Name: Ms.Vennila Gopal
Class : I BBM
Objectives of business firms - Profit Maximisation - Social responsibilities - Demand
analysis - Law of Demand - Elasticity of demand.
Objectives of business firms:
1. The assumptions of the neo-classical (or profit-maximising) model of the firm and the limitations of
2. The differences between the profit-maximising model and the managerial models of the firm
3. The differences between the profit-maximising model and the behavioural model of the firm
The Growth of Firms
• Generated through increasing sales
• To increase sales firms need to:
– Market effectively
– Invest in new equipment and capital
– Invest in labour
• Through amalgamation, merger
or takeover (acquisitions)
• Mergers – agreed amalgamation between two firms
• Takeover – One firm seeking control over another
– Could be ‘friendly’ or ‘hostile’
• Cost Savings
– External growth may be cheaper than internal growth – acquiring an underperforming
or young firm may represent a cost effective method of growth
• Managerial Rewards
– External growth may satisfy managerial objectives – power, influence, status
• Shareholder Value
– Improve the value of the overall business for shareholders
• Asset Stripping
– Selling off valuable parts of the business
• Economies of Scale
– The advantages of large scale production that lead to lower unit costs
– Improve technical, productive or allocative efficiency
– The whole is more efficient than the sum of the parts (2 + 2 = 5!)
• Control of Markets
– Gain some form of monopoly power
– Control supply
– Secure outlets
• Risk Bearing
– Diversification to spread risks
The profit-maxing assumption can be interpreted in two ways:
1. Maximisation of profit in the short-run
i.e. the firm has a given set of plant and equipment and makes as much profit as it can with that
2. Long-run profit maximisation
i.e. maximise the wealth of the shareholders
In most situations these are consistent with each other. Shareholder wealth is maximised by selecting
the most profitable set of plant and equipment and then operating it in the most profitable way. BUT
THERE MAY BE EXCEPTIONS - making maximum short term profit might trigger entry or government
• Profit maximisation – assumed to be the standard motive of firms in the private sector
• Profit maximisation occurs where Marginal Cost = Marginal Revenue
• MC = MR
• The firm will continue to increase output up to the point where the cost of producing one extra
unit of output = the revenue received from selling that last unit of output
• This assumes that firms seek to operate at maximum efficiency
• Total Revenue
• Average Revenue
• Marginal Revenue
• In this model the policies to achieve revenue maximisation may be different to those adopted to
Other Objectives of Firms
• Sales maximisation:
– Attempts to maximise the volume of sales rather than the revenue gained from them
• Share Price Maximisation:
– Pursuing policies aimed at increasing the share price
• Profit Satisficing:
– Generating sufficient profits to satisfy shareholders but maximising the rewards to the
managers/board and avoiding attention from rivals or regulatory authorities
Market Demand Curve
• Shows the amount of a good that will be purchased at alternative prices.
• Law of Demand
n The demand curve is downward sloping.
Law of Demand
In economics, the law of demand is an economic law that states that consumers buy more of a
good when its price decreases and less when its price increases (ceteris paribus).The greater the
amount to be sold, the smaller the price at which it is offered must be in order for it to find
Law of demand states that the amount demanded of a commodity and its price are inversely
related, other things remaining constant. That is, if the income of the consumer, prices of the
related goods, and tastes and preferences of the consumer remain unchanged, the consumer’s
demand for the good will move opposite to the movement in the price of the good.
"If the price of the good increases, the quantity demanded decreases, while if price of the
good decreases, its quantity demanded increases."
Every law will have limitation or exceptions. While expressing the law of demand, the
assumptions that other conditions of demand were unchanged. If remain constant, the inverse
relation may not hold well. In other words, it is assumed that the income and tastes of consumers
and the prices of other commodities are constant. This law operates when the commodity’s price
changes and all other prices and conditions do not change. The main assumptions are
Habits, tastes and fashions remain constant
Money, income of the consumer does not change.
Prices of other goods remain constant
The commodity in question has no substitute
The commodity is a normal good and has no prestige or status value.
People do not expect changes in the prices.
Price elasticity of demand
Price elasticity of demand (PED or Ed) is a measure used in economics to show the
responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its
price. More precisely, it gives the percentage change in quantity demanded in response to a one
percent change in price (holding constant all the other determinants of demand, such as income).
It was devised by Alfred Marshall.
Price elasticities are almost always negative, although analysts tend to ignore the sign
even though this can lead to ambiguity. Only goods which do not conform to the law of demand,
such as Veblen and Giffen goods, have a positive PED. In general, the demand for a good is said
to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is,
changes in price have a relatively small effect on the quantity of the good demanded. The
demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one (in
absolute value): that is, changes in price have a relatively large effect on the quantity of a good
Revenue is maximised when price is set so that the PED is exactly one. The PED of a
good can also be used to predict the incidence (or "burden") of a tax on that good. Various
research methods are used to determine price elasticity, including test markets, analysis of
historical sales data and conjoint analysis.
PED is a measure of the sensitivity (or responsiveness) of the quantity of a good or service
demanded to changes in its price. The formula for the coefficient of price elasticity of demand
for a good is:
This measure of elasticity is sometimes referred to as the own-price elasticity of demand
for a good, i.e., the elasticity of demand with respect to the good's own price, in order to
distinguish it from the elasticity of demand for that good with respect to the change in the price
of some other good, i.e., a complementary or substitute good. The latter type of elasticity
measure is called a cross-price elasticity of demand.
As the difference between the two prices or quantities increases, the accuracy of the PED given
by the formula above decreases for a combination of two reasons. First, the PED for a good is
not necessarily constant; as explained below, PED can vary at different points along the demand
curve, due to its percentage nature. Elasticity is not the same thing as the slope of the demand
curve, which is dependent on the units used for both price and quantity. Second, percentage
changes are not symmetric; instead, the percentage change between any two values depends on
which one is chosen as the starting value and which as the ending value. For example, if quantity
demanded increases from 10 units to 15 units, the percentage change is 50%, i.e., (15 − 10) ÷ 10
(converted to a percentage). But if quantity demanded decreases from 15 units to 10 units, the
percentage change is −33.3%, i.e., (15 − 10) ÷ 15.
Two alternative elasticity measures avoid or minimise these shortcomings of the basic elasticity
formula: point-price elasticity and arc elasticity.
One way to avoid the accuracy problem described above is to minimise the difference between
the starting and ending prices and quantities. This is the approach taken in the definition of point-
price elasticity, which uses differential calculus to calculate the elasticity for an infinitesimal
change in price and quantity at any given point on the demand curve: 
In other words, it is equal to the absolute value of the first derivative of quantity with respect to
price (dQd/dP) multiplied by the point's price (P) divided by its quantity (Qd).
In terms of partial-differential calculus, point-price elasticity of demand can be defined as
follows: let be the demand of goods as a function of parameters price and wealth, and let be
the demand for good . The elasticity of demand for good with respect to price pk is
However, the point-price elasticity can be computed only if the formula for the demand function,
Qd = f(P), is known so its derivative with respect to price, dQd / dP, can be determined.
A second solution to the asymmetry problem of having a PED dependent on which of the two
given points on a demand curve is chosen as the "original" point and which as the "new" one is
to compute the percentage change in P and Q relative to the average of the two prices and the
average of the two quantities, rather than just the change relative to one point or the other.
Loosely speaking, this gives an "average" elasticity for the section of the actual demand curve—
i.e., the arc of the curve—between the two points. As a result, this measure is known as the arc
elasticity, in this case with respect to the price of the good. The arc elasticity is defined
This method for computing the price elasticity is also known as the "midpoints formula",
because the average price and average quantity are the coordinates of the midpoint of the straight
line between the two given points. However, because this formula implicitly assumes the
section of the demand curve between those points is linear, the greater the curvature of the actual
demand curve is over that range, the worse this approximation of its elasticity will be.
Production function - Factors of production - Laws of diminishing returns and Law of
variable proportions - Economics of Scale – Cost and Revenue Curves - Break - even- point
In microeconomics and macroeconomics, a production function is a function that
specifies the output of a firm, an industry, or an entire economy for all combinations of inputs.
This function is an assumed technological relationship, based on the current state of engineering
knowledge; it does not represent the result of economic choices, but rather is an externally given
entity that influences economic decision-making. Almost all economic theories presuppose a
production function, either on the firm level or the aggregate level. In this sense, the production
function is one of the key concepts of mainstream neoclassical theories. Some non-mainstream
economists, however, reject the very concept of an aggregate production function.
Concept of production functions
In micro-economics, a production function is a function that specifies the output of a
firm for all combinations of inputs. A meta-production function (sometimes metaproduction
function) compares the practice of the existing entities converting inputs into output to determine
the most efficient practice production function of the existing entities, whether the most efficient
feasible practice production or the most efficient actual practice production. In either case, the
maximum output of a technologically-determined production process is a mathematical function
of one or more inputs. Put another way, given the set of all technically feasible combinations of
output and inputs, only the combinations encompassing a maximum output for a specified set of
inputs would constitute the production function. Alternatively, a production function can be
defined as the specification of the minimum input requirements needed to produce designated
quantities of output, given available technology. It is usually presumed that unique production
functions can be constructed for every production technology.
By assuming that the maximum output technologically possible from a given set of inputs
is achieved, economists using a production function in analysis are abstracting from the
engineering and managerial problems inherently associated with a particular production process.
The engineering and managerial problems of technical efficiency are assumed to be solved, so
that analysis can focus on the problems of allocative efficiency. The firm is assumed to be
making allocative choices concerning how much of each input factor to use and how much
output to produce, given the cost (purchase price) of each factor, the selling price of the output,
and the technological determinants represented by the production function. A decision frame in
which one or more inputs are held constant may be used; for example, capital may be assumed to
be fixed (constant) in the short run, and labour and possibly other inputs such as raw materials
variable, while in the long run, the quantities of both capital and the other factors that may be
chosen by the firm are variable. In the long run, the firm may even have a choice of technologies,
represented by various possible production functions.
The relationship of output to inputs is non-monetary; that is, a production function relates
physical inputs to physical outputs, and prices and costs are reflected in the function. But the
production function is not a full model of the production process: it deliberately abstracts from
inherent aspects of physical production processes that some would argue are essential, including
error, entropy or waste. Moreover, production functions do not ordinarily model the business
processes, either, ignoring the role of management. (For a primer on the fundamental elements of
microeconomic production theory, see production theory basics).
The primary purpose of the production function is to address allocative efficiency in the
use of factor inputs in production and the resulting distribution of income to those factors. Under
certain assumptions, the production function can be used to derive a marginal product for each
factor, which implies an ideal division of the income generated from output into an income due
to each input factor of production.
Production function as an equation
There are several ways of specifying the production function.
In a general mathematical form, a production function can be expressed as:
Q = f(X1,X2,X3,...,Xn)
Q = quantity of output
X1,X2,X3,...,Xn = quantities of factor inputs (such as capital, labour, land or raw
materials). This general form does not encompass joint production; that is a production
process that has multiple co-products or outputs.
One way of specifying a production function is simply as a table of discrete outputs and input
combinations, and not as a formula or equation at all. Using an equation usually implies
continual variation of output with minute variation in inputs, which is not realistic in all cases.
Fixed ratios of factors, as in the case of laborers and their tools, might imply that only discrete
input combinations, and therefore, discrete maximum outputs, are of practical interest.
One formulation is as a linear function:
Q = a + bX1 + cX2 + dX3 + ...
where a,b,c, and d are parameters that are determined empirically.
Another is as a Cobb-Douglas production function:
The Leontief production function applies to situations in which inputs must be used in fixed
proportions; starting from those proportions, if usage of one input is increased without another
being increased, output will not change. This production function is given by
Other forms include the constant elasticity of substitution production function (CES), which is a
generalized form of the Cobb-Douglas function, and the quadratic production function. The best
form of the equation to use and the values of the parameters (a,b,c,...) vary from company to
company and industry to industry. In a short run production function at least one of the X's
(inputs) is fixed. In the long run all factor inputs are variable at the discretion of management
Stages of production
To simplify the interpretation of a production function, it is common to divide its range into 3
stages. In Stage 1 (from the origin to point B) the variable input is being used with increasing
output per unit, the latter reaching a maximum at point B (since the average physical product is
at its maximum at that point). Because the output per unit of the variable input is improving
throughout stage 1, a price-taking firm will always operate beyond this stage.
In Stage 2, output increases at a decreasing rate, and the average and marginal physical product
are declining. However the average product of fixed inputs (not shown) is still rising, because
output is rising while fixed input usage is constant. In this stage, the employment of additional
variable inputs increases the output per unit of fixed input but decreases the output per unit of the
variable input. The optimum input/output combination for the price-taking firm will be in stage
2, although a firm facing a downward-sloped demand curve might find it most profitable to
operate in Stage 1.
In Stage 3, too much variable input is being used relative to the available fixed inputs: variable
inputs are over-utilized in the sense that their presence on the margin obstructs the production
process rather than enhancing it. The output per unit of both the fixed and the variable input
declines throughout this stage. At the boundary between stage 2 and stage 3, the highest possible
output is being obtained from the fixed input.
Laws of diminishing returns and Law of variable proportions
Diminishing returns (also called diminishing marginal returns) refers to how the marginal
production of a factor of production starts to progressively decrease as the factor is increased, in
contrast to the increase that would otherwise be normally expected. According to this
relationship, in a production system with fixed and variable inputs (say factory size and labor),
each additional unit of the variable input (i.e., man-hours) yields smaller and smaller increases in
outputs, also reducing each worker's mean productivity. Conversely, producing one more unit of
output will cost increasingly more (owing to the major amount of variable inputs being used, to
This concept is also known as the law of diminishing marginal returns or the law of
increasing relative cost.
Statement of the law
The law of diminishing returns has been described as one of the most famous laws in all of
economics.[ In fact, the law is central to production theory, one of the two major divisions of
neoclassical microeconomic theory. The law states "that we will get less and less extra output
when we add additional doses of an input while holding other inputs fixed. In other words, the
marginal product of each unit of input will decline as the amount of that input increases holding
all other inputs constant." Explaining exactly why this law holds true has sometimes proven
Diminishing returns and diminishing marginal returns are not the same thing. Diminishing
marginal returns means that the MPL curve is falling. The output may be either negative or
positive. Diminishing returns means that the extra labor causes output to fall which means that
the MPL is negative. In other words the change in output per unit increase in labor is negative
and total output is falling
Returns and costs
There is an inverse relationship between returns of inputs and the cost of production. Suppose
that a kilogram of seed costs one dollar, and this price does not change; although there are other
costs, assume they do not vary with the amount of output and are therefore fixed costs. One
kilogram of seeds yields one ton of crop, so the first ton of the crop costs one extra dollar to
produce. That is, for the first ton of output, the marginal cost (MC) of the output is $1 per ton. If
there are no other changes, then if the second kilogram of seeds applied to land produces only
half the output of the first, the MC equals $1 per half ton of output, or $2 per ton. Similarly, if
the third kilogram produces only ¼ ton, then the MC equals $1 per quarter ton, or $4 per ton.
Thus, diminishing marginal returns imply increasing marginal costs. This also implies rising
average costs. In this numerical example, average cost rises from $1 for 1 ton to $2 for 1.5 tons
to $3 for 1.75 tons, or approximately from 1 to 1.3 to 1.7 dollars per ton.
In this example, the marginal cost equals the extra amount of money spent on seed divided by the
extra amount of crop produced, while average cost is the total amount of money spent on seeds
divided by the total amount of crop produced.
Cost can also be measured in terms of opportunity cost. In this case the law also applies to
societies; the opportunity cost of producing a single unit of a good generally increases as a
society attempts to produce more of that good. This explains the bowed-out shape of the
production possibilities frontier.
Returns to scale
The marginal returns discussed refer to cases when only one of many inputs is increased (for
example, the quantity of seed increases, but the amount of land remains constant). If all inputs
are increased in proportion, the result is generally constant or increased output.
As a firm in the long-run increases the quantities of all factors employed, all other things being
equal, initially the rate of increase in output may be more rapid than the rate of increase in inputs,
later output might increase in the same proportion as input, then ultimately, output will increase
less proportionately than input.
Economies of scale
Economies of scale, in microeconomics, refers to the cost advantages that a business obtains due
to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of
output is increased. "Economies of scale" is a long run concept and refers to reductions in unit
cost as the size of a facility and the usage levels of other inputs increase. Diseconomies of scale
are the opposite.
The common sources of economies of scale are purchasing (bulk buying of materials
through long-term contracts), managerial (increasing the specialization of managers), financial
(obtaining lower-interest charges when borrowing from banks and having access to a greater
range of financial instruments), marketing (spreading the cost of advertising over a greater range
of output in media markets), and technological (taking advantage of returns to scale in the
production function). Each of these factors reduces the long run average costs (LRAC) of
production by shifting the short-run average total cost (SRATC) curve down and to the right.
Economies of scale are also derived partially from learning by doing.
Economies of scale is a practical concept that is important for explaining real world phenomena
such as patterns of international trade, the number of firms in a market, and how firms get "too
big to fail". The exploitation of economies of scale helps explain why companies grow large in
some industries. It is also a justification for free trade policies, since some economies of scale
may require a larger market than is possible within a particular country — for example, it would
not be efficient for Liechtenstein to have its own car maker, if they would only sell to their local
market. A lone car maker may be profitable, however, if they export cars to global markets in
addition to selling to the local market. Economies of scale also play a role in a "natural
Economies of scale and returns to scale
Economies of scale is related to and can easily be confused with the theoretical economic
notion of returns to scale. Where economies of scale refer to a firm's costs, returns to scale
describe the relationship between inputs and outputs in a long-run (all inputs variable)
production function. A production function has constant returns to scale if increasing all inputs
by some proportion results in output increasing by that same proportion. Returns are decreasing
if, say, doubling inputs results in less than double the output, and increasing if more than double
If a mathematical function is used to represent the production function, and if that
production function is homogeneous, returns to scale are represented by the degree of
homogeneity of the function. Homegeneous production functions with constant returns to scale
are first degree homogeneous, increasing returns to scale are represented by degrees of
homogeneity greater than one, and decreasing returns to scale by degrees of homogeneity less
If the firm is a perfect competitor in all input markets, and thus the per-unit prices of all
its inputs are unaffected by how much of the inputs the firm purchases, then it can be
shown that at a particular level of output, the firm has economies of scale if and only if it
has increasing returns to scale, has diseconomies of scale if and only if it has decreasing returns
to scale, and has neither economies nor diseconomies of scale if it has constant returns to scale.
In this case, with perfect competition in the output market the long-run equilibrium will involve
all firms operating at the minimum point of their long-run average cost curves (i.e., at the
borderline between economies and diseconomies of scale).
If, however, the firm is not a perfect competitor in the input markets, then the above
conclusions are modified. For example, if there are increasing returns to scale in some range of
output levels, but the firm is so big in one or more input markets that increasing its purchases of
an input drives up the input's per-unit cost, then the firm could have diseconomies of scale in that
range of output levels. Conversely, if the firm is able to get bulk discounts of an input, then it
could have economies of scale in some range of output levels even if it has decreasing returns in
production in that output range.
Cost and Revenue Curves
A cost curve is a graph of the costs of production as a function of total quantity produced. In a
free market economy, productively efficient firms use these curves to find the optimal point of
production, where they make the most profits. There are various types of cost curves, all related to each
other. The two basic categories of cost curves are total and per unit or average cost curves.
Short-run average variable cost curve (SRAVC)
Average variable cost (which is a short-run concept) is the variable cost (typically labor cost) per
unit of output: SRAVC = wL / Q where w is the wage rate, L is the quantity of labor used, and Q
is the quantity of output produced. The SRAVC curve plots the short-run average variable cost
against the level of output, and is typically U-shaped.
Short-run average total cost curve (SRATC or SRAC)
The average total cost curve is constructed to capture the relation between cost per unit of output
and the level of output, ceteris paribus. A perfectly competitive and productively efficient firm
organizes its factors of production in such a way that the average cost of production is at the
lowest point. In the short run, when at least one factor of production is fixed, this occurs at the
output level where it has enjoyed all possible average cost gains from increasing production.
This is at the minimum point in the diagram on the right.
Short-run total cost is given by
STC = PKK+PLL,
where PK is the unit price of using physical capital per unit time, PL is the unit price of labor per
unit time (the wage rate), K is the quantity of physical capital used, and L is the quantity of labor
used. From this we obtain short-run average cost, denoted either SATC or SAC, as STC / Q:
SRATC or SRAC = PKK/Q + PLL/Q = PK / APK + PL / APL,
where APK = Q/K is the average product of capital and APL = Q/L is the average product of
Short run average cost equals average fixed costs plus average variable costs. Average fixed cost
continuously falls as production increases in the short run, because K is fixed in the short run.
The shape of the average variable cost curve is directly determined by increasing and then
diminishing marginal returns to the variable input (conventionally labor).
Long-run average cost curve (LRAC)
The long-run average cost curve depicts the cost per unit of output in the long run—that
is, when all productive inputs' usage levels can be varied. All points on the line represent least-
cost factor combinations; points above the line are attainable but unwise, points below
unattainable given present factors of production. The behavioral assumption underlying the curve
is that the producer will select the combination of inputs that will produce a given output at the
lowest possible cost. Given that LRAC is an average quantity, one must not confuse it with the
long-run marginal cost curve, which is the cost of one more unit.:232 The LRAC curve is
created as an envelope of an infinite number of short-run average total cost curves, each based on
a particular fixed level of capital usage.:235 The typical LRAC curve is U-shaped, reflecting
increasing returns of scale where negatively-sloped, constant returns to scale where horizontal
and decreasing returns (due to increases in factor prices) where positively sloped.:234 Contrary
to Viner, the envelope is not created by the minimum point of each short-run average
cost curve. This mistake is recognized as Viner's Error.
In a long-run perfectly competitive environment, the equilibrium level of output
corresponds to the minimum efficient scale, marked as Q2 in the diagram. This is due to the
zero-profit requirement of a perfectly competitive equilibrium. This result, which implies
production is at a level corresponding to the lowest possible average cost,:259 does not imply
that production levels other than that at the minimum point are not efficient. All points along the
LRAC are productively efficient, by definition, but not all are equilibrium points in a long-run
perfectly competitive environment.
In some industries, the bottom of the LRAC curve is large in comparison to market size
(that is to say, for all intents and purposes, it is always declining and economies of scale exist
indefinitely). This means that the largest firm tends to have a cost advantage, and the industry
tends naturally to become a monopoly, and hence is called a natural monopoly. Natural
monopolies tend to exist in industries with high capital costs in relation to variable costs, such as
water supply and electricity supply.
Short-run marginal cost curve (SRMC)
A short-run marginal cost curve graphically represents the relation between marginal (i.e.,
incremental) cost incurred by a firm in the short-run production of a good or service and the
quantity of output produced. This curve is constructed to capture the relation between marginal
cost and the level of output, holding other variables, like technology and resource prices,
constant. The marginal cost curve is U-shaped. Marginal cost is relatively high at small
quantities of output; then as production increases, marginal cost declines, reaches a minimum
value, then rises. The marginal cost is shown in relation to marginal revenue, the incremental
amount of sales revenue that an additional unit of the product or service will bring to the firm.
This shape of the marginal cost curve is directly attributable to increasing, then decreasing
marginal returns (and the law of diminishing marginal returns. Marginal cost equals w/MPL.:191
For most production processes the marginal product of labor initially rises, reaches a maximum
value and then continuously falls as production increases. Thus marginal cost initially falls,
reaches a minimum value and then increases.:209 The marginal cost curve intersects both the
average variable cost curve and (short-run) average total cost curve at their minimum points.
When the marginal cost curve is above an average cost curve the average curve is rising. When
the marginal costs curve is below an average curve the average curve is falling. This relation
holds regardless of whether the marginal curve is rising or falling.
Long-run marginal cost curve (LRMC)
The long-run marginal cost curve shows for each unit of output the added total cost incurred in
the long run, that is, the conceptual period when all factors of production are variable so as
minimize long-run average total cost. Stated otherwise, LRMC is the minimum increase in total
cost associated with an increase of one unit of output when all inputs are variable.
The long-run marginal cost curve is shaped by economies and diseconomies of scale, a long-run
concept, rather than the law of diminishing marginal returns, which is a short-run concept. The
long-run marginal cost curve tends to be flatter than its short-run counterpart due to increased
input flexibility as to cost minimization. The long-run marginal cost curve intersects the long-run
average cost curve at the minimum point of the latter. When long-run marginal costs are below
long-run average costs, long-run average costs are falling (as to additional units of output). When
long-run marginal costs are above long run average costs, average costs are rising. Long-run
marginal cost equals short run marginal-cost at the least-long-run-average-cost level of
production. LRMC is the slope of the LR total-cost function.
Cost curves and production functions
Assuming that factor prices are constant, the production function determines all cost functions.
The variable cost curve is the inverted short-run production function or total product curve and
its behavior and properties are determined by the production function. Because the production
function determines the variable cost function it necessarily determines the shape and properties
of marginal cost curve and the average cost curves.
If the firm is a perfect competitor in all input markets, and thus the per-unit prices of all its inputs
are unaffected by how much of the inputs the firm purchases, then it can be shown that at a
particular level of output, the firm has economies of scale (i.e., is operating in a downward
sloping region of the long-run average cost curve) if and only if it has increasing returns to scale.
Likewise, it has diseconomies of scale (is operating in an upward sloping region of the long-run
average cost curve) if and only if it has decreasing returns to scale, and has neither economies
nor diseconomies of scale if it has constant returns to scale. In this case, with perfect competition
in the output market the long-run market equilibrium will involve all firms operating at the
minimum point of their long-run average cost curves (i.e., at the borderline between economies
and diseconomies of scale).
If, however, the firm is not a perfect competitor in the input markets, then the above conclusions
are modified. For example, if there are increasing returns to scale in some range of output levels,
but the firm is so big in one or more input markets that increasing its purchases of an input drives
up the input's per-unit cost, then the firm could have diseconomies of scale in that range of
output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have
economies of scale in some range of output levels even if it has decreasing returns in production
in that output range.
Examples of cost functions
Total Cost = Fixed Costs (FC) + Variable Costs (VC):
FC = 420
VC = 60Q + Q2
C = 420 + 60Q + Q2
Marginal Cost (MC) = ∂C/∂Q; MC equals the slope of the total cost function and of the
variable cost function:
MC = 60 +2Q
Average Total Cost (ATC) = Total Cost/Q:
ATC = (420 + 60Q + Q2)/Q
ATC = 420/Q + 60 + Q
Average Fixed Cost (AFC) = FC/Q:
AFC = 420/Q
Average Variable Cost = VC/Q:
AVC = (60Q + Q2)/Q
AVC = 60 + Q
ATC = AFC + AVC
AFC = ATC - AVC*
The vertical distance between the ATC curve and AVC curve represents AFC.
The MC curve is related to the shape of the ATC and AVC curves:
At a level of Q at which the MC curve is above the average total cost or average variable
cost curve, the latter curve is rising
If MC is below average total cost or average variable cost, then the latter curve is falling.
If MC equals average total cost, then average total cost is at its minimum value.:212
If MC equals average variable cost, then average variable cost is at its minimum value.
Both the SRAC and LRAC curves are typically expressed as U-shaped. : However, the
shapes of the curves are not due to the same factors. For the short run curve the initial downward
slope is largely due to declining average fixed costs. Increasing returns to the variable input at
low levels of production also play a role, while the upward slope is due to diminishing marginal
returns to the variable input .With the long run curve the shape by definition reflects economies
and diseconomies of scale. At low levels of production long run production functions generally
exhibit increasing returns to scale, which, for firms that are perfect competitors in input markets,
means that the long run average cost is falling; the upward slope of the long run average cost
function at higher levels of output is due to decreasing returns to scale at those output levels.
Break - even- point analysis.
Break-even analysis is a technique widely used by production management and management
accountants. It is based on categorising production costs between those which are "variable"
(costs that change when the production output changes) and those that are "fixed" (costs not
directly related to the volume of production).
Total variable and fixed costs are compared with sales revenue in order to determine the level of
sales volume, sales value or production at which the business makes neither a profit nor a
loss (the "break-even point").
The Break-Even Chart
In its simplest form, the break-even chart is a graphical representation of costs at various levels
of activity shown on the same chart as the variation of income (or sales, revenue) with the same
variation in activity. The point at which neither profit nor loss is made is known as the "break-
even point" and is represented on the chart below by the intersection of the two lines:
In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At
low levels of output, Costs are greater than Income. At the point of intersection, P, costs are
exactly equal to income, and hence neither profit nor loss is made.
Fixed costs are those business costs that are not directly related to the level of production or
output. In other words, even if the business has a zero output or high output, the level of fixed
costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of
investment in production capacity (e.g. adding a new factory unit) or through the growth in
overheads required to support a larger, more complex business.
Examples of fixed costs:
- Rent and rates
- Research and development
- Marketing costs (non- revenue related)
- Administration costs
Variable costs are those costs which vary directly with the level of output. They represent
payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs
such as commission.
A distinction is often made between "Direct" variable costs and "Indirect" variable costs.
Direct variable costs are those which can be directly attributable to the production of a particular
product or service and allocated to a particular cost centre. Raw materials and the wages those
working on the production line are good examples.
Indirect variable costs cannot be directly attributable to production but they do vary with output.
These include depreciation (where it is calculated related to output - e.g. machine hours),
maintenance and certain labour costs.
Whilst the distinction between fixed and variable costs is a convenient way of categorising
business costs, in reality there are some costs which are fixed in nature but which increase when
output reaches certain levels. These are largely related to the overall "scale" and/or complexity of
the business. For example, when a business has relatively low levels of output or sales, it may
not require costs associated with functions such as human resource management or a fully-
resourced finance department. However, as the scale of the business grows (e.g. output, number
people employed, number and complexity of transactions) then more resources are required. If
production rises suddenly then some short-term increase in warehousing and/or transport may be
required. In these circumstances, we say that part of the cost is variable and part fixed.
Market structure and prices - Pricing under perfect Competition - Pricing under
Monopoly - Price discrimination - Pricing under Monopolistic competition - Oligopoly.
Market structure and prices
Market structure (also known as the number of firms producing identical products.)
Monopolistic competition, also called competitive market, where there are a large
number of firms, each having a small proportion of the market share and slightly
Oligopoly, in which a market is dominated by a small number of firms that together
control the majority of the market share.
Duopoly, a special case of an oligopoly with two firms.
Oligopsony, a market, where many sellers can be present but meet only a few buyers.
Monopoly, where there is only one provider of a product or service.
Natural monopoly, a monopoly in which economies of scale cause efficiency to increase
continuously with the size of the firm. A firm is a natural monopoly if it is able to serve
the entire market demand at a lower cost than any combination of two or more smaller,
more specialized firms.
Monopsony, when there is only one buyer in a market.
Perfect competition is a theoretical market structure that features unlimited contestability
(or no barriers to entry), an unlimited number of producers and consumers, and a
perfectly elastic demand curve.
The imperfectly competitive structure is quite identical to the realistic market conditions where
some monopolistic competitors, monopolists, oligopolists, and duopolists exist and dominate the
market conditions. The elements of Market Structure include the number and size distribution of
firms, entry conditions, and the extent of differentiation.
These somewhat abstract concerns tend to determine some but not all details of a specific
concrete market system where buyers and sellers actually meet and commit to trade. Competition
is useful because it reveals actual customer demand and induces the seller (operator) to provide
service quality levels and price levels that buyers (customers) want, typically subject to the
seller’s financial need to cover its costs. In other words, competition can align the seller’s
interests with the buyer’s interests and can cause the seller to reveal his true costs and other
private information. In the absence of perfect competition, three basic approaches can be adopted
to deal with problems related to the control of market power and an asymmetry between the
government and the operator with respect to objectives and information: (a) subjecting the
operator to competitive pressures, (b) gathering information on the operator and the market, and
(c) applying incentive regulation.
Quick Reference to Basic Market Structures
Seller Entry Seller Buyer Entry Buyer
Barriers Number Barriers Number
Perfect Competition No Many No Many
No Many No Many
Oligopoly Yes Few No Many
Oligopsony No Many Yes Few
Monopoly Yes One No Many
Monopsony No Many Yes One
The correct sequence of the market structure from most to least competitive is perfect
competition, imperfect competition,oligopoly, and pure monopoly.
The main criteria by which one can distinguish between different market structures are: the
number and size of producers and consumers in the market, the type of goods and services being
traded, and the degree to which information can flow freely.
Perfect competition describes markets such that no participants are large enough to have the
market power to set the price of a homogeneous product. Because the conditions for perfect
competition are strict, there are few if any perfectly competitive markets. Still, buyers and sellers
in some auction-type markets, say for commodities or some financial assets, may approximate
the concept. Perfect competition serves as a benchmark against which to measure real-life and
imperfectly competitive markets.
Basic structural characteristics
Generally, a perfectly competitive market exists when every participant is a "price taker", and no
participant influences the price of the product it buys or sells. Specific characteristics may
Infinite buyers and sellers – Infinite consumers with the willingness and ability to buy
the product at a certain price, and infinite producers with the willingness and ability to
supply the product at a certain price.
Zero entry and exit barriers – It is relatively easy for a business to enter or exit in a
perfectly competitive market.
Perfect factor mobility - In the long run factors of production are perfectly mobile
allowing free long term adjustments to changing market conditions.
Perfect information - Prices and quality of products are assumed to be known to all
consumers and producers.
Zero transaction costs - Buyers and sellers incur no costs in making an exchange
Profit maximization - Firms aim to sell where marginal costs meet marginal revenue,
where they generate the most profit.
Homogeneous products – The characteristics of any given market good or service do
not vary across suppliers.
Constant returns to scale - Constant returns to scale ensure that there are sufficient
firms in the industry.
In the short term, perfectly-competitive markets are not productively efficient as output will not
occur where marginal cost is equal to average cost, but allocatively efficient, as output will
always occur where marginal cost is equal to marginal revenue, and therefore where marginal
cost equals average revenue. In the long term, such markets are both allocatively and
Under perfect competition, any profit-maximizing producer faces a market price equal to its
marginal cost. This implies that a factor's price equals the factor's marginal revenue product. This
allows for derivation of the supply curve on which the neoclassical approach is based. (This is
also the reason why "a monopoly does not have a supply curve.") The abandonment of price
taking creates considerable difficulties to the demonstration of existence of a general
equilibrium except under other, very specific conditions such as that of monopolistic
Pricing under Monopoly
THE MONOPOLISTS DEMAND CURVE- CONSTRAINTS ON MONOPOLY
Be careful of saying that "monopolies can charge any price they like" - this is wrong. It
is true that a firm with monopoly has price-setting power and will look to earn high
levels of profit. However the firm is constrained by the position of its demand curve.
Ultimately a monopoly cannot charge a price that the consumers in the market will
A pure monopolist is the sole supplier in an industry and, as a result, the monopolist
can take the market demand curve as its own demand curve. A monopolist therefore
faces a downward sloping AR curve with a MR curve with twice the gradient of AR.
The firm is a price maker and has some power over the setting of price or output. It
cannot, however, charge a price that the consumers in the market will not bear. In
this sense, the position and the elasticity of the demand curve acts as a constraint on
the pricing behaviour of the monopolist. Assuming that the firm aims to maximise
profits (where MR=MC) we establish a short run equilibrium as shown in the diagram
Assuming that the firm aims to maximise profits (where MR=MC) we establish a short
run equilibrium as shown in the diagram below.
The profit-maximising output can be sold at price P1 above the average cost AC at output Q1.
The firm is making abnormal "monopoly" profits (or economic profits) shown by the yellow
shaded area. The area beneath ATC1 shows the total cost of producing output Qm. Total costs
equals average total cost multiplied by the output.
A CHANGE IN DEMAND
A change in demand will cause a change in price, output and profits.
In the example below, there is an increase in the market demand for the monopoly supplier. The
demand curve shifts out from AR1 to AR2 causing a parallel outward shift in the monopolist's
marginal revenue curve (MR1 shifts to MR2). We assume that the firm continues to operate with
the same cost curves. At the new profit maximising equilibrium the firm increases production
and raises price.
Total monopoly profits have increased. The gain in profits compared to the original price and
output is shown by the light blue shaded area.
Not all monopolies are guaranteed profits - there can be occasions when the costs of
production are greater than the average revenue a monopolist can charge for their
products. This might occur for example when there is a sharp fall in market demand
(leading to an inward shift in the average revenue curve). In the diagram below notice
that ATC lies AR across the entire range of output. The monopolist will still choose an
output where MR=MC for this reduces their losses to the minimum amount.
How do monopolies continue to earn supernormal profits in the long run - revise
barriers to entry. See also the pages on price discrimination
Mobile Phone Operators and Supernormal Profits
In the first of its mobile market reviews, OFTEL, the telecommunications industry
regulators has found that mobile phone operators are making profits greater than
would be expected in a fully competitive market. Their research finds that mobile
phone charges have fallen by nearly a quarter since January 1999. And, the level of
consumer satisfaction with their mobile phone service continues to run high (at
But the OFTEL review finds that consumers do not have sufficient information on the
range of prices available from the mobile phone networks and they are being over-
charged for calls between mobile networks. OFTEL have stated that some sectors of
the industry may require more intensive regulation unless there are improvements in
pricing in the coming months.
Price discrimination or price differentiation exists when sales of identical goods or
services are transacted at different prices from the same provider. In a theoretical market with
perfect information, perfect substitutes, and no transaction costs or prohibition on secondary
exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of
monopolistic and oligopolistic markets, where market power can be exercised. Otherwise, the
moment the seller tries to sell the same good at different prices, the buyer at the lower price can
arbitrage by selling to the consumer buying at the higher price but with a tiny discount. However,
product heterogeneity, market frictions or high fixed costs (which make marginal-cost pricing
unsustainable in the long run) can allow for some degree of differential pricing to different
consumers, even in fully competitive retail or industrial markets. Price discrimination also occurs
when the same price is charged to customers which have different supply costs.
Price discrimination requires market segmentation and some means to discourage
discount customers from becoming resellers and, by extension, competitors. This usually entails
using one or more means of preventing any resale, keeping the different price groups separate,
making price comparisons difficult, or restricting pricing information. The boundary set up by
the marketer to keep segments separate are referred to as a rate fence.
Price discrimination is thus very common in services, where resale is not possible;an
example is student discounts at museums. Price discrimination in intellectual property is also
enforced by law and by technology. In the market for DVDs, DVD players are designed - by law
- with chips to prevent use of an inexpensive copy of the DVD (for example legally purchased in
India) from being used in a higher price market (like the US). The Digital Millennium Copyright
Act has provisions to outlaw circumventing of such devices to protect the enhanced monopoly
profits that copyright holders can obtain from price discrimination against higher price market
Price discrimination can also be seen where the requirement that goods be identical is
relaxed. For example, so-called "premium products" (including relatively simple products, such
as cappuccino compared to regular coffee) have a price differential that is not explained by the
cost of production. Some economists have argued that this is a form of price discrimination
exercised by providing a means for consumers to reveal their willingness to pay.
Types of price discrimination
First degree price discrimination
In first degree price discrimination, price varies by customer's willingness or ability to pay.
This arises from the fact that the value of goods is subjective. A customer with low price
elasticity is less deterred by a higher price than a customer with high price elasticity of demand.
As long as the price elasticity (in absolute value) for a customer is less than one, it is very
advantageous to increase the price: the seller gets more money for fewer goods. With an increase
of the price elasticity tends to rise above one. One can show that in the optimum the price, as it
varies by customer, is inversely proportional to one minus the reciprocal of the price elasticity of
that customer at that price. This assumes that the consumer passively reacts to the price set by the
seller, and that the seller knows the demand curve of the customer. In practice however there is a
bargaining situation, which is more complex: the customer may try to influence the price, such as
by pretending to like the product less than he or she really does or by threatening not to buy it.
Second degree price discrimination
In second degree price discrimination, price varies according to quantity sold. Larger
quantities are available at a lower unit price. This is particularly widespread in sales to industrial
customers, where bulk buyers enjoy higher discounts.
Additionally to second degree price discrimination, sellers are not able to differentiate
between different types of consumers. Thus, the suppliers will provide incentives for the
consumers to differentiate themselves according to preference. As above, quantity "discounts",
or non-linear pricing, is a means by which suppliers use consumer preference to distinguish
classes of consumers. This allows the supplier to set different prices to the different groups and
capture a larger portion of the total market surplus.
In reality, different pricing may apply to differences in product quality as well as quantity. For
example, airlines often offer multiple classes of seats on flights, such as first class and economy
class. This is a way to differentiate consumers based on preference, and therefore allows the
airline to capture more consumer's surplus.
Third degree price discrimination
In third degree price discrimination, price varies by attributes such as location or by customer
segment, or in the most extreme case, by the individual customer's identity; where the attribute in
question is used as a proxy for ability/willingness to pay.
Additionally to third degree price discrimination, the supplier(s) of a market where this
type of discrimination is exhibited are capable of differentiating between consumer classes.
Examples of this differentiation are student or senior discounts. For example, a student or a
senior consumer will have a different willingness to pay than an average consumer, where the
reservation price is presumably lower because of budget constraints. Thus, the supplier sets a
lower price for that consumer because the student or senior has a more elastic price elasticity of
demand (see the discussion of price elasticity of demand as it applies to revenues from the first
degree price discrimination, above). The supplier is once again capable of capturing more market
surplus than would be possible without price discrimination.
In price skimming, price varies over time. Typically a company starts selling a new product at a
relatively high price then gradually reduces the price as the low price elasticity segment gets
These types are not mutually exclusive. Thus a company may vary pricing by location, but then
offer bulk discounts as well. Airlines use several different types of price discrimination,
Bulk discounts to wholesalers, consolidators, and tour operators
Incentive discounts for higher sales volumes to travel agents and corporate buyers
Seasonal discounts, incentive discounts, and even general prices that vary by location. The price
of a flight from say, Singapore to Beijing can vary widely if one buys the ticket in Singapore
compared to Beijing (or New York or Tokyo or elsewhere). In online ticket sales this is achieved
by using the customer's credit card billing address to determine his location.
Discounted tickets requiring advance purchase and/or Saturday stays. Both restrictions have the
effect of excluding business travelers, who typically travel during the workweek and arrange
trips on shorter notice.
First degree price discrimination based on customer. It is not accidental that hotel or car rental
firms may quote higher prices to their loyalty program's top tier members than to the general
The first/second/third degree taxonomy of price discrimination is due to Pigou (Economics of
Welfare, 4th edition, 1932). See, e.g., modern taxonomy of price discrimination. However, these
categories are not mutually exclusive or exhaustive. Ivan Png (Managerial Economics, 2nd
edition, 2002) suggests an alternative taxonomy:
Complete discrimination -- where each user purchases up to the point where the user's
marginal benefit equals the marginal cost of the item;
Direct segmentation -- where the seller can condition price on some attribute (like age or
gender) that directly segments the buyers;
Indirect segmentation -- where the seller relies on some proxy (e.g., package size, usage
quantity, coupon) to structure a choice that indirectly segments the buyers.
The hierarchy—complete/direct/indirect—is in decreasing order of
Complete price discrimination is most profitable, and requires the seller to have the most
information about buyers. Indirect segmentation is least profitable, and requires the seller to have
the least information about buyers.
Pricing under Monopolistic competition
Monopolistic competition is a form of imperfect competition where many competing producers
sell products that are differentiated from one another (that is, the products are substitutes, but,
with differences such as branding, are not exactly alike). In monopolistic competition firms can
behave like monopolies in the short-run, including using market power to generate profit. In the
long-run, other firms enter the market and the benefits of differentiation decrease with
competition; the market becomes more like perfect competition where firms cannot gain
economic profit. Unlike perfect competition, the firm maintains spare capacity. Models of
monopolistic competition are often used to model industries. Textbook examples of industries
with market structures similar to monopolistic competition include restaurants, cereal, clothing,
shoes, and service industries in large cities. The "founding father" of the theory of monopolistic
competition was Edward Hastings Chamberlin in his pioneering book on the subject Theory of
Monopolistic Competition (1933). Joan Robinson also receives credit as an early pioneer on the
Monopolistically competitive markets have the following characteristics:
There are many producers and many consumers in a given market, and no business has
total control over the market price.
Consumers perceive that there are non-price differences among the competitors' products.
There are few barriers to entry and exit.
Producers have a degree of control over price.
There are six characteristics of monopolistic competition (MC):
free entry and exit in long run
Independent decision making
Buyers and Sellers have perfect information
MC firms sell products that have real or perceived non-price differences. However, the
differences are not so great as to eliminate goods as substitutes. Technically the cross price
elasticity of demand between goods would be positive.In fact the XED would be high. MC
goods are best described as close but imperfect substitutes. The goods perform the same basic
functions. The differences are in "qualities" and circumstances such as type, style, quality,
reputation, appearance, and location that tend to distinguish goods. For example, the function of
motor vehilces is basically the same - to get from point A to B in reasonable comfort and safety.
Yet there are many different types of motor vehicles, motor scooters, motor cycles, trucks, cars
Free entry and exit
In the long run there is free entry and exit. There are numerous firms awaiting to enter the market
each with its own "unique" product or in pursuit of positive profits and any firm unable to cover
its costs can leave the market without incurring liquidation costs. This assumption implies that
there are low start up costs, no sunk costs and no exit costs.
Independent decision making
Each MC firm independently sets the terms of exchange for its product. The firm gives no
consideration to what effect its decision may have on competitors. The theory is that any action
will have such a negligible effect on the overall market demand that an MC firm can act without
fear of prompting hightened competition. In other words each firm feels free to set prices as if it
were a monopoly rather than an oligopoly.
MC firms have some degree of market power. Market power means that the firm has control
over the terms and conditions of exchange. An MC firm can raise it prices without losing all its
customers. The firm can also lower prices without triggering a potentially ruinous price war with
competitors. The source of an MC firm's market power is not barriers to entry since there are
none. An MC firm derives it's market power from the fact that it has relatively few competitors,
competitors do not engage in strategic decision making and the firms sells differentiated
product. Market power also means that an MC firm faces a downward sloping demand curve.
The demand curve is highly elastic although not "flat".
Buyers know exactly what goods are being offered, where the goods are being sold, all
differentiating characteristics of the goods, the good's price, whether a firm is making a profit
and if so how much.
Market Structure comparison
Numbe Marke Elasticity Product Profit
Excess Efficienc Pricing
r of t of differentiatio maximizatio
profits y power
firms power demand n n condition
Perfect Perfectly Price
Infinite None None No Yes P=MR=MC
Competition elastic taker
Monopolisti Yes/No Price
c Many Low 
High (Short/Long No MR=MC 
competition )  ]
Relativel Absolute Price
Monopoly One High y (across Yes No MR=MC 
An oligopoly is a market form in which a market or industry is dominated by a small number of
sellers (oligopolists). The word is derived, by analogy with "monopoly", from the Greek ὀλίγοι
(oligoi) "few" + πωλειν (polein) "to sell". Because there are few sellers, each oligopolist is likely
to be aware of the actions of the others. The decisions of one firm influence, and are influenced
by, the decisions of other firms. Strategic planning by oligopolists needs to take into account the
likely responses of the other market participants.
Oligopoly is a common market form. As a quantitative description of oligopoly, the four-firm
concentration ratio is often utilized. This measure expresses the market share of the four largest
firms in an industry as a percentage. For example, as of fourth quarter 2008, Verizon, AT&T,
Sprint Nextel, and T-Mobile together control 89% of the US cellular phone market.
Oligopolistic competition can give rise to a wide range of different outcomes. In some situations,
the firms may employ restrictive trade practices (collusion, market sharing etc.) to raise prices
and restrict production in much the same way as a monopoly. Where there is a formal agreement
for such collusion, this is known as a cartel. A primary example of such a cartel is OPEC which
has a profound influence on the international price of oil.
Profit maximization conditions: An oligopoly maximizes profits by producing where marginal
revenue equals marginal costs.
Ability to set price: Oligopolies are price setters rather than price takers.
Entry and exit: Barriers to entry are high. The most important barriers are economies of scale,
patents, access to expensive and complex technology, and strategic actions by incumbent firms
designed to discourage or destroy nascent firms.
Number of firms: "Few" – a "handful" of sellers. There are so few firms that the actions of one
firm can influence the actions of the other firms.
Long run profits: Oligopolies can retain long run abnormal profits. High barriers of entry
prevent sideline firms from entering market to capture excess profits.
Product differentiation: Product may be standardized (steel) or differentiated (automobiles).
Perfect knowledge: Assumptions about perfect knowledge vary but the knowledge of various
economic actors can be generally described as selective. Oligopolies have perfect knowledge of
their own cost and demand functions but their inter-firm information may be incomplete. Buyers
have only imperfect knowledge as to price cost and product quality.
Interdependence: The distinctive feature of an oligopoly is interdependenceOligopolies are
typically composed of a few large firms. Each firm is so large that its actions affect market
There is no single model describing the operation of an oligopolistic market. The variety and
complexity of the models is due to the fact that you can have two to 102 firms competing on the
basis of price, quantity, technological innovations, marketing, advertising and reputation.
Fortunately, there are a series of simplified models that attempt to describe market behavior
under certain circumstances. Some of the better-known models are the dominant firm model, the
Cournot-Nash model, the Bertrand model and the kinked demand model
Dominant firm model
In some markets there is a single firm that controls a dominant share of the market and a group
of smaller firms. The dominant firm sets prices which are simply taken by the smaller firms in
determining their profit maximizing levels of production. This type of market is practically a
monopoly and an attached perfectly competitive market in which price is set by the dominant
firm rather than the market. The demand curve for the dominant firm is determined by
subtracting the supply curves of all the small firms from the industry demand curve.
Pricing under factors of production; wages - Marginal productivity theory - Interest -
Keyne's Liquidity preference theory – Theories of Profit - Dynamic theory of Profit - Risk
Theory - Uncertainty theory.
Pricing under factors of production
Factors of production (or productive inputs or resources) are any commodities or services
used to produce goods and services. 'Factors of production' may also refer specifically to the
primary factors, which are stocks including land, labor (the ability to work), and capital goods
applied to production. The primary factors facilitate production but neither become part of the
product (as with raw materials) nor become significantly transformed by the production process
(as with fuel used to power machinery).
'Land' includes not only the site of production but natural resources above or below the soil.
Recent usage has distinguished human capital (the stock of knowledge in the labor force from
formal education and job training as part of labor. and sometimes entrepreneurship.
Sometimes the overall state of technology is described as a factor of production. The number
and definition of factors varies, depending on theoretical purpose, empirical emphasis, or school
of economics. The primary factors facilitate production but neither become part of the product
(as with raw materials) nor become significantly transformed by the production process (as with
fuel used to power machinery).
Differences are most stark when it comes to deciding which factor is the most important. For
example, in the Austrian view—often shared by neoclassical and other "free market"
economists—the primary factor of production is the time of the entrepreneur, which, when
combined with other factors, determines the amount of output of a particular good or service.
However, other authors argue that "entrepreneurship" is nothing but a specific kind of labor or
human capital and should not be treated separately.
Marginal productivity theory
The marginal revenue productivity theory of wages, also referred to as the marginal revenue
product of labor and the value of the marginal product or VMP L, is the change in total revenue
earned by a firm that results from employing one more unit of labor. It is a neoclassical model
that determines, under some conditions, the optimal number of workers to employ at an
exogenously determined market wage rate.
The idea that payments to factors of production equilibrate to their marginal productivity had
been laid out early on by such as John Bates Clark and Knut Wicksell, who presented a far
simpler and more robust demonstration of the principle. Much of the present conception of that
theory stems from Wicksell's model.
The marginal revenue product (MRP) of a worker is equal to the product of the marginal product
of labor (MP) and the marginal revenue (MR), given by MR×MP = MRP. The theory states that
workers will be hired up to the point where the Marginal Revenue Product is equal to the wage
rate by a maximizing firm, because it is not efficient for a firm to pay its workers more than it
will earn in profits from their labor.
The marginal revenue product of labour MRPL is the increase in revenue per unit increase in the
variable input = ∆TR/∆L
MR = ∆TR/∆Q
MPL = ∆Q/∆L
MR x MPL = (∆TR/∆Q) x (∆Q/∆L) = ∆TR/∆L
Note that the change in output is not limited to that directly attributable to the additional worker.
Assuming that the firm is operating with diminishing marginal returns then the addition of an
extra worker reduces the average productivity of every other worker (and every other worker
affects the marginal productivity of the additional worker) - in English everybody is getting in
each other's way.
As above noted the firm will continue to add units of labor until the MRPL = w
MRPL = w
MR(MPL) = w
MR = w/MPL
MR = MC which is the profit maximizing rule.
Marginal Revenue Product in a perfectly competitive market
Under perfect competition, marginal revenue product is equal to marginal physical product (extra
unit produced as a result of a new employment) multiplied by price.
This is because the firm in perfect competition is a price taker. It does not have to lower the price
in order to sell additional units of the good.
MRP in monopoly or imperfect competition
Firms operating under conditions of monopoly or imperfect competition are faced with
downward sloping demand curves. If they want to sell extra units of output, they must lower
price. Under such market conditions, marginal revenue product will not equal MPP×Price. This
is because the firm is not able to sell output at a fixed price per unit.
The MRP curve of a firm in monopoly or imperfect competition will slope downwards at a faster
rate than in perfect competition. This can be explained as follows:
1. MPP slopes downwards because of the operation of the Law of Diminishing Returns.
MRP depends on MPP.
2. Because the firm faces a downward sloping demand curve for its product, it must lower
price to sell extra units of output.
Keyne's Liquidity preference theory
Liquidity preference in macroeconomic theory refers to the demand for money, considered as
liquidity. The concept was first developed by John Maynard Keynes in his book The General
Theory of Employment, Interest and Money (1936) to explain determination of the interest rate
by the supply and demand for money. The demand for money as an asset was theorized to
depend on the interest foregone by not holding bonds. Interest rates, he argues, cannot be a
reward for saving as such because, if a person hoards his savings in cash, keeping it under his
mattress say, he will receive no interest, although he has nevertheless, refrained from consuming
all his current income. Instead of a reward for saving, interest in the Keynesian analysis is a
reward for parting with liquidity.
According to Keynes, demand for liquidity is determined by three motives:
1. the transactions motive: people prefer to have liquidity to assure basic transactions, for
their income is not constantly available. The amount of liquidity demanded is determined
by the level of income: the higher the income, the more money demanded for carrying
out increased spending.
2. the precautionary motive: people prefer to have liquidity in the case of social unexpected
problems that need unusual costs. The amount of money demanded for this purpose
increases as income increases.
3. speculative motive: people retain liquidity to speculate that bond prices will fall. When
the interest rate decreases people demand more money to hold until the interest rate
increases, which would drive down the price of an existing bond to keep its yield in line
with the interest rate. Thus, the lower the interest rate, the more money demanded (and
The liquidity-preference relation can be represented graphically as a schedule of the money
demanded at each different interest rate. The supply of money together with the liquidity-
preference curve in theory interact to determine the interest rate at which the quantity of money
demanded equals the quantity of money supplied
Theories of Profit
Risk theory connotes the study usually by actuaries and insurers of the financial impact
on a carrier of a portfolio of insurance policies. For example, if the carrier has 100 policies that
insures against a total loss of $1000, and if each policy's chance of loss is independent and has a
probability of loss of p then the loss can be described by a binomial variable. With a large
enough portfolio however, we can use the Poisson function for the frequency of loss variable
where λ is used as the mean equal to the number of policies multiplied by p.
Risk theory is a theory of decision-making under probabilistic uncertainty. From
mathematical point of view it is a branch of probability theory, while its applications cover all
aspects of life. Financial applications are most advanced, including banking, insurance,
managing market and credit risks, investments and business risks. To name just a few, there are
also applications to managing risks of health hazard, environment pollution, engineering and
The Heisenberg uncertainty principle states by precise inequalities that certain pairs of
physical properties, such as position and momentum, cannot be simultaneously known to
arbitrarily high precision. That is, the more precisely one property is measured, the less precisely
the other can be measured. The principle states that a minimum exists for the product of the
uncertainties in these properties that is equal to or greater than one half of the reduced Planck
constant (ħ = h/2π).
Published by Werner Heisenberg in 1927, the principle means that it is impossible to determine
simultaneously both the position and momentum of an electron or any other particle with any
great degree of accuracy or certainty. Moreover, the principle is not a statement about the
limitations of a researcher's ability to measure particular quantities of a system, but it is a
statement about the nature of the system itself as described by the equations of quantum
In quantum physics, a particle is described by a wave packet, which gives rise to this
phenomenon. Consider the measurement of the position of a particle. It could be anywhere. The
particle's wave packet has non-zero amplitude, meaning the position is uncertain – it could be
almost anywhere along the wave packet. To obtain an accurate reading of position, this wave
packet must be 'compressed' as much as possible, meaning it must be made up of increasing
numbers of sine waves added together. The momentum of the particle is proportional to the
wavenumber of one of these waves, but it could be any of them. So a more precise position
measurement – by adding together more waves – means the momentum measurement becomes
less precise (and vice versa).
Government and Business - Performance of public enterprises in India - Price policy in
public utilities, Government measures to control Monopoly in India - MRTP Act.
Government and Business
Business-to-government (B2G) is a derivative of B2B marketing and often referred to as a
market definition of "public sector marketing" which encompasses marketing products and
services to various government levels - including federal, state and local - through integrated
marketing communications techniques such as strategic public relations, branding, marcom,
advertising, and web-based communications.
B2G networks provide a platform for businesses to bid on government opportunities which are
presented as solicitations in the form of RFPs in a reverse auction fashion. Public sector
organizations (PSO's) post tenders in the form of RFP's, RFI's, RFQ's, Sources Sought, etc. and
suppliers respond to them.
Government agencies typically have pre-negotiated standing contracts vetting the
vendors/suppliers and their products and services for set prices. These can be state, local or
federal contracts and some may be grandfathered in by other entities (ie. California's MAS
Multiple Award Schedule will recognize the federal government contract holder's prices on a
GSA General Services Administration Schedule).
There are multiple social platforms dedicated to this vertical market and they have risen in
popularity with the onset of the ARRA/Stimulus Program and increased government funds
available to commercial entities for both grants and contracts.
Price policy in public utilities
The Public Utility Regulatory Policy Act (PURPA) was passed in 1978, in the midst of the
energy crises that ripped through industrial world economies. Faced with predictions that the
price of oil would rise to $100 a barrel, Congress acted to reduce dependence on foreign oil, to
promote alternative energy sources and energy efficiency, and to diversify the electric power
One of the most important effects of the law was to create a market for power from non-utility
power producers, which now provide 7 percent of the country's power. Before PURPA, only
utilities could own and operate electric generating plants. PURPA required utilities to buy power
from independent companies that could produce power for less than what it would have cost for
the utility to generate the power, called the "avoided cost."
PURPA has been the most effective single measure in promoting renewable energy. Some credit
the law with bringing on line over 12,000 megawatts of non-hydro renewable generation
capacity. The biggest beneficiary of PURPA, though, has been natural gas-fired "cogeneration"
plants, where steam is produced along with electricity.
Much has changed since PURPA was implemented. The price of oil has declined and supplies of
natural gas have increased, driving down the cost of electricity. Many independent power
producers signed contracts in the 1980s with prices that are higher than current spot market
prices. Critics of PURPA say it is unfair to make utilities honor those contracts, and they blame
independents for high power prices. In fact, all of these contracts were based on the avoided cost
of electricity at the time; in other words, if utilities had built their own power plants, prices
would be even higher now.
Critics also complain that PURPA is not compatible with an increasingly competitive power
market. The Energy Policy Act of 1992 encouraged wholesale power competition, and recent
rules by the Federal Energy Regulatory Commission (FERC) opened up transmission lines to all
generators equally. But utilities are still able to generate wholesale power and compete unfairly
with independents. And there is no other law that requires utilities to use competitive bidding to
find the lowest power prices.
PURPA is the only existing federal law that requires competition in the utility industry and the
only law that encourages renewable. Both of these goals must be preserved. But despite its
benefits, PURPA is no longer much help for renewable. Due to current low avoided costs, few
renewables are able to compete with new natural gas turbines. Technically, PURPA only calls
for renewable energy if it is cost competitive with conventional polluting resources. Many of the
benefits of renewables are not included in the price, such as clean air, but PURPA makes no
provision for including these. By strictly interpreting the law, FERC has expressly forbidden
non-price factors in PURPA decisions. Moreover, as the guaranteed prices of PURPA contracts
signed in the 1980s expire, many renewable power generators are going out of business.
The bottom line is that as long as fossil fuel price forecasts are low, there will be very little
development of new renewable energy. What is needed is a new law that accounts for the full
range of benefits of renewable energy, like reduced pollution, less global warming, domestic and
local economic development, and reduced dependence on foreign energy sources. Such a law
must be part of electric industry restructuring legislation. The renewables portfolio standard can
move large amounts of clean energy into the mainstream; the system benefits fund can support
new and emerging energy sources; and closing loopholes in the Clean Air Act for old coal plants
will reduce the unfair advantage those gross polluters enjoy.
In short, PURPA can only be replaced with a better law, not with no law. Any legislation must
create an equal playing field for utilities and independent power producers, and must protect the
environmental benefits of renewable energy and cogenerates.
Government measures to control Monopoly in India
a government-granted monopoly (also called a "de jure monopoly") is a form of coercive
monopoly by which a government grants exclusive privilege to a private individual or firm to be
the sole provider of a good or service; potential competitors are excluded from the market by
law, regulation, or other mechanisms of government enforcement. As a form of coercive
monopoly, government-granted monopoly is contrasted with a non-coercive monopoly or an
efficiency monopoly, where there is no competition but it is not forcibly excluded. Amongst
forms of coercive monopoly it is distinguished from government monopoly or state monopoly
(in which government agencies hold the legally-enforced monopoly rather than private
individuals or firms) and from government-sponsored cartels (in which the government forces
several independent producers to partially coordinate their decisions through a centralized
organization). Advocates for government-granted monopolies often claim that they ensure a
degree of public control over essential industries, without having those industries actually run by
the state. Opponents often criticize them as political favors to corporations. Government-granted
monopolies may be opposed by those who would prefer free markets as well as by those who
would prefer to replace private corporations with public ownership.
Under mercantilist economic systems, European governments with colonial interests often
granted large and extremely lucrative monopolies to companies trading in particular regions,
such as the Dutch East India Company. Today, government-granted monopolies may be found in
public utility services such as public roads, mail, water supply, and electric power, as well as
certain specialized and highly-regulated fields such as education and gambling. In many
countries lucrative natural resources industries, especially the petroleum industry, are controlled
by government-granted monopolies. Franchises granted by governments to operate public
transit through public roads are another example.
The MRTP Act, 1969
Post independence, many new and big firms have entered the Indian market. They had little
competition and they were trying to monopolize the market. The Government of India
understood the intentions of such firms. In order to safeguard the rights of consumers,
Government of India passed the MRTP bill. The bill was passed and the Monopolies and
Restrictive Trade Practices Act, 1969, came into existence. Through this law, the MRTP
commission has the power to stop all businesses that create barrier for the scope of competition
in Indian economy.
The MRTP Act, 1969, aims at preventing economic power concentration in order to avoid
damage. The act also provides for probation of monopolistic, unfair and restrictive trade
practices. The law controls the monopolies and protects consumer interest.
Monopolistic Trade Practice –
Such practice indicates misuse of one’s power to abuse the market in terms of production and
sales of goods and services. Firms involved in monopolistic trade practice tries to eliminate
competition from the market. Then they take advantage of their monopoly and charge
unreasonably high prices. They also deteriorate the product quality, limit technical development,
prevent competition and adopt unfair trade practices.
Unfair Trade Practice –
The following may result in an unfair trade practice:
False representation and misleading advertisement of goods and services.
Falsely representing second-hand goods as new.
Misleading representation regarding usefulness, need, quality, standard, style etc of goods
False claims or representation regarding price of goods and services.
Giving false facts regarding sponsorship, affiliation etc. of goods and services.
Giving false guarantee or warranty on goods and services without adequate tests.
Restrictive Trade Practice –
The traders, in order to maximize their profits and to gain power in the market, often indulge in
activities that tend to block the flow of capital into production. Such traders also bring in
conditions of delivery to affect the flow of supplies leading to unjustified costs.
About the MRTP Act, 1969
The MRTP Act extends to the whole of India except the state of Jammu and Kashmir. This law
To ensure that the operation of the economic system does not result in the concentration
of economic power in hands of few,
To provide for the control of monopolies, and
To prohibit monopolistic and restrictive trade practices.
Unless the Central Government otherwise directs, this act shall not apply to:
1. Any undertaking owned or controlled by the Government Company,
2. Any undertaking owned or controlled by the Government,
3. Any undertaking owned or controlled by a corporation (not being a company) established
by or under any Central, Provincial or State Act,
4. Any trade union or other association of workmen or employees formed for their own
reasonable protection as such workmen or employees,
5. Any undertaking engaged in an industry, the management of which has been taken over
by any person or body of persons under powers by the Central Government,
6. Any undertaking owned by a co-operative society formed and registered under any
Central, Provincial or state Act,
7. Any financial institution.
MRTP Commission and Filing of Complaint –
For the purpose of this Act, the Central Government has established a commission to be known
as the Monopolies and Restrictive Trade Practices Commission. This commission shall consist of
a Chairman and minimum 2 and maximum 8 other members, all to be appointed by the Central
Government. Every member shall hold the office for a period specified by the Central
Government. This period shall not exceed 5 years. However, the member will be eligible for re-
In case of any unfair trade practice, monopolistic trade practice and/or restrictive trade practice, a
complaint can be filed against such practices to the MRTP commission. The procedure for filing
a complaint is as follows:
Complaint is filed either by the individual consumer or through a registered consumer
The Director General of the MRTP commission would carry on the investigation for
finding facts of the case.
If the prima facie case is not made, the complaint is dismissed. If the compliant is true, an
order is passed to its effect.
The commission restricts and restrains the concerned party from carrying on such
practices by granting temporary injunction.
Then the final order is passed. The complainant may be compensated for his loss.