Self Learning Material

ECONOMICS FOR BUSINESS MANAGERS

BACHELOR OF COMMERCE

NAAC ‘A’

CENTRE FOR DISTANCE AND ONLINE EDUCATION

(ଦୂରଏବଂ ଅନଲାଇନ୍ଶିକ୍ଷାକେନ୍ଦ୍ର)
FAKIR MOHAN UNIVERSITY
VYASA VIHAR, BALASORE
ODISHA, INDIA – 756019
Email:cdce_fmu@yahoo.co.in
Website: www.fmuniversity.nic.in
© Centre for Distance and Online Education, Fakir Mohan University, VyasaVihar,
Balasore, Odisha, India - 756019

The study material is developed exclusively for the use of the students admitted under
DDCE, Fakir Mohan University.

Name of the Study Material:Economics for business managers EBM

Author’s Name:

Mrs. Priyadarshini Beura

Asst. Prof. in Economics
Dept. of Economics
NSCB Govt.College ,Sambapur

Centre for Distance and Online Education

Fakir Mohan University, VyasaVihar, Balasore, Odisha, India - 756019
www.fmuniversity.nic.in
 INFORMATION TECHNOLOGY FOR
MANAGERS CONTENTS

Page No.
Unit I Introduction to managerial economics 1

Unit II Concept and theory of profit 14

Unit III Concept of demand and supply 34

Unit IV Basics of production function 56

Price and output relationship under different

Unit V market structure 90
Economics for Business Managers Fakir Mohan University

UNIT 1

INTRODUCTION TO MANAGERIAL
ECONOMICS

STRUCTURE

1.1 Introduction
1.2 Objectives
1.3 Introduction to managerial economics
1.4 Scope and subject matter of managerial economics
1.5 Basic Concepts and Techniques of Managerial Economics
1.6 Nature of managerial economic problem
1.7 Nature of economic analysis
1.8 Role and responsibility of managerial economist
1.9 Implicit and explicit cost
1.10 Summary
1.11 Glossary
1.12 Questions and Exercises

1.1 INTRODUCTION

A subfield of economics known as managerial economics analyzes individual

business choices using microeconomic theory. Concentrating on the instruments
and strategies that managers employ to make wise decisions for their companies, it

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closes the gap between economic theory and real-world company operations. In
simple term, managerial economics means the application of economic theories to
solve the problem of business management. One way to think of managerial
economics is as economics applied to firm-level problem solving. The corporate
executive can make assumptions and do analysis with it. Even though economics
places a strong emphasis on maximizing profit, every company aims to achieve a
satisfactory profit. Thus, it becomes imperative to rethink economic concepts for the
real world. The discipline of managerial economics does this task.

1.2 OBJECTIVE

After reading this you will be able to understand;

 Meaning of managerial economics
 Scope and subject matter of managerial economics
 Nature of managerial economics
 Basic concepts and techniques
 Role and responsibility of managerial economist
 Explicit and implicit cost

1.3 INTRODUCTION TO MANAGERIAL ECONOMICS

The field of managerial economics studies how business executives and other
decision-makers ought to arrive at decisions. Economic analysis is used in managerial
economics to explain ideas like cost, demand, profit, and competitiveness. It connects
economic theory with practical applications. Managerial economics focuses on optimizing
company decisions based on corporate objectives and scarcity constraints, often using
operations research and programming techniques. Managerial economics is an evolving
science that applies economic theories, models, concepts, and categories to address new
commercial and managerial challenges in a dynamic economy.

1.4 SCOPE AND SUBJECT MATTER OF MANEGERIAL ECONOMICS

Managerial economics covers a wide range of themes and analytical methods that
enable managers to make educated decisions. It combines economic theory and commercial
experience to improve decision-making and forward planning. Here are the primary areas
covered under the scope of management economics.

1. Demand Analysis and Forecasting:

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Demand: It identifies factors that impact consumer demand for a product or service,
including price, income, preferences, and substitutes.

Forecasting demand: It predicts future demand using statistical and economic models
based on past data and market patterns. Accurate demand forecasting improves
production planning, inventory management, and capacity use.

2. Production and Cost Analysis:

The Production Function analyses the relationship between inputs (labour,
capital, materials) and outputs to optimize production efficiency.

Cost Function: it examines the behavior of costs (fixed, variable, and total) in
response to changes in production levels. This includes recognizing economies of
scale and the learning curve.

3. Price Decisions and Strategies:

Pricing methods: Pricing methods involve determining the best price for a product or
service based on cost, demand, and competition. Cost-plus pricing, value-based
pricing, and dynamic pricing are among the methods used.

Price discrimination: is the practice of charging different rates to different groups of

consumers based on their willingness to pay to maximize their income.

4. Profit Management:
Profit Planning: establishing goals for profit and creating strategies to reach them
through revenue management and cost reduction.

Breakeven Analysis: Calculating the amount of sales or output required to pay all cost
and achieve profitability.

5. Market Structure and Competition:

Market analysis: Recognizing the effects of various market configurations, including
as oligopoly, monopoly, and perfect competition, on pricing and company strategies.

Competitive Strategy: Creating plans to effectively compete in a range of market

scenarios; these include decisions about product differentiation, pricing, and market
entry and departure.
6. Capital Budgeting:
Investment Apprisal: Assessing the viability and profitability of long-term investment
projects by utilizing methods such as Net Present Value (NPV), Internal Rate of
Return (IRR), and Payback Period.

Risk Analysis: Analyzing and incorporating investment-related risks into the

decision-
making process.

7. Decision-making under uncertainty:

Risk and uncertainty: Using risk analysis and decision-making methods (such as
decision trees and sensitivity analysis) to make educated decisions in uncertain
situations.

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Expected value analysis: calculating the projected results of many options and
selecting the option with the largest predicted return.
8. Government and Regulatory policies:
Impact of policy: Evaluating the impact that laws, regulations, and other government
policies have on the tactics and operations of businesses.
Compliance and strategy: Maintaining adherence to legal obligations and modifying
company plans to reflect policy shifts.

9. Optimization Techniques:
Linear programming: Using mathematical models to optimize resource allocation
and produce the best results within specified restrictions.
Marginal analysis: Using marginal cost and marginal income concepts to create the
best production and pricing decisions.

10. Strategic Planning:

Long-term planning: Creating long-term business strategy using economic
predictions, market trends, and competitive analysis.
Resource management: Effectively allocating resources to accomplish
strategic objectives and preserve a competitive advantage.

11. Behavioural Economics:

Behavioral Factor: Utilizing behavioral economics' insights to comprehend how
psychological variables affect financial decisions.
Nudging and incentives: Creating incentives and nudges to influence customers and
staff behavior in desired ways.

1.5 BASIC CONCEPTS AND TECHNIQUES OF MANAGERIAL

ECONOMICS

CONCEPTS
Managerial economics uses various fundamental principles and strategies
to assist managers in making sound and efficient decisions. Here are some of the core
principles and strategies widely utilized in managerial economics:

1. Opportunity Cost

The worth of giving up the next best option while making a choice. It stands for the
advantages that might have resulted from selecting the other course of action.

2. Marginal Analysis
It investigates the extra benefits and expenses of a decision. Key concepts include
marginal cost (MC) and marginal revenue (MR), which are used to assess the best
amount of production or other activities.

3. Demand and Supply Analysis

Demand: The correlation between the price of a product and the amount that buyers
desire to purchase. It is influenced by elements like income, preferences, and the cost
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of comparable things.
Supply: The link between a good's price and the amount supplied by producers,
which is influenced by production costs, technology, and input prices.

4. Market structure
Market structures include perfect competition, monopolies, monopolistic competition,
and oligopoly. Each possesses distinct qualities that influence pricing and production
decisions.

5. Elasticity
It measures the responsiveness of quantity demanded or supplied to price, income,
and other factors.
Price elasticity of demand: The ratio of the percentage change in quantity demanded
to the percentage change in price.
Income elasticity of demand: The ratio of the percentage change in quantity
demanded to the percentage change in income
Cross elasticity of demand: The ratio of the percentage change in quantity demanded
of one good to the percentage change in price of other good .

6. Production and Cost function

Production Function: Describes the relationship between inputs (labor, capital, etc.)
and the output produced.
Cost Function: Describes the relationship between output and production costs,
including both fixed and variable costs.

7. Break-even Analysis
Determines the level of sales or production when total revenue matches total costs and
there is no profit or loss.

TECHNIQUES

1. OPTIMIZATION TECHNIQUES
Linear Programming: A mathematical strategy for determining the greatest feasible
outcome (such as maximum profit or lowest cost) given certain constraints.

Constraint Optimization: Lagrange multipliers are used to maximize or minimize an

objective function given restrictions.

2. FORECASTING
Predictive techniques using historical data. Time series analysis, regression analysis,
and qualitative techniques are all common procedures.

3. REGRESSION ANALYSIS
A statistical technique for estimating the relationships between variables. It aids in
understanding how the dependent variable changes as one or more independent
factors are varied.
4. GAME THEORY
A paradigm for understanding strategic interactions among firms. It aids in
understanding competitive behaviors and formulating tactics in situations where the
outcome is dependent on the actions of numerous players.

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5. COST-BENEFIT ANALYSIS
A systematic method for estimating and comparing the advantages and cost of a
decision or project. It aids in deciding whether the benefits outweigh the expenses and
by what margin.

6. DECISION TREE
A graphical representation of decision-making options. It aids in determining the
expected values of various decision paths under uncertainty.

7. CAPITAL BUDGETING
Techniques for assessing long-term investment initiatives. Common approaches
include Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period.

8. RISK ANALYSIS
Techniques for assessing and managing uncertainty and risk in decision-making.
Sensitivity analysis, scenario analysis, and simulation are all examples of tools.

1.6 THE NATURE OF MANAGERIAL ECONOMIC PROBLEM

It focuses on using economic concepts and instruments to solve particular problems

and reach choices that maximize resource use inside a company. Usually, these issues
include:

1. SCARCITY OF RESOURCES
Allocation issue: Choosing how to deploy scarce resources like capital, labor, and raw
materials in order to maximize efficiency and profit.
Trade-offs: Balancing competing wants and objectives with limited resources, where
selecting one option typically implies foregoing another.

2. DECISION- MAKING UNDER UNCERTAINTY

Risk Assessment: Evaluating the uncertainties that come with different options, such
as market conditions, technical advances, and competitive actions.
Uncertainty Management: Using methods like as probability analysis, decision trees,
and scenario planning to reduce risks and make more informed decisions.

3. COMPLEXITY OF MARKET DYNAMICS

Understanding market structure: Examining the effects of various market
structures, such as oligopoly, monopoly, and perfect competition, on production
choices, pricing, and competitive tactics.
Consumer behavior: Recognizing and adapting to shifts in the tastes, spending habits,
and income levels of customers.

4. OPTIMIZATION CHALLENGES
Cost Management: finding ways to minimize costs (fixed and variable) without
sacrificing or raising the caliber of the output or the level of customer satisfaction.

Profit Maximisation: Determine the ideal amount of production or service provision

that optimizes profit while taking into account factors such as demand elasticity and
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production costs.

5. STRATEGIC DECISION MAKING

Long - term planning: Developing plans and policies that are consistent with
corporate
goals and respond to changes in the external environment (for example, technological
improvements and regulatory changes).
Competitive Strategy: Pricing strategies, product differentiation, and market
positioning are examples of approaches used to acquire a competitive edge.

6. ETHICAL AND SOCIAL CONSIDERATION

Stakeholder management: Addressing the interests and aspirations of different
stakeholders, such as consumers, employees, shareholders, and the community.
Corporate Social Responsibility: Balancing economic goals with ethical issues
including
sustainability, fair labor practices, and environmental effects.

7. MEASUREMENT AND EVALUATION

Performance Metrics: Creating and implementing relevant measures (such as financial
ratios and key performance indicators) to evaluate the efficacy of decisions and plans.
Feedback Mechanism: Creating systems for monitoring and adjusting strategy
depending on performance results and market input.

8. DYNAMIC NATURE OF BUSINESS ENVIRONMENT

Adaptability: Adjusting to changes in consumer tastes, technical improvements,
economic conditions, and regulatory needs.
Innovation: Identifying and leveraging opportunities for innovation in products,
services, processes, and business models.

9. GOVERNMENT AND REGULATORY INFLUENCES

Compliance: Ensuring compliance with laws, regulations, and industry standards that
affect business operations, pricing practices, and market entry tactics.
Policy Analysis: Evaluating the impact of government policies (such as taxation,
subsidies, and trade policy) on business decisions and competitiveness.

10. TECHNOLOGICAL INTEGRATION

Digital transformation: Using technology to improve operational efficiency, customer
engagement, and decision-making processes (for example, big data analytics, artificial
intelligence).

1.7 THE NATURE OF ECONOMIC ANALYSIS

It is a systematic technique to analyzing and interpreting economic phenomena,

making forecasts, and directing decision-making. The following are the key
characteristics that determine the nature of economic analysis:

1. Scientific Approach

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Theories and empirical evidence: Economic analysis is based on economic theories,

which provide frameworks for understanding how individuals, firms, and governments make
decisions and interact in markets. It combines theoretical insights with empirical evidence
derived from data and observations to test hypotheses and validate them.
2. Objectives and rationale
Objective analysis: Economic analysis is to be impartial and neutral, emphasizing factual
facts and logical reasoning over personal beliefs or subjective judgments.

Rational expectation: Assumes that individuals and businesses form future expectations using
all available information, resulting in rational decision-making.
3. Marginal Analysis
Marginalism: The concept of marginal analysis is central to economic analysis, as it
investigates the incremental costs and benefits of decisions. It aids in finding the best levels
of output, consumption, and investment.
4. Predictive and perspectives:
Predictive power: Economic analysis seeks to forecast how individuals, businesses, markets,
and economies will react to changes in factors such as prices, income, and policies.

Perspective guidance: It offers prescriptive advice by recommending the best tactics and
policies to achieve specific goals, such as optimizing welfare, efficiency, or profitability.

5. Microeconomic and Macroeconomic Perspectives

Microeconomic Analysis: Individual actors (consumers, enterprises) and markets are the
focus of this study, which examines behaviors, decisions, and interactions at the micro level.

Macroeconomic Analysis: Examines aggregate phenomena such as national income,

inflation, unemployment, and economic growth while taking the economy as a whole.
6.Policy Implications
Policy Analysis: Economic analysis guides policy decisions by assessing the probable effects
of policies (such as taxation, regulation, and monetary policy) on individuals, firms, and the
overall economy.

Cost-Benefit Analysis: Assesses the costs and benefits of policy actions to determine their
effectiveness and societal welfare consequences.
7. Interdisciplinary Approach
Integration with other discipline: Economic analysis frequently incorporates ideas from other
disciplines, such as psychology, sociology, political science, and mathematics, to provide a
thorough understanding of economic behaviors and results.
8. Dynamic and Evolving
Continuous learning: Economic analysis evolves to meet new difficulties, technology
breakthroughs, globalization, and shifts in consumer behavior and tastes.

Adaptation to change: Economists are constantly refining ideas, techniques, and models in
response to new data and insights from empirical studies.

9. Ethical Consideration
Ethical Framework: When examining economic policies and outcomes, economists take into
account ethical considerations such as distributional equity, fairness, and social welfare.

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1.8 ROLE AND RESPONSIBILITY OF MANAGERIAL ECONOMIST

1. STUDIES BUSINESS ENVIRONMENT

The analysis of the corporate environment falls under the purview of the management
economist. For an organization to function properly, every external aspect affecting that
functioning must be thoroughly studied. He researches a range of topics, providing
periodic updates to management on things like the economy, business cycle, price
trends, degree of competition, and national income growth.
2. ANALYSE OPERATION OF BUSINESS
He examines how businesses operate internally and assists management in reaching better
internal operating decisions. Managerial economists advise managers on how to create
policies about internal business operations through their analytical and forecasting abilities.

3. PRODUCT PLANNING
Managerial economist is responsible for scheduling all production activities of business. He
evaluates the capital budget of organizations and accordingly helps in deciding timing and
locating of various actions.

4. DEMAND FORECASTING AND ESTIMATION

Proper estimate and forecasting of future trends assists businesses in reaching the required
profitability and growth. Managerial economists succeed in projecting future uncertainty or
trends by thoroughly studying all internal and external factors.

5. ECONOMIC INTELLIGENCE
He delivers economic intelligence by communicating all economic data to management.
Managerial economists keep management informed of all current economic trends so that
they can confidently speak at seminars and conferences.

6. PERFORMING INVESTMENT ANALYSIS

A managerial economist evaluates several investment options and selects the most
appropriate one. He researches and discovers new business opportunities to increase profits.

7. FOCUS ON EARNING PROFIT

He supports management in generating a reasonable profit on the money invested in the
business. Managerial economists oversee organizational activities to ensure that all
operations are running efficiently by the plans and policies established.

8. MAINTAINING BETTER RELATION

A management economist maintains better relationships with all internal and external
stakeholders in the organization. It is his responsibility to foster a calm and cooperative
environment within the organization, to reduce any potential for conflict.

1.9 IMPLICIT AND EXPLICIT COST

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IMPLICIT COST

Implicit costs are the opportunity expenses of using resources that a company already owns
or employs for commercial activities. These costs do not need a direct monetary payment, but
rather reflect the value of resources in their optimal alternative uses.

FEATURES:
 Implicit costs are not documented in a firm's accounting records because they do not
entail cash outflows.
 They are evaluated when calculating economic profit, which subtracts both explicit
and implicit costs from total revenue to assess a firm's true profitability.
 Implicit costs highlight the need to consider alternate uses of resources when making
economic decisions.
EXAMPLE
1. Owner’s interest: The value of the owner's or entrepreneur's time and effort invested
in the business, which could be used in other ventures.
2. Foregone interest: The interest or income that could have been obtained had the
capital of the company been invested somewhere else.
3. Use of own asset: The rental value or depreciation of owned equipment, machinery,
or buildings used in production

EXPLICIT COST

Explicit costs refer to the direct monetary payments made by a firm for the use of resources
purchased from others in the market. These costs involve actual out-of-pocket expenses that
are recorded and reported in the firm's accounting statements.

FEATURES
 Explicit costs are easily quantifiable and identifiable as they involve cash payments or
contractual obligations.
 They are recorded as expenses on the firm's income statement, reducing taxable
income and profitability.
EXAMPLES
• Wages and Salaries: Payments to employees for their labor services.

• Raw Materials: Purchase costs of materials and supplies used in production.

• Rent: Payments made for leasing or renting office space, factories, or equipment.
• Utilities: Expenses for electricity, water, heating, and other utility services.

• Advertising: Costs incurred for promoting products or services.

• Interest Payments: Interest expenses on borrowed capital or loans.

1.10 SUMMARY

 Managerial economics is the amalgamation of economic theory with business

practices so as to ease decision making and future planning by management.

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 Managerial economics covers a wide range of themes and analytical methods that
enable managers to make educated decisions. It combines economic theory and
commercial experience to improve decision-making and forward planning.
 Implicit costs are the opportunity expenses of using resources that a company
already owns or employs for commercial activities. These costs do not need a
direct monetary payment, but rather reflect the value of resources in their optimal
alternative uses.
 Explicit costs refer to the direct monetary payments made by a firm for the use of
resources purchased from others in the market. These costs involve actual out-of-
pocket expenses that are recorded and reported in the firm's accounting
statements.

1.11 GLOSSARY

Opportunity cost: The next best alternative that can be sacrificed.

Managerial economics: Managerial economics is pragmatic. It is concerned with
analytical tools and techniques of economics that are useful for decision making in
business.
Economic Theory: Economic Theory is a system of inter-relationships. Among the
social sciences, economics is the most advanced in terms of theoretical orientations.
Managerial theory: Managerial theory refers to those aspects of economic theory and
application which are directly relevant to the practice of management and the decision
making process.
Market-oriented economy: The market-oriented economy is the fundamental feature of
capitalism. Market mechanism is pivotal in a capitalist economy

1.12 QUESTION AND EXERCISES

SHORT ANSWER QUESTIONS

1. Define managerial economics.

2. What is Managerial theory?
3. What is Market-oriented economy?
4. What is Economic Analysis?

5.Why managerial economics is importance for business operations? Discuss. - - - - - - - -

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6 What are the uses of managerial economics? Is managerial economics a positive or
normative science? Discuss. - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
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LONG QUESTIONS
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1. Discuss the concept managerial economics.

2. State the nature of Managerial economics.
3. Discuss the scope of managerial economics.
4. Is managerial economics a positive or normative science? Discuss.
5. Explain the Methods of Economic Analysis

UNIT 2

CONCEPT AND THEORY OF PROFIT

STRUCTURE

2.1 Introduction
2.2 Objective
2.3 The circular flow of economic activity
2.4 Nature of the firm
2.5 Objective of the firm
2.6 Maximizing versus satisfying
2.7 The concept of economic profit
2.8 Theories of Profit
2.9 Accounting and Economic Interpretation of Profit
2.10 Policies on Profit Maximization
2.11Profits for control
2.13 Summary
2.14 Glossary
2.15 Questions and exercise

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2.1 INTRODUCTION

A profit might signify different things to different individuals. Examples of these people
include business owners, accountants, politicians, employees, and economists. Simply put,
profit is a positive gain from the company. operations or investment following the deducting
of all costs or expenses. In the language of economics, profit is the benefit that an
entrepreneur receives from bringing together all the elements of production to meet the needs
of people in the economy who are dealing with uncertainty. Simply said, a profit is an amount
of money that goes to the investor. Profit in accounting refers to excess revenue overall
expenses that have been paid out. In the language of economics, a profit is referred to as pure,
economic, or just profit.

2.2 OBJECTIVE

After reading this you will be able to understand;

 Meaning of profit
 Nature and objective of firm
 Concept of economic and accounting profit
 Theories of profit

2.3 THE CIRCULAR FLOW OF ECONOMIC ACTIVITY

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What constitutes an economic activity? Is it only an income-generating activity? Is there only

production activity? In popular language, this may be the only definition of economic
activity. But what is the motivation behind earning? Income or production? Is it the
expenditure of income or the utilization of what is produced? There is no point in generating
anything if no one is going to use it. Economic activities involve both earning and spending
income, as well as producing and using goods. In its broadest meaning, economic activity
encompasses both production and consumption.

It is a model that demonstrates the movement of commodities, services, and resources

throughout different sectors of an economy, with a primary focus on two important players:
families and businesses. Here is a simplified overview:

COMPONENTS

HOUSEHOLDS:
 Provide factors of production (land, labor, capital, entrepreneurship) to firms.
 Receive income in the form of wages, rent, interest, and profits.

FIRMS:

 Produce goods and services using the factors of production.

 Sell these goods and services to households.

FLOW OF RESOURCES

FACTOR MARKET:

 Households supply factors of production to firms.

 Firms pay households for these resources.

PRODUCT MARKET:

 Firms supply goods and services to households.

 Households spend their income to purchase these goods and services.

MONEY FLOW

 Money flows from firms to households as payment for resources.

 Money flows back from households to firms as payment for goods and services.

EXPANDED MODEL
A more extensive version includes the government as well as the foreign sector.

GOVERNMENT:

 Collects taxes from households and firms.

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 Provides public goods and services.

 Engages in transfer payments.

FOREIGN SECTOR:

 Involves exports and imports.

 Facilitates international trade and investment.

IMPORTANCE

 Helps understand economic activity and income distribution.

 Highlights interdependence between different sectors.
 Useful for analyzing the impact of economic policies.

This model is a fundamental notion for understanding how economies work, emphasizing the
ongoing and cyclical nature of economic transactions.

Scarce-Resource Criterion

Numerous things are necessary for survival; in addition to being necessary,completely

necessary, just like sunshine and air. Do these come at a cost that we must pay? No, there is
no cost associated with having sunshine and air because,We have an abundance of these in
nature. There is no shortage of the natural resources that provide sunshine and air. Because
such resources don't have any market value, it is convenient to refer to them as non-economic
resources. Therefore, any production from these resources—such as sunshine and air—may
be classified as non-economic, and any use of these resources can be classified as non-
economic activity. Therefore, economic activity does not include any good or service that
comes from non-economic resources. The nature of the firm in business economics is
comprehending why firms exist, how they function, and their role in the economy.

Price Criterion

Certain activities are the outcome of using limited resource, but don't have any commercial
value at all. For instance, physical activity, sports, hobbies, and morning strolls are all
impacted by the limited labor resources. Despite this, these, In the market, activities are not
valued. These are not commercial operations. This provides us with an extra standard by
which to evaluate any activity as economic in nature. The first condition was the scarcity of
resources. The product or service that results from the activity now has to be able to
command a price in the market as the second requirement. We may refer to it as the cost
factor.

Modified Criterion

The price criteria must be adjusted when it comes time to assign a price. Setting a price in
practice is another matter entirely from simply demanding one. Even when a product may
have a price, it can frequently be challenging to give it a fair value. Consider the numerous
home tasks that family members perform, such as cooking, cleaning, laundry, watching after
kids, helping them with their schoolwork, seeing to the sick, shining shoes, shaving, ironing

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clothes, caring for the elderly, and so forth. We all work in our families doing these kinds of
jobs. The majority of these tasks can be completed by buying them from the market or by
hiring tutors, nurses, washermen, and other domestic help.

As we've seen above, self-consuming domestic jobs can have a cost, but it can be
quite challenging to put a monetary figure on them.Though conceptually these jobs should be
included in economic activity, their exclusion from its purview stems from measurement
challenges. Accordingly, the criterion "command a price" are changed to "has a price or is
capable of being assigned a price" in practical estimations. As a result, all activities that could
be valued but aren't able to be valued are excluded. With the modified criterion, economic
activities are essentially divided into "measurable" and "non-measurable" categories, with
only measurable activities falling under its purview. In India, practical estimations are made
using these criteria.

CLASSIFICATION OF ECONOMIC ACTIVITY

Production won't be useful unless there are consumers for the goods that are generated.
Purchases of goods and services are made either to fulfil needs or to generate additional
products and services. Acquisitions made for Purchases made for consumption satisfy
desires. Investment purchases are those made in order to increase production of products and
services. Investment and consuming activities are the terms used to describe the actions
connected to these two purchases. These are also economic activity, just like production.
Thus, the primary economic activities can be broadly categorized as follows:

1) Production
2)Consumption
3) Financial Injection/Investment

RELATION BETWEEN PRODUCTION CONSUMPTION AND INVESTMENT

The basic economic activities are related to each other in two ways. First, if we know the
amount of any two of these we can find out the amount of third Circular Flow of Economic
Activity 29 activity. Suppose we are told that the amount of production is Rs.100 crores and
the amount of consumption is Rs.80 crores. By subtracting consumption (Rs.80 crores) from
production (Rs.100 crores) we get investment (100-80 = Rs.20 crores) . So Production =
Consumption + Investment Consumption = Production – Investment Investment = Production
– Consumption Second, the three activities influence each other. More production means
possibility of more consumption and more investment. Given production if there is more of
consumption there would be less of investment, or, more investment means less of
consumption. More investment leads to more production which in turn makes possible more
consumption and investment. More investment in turn may lead to more production and leads
to cumulative effects. More consumption may encourage more investment and consequently
more production. More production which in turn may lead to further increase in consumption
and investment.
Production = Consumption + Investment
Consumption = Production – Investment
Investment = Production – Consumption

The circular flow of economic activity is explained with the help of the below diagram.

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Figure 2.1

2.4 NATURE OF THE FIRM

A business is defined as a group of people who have come together, organized, and are
determined to alter their individual contributions in order to yield structures. The organization
is responsible for setting up the components of creation in order to provide labor and goods
meant to meet the needs of the families. Any organization that wishes to continue in existence
must define its own goals, and all organizations do just that. Let's talk about the
organization's main goals:

1. To fulfill the organizational goal

2. To achieve the greatest outcome possible
3. To obtain the maximum possible profit
4. To ensure that the association's benefits are increased
5. To ensure that the two clients and other partners experience the highest level of fulfilment
possible
6. To maximize profits

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2.5 OBJECTIVE OF THE FIRM

The seven primary objectives of a business are outlined below.

1.Profit maximisation
2. Several Goals
3. Maximizing Marris Growth
4. Baumol's Maximization of Sales
5. Optimization of Output
6. Profits from Security
7. Maximizing Satisfaction.

1.Profit maximisation

According to the traditional idea of the firm, maximizing profits is a company's main goal.
Price and output of a given product under perfect competition are set with the sole goal of
maximizing profits, based on the assumptions of given tastes and technology. The company
is expected to function as one of many producers unable to affect the product's market
pricing. It is the one who sets prices and modifies quantities. Thus, variables outside of the
company impact the demand and cost circumstances for the product of the company.
According to this idea, pure profits—a surplus above the average cost of production—are
referred to as maximum profits. It is the sum that remains in the business owner's possession
following payments. The rules for profit maximisation are;

(1) MC = MR and
(2) MC should cut MR from below.

2. Several Goals

The motivation behind the differences in goals between modern corporations and neo-
classical firms stems from the fact that modern corporations are driven by different goals due
to the distinct roles of shareholders and managers, while the profit maximization objective is
linked to entrepreneurial behavior. In the latter case, shareholders essentially have no control
over the managers' decisions.
Berle and Means proposed that managers' objectives differ from shareholders' as early
as 1932. They have no interest in maximizing profits. Instead than managing companies in
the best interests of shareholders, they do so for personal gain. Because they don't know
enough about the companies they own, they can't really influence managers.Most
shareholders are unable to attend a company's annual general meeting.

3. Maximizing Marris Growth

Robin Marris created a dynamic balanced growth maximising theory of the company in his
1964 book The Economic Theory of 'Managerial' Capitalism. He focuses on the idea that
managers oversee large, contemporary companies, and that owners make management
decisions for their companies.
The owners want to maximize their dividends and share prices, and the managers
want to maximize the company's growth rate. Marris creates a balanced growth model in

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which the manager selects a continuous growth rate at which the firm's sales, profits, assets,
etc., expand in order to create a relationship between such a growth rate and the share prices
of the company.He will have more if he selects a faster growth rate.

CRITICISMS
1. Marris assumes a given price structure for the firms. He, therefore, does not explain
how prices of products are determined in the market
2. It ignores the problem of oligopolistic interdependence of firms.
3. This model also does not analyse interdependence created by nonprice competition.
4. The model assumes that firms can grow continuously by creating new products. This
is unrealistic because no firm can sell anything to the consumers. After all, consumers
have their preferences for certain brands which also change when new products enter
the market.
5. The assumption that all major variables such as profits, sales and costs increase at the
same rate is highly unrealistic.
6. It is also doubtful that a firm would continue to grow at a constant rate, as assumed
by Marris. The firm might grow faster now and slowly later on.

4. Baumol's Maximization of Sales

According to Baumol's research, American oligopoly companies pursue the goal of

maximizing sales. According to Baumol, managers attempt to increase firm sales even at the
price of profits in order to get reputation and greater compensation because ownership and
control are now separated in modern corporations. As a consultant for several companies,
Baumol notes that business managers frequently say, "Our sales were up to three million
dollars," in response to questions about how their operations performed the previous year.
Baumol contends that maximizing sales or revenue rather than profits is more in line with
how businesses actually operate. According to data cited by Baumol, maximizing income in
the short term might be compatible with maximizing profits in the long term. However,
maximizing sales is thought to be the short- and long-term objective.

Figure 2.2

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Baumol’s model is illustrated in Figure 2.2 where TC is the total cost curve, TR the total
revenue curve, TP the total profit curve and MP the minimum profit or profit constraint line.
The firm maximises its profits at OQ level of output corresponding to the highest point В on
the TP curve. But the aim of the firm is to maximise its sales rather than profits. Its sales
maximisation output is OK where the total revenue KL is the maximum at the highest point
of TR. This sales maximisation output OK is higher than the profit maximisation output OQ.
But sales maximisation is subject to minimum profit constraint. Suppose the minimum profit
level of the firm is represented by the line MP. The output OK will not maximise sales as the
minimum profits OM are not being covered by total profits KS. For sales maximisation, the
firm should produce that level of output which not only covers the minimum profits but also
gives the highest total revenue consistent with it. This level is represented by OD level of
output where the minimum profits DC (=OM) are consistent with DE amount of total revenue
at the price DE/OD, (i.e., total revenue/total output).

5. Optimization of Output

Milton Kafolgis proposes that a business firm's goal should be to maximize output. "Firm
performance is often measured directly in terms of physical output, with revenue taking a
secondary position," he says. Kafolgis thus favors output maximization as a firm's goal over
both profit and revenue maximization. When faced with a minimum profit threshold, a
company seeks to maximize production. Instead of using the money for advertising, it will
use it to increase production. As a result, the company will create more, even though its
revenue sales might be lower than those of the company that maximizes sales.

6. Profits from Security

According to Rothschild, the company's motivation is the desire for security profits rather
than the maximization of profits. He stated, "There is another motive, the desire for security
profits, which is probably of a similar order of magnitude as the desire for maximum
profits." According to Rothschild, the goal of maximizing profit can only be achieved in
situations where there is perfect or monopolistic competition, meaning that a large number of
firms compete with each other and no firm faces a security issue, as is the case with
monopoly firms. However, in an oligopolistic market, maximizing profits is not a firm's
motivation. It fights relentlessly to get into and stay in a stable position.

7. Maximizing Satisfaction.

Scitovsky favours maximisation of satisfaction in preference to the profit-maximisation

objective of the firm. He is concerned with managerial effort and the distaste that managers
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have for work. According to him an entrepreneur would maximise profits only if his choice
between more income and more leisure is independent of his income. In other words, the
supply of entrepreneurship should have zero income elasticity.

2.6 MAXIMIZING VRS SATISFYING

Maximizing

 Objective:
o Aim for the highest possible outcome, typically profit maximization.
 Decision-Making:
o Analyze all options thoroughly to find the optimal solution.
 Approach:
o Requires comprehensive data and analysis.
 Challenges:
o Can be complex and time-consuming.
 Example:
o A firm uses detailed market analysis to set prices that maximize profit
margins.

Satisficing

 Objective:
o Achieve satisfactory or acceptable results rather than the optimal.
 Decision-Making:
o Settle for a good enough solution that meets minimum criteria.
 Approach:
o More practical, focusing on quick and adequate decisions.
 Challenges:
o May miss out on potentially better outcomes.
 Example:
o A company chooses a pricing strategy that is sufficient to maintain steady
growth without maximizing profits.

Comparison

 Complexity:
o Maximizing involves more complex analysis, while satisficing is simpler.
 Time:
o Satisficing can be quicker, allowing for faster decision-making.
 Risk:
o Maximizing might involve higher risks for potentially greater rewards;
satisficing reduces risk by avoiding exhaustive analysis.

Application

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 Firms might use maximizing strategies in stable environments where data is reliable.
 Satisficing is often applied in uncertain or rapidly changing conditions where quick
decisions are necessary.

2.7 CONCEPT OF ECONOMIC PROFIT

The difference between sales income and the explicit costs incurred in providing the
company's goods and services, including any opportunity costs, is known as an economic
profit. Opportunity costs are a subset of implicit costs that are set by management and
change according to various circumstances and viewpoints.

Accounting profit and economic profit are frequently examined together in analysis.
The profit that appears on an organization's income statement is known as accounting profit.
Another name for it is "net income." Accounting profit, which is a component of a company's
mandated financial reporting and transparency, compares actual inflows and outflows of
money.
Contrarily, economic profit is neither obliged to be disclosed to investors, regulators,
or financial institutions, nor is it shown on a company's financial statements. One can apply
economic profit to a "what if" examination. Businesses and people may decide to take
economic profit into account when making decisions about production levels or other
business options. Foregone profit considerations can be substituted with economic profit.

CALCULATION OF ECONOMIC PROFIT

The calculation for economic profit can vary by entity and scenario. In general, it can be
captured as follows:

Economic profit=revenues−explicit costs−opportunity costs

If opportunity costs were taken out of this calculation, the result would be only the
accounting profit. But the economic profit appears when you also deduct the opportunity
costs. For better or worse, it can be used to contrast with alternative options that a corporation
could have pursued.
Explicit costs are disclosed by businesses on their income statement. Net income after
capital, indirect, and direct cost subtraction is the accounting profit shown on the income
statement's bottom line.

The most fundamental explicit cost utilized in per-unit cost analysis is the cost of goods sold.
To get an economic profit per unit, a business might therefore also divide its opportunity
costs by units in the aforementioned calculation.

Advantages and Disadvantages of Economic Profit

1. Economic profit figures can be helpful for business decision-making. By studying the
effect on net income of subtracting not just explicit costs but the estimated costs of
giving up potential business opportunities, companies can size up the wisdom of
business ventures from high to low before launching one or more.

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2. Economic profit can also be reviewed after the fact. Lessons can be learned about the
choices that were made.
3. Economic profit can show management how efficiently the company has been using
its resources.

Disadvantages

1. The economic profit figure is theoretical because opportunity costs are based on
assumptions. Since the opportunity wasn’t taken, a company doesn’t know the exact
amount of revenue that might have been made.
2. The calculation of economic profit over the short-term can lead to inappropriate
conclusions about the business option chosen. That’s because short-term losses can be
inevitable before expected long-term profitability. It’s smarter to analyze economic
profits over long-term time periods.

2.8 THEORIES OF PROFIT

Profits of businesses depend on the successful management of risks and uncertainties by

entrepreneurs. These risks can be cost risks due to change in wage rates, prices, or
technology, and other market risks. Different economists have presented different views on
profit. The dynamic theory, innovation theory, risk-bearing theory, uncertainty theory, and
marginal productivity theory are the principal theories of profit. According to the dynamic
theory, entrepreneurs take advantage of these changes in the economy to create profit.
According to the innovation theory, entrepreneurs are the ones who drive innovations and
they play a major part in generating profits. According to the risk-bearing theory, making
money in the business is a reward for taking on risks and uncertainties. Entrepreneurs that
successfully manage uncertainty are rewarded with profits, according to the Uncertainty
Theory, which makes a distinction between quantifiable risk and immeasurable uncertainty.
Finally, the theory of marginal productivity suggests that the market's equilibrium between
the supply and demand of entrepreneurs determines profit, with the entrepreneur's marginal
productivity playing a role.

1. The Dynamic Theory of Profit

Joseph Schumpeter was the one who first proposed the Dynamic Theory of Profit. This idea
holds that the economy's dynamic fluctuations are what lead to profit. Variations in
population size, consumer tastes, and technology could all contribute to these shifts.
According to this theory, business owners profit from these developments. They are viewed
as trailblazers who are always searching for ways to surpass their rivals.

3. The Theory of Innovation and Profit

Joseph Schumpeter also proposed the Innovation Theory, which emphasizes the role of
inventions in the process of profit development. The ability of an organization to make
money increases as a result of innovations such as the launch of new goods, improvements in
production methods, or the opening of new markets. Consequently, this results in earnings.
According to Schumpeter, the entrepreneur is the one who propels these ideas and makes
money from them.

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4. Risk bearing theory of profit

The Person at Risk F. H. Knight established the Theory of Profit. According to this view,
making money in business is the reward for taking on risks and uncertainties. Risks of all
kinds, including financial, operational, competitive, and managerial ones, are present in any
firm. All of these risks are assumed by the entrepreneur, who also makes judgments in the
face of uncertainty. Thus, the entrepreneur receives gains in exchange for taking on the
associated risks.

5. The Uncertainty Theory of profit

F. H. Knight presented the Uncertainty Theory of Profit in addition to the Risk-bearing

Theory. This theory states that there is a distinction between uncertainty, which cannot be
measured, and risk, which can. The unpredictability of the corporate environment is the
source of uncertainty. Entrepreneurs are therefore faced with ambiguity when they make
decisions without having full knowledge or clarity regarding the consequences. Knight
thought that businesses should profit from their ability to effectively manage uncertainty.

Marginal Productivity Theory of Profit

The classical and neoclassical economic models serve as the foundation for the
marginal productivity theory. This theory states that the market's equilibrium between
the supply and demand of entrepreneurs determines profit. Excess profits are made
when there is a shortage of entrepreneurs compared to the demand, and vice versa. In
this instance, the entrepreneur's marginal production determines the profit. Each of
them makes a different contribution to the creation of profit, which is based on how
valuable their resource allocation and wise decisions are.

2.9 ACCOUNTING AND ECONOMIC INTERPRETATION OF PROFIT

ECONOMIC PROFIT

The difference between sales income and the explicit costs incurred in providing the
company's goods and services, including any opportunity costs, is known as an economic
profit.
Opportunity costs are a subset of implicit costs that are set by management and
change according to various circumstances and viewpoints.

Accounting profit and economic profit are frequently examined together in analysis.
The profit that appears on an organization's income statement is known as accounting profit.
Another name for it is "net income." Accounting profit, which is a component of a company's
mandated financial reporting and transparency, compares actual inflows and outflows of
money.
Contrarily, economic profit is neither obliged to be disclosed to investors, regulators,
or financial institutions, nor is it shown on a company's financial statements. One can apply

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economic profit to a "what if" examination. Businesses and people may decide to take
economic profit into account when making decisions about production levels or other
business options. Foregone profit considerations can be substituted with economic profit.

CALCULATION OF ECONOMIC PROFIT

The calculation for economic profit can vary by entity and scenario. In general, it can be
captured as follows:

Economic profit=revenues−explicit costs−opportunity costs

If opportunity costs were taken out of this calculation, the result would be only the
accounting profit. But the economic profit appears when you also deduct the opportunity
costs. For better or worse, it can be used to contrast with alternative options that a corporation
could have pursued.

Explicit costs are disclosed by businesses on their income statement. Net income after capital,
indirect, and direct cost subtraction is the accounting profit shown on the income statement's
bottom line.

The most fundamental explicit cost utilized in per-unit cost analysis is the cost of goods sold.
To get an economic profit per unit, a business might therefore also divide its opportunity
costs by units in the aforementioned calculation.

Advantages and Disadvantages of Economic Profit

4. Economic profit figures can be helpful for business decision-making. By studying the
effect on net income of subtracting not just explicit costs but the estimated costs of
giving up potential business opportunities, companies can size up the wisdom of
business ventures from high to low before launching one or more.
5. Economic profit can also be reviewed after the fact. Lessons can be learned about the
choices that were made.
6. Economic profit can show management how efficiently the company has been using
its resources.

Disadvantages

6. The economic profit figure is theoretical because opportunity costs are based on
assumptions. Since the opportunity wasn’t taken, a company doesn’t know the exact
amount of revenue that might have been made.
7. The calculation of economic profit over the short-term can lead to inappropriate
conclusions about the business option chosen. That’s because short-term losses can be
inevitable before expected long-term profitability. It’s smarter to analyze economic
profits over long-term time periods.

ACCOUNTING PROFIT

A company's earned profit, net income, or bottom line are other names for accounting profit.
Accounting profit is shown on an organization's income statement, as opposed to economic
profit. According to generally accepted accounting rules, it is the profit that remains after
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various costs and expenses are deducted from the total revenue or sales (GAAP). Those
expenses consist of:

 Labor costs, such as wages and salaries

 Any inventory needed for production
 Raw materials
 Transportation and storage costs
 Production costs and overhead
 Sales and marketing costs

Accounting profit is the amount of money that remains after operating expenses are
subtracted. Explicit costs are just the precise sums that an organization pays for those
expenses at that time, such salaries. Accounting profit, also known as net income, is typically
reported on a quarterly and annual basis and is used to assess a company's financial health.

2.10 POLICIES ON PROFIT MAXIMIZATION

Most people agree that a company's primary goal is to turn a profit.Its profit margin is
thought to be the main indicator of its success. According to economic theory, a firm's
primary policy should be to maximize profits. Modern businesses reject this viewpoint and
put the principle of profit maximization on the back burner. This is not to argue that modern
businesses do not pursue profitability. They definitely strive for maximum profits, but they
also have other objectives.These make up the policy for profit maximisation.

(i) Industry Leadership

Being a leader in the industry can mean producing the most number of product
lines or reaching the largest sales volume. Leadership in the sector requires a
sufficient level of profit that is commensurate with the amount of capital invested,
the labor force used, and the volume of output generated.
(ii) RESTRICTING THE ENTRY
No competitors are likely to enter the market if a company restricts its earnings.
Reasonable profits are necessary to ensure the business's survival and expansion.
Joel Dean states, "Competitors can enter the market as soon as they realize it is
profitable and figure out how to move the patents and make the required
adjustments in design, technique, and production plant and market penetration."
(iii) POLITICAL IMPACT
High profits are viewed as a company's death wish. The government may revert to
high taxes or nationalization if it learns that the companies are making enormous
profits. The government may implement price control and profit restriction laws in
order to avoid high profits, which are sometimes viewed as a sign of monopoly
power.

(iv) CONSUMER GOODWILL

The customer is the cornerstone of any company. Businesses must limit their
profit margins in order to preserve customer goodwill.By keeping profits low,
businesses may aim to win over customers.These days, businesses place such a
high importance on customer loyalty that they frequently organize campaigns
using marketing.

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(v) WAGE CONSIDERATION

Increased profits could be interpreted as proof of capacity to pay greater
wages.Naturally, the labor groups will demand greater pay, bonuses, and other
benefits if they learn that the companies are paying out larger dividends to their
shareholders.In these situations, businesses maintain a respectable profit margin in
the sake of amicable employee relations.

(vi) LIQUIDITY PREFERENCE

Many concerns prioritize liquidity over profit maximization because they place a
higher value on a company's capital soundness. Preference for liquidity refers to
the desire to retain cash on hand for daily transactions. The ratio of current assets
to current liabilities is the first thing that draws notice on the balance sheet. To
ensure capital stability, businesses retain high cash and make less profits.

(vii) AVOID RISK

Another goal of modern business is risk avoidance, for which companies must
limit profit.Risk is a major factor in profit maximization. When establishing a new
venture, managers must make decisions in the face of several
uncertainty.Experienced managers very frequently steer clear of such hazards. In
an oligopolistic market, enterprises may prioritize minimizing losses.The
avoidance of loss is the fundamental tenet of business economics, not the
maximization of profit.

ALTERNATIVE POLICIES OF PROFIT MAXIMIZATION

Profit maximization has, up until now, been the magnificent market key that unlocked all
doors leading to an understanding of the behavior of the entrepreneur, according to Prof. K.
Rothschild.It has always been understood that factors such as family pride, moral and ethical
considerations, low intelligence, and similar circumstances may alter the outcomes derived
from the maximum profit assumption. However, it was appropriate to assume that these
unsettling occurrences are sufficiently exceptional to warrant their exclusion from the main
body of price theory. However, there is another reason that should not be disregarded at all
and that is most likely on par with the need for maximal profits: the desire for stable profits.
He has proposed that an enterprise's long-term survival is its main motivation.
He asserts that the premise of profit maximization applies without a doubt to
monopolistic or perfect competition scenarios.The goal of the corporation is to earn
monopoly profits under monopolistic conditions. He claims that the presumption of profit
maximization is insufficient in the event of an oligopoly.

According to W.J. Baumol, the firm's ultimate goal should be to maximize sales.
According to him, the producer will disregard expenses incurred in order to maximize output
and profits. If the company's sales rise, it indicates that the producer is earning a regular rate
of return on investment in addition to covering costs.The notion of profit maximization is
compared to Baumol's theory of sales maximization as a reasonable producer behavior.

If the producer is meant to maximize his satisfaction, Benjamin Higgins, Mekin

Reder, and Tibor Scitovsky have proposed another alternative theory to the theory of profit
maximization: the theory of utility maximization.They have included leisure as a variable in

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their method.One key component of individual wellbeing is leisure.The producer will be able
to enjoy less relaxation if he puts in more work.It is stated that when a producer's net profit is
at its highest, they will be most satisfied.

According to Donaldson and Lorsch, career managers favor long-term stability and
expansion of their companies, which are only achievable when they achieve maximum
current earnings. To ensure business riches and ensure existence, self-sufficiency, and
success, top managers put in a lot of effort.The certainty of a means of survival increases with
affluence.

2.11 PROFIT FOR CONTROL

It refers to the use of profit measures as a means to control and manage a firm's operations
and performance. This concept typically involves setting profit targets and using them to
evaluate and guide decision-making within the organization. Here’s a breakdown:

1. Performance Measurement:
o Profits are used as a key performance indicator to assess the efficiency and
effectiveness of different departments or business units.
2. Budgeting and Targets:
o Profit targets are set as part of budgeting processes. Departments or units are
expected to meet these targets to demonstrate their performance.
3. Incentives and Rewards:
o Profit-based incentives, such as bonuses or commissions, are often linked to
achieving or exceeding profit targets.
4. Resource Allocation:
o Profit measures help in allocating resources more effectively by identifying
which areas or products are generating the most profit.
5. Decision-Making:
o Decisions on pricing, cost control, and investment are influenced by the
impact on profitability.
6. Accountability:
o Managers are held accountable for achieving profit targets, aligning their
actions with the firm's overall financial goals.

Benefits

 Focus on Profitability:
o Encourages a focus on generating and maximizing profits.
 Alignment of Goals:
o Aligns individual and departmental goals with the firm's financial objectives.

Challenges

 Short-Term Focus:
o May lead to a focus on short-term profits at the expense of long-term growth
or sustainability.
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 Misaligned Incentives:
o Can sometimes result in misaligned incentives, where employees prioritize
profit over other important factors like customer satisfaction or quality.

Using profits for control helps firms monitor and drive performance, ensuring that resources
are used efficiently and that financial goals are met.

2.13 SUMMARY

 Profits of businesses depend on the successful management of risks and uncertainties

by entrepreneurs. These risks can be cost risks due to change in wage rates, prices, or
technology, and other market risks. Different economists have presented different
views on profit. The dynamic theory, innovation theory, risk-bearing theory,
uncertainty theory, and marginal productivity theory are the principal theories of
profit.
 According to economic theory, a firm's primary policy should be to maximize profits.
Modern businesses reject this viewpoint and put the principle of profit maximization
on the back burner. This is not to argue that modern businesses do not pursue
profitability. They definitely strive for maximum profits, but they also have other
objectives.These make up the policy for profit maximisation.
 Profit maximization has, up until now, been the magnificent market key that unlocked
all doors leading to an understanding of the behavior of the entrepreneur, according to
Prof. K. Rothschild.It has always been understood that factors such as family pride,
moral and ethical considerations, low intelligence, and similar circumstances may
alter the outcomes derived from the maximum profit assumption.

2.14 GLOSSARY

Economic profit: Difference between revenue received from sale and the explicit
cost.
Profit maximization: Generating highest possible profit for business after cost is
deducted
Circular flow: The unendingflow of production of goods and services and income ,
expenditure in an economy.

2.15 QUESTIONS AND EXERCISES

1. What is economic profit?

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2. What is profit maximisation?

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3. What is the objective of the firm?

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LONG QUESTIONS

1) Explain briefly the circular flow of economic activity?

2) Explain the nature and objective of the firm in business activities?

3) Discuss the different theories of profit.

4) Distinguish between maximising and satisfying.

5) Explain different policies for profit maximisation?

UNIT 3

CONCEPT OF DEMAND AND SUPPLY

STRUCTURE

3.1Introduction
3.2 Objectives
3.3 The demand schedule and demand curve
3.4The demand function

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3.5Price elasticity of demand

3.6Interpretation of elasticity of demand
3.7Income and cross elasticity of demand
3.8Business and economic forecasting
3.9 Method of forecasting: expert opinion
3.10Market experiment and survey
3.11 Summary
3.12 Glossary
3.13 Questions and Exercises

3.1 INTRODUCTION

Demand is the measure of how much (quantity) consumers want to purchase a good or
service. The amount of a product that people are willing to purchase at a given price is known
as the quantity demanded; the link between quantity demanded and price is referred to as the
demand relationship. Supply is a measure of what the market is willing to give. The theory
that explains how the supply and demand of a resource interact is known as the law of supply
and demand. The relationship between a product's availability and demand—or desire—for it
determines its price, according to the law of supply and demand. In general, prices rise in
response to low supply and high demand; conversely, the higher the supply and the lower is
the price and vice versa.

3.2 OBJECTIVE

After reading this you will be able to understand;

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 Demand schedule and demand curve

 Demand function
 Price, income and cross elasticity of demand
 Business and economic forecasting
 Method of forecasting

3.3 DEMAND SCHEDULE AND DEMAND CURVE

The desire or need for something is known as demand. Demand in economics refers to the
effective demand, or the quantity that consumers are willing to buy at a specific price and for
a specific length of time. Demand is the result of three factors: the willingness to pay, the
ability to pay, and the desire to own anything. Demand is the ability or willingness to
purchase a specific good at a specific moment in time.
Demand is plotted on a graph by economists as a demand curve, which often slopes
downward, after demand is recorded on a demand schedule. The downward slope illustrates
how quantity demanded and price are related: quantity demanded rises when price falls. any
consumer, in theory, has a demand curve for any product they would consider purchasing,
and this curve equals the marginal utility curve. The market demand curve for that product is
obtained by adding the demand curves of each customer. The market demand curve and the
social utility curve are equivalent in the absence of externalities.
A demand schedule is a table that displays the quantity of an item or service that is
wanted at various price points in the field of economics. A demand schedule can be plotted on
a chart with price on the Y-axis and quantity on the X-axis as a continuous demand curve.
Two columns are the most typical layout for a demand schedule. A product's price is
listed in the first column either descending or rising. The quantity of the product that is
wanted or demanded at that pricing is listed in the second column. Market research is used to
decide the price. The demand curve, which is produced by graphing the data in the demand
schedule, provides a clear illustration of the link between price and demand and makes it
simple to estimate the demand for a good or service at any position along the curve.

IMPORTANCE OF DEMAND SCHEDULE

In economics, demand schedules are crucial for forecasting future economic activity and
helping managers anticipate the performance of their product or products. A demand schedule
has several distinct elements of value as a result.

 Demand schedules drive pricing decisions: Businesses are able to compile

information and determine which price point best fits the desired level of market
demand. The link between points along this demand schedule frequently determines
the final price a customer pays for the commodity they desire.
 Demand schedules inform Of elasticity: Demand schedules effectively convey
whether a product is elastic or inelastic, even though the information is genuinely
driven by the underlying facts. It is possible to materially alter the price of an elastic
good without significantly affecting consumer demand. However, inelastic items may
see sharp drops in value when prices rise. The management is more informed on how
to handle pricing strategy using this information.

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 Demand schedules lead manufacturing estimates: After determining its price point, a
business can utilize the demand schedule to project how many units it will sell over
time. As a result, the business will be able to more accurately predict how much labor,
machinery, and raw materials it will require when in order to meet market
expectations. This can also enable the business to schedule ahead of time and lock in
advantageous pricing since it will be aware that there might be a specific degree of
demand at particular times.
 Demand schedules translate to other products: An organization might use its enhanced
understanding of the market and its target customer base to additional items. This
involves projecting potential outcomes in the event that the business introduces a
whole new line of products in the future.

EXAMPLE OF DEMAND SCHEDULE

Consider the case of a business attempting to decide on the most advantageous pricing plan
for a recently purchased 40" 4K HDTV. After completing a market research and surveying
prospective customers, the business created the demand schedule that is shown below.
Table 3.1
Demand Schedule, Example (Market
Only)
Price per TV Estimated Demand
$1,500 1,000
$1,250 1,250
$1,000 2,000
$850 3,000
$750 5,000

TYPES OF DEMAND SCHEDULE

 Individual demand schedule: This demand schedule shows a customer's specific

demand for a certain good in relation to its price. The individual demand curve is a
graphical depiction of the individual demand schedule. Here, the price of a particular
commodity is represented by the y-axis, while demand is represented by the x-axis.

 Market demand schedule: The total of each individual demand schedule is referred to
as the market demand schedule. In summary, it shows how different customers'
demands for a given good relate to its cost. The market demand curve is a graphical
depiction of the market demand schedule. In this case, the price of a particular
commodity is again represented by the y-axis, and the x-axis shows the market
demand expressed in units.

DEMAND CURVE

The graph that shows the link between a commodity's price and the quantity of it that
buyers are willing and able to buy at a given price is called the demand curve. It is a demand
timetable represented graphically.

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The demand curve for each individual customer is the source of the demand curve for
all consumers combined. In order to predict the equilibrium price and equilibrium quantity of
a market that is competitive, demand curves are frequently paired with supply curves. The
demand curve that the monopolist faces in a monopolistic market is just the market demand
curve.

DRAWING DEMAND CURVE

The demand curve is based on the demand schedule. The demand schedule shows exactly
how many units of a good or service will be purchased at various price points. For example,
below is the demand schedule for bread :

Table 3.2

It is significant to remember that quantity demanded rises as price falls. The law of demand
governs the interaction. It seems sense that there would be more demand for an item or
service if it were less expensive.

DEMAND CURVE

From the demand schedule above, the graph can be created:

Fig. 3.1

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In this figure the OX axis represents the quantity demanded and OY axis represents the price.
It is clearly shown in the above figure that the price and quantity demanded shares a negative
relationship among themselves. As the price of a good increases its quantity demanded falls
as shown in the figure. When we join all such points we get a curve which is downward
sloping from left to right.

SHIFT IN THE DEMAND CURVE

A shift in demand is an alteration in the amount of a good or service that buyers are willing to
purchase at any given price point, brought about by or impacted by changes in economic
variables unrelated to price. When the amount of a good or service demanded at each price
point varies, the demand curve moves. The demand curve moves to the right if the amount
demanded rises at each price point. On the other hand, the demand curve will move to the left
if the amount demanded at each price point declines. Changes in the amounts that customers
are wanting at every price point are therefore reflected in movements in the demand curve.

3.4 THE DEMAND FUNCTION

In demand analysis, it is important to understand that a variety of crucial factors, or

determinants, influence the quantity of a certain product that customers will choose to buy at
any given time. It is expressed in technical terms as the demand function for the specified
product.
A demand function in mathematical terms expresses the functional relationship between the
demand for the product and its various determining variables.

Dx = f (Px, Ps, Pc, Yd, T, A, N, u)

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Where, The ‘own price’ of the product itself (P)

The price of the substitute and complementary goods (Ps or Pc)
The level of disposable income (Yd) with the buyers (i.e., income left after direct taxes)
Change in the buyers’ taste and preferences (T)
The advertisement effect measured through the level of advertising expenditure (A)
Changes in population number or the number of the buyers (N)

Using the symbolic notations, we may express the demand function, as follows: Here, we
assumed commodity X; hence, Dx represents the amount demanded for the commodity X and
Px refers to the price of X. Further, u is incorporated to recognize ‘other’
unspecified/unknown determinants of the demand for commodity X.

3.5 PRICE ELASTICITY OF DEMAND

One of the key ideas in neoclassical economic theory is elasticity. Understanding the
prevalence of indirect taxation, marginal notions in relation to the firm theory, wealth
distribution, and various product kinds in relation to the consumer choice theory are all aided
by this knowledge. Furthermore, elasticity is vital to any discussion of welfare distribution,
especially when it comes to government, producer, and consumer surplus.
Numerous factors, including the commodity's price, the price of similar commodities,
the buyer's income, likes and preferences, etc., influence demand for a given good. Elasticity
refers to the level of reaction. The degree of demand responsiveness is known as its elasticity.
A commodity's demand fluctuates in response to changes in its price, that of related items,
income, etc. Therefore, the elasticity of demand has three dimensions:
Mathematical expression of elasticity of demand is:

percentage change in quantity demanded

ED= -----------------------------------------------------------
Petrcentage change in price

The relationship between price p and the quantity of demand q can sometimes be modeled by
a function, either q=q(p) or p=p(q). The price elasticity of demand can be calculated from
the derivative of the quantity with respect to price:

dq/q P dq
E= ----- = ---- . ----
dp/p q dps
Price elasticity of demand means degree of responsiveness of demand for a commodity to the
change in its price. For example, if demand for a commodity rises by 10% due to 5% fall in
its price, Price elasticity of demand (ep)
= Percentage change in quantity demanded
_______________________________________
Percentage change in price of the commodity

= 10/-5
= (-2)

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Ep will always be negative due to inverse relationship of price and quantity demanded.

3.6 INTERPRETATION OF PRICE ELASTICITY OF DEMAND

TYPES OF PRICE ELASTICITY OF DEMAND

You must have observed that we continue to consume the same amount of salt even when its
price increases. Put another way, the amount of salt that is required does not adjust in
response to changes in price. However, what occurs if apple prices increase? We begin
buying fewer apples at a higher price; in other words, demand for apples adjusts to price
fluctuations. As a result, the degree to which quantity demanded responds to a change in price
may vary, or the elasticity of demand. The price elasticity of demand in this situation is often
divided into the following five groups:

1) PERFECTLY INELASTIC DEMAND(Ed=0): The demand for a commodity is

called perfectly inelastic when quantity demanded does not change at all in response
to change in its prices. Graphically, the demand curve in parallel to y-axis as shown in
below Figure.3.2

Table 3.3

Price (rupees per Quantity

kg) demanded(In kg)
10 2
15 2
20 2

Fig 3.2

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This fig 3.2 shows the perfectly inelastic demand curve. When the demand for a commodity
does not change at all or there is very insignificant change with the change in the price , it is
the case of perfectly inelastic demand. Here the demand curve becomes a straight line vertical
to X axis. F or example: when price of salt falls ,the demand for salt became constant.

2) RELATIVELY INELASTIC DEMAND(Ed<1): When the percentage change in the

quantity required of a commodity is less than the percentage change in the
commodity's price, the demand for that commodity is said to be less than unit elastic
or comparatively inelastic. The demand curve is more pronounced graphically, as seen
in Fig. 3.3. Food, medicine, and other necessities have less demand than unit
elasticities.

Table 3.4

Price (rupees per Quantity

kg) demanded(In kg)
10 4

20 3

The diagrammatic representation of perfectly inelastic demand curve is given below.

Fig 3.3

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In the above figure, the demand curve shows that OQ1unit are demanded when the
price is OP1.As price falls to OP2 the demand increase to OQ2.Here Q1Q2<P1P2.So
Ed<1.

3) UNITARY ELASTIC DEMAND(Ed=1): When percentage change in quantity

demanded of a commodity equals percentage change in its price, the demand for the
commodity is called unit elastic (See table 3.5). Graphically, demand curve is
rectangular hyperbola as shown in fig. 3.4.

Table 3.5

Price (rupees per Quantity

kg) demanded(In kg)
20 40

30 20

Fig 3.4

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Here the demand curve can assume the shape of a rectangular hyperbola which shows
the change in quantity demanded is as same as change in price .Here PP1 =QQ1.That
means if price fall by 10%then demand exactly rises by 10%.

4) RELATIVELY ELASTIC DEMAND(ED>1): A commodity's demand is referred to

as more than unit elastic or extremely elastic when the percentage change in the
quantity demanded of it exceeds the percentage change in its price (see table(3.6).
Figure 3.5 illustrates how the demand curve is flatter graphically. Luxury products
have a demand that is not unit elastic.
Table 3.6

Price (rupees per Quantity

kg) demanded(In kg)
20 40

30 20

This can be illustrated diagrammatically:

Figure 3.5

As shown in the diagram , given the demand curve DD , a change in price by P1P2
results in a change in quantity demanded by Q1Q2.

And here Q1Q2>P1P2

Here the Ed>1

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5) PERFECTLY ELASTIC DEMAND : The demand for the commodity is called

perfectly elastic when its demand expands or contracts to any extent without or very
little change in its price (see table 3.7). Graphically, the demand curve is parallel to X-
axis as shown in Fig. 3.6.

Table 3.7

Price (rupees per Quantity

kg) demanded(In kg)
20 20

20 40

Figure 3.6

That means a little change in price leads to an infinite change in quantity demanded.
And here Ed= .

FACTORS AFFECTING PRICE ELASTICITY OF DEMAND

As was previously mentioned, some items are more responsive to price changes in
terms of quantity requested than others. For instance, the demand for luxury products
may be significantly impacted by even a tiny price shift, yet the demand for salt may
not be impacted by a significant price change. This indicates that the price elasticity of
demand varies depending on the commodity. The following variables could have an
impact on a good's price elasticity of demand:

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1. Availability of close substitute: A commodity's demand is typically more elastic when

there are many replacements available than when there are none. Coca-Cola, Pepsi,
Limca, and so forth are suitable alternatives. Customers will switch to coke
replacements even if the price of the beverage increases slightly. Conversely, the lack
of close substitutes for electricity will make the demand for it less elastic.
2. Nature of the commodity: Because we must consume needs like food grains and
medications in the bare minimum, regardless of cost, the demand for these goods is
less elastic. However, because consumers may put off using comforts and luxuries
like air conditioners and refrigerators in the future if their prices increase, demand for
these goods is more elastic.
3. Share in total expenditure: The elasticity of demand for a commodity increases with
the percentage of income spent on it. If a very tiny percentage of income is spent on a
commodity, the demand for that commodity is inelastic.
4. Level of price: A commodity's elasticity of demand rises with a proportion of revenue
spends on it. The demand for a good or service is inelastic if a very little portion of
money is spent on it.
5. Level of income: Demand for a commodity is generally less elastic for higher income
level groups in comparison to people with low incomes. For example, if price of a
good rises, a rich consumer is not likely to reduce his demand but a poor consumer
can reduce his demand for that commodity.
6. Habit: Consumer behavior has an impact on the price elasticity of demand for
commodities. A chain smoker, for instance, won't cut back on his smoking even if cig
prices increase.

3.7 INCOME AND CROSS ELASTICITY OF DEMAND

Income elasticity of demand refers to the degree of responsiveness of demand for a

commodity to the change in income of its buyer. Suppose, income of buyer rises by
10% and his demand for a commodity rises by 20%, then, Income elasticity of
demand (ey)
% change in quantity demanded
= __________________________

% change in price of the commodity

=20/10=2

Although many items have positive income elasticities and many have negatives, the most
widely used elasticity in economics is the price elasticity of demand, which is usually always
negative.

 A negative income elasticity of demand is associated with inferior goods; an increase

in income will lead to a fall in the quantity demanded.
 A positive income elasticity of demand is associated with normal goods; an increase
in income will lead to a rise in quantity demanded.

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 If income elasticity of demand of a commodity is less than 1, it is a necessity

good.
 If the elasticity of demand is greater than 1, it is a luxury good or a superior
good.
 A zero income elasticity of demand means that an increase in income does not change
the quantity demanded of the good.

Demand's elasticity of income can be used to predict future consumption trends and to
inform business investment choices. The "selected income elasticities" below, for
instance, imply that as earnings rise over time, consumers' budgets will be allocated
more toward buying cars and dining out and less toward cigarettes and margarine.

CROSS ELASTICITY OF DEMAND

Cross elasticity of demand means the degree of responsiveness of demand for a commodity to
the change in price of its related goods (substitute goods or complementary goods). Suppose,
demand for a commodity rises by 10% due to 5% rise in price of its substitute good, then
Cross elasticity of demand (Ec)
= % change in quantity demanded
___________________________
% change in price of related good
=10/5= 2
Thus the numerical co-efficient of cross elasticity of demand may be either positive or
negative . substitute goods have positive, cross elasticity of demand, jointly demanded or
complementary products have negative cross elasticity of demand.
In economics, the cross (or cross-price) elasticity of demand measures the effect of
changes in the price of one good on the quantity demanded of another good. This reflects the
fact that the quantity demanded of good is dependent on not only its own price (price
elasticity of demand) but also the price of other "related" good. The cross elasticity of
demand is calculated as the ratio between the percentage change of the quantity demanded for
a good and the percentage change in the price of another good, ceteris paribus.

3.8 BUSINESS AND ECONOMIC FORECASTING

Using a variety of indicators, economic forecasting is the process of trying to project the state
of the economy. Creating statistical models using inputs from multiple important factors is
the process of forecasting, usually aimed at estimating the GDP growth rate in the future.
Inflation, interest rates, retail sales, worker productivity, worker confidence, industrial
production, and unemployment rates are examples of primary economic indicators.

 Economic forecasting is the process of attempting to predict future conditions of the

economy using a combination of widely followed indicators.
 Government officials and business managers use economic forecasts to determine
fiscal and monetary policies and plan future operating activities, respectively.
 Since politics are highly partisan, many rational people regard economic forecasts
produced by governments with healthy doses of skepticism.
 The challenges and subjective human behavioral aspects of economic forecasting also
lead private-sector economists to regularly get predictions wrong.

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The practice of economic forecasting dates back many centuries. But the 1930s Great
Depression is credited with giving rise to the current levels of analysis. Following that
catastrophe, there was increased emphasis on comprehending the functioning and
future trajectory of the economy. As a result, a wider range of statistical and analytical
methods were created.
Economic predictions aim to anticipate GDP growth rates, either quarterly or
annually. GDP is the primary macro number that many firms and governments use to
guide their decisions about hiring, spending, investments, and other key policies that
affect the overall economy.

BUSINESS FORECASTING

The instruments and methods used to forecast business developments, such as sales,
expenses, and profits, are referred to as business forecasting. Creating more effective
plans based on these well-informed projections is the aim of business forecasting.
Quantitative or qualitative models are used to gather and evaluate historical data in
order to find trends that can be used to guide demand planning, financial operations,
production planning, and marketing strategies.

The business forecasting process entails:

 Identify the problem, data point, or question that will be the basis of the systematic
investigation.
 Identify relevant, theoretical variables and determine the ideal manner for collecting
datasets.
 Make estimates about future business operations based on information collected
through investigation.
 Choose the model that best fits the dataset, variables, and estimates. The chosen
model conducts data analysis and a forecast is made.
 Note the deviations between actual performance and the forecast. Use this information
to refine the process of predicting and improve the accuracy of future forecasts.

IMPORTANCE OF BUSINESS FORECASTING

Almost every decision made in corporate management requires the use of projections,
regardless of the industry. Through the use of business forecasting, managers can
better comprehend and uncover planning flaws, adjust to changing conditions, and
gain efficient control over their operations
Identifying the viability of taking on current competitors, gauging the
likelihood of generating demand for a product, projecting the expenses of ongoing
monthly invoices, projecting future sales volumes based on historical sales data,
effectively allocating resources, projecting profits and budgeting, and closely
examining the suitability of management choices are a few examples of business
forecasting.
Business managers and forecasters can benefit from the use of business
forecasting software by being able to readily prepare forecast reports and have a better
understanding of predictions and how to base strategic decisions on them. Clear, real-
time visualization of company performance is a must for any high-quality business
forecasting system since it enables quick analysis and efficient business planning.

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The use of forecasting in business is a blend of data science and

business intelligence, and it involves both art and science. Inexperience and bad
judgment are common causes of business forecasting difficulties. When assumptions
are mixed with unforeseen circumstances, it can be risky and lead to wildly incorrect
forecasts. Even with business forecasting's drawbacks, an organization will benefit
greatly from any knowledge it can obtain about likely future trends.

3.9 METHOD OF FORECASTING: EXPERT OPINION

Business forecasting and planning can be conducted by either quantitative modeling methods
or qualitative modeling methods:

QUANTITATIVE TECHNIQUE IN BUSINESS FORECASTING

A long-term technique for business forecasting, quantitative forecasting solely considers

measurable data, such as statistics and historical data. Trends or rates of change are found by
looking at historical performance. These kinds of business forecasting are particularly helpful
for long-term planning in the industry. Among the quantitative models are:

TREND ANALYSIS METHOD : This forecasting technique, also referred to as "Time

Series Analysis," eliminates outliers and gives more weight to more recent data for predicting
future events. When there is a substantial amount of historical data exhibiting distinct and
consistent trends, this approach works well. This is the most popular and economical
approach.

ECONOMIC MODELING : This method of forecasting, also known as "Time Series

Analysis," reduces the influence of outliers and prioritizes more recent data when making
predictions about the future. This method is effective when there is a significant body of
historical data showing clear and consistent trends. This is the most widely used and cost-
effective strategy.

INDICATOR APPRIOACH: This method estimates the performance of the trailing

indicators by utilizing the data from the leading indicator and observing the correlation
between specific indicators. One kind of KPI is a lag indicator, which measures company
performance after the fact and sheds light on how business strategies affect the outcomes
attained.
‍

QUALITATIVE TECHNIQUE IN BUSINESS FORECASTING

Short-term projections using qualitative forecasting are based on the opinions of "market
mavens" or industry gurus. When projecting markets for which there is not enough historical
data to draw statistically meaningful conclusions, these strategies are very helpful. Among the
qualitative models are:

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MARKET RESEARCH: Large-scale surveys and polls are done with potential customers to
find out how much they will spend on a certain good or service, with the goal of estimating
the margin of error.

DELPHI MODEL: A panel of experts are polled on their opinions regarding specific topics.
Their predictions are compiled anonymously and a forecast is made.

EXPERT OPINION

The expert opinion method of forecasting demand is an approach that uses the insights and
knowledge of industry experts to predict future demand for products or services. This method
combines qualitative and quantitative techniques and is particularly useful when there is
limited historical data, or in rapidly evolving or uncertain markets. The process involves six
steps:
1. Identify experts with extensive knowledge and experience in the product or service
domain.
2. Prepare relevant questions to gather critical data, such as market trends, customer
preferences, and changes in the competitive landscape.
3. Conduct interviews or surveys with the selected experts using a structured approach.
4. Analyze the data collected, using statistical techniques or qualitative analysis methods, to
identify patterns, trends, and other common factors.
5. Generate a demand forecast for the product or service, incorporating qualitative
information from the expert insights.
6. Continuously review and refine the demand forecast as new information becomes available
or market conditions change, by maintaining ongoing dialogue with the experts.

3.10 MARKET EXPERIMENTS AND SURVEY

Market experiments refer to those methods which are conducted through the following two
ways:
 Experiment in Actual market (also termed as test area method)
 Experiment in Simulated market (also termed as laboratory method )

EXPERIMENT IN ACTUAL MARKET

The market is the location where products and services are purchased and traded. This
approach of demand forecasting involves estimating demand at the actual or genuine market.
When it comes to new items, the real market experiment approach is really helpful. How is
the market test conducted? What does "test area" mean? The forecaster could decide to
estimate demand in a certain segment of the industry. This test area could include particular
cities, a particular area, or even a sample of customers. These could be chosen depending on a
few shared qualities. One might infer the demand estimate for the entire market based on the
basis of result of this test.
Additionally, more than one test region could be chosen to determine
how different elements—such as price and advertising strategies—affect the product's
demand. In order to see how these factors affect demand, the forecaster may alter these

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variables in the test regions. Additionally, the forecaster has the option to alter any one of the
elements or all of them simultaneously. Thus, it was possible to estimate demand and record
how customers responded to changes in many aspects. The main benefit of this approach is
that it allows the forecaster to assess demand at different levels by giving them a sense of
how demand might shift in response to changes in prices and promotional activities.
This process takes a long time and is highly costly. Furthermore, costs
would increase with the number of test sites or their size. If done so at a very small scale, the
resulting image might not accurately reflect the entire market. The choice of a suitable test
region is therefore crucial to the method's success.

EXPERIMENT IN SIMULATED MARKET

This approach is also included in the category of market experiments. In this instance, a set of
target consumers is chosen, and a simulated market is used to conduct the market experiment,
as opposed to genuine market experiments that are conducted in real marketplaces. Based on
the responses of this consumer group, the market's demand is estimated through the use of
such an experiment.

A set amount of money is given to the group of customers in this demand

forecasting approach, and they are asked to shop in a simulated store. Customers are
questioned about how much they would buy of the goods that are displayed in the store.
Customers' purchases at the dummy store are documented. Changes in the product's pricing,
packaging, and promotional strategies may be implemented during the experiment to observe
how customers react to these adjustments; these changes are also noted for the forecast.
This approach is a step up from the survey method because it asks customers
to purchase the product, which yields more accurate findings. This approach would be helpful
for the introduction of new products as well.
However, because this is a simulated market, customer responses could
differ from those in the real one. The sample in this procedure also needs to be chosen
carefully. Due of its high cost, this approach may only be used on a limited number of
customers. Since the real market might be very large, any conclusions made based on the
actions of a tiny sample of consumers might not produce results that are practical.

3.10 SUMMARY

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 Demand is the desire or want for something. The economics meaning of demand is
the effective demand, i.e., the amount the buyers are willing to purchase at a given
price and over a given period of time. Demand is the desire to own anything, the
ability to pay for it, and the willingness to pay.
 Market demand analysis is a core topic in managerial economics, for it seeks to search
out and measures the determinants of demand, thus, forces governing sales of a
product.
 The demand for a product refers to the amount of it which will be bought per unit of
time at a particular price. Consumer demand for a product may be viewed at two
levels: (i) Individual demand, and (ii) Market demand.
 The demand side of the market is represented by the demand schedule. It is tabular
statement narrating the quantities of a commodity demanded in aggregate by all the
buyers in the market at different prices over a given period of time. A market demand
schedule, thus, represents the total market demand at various prices.
 In economic analysis, the technical jargon ‘changes in quantity demanded’ and
‘changes in demand’ altogether have different meanings. The phrase ‘changes in
quantity demanded’ relates to the law of demand. It refers to the changes in the
quantities purchased by the consumer on account of the changes in price.
 A variation in demand implies ‘extension’ or ‘contraction’ of demand. When with a
fall in price more of a commodity is bought, there is an extension of demand.
Similarly, when a lesser quantity is demanded with a rise in price, there is a
contraction of demand. In short, demand extends when the price falls and it contracts
when the price rises. The terms ‘extension’ and ‘contraction’ are technically used in
stating the law of demand.
 The term ‘elasticity of demand’, when used without qualifications, is commonly
referred to as price elasticity of demand. This is a loose interpretation of the term. In a
strict logical sense, however, the concept of elasticity of demand should measure the
responsiveness of demand for a commodity to changes in the variables confined to its
demand function. There are, thus, as many kinds of elasticity of demand as its
determinants.

3.11 GLOSSARY

a. Demand: Demand is the desire or want for something. The economics

meaning of demand is the effective demand, i.e., the amount the buyers are
willing to purchase at a given price and over a given period of time. Demand
is the desire to own anything, the ability to pay for it, and the willingness to
pay.

b. Individual demand: Individual demand refers to the demand for a commodity

from the individual point of view. The quantity of a product consumer would
buy at a given price over a given period of time is his individual demand for
that particular product.

c. Law of demand: It refers to the changes in the quantities purchased by the

consumer on account of the changes in price

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d. Price elasticity of demand: Price elasticity of demand PED is a measure used

in economics to show the responsiveness, or elasticity, of the quantity
demanded of a good or service to a change in its price.
e. Income elasticity of demand: Income elasticity of demand measures the
responsiveness of the demand for a good to a change in the income of the
people demanding the good, ceteris paribus. It is calculated as the ratio of the
percentage change in demand to the percentage change in income.

f. Cross elasticity demand: The cross elasticity demand refers to the degree of
responsiveness of demand for a commodity to a given change in the price of
some related commodity. The cross elasticity of demand between any two
goods X and Y is measured by dividing the proportionate change in the
quantity demanded of X by the proportionate change in the price of Y.

g. 3.12 QUESTIONS AND EXERCISES

Short answer questions

1. Give the meaning of Demand.
2. What are Individual Demand and Market Demand?
3. What is Law of Demand?
4. What is Economic forecasting?
5. What is elasticity of demand?
6. On what factors does elasticity of demand depend? Explain.

LONG QUESTIONS
1. Explain the Determinants of Demand.
2. Write note on: Demand Function.
3. State the exceptions to the Law of Demand.
4. Discuss the change in Quantity Demanded versus Change in Demand.
5. Discuss the reasons for Change in Demand.
6. Explain Demand Distinctions: Types of Demand.
7. Discuss Supply functions. 8. Explain determination of equilibrium price and quantity.
8. Explain the concept of cross elasticity of demand. Indicate its usefulness in the
classification of market situations.
9. Distinguish between price elasticity, income elasticity and cross elasticity of demand
10. What is point elasticity of demand? How is it measured?

1. Prepare a report on market demand of Honda Activa. - - - - - - - - - - - - - - - - - - - - - - - - - -

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2. The students are required to identify various types of demand for different services. - - - - -
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3. Discuss the change in Quantity Demanded versus Change in Demand. Discuss the reasons
for Change in Demand. - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
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4. 1. Why perfectly elastic demand curve is Horizontal? Discuss. - - - - - - - - - - - - - - - - - - - -
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5. Explain the concept of cross elasticity of demand. Indicate its usefulness in the
classification of market situations. - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
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6. Distinguish between price elasticity, income elasticity and cross elasticity of demand. - - - -
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UNIT 4

BASIC OF PRODUCTION FUNCTION

STRUCTURE

4.1Introduction
4.2 Objectives
4.3 Production function
4.4 One variable input production function
4.5 Two variable input production function
4.6 Iso quants
4.7 Formulation of cobb-Douglas production function
4.8 The theory of cost

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4.9 Summary
4.10 Glossary
4.11Questions and Exercises

4.1 INTRODUCTION

The process of converting inputs, such as labor, capital, and raw materials, into completed
items or services that may be sold on the market or utilized to fuel additional production is
known as production. It entails a variety of tasks, such as production, assembling, processing,
and delivery, all with the goal of enhancing the inputs to yield a functional product.
Production is a basic idea in economics that serves as the foundation for the study of
how economies work, with an emphasis on how resources are distributed and used to meet
the needs and wants of people.
Today, achieving maximum production efficiency or minimizing costs for a given
output is one of the top issues for corporate managers. A company can only thrive in a
competitive market if it can generate goods and services at a cost that is competitive.
Therefore, company managers ought to try to maximize output for a given amount of inputs
or decrease the cost of production. When trying to keep manufacturing costs as low as
possible, managers must answer a few fundamental questions. These are:
1. How does output change with the increase in quantity of inputs?
2. How can production be optimized to achieve reduction in cost?
3. How does technology helps in minimizing the cost of production?
4. How to achieve the least cost combination of inputs for a given output?

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4.2 OBJECTIVES

After studying this module, you would be able to

 Know about the Production Function.
 Derive the relationship between AP, MP& TP
 Learn about iso quants
 Theory of cost
 Know about cost output relationship

4.3 PRODUCTION FUNCTION

A production function is a mathematical expression that provides a physical explanation of

the technical relationship between input and output over a certain time period. According to
Koutsoyiannis, “ the production function is purely a technical relation which connects factor
inputs and output. The generic form of the production function states that the quantity of
inputs and production methods determine the output of any commodity. Considering the state
of technology, a commodity is produced utilizing a variety of techniques that employ various
combinations of variables. For e.g. the production of cloth requires cotton or polymer or silk
as raw material with power loom, handloom or even computerised machines. The same
product can be made in a number of ways with various raw material and technological
combinations. As a result, different technically sound production techniques are possible. The
production function includes all of these technically sound techniques.
A production function is a timetable that displays the greatest amount of a good
produced in a given amount of time for each combination of inputs and technological
condition. A given level of output is produced using a diverse set of inputs, any of which may
be technically efficient.

Suppose, a manufacturing firm employs only two factors- Labour (L) and Capital (K) in
manufacturing steel chairs. Then, general form of its production function can be written as:

Q= f (L, K)

Where Q= Quantity of steel chairs produced, L= Labou, K= Capital

The above production function shows that quantity of steel chairs produced depends on the
quantity of Labour (L) and Capital (K) employed. The production of steel chairs can be
increased by increasing K and L. The time period (i.e. short run or long run) considered for
increasing production is used to decide whether both K and L or only L will be increased.

Employing extra labor alone will boost steel chair output in the near term. Since these
elements are flexible in the long run, increasing labor and capital employment will boost
production over time.

Accordingly, production function can be of two kinds:

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1. Short run production function

2. Long run production function

The short run production function can be written as:

Q= f (K, L) Where K means that capital is fixed in amount.
The long run production function can be written as:
Q= f (K, L)

ASSUMPTIONS
The production function is based on some assumptions. These are:

1. There is perfect division of both inputs and output.

2. Only two factors of production are employed- capital and labour.
3. Imperfect substitution between labour and capital.
4. Technology is given and constant.
5. In the short run, supply of fixed factors is inelastic

IMPORTANCE

1. The production function aids in estimating the level of production when inputs are
given in physical units.
2. When many permutations of inputs result in the same degree of output, it becomes
equal.
3. It shows how the company can switch out one input for another without affecting the
overall output.
4. It takes into account two different kinds of input-output relationships: the "law of
returns to scale" and the "law of variable proportions." The short-run output pattern
can be explained by the law of variable propositions, which states that as output
increases, so do the units of variable inputs. However, as all input units are increased
over time, the law of returns to scale explains the output pattern.
5. The production function aids in choosing the least amount of inputs necessary to
produce the desired output when pricing is taken into account.
6. The production function describes the lowest amounts of different inputs needed to
create a given quantity of output or the maximum quantity of output that can be
produced from any particular quantities of various inputs.

4.4 ONE VARIABLE INPUT PRODUCTION FUNCTION

Producers can alter output in the near term by adjusting the variable components alone.
Assume that a company employs two factors: capital and labor, where capital is a fixed
element and labor is a variable. The ratio in which these components are used will alter if
labor is increased to enhance output while maintaining the same level of capital. Therefore,
the only way to alter output is to alter labor. Variable proportion production function is
another name for this kind of production function. In essence, it is a short-run production

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function that displays the highest output that can be achieved by varying the number of
variable factors while maintaining the fixed values of the other factors.

The short run production function can be written as:

Q= f (K, L)

TOTAL PRODUCT (TP)

It is the total amount of things that a company is capable of producing in a given amount of
time. By using more and more units of the variable factor, i.e. labor, a firm's TP can be
increased. Figure 4.1 illustrates how, initially, the use of a growing number of variable factors
causes TPL to increase at an increasing pace. Once a certain point is reached, the rate of rise
decreases as the factor is used more frequently. The amount of variable components does not
always translate into an increase in the final result. For instance, if a company hires workers
who are more than the manufacturing can produce, they won't be in Aa efficient position to
work.Thus TP curve first increase at an increasing rate then reaches its maximum and at last
starts falling.

MARGINAL PRODUCT(MP)

A change in total production resulting from the usage of an additional unit of a variable factor
is known as the marginal product. For instance, a company that employed ten laborers might
produce a total of one thousand chairs.
Now, with one more laborer added, the total production rises to 1050 chairs, which is
the result of 11 laborers. The marginal product of 11th labor is 50 chairs since it increased
production by 50 chairs overall.

The marginal product of labour can be written as:

MPL = Change in Total Product
_____________________
Change in Labour
= Δ TPL
_______
ΔL
The formula for calculating MPL is;
MPL for nth unit =TPn – TPn-1
n= number of labour units
In fig 4.1, marginal product rises in the beginning. When total product is maximum, it
become zero. Here total product is not increased with the use of extra units of variable factor.
Ultimately, marginal product becomes negative when total product declines.

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FIGURE 4.1

AVERAGE PRODUCT

Average product of an input is total product divided by the total quantity of labour employed
to produce this output. It measures on an average how much output is produced by each
labour. Thus, APL = Total Product Labour Input As can be seen in fig. 4.1, like marginal
product, average product also rises initially and then falls. It is inverted U-shape curve and
can never be zero or negative.

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RELATIONSHIP OF TP, MP AND AP

With the help of TPL curve, we can derive APL and MPL curve as graphically illustrated in
fig. 4.1. TPL is total product of labour curve. Here it is assumed that only variable factor is
labour and the amount of capital is fixed (K). TPL rises when quantity of labour increases but
the increase become smaller and smaller.

Relationship between TP and AP Curves

1. APL at a point is given by the slope of the straight line from the origin upto a point on the
TPL curve. Till point a, the value of the slope increases and after that it declines.
2. In the beginning, APL curve increases, becomes maximum and then declines.
3. APL is positive as long as TPL is positive.
4. It is always greater than zero

Relationship between TP and MP CURVE

1. MPL at any point on total product curve is the slope of the tangent at that point or MPL
between two points is the slope of the line joining the two points on TPL curve. Till point c,
the value of the slope increases, then declines until TPL is maximum. MPL is zero at that
points and after that it becomes negative.
2. In the beginning, MPL increases, becomes maximum when the slope of the tangent is
steepest and then falls.
3. MPL is zero, when TPL is maximum and become negative when TPL declines.
4. Area under MPL curve gives TPL.

Relationship between AP and MP Curves

1. In the beginning, when both APL and MPL curves are increasing, MPL increases greater
rate than APL curve. Both curves increase till fixed input (K) is underutilized.
2. Both APL and MPL curves decline, but MPL curve declines at a higher rate than APL
curve.
3. MPL is equal to APL, when APL curve is maximum.
4. When MPL starts falling, APL continues to increase.

EMPIRICAL ESTIMATION AND MANAGERIAL USE

one-variable production function is a simplified form of a production function that focuses on

the relationship between output and a single input, typically labor or capital. This can be
represented as:
Q=f(X)
Where:
 Q is the quantity of output.
 X is the single input (e.g., labor or capital).

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Example: Estimating a Production Function with Labor as the Only Input

Let's assume we have data on the number of workers employed (labor, L) and the quantity of
output (Q) produced by a firm. We want to estimate a production function of the form:
Q=a+bL
Where:
 a is a constant term (intercept).
 b is the marginal product of labor (the additional output produced by an additional
unit of labor).

Empirical Estimation
Suppose we have the following data:

TABLE 4.1

Labor Output
2 50
4 80
6 110
8 130
10 140

We can use statistical methods, like linear regression, to estimate the parameters a and
b.Let's perform a simple linear regression on this data.

Calculation:
The linear regression model estimates the relationship between L (independent variable) and
Q (dependent variable). The model assumes:
Q=a+bL
Using statistical software or manual calculations, you can find the estimates of a and b.
For this example, let's assume that after running the regression, we get:
 a=30 (constant term)
 b=11 (coefficient of labor)
So, the estimated production function is:
Q=30+11L

Interpretation:
 The constant term a=30 suggests that if no labor is employed (i.e., L=0), the firm
would still produce 30 units of output, possibly due to the use of other inputs like
capital.
 The coefficient b=11 means that for each additional unit of labor employed, the output
increases by 11 units.
This simple model shows how output depends on labor input and allows us to predict output
levels for different labor inputs.

MANAGERIAL USE OF ONE VARIABLE PRODUCTION FUNCTION

The one-variable production function can be highly useful for managerial decision-making in
several ways, particularly in understanding and optimizing the use of a single input, such as
labor. Here are some key managerial applications:

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1. LABOR PLANNING AND OPTIMISATION:

 Output prediction: The one-variable production function can be used by
managers to forecast the level of output for a specific number of labor units.
This facilitates the creation of production schedules and guarantees the
effective distribution of human resources.
 Determining Optimal Labor Input: Managers can ascertain the ideal
workforce size required to reach a target production level by analyzing how
output varies with varying labor levels. This lowers expenses by preventing
either understaffing or overstaffing.
2. COST MANAGEMENT
 Cost estimation: The production function aids in anticipating how changes in
labor input will affect overall production costs because labor expenditures
make up a sizable portion of total production costs. With this information,
managers can more efficiently plan budgets and control expenses.
 Marginal productivity analysis: Managers can examine the marginal product
of labor (MPL), or the extra output produced by using one more unit of labor,
using the use of the production function. Determining whether to invest in
other areas or recruit more staff requires an understanding of MPL.

3. CAPACITY UTILIZATION
 Maximizing utility: Managers can determine whether the present labor input
is being used effectively by using the production function. It may be a sign of
underutilized labor if production is below capacity; changes can be made to
increase productivity.
 Identifying diminishing return: When adding more labor results in diminishing
returns, the production function can show this (where additional workers
contribute less to output than prior ones). This aids managers in avoiding wasteful
labor utilization and concentrating on other areas that require development.

4. PRICING AND PROFITABILITY

 Setting price: Managers can calculate the cost of producing extra units by
comprehending the labor-output relationship. Setting pricing that cover costs
and produce the desired profit margin requires knowledge of this information.
 Profit maximization: Managers can use the production function to determine
the level of labor input that maximizes profit. This involves analyzing the
point where the additional revenue generated by hiring one more worker
equals the additional cost of that worker.
5. SCENARIO PLANNING
 Impact of labour changes: The production function is a tool that managers
can use to model various scenarios, including shifts in labor availability, wage
rates, or productivity gains. This facilitates making well-informed decisions in
a variety of situations and preparing for a variety of possibilities.
 Investment decision: Making decisions about investing in automation,
training, or other productivity-enhancing initiatives can be informed by the
production function, which offers insights into how changes in labor input
effect output.

6. BENCHMARKING AND PERFORMANCE EVALUATION

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 Comparing performance: Managers can compare the company's productivity

to competitors' or the industry's norms using the production function. This
makes it easier to see where the company is falling short and where it can
catch up.
 Performance metrics: Key performance indicators (KPIs) pertaining to labor
efficiency can be created using the production function, which will assist
managers in assessing and enhancing worker performance.

Managers can increase profitability and competitive advantage by

using the insights from a one-variable production function to drive their
decisions about labor utilization, cost control, and overall production
efficiency.

4.5 TWO VARIABLE INPUT PRODUCTION FUNCTION

A more intricate type of production function that takes into account the relationship between
output and two inputs, usually labor (L) and capital (K), is called a two-variable input
production function. A more sophisticated comprehension of the ways in which various
combinations of these inputs influence the production process is made possible by this kind
of function.
The two-variable production function can be represented as:
Q=f(L,K)
Where:
 Q is the quantity of output.
 L is the amount of labor.
 K is the amount of capital.

A common example of a two-variable production function is the Cobb-Douglas

production function, which is often written as:

Q=A×Lα×Kβ

 Where: A is a constant representing total factor productivity.

 αand β are the output elasticities of labor and capital, respectively. These
parameters measure the percentage change in output resulting from a 1%
change in labor or capital.
 L is labor input.
 K is capital input.

FEATURES

1. Returns to Scale: The function can exhibit different types of returns to scale
depending on the values of α\alphaα and β\betaβ:
 Constant Returns to Scale: If α+β=1\alpha + \beta = 1α+β=1, doubling both
inputs will double the output.

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 Increasing Returns to Scale: If α+β>1\alpha + \beta > 1α+β>1, doubling

both inputs will more than double the output.
 Decreasing Returns to Scale: If α+β<1\alpha + \beta < 1α+β<1, doubling
both inputs will less than double the output.
2. Substitutability: The two inputs can often be substituted for each other to some
extent. For example, in some cases, more capital can compensate for less labor, and
vice versa.
3. Marginal Products:
 Marginal Product of Labor (MPL): The additional output produced when
one more unit of labor is added, holding capital constant.
 Marginal Product of Capital (MPK): The additional output produced when
one more unit of capital is added, holding labor constant.

Managerial Implications:

 Input Combination: Managers can use the two-variable production function to

determine the most efficient combination of labor and capital to maximize output or
minimize costs.
 Investment Decisions: Determining whether to increase labor, capital, or a
combination of the two can be aided by having a better understanding of how output
reacts to changes in labor and capital.
 Cost Efficiency: Managers can determine the least-cost combination for generating a
specific level of output by weighing the trade-offs between labor and capital.
In conclusion, a two-variable input production function gives businesses a more
thorough understanding of the production process, enabling them to more effectively
allocate their resources and maximize output.

4.6 ISO QUANTS

The isoquant curve, also known as a "Equal Product Curve," "Production Indifference
Curve," or "Iso-Product Curve," is a firm's equivalent of the consumer's indifference curve. It
is a curve that displays all the combinations of inputs that result in the same level of output.
Since "quant" means quantity and "iso" means equal, an isoquant represents a constant
quantity of output.

The concept of isoquant can be explained with the help of a schedule as below.;

TABLE 4.2

Combination of Units of labor (L) Units of capital (K) Out put in KG

labor and capital
A 5 9 100
B 10 6 100
C 15 4 100
D 20 3 100

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The above table is based on the assumption that only two factors of production, namely,
Labor and Capital are used for producing 100 kg.
Combination A = 5L + 9K = 100 kg
Combination B = 10L + 6K = 100 kg
Combination C = 15L + 4K = 100 kg
Combination D = 20L + 3K = 100 kg

Combinations A, B, C, and D demonstrate how different labor and capital combinations can
be used to produce 100 meters of cloth. As a result, an isoquant schedule is one that uses
various combinations of production parameters to produce the same amount of output.

The iso product curve is given below which is a graphical representation of iso product
schedule.

It shows different combination of input i.e labor and capital to produce a given
quantity of output.

ISOQUANT MAP

A collection of isoquants that represent various output levels are represented by an

isoquant map. Each isoquant in an isoquant map displays different labor and capital
combinations that can be used to generate a specific amount of output.

Figure 4.3

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It is a set of isoquants that shows the maximum attainable output from any given
combination of input.

FEATURES OF ISOQUANTS
Different features of isoquants are explained as below

1 . Higher isoquant shows higher level of output: This is because of the fact that on the
higher isoquant, we have either more units of one factor of production or more units of both
the factors. This has been illustrated in figure 4.4. In figure 4.4, points A and B lie on the
isoquant IQ1 and IQ2respectively.

At point A we have = OL units of Labor and OK units of capital. At point B we have = OL1
units of Labor and OK1 units of capital. Though the amount of capital (OL) is the same at
both the points, point B is having LL1 units of labor more. Therefore, it will yield a higher
output. Hence, it is proved that a higher isoquant shows a higher level of output.

Figure 4.4

5. Two isoquants can not cut each other: Since each isoquant represents a distinct
output level, isoquants do not intersect. The same set of inputs can't result in two
distinct output levels, as implied by the intersection of two isoquants.this can be
illustrated with the below figure 4.5.

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Figure 4.5

In figure 4.5, the isoquant IQ1 shows say 100 units of output produced by various
combinations of labor and capital and the curve IQ2 shows says 200 units of output, On
IQ1, we have A = C, because they are on the same isoquant. On IQ2, we have A = B
Therefore B = C This is however inconsistent since C = 100 and B = 200. Therefore,
isoquants cannot intersect.

3. Isoquants are convex to the origin: As a reflection of the falling marginal rate of
technological substitution (MRTS), isoquants are convex to the origin. The amount of the
other input needed to maintain the same output level reduces at a declining rate when more of
one input is used.

Figure 4.6

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In figure 4.6, as the producer moves from point A to B, from B to C and C to D along an
isoquant, the marginal rate of technical substitution (MRTS) of labor for capital
diminishes. The MRTS diminishes because the two factors are not perfect substitutes. In
figure 4.6, for every increase in labor units by (ΔL) there is a corresponding decrease in
the units of capital (ΔK).

It cannot be concave as shown in figure 4.7. If they are concave, MRTS of labor for
capital increases. But this is not true of isoquants.
Figure 4.7

Since MRTS must diminish isoquants must be canvex to the origin.

4 . No isoquant can touch either of the axis: If an isoquant touches the X-axis it would
mean that the commodity can be produced with OL units of labor and without any unit of
capital.

Figure 4.8

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Point C on the Y-axis implies that the commodity can be produced with OC units of
capital and without any unit of labor. However, this is wrong because the firm cannot
produce a commodity with one factor alone.

5. Isoquants are negatively sloped: An isoquant slopes downwards from left to right.
The logic behind this is the principle of diminishing marginal rate of technical
substitution. In order to maintain a given output, a reduction in the use of one input must
be offset by an increase in the use of another input.
Figure 4.9

Figure 4.9 shows that when the producer moves from point A to B, the amount of labor
increases from OL to OL1, but the units of capital decreases from OK to OK1, to
maintain the same level of output.

6 . Isoquants need not be parallal: An isoquant's form is determined by the technical

substitution rate's marginal rate. Two components do not have to be parallel as the rate of
substitution between them does not have to be the same in every isoquant schedule.
Figure 4.10

7 . Each isoquants is oval shaped: An important feature of an isoquant is that it enables the
firm to identify the efficient range of production consider figure 4.11.
sFigure 4.11

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MANAGERIAL USE OF ISOQUANTS

In production theory and economics, isoquants are curves that show many combinations of
inputs that produce the same level of output. Managerial decision-making can greatly benefit
from knowing and applying isoquants in a number of ways. An outline of the applications of
isoquants in managerial settings is provided below:
1. INPUT SUBSTITUTION
 Understanding trade offs: Managers can learn how to switch out one input for
another while keeping output at the same level with the use of isoquants. For
example, isoquants can show how quickly one input may be switched out for
another without compromising output if a business is thinking about replacing
labor with capital (or vice versa).


Cost efficiency: Managers can determine the most economical mix of inputs
by examining isoquants. This aids in reaching targeted output levels while
reducing expenses.
2. PRODUCTION PLANNING
 Optimum input mix: Isoquants can be used by managers to identify the best
combination of inputs to generate a specific amount of output. This is
especially helpful for scheduling and planning production.

 Resource allocation: Isoquants support the allocation of resources to various

production processes, guaranteeing that inputs are used efficiently.

3. ANALYSING RERTURNS TO SCALE

 Scale economics: Managers can determine if the production function shows
increasing, constant, or declining returns to scale by looking at the form and
position of isoquants. Scaling operations and capacity planning are made
easier with this understanding.

4. PRODUCTION FUNCTION
 Understanding MRTS: The MRTS is represented by the slope of the
isoquant, which shows how much of one input can be changed without
affecting the output. With this knowledge, managers may choose the best
combinations of inputs.

 Input efficiency: Managers can use isoquants to identify diminishing returns,

or the point at which adding more of one input would result in less incremental
output.

5. COST MINIMIZATION

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 Cost curves analysis: To determine the least-cost combination of inputs for a

specified output level, managers can combine isoquants with isocost lines,
which indicate combinations of inputs that cost the same. The ideal input
combination is shown by the point where an isoquant is tangent to an isocost
line.

6. SCENARIO ANALYSIS
 What if analysis: Managers can predict different scenarios based on changes
in production practices, technology, or input pricing by using isoquants. This
can be useful in assessing the possible effects of modifications on costs and
production efficiency.

7. STRATEGIC DECISSION MAKING

 Long term planning: Knowing isoquants can help with strategic planning,
which can improve alignment with overarching business objectives when
making decisions about new technology investments or changes to production
strategies.
The application of isoquants by managers offers a useful
foundation for examining and improving production processes. Managers can
increase operational efficiency and competitiveness by using the insights from
isoquants to guide strategic planning, cost management, and resource
allocation decisions.

4.7 FORMULATION OF COBB DOUGLASS PRODUCTION FUNCTION

In economics, the Cobb-Douglas functional form of production functions is widely used to

represent the relationship of an output to inputs. It was proposed by Knut Wicksell (1851 -
1926), and tested against statistical evidence by Charles Cobb and Paul Douglas in 1928.
In a research they published in 1928, Charles Cobb and Paul Douglas modeled the
expansion of the American economy from 1899 to 1922. They examined a spartan
interpretation of the economy in which the quantity of labor and capital invested determine
the production output. Despite the fact that there are numerous other elements that affect
economic performance, their model turned out to be incredibly accurate.

The function they used to model production was of the form: P(L, K) = bL^αK^β
where:

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 P = total production (the monetary value of all goods produced in a year)

 L = labor input (the total number of person-hours worked in a year)
 K = capital input (the monetary worth of all machinery, equipment, and
buildings)
 b = total factor productivity
 α and β are the output elasticities of labor and capital, respectively. These
values are constants determined by available technology

Ceteris paribus, output elasticity quantifies how sensitive output is to variations in the
amounts of labor or capital used in production. For instance, if α = 0.15, then an increase in
labor of 1% would result in an increase in output of roughly 0.15%.

Further, if: α + β = 1, the production function has constant returns to scale. That is, if L and K
are each increased by 20%, then P increases by 20%.

A technical feature of production known as returns to scale studies variations in

output following a proportionate change in all inputs (where all inputs rise by a constant
factor). Constant returns to scale (CRTS), commonly known as returns to scale, exist if
output rises by that same proportionate change.Decreasing returns to scale occur when output
grows less than that proportionate change (DRS). There are increasing returns to scale (IRS)
if output grows by a greater percentage.

However, if α + β < 1, returns to scale are decreasing, and if α + β > 1, returns to scale are
increasing. Assuming perfect competition, α and β can be shown to be labor and capital’s
share of output.

ASSUMPTIONS
If the production function is denoted by P = P(L, K), then the partial derivative ∂P/ ∂L is the
rate at which production changes with respect to the amount of labor. Economists call it the
marginal production with respect to labor or the marginal productivity of labor. Likewise, the
partial derivative ∂P/ ∂K is the rate of change of production with respect to capital and is
called the marginal productivity of capital. In these terms, the assumptions made by Cobb and
Douglas can be stated as follows:
1. If either labor or capital vanishes, then so will production.
2. The marginal productivity of labor is proportional to the amount of production per unit of
labor.
3. The marginal productivity of capital is proportional to the amount of production per unit
of capital.

Because the production per unit of labor is P/ L , assumption 2 says that ∂P /∂L = α P /L
for some constant α. If we keep K constant(K = K0) , then this partial differential equation
becomes an ordinary differential equation:
Dp/ dL = α P/L
This separable differential equation can be solved by re-arranging the terms and integrating
both sides:
1 /P dP = α 1 /L dL
ln(P) = α ln(cL)

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ln(P) = ln(cLα )

And finally,
P(L, K0) = C1(K0)L α (1)
where C1(K0) is the constant of integration and we write it as a function of K0 since it could
depend on the value of K0. Similarly, assumption 3 says that;
∂P/ ∂K = β P/ K
Keeping L constant(L = L0), this differential equation can be solved to get:
P(L0, K) = C2(L0)Kβ
(2)
And finally, combining equations (1) and (2):
P(L, K) = bLαKβ (3)
where b is a constant that is independent of both L and K. Assumption 1 shows that α > 0 and
β > 0.
Notice from equation (3) that if labor and capital are both increased by a factor m, then
P(mL, mK) = b(mL) α (mK) β
= mα+β bLαKβ
= mα+ β P(L, K)
If α + β = 1, then P(mL, mK) = mP(L, K), which means that production is also increased by a
factor of m.

4.8 THE THEORY OF COST

Cost can be described as the total monetary value of all the sacrifices made in order to
produce goods and services, for example. When making decisions for a firm, costs are
crucial. The base price is determined by the cost of manufacture. It aids managers in making
the right choices on things like what price to quote, whether to place a specific order for
inputs, whether to drop or add a product to the lineup, and so on.
Generally speaking, costs are the financial outlays a company incurs during the
production process. The owner-manager's income and the estimated worth of the business
owner's personal assets and services were also included in the cost.

DETERMINANTS

These are the different determinants of cost.

(a) Size of plant: The cost and size of the plant are inversely correlated. Cost decreases with
plant size and vice versa.
(b) Level of Output: There is a clear correlation between cost and output level. Greater
output translates into higher costs (i.e., total cost), and vice versa.
(c) Price of Inputs: Cost and the price of inputs are directly correlated. Cost increases in
tandem with input price increases.
(d) State of technology: More modern and upgraded the technology implies lesser cost and
vice versa.
(e) Management and administrative efficiency: Cost and efficiency have an inverse
relationship. The product will be better and cost less if management and administration are
more efficient. If there are administrative and management inefficiencies, costs will go up.

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CONCEPT OF COST

Cost is a fundamental element in corporate decision making. In order to make wise business
decisions, the business manager must understand several cost concepts and how they are
used.
1.Actual cost: Cost refers to the real money spent on the production of goods and services.
Some examples of actual costs are the value of raw materials, wages, rent, salaries paid,
interest on borrowed capital, etc. Other names for actual cost include absolute cost, outlay
cost, and money cost.
2. Opportunity Cos: The gains that are lost from not using a particular resource for its
greatest possible use are used to calculate the opportunity cost. For instance, the same raw
materials may be used to make military hardware as well as automobiles. Opportunity cost's
primary points are:
A) The opportunity cost of any commodity is only the next best alternative forgone.
B) The next best alternative commodity that could be produced with the same value of
the factors, which are more or less the same.
C) It helps in determining relative price of factor input at different places.
D) It helps in determining the remuneration to services.
E) It helps the manager to decide what he should produce in the factory.
3. Explicit cost: A cost that is directly incurred by the business, company, or organization
during production is known as an explicit cost. The company accountant maintains a record
of the explicit cost. Raw materials, rent, salaries, and wages are a few instances of clear costs.
Another name for the explicit cost is out-of-pocket expense. This expense is useful for
computing economic and accounting profit.
4. Implicit cost: Its exact opposite is the implicit cost, which is the expense that the business
or corporation does not bear directly. There is no financial outflow associated with implicit
costs. It is said to be traced back even if it is not in the record. The owner's compensation or
the interest on their capital are two common examples of implicit costs. Imputed cost is
another name for the implicit cost. Prices of factor inputs at various locations are solely
determined to yield the economic profit through implicit cost.
5. Incremental cost: The additional expenses resulting from a change in the volume of
output or the type of activity are known as incremental costs. It could involve introducing a
new product, altering the route of distribution, installing new equipment, etc. Although it
seems to resemble marginal cost, it is not the same as managerial cost. Marginal cost is the
price per additional unit of output.
6. Sunk cost: Sunk costs are expenses that are unchangeable. Uncured costs are referred to as
sunk costs. Take the expense involved in building a plant, for instance. Costs are already
incurred during the construction of the factory facility. The building must be used for the
purposes that were initially intended. It cannot be changed in response to changes in
operation. One instance of sunk cost is the purchase of machinery.
7. Shutdown cost: Shutdown costs are expenses that would be spent should plant activities
be suspended but that might be avoided if operations were carried out as planned. For
instance, the price of building shelters to protect exposed property and covering plant
equipment, or the cost of fixed costs and upkeep, etc.
8. Abandonment cost: The costs incurred when a fixed asset is completely removed from
service are known as abandonment costs. These could happen as a result of the company's
improvisation or obsolescence. Abandonment charges consequently involve the asset's
disposal issue.

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9. Book cost: Book costs are business expenses that are recorded in the books of accounts
without requiring a cash payment; instead, a provision is made for them so that they can be
included in the profit and loss statement and qualify for tax benefits.
10. Out of pocket cost: Expenses or costs that include ongoing payments to other parties
outside the company are referred to as out-of-pocket charges. The term "out of pocket costs"
refers to all of the explicit costs.
11.Past cost: Actual expenses paid in the past are known as past costs. Since there is no room
for managerial discretion and the previous expenditures have already been expended, these
costs are disclosed in the financial records. The administration is unable to make any changes
in the present even if it discovers that the previous expenses were exorbitant.
12. Future cost: Future costs are those that will need to be paid for in the not too distant
future. This is merely an estimate. Future expenses are important for managerial choices since
they allow the management to assess the expenditure's acceptability. If the management
believes that future costs will be exceptionally high, it may choose to either lower them or
postpone using them.
13. Direct cost: Direct costs are associated with a particular procedure or good. Since we are
able to link them specifically to a certain process, product, or activity, they are also known as
traceable expenses. When the activity or product changes, they may also alter.Expenses
associated with production, such as those related to manufacturing or client acquisition, are
examples of direct expenses.
14. Indirect cost: Untraceable or indirect expenses are those that are not directly related to a
particular business activity or component. For instance, higher electricity costs or income
taxes that must be paid. Indirect costs are significant because they have an impact on overall
profitability even though we are unable to track them.
15.Fixed cost: The amount a company spends in the short term on fixed inputs is known as
its fixed cost. Therefore, fixed costs are expenses that don't change depending on the volume
of output. Even in the event that the company produces no product, these costs do not alter.
For this reason, fixed costs are also referred to as overhead or supplemental costs.
Figure 4.12

16.Variable cost: Costs that directly alter in response to variations in output volume are
known as variable costs. Variable costs rise in tandem with increased output, fall in tandem
with declining product costs, and reach zero when production ceases.

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Figure 4.13

17. Semi variable cost: This category of expenses falls in between variable and fixed costs.
It isn't entirely fixed or totally variable in respect to variations in output. This kind of
expense, referred to as semi-variable cost, consists of both fixed and variable costs. For
instance, an energy bill often consists of two charges: a variable price that varies according to
the number of units used and a set charge called meter rent. The total amount paid is
considered a semi-variable cost.
Figure 4.14

18. Total cost: Total cost is the total expenditure incurred in the production of goods and
services.
TC= TFC+TVC
19. Average cost: - Average cost is not actual cost, It is obtained by dividing the total cost by
the total output.
AC= Total Cost/Units Produced
20. Marginal cost: - The cost incurred on producing one additional unit of commodity is
known as marginal cost. Thus it shown a change in total cost when one more or less unit is
produced.
MC= TCn – TC(n-1
19. Short run cost: In the short term, there is not enough time to grow the sector; instead, the
increased demand must be satisfied within the confines of the current industry due to a
number of issues that cannot be altered quickly. Accordingly, short run expenses are those
that change with output while capital equipment and fixed plant stay the same.
20. Long run cost: An industry's scale can eventually grow to accommodate the rising
demand for its products; for example, over time, all production variables can be increased in
accordance with demand. Therefore, long-term costs are those that change with output when
all input components, such as plants and equipment, change.

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MANAGERIAL USES OF COST

When it comes to planning, regulating, and optimizing corporate operations, cost is a crucial
factor in managerial decision-making. The following is how managers apply cost data:
1 . Pricing decision: In order to establish product pricing that both cover costs and turn a
profit, managers examine costs. Determining the lowest price point necessary to break even
requires an understanding of fixed and variable costs.
2. Budgeting and forecasting: To create financial predictions and budgets, cost data is
necessary. Managers can better plan their finances by using past cost data to forecast future
revenues and expenses.
3. Cost control: Cost data is used to make financial projections and budgets. By forecasting
future revenues and expenses using historical cost data, managers can make better financial
plans.
4. Profitability analysis: Managers are able to assess the profitability of various departments,
services, and products by having a clear understanding of expenses. Making decisions on the
expansion, reduction, or discontinuation of product lines or services is aided by this study.
5. Decision making: Costs have a significant role in many decisions, including whether to
enter a new market, manufacture or purchase a product, or invest in new machinery or
technology.
6. Performance measurement: Cost data is used by managers to track and evaluate
performance over time or in comparison to industry standards. This aids in evaluating the
efficacy of cost-management initiatives and the operational efficiency.
7. Cost Volume Profit analysis(CVP): CVP analysis is a tool used by managers to
comprehend the connection between expenses, sales volume, and profit. Determining how to
scale operations, set sales goals, and comprehend how cost changes affect profitability are all
aided by this.
8. Inventory management: Cost data is essential for managing and valuing inventories. Cost
information is used by managers to determine optimal inventory levels, reorder points, and
holding and stockout costs.

COST OUTPUT RELATIONSHIP IN SHORT RUN

A short-term shift in output can only be achieved by altering the variable inputs, such as labor
and raw materials. Short-term fixed inputs include land, buildings, machinery, and other
equipment. In other words, the short run is a time frame that is insufficient to increase the
amount of fixed inputs. Therefore, Total Cost (TC) in the short term is made up of two
components: Total Variable Cost (TVC) and Total Fixed Cost (TFC).
TFC doesn't change throughout the course of the duration and is independent of
exercise level. Even if the business is temporarily closed, these expenses will still be incurred
by the company. Even while TFC doesn't change, the fixed cost per unit does as production
levels do.
However, TVC rises in response to an increase in activity and falls in response to a
drop in activity. There are no variable costs in the event that the business closes. While
variable cost per unit is constant, TVC is not.
So in the short-run an increase in TC implies an increase in TVC only.

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Thus: TC = TFC + TVC TFC

= TC – TVC TVC
= TC – TFC TC
= TFC when the output is zero.
The diagram below shows Short-run cost output relationship.
Figure 4.15

In the graph X-axis measures output and Y-axis measures cost. TFC is a straight line parallel
to X-axis, because TFC does not change with increase in output. TVC curve is upward rising
from the origin because TVC is zero when there is no production and increases as production
increases. The shape of TVC curve depends upon the productivity of the variable factors. The
TVC curve above assumes the Law of Variable Proportions, which operates in the short-run.
TC curve is also upward rising not from the origin but from the TFC line. This is
because even if there is no production the TC is equal to TFC.
Because the distance indicates the amount of fixed cost, which never changes, the vertical
distance between the TVC curve and TC curve stays constant throughout. Thus, the TVC
curve and the TC curve exhibit the same behavioral pattern.

Short run average cost and marginal cost:

When costs are stated as costs per unit, they take on greater significance. It is possible to
calculate cost per unit using fixed, variable, total, and marginal costs.

The following table and diagram shows the cost output relationship in short run.
Table 4.2

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Figure 4.16:

:
Average fixed cost(AFC): Average fixed cost is obtained by dividing the TFC by the number
of units produced.
Thus: AFC = TFC/Q where, ‘Q’ refers quantity of production.
Since TFC is constant for any level of activity, fixed cost per unit goes on diminishing as
output goes on increasing. The AFC curve is downward sloping towards the right throughout
its length, with a steep fall at the beginning.
Fixed cost per unit decreases as production increases because TFC is constant at all
activity levels. Over its whole length, the AFC curve slopes downward and to the right, with a
sharp drop at the start.

Average variable cost(AVC):Average Variable Cost is obtained by dividing the TVC by the
number of units produced. Therefore: AVC = TVC / Q
Due to the operation of the Law of Variable Proportions AVC curve slopes downwards till it
reaches a certain level of output and then begins to rise upwards.

Average total cost(ATC): Average Total Cost or simply Average Cost is obtained by dividing
the TC by the number of units produced. Thus: AVC = TVC / Q ATC = TC / Q.

The AFC and AVC curves have a significant impact on the ATC curve. ATC curve declines at
first because AFC and AVC curves both start off declining. The tendency is maintained
throughout by the AFC curve, albeit at a decreasing rate. The AVC curve follows the trend
until it hits a particular level, at which point it begins a gradual rise. The ATC curve declines
for a little while longer before reaching its lowest point, which is plainly farther away than
the lowest point of the AVC curve because this rise initially occurs at a slower rate of fall than
the rate of decrease in the AFC curve.The ATC curve then begins to increase as a result of the
AVC curve's rate of ascent exceeding its rate of decrease.

Marginal cost(MC): Marginal Cost is the increase in TC as a result of an increase in output

by one unit. In other words it is the cost of producing an additional unit of output.

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MC is based on the Law of Variable Proportions. A downward trend in MC curve shows

decreasing marginal cost (i.e. increasing marginal productivity) of the variable input.
Similarly an upward trend in MC curve shows increasing marginal cost (i.e. decreasing
marginal productivity). MC curve intersects both AVC and ATC curves at their lowest points.
The relationship between AVC, AFC, ATC and MC can be summed up as follows.
1. If both AFC and AVC fall ATC will also fall because ATC = AFC + AVC
2. When AFC falls and AVC rises
(a) ATC will fall where the drop in AFC is more than the rise in AVC
(b) ATC remains constant if the drop in AFC = the rise in AVC, and
(c) ATC will rise where the drop in AFC is less than the rise in AVC.
3. ATC will fall when MC is less than ATC and ATC will rise when MC is more than ATC.
The lowest ATC is equal to MC.

COST OUTPUT RELATIONSHIP IN LONG RUN

Understanding what the term "long run" means is essential for researching the cost-output
connection over an extended period of time. It is well recognized that an industry may grow
to accommodate the rising demand for its products over time, and as a result, all production
parameters can be adjusted over time to suit changing demands. Long-term expenses are
therefore those that change with output while all other input components, such as plant and
equipment, change.
Figure 4.17

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As per the above figure suppose that at a given time the firms operate under plant SAC2 and
produces output OQ. If the firm decides to produce output OR and continues with the current
plant SAC2 its average cost will be uR. But if the firm decides to increase the size of the
plant to plant SAC3 its average cost of producing OR output would then be TR. Since cost
TR is less than the cost on old plant uR, therefore new plant SAC3 is preferable and should
be adopted. Thus the long run cost of producing OR output will be TR which can be obtained
by increasing the plant size.

COST CONTROL

Through competitive analysis, we aim to control overall costs in the process of cost control. It
makes certain that the production costs don't exceed the budgeted amounts. The first step in
the process of controlling costs is creating a budget that takes production into account. After
that, we assess the real performance. Next, we calculate the differences between the actual
and budgeted costs and investigate the causes of those differences. Lastly, we put the required
measures into practice to fix the disparities.
The main purpose of cost accounting is cost control. A cost accountant evaluates real
expenses under cost management, compares them to standards, and identifies variances. To
lessen the differences, redial steps are then implemented. It entails taking a number of steps to
ensure that costs stay within allocated limits and don't go overboard. Reducing the overall
cost of production is the main goal of cost control.

FEATURE OF COST CONTROL

It has following features.
1 . It is an attempt to keep the expenses within the control.
2 . It's an ongoing process that involves creating targets and standards, creating budgets, and
then regularly comparing the real to these targets.
3. It requires a continuous cost control report to identify the variances to be resolved.
4. It serves as a source of inspiration and incentive for staff members to meet financial
objectives and maintain cost control.
5. In order to achieve better results with the same resources, it is not only focused on cutting
costs but also on making efficient use of such resources.

ADVANTAGES OF COST CONTROL

The main advantages of cost control are:

1. hrough the resolution of variances between real and expected standards, cost control
aids in achieving the expected return on capital spent in a corporation.
2. Improved manufacturing standards are achieved through cost control, even with the
company's limited resources.
3. Cost control reduces the prices or tries to maintain it by reducing the cost.
4. Cost control leads to economic use of resources.
5. It increases profitability and competitive position of a company.
6. It enhances credit worthiness of the company.
7. It prospers and increases economic stability of the industry.
8. It increases the sales of the company and maintains the level of employment.

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DISADVANTAGES OF COST CONTROL

The main disadvantages of cost control are:

1. It reduces the flexibility and process improvement in a company.
2. It restricts innovation by emphasizing to reaching the preset standards
3. It requires skilled personnel to set standards.
4. It lacks creativity as it is concerned with following the current standards
5. It does not lead to improvement in standards

TECHNIQUES OF COST CONTROL

 Standard costing: Establishing a standard cost, comparing it to real costs, and

examining any differences is known as standard costing. It supports cost estimation
and the identification of variation reasons.
 Inventory control: Inventory control is the process of controlling the acquisition and
use of materials to keep up production without preventing the inflow of additional
finances. It attempts to minimize material waste and promotes efficient use of it.
 Budgetary control: The process of ongoing comparison is known as budgetary
control. It operates by establishing budgets and regularly comparing them to actual
spending. It involves determining the causes of deviations and updating the budgets to
reflect requirements. It facilitates regulating, coordinating, and planning.
 Ratio analysis: Ratio analysis shows how several variables relate to one another.
Recognizing organizational trends is beneficial. Ratio analysis is also used to compare
various firms on several fronts. Its primary purpose is to compare performance to
external standards and other organizations.
 Variance analysis: Variance analysis is a method of cost control. It involves the
identification of the amount of variance and to analyze the reasons of these variances.
A variance is which varies from the standards set. It can be favourable or
unfavourable.
FEATURE OF A GOOD COST CONTROL SYSTEM

According to Jacobson and Backer, effective cost control should have the following
characteristics.

a. Delineation of center’s responsibility, i.e., deciding responsibility centers

b. The delegation of prescribed authority
c. Various cost standards
d. The relevance of controllable cost
e. Cost reporting; and
f. Cost reduction

COST REDUCTION

Cost cutting guarantees lower costs per unit and increases the company's profitability to the
highest level. The goal of cost reduction is to eliminate needless expenditures related to
product distribution, selling, and storage that arise during the production process. The

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following key components should be our primary focus when identifying cost reduction:
savings in production costs per unit, preservation of product quality, and non-volatile savings.
Cost reduction is real and permanent reduction in unit cost of goods and services
provided by the organization with effecting their quality and efficiency. There are different
techniques used for cost reduction which can be budgetary control, standard costing, material
control, labour control and overhead control. Cost reduction focuses on decreasing per unit
cost of a product. Cost reduction is a continuous process. It has no visible end.

FEATURE OF COST REDUCTION

It has following features.
1 . A true cost reduction can be achieved by bringing down the cost of production.
2 . Cost-cutting measures include long-term cost reduction. There are many internal causes
for it. For instance, because it is not permanent, a reduction in government taxes is not
regarded as a cost reduction.
3. Increasing the amount produced is another way to cut costs. That implies that while
spending will decrease, output will rise.

4 Unit cost is reduced either by decreasing the expenditure at a given level of output.
5. Cost reduction doesn’t decline the quality of production. It remains the same.

ADVANTAGES OF COST REDUCTION

The main advantages of cost reduction are:

a. Cost reduction increases the profitability of an organization.
b. Cost reduction enhances the cash flow of the company.
c. Cost reduction program helps in achieving the goals of the company.
d. It is permanent in nature which affects the organizational performance in the long run.
e. Cost reduction does not impair the quality of the production while reducing the cost.

DISADVANTAGES OF COST CONTROL

The main disadvantages of cost control are:

a. Employees and workers inside an organization typically strive to oppose and dislike
the implementation of cost-reduction programs. These are thought to be challenging
to put into practice.
b. Programs for cutting costs are always in progress. There is a constant effort to cut
costs. However, the majority of firms apply them haphazardly.
c. A cost-reduction strategy necessitates extensive study, raising the company's
expenses.
d. The Cost reduction technique needs to be implemented in a planned manner.
e. The cost reduction technique cannot be applied in all the cases.

4.9 SUMMARY

 A production function is a mathematical expression that provides a physical

explanation of the technical relationship between input and output over a certain time
period. According to Koutsoyiannis, “ the production function is purely a technical
relation which connects factor inputs and output. The generic form of the production

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function states that the quantity of inputs and production methods determine the
output of any commodity. Considering the state of technology, a commodity is
produced utilizing a variety of techniques that employ various combinations of
variables.
 Producers can alter output in the near term by adjusting the variable components
alone. Assume that a company employs two factors: capital and labor, where capital is
a fixed element and labor is a variable. The ratio in which these components are used
will alter if labor is increased to enhance output while maintaining the same level of
capital. Therefore, the only way to alter output is to alter labor. Variable proportion
production function is another name for this kind of production function.
 Cost is a fundamental element in corporate decision making. In order to make wise
business decisions, the business manager must understand several cost concepts and
how they are used.

4.10 GLOSSARY

Sunk cost: Money that already has spent and can not recover.

Law of variable proportion: when the quantity of one variable increased keeping all
other constant there will be a decline in MP of that factor .

Return to scale:Proportionality of change in output after the amount of all input in

production have been changed by the same factor.

Cost Reduction: Reducing cost without affecting quality.

Cost Management: Collection analysis and presentation of data to manage the cost.

Budgetary Control: Controlling the cost by creating budgets. Standard Costing:

Setting standards to compare with actual performance.

4.11 QUESTIONS AND EXERCISES

SHORT QUESTIONS
1.Define production
2. Define production function
3. Distinguishes between short period and long period production functions
4. What is meant by IPP?
5. Define APP.
6. Define MPP.
7. Explain the relationship between TPP and MPP.
8. Explain the relationship between APP and MPP.
9. Explain the law of variable proportions with the help of a schedule and a diagram.
10. What are the reasons of the operation of law of variable proportions?

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11. What are general shapes of APP and MPP?

12. Distinguish, between fixed factors and variable factors.

LONG QUESTIONS

1. Define concept of cost control with its features and example.

2. What are different advantages and disadvantages of cost control?
3. Differentiate between cost control and cost reduction.
4. Explain different techniques used under cost control.
5. What do you mean by cost reduction? Discuss its advantages and disadvantages
6. Explain the law of variable proportion
7. Explain the return to scale.
8. distinguish the short run and long run cost.

UNIT 5

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BASIC OF PRODUCTION FUNCTION

STRUCTURE

5.1Introduction
5.2Objectives
5.3Perfect competition
5.4 Monopoly
5.5Monopolistic competition
5.6Oligopoly
5.7 Game theory and oligopolistic behavior
5.8 Duopoly
5.9 Regulatory aspect of monopoly
5.10 Pricing strategy
5.11Summary
5.12 Glossary
5.13Questions and Exercises

5.1 INTRODUCTION

Managers must use the data they have on costs and demand to decide on strategies for
pricing, output, and other factors in order to maximize profits or shareholder wealth.
Managers must, however, also be mindful of the kind of market structure in which they
function since this has a significant impact on strategy; this holds true for both short- and
long-term decisions about expanding into new markets or altering capacity.
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It is helpful to begin by outlining the features of markets and the various forms of
market structure, along with a broad analysis of the connections between conduct, structure,
and performance. After that, the four primary market structure types are examined and their
strategic implications explained.

5.2 OBJECTIVE

After studying this unit you will be able to understand:

 You will know about perfect competition.
 Know about monopoly and monopolistic competition
 Know about duopoly, oligopoly and game theory
 Know more about the pricing strategy

5.3 PERFECT COMPETITION

A market for a commodity in which a sizable number of unorganized buyers and sellers
compete with one another in the purchase and selling of the commodity without having any
personal influence over the market price of the commodity is referred to as perfectly
competitive. Thus, it is a market structure where a large number of customers and sellers
exchange uniform products free from government intervention.
Mrs John Robinson has defined perfect competition in terms of price elasticity of
demand. According to her, “Perfect competition prevails when the demand for the output of
each producer is perfectly elastic”.
According to Leftwitch, “Perfect competition is a market in which there are many
firms selling identical products with no firm large enough relative to the entire market to be
able to influence market price”
In summary, a perfectly competitive market is one in which a sizable number of
buyers and sellers are engaged in the purchase and sale of goods. All producers produce
identical products. When a market is completely competitive, all producers must accept the
price that is determined by supply and demand. The "one market, one price" golden rule
functions fully and constantly in an environment of perfect competition.
FEATURES OF PERFECT COMPETITION

The different features of perfect competition are as follows.

1. Large number of buyers and sellers: Even if there are many buyers and sellers in a
perfect market, each one only purchases or sells a little portion of the production. It is
not possible for individual vendors or purchasers to affect supply or demand.
Individual sellers are price takers; an industry operating in perfect competition
determines prices by balancing supply and demand.
2. Homogeneous product: In a market with perfect competition, vendors are expected
to offer only identical goods. All of the consumers in the market must believe that
their items are the same. Sellers should not differentiate their items based on factors
such as quality, variety, color, style, packaging, or other aspects of the product's sale.
Therefore, in a market with perfect competition, customers have no other reason to
choose one seller over another and buy a seller's product other than price.
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3. Free entry and free exit: In a market with perfect competition, any company can
enter or exit the sector. In a sector with perfect competition, businesses are free to
enter and exit at any time. Company may come in to split the profits or it may depart
to prevent losses. Businesses are not required by law or society to stay in or leave a
given industry. This requirement must be met, particularly for the industry's long-term
equilibrium.
4. Maximization of profit: Under perfect competition, all the firms have a common
goal of profit maximization. No other goal is being pursued by any firm.
5. Perfect knowledge of market among buyers and sellers: It is imperative that both
buyers and sellers possess complete awareness of the market conditions within which
they are functioning. Sellers need to be aware of the pricing that other vendors in the
market are quoting. In a similar vein, buyers need to be aware of the prices that
various vendors are asking in order to attempt to buy from the seller offering the best
deal. In theory, this means that neither the sellers nor the purchasers may take
advantage of the party by deceiving them.
6. Perfect mobility of goods and factors of production: Under perfect competition
across industries, there is perfect mobility of factors and goods. A factor can go to any
industry where he can be paid more, and a good can be sold where it can command a
high price. In terms of pricing or production factor, no company is monopolistic.
7. Very less transportation cost: Under perfect competition transportation costs will not
influence the price of the product. There will not be any change in the price due to
location of different sellers.
8. No govt. intervention: In the market, there is no state or government. It indicates that
no tariffs or other forms of government support are being applied to the demand for
any particular commodity. Firm is therefore a price taker.

PRICE DETERMINATION UNDER PERFECT COMPETITION

The price determination under perfect competition can be explained under three
situations:
 Market period price
 Short period price
 Long period price

MARKET PERIOD PRICE

The market period is a brief window of time during which neither supply nor demand can
change. Temporary factors have an impact on demand during the market time. During the
market phase, the supply is completely elastic. When it comes to perishable items, the
quantity demanded does not affect the supply, regardless of how much is available. When it
comes to durable products, you can bring them from the store to change the supply. If there is
less demand, some quantity can be placed into stock; conversely, if there is less demand,
supply can be boosted by bringing in more inventory from the store.

To study price determination in such a market, goods are divided into two parts i.e. perishable
goods and durable goods.
 PERISHABLE GOODS: Items that spoil quickly and cannot be refrigerated or
stored include fish, vegetables, milk, and other items that would go bad if maintained.
As a result, every last bit of the specified stock must be sold on the open market for

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the best price. Thus, the supply curve is perfectly inelastic during the market period.
The Y-axis is parallel to it. This is depicted in the following figure:

FIGURE 5.1

This diagram shows the price determination of market period price. MS is the supply curve,
DD is the initial demand curve which intersects the supply curve MS at point E. The
equilibrium price is OP and the quantity demanded and supplied is equal to OM. Now due to
a sudden rise in the demand for product shifted DD to D1D1, now the new equilibrium is at
point E1 and the price increases to OP1. If demand decreases, the demand curve shifted
D2D2, and the new equilibrium price becomes OP2. This shows that in case of perishable
goods, price increase or decrease with change in demand, supply being perfectly inelastic.

 DURABLE GOODS: When it comes to durable products, supply can be somewhat

adjusted from stock but eventually becomes perfectly inelastic. Although the supply
of these commodities is limited until the stock runs out, it can be raised even
throughout the market period. In this instance, the firm has a "minimum reserve price"
below which they would be unwilling to sell the goods. Businesses stock the items
when prices start to drop below the "minimum reserve price" and wait for demand to
pick up and prices start to rise beyond the minimum level. Thus, supply can be
changed within a market period, but only in relation to the amount that is in stock.
The forces of the market dictate the cost of durable goods. This is shown in below
figure 5.2.
FIGURER 5.2

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In this figure quantity is measured on ‘OX’ axis and price is taken on ‘OY’ axis. DD
is the demand curve and TS is the total supply of durable goods in the market period.
OM is the total supply of durable goods minimum price is set at OT. If the demand
curve is D1D1, and it intersects the supply curve TES at point E1, the equilibrium
price is OP1. A shift in the demand curve from D1D1 to DD shows an increase in
demand, and along with it the new equilibrium price rises from OP1 to OP. Thus, the
further increase in demand beyond DD will have only the effect of raising the price,
and the quantity supplied remains unchanged.

SHORT PERIOD PRICE

A short period is when supply is modified to a restricted degree. It indicates that supply has
been modified to match current production capacity. Overworking production variables can
increase supply in response to rising demand. A manufacturer can quickly alter just the
variable production parameters; the fixed factors stay fixed.

Figure 5.3

This diagram shows equilibrium of industry. Initially, demand and supply equalize on point
E, determining the price which will be taken by the firm as given and firms earn just normal
profits. In case demand increases, demand curves shift upward to D2 resulting into change in

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equilibrium on point E2. Accordingly, firms average revenue and marginal revenue curve
shift upward and firm will attain equilibrium on point E2 earning excess profit. In case
demand decreases, demand curve shift downward to D1 resulting into equilibrium in the
industry on point E1. Accordingly, AR/MR of the firm shift downward. The firm attains
equilibrium in (a) diagram. The firm undergoes loss but will continue as it fulfills the variable
cost. Hence, it is proved that in short period, firm faces three possibilities: (a) earn excess
profit, (b) earn normal profit, (c) loss.

LONG PERIOD PRICE

A long period is when the fixed factor turns variable. Thus, with time, every fixed factor
becomes erratic. A typical price is one that is established over an extended period of time.
Over an extended duration, supply fully satisfies demand. During this time, it is possible to
replace outdated machinery, plants, and equipment with new ones. Under perfect
competition, firms are free to enter and depart the market at any time. In long period, neither
excess profit nor loss can occur. Only normal profits will occur. And price thus determined
called, Normal price. So, normal price is a price which tends to prevail in the market. It is a
probable but not a real price. In long period supply are in equilibrium at that point normal
price will be determined.

Figure 5.4

In the long period, there is no tendency of new firms to enter into market and old firms to
leave the industry. Industry attains equilibrium as usual where demand equalizes supply. In
case of firm, if there is excess profit, new firms will enter into the market. If there is loss,
some firms will leave the market. Only those firms will attain equilibrium which earns just
normal profit. It means in a long period firm will attain equilibrium where three conditions
satisfied. Firstly MC=MR, secondly MC cut MR from below and lastly MC=MR=AR=AC In
this diagram industry attain equilibrium where demand and supply are equal to each other.

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Firm attain equilibrium where all the three conditions are applicable. Firm earn just normal
profit.

5.4 MONOPOLY

The word monopoly has been derived from the combination of two words i.e., ‘Mono’ and
‘Poly’. Mono refers to a single entity and poly to control. In this way, monopoly refers to a
market situation in which there is only one seller of a commodity.

There are no close substitutes for the commodity that monopoly firm produces and there are
barriers to entry. The single producer may be in the form of individual owner or a simple
partnership or a joint stock company. In other words, under monopoly there is no difference
between firm and industry.
A monopolist has complete control over the commodity supply. It uses its monopoly power to
set the price because it controls the commodity's supply.
So, a monopolist who is a lone seller or producer could be a king without a crown. The cross-
elasticity of demand between the monopolist's product and any other seller's product needs to
be extremely low in order for there to be an effective monopoly.

“Monopoly is a market situation in which there is a single seller. There are no close
substitutes of the commodity it produces, and there are barriers to entry”. -Koutsoyiannis

“Under pure monopoly there is a single seller in the market. The monopolist’s demand
is market demand. The monopolist is a price-maker. Pure monopoly suggests no substitute
situation”. -A. J. Braff

“Pure monopoly is represented by a market situation in which there is a single seller

of a product for which there are no substitutes; this single seller is unaffected by and does not
affect the prices and outputs of other products sold in the economy.” -Bilas

FEATURES OF MONOPOLY

1. SINGLE SELLER: There is just one seller, and he has the ability to manage the
product's supply. But because there are so many customers, he is powerless to regulate
the product's demand.
2. NO CLOSE SUBSTITUTE: There are no close substitutes for the product. Either
they have to buy the product or go without it.
3. CONTROL OVER PRICE: The monopolist sets the price since they control the
supply. He might occasionally use pricing discrimination. He might set various prices
for certain groups of customers. A monopolist is able to control the price or the
amount of output, but not both at once.
4. NO ENTRY: While the monopolist enjoys monopoly power, other producers are not
free to enter the market. Strong barriers exist for new businesses to enter. Natural,
technological, legal, and financial barriers could prevent new producers from entering
the market.

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5. NO DIFFERENCE BETWEEN FIRM AND INDUSTRY: An industry and a firm

have the same characteristics when there is a monopoly. Since there is only one
company, that one company is the entire industry.

DEMAND AND REVENUE CURVE UNDER MONOPOLY

It is important to understand the nature of the demand curve facing a monopolist. The
demand curve facing an industrial firm under perfect competition, is a horizontal
straight line, but the demand curve facing the whole industry under perfect
competition is sloping downward.

This is true since demand is created by all customers, and the demand curve for a
product as a whole typically slopes downward. The entire competitive industry is in
direct competition with the consumers' downward-sloping demand curve. A single
company operating in perfect competition is not confronted by a demand curve that
slopes downward. However, in a monopoly, a single company owns the whole
industry. Consequently, the monopolist must contend with the entirety of the
consumer demand for a given good. A downward-sloping demand curve confronting
the monopolist is caused by the downward-sloping customer demand curve for a
product.

Demand curve facing the monopolist will be his average revenue curve. Thus, the
average revenue curve of the monopolist slopes downward throughout its length.
Since average revenue curve slopes downward, marginal revenue curve will lie below
it. This follows from usual average-marginal relationship. The implication of marginal
revenue curve lying below average revenue curve is that the marginal revenue will be
less than the price or average revenue.
Figure 5.5 demand curve of monopolist slope downward

Figure 5.6 Marginal and Average revenue curve under monopoly

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When monopolist sells more, the price of his product falls; marginal revenue therefore
must be less than the price. In Fig. 10.2, AR is the average revenue curve of the
monopolist and slopes downward. MR is the marginal revenue curve and lies below
AR curve. At quantity OM, average revenue (or price) is MP and marginal revenue is
MQ which is less than MP.

EQUILIBRIUM OF MONOPOLY FIRM

Under monopoly, for the equilibrium and price determination, two different
conditions need to be satisfied:
1) Marginal revenue must be equal to marginal cost.
2) MC must cut MR from below.
However, there are two approaches to determine equilibrium price under monopoly
such as ;
1) Total Revenue and Total Cost Approach.
2) Marginal Revenue and Marginal Cost Approach.

TOTAL REVENUE AND TOTAL COST APPROACH

Monopolist can earn maximum profits when difference between TR and TC is maximum. By
fixing different prices, a monopolist tries to find out the level of output where the difference
between TR and TC is maximum. The level of output where monopolist earns maximum
profits is called the equilibrium situation. This can be explained with the help of Fig. 5.7.

Figure 5.7

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In Fig. 5.7, TC is the total cost curve. TR is the total revenue curve. TR curve starts from the
origin. It indicates that at zero level of output, TR will also be zero. TC curve starts from P. It
reflects that even if the firm discontinues its production, it will have to suffer the loss of fixed
costs. Total profits of the firm are represented by TP curve. It starts from point R showing that
initially firm is faced with negative profits. Now as the firm increases its production, TR also
increases. But in the initial stage, the rate of increase in TR is less than that of TC. Therefore,
RC part of TP curve reflects that firm is incurring losses. At point M, total revenue is equal to
total cost. It shows that firm is working under no profit, no loss basis. Point M is called the
breakeven point. When firm produces more, beyond point M, TR will be more than TC. TP
curve also slopes upward. It shows that firm is earning profit. Now as the TP curve reaches
point E then the firm will be earning maximum profits. This amount of output will be termed
as equilibrium output.

MARGINAL REVENUE AND MARGINAL COST APPROACH

According to marginal revenue and marginal cost approach, a monopolist will be in
equilibrium when two conditions are fulfilled i.e.,
(i) MC = MR and (ii) MC must cut MR from below.
The study of equilibrium price according to this analysis can be conducted in two time
periods.
1) The Short Run
2) The Long Run

SHORT RUN EQUILIBRIUM UNDER MONOPOLY

The term "short period" describes the time frame during which the monopolist is forced to
use a specific existing plant. Stated differently, the monopolist is unable to quickly alter
permanent components like as plant, machinery, etc. A monopolist can change the variable
components to increase his output. The monopolist may experience losses, super-normal
profits, or regular earnings at this time. These three cases are as follows.

Supernormal profit:
If the price determined by the monopolist in more than AC, he will get super normal profits.
The monopolist will produce up to the level where MC=MR. This limit will indicate
equilibrium output. In Fig. 5.8 output is measured on X-axis and price on Y-axis. SAC and
SMC are the short run average cost and marginal cost curves respectively while AR and MR
are the average revenue and marginal revenue curves respectively.
Figure 5.8

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The monopolist is in equilibrium at point E because at point E both the conditions of

equilibrium are fulfilled i.e., MR = MC and MC intersects the MR curve from below. At this
level of equilibrium the monopolist will produce OQ level of output and sells it at AQ price
which is more than average cost BQ by AB per unit. Therefore, in this case total profits of the
monopolist will be equal to shaded area ABPC.

Normal profit:
A monopolist in the short run would enjoy normal profits when average revenue is just equal
to average cost. We know that average cost of production is inclusive of normal profits. This
situation can be illustrated with the help of Fig 5.9.

Figure 5.9

In Fig. 5.9 above the firm is in equilibrium at point E. Here marginal cost is equal to marginal
revenue. The firm is producing OM level of output. At OM level of output average cost curve
touches the average revenue curve at point P. Therefore, at point ‘P’ price MR is equal to
average cost of the total product. In this way, monopoly firm enjoys the normal profits.

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Minimum loss

The monopolist might have to suffer losses in the near term. This circumstance arises when
the price drops below the variable cost in the short term. Put another way, the monopolist will
keep producing as long as pricing keeps up with average variable costs even if prices decline
as a result of a downturn in demand and a depression. A monopolist will cease manufacturing
if the price drops below the average variable cost. In the short term equilibrium, a monopolist
may therefore incur the least amount of loss, which is equal to fixed costs. Consequently,
average variable cost and equilibrium price will be same. Fig. 5.10. also provides an
explanation for this circumstance.
Figure 5.10

In Fig. 5.10, above monopolist is in equilibrium at point E. At point E marginal cost is equal
to marginal revenue and he produces OM level of output. At OM level of output, equilibrium
price fixed by the monopolist is OP1. At OP1 price, AVC touches the AR curve at point A. It
signifies that the firm will cover only average variable cost from the prevailing price. At OP1
price, firm will bear loss of fixed cost i.e., A per unit. The firm will bear the total loss equal to
the shaded area PP1 AN. Now if the price falls below OP1, the monopolist will stop
production. It is so, because, if he continues production, he will have to bear the loss of
variable costs along with fixed costs.

Illustration 2.
Only one firm produces and sells soccer balls in the country of Wiknam, and as the story
begins, international trade in soccer balls is prohibited. The following equations describe the
monopolist’s demand, marginal revenue, total cost, and marginal cost:
Demand : P = 10 – Q
Marginal Revenue : MR = 10 – 2Q
Total Cost : TC = 3 + Q + 0.5 Q2
Marginal Cost : MC = 1 + Q Where Q is quantity and P is the price.

(a) How many units does the monopolist produce? At what price are they sold? What is the
monopolist’s profit?

Solution: P = 10 – Q
MR = 10 – 2Q
TC = 3 + Q + 0.5Q2
MC = 1 + Q

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Monopolist will produce where: MR = MC 10 – 2Q

= 1 + Q 3Q
=9Q
=3
Quantity are sold at price given by: P = 10 – Q
= 10 – 3
P = $7
Monopolist profit (Rupees) is given by:
Profit = TR–TC
= [7 × 3] – [3 + 3 + 0.5 × 33 ]
= 21 – [6 + 9/2]
= [21 – 21/22]
= 10.5
Profit = $10.5

LONG RUN EQUILIBRIUM UNDER MONOPOLY

The long run is the time frame during which production factors can be altered to alter output.
Put another way, since every variable may be altered, a monopolist would select the plant size
that best suits a given degree of demand. In this case, equilibrium would be reached at the
output level when the marginal revenue curve is lowered by the long-run marginal cost.
To illustrate this, go to Fig. 5.11 .

Figure 5.11

In Fig. 5.11, above monopolist is in equilibrium at OM level of output. At OM level of output

marginal revenue is equal to long run marginal cost and the monopolist fixes OP price. HM is
the long run average cost. Price OP being more than LAC i.e., HM which fetch the
monopolist super normal profits. Accordingly, the monopolist earns JM – HM = JH super
normal profit per unit. His total super normal profits will be equal to shaded area PJHP1.

PRICE DISCRIMINATION UNDER MONOPOLY

A single seller of a good known as the monopolist is present in a monopoly. Because the
monopolist controls decisions about supply, demand, and pricing, they can set prices to
maximize profit.

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For the same commodity, the monopolist frequently charges various prices to different
customers. Price discrimination is the practice of charging various prices for the same goods.

According to Robinson, “Price discrimination is charging different prices for the same
product or same price for the differentiated product.”

TYPES OF PRICE DISCRIMINATION

Price discrimination is a common pricing strategy used by a monopolist having discretionary
pricing power. This strategy is practiced by the monopolist to gain market advantage or to
capture market position. There are three types of price discrimination, which are shown
below:

Personal: When different people are charged different prices, it is referred to as personal
pricing discrimination. The varying pricing are determined by the income bracket of the
customers as well as their propensity to buy. For instance, a doctor bills wealthy and
impoverished patients differently.

Geographical: When the monopolist sets different prices for the same commodity at several
locations, it is considered a kind of price discrimination. If people who purchase goods at a
lesser cost are unable to sell to individuals who are paying a greater price to the company,
then discrimination of this kind may occur.

On the basis of use: When a product's utilization determines its price, this type of price
discrimination takes place. An electricity supply board, for example, levies higher fees for
commercial use of electricity and lower rates for residential use. Peakload pricing, which is
the practice of charging customers different fees at different times of the day, is a kind of
discrimination similar to this.

DEGREE OF PRICE DISCRIMINATION

First degree price discrimination: is used to describe a form of price discrimination where a
monopolist sets the highest price that any buyer is willing to pay. This type of discrimination
is sometimes referred to as perfect price discrimination since it takes full advantage of

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consumers. Customers do not benefit from any consumer surplus under this pricing
discrimination. Doctors and attorneys practice first degree.
Second degree price discrimination: refers to a form of price discrimination when
purchasers are separated into several groups and charged varying prices based on their
willingness to pay. This kind of pricing discrimination is used by airlines and railroads.
Third degree price discrimination: refers to a form of price discrimination where a
monopolist separates the market into smaller segments and sets separate prices for each
segment. Consequently, market segmentation is another name for third-degree pricing
discrimination.
In this type of price discrimination, the monopolist is required to segment market in a
manner, so that products sold in one market cannot be resold in another market. Moreover,
he/she should identify the price elasticity of demand of different submarkets. The groups are
divided according to age, sex, and location. For instance, railways charge lower fares from
senior citizens. Students get discount in cinemas, museums, and historical monuments. We
are explaining it with help of Fig. 5.12, which has three segments (a), (b) and (c).
Figure 5.12

Segments (a) and (b) depict markets with inelastic and elastic demand curves respectively.
The segment (c) has horizontal sum of the AR and MR curves of (a) and (b), denoted as AR t
and MR t. The firm has a single Average Total Cost curve and corresponding Marginal Cost
Curve. Inter-section of this MC with MR t gives us equilibrium output OQ for the firm. It
also shows the MR for the firm, which maximises its profits. The firm will like to realise the
same MR from each of the units sold in either of those two market segments. So, wherever
the extended line EM cuts MRa and MRb (points Ea and Eb respectively) will be used to
determine equilibrium outputs Q aO and Q bO for the two market segments. The prices will
be what the consumers are ready to pay for the respective quantities, that is, Pa and P b. Note
two points: The monopolist offers larger quantities in market with relatively elastic demand
curve and smaller in market with inelastic demand. We find that Q b > Q a. However, the
price change in the segment (a)with inelastic demand, P a is greater than price in segment (b)
P b. So we can say that buyers with inelastic demand will face a double disadvantage at the
hands of a monopolist: They end up buying smaller quantities and have to pay higher prices.

5.5 MONOPOLISTIC COMPETITION

Monopolistic competition is a type of market structure where many firms sell similar but not
identical products. Therefore, product differentiation is main quality of monopolistic
competition.

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Features

1. Large number of buyers and sellers: Companies that manufacture unique products
and sellers are many in monopolistic competition.
2. Product differentiation: The primary characteristic of monopolistic competition is
product differentiation. Product differentiation refers to the availability of several
product kinds, brands, and attributes to consumers within a predetermined time frame.
When a consumer can distinguish between two products, there is product
differentiation. There are several companies in this, yet their items are nearly exact
replicas of one another despite having slight differences. Product characteristics
including shape, size, color, durability, and quality, among others, allow for product
distinction. There are numerous instances of differentiating products, such as Lux,
Godrej, Camay, Rexona, and other bath soaps.
3. Free entry free exit: Similar to ideal competition, monopolistic competition allows
businesses in the market to freely enter and exit. It is important to note that
Chamberlin used the term "group" in the industry to refer to a collection of companies
that engage in monopolistic competition and generate unique products.
4. Selling cost: The fact that each company invests more in product promotion under
monopolistic competition is a crucial feature of it. The company advertises in
newspapers, movie theaters, magazines, radio, television, etc. to sell as much of its
goods as possible. Selling costs are the total amount invested in all of them.
5. Price control: Every company can only control so much of the product's price. In
monopolistic competition, the average income and limit end income curve of a firm
decline like a monopoly. This implies that the company can raise the price for fewer
products and slow down the price for more products in this scenario. Because of
product differentiation, a firm in monopolistic competition can regulate the cost of its
manufacturing. Nonetheless, under monopolistic competition, corporations do not
have complete control over cost because there are close substitutes for competing
products. Every company's costs are impacted, up to a certain point, by the cost
policies of its rivals in the market.
6. Limited mobility: In monopolistic competition, sources of production and products
and do not have mobility in services.
7. Imperfect knowledge: Every company can only control so much of the product's
price. In monopolistic competition, the average income and limit end income curve of
a firm decline like a monopoly. This implies that the company can raise the price for
fewer products and slow down the price for more products in this scenario. Because
of product differentiation, a firm in monopolistic competition can regulate the cost of
its manufacturing. Nonetheless, under monopolistic competition, corporations do not
have complete control over cost because there are close substitutes for competing
products. Every company's costs are impacted, up to a certain point, by the cost
policies of its rivals in the market.
8. Non price competition: The primary feature of monopolistic competition is that it
allows several businesses to compete with one another without raising the prices of
their goods; companies that produce "Surf" and "Ariel" are two examples of such
businesses. You will receive a glass utensil if you open a "Surf" box, and a steel spoon
if you open a "Ariel" box. Businesses do this by offering a variety of services, goods,
and amenities to consumers in an effort to draw them in and purchase their products.
We refer to this kind of competition as non-price competition.

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EQUILIBRIUM UNDER MONOPOLISTIC COMPETITION

In the situation of monopolistic competition, if any firm wants to sell maximum quantity
of its production then it has to decrease the cost. That’s why, in the situation of
monopolistic competition, Average Revenue Curve (AR Curve) and Marginal Revenue
(MR Curve) fall down in the form of left to right. In monopolistic competition, a firm
produce till the point or limit at which (i) Marginal Revenue is equal to Marginal Cost
(MR = MC) and (ii) Marginal Revenue Curve cuts Marginal Cost Curve from the lower
side. In this situation firm is in the condition of balancing by the production. The study of
equilibrium firm in monopolistic competition can be done in two different durations—
(1) Short Run and (2) Long Run Short Run

Equilibrium in Monopolistic Competition

The term "short run" refers to the period of time during which rising demand can only be met
by increasing the use of variable resources. There is never enough time to enhance or
decrease fixed manufacturing resources like buildings, machines, and plants. In the short
term, a business will be in equilibrium when (1) MC = MR and (2) the MC curve is cutting
the MR curve. In this amount of time, a firm may meet three conditions: (1) Super Normal
Profits, (2) Normal Profits and (3) Minimum Losses.

SUPER NORMAL PROFIT: Firm is in equilibrium at point E because marginal cost and
marginal revenue are equal (MR = MC) on point E and MC curve cut MR curve from the
lower side. It is known by point E that OM will be equilibrium production of firm. The cost
of equilibrium production is OC (= AM). The cost (AM) of equilibrium production will be
less (AM ˂ BM) than average Revenue BM so every unit of firm is obtained Super Normal
Profits BM – AM = AB. Firm has total super normal profit ABCP.
Figure: 5.13

NORMAL PROFIT: A monopolistic competition firm may see typical earnings in the short
term. At point E, the company will be in an equilibrium state since (i) MC = MR and (ii) the
MC curve cuts MR from the lower side. By point E, it is established that OM will represent

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the equilibrium production. Both the average cost and the cost of equilibrium production are
OP (AM) (AM). The AR curve touches the AC curve at point A, which explains the cause.
For this reason, average cost (AC) and cost (AR) are equal (AR = AC) when there is
equilibrium. Therefore, the company will only see typical profits.
Figure: 5.14

MINIMUM LOSS: Firm can also have loss of fixed cost in short-run. This is the minimum
loss of firm. Firm will be in equilibrium at point E. At this point, MC = MR and MC curve
cuts MR curve from the lower side. In the equilibrium condition, firm will produce OM. The
cost of equilibrium quantity OM is OP (= BM) and average cost OP1 (= NM). A short-run
average cost of firm more than (SAC > AR). So firm will have per unit loss of NM – BM =
BN. Total loss of firm will be the area of NBPP1.
Figure: 5.15

ong-Run Equilibrium in Monopolistic Competition

Long-Run Equilibrium in Monopolistic Competition

Long-term refers to the amount of time that businesses can alter the level of their plants, new
businesses can enter the market, and existing businesses can exit it. Remember that goods

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that are distinct in monopolistic competition are not interchangeable. In the industry,
Chamberlin has referred to companies that make unique products as "product groups."
Figure: 5.16

The
long-run marginal curve (LMC) and the long-run average cost curve (LAC) are shown in
Figure. Lead curves are represented by MR and AR, respectively. At point E, MR and MC
have the same value. It will therefore be the equilibrium point. At this moment, OM will be
generated at a cost of OP(=AM). At point A, the average revenue curve on the equilibrium
production OM touches the long-run average cost curve. Cost and long-run average cost (AR
= LAC) are hence equivalent in the equilibrium condition. Businesses are therefore only
making average profits. At 'A', the Point of Tangency, LAC and AR will make their most
money. The rationale is that, on any other expense, the long-run average's average cost (AC)
exceeds its average revenue (AR).

5.6 OLIGOPOLY

A market structure known as an oligopoly is defined by a few dominant enterprises in the

market. Due to their substantial market strength, these companies can control prices and other
aspects of the market. An oligopoly's salient characteristics are:

FEATURES

1. INTERDEPENDENCE: The primary attribute of an oligopoly is the decision-

making interdependence of the numerous enterprises.
All of the companies in an oligopolistic industry are aware of this. An industry made
up of a small number of sizable businesses will undoubtedly prompt countermoves
from other businesses in the sector if one of these businesses launches a significant
marketing campaign or creates a novel product model that quickly gains traction.
As a result, several businesses depend heavily on one another.
2. ADVERTISING: A significant policy change made by one company in an
oligopolistic market is likely to have an instant impact on other companies in the same

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industry. As a result, competing companies are constantly on the lookout for any
actions taken by the company that alters policies on its own. Thus, in the hands of an
oligopolist, advertising is a potent tool. An oligopolistic company may launch a
vigorous marketing campaign in an attempt to take up a sizable portion of the market.
It is evident that other businesses in the sector will object to its protective advertising.
Advertising is not required in a market with perfect competition, but monopolists may
find that it is profitable to advertise their products when they are novel or when there
are a lot of potential customers who have never tried them.
3. GROUP BEHAVIOUR: In an oligopoly, group behavior is the most important factor.

The group can consist of two, three, five, or even fifteen enterprises, but not several
hundred. Whatever the figure, it is relatively low so that every company is aware that
its actions will impact other companies within the group. On the other hand, in a
perfect market, numerous businesses compete with one another to maximize their
revenues.
The circumstances under monopolistic competition are comparable. There is only one
corporation that maximizes profits in a monopoly. Whether a market is thought of as
competitive or monopolistic, a firm's behavior is typically predictable.
In oligopoly, however, this is not possible due to various reasons:
(i) The firms constituting the group may not have a common goal
(ii) The group may or may not have a formal or informal organization with accepted
rules of conduct
(iii) The group may be dominated by a leader but other firms in the group may not
follow him in a uniform manner.
4. COMPETITION: This brings up another characteristic of an oligopolistic market:
competition. Since there are few sellers in an oligopoly, any action taken by one seller
has an instant impact on the competitors. This means that every seller is constantly
vigilant and closely monitors the movements of its competitors in order to prepare a
countermove.

5. BARRIER TO ENTRY: There are no obstacles to entering or leaving an

oligopolistic industry due to the intense rivalry. Long-term entry barriers, on the other
hand, have a tendency to prevent new businesses from joining the market.

These may be:

(a) Economics of scale enjoyed by a few large firms;
(b) Control over essential and specialized inputs;
(c) High capital requirements due to plant costs, advertising costs, etc.
(d) Exclusive patents; and licenses; and
(e) The existence of unused capacity which makes the industry unattractive.
6. LACK OF UNIFORMITY: The lack of consistency in the sizes of the enterprises is
another characteristic of an oligopoly market. Businesses range widely in size. There
might be small ones and enormous ones. A situation like this is unbalanced. The
American economy is rife with situations like this. It is uncommon to find a
symmetrical scenario with uniformly sized enterprises.
7. EXISTENCE OF PRICE RIGIDITY: Each firm operating in an oligopoly must
adhere to its price. When a company seeks to lower its pricing, its competitors will
counterattack by cutting their prices even more. This will result in a pricing war that
no party wins. Nevertheless, if a company raises its pricing in an attempt to boost

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earnings, its competitors won't do the same. Because of this, no company wants to
raise or lower prices. The rigidity in prices will occur.
8. NO UNIQUE PATTERN OF PRICING BEHAVIOUR: There are two competing
motivations behind the rivalry that results from the oligopolists' dependency. Each
seeks to maximize profits while maintaining their independence. In order to achieve
this, they respond and act in response to one another's price-output fluctuations, which
are a constant source of uncertainty.
However, driven once more by the need to maximize profits, every seller wants to
work with his competitors to lessen or do away with the element of uncertainty. Every
competitor agrees, either formally or implicitly, to price-output adjustments.
9. INDETERMINATENESS OF DEMAND CURVE: In market configurations that
aren't oligopolistic, a firm faces a fixed demand curve. However, due to the
oligopolists' dependency, a demand curve for these sellers cannot be created, with the
exception of circumstances in which the interdependence's shape is clearly defined. In
actual commercial activities, the demand curve is uncertain. In an oligopolistic
market, a company lowering its pricing can anticipate at least three distinct responses
from the other vendors.

NON-COLLUSIVE OLIGOPOLY: SWEEZY’S KINKED DEMAND CURVE

MODEL

Price rigidity is a crucial aspect of an oligopoly market. Additionally, the traditional

demand curve is not employed to explain the pricing rigidity in this market. Paul
Sweezy provided the finest explanation of the concept of utilizing a non-conventional
demand curve to depict non-collusive oligopoly (i.e., when sellers compete with their
rivals) in 1939. Sweezy describes pricing rigidity in an oligopoly market structure
using a kinked demand curve.

The demand curve's kink results from sellers' asymmetrical behavioral patterns. When
a vendor raises the price of their goods, competitors won't follow suit, which results in
a significant loss of sales for the initial seller. Put another way, competitors won't
notice any price increases.

However, if a company lowers the price of its goods, other companies will follow suit
in order to keep their clientele. Put differently, there will be a corresponding price
reduction for every pricing. The first firm's price reduction will therefore have
minimal benefit. This behavioral tendency will cause the demand curve to kink at the
dominant market price.

Suppose, the prevailing price of an oligopoly product in the market is QE or OP of

Fig. 5.17. If one seller increases the price above OP, rival sellers will keep the prices
of their products at OP. As a result of high price charged by the firm, buyers will shift
to products of other sellers who have kept their prices at the old level. Consequently,
sales of the first seller will drop considerably.
Figure 5.17

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KINKED DEMAND CURVE AND OLIGOPOLY EQUILIBRIUM

That is why demand curve in this zone (dE) is relatively elastic. On the other hand, if
a seller reduces the price of his product below QE, others will follow him so that
demand for their products does not decline. Thus, demand curve in this region (i.e.,
ED) is relatively inelastic. This behavioural pattern thus explains why prices are
inflexible in the oligopoly market — even if demand and costs change. The kink in
the demand curve at point E results in a discontinuous MR curve.

The MR curve has two segments :

At output less than OQ the MR curve (i.e., dA) will correspond to DE portion of AR
curve, and, for output larger than OQ, the MR curve (i.e., BMR) will correspond to
the demand curve ED. Thus, discontinuity in MR curve occurs between points A and
B. In other words, between these two points, MR curve is vertical. Equilibrium is
achieved when MC curve passes through the discontinuous portion of the MR curve.
Thus the equilibrium output is OQ, to be sold at a price OP.

Let's say that expenses increase. The MC curve will therefore go up from MC1 to
MC2. The output and resulting price stay the same at OP and OQ, respectively. This
fact clarifies why prices are sticky. Stated differently, prices in oligopolistic
businesses tend to be more stable than costs.

The model appears appealing at first because it provides a realistic explanation for the
behavior of corporations. However, the model has some drawbacks.
First of all, it gives no explanation for how the ruling price is arrived at. It clarifies
why there is a kink in the demand curve at the governing price.

It is not a pricing theory in this sense. Second, the conclusion about pricing rigidity is
not always valid. Based on empirical evidence, it appears that prices must rise over
the kink due to increased costs. In spite of these drawbacks, textbook writers like this
concept.

COLLUSIVE OLIGOPOLY

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We address the economics of agreement amongst the businesses in an undifferentiated

oligopolistic industry in a model of collusive oligopoly. These businesses are referred
to as a cartel when they band together and decide to set pricing and outputs in order to
maximize industry profits overall.

ASSUMPTION

a. There are only two firms in the oligopolistic industry, i.e., here we have a case
of duopoly.
b. Each firm produces and sells a product that is a perfect substitute for that of
the other.
c. The product is perishable.
d. There are many knowledgeable buyers of the product.
e. Each firm knows the market demand for the product.
f. The two firms have different cost curves.
g. Both the firms have the same expectations about the prices and productivities
of the inputs which they use.
h. The price of the product is the sole parameter of action of each firm.
i. The two firms are contemplating whether or not to form a cartel and agree
upon a price that will promise the maximum maximorum of profits per period
to both of them jointly

PRICE LEADERSHIP MODEL

The non-collusive oligopoly model, also known as Sweezy's model, is predicated on

the idea that, notwithstanding their interdependence in the market, oligopoly enterprises
behave independently. There could be uncertainty as a result of fierce pricing rivalry.
Now, the challenge is how oligopoly enterprises eliminate ambiguity. In actuality,
businesses enter into pricing agreements with one another as opposed to engaging in rivalry
or a price war. Collusion may be used to describe such agreement, whether it is explicit (or
formal) or implicit (or informal).

Every company always aspires to become stronger and more powerful than its competitors.
Because of this, oligopolist industries see the rise of a small number of strong rivals that are
difficult for other strong companies to overthrow.

In order to take full advantage of the situation, some of these businesses cooperate or work in
concert with one another. Collusion is actually a natural propensity in oligopolist industries.
The two most significant types of collusion are mergers and acquisitions and price leadership
cartels.

Oligopolists sometimes work on informal, tacit collusive arrangements when launching a

formal agreement proves problematic.
Price leadership is one of the most prevalent types of informal collusion.

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When one company—which might be a big or dominant company—initiates pricing changes

while other companies follow suit, this is known as price leadership.

An example of dominant firm price leadership is shown in Fig. 5.18 where DT is the industry
demand curve. Since small firms follow the leader—the dominant firm—they behave as
“price-takers”. MCs is the horizontal summation of the MC curves of all small firms

Suppose, the dominant firm sets the price at OP1 (where DT and MCs intersect each
other at point C). The small firms meet the entire demand P1C at the price OP1. Thus, the
dominant firm has nothing to sell in the market. At a price of OP3, the small firm will supply
nothing. It is obvious that price will be set in between OP1 and OP3 by the leader.

Figure 5.18

The demand curve faced by the leader firm of the oligopoly industry is determined for any
price—it is the horizontal distance between industry demand curve, DT, and the marginal cost
curves of all small firms, MCS. In Fig. 5.18, DL is the leader’s demand curve and the
corresponding MR curve is MRL.

Being a leader in the industry, the dominant firm’s supply curve is represented by the MCL
curve. Since it enjoys a cost advantage, its MC curve lies below the MCS curve. A dominant
firm maximizes profit at point E where its MCL and MRL intersect each other. The
corresponding output of the price leader is OQL. Price thus determined is OP2. Small firms
accept this price OP2 and sell QLQT (=AB) amount – industry demand the OQT output. In

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actual practice, the analysis of price leadership is complicated, particularly when new firms
enter the industry and try to become the leader or dominant.

5.7 GAME THEORY AND OLIGOPOLISTIC BEHAVIOR

In an oligopolistic market, there are a few dominating enterprises. When there are few
companies in the market making or selling a product, oligopoly is said to prevail. Another
name for oligopoly is "competition among the few." Duopoly is a specific type of oligopoly
in which two businesses are in direct competition with one another. Each firm in an oligopoly
has sufficient market strength to keep it from becoming a price taker, but because of interfirm
competition, it is unable to view the market demand curve as its own demand curve. Because
oligopolistic enterprises compete so fiercely, economists refer to it as "cutthroat competition."

All the firms under oligopoly industry are behaving strategically. But when firms are
behaving strategically, the oligopolistic firm faces a basic dilemma i.e.

(i) To cooperate with other firms or

(ii) To compete with other firms.

When an oligopolistic firm is cooperating with other firms, it gives rise to cooperative
solution but if firms compete with each other, it gives rise to non-cooperative equilibrium.

THE COOPERATIVE SOLUTION

An industry's firms can maximize their combined earnings if they work together to produce
the monopolistic output. Firms may choose to collaborate informally or formally. Formal
cooperation occurs when all of the businesses in an oligopolistic industry agree to abide by
specified rules of conduct regarding output, price, and other factors following consultation
and discussion. The term collusive oligopoly is another name for this formal cooperation.
On the other hand, the tacit cooperation among firms occurs when all the firms under
oligopolistic industry without consultation and discussion have developed some
understanding between them and pursues a uniform policy with regard to price output etc. So,
if the firms tacitly or formerly cooperate they will reach to a cooperative solution.

NON COOPERATIVE EQUILIBRIUM OR NASH EQUILIBRIUM

Businesses can approach the non-cooperative equilibrium when they continue to calculate
their own gains exclusively, without collaborating with others. It's referred to as a Nash
equilibrium or noncooperative equilibrium.

John Nash, a mathematician who won the 1951 Nobel Prize in Economics, introduced
the idea of Nash equilibrium for the first time. In a Nash equilibrium, each firm's optimum
course of action is to continue operating as it is now, taking into account the current actions
of the other firms. In game theory, the idea of Nash equilibrium is frequently utilized.

OLIGOPOLY AS A GAME

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In a study published in 1994, economist Oskar Morgenstern and mathematician John Von
Neumann examined a series of issues or games in which two or more players pursue
independent goals and no player can control the result. In an oligopolistic market, every firm
must decide on a reasonable course of action from among a wide range of options while
considering the potential backlash from rivals whose countermoves could have an impact on
them. The oligopolistic behavior of rival enterprises is analyzed by game theory as a
sequence of proactive actions and reactive countermoves. A strategy is a path of action that a
player selects while the game is being played. Players make strategic decisions without
having a clear idea of the rival's plan of attack. In this case, businesses are presumed to be
preparing for competitor responses. By making particular decisions, each player hopes to
maximize their own reward, but the final result also depends on what the other players do.
The payoff matrix displays each player's benefit based on their choice as well as the choice of
their rivals.

Types of Games: In normal (or strategic) form games, players are moving moves
simultaneously whereas in extensive form games, players are moving moves in some order
overtime. ‘One shot’ game is a game that is played only once and super game that is repeated
an infinite number of times.

When applying game theory to an oligopoly, firms are the participants, the game is played in
a market, the strategies used are decisions about prices and output, and the rewards are
profits.
Let's use an example to clarify the idea of balance.

We are taking the case of two firms who are producing a homogeneous product and each firm
has two possible strategies i.e.
 Each firm can produce an output equal to one half of the monopoly output (the passive
strategy) and jointly sharing the monopoly profit.
 Each firm can produce an output equal to two-third of the monopoly output (the aggressive
strategy).
The strategic form of the game can be written as: Players: There are two players-
Firm A and Firm B. Game: Botha and B is producing output in the market. Strategy: Each
firm can produce an output equal to either one-half of the monopoly output or two thirds of
the monopoly output. Payoff Matrix: Profit of each firm given its decision of its competitors.
The Payoff Matrix is given in Table 1.

In Table 1, the figure in the four boxes show the profit of firm A and firm B. Let us
explain these payoffs.

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 The upper left hand corner of the payoff matrix tells us that if both firms are
producing one-half of the monopoly output, both firms would make a profit of Rs 20
each.
 The upper right hand corner tells us that if firm B produces one half of monopoly
output and firm A produces two-third of monopoly output, firm B would make a profit
of Rs 15 and firm A Rs 22.
 The lower left hand corner tells us that if firm B produces two-third of monopoly
output and firm A produces one-half of monopoly output, firm B would make a profit
of Rs22 and firm A Rs15.
 The lower right hand corner tells us that if firm B produce two-third of monopoly
output and firm A also choose to produce two-third of monopoly output, both would
make a profit of Rs17 each.
Now the question is what the two firms would do to i.e. to cooperate with each other
or compete with each other. The possible solution could be:
i. The Passive (or Cooperative) Solution: If both firms cooperate with each other
i.e. both are producing one-half of the monopoly output then they both are getting a
profit of Rs 20 each. Under cooperative solution both are jointly producing the
monopoly output and sharing profit equally among them. The cooperative solution is
achieved by playing strategy (one half monopoly output, one half monopoly output).
ii. The Aggressive (Non-Cooperative) or Nash Equilibrium: Nash Equilibrium is
the equilibrium where each firm is doing the best it can give what its competitors are
doing and each firms proceed by calculating only their own gains without cooperating

Definition: A strategy 𝑠𝑖 ∗ is a best response to a strategy vector 𝑠−𝑖 ∗ of the other

with others.

player if 𝜋𝑖(𝑠𝑖 ∗ , 𝑠−𝑖 ∗ ) ≥ 𝜋𝑖 (𝑠𝑖 , 𝑠−𝑖 ∗ )For all𝑠𝑖 .

Here 𝑠𝑖 ∗ is a “dominant strategy” in the sense that it is a best strategy to play

provided the other players do in fact play the strategy combination𝑠−𝑖 ∗ . There must
be a condition to ensure that player i is correct in his inference that the other players
are correct in their inferences. This gives us the following definition.

The strategy vector 𝑠 ∗ = 𝑠1 ∗ , 𝑠2 ∗ , … … … . , 𝑠𝑛 ∗ is a Nash equilibrium if

𝜋𝑖(𝑠𝑖 ∗ , 𝑠−𝑖 ∗ ) ≥ 𝜋𝑖(𝑠𝑖 , 𝑠−𝑖 ∗ )For all 𝑠𝑖 and all𝑖.

Table 1 has a single Nash equilibrium. Producing two thirds of the monopolistic
output, where each firm is making a profit of Rs. 17, is the optimal course of action
for each firm. Here, neither company has a reason to change their stance other than
working together with the other company. Each firm in a different cell is motivated to
alter its production in light of the other firm's output. Assume that in Table 1, firm B
would decide to generate two thirds of the monopoly output if firm A decided to
create half of it. This is the case because firm B makes a profit of Rs. 22 while
generating two-thirds of the monopoly output, which is greater than Rs. 20 when
producing.

But if firm A choose to produce two-third of the monopoly output then firm B would
also choose to produce two-third of the monopoly output as it is giving a profit of Rs
17 which is more than Rs 15 (when he is producing one half of the monopoly output).
So there is one Nash Equilibrium when both firms are producing two-third of the
monopoly output. Neither firm has an incentive to depart from this position.

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STRATEGIC BEHAVIOR: We reach Nash equilibrium when every firm acts

strategically, that is, when it choose its best course of action while considering the
options available to it from its competitors. If firm A were aware of what firm B was
up to, what action would it take? Firm B has two options, meaning that he can either
generate two thirds or half of the monopolistic output. Initially, if company B is
generating 50% of the monopolistic output, what would be the optimal course of
action for company A? Firm A will make a profit of Rs 20 if firm B produces half of
the monopolistic production and firm A also selects the same. However, should
company A decide to generate two-thirds of the monopolistic output. In either
scenario, producing two-thirds of the monopolistic output is business A's optimal
course of action.
Acting aggressively is the prevailing tactic. A dominating strategy is one that
performs best regardless of what the opponent does. The main strategy employed by
both enterprises in this game is to create two thirds of the monopoly output. Firm B
will use a similar logic. Thus, both ultimately produce one and a third times the
monopoly output jointly and make a profit of Rs 17.

BREAK DOWN OF COOPERATION: When businesses act strategically, Nash

equilibrium is reached, which is why tacit collaboration frequently breaks down.
Assume that both businesses are working together, producing half of the monopoly's
production, and making a profit of Rs. 20 apiece. Firm A's profit will rise if it
increases output,but Firm B's profit would decrease. Because of firm A's actions, the
industry price decreases, reducing firm B's earnings from its same output. By
diverting businesses from the joint maximizing monopoly output, company A's
cheating lowers the joint profits. As a result, firm B's profits would decrease more
than firm A's profits increased.
Firm B is thus subject to the same consideration, therefore both companies have an
incentive to deviate from the output level that maximizes joint profits. Hence, both
firms have an incentive to deviate from the joint maximizing output when one does.
Each person that employs this self-serving tactic moves toward a noncooperative
equilibrium with fewer profits than at the cooperative solution. In the non-cooperative
equilibrium, the combined production of the two enterprises amounts to one and a
third times that of the monopoly.

PRISIONER’S DILLEMA

This section examines the prisoner's dilemma game, in which both players lose out on
a cooperative solution compared to a non-cooperative one. The Nash equilibrium has
the drawback of not always producing Pareto-efficient results. Assume that two
individuals, identified as inmates A and B, have been apprehended for their roles in a
bank heist. They are questioned individually to prevent them from speaking to one
another in an effort to get a confession from them. Table 2 provides the reward matrix
for this particular game.

PRISONER A
PRISONER B CONFESS NOT CONFESS
CONFESS 5,5 10,10
NOT CONFESS 0,10 8,8

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The Strategic form of the game can be written as:

Players: Two players-Prisoner A and Prisoner B.
Strategy: Each player can either confess or not confess his crime.
Payoff Matrix: The payoffs are showing the years of imprisonment

 The upper left hand corner of the payoff matrix tells us that if both prisoners confess
the crime, both would get an imprisonment of 5 years each.
 The upper right hand corner tells us that if prisoner A confesses and prisoner B not
confesses then prisoner A would get 10 years of imprisonment and prisoner B would
go free.
 The lower left hand corner tells us that if prisoner A not confesses and prisoner B
confesses, then prisoner A would get no imprisonment and prisoner B would get 10
years of imprisonment.
 The lower right hand corner tells us that if prisoner A not confesses a crime and
prisoner B also not confesses than both get 8 years of imprisonment each.

Here each prisoner faces an uncertainty regarding how the other person will behave
i.e. whether he will confess or not confess. So each person has to make an
independent choice whether to confess or not to confess a crime.

Prisoner A reasons as follows

First: If prisoner B confesses a crime, and prisoner A also chooses the same then
prisoner A will get 5 years of imprisonment. But if prisoner A chooses not to confess
then prisoner A will get no imprisonment. Thus, the best strategy of Player A is not
confess a crime. So, person A claimed my best strategy is not to confess.

Secondly: If prisoner B not confesses a crime and prisoner A also chooses the same
then prisoner A will get 8 years of imprisonment. But if prisoner A chooses to confess
then prisoner A will get 10 years of imprisonment. Thus, the best strate.gy of Player B
is not confess a crime. So, person B claimed my best strategy again is not to confess.
Prisoner B will also reason in the same way. As a result they both end up by not
confessing a crime and getting 8 years of imprisonment. This is the Nash Equilibrium.
But if they had been able to communicate with each other, they would both have
confessed the crime and get 5 years of imprisonment. Once again, the non-cooperative
equilibrium makes both prisoners worse off than if they were able to cooperate i.e. if
both are making decisions they end up by not confessing a crime.

5.7 DUOPOLY

A systematic analysis of oligopoly is challenging due to the uncertainty surrounding

the behavior pattern of a firm operating in an oligopoly, which arises from their
unpredictable actions and reactions. However, based on various behavioral
hypotheses, economists from both the classical and modern schools have created a
wide range of models. These models can be largely divided into two groups: (I)
current oligopoly models and classical duopoly models Duopoly models state that
when a product has just two sellers, duopoly exists.

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Duopoly is a special case of oligopoly. Duopoly is a special case in the sense that it is
limiting case of oligopoly as there must be at least two sellers to make the market
oligopolistic in nature.

1. The Cournot’s Duopoly Model

2. The Chamberlin Duopoly Model
3. The Bertrand’s Duopoly Model
4. The Edgeworth Duopoly Model

1 . COURNOT’S DUOPOLY MODEL:

Augustin Cournot, a French economist, was the first to develop a formal duopoly model in
1838. To illustrate his model, Cournot assumed:

(a) Tow firms, each owing an artesian mineral water well

(b) Both operate their wells at zero marginal cost2;
(c) Both face a demand curve with constant negative slope;
(d) Each seller acts on the assumption that his competitor will not react to his decision to
change his and price. This is Cournot’s behavioural assumption.

Based on this model, Cournot has determined that every vendor charges the same price and
eventually supplies one-third of the market. whereas there is still a third of the market that is
unfilled.

Diagrammatic Representation:
In Figure 1, Cournot's duopoly model is displayed. Assume there are just two firms to start
the analysis. Initially, that, A, and B. In the market, A is the lone vendor of mineral water.
To optimize his earnings (or income), he offers quantity OQ at price OP2, where his MC = O
MR. His all earnings come to OP2PQ.

Figure 5.19

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Now let B enters the market. The market open to him is QM which is half of the total market.
He can sell his product in the remaining half of the market. He assumes that A will not
change his price and output as he is making the maximum profit i.e., A will continue to sell
OQ at price OP2 Thus, the market available to B is QM and the demand curve is PM.

When B sells ON at price OP1, he maximizes his revenue. His total revenue is at QRP'N.
Keep in mind that B only provides QN = 1/4 = (l/2)/2 of the market.) When B enters, the
price drops to OP1. As a result, A's projected profit drops to OP1 PQ.
When presented with this circumstance, A tries to modify his output and price to fit the new
parameters. He believes that since B is generating the most profit possible, he won't alter his
output QN or price OP1.
Accordingly, A assumes that B will continue to supply 1/4 of market and he has 3/4 (= 1 – 14)
of the market available to him. To maximise his profit. Supplies 1/2 of (3/4), i.e., 3/8 of the
market. Note that A’s market share has fallen from 1/2 to 3/8. Now it is B’s turn to react.
Considering Cournot’s assumption, B assumes that A will continue to supply only 3/8 of the
market and market open to him equals 1 – 3/8 = 5/8. In order to maximise his profit under the
new conditions B supplies 1/2 x 5/8 = 5/16 of the market. It is now for A to reappraise the
situation and adjust his price and output accordingly.

This cycle of action and reaction keeps happening in subsequent times. A continues to lose
market share while B gains it during this process. When their market shares are equal at one-
third each, the situation is finally reached.
Any more attempts to modify the output provide the same outcome.
As a result, the businesses settle into an equilibrium where each one serves 1/3 of the market.
The table below displays the equilibrium of firms based on Cournot's model:

Cournot’s equilibrium solution is stable. For given the action and reaction, it is not possible
for any of the two sellers to increase their market share. It can be shown as follows: A’s
share= 1/2(1 – 1/3) = 1/3. Similarly B’s share = 1/2 (1 – 1/3) = 1/3.
Cournot’s model of duopoly can be extended to the general oligopoly. For example, if there
are three sellers, the industry, and firms will be in equilibrium when each firm supplies 1/3 of
the market. Thus, the three sellers together supply 3/4 of the market, 1/4 of the market

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remaining unsupplied. The formula for determining the share of each seller in an oligopolistic
market is: Q -f- (n + 1), where Q = market size, and n = number of sellers.

2 . CHAMBERLIN’S DUOPOLY MODEL:

The interdependence of enterprises in a given market is acknowledged by Chamberlin's

duopoly model. According to Chamberlin, oligopoly enterprises are not so ingrained in the
actual world that they are unable to draw lessons from the past. Nonetheless, he adopts the
same presumptions as the proponents of antiquated classical frameworks. Put otherwise, his
model is predicated on the same assumptions: homogeneous products; enterprises of the same
size and costs; no new firms entering the market; and complete awareness of demand.

Understanding the interdependence of businesses in an oligopolistic market has produced a

finding that differs significantly from Cournot's. According to Chambrilin, businesses are
aware that their choices on pricing and output would undoubtedly elicit responses from other
businesses. He does not, therefore, envision a price war in oligopolistic marketplaces.
Additionally, he eliminates the chance that businesses could gradually modify their outputs to
reach equilibrium at a lower production level than a monopoly would allow.Understanding
the interdependence of businesses in an oligopolistic market has produced a finding that
differs significantly from Cournot's. According to Chambrilin, businesses are aware that their
choices on pricing and output would undoubtedly elicit responses from other businesses. He
does not, therefore, envision a price war in oligopolistic marketplaces. Additionally, he
eliminates the chance that businesses could gradually modify their outputs to reach
equilibrium at a lower production level than a monopoly would allow.Firms in an
oligopolistic market will set the monopoly price in order to maximize their individual and
joint profits if they are conscious of their mutual dependency and eager to learn from their
past mistakes. An explanation of Chamberlin's model can be found in the duopoly market
framework. Similar to Cournot, Chamberlin assumes a linear demand for the good. For the
sake of simplicity, let us suppose that the cost of creating the good is zero even in this
scenario. Figure 5.20 presents an illustration of the Chamberlin model. This figure represents
the market demand curve, or DQ. Firm A will produce output OQ1 if it enters the market first
because, at this level of output, its marginal revenue equals its marginal cost (MR = MC = 0).
This will maximise its profits. At price OP) elasticity of demand is unity. Firm B entering
market at this stage considers that its demand curve is CQ and will thus produce Q1Q2 so as
to maximise its profit. It will charge price OP2.
Figure 5.20

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It now realizes that it cannot sell QQ1 quantity at the monopoly price and thus decides
to reduce the output to QQ3, which is one-half of the monopoly output QQ1. Firm B
can continue to produce quantity Q1Q2 which is same as Q3Q1. The industry output
thus is OQ1 and the price rises to the level OP1. This is an ideal situation from the
point of view of both firms A and B. In this case, the joint output of the two firms is
monopoly output and they charge monopoly price. Thus, considering the assumption
of equal costs (costs = 0) the market will be shared equally between firms A and B.

2 . BERTRAND’S DUOPOLY MODEL:

In 1883, French mathematician Bertrand created his own duopoly model. Regarding its
behavioral premise, Bertrand's model is different from Cournot's model. Under Bertrand's
model, each seller sets his price based on the premise that his rival's price, not his output,
stays constant, but under Cournot's model, each seller assumes his rival's output to remain
constant.The emphasis of Bertrand's model is price competition. The duopolists' reaction
function is one of his analytical tools. Iso-profit curves serve as the foundation for the
derivation of reaction functions. For a given level of profit, an iso-profit curve is created
using several pricing combinations that the competing companies charge. Assuming that
there are just two businesses, A and B, he measured the prices of each along the vertical
and horizontal axes, respectively.

Their iso-profit curves are drawn on the basis of the prices of the two firms. Iso-profit
curves of the two firms are concave to their respective prices axis, as shown in Fig.5.21
and 5.22. Iso- profit curves of firm A are convex to its price axis PA (Fig. 5.21) and those
of firm B are convex to PB (Fig. 5.22).

Figure 5.21 figure 5.22

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In Figure 5.22, we have curve A, which shows that A can earn a given profit from the
various combinations of its own and its rival’s price. For example, price combinations at
points, a, b and c yield the same level of profit indicated by the iso-profit curve A1. If
firms B fixes its prices Pb1– firm A has two alternative prices, Pa1 and Pa2, to make the
same level of profits. When B reduces its price, A may either raise its price or reduce it. A
will reduce its price when he is at point c and raise its price when he is at point a. But
there is a limit to which this price adjustment is possible. This point is shown by point b.
So there is a unique price for A to maximize its profits. This unique price lies at the
lowest point of iso-profit curve. The same analysis applies to all other iso-profit curves,
A1 A2 and A3 we get A’s reaction curve. Note that A’s reaction curve has a rightward
slant. This is so because, iso-profit curve tends to shift rightward when A gains market
from his rival B. Following the same process, B’s reaction curve may be drawn as shown
in Fig. 5.22.

The equilibrium of duopolists suggested by Bertrand’s model may be obtained by putting

together the reaction curves of the firms A and B as shown in Fig. 5.23.

Figure 5.23

Point E is the equilibrium point since it is where the reaction curves of A and B intersect
and their expectations actualize. There is stability in this equilibrium. Therefore, if any of

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the corporations disagree up until this point, it will set off a chain of events and reactions
that will bring them all back to point E.

3 . EDGEWORTH’S DUOPOLY MODEL:

In 1897, Edgeworth created his duopoly model. Edgeworth's model adopts Bertrand's
supposition that every seller believes his competitor's pricing will be constant rather than
his own output. Fig. 5.24 is an illustration of his model.
Figure 5.24

In this figure we have supposed that there are two sellers, A and B, in the market who
face identical demand curves. A has his demand curve DDA and as DDA Let us also
assume that seller A has a maximum capacity of output OM and B has a maximum output
capacity of OM’. The ordinate ODA measures the price. To explain Edgeworth’s model,
let us assume, to begin with, that A is the only seller in the market. Following the profit
maximising rule of a monopoly seller, he sells OQ and charges a price, OP2. His
monopoly profit under zero cost, equals OP2EQ Now, let B enter the market. B assumes
that A will not change his price since he is making maximum profit. He sets his price
slightly below A’s price (OP2) and is able to sell his total output. At this price, he
captures a substantial part of A’s market. Conversely, Seller A reports a decline in sales.
Setting his pricing just below B's, A tries to reclaim his market. This causes the vendors
to engage in a price war.
Price-cutting is one form of the price war that lasts until the price hits OP1. Both A and B
can sell their total output at this price; A sells OQ and B sells OQ'. Thus, one could
anticipate that the price of OP1 would remain constant. Edgeworth, however, contends
that price OP1 shouldn't be constant.

The sellers notice an intriguing fact when price OP is set in the market, which is the
straightforward explanation. In other words, each seller believes he can raise his price to
OP2 and make a 100% profit, even though he realizes his adversary is selling his entire
output and won't adjust his price.
Their action and response are based on this realization. Let seller A take the lead, for
instance, and increase his price to OP2. Considering that A keeps his price OP2.B
discovers that he can sell his full output at a higher price and make more money if he sets
his price at a level that is marginally below OP2. As a result, B increases his price in line
with his strategy.

Now it is A’s turn to know the situation and react. A finds that his price is higher than B’s
price and his total sale has fallen. Therefore assuming B to retain his price, A reduces his
price slightly below B’s price. Thus, the price-war between A and B begins once again.
This process continues indefinitely and price keeps moving up and down between OP1

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and OP2 Obviously, according to Edgeworth’s model of duopoly, equilibrium is unstable

and indeterminate since price and output are never determined. In the words form
Edgeworth, “there will be an indeterminate tract through which the index of value will
oscillate, or, rather will vibrate irregularly for an indefinite length of time”.

5.8 REGULATORY ASPECT OF MONOPOLY

Economic policy must regulate monopolies because they can result in unfair business
practices and inefficiencies that hurt consumers and the economy as a whole. Governments
and regulatory agencies use a variety of tactics and interventions to manage the authority and
conduct of monopolistic enterprises. This is known as the regulatory component of
monopolies. Key elements of monopoly regulation are as follows:
1 . ANTI TRUST LAW: The goal of antitrust laws is to foster competition and stop
monopolies from emerging. Their goal is to shield customers from monopolistic tactics that
can result in increased costs, worse products, and fewer options. For example; The Sherman
Antitrust Act in the United States is one of the most well-known antitrust laws, which
prohibits monopolistic behavior and attempts to monopolize a market. Similar laws exist in
other countries, such as the Competition Act in the UK and the Competition Law in the
European Union.
2 . PRICE REGULATIONS: Regulations may limit the prices that a monopoly is permitted
to charge in order to guard against price gouging and to make sure that customers are not
taken advantage of. To restrict the amount that a monopoly can charge for its goods or
services, price limits may be put in place. As an alternative, regulators can mandate that
monopolies use cost-plus pricing, in which prices are determined by adding a fair profit
margin to manufacturing costs.
3. QUALITY STANDARDS: Monopolies might not have strong incentives to continue
providing high-quality goods or services if there is no competition. Standards may be
imposed by regulatory organizations to guarantee that customers obtain a particular caliber of
product and service. For example: Utilities like electricity and water providers, which often
operate as natural monopolies, are typically subject to regulations that mandate service
reliability, safety standards, and customer service levels.
4 . MARKET LIBERALISATION: Governments may take steps to introduce competition
into markets where monopolies exist. This can involve breaking up monopolies,
deregulating certain aspects of the market, or encouraging new entrants.
For instance, deregulation of the telecom sector has lowered consumer costs and
enhanced competitiveness in many nations. Governments may occasionally dismantle
monopolies into smaller, rival companies, as was the case with the 1980s dissolution of
AT&T in the United States.

5 . PUBLIC OWNERSHIP: When a monopoly is considered necessary, as in the case of

utilities or public services, ownership of the monopoly may be taken over by the
government to guarantee that it functions in the public interest rather than for profit. For
example; Some countries have publicly owned monopolies in areas like postal services,
railways, and healthcare. The government controls these entities to ensure they serve the
public efficiently and equitably.
6 . MONITORING AND REPORTING: Regulatory agencies keep a close eye on
monopolistic companies to make sure that laws and rules are being followed. This

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monitoring aids in the identification and prevention of unfair pricing practices, abuses of
market dominance, and anti-competitive activity. Regulators employ audits,
investigations, and regular reporting requirements as tools to prevent monopolies.
7 .PENALTY AND SANCTION: A monopoly may be subject to fines or other
consequences if it breaks rules. These may take the form of penalties, directives to sell
assets, or demands to alter corporate procedures. For example; As seen in cases involving
major internet corporations and financial institutions, regulatory organizations have the
authority to levy substantial fines on monopolistic firms found guilty of engaging in anti-
competitive actions.

5.9 PRICING STRATEGY

Pricing is an exercise, under pricing will results in losses and over pricing will make the
customers run away. To determine pricing in a scientific manner. It is necessary to understand
the pricing objectives,pricing methods,procedures and policies.

1 . COST BASED PRICING METHOD

COST PLUS PRICING: The most basic pricing strategy is cost-plus pricing. To determine
the selling price, the company computes the cost of production and adds a percentage (profit)
to that figure. Despite being straightforward, this strategy has two drawbacks: it ignores
demand and makes no attempt to predict whether or not potential buyers will buy the goods at
the estimated price.There are two variations of this: full cost pricing, which adds a percentage
markup and accounts for both variable and fixed costs. The alternative is direct cost pricing,
which consists of variable costs plus a percentage markup. This strategy is only employed
during times of intense competition because it typically results in a loss over time.

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MARGINAL COST PRICING: The selling price is set so that, depending on the state of
the market, it completely or partially recovers fixed expenses and covers all variable or
marginal cost.This is sometimes referred to as target profit pricing or break-even pricing.

2 . COMPETITION BASED PRICING METHOD

SEALED BID PRICING: Governmental and other public entities request price estimates in
order to ensure that competing bids are considered objectively. Vendors that are interested are
duly informed about the request for bids, and they have to fulfill strict guidelines on the
format of their bids as well as a deadline for bidding. Sometimes sealed bids are revealed to
the public in front of all bidders. The order is given to the lowest bidder.

GOING RATE PRICING: This is an instance where the firm's price is competitive with the
industry average. For example, the current market rate at a certain moment is used to
establish the price when someone wants to buy or sell gold.Typically, the price is established
using the going market rate at a specific moment in time.

3 . DEMAND ORIENTED PRICING METHOD

Demand-oriented pricing guidelines suggest setting prices based on the degree of demand as
well as customer preferences and perceptions. As a result, the seller must lower the price of
his goods if he wants to sell more, and he may only sell a small amount of his goods if he
wants to get a good price.

PERCEIVED VALUE PRICING: Value perception Pricing takes into account the buyer's
estimation of the product's value as well as the pricing model. In this case, the price guideline
requires the business to create methods for determining how much customers think a product
is worth in relation to its other products.

DIFFERNTIAL PRICING: Simply put, differential pricing is price discrimination. It entails

charging various prices for the same good or service in several market niches. Price
differential is influenced by a number of factors, including the consumers' type, purchase
volume, season, and place of residence. For instance. charges for phones and APSRTC
charges.

4 . STRATEGY BASED PRICING METHOD

MARKET SKIMMING: Most skimming involves the sale of items at a higher price.
Skimming is typically done in the electronic market when a new range, such DVD players or
smart phones, is first released into the market at a premium price in order to recover the cost
of investment of the original research into the product. Targeting "early adopters" of a service
or product is a common usage for this tactic.

MARKET PENETRATION: The market skimming approach is precisely the opposite of

this.Here, the product's price is set so low that the business can gain market share. As
volumes rise and market share grows, the business turns a profit.

TWO - PART PRICING: Market-dominant companies can increase earnings by using the
two-part pricing method. A company uses this tactic to charge a set price for the right to buy
its goods plus a per-unit fee for each item that is bought. This tactic is typically used by

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entertainment establishments including health clubs, golf courses, country clubs, and athletic
clubs. They charge a monthly or per-visit fee in addition to a set beginning price.

BLOCK PRICING: Another strategy a company with market power can use to increase
profits is block pricing.One pack of six Lux soaps or five packs.by offering a specific number
of product units as a single bundle.

COMMODITY BUNDLING: The act of grouping two or more distinct products together
and offering them for sale at a single bundle price is known as commodity bundling.This
approach is demonstrated by the package offers made by airlines and vacation
operators.Computer companies provide PCs, constructing them in accordance with client
requirements and selling them at a discounted price.

PEAK LOAD PRICING: This is especially useful for public commodities like public
transportation in urban areas, where demand is typically higher during the day (peak period)
than at night (off-peak period). The marginal benefits of capacity are found by deducting the
marginal costs of operation from the initial requests. These benefits must then be vertically
aggregated and equal to the marginal cost of expanding capacity.

5.10 SUMMERY

 A market for a commodity in which a sizable number of unorganized buyers

and sellers compete with one another in the purchase and selling of the
commodity without having any personal influence over the market price of the
commodity is referred to as perfectly competitive. Thus, it is a market
structure where a large number of customers and sellers exchange uniform
products free from government intervention.
 The word monopoly has been derived from the combination of two words i.e.,
‘Mono’ and ‘Poly’. Mono refers to a single entity and poly to control. In this
way, monopoly refers to a market situation in which there is only one seller of
a commodity.
 Monopolistic competition is a type of market structure where many firms sell
similar but not identical products. Therefore, product differentiation is main
quality of monopolistic competition.
 A systematic analysis of oligopoly is challenging due to the uncertainty
surrounding the behavior pattern of a firm operating in an oligopoly, which
arises from their unpredictable actions and reactions. However, based on
various behavioral hypotheses, economists from both the classical and modern
schools have created a wide range of models.

5.11 GLOSSARY

Peak load pricing: Business charges higher price during high demand

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Buyer’s market: a market for good where price are falling and more parties are there
interested in selling than buying

Pay off matrix: double entry table with all payment made by one player to other for each
adopted strategy.

5.12 QUESTIONS AND EXERCISES

SHORT QUESTIONS

1) How a public monopoly is different from a private monopolist

firm? ...................................................................................................................... .........................
............................................................................................. ...........................................................
...........................................................
2) How does the public monopoly firm make price and output
decisions? ...................................................................................................................... .................
..................................................................................................... ...................................................
...................................................................
3) What do you mean by Mark up
pricing? ...................................................................................................................... .....................
................................................................................................. .......................................................
...............................................................

LONG QUESTIONS

1. Explain briefly the perfect competition and its features?

2. Distinguish between collusive and non collusive oligopoly.

3. Explain the price discrimination under monopoly.

4. Distinguish monopoly and monopolistic competition.

5. Expalin the game theory in oligopolistic market competition?

6. Explain the regulatory aspect of monopoly?

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