Contents

Contents 1

1 Production Function 5
1.1 Production Function . . . . . . . . . . . . . . . . . . . . . . . . 5
1.1.1 Features of production function . . . . . . . . . . . . . . 7
1.1.2 Types of Production Function . . . . . . . . . . . . . . . 7
1.2 Some Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.3 Properties of Iso-quants . . . . . . . . . . . . . . . . . . . . . . 14
1.4 Production: Single Variable Factor . . . . . . . . . . . . . . . . 19
1.5 Producers Equilibrium . . . . . . . . . . . . . . . . . . . . . . . 22
1.5.1 Output Maximisation . . . . . . . . . . . . . . . . . . . 22
1.5.2 Cost Minimisation . . . . . . . . . . . . . . . . . . . . . 24

2 Cost Concepts 27
2.1 Types of Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
2.2 Cost Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
2.3 Short-run Cost Behaviour . . . . . . . . . . . . . . . . . . . . . 29
2.3.1 Economies of Scale . . . . . . . . . . . . . . . . . . . . . 32

3 Revenue Concepts 43
3.1 TR, AR and MR in Perfect Competition . . . . . . . . . . . . . 44
3.2 TR, AR and MR in Imperfect Competition . . . . . . . . . . . 45

4 Objectives of Firm 49
4.1 Various Objectives of Firm . . . . . . . . . . . . . . . . . . . . 50
4.2 Profit Maximisation with T R and T C . . . . . . . . . . . . . . 52
4.3 Profit Maximisation with M R and M C . . . . . . . . . . . . . 54

5 Break Even Analysis 57

5.1 Break-Even . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

1
 5.2 Uses of Breakeven Analysis . . . . . . . . . . . . . . . . . . . . 59

6 Perfect Competition 67
6.1 Classification of Markets . . . . . . . . . . . . . . . . . . . . . . 68
6.2 Criterion for classification of firms into industries . . . . . . . . 68
6.3 Perfect Competition . . . . . . . . . . . . . . . . . . . . . . . . 70
6.4 Short Run Equilibrium . . . . . . . . . . . . . . . . . . . . . . . 72
6.5 Shut Down Point . . . . . . . . . . . . . . . . . . . . . . . . . . 75
6.6 Long Run Equilibrium . . . . . . . . . . . . . . . . . . . . . . . 76

7 Monopoly 79
7.1 Features of Monopoly . . . . . . . . . . . . . . . . . . . . . . . 79
7.2 Classification of Monopoly Market . . . . . . . . . . . . . . . . 81
7.3 Short Run Equilibrium . . . . . . . . . . . . . . . . . . . . . . . 82
7.4 Monopoly and Pure Competition . . . . . . . . . . . . . . . . . 84
7.5 Discriminatory pricing . . . . . . . . . . . . . . . . . . . . . . . 89

8 Monopolistic Competition 93
8.1 Features of Monopolistic Competition . . . . . . . . . . . . . . 94
8.2 Price Output Determination . . . . . . . . . . . . . . . . . . . . 96
8.2.1 Short Run Equilibrium . . . . . . . . . . . . . . . . . . 96
8.3 Long-Run Equilibrium . . . . . . . . . . . . . . . . . . . . . . . 99
8.3.1 Model I: Equilibrium with the entry of new firms . . . . 99
8.4 Perfect vs Monopolistic Market . . . . . . . . . . . . . . . . . . 100

9 Oligopoly 105
9.1 Characteristic Features of Oligopoly . . . . . . . . . . . . . . . 106
9.2 Cournot’s Duopoly Model . . . . . . . . . . . . . . . . . . . . . 110
9.3 Sweezy’s Kinked Demand Model . . . . . . . . . . . . . . . . . 112
9.3.1 Sweezy’s Kinked Demand Model . . . . . . . . . . . . . 114

2
Chapter 1

Production Function

Production: Production involves a transformation of inputs into outputs

along with an addition of use value. Production covers not only physical
transformation or physical output but also services rendered, as there is also
value addition. The inputs could be land, labour, capital, entrepreneurship
etc. and the output could be tangible goods or intangible services.
A technical problem: In real life, manufacturers want to know the quantity
of each input that will be required to produce a given output so that they can
assess their requirements of inputs and estimate the cost.

1.1 Production Function

The production function expresses time specific relationship between flows
of inputs and resulting output flows. More precisely, a production function
explains combinations of quantities of different inputs to yield a given quantity
of output or the maximum output that can be produced from the given
quantities of inputs.
The production function is a technical relation that describes the proportions
of inputs to each other to produce any particular quantity of output. Since
production function is related to the physical aspects of production, it is more
a concern of technicians than of economists. Only a technician can tell how
a specific quantity of output can be produced by different combinations of
various productive resources. Production function can be expressed as,
Q = f (N, L, C, E, T . . . , ν, γ) (1.1)
where, N - natural resources L - labour

3
 C – Capital, E - Entrepreneurship,
T - Technology. ν - returns to scale
γ - efficiency parameter

Production function depends on quantities of resources used, state of tech-

nology, possible process, size of firms, nature of the organisation and how
factors are combined. A commodity may be produced by various methods of
production.

Process
( )→ (P1) (P2) (P3)
L 2 3 4
Q=
K 3 2 1

Graphically above production function is presented the Figure 1.1

p1

p2

p3

O
L

Figure 1.1: Production Function

Production method A is technically efficient relative to any other method,

say B, if A uses less of at least one factor and no more of any other factor.
Method B is technically inefficient compared to A if it uses more of at least
one factor and no less of any other factor. If process A uses less of one and
more of another factor as compared to process B, then the efficiency of A and
B is not comparable.

The theory of production describes laws of production. A technically efficient

method is not necessarily economically efficient. The choice of any particular
technique is an economic issue. All the technically efficient methods to produce
a given level of output are shown by iso-quant which assumes different shapes
depending on the rate and degree of substitutability of factors.

4
1.1.1 Features of production function
1. Production function represents the purely technical relationship between
physical quantities of inputs and outputs. It is not related to factor
remuneration or product price.

2. It is a flow concept. It means every change in inputs will be reflected in

the quantity of output.

3. Output is the result of joint use of factors of production.

4. Productivity of a single factor can be measured only then all other things
are constant.

5. The number of factors and their combination depend on the state of

technological knowledge.

6. In specifying production function, we have to take into account the

variability of the factors of production and also whether they are divisible
or non-divisible.

7. Functional relationship between input and output depends on the time.

1.1.2 Types of Production Function

Production function can be classified based on different factors like time, the
nature of the equation, a combination of factors etc.

1. Short-term and long-term production function: A long run is a

period during which all factors of production are changeable or no factor
is fixed. Therefore, long-run production function can be written as,

Q = f (N, L, C, E, T . . . , ν, γ) (1.2)

A short run is a period during which at least one factor of production is

not changeable or all the factors cannot be changed. Therefore, short
run production function can be written as,

Q = f (N, L, C̄, E, T̄ . . . , ν̄, γ̄) (1.3)

where capital, technology, returns to scale and efficiency is considered to

be constant.

2. Fixed and variable proportion production function: Production

function can be classified as a fixed proportion or variable proportion

5
 production function, based on factor combination. In fixed-proportion
production, the factors can be combined in a certain fixed ratio. More or
less any one factor does not work. For example, the vehicle and driver
need to be in a 1:1 ratio. In variable proportion, production factors can
be combined in different ratios. For example, by increasing the number
of tyres, a vehicle can be used to carry more load.

When only one factor is variable production function is expressed by the law
of variable proportion. When two factors are variable production function is
expressed as an iso-quant. When all the factors of production are variable
by the same proportion, the production function is expressed by returns to
scale.

1.2 Some Definitions

1. Total Product Curve: The production function can be shown geomet-
rically with the help of the total product curve. A total product curve
shows the level of output at the different quantities of factors measured
on the horizontal axis. Change in output due to the factor measured on
the X-axis is shown by movement along the curve and change in output
due to other factors is shown by a shift in the total product curve.

q2 = f (L)K2

q1 = f (L)K1

O
L

Figure 1.2: Total Product Curve

In Figure 1.2, if the quantity of labour, measured along the horizontal

axis, changes output change is shown by moving along the curve. If the
are changes in any other factors change in output will be shown by shifts
of the total product curve. In Figure 1.2, q1 is the total product curve
when capital is K1 and q2 is the total product curve when capital is K2 .

2. Marginal Product: Marginal product is a change in output due to a

unit change in the factor of production. It is the first order derivative of

6
 the total product function.
dQ
Marginal Product of Labour M PL = (1.4)
dL
dQ
Marginal Product of Capital M PK = (1.5)
dK

3. Iso-quant (Q̄i ): When two factors are variable, the graphical production
function is shown by a map of iso-quants. Iso-quant means equal quantity.
An iso-quant is a locus of points that shows all possible combinations of
factors (say labour and capital) of production which produces a given
specific quantity of output, other things being equal. If the production
function is a variable proportion production function, the given quantity
of output can be produced by using more of one factor (L) and less of
another (K) or vice versa. If we join all possible points it will give a curve
known as iso-quant or producer’s indifference curve or transformation
curve or equal product curve or product indifference curve etc.

The shape of an iso-quant depends on how two variable factors are

combined. Depending on their shape they can be classified in Figure 1.3.

K K K K

p1

p2
Q̄ p3
p4
Q̄ Q̄ Q̄
O
L L L L

(a) Linear (b) I-output (c) Kinked (d) Convex

Figure 1.3: Types of Iso-quant

(a) Linear iso-quant: It is a downward sloping straight line. It shows

the perfect substitutability of factors. Its slope shows a constant
rate of technical substitution of factors. Figure 1.3a

(b) Input-output iso-quant or Leontief Iso-quant: If the produc-

tion function is fixed proportion or there is strict complementarity
or zero substitutability, for every quantity there will be a single
method to produce it. In this case, iso-quant is called input-output
or Leontief iso-quant. Figure 1.3b.

7
 (c) Kinked Iso-quant or Linear Programming Iso-quant or
Activity Analysis Iso-quant: If the production function tends
to be a fixed proportion production function but it allows limited
substitutability factors, the iso-quant is called kinked iso-quant. It
shows that production processes are not divisible. The production
of a given quantity is possible with quite a few processes. One
process is a hard substitute for every other process. It is the reality
of the production processes. Figure 1.3c.

(d) Convex iso-quant: If every smaller change in input is possible

then iso-quant is convex. It shows continuous substitutability over a
certain range. It is an approximation of a realistic kinked iso-quant.
With every increase in the number of possible processes kinks in
kinked iso-quant come closer and iso-quant becomes smothered or
convex. Figure 1.3d.

Each iso-quant shows a unique quantity of output or for each specific

quantity, there is a unique iso-quant. Changes in factor combinations
producing the same quantity are shown by moving along the iso-quant.
While changes in quantity produced are shown by shifts of iso-quant.

4. Factor Intensity: Factors can be combined in variable proportions.

Their proportion to each other is called factor intensity. It shows if a
given factor is used more or less in proportion to other factors. Factor
intensity is the ratio of the quantity of one factor to another. It is useful
to check changes the cost of production by changing faster intensity. In

p1

p2
p3

p4
Q̄
O
L

Figure 1.4: Factor Intensity

the figure 1.4 capital is measured on ordinate axis and labour on abscissa
axis. The slope of lines OP1 , OP2 , OP3 and OP4 show factor intensity
or ratio capital to labour ratio. The upper part of the iso-quant shows

8
 capital intensive production while in lower part it is labour intensive
production.

5. Product line: Iso-quant depicts the same level of output with different
combinations of factors. The output produced depends on factor prices.
Producers to minimise the cost of production changes factor intensity.
This course of change in factor intensity is shown by a product line.
A product line shows movement from one iso-quant to another as we
change single or multiple factors. Product lines are not influenced by the
price of goods but by factor prices. The product line shows technically
possible alternative paths of output expansion. A product line or curve
can be linear or non-linear.

K K
K

PL PL

Q̄
Q̄
PL Q̄
Q̄
Q̄ Q̄
Q̄ Q̄ O O
Q̄ L L
O
L
(b) All Factors (c) Disproportionate Vari-
(a) Single Variable Factor Variable ation

Figure 1.5: Product Lines

If only one factor is variable product line is a straight line (Figure 1.5a)
parallel to the axis along which the variable factor is measured. If both
factors are changed in a fixed proportion, the factor line (Figure 1.5b)
will start from the origin and will be a straight upward sloping. If both
the factors are changed in variable proportion, the factor line (Figure
1.5c) will be a curve originating from the origin.

6. Isocline: Isocline is a product line at which the MRS of factors is

constant. The isocline of homogeneous production function is a straight
line. If the production function is non-homogeneous isocline will twiddle.

7. Income /Budget /Iso-cost: Assume a situation in which the pro-

ducer has a limited amount of money and real resources are to be
purchased/hired in the factor market. What quantity of resources he
can buy/hire depends on his money and factor prices. With a limited
amount of money, if a producer buys/hires more of one factor he will
have less of other factors.

9
Considering only two factors labour (L) and capital(C), we plot all such
possible combinations which can be bought/hired by the producer with
his limited resources. On joining these points we will have a downward
sloping curve called iso-cost. It shows all possible combinations of factors
which can be bought/hired by the producer with a given limited money
resources, provided he spends full of his money. The curve will be straight
if prices are constant. For variable prices it becomes non-linear. It is also
known as the budget line because it shows the budget of the producer.
It is also known as the factor price line because it shows the prices of
factors.

Assume that the producer has |100, the wage rate is |20 and the interest
rate is |10. We will have Table 1.1.
Table 1.1: Iso-cost of |100

Factors Combinations
A B C D E F
wage rate (w) = |20 0 1 2 3 4 5
interest rate (i)= |10 10 8 6 4 2 0

10 A(0,10)
B(1,8)
8
Capital (C)

C(2,6)
6
D(3,4)
4
E(4,2)
2
F(5,0)
0
1 2 3 4 5
Labour (L)

Figure 1.6: Iso-Cost Line

For example, assume that a producer has amount of |100, wage rate w
is |20 and rate of interest i is |10. Therefore, consumer can hire 5 units
of L at maximum and nothing of C or 10 units of C and nothing of
L. Between these two extreme possibilities, producer can hire/purchase
their different combinations as shown in the Table 1.1 and Figure 1.6.

It is also called an iso-cost line because it shows the relative prices of

10
 factors. If the price of any factor(s) changes, while that of the other is
constant, one will become relatively costlier and the other cheaper. In
this case, the price line will shift accordingly.

(a) If the factor along Y-axis becomes costlier, the iso-cost line will
become flattered.

(b) If the factor along Y-axis becomes cheaper, the iso-cost line will
become steeper.

(c) If the factor along X-axis becomes costlier, the iso-cost line will
become steeper.

(d) If the factor along the X-axis becomes cheaper, the iso-cost line will
become flattered.

(e) If both factors’ prices changed in the same proportion, none of them
will be costlier or cheaper. The new price line will be parallel to
the origin.

8. Marginal Rate of Technical Substitution: This concept parallel to

the marginal rate of substitution in the indifference curve and marginal
utility or marginal productivity in cardinal measurement. M RT S of a
given factor is the number of units of another factor required to substitute
one unit of the given factor, while keeping output constant. For example,
M RT SXY is a number of units of Y required to substitute one unit of
factor X, while production is unchanged.

change in no units of capital

M RT SLK = (1.6)
change in no units of labour
change in no units of labour
M RT SKL = (1.7)
change in no units of capital
The M RT S of the factor measured on the horizontal axis is always equal
to the slope of iso-quant. The M RT S negative when both factors are
positively productive. It is zero when factor is not productive. It is
positive when one factor is negatively productive. The M RT S of a given
factor decreases along with an increase in its quantity. It means that with
an increase in a factor, say labour, and a decrease in another factor, say
capital, increased factor labour will work with smaller per-head capital
and it finds difficult to work. Therefore, with unit increase in labour, we
can decrease only smaller and smaller quantity of capital.

9. Elasticity of Substitution: To measure a degree of substitutability

11
 M RS is not a good measure because it depends on the unit of measure-
ment of factors. For example, if we measured one factor in a number of
units or dozens or 100s, then M RS changes and will become incompara-
ble. Here elasticity of substitution would be a better measure. It is rare
of a percentage change in capital-labour ratio to a percentage change
M RS.
percentage change in K/L
σ =
percentage change in M RS
d(K/L)
(K/L
= d(M RS)
(1.8)
M RS

It would be a pure number independent of the unit of measurement.

1.3 Properties of Iso-quants

Iso-quant means equal quantity. Iso-quant is the producer’s indifference curve
which shows an equal level of output with different combinations of factors. It
is a locus of points that shows all possible combinations of factors (say labour
and capital) of production which give the same quantity of output. If we join
these points of locus we will have a curve or a line. First, we will assume that
iso-quant is a straight line and will try to find its slope.

1. Iso-quant slopes downward from left to right: If iso-quant is a

straight line. There are three possibilities- it is parallel to one of the
axes or it slopes upward or slopes downward. Each of these possibilities
has its implications.

K K

Q̄

K2 B
A B
K̄ Q̄

K1 A

O O
L1 L2 L L1 L2 L

Figure 1.7: Slope of Isoquant

An iso-quant parallel to any of axes implies that, with a given constant

quantity of a factor, any change in the variable factor does not change
output. It means the variable factor has zero productivity. Or increase

12
 in the quantity of a factor in production, does not release any quantity
of other factors. The upward sloping iso-quant means to produce same
quantity, with increase in quantity of one factor we will have to increase
use of factors also. It simply means productivity of one factor is negative.
Therefore, an iso-quant cannot be upward-sloping or parallel to any of
the coordinate axes.

(L − δL, K + δK) (L + δL, K + δK)

K1
(L, K)

(L − δL, K − δK) (L + δL, K − δL)

Q̄
O
L1 L

Figure 1.8: Iso-quant slopes downward

The third possibility implies that, other things being equal, if the producer
decreases one of the factors of production he will have to increase another
factor to maintain the same output. Similarly, if he increases any of
the factors, it will allow him to decrease other factor while maintaining
the same level of output. This condition will be fulfilled only by the
iso-quant sloping negatively.

What is true about factor productivity?

(a) All units of every factor are equally productive.
(b) All units of every factor are differently productive.
(c) Some units of some factors are equally productive while
other units are differently productive.
(d) All units of some factor may be equally productive (ma-
chines) and of other factor differently productive (labour).

2. Iso-quant is convex to origin: When it has been established that

iso-quant slopes negatively, there arise 3 possibilities- iso-quant is a
straight line or it is concave to the origin or it is convex to the origin.
This property of iso-quant explains changes in the productivity of factors

13
when they substitute each other.

A straight-line iso-quant means that the rate of substitution between

the factors remains constant irrespective of their quantities. It implies
that factor combinations do not affect factor productivity and all units
of factor are homogeneous. But in reality, the productivity of factors
(like marginal utility) decreases with more of it. Therefore, it releases
less of other factors in substitution. That is why an iso-quant cannot be
a straight line.

A concave to origin iso-quant implies that with an increase in the quantity

of a factor, other things being equal, its productivity increases. In other
words, when we substitute labour for capital, the productivity of labour
increases and that of capital decreases. It means every next factor unit
is better or less productive factors are preferred to more productive
factors. It advocates continuous substitution of one factor by other. It
also implies single factor production. But the reality is that factors are
not perfect substitutes and iso-quant cannot be concave to the origin.

When factors are employed they are combined in a certain ratio. Assume
that all factors units are equally productive. If one factor is decreased, to
keep production constant, we have to increase another factor. Therefore,
their proportion with each other changes. It reduces marginal produc-
tivity of increased factor and that of decreased factor increases. It is
because the increased factor will have smaller per-head availability of
other resources and decreased factor will have larger per-head availability
of other resources. This effect arises out of factor coordination.

The convexity of an iso-quant shows that with an increase in the quantity

of a factor its marginal productivity decreases. The decreasing marginal
productivity is a result of the under-utilisation of the increased factor. If
one factor is substituted for other, an increased factor will be combined
with less of decreased factor. This will reduce the marginal productivity
of the increased factor and that of decreased factor will increase. It
is also true that while recruiting more productive units of factor are
preferred to less productive units and while removing factor units lesser
productive units will be removed. It means that, while producing, with
every successive increase in labour (capital), it will release decreasing
quantity of capital (labour) from production. Therefore, iso-quant is
always convex to the origin.

Thus we can say that convexity of iso-quant is result of two thins, one
factor co-ordination and non-homogeny of factors.

14
 K

(1,20)

(2,15)

(3,11)

(4,8)
(5,6)
(6,5)
Q̄

O
L

Figure 1.9: Iso-quant is convex

3. The larger is the distance of an iso-quant from the origin the

higher is output shown by it: In the Figure 1.10 Q̄1 and Q̄2 are two
iso-quants showing two different levels of output.

B(4,6)

A(4,4) Q̄2

Q̄1
O
L

Figure 1.10: Iso-quant and level of Output

At a point, A on Q̄1 the producer uses 4 units of labour L and 4 units of

capital C. While at point B he uses 4 units of labour L and 6 units of
capital C. Therefore, production at point B must be greater than that
at point A, because at point B producer uses the same number of units
of labour as at point B, but more of capital. In this way, we can say
production on Q̄2 must be greater than production on Q̄1

15
4. Iso-quants cannot intersect to each other: If two iso-quant intersect
each other, they violate the law of transitivity. Let us see what happens
when two iso-quant intersects with each other. In Figure 1.11, we can
say the quantity produced at points A and B is the same, as they are
on the same iso-quant. Similarly, we can say the quantity produced at
points B and C also is the same. Thus, as per the law of transitivity, (if
A = B and B = C, then A = C) quantity produced at points A and C
must be same. But as A and C lie on different indifference curves. The
output at these points cannot be same. This inconsistency is the result
of their intersection, therefore, they cannot intersect with each other.
C

B
y
A
Q̄2
Q̄1
O x L

Figure 1.11: Isoquants cannot Intersect

5. Iso-quants are oval shaped: If one factor of production continuously

increased, its marginal productivity decreases to become zero and then
negative. If marginal productivity of both factors is positive, iso-quant
slopes negatively. If marginal productivity of a factor is zero, iso-quant
becomes parallel to the axis on which the factor is measured. If marginal
productivity of any factor is negative iso-quant slopes upward while
going away from the axis on which that factor is measured. It means
when negatively productive factor is increased, to keep output constant,
we have to increase other factor also.

When iso-quant becomes parallel to X-axis, it means the productivity

of labour is zero. If further it becomes positively sloping, it shows
labour productivity is negative. To compensate negative productivity
of labour, producers will have to use an increased quantity of capital
too. On the other hand, when iso-quant becomes parallel to Y-axis, it
means the productivity of capital is zero. If further it becomes positively
sloping, it shows capital productivity is negative. To compensate negative
productivity of increased capital producers will have to use an increased
quantity of labour too. Therefore, iso-quant is oval-shaped.

16
 K

Q̄

D
B

O L

Figure 1.12: Iso-quant: Oval shaped

1.4 Production: Single Variable Factor

The Law of Variable Proportion (LVP)
The law of variable proportion explains the relationship between output and
a variable factor other factors being constant. It is also known as the law
of returns. The law of variable proportion states that as the quantity of a
variable factor increases, other things remain constant, the output will increase
more than proportionately (at an increasing rate) in the beginning, and then
it may increase in the proportion (at a constant rate) and ultimately less than
proportionately (at the diminishing rate).

The law of variable proportion can be split into four stages depending on the
rate at which the total product is increasing.

Table 1.2: Variable Proportions

Stage TP increases @ AP MP
Stage I ↑ rate ↑ ↑ & > AP
Stage II constant rate constant constant= AP
Stage III ↓ rate ↓ ↓ and < AP
Stage IV decreases +ve ↓ and −ve

Stage I: Increasing Average Returns

Total products increase at an increasing rate. An M P and AP also increase
and M P > AP . In Figure 1.14, in this stage, the slope of the T P curve
increases. M P curve lies above the AP curve.

17
 Table 1.3: The Law of Variable Proportion

VF TP AP MP
1 30 30 30
2 80 40 50
3 150 50 70
4 240 60 90
5 330 66 90
6 420 70 70
7 490 70 70
8 540 67.5 50
9 570 63.3 30
10 580 58 10
11 570 51.8 -10
12 540 45 -30

The phase of increasing returns arises because of the indivisibility of fixed

factors. When fixed factors are proportionately abundant relative to the
variable factor, the fixed factor(s) remains under-utilised. When more of the
variable factors are used with the same quantity of the fixed factor(s), the
latter is used more effectively. This causes more than a proportionate increase
in production. The increase in the product also may be because of improved
coordination between variable factors. This stage comes to an end when M P
of the variable factor is the highest and equal to M P .

Stage II-Constant Average Returns

Total products increase at a constant rate. M P and AP remains constant
and M P = AP . In Figure 1.14, the slope of the T P curve remains constant.
M P and AP curves run together. This stage results because of the proper
combination of fixed and variable factors. There is an optimal exploitation
variable factor and slight underutilisation of fixed factors. The total product
increases at a constant rate because the increase in variable factor causes a
decrease in its marginal productivity but it will be just compensated by more
efficient use of slightly under-utilised fixed factors. This stage lasts when fixed
factors are used at optimum.

18
TP

TP

PT↑ PT↑ PT↑

L1 L2 L3 L
Stage I Stage II Stage III Stage IV
TP MP↑ MP MP↓

AP
L1 L2 L3 L
MP

Figure 1.13: The Law of Variable Proportion

Stage III-Diminishing Average Returns

The total product increases at a diminishing rate. M P and AP decline.
M P < AP . The slope of the T P curve diminishes.

Production reaches stage III when the fixed factor is combined with a pro-
portionately more variable factor. Therefore, there will be an over-utilisation
of fixed factors and an under-utilisation of variable factors. This causes a
decrease in the marginal product of the variable product or an increase in the
total product at a diminishing rate. This stage comes to an end when T P is
maximum or M P = 0.

Stage IV- Diminishing Total Returns

All three products fall of which MP is negative. This starts when the variable
factor becomes excess relative to the fixed factor(s). Additional units of
variable factor, instead of adding to the T P hinder production. This stage is
the result of overcrowding of variable factors.

19
TP

TP

L1 L2 L
Stage I Stage II Stage III
TP

AP
L1 L2 L

MP

Figure 1.14: The Law of Variable Proportion

Where does the producer produce?

In technical sense production with the proper combination of a fixed and
variable factor is advisable, if considering productivity and cost variable and
fixed factors are equally priced. This implies production at the endpoint
of stage II. However, business firms decide on their production at profit
maximising combination. Because of factor prices, the firm may produce some
different combinations of variable and fixed factors. The firm will increase the
variable factor (say labour) up to the point where the marginal product of the
labour equals the given wage rate in the labour market.

1.5 Producers Equilibrium

1.5.1 Output Maximisation
A producer’s equilibrium is a state of production that which producer does
not want to change. Such a state would be at maximum output. In the short
run, other things being constant, the producer tries to maximise his output

20
or minimise cost. It is because in the short run output maximisation or cost
minimisation is in line with profit maximisation.

π = R−C
= p·q−C (1.9)

If p and C are constant, we maximise profit π by maximising output and if p

and Q are constant by minimising cost C.

π =p·Q−C (1.10)

An objective of a firm is profit maximisation i.e. maximisation of the difference

between total revenue (R) and total cost (C).

K
c

IS400
f IS300
IS200
h
IS100
O
L L

Figure 1.15: Producer’s Equilibrium: Output Maximisation

In Figure 1.15, each of the iso-quants IS100 , IS200 , IS300 and IS400 shows a
specific level of output that can be produced with different combinations of
factors. KL is an iso-cost line which shows all possible combinations of factors
which can be purchased or hired, at given prices of factors, with given limited
resources. The producer can produce at any point on or below the iso-cost
line. If he produces on the iso-cost line he will use his total resources and if he
produces below the iso-cost line he will produce with less than full resources.
He cannot reach above the iso0cost line.

If the producer prefers to produce with his full resources (M ) he can do it

at a point on KL. Suppose the producer produces at point c by using more
capital and less labour, he will have an output of 100 units. If he increased
labour and decreased capital to shift production at point d he reaches the
output of 200 units with the same cost of production shown by the iso-cost

21
line. With his further move to point e with even more labour and less capital,
he will produce an output of 300 units. Again if he increased labour and
decreased capital to shift to point f or h he will merely find that the quantity
produced has decreased to 200 or 100 respectively. Therefore, the producer
would like to produce at point e, where his output is maximum at a given
constant cost. In other words, all points of KL other than e lie below iso-quant
than IS300 .

In Figure 1.15, point e on KL differs from other points, in the sense that at
point e, the iso-cost line and iso-quant are tangent to each other, while at any
other point of KL, they intersect each other. Therefore, we can infer that
the producer is at equilibrium when iso-quant and iso-cost lines are tangent
to each other. It also means that iso-quant and iso-cost lines have the same
slope.

Slope of isoq-uant = slope of iso-cost line

M RT SLC = K/L

where,

M RT SLC - marginal rate of technical substitution of L for K,

K - maximum of amount that which firm can have,
L - maximum of amount labour that the firm can have

1.5.2 Cost Minimisation

As we have defined a producer’s equilibrium is a state of production that
the firm does not want to change. At a given set of variables or production
conditions, the firm tries to minimise its cost, because in the short run output
maximisation or cost minimisation is in line with profit maximisation.

In Figure 1.16, IS is an iso-quant of 300 units of output that can be produced

with the help of different combinations of factors. KL1 , KL2 , KL3 and KL4
are iso-cost lines at different levels of budget.

Suppose the firm produces an output of 300 at point a, at a cost of |400.

If it shifted production to point b it can produce the same quantity at the
decreased cost of |300.

Further, the shift of production to point c reduces the cost to |200. If the firm
made the further experiment of producing at d or e, it will merely find that
the cost of production is increased to |300 or |400 respectively.

Therefore, the producer would like to produce at point c because it is the least

22
 C

K4
a
K3

K2 b
K1

d e IS300
O
L1 L2 L3 L4 L

Figure 1.16: Producer’s Equilibrium: Cost Minimisation

cost production.

In the Figure 1.16, point c of iso-quant IS300 is different from other points
like a, b, d and e because at point c iso-quant IS300 is tangent to iso-cost line
K2 L2 , while at other points like a, b, d and e it intersects to iso-cost lines.
Therefore, we can infer that the producer’s equilibrium is decided at the point
where the iso-quant and iso-cost lines are tangent to each other.

Slope of isoq-uant = slope of iso-cost line

M RT SLC = K2 /L2

where,

M RT SLC - marginal rate of technical substitution of L for K,

K2 - maximum of capital that firm can purchase
L2 - maximum of labour that the firm can hire

23
24
Chapter 2

Cost Concepts

Production function, being technical, is not much useful for firms in their
decision-making. What a firm needs is cost functions, which are derived from
production functions. Production incurs expenses on factors. The total of
expenses incurred plus normal profit is the cost of production. Costs are
different and important for different people, therefore, they calculate the same
cost from different angles. Depending on their views cost can be classified
differently.

2.1 Types of Costs

1. Real and Nominal Cost: Real cost refers to the physical quantities of
various factors used and sacrifice involved in production. They cannot
be measured explicitly and added together, as they are in heterogeneous
units. Nominal cost refers to the payment made to the factors used in
production i.e. the total of rent, wages, interest etc. Total money costs
can be classified as explicit and implicit costs. Firms are more concerned
about the nominal costs while arranging resources than real costs.

2. Explicit and Implicit Costs: Explicit cost is a contractual cash

payment, which firms make to the factor owners for purchasing or hiring
their factors. It includes all money payments actually made to the factor
owners. Implicit cost is the cost of self-owned factors, which are employed
by the entrepreneur. The implicit cost is an opportunity cost of factors
self-owned and self-employed by the entrepreneur, i. e. money income
that these self-owned factors would have earned in the alternative uses.

25
 In the short run, firms are careful about their explicit cost and in the
long run, while investing resources or shifting self-owned resources from
one to other uses, they think of implicit cost.

3. Accounting or Business Cost and Full or Economic Cost: Ac-

counting cost is an actual or explicit cost that is entered in books of
account as they are paid paid by the entrepreneurs to the owner’s factors.
Accounting cost outlines actual expenditures incurred for production.
On the other hand, economic cost includes not only explicit costs but
also implicit costs. The economic cost is an aggregate of implicit cost,
normal profits and explicit cost.

4. Opportunity Cost: It is quite true that the resources are limited;

therefore, the production of one good can only be at the cost of the
production of another good. The quantity of the other goods that is
missed, is an opportunity cost of the commodity produced. Opportunity
cost is the minimum remuneration which a factor must receive to prevent
it from leaving the present use for alternate uses. The opportunity cost
(or transfer earnings) of the given goods is the next best alternative
that is forgone or sacrificed. For example, a farmer who is producing a
quintal of wheat can also produce 2 quintals of potatoes with the same
resources. Then, the opportunity cost of a quintal of wheat is 2 quintals
of potatoes and vice versa.

5. Private and Social Cost: Private cost is an economic cost, actually

incurred by the firm. It includes both explicit and implicit costs. Social
cost, on the other hand private cost and external costs. External cost
includes (a) the cost in the form of free resources for which the firm is
not required to pay, like air. and (b) the cost in the form of ‘disutility’
caused by pollution to air, water, and noise pollution, etc.

6. Internal and External Costs: Internal costs are the result of the own
actions of the firm. That is the cost incurred to buy and hire resources.
Changes in internal costs are shown by movement along the cost curves.
External costs arise outside the firm due to changes in the economic
environment. They accrue to the firm because of the actions of other
firms in and out of the industry. They are reflected in the shift of cost
functions.

2.2 Cost Function

Cost functions are derived from production function, which shows the combi-
nation of physical factors. Total cost is an aggregate expenditure incurred for

26
production given the level of output. It refers to the total outlays of money
expenditure, both explicit and implicit for the resources used to produce a
given output. It is derived by adding products of factor quantities and their
prices.
TC = N · r + L · w + C · i + E · π (2.1)
Costs are distinguished as short-run and long-run. A short run is a period
during which at least one factor is fixed while in the long run, all factors are
variable. The short-run cost consists of fixed costs. The long-run cost consists
of both fixed and variable costs. Long-run costs are ex-ante costs or planning
costs, as they can be used for planning future output. Fixed cost mainly
consists of capital. Therefore, before an investment firm is in the long run and
once the investment is done it is in the short run.

In the short-run, total cost consists of total fixed cost (T F C) and total
variable cost (T V C). Costs incurred on fixed factors is called fixed cost and
that incurred on variable factors is called variable cost.

TC = TFC + TV C (2.2)

Fixed costs are constant for all the levels of output. Even if no output is
produced, a fixed cost is to be paid. Therefore, T F C graphically is denoted
by a horizontal straight line. The presence of fixed cost indicates the short
run.

Variable cost varies with the level of output. It starts from 0 for no output
and increases along with output. Initially, at a lower level of output, due to
net economies of scale, it increases at a diminishing rate and at a higher level
of output, due to net diseconomies of scale increasing at an increasing rate.
At a lower level of output fixed factors are combined with a smaller quantity
of variable factors. It causes the underutilisation of fixed factors. Therefore,
with an increase in output variable cost increases at a diminishing rate in
the beginning. It increases at a constant rate when fixed and variable factors
are combined optimally. It rises at an increasing rate when variable factors
outnumber the fixed factors and the former are under-utilised.

Any point on the cost curve shows the minimum cost to produce the given
output. It is possible to produce the same output with a cost higher than that
shown by the corresponding point on the cost cure.

2.3 Short-run Cost Behaviour

Firms have a great concern about costs because it strongly influence their profit
level. Cost behaviour is not uniform over all the levels of output. To study the

27
cost behaviour we classify and calculate it in a suitable way. The total cost is
divided into total fixed cost (T F C) and total variable cost (T V C). Further,
they are calculated for averages and marginal changes ie. total cost (T C),
total fixed cost (T F C), total variable cost (T V C), average total cost (AC),
average fixed cost (AF C), average variable cost(AV C), marginal cost (M C).
TC
TC = R + W + I + Π AC = M C = T Cn − T Cn−1
Q
TFC
TFC = R + I AF C =
Q
TV C
TV C = W + Π AV C = M C = T V Cn − T V Cn−1
Q
Where
R - rent, W.- wages, I - interest, Π - profit

If we developed a hypothetical example, it will help us to understand the

short-run behaviour of the costs. Consider the Table 2.1 in which TFC is |30
and variable cost changes along with output. We have to study the pattern of
changes in different types of costs.

Table 2.1: Cost Behaviour

Unit TFC TVC TC TFC AVC AC MC

0 30 0 30 ND ND ND NA
1 30 37 67 30 37.0 67.3 37
2 30 63 93 15 31.5 46.5 26
3 30 80 110 10 26.7 36.7 17
4 30 90 120 7.5 22.5 30.0 10
5 30 95 125 6.0 19.0 25.0 5
6 30 100 130 5.0 16.7 21.7 5
7 30 110 140 4.2 15.7 20.0 10
8 30 127 157 3.7 15.9 19.6 17
9 30 153 183 3.3 17.0 20.3 26
10 30 190 220 3.0 19.0 22.0 37

If we plotted Table 2.1, we will have graphs1 as in Figure 2.1.

1. Fixed Cost: It is independent of output. It is a short-run cost and

constant for all the levels of output. Therefore, T F C is a horizontal
straight line.

2. Total Variable Cost: It starts from zero at no output and rises initially
(due to economies) at a diminishing rate, then at a constant rate and at
1 Figure are for representative purpose and not in proportion

28
 cost cost
TC

TVC
MC AC
AVC

TFC

AFC
O O
Output Output

(a) Total Costs (b) Average and Marginal Costs

Figure 2.1: Short-run Cost Behaviour

a larger output, (due to diseconomies) at an increasing rate.

The behaviour of variable cost is the result of factor combination. If the

factor combination becomes better it increases at a diminishing rate, if
it remains the same at a constant rate and deteriorated at an increasing
rate. The reason for T V C rising at a diminishing rate is bettering factors
combination, particularly fixed factors in relation to variable factors. It
rises at an increasing rate which means that factor combinations are
worsening.

3. Total Cost: Total cost is the sum of total fixed and total variable costs.
It starts at a fixed cost for zero levels of output and rises in the same
pattern as T V C for the same reasons. The difference between T V C and
T C is always equal to T F C. Therefore, the T V C and T C curve run
equidistant to each other. The behaviour of T C is not influenced by
T F C.

4. Average Fixed Cost: It is a rectangular hyperbola2 to show that its

product with quantity is always equal to T F C.

5. Average Variable Cost: Initially at a lower level of output it decreases

along with an increase in output, reaches the minimum and finally rises
at larger output. AV C curve is ‘U’ or ⌣ (smile) shaped3 . The fall in an

2 A rectangular hyperbola is a curve or relationship between two variables when the

product of two variables is constant i.e. k̄ = xy. With the increase in the magnitude of the
variable such curve approaches the axis of the variable but never cuts the axis.
3 U or ⌣ is not symmetrical

29
 AV C is due to economies of scale while the rise is due to diseconomies.

6. Average Total Cost: Initially AC also decreases, reaches the minimum

and then increases. AC curve is also ‘U’ or ⌣ (smile) shaped. For all
the levels of output, AC is equal to or higher than AV C. If there is no
fixed cost AC is equal to AV C and if there is a fixed cost AC is higher
than AV C.

7. Marginal Cost: Marginal cost is an addition to the total cost due to an

additional unit of output. Marginal cost is calculated as T Cn − T Cn−1 .
The marginal cost curve is ‘U’ or ⌣ (smile) shaped. It means initially it
decreases, reaches the minimum and then increases, in such a way that
it becomes equal to AV C and AC at the latter minimum value. In other
words, M C intersects AV C and AC from below at their lowest points.

Observations

1. The minimum value of M C (point of M C curve) appears at a smaller

output, followed by the minimum value of AV C (point of AV C curve)
followed by the minimum value of AC (point of AC curve).

2. An M C curve cuts an AV C and AC curves from below at their minimum

points.

3. With the increase in the output the difference between AV C and AC

decreases as fixed cost spread on a larger number of units.

2.3.1 Economies of Scale

economies and diseconomies of scale
As a business grows or its output increases, the total cost will increase but the
unit cost may fall or rise thereby the business may benefit or lose from such
output changes. The fall in an average cost as output increases is known as
economies of scale and a rise in average cost is known as diseconomies of scale.
When a change in average cost is due to the output of a business firm it is
called a scale economy or scale diseconomy and when average cost changes
due to an increase in the number of plants it is called an external economy
or diseconomies. Scale economies determine the shape of the unit cost curves
and external economies determine the position of the unit curves. Changes in
scale economies are shown with movement along the unit curves and changes
in external economies are shown with shift of unit curves.

Scale economies can be divided into real and pecuniary economies. Real
economies are related to a fall in physical quantities of inputs and pecuniary

30
economies arise from lower prices paid for acquiring inputs used in production.
Real economies can be classified as production, managerial, marketing, logistic
economies etc.

Production economies consist of labour economies, technical economies and

inventory economies.

Labour economies arise in the form of specialisation of labour, time-saving,

automation of processes and cumulative volume economies.

A larger scale allows division of labour and specialisation which results in

skill improvement and enhancement of productivity due to which real cost
decreases. In smaller units, single labour may be assigned multiple jobs due
to which his potential skills remain underutilised. If labour division is made
in small firms skilled labour would remain underutilised.

Labour division also saves time lost from leaving one job to another job.

Labour division promotes the invention of tools and machines which facilitates
work.

The cumulative effect of large scale means an increase in the skills of engi-
neers foremen and workers due to repetition of the same job. Cumulative
volume experience leads to an increase in productivity and a decrease in real
cost.

Technical economies or fixed capital economies result from the specialisation

of capital equipment and the indivisibility of techniques which is common in
modern times. Thus, the mode of production can be more mechanised to
reduce costs if production is at a larger scale.

Suppose that there are three processes of producing a commodity i.e. small,
medium and large as shown in the above diagram. When production is
lesser than quantity Q1 , total cost increases proportionately with output or
AC = M C, because there is no fixed cost. Output Q1 , if produced by plant
small or medium would cost C1 . But with the same cost C1 , we can also produce
any output in the range Q1 to Q2 , therefore, AC will continuously decrease
(rectangular hyperbola) over this range. Again quantity Q2 , if produced either
by plant 2 or 3 will cost C2 . But with the same cost C2 , we can produce
any output in the range Q2 to Q3 , therefore, AC will continuously decrease
(rectangular hyperbola).

Inventory economies result from stochastic or random changes in supply,

demand and reserve capacity. Stock raw materials and output of business firms

31
 C

TC

C2

C1

O
Q
(I) (II) (III) (IV)
C

c1

c2

c3 AC
O
Q1 Q2 Q3 Q4 Q

increase with scale but not proportionately. It is mainly because of statistical

behaviour; the larger the magnitude of the variable smaller the fluctuations.
Therefore, larger firms need a comparatively smaller stock of raw materials
and output. The larger the firm the larger is number of customers and the
smaller would be fluctuations. In larger firms with cumulative experience,
breakdowns become lesser frequent and their management becomes more
efficient. Therefore, the firm need not increase reserve capacity along with the
expansion of production capacity.

Marketing economies

Marketing economies are in the form of advertising, sales arrangements, model-

change economies etc.

Advertising expense, particularly in modern times, advertising is a regular

activity of firms to occupy the minds of actual and potential customers.
Advertising budgeting increases less than proportionately with scale. The
same is true of other promotional activities salesmen, and distribution of free
samples. Large firms can afford to have showrooms with service centres. The
modern trend is to have frequent variations in the product to counter variations
by opponents and to attract new customers. This is economical only for larger
scale.

32
Managerial economies which are partly production and partly selling cost, arise
because of specialisation and mechanisation of management. In large firms
division of managerial tasks such as production, finance, personnel, marketing
etc. is more practical and economical compared to small firms where it may
not be even feasible. Such decentralisation reduces distortions and delays,
allows managers to study their area deeply, and increases knowledge, skill and
efficiency. Large firms apply most modern technology like virtual supervision
of projects. However, according to traditional economic theory, managerial
economies are subject to decreasing returns due to loss of control, delayed
decisions, leakage of information and misinterpretation of directives. Others
believe that managerial economies need not be the result of the increase in
the size of plants. Even if they are there, they are outweighed by technical
production economies

. Transport and storage

Both transport and storage costs are partly production and partly sales
costs. Storage cost, no doubt because of the surface-area-to-volume ratio,
will decrease with an increase in scale. Transport cost does not show any
monotonous behaviour as it has many facets like distance, weight-volume,
mode of transportation, transport cost to price ratio, passing of transport cost
to the buyers etc.

Pecuniary Economies

These economies consist of lower prices of raw materials due to bulk buy-
ing, lower cost of external finance, lower advertising prices, transport rates,
monopsonistic power etc.

Empirical Evidence on the Shape of cost curves

The majority of the empirical cost studies suggest that the U-shaped cost
curve is not a reality. Short-run TVC is best approximated by upward sloping
straight line i.e. AVC and MC are constant. In the long run, AC falls sharply
at lower levels of output and subsequently remains constant at larger levels of
output.

A. Statistical Cost Studies

Statistical studies consist of an application of regression analysis or extrapola-

tion to time series data or cross-section data. The time series data is more
suitable for short-run cost functions while cross-section data is suitable for
long-run cost estimation. (why?) Once data is collected we need to find the
curve of best fit. This curve may be linear or nonlinear-quadratic or cubic

33
function.

Linear Quadratic Cubic

T C = b1 X + µ T C = b1 X + b2 X 2 + µ T C = b1 X − b2 X 2 + b3 X 3 + µ
C C C
AC = = b1 AC = = b1 + b2 X AC = = b1 − b2 X + b3 X 2
X X X
dC dC dC
MC = = b1 MC = = b1 + 2b2 X MC = = b1 − 2b2 X + 3b3 X 2
dX dX dX
Interpretation problems

Statistical data are pecuniary data, not real data or opportunity cost ideally
required for estimation of cost functions. It does not include profit and
pollution. In brief, statistical cost functions. are based on ex-post data,
therefore, cannot refute the U shape of cost curves of traditional theory, which
shows X ex-ante relationship between cost and output. Ideally, the length of
the time period should cover the complete production cycle of the commodity.
However, the time period of the accountants does not coincide with the
true time period over which the production cycle is completed. Usually, the
accounting data are aggregate data for two or many production periods.

Data deficiencies

Specification of functions in statistical cost studies has been criticised for

failing to deal adequately with changes in technology and in factor prices.
While collecting data for short-run cost estimation technology is assumed to
be constant, though in reality firm may be using changed technology. In the
case of cross-sectional data, it is assumed that technology is constant in all
samples. It is also true that cost functions suffer from the problem of change in
the factor prices. Particularly in the estimation of short-run cost functions on
the basis of time series data. In the case of cross-sectional data, this problem
can be avoided if the sample should be in the same location. The same is true
about changes in the quality of products. If the quality of the product goes
up or down that cannot be included in the cost functions.

Criticisms of Long run cost studies

B. Studies based on a questionnaire Eiteman and Guthrie presented selected

firms with various graphs of costs and were asked to state which shape they
thought their own costs were. Most of the firms reported that their cost would
not increase in the long run but will remain constant over some range of
output.

C. Engineering costs

34
This method depends on the technical relationship between input and output.
The first stage in the engineering method is an estimation of the production
function. deciding optimal input combinations for producing any given level
of output i.e. least cost combination.

The second stage is the estimation of the cost curves from technical information
provided by the engineering production function. Production function gives
different factor combinations that produce a given level of output. We have
to estimate, for each level of output, the total cost of all possible factor
combinations. Choose the least expensive one as the one for that output. The
long-run cost curves can be derived from the least const combinations for each
level of output. Technically optimal input combinations are multiplied by
factor prices.

Engineering costs are a close approximation to the production costs by avoiding

problems if changes in technology and factor prices. However, they are not good
guides for managerial costs. In engineering costs relations are derived from
small-scale pilot projects and applied to larger ones which may underestimate
costs. (Refer to AA Walter Econometric Production and Cost Functions)
===========

Economies of scale refer to the factors which contribute to minimise the

long-run average cost when production is increased.

Scale economies of scale: Scale economies arise from the growth of the firm
itself. Examples include:

Economies of superior technique: Large-scale businesses can afford to invest

in expensive and specialist capital machinery. For example, a national chain
supermarket can invest in technology that improves stock control and helps
to control costs. It would not, however, be viable or cost-efficient for a small
corner shop to buy this technology.

Specialisation of the workforce: Within larger firms, they split complex produc-
tion processes into separate tasks to boost productivity. The division of labour
in the mass production of motor vehicles and in manufacturing electronic
products is an example. This happens because of repeat ion of the same
work.

The law of increased dimensions: This is linked to the cubic law where doubling
the height and width of a tanker or building leads to a more than proportionate
increase in the cubic capacity – an important scale economy in distribution
and transport industries and also in travel and leisure sectors

35
Marketing economies of scale and monopsony power: A large firm can spread
its advertising and marketing budget over a large output and it can purchase
its factor inputs in bulk at negotiated discounted prices if it has monopsony
(buying) power in the market. A good example would be the ability of the
electricity generators to negotiate lower prices when negotiating coal and gas
supply contracts. The major food retailers also have monopsony power when
purchasing supplies from farmers and wine growers

Managerial economies of scale: This is a form of division of labour. Large-scale

manufacturers employ specialists to supervise production systems. Better man-
agement; investment in human resources and the use of specialist equipment,
such as networked computers that improve communication raise productivity
and reduce unit costs.

Financial economies of scale: Larger firms are usually rated by the financial
markets to be more ‘credit worthy’ and have access to credit facilities, with
favourable rates of borrowing. In contrast, smaller firms often face higher
rates of interest on their overdrafts and loans. Businesses quoted on the stock
market can normally raise fresh money (i.e. extra financial capital) more
cheaply through the issue of equities. They are also likely to pay a lower
rate of interest on new company bonds issued through the capital markets.
Economies if linked process: A large firm can arrange production activities in
a continuous sequence without any loss of time. Most of the processes need
continuous operation and if they are discontinued cause higher cost4 . A small
laundry shop providing service as and when received customers may have a
higher cost than a big laundry shop which works continuously.

Economies of by-products: A large firm can avoid waste of materials which

it can economically use for manufacturing by-products. For example, sugar
production also excretes molasses which can be used for alcohol production
which in turn can be utilised for energy production. Thus reducing energy
bills. But small sauger factories may not excrete molasses sufficient to run the
project for a whole year and it may not be economical to run an energy plant
only for a part of a year.

Network economies of scale: There is growing interest in the concept of a

network economy of scale. Some networks and services have huge potential
for economies of scale. That is, as they are more widely used (or adopted),
they become more valuable to the business that provides them. The classic

4 Small businesses may need to discontinue their operations because of small size. If the

operation involved a heating process, closing production may cause heavy energy losses. It
is a common phenomenon that all rotating things consume larger energy till it takes full
speed. Stopping rotations and restarting them cause loss of energy.

36
examples are the expansion of a common language and a common currency.
We can identify network economies in areas such as online auctions, and air
transport networks. Network economies are best explained by saying that the
marginal cost of adding one more user to the network is close to zero, but the
resulting benefits may be huge because each new user to the network can then
interact, and trade with all of the existing members or parts of the network.
The rapid expansion of e-commerce is a great example of the exploitation of
network economies of scale.

External economies of scale: External economies of scale occur outside of a

firm, within an industry.

Economies of location: When an industry’s scope of operations expands it

can develop its own better transportation network, resulting in a subsequent
decrease in cost for a company working within that industry, external economies
of scale are said to have been achieved. Raw material processing industries or
where processing involves loss of weight, like cotton, crude oil, or sugarcane
processing, may find it economical to start operations near to the source of raw
material. Industry in which output is voluminous or delicate or instantaneously
serviceable like food, would establish themselves near the market.

Economies of research and development: Another good example of external

economies of scale is research and development facilities that several businesses
in an area can benefit from. Likewise, the relocation of component suppliers
and other support businesses close to the main centre of manufacturing is also
an external cost saving.

Economies of vertical disintegration: The growth of industry will make it

possible to split up production and some subsidiary jobs can be done more
effectively by specialised firms. Economies of subsidiary industries: The wastes
of the main industry may be used by subsidiary industries to produce by-
products. Economies of trade association: Associations may be useful in
different ways.

Diseconomies of scale: A firm may eventually experience a rise in long-run

average costs caused by diseconomies of scale. Diseconomies of scale a firm
may experience related to: Control – monitoring the productivity and the
quality of output from thousands of employees in big corporations is imperfect
and costly – this links to the concept of the principal-agent problem – how
best can managers assess the performance of their workforce when each of the
stakeholders may have a different objective or motivation?

Co-operation - workers in large firms may feel a sense of alienation and

37
subsequent loss of morale. If they do not consider themselves to be an integral
part of the business, their productivity may fall leading to wastage of factor
inputs and higher costs

Competition: a large number of firms and increasing competition may result

in low profitability.

Economies of scale and welfare of consumers: There are some disadvantages

and limitations of the drive to exploit economies of scale.

Standardisation of products: Mass production might lead to a standardisa-

tion of products – limiting the amount of effective consumer choice in the
market

Lack of market demand: Market demand may be insufficient for economies

of scale to be fully exploited. Some businesses may be left with a substantial
amount of excess capacity if they over-invest in new capital

Developing monopoly power: Businesses may use economies of scale to build

up monopoly power in their own industry and this might lead to a reduction
in consumer welfare and higher prices in the long run – leading to a loss of
allocative inefficiency

Protecting monopoly power: Economies of scale might be used as a form of

barrier to entry – whereby existing firms have sufficient spare capacity to
force prices down in the short run if there is a threat of the entry of new
suppliers

Suppose that the TC function is linear i.e.

TC = b0 + b1 Q (2.3)
TFC + TV C
b0
Average fixed cost is rectangular hyperbola, AF C =
Q

b1 Q
Average variable cost is a straight line parallel to TC curve, AV C = =
Q
b1

b0
Average total cost is AT C = + b1
Q

dT C
Marginal cost MC = = b1
Q

38
Over the range of reserve capacity M C = AV C = b1 , while AC falls continu-
ously at the rate same as AFC.

A lump sum and a fixed royalty for each copy of a book sold is payable to the
author. He gets in all |1800 and |3600 respectively when 600 and 1500 copies
are sold. What sum he will get when 2600 copies are sold?

Let L stands for a lump sum and R for the royalty per each book sold. We
have, L + 600R = 1800
L + 1500R = 3600
Solving the above equations,
900R = 1800
R = 2 Putting value of R in equations
L + 600(2) = 18000
L = 600 His remuneration when 2600 copies are sold
600 + 2(2600) = 600 + 5200 = 5800 Thus, the author gets a lump sum royalty
of |6000 along with |2 for each copy of the book sold. His total royalty for
2600 copies will be |5800.

The short-run cost function of a food manufacturer is given by C = 100 +

10x − 10x2 + x3

39
40
Chapter 3

Revenue Concepts

Proceeds received by the firm from the sales of output are called revenue.
Though it is received by the firm, it is not the same as income to the en-
trepreneur. It includes cost as well as profit.

1. Total Revenue: Total revenue is money proceeds received by the firm

from the sales of a given output. It is equal to the product of price and
quantity sold. i.e.

Total revenue (T R) = Price (P ) × Quantity sold (Q)

TR = P.Q (3.1)

2. Average Revenue: It is revenue per unit of output sold. It is the same

as the price. It can be calculated as the ratio of TR to quantity. i.e.

Total Revenue T R
Average Revenue (AR) = = (3.2)
Quantity Q

3. Marginal Revenue: Marginal revenue of a given unit of output is an

addition made by that unit to the total revenue. It is calculated as,

Marginal Revenue (M R) = T Rn − T Rn−1 (3.3)

41
3.1 TR, AR and MR in Perfect Competition
Perfect competition is a type of market in which there is a large number of
buyers and sellers, none of which is so significant as to control or even influence
the market, i. e. they are price takers. They sell and buy the product at
a price decided by the market demand and supply. It means the seller can
sell as much as he wants and the buyer can buy as much as he needs, at the
prevailing market price.

In other words, the seller needs not to charge lower than the market price to
sell more and no consumer will pay him higher than the market price. On the
other hand, buyers need not pay higher than the market price to buy a larger
quantity and cannot have anything at lower than the market price.

The relationship between TR, AR and MR under perfect competition can be

explained with the help of Table 3.1 and Figure 3.1.

Table 3.1: TR, AR and MR under Perfect Competition

Output 0 1 2 3 4 5 6 7 8 8 10
Price 10 10 10 10 10 10 10 10 10 10 10
TR 0 10 20 30 40 50 60 70 80 90 100
AR — 10 10 10 10 10 10 10 10 10 10
MR — 10 10 10 10 10 10 10 10 10 10

R/C

TR

AR=MR

O
1 Output

Figure 3.1: TR, AR and MR under Perfect Competition

The Table 3.1 and Figure 3.1 shows that with an increase in output;

1. Total revenue increases in proportion to output at a constant rate of the

42
 market price. Therefore, the T R curve starts from the origin and rises
upward as a straight line with a slope equal to the market price.

2. Average revenue and marginal revenue both are constant at market price
for all the levels of sales. Therefore, the AR and M R curves overlap
each other and are parallel to the X-axis.

3. AR or M R are equal to each other at a unit quantity or AR and M R

curve intersect each other at a unit quantity.

3.2 TR, AR and MR in Imperfect Competi-

tion
Imperfect competition is a type of market in which there are many sellers, but
either all of them or a few of them, are significant enough to control or at
least influence the market. Therefore, they are price makers or influencers.
They can sell a larger quantity by reducing the price. This makes the market
demand curve slope downward. It means a seller can sell more quantity by
charging a lower price or can charge a higher price by accepting lower sales.
On the other hand, a buyer will buy a larger quantity at a lower price and a
lower quantity at a higher price.

The relationship between T R, AR and M R under an imperfect market can

be explained with the help of Table 3.2 and Figure 3.2.

Table 3.2: TR, AR and MR under Perfect Competition

Output 0 1 2 3 4 5 6 7 8 8 10 11
Price 20 19 18 17 16 15 14 13 12 11 10 9
TR 0 19 36 51 64 75 84 91 96 99 100 99
AR — 19 18 17 16 15 14 13 12 11 10 9
MR — 19 17 15 13 11 9 7 5 3 1 -1

Above table 3.2 and fig 3.2 shows that with increase in quantity produced;

1. TR increases with output at a diminishing rate (MR is decreasing),

then reaches the maximum when (M R = 0) and finally declines (MR is
negative) i.e. practically TR curve rises with diminishing slope.

2. Average revenue continuously decreases to show that to sell more quantity,

sellers will have to decrease the price of the product.

43
 R/C

TR

AR
O Output
1
MR

Figure 3.2: TR, AR and MR under Perfect Competition

3. Marginal revenue also diminishes faster than average revenue and it is

always lesser than average revenue.

Linear, Concave and Convex AR and MR

When AR are convex to the origin M R is also convex and lies nearer to the
price axis than the AR curve. in Figure 3.3a, a < b.

When AR is a straight line M R is also straight and lies exactly half a distance
away from the price and AR curve. in Figure 3.3b, a = b.

When AR is concave to the origin M R is also concave and lies nearer to the
AR curve than the price axis. in Figure 3.3c, a > b.

R/C R/C R/C

a<b a=b a>b

a b a b a b
AR

MR MR TR
O O O MR AR
Q Q Q

(a) Convex (b) Linear (c) Concave

Figure 3.3: Convex, Linear and Concave AR and MR

Example 3.1. The demand for the product is given by p = 20 + 5q − q 2 , find

the marginal revenue at q=3.

44
Sol.

Total Revenue (TR) = p · q = (20 + 5q − q 2 )q

= 20q + 5q 2 − q 3
d(T R)
MR =
dq
d(20q + 5q 2 − q 3 )
=
dq
= 20 + 10q − 3q 2
M R3 = 20 + 10(3) − 3(3)2
= 20 + 30 − 27 = 23

45
46
Chapter 4

Objectives of Firm

Firm: A basic unit of productive activities is a firm. It is an individual

production unit.

Industry: An industry is a group of all business firms producing homogenous

or the same product

Normal Profit: Factor remuneration to an entrepreneur for his contribution

to the production is called normal profit . It is the minimum amount of money
that induces an entrepreneur to continue in the current business. In other
words, normal profit is the minimum return which an entrepreneur must receive
to continue the current production. Anything less than or above-normal profits
is called loss or excess profit respectively. Normal profit is a part of the total
cost and is decided by the factor market. Individual factor owners as well as
business firms have to accept the same.

Supernormal Profit: Any profit over and above the normal profit is a ‘bonus’
for the firm, as it is more than the minimum needed to induce the entrepreneur
to continue the present production. We call it supernormal or excess profit.
It is neither a part of production cost nor remuneration to any factor but
is received by the entrepreneur. It is the result of market disequilibrium i.e.
demand > supply. However, supernormal profit signals other firms to enter
the industry and the existing ones will leave the industry if there are losses.

Equilibrium of Firm: When a business firm for any reason, generally profit,
does not want to change its output is in equilibrium. Equilibrium is the best
possible production condition for the firm and wherefrom it does not want

47
to move. It does not want to change output because any change in output
will be adverse. Equilibrium is not a static but dynamic concept, along with
changes in other things equilibrium changes.

A Representative Firm: A hypothetical business firm whose choices rep-

resent the industry is called a representative firm. All business firms vary
in different aspects and their market behaviour may differ widely. But some
features are common amongst most business firms and may be held by one
or few business firms. Such business firm(s) is/are called a representative
business firm. The industry, therefore, can be modelled by a representative
firm’s technology, capital-output ratio and output. To simplify the study
we assume that all firms in an industry have constant returns to scale and
technology and that every firm act as a price taker

4.1 Various Objectives of Firm

Profit is a general objective of business firms because it helps them survive
and expand. It is true, particularly when the owner and manager of the
business are the same person. But in today’s globalised world businesses
grow internationally, to raise capital they adopt joint-stock nature, in which
management separates from the owners who have no control in day-to-day
affairs. All decisions are taken by the management who is answerable to the
board of directors. Because of this managers are free to follow their own
objectives like staff maximisation, sales maximisation, growth maximisation,
utility maximisation etc. It happens because the manager believes that his
interest lies in objectives other than profit maximisation.

1. Profit Maximisation: Profit is the most common objective of business

firms because it is essential for survival and expansion. Therefore, the
firms care that they are capable of and are earning enough profit. Profit
is of two types; normal profit and excess profit. Normal profit is a
factor in remuneration to the entrepreneur for his contribution to the
business. It is decided by the factor market. It is residual after payment
of rent, interest and wages. Excess profit is a receipt to entrepreneurs
over and above the normal profit. It is received by entrepreneurs, not
for contribution to the business; but due to the disequilibrium of the
market. It is equal to the difference between total revenue and total
cost at the given level of output. It is excess profit that managers want
to maximise. It can be maximised either by increasing total revenue or
decreasing cost or by doing both simultaneously.

2. Staff Maximisation: When a manager is different from the owner, he

48
 may prefer to follow the objective of staff maximisation. It is because he
may think he can derive more satisfaction, more prestige and even more
salary, by being a boss of a larger number of employees.

profit

E EP
ES
IC4

IC4
IC1 IC2
O
S1 S2 S3 P Staff

Figure 4.1: Staff Maximisation

OP is a profit curve which shows that in the beginning profit increases

with staff due to better utilisation of fixed resources, reaches the maxi-
mum and falls due to a decrease in labour productivity. In Figure 4.1,
IC1 , IC2 , IC3 and IC4 are manager’s indifference curve. If a business
firm employs S1 of staff, it will see scope to increase staff as well as
profit. If it employs S2 staff, profit would be the maximum possible; but
not the manager’s satisfaction. If the manager increased his staff to S3 ,
he would get the highest possible satisfaction shown by IC3 . Therefore,
instead of producing with S2 staff with maximum profit, the manager
produces with S3 employees at a lower profit. The manager cannot reach
IC4 .

3. Sales Maximisation: A manager may also think that he can derive

more prestige, satisfaction and even salary by being the manager of
a company with a large market share. Therefore, he may follow sales
maximisation rather than profit maximisation.

Again OP is a profit curve that initially shows the direct relationship

between profit and sales because of improving utilisation of factors and
then the relationship turns inverse as a result increase in the average cost
of production. At S1 employment manager finds a chance for an increase
in profit along with an increase in his satisfaction. Instead of producing
and selling at quantity S2 with maximum profit, the firm produces S3
quantity where profit is less than maximum but the manager’s interest

49
 is maximised.

4. Growth Maximisation: Sometimes the manager is more inclined to

growth rate maximisation even after knowing that growth maximisation
does not guarantee maximum profit. He may search for his interest in
the growth rate. In Figure ??, the supply growth function (S) shows the
positive relationship between profit and supply growth rate. It means
that at a higher profit, the firm would like to increase its supply growth
rate. The demand growth curve, initially at the lower growth rate, shows
the direct relationship between the profit rate and demand growth rate
and then it turns inverse at the higher supply growth rate.
profit

E EP S
ES

O g1 g2 g g3 P growth rate

Figure 4.2: Growth Maximisation

When the growth rate is less than g like g1 , g2 demand growth rate is
higher than the supply growth rate. It shows the scope for the expansion
of firms’ output. The firm which has targeted growth rate maximisation
would go on increasing its supply growth till it equals the demand growth
rate. Once the supply growth rate equals the demand growth rate, it
will not increase the supply growth rate further. This is because it will
create stock, which will bring down prices and profit. Therefore, the
firm’s equilibrium position, irrespective of profit, is at point E where
demand and supply growth rate equals i.e. growth rate g.

4.2 Profit Maximisation with T R and T C

Profit is the most common and obvious objective of business firms because
it decides survival (normal profit) and expansion (supernormal profit). A
rational entrepreneur will change his output if he thinks by doing so he can
increase his profit or decrease his loss. A business firm will be in equilibrium
when it earns the maximum possible profit. In other words, the firm will
have no intent either to expand or contract its output when it is earning the

50
maximum possible profit. The profit will be the maximum if the difference
between T R and T C is the maximum (or when the distance between the T R
curve and T C curve is the maximum or when at the given output, tangent to
T R and T C curve are parallel to each other)

R/C

TC

TR

O
Q1 Q Q2 Output

Figure 4.3: Profit Maximisation with TR and TC

In the figure, T C is the total cost curve, which initially at a lower level of
output increases at a diminishing rate and then at an increasing rate at a higher
level of output. TR is the total revenue curve is a straight line originating
from the origin and sloping upward. It shows the perfect competition.

In the beginning when output is lower than Q1 firm incurs losses, (T C >
T R) because the total fixed cost (TFC) spreads thickly on a smaller output.
Therefore, the firm increases its output to decrease losses. At quantity, Q1
firm earns no loss and no profit, as T R = T C. If the output is more than Q1 ,
profit appears and rises (due to economies of scale) to become the maximum
at quantity Q, where the difference between T R and T C is maximum or in
the figure distance between T R and T C curves is maximum. This distance
would be the maximum when tangents to T R and T C, at any given level of
output, are parallel to each other. Thus, profit would be maximum at Q. If
the firm produces any quantity more or less than Q profit will be less than the
maximum. If he dared to produce Q2 , profit will disappear and production of
more than Q2 will earn losses.

Therefore, the producer will be in equilibrium with the maximum possible

51
profit at the output of Q, and the slope of T R and T C curve is the same.

4.3 Profit Maximisation with M R and M C

Profit is the most general, objective of a business firm. Firms are in equilibrium
when profit is the maximum. Profit would be maximum when the difference
between T R and T C is maximum, provided T R > T C, or the distance between
T R and T C curve is maximum. Distance between these two curves would
be maximum when slopes of T R are equal to the slope of T C. The slopes of
the T R and T C curve are M R and M C respectively. Thus, profit will be the
maximum when M R = M C.

Table 4.1: Profit Maximisation

Output 0 1 2 3 4 5 6 7 8 9 10 11 12
MR — 20 19 18 17 16 15 14 13 12 11 10 9
MC — 24 21 18 15 12 9 6 9 12 15 18 21
π -4 -2 0 2 4 6 8 4 0 -4 -8 -12
Π -4 -6 -6 -4 0 6 14 18 18 14 6 -6

Assume that there is no fixed cost. Therefore, at zero level of output, there is
no revenue and no cost and hence neither profit nor loss.

1. When the 1st unit of output is produced, it adds |20 to revenue and |24
to the cost. Therefore, the firm earns a loss of |4 (π) due to the first
unit.

2. The 2nd unit adds |19 to the revenue and |21 to the cost. Therefore,
the firm’s loss increases by |2 and becomes |6.

3. Production of the 3rd unit adds equally to the cost and revenue, therefore,
the loss remains unchanged at |6.

4. The 4th unit adds |2 more to the revenue than to the cost. Therefore,
Los decreases by |2 and comes to |4.

5. Production of 5th unit reduces loss to zero.

6. After the 5th unit every unit adds more to the revenue than to the cost.
It increases profit till production reaches the 9th unit.

7. Once again 10th unit adds more to the cost and less to the revenue,

52
 therefore profit decreases. After this, every additional unit adds more
to the cost and less to the revenue. This results in a decrease in total
profit.

Knowing this pattern of changes in revenue and cost, the firm will produce only
9 units which maximises its profit. Therefore, the firm will be in equilibrium
at the output of 9 units with the maximum possible profit.

R/C

MC

MR

O
Q1 Q2 Output

Figure 4.4: Profit Maximisation with AR and MR

In Figure 4.4, M R is the marginal revenue curve and M C is the marginal cost
curve. The M R curve shows an addition to total revenue and the M C shows
an addition to the total cost.

At a lower level of output, M C is higher than M R because of diseconomies of

scale. As production increases both M R and M C decrease, but M C decreases
faster than M R, reaches the minimum and then rises. At the output, less
than Q1 , an additional unit of output adds more to the cost and than revenue,
i.e. M C > M R. With every additional unit, loss increases. Even after that
production will be increased because, with an increase in production difference
between M R and M C tapering, it becomes zero at quantity Q1 . It means
that every additional unit adds less and less to loss. Unit Q1 add nothing to
the loss. It is a sign of forthcoming economies and profit.

After Q1 , every additional unit adds more to the revenue and less to the cost.
Hence, the firm will increase production, till an additional unit adds more to
the T R and less to the T C i.e. M R > M C. At quantity Q2 , an addition to
the T R and T C is equal keeping profit at the maximum.

If production is increased more than Q2 , M R < M C and profit will diminish,

which will not be preferred by the business firm. That is why the business
firm will not increase production by more than Q2 . It means the firm’s profit

53
would be maximum at quantity Q2 , where M R = M C. This is the first order
or essential condition of profit maximisation.

In Figure 4.4, there are two points (A and B) or quantities (Q1 and Q2 ) at
which M R = M C. But profit is not maximum at both quantities. To identify
the profit maximising point we need second-order or sufficient condition. Points
A and B differ from each other in the sense that at point A or Q1 quantity,
M C intersects M R from above or slope of M C < slope of M R and at point
B or Q2 quantity M C intersects M R from below or slope of M C > slope of
M R. Profit is maximum at later.

The condition that at M C intersect M R from below or at the intersection

with M R, the slope of M C should be greater than that of M R is called the
second-order condition of profit maximisation.

For profit maximisation,

TheFirst order condition, MR = MC

The Second order condition at intersection slope of M C > slope of M R

54
Chapter 5

Break Even Analysis

5.1 Break-Even

The study of the relationship among cost, scale and profit is called cost-volume-
profit analysis, break-even analysis or profit-contribution analysis. It involves
the study of the revenue and cost of the firm considering the volume of sales.
It finds the volume of sales at which a firm’s total revenue is equal to the total
cost.

There are three situations for the firm i.e. be in losses or be in profit or be
with no loss no profit. Every firm knows that at a smaller output, it is likely
to make losses because TFC spreads thickly on a small number of units. As
output increases, TFC spreads on a larger number of units and loss decreases.
At some particular quantity where T R = T C there the no profit and no loss
to the business firm. If output increases more than that particular quantity
profit appears and increases along with an increase in output. That particular
quantity where T R = T C, separates loss-making production possibilities from
profit-making production possibilities. That is why it is called break-even.

Break-even may be taken as an analysis that breaks total production possi-

bilities in profit-making or loss-making possibilities. In a set of production
possibilities, there are smaller or bigger losses and in another set of possibili-
ties, there is smaller or bigger profit. Profit and loss-making conditions are
separated by a single condition at which TR = TC and there is neither profit
nor loss. This point at which T R and T C curves interest each other is known
as the break-even point and the quantity at which it happens is known as the

55
break-even quantity and the whole table or figure is known as the break-even
chart.
R/C

TR

B
TC

TFC

O
QB Output

Figure 5.1: Break-even Chart

In Figure 5.1 T R is the total revenue curve, T C is the total cost curve and
T F C is the total fixed cost curve respectively. At lower levels of output like q1 ,
there are losses to the firm because of heavy TFC. As output increases TFC
spreads larger which reduces losses. T R equals T C at quantity QB , therefore,
QB is a break-even quantity. The T R and T C curves intersect each other at
point B which, therefore, is the break-even point.

The figure shows that if the firm produces less than the break-even quantity
QB there would be losses and if it produces more than the break-even quantity
there would be profit. Taking into consideration all types of possibilities firm
has to decide the quantity to be produced.

At break-even quantity, T R = TC (5.1)

But T R = P · QB , (5.2)
TC = TFC + TV C (5.3)
TV C = AV C · QB (5.4)
By substituting 5.2, 5.3 and 5.4 in equation 5.1
P · QB = T F C + AV C · QB
P · QB − AV C · QB TFC
QB(P ˘AV C) = TFC
TFC
QB = (5.5)
P − AV C

56
5.2 Uses of Breakeven Analysis
The break-even analysis presents a microscopic picture of the profit structure
of the business. It enables to plan of managerial actions to maintain and
increase the profitability of the firm.

1. Survival: If a firm wants to survive in the long run, it should avoid losses
in the short run. The break-even warns of the quantity more than which
the firm must produce.

2. Safety Margin: The breakeven analysis helps the firm to find a safety
margin, the extent to which the firm can afford to reduce sales before
it starts incurring losses. The safety margin lets a firm incurring losses
know the minimum sales to avoid losses.

3. Volume of Sales: The break-even analysis may be used for determining

the volume of sales necessary to achieve the targeted profit. It helps to
manage the volume of sales to maintain the previous level of profit. It
enables the management to judge whether a required increase in sales
will be feasible when a price change occurs.

4. Change in Cost: Break-even analysis enables management to under-

stand how a change in cost will affect the profit margin. Changes in
the cost will shift the T C curve and thereby will change the break-even
quantity.

5. Expansion Capacity: Break-even analysis will help the firm to know

whether an expansion of production capacity is required.

6. Change in Prices: Break-even chart can be modified to know profit at

different prices, at constant cost and demand.

7. Purchase Decision: The break-even analysis helps to decide on the

questions of self-manufacturing or outsourcing of intermediate compo-
nents of the product.

8. Sales Promotion: It may help the business firm to decide on the issue
of promotion of the product. If the increase in revenue is greater than
the increase in cost then only sales promotion is advisable.

Example 5.1. Fixed factory overheads cost 60000

Fixed selling overheads cost 12000
Variable manufacturing cost per unit 12
Variable selling cost per unit 3

57
 Selling price per unit 24

Calculate the break-even point in terms of sales and sales value and quantity
to be sold for |90000 profit.

TFC
Sol. Break-even quantity QB = ;
P − AV C
Given TFC= 60,000 + 12,000 = 72,000, AVC = 12 + 3 = 15, and
P = 24
By substituting the above values in the equation,

72, 000 72, 000

QB = = = 8000
24 − 15 9

Break-even sales or quantity is 8,000 units

Break-even sales value, T R = P · QB = 24 × 8000 = 192000
The Break-even sales value is 192,000 units.

At a profit of 90,000
T R − T C = 90, 000

TR is linear and TC is assumed to be linear, therefore, P = 24 and AVC = 15

TR − TC = 90, 000
P · Q − (T F C + AV C · Q) = 90, 000
24 · Q − 15 · Q = 90, 000 + 72, 000
(24 − 15)Q = 162, 000
162, 000
Q = = 18, 000
9

Example 5.2. From the following data, calculate

(a) P/V ratio
(b) Break-even sales with the help of the P/V ratio.
(c) Sales required to earn a profit of Rs. 4,50,000

Fixed Expenses = Rs. 90,000

Variable Cost per unit:
Direct Material = |5
Direct Labour = |2
Direct Overheads = |100
Selling Price per unit = |12

58
Sol. Given P = |12 TFC = 90000+100 = |90,100 AVC = 5+2 = |7

TFC
QB =
P − AV C
90100
QB =
12 − 7
90100
= = 18020
5

Example 3. Calculate the break-even point and net sales value

Direct material cost per unit 10

Direct labour cost per unit 5
Fixed overhead 50000
Variable overheads at 60 % on direct labour
Selling price per unit 25
Trade discount 4%

If sales are 10 % and 25 % above the break-even volume, determine the profit.

Example 5.3. Variable cost per unit 15

Fixed expenses 540000
Selling price per unit 20

What should be the selling price per unit, if the break-even point should be
brought down to 6,000 units?

Sol : TFC = 540000, AVC = 15, P = 20

TFC
QB =
P − AV C

59
 540000
QB =
20 − 15
540000
QB = = 108000
5
540000
6000 =
P − 15
6000P − 90000 = 540000
6000P = 450000
6P = 450
P = 450/6 = 75

Example 5.4. The fixed costs amount |50,000 and the percentage of variable
costs to sales is given to be 66 %. If 100 % capacity sales are |3,00,000, find
out the break-even point and the percentage sales when it occurred. Determine
profit at 80% capacity:

Example 6. how much the value of sales must be increased by the company to
break even:

Sales 300000 Fixed cost 150000 Variable cost 200000

Example 7. Calculate: (i) The number of fixed expenses. (ii) The number of
units to break even. (iii) The number of units to earn a profit of Rs. 40,000.
The selling price per unit can be assumed at Rs. 100. The company sold in
two successive periods 7,000 units and 9,000 units in and incurred a loss of Rs.
10,000 and earned Rs. 10,000 as profit respectively.

Example 8. A company is making a loss of Rs. 40,000 and relevant information

is as follows: Sales Rs. 1,20,000; Variable Costs Rs. 60,000; Fixed costs Rs.
1,00,000. Loss can be made good either by increasing the sales price or by
increasing sales volume. What are Break-even sales if (a) Present sales level is
maintained and the selling price is increased. (b) If the present selling price is
maintained and the sales volume is increased. What would be sales if a profit
of Rs. 1,00,000 is required?

Example 9 A firm has the following income statement For a month. Sales: 3,000
units at $80/unit Less: Cost of Goods Sold. Variable Production Cost 180000
Fixed Production Cost 198006 Gross Margin. Selling and Administrative
Expenses Variable Selling Cost. 21000 Fixed Selling Expenses 7500 Net
Income Before Taxes 11700 Find the firm’s breakeven output. If it wishes
to have a monthly net income before taxes of $18,000 and its cost structure
remains as above, what quantity of output will it need to sell? If its variable

60
production costs increase by $4 per unit, what will be its breakeven output?
After the increase in costs in 3, what output will it need to sell if it wishes
to have the $18,000 monthly pretax profit stated earlier? Given the variable
production cost increase but no change in fixed costs, what will be the firm’s
monthly profit if it sells 4,000 units of output per month?

Example 10 On investigation, it was found that the variable cost in XYZ Ltd
is 80 per cent of the selling price. If the fixed expenses are Rs 10,000, calculate
the break-even sales of the company.

Another firm, IMN Company Ltd, having the same amount of fixed expenses,
has its break-even point at a lower figure than that of XYZ Ltd. Comment
on the causes. Solution BEP (amount) = Rs 10,000/ P/V ratio (100 per
cent-Variable cost to volume ratio = 0.80) = Rs 10,000/0.20 = Rs 50,000
(XYZ Ltd) The lower break-even point of IMN Ltd vis-à-vis XYZ Ltd is due
to its lower variable expenses to volume ratio, which in turn may be either due
to its lower VC per unit or higher SP per unit, eventually yielding a higher
contribution margin and, hence, higher P/V ratio and lower BEP.

Example 5.5. Demand function is Q = 4500 − P and cost function is

C = 150000 + 400Q. Find out the equilibrium price, output and profit.

Sol. Given Q = 4500 − P i.e P = 4500 - Q C = 120000 + 400Q

Revenue function,
TR = P · Q = (4500 − Q)Q = 4500Q − Q2
Profit function, Π
Π = TR − C = 4500Q − Q2 − (120000 + 400Q)
= 4500Q − Q2 − 120000 − 400Q
Π = 4100Q − Q2 − 120000
Profit will be maximum at,
dΠ d(4100Q − Q2 − 120000)
= =0
dQ dQ
4100 − 2Q = 0
Q = 2050
The maximum profit will be,
Π2050 = 4100 × 2050 − (2050)2 − 120000
= 40, 82, 500
P2050 = 4500 − Q = 4500 − 2050 = 2450

61
Example 5.6. Total cost function of a manufacturing firm is C = 2x3 − x2 +
3x + 5 and marginal revenue function M R = 8 − 3x. Determine the profit
maximisation output.

Sol. Given C = 2x3 − x2 + 3x + 5 M R = 8 − 3x

dC d(2x3 − x2 + 3x + 5)
MC = =
dx dx
MC = 6x2 − 2x + 3

At profit maximising quantity, M R = M C,

8−3 = 6x2 − 2x + 3
2
6x + x − 5 = 0
2
6x + 6x − 5x − 5 = 0
6(x + 1) − 5(x + 1) = 0
(6x − 5)(x + 1) = 0
6x − 5 = 0 or x+1=0
x = 5/6 or x = −1
=⇒ x = 5/6 ∵ x ̸= −ve

Example 5.7. Demand fiction is q = 20 − 2p, The initial price is 4. If the

price increases by 25 per cent find an elasticity of demand.

Sol. Given p = 4, q = 20 − 2p

q = 20 − 2p = 20 − 2 × 4 = 20 − 8 = 12
new price P1 = 1.25 × 4 = 5
new quantity q1 = 20 − 2(5) = 10
change in price ∆p = 1
change in quantity ∆q = −2

∆q p
ep = ×
∆p q
− 2 12
= ×
1 5
= −4.8

62
Example 5.8. If cost function is 1000 + 100x − 50x2 + 13 x3 . Find out functions
for fixed cost, variable cost, average fixed cost, average cost, average variable
cost, and marginal cost.

Sol.

Example 5.9. A machine was bought at 12000. Its operation cost function
is (20t2 + 15t). Its resale value function is (6880 − 60t2 ). How many years
it must be used? (Find the minimum and maximum quantities or range of
economical production at price)

Sol. Given Fixed cost = 12000, variable cost = 20t2 + 15t, resale value =
6880 − 60t2 .

TC = Fixed Cost + Variable Cost - resale value

= (12000) + (20t2 + 15t) − (6880 − 60t2 )
= 12000 + 20t2 + 15t − 6880 + 60t2 )
TC 80t2 + 15t + 5120
=
80t2 + 15t + 5120
AC =
t
5120
= 80t + 15 +
t
d(AC) 80t + 15 + 5120
t
=
dt dt
5120
= 80 − 2
t
512
= 8− 2
t

Example 5.10. Find elasticity of demand

63
64
Chapter 6

Perfect Competition

Why is an MC Curve Supply Curve?

Excess profit is a result of the disequilibrium of the market. It is a short-run

phenomenon. In the long-run equilibrium of the market, only normal profit is
expected. It means cost and revenue will be equal. That is why business firms
think very much of changes in cost and revenue. If marginal revenue is more
than or equal to its marginal cost, the firm will produce and sell that unit. If
marginal revenue is less than its marginal cost the firm will not produce and
sell that unit because it will incur losses. In brief marginal cost is the price at
which firm supplies goods. The same is shown by the supply curve.

Suppose that a business firm is to produce its 1st unit of output which costs
|100 including rent, wages, interest and normal profit. The firm will offer that
unit at a price |100 or above. If the market price is less than |100 the unit
will not be produced. Likewise, if the 2nd unit costs |120 (M C) firm will offer
it at a price |120 or above. Thus, every unit will be offered in the market at
a price equal to its M C. That is why M C is the supply price and the M C
curve is the supply curve. But this is not true when M C < AV C. This is
because, at such a low level of MC, it always benefits the to shut down.

Thus, we can say that the M C curve above the AV C curve is the supply curve
of an individual business firm.

65
6.1 Classification of Markets
Markets are of varied types with smaller or bigger differences. We can classify
them on different criteria. The basic criteria of classification are substitutability
of products, interdependence and freedom of entry.

Table 6.1: Market Classification

Market Criterion
Substitutability Interdependence Monopoly Power
of Products of Sellers
dqj Pi dpj qi pa − pc
ep,ji = eq,ji = E=
dpi qj dqi pj pc
Pure Competition →∞ 0 < eq,ji < ∞ →0
Monopolistic Com- 0 < ep,ji < ∞ →0 →0
petition
Pure Oligopoly →∞ 0 < eq,ji < ∞ E>0
Heterogeneous 0 < ep,ji < ∞ 0 < eq,ji < ∞ E>0
Oligopoly
Monopoly →0 →0 bolcked entry

6.2 Criterion for classification of firms into in-

dustries
1. Firm: It is the basic unit of production. It is an individual production
unit.

2. Industry: When all the business firms producing a homogenous or same

product are grouped, it forms an industry.

Firstly, the concept of the industry is very useful because it reduces

the complexity of relations between all the firms of an economy to
manageable dimensions. In a broad sense, each firm competes with every
other firm in the economy and therefore, a general equilibrium approach
would be more appropriate for the study of the economic behaviour of an
individual firm. But such aggregate economic models are more suitable
for studying and predicting aggregate magnitudes. The study of the
behaviour of a firm makes it necessary to demarcate the study to closely
inter-related firms to gain deeper insight into them. The concept of the
industry has been developed to include firms that are closely related to

66
 one another.

The concept of the industry makes it possible to derive a set of general

rules from which we can predict the behaviour of competing members of
a group called industry.

The concept of the industry provides the framework for the analysis of
the effects of entry on the behaviour of the firm.

The empirical research would be unmanageable if one had to work with

wholesome data about the economy.

Firms and industries are classified either based on the product being
produced when their products are close substitutes or the method of
production based on production processes and/or raw materials being
used.

To use the criterion of product similarity we will have to divide them

based on cross elasticity of demand. But the value of cross elasticity
is required to classify them a priori theoretical ground. For example,
in the transportation industry, we can include water, road and air
transportation. But in pricing decisions, this is not useful. In perfect
competition cross elasticity of demand for each product is infinite while
in monopolistic competition cannot be. Both Chamberlin and John
Robinson said, with a differentiated product, each firm has its market
and some degree of monopoly power but also recognised the necessity of
retaining the concept. Triffin argued that all goods are to some degree
substitutable for one another in that they compete for a part of the
income of the consumer. Every firm competes with all other firms in the
economy. Thus, he concluded into irrelevance of the concept of industry.
But for others, rejection is unnecessary and undesirable.

In the similarity of processes criterion, similarity may lie in the method

of production, the raw material used or the channels of distribution.

3. Normal profit: Factor remuneration to an entrepreneur is called normal

profit. It is the minimum amount required by the entrepreneur to stay
in the current business. In other words, normal profit is the minimum
return which the entrepreneur must receive to stay or continue in the
current business. Anything less than or above-normal profits is called
loss or supernormal profits respectively. Normal profit is a part of total
cost and is decided by the factor market and individual factor owners as
well as business firms have to accept the same.

67
 4. Supernormal profit: Any profit over and above normal profit is a
‘bonus’ for the firm, as it is more than what it needs to keep itself in
the industry. We call it supernormal or excess profit. It is neither a
part of production cost nor remuneration to factor but is received by the
entrepreneur because of market disequilibrium. However, supernormal
profit is a signal to other firms. A new business firm will enter an industry
if there is supernormal profit and the existing one will leave the industry
if there are losses.

5. Equilibrium of firm: When a business firm for any reason, generally

profit, does not want to change its output it is said to be in equilibrium.
Equilibrium is the best possible production condition for the firm, in
a given set of conditions and wherefrom it does not want to move. It
does not want to change output because any change will be adverse.
Equilibrium is not a static but dynamic concept because, with changes
in other things, equilibrium will change.

6. Representative firm: A hypothetical business firm whose choices are

representative of the industry is known as a representative firm. All
business firms vary in different aspects and their market behaviour may
differ widely. But some features are common among most business firms
and may be beheld by one or few business firms. Such business firm(s)
is/are called the representative business firm. The industry, therefore,
can be modelled by a representative firm’s technology, capital-output
ratio and output. To simplify the study we assume that all firms in an
industry have the same constant returns to scale, technology and every
firm acts as a price taker.

6.3 Perfect Competition

According to Boulding, “a competitive market may be defended as a large
number of buyers and sellers all engaged in the purchase and sale of an
identically similar commodity, who are in close contact with one another and
who buy and sell freely among themselves”.

Perfect competition is a type of market in which there is a large number of

buyers and sellers who are too insignificant to influence the market. Therefore,
they are price takers and there is a complete absence of rivalry among the
individual firms in the market. They cannot charge a higher price because no
one will buy from them at a price higher than the market price and need not
charge a lower price to sell more quantity as they can sell any quantity at the
market price. The demand curve in this market is horizontal and the price

68
elasticity of demand is infinite.

1. A Large Number of Sellers: There is a large number of firms in

the industry. The existence of a large number of firms ensures that an
individual firm, however large, supplies only a small part of the market
supply and exercises no influence on the working of the market. The
number of buyers and sellers is so large that none of them can influence
the market.

2. Free Entry and Exit: This assumption is supplementary to the as-

sumption of a large number of firms and no rivalry among sellers. Buyers
and sellers are free to enter or exit the market at their will without
restrictions. As each buyer and seller is an insignificant part of the
market, new buyers and sellers will not be able to change the nature of
the market.

3. Homogenous Product: In a perfectively competitive market, the prod-

ucts of all the participating firms are identical in technical characteristics.
There is no way to differentiate between the products of one and another
firm. If products were differentiable, it would have given some discretion
to the firms in setting their product price, but in perfect competition,
this is ruled out ex hypothesi. Since products are homogenous, the price
is the same.

4. Demand Curve: The assumptions of a large number of sellers and

product homogeneity imply that every individual firm is a price taker or
that the demand curve is infinitely elastic or horizontal. It also means
that the firm can sell and the buyer can buy any amount of output at
the prevailing market price. The demand curve of an individual firm is
also its AR and M R curve.

Price

A B
D

O q1 q2 Quantity

Figure 6.1: Demand Curve

69
 5. Perfect Knowledge: Buyers and sellers have perfect knowledge of the
market. Sellers cannot charge more than the market price and if any
seller tries to charge, he will lose all his buyers. Similarly, no buyer can
have goods at a price lower than the market price.

6. Perfect Mobility of Factors: Factors of production are free to move

from one firm to another or from one line of production to another or
from one region to another.

7. No Transportation Cost: Transportation costs are ignored or are

assumed to be absent in perfect competition. This assumption is to
simplify the model rather than reality. It is because the inclusion of
transportation costs would violate the model of perfect competition.

8. No Government Intervention: The government follows a laissez faire

policy and does not interfere in the economic activities of the people.

9. No Advertisement: Since all products are identical in features like

quality, taste, design etc, there is no scope for product differentiation
and advertisement.

10. Non-increasing Returns to Scale: The lack of increasing returns to

scale (or economies of scale) ensures that there will always be a sufficient
number of firms in the industry.

If all these conditions are fulfilled there would be perfect competition and only
one price will prevail in the market at a given time.

6.4 Short Run Equilibrium

A short run is a period in which at least a few factors are fixed or unchangeable.
In the short run, all types of changes in the business firm are not possible.
Therefore, a new business firm can not join or an existing one cannot leave the
industry. In brief, the supply of industry would be changeable due to variable
factors only.

In general, the main objective of a business firm is profit maximisation,

therefore, we can say that a firm would be in equilibrium when it is earning
the maximum possible profit or when it charges a price and produces quantity
that maximises profit. Profit would be maximum when M R = M C. In the
short run, a firm can be in equilibrium with profit or with no profit no loss or
with losses.

70
It is because when M R > M C, every increase in output raises T R more than
the increase in T C. Therefore, profit will increase so far as M R > M C. On
the other hand, if M R < M C, every increase in output will raise T R less an
increase in T C. Therefore, profit will decrease. A firm having M R < M C,
if decreases output will face a smaller decrease in T R and a larger decrease
in T C, thus profit will increase or loss will decrease. It means that when
M R > M C the firm will increase its output and when M R < M C it will
decrease output. Thus, the firm will neither increase nor decrease output, if
M R = M C.

Profit earning equilibrium

In figure 6.2 AC and MC curve shows cost conditions, whereas AR and MR
curves show revenue or market conditions.

R/C
MC AC

E
P AR = MR

C A

O
Q Output

Figure 6.2: Profit Earning Short-run Equilibrium

If the price decided by the market is P , the firm’s equilibrium will be at e

where M R = M C. In this case, AR(P ) > AC(C); therefore, the firm will earn
a supernormal profit. The firm will be in equilibrium by producing quantity Q,
charging price P and earning excess profit P EAC shown by the dotted area.

If the firm produces less than quantity Q, M R would be greater than M C

and profit less than the maximum. It also means that with an increase in
output, T R would increase more than the increase in T C. Therefore, profits
will go up.

If the firm produces more than quantity Q, M R would be lesser than M C,

which also means that with a decrease in output, T R would decrease lesser
than the decrease in T C. Therefore, profit will increase. If the firm produces
at a point E, where M R = M C, it will earn the maximum possible profit and
will have no intention of changing output so far as cost and revenue conditions
are the same.

71
No loss no profit equilibrium
If the market price is P, the firm will be in equilibrium at point E, where
M R = M C. In this case AR = AC, therefore, the firm will have neither
excess profit nor losses but only normal profit. If the firm produces more or
less than quantity Q losses will appear.

R/C

MC AC

E
P AR = MR

O
Q Output

Figure 6.3: No loss no profit Earning Short-run Equilibrium

Loss earning equilibrium

If the market price is P the firm will be in equilibrium at point E, where
M R = M C. In this case AR < AC, therefore, the firm will earn losses. If the
firm produces more or less than quantity Q, losses to the business firm will
rise. Therefore, the firm will neither increase nor decrease its output.

R/C

MC AC

A
C
P AR = MR
E

O
Q Output

Figure 6.4: Loss Making Short-run Equilibrium

72
6.5 Shut Down Point
When a firm produces and sells, there are three possibilities; either excess profit
(T R > T C) or normal profit (T R = T C |no loss no profit) or losses (T R < T C).
If a firm earns excess or normal profit ( i. e. T RT C or AR = AC), whether it
will continue production or not, depends on T R > or = or < T V C.

If T R > T V C firm will continue its production because a loss would be less
than T F C which is a loss on closing production. If T R < T V C firm will
stop production because by doing so it would restrict its loss to T F C and if
continued production loss will be greater than T F C.

When T R = T V C, in the short run, losses would be the same as T F C,

whether either firm produces or not. Such a type of equilibrium point where
loss is equal to T F C or T R = T V C, and therefore, the firm is indifferent
between production and no production, is called shut-down point. At this
point AR = AV C. It is called a shutdown point because at this point or any
equilibrium below it, the firm will shut down its operation.

To summarise

TR > TVC (AR > AVC) Losses < TFC Production continues
TR = TVC (AR = AVC) Losses = TFC Production stopps
TR < TVC (AR < AVC) Losses > TFC Production stopps

Shut down point can be better explained by the following figure. If the
market condition is shown by AR2 = M R2 loss-making firm will continue its
production. It is because out of TR firms can pay full TVC and a part of
TFC, reducing losses lesser than TFC. If it closed its operation, it will have
no TVC as well as TR and loss equal to TFC.

TFC TVC TC TR Loss

10,000 5000 15000 13000 2000/10000
10,000 5000 15000 10000 5000/10,000
TR > TVC
10,000 5000 15000 8000 7000/10,000
10,000 5000 15000 6000 9000/10,000
10,000 5000 15000 5000 5000/5000 TR = TVC
10,000 5000 15,000 4000 11000/10,000
TR > TVC
10,000 5000 15000 3000 12,000/10,000

73
 R/C

MC AC
AVC

P2 AR2 = M R2
E2
E
P AR = MR
E1
P1 AR1 = M R1

O
Q1 Q Q2 Output

Figure 6.5: Shut-Down Point

If the market conditions are given by M R1 = M C1 , T R would not be enough

to pay even T V C, making the firm’s losses equal to T F C plus a part of the
variable cost. Therefore, the firm should close production so that loss is limited
to T F C only.

If the market conditions are shown by M R = M C, it would be indifferent to a

firm to close down or continue production because in either case loss would be
equal to T F C. It is because, if it produces T R would be just enough to pay
T V C only and the loss would be equal to T F C. If it did not produce there
would be no revenue as well as variable cost and again loss would be equal to
T F C.

6.6 Long Run Equilibrium

Perfect competition refers to the market where there is a large number of
buyers and sellers and none of them is so significant as to influence the market.
The market price is decided by market demand and supply and is taken by
each buyer and seller. At a given market price seller can sell as much as he
wants. He needs not to reduce the price to sell more and he cannot charge a
higher price than the market price. There is free entry and exit.

The long run is a period in which no factors are fixed or unchangeable. In the
long run business firms can make any kind of change in their production as
well as they can exit the industry or new business firms can join the industry.
Therefore, changes in the market supply happen because of the expansion or
contraction of the output of existing firms and an increase or decrease in the
number of business firms in the industry.

74
The business firm produces for the sake of profit, therefore, it will be in
equilibrium, if it earns the maximum possible profit. Maximum profit or
equilibrium will be attained where M R = M C.

If the market condition is shown by AR = M R there would be an excess

profit to the representative business firm in the industry. Other business firms
outside the industry, which either are not earning excess profit at all or are
earning less than that of the representative firm, will enter the industry. Then,
there will be an increase in industrial output and supply, thereby a price
decrease. Decreased prices, with the same cost conditions, will decrease excess
profit. It will make the entry of new firms less attractive, but new firms will
continue to enter till there is a smaller or bigger excess profit.

On the other hand, if there are losses to the representative business firm, few
existing high-cost business firms will wind up and exit from the industry. This
will reduce supply, increase the price and at the same cost conditions losses
will come down. This will be continued till losses are eliminated and normal
profit is established.

R/C

MC
AC

P2 E2 AR2 = M R2
E
P AR = MR
E1
P1 AR1 = M R1

O
Q1 Q Q2 Output

Figure 6.6: Long-run Equilibrium under Perfect Competition

Suppose that price prevailing in the market is P2 . In perfect competition

P = AR2 = M R2 , therefore, AR and M R curve will be AR2 = M R2 . The
business firm will be in equilibrium by producing quantity Q2 and earning
excess profit. This supernormal profit will attract the entry of new business
firms. Thus, production and supply will increase, and the price will decrease.
This will shift the AR = M R curve in the downward direction. The equilibrium
of representative business firms will be at a lower price and lower output. The
joining of new business firms, decrease in price and downward shift of AR will
continue till market price reaches P and AR and M R are shown by AR = M R.
Once the price reached P , there will be only a normal profit, no firm outside

75
the industry will enter the industry. Other things being the same, there will
be no entry or exit, no change in supply, no change in price and only normal
profit. This would be the long-run equilibrium of the business firm.

On the other hand, if the market price is P1 , in the short run firm will be in
equilibrium at point E2 , with losses. All business firms may not have the same
cost conditions. Marginal firms or higher-cost firms will have larger losses.
Higher losses firms will find their survival difficult in the industry, so they
will move out. This will reduce the number of firms and supply. Reduced
supply will increase the price and an upward shift of the AR = M R curve
to AR1 = M R1 . With given cost conditions each business firm will face
decreasing losses. This process of exit of high-cost business firms, decrease
in supply, increase in price and upward shift of AR = M R will continue till
price reaches P , where there is no loss or any profit. As there is no loss and
no profit, any firm will have no reason to leave the industry. Thus, with no
exit, no decrease in supply, and no increase in price and the firm will be in
equilibrium at point E and with the production of quantity Q.

There be losses or profit to the business firm in the short run, accordingly, there
would be a firm’s exit or entry to ensure normal profit for the representative
firm in the long run. Once this position is achieved there would be no reason
for firms to leave or for new firms to enter the industry. Thus, in the long run,
the firm will be in equilibrium with no loss and no profit.

At long-run equilibrium,

P = AR = M R = M C; and TR = TC (6.1)

Where firms will join and leave?

There are different industries, some of them are earning profits, others incur
losses and a few more are with no loss no profit. Those earning losses, in the
long run, will stop their production and will shift to other lines of production.
A preferable destination for the factors will be an industry with excess profit.

All the firms in the loss-making industry will not earn an equal loss. High-cost
firms will earn more losses compared to low-cost firms. The firms earning
unbearable losses will leave first to join other profit-making industries.

76
Chapter 7

Monopoly

Monopoly is a single-producer market. According to Koutsoyiannis, ‘Monopoly

is a market structure in which there is a single seller, there are no close
substitutes for the commodity it produces and there are barriers to entry.”
In the words of Baumol, “A pure monopoly is defined as a firm that is also
industry.

This single seller may be in the form of an individual owner or a single

partnership or a joint stock company. Such a single firm in the market is
called a monopolist. The monopolist is a price maker and has control over the
market supply of goods. But it does not mean that he can set both price and
output level. A monopolist can decide either of the two i.e. price or output.

In short, a monopoly is a form of market where there is a single seller without

any rivals or competitors. The degree of competition in monopoly is zero. The
seller dictates the price to the consumers.

7.1 Features of Monopoly

1. Single Seller and Negation of Competition: In Monopoly, there
is only one seller. Since the monopolist has absolute control over the
production and sale, the entry of potential rivals is barred. As there is
no entry and exit, it is a complete negation of competition.

2. No Entry and Exit: In a monopoly market there is a complete barrier

to the entry of new firms. As there is only one seller, his exit is the same

77
 as the closure of the market; therefore, the seller cannot exit from the
market. The possible barriers are licensing, franchise, resource ownership,
patents and copyright, high start-up cost, and decreasing average total
costs.

3. Monopoly as an Industry: The characteristic feature of a single

seller eliminates the distinction between firm and industry. A monopolist
firm is itself ‘an industry’. The whole market demand curve is also the
demand curve for a monopoly seller.

4. Homogenous Product: As there is a single firm in the industry,

the product is homogeneous. With the absence of the availability of a
substitute, the buyer has to purchase what is available at the tagged
price.

5. No Close Substitute: Under monopoly as there is a single producer

no substitute for his product. As the commodity in question has no
close substitute, the monopolist is at liberty to change his price. Under
monopoly, the cross elasticity of demand is zero.

6. Absence of Supply Curve: The monopolist does not have a supply

curve independent of the demand curve. The monopolist simultaneously
examines demand (hence marginal revenue) and cost (marginal) when
deciding how much to produce and what to charge. Under a monopoly,
the marginal cost curve is not a supply curve because monopolists can
sell different quantities at different prices.

7. Price Discrimination: Price discrimination is a practice of charging

different prices from different buyers or groups of buyers for the same
good or service. A monopolist has the leverage to carry out price
discrimination as he is the market supply and acts as per his suitability.

8. Nature of Demand Curve: In the case of monopoly one firm consti-

tutes the whole industry. The entire demand of the consumers goes to the
monopolist. Since the demand curve of the individual consumer slopes
downward, the monopolist faces a downward-sloping demand curve. It
means a monopolist can sell more of his output at a lower price and can
charge a higher price at the cost of a decrease in sales.

9. Price Maker: The demand curve in the monopoly market is downward

sloping and steeper than any other market, other things being constant.
The price elasticity of demand is least in monopoly. Inelastic demand
shows higher pricing-making power.

78
 10. Lack of Innovation: On account of its market domination, monopolies
tend to lose efficiency; new designing and dexterous marketing are not
seen.

7.2 Classification of Monopoly Market

A monopoly is a single-seller market. It can be classified based on the style of
working, origin, and other external factors.

1. Perfect Monopoly v/s Imperfect Monopoly: Perfect monopoly is

also called an absolute monopoly. In this case, a single seller is having
no close or far substitutes for his product. There are no rivals to him
even for consumers’ income. There is a zero level of competition. Such
a monopoly practically is very rare. An imperfect monopoly is also
called a relative monopoly or simple or limited monopoly. It refers to a
single-seller market having no close substitutes but may have a remote
one.

2. Private Monopoly v/s Public Monopoly: When production is

owned, controlled and managed by a private body, it is called a private
monopoly. Such a type of monopoly is profit-oriented. On the other
hand, if production is owned, controlled and managed by government
bodies, it is called a public monopoly. It is welfare and service-oriented.
So, it is also called a ’Welfare Monopoly.

3. Simple Monopoly v/s Discriminating Monopoly: A simple monopoly

firm charges a uniform price for all units of output from the same or
different customers in the same or different markets. A discriminating
monopoly firm charges different prices for different units of the same
product from the same or different customers in the same or different
markets. It prevails in more than one market or a single market is
divided into segments.

4. Natural Monopoly v/s Legal Monopoly: Natural Monopoly emerges

as a result of natural advantages like a good location, abundant mineral
resources, etc. e.g. gulf countries enjoy monopoly power in crude oil
exploration because of plenty of natural oil resources. When a monopoly
exists on account of trademarks, patents, copyrights, statutory regulation
of government etc, it is called a legal monopoly.

5. Technological Monopoly: The size of the market may be such as not

to support more than one optimum size plant. It emerges as a result of
economies of large-scale production, use of capital goods, new production

79
 methods, etc. e.g. electricity supply.

6. Joint Monopoly: When several business firms acquire a monopoly

position through amalgamation, cartels, syndicates, etc, it becomes a
joint monopoly. e.g. Actually, pizza-making firms and burger-making
firms are competitors of each other in the fast-food industry. But when
they combine their businesses that lead to reduced competition. So they
can enjoy monopoly power in the market.

7. Limit Pricing: The existing firms may adopt a limit-pricing policy to

prevent the entry of new business firms. Such policy may be combined
along with other policies such as heavy advertising or continuous product
differentiation which render entry unattractive.

7.3 Short Run Equilibrium

A monopoly is a single-seller market having no substitute. The degree of
competition is zero. Thus, if a buyer is to buy the commodity, he can buy it
only from the monopolist. But a monopolist, as he faces a downward-sloping
demand curve, can decide either price or output. A monopolist can increase
his sales by charging a lower price or can charge a higher price by accepting
lower quantity sales.

The short run is a period in which the firm cannot change all the factors to
make extensive changes in output. Production can be increased or decreased
by changing the number of variable factors. Accordingly, the firm changes
output to maximise profit.

In general, monopoly firms pursue profit maximisation. Therefore, the mo-

nopolist would be in equilibrium when profit is the maximum or loss is the
minimum possible. Profit maximisation (or loss minimisation) condition is
M R = M C. Thus, a monopoly firm will be in equilibrium when M R = M C.

In Figure 7.1, cost conditions are shown by AC and M C curves and AR

and M R curves show market conditions. The firm is in equilibrium at point
E, (M R = M C) where the firm produces quantity Q, charges price P and
earns excess profit P ABC. As AR > AC at point E firm is in profit-making
equilibrium.

In this case, If the firm produces less than quantity Q, M R > M C, which
means an increase in output will increase T R more than T C and profit rises.
The firm will continue to increase output so far as M R > M C. It will stop to
increase output when M R = M C at quantity Q, where profit is maximum.

80
 R/C

MC AC

A
P
AR
E
C
B
MR

O
Q Output

Figure 7.1: Profit making Equilibrium under Monopoly

On the other hand, if the firm produces more than quantity Q, M R < M C,
which means that a decrease in output will decrease T R lesser T C. By avoiding
additional losses from marginal units, profit increases. In this case, also the
firm will continue to decrease output until M R = M C at quantity Q where
profit is maximum.

In both cases, the firm will produce quantity Q, which maximises profit.
Further, it will have no intention of changing output, provided cost and
revenue conditions are the same. Thus, the firm will be in equilibrium by
charging price P and selling quantity Q.

R/C

MC
AC

B
C
P A

AR
E
MR
O
Q Output

Figure 7.2: Loss making Equilibrium under Monopoly

In Figure 7.2 the firm is in equilibrium at point E where it produces quantity

Q, charges price P and earns a loss of CBAP . If the firm produces a quantity
less than Q, M R would be higher than M C. It means if production increases,

81
total revenue will increase more than total cost. Thus, the loss will come down.
The firm will continue to increase its output so far as M R > M C because
by doing so loss will decrease. The output increase will be continued until
M R > M C. Finally, the firm will reach output Q.

If the firm produces more than Q, M R would be smaller than M C. It means

if output decreases, total revenue will decrease less than total cost. Thus, the
loss will come down. Here also, the firm will continue to reduce output to
reach M R = M C. Finally, the firm will reach an output of Q.

7.4 Monopoly and Pure Competition

Monopoly Perfect Competition
Seller Single seller A large number of sellers
Product Product may or may not be Homogeneous product
homogeneous
Openness No entry or exist Free entry and exit
Cost In both markets, short-run and long-run cost curves are smiles
curves "⌣" shaped i.e. a single level of optimum output or no reserve
capacity. In the short run, the ⌣ shape is due to increasing
and diminishing returns to the variable factors and in the
long run, it is due to increasing and diminishing managerial
efficiency.
Demand Downward sloping demand Horizontal or perfectly elastic
curve demand curve
UncertaintyIn both the markets uncertainty is denied with the assumption
of perfect knowledge.
Price Decides either output or price Decides output but not price
and and there is scope for selling and no scope for selling dex-
output activities terity
Research Research incentives are there Research incentives are there
Incen- in product development. in cost cutting.
tives
EquilibriumAtomistic profit maximisation decision at marginalistic rule
M R = M C, ignoring reactions of other firms
Static Both are static models in the sense that decisions in one period
Model do not affect that in the other period.
Continued on the next page. . .

82
 Table 7.1:Monopoly and Pure Competition (contd. . . )
Monopoly Perfect Competition
Price Equilibrium output is smaller Equilibrium output is larger
and and the price is higher com- and the price is lower com-
Output pared to pure competition pared to any imperfect com-
Level petition
Elasticity Market demand elastic is be- Market demand elasticity can
cause if it is inelastic monopo- be anything.
lists will increase the price to
increase revenue.
Cost Op- Firm produce at more than In the long-run firms in pure
timum least cost and there is excess competition produce at the
capacity least cost. Neither underutil-
isation nor over-utilisation of
plants.
Supply In monopoly supply function In perfect competition sup-
Func- is not uniquely determined ply function is uniquely deter-
tion i.e. at the same price differ- mined along the M C curve i.
ent quantities and for different e. there is a one-to-one re-
prices, the same quantity may lationship between price and
be supplied. quantity supplied.
Excess In the long run excess profit Only normal profit in the long
Profit or losses are possible. run.
Short There is no distinction be- In perfect competition in-
and tween short and long run. An crease in demand will increase
Long- increase in demand will in- price and output in the short
run crease output which, depend- run. In the long-run output
Distinc- ing on the extent of the in- will increase but price may de-
tion crease in demand, will be sold crease (decreasing cost indus-
at a lower price (if the new de- try) or will remain the same
mand curve intersects the old (constant cost industry) or
one on the left of the mini- will increase (increasing cost
mum of LAC ?) or the same industry).
or higher price (if the new
demand curve is more elastic
than original or intersect the
old one on the right of the min-
imum of LAC?).
Continued on the next page. . .

83
 Table 7.1:Monopoly and Pure Competition (contd. . . )
Monopoly Perfect Competition
An in- Increase in fixed costs cuts An increase in fixed cost will
crease down or eliminates excess not affect short-run equilib-
in Fixed profit but equilibrium remains rium as MC is unchanged and
costs unaffected. If the increase is in the long run, it will close if
substantial, it brings loss to there are losses.
the firm and in the long run,
it may close down.
Increase With the increase in variable cost output decreases and price
in Vari- increases in both the markets but changes are more acute in
able pure competition.
Cost
Lump- Imposition of lump sum tax brings an effect same as the
sum increase in fixed cost in both the markets.
Tax
Specific If the MC curve is horizontal In perfect competition burden
tax monopolist will bear a part of of specific tax is passed partly
the specific tax burden. to the consumer so far as the
supply curve is sloping up-
ward. If it is horizontal the
whole tax burden is passed on
to the consumer.

Mathematical Expression

The market demand is,

P = f (Q) = f (Q1 + Q2 ) (7.1)

The cost conditions of plants are,

C1 = f1 (Q1 ) (7.2)
C2 = f2 (Q2 ) (7.3)

The monopolist aims at maximisation of profit function,

Π = R − C1 − C2 (7.4)

84
 ∂Π ∂Π
Profit maximisation conditions are, = 0 and =0
∂Q1 ∂Q2

∂Π ∂R ∂C1
= − =0 (7.5)
∂Q1 ∂Q1 ∂Q1
∂R ∂C1
= (7.6)
∂Q1 ∂Q1
M R1 = M C1 (7.7)

Similarly,

∂Π ∂R ∂C2
= − =0 (7.8)
∂Q2 ∂Q2 ∂Q2
∂R ∂C2
= (7.9)
∂Q2 ∂Q2
M R2 = M C2 (7.10)

As the firm sells the output of both plants in the same market, M R1 = M R2 =
M R. Therefore, from Equation 7.7 and 7.10 we have,

M R = M C1 = M C2 (7.11)

The second-order condition of profit maximisation is,

∂2R ∂2C ∂2R ∂2C

< and < (7.12)
∂Q21 ∂Q22 ∂Q22 ∂Q21

That is the rate of change of MC must be greater than that of MR.

Example 7.1. A monopolist demand function is Q= 200 - P, cost functions

of two plants are C1 = 20Q and C2 = Q22 .

Sol. Q= 200 - P i.e P= 200 - Q

Revenue function is,

R = PQ = (200 − Q)Q
= 200Q − Q2
MR = 200 − 2(Q1 + Q2 )
= 200 − 2Q1 − 2Q2

Cost functions are,

C1 = 20Q C2 = Q22

85
M C1 = 20 M C2 = 2Q2

At equilibrium, M R = M C
200 − 2Q1 − 2Q2 = 20 200 − 2Q1 − 2Q2 = 2Q2
2Q1 + 2Q2 = 180 2Q1 + 4Q2 = 200

Solving for Q1 and Q2 ,

2Q1 + 2Q2 =180

−2Q1 -4Q2 = -200
−2Q2 =-20
Q2 =10
2Q1 + 2Q2 =180
2Q1 + 2 × 10 =180
2Q1 =160
Q1 =80

Q = Q1 + Q2 = 80 + 10 = 90
P = 200 − Q = 200 − 90 = 110
Total Revenue = P × Q = 110 × 90 = 9900
C1 = 20Q1 = 20 × 80 = 1600
C2 = Q22 = 102 = 100
C = C1 + C2 = 1600 + 100 = 1700
Total Profit, Π = 9900 − 1700 = 8200

Example 7.2. A monopolist demand function is Q= 200 - 2P, cost functions

of two plants are C1 = 10Q and C2 = 0.25Q22 .

Sol. Q= 200 - 2P i.e P= 100 - 0.5Q

Revenue function is,

R = PQ = (100 − 0.5Q)Q
= 100Q − 0.5Q2
MR = 100 − (Q1 + Q2 )
= 100 − Q1 − Q2

Cost functions are,

86
C1 = 10Q C2 = 0.25Q22
M C1 = 10 M C2 = 0.5Q2

At equilibrium, M R = M C
100 − Q1 − Q2 = 10 100 − Q1 − Q2 = 0.5Q2
Q1 + Q2 = 90 2Q1 + 3Q2 = 200

Solving for Q1 and Q2 ,

Q1 + Q2 =90
−Q1 −1.5Q2 = -100
−0.5Q2 =-10
Q2 =20
Q1 + Q2 =90
Q1 + 20 =90
Q1 =70

Q = Q1 + Q2 = 70 + 20 = 90
P = 100 − 0.5Q = 100 − 45 = 55
Total Revenue = P × Q = 55 × 90 = 4950
C1 = 10Q1 = 10 × 70 = 700
C2 = 0.25Q22 = 0.25 × 202 = 100
C = C1 + C2 = 700 + 100 = 800
Total Profit, Π = 4950 − 800 = 4150

7.5 Discriminatory pricing

Price discrimination is an act of selling the same product at different prices
to different buyers when the cost of production is the same or different but
not as different as the price charged. The product may be the same or may
have slight differences. The base of price discrimination can be the buyer’s
preference, income, location, time of buying and the ease of availability of
substitutes. Due to these differences, the demand function of buyers is different.
A monopoly firm, which adopts the policy of price discrimination, is known as
a discriminating monopoly.

Price discrimination is more common in monopolies because the monopolist

controls the market but in another form of imperfect competition also price
discrimination is possible. It is mainly through product differentiation, which

87
creates a type of monopoly power for the seller and therefore, a smaller degree
of discrimination is possible for the firm.

For effective implementation of price discrimination, the buyers or sub-markets

with different price elasticities must be effectively separated so that no reselling
can take place. Price discrimination is not related to production but sales only.
The objective of price discrimination is profit maximisation. Therefore, the
firm will sell an additional output in the market with higher marginal revenue.

First-degree price discrimination

When a monopolist charges a different price for each unit of output, it is called
first-degree price discrimination. The price charged for each unit is equal to
its marginal utility and the monopolist extracts the whole consumer surplus.
Therefore, it is called perfect discrimination by Mrs John Robinson.

P P

45
40 |40
35
30 |30
25
|20
D D

O O
Q Q

(a) First Degree (b) Second Degree

Figure 7.3: Price Discrimination

Second-degree price discrimination

When buyers of the product are divided into different groups and each group
is charged a different price, it is called second-degree price discrimination. For
each group price charged is equal to the marginal utility of the last unit of that
group. Non-marginal units/buyers have a consumer surplus, while marginal
units/buyers do not have a consumer surplus. In this kind of discrimination,
the seller appropriates a part of the consumer surplus and the rest is available
to the consumers. The share of buyers in the consumer’s surplus is directly
proportional to the size of the group.

88
Third Degree Price Discrimination
In this type of discrimination, different prices are charged in different segments
of the same market. Quantity supplied in each segment of the market will
be such that M R is equal in both markets. Accordingly, different prices will
prevail in different segments as shown in Figure 7.4. By doing so firms’ revenue
and profit would be the maximum possible.

AR2

M R2 AR1

M R1

Q2 0 Q1

Figure 7.4: Third Degree Price Discrimination

89
90
Chapter 8

Monopolistic Competition

Monopolistic Market

Classical economics classified markets only into two extreme types, pure
competition and monopoly. On one side, it is a monopoly when competition is
nil in an absolute sense. But in reality, a monopolist has to compete with others,
at least, for the buyer’s money income. Therefore, in a sense, every good is a
substitute for other goods. On the other side, the existence of heterogeneous
products, advertising, and selling strategies, which are realities of the market,
could not be explained by pure competition. The pure competition model
predicts that under decreasing cost conditions firms will grow infinitely large
but in real life, they limit their output. Thus, the existence of a market
between these two extreme types is possible. Such a market is known as a
monopolistic market.

To summarise, a monopolistic market is a kind of market in which there are

many sellers and at least a few of them can influence, if not control, the market
because either they are quantitatively significant or they produce a slightly
differentiated product. The model of monopolistic competition describes a
general market structure in which firms have many competitors, but each
one sells the same but slightly different products. In this type of market,
sellers can influence the market either by changing prices or by making a
product appear different. They can decrease the price to sell more or can
charge a higher price by accepting lower quantity sales. Despite the existence
of close substitutes, each firm acts as a monopolist of its product which it
is. Monopolistic competition as a market structure was first identified in the
1930s by American economist Edward Chamberlin and English economist Joan

91
Robinson

Product Differentiation
Product differentiation means that products are slightly different and quite
similar so they are close substitutes. According to Chamberlain, along with
price, demand for goods is determined also by the style of the product, the
services associated with it and the selling activities of the firm. He, therefore,
introduced two additional policy variables in the theory of the firm: the
product itself and selling activities. Product differentiation is intended to
influence market demand by differentiating products from others. It can be
real or fancied. Real differences are in the form of differences in the factor
inputs, location of the firm, product accessibility, and the services offered by
the firm. Fancied differentiation arises from advertising, packaging, design
or brand name etc. The effect of product discrimination is an increase in
monopoly power and discretion in determining the price. Thus, each seller is a
monopolist of his product. The greater the differentiation, the greater would
be monopoly power. Discretion would be limited because there is competition
from close substitutes from other firms. Since each seller is a monopolist but
has competitors, it is a competing monopoly or monopolistic competition.

Product Group
Heterogeneous products due to product differentiation create difficulties in
market analysis. Therefore, Chamberlin replaced the concept of the industry
with a product group. Products in a group should be substitutes, technolog-
ically (same want) and economically (similar prices). Theoretically, goods
with high prices and cross elasticities are in a product group. But how high
is judgemental? In Chamberlin’s group, due to product differentiation, there
will be no equilibrium price but an equilibrium cluster of prices, which like
market equilibrium price, will change along with changes in demand and cost.

8.1 Features of Monopolistic Competition

1. Many Sellers: There is a large number of sellers producing the same
but differentiated products. Since the number of sellers is large, each
firm supplies only a very small part of the market supply. So, no seller is
in a position to control the price of the product and competition among
them is very keen.

2. Influence over the price: As products are close substitutes of each

other, any fall in the price of a commodity will attract customers of
other sellers. Therefore, with a fall in price quantity demanded increases.

92
 Thus, under monopolistic competition, a firm cannot fix the price but
influences it. A firm can increase the price by accepting smaller sales or
can sell more by reducing the price.

3. Product Differentiation: It is one of the most important features

of monopolistic competition. Every producer tries to keep his product
dissimilar to his rival’s product to maintain his separate identity. So
each firm has an absolute monopoly in its differentiated product. The
firm brings about differentiation in several ways like physical product
differentiation, where firms use size, design, colour, shape, performance
or marketing differentiation, where firms try to differentiate their product
by distinctive packaging and other promotional techniques or human
capital differentiation, where the firm creates differences through skill,
training, uniform, antiquate of employees or differentiation through
distribution, including distribution via mail order or through internet
shopping.

4. Freedom of Entry and Exit: The entry and exit is free. Since each
firm is small in size and is producing close substitutes, any new firm can
enter the industry or group in the long run. Each new firm produces
a differentiated product. Freedom of entry and exit of firms increases
competition.

5. Selling Cost: It is another unique feature of this market. Selling cost is

the cost incurred for sales promotion. Since products are differentiated
change in advertising and other forms of sales promotion is an integral
part of marketing. Through these methods, the firm tries to make a
favourable shift in demand for its product and tries to capture more
market. This cost includes sales promotion expenses, advertisement
expenses, salaries of marketing staff, etc.

6. Absence of Interdependence Since there is a large number of firms,

the market share of each firm is negligible. As firms are not enough
strong to affect the market, their business strategies will not affect their
rivals. Any action of one firm does not affect another firm. The firm
selling differentiated product has limited monopoly power and therefore,
have independent policies regarding price and output. Thus, the firms
are independent.

7. Competition among the Sellers: Under this market competition

among the sellers takes place in two different ways.

• Price competition: Firms produce the same but differentiated

93
 products which are substitutes for each other. Thereby they have
price competition. Each firm fixes its price arbitrarily, lowering the
price of the product can sell more.

• Non-price competition: Firms under monopolistic competition

differentiate their products to win over customers. This results in a
non-price type of competition among the firms.

8. Concept of Group: Since products in monopolistic competition are

not homogeneous, which is the essence of perfect competition, there is
no industry in monopolistic competition. In place of the Marshallian
concept of industry, Chamberlin introduced the concept of the group in
monopolistic competition. A group is a cluster of firms producing closely
related but differentiated products. Firms that produce the same type of
product with high positive cross elasticity of demand constitute a ’group’
or a ’product group’. Through this concept, he was able to distinguish
between close and far substitutes. In a way, according to him, the group
was to include close substitutes and industry-far substitutes with wide
variations because of which it becomes a meaningless concept.

9. Falling Demand Curve: In monopolistic competition, a firm is facing

a downward sloping demand curve i.e. elastic demand curve. It means
one can sell more at a lower price and vice versa.

8.2 Price Output Determination

A firm under monopolistic competition faces more complexities than a perfectly
competitive market. The equilibrium of an individual monopolistic firm
involves equilibrium concerning the price, the nature of the product and
advertising outlay. Chamberlain did not use M R and M C curves, but they
are implicit in his analysis. To explain the equilibrium of firm and industry
Chamberlain had mad ‘heroic’ assumption i.e. all firms have identical costs and
despite product differentiation, all firms have identical demand or consumers’
preferences for their products are evenly distributed among firms.

8.2.1 Short Run Equilibrium

A monopolistic market is a type of imperfect market in which there are many
sellers of which at least a few are so significant as to influence the market
by changing quantity supplied, price charged or differentiating their product
from others. A seller can sell more by reducing price or he can charge a higher
price by accepting lower sales. Or he can make his product appear different
from other’s products so that he can attract new customers while holding an

94
existing one. It means that the demand curve or firm’s average revenue curve
is sloping downward from left to right.

A short run is a period in which at least a few factors are fixed or unchangeable.
In the short run, all types of changes in the business firm are not possible,
therefore, neither an existing business firm can make any extensive changes in
the production unit nor a new business firm can join the industry nor existing
one can exit the industry. In brief production capacity of each business is
limited by time horizon and the supply of industry would be changeable only
due to variable factors.

In general, firms pursue the objective of profit maximisation or loss minimisa-

tion. Therefore, a monopolistic firm would be in equilibrium when profit is
the maximum possible or losses are the minimum possible. The profit maximi-
sation condition is M R = M C at the positive slope of M C or M C intersect
M R from below. Thus, the monopolistic firm also will be in equilibrium when
M R = M C.

Profit making equilibrium

R/C

MC
AC
A
P
AR
E
C
B
MR

O
Q Output

Figure 8.1: Profit making Equilibrium under Monopolistic Market

In Figure 8.1, cost conditions are shown by AC and M C curve and AR and
M R curve show market conditions. Point E is the equilibrium point because
M R = M C at the latter’s positive slope. Therefore, the firm produces quantity
Q and charges price P and earns excess profit P ABC as AR > AC.

If the firm produces less than quantity Q, M R would be greater M C, which

means if the firm produces more T R will increase more than the increase in
T C. Therefore, the firm will increase its output until M R = M C at output
Q. In the case firm produces more than quantity Q, M R will be less than

95
M C, which means that if a firm reduces output profit will increase by avoiding
losses due to marginal units. Or in other words, on decreasing output, T R will
decrease less than the decrease in T C. Therefore, the firm will reduce output
until M R = M C at quantity Q.

In both cases, the firm will change the output to produce quantity Q, which
maximises its profit. Further, it will have no intention of changing output so
far as cost and revenue conditions are the same. Thus, the firm will be in
equilibrium by charging price P and selling quantity Q.

Loss making equilibrium

In Figure 8.2 the firm will produce quantity Q where M R = M C and losses are
minimum. If it produced less or more than Q, losses will increase. Therefore,
it will restore production at quantity Q.

R/C

MC
AC

B
C
P A

AR
E
MR
O
Q Output

Figure 8.2: Loss making Equilibrium under Monopolistic Market

The firm in Figure 8.2 is in equilibrium with a loss of CBAP at quantity Q

and price P . If the firm produces less than quantity Q, M R would be greater
than M C. It means an increase in output will cause T R to increase more than
T C, and loss will come down. Therefore, the firm will continue to increase
output till M R > M C. It will stop producing more when M R = M C. On
the other hand, if the firm produces more than Q, M R would be lesser than
M C. If the firm reduces its output, a decrease in T R would be lesser than
the decrease in T C and the loss will come down. The firm will continue to
decrease output until it reaches M R = M C at quantity Q where profit is the
maximum.

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8.3 Long-Run Equilibrium
A long run is a period in which no factor is fixed or unchangeable. In the
long run, existing business firms can make all kinds of changes in business
plants, as well as an existing firm can exit or new business firms can join the
industry. Therefore, whenever there is excess profit to the representative firm,
the industry will attract firms outside the industry, or altogether new firms
will enter. This will increase supply and will cause a fall in price. Decreased
prices, with no reason for the cost to change, will reduce profit. The entry of
new business firms will continue until excess profit is not eliminated. Once
excess profit is eliminated, there will be no reason for new firms to enter this
industry. Supply and price will remain unchanged.

On the contrary, when there are losses in the industry for a representative firm,
a few high-cost firms will exit the industry. Supply will come down causing a
price fall. There being no reason for costs to decrease, losses will come down.
The exit of high-cost firms will continue till a normal profit is not established.
Once there is a normal profit and no firms will give up the industry. Thus,
no changes in supply and price. Hence, under a monopolistic market, in the
long run, only normal profit is possible. Chamberlin developed three models
of equilibrium in the long run.

8.3.1 Model I: Equilibrium with the entry of new firms

In this model, existing firms are assumed to be in the short-run equilibrium
with excess profit. Therefore, the existing firms will have no incentive to
change their price because any change will reduce their profit. New firms are
attracted to the group by supernormal profit. This will increase supply and
will decrease the price. Thus, the new equilibrium price would be lower than
the earlier equilibrium price.

In the figure, 8.3 cost structure of the business firm, in the long run, is shown
by LAC and LM C. The demand conditions are shown by the demand curve
or AR curve D1 /AR1 . The firm would be in equilibrium at point e1 while
charging the price P1 and selling quantity Q1 at which M R = M C. At this
equilibrium as AR > AC, there is supernormal profit.

Supernormal profit will attract new firms into the industry. This will increase
the total supply in the market while demand remains the same. As the same
demand will be shared by a larger number of business firms, each firm in
the market will experience decreased demand i.e. the downward shift of the
demand curve. Thus, along with the entry of new firms supply will increase,
and demand and price will decrease.

97
 R/C

MC

AC

P1

E1
D1 /AR1
E D/AR
M R1
MR
O
Q Q1 Output

Figure 8.3: Long-run Monopolistic Equilibrium Model I

With the downward shift of the demand function, the firm adjusts the price
and reaches a new equilibrium position with new equality of M R and M C
and a lower price. This adjustment will continue until the demand curve is
tangential to the AC curve (like D/AR). Now supernormal profit is wiped out
as AR = AC, therefore, no new firm will join and no change in the equilibrium
point. Thus, equilibrium with price P = AC will remain stable.

8.4 Perfect vs Monopolistic Market

Both monopolistic and perfectly competitive firms try to minimise costs and
maximise profit. Cost functions, decided by the nature of the factor market
assumed to be perfectly competitive, are the same for both kinds of markets.
While monopolistic and perfect competition has marked differences.

1. Number Competitors: Perfect competition markets are populated by

very many numbers of buyers and sellers whereas a monopolistic market
involves several or many but is not as large as a perfect competition
market.

2. Barriers to Entry: Barriers to entry are factors and circumstances that

prevent the entry of would-be competitors. Theoretically, both markets
have free entry and exit but practically in a monopolistic competition
market, there are barriers, though not enough strong to prevent entry.

3. Product Differentiation: There is zero product differentiation in a

98
 perfectly competitive market. Products are homogeneous and perfect
substitutes for each other. In a monopolistic market, there is great
absolute product differentiation, therefore, firms’ products are imperfect
substitutes for each other.

4. Elasticity of Demand: The demand in a perfectly competitive firm is

infinitely elastic; whereas that in the monopolistic market is relatively
elastic. A low coefficient of elasticity is indicative of barriers to entry or
monopoly power.

5. Excess Profits: Both perfectly competitive business firms, as well as

monopolistic business firms, can earn an excess profit (or losses) in the
short run but only normal profit in the long run.

6. Profit Maximisation: Both a perfect competition firm as well a

monopolistic firm maximise their profits by producing the quantity at
which M R = M C. But at perfect competition equilibrium price = M R
and under monopolistic equilibrium price > M R.

7. Demand Curve: The demand curve of a perfectly competitive firm is

horizontal while that of a monopolistic firm is downward sloping.

8. Price: If cost conditions and equilibrium quantity of both perfectly

competitive firm and monopolistic firm, by chance, happen to be the
same, the monopolistic firm charges a higher price than the perfectly
competitive firm.

R/C
MC AC

A
PM ARM
PP AR =MR

MR

O
Q Output

Figure 8.4: Price differences

9. Output: If the cost conditions and equilibrium price of both a perfectly

competitive firm and monopolistic firm, by chance, happen to be the
same, the monopolistic business firm produces a smaller quantity than a

99
 perfectly competitive firm. It is mainly because in perfect competition
marginal cost and marginal revenue are the same; while in monopolis-
tic competition they separate from each other and slope downwards.
Therefore, the M R curve in monopolistic competition, compared to the
perfect competition MR curve, intersect the M C curve at a lower output
and the firm achieves equilibrium at a smaller output. Thus, the output
produced by a perfectly competitive firm, at a given cost, is always
greater than that a monopolistic firm would have produced.

R/C
MC AC

A E
P AR =MR

ARM

MR
O
QM QP Output

Figure 8.5: Output Differences

10. Efficiency: In the long run, both perfectly competitive business firms
and monopolistic business firms are in equilibrium with normal profit.
At the long-run equilibrium perfectly competitive business firm produces
at the minimum possible average cost while a monopolistic business firm
always produces at an average cost that is higher than the minimum
possible. Thus, in the long-run equilibrium, the average cost of pro-
duction in a perfectly competitive firm is always lower than that of a
monopolistic firm. We can say, therefore, perfectly competitive business
firms are more efficient than monopolistic business firms.

11. Excess Capacity: Production at the minimum possible average cost

would be ideal. But in monopolistic competition, long-run equilibrium is
attained at output lower than such ideal output. Therefore, monopolistic
competition has been attacked on the ground that it leads to excess
capacity.

But according to Chamberlain, the criticism of excess capacity and

misallocation of resources is valid only if one assumes that the demand
curve of the individual firm is horizontal. According to him, if the
demand curve is downloaded sloping and there is price competition

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 R/C

MC AC

A
P AR =MR
ARM

MR
O
QM QO Output

Figure 8.6: Efficiency Differences

R/C

MC AC

A
ACM
ACP AR =MR
ARM

MR
O
QM QO Output

Figure 8.7: Excess Capacity

with free entry and exit, the ideal output cannot be considered as the
socially optimal output level. Consumers desire a variety of products
and they are prepared to pay a higher price for differentiated products.
Therefore, higher cost resulting from the differentiation of product is
socially acceptable. Therefore, the difference between actual output and
a minimum cost output is not a measure of the excess capacity but of
the social cost of producing and offering greater variety.

According to Chamberlain, there will not be a considerable difference

between the minimum cost output and monopolistic output because
monopolistic firms have a very elastic demand curve. In the case, the
firm avoids price competition (ignored market demand dd) and focused
on non-price competition (market share DD), there would be excess
capacity. According to Chamberlain excess capacity is the difference
between x1 and x in Figure ??.

101
 12. Welfare: AR of a business firm is also demand curve and the M C curve
above the AV C curve is the supply curve. The demand curve shows the
price offered by or indirectly marginal utility from the respective units to
the society. On the other hand, the supply curve shows the price sought
by or marginal disutility from respective units to society. Thus, with
an increase in output social welfare will go on increasing till AR > M C.
It will reach the maximum when AR = M C. A perfectly competitive
business firm is in equilibrium when AR = M C while a monopolistic
business firm is in equilibrium when AR > M C. It means that if the
monopolistic business firm produces more than the equilibrium quantity
it may not maximise its profit but will maximise social welfare.

R/C

MC AC

A
ACM
ACP AR =MR
ARM

MR
O
QM QO Output

Figure 8.8: Welfare Differences

From the point of view of social welfare monopolistic competition suffers

from the fact that the price is higher than the M C. Socially, the
output should be increased until the price equals M C. However, this
is impossible since it will result in long-run losses to all the firms: the
LRMC intersects the DD below the AC curve.

Example 8.1. A monopolistic business firm has a demand function p =

20˘0.001x. Its cost function is C = 15x + 2000. Calculate its maximum profit.

Sol. : Profit is given by = TR – TC TR = p.x = 20 x- 0.001 x2 TC = 15

102
Chapter 9

Oligopoly

Oligopoly is “competition among a few". In brief, an oligopoly is a kind of im-

perfect market where few firms produce, either homogeneous or differentiated,
products that are close substitutes for each other. Thus, oligopoly prevails
when there are few interdependent and influential native firms producing and
selling homogenous or differentiated products. Their decisions depend on the
ease of entry and lag, which they forecast, between their action and the rivals’
reactions.

The degree of substitutability, interdependence and ease of entry are important

attributes of oligopoly. The degree of substitutability among products can be
measured by cross-price elasticity. The degree of interdependence of a firm
may be measured by unconventional cross-quantity elasticity. The ease of
entry may be measured by Bain’s concept of the ‘condition of entry’ =

There is no clear borderline between a few and many. Usually, an oligopoly is

understood to prevail when the numbers of sellers are two to ten. Oligopoly is
of two types - oligopoly without product differentiation or pure oligopoly and
oligopoly with product differentiation.

• Duopoly: A Duopoly is the simplest form of oligopoly in which only two

firms dominate a market.

• Oligopsony: In oligopsony, there are few buyers and a large number of

sellers. The other characteristics are the same as an oligopoly.

• Bilateral Oligopoly: A market with a few sellers (oligopoly) and a few

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 buyers (oligopsony) is a bilateral oligopoly.

• Cartel: When there is formal collusion (to increase prices and restrict
production in the same way as a monopoly) among oligopolistic firms to
reduce risk and foster joint profit, it is Cartel.

9.1 Characteristic Features of Oligopoly

1. Few Sellers: Usually oligopoly is understood to prevail when the
numbers of sellers are two to ten. It is dominated by a small number of
sellers who can exert control over supply and market prices.

2. Entry Barriers: Theoretically, entry and exit in an oligopoly are

free but practically there are barriers raised by existing firms for the
new entrant. The barriers can be in the form of patents, copyrights,
government rules/regulations or ownership of scarce resources.

3. Homogenous or Differentiated Products: In this market firms

produce close substitutes for each other. If price competition is not
giving the desired result firms may resort to non-price competition. It
will make their products different from each other.

4. Interdependence: The firms in an oligopoly are interdependent in

making a decision. They are interdependent because competitors are few
and any change in price or product design by a firm will have a direct
effect on its rival firms, which in turn may retaliate by changing its own
price and output. Thus, an oligopoly firm considers not only the market
demand for its product but also the reaction pattern of other firms in
the industry. No firm can fail to take into account the reaction of other
firms to its price and output decisions. There is, therefore, a good deal
of interdependencies of the firm under oligopoly.

5. Advertising and selling costs: The firms under an oligopolistic market

employ aggressive and defensive weapons to gain a greater share in the
market and to maximise sales. So firms have to incur a great expenditure
on advertisement and other measures of sales promotion. In no other
market do advertising and selling cost plays so important role as in the
oligopolistic market. Prof. Baumol has described it as a matter of life
and death.

6. Group behaviour: Another important feature of oligopoly is group

behaviour. In perfect competition, monopoly as well as monopolistic
competition, the business firms are assumed to behave to maximise their

104
 profits. Because of the strong interdependence among the firms, the
profit-maximising behaviour in an oligopoly may not be valid. If they
will cooperate or fight with each other to promote interest is not certain.
While fighting with a firm may be aggressive or passive.

7. Uncertainty: This characteristic is the direct result of the interdepen-

dence of oligopolistic firms. Mutual interdependence creates uncertainty
for all firms. No firm can predict the consequence of its price-output
decision i.e. a firm cannot predict, in response to its price change. if the
rival firms will change their price or not.

8. Indeterminateness of Demand Curve: In perfect competition, every

firm’s demand curve is perfectly elastic. In a monopoly there are no
substitutes, therefore the firm will be unaffected due to competitors.
In monopolistic competition, competitors are not enough stronger to
influence each other significantly. Therefore, a monopolistic firm can
assume that its rival firms will keep it unaffected. Thus, the demand
curve for a monopolistic firm can be taken as definite. But in the case of
oligopoly, each firm can affect other firms. As a result, they can change
each other’s demand curve. Therefore, an oligopolistic firm loses the
definiteness of the demand curve.

9. Cartel: Oligopoly is a hybrid of monopoly and monopolistic competition.

To avoid uncertainty arising out of competition in the market oligopolists
can come together to form a cartel. By forming a cartel they can
assure each other of peaceful co-existence, no price war and promotional
expenditure.

10. Elements of Monopoly: By the number of sellers oligopoly is nearer

to monopoly; therefore, there exist some elements of monopoly. Under
an oligopoly with product differentiation, each firm controls a large part
of the market by producing a differentiated product. In such a case it
acts in its sphere as a monopolist by laying price and output.

11. Price Rigidity: Under oligopoly, price tends to be rigid and sticky. If a
firm reduced its price with an expectation that it will attract customers
from rivals, rival firms, in fear of losing customers, will follow the same
suit. It will keep the firm indifferent. On the other hand, if a firm in
the oligopolistic market increased its price, rivals will not follow and the
former will end with the loss of customers. It will result in price rigidity.

12. Sloping demand curve: An oligopolistic firm faces a downward-sloping

demand curve; however price elasticity depends on the rival’s reaction

105
 to change its price, investment and output.

Many industries experience an oligopoly market situation due to some factors

related to production techniques and demand conditions. A few more factors
may be created by the firms themselves.

Why oligopoly?
A modern trend is to develop and design an improved variant of an existing
product. It requires research and development for which a large fixed cost is
needed. This is possible for bigger firms only. If the market is too small to
support a large number of firms, others will be wiped out from the market. Once
a few firms established themselves well in the market, they may create artificial
barriers for the new entrants. To become even bigger and stronger among
existing firms, two or more firms may resort to overtaking other firms, or two
or more firms may decide to merge. On the demand side also, customers prefer
differentiated products but within a range. It means customers want their
product to be different from others but not so different that their comparison
is impossible. It is because customers can derive utility from comparing their
goods with others. For example, people would like to watch different TV
programmes but no one wants to be a single watcher of that programme.
Similarly, people would like to buy a car which other people don’t have but
simultaneously they would like to have a club of users of the same cars. Thus,
fixed cost, economies of scale, barriers to entry, product differentiation and a
few created causes are behind oligopoly.

Indeterminacy
A significant consequence of the interdependence of oligopolistic firms is a
wide variety of behavioural patterns. Rivals may co-operate in pursuit of an
objective or they may prefer to fight each other. If they co-operated, it may
last long or may turn into even stronger rivals. Their cooperation agreement
may follow a variety of patterns.

While deriving demand curve assumption is ceteris paribus, which is not

possible in perfect competition, monopoly and monopolistic markets. It is
because either there is no firm interdependence (no rival firms, a case of
monopoly) or even if there is, their interdependence is negligible (rivalry is
negligible in a case of monopolistic competition) or zero (no rivalry in a case
of perfect competition).

Therefore, deriving the demand curve in another form of market assumption

of ceteris paribus is easy to hold. But in the case of the oligopolistic market
individual firms are enough significant and can change the fate of other firms,

106
through their actions and reactions. That is why the rival’s reaction is uncertain
and noticeable. Here we must remember that there is no rivalry between firms
in monopoly and perfect competition. Thus, we cannot drive the demand
curve in an oligopoly market. There is guessing of others and by others. In
the absence of a demand curve, we cannot provide a solution for price-output
determination in an oligopoly.

Again, a determinate price-output solution is reached while following the profit

maximisation objective. But the validity of profit maximisation is challenged
in oligopoly. A few of the objectives of an oligopolistic firm are ‘maximising
stable profit over a long period rather than profit at a time, sales maximisation,
utility maximisation, growth maximisation, and satisfaction maximisation.
This objective controversy further deepens indeterminacy.

Because of indeterminacy, there is no single determinate solution but several

indeterminate solutions.

Approaches to Oligopoly

Unlike other markets, an oligopolistic firm need not take into account the
effects of its own decisions on its rivals. It has to decide either to compete
with the rival firms following an individual interest or to cooperate with them
to promote the joint interest. It has to strategise either for the whole group or
individual firm.

Some economists like Cournot and Bertrand assumed that oligopolistic firms
ignore interdependence, making their demand curve determinate. With this,
assuming the profit maximisation objective, we can apply the marginalistic
rule for price and output determination.

Another approach assumes that an oligopolistic firm can estimate the reaction
curve of its rival firm. Chamberlin assumed that firms recognise their interde-
pendence and try to maximise their joint profit. P. M. Sweezy, Hall and Hitch
assume that a price reduction will be followed by the rival firms but not a price
increase. One more approach assumes that firms recognise interdependence,
will pursue a common interest, will form collusion to maximise joint profit and
will share profit and output. Another variant subscribes that oligopolist firms
will accept one firm as a leader which may be a low-cost firm or dominant
firm or barometric firm. One more approach, by Newmann and Morgenstern,
called game theory assumes that oligopolistic firms calculate optimum moves
by the rival firms and decide their counter moves.

107
9.2 Cournot’s Duopoly Model
The French economist Augustin Cournot developed a duopoly model in 1838.
He illustrated his model with two firms selling mineral water derived at zero
cost. He assumed a straight-line market demand curve and that rival will not
change its output. These assumptions are for simplification.

There are two oligopolist firms A and B, each owning a source of cost-free
mineral water. Also, assume a linear market demand curve. Firm A produces
and sells to maximise profit. As marginal cost is zero profit is the same as
total revenue. It will produce and sell the quantity at which profit or total
revenue is maximum. E is the midpoint of the demand curve where elasticity
is the unit. At any price above P , demand is elastic, therefore, a price decrease
will cause an increase in total revenue or profit. On the other hand, for a price
lower than P demand is inelastic, therefore, a price increase will increase total
revenue or profit. The total revenue or profit will be maximum at price P and
quantity A at which demand is unitary elastic.

Period I: Thus, seller A will produce and sell quantity Q, which is half of the
market demand at zero price. The seller B, while assuming that seller A will
continue to sell the same quantity, will take CD as his demand curve. Like
seller A, he will maximise his profit by supplying half of the market demand
available for him i. e. 1/4 of total demand.

P
D

E
P

E’
P’

A B D’ Q

Figure 9.1: Reaction of Cournot’s Firms

Period II: Reacting to the market entry of firm B, supplying 1/4 of market
demand, firm A will find that only 3/4 of the market is available and will
decide to reduce its supply to half of 3/4 not supplied by B i. e. 3/8 of total

108
market demand. When firm A has reduced its supply to 3/8 of total market
demand, firm B will find that 5/8 of market demand is available and will
supply half of that i. e. 5/16.

Period III: In period third firm A will assume that firm B will continue
to produce 5/16 of the total market demand and will produce half of the
remainder market demand i. e. 11/16 of the total market demand.

In the same way, there will be n number of adjustments by both the firms as
shown in Table 9.1 and Figure 9.1. In the case of firm A, the expression in the

Table 9.1: Reaction of Cournot’s Firms

Firm A Firm
 B
1 1 1 1
1 = = =
2 2 2 4

1 1 3 1 1 1 3 5 1 1
   
2 = 1− = = − = 1− = = +
2 4 8 2 8 2 8 16 4 16

1 5 11 1 1 1 1 11 21 1 1
   
3 = 1− = = − − = 1− = = + +
2 16 16 2 8 32 2 16 64 4 16
1
64

1 21 43 1 1 1 43 85 1 1
   
4 = 1− = = − − = 1− = = + +
2 64 128 2 8 2 128 256 4 16
1 1 1 1
− +
32 128 64 256

Product of A at equilibrium Product of B at equilibrium

1 1 1 1 1 1 1 1
= − − − − ... = + + + + ...
2 8 32 128 4 16 64 256
 1  2
1 1 1 1 1 1
= − = + + +
"  1 2 # 4 4 4 4 4
1 1 1 1 1 2 1 1 3
   
+ + + ... + ...
8 8 4 8 4 4 4

square bracket is a declining geometric progression with ratio r = 14 . Using

the summation formula for an infinite geometric series we have,

a
QA = (9.1)
1−r

where, QA = total product of firm A, a= the first term of series = 12 , r = ratio

= 14 )

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Product of firm A at equilibrium
1 1
1 1 1 4 8 1
QA = − 8 1 = − 8
3 = − = = (9.2)
2 1− 4
2 4
2 24 24 3

In the case of a firm, the B expression is an increasing geometric progression

with ratio r = 14 . We have,

Product of firm B in equilibrium

1 1
1
= 4
1 = 4
3 = (9.3)
1− 4 4
3

Thus, over a period each firm will adjust its output and supply in such a
way that each firm produces and sells 13 of total market demand keeping the
remainder 13 unsupplied by both the firms. If there are 3 firms each will supply
4 of the market and the remainder 4 demand will be kept unsupplied. If thee
1 1

are 4 sellers each will supply 5 and the remainder 15 will be kept unsupplied. If
1

there are n suppliers each will supply n+11

and the remaining n1 would remain
unsupplied.

Thus, it is assumed that an individual seller will keep his supply constant and
the market equilibrium will be stable. But empirically this model is limited
and has been criticised because of its assumptions.

It assumes that the seller does not learn from the past. Similarly, the assump-
tion of costless production, though can be relaxed, is not practical. The model
is closed because several firms are assumed to be constant. But the beauty of
the model is that with an entry of a new firm price and unsupplied market
demand decrease and the market moves towards perfect competition. It means
the market can be extended to cover any number of sellers.

The model explains that in the succeeding period, the output of the bigger
seller(s) will decrease while that of the smaller seller(s) will increase. But the
model does not explain how long this adjustment process will take to reach
the final equilibrium.

9.3 Sweezy’s Kinked Demand Model

Chamberlin’s Kinked Demand Curve
A market demand curve is derived by the horizontal summation of the indi-
vidual demand curves of firms in the market. An individual firm’s demand
curve (dd′ ) is flatter than actual sale or share-of-the market demand curve.

110
But, in the short run, an individual business firm may attract customers of
other sellers by charging lower prices. Similarly, it may lose customers to
others, if it increases price. It means any change in price by an individual firm
will cause a greater percentage change in its demand compared to the change
in market demand. That is, in the short run, an individual firm’s demand
curve is more elastic than the market demand curve. Therefore, an individual
firm’s demand curve will intersect the market demand curve from below as
shown in Figure 9.2. This gives rise to a kinked demand curve. Hall and Hitch
used a kinked demand curve to analyse price stickiness or price rigidity.

Price Rigidity

Price rigidity is a special feature of an oligopoly market. It is because the

presence of only a few sellers increases interdependence i.e. strategy of one
seller affects every other. If any one of them increases the price, others will
not follow him and the former will lose his customers to others. Contrary, if
he decreases the price, others also will follow him and he will not gain any
additional buyers. Therefore, he will come to know that change in price, in
either direction, will not benefit him and sellers will charge the prevailing
price.

Assume the simplest form of oligopoly i.e duopoly in which dd′ is an individual
demand curve and D′ D is actual sale or share-of-the market demand curve
(refer Figure 9.2). The individual demand curve dd′ is flatter than actual sale
curve D′ D. Figure 9.2 shows that if demand is less than q, buyers will buy on
the individual demand curve as it offers a lower price. Conversely, if demand is
more than q, buyers will buy on the share-of-the market demand curve. Thus,
dashed segments of both demand curves will not be functional. Therefore, the
practical or working demand curve in the market will be dkD.

If the price prevailing in the market is more than P , the demand curve faced
by the firm is elastic; and the firm can increase its revenue by decreasing price.
Thus, the firm continuously decreases price so far as it is facing the elastic
demand curve and reaches point k, charging price P . On the other hand, if
the price is less than P , the firm will face inelastic demand and can increase
revenue by increasing the price. Thus, the firm continuously increases price so
far as facing inelastic demand and reaches point k charging price P .

Once the firm reached at price P , it will not change the price. It is because,
when the firm increases its price, it faces an elastic demand, which advocates a
decrease in price. If he decreases the price, it faces an inelastic demand which
advocates an increase in price. Therefore, there will be no change in the price.

111
 Price

D′

k
p

d′
D
O a q b Quantity

Figure 9.2: Kinked Curve

This price rigidity is because of a kink in the demand curve at point k.

9.3.1 Sweezy’s Kinked Demand Model

Chamberlin’s kinked demand was used by P. Sweezy to explain the equilibrium
of firms in an oligopoly market. A kinked demand curve is a result of the
intersection of the individual demand curve (dd′ ) and actual sale or share-of-the
market demand curve. It shows a certain kind of behavioural pattern of a firm
in the oligopolistic market.

M C4
A
M C3
p1 k
p M C2

M C1
m1

D
m2

O q1 q Q

M R1

Figure 9.3: Oligopoly Equilibrium

112
In an oligopoly market as there are few sellers. Any change in one’s strategy
affects others. In Figure 9.3 the market condition is shown by the average
revenue curve (AkD) and the marginal revenue curve (A − −M R), while cost
conditions are given by M C curves. The average revenue curve is kinked at k
as a result of the intersection of the individual demand curve and the market
demand curve. The upper prong Ak of the average revenue curve is elastic and
the lower prong (kD) is inelastic. The M R curve is discontinuous from point
m1 to m2 because AR is kinked at point k. The firm will be in equilibrium at
the quantity at which profit is maximum or M R = M C.

Suppose that initial cost conditions are by M C1 , the firm will charge price p
and will produce quantity q.

If costs increased and new cost conditions are shown by M C2 , again firm will
produce the same quantity q and will keep the price unchanged at p. This is
because at this quantity M R = M C. Similarly, if the cost went up as shown by
M C3 , again firm will change neither quantity produced nor the price charged.

In this case, costs increased to M C4 , and equality between M R and M C is

at a lower quantity and higher price. The new equilibrium quantity and the
price will be q1 and p1 respectively. On the other hand, if cost decreased below
M C1 quantity produced will be more than q and the price charged will be less
than p. It means when M C changes but the M C curve passes through the
dashed part (m1 m2 ) of the M R curve, there will be no change in the output
and price charged.

P P

k′ M C2
P′
k k′
P M C1 P
AC2 MC
AC1 AC

AR1

AR AR

O O
q′ q Q q q′ Q
M R1 M R1 M R2

(a) Changed in Price (b) Change in Output

In the case (Figure 9.4a), the rise in cost is experienced equally by all the
firms, each individual firm may assume that all other firms also intend to

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maintain the profit margin and increases price. The point of kink shifts to the
northwest from k to k ′ . Thus, the equilibrium price (p′ ) would be higher and
output (q ′ ) would be lower. The decision to price rise is taken to maintain the
profit margin.

If the demand curve is kinked, the shift of the demand curve in a certain range
may affect output without a change in the price (Figure 9.4b). It happens
when cost curves pass through a discontinuous part of M R.

This model does not explain equilibrium price and output determination but
price rigidity. The kinked-demand curve is the result of the mindset of the
oligopolist that others will follow the precept but not increase in price. This
model doesn’t decide the level of kink in the demand curve.

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