Unit-3

Cost Theory and Analysis:

Profit is the ultimate aim of any business and the long-run prosperity of a firm
depends upon its ability to earn sustained profits. Profits are the difference between
selling price and cost of production. In general, the selling price is not within the
control of a firm but many costs are under its control. The firm should therefore aim
at controlling and minimizing cost. Since every business decision involves cost
consideration, it is necessary to understand the meaning of various concepts for clear
business thinking and application of right kind of costs.
COST CONCEPTS: A managerial economist must have a clear understanding of
the different cost concepts for clear business thinking and proper application. The
several alternative bases of classifying cost and the relevance of each for different
kinds of problems are to be studied.
The various relevant concepts of cost are:
1. Opportunity costs and outlay costs: Out lay cost also known as actual costs
obsolete costs are those expends which are actually incurred by the firm these are
the payments made for labour, material, plant, building, machinery traveling,
transporting etc., These are all those expense item appearing in the books of account,
hence based on accounting cost concept. On the other hand opportunity cost implies
the earnings foregone on the next best alternative, has the present option is
undertaken. This cost is often measured by assessing the alternative, which has to be
scarified if the particular line is followed. The opportunity cost concept is made use
for long-run decisions. This concept is very important in capital expenditure
budgeting. This concept is very important in capital expenditure budgeting. The
concept is also useful for taking short-run decisions opportunity cost is the cost
concept to use when the supply of inputs is strictly limited and when there is an
alternative. If there is no alternative, Opportunity cost is zero. The opportunity cost
of any action is therefore measured by the value of the most favorable alternative
course, which had to be foregoing if that action is taken.
2. Explicit and implicit costs: Explicit costs are those expenses that involve
cash payments. These are the actual or business costs that appear in the books of
accounts. These costs include payment of wages and salaries, payment for raw-
materials, interest on borrowed capital funds, rent on hired land, Taxes paid etc.
Implicit costs are the costs of the factor units that are owned by the employer
himself. These costs are not actually incurred but would have been incurred in the
absence of employment of self – owned factors. The two normal implicit costs are
depreciation, interest on capital etc. A decision maker must consider implicit costs
too to find out appropriate profitability of alternatives.
3. Historical and Replacement costs: Historical cost is the original cost of an
asset. Historical cost valuation shows the cost of an asset as the original price paid
for the asset acquired in the past. Historical valuation is the basis for financial
accounts. A replacement cost is the price that would have to be paid currently to
replace the same asset. During periods of substantial change in the price level,
historical valuation gives a poor projection of the future cost intended for managerial
decision. A replacement cost is a relevant cost concept when financial statements
have to be adjusted for inflation.
4. Short – run and long – run costs: Short-run is a period during which the
physical capacity of the firm remains fixed. Any increase in output during this period
is possible only by using the existing physical capacity more extensively. So short
run cost is that which varies with output when the plant and capital equipment in
constant. Long run costs are those, which vary with output when all inputs are
variable including plant and capital equipment. Long-run cost analysis helps to take
investment decisions.
5. Out-of pocket and books costs: Out-of pocket costs also known as explicit
costs are those costs that involve current cash payment. Book costs also called
implicit costs do not require current cash payments. Depreciation, unpaid interest,
salary of the owner is examples of back costs. But the book costs are taken into
account in determining the level dividend payable during a period. Both book costs
and out-of-pocket costs are considered for all decisions. Book cost is the cost of self-
owned factors of production.
6. Fixed and variable costs: Fixed cost is that cost which remains constant for
a certain level to output. It is not affected by the changes in the volume of production.
But fixed cost per unit decrease, when the production is increased. Fixed cost
includes salaries, Rent, Administrative expenses depreciations etc. Variable is that
which varies directly with the variation is output. An increase in total output results
in an increase in total variable costs and decrease in total output results in a
proportionate decline in the total variables costs. The variable cost per unit will be
constant. Ex: Raw materials, labour, direct expenses, etc.
7. Post and Future costs: Post costs also called historical costs are the actual
cost incurred and recorded in the book of account these costs are useful only for
valuation and not for decision making. Future costs are costs that are expected to be
incurred in the futures. They are not actual costs. They are the costs forecasted or
estimated with rational methods. Future cost estimate is useful for decision making
because decision are meant for future.
8. Traceable and common costs: Traceable costs otherwise called direct cost,
is one, which can be identified with a products process or product. Raw material,
labour involved in production is examples of traceable cost. Common costs are the
ones that common are attributed to a particular process or product. They are incurred
collectively for different processes or different types of products. It cannot be
directly identified with any particular process or type of product.
9. Avoidable and unavoidable costs: Avoidable costs are the costs, which can
be reduced if the business activities of a concern are curtailed. For example, if some
workers can be retrenched with a drop in a product – line, or volume or production
the wages of the retrenched workers are escapable costs. The unavoidable costs are
otherwise called sunk costs. There will not be any reduction in this cost even if
reduction in business activity is made. For example cost of the ideal machine
capacity is unavoidable cost.
10. Controllable and uncontrollable costs: Controllable costs are ones, which
can be regulated by the executive who is in change of it. The concept of
controllability of cost varies with levels of management. Direct expenses like
material, labour etc. are controllable costs. Some costs are not directly identifiable
with a process of product. They are appointed to various processes or products in
some proportion. This cost varies with the variation in the basis of allocation and is
independent of the actions of the executive of that department. These apportioned
costs are called uncontrollable costs.
11. Incremental and sunk costs: Incremental cost also known as different cost
is the additional cost due to a change in the level or nature of business activity. The
change may be caused by adding a new product, adding new machinery, replacing a
machine by a better one etc. Sunk costs are those which are not altered by any change
– They are the costs incurred in the past. This cost is the result of past decision, and
cannot be changed by future decisions. Investments in fixed assets are examples of
sunk costs.
12. Total, average and marginal costs: Total cost is the total cash payment made
for the input needed for production. It may be explicit or implicit. It is the sum total
of the fixed and variable costs. Average cost is the cost per unit of output. If is
obtained by dividing the total cost (TC) by the total quantity produced (Q)
Marginal cost is the additional cost incurred to produce and additional unit of
output or it is the cost of the marginal unit produced.
13. Accounting and Economics costs: Accounting costs are the costs recorded
for the purpose of preparing the balance sheet and profit and ton statements to meet
the legal, financial and tax purpose of the company. The accounting concept is a
historical concept and records what has happened in the post. Economics concept
considers future costs and future revenues, which help future planning, and choice,
while the accountant describes what has happened, the economics aims at projecting
what will happen.

COST-OUTPUT RELATIONSHIP:
A proper understanding of the nature and behavior of costs is a must for regulation
and control of cost of production. The cost of production depends on money forces
and an understanding of the functional relationship of cost to various forces will help
us to take various decisions. Output is an important factor, which influences the cost.
The cost-output relationship plays an important role in determining the optimum
level of production. Knowledge of the cost-output relation helps the manager in cost
control, profit prediction, pricing, promotion etc. The relation between cost and its
determinants is technically described as the cost function.

Considering the period the cost function can be classified as (a) short-run cost
function and (b) long-run cost function. In economics theory, the short-run is defined
as that period during which the physical capacity of the firm is fixed and the output
can be increased only by using the existing capacity allows to bring changes in
output by physical capacity of the firm.
(a) Cost-Output Relation in the short-run: The cost concepts made use of in
the cost behavior are total cost, Average cost, and marginal cost. Total cost is
the actual money spent to produce a particular quantity of output. Total cost
is the summation of fixed and variable costs.
TC=TFC+TVC
Up to a certain level of production total fixed cost i.e., the cost of plant,
building, equipment etc, remains fixed. But the total variable cost i.e., the cost
of labour, raw materials etc., Vary with the variation in output. Average cost
is the total cost per unit. It can be found out as follows.
AC= TC/Q
The total of average fixed cost (TFC/Q) keep coming down as the production
is increased and average variable cost (TVC/Q) will remain constant at any
level of output. Marginal cost is the addition to the total cost due to the
production of an additional unit of product. It can be arrived at by dividing
the change in total cost by the change in total output. In the short-run there
will not be any change in total fixed cost. Hence change in total cost implies
change in total variable cost only.

The above table represents the cost-output relation. The table is prepared on
the basis of the law of diminishing marginal returns. The fixed cost Rs. 60
May include rent of factory building, interest on capital, salaries of
permanently employed staff, insurance etc. The table shows that fixed cost
is same at all levels of output but the average fixed cost, i.e., the fixed cost
per unit, falls continuously as the output increases. The expenditure on the
variable factors (TVC) is at different rate. If more and more units are
produced with a given physical capacity the AVC will fall initially, as per
the table declining up to 3rd unit, and being constant up to 4th unit and then
rising. It implies that variable factors produce more efficiently near a firm’s
optimum capacity than at any other levels of output.
And later rises. But the rise in AC is felt only after the start rising. In the
table ‘AVC’ starts rising from the 5th unit onwards whereas the ‘AC’ starts
rising from the 6th unit only so long as ‘AVC’ declines ‘AC’ also will
decline. ‘AFC’ continues to fall with an increase in Output. When the rise in
‘AVC’ is more than the decline in ‘AFC’, the total cost again begin to rise.
Thus there will be a stage where the ‘AVC’, the total cost again begin to rise
thus there will be a stage where the ‘AVC’ may have started rising, yet the
‘AC’ is still declining because the rise in ‘AVC’ is less than the droop in
‘AFC’. Thus the table shows an increasing returns or diminishing cost in the
first stage and diminishing returns or diminishing cost in the second stage
and followed by diminishing returns or increasing cost in the third stage.
The short-run cost-output relationship can be shown graphically as follows.

In the above graph the “AFC’ curve continues to fall as output rises an
account of its spread over more and more units Output. But AVC curve (i.e.
variable cost per unit) first falls and than rises due to the operation of the law
of variable proportions. The behavior of “ATC’ curve depends upon the
behavior of ‘AVC’ curve and ‘AFC’ curve. In the initial stage of production
both ‘AVC’ and ‘AFC’ decline and hence ‘ATC’ also decline. But after a
certain point ‘AVC’ starts rising. If the rise in variable cost is less than the
decline in fixed cost, ATC will still continue to decline otherwise AC begins
to rise. Thus the lower end of ‘ATC’ curve thus turns up and gives it a U-
shape. That is why ‘ATC’ curve are U-shaped. The lowest point in ‘ATC’
curve indicates the least-cost combination of inputs. Where the total average
cost is the minimum and where the “MC’ curve intersects ‘AC’ curve, It is
not be the maximum output level rather it is the point where per unit cost of
production will be at its lowest.
The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up
as follows:
1. If both AFC and ‘AVC’ fall, ‘ATC’ will also fall.
2. When ‘AFC’ falls and ‘AVC’ rises
a. ‘ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.
b. ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
c. ‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’
b. Cost-output Relationship in the long-run: Long run is a period, during which
all inputs are variable including the one, which are fixes in the short-run. In the
long run a firm can change its output according to its demand. Over a long period,
the size of the plant can be changed, unwanted buildings can be sold staff can be
increased or reduced. The long run enables the firms to expand and scale of their
operation by bringing or purchasing larger quantities of all the inputs. Thus in the
long run all factors become variable. The long-run cost-output relations therefore
imply the relationship between the total cost and the total output. In the long-run
cost-output relationship is influenced by the law of returns to scale. In the long
run a firm has a number of alternatives in regards to the scale of operations. For
each scale of production or plant size, the firm has an appropriate short-run
average cost curves. The short-run average cost (SAC) curve applies to only one
plant whereas the long-run average cost (LAC) curve takes in to consideration
many plants.
The long-run cost-output relationship is shown graphically with the help of
“LCA’ curve.
To draw on ‘LAC’ curve we have to start with a number of ‘SAC’ curves. In the
above figure it is assumed that technologically there are only three sizes of plants
– small, medium and large, ‘SAC’, for the small size, ‘SAC2’ for the medium
size plant and ‘SAC3’ for the large size plant. If the firm wants to produce ‘OP’
units of output, it will choose the smallest plant. For an output beyond ‘OQ’ the
firm wills optimum for medium size plant. It does not mean that the OQ
production is not possible with small plant. Rather it implies that cost of
production will be more with small plant compared to the medium plant. For an
output ‘OR’ the firm will choose the largest plant as the cost of production will
be more with medium plant. Thus the firm has a series of ‘SAC’ curves. The
‘LCA’ curve drawn will be tangential to the entire family of ‘SAC’ curves i.e.
the ‘LAC’ curve touches each ‘SAC’ curve at one point, and thus it is known as
envelope curve. It is also known as planning curve as it serves as guide to the
entrepreneur in his planning to expand the production in future. With the help of
‘LAC’ the firm determines the size of plant which yields the lowest average cost
of producing a given volume of output it anticipates.

BREAKEVEN ANALYSIS
The study of cost-volume-profit relationship is often referred as BEA. The term
BEA is interpreted in two senses. In its narrow sense, it is concerned with finding
out BEP; BEP is the point at which total revenue is equal to total cost. It is the
point of no profit, no loss. In its broad determine the probable profit at any level
of production.
Assumptions:
1. All costs are classified into two – fixed and variable.
2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change
in the volume of production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
8. Volume of sales and volume of production are equal. Hence there is no
unsold stock.
9. There is only one product or in the case of multiple products. Sales mix
remains constant.
Merits:
1. Information provided by the Break Even Chart can be understood more
easily then those contained in the profit and Loss Account and the cost
statement.
2. Break Even Chart discloses the relationship between cost, volume and
profit. It reveals how changes in profit. So, it helps management in
decision-making.
3. It is very useful for forecasting costs and profits long term planning and
growth.
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the
industry.
7. Analytical Break-even chart present the different elements, in the costs –
direct material, direct labour, fixed and variable overheads.
Demerits:
1. Break-even chart presents only cost volume profits. It ignores other
considerations such as capital amount, marketing aspects and effect of
government policy etc., which are necessary in decision making.
2. It is assumed that sales, total cost and fixed cost can be represented as
straight lines. In actual practice, this may not be so.
3. It assumes that profit is a function of output. This is not always true. The
firm may increase the profit without increasing its output.
4. A major draw back of BEC is its inability to handle production and sale of
multiple products.
5. It is difficult to handle selling costs such as advertisement and sale
promotion in BEC.
6. It ignores economics of scale in production.
7. Fixed costs do not remain constant in the long run.
8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because
generally there may be opening stock.
10.When production increases variable cost per unit may not remain constant
but may reduce on account of bulk buying etc.
11.The assumption of static nature of business and economic activities is a
well-known defect of BEC.
1. Fixed cost 2. Variable cost 3. Contribution 4. Margin of safety 5. Angle
of incidence 6. Profit volume ratio 7. Break-Even-Point
1. Fixed cost: Expenses that do not vary with the volume of production are known
as fixed expenses. Eg. Manager’s salary, rent and taxes, insurance etc. It should be
noted that fixed changes are fixed only within a certain range of plant capacity. The
concept of fixed overhead is most useful in formulating a price fixing policy. Fixed
cost per unit is not fixed.
2. Variable Cost: Expenses that vary almost in direct proportion to the volume of
production of sales are called variable expenses. Eg. Electric power and fuel,
packing materials consumable stores. It should be noted that variable cost per unit is
fixed.
3. Contribution: Contribution is the difference between sales and variable costs and
it contributed towards fixed costs and profit. It helps in sales and pricing policies and
measuring the profitability of different proposals. Contribution is a sure test to
decide whether a product is worthwhile to be continued among different products.
Contribution = Sales – Variable cost
Contribution = Fixed Cost + Profit.
4. Margin of safety: Margin of safety is the excess of sales over the break even
sales. It can be expressed in absolute sales amount or in percentage. It indicates the
extent to which the sales can be reduced without resulting in loss. A large margin of
safety indicates the soundness of the business. The formula for the margin of safety
is:
Present sales – Break even sales or Profit / P.V. ratio
Profit Margin of safety can be improved by taking the following steps.
1. Increasing production
2. Increasing selling price
3. Reducing the fixed or the variable costs or both
4. Substituting unprofitable product with profitable one.
5. Angle of incidence: This is the angle between sales line and total cost line at the
Break-even point. It indicates the profit earning capacity of the concern. Large angle
of incidence indicates a high rate of profit; a small angle indicates a low rate of
earnings. To improve this angle, contribution should be increased either by raising
the selling price and/or by reducing variable cost. It also indicates as to what extent
the output and sales price can be changed to attain a desired amount of profit.
6. Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful
ratios for studying the profitability of business. The ratio of contribution to sales is
the P/V ratio. It may be expressed in percentage. Therefore, every organization tries
to improve the P. V. ratio of each product by reducing the variable cost per unit or
by increasing the selling price per unit. The concept of P. V. ratio helps in
determining break even-point, a desired amount of profit etc.

7. Break – Even- Point: If we divide the term into three words, then it does not
require further explanation.
Break-divide
Even-equal
Point-place or position Break

Even Point refers to the point where total cost is equal to total revenue. It is a point
of no profit, no loss. This is also a minimum point of no profit, no loss. This is also
a minimum point of production where total costs are recovered. If sales go up beyond
the Break Even Point, organization makes a profit. If they come down, a loss is
incurred.
MARKET
Market is a place where buyer and seller meet, goods and services are offered for the
sale and transfer of ownership occurs. A market may be also defined as the demand
made by a certain group of potential buyers for a good or service. The former one is
a narrow concept and later one, a broader concept. Economists describe a market as
a collection of buyers and sellers who transact over a particular product or product
class (the housing market, the clothing market, the grain market etc.). For business
purpose we define a market as people or organizations with wants (needs) to satisfy,
money to spend, and the willingness to spend it. Broadly, market represents the
structure and nature of buyers and sellers for a commodity/service and the process
by which the price of the commodity or service is established. In this sense, we are
referring to the structure of competition and the process of price determination for a
commodity or service. The determination of price for a commodity or service
depends upon the structure of the market for that commodity or service (i.e.,
competitive structure of the market). Hence the understanding on the market
structure and the nature of competition are a pre-requisite in price determination.
Different Market Structures: Market structure describes the competitive
environment in the market for any good or service. A market consists of all firms
and individuals who are willing and able to buy or sell a particular product. This
includes firms and individuals currently engaged in buying and selling a particular
product, as well as potential entrants. The determination of price is affected by the
competitive structure of the market. This is because the firm operates in a market
and not in isolation. In marking decisions concerning economic variables it is
affected, as are all institutions in society by its environment
Perfect Competition: Perfect competition refers to a market structure where
competition among the sellers and buyers prevails in its most perfect form. In a
perfectly competitive market, a single market price prevails for the commodity,
which is determined by the forces of total demand and total supply in the market.
Characteristics of Perfect Competition The following features characterize a
perfectly competitive market:
1. A large number of buyers and sellers: The number of buyers and sellers
is large and the share of each one of them in the market is so small that
none has any influence on the market price.
2. Homogeneous product: The product of each seller is totally
undifferentiated from those of the others.
3. Free entry and exit: Any buyer and seller is free to enter or leave the
market of the commodity.
4. Perfect knowledge: All buyers and sellers have perfect knowledge about
the market for the commodity.
5. Indifference: No buyer has a preference to buy from a particular seller
and no seller to sell to a particular buyer.
6. Non-existence of transport costs: Perfectly competitive market also
assumes the non-existence of transport costs.
7. Perfect mobility of factors of production: Factors of production must be
in a position to move freely into or out of industry and from one firm to
the other.
Under such a market no single buyer or seller plays a significant role in price
determination. One the other hand all of them jointly determine the price. The price
is determined in the industry, which is composed of all the buyers and seller for the
commodity. The demand curve facing the industry is the sum of all consumers’
demands at various prices. The industry supply curve is the sum of all sellers’
supplies at various prices.
Pure competition and perfect competition: The term perfect competition is used
in a wider sense. Pure competition has only limited assumptions. When the
assumptions, that large number of buyers and sellers, homogeneous products, free
entry and exit are satisfied, there exists pure competition. Competition becomes
perfect only when all the assumptions (features) are satisfied. Generally pure
competition can be seen in agricultural products. Equilibrium of a firm and industry
under perfect competition Equilibrium is a position where the firm has no incentive
either to expand or contrast its output. The firm is said to be in equilibrium when it
earn maximum profit. There are two conditions for attaining equilibrium by a firm.
They are: Marginal cost is an additional cost incurred by a firm for producing and
additional unit of output. Marginal revenue is the additional revenue accrued to a
firm when it sells one additional unit of output. A firm increases its output so long
as its marginal cost becomes equal to marginal revenue. When marginal cost is more
than marginal revenue, the firm reduces output as its costs exceed the revenue. It is
only at the point where marginal cost is equal to marginal revenue, and then the firm
attains equilibrium. Secondly, the marginal cost curve must cut the marginal revenue
curve from below. If marginal cost curve cuts the marginal revenue curve from
above, the firm is having the scope to increase its output as the marginal cost curve
slopes downwards. It is only with the upward sloping marginal cost curve, there the
firm attains equilibrium. The reason is that the marginal cost curve when rising cuts
the marginal revenue curve from below.

Fig 3.A
The equilibrium of a perfectly competitive firm may be explained with the help of
the fig 3.A.
In the given fig. PL and MC represent the Price line and Marginal cost curve. PL
also represents Marginal revenue, Average revenue and demand. As Marginal
revenue, Average revenue and demand are the same in perfect competition, all are
equal to the price line. Marginal cost curve is U- shaped curve cutting MR curve at
R and T. At point R marginal cost becomes equal to marginal revenue. But MC curve
cuts the MR curve fro above. So this is not the equilibrium position. The downward
sloping marginal cost curve indicates that the firm can reduce its cost of production
by increasing output. As the firm expands its output, it will reach equilibrium at point
T. At this point, on price line PL; the two conditions of equilibrium are satisfied.
Here the marginal cost and marginal revenue of the firm remain equal. The firm is
producing maximum output and is in equilibrium at this stage. If the firm continues
its output beyond this stage, its marginal cost exceeds marginal revenue resulting in
losses. As the firm has no idea of expanding or contracting its size of out, the firm is
said to be in equilibrium at point T.
Pricing under perfect competition
The price or value of a commodity under perfect competition is determined by the
demand for and the supply of that commodity. Under perfect competition there is
large number of sellers trading in a homogeneous product. Each firm supplies only
very small portion of the market demand. No single buyer or seller is powerful
enough to influence the price. The demand of all consumers and the supply of all
firms together determine the price. The individual seller is only a price taker and not
a price maker. An individual firm has no price policy of it’s own. Thus, the main
problem of a firm in a perfectly competitive market is not to determine the price of
its product but to adjust its output to the given price, So that the profit is maximum.
Marshall however gives great importance to the time element for the determination
of price. He divided the time periods on the basis of supply and ignored the forces
of demand. He classified the time into four periods to determine the price as follows.
1. Very short period or Market period
2. Short period
3. Long period
4. Very long period or secular period
Very short period: It is the period in which the supply is more or less fixed because
the time available to the firm to adjust the supply of the commodity to its changed
demand is extremely short; say a single day or a few days. The price determined in
this period is known as Market Price.
Short Period: In this period, the time available to firms to adjust the supply of the
commodity to its changed demand is, of course, greater than that in the market
period. In this period altering the variable factors like raw materials, labour, etc can
change supply. During this period new firms cannot enter into the industry.
Long period: In this period, a sufficiently long time is available to the firms to adjust
the supply of the commodity fully to the changed demand. In this period not only
variable factors of production but also fixed factors of production can be changed.
In this period new firms can also enter the industry. The price determined in this
period is known as long run normal price.
Secular Period: In this period, a very long time is available to adjust the supply
fully to change in demand. This is very long period consisting of a number of
decades. As the period is very long it is difficult to lay down principles determining
the price.
Price Determination in the market period
The price determined in very short period is known as Market price. Market price is
determined by the equilibrium between demand and supply in a market period. The
nature of the commodity determines the nature of supply curve in a market period.
Under this period good are classified in to (a) Perishable goods and (b) Non-
perishable goods.
Perishable Goods: In the very short period, the supply of perishable goods like fish,
milk vegetables etc. cannot be increased. And it cannot be decreased also. As a result
the supply curve under very short period will be parallel to the Y-axis or Vertical to
X-axis. Supply is perfectly inelastic. The price determination of perishable goods in
very short period may be shown with the help of the following fig 3.B
Fig-3.B
In this figure quantity is represented along X-axis and price is represented along Y-
axis. MS is the very short period supply curve of perishable goods. DD is demand
curve. It intersects supply curve at E. The price is OP. The quantity exchanged is
OM. D1 D1 represents increased demand. This curve cuts the supply curve at E1.
Even at the new equilibrium, supply is OM only. But price increases to OP1. So,
when demand increases, the price will increase but not the supply. If demand
decreases new demand curve will be D2 D2. This curve cuts the supply curve at E2.
Even at this new equilibrium, the supply is OM only. But price falls to OP2. Hence
in very short period, given the supply, it is the change in demand that influences
price. The price determined in a very short period is called Market Price.
Non-perishable goods: In the very short period, the supply of non-perishable goods
like cloth, pen, watches etc. cannot be increased. But if price falls, preserving some
stock can decrease their supply. If price falls too much, the whole stock will be held
back from the market and carried over to the next market period. The price below,
which the seller will refuse to sell, is called Reserve Price. The Price determination
of non-perishable goods in very short period may be shown with the help of the
following fig 3.C
Fig 3.C
In the given figure quantity is shown on X-axis and the price on Y-axis. SES is the supply
curve. It slopes upward up to the point E. From E it becomes a vertical straight line. This is
because the quantity existing with sellers is OM, the maximum amount they have is thus OM.
Till OM quantity (i.e., point E) the supply curve sloped upward. At the point S, nothing is
offered for sale. It means that the seller with hold the entire stock if the price is OS. OS is thus
the reserve price. As the price rises, supply increases up to point E. At OP price (Point E), the
entire stock is offered for sale. Suppose demand increases, the DD curve shift upward. It
becomes D1D1 price raises to OP1. If demand decreases, the demand curve becomes D2D2.
It intersects the supply curve at E3. The price will fall to OP3. We find that at OS price, supply
is zero. It is the reserve price.
Price Determination in the short period
Short period is a period in which supply can be increased by altering the variable factors. In
this period fixed costs will remain constant. The supply is increased when price rises and vice
versa. So the supply curve slopes upwards from left to right. The price in short period may be
explained with the help of a diagram.
Fig-3.D
In the given diagram MPS is the market period supply curve. DD is the initial demand curve.
It intersects MPS curve at E. The price is OP and out put OM. Suppose demand increases, the
demand curve shifts upwards and becomes D1D1. In the very short period, supply remains
fixed on OM. The new demand curve D1D1 intersects MPS at E1. The price will rise to OP1.
This is what happen in the very short-period. As the price rises from OP to OP1, firms expand
output. As firms can vary some factors but not all, the law of variable proportions operates.
This results in new short-run supply curve SPS. It interests D1 D1 curve at E4. The price will
fall from OP1 to OP4. It the demand decreases, DD curve shifts downward and becomes D2D2.
It interests MPS curve at E2. The price will fall to OP2. This is what happens in market period.
In the short period, the supply curve is SPS. D2D2 curve interests SPS curve at E3. The short
period price is higher than the market period price.
Price determination in the long period (Normal Price)
Market price may fluctuate due to a sudden change either on the supply side or on the demand
side. A big arrival of milk may decrease the price of that production in the market period.
Similarly, a sudden cold wave may raise the price of woolen garments. This type of temporary
change in supply and demand may cause changes in market price. In the absence of such
disturbing causes, the price tends to come back to a certain level. Marshall called this level is
normal price level. In the words of Marshall Normal value (Price) of a commodity is that which
economics force would tend to bring about in the long period. In order to describe how long
run normal price is determined, it is useful to refer to the market period as short period also.
The market period is so short that no adjustment in the output can be made. Here cost of
production has no influence on price. A short period is sufficient only to allow the firms to
make only limited output adjustment. In the long period, supply conditions are fully sufficient
to meet the changes in demand. In the long period, all factors are alterable and the new firms
may enter into or old firms leave the; industry. In the long period all costs are variable costs.
So supply will be increased only when price is equal to average cost. Hence, in long period
normal price will be equal to minimum average cost of the industry. Will this price be more or
less than the short period normal price? The answer depends on the stage of returns to which
the industry is subject. There are three stages of return on the stage of returns to which the
industry is subject. There are three stages of returns.
1. Increasing returns or decreasing costs.
2. Constant Returns or Constant costs.
3. Diminishing returns or increasing costs.
1. Determination of long period normal price in decreasing cost industry:
At this stage, average cost falls due to an increase in the output. So, the supply curve at this
stage will slope downwards from left to right. The long period Normal price determination at
this stage can be explained with the help of a diagram.

Fig-3.E
In the diagram, MPS represents market period supply curve. DD is demand curve. DD cuts
LPS, SPS and MPS at point E. At point E the supply is OM and the price is OP. If demand
increases from DD to D1D1 market price increases to OP1. In the short period it is OP2. In the
long period supply increases considerably to OM3. So price has fallen to OP3, which is less
than the price of market period.
2. Determination of Long Period Normal Price in Constant Cost Industry:
In this case average cost does not change even though the output increases. Hence long period
supply curve is horizontal to X-axis. The determination of long period normal price can be
explained with the help of the diagram. In the fig. 6.9, LPS is horizontal to X-axis. MPS
represents market period supply curve, and SPS represents short period supply curve. At point
‘E’ the output is OM and price is OP. If demand increases from DD to D1D1 market price
increases to OP1. In the short period, supply increases and hence the price will be OP2. In the
long run supply is adjusted fully to meet increased demand. The price remains constant at OP
because costs are constant at OP and market is perfect market.
Fig-3.F
3. Determination of long period normal price in increase cost industry: If the industry is
subject to increasing costs (diminishing returns) the supply curve slopes upwards from left to
right like an ordinary supply curve. The determination of long period normal price in increasing
cost industry can be explained with the help of the following diagram. In the diagram LPS
represents long period supply curve. The industry is subject to diminishing return or increasing
costs. So, LPS slopes upwards from left to right. SPS is short period supply curve and MPS is
market period supply curve. DD is demand curve. It cuts all the supply curves at E. Here the
price is OP and output is OM. If demand increases from DD to D1D1 in the market period,
supply will not change but the price increases to OP1. In the short period, price increase but
the price increases to OP1. In the short period, price increases to OP2 as the supply increased
from OM to OM2. In the long period supply increases to OM3 and price increases to OP3. But
this increase in price is less than the price increase in a market period or short period.

Fig-3.G
Monopoly
The word monopoly is made up of two syllables, Mono and poly. Mono means single while
poly implies selling. Thus monopoly is a form of market organization in which there is only
one seller of the commodity. There are no close substitutes for the commodity sold by the
seller. Pure monopoly is a market situation in which a single firm sells a product for which
there is no good substitute.
Features of monopoly
The following are the features of monopoly.
1. Single person or a firm: A single person or a firm controls the total supply of the commodity.
There will be no competition for monopoly firm. The monopolist firm is the only firm in the
whole industry.
2. No close substitute: The goods sold by the monopolist shall not have closely competition
substitutes. Even if price of monopoly product increase people will not go in far substitute. For
example: If the price of electric bulb increase slightly, consumer will not go in for kerosene
lamp.
3. Large number of Buyers: Under monopoly, there may be a large number of buyers in the
market who compete among themselves.
4. Price Maker: Since the monopolist controls the whole supply of a commodity, he is a price-
maker, and then he can alter the price.
5. Supply and Price: The monopolist can fix either the supply or the price. He cannot fix both.
If he charges a very high price, he can sell a small amount. If he wants to sell more, he has to
charge a low price. He cannot sell as much as he wishes for any price he pleases.
6. Downward Sloping Demand Curve: The demand curve (average revenue curve) of
monopolist slopes downward from left to right. It means that he can sell more only by lowering
price.
Types of Monopoly
Monopoly may be classified into various types. The different types of monopolies are
explained below:
1. Legal Monopoly: If monopoly arises on account of legal support or as a matter of legal
privilege, it is called Legal Monopoly. Ex. Patent rights, special brands, trade means, copyright
etc.
2. Voluntary Monopoly: To get the advantages of monopoly some private firms come together
voluntarily to control the supply of a commodity. These are called voluntary monopolies.
Generally, these monopolies arise with industrial combinations. These voluntary monopolies
are of three kinds (a) cartel (b) trust (c) holding company. It may be called artificial monopoly.
3. Government Monopoly: Sometimes the government will take the responsibility of supplying
a commodity and avoid private interference. Ex. Water, electricity. These monopolies, created
to satisfy social wants, are formed on social considerations. These are also called Social
Monopolies.
4. Private Monopoly: If the total supply of a good is produced by a single private person or
firm, it is called private monopoly. Hindustan Lever Ltd. Is having the monopoly power to
produce Lux Soap.
5. Limited Monopoly: if the monopolist is having limited power in fixing the price of his
product, it is called as ‘Limited Monopoly’. It may be due to the fear of distant substitutes or
government intervention or the entry of rivals firms.
6. Unlimited Monopoly: If the monopolist is having unlimited power in fixing the price of his
good or service, it is called unlimited monopoly. Ex. A doctor in a village.
7. Single Price Monopoly: When the monopolist charges same price for all units of his product,
it is called single price monopoly. Ex. Tata Company charges the same price to all the Tata
Indiaca Cars of the same model.
8. Discriminating Monopoly: When a Monopolist charges different prices to different
consumers for the same product, it is called discriminating monopoly. A doctor may take Rs.20
from a rich man and only Rs.2 from a poor man for the same treatment.
9. Natural Monopoly: Sometimes monopoly may arise due to scarcity of natural resources.
Nature provides raw materials only in some places. The owner of the place will become
monopolist. For Ex. Diamond mine in South Africa.
Pricing under Monopoly: Monopoly refers to a market situation where there is only one
seller. He has complete control over the supply of a commodity. He is therefore in a position
to fix any price. Under monopoly there is no distinction between a firm and an industry. This
is because the entire industry consists of a single firm.

Fig 3.H
Being the sole producer, the monopolist has complete control over the supply of the
commodity. He has also the power to influence the market price. He can raise the price by
reducing his output and lower the price by increasing his output. Thus he is a price-maker. He
can fix the price to his maximum advantages. But he cannot fix both the supply and the price,
simultaneously. He can do one thing at a time. If the fixes the price, his output will be
determined by the market demand for his commodity. On the other hand, if he fixes the output
to be sold, its market will determine the price for the commodity. Thus his decision to fix either
the price or the output is determined by the market demand. The market demand curve of the
monopolist (the average revenue curve) is downward sloping. Its corresponding marginal
revenue curve is also downward sloping. But the marginal revenue curve lies below the average
revenue curve as shown in the figure. The monopolist faces the down-sloping demand curve
because to sell more output, he must reduce the price of his product. The firm’s demand curve
and industry’s demand curve are one and the same. The average cost and marginal cost curve
are U shaped curve. Marginal cost falls and rises steeply when compared to average cost.
Price output determination (Equilibrium Point)
The monopolistic firm attains equilibrium when its marginal cost becomes equal to the
marginal revenue. The monopolist always desires to make maximum profits. He makes
maximum profits when MC=MR. He does not increasing his output if his revenue exceeds his
costs. But when the costs exceed the revenue, the monopolist firm incur loses. Hence the
monopolist curtails his production. He produces up to that point where additional cost is equal
to the additional revenue (MR=MC). Thus point is called equilibrium point. The price output
determination under monopoly may be explained with the help of a diagram. In the diagram
3.I the quantity supplied or demanded is shown along X-axis. The cost or revenue is shown
along Y-axis. AC and MC are the average cost and marginal cost curves respectively. AR and
MR curves slope downwards from left to right. AC and MC and U shaped curves. The
monopolistic firm attains equilibrium when its marginal cost is equal to marginal revenue
(MC=MR). Under monopoly, the MC curve may cut the MR curve from below or from a side.
In the diagram, the above condition is satisfied at point E. At point E, MC=MR. The firm is in
equilibrium. The equilibrium output is OM.
The above diagram (Average revenue) = MQ or OP
Average cost = MR
Profit per unit = Average Revenue-Average cost=MQ-MR=QR
Total Profit = QRXSR=PQRS

Fig-3.I
The area PQRS resents the maximum profit earned by the monopoly firm. But it is not always
possible for a monopolist to earn super-normal profits. If the demand and cost situations are
not favorable, the monopolist may realize short run losses. Through the monopolist is a price
marker, due to weak demand and high costs; he suffers a loss equal to PABC.
If AR > AC -> Abnormal or super normal profits.
If AR = AC -> Normal Profit
If AR < AC -> Loss
In the long run the firm has time to adjust his plant size or to use existing plant so as to
maximize profits.

Monopolistic competition
Perfect competition and pure monopoly are rate phenomena in the real world. Instead, almost
every market seems to exhibit characteristics of both perfect competition and monopoly. Hence
in the real world it is the state of imperfect competition lying between these two extreme limits
that work. Edward. H. Chamberlain developed the theory of monopolistic competition, which
presents a more realistic picture of the actual market structure and the nature of competition.

Characteristics of Monopolistic Competition

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

Price – Output Determination under Monopolistic Competition

Since under monopolistic competition different firms produce different varieties of products,
different prices for them will be determined in the market depending upon the demand and cost
conditions. Each firm will set the price and output of its own product. Here also the profit will
be maximized when marginal revenue is equal to marginal cost.
Short-run equilibrium of the firm: In the short-run the firm is in equilibrium when marginal
Revenue = Marginal Cost. In Fig 3.J AR is the average revenue curve. NMR marginal revenue
curve, SMC short-run marginal cost curve, SAC short-run average cost curve, MR and SMC
interest at point E where output in OM and price MQ (i.e. OP). Thus the equilibrium output or
the maximum profit output is OM and the price MQ or OP. When the price (average revenue)
is above average cost a firm will be making supernormal profit. From the figure it can be seen
that AR is above AC in the equilibrium point. As AR is above AC, this firm is making abnormal
profits in the short-run. The abnormal profit per unit is QR, i.e., the difference between AR
and AC at equilibrium point and the total supernormal profit is OR X OM. This total abnormal
profits is represented by the rectangle PQRS. As the demand curve here is highly elastic, the
excess price over marginal cost is rather low. But in monopoly the demand curve is inelastic.
So the gap between price and marginal cost will be rather large.

Fig-3.J
If the demand and cost conditions are less favorable the monopolistically competitive firm may
incur loss in the short-run fig 3.K Illustrates this. A firm incurs loss when the price is less than
the average cost of production. MQ is the average cost and OS (i.e. MR) is the price per unit
at equilibrium output OM. QR is the loss per unit. The total loss at an output OM is OR X OM.
The rectangle PQRS represents the total loses in the short run.

Fig-3. K
Long – Run Equilibrium of the Firm:
A monopolistically competitive firm will be long – run equilibrium at the output level where
marginal cost equal to marginal revenue. Monopolistically competitive firm in the long run
attains equilibrium where MC=MR and AC=AR Fig 3.L shows this trend.

Fig-3.L
Oligopoly
The term oligopoly is derived from two Greek words, oligos meaning a few, and pollen
meaning to sell. Oligopoly is the form of imperfect competition where there are a few firms in
the market, producing either a homogeneous product or producing products, which are close
but not perfect substitute of each other.
Characteristics of Oligopoly
The main features of oligopoly are:
1. Few Firms: There are only a few firms in the industry. Each firm contributes a sizeable share
of the total market. Any decision taken by one firm influence the actions of other firms in the
industry. The various firms in the industry compete with each other.
2. Interdependence: As there are only very few firms, any steps taken by one firm to increase
sales, by reducing price or by changing product design or by increasing advertisement
expenditure will naturally affect the sales of other firms in the industry. An immediate
retaliatory action can be anticipated from the other firms in the industry every time when one
firm takes such a decision. He has to take this into account when he takes decisions. So the
decisions of all the firms in the industry are interdependent.
3. Indeterminate Demand Curve: The interdependence of the firms makes their demand curve
indeterminate. When one firm reduces price other firms also will make a cut in their prices. So
he firm cannot be certain about the demand for its product. Thus the demand curve facing an
oligopolistic firm loses its definiteness and thus is indeterminate as it constantly changes due
to the reactions of the rival firms.
4. Advertising and selling costs: Advertising plays a greater role in the oligopoly market when
compared to other market systems. According to Prof. William J. Banumol “it is only oligopoly
that advertising comes fully into its own”. A huge expenditure on advertising and sales
promotion techniques is needed both to retain the present market share and to increase it. So
Banumol concludes “under oligopoly, advertising can become a life-and-death matter where a
firm which fails to keep up with the advertising budget of its competitors may find its
customers drifting off to rival products.”
5. Price Rigidity: In the oligopoly market price remain rigid. If one firm reduced price it is with
the intention of attracting the customers of other firms in the industry. In order to retain their
consumers they will also reduce price. Thus the pricing decision of one firm results in a loss
to all the firms in the industry. If one firm increases price. Other firms will remain silent there
by allowing that firm to lost its customers. Hence, no firm will be ready to change the
prevailing price. It causes price rigidity in the oligopoly market.