance of business
economics. Business Economics is also called as Managerial Economics.
It involves application of econ omic theory and practice to business. In
business, decision making is very important. Decision making is a process
of selecting one course of action out of available alternatives. Thus
business economics serves as a link between economic theory and
decisio n-making in the context of business. Scope of business economics
involves Market Demand and Supply, Production and Cost Analysis,
Market structure and Pricing Techniques, Forecasting and coverage of risk
and uncertainty, Inventory Management, Allocation of resources, Capital
Budgeting etc. We have also discussed basic tools in economics such as
opportunity cost, marginalism and incrementalism. Business economics munotes.in
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Introduction to Business
Economics
7 deals with many economic relations and various concepts such as
variables, functions, equations, graph, curves and slopes.
1.5 QUESTIONS
1) Discuss scope and importance of business economics.
2) Write short note on Opportunity Cost.
3) Write short note on Marginalism
4) Discuss use of marginal analysis in decision making.
5) Write short note on Incre mentalism.
6) Explain following concepts -
a. Variables
b. Functions
c. Equations
d. Graph
e. Curves
f. Slopes
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8 2
MARKET DEMAND AND MARKET
SUPPLY
Unit Structure :
2.0 Objectives
2.1 The basics of market demand, market supply and equilibrium price
2.2 Shifts in the demand and supply curves and equilibrium
2.3 Summary
2.4 Questions
2.0 OBJECTIVES
1) To study the ba sics of market demand, market supply and equilibrium
price.
2) To study shifts in the demand and supply curves and equilibrium.
2.1 MARKET DEMAND, MARKET SUPPLY AND
EQUILIBRIUM PRICE
In economics both demand and supply are the important forces through
which market economy functions. Individual’s demand is desire backed by
his / her ability and willingness to pay. There is an indirect or negative
relationship between price and quantity demanded. Individual Supply is
the amount of a product that producer is wi lling to sell at given prices.
There is a direct or positive relationship between price and quantity
supplied.
Market Demand
Individual demand for a product is based on an individual’s choice /
Preference among different products, price of the product, inc ome etc.
Individual demand is nothing but desire backed by individual’s ability and
willingness to pay. By summing up the demand of all the consumers or
individuals for the product we get market demand for that particular
product.
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Market Demand and Market
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9 Table 2.1Market Dema nd Schedule
Price Demand of
Individual A Demand of
Individual
B Market Demand
(Demand of Individual A +
Demand of Individual B)
10 5 7 12
20 4 6 10
30 3 5 8
40 2 4 6
50 1 3 4
The above table 2.1 represents demand schedule of individual A,
individual B and Market Demand. Same schedule can be represented with
the help of a graph.
Diagram 2.1 Market Demand Curve
Diagram 2.1 represents demand curve of individual A, individual B and
Market Demand. DA is a demand curve of individual A. DB is the
deman d curve of individual B. DM is the market demand curve. All curves
are downward sloping indicating negative relationship between price and
quantity demanded. munotes.in
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Business Economics -I
10 Market Supply
Individual Supply is the amount of a product that producer is willing to
sell at giv en prices. By summing up the supply of all the producers for the
product we get market supply for that particular product.
Table 2.2 Market Supply Schedule
Price Supply of
Producer A Supply of
Producer B Market Supply
(Supply of Producer A +
Supply of Prod ucer B)
10 1 3 4
20 2 4 6
30 3 5 8
40 4 6 10
50 5 7 12
The above table 2.2 represents supply schedule of producer A, producer B
and Market supply. Same schedule can be represented with the help of a
graph.
Diagram 2.2 Market Supply Curve
Diagram 2.2 represents supply curve of producer A, producer B and
Market supply. SA is a supply curve of producer A. SB is the supply curve munotes.in
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Market Demand and Market
Supply
11 of producer B. SM is the market supply curve. All curves are upward
sloping indicating positive relationship between price and quantity
demanded.
Equilibrium Price
The market price where the quantity of goods supplied is equal to the
quantity of goods demanded is called as equilibrium price. This is the
point at which the market demand and market supply curves intersects.
Tabl e 2.3 Equilibrium Price Schedule
Price Market Demand Market Supply
10 12 4
20 10 6
30 8 8
40 6 10
50 4 12
The above table 2.3 represents schedule of equilibrium price. Same
schedule can be represented with the help of a graph to locate equilibrium
price. Even in the table itself it is very clear that 30 is equilibrium price as
at this price, market demand is equal to market supply i.e. 8 units.
Diagram 2.3 Equilibrium Price.
Diagram 2.3 represents Equilibrium Price. DM is the market demand
curve. D M is downward sloping curve indicating inverse or negative
relationship between price and quantity demanded. SM is the market
supply curve. SM is upward sloping curve indicating direct or positive munotes.in
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Business Economics -I
12 relationship between price and quantity supplied. DM and SM curves
intersect each other at point E where equilibrium price is 30 and
equilibrium quantity demanded and supplied is 8 units.
Check your Progress :
1) What do you mean by Individual Demand & Market Demand?
2) What do you mean by Individual Supply & Mark et Supply?
3) Define Equilibrium Price.
2.2 SHIFTS IN DEMAND AND SUPPLY CURVES
AND EQUILIBRIUM
2.2.1 SHIFTS / CHANGES IN DEMAND :
Shifts in demand takes place due to changes in non -price factors such as
income, population, government policies, tastes, pr eferences, habits,
fashion etc. Whenever there are favourable changes in these factors then
the demand curve shifts outward. It is also known as Increase in Demand.
Whenever there are unfavourable changes in these factors then the demand
curve shifts inwar d. It is also known as Decrease in demand.
Diagram 2.4 Changes in Demand
In the above diagram D is the original demand curve. At price P, OQ
quantity is demanded. If there are favourable changes in the non -price
factors affecting demand then the demand curve shifts outward and
becomes D1. Here we can see that at same price P, now more quantity i.e.
OQ1 quantity is demanded. If there are unfavourable changes in the non -
price factors affecting demand then the demand curve shifts inward and
becomes D2. Here we can see that at same price P, now less quantity i.e.
OQ2 quantity is demanded. Shift from D to D1 is known as Increase in
Demand and shift from D to D2 is known as Decrease in Demand. munotes.in
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Market Demand and Market
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13 2.2.2 SHIFTS / CHANGES IN SUPPLY
Shifts in supply takes place due to changes in non -price factors such as
cost of production, government policies, state of technology etc.
Whenever there are favourable changes in these factors then the supply
curve shifts outward. It is also known as Increase in supply. Whenever
there are unfavourable changes in these factors then the supply curve
shifts inward. It is also known as Decrease in supply.
Diagram 2.5 Changes in Supply
In the above diagram S is the original supply curve. At price P, OQ
quantity is supplied. If there are favou rable changes in the non -price
factors affecting supply then the supply curve shifts outward and becomes
S1. Here we can see that at same price P, now more quantity i.e. OQ1
quantity is Supplied. If there are unfavourable changes in the non -price
factors a ffecting supply then the supply curve shifts inward and becomes
S2. Here we can see that at same price P, now less quantity i.e. OQ2
quantity is supplied. Shift from S to S1 is known as Increase in Supply and
shift from S to S2 is known as Decrease in Supp ly.
2.2.3 SHIFTS IN EQUILIBRIUM
The market price where the quantity of goods supplied is equal to the
quantity of goods demanded is called as equilibrium price. This is the
point at which the market demand and market supply curves intersects.
Whenever ther e are changes in demand and supply, position of
equilibrium will change.
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14 Diagram 2.6 Effects of Changes in Demand on Equilibrium
In the above diagram D is the original demand curve and S is the original
Supply curve. At equilibrium E, equilibrium pric e is P and equilibrium
quantity demanded and supplied is OQ. If there are favourable changes in
the non -price factors affecting demand then the demand curve will shift
outward and become D1. Now the new equilibrium is at E1. At E1,
equilibrium price is P1 and equilibrium quantity demanded and supplied is
OQ1. If there are unfavourable changes in the non -price factors affecting
demand then the demand curve will shift inward and become D2. Now the
new equilibrium is at E2. At E2, equilibrium price is P2 and e quilibrium
quantity demanded and supplied is OQ2. Thus increase in demand leads to
higher price and decrease in demand leads to lower prices.
Diagram 2.7 Effects of Changes in Supply on Equilibrium
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Market Demand and Market
Supply
15 In the above diagram D is the original demand curve and S is the original
Supply curve. At equilibrium E, equilibrium price is P and equilibrium
quantity demanded and supplied is OQ. If there are favourable changes in
the non -price factors affecting supply then the supply curve will shift
outward and become S1 . Now the new equilibrium is at E1. At E1,
equilibrium price is P1 and equilibrium quantity demanded and supplied is
OQ1. If there are unfavourable changes in the non -price factors affecting
supply then the supply curve will shift inward and become S2. Now the
new equilibrium is at E2. At E2, equilibrium price is P2 and equilibrium
quantity demanded and supplied is OQ2. Thus increase in supply leads to
lower price and decrease in supply leads to higher prices.
Check you Progress :
1) List out the factors th at lead to changes in demand.
2) List out the factors that lead to changes in supply.
2.3 SUMMARY
In economics both demand and supply are the important forces through
which market economy functions. Individual demand for a product is
based on an individua l’s choice / Preference among different products,
price of the product, income etc. Individual demand is nothing but desire
backed by individual’s ability and willingness to pay. By summing up the
demand of all the consumers or individuals for the product we get market
demand for that particular product. Individual Supply is the amount of a
product that producer is willing to sell at given prices. By summing up the
supply of all the producers for the product we get market supply for that
particular product. The market price where the quantity of goods supplied
is equal to the quantity of goods demanded is called as equilibrium price.
Existence, growth and future of business or firm depend on what price
market determines for its product. In this unit we studi ed derivation of
individual and market demand and supply curves along with derivation of
equilibrium price and quantity. We have also seen how shifts in demand
and supply takes place along with their effect on equilibrium level of price
and quantity.
2.4 QUESTIONS
1) Write short note on Market Demand.
2) Write short note on Market Supply.
3) Write short note on Equilibrium Price.
4) Complete the following table and draw the graph.
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16 Price Demand of Individual A Demand of Individual B Market
Demand
10 15 10 ?
20 14 9 ?
30 13 8 ?
40 12 7 ?
50 11 6 ?
5) Complete the following table and draw the graph.
Price Supply of Producer A Supply of Producer B Market Supply
10 8 6 ?
20 9 7 ?
30 10 8 ?
40 11 9 ?
50 12 10 ?
6) Write short note on changes in Demand.
7) Write sho rt note on changes in supply.
8) What are the effects of changes in Demand on equilibrium?
9) What are the effects of changes in Supply on equilibrium?
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17 3
DEMAND ANALYSIS
Unit Structure :
3.0 Objectives
3.1 Introduction
3.2 Demand function
3.3 Determinant of demand
3.4 Meaning of demand
3.5 Law of demand
3.6 Nature of demand curve under different markets
3.7 Elasticity of demand
3.8 Price elasticity of de mand
3.9 Factors affecting price elasticity
3.10 Measures of price elasticity
3.11 Degrees of price elasticity of demand
3.12 Income elasticity of demand.
3.13 Cross elasticity of demand.
3.14 Promotional elasticity of demand
3.15 Concepts of revenue.
3.16 Summary
3.17 Questions
3.0 OBJECTIVES
To understand the demand and its function.
To study the various factors which determines the demand.
To familiarise with the various concepts of elasticities of demand.
To understand with the concepts of revenue.
3.1 INTRODUCTION
In economics both demand and supply are the important forces through
which market economy functions. The demand function shows the
relationship between the quantity demanded and its various determinants.
In this chapter we will explain the demand function in detail and the munotes.in
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Business Economics -I
18 nature of demand curve under different market situation. We will also
explain the relationship between elasticity of demand and revenue
concepts.
3.2 DEMAND FUNCTION
Demand function is an arithmetic expression that shows the functional
relationship between the demand for a commodity and the various factors
affecting it. This includes the income of a consumer and the price of a
commodity along with other various determining factors affecting
demand. The demand for a commodi ty is the dependent variable, while its
determinants factors are the independent variables.
The demand for a commodity depends on various factors which
determines the quantity of a commodity demanded by various individuals
or a group of individuals. The fo llowing equation shows the demand
function which expresses the relationship between the quantity demanded
of a commodity X and its determinants. x x yQd = f P , Y, P , T, A
Where, x Qd= Quantity demanded of commodity X. xP= Price of commodity X. Y= income of a consumer. yP= Price of related commodities. T= Taste and Preference of an individual consumer. A= Adverting expenditure made by producer.
3.3 DETERMINANTS OF DEMAND
The important determinants of demand for a commodity are explained
below:
1. Price of commodity (P x): The price of commodity is very important
determinants of demand for any commodity. Other th ings remaining
same, the rise in price of the commodity, the demand for the
commodity contracts, and with the fall in price, its demand expands.
So, the quantity demanded and price shows an inverse relationship in
the case of normal goods. In other word ch anges in price brings
changes in the consumer’s demand for that commodity.
2. Income (Y): Another important determinant of demand for a
commodity is consumer’s income. Change in consumer’s income also
influences the change in consumer’s demand for a commoditi es. The
demand for normal goods increases with the increasing level of munotes.in
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Demand Analysis
19 income and vice versa. it shows a direct relationship between income
and quantity demanded.
3. Price of related commodities (P y):The demand for a commodity is
also affected by the price of other commodities, especially of
substitute or complementary goods. A good may have some related
goods either substitute or complementary. The relation between two
may be different.
Substitute Goods: Substitute Goods are those goods which can be
substituted from each other. For Instance Tea & Coffee. When the rise in
the price of Tea causes rise in demand for Coffee because there is no
change in price of coffee such goods are called as substitute goods. In
other words the relation between two substitute goods are positive. An
incase the price of one commodity increase the demand for other.
Complementary Goods: Complementary goods are those goods which
one purchased together. For Instance Car & Petrol. when their a rise in
price of Petrol leads to fall i n demand for Car such goods are called
complementary good. In other words, the relation between two
complementary goods are negative. An increase in price of one
commodity leads to decrease in demand for other.
4. Taste and Preference (T): The demand for a commodity also depends
on the consumer’s taste and preferences such as change in fashion,
culture, tradition etc. As the consumers taste and preference for a
particular commodity changes the demand for that particular
commodity also changes. Therefore, Tas te and Preference of a
consumer plays an important role.
5. Advertising expenditure (A): Advertising expenditure by a firm
influence the demand for a commodity. The advertisements by the
manufacturer and sellers attract more customers towards the
commodity . There exists positive relationship between advertising
expenditure and demand for the commodity.
3.4 MEANING OF DEMAND
The demand in economics means the desires to purchase the commodity
backed by willingness and the ability to pay for it.
Demand= De sire + Willingness to buy + Ability to pay
3.5 THE LAW OF DEMAND
The law of demand was propounded by the famous economist Alfred
Marshall in early 189 3. Due to the general observation of law, economists
have come to accept the validity of the law under mos t situations. The law
of demand states that other thing being equal the relationship between the
price and the quantity demanded of a commodity are inversely related to
each other. In other words, when the price of a commodity rises the munotes.in
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Business Economics -I
20 quantity demand for the commodity falls. The law of demand helps to
explain the consumer’s choice behaviour due to change in the price of a
commodity.
Assumptions:
The law of demand is based on the following assumption given below:
1. No change in consumers income: There should not be any change in
the consumer income while operating under the law of demand. If
income of a consumer increases the consumer may buy more goods at
the same price or buy the same quantity even if price increases. The
income is assumed to be constant, a s it may lead to enticement to the
consumer to buy more goods and raise the demand for a commodity
despite an increase in the price of commodity.
2. No change in the price of other goods: The price of substitute goods
and complimentary good should remain the same. If any of the price
changes may lead to change in the demand for the other commodity
and it will change the consumer preference will affect the law of
demand.
3. No change in taste and preference: The law assumes that the
consumer’s taste and preference for a commodity remains the same. If
there is a change in consumer’s taste and preferences there will be a
change in the demand for the commodity.
4. No expectation of change in the future price: The law of demand
remains valid if there is no change in futu re expectation about price of
commodities. If consumer is expecting rise in price in future, he will
buy more quantities even at a higher price in present time and vice -
versa.
5. No change in the size and composition of population: The law also
assumes that t he size and composition of the total population of a
country should not change. That means, the population must neither
increase nor decrease. Because a rise in the populations would increase
the demand for commodities. Along with the size of population,
composition of population also matters. If number of senior citizens is
more then the demand for medical care will be more. If female
population is more then the demand for cosmetics will be more.
6. No change in government polices: The law assumes that there is no
change in the government policy which will either increases or
decreases the demand for the commodity.
Demand Schedule and Demand Curve:
The law of demand can be simply explained through a demand schedule
and demand curve. The demand schedule is a ta bular representation of the
law of demand which is shown below:
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Demand Analysis
21 Demand Schedule: Table 3.1
Price (`) Quantity demanded of a commodity ‘X’
(Units)
50 10
40 20
30 30
20 40
10 50
Representation of table:
It can be seen from the above table, that when the price of a commodity
‘X’ is `50 per unit, the consumer purchases 10 units of the commodity.
Further when the price of the commodity falls to `40, he purchases 20
units of commodity. Similarly, when the price falls further the quantity
demand by the con sumer goes on increasing by 30 units as so on. This
demand schedule shows the inverse relationship between the price and
quantity demanded of a commodity.
Demand curve:
Quantity Demand
Diagram 3.1
The demand schedule can also be explained through demand curve in a
simpler way. The demand curve is a graphical representation of the
quantities of good demanded by the consumer at various possible price in
a period of time. The Diagram shows quantity demanded on X -axis and
the price of a commodity on Y -axis. If the demand schedule is plotted on
the demand curve, we get the various price -quantity combination points
and if we join these points, we get the downward slopping demand curve. munotes.in
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Business Economics -I
22 Thus, the downward sloping demand curve according to law of demand
shows, the inverse relationship between price and quantity demanded.
Exceptions to the Law of Demand: The law of demand is generally valid
in most of the cases but there are few cases where the law is not
applicable. Such cases are explained below:
1. Goods having pres tige value (Veblen effect): This exception to the
law of demand was propounded by an economists Thorstein Veblen in
his work ‘conspicuous consumption’. According to him, some
consumer measures the utility of a commodity by its price i.e., the
higher the pr ice of a commodity, the higher its utility. For example,
People sometimes buy certain expensive or prestigious goods like
diamonds at high prices not due to their intrinsic value but only
because it has snob value. On the other hand, as price falls, they
demand less due to the loss of its snob value. This effect is called as
Veblen effect or Snob value.
2. Giffen goods: Another exception to the law of demand was put
forwarded by the economists Sir Robert Giffen. There is a direct price
– demand relationship in case of giffen goods. When with the rise in
the price of a giffen goods, its quantity demand increases and with the
fall in its price its quantity demand decreases, the demand curve will
slope upward to the right hand side and not downward.
3. Price Expecta tions: When the consumer expects there is rise in price
of a commodity in future, he/she may purchase more of commodity at
present. Where the law of demand is not applicable.
4. Emergencies: During the time of emergencies such as natural and
man-made calamiti es, the law of demand becomes ineffective. In such
circumstances, people often fear the shortage of the necessity goods
and hence demand more goods and services even at higher prices.
5. Change in fashion and taste &preferences: The change in taste and
preferences of the consumers denies the effect of law of demand. The
consumer tends to buy those commodities which are in trends in the
market even at higher prices. On the other hand, when a product goes
out of fashion, a reduction in the price of the product m ay not
increases the demand for it.
Check your Progress :
1) Who propounded the theory of law of demand?
2) What relationship does law of demand state between demand & price?
3) What is Veblen effect?
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Demand Analysis
23 3.6 NATURE OF DEMAND CURVE UNDER
DIFFERENT MARKETS
Economist have classified the various markets prevailing in a capitalist
economy into (a) perfect competition or pure competition, (b)
monopolistic competition, (c) oligopoly and (d) monopoly. According to
Cournot, a French economist, “Economist understan d by the term market
not any particular market place in which things are bought and sold but the
whole of any region in which buyers and sellers are in such free
interaction with one another that the price of the same good tends to
equality easily and quic kly’’. The type of different market depends on
number of factors. Accordingly, the nature of demand curve is different in
different market. The nature of demand curve under various market
structure are as follows:
Demand Curve in Perfect Competition:
Perfect competition is said to prevail when there are large number of
producers (firms) producing and selling homogenous product. The
maximum output produce by the individual firm is very small relatively to
the total demand to the industry product so that fir m cannot affect the
price by varying its supply of output. The seller is the price taker he
accepts the price determined in the market by market demand and market
supply. Thus, the individual price under perfect competition is determine
by the market deman d and market supply.
Market Demand Curve: The market demand curve under perfect
competition is downward sloping. Because price and quantity demand are
inversely related to each other as the price of a commodity increases the
demand for that good decreases. The market price at which the firms will
sell their commodity is determined by the interaction of market demand
and market supply. Once the market determines the price for the
commodity all firms will fix their price equals to market price as they are
price taker under the perfect competition. Thus, the individual demand
curve is equal to the equilibrium price of the market. The Diagram 3.3.
shows the market demand curve which is downward sloping and P 0 is the
equilibrium market price which is followed by all the individual firm and
the individual firm is facing the horizontal demand curve. munotes.in
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Business Economics -I
24
Diagram 3.2
Individual Firm demand curve: Demand curve facing an individual firm
working under prefect competition is perfectly elastic i.e. a horizontal
straight line parallel to X axis at a given price which is determined by the
market demand sand market supply. The Diagram 3.3 shows Qty
demanded on X axis and Price of the commodity on Y axis. Where OP 1 is
the price determined by the interaction of market demand an d market
supply curve. It shows if firm tries to lower the price, he will get negative
profit.
Diagram 3.3
Demand Curve under Monopoly: Monopoly is a market where there is
single firm producing and selling product which has no close substitute.
As being the single seller monopoly has a control on supply and he can
also decide the price of a commodity. But however, a rational monopolist
who aim at maximum profit will control either price or supply. As
monopolists is the only single seller in the market, h e constitutes the
whole industry. Therefore, the demand curve under monopoly market is
downward sloping and has a steeper slope as shown in the Diagram 3.4.
below: munotes.in
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Demand Analysis
25
Diagram 3.4
Thus, in monopoly there is a strong barrier to entry new firm in the
industry. If the monopolist firm wants to increases the sale in the market,
he has to lower the price of its commodity.
Demand curve under Monopolistic competition: In the monopolistic
market there is a large number of firms producing or selling somewhat
differentiated product which have close substitute. As a result, demand
curve facing a firm under monopolistic competition is sloping downward
and has a flatter shape which is highly elastic and this indicate that a firm
enjoy some control over the price of a comm odity. The demand curve
facing an individual firm under monopolistic competition is shown in the
following Diagram 3.5.
Diagram 3.5
Demand curve under oligopoly market : Oligopoly is a market where
there are few firms or sellers producing or selling dif ferentiated products.
The fewness of firm ensures that each of them will have some control over
the price of the product and the demand curve facing each other will be
downward sloping which indicates the price elasticity of demand for each munotes.in
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Business Economics -I
26 firm will not b e infinite. As there are interdependence of firm. Any
decision regarding change in the price of output attracts reaction from the
rival firms. Therefore, the demand curve for an oligopoly firm is
indeterminate, i.e. it cannot be drawn accurately as exact b ehaviour pattern
of a producer with certainty.
The demand curve faced by the firm under oligopoly is shown in the
following Diagram 3.6:
Diagram 3.6
The demand curve facing an oligopolist is kinked in nature. The kink is
formed at a prevailing level the point K because the segment of the
demand curve above the prevailing price level i.e. Kd is highly elastic and
the segment the segment below the prevailing price level i.e. Kd 1 is
inelastic. This is due to different reaction of the different firm.
3.7 EL ASTICITY OF DEMAND
Elasticity of demand helps us to estimate the level of change in demand
with respect to a change in any of the determinants of demand. The
concept of elasticity of demand helps the firm or manager in decision
making with respect to pric ing, promotion and production polices. It has a
very great importance in economic theory ss well for formulation of
suitable economic policy.
Meaning of elasticity:
Elasticity is the measure of the degree of responsiveness of change in one
variable to the degree of responsiveness change in another variable.
Thus, Elasticity = % change in A% change in B
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Demand Analysis
27 The concept of elasticity of demand therefore refers to the degree of
responsiveness of quantity demanded of a good to the change in its price,
consumers income and price of related goods.
Check your Progress :
1) In which market condition market demand & market supply
determines the price of commodity?
2) Why Oligopoly demand Curve is kinked?
3) What is Elasticity?
3.8 PRICE ELASTICITY OF DEMAND
Price elas ticity of demand shows the degree of responsiveness of quantity
demanded of a good to the change in its price, other factors such as
income, prices of related commodities that determines demand for the
commodity which are held constant. In other words, pri ce elasticity of
demand is defined as the ratio of the percentage change in quantity
demanded of a commodity to a percentage change in price of the
commodity. Thus,
ep = Percentage change in quantity demanded
Percentage change in price
The demand curve for most of the commodities, is downward sloping due
to the inverse relationship between quantity demanded and price of the
commodity, the value of the price elasticity of demand will always be
negative. While interpreting the price elasticity of demand the n egative
sign is ignored or omitted. This is because we are interested in measuring
the magnitude of responsiveness of quantity demanded of a good to
changes in its prices.
3.9 FACTORS AFFECTING PRICE ELASTICITY OF
DEMAND
The price elasticity of demand depe nds upon number of factors which
affects its elasticity. They are as follows:
a. Nature of goods or commodity: The elasticity of demand for a
commodity depends upon the nature of the commodity, i.e., whether
the commodity is a necessary, comfort or luxury go od. The elasticity
of demand for a necessary commodity is relatively small. For example,
if the price of such a good rise, its buyers generally are not able to
reduce its demand as its necessity commodity.
The elasticity of demand for a luxury good is usua lly high. This is because
the consump tion of a such good, unlike that of a necessary commodity,
can be delayed. That is why if the price of such a commodity increase, the
demand for the good can be significantly reduced. munotes.in
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Business Economics -I
28 b. Availability of Substitute Goods: The price elasticity of demand also
depends upon the substitution of goods. If there is a close substitute for
a particular commodity in the market, then the demand for such
commodity would be relatively more elastic. For example, since tea
and coffee are close substitute for each other in the commodity market,
a rise in the price of coffee will result in a considerable fall in its
demand and a consequent rise in the demand for tea. Therefore, a
demand for coffee will be relatively more elastic because of t he
availability of tea in the market.
c. Alternative and Variety of Uses of the Product: as we know that the
resources have an alternative use. The demand for such goods has
many uses. The more the alternative and variety of uses of a good, the
more would be its elasticity of demand. For example, Electricity is
used for many purposes such as lighting, heating, cooking, ironing and
also use as a source of power in many industries & households. That is
why when the price of electricity increases, its demand will decrease
and vice versa.
d. Role of Habits and custom: i f the consumer has a habit of something,
he will not reduce his consumption even if the price of such
commodity increases the demand for them do not decreases
considerably and so their elasticity of dem and will be inelastic. Ex;
Alcohol, Cigarettes which are injurious for health but people still
consume it because of their habit.
e. Income Level of the consumer: The elasticity of demand differs due
to the change in the income level of the households. Elast icity of
demand for a commodity is low for higher income level groups then
the people with low incomes. This is because rich people are not
influenced much by changes in the price of goods. Poor people are
highly affected by the increase or decrease in the price of goods. As a
result, demand for the lower income group is highly elastic in demand.
f. Postponement of Consumption: if the consumer postponed the
consumption of commodity in future the demand is relatively elastic.
For example, commodities whose dema nd is not urgent, have highly
elastic demand as their consumption can be postponed if there is an
increase in their prices. However, commodities with urgent demand
like medicines have inelastic demand because it is an essential
commodity whose consumption cannot be post pended.
g. Time Period: Price elasticity of demand is related to a period of time.
The elasticity of demand varies directly with the time period. In the
short run the demand is generally inelastic and in long -run it becomes
relatively elastic . This is because consumers find it difficult to change
their habits, in the short run, in order to response to the change in the
price of the commodity. However, demand is more elastic in long run
as their other substitutes available in the market, if the price of the
given commodity rises.
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Demand Analysis
29 3.10 MEASUREMENTS OF PRICE ELASTICITY OF
DEMAND
There are various methods of measuring price elasticity of demand some
of the important methods are explained below:
A. Percentage method: This method is associated with the name of Dr
Alfred Marshall. This method is known by various names such as
Proportionate method, Ratio method, Arithmetic method, and Flux
method. The price elasticity of demand in this method is measured by
dividing percentage change in quantity demanded by the percentage
change in the price. In other it is the ratio of the percentage change in
quantity demanded of a commodity by the percentage change in the
price of the commodity itself.
Thus,
Ep= Percentage change in quantity demanded
Percentage change in price
Symbolically, Ep =
÷
=
Where, q = original quantity demanded.
p = original price.
Δq = change in quantity demanded.
Δ p= change in price.
As mentioned above, the price elasticity of demand has a negative sign
this is due to inverse relationship between price and quantity demanded.
But for simplicity in understanding the magnitude or the degree of
responsiveness we ignore the negative sign and take only numerical value
of elasticity.
B. Point method: Prof. Marshall devised a geometrical method for
measuring the elasticity of demand at a point on the demand curve. In
other word, the point elasticity of demand measures the elasticity of
demand at the p oint on the demand curve.
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30 This can be illustrated by the following given example:
Table 3.2
Price of commodity
X Quantity demanded
of X Point
20
15
60
90
A
B
The above table is represented in the following Diagram 3.7.
Diagram 3.7
The elasticity is at point A & B
Elasticity at point A = //qqpp 30/605/2030 105 601.10
Elasticity at point B 30/905/530 55 900.33
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Demand Analysis
31 C. Arc elasticity of demand: In the above measure we have studied the
measurement of elasticity at a point on a demand curve. When
elasticity is measured between two points on the same demand curve,
it is known as arc elasticity. According to Prof. Baumol, “Arc
elasticity is a measure of the average responsiveness to the change in
price exhibited by a demand curve over some finite stretch of the
demand curve.”. Any two points on the same demand curve make an
arc shows the arc elasticity of demand. In other words, arc price
elasticity of demand measures elasticity of demand at two points on
the demand curve.
12 1222qpEpqq p p
21 21
21 21
21 21
212190 60 15 2015 20 90 6030 35
5 150
1.39
qq p p
qq p p
qq p p
ppqq
D. Geometrical measure of elasticity of demand: If there is a linear
demand curve the point elasticity of demand is measured by
geometrical method i.e. it is the ratio of lower segment of t he demand
curve below the point to the upper segment of the demand curve above
the point on the demand curve.
Symbolically,
Ep = Lower segment of the demand curve below the point
Upper segment of the demand curve above th e point
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32 The geometric method can be explained through the Diagram 3.8 given
below:
Diagram 3.8
3.11 DEGREES OF ELASTICITY OF DEMAND
Different commodities have different elasticities of demand. Some
commodities have more elastic demand then othe rs, while other
commodities have relative elastic demand. The elasticity of demand
ranges from zero to infinity (0 -∞). It can be equal to zero, one, less than
one, greater than one and equal to unity.
“The degree of responsiveness to the change in demand i n a market for a
commodity is great or small, as the amount demanded increases much or
little for a given fall in price and diminishes much or little for a given rise
in price of the commodity”.
The various level or the degree of elasticity of demand is ex plained in
brief below:
1. Perfectly elastic demand (E p = ∞): The demand is said to be perfectly
elastic, if slight change in price leads to infinite change in the quantity
demanded of the commodity. In other words, it is the level of
responses where the consumer is able to buy all the available
commodity at a particular price where the demand is elastic. The
demand curve under this situation is horizontal straight line parallel to
X axis shown in the Diagram 3.9 below. This type of demand curve is
relevant in perfect competition. But in the real world, this cas e is
exceptionally rare and are not of any practical interest.
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Demand Analysis
33
Diagram 3.9
2. Perfectly inelastic demand (E p = 0): The demand is said to be
perfectly inelastic, if the demand for a commodity does not change
with a change in price of the commodity. In ot her words, the perfectly
inelastic demand of a commodity is opposite to the perfectly elastic
demand. Under the perfectly inelastic demand, a rise or fall in price of
a commodity the quantity demanded for a commodity remains the
same. The elasticity of dem and will be equal to zero. The demand
curve is vertical straight line parallel to Y -axis shown in the Diagram
3.10.
Diagram 3.10
3. Unitary elastic demand (E p = 1): Demand is said to be unitary elastic
when the percentage change in the quantity demanded fo r a
commodity is equal to the percentage change in its price. The
numerical value of unitary elastic of demand is exactly equal to one munotes.in
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Business Economics -I
34 i.e. Marshall calls it as unit elastic. The demand curve is rectangular
hyperbola shown in the Diagram 3.11.
Diagram 3.11
4. Relatively Elastic demand (E p> 1): Demand is said to be relatively
elastic, when the percentage change in quantity demanded of a
commodity is greater than the percentage change in its price. In other
words, it refers to a situation in which a small change in price leads to
a great change in quantity demanded. The demand curve under this
situation is flatter as shown in Diagram 3.13. Such demand curve is
seen under monopolistic competition.
Diagram 3.12
5. Relatively Inelastic demand (E p< 1): Demand i s relatively inelastic
when the percentage change in the quantity demanded of a commodity
is less than the percentage change in the price of the commodity. The
demand curve under this situation is steeper shown in Diagram 3.13.
Such demand curve is observe d under monopoly market. munotes.in
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Demand Analysis
35
Diagram 3.13
Check your Progress :
1) What is the nature elasticity of demand for luxurious good?
2) List down the degrees of Elasticity of Demand.
3.12 INCOME ELASTICITY OF DEMAND
As we have discussed earlier the factor which determines elasticity of
demand for a commodity. The consumer’s income is one of the important
determinants of demand for a commodity. The demand for a commodity
and consumer’s income is directly related to each other, unlike price -
demand relationship.
Income elasticity of demand shows the degree of responsiveness of
quantity demanded of a commodity to a small change in the income of a
consumer. In other words, the degree of responsiveness of quantity
demanded to a change in income is measured by dividing the
proportionate change in quantity demanded of a commodity by the
proportionate change in the income of a consumer.
Percentage change in purchases of a commodityIncome Elasticity =Percentage change in income
3.12.1 MEASUREMENT OF INCOME ELASTICITY OF DEMAND
The income elasticity of demand can be calculated by either point method
or arc method.
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Business Economics -I
36 Point income elasticity of demand is measured by following formula: //yQQEYY
QYYQ
QYYQ
Where, Q = Original Quantity Demanded.
Y= Original Income.
ΔQ= Change in Quantity Demanded.
ΔY= Change in Income.
Arc income elasticity of demand is measured by following formula: 21 2 121 2 1yQQ YYEYY QQ
Income elasticity of demand being zero is a great significance. It implies
that a given increase in the income of a consumer does not at all lead to
any increase in quantity demanded of a commodity or expenditure on it.
Classification of goods based on income elasticity of demand: We can
broadly classify the various goods on the basis o f value of income
elasticity of demand.
1. Normal Goods: Normal goods are those goods which are usually
purchased by consumer as his income increases. In other words,
normal good means an increase in income causes an increase in the
demand for a commodity. It has a positive income elasticity of
demand. Normal goods are further classified as:
a. Necessity goods: A good with an income elasticity less than one
and which claims declining proportion of consumers income as he
becomes richer is called a necessity good. Necessity goods are
those goods where an increase in income of a consumer leads to
less than proportionate increases in the demand for a commodity.
For example, daily used goods, basic goods etc. the income
elasticity of demand for such goods positive and less then unity.
i.e. Ey< 1.
b. Luxuries goods: A good having income elasticity more than one
and which therefore bulks larger in consumers budget as he
becomes richer is called a luxury good. Luxuries goods are those
goods where a change in income leads t o direct and more than
proportionate change in quantity demand for a commodity. For munotes.in
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Demand Analysis
37 example, diamonds, expensive cars, etc. Thus, income elasticity of
demand for such goods is positive and greater than one i.e. E y > 1.
c. Comfort goods: Comfort goods are t hose goods where change in
income leads to direct and proportionate change in quantity
demanded. For example, semi -luxury goods and comfort items.
Income elasticity of such goods are positive and unity. i.e. E y = 1.
2. Inferior goods: Inferior goods are thos e goods are where consumer
buys less of goods as his income increases. Goods having negative
income elasticity are known as inferior goods. As income of a
consumer increases his demand for goods shifts from inferior to
superior. The income elasticity for s uch goods are 0yE.
3. Neutral goods: when a change in income of a consumer brings no
change in the quantity demanded of a commodity. For example, salt,
rice, pulses etc. elasticity for such goods are 0yE.
3.13 C ROSS ELASTICITY OF DEMAND
Sometimes we find two goods are inter -related to each other either they
are substitute goods or commentary goods. Cross elasticity of demand
measures the degree of responsiveness of demand for one good in
responsive to the change in the price of another good.
cPercentage change in quantity demanded of commodity 'X'E=Percentage change in the price of commod ity 'Y'
Classification of goods based on value of cross elasticity of demand:
a. Substitution: If the value of elasticity between two goods are positive
the goods are said to be substitute to each other. For example, Tea and
coffee, if the price of tea increases the demand for coffee increases.
b. Complementary: if the value of elasticity between two goods are
negative the goods are said to be complementary. For example, car and
petrol, if the price of petrol in creases the demand for car decreases.
c. Unrelated: if the value of elasticity between two goods are zero then
the goods are said to be unrelated to each other. For example, table and
car, if the price of table increases there is no change in the demand for
car.
3.14 PROMOTIONAL ELASTICITY OF DEMAND
It is also known as ‘Advertisement elasticity’. In modern times an increase
in expenditure on advertisement or promotion leads to an increase in the
demand for a commodity Promotional elasticity of demand is th e
proportional change in quantity demand due to proportionate change in munotes.in
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Business Economics -I
38 promotional expenditure. In other words, percentage change in the
quantity of demand for a commodity divided by the percentage change in
promotional expenditure shows the promotional e lasticity of demand.
APercentage change in quantity demandedE Percentage change in advertisement expenditure
The greater the elasticity of demand, its better for a firm to spend more on
promotional activities. The promotional elasticity of demand is usually
positive.
Check your Progress :
1) How income of a Consu mer related to the demand of the commodity?
2) If the Consumer income increase. What will be the elasticity of
demand for necessity goods?
3.15 CONCEPTS OF REVENUE
The term revenue refers to the income obtained by a firm or a seller
through the sale of co mmodity at different prices. The revenue is classified
as:
1. Total revenue: The total revenue or income earned by a firm or
producer from the sale of the output he produced is called the total
revenue. Thus, the total revenue is the price multiply the quanti ty of
output.
TR = P×Q
Where,
TR = Total Revenue.
P = Price of a commodity.
Q = Total Output sold.
Thus, Total revenue is the sum of all sales, receipts or income of a firm in
the market.
2. Average revenue: The average revenue refers to the revenue o btained
by the firm by selling the per unit of output of a commodity. It is
obtained by dividing the total revenue by total unit of output sold in
the market.
AR = TR
Q
Or
AR = P
Where, AR= Average revenue.
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Demand Analysis
39 The average revenue curve shows that the price of the firm’s product is the
same at each level of output. In other words, the average revenue curve of
a firm is also the demand curve of the co nsumer.
3. Marginal revenue: Marginal revenue is the additional revenue earned
by selling an additional unit of the commodity. In other words,
Marginal revenue is the change in total revenue due to the sale of one
additional unit of output. Thus, marginal revenue is the addition
commodity made to the total revenue by selling one more unit of the
commodity. In algebraic terms, marginal revenue is the net addition to
the total revenue by selling n units of a commodity instead of n – 1.
Thus, MR n = TRn - TRn-1
Or
MR = ΔTR
ΔQ
Relationship between price elasticity and total revenue: Elasticities of
demand can be divided into three broad categories: elastic, inelastic, and
unitary. An elastic demand is one in which the elasticity is greater than
one, indicating a high responsiveness to changes in price. Elasticities that
are less than one indicates low responsiveness to price changes and
correspond to inelastic demand. Unitary elasticities indicate proportional
responsiveness of either demand or supply, as summarized in the
following table:
Total
revenue Change in price Elasticity Reasons
Increase
Decrease Fall
Rise Ep > 1 Percentage change
in quantity
demanded is
greater than the
percentage change
in price.
Decrease
Increase Fall
Rise Ep < 1 Percentage change
in quantity
demanded is
smaller than
percentage change
in price.
Unchanged
Unchanged Fall
Rise Ep = 1 Percentage change
in quantity
demanded is equal
to percentage
change in price.
Table 3.3 munotes.in
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40 The relationship between the price elastic ity and total revenue shows the
following analysis from the above table.
A. When demand is elastic, price and total revenue move in opposite
directions.
B. When demand is inelastic, price and total revenue moves in same
direction.
C. When demand is unitary elastic, total revenue remains unchanged with
the price changes.
This relationship can be easily understood by the following diagram: 3.14
Relationship between price elasticity and Average revenue and Marginal
revenue: The relationship between AR, MR and elasticit y of demand is
very useful to understand at any level of output.
This relationship is also very useful to understand the price -determination
under different market conditions. It has been discussed that average
revenue curve of a firm is the same thing as the demand curve of the
consumer for the product of the firm under market.
This relationship can be explained with the following diagram: 3.14
Diagram 3.14
3.16 SUMMARY
In this unit we have analysed the demand concept and its various function
along with the law of demand. In economics both demand and supply are
the important forces through which market economy functions. But in this
unit, we will focus more on demand side. The demand function shows the
relationship between the quantity demanded a nd its various determinants.
In this chapter we will explain the demand function in detail. Demand
function is an arithmetic expression that shows the functional relationship
between the demand for a commodity and the various factors affecting it. munotes.in
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Demand Analysis
41 It has also explained he nature of demand curve under different market
situation. We have also discussed the nature of demand curve under
different market conditions with the various elasticity concepts and its
measures in detail. Elasticity of demand helps us to estimate the level of
change in demand with respect to a change in any of the determinants of
demand. The concept of elasticity of demand helps the firm or manager in
decision making with respect to pricing, promotion and production
polices. The elasticity of demand measures the elasticity of four important
factors i.e. price, income, cross and promotional with three important
measures of point, arc and geometric measures of elasticity. The unit also
deals with the various revenue of the firm in business a nd their
relationship in detail.
3.17 QUESTIONS
1. Explain the law of demand and the factors with determines the
demand.
2. Explain the nature of demand curve under different markets.
3. What is demand function? Explain in detail.
4. What is elasticity? Explain price elasticity of demand in detail.
5. Explain the measurements of price elasticity of demand.
6. Discuss the different degrees of elasticity of demand.
7. What are the factors affecting price elasticity of demand?
8. Write a note on:
a) Income elasticity of demand.
b) Cross elasticity of demand.
c) Promotional elasticity of demand.
9. Explain the concepts of revenue in detail.
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42 4
DEMAND ESTIMATION AND
FORECASTING
Unit structure:
4.0 Objectives
4.1 Introduction
4.2 Meaning
4.3 Significance of demand forecasting
4.4 Steps in demand forecasting
4.5 Methods in demand forecasting
4.6 Summary
4.7 Question
4.0 OBJECTIVES
To understand the meaning and significance of demand forecasting
To learn the steps, involve in estimating demand forecasting
To understand the methods of demand forecasting
4.1 INTRODUCTION
Business is a serious job. Manager or the business firms has to take certain
decision to run their business smoothly without any disturbance in his
business. Demand forecasting play a vital role in business planning.
Business enterprises need to plan their activities. Most of the business
decisions of a firm under an o rganization are made under the conditions of
risk and uncertainty. Demand forecasting is a systematic process that
involves anticipating the demand for the product and services of an
organization in future under a set of uncontrollable and competitive forc es
in the economy.
Demand forecasting helps the business firms to take appropriate decision
about the production and the use of factors of production to fulfil the
future demand of the commodity.
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43 4.2 MEANING
Demand forecasting means estimation of dema nd for the product for a
future period. Demand forecasting enables an organization to take various
decisions in business, such as planning about production process,
purchasing of raw materials, managing funds in the business, and
determining the price of t he commodity. A business organization can
forecast demand for his product by making own estimations called guess
or by taking the help of specialized consultants or market research
agencies.
4.3 SIGNIFICANCE OF DEMAND FORECASTING
Demand forecasting play s an important function in the management of
various business decision. Forecasting help the business firm to know
what is likely to happened in future and to reduce the degree of risk and
uncertainty in business and to make various business policy decisio n and
action of the future. Thus, a demand forecasting is meant to guide business
policy decision.
The significance of demand forecasting are as follows:
1) Fulfils the sobjective: Demand forecasting implies that every business
unit starts with certain pre-determined objectives. Demand forecasting
helps in fulfilling these objectives. An organization estimates the
current demand for its products and services in the market and move
forward to achieve the set goals.
For example, an organization has set a target of selling 60, 000 units of
its products. In such a case, the organization would make demand
forecasting for its products. If the demand for the organization’s
products is low, the organization would take remedial actions, so that
the set objective can be achieved.
2) Production planning: Demand forecasting is important to forecast the
future production plan of business firm. There is a gestation period
between production of goods and services and demand for it. Demand
forecasting help to eliminate th ose gaps between demand and supply
of goods preventing shortages and surplus.
3) Distribution and avoidance of wastage of resources planning: The
business firm has to take decision regarding the distribution of capital,
machinery, raw material in the produc tion process. So that if there is
any shortage of those resources can be arranged prior through
estimation. Making a right and correct estimation of using resources
reduces the usage of it.
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44 4) Sales distribution policy: Sales of goods and service gives reve nue to
the firm’s demand. Forecasting is nothing but estimating the sales of
the product. To formulate realistic sales targets and to make
arrangements for the movement of production for the movement of
product region wise, demand forecasting is very essen tial. This can
help to formulate an effective sales policy, and therefore, to increase
sales revenue.
5) Price policy: The firm has to make decision regarding the price of
goods and services which is a critical job. The firm has to make
appropriate price pol icy so that there is no price fluctuation in the
future.
6) Reduce business risk: Every business has certain risk. Demand
forecasting help the business firm to make appropriate business
decision to reduce such risk and uncertainty to a certain extent.
7) Inve ntory planning: Inventories are goods and raw materials held by
the firm future sale. Demand forecasting helps in devising appropriate
inventory management policies.
Check your Progress :
1) How demand forecasting health business firm in predicating futu re
demand for his product?
2) List down the factors determining nature of demand forecasting.
4.4 STEPS IN DEMAND FORECASTING
The demand forecasting finds its significance during large -scale
production of goods and services. During such period of time f irms may
often face difficulties in obtaining a fairly accurate estimation of future
demand. Thus, it is essential for a firm to forecast demand systematically
and scientifically to arrive at desired objective. Therefore, the following
steps are to be take n to facilitate a systematic demand forecasting:
1. Determining the objective: The very first step in demand forecasting
is to determine its objective of forecasting. The objective for which the
demand forecasting is to be done must be clearly specified. The
objective of forecasting may be defined in terms of; long -term or
short -term demand, the whole or only the segment of a market for a
firm’s product, overall demand for a product or only for a firm’s own
product, firm’s overall market share in the industry, etc. The objective
of the demand must be determined prior in the process of demand
forecasting begins as it will give direction to the whole research.
2. Nature of forecast: After determining the objective of forecasting the
second important step is to ident ified the nature of demand forecasting.
Its based on the nature of forecasting. munotes.in
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45 3. Nature of commodity: While forecasting it is important to understand
the nature of the product whether it is consumer goods or producer
goods, perishable goods or durable goods . If the good is perishable the
forecasting is to be done in a short period of time and for durable
goods it may be done in long run.
4. Determinants of demand: Determinants of demand play an important
role in determining the forecasting as different commodit y have
different factor determination of demand which depends upon the
nature of commodity and nature of forecasting. The important
determinants are price of the commodity, price of related goods,
income of a consumer etc.
5. Identifying the relevant data: Necessary data for the forecasting are
collected, then tabulated, analysed and cross -checked by the firm. The
data are interpreted by applying various statistical or graphical
techniques, and then to draw necessary deductions there from. The
forecaster has to decide whether to choose primary or secondary data.
The primary data are the first -hand data which has never been
collected before. While the secondary data are the data already
available. Often, data required is not available and hence the data are
to be adjusted, even manipulated, if necessary, with a purpose to build
a data consistent with the data required. Then after collecting the
relevant data from different sources and proceed for the further step.
6. Selecting the method: After collecting the rele vant data the firm
choose the appropriate method of forecasting the demand. Appropriate
method of sales forecasting is selected by the company considering the
relevant information, purpose of forecasting and the degree of
accuracy required. The choice of m ethod has to be appropriate and
logical. If the required data is not available toward the method, the
forecaster may force to use less reliable method. The forecaster should
use a method which should not be too time consuming and it should be
reliable for long term.
7. Testing accuracy: After making a choice of method the forecaster
needs to test the accuracy of it. There are various methods choose to
test the accuracy. This testing helps to reduce the margin of error and
thereby helps to improve its validity for the purpose of decision
making
8. Evaluation and conclusion: the last and final step are to evaluate the
forecasting and to draw a conclusion from it.
4.5 METHODS OF DEMAND FORECASTING
The main challenge to the forecaster while forecasting the demand is to
select an effective technique or method. Broadly speaking methods of
demand forecasting are classified into Qualitative methods and
Quantitative methods. Which can also be classified as Survey method and munotes.in
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46 Statistical method. The forecaster may choose any of the method
depending upon the data which is available. Under these two broad
categories, there are other specific methods which is been choose to
analysis the data. These two methods will be discussed below:
A. Survey method: This method is also call ed as qualitative method of
demand forecasting. This method is one of the most common and
direct method of demand forecasting in the short run. In this method
the future purchase plans of the consumers and their aims are included.
An organization conducts these surveys with consumers to determine
the demand of their existing products and services and forecast the
future demand of their product accordingly.
The forecaster may undertake the following survey methods:
a) Expert’s opinion: This method is based o n the opinion of expert who
predict the demand for a product based on his experiences and his
knowledge in the particular specialised field. The expert may be from
the same organisation or may be hired from outside. They may be
salesman, sales manager, mar keting expert, market consultant etc they
act as experts who can assess the demand for the product in different
areas, regions, or cities. This method involves the opinion of three or
four experts. Each expert will be asked about his opinion regarding the
demand for the product and the expert through his personal experience
give his opinion for the product and forecast the demand. This method
is very simple to use and it requires less statistical work. Due to
expert’s personal views the time for forecasting is short and the cost
involve is also low. On the other side as its expert’s personal opinion
or guess where its likely to be biased.
b) Delphi method: Delphi method is a group decision -making technique
of forecasting demand. In Delphi method, a group of ex perts gives
their opinion on the demand for the products of individual firm in
future based on questions which have been asked by the firm. These
questions are repeatedly asked until a result is obtained. In addition,
each and every expert is provided info rmation regarding the estimates
made by other experts in the group, so that he/she can revise his/her
estimations with respect to others’ estimates. In this way, the
forecasters cross check among experts to reach more accurate decision
making. The main adv antage of this method is that it is time and cost
effective as a number of experts are approached in a short time without
spending much time on other resources. However, this method may
lead to appropriate decision making. This method allows the forecaster
to solve the problem to the experts at once and have instant response.
But the success of this method depends upon the skills, experience,
knowledge, and aptitude of the expert.
c) Consumer survey method: In this method, the consumers are directly
approach ed to unveil their future purchase plans. This method is the
most direct method because forecasting is done by interviewing all
consumers or a selected group of consumers out of the relevant
population through various other methods of survey. The firm may munotes.in
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47 choose for complete enumeration method, sample survey method and
end use method for sample surveys depending upon the nature of
forecasting. The following methods are described in brief below:
i. Complete enumeration method: Under the Complete Enumeration
Survey, the forecaster undertakes the survey of the whole population
who demand for the commodity. The firm may go for a door to door
survey by making questionnaire to get the data requires. This method
has an advantage of first hand data, unbiased informati on, yet it has its
share of disadvantages also. The major limitation of this method is that
it requires lot of resources, manpower and time period. There may be a
chance where the consumer or the population may give false statement
or may deliberately misg uide the investigators due to which there may
be chance of data error. In this method, consumers may be unwilling to
reveal their purchase plans due to personal privacy or commercial
secrecy.
ii. Sample survey method: This method is also known as test market. In
this method the forecaster selects the samples of consumer from the
relevant population instead of considering the whole population. If
sample is the true representative of data, there is likely to be no
significant difference in the results obtained b y the survey. Apart from
that, this method is less tedious and less costly then the complete
enumeration method. A sample survey technique is a variant of test
marketing. Product testing basically involves employing the product
with a number of users for a set of periods of time. Their reactions to
the product are noted after a period of time and an estimate of likely
demand is made from the result. These are suitable for new products or
for completely modified old products for which there is no prior data
available. It is a more scientific method of estimating like demand
because it stimulates the national launch in a very closely defined geo -
graphical area. Their can be a sampling error in this method as the size
of sample is small i.e. smaller the size of sample larger the sampling
error.
iii. End-use method: This method is quite useful for industries which are
mainly producer’s goods and when a product is used for more than one
use. In this method, the sale of the product is projected on the basis of
demand survey of the industries which are using this product as an
intermediate product, that is, the demand for the final product is the
end user demand of the intermediate product which are used in the
production of this final product is considered. The end use method of
demand estimation of an intermediate product may involve many final
good industries using this product at home and abroad. It helps us to
understand inter -industry’ relations. The major efforts required by this
type of method are not in its oper ation but in the collection and
presentation of data. This will help the forecaster to manipulate the
future demand. This policy helps the government to frame many of its
policies. Its major limitations are that it requires every firm to have a
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48 d) Market experiments: This method involves collecting necessary
information regarding the current and future demand for a product in
the market. This method carries out the studies and experiments on
consumer behavio ur under actual market conditions. In this method,
some areas of markets are selected with similar features, such as
income level , population, cultural and political background, and
tastes of consumers. The market experiments are carried out with the
help of changing prices and expenditure, so that the resultant changes
in the demand are recorded. These results help in forecasting future
demand.
i. Actual market experiment: This method is conducted in the actual
market place in several ways. One method is t o select several
market or stores with similar characteristics. This method is very
useful in the process of introducing a product for which no other
data exist.
ii. Simulated market experiment: This method is also called as
consumer clinic or laboratory exp eriment. Under this method the
firm make a set of consumers and give them a sum of money and
asked them to shop in a stimulated store. While shopping the
consumer reaction towards the change in price of a product,
packaging, advertisement etc are taken int o consideration.
B. Statistical methods: This method is also called as quantitative
method. Statistical method is most useful in demand forecasting. In
order to key objectivity, that is, by consideration of all implications
and viewing the problem from an ex ternal point of view, the statistical
methods are used to forecast the demand of the product to get the
accurate solution to the problems. The following are some statistical
methods which are been used now a day:
I. Trend method: A firm existing for a long t ime will have its own
data regarding sales for past years. Such data when arranged in a
chronologically manner will yield what is referred to as ‘time
series. Time series method shows the past sales with effective
demand for a particular product under norm al conditions. Such
data can be given in a tabular or graphic form for further analysis.
This is the most popular method among business firms, partly
because it is simple and cheap and partly because time series data
often show a persistent growth trend. T ime series has got four
types of components namely, Secular Trend (T), Secular Variation
(S), Cyclical Element (C), and an Irregular or Random Variation
(I). These time elements are expressed by the equation O = TSCI.
Secular trend refers to the long run c hanges that occur as a result of
general tendency. Seasonal variations refer to the changes in the
short run weather pattern or the social habits. Cyclical variations
refer to the changes that occur in industry during a depression and
boom period. Random v ariation refers to the factors which are munotes.in
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49 generally able such as wars, strikes, natural calamities such as
flood, famine and so on. When a prediction is made the seasonal,
cyclical and random variations are removed from the observed
data. Thus, only the sec ular trend is left. This trend is then
projected. Trend projection fits a trend line into a mathematical
equation. The trend can be estimated by using any one of the
following methods:
(a) The Graphical Method: Graphical method is the simplest
technique t o determine the trend analysis. All values of output or
sale of product for different years are plotted on a graph and a
smooth free hand curve is drawn passing through as many points
as possible on the graph. The direction of this free hand curve is
eithe r upward or downward and shows the possible trend.
(b) The Least Square Method: Under the least square method of
forecasting, a trend line can be fitted to the time series data with
the help of statistical techniques such as least square method of
regress ion. When the trend in sales over time is given by straight
line, the equation of this line is in the form of: y = a + bx. Where
‘a’ is the intercept and ‘b’ shows the impact of the independent
variable. We have taken two variables i.e. the independent var iable
x and the dependent variable y. The line of best fit establishes a
kind of mathematical relationship between the two variables v and
y. This is expressed by the regression у on x.
In order to solve the equation v = a + bx, we have to make use of the
following normal equations:
Σ y = na + b ΣX
Σ xy =a Σ x+b Σ x2
II. Regression method: regression methods attempts to assess the
relationship between at least two variables (one or more
independent and one dependent), the purpose is to predict the value
of the dependent variable from the specific value of the
independent variable. The foundation of this prediction generally is
historical data. This method starts from the assumption that a basic
relationship exists between two variables. An interactive statis tical
analysis computer package is used to formulate this mathematical
relationship.
Check your Progress :
1) List down the steps of demand forecasting.
2) Define survey method of demand forecasting.
3) Define Delphi method of demand forecasting.
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50 4.6 SUMMARY
This unit study the demand estimation and its forecasting. Demand
forecasting play a vital role in business planning. Business enterprises
need to plan their activities. Most of the business decisions of a firm under
an organization are made und er the conditions of risk and uncertainty.
Demand forecasting is a systematic process that involves anticipating the
demand for the product and services of an organization in future under a
set of uncontrollable and competitive forces in the economy. Deman d
forecasting helps the business firms to take appropriate decision about the
production and the use of factors of production to fulfil the future demand
of the commodity. It had studied the importance or significance of demand
forecasting. Demand forecast ing plays an important function in the
management of various business decision. Forecasting help the business
firm to know what is likely to happened in future and to reduce the degree
of risk and uncertainty in business and to make various business policy
decision and action of the future. The unit explains the various steps in
forecasting demand. It has also explained the two major methods of
demand forecasting in detail.
4.7 QUESTIONS
1. What is demand forecasting? Explain its importance.
2. Discuss th e steps to be taken to estimate demand forecasting.
3. Explain the survey methods of demand forecasting.
4. Examine the statistical methods of demand forecasting.
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51 5
SUPPLY AND PRODUCTION DECISIONS
Unit Structure :
5.0 Objectives
5.1 Meaning of production
5.2 Production function
5.3 Types of production function
5.4 Law of variable proportion
5.5 Law of returns to scale
5.6 Isoquants
5.7 Properties of isoquan ts
5.8 Types of isoquants
5.9 Ridge lines
5.10 Producer’s equilibrium
5.11 Expansion path
5.12 Summary
5.13 Questions
5.0 OBJECTIVES
To study the meaning, functions and types of production function
To understand the law of variable proportion and law of returns to
scale
To study the concept isoquants and its property and types
To understand the producer’s equilibrium and expansion path
5.1 MEANING OF PRODUCTION
The term ‘production’ is very important and broader concept in
economics. To meet the daily demand of a consumer production is
essential part. Production is a process by which various inputs are
combined and transformed into output of goods and services, for which
there is a demand in the market. In other words, Production is a process of
combini ng various material inputs and immaterial inputs in order to make
something for consumption. The essences of production are the creation of
utilities and the transformation of inputs or resources into output. Inputs munotes.in
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52 are the resources used in the production of goods and services the
important resources or input in production are land, labour, capital, and
entrepreneur. Production process creates economic well being into the
nation. Thus, production is a process which creates utility and value in
exchange.
The theory of production function is concern with the problem in the
production process in a certain level of output. It analyses the relation
between cost and output and help the firm to determine its profit. All firms
that aims at maximising their profit m ust make their decision regarding
production on the bases of the following three decision:
a. How much output to produce and supply in the market?
b. How to produce the product, i.e. which technique of production or
combination of production to used have to be decided?
c. How much quantity of input is demanded to produce the output of the
product?
Thus, the above three decisions are interrelated and have to be taken by
the firm during the production process.
5.2 PRODUCTION FUNCTION
In economics, a production funct ion is the functional relationship between
physical output of a production process to physical inputs or factors of
production. In other words, production function denotes an efficient
combination of input and output. The factors which are used in the
production of goods and services are also called as agents of production.
Production function of a business firm is determined by the state of
technology. More specifically, production function shows the maximum
volume of physical output available from a given set of inputs, or the
minimum set of inputs necessary to produce any given level of output.
Definition: With the above statements we can define the production
function as: “A production function refers to the functional relationship,
under the given tec hnology, between physical rates of input and output of
firm, per unit of time”.
Mathematically, production function can be express as: Q = f (N, L, K, E,
T, etc.)
5.3 TYPES OF PRODUCTION FUNCTION
I. The production function can be broadly categorised into t wo based
on the time period i.e. a) Short run production function and b) long run
production function.
A) Short run production function: The short run is defined as the period
during which at least one of the input is fixed. According to the following
shortrun production function, labour is the only variable factor input
while the rest of the inputs are regarded as fixed. In other words, the short
run is a period in which the firm can adjust production by changing munotes.in
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53 variable factors such as materials and l abour but cannot change fixed
factors such as land, capital, etc. Thus, in short run some factors are fixed
and some are variable.
B) Long run production function: The long run production function is
defined as the period of time in which all factors of p roduction are
variable. In the long run there is no distinction between the fixed or
variable factor as all factors in the long run are variable.
II. The production function can also be classified on the basis of factor
proportion i.e.
a) Fixed proportio n production function and b) Variable proportion
production function.
A. Fixed proportion production function : The fixed proportion
production function, also known as a Leontief Production Function
which implies the fixed factors of production function such a s land,
labour, raw materials are used to produce a fixed quantity of an output
and these factors of production function cannot be substituted for the
other factors. In other words, in such factors of production function
fixed quantity of inputs is used to produce the fixed quantity of output.
All factors of production are fixed and cannot be substituted for one
another. The concept of fixed proportion production function can be
further expained with the help of a Diagram 5.1 as shown below:
Diagram 5.1
B. Variable proportion production function : The variable proportion
production function supposes that the ratio in which the factors of
production such as labour and capital are used in a variable proportion.
Also, the different combinations of factors can be used to produce the
given quantity, thus, one factor can be substituted for the other factor.
In the case of variable proportion production function, the technical munotes.in
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54 Coefficient of production function is variable, i.e. the important
quantity of outpu t can be achieved through the combination of
different quantities of factors of production, such as these factors can
be varied by substituting one factors to the other/ factors in its place.
The concept of variable proportion production function can be f urther
explained from an isoquant curve, as shown in the Diagram 5.2 below:
Diagram 5.2
In the above diagram, the isoquant curves show that the different
combinations of factors of technical substitution shows that it can be
employed to get the require d amount of output in the production process.
Thus, for the production of a given level of product, the input factors can
be substituted from another factor input.
5.4 LAW OF VARIABLE PROPORTION
The law of variable proportion is a short run production fu nction theory.
This law plays a very important role in the economic theory, which
examines the production function with which one variable factor keeping
the other factors input fixed. This law is explained by the classical
economists to explain the behavi our of agricultural output. In other words,
it examines the behaviour of the production in the short run when the
quantity of one factor is varied, keeping the quantity of another factor’s
constant. Thus, the law of variable proportion is the new name for the
famous theory “The Law of Diminishing Marginal Returns” of classical
economist.
Alfred Marshall, had discussed the law in relation to agriculture, according
to him, “an increase in the capital and labour applied in the cultivation of
land causes in g eneral a less than proportionate increase in the amount of
product raised unless it happens to coincide with an improvement in the
art of agriculture”. Marginal productivity of labour in agriculture is zero.
Assumptions : The law of variable proportion is based on the following
assumptions: munotes.in
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55
a. The state of technology is assumed to be given and constant.
b. There must be some inputs whose quantity must be kept as fixed or
constant. Such input factors are called fixed factors.
c. All units of variable factors in puts are homogenous.
d. The law is based upon the possibility of varying the proportions in
which the various factors can be combined to produce the level of
output. Let us assume the labour is the variable factor in our
explanation.
Change in output due to increase in variable factors can be explain with
the table given below:
Units of Variable
factor (LABOUR) Total Product
(TP) Average
Product (AP) Marginal
Product (MP)
0 0 0
1 5 5 5
2 12 6 7
3 27 9 15
4 48 12 21
5 75 15 27
6 80 15.33 15
7 91 13 11
8 98 12.5 7
9 98 10.8 0
10 92 9.2 6
Table 5.1
Explanation of the table:
In the above table the labour is consider as a variable factor and all other
factors are assumed to be constant according to the law. With the increase
in the variable factor i.e. labour there is a change in the level of TP, AP,
and MP.
Total product: The total product is the total amount of output produced
by using all the variable input in a fixed proportion in production. The
total product increases with the increase in th e unit of labour and reaches
to the maximum and they’re after decline with further more increase in the
variable factor.
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56 Average product: The average product is the per unit of product
produced by the firm with the per unit of variable factor inputs. It is
obtained by dividing the total product by the unit of total variable factor.
The average product increases initially and then declines.
Marginal product: Marginal product is the additional output produced by
an additional unit of variable factor. Margin al product increases and
thereafter falls when TU becomes maximum MU becomes zero and
further becomes negative.
Diagram: the law of diminishing marginal returns can be explained with
the following diagram:
Diagram 5.3
The above diagrams show three phase s with the changes in the output can
be explained below:
Phase 1: In phase 1 the total product is increasing at increasing rate where
average product is also increases at a diminishing rate and reaches at its
maximum and marginal product increases initial ly and then decreases.
Phase 2: In phase 2 the total product increases at a diminishing rate and
reaches its maximum point. Where the average product is starts declining
and the marginal product diminishes and become zero.
Phase 3: In this phase total prod uct starts declining. Where average
product is continuously declining and marginal product becomes negative.
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57 5.5 LAW OF RETURNS TO SCALE
As the law of variable proportion is a short run production function theory,
law of returns to scale is a long run p roduction function theory. In this
theory all factors of production are variable no factors are fixed. With the
change in the factors of production scale of production will change
accordingly.
According to Koutsoyiannis “The term returns to scale refers t o the
changes in output as all factors change by the same proportion.”
Types of return to scale:
The concept of returns to scale assumes only two factors of productions
i.e. capital and labour this analysis enables us to understand the change or
scale in production due to change in the factors of production in terms of
isoquants or equal product curves.
Increasing returns to scale: Increasing returns to scale means an increase
in a level of output more than the increase in the inputs. For example, if an
output increases by 35% with an increase in all inputs by only 15%
increasing returns to scale prevails. In other words, a proportionate change
in output brings about less proportionate change in inputs it is called
increasing returns to scale. Where, OA>A B>BC.
Diagram 5.4
Decreasing returns to scale: Decreasing returns to scale means an
increase in a level of output less that the increase in the inputs. For
example, if an output increase by 25% with an increase in all inputs by
35% decrease in returns to scale prevails. In other words, a proportionate
change in output brings more proportionate change in inputs it is called
decreasing returns to scale. Where OA
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58
Diagram 5.5
Constant returns to scale: Constant returns to scale means an increase in
a level of output is constant that the increase in the inputs. For example, if
an output increase by 25% with an increase in all inputs by 25% constant
in returns to scale prevails. In other words, a proportionate change in
output brings constant change in inputs it is called constant returns to
scale. Where OA=AB=BC.
Diagram 5.6
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59 Check your Progress :
1) Define Production Functions.
2) Define total product, average product & marginal product.
3) Explain constant returns to scale.
5.6 ISOQUANTS
Meanin g: The term “iso quants” is derived from Greek word iso means
“equal” and quants means “quantity”. Thus, iso quant means equal
quantity. An iso quant is also known as iso production curve, iso
indifference, equal production curve by various economists. The isoquants
have its properties which are similar to those generally assumed for
indifference curve theory of the theory of consumer’s behaviour analysis.
Isoquant is defined as “a locus of all the combination of two factors of
production that yields that yield the same level of output.”
Thus, an iso quant is a combination of any two factor inputs that
represents and produce the same level of output. Any two combinations of
input factors e.g. Labour and capital are used in which one factor is
increased by d ecreasing the other factor of input to maintain the same
level of production.
Isoquant can be explained with the schedule and graph given below:
Factor combinations to produce a given level of output.
Factor combination Labour Capital Output
A 1 150 500
B 2 100 500
C 3 75 500
D 4 50 500
E 5 25 500
Table 5.2
The above table shows the five combination of inputs i.e. Labour and
Factor unit which yield the same level of output of 500 units. Which says
any point on the iso quant will give the same level of output. To show this
we draw the iso quant drawn below:
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Diagram 5.7
Iso-quant map:
An iso quant map represents a set of iso quant curves shows the
combination of input factor at the various level of output. A higher level of
isoquant represents the higher level of output. Thus, in simple word, iso
quant map is a family of iso quant representing the various iso quant
curve at a particular level of output. The iso quant map can be represented
with the diagram given below:
Diagram 5.8
The fig above shows the various iso quants representing the various level
of output at different combination of input factors. IQ 1 , IQ 2 and IQ 3 shows
the iso quant which produces 100,200 and 300 units of output respectively
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61 level of output at different level of Iso quant.as we had said higher the Iso
quant represents higher the value of output.
5.7 PROPERTIES OF ISO -QUANTS
1. Iso-quant curve slopes downwards: The iso quant curve slopes
downwards from left to right i.e. it has a negative slope. The slope is
downward because it operates under law of MRTS, when we increase
labour as a factor, we have to decrease capital factor to produce a same
level of output. The downward sloping iso quant curve ca n be explaining
the help of following Diagram 5.9.
Diagram 5.9
Thus, the iso quant can be downward sloping from left to right. There
can’t be an upward sloping iso quant curve because it shows that a given
product can be produce by using less of both t he input factor. Similarly, an
isoquant cannot be horizontal or vertical because it also doesn’t represent
the equilibrium position of a firm. Only the downward sloping supply
curve represents the characteristics of iso quant.
2. Iso-quant are convex to the origin: As we had discussed in the above
property that the iso quant curve is downward sloping and it has a
negative slope and it operates under law of Marginal rate of Technical
Substitution (MRTS). It says that it equals the ratio of the marginal
produc t if labour and marginal product of capital i.e. one factor is given up
to get one additional unit of other factor to produce the same of output
which creates a convexity of iso quant curve.
Thus, the slope of iso quant can be represented by,
LLKKMPKMRTSL MP
The above equation represents ratio of change in capital and labour should
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62 and capital which is equal to the ratio of marginal product of labour and
capital.
The convexity of iso quant means that as we move down the curve less
and less of capital given up for an additional unit of labour so to produce
the same level of output. The convexity of iso quant can be observed from
the Diagram 5.10. Given below
Fig 5.10
Thus, the iso quant can be convex to the origin but not the concave
because it would mean that MRTS will increase instead of decreasing i.e.
labour will increase at a constant rate the amount of capital given up will
goes on increasing.
3. Iso-quants do not intersect: The properties of iso quants say that
two iso quant will never intersect each other. To explain this, we will take
a help of following Diagram 5.11:
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Diagram 5.11
The above fig represents two different iso quant IQ 1and IQ 2, wher e it
represents the level of output 100 and 200 units respectively. Point a
represents 100 units of output on IQ 1 and point c represents 200 units of
output on IQ 2. The point b shows the intersection of both the iso quants
where is logically not possible to identify the level of output.
4. Iso-quant cannot touch either of the axis: an iso quant cannot only
touch x axis or y axis or any either axis because it will represent that the
isoquant only produce goods by using one factors of production either by
using only capital or only labour which is practically not possible and
which is unrealistic.
Diagram 5.12
5. Higher the iso -quant higher the level of production: if there is a
multiple iso quant showing different level of production in one diagram.
Where the higher the iso quant i.e. the iso quant far from the origin
indicates higher level of output and the iso quant close to the origin
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64
Diagram 5.13
5.8 TYPES OF ISO -QUANT
The iso quant have various shapes which depen ds upon the degree of
substitutability of factors in production. On the bases of that the types of
isoquant are derive. The following are the various types of iso quant
based on the degree of substitutability of substitution:
1. Liner iso -quant: if the iso quant is liner one i.e. downward sloping
straight line it assumes that there is a perfect substitutability of the factors
of productions. It means that capital and labour can be easily substitute
from each other. i.e. the rate at which labour can be subst ituted for capital
in production (i.e. MRTS LK) is constant. This can be seen from the
following Diagram 5.14 given below:
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65
The above diagram shows that there is a perfect substitutability of labour
and capital at the points A & B where poi nt A on iso quant represents the
level of output can be produce with capital alone i.e. without using any
labour on the other hand point B represents the same level of output can be
produce with labour alone i.e. without any use of capital. This in reality is
not possible because no production can be done with using any of the
factor alone.
2. Right angled iso -quant: if the iso quant is right angled it assumes that
there is a perfect complementarily i.e. it assumes that there is a perfect
substitutability of factors of production. This shows that there is only one
method is used for production of the commodity. In this type the iso quant
is formed as right angled as shown in the following fig. which shows
labour and capital are used in a fixed proportion i.e. output can be
increased by increasing labour and capital in fixed proportion. This type of
isoquant is known by many names such as input output iso quant and
Leontief iso quant.
Diagram 5.15
3. Kinked iso -quant: This type of iso quant assumes only limit ed
substitutability only at the kinked of the iso quant. That means the
substitutability of labour and capital is only possible at the kinked of the
isoquant in the production. i.e. in the fig. the substitutability is possible at
the point A, B, C and D. This type of iso quant is also called as ‘liner
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Diagram 5.16
4. Smooth convex iso -quant: The classical economic theory has adopted
this type of iso quant for analysis as its simpler to understan d. This iso
quant assumes the continuous substitutability of labour and capital over a
certain range beyond which there is zero substitutability of factors in
production. This iso quant fulfils all the criteria of iso quant. The
derivation of this smooth c onvex iso quant is explained below:
To explain the derivation of iso quant we assume that there is a various
combination of factor inputs of labour and capital used to produce 100
units of output. The combination is a such where one factor is increased by
reducing the other factor input to produce the same level of output in
production. All this combination is technically efficient in production.
Various combinations of labour and capital to produce 100 units of output.
Factor combination Labour Capital
A 10 60
B 20 50
C 30 40
D 40 30
Table 5.3
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67 If we plot all this combination on a graph, we obtain an IQ curve.
Diagram 5.17
5.9 RIDGE LINES
The ridge lines are the locus of points of an iso quants where the marginal
product of factors is zero. An isoquant is oval shaped as shown in diagram
but its area of rational operation lies between the ridge lines. The firm will
produce only in those segments of isoquants which are convex to the
origin and lie between the ridge lines. The ridge lin es are the locus of
points of isoquants where the marginal products (MP) of factors are zero.
The upper ridge line implies zero MP of capital and the lower ridge line
implies zero MP of labour. Production techniques are only efficient inside
the ridge line s. The marginal products of factors are negative and the
methods of production are inefficient outside the ridge lines. The ridge
lines can be explained through the help of following diagram:
Diagram 5.18 munotes.in
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68 In the above Diagram curves ОA and OB are the ridge lines on the oval
shaped iso quants and in between these lines on points G, J, L and N and
H, К, M and P economically feasible units of capital and labour can be
employed to produce 100, 200, 300 and 400 units of the product .
For example, ОТ units of labour and ST units of the capital can produce
100 units of the product, but the same output can be obtained by using the
same quantity of labour ОТ and less quantity of capital VT. Thus, only an
unwise producer will produce in the dotted region of the iso quant 100.
The dotted segments of isoquants form the uneconomic regions of
production because they require an increase in the use of both factors with
no corresponding increase in output. If points G, J, L, N, H, К, M and P
are connected with the lines OA and OB, they are the ridge lines. On both
sides of the ridge lines, it is uneconomic for the firm to produce while it is
economically feasible to produce inside the ridge lines.
Check your Progress :
1) Define isoquant.
2) Why isoquant cannot intersect each other.
3) Define ridge lines.
5.10 PRODUCER’S EQUILIBRIUM
Producer’s equilibrium is also known as least cost combination of inputs
and optimal combination of inputs. The main aim of any firm or a
producer is to maxim ise his profit either by increasing the level of output
or sale or by producing the output at lower cost. A firm by analysing its
production function can choose the combination of factors inputs which
cost him least in his production which is technically e fficient. In this way a
firm can maximise its profit. There are two ways to determine the least
cost combination of factors to produce the given output. i.e.
a) Finding the Total cost of Factor combinations.
b) Geometrical method.
a) Finding the Total cost of fa ctor combination: This method helps the
producer to choose the combination by finding the total cost of production.
The cost of each factor combination is found by multiplying the price of
each factor by its quantity and then summing it for all inputs. The firm
will choose those combination of inputs of which total cost is least. To
explain this in detail we will explain it with the help of following
illustration.
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69 Least cost production technique
Method Labour
(units) Capital
(units) Labour cost
(100 per unit) Capital cost
(200 per unit) Total
cost
A 8 10 8×100 = 800 10×200 = 2000 2800
B 6 15 6×100 = 600 15×200 = 3000 3600
Table 5.4
The above table shows two methods of production A and B. There are two
factors of production labour and capital. Th e producer has to choose any
to the combination or method where the cost of labour per unit is 100 Rs
and cost of capital per is 200 Rs. If the firm choose method A where he
can use 8 units of labour and 10 units of capital where the total cost of
producti on is 2800 Rs. And if he chooses method B where he can 6 units
of labour and 15 units of capita to produce the same level of output and
where the cost of production is 3600 Rs. It is efficient for the firm to
choose method A then B because the same level o f output can be produced
at a leaser cost with method A.
b) Geometrical method: Another important method to determine the
least cost combination of factors is geometrical method. It is the easiest
method to explain with the help of iso quant map and iso cost line. We
explain both this method in detail below:
Iso-quant map: As we have already explained what iso quant map is. It
shows all the possible combination of factors that can be produce at
different level of output. This is shown in fig. higher the iso quant
represents higher the level of output. In other words, iso quant closer to
the origin denotes a lower level of output.
Diagram 5.19 munotes.in
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70 Iso-cost line: The iso cost line is similar to as budget line or price line of
consumer theory. Iso cost line ma y be defined as the line which shows
different possible combinations of labour and capital that a producer can
afford to buy given his total expenditure to be incurred on these factors
and price of the factors. In other, it is the line which shows the vari ous
combinations of factors that will result in the same level of total cost. It
refers to those different combinations of two factors that a firm can obtain
at the same cost. Iso cost line can be explained with following Diagram
5.20
Diagram 5.20
In the above fig the line AB is the iso cost line which shows a firm can
hire OA of capital OB of labour or any combination of capital and labour
on AB curve. Thus, iso cost line is the locus of all those combinations of
labour and capital which, given the prices of labour and capital, could be
brought for a given amount of money. The slope of the iso cost line is
equal to the ratio of the factor prices, that is, the slope of the iso cost line KLPP.
Where, P L is the price of labour an d P k is the price of capital.
If the money to be spend on the factors increases the iso cost line will shift
to the right and it denotes that, with the given factor prices, the firm could
buy more of the factors. The iso cost lines closer to the origin sh ow a
lower total cost outlay.
Optimal input combination for minimising cost:
If the firm has to produce a product with the given output by the minimum
cost, he will choose optimal minimising cost method. In this method the
firm will minimise its cost at the point where the iso quant is tangent to the
iso cost line. To explain this, we will take a help of the following Diagram
5.21 given below:
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71
Diagram 5.21
Explanation of the diagram:
Labour is taken on X axis where the capital on Y IC, I1C1, and I 2C2 are
the family of Iso cost lines. IQ denotes the single iso quant which
produces the desired level of output. The iso cost line having a same slope
because the factor price is assumed to be constant. The firm minimises its
cost at the point ‘E’ where t he iso quant IQ and Iso cost I1C1 are tangent.
It shows the producer can produce the given output by using minimum
quantity of input at minimum or least cost.
Thus, at the point ‘E ’at the point of tangency the ratio of the marginal
product of two factor s i.e. labour and capital is equal to the ratio of their
factor prices. To illustrate,
MPLMPKSlope of isoquant. PLPKSlope of iso cost line
Optimal input combination for maximisation of output:
In this method t he firm has to maximise its output for a given cost. The
equilibrium condition is this method is a s same as the minimisation
method of output. But the maximisation of output method is conceptually
different then the minimisation method. The following conc ept can be
explained by the given diagram below:
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72
Diagram 5.22
Explanation of the diagram:
Labour is taken on the X axis and capital on Y axis. AB is the firms Iso
cost line. Q, Q1, Q2 is the iso quant.
The maximum level of output a firm can prod uce is at the point ‘E’ where
the isoquant Q1 is tangent to the iso cost line AB. The point above the ‘E’
will be on the Iso quant Q2 which is higher but nit attainable for the firm
and iso quant Below the point ‘E’ is less productive.
Thus, the above tw o analysis minimisation output and maximisation of
output helps the firm to maximise their profits according to the factor cost
or factor prices.
5.11 EXPANSION PATH
Expansion path is also called scale line. The expansion path is so called
because if th e firm decides to expand its operations, it would have to move
along this path. The expansion path in simple word is defined as the locus
of the points of tangency between the isoquants and iso cost lines. The
expansion paths show how a business firm tries to expand his output in the
long run with the given factor prices and the given various factor
combinations. This can be explained with the following diagram given
below:
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Diagram 5.23
Explanation of the diagram:
X axis examines Labour and Y axis Ca pital. IC, I1C1 and I2C2 are the
isocost line parallel to each other which shows factor prices are assumed
to be constant. Q, Q1 and Q2 are the Iso quant. ‘e’ is the point of tangency
which shows a firm can produce Q level quantity of output with least co st
and least combination of factors of production. Similarly, if firms want to
increase his level of output, he will be on point e1 and point e2 for the
maximum level of output at minimum cost and minimum level of factor
inputs. If we join all this tangenc y point E, E1 and E2 we will get a line
OE called as expansion path or scale line. It is important to note that at the
tangency point e, e1 and e2 the marginal rate of technical substitution of
labour for capital is equal to the ratio of factor prices.
Expansion path helps the business firm to find the cheapest way to
produce each level of output with given factor price. It helps the firm to
produce those level of output with the least cost and by using the least
factor combination of input.
5.12 SUMMAR Y
The current unit had studied the production function and various concepts
of production decision which helps the firm to take the appropriate
production and supply decision. The term ‘production’ is very important
and broader concept in economics. To me et the daily demand of a
consumer production is essential part. Production is a process by which
various inputs are combined and transformed into output of goods and
services, for which there is a demand in the market. It has discussed two
very important t heory of production function. The law of variable
proportion is a short run production function theory. This law plays a very munotes.in
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74 important role in the economic theory, which examines t he production
function with one variable factor keeping the other factors input fixed.
Law of returns to scale is a long run production function theory. In this
theory all factors of production are variable no factors are fixed. With the
change in the fact ors of production scale of production will change
accordingly. The unit has also discussed the concept of iso quant and its
properties in detail and concluded with producer’s equilibrium and
expansion path.
5.13 QUESTIONS
1) Explain the law of variable prop ortion in detail.
2) Explain the law of returns to scale.
3) What is isoquant? Discuss its properties in detail.
4) Define isoquant. Explain the different types of isoquants.
5) Write a short note on:
a. Ridge lines
b. Expansion path
c. Producers behaviour
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75 6
ECONOMIES OF SCALE AND
DISECONOMIES OF SCALE
Unit Structure :
6.0 Objectives
6.1 Introduction
6.2 Economies of scale
6.3 Internal economies of scale
6.4 Internal diseconomies of scale
6.5 External economies of scale
6.6 External diseconomies of scale
6.7 Economies of scope
6.8 Summary
6.9 Questions
6.0 OBJECTIVES
To study the internal and external economies and diseconomies of
scale
To understand the economies of scope
6.1 INTRODUCTION
Adam smith in his famous book ‘Wealth of the Nation’ 1776 analyse the
advantages of Division of labour which is capable of generating
economies of scale in static as well as in dynamic sense. Economies of
scale is a real phenomenon to the real -world situation which helps to
understand the real situation in t he world economy. In microeconomics,
economies of scale is a cost advantage method of production where the
firm operates its level of output by producing the scale of operation with
cost per unit of output decreases with the increasing scale of output.
Whe re the diseconomies of scale are the opposite of economies of scale.
6.2 ECONOMIES OF SCALE
According to Alfred Marshall Economies of scale are broadly classified
into Internal economies of scale and external economies of scale. In the
large -scale produ ction, the cost of production should be low which is munotes.in
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76 called as economies of scale. A firm enjoy internal economies of scale
when he expands his size or scale of production in economy by making
changes in the internal factors of production. Where on the oth er hand a
firm enjoy internal economies of scale when he expands his size of
production in economy by making changes in the external factors of
production. So now we will explain both internal and external economies
of scale in details.
6.3 INTERNAL ECONO MIES OF SCALE
Internal economies of scale are an increase in the scale or size of
production or output of a firm these are solely enjoyable by firm
independently by making changes in the input factors of production into
his business. The internal economie s of scale have various different types
which are as follows:
1) Labour economies: Adam smith in this book “An inquiry into the
nature and causes of the wealth of the nation” 1776 emphasised on the
division of labour. Economies of labour also implies the be nefit which is
arising in the scale of economy due to division of labour. Division of
labour increases the efficiency in production which leads to increase in the
size of output. Division of labour bring specialisation in labour skills and
also saves time which in turn increases the level or scale of output. Thus,
with the specialisation of division of labour the firm produces large scale
of production.
2) Technical economies: technique of production also increases the scale
of production. In other words, te chnical economies refer to increase in the
scale of production due to change in technical or methods of production
which reduces the cost of production. Technical economies increase the
dimension of firms where the average cost of production decreases and
average revenue will be high.
3) Managerial economies: Manager plays an important role in managing
business activities. Managerial economies refer to the specialisation of
managerial function which increases the level of output. It is a mangers
duty to car ry out all the managerial decision efficiently and effectively in
the business organisation. Division of managerial activities increases the
management of the business efficiently.
4) Financial economies: finance plays and important role in process of
produ ction. It is one of the important and essential factors of production. It
is always observed that the large firms enjoy the benefit of better credit
facility from banks then the small -scale firm. They also get the credit
quickly and easily then the small f irm or producer.
5) Marketing economies: marketing economies deals with the process of
buying raw materials and selling of finished goods. A large firm have a
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77 because it buys in bulk then th e small firm. This in turn helps him to
produce more at less cost and sell large amount of output in the market
than the small firm.
6) Transport and storage: The large -scale firm have its own transport
and storage facility which reduces his transportation a nd storage cost. This
reduces the average cost of large -scale firm and increase the scale of
output or revenue. Where the small -scale firms hire or pay rent for the use
of transport and storage facility.
6.4 INTERNAL DISECONOMIES OF SCALE
If the firm is unable to manage the level of output or the scale of operation
diseconomies of scale occurs. If firm do not understand the importance of
the specialisation of division of labour and specialisation of division
management activities the level of output or scale of operation decreases
leads to diseconomies of scale in economy. Suppose a firm take huge
amount of loan from a financial institution or banks to expand his level of
output. Such loan increases the burden on firm to prove their credit leads
to fina ncial diseconomies of scale.
Check your Progress :
1) What are Internal Economies of Scale?
2) What are Internal Diseconomies of Scale?
6.5 EXTERNAL ECONOMIES OF SCALE
External economies of scale refer to those economies which provides
benefits and faci lities to all firms of given industry. It is an economy
which is enjoyed by all firms of industry irrespective of their size of
operation. External economies of scale are also of various types which are
follows:
1) Localisation economies: when a number of fi rms are located on one
place with an objective of deriving the mutual benefits of training of
skilled labour, provision of better transport facility etc. all these advantage
helps the firm to reduce cost of production. Thus, localisation economies
refer to concentration of a particular industry in one area which results in
the development of conditions of industry which will reap the mutual
benefits of all firms in the economy.
2) Disintegration economies: disintegration means firms splitting up its
operation and the process of manufacture and handing over the specialised
agency and institution is called economies of disintegration. There are two
types of disintegration such as vertical and horizontal disintegration of
economies. The firm which operates on dis integration of economies of
scale will be able to get economies of scale when it operates on a large
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78 3) Information economies: proper information in economy plays an
important role for the producer to grow his economy. Networking with
each other enabl es firms to make marketing and technical information
easily.
4) By-product economies: to manufacture by -products a large -scale firm
make use of waste material. This will help all the firm in the industry to
reduce the waste in the economy and make efficient use of resources. This
will ultimately reduce the cost of production and increase the level of
output.
6.6 EXTERNAL DISECONOMIES OF SCALE
External diseconomies of scale results when there is an increasing in the
total cost of production beyond the contr ol of a company and it reduces
the level of output. The increase in costs can be due to increase in the
market price of factors of production. The external diseconomies are not
suffered by a single firm but by whole firms operating in a given industry.
These diseconomies arise due to much concentration and localization of
industries beyond a certain stage. For example, Localization may lead to
increase in the demand for transport and, therefore, transport costs rise and
it leads to diseconomies of scale in the economy.
6.7 ECONOMIES OF SCOPE
Economies of scope refer to a situation where in the long -run a firm tries
to reduce average and marginal cost of production by producing large
varieties of output. In other words, economies of means a firm produces
multiple products instead of producing one single product to increases his
scope of output by using the same equipment’s and machine as a result of
this average cost decreases.
Economies of scope is different from economies of scale, in that where the
former means producing a variety of different products or multiple of
product together to reduce costs while the latter means producing more of
the same product in order to reduce the costs by increasing the efficiency
in production.
Economies of scope can arise from the co -production relationships
between the final products or the actual products. In economic terms these
goods are complements in production. This is when the production of one
good automatically produces another good as a by -product or a kin d of
side-effect in the production process. Sometimes one product might be a
by-product of another, but have value for use by the producer or for sale.
Finding a productive use or market for the co -products can reduce costs or
increase revenue.
For exampl e, dairy farmers separate milk into whey and curds, with the
curds going on to become cheese. In the process they also end up with a munotes.in
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79 lot of whey, which they can use as a high protein feed for livestock to
reduce their feed costs or sell as a nutritional pr oduct to fitness enthusiasts
and weightlifters for additional revenue. Another example of this is the
black liquor produced by the processing of wood into paper pulp. Instead
of being just a waste product that might be costly to dispose of, black
liquor is burned as an energy source to fuel and heat the plant, saving
money on other fuels, or can even be processed into more advanced bio -
fuels for use on -site or for sale. Producing and using the black liquor saves
costs on producing the paper.
Check your Pro gress :
1) What do you mean by Economies of scope?
2) What is by product economies?
6.8 SUMMARY
The current unit studied the concept of economies and diseconomies of
scale in detail. According to Alfred Marshall Economies of scale are
broadly classified into Internal economies of scale and external economies
of scale. In the large -scale production, the cost of production should be
low which is called as economies of scale. Internal economies of scale are
an increase in the scale or size of production or output of a firm these are
solely enjoyable by firm independently by making changes in the input
factors of production into his business.
External economies of scale refer to those economies which provides
benefits and facilities to all firms of given ind ustry. It is an economy
which is enjoyed by all firms of industry irrespective of their size of
operation. It also discuss the internal factors and external factors of scale
in details.
6.9 QUESTIONS
1) Explain the internal and external economies of scale.
2) Explain in brief external economies and diseconomies of scale.
3) Write a short note on: Economies of scope.
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COST CONCEPTS
Unit Structure :
7.0 Objectives
7.1 Concepts of cost
7.2 Cost and output relationship in the short run and in the long run
7.3 Short run and long run cost curves and numerical problems
7.4 Long run average cost and Learning curve
7.5 Summary
7.6 Questions
7.0 OBJECTIVES
To study various concepts of cost
To understand the relationship between short run and long run cost
curves
To study the concept of break -even analysis and und erstand its
application in business
7.1 CONCEPTS OF COST
A firm who wants to maximize their profit concentrates on revenue and
cost of the firm. Profit of the firm can be increased either by increasing
revenue or by reducing cost. Firm generally cannot influence revenue
because it is determined by the market forces but it is possible for the firm
to reduce cost by producing maximum output or by increasing efficiency
of the organization.
For managerial decision -making, cost is very important because it helps to
decide price for the commodity. It also helps to decide w hether to increase
the production or not. Therefore, understanding of cost concepts is very
important.
a. Private cost and Social cost:
Costs which are directly incurred by the individual or firm producing good
or service is called private cost. This cost giv es private benefit to an
individual or firm engaged in relevant activity. Some of the examples of
private cost are firm’s expenditure on purchase of raw material, payment
of rent, wages and salaries, interest, insurance, depreciation etc. Similarly munotes.in
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Cost Concepts
81 company ’s expenditure for its labor, advertising cost for the promotion of
goods, transportation cost to carry goods from company to the market are
also considered as private cost.
Social cost on the other hand is bared by the society as a result of
production of commodity. Even though social cost occurs due to
production of a commodity it is not bared by the producer. It consists of
external cost. E.g.: If a factory is located in a residential area causes air
pollution. Due to pollution as the health of the peopl e living in that area
affects, they have to spend money on medical facilities. Even though this
cost occurs due to the factory, it is passed on to the society at large.
Externalities are included in the social cost.
b. Historical cost and Replacement cost:
The original money value spent at the time of purchasing of an asset is
called historical cost. Most of the assets in the balance sheet are at the
historical cost. One of the advantages of historical cost is that records
maintained on the basis of historica l cost are considered to be reliable,
consistent, comparable and verifiable. Historical cost does not reflect
current market valuation.
The amount which has to be spent at the time of replacing of the existing
asset is called the replacement cost. This cos t reflects the current market
prices. If we consider an increase in prices over the years, replacement
cost will be greater than historical cost. If we consider fall in prices over
the years, replacement cost will be less than historical cost and if we
consider prices to be constant over the years, replacement cost and
historical costs are the same.
c. Fixed cost and Variable cost:
Fixed cost refers to the firm’s expenditure on fixed factors of production.
Even if no output is produced, fixed cost needs to be paid. Even if output
increases in the short run, fixed cost remains constant. E.g.: If a
businessman borrows money from a bank to start his business. Initially
even if his output is zero, he has to pay the interest on borrowed capital.
Rent on land, insur ance premium, tax payment are some of the examples
of fixed cost. Addition of all fixed cost gives Total Fixed Cost.
Variable cost on the other hand refers to the firm’s expenditure on variable
factors of production. When no output is produced, variable co st is zero.
As output increases, variable cost also increases. Payment for raw
material, wages and salaries of the workers are some of the examples of
variable cost. Addition of all variable costs gives the Total Variable Cost.
d. Total cost, Average cost and Marginal cost:
Total cost (TC) – Firms total expenditure on all fixed and variable factors
for producing a commodity is called the Total cost of production.
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82 Therefore TC= TFC+TVC
For zero level of output there is some total cost. It increases with an
increase in the level of output.
Average Cost (AC) or Average Total Cost (ATC) – It refers to the per
unit cost of producing a commodity. It is calculated by the following
formula
AC = TC/Q
Where AC = Average cost TC = Total cost Q = Number of units
produced
Average cost can also be calculated by using following formula -
AC or ATC = AFC+AVC
Where AC - Average Cost AFC - Average Fixed Cost
AVC - Average Variable Cost
Average Fixed Cost (AFC) - It is the per unit fixed cost of production. It
can be calculated by the following formula
AFC= TFC/Q
Where TFC= Total Fixed Cost Q = Number of units produced
Average Variable Cost (AVC) - It is the per unit variable cost of
production. It can be calculated by the following f ormula
AVC= TVC/Q
Where TVC= Total Variable Cost Q= Number of units produced
Marginal Cost (MC) - It is the addition made to the total cost. Or cost of
producing an additional unit of output is called as the marginal cost. It can
be calculated by using following formula
MC = Change in total cost/ change in output TCQ
Where, TC= Change in Total Cost
Q = Change in Output
OR
MC= TCn - TCn-1
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Cost Concepts
83 Eg: If total cost of producing 2 cars is Rs. 3, 00,000 and the total cost of
producing 3 cars is Rs. 4, 50,000. Then the marginal cost is Rs. 1, 50,000
i.e. the cost of producing an additional unit of output.
e. Sunk Cost and Incremental Cost:
In order to enter in to the market certain costs are incurred by the firm.
These costs are known as Sunk cost. It includes the cost by the firm for
setting up the business, advertisement etc. These costs cannot be recovered
by the firm if they decide to exit the ma rket.
Incremental cost refers to a change in total coat as a result of policy
change or a change in managerial decision. The concept of incremental
cost is broader as compared to marginal cost.
Marginal cost considers a change in total cost due to a unit c hange in
output whereas incremental cost considers a change in total cost due to an
introduction of new product, change in advertising strategy, additional
batch of output etc. The concept of incremental cost is more relevant as
compared to marginal cost b ecause the firm increases its output in batches
and not by unit only.
f. Implicit Cost and Explicit Cost:
Implicit cost refers to the cost of all own factors which the entrepreneur
employs in the business. It includes salary and wages for the service of
entre preneur, interest on capital invested by the entrepreneur etc. Implicit
costs are also called indirect cost because direct cash payment is not made
to own factors of production.
If entrepreneur sold these services to others, he would have earned money.
Therefore, implicit cost is also the opportunity cost of factors owned by
him.
Explicit cost on the other hand is the direct cash payment made by the firm
for purchasing or hiring of various factors of production. E.g. rent paid for
hiring of land, money spen t for purchasing for raw material, wages and
salaries paid to the employees, expenditure on transport, power,
advertising etc.
g. Accounting and Economic Cost:
Accounting cost includes only explicit cost i.e. the firm’s expenditure on
purchasing of various fa ctors of production. For financial purpose and tax
purpose, accounting cost is important.
Economic cost on the other hand includes both explicit and implicit cost.
This cost is important for managerial decision making. Therefore an
economist who wants to t ake any decision considers both explicit and
implicit cost.
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84 Check your Progress :
1) Give two examples of Private Cost & Social Cost.
2) Explain concepts of total fixed cost & total variable cost.
3) Consider a firm who is producing a truck. What are t he various fixed
and variable factors of production it require? Make a list of all those
factors.
4) The total cost of producing 5 TV Sets is Rs. 1,00,000 if the firm
produces 6 TV sets its total costs increases to Rs. 1,35,000. What is the
marginal cost for 6th TV Sets.
7.2 COST AND OUTPUT RELATIONSHIP IN THE
SHORT RUN AND IN THE LONG RUN
Relationship between TFC, TVC and TC in the short run
TFC is the firm’s total expenditure on fixed factors of production. For zero
level of output TFC is zero. It remai ns constant for all the levels of output.
TVC on the other hand is the firm’s total expenditure on variable factors
of production. For zero level output TVC is zero. It increases with an
increase in the level of output.
Total cost is the additional of Tota l Fixed Cost and Total Variable Cost. In
the following table relationship between TFC, TVC and TC is discussed
for different units of output
Table 7.1 Output TFC TVC TC
0 50 0 50
1 50 20 70
2 50 35 85
3 50 45 95
4 50 65 115
5 50 95 145
6 50 140 190
7 50 200 250
8 50 280 330
(All Costs in Rupees) munotes.in
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85 Explanation – In table 7.1 First column shows various levels of output
starting from zero units to 8 units. Second column shows TFC. As fixed
factors of production are constant for certain level of outpu t TFC is also
constant for all level of output. For zero level of output also TFC is Rs. 50.
Third column shows TVC which is zero for zero level of output. With an
increase level of output TVC initially increases at decreasing rate then
increases at an inc reasing rate. This is because of the law of variable
proportions. Forth column shows TC which is the addition of TFC and
TVC. TC increases with an increase level in the output. TC increases in
the same proportions as increased in TVC.
This relation betwe en TFC, TVC and TC can be explained with the help of
following diagram.
Two curves are parallel to each other.
Diagram 7.1
By plotting different combinations of output and TFC, TVC and TC, we
have TFC curve, TVC curve and TC curves.
Diagram shows that TFC curve is a straight -line curve parallel to X axis.
This is because when output is zero, some fixed cost has to be paid and
this cost remains constant for all the levels of output. TFC curve is
horizontal.
TVC curve starts at the point of origin becaus e when output is zero, TVC
is also zero. TVC curve initially increases at a diminishing rate with an
increase in the level of output and then increases at an increasing rate.
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86 As TC is the addition of TFC and TVC, TC curve is above TFC and TVC
curves. The shape of TC curve is same as the TVC curve. The gap
between TC and TVC curve measures TFC.
Cost and output relationship:
Cost Function
Production function gives the functional relationship between the level of
output and the various factor inputs (land, la bor, capital and entrepreneur).
The cost of production depends on the level of output produced, nature of
technology used, prices of factors of production. Thus, the cost function is
derived from the production function. The cost function is given as -
C = f (Q, T, Pf)
Where C = total cost Q = Level of output produced T = Technology
Pf = Prices of factors f = Functional relationship
If we assume that technology, prices of factors are constant, total cost
increases with an increase in the le vel of output i.e. C = f(Q).
Any change in production function will shift cost function either up or
down. E.g. Use of better techniques of production, use of better -quality
raw material, use of efficient labors etc. will improve the production
function an d thus reduce the cost function. Similarly use of poor -quality
raw material, inefficient techniques of production, unskilled labor will
shift the production function up.
The relationship between cost and output needs to be studied in the short
run and in t he long run.
7.3 SHORT RUN COST - OUTPUT RELATIONSHIP
As the name suggests short run is a very short period where the firm
produces its output by changing only variable factors of production. This
is because in the short run fixed factors of production re main constant for
all the levels of output. Following table shows the behavior of output and
various costs in the short run.
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87
(Table 7.2)
Output TFC TVC TC AFC AVC AC MC
0 50 0 50 - - - -
1 50 20 70 50 20 70 20
2 50 35 85 25 17.5 42.5 15
3 50 45 95 16.66 15 31.66 10
4 50 65 115 12.5 16.25 28.75 20
5 50 95 145 10 19 29 30
6 50 140 190 8.33 23.33 31.66 45
7 50 200 250 7.14 28.57 35.71 60
8 50 280 330 6.25 35 41.25 80
(All costs in Rupees)
In the above table output is sh own in the (1st) column, which increases
from 0 units to 8units. For all the levels of output TFC in column (2)
remain constant i.e. Rs. 50. TVC in the (3rd) column is zero for zero level
of output. And then increases with an increase in the level of outpu t. In
column (4) TC is calculated by adding TFC and TVC.
AFC in column (5) is calculated by using the formula TFC/Q. As TFC
remain constant for all the levels of output, AFC continuously declines
with an increase in the level of output.
AVC in column (6) is calculated by using formula TVC/Q. Initially AVC
declines. At third level of output it reaches to the minimum and then
increases with an increase with an increase in the level of output.
AC in column (7) is calculated by using the formula TC/Q. AC also
declines initially reaches to the minimum point at 4th unit of output and
then increases with an increase in the level of output.
MC in column (8) is the cost of producing an additional unit of output. It
is calculated by the formula TCQorTVCQ. This is because TC increases
by the same amount as increase in TVC. MC initially declines, reaches to
minimum and increases thereafter.
Diagrammatic relationship between AFC, AVC, AC and MC is as
follows -
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88
Diagram 7.2
Explanation:
1. As AFC is continuously declining. AFC curve slopes downward from
left to right.
2. Initially AVC curve is declining, reaches to a minimum and then
increases with an increase in the level of output. AVC curve starts
increasing after a no rmal capacity level of output is produced. More
intensive use of various factors of production leads to an increase in
AVC.
3. AC curve lies above AFC and AVC curves because AC is the addition
of AFC and AVC. AC curve initially declines due to fall in AFC
curve. AC curve reaches to minimum point and then increases due to
an increase in AVC curve. AC curve is a U -shaped curve.
4. MC curve is also a U -shaped curve. MC curve also falls in the
beginning, reaches to the minimum and then increases. When MC
curve starts rising, it intersects the AVC curve and AC curve at their
minimum point.
Relationship between AC and MC:
AC is the per unit cost of production and marginal cost is the cost of
producing an additional unit of output. Relationship between AC and MC
can be discussed with the help of following diagram.
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89
Diagram 7.3
• For initial levels of output AC and MC both curves are declining,
but MC is less than AC. When MC is less than AC it means that cost of
producing an additional unit of output is less tha n per unit cost of
production. As MCAC curve is declining.
• At a certain level of output (optimum level of output) AC is
minimum. At this point MC curve intersects AC curve. Thus AC=MC. It
means that cost of producing an additional unit of output is exactly equal
to the average cost of production. As AC=MC, new AC must be equal to
the old average cost.
• At higher levels of output AC and MC both are increasing but
MC>AC. It means that the cost of producing an ad ditional unit of output is
greater than the average cost of production. As MC>AC, new average cost
must be greater than old average cost. Therefore, AC curve is rising.
From the above explanation we can conclude that when
• MC• MC=AC, AC curve is flat as MC pulls AC horizontally.
• MC>AC, MC pulls the AC curve up.
• Long run cost and output relationship
As the name suggests long run refers to a sufficiently long period. As the
long period is available, firm can make necessary change in all factors of
production as per the changes in demand. Thus, in long run all factors of
production are variable. Hence there are no fixed cost in the long run.
Depending on the type of industry the length of long run can differ. For a
firm producing a particular product, long run may be years.
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90 In the long run firm can make proper planning and build that size of plant
which will minimize the cost of production for producing optimum level
of output. Once the particular plant has been built, the firm op erates in the
short run. This means that even though firm operates in the short run, it
plans in the long run.
Check your Progress :
1) Is it possible to have a straight line TVC and TC curves? Justify.
2) On the basis of following data calculate TVC, AVC and MC
Output 0 1 2 3 4
TC 70 100 150 220 300
3) Discuss Relationship between AC & MC.
7.4 LONG RUN AVERAGE COST CURVE
Different plant sizes are available to the firm to operate in the long run.
For a specific level of output, the plant of specific s ize is more suitable.
For every size of plant there will be a specific average cost and thus a
specific average cost curve. In the long run different short run average cost
curves are available for different sizes of plant. The firm has to choose the
speci fic size of plant for its operation.
Derivation of Long run average cost curve with a number of short run
average cost curves can be discussed with the help of following diagrams -
Diagram 7.4
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Cost Concepts
91 Here we assume that there are three sizes of plant.
Above f igure shows that there are three plants available to the firm and are
shown by three different cost curves - SAC1, SAC2 and SAC3. For a
particular level of output, a specific plant is most suited.
Above diagram shows that for producing OQ level of output o n plant
SAC1, cost is BQ and on plant SAC2 cost is AQ. This shows that OQ
level of output can be produced with lower cost QB with SAC1 as
compared to plant SAC2.
If the firm wants to produce OQ1 level of output, it can be produced either
with plant SAC1 or SAC2. But it is better for the firm to go with plant
SAC2 because as shown in the diagram higher level of output OQ2 can be
produced with much lower cost on SAC2. With plant SAC2, output
greater than OQ1 and less than OQ3 can be produced at lower average
cost.
For output greater than OQ3 firm will use plant SAC3 because the average
cost with SAC2 will be greater as compared to average cost with SAC3.
Derivation of LAC
Diagram 7.5
From the above explanation it is clear that in the long run the firm has
alternative plant sizes available for the production and the firm will choose
that plant size which gives minimum average cost for producing a given
level of output. Accordingly ( Fig 7.4) with three short run average cost
curves the Long run Average Cost curve is HBCEGI.
If we assume that there are infinite plant sizes available, there are number
of short run average cost curves corresponding to each plant size.
Therefore, the LAC will be a smooth U -shaped curve as shown in
(Diagram 7.5) above. munotes.in
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92 As LAC cur ve is a locus of points of the lowest average cost of producing
different levels of output. Every point of LAC will have a tangency point
with SAC curve. It can be seen from the above diagram that LAC curve is
tangent to the minimum point of SAC3 curve onl y at the optimum level of
output OQ. Plant SAC3 is considered as the optimum size of plant because
it produces optimum level of output OQ with minimum cost CQ.
For any output less than OQ, LAC curve is tangent to SAC curve on its
declining part ie. at poin t A and B on SAC1 and SAC2. For any output
greater than OQ, LAC curve is tangent to SAC curve on its increasing part
i.e. At point D and E on SAC4 and SAC5.
It can be seen from (Diagram 7.5) that LAC curve initially declines,
reaches to minimum and again i ncreases with an increase in the level of
output. LAC curve is much flatter than SAC curves. LAC curve declines
due to economies of scale and increases due to diseconomies of scale.
As the LAC curve includes the family of short run average cost curves, it
is called an Envelop curve. In the long run firm can also plan to increase
its scale of production and therefore LAC curve is also called the
Planning Curve.
Learning curve:
The learning curve shows an inverse relationship between an average cost
of produc tion and the level of output. This means that as firm produces
more and more output, its average cost of production declines. Therefore,
the learning curve slopes downward from left to right. Following diagram
explains the learning curve effect.
Diagram 7.6
In the above diagram X axis represents total output and Y axis represents
the average cost. It shows that average cost is RS.6000 for producing 10
units of output. As output increases to 20, 30 and 40 units, average cost munotes.in
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Cost Concepts
93 declines to 4000, Rs. 3000 and Rs. 2000 respectively. Points P, Q, R and S
shows different combinations of output and average cost.
Learning curve effect is a result of an experience which the firm gains
during the process of production. When the firm is new, it takes time for
the firm to produce the output. Thus, the costs are high. As firm becomes
older, it learns to use new techniques of production, efficient way of using
raw material and skills. Workers also become efficient over a period of
time. All this will help to reduce the ave rage cost of production. Firm
learn to reduce cost through experience. Therefore, learning curve is also
called an Experience curve . The effect of learning curve applies to the
manufacturing and service sector.
As shown in the diagram learning curve initi ally declines faster and then
declines at a slower rate. This means that when the production process is
new, average cost declines much faster as compared to the old production
process.
Check your Progress :
1) What do you mean by Envelope Curve?
2) What do you mean by Learning Curve?
7.5 SUMMARY
This unit studies the cost function which is being derived from the
production function. It discusses different concepts of costs with examples
and explains the behaviour of cost curves in the short run and long r un. It
also includes calculations of various costs like TFC, TVC, TC, AFC,
AVC, AC and MC.
This unit explains how firm learns to reduce their average cost of
production through experience over a period of time through the concept
of learning curve or exper ience curve.
7.6 QUESTIONS
Q.1 Explain the following concepts -
a) Implicit cost and Explicit cost
b) Private cost and Social cost
c) Historical cost and Replacement cost
d) Total cost, Average cost and Marginal cost
e) Fixed cost and Variable cost
f) Opportunity cost
Q.2 Explain the relationship between TFC, TVC and TC with the help of
diagram. munotes.in
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94 Q.3 Define AC,AFC, AVC and MC and also discuss the relationship
between them.
Q.4 Bring out the relationship between AC and MC.
Q.5 Explain the derivation of Long run Average Cos t curve.
Q.6 Discuss the Learning curve effect.
Q.7 If the Total fixed cost of production is rs.75, with the help of
following data, calculates TC, AC, AFC, AVC, MC.
Output 0 1 2 3 4 5
TVC 0 35 50 70 100 160
Q.8 With the help of following information, c omplete the table given
below.
Output TFC TVC TC AFC AVC AC MC
0 80 0
1 80 40
2 80 70
3 80 120
4 80 190
5 80 290
6 80 420
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95 8
EXTENSION OF COST ANALYSIS
Unit Structure :
8.0 Objectives
8.1 Concept of break - even point
8.2 Changes in break - even point due to price, fixed cost and variable cost
8.3 Application of break - even analysis
8.4 Limitations
8.5 Case study
8.6 Summ ary
8.7 Questions
8.0 OBJECTIVES
To understand the concept of break - even point
To understand the effects of change in price, fixed cost and variable
cost on break - even point
To study the actual application of break -even analysis in business
To study the limitations of break -even analysis
8.1 CONCEPT OF BREAK -EVEN POINT
Break -even analysis studies the relationship between total cost, total
revenue, total profits and losses over a range of output. Break -even point
is a point where the total revenue of the firm is equal to total cost.
Therefore, at break -even point there is no profit, no loss.
Break -even analysis technique is used in the business to determine the
level of production or sales volume which is necessary for the business to
cover its cost of doing a business. In financial analysis the concept of
break -even point is most commonly used. The concept of break -even point
can be explained with the help of following table -8.1
Output TR TC Profit/ Loss
0 0 1200 -1200
1 1000 1500 -500
2 1400 1800 -400
3 2000 2000 0
4 2600 2200 400
5 3500 3000 500
Table 8.1 munotes.in
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96 Above table shows that break -even level of output is 3 units because,
firms TR and TC are equal at 3 units of output and therefore there is no
profit, no loss.
Break -even point can also b e explained with the help of following diagram
Diagram 8.1
Above diagram is drawn on the basis of the assumption that TR and TC
curves are linear i.e. TR and TC increases at a constant rate with an
increase in the level of output. Therefore, TR and TC curves are straight
lines.
For initial levels of output total cost is greater than total revenue therefore
the firm is making loss. At output OQ, firm stops making loss, TR=TC
therefore there is no profit no loss. Thus, OQ is the break -even output and
B1 is the break -even point. After OQ level of output total revenue is
greater than total cost and thus firm starts making profit.
When TR and TC curves are linear, there is only one break - even point.
According to above diagram entire output after break -even output gives
profit. However, this may not be true because of changes in price and cost.
If we do not consider constant change in TR and TC, TR and TC curves
are non -linear. In this case we have more than one break -even point as
shown in the following di agram -
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Extension of Cost Analysis
97
Diagram 8.2
In the above diagram on the Y axis we measure cost and revenue and on
the X axis we measure output.
In case of non -linear TR and TC curves there two break -even points P and
Q, indicating lower level of output OM and higher level of output ON
respectively. For any output less than OM and greater than ON, firm
makes losses because TC>TR. Between the range of output M and N,
TR>TC and thus firm makes profit.
8.2 CHANGES IN BREAK - EVEN POINT DUE TO
PRICE, FIXED COST AND VARIABLE COST
Break-even point or break -even quantity changes due to change in
following factors -
• Changes in price
• Changes in fixed cost
• Changes in variable cost
Changes in break -even quantity and break -even point due to above factors
can be discussed with the help of f ollowing example -
• Changes in price
Any change in price will have an effect on total revenue and therefore also
on break -even point.
If we consider the same example 1 and consider an increase in price to
Rs.17, and keep fixed cost and average variable cos t constant, break -even
quantity is -
QB = FC/ P -AVC
= 4000/17 -7
= 4000/10
= 400 units. munotes.in
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98 If we consider fall in price to Rs. 12, keeping fixed cost and average
variable cost constant, break -even quantity is -
QB = FC/P -AVC
= 4000/12 -7
= 4000/5
= 800 units.
This shows that with an increase in price, break -even quantity falls and
with a fall in price, break -even quantity increases.
Effect of changes in price on break -even point and break -even quantity
can be explained wit h the help of following diagram.
Diagram 8.3
In the above diagram X axis measures output and Y axis measures cost
and revenue. With an initial TR and TC curves A is the break -even point,
where TR and TC curves intersects. If price increases, TR curve shifts
upward from TR to TR1. This will bring down the break -even point from
A to A1. Similarly, with a fall in price, TR curve shifts downward to TR 2
and thus break -even point also shifts to A 2.
• Changes in fixed cost
For the same mathematical example 1 if we change the fixed cost and
keep price and average variable cost constant, we have changes in
breakeven quantity.
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Extension of Cost Analysis
99 Suppose fixed cost increases to Rs. 5000, break -even quantity is -
QB = FC/P -AVC
= 5000/15 -7
= 5000/8
= 625 units.
If fixed cost falls to Rs. 3600, break -even quantity is -
QB = FC/P -AVC
= 3600/15 -7
= 3600/8
= 450 units.
This shows that with an increase in fixed cost, break -even quantity
increases and with a fall in fixed co st, break -even quantity falls.
Changes in break -even point due to changes in fixed cost can be explained
with the help of following diagram -
Diagram 8.4
On the X axis we measure output and on the Y axis we measure cost and
revenue. With an initial TR and TC curves initial break -even point is B
initial break even quantity is OQ if fixed cost increases, TFC curve shifts
upward to TFC1. As total cost is the addition of TFC and TVC, TC curve
will also shift upward to TC1. This shifts the break -even point at higher
level to B1. Break even quantity has also increased from OQ to OQ 1.
On the other hand, if TFC falls, TFC curve will shift downward to TFC 2.
This will shift the TC curve down to TC 2. Therefore, new break -even
point is B 2 & new break even quantity falls from OQ to OQ 2. munotes.in
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100 • Changes in variable cost per unit
Using the same mathematical problem if we keep price and fixed cost
constant and change the variable cost per unit, we have a change in break -
even quantity.
Suppose the average variable cost per un it increases to Rs. 10, break -even
quantity is
QB = FC/P -AVC
= 4000/15 -10
= 4000/5
= 800 units.
If variable cost per unit falls to Rs. 5, break -even quantity is
QB = FC/P -AVC
= 4000/15 -5
= 4000/10
= 400 units.
This s hows that with an increase in per unit variable cost, break -even
quantity increases and with a fall in average variable cost, break -even
quantity falls.
This can be discussed with the help of following diagram -
Diagram 8.5
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Extension of Cost Analysis
101 In the above diagram X axis measures output and Y axis measures cost
and revenue. Initial break -even point is C where TR and TC curves
intersect. Initial break even quantity is OQ. With an increase in TVC,
TVC curve shifts to TVC1. This also shifts TC curve to TC1. TVC1 and
TC are p arallel to each other. Thus, the new break -even point shifts
upward to C 1 & break even quantity increases from OQ to OQ 1.
With a fall in TVC, TVC curve shifts to TVC 2, shifting down TC curve to
TC 2. Thus, the new break -even point also shifts down to C 2. Again, TVC2
and TC2 are parallel to each other. New break even quantity falls from OQ
to OQ 2.
Check your Progress :
1) What is the important of Break -Even Point?
2) If FC = 2000, Price per unit = Rs. 12 & AVC = Rs. 8 Calculate Break -
even Quantity.
3) Find out the Break -even Point for the firms having following data.
Output 0 1 2 3 4 5 6
TR 0 150 180 270 350 400 560
TC 120 150 170 250 340 390 500
8.3 APPLICATION OF BREAK -EVEN ANALYSIS
Business firms are interested in understanding break -even analy sis
because it helps to determine that level of output which will help the firm
to cover its entire cost and thus to make profit. Break -even point is the
point where the firm starts making profit. Break -even analysis is used in
the business for following p urposes.
• Targeting profits - Firm has to target the level of profit for short run
and long run. Break -even point gives the level of output where the
firm starts making profit. Thus, for setting profit targets, break -even
analysis is important.
• Recovery of cost- At break -even point firm covers its entire cost of
production (including fixed and variable cost). Understanding of
break -even can help the firm to manage its costs in a better manner ie.
the firm can try to reduce cost in order to have early break -even.
• Helps in deciding techniques of production - different techniques of
production are available to the firm. Each technique differs in
efficiency and cost. Break -even analysis helps in deciding a proper
technique of production.
• Effects of changes - in or der to be competitive, firm needs to make
changes in their pricing, marketing and other policies. Any change in
this policy will have an effect on revenue and cost of the firm and
thereby on break -even point. Any change in break -even point will
finally hav e an effect on profitability of the firm. munotes.in
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Business Economics -I
102 • Deciding sales and marketing policies - it is possible for the firm to
lower break -even point by using new marketing strategies. But an
increase in marketing cost will increase the cost of production and thus
will i ncrease the break -even point. Therefore, it is necessary for the
firm to find proper sales and marketing policies to achieve its break -
even point.
• Utilization of capacity - it is possible for the firm to reduce its average
cost when it uses its full capaci ty and thereby reduces wastages and
improves efficiency of resources. This will help to reach break -even
point quickly.
• Capital raising capacity - once the break -even point is reached, it is
possible for the firm to raise capital for its future expansion. P ossibility
of making profit for those firms is high who have reached their break -
even and therefore financial institutions are also ready to give loans to
these firms. On the other hand, firms who have not reached their
break -even finds it difficult to rai se loans from the financial
institutions.
8.4 LIMITATIONS OF BREAK -EVEN ANALYSIS
Various limitations of break -even are as follows -
• Linear TR and TC curves gives wrong impression that the entire
output after break -even point is profitable. But this is not always true.
• In case of single product unit, break -even analysis can be applied. But
in case of multiple or joint products it is difficult to apply break -even
analysis as long as cost cannot be determined for each of the product.
• The data required for break -even analysis including costs, price etc. is
generally historical. If historical data is not proper for estimating
future costs and prices, break -even analysis cannot be usefully applied.
• If it is possible to clearly classify costs as fixed and vari able costs,
break -even analysis is more useful. But sometimes it is not possible to
have such classification of costs.
Even though there are various limitations of break -even analysis, it is
useful in production planning if proper data is obtained.
8.5 CASE STUDY
Break -even level of output can be algebraically determined by using
following formula
BQ = FC/Fixed cost/ Price - Average variable cost i.e. BQ = FC/ P -AVC
Where BQ = Break -even quantity P= Price per unit AVC= Average
Variable Cost
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Extension of Cost Analysis
103 Example 1-
Suppose fixed cost for the firm is Rs. 4000, price per unit of output is Rs.
15 and the Average Variable Cost is Rs. 7, its break -even quantity is -
BQ = FC/ P -AVC
4000/15 -7
4000/8
BQ= 500 units
Break -even sales volume can be calculated by multiplying break -even
quantity by the price per unit of output.
BS = BQ*P
Where BS= Break -even sales volume
BQ= Break even quantity P= Price per unit
BS= 500*15
= Rs.7500
8.6 SUMMAR Y
Extension of cost analysis introduce the concept of break -even point. Here
the concept of break -even point is studied with the help of linear and
nonlinear TR and TC curves. The calculation of break -even sales volume
in units and break even sales volume in amount is also studied with the
help of numerical examples this unit also explains changes in break -even
point due to change in TFC or TVC for price per unit of a commodity.
In the last part of this unit application of break -even analysis and
limitat ions of break -even analysis are studied
8.7 QUESTIONS
1. Explain the concept of break -even point with the help of diagram.
2. Discuss with the help of diagram how break -even point changes due to
change in price and fixed cost.
3. Explain changes in break -even p oint due to change in total variable
cost.
4. Discuss the implications and limitations of break -even analysis.
5. Suppose the TFC of the firm is rs.5000, AVC is rs.25 and price per unit
is rs.40, calculate break -even quantity and break -even sales volume.
i. If TFC increases to rs.6000, what will happen to break -even quantity
and sales volume?
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Business Economics -I
104 ii. If price per unit reduces to rs.35, what will happen to break -even
quantity and sales volume?
6. With the help of following data find out lower and upper level of break -
even quantity.
Output TR TC
0 2500 3500
1 2200 3000
2 2000 2000
3 1800 1500
4 1500 1300
5 1000 1000
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105 9
PERFECT COMPETITION
Unit Structure :
9.0 Objectives
9.1 Meaning
9.2 Features of perfect competition
9.3 Profit Maximisation
9.4 Perfect Competition in the Short Run
9.5 Long run equilibrium of a firm
9.6 Equilibrium of a firm and industry under pe rfect competition
9.7 Summary
9.8 Questions
9.0 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 equ ilibrium of a firm.
To understand the equilibrium of a firm and industry under perfect
competition .
9.1 MEANING
The theory of perfect competition has originated in the late 19th century.
The first laborious definition of perfect competition and resultant s ome 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 hypothetical in nature. In this m arket
producers 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.
A perfectly competitive firm is als o known as a price taker because the
pressure of competing firms in the market forces other firms to accept the munotes.in
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Business Economics I
106 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. The market price in the perfect competition is determined
by the market supply and market 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.
9.2 FEATURES OF PERFECT COMPETITION
Perfect competition can be generally understood by its following
important features:
1. Large number of buyers and sellers: 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 influe nce 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 firm 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 similar 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 market 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 neither change
the size of thei r plants, 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 information: It is assumed that ther e 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 and buyer to take appropriate decision to influence the market
demand and supply collectively.
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 labour and capital are assumed t o be mobile. The munotes.in
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Perfect Competition
107 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 price exist in perfect competition ?
2) Why we don’t consider transportation cost?
9.3 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 earns
profit when Total revenue which has ea rned 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 the quantity of output produce by the
average co st.
TC = Q ×AC
Average revenue (AR) is the revenue generated by selling per unit of
output.
AR = TR
Q
Where AR is the Average Revenue.
Hence if, P × Q = TR = AR
Q
Therefore, we can say that,
P = AR
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Business Economics I
108 Therefore, we s ay 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 possible for a firm to earn profits which can be po sitive,
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 business 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
Margi nal 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 the profits in a perfectly competitive market, the
firms set the price where the marginal revenue equal to ma rginal cost
(MR=MC). The MR curve is the slope of the revenue curve, which is also
equal to the demand curve (DD), price (P) and the Marginal and Average
Revenue curve. Therefore, In the short term, it is possible for a firm to
earn economic 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.
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Perfect Competition
109
Diagram 9.1
Perfect Competition in the Short Run: In the short run, it is possible for
an individual firm to make an economic profit. This state is shown in the
above Diagram 9.1, as the price or average revenue, denoted by P, is
above the average cost denoted by AR.
In the long run, if firms try 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 g oes
down, the economic profits will decrease until they become zero.
When the price is less than the average total cost of the production, at that
time the firms are making a loss. In the long run, if firms in a perfectly
competitive market are earning neg ative economic profits, then more firms
will leave the market and which in turn will shift the supply curve left of
the diagram. As the supply curve shifts to the left, the price will rise. As
the price rises, the economic profits 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 co st (MC) curve at the minimum point of the
average cost (AC) curve. munotes.in
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Business Economics I
110
Diagram 9.2
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
demand curve of each individual f irm 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).
9.4 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.
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 MC is
increasing at the point or MC i s cutting MR from below. munotes.in
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Perfect Competition
111 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 marginal cost with price
to attain the equi librium 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
incur l oss. The Diagram 9.3 which is given below will explain the firm’s
equilibrium situation in the short run.
Diagram 9.3
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 where Marginal Cost is
equal to Marginal Revenue (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 munotes.in
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Business Economics I
112 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 when 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 profit which a firm must get to survive into t he
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.
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Perfect Competition
113 3. Loss or Sub -normal profit: when a firm fails t o earn even normal
profit and still continue to operate his business by incurring into loss.
Such situation can be explained as flow:
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: When the firm not even able to earn variable cost
he better tries to shut down his business or stops operating for that
particular time.
Diagram 9.4
In the above Diagram 9.4 when the price is OP, the firm produces the
equilibrium level of output which is OQ 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
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Business Economics I
114 where at least he can cover up his Total Variable Cost. It is because that
variable cost enables the firm to operate in his business.
Check your Pr ogress :
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?
9.5 LONG RUN EQUILIBRIUM OF A FIRM
The long run is a period 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 or decrease their output by
changing their capital eq uipment; 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 a llow 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
existing 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 therefore 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
longrun equilibrium, besides marginal cost being equal to price, the price
must also be equal to average cost (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 supernormal profits will attracts the new firms to enter i nto the
industry.
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 intensive competition for factors of
production will be g enerated. The firms will continue entering the industry
until the price is equal to average cost so that all firms are earning only
normal profits. munotes.in
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Perfect Competition
115 These can be explained with the help of the following Diagram 9.5 given
below:
Diagram 9.5
Diagram 9.5 represents 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
equilibrium point MR = MC. As said the firm earns normal pro fit 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.
9.6 EQUILIBRIUM OF A FIRM AND INDUSTRY
UNDER PERFECT COMPETITION
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 equating 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. munotes.in
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Business Economics I
116 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 curve from below and after the point of equilibrium it m ust 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 9.6
In Diagram 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 production when it reaches the
OM1 level of output where the firm sa tisfies 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 revenue beyond the equilibrium
point B. The same conclusions hold good in the case of a straigh tline MC
curve as shown in Diagram 9.6. (B)
9.7 SUMMARY
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 competiti on 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 firm is also
known as a pri ce 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 munotes.in
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Perfect Competition
117 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.
9.8 QUESTIONS
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 long run equilibrium of the firm under perfect competition.
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118 10
MONOPOLY
Unit Structure :
10.0 Objectives
10.1 Meaning of monopoly
10.2 Features of monopoly
10.3 Sources of monopoly power
10.4 Equilibrium of a monopoly firm
10.5 Summary
10.6 Questions
10.0 OBJECTIVES
To understand the meaning and features of m onopoly market.
To study the sources of monopoly power.
To understand the equilibrium of a firm under monopoly market.
10.1 MEANING
The word monopoly has been derived from the combination of two words
i.e., ‘Mono’ and ‘Poly’. Mono refers to a single and po ly 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 subs titutes 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 price taker in the market where he is the only or a sole
seller in the market, where he has cont rol 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.
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Monopoly
119 10.2 FEATURES OF MONOPOLY
The following are some featur es 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 assum ed 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 monopolist 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 separately.
10.3 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 conduct ing 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 allow ed 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 i n
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 monopoly, there is great to absolute product differentiation in the
sense that there is no availabl e substitute for a monopolized good. The
monopolist is the sole supplier of the commodity in the market.
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120 3. Legal protection: Legal is an artificial power which a firm has to
protect this product from various market competition and make a product
unique or d ifferent. 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 from the other product in the market.
4. Barriers to Entry: Barriers to entry are factors and cir cumstances 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 str ong 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
market, he has sole control over the resources which is use for production
of the product. The so urce of control comes either from the natural or legal
power.
10.4 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 reve nue (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 equilibrium condition: There are two possibilities for a firm’s
Equilibrium in Monopoly. These are:
The f irm 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 Excess Profit: At Excess profit the firm is in
equilibrium at the point E where the Marginal Cost i s 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,
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121
Diagram 10.1
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 excess 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 10.2. munotes.in
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122
Diagram 10.2
Profit = TR – TC
Where, TR = P × Q
= OP × OQ
= OQRP
TC = Q × AC
= OQ × VU
= OQVU
Therefore, Loss = OQRP – OQVU
= PRVU
Thus, the firm earns the excess profit. TR Long run equilibrium condition: In the long -run, a monopolist can
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 lie to the right and intersect.
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123 A monopolist usually earns excess profit in the long run. This ca n be
understood by the following fig 10.3.
Diagram 10.3
Profit = TR – TC
Where, TR = P × Q
= OP × OQ
= OQTP
TC = Q × AC
= OQ × QS
= OQSN
Therefore, Profit = OQTP – OQSN
= 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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124 10.5 SU MMARY
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 fi rm 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.
10.6 QUES TIONS
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.
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125 11
MONOPOLISTIC COMPETITION
Unit Structure :
11.0 Objectives
11.1 Features of monopolistic competition
11.2 Equilibrium of a firm under monopolistic competition in the short
run and in the long run
11.3 Production and selling cost
11.4 Role of advertising (real life examples)
11.5 Excess capacity and inefficiency
11.6 Summary
11.7 Questions
11.0 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 capacity is cr eated under monopolistic
competition
• To study the role of advertising along with advantages and
disadvantages with real life examples
11.1 FEATURES OF MONOPOLISTIC COMPETITION
Perfectly competitive market and monopoly market are extreme and
therefore 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.
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 competition, each seller has its munotes.in
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126 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 competition
• Fairl y 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 of 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 a re 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 lo ss 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 p roducts etc.
• Product differentiation - As goods are close substitutes of each 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, packing, 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 flatter 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 competition.
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127
Diag ram 11.1
• 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 long 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 products like so aps, 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 its product. Ray mond 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 w hich 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 - Customers would lik e 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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128 • 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 services while
consu ming 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 consumers have s ome 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 mo nopoly power over loyal customers.
11.2 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=MC. This is the
equilibrium level of output for the firm.
Diagram 11.2
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 munotes.in
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Monopolistic Competition
129 are more elastic or flatter. SAC and SMC are the short run av erage 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=OQER. As TR>TC, Excess profit = REMP (OQMP -OQER)
• Norm al 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 11.3
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 l oss. With the help of following diagram we can explain the
case of loss.
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130
Diagram 11.4
With given revenue and cost curves, firm is in equilibrium at point at point
E2, where MR and MC curves intersects.
Equilibrium output= OQ2 and equilibrium price = OP 11. TR= OQ 2L2P2,
TC=OQ 2N2M11. 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 wil l continue with the business and when TRfirm should stop its operations.
Long run equilibrium of a firm under monopolistic competition:
In the long run it is possible for the firm to make all necessary changes in
its fixed factors of production. As all costs are variable, firm cannot
continue to operate with loss. As there is free entry and 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 leav e 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 diagram.
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131
Diagr am 11.5
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.
11.3 PRODUCTION COST AND SELLING COST
Production cost includes a ll 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. Through
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, g ifts, 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.
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132
Diagram 11.6
As shown in the diagram, the difference between Average Cost (AC) a nd
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. Simila rly 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 incurred 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 tryi ng 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 at 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 an d 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.
• Gifts - various gifts are offered by the companies on purchase of a
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Monopolistic Competition
133 • 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 importan t 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 cost
Selling cost affects the con sumers 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 following diagrams.
Diagram 11.7
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 1D1 and further to D 2D11. The prod ucer is able to sell more
quantity OQ 1 and OQ 2 at 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 will become more elastic. ie D1D1. If firm reduces price to
OP1, its demand will increase to OQ 11. But at the same time firm incurs
the selling cost, it will be able to sell more i.e. OQ 1 at price OP 1.
Effect of selling cost on profit
Effect of selling cost on profit can be explained with t he help of following
diagram
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134
Diagram 11.8
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 starting 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 =
M1N1R1P1.
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 profit after selling cost is also greate r than the level of profit
before selling cost. 11 1 1MNRP M N RP
11.4. ROLE OF ADVERTISEMENT
Due to the availability of close substitute products, advertisement or
selling cost plays an important role under monopolistic competition. These
advert isements are undertaken 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
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Monopolistic Competition
135 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 prod uct. 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 advertisements are called
manipulative o r 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
availability of various products, their ad vantages 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 to increase in demand will lead
to increas e 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 people are happy with the quality
of the produ ct, 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 sometimes 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.
• If an advertisement is not successful in increasing demand for a
product, adv ertisement 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
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136 • Advertisements by the financial ins titutions 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, family problems etc.
• In most of the advertiseme nts 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 amount of money on advertisement to
increase t he 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
competitive market, there is a need of selling cost. J ustify your answer.
11.5 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 capacity leads to excess capacity. Following diagram explains
the case of excess capacity.
Diagram 11.9 munotes.in
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Monopolistic Competition
137 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 co mpetition 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
perfect competition produces optimum level of output (OQ) wi th
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 produces 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 successful 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.
4. Selling cost -Under monopolistic competition firm undertakes huge
expenditure on advertising 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 produc ts, there is a very little scope for specialization. Thus
the advantages of large scale production are not possible.
11.6 SUMMARY
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 the short run and in the long run. It
concentrates on produ ct differentiation and also explains the factors that
leads to product differentiation. munotes.in
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138 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 fi rm with the help of diagrams. It also
explains excess capacity and wastages under monopolistic competition.
11.7 QUESTIONS
1. Discuss the features of monopolistic competition.
2. Write a note on product differentiation.
3. Explain the short run equilibri um 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.
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139 12
OLIGOPOLISTIC MARKET
Unit Structure :
12.0 Objectives
12.1 Features of oligopoly
12.2 Collusive and non -collusive oligopoly
12.3 Summary
12.4 Questions
12.0 OBJECTIVES
• To understand the features of oligopoly
• To understand the difference between coll usive and non - collusive
oligopoly models
• To understand the types of collusions
• To understand the price leadership, its types and limitations.
12.1 OLIGOPOLY MARKET CAN BE WELL
UNDERSTOOD 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 oligop oly 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
enter the market but in reality, it is difficult because of the
technologic al, 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 reactions of the
rival firms. munotes.in
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140 • Uncertainty - as the firms are interdependen t for deciding the price
and output, it creates the atmosphere of uncertainty. If one seller
increases his output to capture large share of the market, others will
react in the same way. If one seller increases the price of his product,
others will not fol low 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 uncertain. This
means that an oligopolist is uncertain about the reactions o f 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 price taker therefore demand curve of the firm
is perfectly elastic (paralle l 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 the demand curve is steeper as the substitute products are not
available. U nder monopolistic competition as close substitute products
are available, demand curve is downward sloping and more elastic or
flatter. This means that under perfect competition, monopoly 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.
Diagra m 12.1
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Oligopolistic Market
141 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 is also and
uncertainty in the market. Identify the market structure.
2) Give few examples of fi rms operating under Oligopoly.
12.2 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 ma rket 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 a nd 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
the firm and to avoid high level of competition.
The agreement may be either formal (open) or tacit (secret). A s the open
agreement to form monopolies are illegal in most of the countries
agreements between the oligopolists are tacit.
Collusions are of two types:
• a. Cartel and b. price leadership
In case of collusive oligopoly, price fixing takes place when all fir ms in
the market try to control supply, to achieve a monopoly like situation. In
this type of oligopoly, firms aim at maximizing collective profit 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 economist Paul M. Sweezy and Oxford economist Hall
and Hitch. munotes.in
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142 Interdependence and uncertainty aspect of oligopoly lea ds 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 determinat ion under oligopoly with
product differentiation economists often used kinked demand curve
model. This model is explained by taking an example of extremely limited
case of oligopoly i.e. Duopoly, where there are only two firms. Therefore
there are two dema nd curves as shown in the following diagram.
Diagram 12.2
As shown in Diagram 12.2 above 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 1D1 is less elastic. These two demand curves i ntersect at
point K. Thus the prevailing price is OP and quantity is OQ. As shown in
the diagram the demand curve faced by an oligopolist is DKD 1. This
demand curve has a kink at point K because the upper segment of demand
curve (segment DK is more elasti c) and the lower segment of the demand
curve (segment KD 1) is less elastic. This difference in elasticities is
because of the reactions of 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 above prevailing price is more elastic.
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Oligopolistic Market
143 • 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, d emand for his goods
increases by a very little amount. Therefore the demand curve below
prevailing price is less elastic.
Therefore DKD 1 is the kinked demand curve under oligopoly. Due to
differences in elasticity, a demand curve has a kink at point K. Th us 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. Therefore 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 kink at a particular
prevailing price. Therefore the MR curve of the firm has a discontinuous
portion as shown in the following diagram.
Diagram 12.3
In the above diagram DKD 1 is the kinked demand curve under oligopoly.
The demand curve has the kink at point K. Therefore MR curve which
lies half way betw een AR curve and Y -axis has a discontinuous portion
RS. MR curve is discontinuous because of the Kink to the demand curve.
Discontinuous portion of the MR curve depends on the difference in
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144 discontinuous portion of the MR curve. MC is the marginal cost curve
which passes through discontinuous portion of the MR 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 discontinuous portion of the MR curve. This will keep
price and output level constant at OP and OQ respectively.
Therefore the price rem ains rigid. If an oligopolistic increases price over
DK portion of the kinked demand curve, the Rivals will not follow due to
the 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 amount. Thus the demand curve is inelastic.
Collusive oligopoly models:
In case of oligopoly there is interdependence of the firms an d there is also,
uncertainty. In order to avoid uncertainty arising out of interdependence,
firms generally enter into an agreement to follow a uniform price and
output policy. This type of agreement helps firms to avoid price wars and
also stiff competiti on. The agreement may be either formal (open) or tacit
(secret). Open agreements are illegal in most of the countries. Thus, the
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 products. In this agreement, the member firms may agree on
price fixing, market share division of profits etc. The cartels are of t wo
types - centralized cartel and market sharing cartel. In case of centralized
cartel there is a common Sales Agency which alone undertakes the selling
operations for all the forms who are party to the agreement. Here the
Central Administrative agency dec ides the product price, distribution of
output, profit sharing for all the firms. All firms agree to surrender 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. munotes.in
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145
Diagram 12.4
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 firms 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
centralized authority.
Firm A sells OM 1 output and Firm B cells OM 2 output. OM1+OM2=OM.
Market price is charged by both the firms. t herefore, 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 A produces and sells greater
quantity as compared to firm B and thus makes higher profits.
A type of cartel d iscussed 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 c ompetition - In case of oligopoly, due
to interdependence of firms and uncertainty, price is rigid i.e. firms follow
a particular price and there is no tendency either to increase or to reduce
the price. At a uniform price firms are free to produce and sel l that level of
output which will maximize their profits. Here even though the firms are
following same price they are free to change the style of their product,
style of advertising the product, additional facilities or discounts may be
given. If all memb er 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 intere sted in charging
lower price cartel may break away. munotes.in
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146 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 are producing
homogeneous product, a monopoly element will exist and all 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
their product. When there are cost differences between the firms all types
of cartels are unstable.
Price leadership:
Price leadership is on e 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.
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 the 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 dominant 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 b ecome 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 fir m and accordingly
adjust their output.
3) Barometric price leadership - In this type of price leadership an old
experienced and most respected firm in the market becomes the leader.
This firm study the changes in market conditions like demand for the
produ ct, cost conditions, level of competition etc. and decides such a price
which protects the interest of all. A leader 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. munotes.in
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147 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.
Diagram 12.5
In the above diagram DD is the demand curve of a market at and DL is the
demand curve of a dominant firm, MR L is the marginal revenue curve and
MC L is the marginal cost of the dominant firm. The domin ant 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. fo r 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 a nd 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 pos sibility 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, if 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 newspaper advertising, munotes.in
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148 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 produc tion - Cost of production for each of
the firm is different. In case of price leadership if the low cost firm
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 th e price
set by low cost firm. If the firms with a lower cost enter into non price
competition it may lead to 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 p roduct 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.
12.3 SUMMARY
This unit explains the characteristics of oligopoly market. It explains two
types of olig opoly 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 m arket is also explained
with the help of intersection of discontinuous marginal revenue curve
under oligopoly and marginal cost curve.
Collusive oligopoly is discussed with the help of cartels and price
leadership.
Two types of cartels are discussed that i s 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 hig h cost firm
2) Price leadership by low cost firm
3) Barometric price leadership
4) Aggressive or exploitative price leadership
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Oligopolistic Market
149 12.4 QUESTIONS
1. Discuss the features of oligopoly market.
2. What is oligopoly? Explain its characteristics.
3. Explain w hy 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 dominan t firm.
9. Discuss price leadership along with limitations.
10. Explain non -collusive oligopoly model.
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150 13
PRICING METHODS
Unit Structure :
13.0 Objectives
13.1 Cost –Plus (Full Cost)/Mark -Up Pricing Method
13.2 Marginal Cost Pricing Method
13.3 Multiple – Product Pricing Method
13.4 Summary
13.5 Questions
13.0 OBJECTIVES
1) To study the concept of Cost plu s pricing.
2) To study the concept of marginal cost pricing.
3) To study the concept of multiple – product pricing.
13.1 COST – PLUS PRICING / FULL COST PRICING /
MARKUP PRICING
Cost-plus pricing is also called as full cost pricing or mark -up pricing.
Two famo us 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 simple met hod 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:
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Pricing Method
151 P = 100 + 200 + (0.5 × 300)
= 300 + 150
= `450
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 les sens 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 is very difficult to estimate precisely the average variable cost and
average total cost and distribute it between the various produ cts
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] If the price is m ore 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.
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152 Case Stud ies – 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 capacity
Total Variable Cost = `1400
Average Variable cost = `1400 / 700 = `2
Overhead Cost = `700
Average Fixed 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 total fix ed 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
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Pricing Method
153 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
=
`100
4] If the cost o f 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 costs 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, calculate full cost price. munotes.in
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154 Full Cost Price =
=
=
Full Cost Price = `27.5 per unit
13.2 MARGINAL COST PRICING
According to marginal cost pricing method price is determined on the
basis of the marginal cost of production. Marginal cost me ans 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.
FIG 13.1
Above diagram shows tha t 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 the help of following diagram.
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Pricing Method
155
Fig 13.2
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 1 and quantity i s 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 2SP2 and TC = OQ 2NM
Profit = MNSP 2.
If price charged by using Marginal Cos t 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 cost pricin g 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 ve ry 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
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Business Economics -I
156 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
capacity and i s 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 variable 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 by full cost pricing?
4) What do you mean by Marginal cost pricing?
13.3 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 optimum
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 separate 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
product prici ng. 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 relationships be tween two
products. These functions are: -
Suppose A & B are two products
MR A =
MR B =
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Pricing Method
157 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 pr oduct 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
diagram.
Fig 13.3
In the above diagram D A, DB& D C are the demand curves of products A, B
and C sold by the firm and MR A, MR B and MR C are the corresponding
marginal revenue curves.
The firm maximizes its profit when MR A = MR B = MR C = MC i.e.
[Marginal Revenue of ea ch product should be equal to each other and that
should be equal to Marginal Cost]
This is shown by points E A, EB, & E C where the equal marginal revenue or
combined marginal revenue (CMR) curve is equal to marginal cost.
Therefore output of product A is OQ 1 and price is P AQ1, for product B
output is Q 1Q2& price is P BQ2, for product C output is Q 2Q3 and price is
PCQ3.
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.
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158 13.4 SUMMARY
In this unit we have seen three pricing methods i.e. Full cost pricing,
Marginal cost pricing and multiple product pricing. Accordin g 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 -up percentage. Marginal cost pricing focus
on marginal costs for determinin g 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 price s
of one product on another.
13.5 QUESTIONS
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 pricin g.
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 pricing metho d.
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. Calculat e 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 400 0 units of its product.
On the basis of above information, calculate full cost price.
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159 14
PRICE DISCRIMINATION
Unit Structure :
14.0 Objectives
14.1 Meaning of Price Discrimination
14.2 Condition for Price Discrimination
14.3 Equilibrium of price discriminating monopolist
14.4 Dumping
14.5 Transfer Pricing
14.6 Summary
14.7 Questions
14.0 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.
14.1 MEANING OF PRICE DISCRIMINATION
Price discrimination refers to the charging of different prices by the
monopolist for the same product.
Few Definitions:
“Price discrimination exis ts when the same product is sold at different
prices to different buyers.” –Koutsoyiannis
“Price discrimination refers to the sale of technically similar products at
prices which are not proportional to their marginal cost.” -Stigler
“Price discriminatio n is the act of selling the same article produced under
single control at a different price to the different buyers.” -Mrs. Joan
Robinson
“Price discrimination refers strictly to the practice by a seller of charging
different prices from different buyers for the same good.” -J.S. Bain munotes.in
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160 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 ty pes 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
indivi duals. 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 ti cket to children and senior citizens
and more for others. Industrial areas are charged more electricity charges
as compared to residential areas. This is same as second degree price
discrimination.
3] Market Price Discrimination – This means charging diff erent prices
for the same product in different markets.
14.2 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 from one buyer to other
between the markets is not at all economical.
3] Political Hurdles – If political bo undaries prevent the movement of
people from one market to other market, a monopolist who operates in
both markets can change different prices for the same commodity.
4] Lack of awareness – When the consumers are ignorant of the price
difference, they wil l not mind paying higher prices than what the others
are paying.
5] Insignificant price difference – When the price difference is very
small, the consumers 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 munotes.in
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Price Discrimination
161 better quality, then it is possible for the monopolist to change higher price
for such consumer s.
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 ch arge a higher price in the protected home market and
lower price in competitive world market.
9] Government Sanctions – Government due to welfare social 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 fo r the monopolist to have price
discrimination.
Check your progress :
1) What do you mean by price discrimination?
2) What are the types of price discrimination?
3) Discuss any two conditions for price discrimination.
14.3 EQUILIBRIUM OF PRICE DISCRIMINATING
MONOPOLIST
For explaining equilibrium of price discriminating monopolist we make
following assumptions: -
1] Monopolist operates in two different markets, i.e. market A & market B
2] Two markets differ in elasticities.
3] Production is u ndertaken 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 diagra m.
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162
Fig 14.1
Above diagram shows that in (Figure -A) & (Figure -B), there are two
markets - Market A & Market B. Market A is relatively inelastic and
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, AR 2 &
MR 2 of market B are flatter.
[AR & MR are the Average & Marginal revenue Curves of the two
markets.] (Figure -C) explains the production.
CMR is the Combined Marginal Revenue Curve in (Figure -C) which is
derived f rom horizontal summation of MR 1 and MR 2.
In figure -C Marginal Cost Curve (MC) intersects the combined marginal
revenue curve at point R. Therefore total output is OQ. This output is
distributed between market A & B in such a way that MR 1 = MR 2 = MC.
In or der to show this equality we have drawn horizontal line RL from
point R in (Figure -C) to Y axis of (Figure -A).
Accordingly OQ 1 output is sold in market A at price OP 1 and OQ 2 output
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
= BRDA
Therefore Price Discrimination monopolist will be in equilibrium when: -
1] Different markets differ in price elasticities enabli ng 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 outpu t.
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163 14.4 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 persis tent Dumping.
The rationale behind dumping is that it enables the exporter’s to compete
in the it enables exporters to compete in the foreign market and capture the
market by selling at a low price, even sometimes below cost and make up
the deficiency i n 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 demand should be different in different markets.
A situation of dumping can be discussed with the help of f ollowing
diagram.
Fig 14.2 munotes.in
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164 In the above diagram AR H and MR H are the average and marginal revenue
curves of the home market. As the seller is monopolist in the home
market, they are downward sloping.
AR W = MR W is 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 world market. Equilibrium output is determined at the point where
combined marginal revenue curve equals the m arginal 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 H and LM
output is sold in the world market at price OP W.
Total output OM = OL + LM.
Price charged in the domestic market (OP H) is greater than price charged
in the world mar ket 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.
14.5 TRANSFER PRICING
Transfer prices are internal prices at which inter mediate goods from
upstream divisions are sold to downstream divisions. [Upstream divisions
are those which are producing intermediate product & downstream
divisions are those that are producing finished product.
In the present day industrial system, ver tical integration is common. [A
firm is considered to be vertically integrated when it contains several
divisions, with some divisions producing parts 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 functioning.
In a vertically integrated firm it is not easy to determine the amount of
profit that should be credit ed to a division producing intermediate good in
such a way that firm’s total profit is maximized. For this management has
to determine appropriate transfer price of intermediate goal.
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165 In our case of determining transfer price we assume that there are onl y 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 manufacturing 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 manu facturing division will sell its
product to cloth using division. This can be explained with the help of
following diagram
Fig 14.3
Here cloth manufacturing division faces horizontal demand curve. For
maximizing profit cloth manufacturing division wil l 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 nece ssarily be equal to input demand of final
good producing unit. If there is excess supply of cloth, it can be sold to munotes.in
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Business Economics -I
166 other users. And if supply of cloth is insufficient, shift making division
can buy cloth from other markets.
2] No External Market
When e xternal 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 hi gh 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 pro duct.
Fig 14.4
In the diagram D S and MR S are the demand (average) & marginal revenue
curves for shirt.
The marginal cost of producing clot to make shirt is MC A and the
marginal cost of transforming cloth into shirt is MC B.
Marginal cost of each ad ditional 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 S quantity of
shirts.
Top management of the integrated firm would solve this problem by
advising the cloth division to change a price that is equal to the marginal
cost of producing cloth.
For shirt makin g division profit maximizing quantity is OQ S& price is OP S
and for cloth unit price is OP A at which cloth unit will supply the exact
amount of cloth that is necessary for producing OQ S amount of shirts.
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167 Check your progress :
1) Define Dumping.
2) What d o you mean by transfer pricing?
14.6 SUMMARY
Price discrimination refers to the charging of different prices by the
monopolist for the same product. In this unit we have seen concept of
price discrimination along with conditions of price di scrimination 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. W e 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 al l 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 fo reign markets. Transfer prices
are internal prices at which intermediate goods from upstream divisions
are sold to downstream divisions.
14.7 QUESTIONS
1) Explain the concept of Price Discrimination.
2) Discuss condition required for Price Discrimination.
3) Expl ain equilibrium of price discriminating monopolist.
4) Write short note on Dumping.
5) Write short note on transfer pricing.
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