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SUBJECT – COMMERCE
SUBJECT CODE – 08
UNIT - III

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 Page Nos.
Chapters Contents of Unit I

1 Managerial Economics / Business Economics 3-5

2 Theory of Profit 1-5

3 Demand Analysis 1-22

4 Theory of Production 1-9

5 Theory of Cost 1-16

6 Market Structure & Pricing 1-25

 CHAPTER 1
Managerial Economics / Business Economics

Managerial Economics:
It essentially constitutes of economic theories and analytical tools that are widely applied to
business decision-making. Therefore to understand the concept of managerial economics it is
important to know “what is economics”?
“Economics is a social science which studies how people – individuals, households, firms and
nations – maximise their gains from their limited resources and opportunities i.e., maximising
behaviour or optimizing behaviour of the people”.
In other words, economics is a social science which studies human behaviour in relation to
optimizing allocation of available resources to achieve the given ends.

Definition of Managerial Economics:

1. Mansfield:
“Managerial economics is governed with the application of economic concepts and economics to the
problems of formulating rational decision making”.

2. Spencer and Seigelman:

 “Managerial economics – it is the integration of economic theory with business practice for the
purpose of facilitating decision making and forward planning by management”.
 In simple words, managerial economics can be broadly defined as the study of economic theories
logic and tools of economic analysis that are used in the process of business decision-making.
Economic theories and techniques of economic analysis are applied to analyse business problems,
evaluate business options and opportunities with a view to arriving at an appropriate business
decision.

Contribution of Economic Theories to Business Economics:

1. One of the most important things which the economic (theories) can contribute to the management
science is building analytical models which help to recognise the structure of managerial problems,
eliminate the minor details that might obstruct decision-making, and help to concentrate on the main
issue.
2. Economic theory contributes to the business analysis a set of analytical methods’, which may not be
applied directly, to specific business problems, but they do enhance the analytical capabilities of the
business analyst.
3. Economic theories offer clarity to the various concepts used in business analysis, which enables the
managers to avoid conceptual pitfalls.

Application of Economics to Business Decisions:

1. It gives a clear understanding of various economic concepts (eg. cost, price and demand, etc) used
in business analysis.
Eg. The concept of cost includes ‘total’, ‘average’, ‘marginal’, ‘fixed’, ‘variable’, ‘actual’ and
‘opportunity’. Economics classifies which cost concepts are relevant and in what context.
2. It helps in ascertaining the relevant variables and specifying the relevant data.
Eg. It helps in deciding what variables need to be considered in estimating the demand for two
different sources of energy – petrol and electricity.

3. Economic theories state the general relationship between two or more economic variables and
also events.

Scope of Managerial Economics:

Economics has two major branches:
1. Microeconomics
2. Macroeconomics
Both these economics are applied to business analysis and decision making. The areas of
business issues to which economic theories can be directly applied may be broadly divided into two
categories –
a) Microeconomics applied to operational or internal issues.
b) Macroeconomics applied to environmental or external issues.

Microeconomics Applied to Operational Issues:

Operational issues are of internal nature which includes:-
1. Choice of business and the nature of product i.e., what to produce.
2. Choice of size of the firm, ie..d, how much to produce
3. Choice of technology, i.e., choosing the factor- combination.
4. Choice of price – how to price the commodity.
5. How to promote sales.
6. How to face price competition
7. How to decide on new investments
8. How to manage profit and capital
9. How to manage an inventory, i.e., stock of finished goods and raw materials.

……………………….
 CHAPTER - 2
THEORY OF PROFIT

Meaning of Profit:
The word ‘profit has different meaning to businessmen, accountants, tax collectors, workers
and economists. In general, profit is regarded as income accruing to the equity holders, in the same
sense as wages accrue to labour, rent accrues to owner of the rentable assets and interest to
moneylenders. To an accountant profit means the excess of revenue over all paid out costs including
both manufacturing and overhead expenses for all practical purpose profit means profit in
accountancy sense plus non-allowable expenses which refers to accounting concept of profit.
Economic concept of profit is of ‘pure and profit’ also called economic profit which is a return over
and above the opportunity cost i.e., the income which a businessman might expect from second best
alternative use of his resources.

Accounting Profit Vs. Economic Profit

In accounting sense, profit is surplus of total revenue over and above all paid-out costs,
including both manufacturing and overhead expenses.
Accounting Profit = TR – (W + R + I + M)
TR = Total revenue
W = Wages and Salaries
R = Rent
I = Interest
M = Cost of Materials
While calculating accounting profit, only explicit or book costs, ie. the costs recorded in the
books of accounts, are considered.
Economic Profit takes into account the explicit and implicit costs. The implicit cost is
opportunity cost. Opportunity cost is defined as the payment that would be necessary to draw forth
the factors of production from their most remunerative alternative employment.
In other words opportunity cost can be defined as the income foregous which a businessman
could make from the second best use of his resources. Economic or pure profits make provisions also
for
a) insurable risks
b) depreciation
c) necessary minimum payment to share holders to prevent them from withdrawing their capital.
Pure profit thus, can be defined as – “a residual let after all contractual costs have met, including
the transfer costs of management, insurable risks, depreciation and payments to shareholders
sufficient to maintain investment at its current level’.
Pure Profit = Total revenue – (explicit costs + implicit costs)

Theories of Profit
1. Walker’s Theory of Profit – Profit as rent of ability:
 This theory of profit was propounded by F.A. Walker. According to him, profit is the rent of
“exceptional abilities that an entrepreneur may possess” over others. Profit is the difference between
the earnings of the least and the most efficient entrepreneurs.
 Walker assumed a state of perfect competition in which all firms are presumed to possess equal
managerial ability. Each firm would receive only the wages of management as ordinary wages. Thus,
under perfectly competitive conditions there would be no pure profit and all firms would earn only
managerial wages which is popularly known as ‘normal profit’.
2. Clark’s Dynamic Theory of Profit:
 This theory was introduced by J.B. Clark, Profits arise in a dynamic economy, not in a static one in
which things do not change significantly; population and capital are stationary; production process
remain same unchanged over time; goods continue to remain homogeneous, factors enjoy freedom of
mobility but do not move because their marginal product in every industry is the same; there is any
risk it is insurable. Therefore, all firms make normal profits ie., the wages of management.
 On the other hand, a dynamic economy has increase in population, increase in capital, improvement in
production technique, changes in the forms of business organisation, an increase in and multiplication
of consumer wants. The major functions of entrepreneurs or managers in a dynamic world are to take
advantage of the generic changes and promote their business, expand their sales and reduce their
costs. The entrepreneurs who successfully take advantage of changing conditions in a dynamic
economy make pure profit, ie., profit in addition to ‘normal profit’.
 Pure profits exist only in the short run. In the long run, competition forces other firms to imitate the
changes made by the leading firms. These leads to a rise in demand for factor of production and
therefore rise in factor prices and rise cost of production. On the other hand, rise in output causes a
decline in product prices, given the demand. The ultimate result is that pure profit disappears. In
Clark’s words, “profit is an elusive sum which entrepreneurs grasp but cannot hold. It slips through
their fingers and bestows itself on all members of the society”. According to Clark, “emergence,
disappearance and re-emergence of profit is a continuous process”.

3. Hawley’s Risk Theory of Profit:

 The risk theory of profit was propounded by F.B. Hawley in 1893. Hawley regarded risk-taking as an
inevitable accompaniment of dynamic production and those who take risks have a sound claim to an
additional reward, known as “profit”. According to Hawley, profit is simply the price paid by society
for assuming business risks. Profit, according to him consists of two parts: one represents
compensation for actuarial or average loss incidental to the various classes of risks necessarily
assumed by the entrepreneur; and the remaining part represents an inducement to suffer the
consequences of being exposed to risk in their entrepreneurial adventures.
 Hawley believed that profits arise from factor ownership only so long as ownership involves risk.
According to him, an entrepreneur has to assume risk to qualify for profits. If an entrepreneur avoids
risk by insuring against it, he would cease to be an entrepreneur and would not receive any profit. In
his opinion, it is the uninsured risks out of which profit arise, and until the uncertainty ends with the
sale of entrepreneur’s product, the amount of reward cannot be determined. Profit, in his opinion is a
residue. Hawley’s theory is thus a residual theory of profit.

4. Knight’s Theory of Profit:

 This theory was given by Frank H. Knight and according to him profit is a residual return for
bearing uncertainty, not for risk. He divided risk into calculable and non-calculable risks.
 Calculable risks are those whose probability of occurrence can be statistically estimated on the basis
of available data for example, risk due to fire, theft, accidents, etc, are calculable and such risks are
insurable. These remains, however an arrear of risk in which probability of risk occurrences cannot
be calculated and the strategies of the competitors may not be precisely assessable. The risk element
of such incalculable events is not insurable and thus the area of incalculable risk is the area of
uncertainty.
 Thus, according to Knight, profit arises from the decisions taken and implemented under the
conditions of uncertainty because decision-making becomes a crucial function of an entrepreneur and
a manager. If his decisions are proved right by the subsequent events, the entrepreneurs make profits
and vice-versa,
5. Schumpeter’s Innovation Theory of Profit:
The innovation Theory of Profit was developed by Joseph A Schumpeter. His theory of profit is
embedded in his theory f economic development. According to Schumpeter’s theory of economic
development under the conditions of stationary equilibrium, the total receipts from the business are
exactly equal to the total outlay and there is no (economic) profit. Profit in excess of management
wages can be made only by introducing innovations in manufacturing techniques and methods of
supplying the goods. Innovation may include:

i. Introduction of a new commodity or a new quality of goods;

ii. The introduction of a new commodity or a new quality of goods.
iii. The emergence or opening of a new market.
iv. Finding the new sources of raw material and
v. Organising the industry in an innovative manner with new techniques.

6. Monopoly Power as a source of Profit:

 Monopoly is said to be another source of pure profit. Most profit theories have been established in the
background of perfect competition. But perfect competition, as conceived in the theoretical model is
either non-existent or is a rare phenomenon. An extreme contrast of perfect competition is the
existence of a monopoly in the market.
 Monopoly is a market situation in which there is a single seller of a commodity without a close
substitute.
Monopoly may arise due to such factors as:
1) Economies of scale.
2) Sole ownership of certain crucial raw materials,
3) Legal sanction and protection
4) Mergers and takeovers.

A monopolist may earn profit by using his monopoly power which includes:
(i) powers to control supply and price.
(ii) powers to prevent the entry of competitors by price cutting
(iii) in some cases, monopoly is the source of pure profit.

……………….
 CHAPTER 3
DEMAND ANALYSIS

Definition:
According to Marshall in his book “Principles of Economics”- “Economics is the study of
mankind in the ordinary business of life; it examines that part of individual and social action
which is most closely connected with the attainment and with the use of the material requisites
of well –being”.

According to Robbins in his book “Nature and Significance of Economic Science” (1931)
Economics is the science which studies human behaviour as a relationship between ends and
scarce means which have alternative uses”.

The subject – matter of economics is so broad that that the study of economics has been
divided into two parts:
1. Micro Economics
2. Macro Economics
Micro Economics

vs.

Macro Economics

These terms were coined by Ragnar Frisch.

According to K.E. Boulding “Micro Economics is the study of particular firms,
particular households, individual prices, wages, incomes, national industries, particular
commodities”.
“Macro Economics deals not with individual quantities as such but with aggregates or
these quantities not with individual incomes but with the national income; not with individual
prices but with the price levels; not with individual outputs but with the national output”.

Micro-Economic Theories
Product Pricing Factor Pricing Theory of Economic Welfare
(Theory of Distribution)

Theory of Theory of Wages Rent Interests Profits

Demand Production and cost

Micro-Economic Analysis
Demand Analysis:
The Theory of Demand starts with the examination of consumer behaviour. Since the market
demand is the summation of the individual demand, hence the nature of individual demand should be
analysed.

The analysis of individual demand is based on following behaviour of the consumers.

1. Consumer is rational
 2. Highest possible satisfaction or utility (axioms of utility maximisation)

To attain highest satisfaction or utility, the consumer should be able to compare the
utilities of various goods from the basket of good. Hence, there are two approaches to
measure utility.
 Cardinalist Approach (Marshallian’s Approach)
 Ordinalist Approach

Cardinalist Approach
According to Cardinalist Approach given by Cardinalist school, utility can be
measured.
(a) Utility can be measured in monetary units or the amount of money which the consumer is
willing to sacrifice
(b) Utility can be measured in subjective units, called utils.
The concept of subjective, measurable utility is attributed to Gossen (1854), Jevons
(1871) and Walrus (1874).
Alfred Marshall in his “Principles of Economics” presented a complete systematic
approach.

Utility:
The term “utility” is defined as the power of a commodity or service to satisfy human
want i.e., to yield a consumers some satisfaction.

Ordinalist Approach
According to Ordinalist School, the utility is not measurable i.e., the consumer does
not know in specific units the utility of various commodities to make his choice rather he can
rank it according to his preference or the level of satisfaction the good provides him.

The main Ordinal Theories are:

1. Indifference – Curve Approach – Hicks and Allen
2. Revealed Preference Approach – Samuelson

Utility Approach

Cardinal Utility Ordinal Utility Revealed Preference Individual Behaviour

(Marshallian Approach) (Hick and Allen Approach) (Samuelson Approach) (Modern Utility Analysis)

Total and Law of Diminishing Law of Equilibrium Consumer Surplus

Marginal Utility Marginal Utility Marginal Utility

………………….
 Chapter - 4
THEORY OF PRODUCTION
Production is the transformation of physical inputs into physical outputs. It is creation or
addition of value. The theory of production provides a framework to help the managers to decide how
to combine various factors or inputs most efficiently to produce the desired output or service.
The relation between input and output of a firm has been called “The Production function”.
Therefore, the theory of production is the study of production functions.

Production function can be of two types:-

1) Short-run production function
2) Long-run Production function

1) Short-Run Production Function:

The time period in which at least one factor or input is fixed and production is increased by varying
other factors is called short-run production function. In the short run output may be increase by using
more of the variable factor(s). While capital (and possibly other factors as well) are kept constant.

2) Long-Run Production Function:

The time period when all factors are variable is called long run. The length of the long run that is the
time period required for changes in all i9nputs depends on the industry.

Eg. For some industries such as making of wooden chairs or tables the long run may be few weeks or
months but for production of steel it may be many years as it takes several years to expand the
capacity of steel production.

Production function with one variable factor

i.e.,

Short run Production function

Before studying long-run production function it is very necessary to understand short run
production function. In short-run production function we study the Production Function when the
quantities of some inputs are kept constant and quantity of one input are varied. This kind of input-
output relationship forms the subject matter of the law of diminishing marginal returns which is also
called “law of variable proportions” and describes return to a factor. This concept is relevant for the
short run because in the short run some factors such as capital equipment, machines, land remain
fixed and factors such as labour, raw materials are increased to expand output. Thus short run two
factor production function can be written as

Q = f (L,
K)

(Bar on K indicates that K is constant)

 Where Q stands for output, (for labour and K for capital which is held constant.

The law of the variable proportions:

If one input is variable and all other inputs are fixed, the firm’s production function exhibits
the law of variable proportions. If the number of units of variable factor is increased, keeping other
factors constant, now output changes is the concern of the law.
Suppose land, plant and equipment are the fixed factors, and labour the variable factor. When
the number of labourers are increased successively to have larger output, the proportion between fixed
factors and variable factor is altered and the law of variable proportions set in.

Definition:
The law of variable proportions states that as the quantity of a variable input is increased by
equal doses keeping the quantities of other output constant, total product will increase, but after a
point at diminishing rate.

In other words:
When more and more units of the variable factor are used, holding the quantities of fixed
factors constant, a point is reached beyond which the marginal product, then, the average and finally
the total product will diminish.

The Law of variable proportion is also known as the law of diminishing returns
To understand this law following concepts must be very clear.
1. Total product.
2. Marginal product
3. Average Product
4. Output elasticity of an input.
Example
MP Output Elasticity
Labour TP
L Q of labour (EL)
1 80 80 80 1
2 170 90 85 1.05
3 270 100 90 1.11
4 368 98 92 1.06
5 430 62 86 0.72
6 480 50 80 0.62
7 504 24 72 0.33
8 504 0 63 0
9 495 -9 55 -0.16
10 480 -15 48 -0.13
Labour – represent the number of workers
TP – Total Product
MP – Marginal product
AP - Average Product
EL - Output Elasticity of labour
1. Total Product:
The total product of a variable factor is the amount of total output produced by a given quantity of the
variable factor, keeping the quantity of other factors such as capital, fixed., as the amount of variable
increases, the total output increases. But the rate of increase in total output varies at different levels of
employment of the variable factor. It will be seen in the table that as more workers are employed with
a given quantity of capital, the total output of the product (TP) increases.
 In the diagram the total product initially increases at a increasing rate and then at a diminishing rate.

2. Marginal Product:
 Marginal Product of a variable factor is the addition made tot eh total production by the employment
of an extra unit of a factor.
Eg. When two workers are employed to produce the product they produce 170 units. Now, if instead
of two workers, three workers are employed and as a result total product increases to 270 i.e, the third
worker has added 100 meters to the total production. Thus the marginal product of the third worker is
100 unit.
 In general, if employment of labour increases by units yielding increases in total output by
units, the marginal product of labour is given by
MPL =

3. Average Product:
Average Product of a variable factor (labour) is the total output (Q) divided by the amount of labour
employed with a given quantity of capital (the fixed factor) used to produce commodity.

APL =

The law of variable proportions is presented diagrammatically in the figure. The TP curve
first rises at an increasing rate upto point B where its slope is the highest.
From point B upwards, see the total product increases at a diminishing rate till it reaches its
highest point C and then its starts falling. The maximum point on AP curve is E where it coincides
with point B on the TP curve from where the total product starts a gradual rise. When the TP curve
reaches its maximum point C, the MP curve becomes zero at point F.
Where TP curves starts declining the MP curves become negative. It is only when the total
product declines the marginal product becomes zero.
 The rising, the falling and the negative phase of the total, marginal and average products are infact
the different stages of the law of variable proportions.

4. Output Elasticity of an Input:

It is an important elasticity of an input. Just as price elasticity of demand for a good is defined as
percentage change in quantity demanded of it that results from a given percentage change in, the
output elasticity of a variable input, say labour is the percentage change in output that is brought about
by a given percentage change in the quantity of variable input used, other factors such as capital
remaining the same. That is

EL =

EL =

= x = .

Since, represents MP of labour and represents average product of labour the equation can
be written as EL = .

The output elasticity of labour is the ratio of marginal product of labour to its average
product.

When the elasticity of production of a variable input being less than one indicates diminishing
returns to that factor.

When the production elasticity is zero means that output does not change at all when a given
percentage change in a variable input. Keeping other factors constant, is used in the production
process.

If or when elasticity of production is less than zero (that is, it is negative), this implies that
output of the commodity decreases as a result of a given percentage increase in the variable input.
 CHAPTER – 5
THEORY OF COST

Cost of Production:
When the input are multiplied by their respective prices and added together, they
give the money value of the inputs, i.e., the cost of production.
Cost of production is an important factor in almost all business analysis and business
decision-making.

Cost Concepts:
The cost concepts are divided into two parts –
1. Accounting cost concept
2. Analytical cost concept.

Accounting Cost Concepts

1. Opportunity cost and actual cost:
 The opportunity cost may be defined as the expected returns from the second best use
of the resources that are foregone due to the scarcity of resources. The opportunity cost
is also called alternative cost.
 Had the resources available to a person, a firm or a society been unlimited, there would
be no opportunity cost.

2. Business Costs and Full Costs:

 Business costs include all the expenses that are incurred to carry out a business. It
includes all the payments and contractual obligations made by the firm together with the
book cost of depreciation or plant and equipment”.
 Full cost includes business cost, opportunity cost and normal profit.

3. Actual or Explicit Costs and Implicit or Imputed Costs:

 The actual or explicit cost are those which are actually incurred by the firm in payment
for labour, material plant, building machinery, equipment, travelling and transport,
advertisement, etc.
 Implicit or imputed costs are not those which do not take the form of cash outlays nor
do they appear in the accounting system.
 Opportunity costs are known as implicit or imputed costs. Implicit costs are not taken
into account while calculating the loss or gains of the business, but they form an
important consideration in deciding whether or not to retain a factor in its present use.
 The explicit and implicit costs together make the economic cost.

4. Out-of Pocket-and Book Costs:

 The items of expenditure that involve cash payments or cash transfers, both recurring
and non-recurring are known as out-of-pocket costs. All the explicit costs (eg. wages,
rent, interest, cost of materials and maintenance, transport expenditure, electricity and
telephone expenses, etc) fall in this category.
 Book costs are those costs which do not involve cash payments, but a provision is
therefore made in the books of account and they are taken into account while finalizing
the profit and loss accounts.
 Analytical Cost
1. Fixed and Variable Costs:
Fixed costs are those that are fixed in volume for a certain quantity of output. It does
not vary with variation in the output between zero and a certain level of output.
It includes:
a) Costs of managerial and administrative staff.
b) Depreciation of machinery, building and other fixed assets.
c) Maintenance of land etc.
The concept of fixed cost is associated with the short-run.
Variable cost are those costs which vary with the variation in the total output.
Variable costs include cost of raw material, running cost of fixed capital such as fuel,
repairs.

2. Total, Average and Marginal Costs:

Total cost is the total actual cost incurred on the production of goods and service. It
refers to the total outlays of money expenditure, both explicit and implicit, on the
resources used to produce a given level of output. It includes both fixed costs and
variable costs.
Average cost is of statistical nature. It is obtained by dividing the total cost (TC) by
the total output (Q) i.e.,
AC =

Marginal cost is defined as the addition to the total costs on account of producing
one additional unit of the product. It is the cost of the marginal unit produced. It is
calculated as TCn – TCn-1 where n is the number of units produced.
MC =

3. Short-Run and Long Run:

 Short run costs are those that have a short-run implication in the process of
production. Such costs are made once eg. payment of wages, cost of raw materials,
etc. Short run cost vary with the variation in output, the size of the firm remaining the
same.
 Long run costs are those that have long – run implications in the process of
production, i.e., they are used over a long range of output. The costs which are
incurred on the fixed factors like plant, building, machinery etc. are known as long-
run costs.

4. Incremental Costs and Sunk Costs:

 Incremental cost refers to the total additional cost associated with the decisions to
expand the output or to add a new variety of product, etc. The concept of
incremental cost is based on the fact that in the real world, it is not practicable to
employ factors for each unit of output separately. Besides in the long run, when
firms expand their production, they hire more of men, materials, machinery and
equipments. The expenditure of this nature are incremental costs.
 Sunk costs are those which are made once and for all and cannot be altered,
increased or decreased, by varying the rate of output, nor can they be recovered.
5. Historical and Replacement Costs:
 Historical cost refers to the cost incurred in past on the acquisition of productive
assets, eg. land, building, machinery, etc.
 Replacement cost refers to the outlay that has to make for replacing an old asset.
The
 Replacement cost figures in business decisions regarding the renovation of the firm.

6. Private and Social Costs:

 Private costs are related to the working of the firm and are used in the cost-benefit
analysis of business decisions.
 Social costs are termed as external costs from the firm’s point of view and social costs
from the society’s point of view.
 Private costs are those which are actually incurred or provided for by an individual or
a firm on the purchase of goods and services from the market. For a firm, all the
actual costs, both explicit and implicit are private costs. Private costs are internalized
costs that are incorporated in the firm’s total cost of production.
 Social cost refers to the total cost borne by the society due to production of a
commodity. Social costs include both private cost and the external cost. Social cost
includes a) the cost of resources for which the firm is not required to pay a price, i.e.,
atmosphere, rivers, lakes etc, and also for the use of public utility services like
roadways etc.

Theory of Cost-The Cost-Output Relations:

The theory of cost deals with the behaviour of cost in relation to a change in output
i.e., the cost theory deals with cost-output relations. The basic principle of the cost
behaviour is that the total cost increases with increase in output. The general form of
the cost function is written as
TC = f(Q)

Short-Run Cost-Output Relations

The basic analytical cost concepts used in the analysis of cost behaviour are
total, average and marginal costs.

Total Cost
The total cost (TC) is defined as the actual cost that must be incurred to produce a
given quantity of output. The short-run TC is composed of major two elements:
i. Total fixed cost (TFC)
ii. Total Variable cost (TVC)
TC = TFC + TVC

TFC (i.e., the cost of plant, building, etc) remains fixed in the short-run,
whereas, TVC varies with the variation in the output.
For a given quantity of output (Q), the average cost, (AC), average fixed cost
(AFC) and average variable cost (AVC) can be defined as follows:
AC = =
= + = AFC + AVC
 Thus,
AFC = and AVC =

and
AC = AFC + AVC
Marginal cost (MC) is defined as the change in the total cost divided by the
change in the total output, i.e.,
MC =
In fact,
MC is the first derivative of cost function ie.,

It may be added here that since = and in the short-run

therefore, . Furthermore, under the marginality concept, where
MC = .

Short-Run Cost Functions and Cost Curves:

The cost out-put relations are determined by the cost function and are exhibited
through cost curves. The shape of the cost curves depends on the nature of the cost
function. Cost functions are derived from actual cost curves depends on the nature
of the cost function. Cost functions are derived from actual cost data of the firms.
Given the cost data, cost function may take variety of forms, eg., linear quadratic or
cubic, yielding different kinds of cost curves.
1. Linear Cost Function:
A linear cost function takes the following form.
TC = q + bQ -1

Where TC = total cost, Q = quantity produced, a = TFC and b = change in TVC due to
change in Q.

Given the cost function in equation 1, AC and MC can be obtained as follows:

AC = = = + b and MC =

Since, ‘b’ is a constant, MC remains constant throughout in case of a linear cost

function.

Eg. to illustrate a linear cost function, let us suppose that an actual cost is given as
TC = 60 + 10Q - Eq. 2

Given, the above cost function, one can easily work out TC, TFC, TVC, MC and
AC for different levels of output.

Tabular Cost Function

Q TFC = 60 TVC = 10Q TC = 60 + 1Q MC = b=10 AC = 60/Q+10
1 60 10 70 - 70.0
2 60 20 80 10 40.0
3 60 30 90 10 30.0
4 60 40 100 10 25.0
5 60 50 110 10 22.0
6 60 60 120 10 20.0
7 60 70 130 10 18.6
8 60 80 140 10 17.5
9 60 90 150 10 16.6
10 60 100 160 10 16.0
If the above table is graphed then the curves will be of the following shapes.

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 CHAPTER 6

MARKET STRUCTURE AND PRICING

Depending on the number of sellers and degree of competition, the market structure is
broadly classified as follows:

Types of Market Structures

No. of firms and
Nature of Industry Control over Method of
Market Structure degree of product
where prevalent price Marketing
differentiation
Large number of firms
1. Perfect Financial markets and Market exchange
with homogenous None
Competition some farm products or auction
products
2. Imperfect
competition
Manufacturing tea,
Many firms with real or Competitive
a) Monopolistic toothpastes, TV sets,
perceived product Some Advertising,
competition shoes refrigerators,
differentiation Quality Rivalry
etc.
Competitive
Little or no. of product Aluminium, steel cars,
b) Oligopoly Some advertising
differentiation passenger cars etc.
quality rivalry
Public utilities, Promotional
A single products Considerable but
c) Monopoly telephones, electricity advertising if
without close substitute usually regulated
etc. supply is large

The market structure determines a firm’s power to fix the price of its product a great
deal. The degree of competition determines a firm’s degree of freedom in determining the
price of its product. The higher the degree of competitions the lower the firm’s degree of
freedom in pricing decision and control over the price of its own product and vice-versa.
Perfect Competition:
In this type of market structure a large number of firms compete against each other
for selling their product. Therefore the degree of competition under this is close to one i.e.,
market is highly competitive firm’s discretion in determining the price of its product is close
to none. In fact, the price is determined by market forces i.e, demand and supply.
Monopolistic competition:
Degree of competition is high but less than one, i.e., the firm’s have some discretion
in setting the price of their products. The degree of freedom in monopolistic competition
depends largely on the number of firms and the level of product differentiation.

Oligopoly:
The control over the pricing discretion increases under oligopoly where degree of
competition is quite low, lower than that under monopolistic competition.
Monopoly:
The degree of competition is close to nil. Monopoly firm has full control over the
price of its product. It is free to fix any price for its product, of course under certain
constraints, viz. i) the objective of the firm and ii). Demand conditions.

Price Determination Under Perfect Competition

Characteristics:
1) A large number of sellers and buyers,
2) Homogeneous product
3) Perfect mobility of factors of production
4) Free entry and free exit of firms
5) Perfect knowledge
6) Absence of collusion or artificial restraint
7) No government intervention.

Perfect Competition vs. Pure Competition

Perfect competition, is an uncommon phenomenon. The actual markets that
approximate to the conditions of perfectly competitive model include share markets,
securities and bond markets, etc.

Sometimes a distinction is made between perfect competition and pure

competition.
Price and Output:
Market price in a perfectly competitive market is determined by the market forces
– market demand and supply. Market demand refers to the demand for the industry as a
whole; it is the sum of the quantity demanded by each individual consumer or uses at
different prices. Similarly market and supply is the sum of quantity supplied by the
individual firms in the industry. The market price is therefore determined for the industry
and is given for each individual firm and for each buyer. Thus, a seller in a perfectly
competitive market is a “price-taker” not a price-maker.

In a perfectly competitive market, therefore, the main problem for a profit

maximising firm is not to determine the price of its product but to adjust its output to
the market-price, so that profit is maximum.
Price determination under perfect competition is analysed under three conditions:
1) Market period or very short run
2) Short run and
3) Long-run

Price Determination in Market Period

In the market period the total output of a product is fixed. Each firm has a stock
of commodity to be sold. The stock of goods with all the firms makes the total supply.
Since the stock is fixed, the supply curve is perfectly inelastic. In this situation price is
determined solely by the demand condition. Supply remains an inactive factor.
 Similarly, given the demand for a product, if its supply decreases suddenly for
such reasons as droughts, floods etc price of the products will shoot up as shows in
the figure.
Price – Determination In the Short-Run:
A short-run is, by definition a period in which firms can, neither change their
scale of production pr quit, not can new firms enter the industry. While in the market
period supply is absolutely fixed; in the short-run, it is possible to increase (or
decrease) the supply by increasing (or decreasing) the variable inputs.
The determination of market price in the short-run is explained in the
diagram (a) and adjustment of output by firms to the market price and firm’s
equilibrium are shows in figure (b).

Given the price P1Q in figure (a) firms are required to adjust their output to
the price PQ so that they maximise their profit.
The process of firm’s output determination is shown in figure (b). since price
is fixed at PQ, firm’s AR = PQ. If AR is constant, MR = AR. The firm’s MR is shown by
AR = MR line. Firms upward sloping MC curve intersect AR = MR at E. at point E, MR
= MC. Point E is therefore firm’s equilibrium. Therefore the profit – maximising
output is OM.

The total maximum Profit has been shown by the area P1TNE.
Profit = (AR – AC).Q
AR = EM
AC = NM
Q = OM

Substituting these values we get

Profit = (EM – NM).OM
= EN x OM
= P1TNE.
P1TNE is maximum supernormal profit or economic profit given the price and cost
curves, in short run.

Firms may make losses in the short-run.

While firms may make supernormal profit, there may be conditions under
which firms make losses in the short-run this may happen if market price decreases
to P’Q’ due to downward shift in the demand curve from DD to D’D’ (a). This will
force a process of output adjustments till firms reach a new equilibrium at point E’.
Here again firm’s AR’ = MR’ = MC.

But in Figure (b) AR <AC. Therefore firms incur loss. But the firms will survive
in the short-run so long as they cover their MC.

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