UNIT - III

THEORY OF PRODUCTION
Production is a process of transforming tangible and intangible inputs into goods or
services. Raw materials, land, labour and capital are the tangible inputs, whereas ideas,
information and knowledge are the intangible inputs. These inputs are also known as factors
of production. For an organisation, the four major factors of production are land, labour,
capital, and organisation. An organisation needs to make an optimum utilisation of these
factors to achieve maximum output.

DEFINITION OF PRODUCTION

According to J.R. Hicks, “Production is an activity whether physical or mental, which is

directed to the satisfaction of other people’s wants through exchange.”

PRODUCTION FUNCTION OR FACTOR OF PRODUCTION :

Production function, basically is an engineering concept but is widely used in

economics for studying production behaviour. The technological relationship between
physical inputs and output is referred to as the production function.

Production function shows the maximum production or output obtained from a

given set of inputs under the present state of technology. It always refers to a period of
time. The production function can be express mathematically in the form of an equation.

Q = f (L1, L2, K, O, T)

Q = Quantity of output
f = Functional relation
L1 = Land
L2 = labour
K = Capital
O = Organisation
T= Technology

Production Function With One Variable Input:

This also called law of diminishing returns or law of diminishing marginal returns or
law of variable proportions. This law applies in short - run. In short – run, if output has to be
increase, organisation can change only variable inputs because some inputs are fixed in short
run. The fixed inputs are land, building, plant, machinery, capital etc. The variable inputs are
labour, raw materials etc. This production function studies what happen to output if only one
input i.e. labour increase continuously without changing other inputs. If only labour increases
to increase output, first stage output increases at increasing rate, second stages output
increase but deceasing rate and in final stage output falls. This law is of universal nature and
it proved to be true in agriculture and industry also.

Definition

According to G. Stigler “If equal increments of one input are added, the inputs of other
production services being held constant, beyond a certain point the resulting increments of
product will decrease i.e. the marginal product will diminish”.

According to F. Benham “As the proportion of one factor in a combination of factors is

increased, after a point, first the marginal and then the average product of that factor will
diminish”.

Units of Total production(tp) Marginal Average product Stages

labour product (ap)
(mp)
0 0 0 0
1 10 10 10 Stages 1
2 22 12 11
3 33 11 11
4 40 7 10 Stages 2
5 45 5 9
6 48 3 8
7 48 0 6.85 Stages 3
8 45 -3 5.62

From the above table and graph, one can identify how the law of variable proportions
operates in three stages. In the first stage, total product increases at an increasing rate. The
marginal product in this stage increases at an increasing rate resulting in a greater increase in
total product. The average product also increases. This stage continues up to the point where
average product is equal to marginal product. The law of increasing returns is in operation at
this stage. The law of diminishing returns starts operating from the second stage onwards. At
the second stage total product increases only at a diminishing rate. The average product also
declines. The second stage comes to an end where total product becomes maximum and
marginal product becomes zero. The marginal product becomes negative in the third stage.
So the total product also declines. The average product continues to decline. The reason for
increasing rate can seen in first stage because of applying more labour leading to effective
utilization fixed inputs that resulting increasing returns. If more labour applied in second
stage, effective utilization of fixed inputs reaches to maximum, leading to diminishing
returns. Even still more labour is applied, resulting to ineffective utilization of fixed inputs
leading to total product decline. The rational stage of operation of business is up to second
stage only.

Production Function With Two Variable Inputs:

Production process that requires two inputs, capital (K) and labour (L) to produce a
given output (Q). There could be more than two inputs in a real life situation, but for a simple
analysis, we restrict the number of inputs to two only. In other words, the production function
based on two inputs can be expressed as

Q = f (K, L)

Where K= capital, L = labour,

Normally, both capital and labour are required to produce a product. To some extent,
these two inputs can be substituted with each other. Hence the producer may choose any
combination of labour and capital that gives him the required number of units of output, from
any one combination of labour and capital out of several such combinations. The alternative
combinations of labour and capital yielding a given level of output are such that if the use of
one factor input is increased , that of another will decrease and vice versa. However, the units
of an input foregone to get one unit of the other input changes depends upon the degree of
substitutability between the two input factors. Based on the techniques or technology used,
the degree of substitutability may vary.

ISO - QUANTS

The term Iso-quants is derived from the words ‘iso’ and ‘quant’ – ‘Iso’ means equal
and ‘quant’ implies quantity. Isoquant therefore, means equal quantity. Isoquant are also
called iso- product curve. An isoquant curve show various combinations of two input factors
such as capital and labour, which yield the same level of output.

As an isoquant curve represents all such combinations which yield equal quantity of output.
Any or every combination is a good combination for the manufacturer, hence he prefers all
these combinations equally. An isoquant curve is also called product indifference curve.
An isoquant may be explained with the help of an arithmetical example.

Combinations Labour (units) Capital (Units) Output (quintals)

A 1 10 50

B 2 7 50

C 3 4 50

D 4 2 50

E 5 1 50

Combination ‘A’ represent 1 unit of labour and 10 units of capital and produces ‘50’
quintals of a product. All other combinations in the table are assumed to yield the same given
output of a product say ‘50’ quintals by employing any one of the alternative combinations of
the two factors labour and capital. If we plot all these combinations on a graphic sheet and
join them, we will get smooth curve called Iso-product curve or Iso-quant curve as shown
below.

Labour is on the X-axis and

capital is on the Y-axis. IQ is
the ISO-Product curve which shows all the alternative combinations A, B, C, D, E which can
produce 50 quintals of a product.

PROPERTIES OF ISO – QUANT

1. Iso-quant curve slope downward from left to right : Isoquant are downward sloping
curves because if one input increase, the other one reduces. There is no question of
increase in both the inputs to yield a same given output. Hence isoquant slope
downward from left to right. A degree of substitution is assumed between the factors
of production.
 2. Do not intersect each other: Two isoquant do not intersect with each other. It is
because, each of these denote a particular level of output. Since different iso- quants
for different levels of output, no two iso-quants intersect with each other.
3. Higher isoquant represent higher level of output: The isoquant which is higher
stage has higher output and vice versa. Greater combination of labor and capital
makes large scale of production. So, higher the isoquant curve, greater will be the
production level.
4. Do not touch axes: The isoquant touches neither X-axis nor Y- axis, as both inputs
are required to produce a given product.
5. Convex to origin: Isoquant are convex to the origin. It is because the input factors are
not perfect substitutes. One input factor can be substituted by other input factor in a
diminishing marginal rate. If the input factors were perfect substitutes, the isoquant
would be a falling straight line.

ISO COST

Iso- cost refers to that cost curve that represent the combination of inputs that will
cost the producer the same amount of money. In other words, each iso-cost denotes a
particular level of total cost for a given level of production. If the level of production
changes, the total cost changes and thus the iso-cost curve moves upwards, and vice versa.

Iso-cost curve is the locus traced out by various combinations of L and K, each of
which costs the producer the same amount of money (C). A set of iso-cost lines can be
drawn for different levels of factor prices or different sums of money. The iso- cost line will
shift to the right when money spent on factors increases or firm could buy more as the factor
prices are given.
LAW OF RETURNS TO SCALE (or) PRODUCTION FUNCTION WITH ALL
VARIABLE INPUTS

This production function applies in long run. In long run all inputs are variable only which
means that to increase the output all inputs can be changed which is possible in long run
because of enough time is available. But all inputs can be changed simultaneously and
proportionally to change the output. Here organisation experience three types of returns. They
are

1. Increasing returns to scale

This states that the volume of output keeps on increasing more proportionately with
every increase in the inputs, Where a given increase in inputs leads to a more than
proportionate increase in the output, the increasing returns to scale is said to
experience because of economies of scale comes to operation like introducing
division of labour and other technological means to increase production. Hence, the
total product increases at an increasing rate.
2. Constant returns to scale
When the scope for division of labour gets restricted, the rate of increase in the total
output remains constant. Constant returns to scale is said to operate states that the rate
of increase/decrease in volume of output is same to that of rate of increase/decrease in
inputs. This is because diseconomies neutralize the economies of scale.
3. Decreasing returns to scale
Where the proportionate increase in the inputs does not lead to equivalent increase in
output, decreasing returns to scale is said to operate. This results in higher average
cost per unit. Here diseconomies dominates economies of scale.
This law can be illustrated with an example of agricultural land. Take one acre of
land. If you fill the land well with adequate bags of fertilizers and sow good quality
seeds, the volume of output increases the following table illustrates further.

Capital Labor( % of increase Output(in % of Law applicable

(in units) in in both inputs units) increase in
units) output

1 3 --- 50 --- ---

2 6 100 120 140 Increasing returns to scale
4 12 100 240 100 Constant returns to scale
8 24 100 360 50 Decreasing returns to scale
Types of Production Function

Production function on the basis of the time period can be divided into two categories: Short
Run Production Function and Long Run Production Function. In these production functions,
the combination and behaviour of variable factors and fixed factors are different.

1. Short Run Production Function:

Short Run is a period of time where output can only be changed by changing the level of
variable inputs. In the short run, some factors are variable and some are fixed. Fixed factors
remain constant in the short run like land, capital, plant, machinery, etc. Production can be
raised by only increasing the level of variable inputs like labour. Therefore, the situation
where the output is increased by only increasing the variable factors of input and keeping the
fixed factors constant is termed as Short Run Production Function. This relationship is
explained by the ‘Law of Variable Proportions.’

2. Long Run Production Function:

Long Run is a span of time where the output can be increased by increasing all the factors of
production whether it is fixed (land, capital, plant, machinery, etc.) or variable (labour). Long
run is enough time to alter all the factors of production. All factors are said to be variable in
the long run. Therefore, the situation where the output is increased by increasing all the
inputs simultaneously and in the same proportion is termed Long Run Production Function.
This relationship is explained by the ‘Law of Returns to Scale.’

COST

The Institute of Cost and Management Accountants (ICMA) has define cost as “ the amount
expenditure, actual or notional, incurred on or attributable to a specified thing or activity”. It
is the amount of resources sacrificed to achieve a specific objective. A cost must be with
reference to the purpose for which it is used and the conditions under which it is computed.
To take decision, managers wish to know the cost of something.

Cost refer to the expenditure incurred to produce a particular product or services. All cost
involve a sacrifice of some kind or other to acquire some benefit. For example , if I want to
eat food, I should be prepared to sacrifice money.

Cost refers to the amount of expenditure incurred in acquiring something. In business firm, it
refers to the expenditure incurred to produce an output or provide service. Thus the cost
incurred in connection with raw material , labour, other heads constitute the overall cost of
production.

COST CONCEPTS OR TYPE OF COST:

A managerial economist must have a clear understanding of the different cost concepts for
clear business thinking and proper application. The several alternative bases of classifying
cost and the relevance of each for different kinds of problems are to be studied. The various
relevant concepts of cost are:

OPPORTUNITY COST:

Opportunity cost is the cost which is sacrificed or foregone because of choosing the best
alternative by ignoring the next best alternative. In simple terms, it is the earning from the
second alternative. It represents the maximum possible alternative income that was have been
earned if the resources were put to alternative use.

Opportunity cost can be distinguished from outlay costs based on the nature of sacrifice.
Outlay costs are those costs that involve cash outflow at some time and hence they are
recorded in the book of account. Opportunity cost refers to earnings/profits that are foregone
form alternative ventures by using given limited facilities for a particular purpose. Hence they
would not be recorded in the books of cost accounts. But they also will be considered in
decision making process of choosing best opportunity.

FIXED COST VS VARIABLE COST

Fixed cost is that cost which remains constant for a certain level to output. It is not affected
by the changes in the volume of production. But fixed cost per unit decrease, when the
production is increased. Fixed cost includes Salaries, Rent, Administrative expenses,
depreciation etc.

Variable is that which varies directly with the variation in output. An increase in total output
results in an increase in total variable costs and decrease in total output results in a
proportionate decline in the total variables costs. The variable cost per unit will be constant.
Ex: Raw materials, labour, direct expenses, etc

EXPLICIT AND IMPLICIT COSTS:

Explicit costs are those expenses that involve cash payments. These are the actual or business
costs that appear in the books of accounts. These costs include payment of wages and
salaries, payment for raw-materials, interest on borrowed capital funds, rent on hired land,
taxes paid etc.

Implicit costs are the costs of the factor units that are owned by the employer himself. These
costs are not actually incurred but would have been incurred in the absence of employment of
self – owned factors. The examples of implicit costs are rent of own building, interest on
capital, remuneration for owners work etc. A decision maker must consider implicit costs too
to find out appropriate profitability of alternatives.

SHORT – RUN AND LONG – RUN COSTS:

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

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

OUT-OF POCKET AND BOOKS COSTS:

Out-of pocket costs also known as explicit costs are those costs that involve current cash
payment. Book costs also called implicit costs do not require current cash payments.
Depreciation, unpaid interest, salary of the owner is examples of book costs.

But the book costs are taken into account in determining the level dividend payable during a
period. Both book costs and out-of-pocket costs are considered for all decisions. Book cost is
the cost of self-owned factors of production.

Sunk cost :

Sunk costs are those which are not altered by any change. They are the costs incurred in the past.
This cost is the result of past decision, and cannot be changed by future decisions. Investments in
fixed assets are examples of sunk costs.

Marginal cost:

Marginal cost is the additional cost incurred to produce additional unit of output or it is the cost of
the marginal unit produced.

COST – OUTPUT RELATIONSHIP IN THE SHORT RUN:

The short run is a period which does not allow changes in the fixed equipment and the size of the
business. In this period, production can be increased to the exlent of unutilized capacity of present
fixed production facilities only.

The cost output relationship in the short run can be studied in term of i) Average fixed cost ii)
Average cost iii) Average total cost.

i) Average fixed cost and output : Average fixed cost is calculated by dividing total fixed
cost by the quantity of output. In short run the average fixed cost go down with increase
in output. The reason is simple to understand the total fixed costs remain the same and
do not, vary with a change in output. In short, there inverse relationship between
average fixed cost and output and this relationship is universal for all types of business.
Graphically, the AFC curve is a downward sloping curve.
ii) Average variable cost and output: Average variable cost (AVC) is calculated by dividing
total variable cost by the quantity of output. As output rises, average variable cost will
come down initially due to operation of low increasing returns but after a point
(optimum output level). It tends to rise steeply because of the operation of law of
diminishing returns. In other words , we would say that average cost curve declines at
first, reaches a minimum and then it start rising. On account of the operation of the law
of variable proportions, the AVC curve is always U – shaped.

iii) Average total cost and output: Average total cost or average cost is calculated by
dividing cost bye the quantity of output. Alternatively, the addition of AFC and AVC gives
average cost in the short run for each output. As the output increases ATC would come
down is the initial stages (as AFC and AVC both fall). A stage will come when the average
variable cost may have started rising, though the average total cost will continue to fall
till the fall in AFC out weights the rise in AVC. This is way the minimum point of ATC
reached for a larger output than the minimum point of AVC. When fall in AFC becomes
equal to rise in AVC, ATC reaches its minimum point which is the optimum point of
output. The important point to note here is that the turning point in case of average cost
would come a bit later them in case of average variable cost. Since as output increase,
variable cost increase faster relatively to fixed costs, the shape of ATC is governed by
AVC.
 Relationship of different cost curves in the short period.
All aspects of short period costs like fixed cost(FC), Variable cost (VC), Average fixed cost
(AFC), Average Variable cost (AVC), Average cost (AC) and marginal cost (MC)

Long run average cost curve or envelope curve : long run average cost refers to minimum possible
per unit cost of producing different quantities of output in the long period. In the words of
Mansfield, “The long run average cost curve is that curve which shows the minimum cost per unit of
producing each output dividing long run total cost by the quantity of output produced. It is
determined by average cost

By dividing long run total cost by the quantity of output produced. It is the lowest average cost
attainable when all inputs are variable that is when any plant size can be constructed.
MARKET
Market is a place where buyer and seller meet, goods and services are offered for the
sale and transfer of ownership occurs. A market may be also defined as the demand made by
a certain group of potential buyers for a good or service. The former one is a narrow concept
and later one, a broader concept. Economists describe a market as a collection of buyers and
sellers who transact over a particular product or product class (the housing market, the
clothing market, the grain market etc.). For business purpose one can define a market as
people or organizations with wants (needs) to satisfy, money to spend, and the willingness to
spend it. Broadly, market represents the structure and nature of buyers and sellers for a
commodity/service and the process by which the price of the commodity or service is
established. In this sense, we are referring to the structure of competition and the process of
price determination for a commodity or service. The determination of price for a commodity
or service depends upon the structure of the market for that commodity or service (i.e.,
competitive structure of the market). Hence the understanding on the market structure and the
nature of competition are a pre-requisite in price determination.
MARKET STRUCTURE
Market structure describes the competitive environment in the market for any good or
service. A market consists of all firms and individuals who are willing and able to buy or sell
a particular product. This includes firms and individuals currently engaged in buying and
selling a particular product, as well as potential entrants.

The determination of price is affected by the competitive structure of the market. This
is because the firm operates in a market and not in isolation.

PERFECT COMPETITION
Perfect competition refers to a market structure where competition among the sellers
and buyers prevails in its most perfect form. In a perfectly competitive market, a single
market price prevails for the commodity, which is determined by the forces of total demand
and total supply in the market.
 A market structure in which all firms in an industry are price takers and in which there
is freedom of entry into and exit from the industry is called perfect competition. The market
with perfect competition conditions is known as perfect market.

Features of perfectly competition

1. A large number of buyers and sellers: The number of buyers and sellers is large and
the share of each one of them in the market is so small that none has any influence on
the market price.

There should be significantly large number of buyers and sellers in the market. The
number should be so large that it should not make any difference in terms of price or
quantity supplied even if one enters the market or one leaves the market.

2. Homogenous products or services: The products and services of each seller should
be homogeneous. They cannot be differentiated from that of one another. It makes no
difference to the buyer whether he buys from firm X or firm Z. In other words, the
buyer does not have any particular preference to buy the goods from a particular
trader or supplier. The price is one and the same in every firm. There are no
concessions or discounts.
3. Freedom to enter or exit the market: There should not be restrictions on the part of
the buyers and sellers to enter the market or leave the market. There should not be any
barriers. The buyers or sellers can enter the market or leave the market whenever they
want.
4. Prefect information available to the buyers and sellers: Each buyer and seller has
total knowledge of the prices prevailing in the market at every given point of time,
quantity supplied, costs, demand, nature of product, and other relevant information.
There is no need for any advertisement expenditure as the buyers and sellers are fully
informed.
5. Perfect mobility of factors of production: There should not be any restrictions on
the utilization of factors of production such as land , labour, capital and so on. In
words, the firm or buyer should have free access to the factors of production.
Whenever capital or labor is required, it should instantly be made available.
6. Each firm is a price taker: An individual firm can alter its rate of production or sales
without significantly affecting the market price of the product. A firm in a perfect
market cannot influence the market through its own individual actions. It has no
alternative other than selling its products at the price prevailing in the market. It
cannot sell as much as it wants at its own set price.
EQUILIBRIUM POINT IN PERFECT COMPETITION MARKET
 In this graph, MC curve cuts MR at two points Q and E. At point Q, MC curve equals to
MR but MC curve cuts MR from above. Hence, point Q is not equilibrium point. At point E,
MC curve equals to MR and MC cuts MR from below. Hence, point E is equilibrium point
and OM is equilibrium output.

EQUILIBRIUM PRICE AND OUTPUT DETERMINATION IN CASE OF

PERFECT COMPETITION
SHORT RUN:
The price and output of the firm are determined, under perfect competition, based on
the industry price and its own costs. The industry price has greater say in this process because
the firm own sales are very small and insignificant.

Abnormal or Super normal Profits

The firm demand curve is horizontal at the price determined in the industry (MR =
AR = price). This demand curve is also known as average revenue curve. This is because if
all the units are sold at the same price, on an average , the revenue to the firm equal its price.
The firms whose average revenue is more than average cost, the firms earn abnormal or super
normal profits (AR>AC). In short run, there is no time either new firms enter or old firms exit
from the market.

Losses
The firm demand curve is horizontal at the price determined in the industry (MR =
AR = price). This demand curve is also known as average revenue curve. This is because if
all the units are sold at the same price, on an average, the revenue to the firm equal its price.
The firms whose average revenue is less than average cost, the firms suffers losses (AR<AC).
In short run, there is no time either new firms enter or old firms exit from the market.
LONG RUN
Having been attracted by supernormal profits, more and more firms enter the
industry. With the result, there will be a scramble for scarce inputs among the
competing firms pushing the input prices. Hence, the average cost increases. The
entry of more and more firms will expand the supply pulling down the market price.
The entry of the firms into the industry continues till the supernormal profit is
completely eroded. In the long run, the firms will be in the position to enjoy only
normal profits but not supernormal profit. Normal profits are the profit that is just
sufficient for the firms to stay in the business (AR=AC).
MONOPOLY

The word monopoly is made up of two syllables, Mono and poly. Mono means single
while poly implies selling. Thus monopoly is a form of market organization in which there is
only one seller of the commodity. There are no close substitutes for the commodity sold by
the seller. Pure monopoly is a market situation in which a single firm sells a product for
which there is no good substitute.
Features of monopoly
1. Single person or a firm: A single person or a firm controls the total supply of the
commodity. There will be no competition for monopoly firm. The monopolist firm is
the only firm in the whole industry.
2. No close substitute: The goods sold by the monopolist shall not have closely
competition substitutes. Even if price of monopoly product increase people will not
go for substitute. For example: If the price of electric bulb increase slightly,
consumer will not go for kerosene lamp.
3. Large number of Buyers: Under monopoly, there may be a large number of buyers
in the market who compete among themselves.
4. Price Maker: Since the monopolist controls the whole supply of a commodity, he is a
price-maker and then he can alter the price.
5. Supply and Price: The monopolist can fix either the supply or the price. He cannot
fix both. If he charges a very high price, he can sell a small amount. If he wants to sell
more, he has to charge a low price. He cannot sell as much as he wishes for any price
he pleases.
 6. Downward Sloping Demand Curve: The demand curve (average revenue curve) of
monopolist slopes downward from left to right. It means that he can sell more only by
lowering price.

EQUILIBRIUM PRICE AND OUT PUT DETERMINATION IN MONOPOLY

Under monopoly, the average revenue curve for a firm is a downward sloping one. It
is because, if the monopolist reduces the price of his product, the quantity demanded increase
and vice- versa. In monopoly, marginal revenue is less than the average revenue because any
monopolist should reduce the price of product if he wants to sell more quantity of output.

The monopolist always wants to maximize his profits. To achieve maximum profits, it
is necessary that the marginal revenue should be more than the marginal cost. In monopoly
market, monopolist always tries to earn abnormal or super normal profits (AR>AC) Here,
there is no difference between short run and long run in monopoly.

MONOPOLISTIC COMPETITION
Monopolistic competition is said to exist when there are many firms and each one
produces such goods and services that are close substitutes to each other. They are similar but
not identical. Product differentiation is the essential feature of monopolistic. Products can be
differentiated by means of unique facilities, advertising, brand loyalty, packaging, pricing,
terms of credit, superior maintenance services, convenient location and so on.

Features of Monopolistic Competition

1. Existence of Many firms: Industry consists of a large number of sellers, each one of
whom does not feel dependent upon others. Every firm acts independently without
bothering about the reactions of its rivals. The size is so large that an individual firm
has only a relatively small part in the total market, so that each firm has very limited
control over the price of the product. As the number is relatively large it is difficult
for these firms to determine its price- output policies without considering the possible
reactions of the rival firms. A monopolistically competitive firm follows an
independent price policy.
2. Product Differentiation: Product differentiation means that products are different in
some ways, but not altogether so. The products are not identical but the same time
they will not be entirely different from each other. It really means that there are
various monopolist firms competing with each other. An example of monopolistic
competition and product differentiation is the toothpaste produced by various firms.
The product of each firm is different from that of its rivals in one or more respects.
Different toothpastes like Colgate, Close-up, Forehans, Cibaca, etc., provide an
example of monopolistic competition. These products are relatively close substitute
for each other but not perfect substitutes. Consumers have definite preferences for the
particular verities or brands of products offered for sale by various sellers.
Advertisement, packing, trademarks, brand names etc. help differentiation of products
even if they are physically identical.
3. Large Number of Buyers: There are large number buyers in the market. But the
buyers have their own brand preferences. So the sellers are able to exercise a certain
degree of monopoly over them. Each seller has to plan various incentive schemes to
retain the customers who patronize his products.
4. Free Entry and Exist of Firms: As in the perfect competition, in the monopolistic
competition too, there is freedom of entry and exit. That is, there is no barrier as
found under monopoly.
5. Selling costs: Since the products are close substitutes, much effort is needed to retain
the existing consumers and to create new demand. So each firm has to spend a lot on
selling cost, which includes cost on advertising and other sale promotion activities.
6. Imperfect Knowledge: Imperfect knowledge about the product leads to monopolistic
competition. If the buyers are fully aware of the quality of the product they cannot be
influenced much by advertisement or other sales promotion techniques. But in the
business world we can see that though the quality of certain products is the same,
effective advertisement and sales promotion techniques make certain brands
monopolistic. For examples, effective dealer service backed by advertisement helped
popularization of some brands though the quality of almost all the cement available in
the market remains the same.
 7. The Group: Under perfect competition the term industry refers to all collection of
firms producing a homogenous product. But under monopolistic competition the
products of various firms are not identical though they are close substitutes. Prof.
Chamberlin called the collection of firms producing close substitutes are The Group.

OLIGOPOLY

The term oligopoly is derived from two Greek words: ‘oligi’ means few and ‘polein’
means to sell. Oligopoly is a market structure in which there are only a few sellers (but more
than two) of the homogeneous or differentiated products. So, oligopoly lies in between
monopolistic competition and monopoly.
Features of Oligopoly:
1. Few firms: Under oligopoly, there are few large firms. The exact number of firms is not
defined. Each firm produces a significant portion of the total output. There exists severe
competition among different firms and each firm try to manipulate both prices and volume of
production to outsmart each other. For example, the market for automobiles in India is an
oligopolist structure as there are only few producers of automobiles.
2. Interdependence: Firms under oligopoly are interdependent. Interdependence means that
actions of one firm affect the actions of other firms. A firm considers the action and reaction
of the rival firms while determining its price and output levels. A change in output or price by
one firm evokes reaction from other firms operating in the market. For example, market for
cars in India is dominated by few firms (Maruti, Tata, Hyundai, Ford, Honda, etc.). A change
by any one firm (say, Tata) in any of its vehicle (say, Indica) will induce other firms (say,
Maruti, Hyundai, etc.) to make changes in their respective vehicles.
3. Non-Price Competition: Under oligopoly, firms are in a position to influence the prices.
However, they try to avoid price competition for the fear of price war. They follow the policy
of price rigidity. Price rigidity refers to a situation in which price tends to stay fixed
irrespective of changes in demand and supply conditions. Firms use other methods like
advertising, better services to customers, etc. to compete with each other.
4. Barriers to Entry of Firms: The main reason for few firms under oligopoly is the
barriers, which prevent entry of new firms into the industry. Patents, requirement of large
capital, control over crucial raw materials, etc, are some of the reasons, which prevent new
firms from entering into industry. Only those firms enter into the industry which is able to
cross these barriers. As a result, firms can earn abnormal profits in the long run.
5. Role of Selling Costs: Due to severe competition and interdependence of the firms,
various sales promotion techniques are used to promote sales of the product. Advertisement is
in full swing under oligopoly, and many a times advertisement can become a matter of life-
and-death. A firm under oligopoly relies more on non-price competition.
6. Group Behavior: Under oligopoly, there is complete interdependence among different
firms. So, price and output decisions of a particular firm directly influence the competing
firms. Instead of independent price and output strategy, oligopoly firms prefer group
decisions that will protect the interest of all the firms. Group Behaviour means that firms tend
to behave as if they were a single firm even though individually they retain their
independence.
7. Nature of the Product: The firms under oligopoly may produce homogeneous or
differentiated product.
i. If the firms produce a homogeneous product, like cement or steel, the industry is called a
pure or perfect oligopoly.
ii. If the firms produce a differentiated product, like automobiles, the industry is called
differentiated or imperfect oligopoly.
8. Indeterminate Demand Curve: Under oligopoly, the exact behaviour pattern of a
producer cannot be determined with certainty. So, demand curve faced by an oligopolist is
indeterminate (uncertain). As firms are inter-dependent, a firm cannot ignore the reaction of
the rival firms. Any change in price by one firm may lead to change in prices by the
competing firms. So, demand curve keeps on shifting and it is not definite, rather it is
indeterminate.

DUOPOLY

Duopoly is a special case of the theory of oligopoly in which there are only two

sellers. Both the sellers are completely independent and no agreement exists between them.

Even though they are independent, a change in the price and output of one will affect the

other, and may set a chain of reactions. A seller may, however, assume that his rival is

unaffected by what he does, in that case he takes only his own direct influence on the price.

If, on the other hand, each seller takes into account the effect of his policy on that of
his rival and the reaction of the rival on himself again, then he considers both the direct and
the indirect influences upon the price. Moreover, a rival seller’s policy may remain unaltered
either to the amount offered for sale or to the price at which he offers his product. Thus the
duopoly problem can be considered as either ignoring mutual dependence or recognizing it

Pricing:
Pricing is the process of determining what a company will receive in exchange for its
product or service. A business can use a variety of pricing strategies when selling a product
or service. The price can be set to maximize profitability for each unit sold or from the
market overall. It can be used to defend an existing market from new entrants, to increase
market share within a market or to enter a new market.

PRICING OBJECTIVES:
Pricing objectives refers to the general and specific objectives which a firm sets for itself in
establishing the price of its products or services and these are not much different from the
marketing objectives of a firm or its overall business objectives.

1. To maximise profits

2. To increase sales

3. To increase the market share

4. To satisfy customers
 5. To meet the competition

6. To generate internal resources to finance expansion and growth

7. To maximise the value of the firm for different stakeholders.

Pricing policies:

Pricing policies are intended to bring consistency in the pricing pattern. They define
how to handle complex issue such as price discrimination and price stability.

Pricing policies play a significant role, not only in the case of single – product firms
but also multi – product firms. A multi – product firm faces more challenges such as
maintaining price differentials between related products, especially substitutes such as deluxe
models and basic models.

Factors consider in pricing policies

 Competitive Situation

 Goal of Profit and Sales

 Long Range Welfare of the Firm

 Flexibility

 Government Policy

 Overall Goals of Business

 Price Sensitivity

PRICING METHODS

COST – BASED PRICING METHODS

1. Cost plus pricing: This is also called full cost or markup pricing. Here the average
cost of normal capacity of output is ascertained and then a conventional margin of
profit is added to the cost to arrive at the price. In other words, find out the product
unit’s total cost and add percentage of profit to arrive at the selling price.
This method is suitable where the cost keep fluctuating from time to time. It is
commonly followed in departmental stores and other retail shops. This method is
simple to be administered but it does not consider the competition factor. The
competitor may produce the same product at lower cost and thus offer it at a lower
price.
2. Marginal cost pricing: In marginal cost pricing, selling price is fixed in such a way
that it covers fully the variable or marginal cost and contributes towards recovery of
fixed costs fully or partly, depending upon the market situations. In times of stiff
 competition, marginal cost offers a guideline as to how far the selling price can be
lowered. This is also called break – even pricing or target profit pricing. Here break –
even analysis helps in taking pricing decisions.

COMPETITION – ORIENTED PRICING:

Some commodities are priced according to the competition in their markets. Thus there are
Going rate method of price and the Sealed bid pricing technique. Under the former a firm
prices its new product according to the prevailing prices of comparable products in the
market.

1. Sealed bid pricing: This method is more popular in tenders and contracts. Each
contracting firm quotes its price in a sealed cover called tender. All the tenders are
opened on a scheduled date and the person who quotes the lowest prices, other things
remaining the same, is awarded the contract.
2. Going rate pricing: Here the price charged by the firm is in tune with the price
charged in the industry as a whole. In other words, the prevailing market price at a
given point of time is the guiding factor. When one wants to buy or sell gold, the
prevailing market rate at a given point of time is taken as the basis to determine the
price, normally the market leaders keep announcing the prevailing prices at a given
point of time based on demand and supply positions.

DEMAND – ORIENTED PRICING

The higher the demand, the higher can be the price. Cost is not the consideration here.
The key to pricing here is the value as perceived by the consumer. This is a relatively modern
marketing concept.

1. Price discrimination: Price discrimination refer to the practice of charging different

prices to customers for the same good. The firm uses its discretion to charge
differently the different customer. It is also called differential pricing. Customers of
different profile can be separated in various ways, such as by different consumer
requirement by nature of product itself, by geographical areas, by income group and
so on.
2. Perceived value pricing: Perceived value pricing refers to where the price is fixed on
the basis of the perception of the buyer of the value of the product.

STRATEGY – BASED PRICING:

1. Market skimming: When the product is introduced for the first time in the market,
the company follows this method. Under this method, the company fixes a very high
price for the product. The main idea is to charge the customer maximum possible. For
 example Sony introduces a particular TV model, it fixed a very high price than other
company.
2. Market penetration: This is exactly opposite to the market skimming method. Here
the price of the product is fixed so low that the company can increase its market share.
The company attains profits with increasing volumes and increase in the market share.
More often , the companies believe that it is necessary to dominate the market in the
long –run than making profit in the short-run.
3. Two – part pricing: The firms with market power can enhance profits by the strategy
of two – part pricing. Under this strategy, a firm charges a fixed fee for the right to
purchase its goods, plus a per unit charge for each unit purchased. Entertainment
houses such as country clubs, athletic clubs, golf courses, and health clubs usually
adopt this strategy. They charge a fixed initiation fee plus a charge per month or per
visit to use the facilities.
4. Block pricing: Block pricing is another way a firm with market power can enhance
its profits. We see block pricing in out day – to – day life very frequently. Six lux
soaps in a single pack or five magi noodles in a single pack.
5. Commodity bundling: Commodity bundling refers to the practice of bundling two or
more different products together and selling them at a single bundle price. The
package deals offered by the tourist companies, airlines hold testimony to this
practice. The package includes the airfare, hotel, meals, sightseeing and so on.
6. Peak load pricing: During seasonal period when demand is likely to be higher, a firm
may enhance profits by peak load pricing. The firm philosophy is to charge a higher
price during peak times than is charged during off – peak times. APSRTC, Air India,
Jet air etc,
7. Cross subsidization: In case where demand for two products produced by a firm is
interrelated through demand or costs, the firm may enhance the profitability of its
operation through cross subsidization.
8. Transfer pricing: Transfer pricing is an internal pricing technique. It refers to a price
at which inputs of one department are transferred to another, in order to maximize the
overall profits of the company. For example kinetic Honda, Hero, Honda.
9. Limit pricing: limit price is a pricing strategy in which a monopoly is selling its
products below the average cost of production to discourage the entrance of new
competitors in market.

PRICING STRATEGIES IN TIMES OF STIFF PRICE COMPETITION

1. Pricing matching: Price matching is a strategy in which a firm promise to match a

lower price offered by any competitor, while announcing its own price. It is necessary
that one should be confident, before this strategy is adopted, that the price cannot be
lower in the market than one offered.
2. Promoting brand loyalty: This is an advertising strategy where the customers are
frequently reminded by the brand value of given product or services. The conviction
here is that the customers, once they are loyal to the given branded product or
 services, will not slip away when the competitors come out with products at lower
prices.
3. Time – to – time pricing: This is also called randomized pricing strategy where the
firm varies its prices form time- to – time, say hour – to – hour or day – to –day. This
method offers two advantages. The rival firms can no more play with price cuts. Also
customers cannot learn from experience which firm charges the lowers price in the
market.
4. Promotional pricing: To promote a particular product, at time, the firm may offer the
product at the most competitive price. Some time, the price of a particular product is
kept intentionally lower to attract the attention of the customer to other products of the
firm.
5. Target pricing: The company operates with a particular targeted profit in mind.
Normally the cost of capital will be one of the yardsticks to guide the targeted rate of
return. How much is the rate of return the other companies are achieving also could be
another yardstick to determine the price. The higher the risk and investment, the
higher is the targeted profit and so is the price.

Product Life Cycle based Pricing

Product life cycle pricing is a strategy for selling products in which pricing correlates with a
product's location in its life cycle. There are four phases within the life cycle, including
launch, growth, maturity and declination. Businesses use product life cycle pricing to better
understand how discounts, clearance prices, new versions and marketing can affect their sales
in each phase. A company may choose to strategize differently depending on the market and
how its product sells.

Here are the four stages of a product life cycle and how sales for a product may look in each
one:

Launch or development stage

The launch phase, or development portion of the life cycle, is when the company first
introduces the product to the market. During this time, the business may record few sales, as
the consumers within the market may be reluctant to purchase a new product. This can be
especially true when a product is unique, resulting in lower competition but slower market
acceptance.

Early or growth stage

The early stage within the product life cycle comes after the launch and is when demand for
the product or service rises. Experts may call this stage the promotional stage, and it can be
when marketing efforts may show positive results. During this stage of the cycle, competitors
may release their own products to compete with yours.

Mid or maturity stage

The maturity stage, or the regular pricing phase, represents a plateau in the product's sales
and awareness. This is the time in the product life cycle where the product shows acceptable
sales and profits. This may be the phase of the cycle where there is the highest level of
competition.

Late or declination stage

Experts may also call the last stage in the product life cycle the clearance phase. It's during
this phase that consumers may choose an alternative product. Many companies plan to
remove the product from production during this stage, as there is less demand for the product.
In this stage, businesses may even lose money by continuing to produce the product.

BREAK EVEN ANALYSIS

A business is said to break even when its total sales are equal to its total costs. It is a point of
no profit or no loss. Break even analysis is defined as analysis of costs and their possible
impact on revenues and volume of the firm. Hence, it is also called the cost – volume- profit
analysis. A firm is said to attain the BEP when its total revenue is equal to total cost.

Assumptions:

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

2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change in the volume
of production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
8. Volume of sales and volume of production are equal. Hence there is no unsold stock.
9. There is only one product or in the case of multiple products sales mix remains
constant.

Significance of BEA

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

production
 To calculate sales required to earn a particular desired level of profit.
 To compare the product lines, sales area, methods of sales for individual company.
  To compare the efficiency of the different firms
 To decide whether to add a particular product to the existing product line or drop one
from it.
 To decide to “make or buy” a given component or spare part.
 To decide what promotion mix will yield optimum sales.
 To assess the impact of changes in fixed cost, variable cost or selling price on BEP
and profits during a given period.

Limitations of BEA

 Break even point is based on fixed cost, variable cost and total revenue.
 A change in one variable is going to affect the BEP
 All cost cannot be classified into fixed and variable costs. There may be semi-variable
costs also.
 In case of multi-product firm, a single chart cannot be of any use. Series of charts
have to be made use of.
 It is based on fixed cost concept and hence holds good only in the short – run.
 Total cost and total revenue lines are not always straight as shown in the figure. The
quantity and price discounts are the usual phenomena affecting the total revenue line.
 Where the business conditions are volatile, BEP cannot give stable results

Determination of break even point

1. Fixed cost
2. Variable cost
3. Contribution
4. Margin of safety
5. Angle of incidence
6. Profit volume ratio

Fixed cost: Expenses that do not vary with the volume of production are known as fixed
expenses. Eg. Manager’s salary, rent and taxes, insurance etc. It should be noted that fixed
changes are fixed only within a certain range of plant capacity.

Variable Cost: Expenses that vary almost in direct proportion to the volume of production or
sales are called variable expenses. Eg. Cost of Raw materials, Labour charges, Electric power
and fuel, packing materials, consumable stores etc. It should be noted that variable cost per
unit is fixed.

Contribution: Contribution is the difference between sales and variable costs and it
contributed towards fixed costs and profit. It helps in sales and pricing policies and
measuring the profitability of different proposals. Contribution is a sure test to decide
whether a product is worthwhile to be continued among different products.
Contribution = Sales – Variable cost

Contribution = Fixed Cost + Profit.

Margin of safety: Margin of safety is the excess of sales over the break even sales. It can be
expressed in absolute sales amount or in percentage. It indicates the extent to which the sales
can be reduced without resulting in loss. A large margin of safety indicates the soundness of
the business. The formula for the margin of safety is:

Profit
Present sales – Break even sales or P . V. ratio

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

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

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

Profit - Volume Ratio is usually called P/ V ratio. It is one of the most useful ratios for studying the
profitability of business. The ratio of contribution to sales is the P/V ratio. It may be expressed in
percentage. Therefore, every organization tries to improve the P/ V ratio of each product by reducing the
variable cost per unit or by increasing the selling price per unit. The concept of P/ V ratio helps in
determining break even-point, a desired amount of profit etc.
BREAK EVEN ANALYSIS (FORMULA)
1.

2.

3.

4.

P/ V RATIO FORMULA
1.

(OR)
2.

(OR)

3.

SALES REQUIRED TO EARN DESIRE PROFIT (FORMULA)

1.

2.

3.

4.
Margin of safety Formula

1 Margin of safety = Actual sales – Breakeven sales

.
2
.

3
.