SUPRIYA JAIN

ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA

BBA 113: MANAGERIAL ECONOMICS

MODULE 3

COST CONCEPT & CLASSIFICATION

Cost analysis refers to the study of behaviors of cost in relation to one or more production criteria,
namely, size of output, scale of operation, prices of factors of production and other relevant
economic variables. This analysis helps management in deciding minimum operating cost. But
before the analysis, a clear understanding of different cost concepts is essential, which is here
under:
Different cost concepts can be used in different situations based upon the business decisions to be
made. Therefore, it becomes important to understand the different cost-concepts and their uses.
Following are the different cost concepts used:

Actual Cost and Opportunity Cost

Actual cost is those costs, which are actually paid by the firm. Like for labor, material, plant,
building, machinery, equipment, traveling, advertising etc. the total money expenses, recorded in
the books of accounts are actual costs.
Whereas Opportunity Cost are not recorded in the books of accounts. But they are the expected
returns from the second best use of the resources, which are foregone or sacrificed. For example:
capital invested by the entrepreneur in his own business, can also be alternatively used for
depositing in bank, say at 10% per annum. Therefore, the interest rate of 10% becomes the
opportunity cost for earning the profit from the business in which capital is actually invested.

Business Cost and Full Cost

Business cost includes all the expenses, which are incurred to carry out business. The concept of
business cost is similar to the actual or real cost. Business cost “include all the payments and
contractual obligations made by the firms along with the book cost of depreciation on plant and
machinery”. That means all cost which are entered in books of accounts are business cost.
The concept of full cost includes business costs, opportunity cost and normal profit. Opportunity
cost is the expected earning foregone from second best use of the resources. Normal profit is a
necessary minimum earning, which a firm must receive to remain in business.

Out-of-Pocket and Book Cost

Those costs, which involve cash payments to outsiders, are known as out-of-pocket cost. For ex:
wages, rent , interest, cost of materials etc. are all out-of-pocket cost as these are paid in cash to
workers, owner of building, banks or suppliers.
On the other hand, there are certain business costs, which are recorded in books of accounts but
do not involve any cash payments, they are known as book cost. For ex: depreciation, interest on
owners own fund, writing of the fictitious expenses are the example of book cost.

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
Explicit and Implicit cost
Those cost which are either paid in cash or recorded in books of accounts are called explicit costs.
For ex: payment of wages, salaries, materials, license fee, and depreciation charges etc is the
example of explicit cost.
Whereas, implicit cost are those cost which neither takes the cash outlays, nor do they appear in
the books of accounts. For ex: use of owner’s building in business although do not include any
cash payment as rent nor it is recorded in the books of accounts, but it can have some rent if let
out to some other person. Such costs are known as implicit cost.

Incremental (or Avoidable or, Escapable) Costs and Sunk (or, Non- Avoidable or Non-
escapable) costs
Incremental cost is the addition in total cost due to a change in the level of business activity
(increase in production) or change in nature of business activity (adding a new product line). For
ex: adding new product line, adding new machinery, increasing production etc. Since these cost
can be avoided by not bringing these changes in the business activity, these are also called
avoidable cost and escapable cost.
On the other hand, Sunk costs are those cost that do not change by changing the nature or the level
of business activity. For ex: all the past costs like depreciation, amortization of past expenses etc.
are the sunk costs. Sunk costs are non-avoidable, as we cannot avoid them, as they belong to the
past.
Direct (or, Traceable or, Assignable) Costs and Indirect (or, Non-traceable or, Non-assignable)
Costs
Those costs, which have direct relationship with a unit of operation like a product, a process or a
department of the firm, are called direct costs. For ex: material used in a pen is direct cost related
to product pen, electricity expenses for painting the car is direct expenses for painting process,
travelling expenses of marketing executive is direct expenses related to marketing department.
On the other hand those cost, which cannot be directly associated with any unit of operation like a
product, a process or a department are known as Indirect or Non-traceable cost. For ex: Expenses
for gatekeeper at factory gate in which pen, pencil, refill, ink are being manufactured is an indirect
expense as it cannot be associated with any single product.

Controllable Costs and Non-Controllable Costs

Controllable Costs are those costs which can be controlled or regulated by executive vigilance. For
ex: cost of inventory, cost of labor, etc. can be controlled through effective management.
On the other hand those costs, which cannot be controlled through management or supervision,
are called non-controllable costs. For ex: depreciation.
Original (or Historical) Costs and Replacement Costs
Historical costs mean cost of an asset at which it was originally purchased or the price paid at the
time of purchase of an asset. For ex: a machine was purchased in the year 2000 at Rs. 2 Lacks,
therefore, even in current year its historical cost will remain same i.e. Rs 2 Lacks irrespective of
its market value.
Whereas, Replacement Costs, means the cost, which will be incurred in replacing an old asset with
a new one. For ex: if firm purchase a new machine for replacing an old machine is costing Rs.
3lacks, therefore, replacement cost will be Rs.3 Lacks.

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
Shutdown Costs and Abandonment Costs
Shutdown costs are those costs, which are incurred in case of temporary suspension of business
operations. These costs could be saved if the operations are allowed to continue. For ex: cost of
security of plant & machinery, staff lay-off expenses, recruitment and training expenses of workers
when the plant will be restarted etc.
Abandonment costs are the cost of fully retiring fixed assets from the use. These costs arise when
there is a complete closer of business activities. For ex: cost of disposal of plant & machinery etc.

Total Fixed Cost (TFC), Total Variable Costs (TVC) and Total Costs (TC)
Those costs, which remain constant, even though, with the increase in production or nil production
are called, fixed costs. For ex: rent of building, salary of factory gatekeeper, depreciation of
machinery etc. is the expenses of fixed nature, as they will remain same irrespective of level of
production. They will be incurred even if output is nil.

On the other hand, variable costs are those costs, which changes with the level of production. In
other words if production increases these costs also increases and if production goes down these
costs decreases. For example: cost of material, cost of labor etc. is variable costs, as they will
change with the change in production. Here important point is that total variable cost curve will
not always be a straight line or linear.
Generally, the rate of increase in total variable cost remains different at different levels. Initially,
total variable cost increase at a falling rate, in the mid-stage it increase at a constant rate and finally
increase at raising rate.
It should be noted that concept of fixed and variable cost is valid in short-run only. In long run
all cost are variable costs.
TC
Fixed
Cost

TF
C Variable Cost

Output

Total Cost

Total cost is a total expenditure incurred on the production of goods and services. It includes
both fixed and variable cost. By cost summing up all the costs (fixed and variable) incurred on
production of a good or service, we can arrive at total cost.
TC = TFC + TVC

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
Average Fixed Cost (AFC)
Per unit cost incurred on fixed factor is called average fixed cost. In other words when we divide
total fixed cost with number of unit produced, we get average fixed cost.
TFC
AFC = ________
Quantity
For example: suppose Ram spends Rs. 1000/- towards the rent of his shop and produces 1000
units in 1st month. Therefore, average fixed cost is 1000/1000 = Re. 1/-. In the same way if in 2nd
month he produces 2000 units, average fixed cost will become 1000/2000 = Re. 0.50. it shows as
the level of output increases, the average fixed cost falls although Total Fixed Cost remains same
at all level of output.

Total Output (1) Total Fixed Cost (2) Average Fixed Cost
(3) = (2)/(1)

0 1000 ;

1000 1000 1

2000 1000 0.50

3000 1000 0.33

4000 1000 0.25

5000 1000 0.20

Average Variable Cost

Average variable cost is found by dividing the Total Variable Cost by the total output.
TVC
AVC = _________
Quantity
As we already know that increase in total variable cost is different at different levels because of
laws of returns. It is also applicable with average variable cost.
Initially, Average variable cost falls, at mid-stage it may remain constant for short-while. Finally
it starts rising. Therefore, AVC curve will b e ‘U’ shaped (dish shaped)

Total Output (1) Total Variable Cost Average Variable

(4) Cost

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
(5) = (4)/(1)

1000 1000 1.00

2000 1800 0.90

3000 2600 0.87

4000 3500 0.88

5000 5000 1.00

Average Cost (AC)

It can be defined as cost per unit. When we divide total cost by number of units produce, figures
we get is average cost. It can also be obtained by adding Average Fixed Cost and Average
Variable Cost.
Total Cost (TC)
Average Cost (AC) = -----------------------
No. Of units Produces (Q)
Or,
AC = AFC + AVC

TO TFC AFC TVC AVC TC AC

0 1000 ; 0 0 1000 ;

1000 1000 1.00 1000 1.00 2000 2.00

2000 1000 0.50 1800 0.90 2800 1.40

3000 1000 0.33 2600 0.87 3600 1.20

4000 1000 0.25 3500 0.88 4500 1.13

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
5000 1000 0.20 5000 1.00 6000 1.20

6000 1000 0.17 6800 1.13 7800 1.30

It is clear that initially average cost falls and after a minimum point it starts rising. That minimum
point shows that level of output at which per unit cost of production will be minimum. In other
words it will be “OPTIMUM CAPACITY”. Optimum capacity means that level of output at which
a firm can produce at the lowest per unit cost of production.

Marginal Cost

Marginal cost can be defined as the addition in total cost because of producing one extra unit of a
product. In other words, it is the cost of marginal unit produced. Marginal cost can be calculated
by following formula:
Marginal Cost (MC) = TC n – TC n-1
Or,
Change in total cost
Marginal Cost (MC) = ----------------------------
Change In total Quantity
The behavior of marginal cost is like average variable cost, falls initially then become constant for
a short while, then start rising. Therefore, Marginal cost curve is also ‘U’ Shaped.

TO (Total TC (Total Average Cost Marginal

Output) Cost) Cost

1 10 10 -

2 19 9.50 9

3 27 9.00 8

4 35 8.75 8

5 44 8.80 9

6 54 9.00 10

7 65 9.30 11

8 77 9.60 12

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
Short-Run Cost-Output Relation

Short-run is a period in which one variable factors of production can be changed ( increase or
decreased) and fixed factors of production cannot be changed. Short-run Cost-Output relation i.e.
the relation between different types of cost in short-run and optimum point of production (output
where cost of production is minimum) can be understood through the use of graph covering all
types of cost. These costs are:
AFC = Average Fixed cost
AVC = Average Variable Cost
AC = Average Cost (AFC + AVC)
MC = Marginal Cost

Relationship between AFC, AVC and AC

Since, AC = AFC + AVC, and both AFC and AVC declines initially, therefore, AC curve also
declines initially.
After a certain level of output, while AFC continue to fall, AVC starts increasing, but the rate of
increase in AVC is less than the rate of decrease in AFC, therefore AC (AFC + AVC) continue to
fall, but at a slower rate.
For example AVC is increasing by Rs. 5/- and AFC is decreasing by Rs.10/-, so AC i.e.+5-10 = -
5 (Still decreasing)
After this point increase in AVC is greater than decrease in AFC, here AC (AVC+AFC) starts
raising, which shows diseconomies of large scale comes into operation.
For example: AVC is increasing by Rs.15/- and AFC is decreasing by Rs.10, so AC i.e., +15 -10
= +5 (increasing)

C M A
O C C AV
C
S
T
AF
C
OUTPUT
Relationship between MC and AVC

When MC < AVC, AVC curve will decline

When MC > AVC, AVC curve will rise

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
When MC = AVC, AVC will be minimum, but it will not be optimum point or the point of
minimum cost. Although, at this point AVC is minimum, but AC is not minimum and for
optimum point AC should be minimum not AVC

M
C AV
C C
O
S
T
OUTPUT

Relationship between MC and AC

When MC < AC, AC curve will decline

When MC > AC, AC curve will rise
When MC = AC, AC will be at its minimum. In other words, MC curve cuts AC curve at its
minimum point L (i.e. optimal point). It is the point where firm cost of production will be
minimum. In above graph, optimum quantity (in short-run) which firm should produce is OQ and
per unit cost ( which is minimum) of producing this quantity will be LQ. If firm is producing less
than OQ it is under-utilization of plant and if firm is producing more than it is over-utilization of
plant.

M
C A
C C
L
O
S
T
OUTPUT
Long-Run Cost-Output Relation

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
In Long-run all inputs (factors of production) or all costs are variable costs, because costs those
were fixed in short-run can easily be varied in long-run. Therefore, in long-run there is no concept
of Fixed Cost (FC) of Average Fixed Cost (AFC). We do not differentiate FC & VC or AFC or
AVC. Son, in long-run we only talk about TC or AC. Here long-run average cost is denoted by
LAC and short-run Average Cost is denoted by SAC. Similarly Lon-run Marginal Cost is denoted
by LMC.
To understand the long-run cost-output relation and to derive long-run cost curves, it will be better
to imagine that a long-run is composed of series of short-run plants. In other words, long-run cost
curve is composed of series of short-run cost curves.

LM
S
C
A SA SAC
C C C C2 3
1 1 C
O C2 3
S
T

Q Q2 Q3 OUTPUT
1
Explanation:
There are three corresponding SAC curves as given by SAC1, SAC2 and SAC3. Thus firm has a
series of SAC Curves, each having a bottom point, showing the minimum short-run average cost
or short-run optimum point or least-cost point.

For ex: C1Q1 is minimum average cost when firm has only one plant i.e., SAC1. Average cost
decreased to C2Q2 ( because of economies of large-scale) when second plant is added and
increased to C3Q3 ( because of diseconomies of large-scale) when third plant is added. The LAC
curve can be drawn by joining the SAC1 curve, SAC2 curve & SAC3 curve, by a curve, which
works as a tangent to all SAC curves. The new curve which we get, is Long-run Average Cost
curve (LAC curve). It is also known as ‘Envelop Curve’ or ‘Planning Curve’- as it serves as a
guide to firm in their plans to expand.

Characteristics or Properties of LAC Curve

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA

• LAC curve is tan genial to various SAC curves.

• LAC curve is ‘U’ shaped of like a ‘dish’. It means that initially AC will decrease with
increase in output until the optimum point is reached (where average cost will be
minimum). After that it starts raising with increase in output. It happens because of
economies and diseconomies of scale.
• LAC curve can never cut a SAC curve. It is always tan genial to it.
• LAC curve will touch ‘optimum scale’ curve at its least cost point. As in above graph,
SAC2 as ‘optimum scale’ curve, because it has the point having minimum cost in long-
run. LAC curve is touching optimum scale curve i.e. SAC2 at its least cost point to i.e., C2.
• LAC curve will touch SAC curve lying to the left of the ‘optimum scale’ curve at the left
of their ‘least cost point’. Like in above graph, LAC curve is touching SAC3 at the left to
C1.
• LAC curve will touch SAC curve lying to the right of the ‘optimum scale’ curve at the right
of their ‘least cost point’. Like in above graph, LAC curve is touching SAC3 at the right to
C3.
• LMC curve i.e., Long-run Marginal cost curve will cut LAC at its minimum point or
optimal point and at this point LAC = LMC = SAC = SMC. It will be the point, which
minimizes the cost of production of the firm in the long-run. In the graph it is C2.

Optimal Plant Size in Long-Run

Conceptually, the optimum size of a firm is one, which ensure the most efficient utilization of
resources. In other words, optimum size of the firm will be one, which minimizes the long-run
average cost.
As in the graph, optimum size consist of plant-2 i.e., SAC2 for production of OQ2 units at the cost
C2Q2.
It firm produces less than this say OQ1 at increased cost C1Q1, we will say that firm is operating
at less than optimal size.
Similarly, increasing production after OQ2 say up to OQ3 will lead to increase in cost C3Q3.
therefore, firm is again not operating at optimal point.
A firm aiming to minimize its average cost over a long-run, must choose a plant which gives
minimum LAC, where LAC = LMC = SAC = SMC. This size of plant assures the most efficient
utilization of resources. Any change in output - sboth increase and decrease, will make the firm to
enter the area of non-optimality.

Usefulness of LAC Curve (Business Implication)

Suppose a firm is not interested in achieving the minimum cost output or want to produce more
than the minimum cot output ( optimal output) i.e., OQ2 in graph. In that case, LAC curve helps a
firm to decide that which plant should firm choose to produce the desired output.
In graph although OQ2 is optimum quantity, which can be produced at lowest cost of C2Q2. But
if firm want to produce OQ1, it can produced either by over-utilization of plant SAC1 or under-
utilization of plant SAC2. If firm produce quantity OQ1 by over-utilization of plant SAC1 the cost

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
of production will be AQ1 and if firm produces quantity OQ1 by under-utilization of plant SAC2,
the cost of production will be BQ1 and certainly BQ1<AQ1. Therefore, it is better for firm to go
for plant SAC2 and under-utilize it for production of quantity OQ1.

SAC SAC
SAC 3
1
2 A
C C
B D
O C
2
S
T
O Q Q Q3 OUTPUT
1 2

Economies and Diseconomies of Scale

By Scale, we mean the scale of operations i.e., the size of plant, size of production, investment in
fixed factors of production like plant & machinery, building etc. when size of plant, size of
production increases, economies of scale emerges i.e., cost per unit of production goods decreases.
Sometimes these economies are over exploited, which leads to diseconomies of scale i.e., cost per
unit starts increasing.
Economies of Scale (Economies of large scale production)
Economies of large scale production can be classified in two categories:
A. Internal Economies

B. External Economies

INTERNAL ECONOMIES
Internal economies are those advantages of large scale of production, which occur to a firm on
accounts of its superior techniques & management. An internal economy arises due to firm’s own
efforts & expansion, while an external economy arises due to efforts of other firms. Internal
economies can broadly be classified under following heads:
1. Labor Economies:

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
Division of Labor: Under division of labor total work is divided into different small tasks.
Each task is assigned to an individual worker. It saves the time involve in changing from one
operation to the other. Saving of labor hours reduces the cost.
Specialization of Labor: When an individual worker is assigned to a single task, doing it
repeatedly, he gets expertise in doing that, it increases the productivity and reduces the wastage.
Both the things ultimately
2. Technical Economies
Specialized Equipments: Firms operating at large scale can replace manual process with
mechanical processes, which reduces the labor cost. For example: use of drum lifters instead of
laborers.
Integration and Automation of processes: Large firms can merge various individual processes
into a large single machine. For example: A large potato chips manufacturing unit can integrate
various process i.e., 1. Peeler, 2. Cutter, 3. Washer, 4.Boiler, 5. Drier, 6.Roaster, 7.Spicer,
8.Packager into a large automatic machine, whose operating cost will be minimum in comparison
to labor-operated individual processes.
3. Marketing Economies:
Firms producing at large scale can purchase its requirement in bulk; thereby get better discounts,
which minimizes cost.
Large firm can minimize their expenditure on advertising, as expenditure on advertising will be
same on producing 1 lacks units & producing 5 lacks units. Larger the output small will be the cost
of advertising. Also gets bulk discounts from advertisement agencies.
Large firms have their exclusive wholesale dealers, which reduce the cost on distribution of the
firm’s production. Large firms (Multi-product firms) also gain on better utilization of ‘sales staff’.
4. Managerial Economies:
Large firms can divide their specialized department and can employ full time expert manger for
these departments, which are responsible and dedicated to look after their concern departments
only, like Marketing Manager, Finance Manager, and Production Manager etc. Therefore, expert
finance manager can work efficiently, in case of getting cheaper source of finance in comparison
to a non-expert finance manager.
Large-scale firms have the opportunity to use advanced techniques of communication, telephones,
fax, computers and their own means of transport. All these helps in quick decision-making and in
saving valuable time of the management.
5. Transportation and Storage Economies:
Large firm can fully utilize the transport facility because of their purchase and sell in large size.
For example: a truck having carrying capacity of 50 drums paint charge freight of Rs.5000/- from
Delhi to Chennai. If a small company whose requirement for full year is just 20 drums will bear a
transportation cost of Rs.5000/- for these 20 drums (Rs.250/- per drum). If a large-scale firm
having consumption of 100 drums a year order for full 50 drums, whose total transportation cost
will be same, reducing per unit transportation cost to Rs.100/- per drum.
Very large firms (like TOYOTA of Japan) ask their suppliers to have a godown nearby their
factory, so that material can be supplied at little minute order, by such term company reduces their
storage cost.
6. Financial Economies

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
Large firms can avail benefit of cheaper finance. A firm, which has acquired reputation and a high
credit rating, can raise capital quickly and easily. Banks are always willing to forward loans to
such companies at very cheap rates as chances of default get reduced.

External Economies
External economies arise to the expanding firms from the advantages arising outside the firm,
without any effort of benefitting firm.
With the expansion of firm, certain specialize raw material suppliers (ancillary units) will come
and make their setup for the firm.
For example: There are many ancillary units in Gurgaon, which are setup only to supply part to
MARUTI. It reduces transportation and storage cost of Maruti and also gives him upper hand in
deciding terms and conditions.
Large firms can easily attract facilities like banking, post-office etc. For Example: GLA University
has easily attracted Indian Overseas Bank to open a counter in college itself. It reduces the banking
cost of GLA.
Diseconomies of Large scale Production
Diseconomies of scale are advantages that arises due to the expansion of production and lead to a
rise in the cost of production. Diseconomies of scale or Diseconomies of large scale of production
can be classified into two categories:
A. Internal Diseconomies

B. External Diseconomies

Internal Diseconomies:
Internal Diseconomies arises when advantages of division of labor and managerial staff
have been fully used; excess capacity of plant, warehouses, transport and communication system
etc. is fully used. With fast expansion of the production scale, personal contacts and
communication between ‘Owners & managers’ and ‘manager & labor’ get rapidly reduced,
resulting inefficiencies.
Very large size of firm replaces close control and supervision by remote control management,
which lead to wastage of time and material. With the increase in the managerial personnel,
decision-making become complex and delayed. Implementation of decision is delayed due to
coordination problem.
Increase in the number of workers encourages labor union activities, which simply means the loss
of output.

External Diseconomies:
External Diseconomies are the disadvantages that originate outside the firm, in the input (factors
of production) markets and due to natural constraints.
With the expansion of the firm, particularly when all the firms of the industry are expanding, the
discounts and concession that are available on the bulk purchase of inputs of concessional finance
come to an end.
Increasing demand for factors of production puts pressure on the input markets and input prices
being to rise causing a rise in cost of production.

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
Excessive use of fixed factors (specially natural factors), increasing the cost of using them. For
example: pumping out water on a large scale will reduce the water level and water has to be
pumped from far lower level at a higher cost.

Meaning of Market

Market mechanism has two sides: demand and supply side. Demand side is presented by the
buyers, while the supply side is constituted by the producer or seller.
Market is a place where buyer and seller exchange (buy or sell) goods by being physically present
at the place. But in terms of economics buyers and sellers need not to be physically present at one
place.
In modern times commodities and services could be bought and sold over telephone and some
other communication means (Internet).

Definition

“The word market signifies the state in which a commodity has a demand at a place where it is
offered for sale” - J.K Mehta
“The market, in economics, is simply the network of dealing in any factor or product between
buyers and sellers” - Carincross
Market generally means a place or a geographical area, where buyer with money and seller with
their goods meet to exchange goods for money. In economics market refers to a group of buyers
and sellers who involve in the transaction of commodities and services.

Characteristics of a Market

1. Presence of buyers and sellers: the presence of buyers and sellers is must for the existence
of a market.
2. A product: In an economic sense, a product or a commodity, this is exchanged amongst
the buyers and sellers for the price.
3. An Area: Market does not necessarily mean a place. Market is a set of buyers, a set of
sellers and a commodity, where buyers are willing to buy and sellers are willing to pay and
there is a price for a commodity. The market for a commodity may be local, regional,
national or international.
4. Competition: Free competition among buyer and seller is also must for a market.
5. One Price: Due to existence of competition in the market the tendency in price is to remain
uniform.

Market Structure
The nature and degree of competition make the structure of the market. Market structure implies
the nature or the form or the extend of competition prevailing in the industry. The market structure
influences firms pricing decision of its product which is depend upon degree of competition varies

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
between zero and one. The higher the degree of competition, the lower the firms’ degree of
freedom in pricing decision and control over the price of the product.
“Market structure refers to the number and the size distribution of buyer and sellers in the market
for a good or services.”

Types of Market Structure

1. Perfect Competition
2. Imperfect Competition

a. Monopoly
b. Monopolistic Competition
c. Oligopoly

PERFECT COMPETITION
Perfect competition is a market situation where there are infinite numbers of sellers (producers),
selling homogeneous goods at a uniform price and no one is big enough to have any appreciable
influence over market price.

Features and Conditions of perfect competition

1. Large number of buyers and sellers

There are a large number of buyers and sellers in a perfect competitive market that neither a single
buyer nor a single seller can influence the price. The price is determined by market forces namely
the demand for and the supply of the product. There will be uniform price in the market. Sellers
accept this price and adjust the quantity produced to maximize their profit. Thus the sellers in the
perfect competitive market are price- takers and quantity adjusters.

2. Homogeneous Product
The products produced by all the firms in the perfectly competitive market must be homogeneous
and identical in all respects i.e. the products in the market are the same in quantity, size, taste, etc.
The products of different firms are perfect substitutes and the cross elasticity is infinite.

3. Perfect knowledge about market conditions

Both buyers and sellers are fully aware of the current price in the market. Therefore the buyer will
not offer high price and the sellers will not accept a price less than the one prevailing in the market.
4. Free entry and Free exit
There must be complete freedom for the entry of new firms or the exit of the existing firms from
the industry. When the existing firms are earning super-normal profits, new firms enter into the
market. When there is loss in the industry, some firms leave the industry. The free entry and free
exit are possible only in the long run, because the size of the plant cannot be changed in the short
run.

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ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
5. Perfect mobility of factors of production
The factors of productions should be free to move from one use to another or from one industry to
another easily to get better remuneration.

6. Absence of transport cost

In a perfectly competitive market, it is assumed that there are no transport costs. Under perfect
competition, a commodity is sold at uniform price throughout the market. If transport cost is
incurred, the firms nearer to the market will charge a low price than the firms far away. Hence it
is assumed that there is no transport cost.

7. Absence of Government or artificial restrictions or collusions

There are no government controls or restrictions on supply, pricing etc. There is also no collusion
among buyers or sellers. The price in the perfectly competitive market is free to change in response
to changes in demand and supply conditions.

PRICE-OUTPUT DETERMINATION UNDER PERFECT COMPETITION:

 Determination of Price by Market Forces
Y
Under perfect competition, the market price is D S
determined by the market forces namely the demand
for the product and the supply of the products. Market
price is decided by the interaction of market demand P
curve and market supply curve. Hence there is uniform R T
price in the market and all the units of the output are I P
sold at the same price. This price is the price at which C
all firms in the market can sell their product, as firm is E
the price taker. No firm can charge price more than
this. This price decides the revenue curve of a firm. S D

In the figure DD is market demand curve (total demand O X

Q
in the market), while SS is the market supply curve Y D’
(total supply made by all the firms). Equilibrium is D QUANTITY S
attained at T where DD curve intersects the SS curve.
At this point market price is OP and quantity sold by S’
U
industry (all the firms) is OQ. All the firms in the P P1
industry will accept Price OP and they will sell their R T
product at the same rate. I P
C V
P
This market price changes only when there is change in E 0
any of market force i.e. either in market demand or in D’
S D
market supply. Suppose if market demand for a
S’
product increases (i.e. demand curve shifts
upwards) and supply remains the same, market O Q Q0 Q1 X
price will move upward. If market supply of a QUANTITY

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ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
product increases (i.e. supply curve shifts downwards), demand remains the same; market
price will fall (as shown in figure).
In the figure, when demand of product increases demand curve shift upward from DD to D’D’,
being supply curve remain same i.e. SS and new equilibrium point (where demand curve intersects
supply curve) is U and new price is OP1. That means price increases from OP to OP1.

When supply of product increases supply curve shifts downward from SS to S’S’, being demand
curve remain same i.e. DD and new equilibrium point (where demand curve intersects supply
curve) is V and new price is OP0. That means price falls from OP to OP0.

Similarly, if market demand for a product decreases (i.e. demand curve shifts downwards)
and supply remains the same, market price will fall. If market supply of a product decreases
(i.e. supply curve shifts upwards), demand
remains the same; market price will rise. S’
Y
D S
In the figure, when demand of product decreases
demand curve shift downward from DD to D’D’,
being supply curve remain same i.e. SS and new P P1 D’ U
equilibrium point (where demand curve intersects R
supply curve) is V and new price is OP0. That Z T
I P
means price decreases from OP to OP0. C P V
0
E S’
When supply of product decreases supply curve
shifts upward from SS to S’S’, being demand curve S D
remain same i.e. DD and new equilibrium point D’
(where demand curve intersects supply curve) is U O X
and new price is OP1. That means price rises from Q1 Q
OP to OP1. QUANTITY

If market demand and market supply will fall or rise in same proportion simultaneously
than there will be no effect on the price of the product.

In the figure, when demand of product decreases demand curve shift downward from DD to D’D’
and supply decreases and supply curve shift upward from SS to S’S’ simultaneously, demand curve
is intersecting supply curve at point Z, where price is OP, which is same at it was on original
equilibrium T.

 Determination of Output or Firm’s Equilibrium

Since a firm in the perfectly competitive market is a price-taker, it has to adjust its level of output
to maximize its profit. The aim of any producer is to maximize his profit (or minimize his losses).
In other words, a firm will like to produce that output which gives him maximum profit (or
minimum losses). Therefore, firms have to determine their maximum profit output (or equilibrium

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
of the firm), through interaction of their individual cost curves and revenue curves. As we know
that firms maximum profit will be at point (or output) where marginal cost curve cuts marginal
revenue curve from below.

Under perfect competition there is uniform price in the market and all the units of the output are
sold at the same price. As a result the average revenue is perfectly elastic. The average revenue
curve is horizontally parallel to X-axis. Since the Average Revenue is constant, Marginal Revenue
is also constant and coincides with Average Revenue. AR curve of a firm represents the demand
curve for the product produced by that firm.

Short run equilibrium or price - output determination under perfect competition

1. The short run is a period in which the number of plants and size of the firm are fixed. In this
period, the firm can produce more only by increasing the variable inputs.
2. As the entry of new firms or exit of the existing firms is not possible in the short-run, the firm
in the perfectly competitive market can either earn super-normal profit or normal profit or incur
loss in the short period.

Super-normal Profit
When the average revenue of the firm is greater than its average cost, the firm is earning super-
normal profit.
Y
SMC SAC
COST & PRICE

E AR
REVENUE,

P L
MR
Super Normal Profit
F
H

O
OUTPUT Q X

In figure, output is measured on the x-axis and price, revenue and cost on the y-axis. OP is the
market price (decided by interaction of market forces). PL is the demand curve or average and the
marginal revenue curve. SAC and SMC are the short run average and marginal cost curves. The
firm is in equilibrium at point ‘E’ where MR = MC and MC curve cuts MR curve from below
at the point of equilibrium. Therefore the firm will be producing OQ level of output. At the OQ

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ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
level of output QE is the average revenue, which the firm is getting and QF is the average cost,
which is firm is incurring. The profit per unit of output is EF (the difference between QE and QF).
The total profits earned by the firm will be equal to EF (profit per unit) multiplied by OQ or HF
(total output). Thus the total profits will be equal to the area HFEP. HFEP is the supernormal
profits earned by the firm.

Normal Profit
When the average revenue of the firm is equal to its average cost, the firm is earning only normal
profit, because normal profit is included in average cost.

In figure (on next page), OP is the market price (decided by interaction of market forces). PL is
the demand curve or average and the marginal revenue curve. SAC and SMC are the short run
average and marginal cost curves. The firm is in equilibrium at point ‘E’ where MR = MC and
MC curve cuts MR curve from below at the point of equilibrium. At the same point AR = AC
(It has been assumed here that a normal profit is included in the AC). Therefore the firm will be
producing OQ level of output. At the OQ level of output QE is both the average revenue and
average cost of the firm. Therefore, firm is earning a normal profit only.

Y SMC SAC
COST & PRICE
REVENUE,

E AR
P L
MR

O
OUTPUT Q X
Loss
When the average revenue of the firm is lesser than its average cost, the firm is incurring a loss in
short-run.

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SAC
Y SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA

COST & PRICE

REVENUE,
F
H
Loss
AR
P L
E MR

O Q X
In figure, PL is the demand curve or average and
OUTPUT the marginal revenue curve. SAC and SMC are
the short run average and marginal cost curves. The firm is in equilibrium at point ‘E’ where
MR = MC and MC curve cuts MR curve from below at the point of equilibrium. Therefore
the firm will be producing OQ level of output. At the OQ level of output QE is the average revenue,
which the firm is getting and QF is the average cost, which is firm is incurring. The loss per unit
of output is EF (the difference between QE and QF). The total loss to the firm will be equal to EF
(loss per unit) multiplied by OQ or HF (total output). Thus the total loss will be equal to the area
HFEP. HFEP is the supernormal profits earned by the firm.

Long run equilibrium, price and output determination

In the long run,
 All factors are variable.
 Firms can increase their output by increasing the number of plants and size of the plant.
 New firms can enter the industry and the existing firms can leave the industry.
As a result, all the existing firms will earn only normal profit in the long run.

If the existing firms earn supernormal profit:

 Existing firm will increase their production by increasing the number of plants.
 The new firms will enter the industry to compete with the existing firms.
As a result, the output produced will increase:
 When the total output increases, the demand for factors of production will increase leading to
increase in prices of the factors. This will result in increase in average cost.
 The supply of the product increases. The demand remaining the same, when the supply of the
product increases, the price of the product comes down. Hence the average revenue will come
down. A fall in average revenue and the rise in average cost will continue till both become
equal. (AR = AC). Thus, all the perfectly competitive firms will earn normal profit in the long
run.

If the existing firms incurring losses:

 Some existing firm will decrease their production by decreasing the number of plants.
 Some existing firm will leave the industry.

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
As a result, the output produced will decrease:
 When the total output decreases, the demand for factors of production will decrease leading to
decrease in prices of the factors. This will result in decrease in average cost.
 The supply of the product decreases. The demand remaining the same, when the supply of the
product decreases, the price of the product goes up. Hence the average revenue will go up. A
rise in average revenue and the fall in average cost will continue till both become equal. (AR
= AC). Thus, all the perfectly competitive firms will earn normal profit in the long run.

Y LMC LAC
COST & PRICE
REVENUE,

E AR
P L
MR

O
OUTPUT Q X
The firm is in equilibrium at point S where LMC = MR = AR = LAC. The long run equilibrium
output is OQ. The firm is earning just the normal profit. The equilibrium price is OP. If the price
rises above OP, the firm will earn abnormal profit, which will attract new firms into the industry.
If the price is less than OP, there will be loss and the tendency will be to exit. So in the long run
equilibrium, OP will be the price and firm will earn only normal profit. Competitive firms are in
equilibrium at the minimum point of LAC curve. Operating at the minimum point of LAC curve
signifies that the firm is of optimum size i.e. producing output at the lowest possible average cost.
Managerial Implications of Perfect Competition
 Managers should try to enter in a perfect competitive market when supply is low and price is
high i.e. well before the competitors enter the market to have the abnormal profit.

 A firm earning abnormal profit should remain ready for competition in a perfect competitive
market, as abnormal profit will attract new firms till all firm earns normal profit.

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ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
 As in perfect competitive market a firm is price taker, therefore to survive in long-run firm
should be amongst the lowest cost producers.

MONOPOLY
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. Pure monopoly is never found in
practice; however in government services like railway, electricity, we generally find monopoly.

Characteristics of Monopoly
1. Single Seller: There is only one seller; he can control either price or supply of his product. But
he cannot control demand for the product, as there are many buyers.

2. No close Substitutes: There are no close substitutes for the product. The buyers have no
alternatives or choice. Either they have to buy the product or go without it.

3. Price: The monopolist has control over the supply so as to increase the price. Sometimes he
may adopt price discrimination. He may fix different prices for different sets of consumers. A
monopolist can either fix the price or quantity of output; but he cannot do both, at the same
time.

4. No Entry: There is no freedom to other producers to enter the market as the monopolist is
enjoying monopoly power. There are strong barriers for new firms to enter. There are legal,
technological, economic and natural barriers, which may block the entry of new producers.

5. No difference between Firm and Industry: Under monopoly, there is no difference between
a firm and an industry. As there is only one firm, that single firm constitutes the whole industry.

Causes for Monopoly

1. Natural: A monopoly may arise on account of some natural causes. Some minerals are
available only in certain regions. For example, South Africa has the monopoly of diamonds;
nickel in the world is mostly available in Canada and oil in Middle East. This is natural
monopoly.

2. Technical: Monopoly power may be enjoyed due to technical reasons. A firm may have
control over raw materials, technical knowledge, special know-how, scientific secrets and
formula that enable a monopolist to produce a commodity. e.g., Coco Cola.

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ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA

3. Legal: Monopoly power is achieved through patent rights, copyright and trade marks by the
producers. This is called legal monopoly.

4. Large Amount of Capital: The manufacture of some goods requires a large amount of capital.
All firms cannot enter the field because they cannot afford to invest such a large amount of
capital. This may give rise to monopoly. For example, iron and steel industry, railways, etc.

5. State: Government will have the sole right of producing and selling some goods. They are
State monopolies. For example, we have public utilities like electricity and railways. These
public utilities are undertaken by the State.
Price and Output Determination in Short-run
A monopolist like a perfectly competitive firm tries to maximize his profits. A monopoly firm
faces a downward sloping demand curve, that is, its average revenue curve. The downward sloping
demand curve implies that larger output can be sold only by reducing the price. Its marginal
revenue curve will be below the average revenue curve. The average cost curve is ‘U’ shaped. The
monopolist will be in equilibrium when MC = MR and the MC curve cuts the MR curve from
below.

SMC
Y
SAC
COST & PRICE
REVENUE,

S
P
Profit
T
H

AR
MR
O
Q X
OUTPUT

In figure, AR is the Average Revenue Curve and MR is the Marginal revenue curve. AR curve is
falling and MR curve lies below AR. The monopolist is in equilibrium at E where MR = MC. He
produces OQ units of output and fixes price at OP. At OQ output, the average revenue is QS and
average cost QT. Therefore the profit per unit is QS-QT = TS. Total profit is average profit (TS)

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ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
multiplied by output (OQ), which is equal to HTSP. The monopolist is in equilibrium at point E
and produces OQ output at which he is earning maximum profit i.e. HTSP.

Does a Monopoly Firm always earn Super-normal Profit?

There is no certainty that a monopoly firm will always earn an economic or super-normal profit.
If a monopoly firm operates at the level of output where MR = MC, its profit depends on the
relative levels of AR and AC.
 If AR > AC, there is super-normal profit
 If AR = AC, the firm earns only normal profit
 If AR < AC, the firm make losses (though only a theoretical concept)

Price and Output Determination in Long-run

The rules regarding optimal output and pricing in the long run are the same as in the short-run. In
long run, monopolists get an opportunity to expand the size of its firm to maximize its long run
profit. In the absence of competition, the monopolist need not produce at the optimal level. He can
produce at sub-optimal level also. In other words, he need not reach the minimum of LAC curve,
he can stop any place where his profits are maximum.

Price Discrimination under Monopoly:

If a monopoly firm fixes up a very high price and charges the same price from all the customers,
it may not be able to attract large number of buyers. On the other hand, if the monopoly firm
discriminates between buyers on the basis of their income and charge price according to their
paying capacity, it may earn maximum profit. Price Discrimination is not possible in perfect
competition as seller has no control over price in it.

“The art of selling the same commodity produced under a single control to different buyers at
different prices is called price discrimination.”

Conditions for Price Discrimination:

 The seller should have some control over the supply of his product i.e. monopoly power.
 The seller should be able to divide his market into two or more sub-markets.
 The price-elasticity of the product should be different in different markets.
 It should not be possible for the buyers of low priced market to resell the product to the buyers
of high priced market.

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA

Price-Output determination in case of Price Discrimination:

Suppose there are two markets to which a price-discriminating monopolist has to sell his product
– market A and market B. Both markets have different price elasticity; demand is more elastic in
market B than in market A.

Y Y Y

Market A Market B Total Market

COST & PRICE

P1
REVENUE,

P2

DB E
TD
E1 E2
DA
MRA MRB TMR
O X O X O X
Q1 Q2 Q
OUTPUT OUTPUT OUTPUT

Figure shows DA and DB as the average revenue curves for the respective markets. MRA and MRB
are the corresponding marginal revenue curves. Since all his output is under one firm, there is only
one marginal cost curve. TMR is the total marginal revenue curve. It is a summation of the two
curves – MRA and MRB.

The discriminating monopolist is guided by the same rule i.e. for maximizing profit MC = TMR.
The discriminating monopolist has only to decide how much to produce but has to distribute the
output in two markets in such a way and at such a price, that he maximizes his profits i.e. MC =
MRA = MRB. In figure, MC and TMR intersect at point E and OQ is therefore total output of the
firm. Parallel line drawn from E shows that in market A, MC cuts MRA (MC = MRA) at E1 i.e
firm should sell OQ1 at price P1Q1 in market A and similarly it cuts MRB (MC = MRB) in market
B at E2 showing firm should sell OQ2 at price P2Q2, to maximize the total profit.

Difference between Perfect Competition and Monopoly

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
The main aim of firms both under monopoly and perfect competition is to maximize profit. In both
the market forms, the firms are in equilibrium at the output level where MC = MR. Differences
are as follows:
S.No. PERFECT COMPETITION MONOPOLY
1 Large number of seller. Single seller.
2 Entry of new firms is free. Entry of new firms is restricted.
3 Infinite price-elasticity. Very low price-elasticity.
4 Price are determined by market forces i.e. Seller is in a position to control the prices
demand and supply. Individual seller has by changing the output, as they are price
not control of it, as they are price taker. maker.
5 Average revenue curve is a horizontal Both average revenue curve and marginal
straight line parallel to X-axis. Marginal revenue curve are downward falling
revenue is equal to average revenue and curves. Marginal revenue is less than
price. average revenue and price.
6 At the equilibrium, MC = MR = AR. That At the equilibrium, MC = MR < AR that is
is price charged is equal to marginal cost of price charged is above marginal cost.
production
7 The firm in the long run comes to Even in the long run equilibrium the firm
equilibrium at the minimum point or the will be operating at a higher level of
lowest point of the long run average cost average cost. The firm stops before
curve. The firm tends to be of optimum optimum size.
size operating at the minimum average
cost.
8 The firm can earn only normal profit in the But monopoly firm earns super normal
long run and may earn super profit in the profit both in short run and long run.
short run.
9 Price will be lower and the output will be Price will be higher and the output will be
larger. smaller.

Managerial Implications of Monopoly

 Firm should not charge the highest price but should charge the right price. Right price is the
one that maximize the profit or where MR = MC.

 Even a manager of monopoly firm must be aware of the possibility of competition in various
forms.

 A monopoly firm may require lowering its price up to a great extent in case of bulk order
keeping in mind the profit maximization.

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
 Even firms that have government-sanctioned monopoly cannot assume that this protection will
last forever. Managers of such monopolies should be ready to face competition through cost
reduction etc.

 With growing globalization, companies enjoying monopoly in domestic markets may now
have to face competition from imports, forcing it to reduce prices and constantly come up with
new or improved product.

Monopolistic Competition
Monopolistic competition, as the name itself implies, is a mixture of monopoly and competition.
Monopolistic competition refers to the market situation in which a large number of sellers produce
goods, which are close substitutes of one another. The products are similar but not identical. The
particular brand of product will have a group of loyal consumers. In this respect, each firm will
have some monopoly and at the same time the firm has to compete in the market with the other
firms as they produce a fair substitute. The essential features of monopolistic competition are
product differentiation and existence of many sellers. The following are the examples of
monopolistic competition in Indian context.
 Shampoo - Sun Silk, Clinic Plus, Ponds, Chik, Velvette, Kadal, Head and Shoulder, Pantene,
Vatika, Garnier, Meera

 Tooth Paste - Binaca, Colgate, Forhans, Close-up, Promise, Pepsodent, Vicco Vajradanti,
Ajanta, Anchor, Babool.

Characteristics of Monopolistic Competition

1. Large Number of firms: Under monopolistic competition, the number of firms producing a
commodity will be very large. The term ‘very large’ denotes that contribution of each firm
towards the total demand of the product is small. Each firm will act independently on the basis
of product differentiation and each firm determines its price-output policies. Any action of the
individual firm in increasing or decreasing the output will have little or no effect on other firms.

2. Product differentiation: Product differentiation is the essence of monopolistic competition.

Product differentiation is the process of altering goods that serve the same purpose so that they
differ in minor ways. Product differentiation is attempted through (a) physical difference; (b)
quality difference; (c) imaginary difference and (d) purchase benefit difference. It may be by
using different quality of the raw material and different chemicals and mixtures used in the
product. Facilities like free servicing, home delivery, acceptance of returned goods, etc. would
make the customers demand that particular brand of product when such facilities are available.
Product differentiation through effective advertisement is another method. This is known as
sales promotion. By frequently advertising the brand of the product through press, film, radio,

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
and TV, the consumers are made to feel that the brand produced by the firm in question is
superior to that of other brands sold by other firms.

3. Selling Costs: From the discussion of ‘product differentiation’, we can infer that the producer
under monopolistic competition has to incur expenses to popularize his brand. This expenditure
involved in selling the product is called selling cost.

4. Freedom of entry and exit of firms: Another important feature is the freedom of any firm to
enter into the field and produce the commodity under its own brand name and any firm can go
out of the field if so chosen. There are no barriers as in the case of monopoly.

5. Non-Price Competition: In a monopolistically competitive market, sellers try to compete on

bases other than price. For example: aggressive advertising, product development, better
distribution arrangements, after sales service etc i.e. by product differentiation.

Determination of Equilibrium price and output under monopolistic competition:

The monopolistic competitive firm will come to equilibrium on the principle of equalizing MR
with MC. Under monopolistic competition the shape of demand curve or average revenue curve
(AR curve) is flatter, as price-elasticity will be high. Therefore, Marginal Revenue curve (MR
Curve) will also be flatter. Each firm will choose that price and output where it will be maximizing
its profit. Figure shows the equilibrium of the individual firm in the short period.

Price-Output determination of a Monopolistic competitive firm in short-run

MC and AC are the short period marginal cost and average cost curves. The sloping down average
revenue and marginal revenue curves are shown as AR and MR.

SMC
Y
SAC

S
P
COST & PRICE

Profit
REVENUE,

H T AR

MR

O
Q X
OUTPUT

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ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA

Equilibrium point is E where MR = MC. The equilibrium output is OQ and the price of the product
is fixed at OP. The difference between average cost and average revenue is ST. The output is OQ.
So, the supernormal profit for the firm is shown by the rectangle PSTH. The firm by producing
OQ units of its commodity and selling it at a price of OP per unit realizes the maximum profit in
the short run. The different firms in monopolistic competition may be making either abnormal
profits or losses in the short period depending on their costs and revenue curves.
 If AR > AC, there is super-normal profit (as shown in above figure)
 If AR = AC, the firm earns only normal profit
 If AR < AC, the firm make losses.

Price-Output determination of a Monopolistic competitive firm in Long Run

In the long run, decision rules will be same as in short run.

If the existing firms earn super normal profit, the entry of new firms will reduce its share in the
market. The average revenue of the product will come down. The demand for factors of production
will increase the cost of production. Hence, the size of the profit will be reduced.

If the existing firms incur losses in the long run, some of the firms will leave the industry increasing
the share of the existing firms in the market. As the demand for factors becomes less, the price of
factors will come down. This will reduce the cost of production, which will increase the profit
earned by the existing firm. Thus under monopolistic competition, all the existing firms will
earn normal profit in the long run.
Managerial Implications for Monopolistic Competition:
 A firm must try to be first into a market through differentiation; brand names, packaging,
advertising, location.

 The managers of the early entrant firms must not sit easy because new entrants are always
looking to grab the super normal profit of those, who are already in market.

 The manager must realize that a monopolistically competed market offers the opportunity for
firms to compete not only by trying to the lowest cost producer but also by effectively
differentiating their products.

 A manager in a monopolistically competitive market need not have to lower prices because of
competition as long as he successfully makes the customer believe that he is supplying the best
product out of all competitors.

OLIGOPOLY
The term Oligopoly refers to a market situation in which few firms produce goods, which are
either close substitutes or homogeneous products. It is also referred as “competition among the
few’. Each firm formulates its price-output strategy keeping in consideration the reactions of the
rival firms.

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ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA

Characteristics of Oligopoly:
1. Interdependence: Under oligopoly, a firm cannot take independent price and output decision.
As the number of competing firms is limited, therefore, each firm has to take into account the
reactions of the rival firms.

2. Indeterminate Demand Curve: An oligopoly firm can never predict its sales correctly. Any
change in price or output by one firm leads to a series of reactions by the rival firms. As a
result, the demand curve of the oligopoly firm remains indeterminate.

3. Role of Selling Cost: Advertisement, publicity and other sales techniques play an important
role in oligopoly pricing. Oligopoly firm employs various techniques of sales promotion to
attract large number of buyers and maximize the profit.

4. Price Rigidity: Oligopoly firm generally sticks to a price, which is determined after a greater
deal of planning and negotiations with the competing firms. A firm will not try to cut the price,
as it would lead to price cut by other firms and leads to a price war. At the same time, an
oligopoly firm will also not raise the price, as the rival firms may not follow him and as a
result, the firm will lose many of its customers.

5. Group Behavior: Oligopoly firms prefer group decision about price and output instead of
independent decision, as decision of one firm has direct effect on the competing firms.
Oligopoly firms try to maximize their profits through collusive action.

Price-Output Determination under Oligopoly:

Model I: This model is given by Prof. Paul Sweezy and known as ‘Price Rigidity Model’ or
‘Kinked Demand Curve Model’. Nature of demand curve or average revenue curve in oligopoly
market is generally ‘kinked’ and it is known as ‘Kinked Demand Curve’. As shown in figure, EQ
is the prevailing price in the market at which quantity OQ can be sold.

If an oligopoly firm tries to increase the price, competing firm may not follow him, therefore,
product of competitor become relatively cheaper for the buyers and firm will loose some of the
customers. In other words demand curve of the firm will become more price elastic as shown in
figure by flatter part of demand curve i.e. AE.
Y
A
E
COST & PRICE
REVENUE,

D=AR

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O Q X
 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA

MR
OUTPUT
Similarly, if oligopoly firm tries to reduce the price to attract more customers, other competing
firms will follow him by reducing their price also. Therefore, customer will remain indifference.
In other words, this part of demand curve will be steeper showing relatively less price elastic
demand i.e. ED.

Therefore, an oligopoly firm is neither benefiting by increasing their price nor by reducing their
price and price will remain stable at EQ. This is also known as ‘price rigidity’. That is why; we
often see ‘collusion’ or grouping of the firms for deciding prices, in an oligopoly market and this
collusion acts as a firm enjoying monopoly.

Model II: This model is known as ‘Price Leadership Model’ under Oligopoly. Under this
model one of the oligopoly firms may be elected as the price leader and the fellow firms accept
the price fixed by this price leader. Different criteria may be used to elect a price leader. It may be
the dominant firm producing largest proportion of the total market supply, firm earning largest
profits, firm producing at minimum cost, selling its product at the minimum price etc.

In figure, AD is the market demand curve, each of the two firms has a demand curve Ad and
marginal revenue curve MR. Firm B is low-cost firm having marginal cost curve MCB located
below the marginal cost curve MCA of firm A.
Y
MCA MCB
A
COST & PRICE
REVENUE,

R
D
M

PA

d
PB
MR
O
QA QB X
OUTPUT

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 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA

Firm B attains equilibrium at point PB where its marginal cost curve MCB intersects the MR curve.
It fixed up price at MQB and produces output OQB.

Firm A attains equilibrium at PA and produces OQA output at RQA price. Firm B will be selected
as the price leader since it charges a lower price, produces larger output at lower cost and makes
larger profit per unit of output.

Firm A cannot sell its products at RQA price. In case it does, it will have to lose some buyers to
Firm B, which fixes up a lower price for its product. Ultimately, Firm A will also fix up price at
MQB and sell OQB units. Both the firm together will sell twice the output as OQB.

Model III: This model is known as ‘Cartel or Collusion Model’. Some times to avoid the price
war all the firms of oligopoly make group or cartel and take decisions jointly like a monopoly.
Here, price would be determined by the joint MC and MR curves of all firms taken together, and
considering them as single monopoly firm. All the firms would then adjust their individual
supplies. Some firms may earn super normal profits and other may earn only normal profit. Due
to such differences in profitability, cartels do not last long.

Business Implication of Oligopoly:

1. Managers of Oligopoly firm should not try to change its price individually.
2. Managers of Oligopoly firm should try to cut their cost and become leader, so that it can
influence the price in his benefit.
3. Oligopoly firms should try to make collusion, if possible, so that they can enjoy the benefits
of monopoly.
4. Oligopoly firms should reasonably focus on sell promotion and advertising.

3. Explain about cost out put relation in short run &long run with neat
sketch.



Short-run cost curves are normally based on a production function with one
variable factor of production that displays first increasing and then decreasing
marginal productivity.Increasing marginal productivity is associated with the
negatively sloped portion of the marginal cost curve, while decreasing
marginal productivity is associated with the positively sloped portion. The
average fixed cost (AFC) curve is the cost of the fixed factor of production

32
 SUPRIYA JAIN
ASSISTANT PROFESSOR
GLA UNIVERSITY
IBM
MATHURA
divided by the quantity of units of the output, while the average variable cost
(AVC) curve cost traces out



the per unit cost of variable factor of production.The U-shaped average total
cost (ATC) curve is derived by adding the average fixed and variable costs.
The marginal cost (MC) intersects both the AVC and ATC curves at their
minimum points. Declining average total costs are explained as the result of
spreading the fixed costs over greater quantities and, at low quantities, the
result of the increasing marginal productivity, in addition. Increasing average
costs occur when the effect of declining marginal productivity overwhelms
the effect of spreading the fixed costs.

LONG RUN:


The long-run cost curves, usually presented in a separate diagram, are also
expressed most commonly in their average, or per unit, form, represented here
in Figure 2. The long-run average



cost (LRAC) curve is shown to be an envelope of the short-run average cost
(SRAC) curves, lying everywhere below or tangent to the short-run curves.


The firm is constrained in the shortrun in selecting the optimal mix of factors
of production and so will never be able to find a cheaper mix than can be
found in the long-run when there are no constraints. If there are a discrete
number of plant sizes available, the LRAC will be the scalloped curve
obtained by joining those parts of the SRAC curves that represent the lowest
cost of production for a given quantity.

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