MODULE 2:PRODUCTION

FUNCTION & MARKET

STRUCTURE
What do we learn?

✔ Production Function and Process, Law of production &

Factors of production, Cobb-Douglas production function.
✔ Economies & Diseconomies of Scale, Cost Concepts &
Various Types of Cost, Short Run & Long Run Cost Curve,
Marginal Cost and Break Even Analysis.
✔ Perfect competition, Monopoly & Monopolistic
competition, Duopoly & Oligopoly - Pricing Strategies
✔ Profit-Maximization & Competitive Markets
Price-Searchers, Cartels
✔ Oligopoly-Advanced Pricing and Auctions-Game Theory
and Asymmetric Information
Production Function
Meaning of Production

“Production is the organized activity of transforming

resources into finished products in the form of
goods and services; and the objective of production
is to satisfy the demand of such transformed
resources” - James Bates and J.R. Parkinson .

Production means transforming inputs (labour

machines, raw materials etc.) into an output.
 Production Process

• Production Process is conversion of raw

inputs (labour, machines, steel, cement) to an
output through technology and knowledge.
 Production Function
✔ Production function shows the
relationship between a given quantity
of input and its maximum possible
out put.
✔ Mathematically expressed in the form
of an equation as
Q = f (a, b, c, d …….n)
Where ‘Q’ stands for the rate of
output of given commodity and a, b, c,
d…….n, are the different factors
(inputs) and services used per unit of
time.
✔ Hence, the output (goods or services) is
the dependent variable and inputs
(land, labour, capital and enterprise)
are the independent variables
 Nature of Production Function

The production function depends upon the following factors

(a) The quantities of inputs to be used.
(b) The state of technical knowledge.
(c) The possible processes of production.
(d) The size of the firm.
(e) The prices of inputs.
Now if these factors change, the production function automatically
changes.
Assumptions of Production Function

Perfect divisibility of both inputs and out put.

Limited substitution of one factor for the others.

Constant technology.

Inelastic supply of fixed factors in the short run.

Fixed & Variable Inputs of Production

Fixed Inputs Variable Inputs

❖Examples : Labour, Raw

❖ Examples:- Building, Land
materials, New Technologies.
etc (though in the long run
these may change). ❖In the long run all factors of
❖ For any level of output, these production vary according to the
quantity of inputs remain the volume of outputs.
same in the short run.
❖ Cost associated with them are ❖The cost of these variable inputs
called as fixed cost. is called variable cost.
 Law of Production-Production Functions in Short
run & Long run

✔ In the short run, input-output relations are studied with one variable
input, while other inputs are held constant . Q = f (L,K) L= Labour, K=
Capital
✔ The Law of production under these assumptions are called “ the Laws of
variable production/proportions”- it is possible to increase the quantities
of one input while keeping the quantities of other inputs constant in order
to have more output (output can be increased by increasing the input
of some variable factor).
✔ In the long run input output relations are studied under “Laws of Returns
to Scale” assuming all the inputs to be variable - it is possible for a firm
to change all inputs up or down in accordance with its scale of operations.
Q = f(L, M, N, K, Tech) N= Natural Resources, M= Management, Tech=
Technologies.

✔ It is to be noted that in economic analysis, the distinction between short-run and long-run is not
related to any particular measurement of time (e.g. days, months, or years).But, refers to the
extent to which a firm can vary the amounts of the inputs in the production process.
Examples of Short run & Long run
Production function
◻ An example of a short run can be a company, ABC,
which is able to produce 10 cars in a day and looks to
produce more cars (15 cars per day) by using the
available infrastructure due to increasing demand
during the season.
◻ An example of a long run can be of the same
company, ABC, permanently looking to expand
production capacity of cars instead of only during the
season. It requires new land, labour, and equipment
in addition to the existing infrastructure.
Laws of Production-Law of variable
proportions(short Run) with Example
Production Schedule of Rice (in Kgs.)
No of Total Average Marginal
Workers Product Product (AP ) Product (MP )
Land in
(L) (TP) TP= Total product
Acres Stage of Returns produced by labours;
1 24 24 24
2
2 72 36 48
2 AP = TP/L;
3 138 46 66
2
4 216 54 78 MP= Difference
2
5 300 60 84 between TPs. Extra
2
6 384 64 84 Stage I-Increasing
2 Returns (incremental) output
2
7 462 66 78 produced by an
2
8 528 66 66 additional labour.
2
9 576 64 48 Marginal productivity
10 600 60 24 Stage II-Diminishing of labour MPL is
2 Returns
11 594 54 -6 measured by ΔQ/ ΔL
2
12 552 46 -42
Stage III-Negative
2 Returns
Laws of Production- Law of variable proportions(short
Run), TP Curve

Production Schedule of Rice (in Kgs.)

No of Total Average Marginal
Workers Product Product Product
Land (L) (TP) (AP ) (MP )
in
Acres Stage of Returns
1 24 24 24
2
2 72 36 48
2
3 138 46 66
2
4 216 54 78
2
5 300 60 84 Stage
2
6 384 64 84 I-Increasing
2 Returns
7 462 66 78
2
8 528 66 66
2
9 576 64 48
2 Stage
10 600 60 24 II-Diminishing
2 Returns
11 594 54 -6
2
12 552 46 -42 Stage
III-Negative
2 Returns
Laws of Production- Law of variable proportions(short
Run), AP & MP Curves

Production Schedule of Rice (in Kgs.)

No of Total Average Marginal
Workers Product Product Product
Land (L) (TP) (AP ) (MP )
in
Acres Stage of Returns
1 24 24 24
2
2 72 36 48
2
3 138 46 66
2
4 216 54 78
2
5 300 60 84 Stage
2
6 384 64 84 I-Increasing
2 Returns
7 462 66 78
2
8 528 66 66
2
9 576 64 48 Stage
2
10 600 60 24 II-Diminishing
2 Returns
11 594 54 -6
2
12 552 46 -42 Stage
III-Negative
2 Returns
Laws of Production- Law of variable proportions (short
Run), 3 Stages of Production

To explain the law of variable proportions, all the 3 TP, AP &

MP curves are combined and presented in the diagram.

Each of them have their maximum points (Point C for TP, Point
E for AP, Point D for MP). It is 600Kgs when labour force is 10
for TP and 66 Kgs when labour force is 7 8 for AP. The MP has
84 kgs when labour force is 5.

The TP curve first rises at an increasing rate up to point A

where its slope is the highest.

From point A upwards, the total product increases at a

diminishing rate till it reaches its highest point C and then it
starts falling.

Point A is called the inflection point up to which the total

product increases at an increasing rate and from where it starts
increasing at a diminishing rate. Both AP & MP curves also rise
with TP curve.
Laws of Production- Law of variable proportions(short
Run), 3 Stages of Production

Both AP & MP curves coincide with

TP curve with their maximum
points, like Point E coincides with
point B on TP curve, point D on
coincides with A on TP curve.
When the TP curve reaches its
maximum point C the MP curve
becomes zero at point F.
When TP starts declining, the MP
curve becomes negative.
It is only when the total product is
zero that the average product also
becomes zero.
 Laws of Production- Law of variable proportions (short
Run), Causes for Increasing Returns

Stage – I Causes for increasing Returns

In the beginning the fixed factors are larger in
quantity (l in Eg 2 acres of Land ) than the
variable factor. Fixed factor is used more
intensively and production increases rapidly
,when more units of the variable factor (labour)
are applied to a fixed factor.
When units of the variable factor are applied in
sufficient quantities, division of labour and
specialization lead to per unit increase in
production and the law of increasing returns
operates.
Fixed factors are indivisible ( they must be
used in a fixed minimum size). So, when more
units of the variable factor are applied on such a
fixed factor, production increases more than
proportionately.
 Laws of Production- Law of variable proportions(short
Run), Causes for Decreasing/Diminishing Returns

Stage – II Causes for decreasing Returns

It is to be noted that the area between BE and CF
shows more and more workers are employed in order
to have larger output.
Thus the total product increases at a diminishing rate
and the average and marginal product decline.
This is the only stage in which production is feasible
and profitable because in this stage the marginal
productivity of labour is positive and maximum,
though starts declining.
Labour cost would increase which would be less
profitable for the farmer. Supervision might lack as
there are more number of labours.
Thus, scarcity or shortage of one factor in relation to
other cause law of decreasing/ diminishing returns.
 Laws of Production- Law of variable proportions(short
Run), Causes for Negative Returns

Stage – III Causes for negative Returns

This stage starts from the dotted line CF where
the MP curve is below the X-axis.
Here the labours are too many in relation to the
available land, making it absolutely impossible
to cultivate it.
Total product starts declining and the marginal
product becomes negative.
Indivisibility and inelasticity of fixed factor and
imperfect substitutability between K and L

Significance of law of variable proportions

It provides answers to questions such as:
a) How much to produce?
b) What number of workers (and other variable factors) to employ in order to
maximize output.
Class Exercise-Calculate AP & MP and mention the 3 stages

No of Total Average Marginal

Land in Workers Product Product Product
Acres (L) (TP) (AP ) (MP )
2 1 8 8 8
2 2 20 10 12
2 3 36 12 16
2 4 48 12 12
2 5 55 11 7
2 6 60 10 5
2 7 60 9 0
2 8 56 7 -4
Laws of Production- Law of variable proportions(short Run) Snap
shot of causes for 3 stages of returns

Stage I: Increasing Returns-TP increases at an increasing rate due to availability

of abundant fixed factor (in our example Land) which is utilized better with
every additional unit of labour (variable factor). division of labour and
specialization lead to per unit increase in production. Both AP and MP also
increase.
Stage II: Decreasing/Diminishing Returns.TP continues to increase but at a
diminishing rate as both variable(labour) and fixed (land) factors are used
beyond their optimum capacity. Increasing labour cost and lack of
supervision lead to decreasing returns. Production is feasible and profitable in
this stage as the marginal productivity of labour is positive and maximum,
though it starts falling down.
Stage III: Negative Returns. TP begins to decline as there are too many labour
for the available land and it becomes scarce as compared to variable factor.
Hence over utilization of capital and setting in of diminishing returns.
Imperfect substitutability between K and L.
Laws of Production – Law of Returns to scale (Long
run Production function)

Long run is a period of time (or planning horizon) in which all factors
(both fixed and variable inputs) of production are variable.
A long- run production function shows the maximum quantity of a good or
service that can be produced by a set of inputs, assuming that the firm is free
to vary the amount of all the inputs being used.
The law of returns to scale explains the technological relationship between
changing scale of input and output.
The law of returns of scale explain how a simultaneous and proportionate
increase in all the inputs affect the total output.
The change in the quantity of the factors is called scale and change in the
output is called returns. So law of returns to scale explains changes in the
output due to changes in the inputs in the long period.
Laws of Production – Law of Returns to scale (Long run
Production function) 3 stages of Returns

Law states that when all inputs are increased in same

proportions and the output is not increased in the same
proportion, the production function follows Law of
Returns and the changes in the output are classified in to
three stages.

Increasing returns to scale

Constant returns to scale

Diminishing returns to scale

 Laws of Production – Law of Returns to scale (Long run
Production function) Example

Marginal Stage of
Unit Scale o f Production Total Returns Returns Returns

1 1 worker + 2 Acres Land 8 8

2 2 workers + 4 Acres Land 17 9 Stage

I-Increasing
3 3 workers + 6 Acres Land 27 10 Returns

4 4 workers + 8 Acres Land 38 11

Stage
II-Constant
5 5 workers + 10 Acres Land 49 11 Returns

6 6 workers + 12 Acres Land 59 10

7 7 workers + 14 Acres Land 68 9 Stage

III-Diminishi
8 8 workers + 16 Acres Land 76 8 ng Returns
Laws of Production – Law of Returns to scale (Long run
Production function) Diagram of 3 stages of Returns

In the diagram scale or combination

of inputs are presented on X-axis
and Marginal returns on Y-axis. As
inputs are increased in the first part
marginal returns curve rising i.e.,
they produce. In the next part the
curve is stable showing constant
returns finally further increase in
input is resulting in decreasing
returns.
Laws of Production – Law of Returns to scale (Long run
Production function) Increasing Returns & its causes

Increasing returns to scale:

This stage occurs when the proportionate increase
in the output is more than proportionate increase in
the inputs, which means when we double the
inputs the output will be more than doubled.

Causes for increasing returns:

1. Specialization (or) Division of labour
2. Indivisible factors.
3. Dimensional economics-cost advantages that
enterprises obtain due to their scale
of operation
4. Volume discounts etc.,
 Laws of Production – Law of Returns to scale (Long run
Production function) Constant Returns

Constant returns to scale:

If the proportionate increase in the output and
proportionate increase in the inputs are same it
is said to be constant returns to scale (when we
double the inputs the output also will be doubled).
There are no causes for constant returns. It is just
an indicator for the ending of increasing returns
and commencement of diminishing returns.
Firms cannot maintain increasing returns to
scale indefinitely after the first stage and enters a
stage when total output tends to increase at a rate
which is equal to the rate of increase in inputs.
 Laws of Production – Law of Returns to scale (Long run
Production function) Diminishing Returns

Diminishing Returns to Scale

In this stage, a proportionate increase in all the
input result only less than proportionate
increase in output . This is because of the
diseconomies of large scale production. When
the firm grows further, the problem of
management arise which result inefficiency
and it will affect the position of output.
Causes for increasing returns:
1. Management problems.
2. Limit to human factor-factors may become
inefficient and less productive.
3. Rise in Prices of inputs.
Differences Between Short and Long run
Production Functions

Basis of Short-Run Production Long-Run Production

Difference Function Function
Functional relationship
Functional relationship between between inputs and output
inputs and output of a of a commodity, where all
commodity, where one of the the factors of production are
Meaning factors of production is fixed. variable.
capital-labour ratio does not
Capital-Labour capital-labour ratio changes change with the change in
Ratio with the change in output. output.
Law Law of variable proportion Law of returns to scale
Entry and Exit There are barriers to entry and Firms are free to enter and
the firms can shut down but exit.
cannot fully exit.
Scale of No change in scale of Change in scale of
production production. production.
Least cost Production Function/The optimal
long run production function

We know that in the long run, all factors of production are variable.
Firms always have to decide that for a given level of output, the cost of
inputs have to be minimised. The optimal mix needs to be found out.
The optimal mix of labor and capital in producing output depends on the
costs and marginal products of the inputs.
Let’s denote the firm’s labor cost per hour by PL and its cost per unit of
capital by PK in producing output Q0. L is the number of labor hours and K
is the amount of capital used. Then the firm’s total cost (TC) of using L and
K units of inputs is
TC = PLL + PKK
The firm seeks to minimize this cost, subject to the requirement that it uses
enough L and K to produce Q0
Least cost Production Function/The optimal
long run production function

Optimal long-run production would be the one when the

firm is able to produce output at least cost when input
costs are equal across all inputs to the ratios of their
marginal products.
For the case of two inputs, we have the following
equation which shows that when total cost is minimized,
the extra output per rupee of input must be the same for
all inputs.
MPL/PL = MPK/PK.
Least cost Production Function/The optimal long run
production function- An Example

Let MPL = 30 units per hour & PL = Rs.15 per hour; Let MPK = 60 and PK = Rs.40.
Then MPL/PL = 30/15 = 2 units per rupee of labor and MPK/PK = 60/40 =1.5
units per rupee of capital.
Because labor’s productivity per rupee exceeds capital’s, it is advantageous for the
firm to increase its use of labor and reduce its use of capital.
The firm could maintain its present output level by using two extra units of labor in
place of one fewer unit of capital - The 60 units of output given up by reducing
capital is exactly matched by (2) X (30) = 60 units of output provided by the
additional labor.
The net savings in total cost is Rs.40 (the saved capital cost) minus Rs.30 (the cost of two
labor hours), or Rs.10. If one input’s productivity per rupee exceeds another’s, the firm
can produce the same output at lower cost by switching toward greater use of the more
productive input. It should continue to make such switches until the ratios in MP L/PL =
MPK/PK come into equality. At that point, the firm will have found its least cost input
mix.
Least cost Production Function/The optimal long run production
function, Graphical Approach- Isoquant Curves

Isoquant curves explain the production

function in a graphical manner.
Isoquant curves show the all possible
combinations of inputs that can produce a
given level of output.
It is a locus of point representing the
various combination of two inputs –capital
and labour –yielding the same output.
An isoquant curve all along its length
represents a fixed quantity of output.
It is called as equal product curve or
production indifference curve.
Least cost Production Function/The optimal long run production
function, Graphical Approach- Isoquant Curves

Consider a production function

Q = 40L - L2 + 54K - 1.5K2,
where a firm could produce Q = 636 units
of output using L =10& K =8 units of
inputs. The same output, Q = 636, can
also be produced using different
combinations of labor and capitalof labor
and 12 units of capital.
Three input combinations along the Q =
636 isoquant, (L= 6, K= 12), (L= 10,
K=8), and (L =14.2, K = 6), are indicated
by points A, B, and C, respectively in the
diagram here.
A separate isoquant has been drawn for
the output Q = 800 units, which lies above
and to the right of the isoquant for Q
=636 because producing a greater output
requires larger amounts of the inputs.
Least cost Production Function/The optimal long run production
function, Graphical Approach- Isoquant Curves

We know that when a firm uses less of one

input, it must use more of the other to
maintain a given level of output.
For example, consider a movement from
point B to point A —a shift in mix from (L =
10, K= 8) to (L = 6, K = 12). Here an
additional 12- 8= 4 units of capital substitute
for 10-6= 4 units of labor.
But moving from point B to point C implies
quite a different trade-off between inputs.
Here 4.2 units of labor are needed to
compensate for a reduction of only 2 units of
capital.
The changing ratio of input requirements
directly reflects diminishing marginal
productivity in each input.
As a result, greater and greater amounts of
the other input are needed to maintain a
constant level of output
Least cost Production Function/The optimal long run production
function, Graphical Approach- Slope of Isoquant Curves &
Marginal Rate of Technical Substitution (MRTS).

The slope of the isoquant at any point is measured by the

ratio of the inputs’ marginal products and given by
ΔK/ΔL (for Q constant) = - MPL/MPK
The greater is labor’s marginal product (and the smaller
capital’s), the greater the amount of capital needed to
substitute for a unit of labor, that is, the greater the ratio
ΔK/ΔL.
This ratio is important and called as the marginal rate of
technical substitution (MRTS) which denotes the rate
at which one input substitutes for the other and is
defined as mentioned in the above equation.
An example would make this clear. At point A (L= 6, K
=12), the marginal products are MPL= 28 and MPK= 18.
At this input combination, the MRTS is 28/18, that is
1.55 and the slope of the isoquant is
-1.55 (much steeper).
 Least cost Production Function/The optimal long run production
function, Graphical Approach- Isocost Curves

Isocost curves show the

combination of inputs the firm can
acquire at a given total cost.
We can draw a host of isocost lines
corresponding to different levels of
expenditures on inputs.
The total cost function as already
explained is TC = PLL + PKK
Suppose the manager sets out to
produce an output of 636 units at
least cost. Which combination of
inputs along the isoquant will
accomplish this objective? The
answer is provided by portraying
the firm’s least-cost goal in graphic
terms
Least cost Production Function/The optimal long run production
function, Graphical Approach- Isocost Curves

In the figure, the isocost lines corresponding to

TC = Rs.120, TC =Rs. 220 and TC = Rs.300
are shown. The slope of any of these lines is
given by the ratio of input prices, ΔK/ ΔL = -
PL/PK.
The higher the price of capital (relative to
labor), the lower the amount of capital that can
be substituted for labor while keeping the
firm’s total cost constant.
Rearranging the TC equation for K, we get K
= TC/PK- (PL/PK)L. For Eg. If the TC = Rs.
120 which is fixed by management, then the
firm can use any mix of inputs satisfying K
=120/15 -(10/15)L or K = 8 - (2/3)L.
 Least cost Production Function/The optimal long run production
function, Graphical Approach- MRTS, Isoquant &Isocost Curves

The firm’s least-cost mix of inputs can be determined

by superimposing isocost lines with the appropriate
isoquants. It is the lowest isocost line that still touches
the given isoquant.
For instance, to produce 636 units of output at minimum
cost, we must identify the point along the isoquant that
lies on the lowest isocost line. The figure shows that this
is point B, the point at which the isocost line is touches
the isoquant. Point B confirms the optimal combination
of inputs is 10 units of labor and 8 units of capital. Since
point B lies on the Rs.220 isocost line, we observe that
this is the minimum possible cost of producing the 636
units.
At this point , the slope of the isoquant and the slope of
the isocost line are the same. The isoquant’s slope is
-MPL/MPK and the isocost line’s slope is - PL/PK.
Thus, the least-cost combination of inputs is
characterized by the condition
The ratio of marginal products exactly matches the
MRTS = MPL/MPK = PL/PK ratio of input prices. The condition marginal
product per rupee of input is same across all
inputs is satisfied.
 Properties of Indifference Curves

Indifference curves slope downward to the right-curve

has a negative slope, when the amount of one good in the
combination is increased, the amount of the other good is
reduced.
Indifference curves are convex to the origin-relatively
flatter in its right-hand portion and relatively steeper in its
left-hand portion, which is that the marginal rate of
substitution of X for Y (MRSxy) diminishes as more and
more of X is substituted for Y.
Indifference curves cannot intersect each other-As
each IC represents one level of satisfaction which
remains constant, two different indifference curves can IC1, IC2, IC3, IC4 represent the
never cross or intersect each other. different levels of satisfaction
A higher indifference curve represents a higher level of consumers by having
of production (satisfaction) than a lower indifference different combinations of
curve. Good X & Y.
Estimation & Measurement of Production
Functions- The Cobb-Douglas Function, Some
inputs on differentiation
Differentiation,
in mathematics, is
the process of
finding the
derivative, or
determines rate of
change.
If y = f(x) is a
function of
x. Then, the rate of
change of “y” per
unit change in “x”
is given by,
dy / dx
Estimation & Measurement of Production
Functions- The Cobb-Douglas Function, Some
inputs on partial differentiation
Partial Differentiation
Suppose we have a function z = f( x, y), then it implies that the function depends on both
the variables x and y where x and y are not dependent on each other. Thus, the
function z partially depends on x and partially on y.
When z is differentiated with respect to x, y remains constant, and when z is differentiated
with respect to y, here x remains constant. These are called as partial derivatives and
denoted as ∂f / ∂x and ∂f / ∂y.
Example: If z = x2 + y2, find all the first order partial derivatives.
◻ fx = ∂f / ∂x = ∂ / ∂x (x2 + y2)
= ∂ / ∂x (x2) + ∂ / ∂x (y2)
= 2x + 0 (as y is a constant)
= 2x
◻ fy = ∂f / ∂y = ∂ / ∂y (x2 + y2)
= ∂ / ∂y (x2) + ∂ / ∂y (y2)
= 0 + 2y (as x is a constant)
= 2y
Estimation & Measurement of Production
Functions- The Cobb-Douglas Function

Estimation and measurement of production functions based on engineering or economic data are done with 4
specifications, namely, Linear production function in the form of Q = aL + bK + c, Production with Fixed
Proportions, Polynomial Functions, and the most famous Cobb-Douglas production function (used for
American Manufacturing Firms) which is given as Q = c L β K α
Estimation & Measurement of Production
Functions- Properties of the Cobb-Douglas Function

Q = f (L,K)= c L β K α where c, α, β are the parameters to be estimated.

The values of α, β lie between 0 and 1.
(a) Exhibits diminishing returns, that is when more labours are added, their
marginal productivity decreases (L is raised to negative power).
MPL= δQ/ δL = c β L β-1Kα
MPk = δQ/ δK = c αKα-1Lβ
(b) The nature of returns to scale in production depends on the sum of the
exponents α+β, that is constant returns occur when α+β =1, decreasing returns
exist when α+β < 1, increasing returns prevail when α+β > 1.
(c ) The Cobb-Douglas function can be conveniently estimated in its logarithmic
form. By taking logs of both sides of above equation, we can derive the
equivalent linear equation as follows.
log(Q) = log(c) + β log(L) + α log (K)
Estimation & Measurement of Production Functions-
The Cobb-Douglas Function, An Example
Estimation & Measurement of Production Functions-
The Cobb-Douglas Function, An Example
Cost Function and Concepts
Cost function (or) Cost of Production

Cost of Production: An entrepreneur pays the price for inputs which he uses in
production- pays wages to employees and labour, pays money for raw materials, fuel
and power, pays rent for the factory building and so on.
Cost function is derived from the production function and it is the expenditure
incurred by the producer (or) firm to produce the goods and services.
Cost theory also has short and long run cost functions, where in the short run, some
factors of production are fixed and in the long run all the factors are variable.
Mathematically, short run and long run cost functions can be written as below
C = f(Q, T, Pf, K f) ----Short Run
C = f(Q, T, Pf) ----Long Run
Where C = Total Cost; Q = Output; T = Technology; Pf = Prices of factors;
K f = Fixed factor (s)
Determinants of Cost

Determinant
factors Relationship with Cost
Size of plant Inverse Relationship
Level of Output Direct Relationship
Price of Inputs Direct Relationship
State of
technology Inverse Relationship

Management and
administrative
efficiency Inverse Relationship
Type of different Cost concepts-Actual &
Opportunity Costs

Actual Costs or Real Costs or Opportunity cost is the cost of producing

Outlay Costs are those that any commodity with the next best alternative
involve financial expenditure cost. For example the inputs which are used
incurred for acquiring inputs to manufacture a truck may also be used in
for producing a commodity. the productions of military equipment.
These expenditures (wages,
payment made for the 1. The opportunity cost of any commodity is the
purchase of raw materials next best alternative forgone.
machinery etc.) are recorded 2. The next best alternative commodity that
in the books of accounts of could be produced with the same value of
the firm. the factors.
3. Helps in determining relative prices of
factor inputs at different places.
4. Helps in examining all reasonable
alternatives before making a decision.
5. It helps the manager to decide what he
should produce in the factory.
Type of different Cost concepts- An Example of
Opportunity Cost

Opportunity cost is the profit lost

when one alternative is selected
over another. For example, you have
Rs.10,00,000 and choose to invest it
in a product line that will generate a
return of 5%.
If you could have spent the money
on a different investment that would
have generated a return of 7%, then
the 2% difference between the two
alternatives is the foregone
opportunity cost of this decision.
Type of different Cost concepts- Short Run & Long
Run, Incremental &Sunk Costs

Shorts run costs are those Incremental costs are the added costs of a
associated with variation in the change in the level of production or the
utilization of fixed facilities, nature of activity. It may be adding a new
whereas long run costs occur product or changing distribution channel, or
when the size and kind of plant adding new machinery, etc. It appears to be
changes. similar to marginal cost, but it is not.
Marginal cost refers to the cost on added unit
Short run cost is relevant when a of output.
firm has to decide whether or not Sunk costs are costs which cannot be altered
to produce more or less with the in any way. For example, cost incurred in
given plant and equipments. Long constructing a factory. When the factory
run cost is useful in making building is constructed costs have already
investment decisions. been incurred and the building has to be used
.It cannot be altered when operations are
increased or decreased. Investment on
machinery is an example of sunk cost.
Type of different Cost concepts-Variable & Fixed
costs, Private, External and Social costs, Explicit &
Implicit Costs

Please learn by yourself with examples (self learning

topics)
◻ Prime or Variable Costs and Supplementary or
Fixed Costs
◻ Explicit & Implicit Costs, Private, External and
Social costs
 Type of different Cost concepts- Total, Average and
Marginal Costs

Fixed costs are those costs Variable costs are the Total costs -When the
which don’t change with change costs which change with fixed cost are added
of the output are called fixed change of the and output with variable costs
costs. quantity. then the total cost can
It means output may be increase be obtained.
It means when the output
(or) decrease but no change in is increased, these costs When the output
these costs. increased and when the increases total costs
Irrespective of the level of output is decreased, these are also increased and
output quantity, the producer costs are also decreased. when the output
must incur this cost. . Example: Expenditure decreases total costs
on raw material, power, are also decreased.
Example: expenditure on the fuel, wage of daily
land, building, salaries of laborers etc.
permanent employees, interest
payment, insurance premium
etc.
Cost Curves of TC, FC and VC

The total fixed cost curve

(TFC) will be parallel to
ox-axis.

The total variable cost

(TVC) curve will be
sloped upwards from “left
to right.

The total cost curve will

slope upwards from the
left to right as there direct
proportional relationship
between output and total
cost.

TC = TFC + TVC
Cost Curves (Short Run Cost Function) -
Average Fixed Cost Curve
Total Total Average Average
Fixed Variable Total Cost Fixed Variabl Marginal
Output Cost Cost (TC) = TFC + Cost e Cost Cost
(Q) (TFC) (TVC) TVC (AFC) (AVC) (MC)
0 20 0 20 ∞ 0 20
1 20 8 28 20.00 8.00 8
2 20 14 34 10.00 7.00 6
3 20 18 38 6.67 6.00 4
4 20 22 42 5.00 5.50 4
5 20 28 48 4.00 5.60 6
6 20 36 56 3.33 6.00 8
7 20 46 66 2.86 6.57 10
8 20 58 78 2.50 7.25 12

It is the average fixed cost per unit of output produced and calculated as
AFC = TFC / Q.

The curve slopes downwards from left to right as the fixed cost decreases with increase in
output.
Cost Curves (Short Run Cost
Function)-Average Variable Cost Curve
Total Total Average Average
Fixed Variable Total Cost Fixed Variabl Marginal
Output Cost Cost (TC) = TFC + Cost e Cost Cost
(Q) (TFC) (TVC) TVC (AFC) (AVC) (MC)
0 20 0 20 ∞ 0 20
1 20 8 28 20.00 8.00 8
2 20 14 34 10.00 7.00 6
3 20 18 38 6.67 6.00 4
4 20 22 42 5.00 5.50 4
5 20 28 48 4.00 5.60 6
6 20 36 56 3.33 6.00 8
7 20 46 66 2.86 6.57 10
8 20 58 78 2.50 7.25 12

It is the average variable cost per unit of output produced and calculated as
AVC = TVC / Q

The curve has U shape – Initially decreases with output, but, starts increasing as more and
more output is produced (Extra labour costs add up to variable cost for increasing output).
Cost Curves (Short Run Cost Function) -
Marginal Cost Curve
Total Total Average Average
Fixed Variable Total Cost Fixed Variable Marginal
Output Cost Cost (TC) = TFC + Cost Cost Cost
(Q) (TFC) (TVC) TVC (AFC) (AVC) (MC)
0 20 0 20 ∞ 0 20
1 20 8 28 20.00 8.00 8
2 20 14 34 10.00 7.00 6
3 20 18 38 6.67 6.00 4
4 20 22 42 5.00 5.50 4
5 20 28 48 4.00 5.60 6
6 20 36 56 3.33 6.00 8
7 20 46 66 2.86 6.57 10
8 20 58 78 2.50 7.25 12

It is the additional cost incurred to produce an additional unit of output and

calculated as changes in the total cost in producing successive units of out put.
MC = TCn - TC n-1 or ΔTC/ΔQ
The curve has U shape like TVC, but slightly deep at the bottom.
Cost Curves (Short Run)- Relationship between
SAC & SMC

SAC declines as more and more output is produced

and so SMC.

As soon as extra units become more expensive

than current units (on average), the overall
average cost (SAC) begins to increase, which
explains the upward arc of the U-shaped SAC
curve.

With other inputs fixed, adding increased amounts of

a variable input (for eg. labor) generates smaller
amounts of additional output; that is, after a point,
labor’s marginal product declines. As a result,
marginal cost (SMC) rises with the level of output.
Short run Average and
The firm’s marginal cost curve intersects its
Marginal cost curves can be
average cost curve at the minimum point of SAC.
denoted as SAC & SMC
respectively.
Cost Curves (Long Run Cost Function)

In the long run, a firm moves from one scale of

plant to the other, that is, starts producing
either large volume of products or moves to
producing different line of products.

There are no fixed costs in the long run and all

the costs are variable.

Long run Average Cost (LAC or LRAC) is

composed of many short run average cost curves
(SACs) pertaining to different scale of plants.

LAC is also called as Planning curve or

Envelope Curve.

SMCs refer to the points intersecting the SACs

at its minimum.
 Cost Volume Profit (CVP) (or) Break Even
Analysis (BEA)

✔With CVP or BEA, firms can determine The main components of CVP
how changes in costs (both variable analysis are:
and fixed) and sales volume affect
profit. Contribution Margin (CM) ratio
and variable expense ratio
✔Firms can better understand overall
performance by looking at how many Break-even point (BEP)
units must be sold to break even
Margin of safety (MoS)
(amount of sales the firm must generate
to cover all production costs) to reach a Changes in net income
certain profit threshold or the margin
of safety. Degree of operating leverage

The discussion is limited to only first 3 components

 Cost Volume Profit (CVP) (or) Break Even Analysis
(BEA)
Per unit
(i) Contribution Margin Ratio and Description Total Cost(in Rs.)
Variable Expense Ratio Sales (20,000
units) 12,00,000 60
CM ratios and variable expense ratios
Less: Variable
are numbers that firms generally want Cost 9,00,000 45
to see to get an idea of how significant Contribution
variable costs are. Margin 3,00,000 15
Less:Fixed
◻ CM Ratio = Contribution Margin / Costs 2,40,000
Sales Net Income 60,000
◻ Variable Expense Ratio = Total Ratios Formula Answer
Variable Costs / Sales Contribution
CM Ratio Margin / Sales 0.25
Decision criteria : A high CM ratio and a Variable Total Variable
Expense Ratio Costs / Sales 0.75
low variable expense ratio indicate low
levels of variable costs incurred Total Fixed Costs / CM
BEP per Unit 16000
Actual Sales –
Margin of (Break-even Sales
Safety X Per unit cost) 2,40,000
 Cost Volume Profit (CVP) (or) Break Even Analysis
(BEA)

(ii) Break-Even Point

◻ The break-even point (BEP), in units, is the
number of products the firm must sell to
cover all production costs, that is the amount
of sales the company must generate to cover
all production costs (variable and fixed
costs).
The formula for break-even point (BEP) is:
◻ BEP =Total Fixed Costs / CM per Unit Ratios Formula Answer
Contribution
◻ The BEP, in units, would be equal to CM Ratio Margin / Sales 0.25
240,000/15 = 16,000 units. Variable Total Variable
Expense Ratio Costs / Sales 0.75
Decision Criteria: Therefore, if the company Total Fixed
sells 16,000 units, the profit will be zero and Costs / CM per
the company will “break even” and only cover BEP Unit 16000
Actual Sales –
its production costs. (Break-even
Margin of Sales X Per unit
Safety cost) 2,40,000
 Cost Volume Profit (CVP) (or) Break Even Analysis
(BEA)
Per unit
Description Total Cost(in Rs.)
(iii) Margin of Safety Sales (20,000
◻ Firms may also want to calculate the margin units) 12,00,000 60
of safety which shows by how much sales Less: Variable
can allowed to be dropped and yet still Cost 9,00,000 45
break even. Contribution
The formula for the margin of safety is: Margin 3,00,000 15
Less:Fixed
◻ Margin of Safety = Actual Sales –
Costs 2,40,000
Break-even Sales
Net Income 60,000
◻ The margin of safety in this example is: Ratios Formula Answer
◻ Actual Sales – Break-even Sales = Contribution
Rs.12,00,000 – 16,000*60 = Rs.2.40,000 CM Ratio Margin / Sales 0.25
Variable Total Variable
◻ This margin can also be calculated as a Expense Ratio Costs / Sales 0.75
percentage in relation to actual sales:
240,000/1,200,000 = 20%. Total Fixed Costs
BEP / CM per Unit 16000
Decision criteria: Therefore, sales can drop by
Rs.240,000, or 20%, and the firm is still not Actual Sales –
losing any money. Margin of (Break-even Sales
Safety X Per unit cost) 2,40,000
Simple Problem for calculating AC & MC

Output Total Cost Average Cost Marginal Cost

(Q) (TC) (AC) (MC)
1 60 60 60
2 80 40 20
3 90 30 10
4 96 24 6
5 100 20 4
6 144 24 44
7 210 30 66
8 320 40 110
9 540 60 220
10 900 90 360
Economies &
Diseconomies of Scale
Economies of Scale

Economies (Advantages/Benefits) of
Scale refer to the cost advantage
experienced by a firm when it increases
its level of output.

The greater the quantity of output

produced, the lower the per-unit fixed
cost.

Economies of scale also result in a fall in

average variable costs (average non-fixed
costs) with an increase in output. This is
brought about by operational
efficiencies and synergies as a result of
an increase in the scale of production.
Economies of Scale- Graphical representation

LRAC Long Run Average Cost

 Economies of Scale- Internal & External
Economies
Economies arising out of large-scale production
can be grouped into two categories; viz.,
internal economies and external economies.

Internal economies- Arise due to factors such

as
(a) cost of production would come down
considerably when a firm expands its production
output and places it in a better position to
compete in the market effectively.
(b) efficiency of the entrepreneur or his
managerial talents.
(c ) the type of machinery used.
(d) the marketing strategy adopted.

External economies- Are the benefits accruing

to each member firm of the industry as a result
of expansion of the industry as a whole.
Economies of Scale- Internal Economies in
detail
Internal Economies of scale can be classified into the following areas
Economies in production -arises through
◻ 1. Technological advantages .
◻ 2. Advantages of division of labour and specialization .
Economies in marketing-facilitated through
◻ 1. Large scale purchase of inputs.
◻ 2. Advertisement economies .
◻ 3. Economies in large scale distribution .
◻ 4. Other large-scale economies .
Managerial economies - achieved through
◻ 1. Specialization in management
◻ 2. Mechanization of managerial function.
Economies in transport and storage
◻ Economies in transportation and storage costs arise form fuller utilization of
transport and storage facilities.
Economies of Scale- External Economies in
detail

External economies to large size firms or well managed small size frims arise from
the benefits they enjoy due to the following factors (For example, food processing
industries are often located close to agricultural fields so that both industries can
reduce their transportation costs).
1. Economies of concentration- When firms within the same industry cluster
together, they can take advantage of the existing infrastructure and supply
networks. Moreover, skilled workers tend to shift close to such clusters for work,
thereby giving firms easy availability to labor
2. Economies of information -When several firms are located close to each other,
they can access perfect information on the prices of inputs. Since all firms
purchase inputs from the same suppliers, the latter cannot charge different prices
from different firms.
3. Tax breaks- When the government of a country offers tax concessions on the
production of a certain product or subsidies on the purchase of certain raw
materials, it reduces the cost of production of all firms in that particular industry.
Diseconomies of Scale

Diseconomies of scale occur when a

firm experiences an increase in its
average costs as its total output
increases. They may be caused by
the following:
Poor leadership or management
Communication issues across the
company
Motivation and morale has decreased
Rapid expansion of the firm leading
to losing focus among employees.
Too much inventory or inefficient
logistics
MARKET STRUCTURES
 What are Markets?

✔Market in economics refer to places where exchange of goods and services take
place and as a result, buyers and sellers would be in contact with one another.
Based on the area or locality the market is classified into 3 types as follows.
What are Market Structures?

✔ Market Structures describe how different

industries are classified and differentiated based
on their degree and nature of competition for
goods and services.
✔ Market structures can be grouped into four
categories: Perfect competition & Imperfect
Competition which are further divided into
monopolistic competition, monopoly duopoly
and oligopoly competition/structures.
Market Structure based on Competition

✔Homogeneous products & services

✔Prices are set by demand and supply
forces

✔Different products and services

✔Prices that are not set by supply and
demand
✔Competition for market share
Buyers may not have complete
information about products and
prices
✔Low/high Barriers to entry and exit.
Market Structures- Features of Perfect
Competition
1. Large number of sellers and buyers: There will be a large number of sellers and buyers
for a good in this market. A single producer or seller cannot change the price by his
actions. Therefore a seller takes the price decided by the market. The producer is a
price taker.
2. Homogeneous Commodities: Products in this market are similar in every aspect. A
consumer gets the same good whenever he purchases and there will be one price all
over the market.
3. Free entry and exit: Any firm can enter into the production and exit as per its desire.
Firms stay in competition as long as they earn super normal profits, but when ends up
with losses, they leave the market.
4. Mobility of factors of production: Factors of production will move from one production
to another easily. This is also useful for free entry and exit of firms factors (land, labour,
capital) move to the production activities where they get higher incomes.
5. Perfect knowledge of market Buyers and sellers in this market
will have a clear knowledge about market conditions. So, there will be one price
throughout the market.
Market Structures- Examples for Perfect
Competition
Market Structures- Features of Monopoly
Competition

1. One Seller and Large Number of Buyers-Firm itself is an industry

by itself and there are large buyers for a good in this market. Seller
is a price maker.
2. No Close Substitutes-There may not be any close substitutes for the
product sold by the monopolist. 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 industry, even when the firm
is making abnormal profits.
4. Price Maker Under monopoly, monopolist has full control over the
supply of the commodity.
5. Downward sloping demand curve, that is as price reduces, demand
increases. Individual demand forms very small part of total demand.
Market Structures - Examples of Monopolies
Market Structures- Features of Duopoly&
Competition and Examples
Duopoly Market is the one where there are
two sellers or two producers or two firms.

It is also one of the forms of oligopoly

markets.

Two primary types of duopolies are The

Cournot Duopoly states that competition
between the two firms is driven by quantity
or availability of the goods and services.
Prices are arrived at based on the
availability.

The Bertrand Duopoly states that

competition would always be driven
by price.
Market Structures- Features of Oligopoly
Competition
1.Less number of firms
The numbers of producers are a few in this market. Each one produces a large part of the total
output. Cartels and Collusions will be formed by the producers.
2. Interdependence
In the oligopoly market the decisions of every producer affect other producers. This is due to
less number of producers in the market. A change in the decisions of a producer (output or
price) makes the other producers to change their decisions.
3. Huge Expenses
Sometimes commodities are produced with small differences. Then each firm makes a huge
expenditure on advertisements .The highest expenditure is incurred by oligopoly firms.
4. Uncertainty
It will be difficult to guess what kind of demand curve will be there for a firm. Every time
when a producer changes his decision, other producers will also change their decision.
Therefore, it is not possible to expect price, output conditions to be the same in this market.
5. Rigid price
In this market firms will not change the price, they follow a rigid price. A firm cannot increase
price because other firms will not raise their prices. Therefore, all the firms will follow a rigid
price without making any changes in it.
Market Structures - Examples for Oligopoly
Competition

A cartel is a formal agreement among firms in an oligopolistic industry. Cartel members may
agree on such matters as prices, total industry output, market shares, allocation of customers,
allocation of territories, bid-rigging, establishment of common sales agencies, and the
division of profits or combination of these. For Example Organization for Economic
Co-operation and Development (OECD) stimulates world trade and economic progress
Market Structures- Features of Monopolistic
Competition
1. Aconsiderable number of producers: A commodity is produced by a considerable
number of producers and no one controls the output in the market. Competition will be high
among the producers.
2. Product differentiation: The commodity of each producer will be different from that of
other producers. The difference may be due to material used, colour design, smell,
packaging, trademark etc.( specific identification in the market)
3. Entry and exit Firms are allowed to enter into production and leave the market. When
profits are high new firms will join. In case of losses, inefficient firms will leave.
4. Expenditure Every firm makes expenditure to sell more output. Advertisement through
newspapers, journals, electronic media, sales representatives, exhibitions, free sampling
help to promote the sales.
5. Imperfect knowledge Buyers will have an imperfect knowledge about commodities.
Sometimes products may be the same but consumers think that a particular good is superior
than another.
6. Price decision Each firm produces a commodity with small differences. It is due to this
reason that a firm will decide the price for its product. The demand curve for a firm will be
downwards sloping and more elastic.
Market Structures- Examples for
Monopolistic Competition
Market Structures - Some more Examples of
Monopolistic Competition

Example #1 – Coffee Shops or Houses or Chains

A Large number of sellers
Product is Similar but not Identical.
Non-Price Competition
Less Pricing Power
Low Barriers to Entry and Exit
Example #2 – Farmers
A Large Number of Sellers
Product is Similar but not Identical.
Product Differentiation
Less Pricing Power
Low Barriers to Entry and Exit
Example #3 – Retail Industry
A Large Number of Sellers
Product Differentiation
Less Pricing Power
Low Barriers to Entry and Exit
Market Structures-Comparative Chart

Also, please do your own search for the same for further reading
 Refer Text books also for more
detailed reading and better
understanding

Pricing Decisions/Strategies for

different Market Structures
Some Definitions

Total Revenue (TR) : The total amount of money that the firm receives
from selling their products or goods and services.
Total Cost (TC) : The total cost incurred by firms in producing goods and
services.
Profit (Normal Profit or Economic Profit) is the gain in business
activity and are the primary measure of the success of any business and is
calculated as total revenue minus total cost.
Profit = TR – TC
Marginal Cost (MC): Per-unit cost of the good or product and it is the
additional cost incurred in producing one more unit of output.
Marginal Revenue (MR) : Per-unit selling price of the good or product
and it is the additional revenue earned by selling one more unit of a
product.
Supernormal profit or abnormal is defined as extra profit above that
level of normal profit.
 Understanding the relationship between Average Cost (AC), Marginal
Cost (MC), Average Revenue (AR) Marginal Revenue(MR),

Marginal Revenue curve is

sloping downwards because,
with one additional unit sold,
only revenue close to
normal revenue will be
generated.

But when started selling

more and more, it is required
to reduce the price of the item
selling (otherwise firms
cannot sell)-Law of
Diminishing Margins.
Average Revenue Curve or Demand Curve,
(which is not the consumers’ demand curve but The more firms sell after a
rather the producers’ demand curve)- The curve normal limit, the more the
represents an average quantity at an average price will diminish and,
price. accordingly, so will revenue.
Formulas to find out the MR and MC
 Profit Maximising Condition Explained-MR&MC
Approach

MC < MR
As long as the cost of producing another unit (MC) remains less than the revenue
received from the sale of an additional unit (MR), that is MC < MR, producer
keeps on adding to profits.

MC > MR
When MC is greater than MR, production of more units will lead a to decline in
profits.

MC= MR
Thus, MR=MC is the equilibrium state where a producer would be able to
maximise profit and MC is greater than MR after the MC=MR Output Level.
 Profit Maximising Condition
Explained-Graphical Illustration

Conditions to maximize profits is that the marginal revenue and

marginal cost must be equal (MC = MR), which is the equilibrium
point on the graph. Producers or firms achieve equilibrium when
there is the widest gap (maximum difference) between MR and
MC; and TR and TC.

In the above graph, Q1 (output) is the point that intersects MR and

MC and if the firm produces less output than equilibrium
quantity Q1, then MR becomes greater than MC, leading to an
overall enhancement of profit.

As the output by the firm approaches the level of Q1, initially, the
MR is slightly greater than MC, Subsequently, as the output
crosses Q1, the marginal cost will substantially increase over the
marginal revenue. As a result, the firm will experience a revenue
loss.

Therefore, the firm can maximize profits only at the point of Q1.
It begins to fall after crossing the point Q1 as MC > MR
Individual & Market Demand-Perfect Competition

We know prices are controlled by market

forces of demand and supply.

The elasticity of demand would be infinity

as small changes in the prices would result
in huge change in demand (Also, the
elasticity of supply).

Demand curve for the market (Total

Market Demand), which includes all firms,
is downward sloping, while the demand
curve for the individual firm is flat or
perfectly elastic, reflecting the fact that the
individual firms take the market price, P
(Price Takers).
Price, Output decision and Profit
Maximisation-Perfect Competition

The profit-maximizing choice for a perfectly

competitive firm will occur where MR = MC.
Here, P becomes the equilibrium point making
marginal revenue equal to marginal cost.
Firms under perfect competition must
manufacture goods equivalent to P to
maximize its profit.
Firms will be able to earn super normal or
abnormal profits in the short run.
Abnormal profit can only be generated when
average revenue (AR) is greater than average
total cost (ATC) ( AR> ATC).
In the long run, all the firms would earn
normal profits with the condition MR = MC.
Graphical illustration of Profit
Maximisation-Monopoly Competition

The best option for profit

maximization for
monopoly is to produce that
quantity of goods which
makes the marginal cost
equal to marginal revenue
(profit maximization rule
), that is, MR = MC.

Like the case of perfect

competition, the producer of
goods needs to fix the
equilibrium price to earn
normal profits in the long
run.
Price, Output decision and Profit
Maximisation-Monopoly Competition
The monopolist will choose to
produce 3 units of output
because MR = MC at Rs.4.The
monopolist will earn Rs.12 in
profits from producing 3 units
of output, the maximum
possible.

Monopolist's search price is a

price of Rs.8 per unit. This
equilibrium price is determined
by finding the profit
maximizing level of
output—where marginal
revenue equals marginal cost
and then looking at the demand
curve to find the price at which
the profit maximizing level of
output will be demanded
 Price, Output decisions & Graphical illustration of Profit
Maximisation- Monopolistic Competition (Short Run)

◻ Monopolistic competition is a type of market

structure where many companies are present in
an industry, and they produce similar but
differentiated products
Short-Run Decisions on Output and Price
◻ Profits are maximized where marginal
revenue (MR) is equal to marginal cost (MC)
◻ The price is determined at a point where the
imaginary line from the equilibrium output
passes through the point of intersection of the
MR, and MC curves and meets the average
revenue (AR) curve, which is also the demand
curve.
◻ Total profit is represented by the rectangle in
the diagram. It is determined by the equilibrium
output multiplied by the difference between AR
and the average total cost (ATC)
Price, Output decisions & Graphical illustration of Profit
Maximisation- Monopolistic Competition (Long Run)

In the long run, companies in monopolistic

competition still produce at a level where
marginal cost and marginal revenue are equal.

However, the demand curve will have shifted to

the left due to other companies entering the
market. The shift in the demand curve is a
result of reduced demand for an individual
company’s products due to increased
competition.

Such an action reduces economic profits,

depending on the magnitude of the entry of new
players.
Price, Output decision and Profit Maximisation-
Oligopoly, Theory of kinked demand curve

Oligopoly is a type of market condition

where there are two-three firms that
dominate the market for a certain type of
good or service.

Pricing and marketing decisions of each

firm affect the other, that is, firms are
interdependent. Profit maximisation may
not be the sole objective. There will be
non-price competition among them.

The market is normally characterised by

price rigidity which can be explained by
kinked demand curves.

In the diagram, consider a typical oligopolist

(acting firm) charges P1 and selling Q1.
AR1 and AR2 are the Average Revenue
curves.
 Price, Output decision and Profit Maximisation-
Oligopoly, Kinked Demand Curve for price rise.

Suppose the acting firm raise

the prices to P2 and other firms
hold on to their old prices, the
acting from would lose the sale
and demand for its products.
This causes an elastic demand
as demand of the acting firm
falls with respect to the price
increase for its products.

PED- Price Elasticity of Demand

 Price, Output decision and Profit Maximisation-
Oligopoly, Kinked Demand Curve for price cut.

Suppose the acting firm cuts the price

below P1, that is P3, and now other firms
also reduce their prices, the acting firm
might get little revenue from increase in
sales and hence the demand is relatively
inelastic as there was only little increase
in sales with respect to this price cut.
Price, Output decision and Profit Maximisation-
Oligopoly, The Kink

Thus, a bent or kink

is created in the
demand or Average
Revenue curve of
oligopolists.
Price, Output decision and Profit Maximisation-
Oligopoly, MR Curve and Equilibrium decision
How the profit maximisation condition is
satisfied or how equilibrium price and quantity
are found- Marginal Cost (MC) curve is arrived at
and drawn through gap in the MR curve. Thus, the
price and quantity would be optimum as long as
the MC curves pass through the gap in MR curves.

The Marginal curves would be 2 when there is a kink

or bent in AR curve. At Q1, these 2 curves do not
intersect (simple vertical intersection only) and MR
drops discontinuously.
Price, Output decision and Profit Maximisation-
Oligopoly, The Price Rigidity even when MC changes
Generally, when marginal cost increases,
the selling prices can be increased by firms.
But, an oligopolist cannot do so because of
the interdependence between firms in the
Oligopoly market.

Predictions of the Theory- This kinked

demand theory model predicts that the
prices would be rigid even when marginal
costs change, that is, increase or decrease.
Examples of Non-Price Competition
 Price, Output decision and Profit Maximisation-
Oligopoly, Overview of Kinked Demand Curve
Theory

Criticism- Unfortunately, the kinked demand curve model is incomplete. It does not explain why the kink occurs at the
price P*. Nor does it justify the price-cutting behavior of rivals. (Price cutting may not be in the best interests of these
firms. For instance, a rival may prefer to hold to its price and sacrifice market share rather than cut price and slash
profit margins.
Pricing, output decision and profit maximisation-
Oligopoly-Game Theory

Game-theory’ can be used to explain

‘interdependence’ and ‘price-stickiness’,
which are both characteristics
of oligopolies.
A game has three central components -
players, outcomes and the need for a
strategy.
In the matrix, pay-off table of two rival
firms can either raise price or lower
price.
Without any co-operation, the rational
option is for both to lower (both get
$70m), but, if one lowers and the other
raises the one that raises will only get Game 'theory' is the formal study of games where
$30m. a player's outcomes are determined by decisions
With co-operation, if they agree to raise they take and those taken by other players.
price together they can get the best Games may involve co-operation between
outcome of $80m each. Hence, firms may players, or conflict between players.
choose to co-operate.
 Factors affecting Pricing decisions- Oligopoly

✔ CO-OPERATIVE BEHAVIOUR: - A situation when firms jointly decide the

prices and output and maximizes their joint profit. This situation is called collusion,
in this situation it becomes profitable for one firm if it cuts the prices and rises
output.

✔ NON- COOPERATIVE BEHAVIOUR: - A situation when they do not co-operate

and decides their prices and output separately and compete with each other. When
firms in oligopoly do not co-operate it is called non- cooperative equilibrium or
Nash equilibrium

Dilemma

In oligopoly the basic dilemma the firms face is whether to co- operate or to compete. If
they co-operate profit will be maximum and if they do not, profit for all will decrease.
Pricing, output decision and profit maximisation-
Oligopoly, The Cournot’s model

Cournot’s model of oligopoly applies where (a)

the firms produce homogeneous goods, (b) they
compete simultaneously on output and market
share, and (c) they expect their rivals to not
change their output in response to any change
that they make.

Cournot assumed that there are two firms each

owning a mineral well, and operating with zero
costs.

Each firm acts on the assumption that its

competitor will not change its output, and
decides its own output so as to maximize profit.

Self Learn the model with mineral well example.

 Pricing, output decision and profit maximisation-
Stackleberg & Bertrand Models

Stackleberg Model:
It is one in which one firm is a leader and other firms are followers. This model applies where: (a)
the firms sell homogeneous products, (b) competition is based on output, and (c) firms choose their
output sequentially and not simultaneously.
The leader is typically a first-mover who chooses its output before other firms can do it. Since other
firms must set their output decision given the leader’s output decision, the leader in a Stackelberg
oligopoly typically has a bigger market share and higher profit than other firms in the oligopoly.
Bertrand Model:
There are two versions of Bertrand model depending on whether the products are homogeneous or
differentiated.
The homogeneous-products-When firms in the oligopoly produce standardized products at same
marginal cost. When the marginal cost is same, it is in the best interest of each firm in oligopoly to
beat its price because the other firms are also trying to beat it. This price war leads to a situation at
which market price is equal to the marginal cost. The output and price level in a Bertrand oligopoly
is the same as in perfect competition.
The differentiated-products-When an oligopoly produces differentiated products, price
competition doesn’t necessarily lead to a competitive outcome. It is because when each firm
produces a differentiated product, its demand doesn’t become zero when it raises its price.According
to this model each producer can always lower the price until price is equal to cost of production.
Pricing Strategies- Skimming, Penetration, Premium &
Psychological pricing
 Pricing Strategies- Price Discrimination

#5 Price Discrimination- A pricing strategy that charges consumers different prices for identical goods
or services. Primary requirements for successful price discrimination are imperfect competition (price
makers), varying elasticities of demand and prevention of resale. Monopoly players employ this to
different buyers in different regions.
 Pricing Strategies-Price Discrimination &
Conditions for employing it

(a) Different price elasticities of demand

The monopolist (Monopoly firms) charges higher price
for the product in a market where price elasticity of (d) Ignorance of the consumers
demand is relatively inelastic and charges relatively If the consumers remain ignorant about
lower price in a market where the price elasticity of the difference in prices of the same
demand is relatively elastic. product in two different markets, then
also the monopolist can easily follow the
(b) Tariff barrier & geographical distance If two policy of price discrimination.
markets are separated by a tariff wall, geography,
then price discrimination can be adopted. For (e) Typical behavior of the consumers
example, the monopolist can sell its product at a
In some cases, a group of consumers
lower price in the foreign market, and at a higher
price in the domestic market which is called as consider higher price as an indicator of
Dumping. higher quality (the so called Veblen
effect). Such typical behavior of the
( c ) Impossibility of resale of a product consumers creates an opportunity for the
(particular service items) monopolist to follow the policy of price
When it is not possible to re sell the product sold by discrimination.
the monopolist, then price discrimination can be
of help in case of service items. For example, a
renowned doctor can charge different fees for
Pricing Strategies-Target, Transfer, Dynamic, Cost
Plus and Limit pricing
Module 2 is Over