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which it describes engineering economics and financial analysis ... , it briefly a management source
which it describes engineering economics and financial analysis ... , it briefly a management source
ENGINEERING ECONOMICS FINANCIAL ANALYSIS III/IV – Open Elective UNIT - II • Introduction to Markets & Pricing Strategies: Market Structures: Types of Competition, Features of Perfect Competition, Monopoly and Monopolistic Competition, Price – Output determination in case of Perfect Competition and Monopoly, Pricing Strategies WHAT IS A MARKET??? Market is a place where buyer and seller meet, goods and services are offered for the sale and transfer of ownership occurs. A market may be also defined as the demand made by a certain group of potential buyers for a good or service. Economists describe a market as a collection of buyers and sellers who transact over a particular product or product class (the housing market, the clothing market, the grain market etc.). WHAT IS A MARKET??? (CONTD…) For business purpose we define a market as people or organizations with wants (needs) to satisfy, money to spend, and the willingness to spend it. Broadly, market represents the structure and nature of buyers and sellers for a commodity/service and the process by which the price of the commodity or service is established. Here we are referring to the structure of competition and the process of price determination for a commodity or service WHAT IS A MARKET??? (CONTD…) The determination of price for a commodity or service depends upon the structure of the market for that commodity or service (i.e., competitive structure of the market). Hence the understanding on the market structure and the nature of competition are a pre-requisite in price determination Determination of price of the product is an important managerial function. Price effects profit through its effect on both revenue and cost. Profit is concerned with difference between cost incurred and revenue generated. It always depends on cost and volume of sales. Management always tries to find the optimum combination of price and output that offers maximum profit to the firm. Thus the understanding of market and market structure with which a firm operates is more helpful in price output decisions. MARKET STRUCTURES Market structures are different market forms based on degree of competition prevailing in the market. It is generally classified into following two forms. MARKET STRUCTURES (CONTD…) Market structure describes the competitive environment in the market for any good or service. The degree of competition may vary among the sellers as well as the buyers in different market situations. Nature of competition among the sellers is viewed on the basis of two major aspects: 1. Number of firms in the Market. 2. Characteristics of products such as whether the products are homogeneous or differentiated. Individual sellers control over the market supply and his hand on price determination basically depends on the above two factors. MARKET STRUCTURES (CONTD…) Perfect competition and Monopoly are the two extremes of the market situations. Other forms of market such as Oligopoly and Monopolistic Competition fall in between these two extremes Oligopoly and Monopolistic competition are the market situations characterized by imperfect competition. PERFECT COMPETITION Perfect competition refers to a market structure where competition among the sellers and buyers prevails in its most perfect form. In a perfectly competitive market, a single market price prevails for the commodity, which is determined by the forces of total demand and total supply in the market. PERFECT COMPETITION According to Prof. Marshall, Perfect competition is defined as “the more nearly perfect a market is, the stronger is the tendency for the same price to be paid for the same thing at the same time in all parts of the market”. According to Prof. Benham, “A market is said to be perfect when all the potential sellers and buyers are promptly aware of the price at which the transactions take place and all of the offers made by others sellers and buyers and when any buyer can purchase from any seller and vice versa”. CHARACTERISTICS OF PERFECT COMPETITION Large Number of Buyers and Sellers: As there are large number of buyers and sellers, no individual buyer or seller can influence the price of the product, which is determined by the collective effort of all the buyers and sellers. Homogeneous Product: As the product of all the firms is homogeneous or identical, all the firms sell their product at the market price. No firm can change any price more than the price prevailing in the market. CHARACTERISTICS OF PERFECT COMPETITION Free Entry and Exit of Firms: All the firms can leave or join the industry. There is no restriction on their entry or exit. Thus if the industry is accruing profits, new firms will enter the market and contrarily if the industry is suffering losses, many firms will leave the market. Perfect Knowledge of Market Conditions: As all the buyers and sellers hold perfect knowledge of all the market conditions, there is free movement of buyers and sellers. Advertisement and selling methods do no have an effect on the consumer behaviour. CHARACTERISTICS OF PERFECT COMPETITION Perfect Mobility of Factors of Production: As all the factors of production are perfectly mobile, factors of production are free to shift to any organization where they are not being paid a fair price. Independence of Decision Making: All buyers and sellers are fully independent. None of them are committed to anyone or anything. Buyers are free to purchase the required commodity from any seller and sellers are free to sell their commodity to any buyer. Price of a commodity tends to be equal all over the market which all the firms have to follow. CHARACTERISTICS OF PERFECT COMPETITION Absence of Selling and Transportation Costs: It is assumed that selling and transportation costs have no role to play in the determination of the price. The price is determined in the industry, which is composed of all the buyers and seller for the commodity. The demand curve facing the industry is the sum of all consumers’ demands at various prices. The industry supply curve is the sum of all sellers’ supplies at various prices. MONOPOLY The term monopoly was derived from Greek term Monopolies which means a single seller. Thus monopoly is a market condition in which there is a single seller of a particular commodity who is called monopolist and has complete control over the supply of his product. There is no close substitutes for the commodity sold by the seller. Pure monopoly is a market situation in which a single firm sells a product for which there is no good substitute. MONOPOLY According to Prof. Thomas, Monopoly is defined as “broadly, the term monopoly is used to cover any effective price control, whether of supply or demand of services or goods; narrowly it is used to mean a combination of manufacturers or merchants to control the supply price of commodities or services”. According to Prof. Chamberlain, “Monopoly refers to the control supply”. According to Prof. Robert Triffin, “Monopoly is a market situation in which the firm is independent of price changes in the product of each and every other firm”. MONOPOLY A monopolist firm is itself an industry, for the distinction between a firm and an industry disappears under monopoly. In technical terms, pure monopoly is a single firm industry where the cross elasticity of demand between its product and the product of other industries is zero. Pure monopoly rarely exists in reality. It is just a theoretical concept as even if there are no substitutes available, some kind of competition would always be there. CHARACTERISTICS OF MONOPOLY Single Person or a Firm: A single person or a firm controls the total supply of the commodity. There will be no competition for monopoly firm. The monopolist firm is the only firm in the whole industry. No close Substitute: The goods sold by the monopolist shall not have closely competition substitutes. Even if price of monopoly product increase people will not go in far substitute. For example: If the price of electric bulb increase slightly, consumer will not go in for kerosene lamp. CHARACTERISTICS OF MONOPOLY Large number of Buyers: Under monopoly, there may be a large number of buyers in the market who compete among themselves. Supply and Price: The monopolist can fix either the supply or the price. He cannot fix both. If he charges a very high price, he can sell a small amount. If he wants to sell more, he has to charge a low price. He cannot sell as much as he wishes for any price he pleases. CHARACTERISTICS OF MONOPOLY Price Maker: Since the monopolist controls the whole supply of a commodity, he is a price-maker, and then he can alter the price. Downward sloping Demand Curve: The demand curve (average revenue curve) of monopolist slopes downward from left to right. It means that he can sell more only by lowering price TYPES OF MONOPOLY Monopoly can be classified into the following different types: Natural Monopoly Public Utility Monopoly Fiscal Monopoly Legal Monopoly Voluntary Monopoly Limited Monopoly Unlimited Monopoly Single Price Monopoly Discriminating Monopoly TYPES OF MONOPOLY Natural Monopoly: It is due to natural factors. For example, particular raw material is concentrated at a particular place and this gives rise to monopoly exploitation of such material. E.g. of monopoly of diamond mines in south Africa, monopoly of raw jute in Bangladesh. TYPES OF MONOPOLY Public Utility Monopoly: Government authorities seize complete control and management of some utilities to protect social interests. For example, posts and telegraph, telephones, electric power, railway transport, provision of water are monopolies of the government. These monopolies, created to satisfy social wants, are formed on social considerations. These are also called as Government or Social Monopolies. TYPES OF MONOPOLY Fiscal Monopoly: To prevent exploitation of employees and consumers, government nationalizes certain industries and acquires fiscal monopoly power over them. For example, Monopoly of Tobacco in France, monopoly of life insurance and general insurance in India. TYPES OF MONOPOLY Legal Monopoly: Some monopolies are engendered and protected under certain laws. Inventors of new processes, articles or devices obtain monopoly powers for such inventions under patent, trade mark and copyright laws. There are many examples of legal monopoly of medicines. Prof. E. W. Taussing observes in his principles of economics, copyrights and patents are the simplest cases of absolute monopoly by law. However Prof. E. H. Chamberlain points out that such cases fall more under monopolistic competition rather than under monopoly. TYPES OF MONOPOLY Voluntary Monopoly: To eliminate competition, and thereby securing higher prices, firms producing a particular product may come together and make monopoly agreements. These are called as industrial combinations and when all firms merge into one organization, such monopoly takes the form of a trust. Associates Cement Companies (ACC) is an example of this kind, where the firms maintain their individual identity and yet enter into monopoly agreements. Such combinations are know as trade associations, pools, cartels and holding companies. TYPES OF MONOPOLY Limited Monopoly: If the monopolist is having limited power in fixing the price of his product, it is called as ‘Limited Monopoly’. It may be due to the fear of distant substitutes or government intervention or the entry of rivals firms. Unlimited Monopoly: If the monopolist is having unlimited power in fixing the price of his good or service, it is called unlimited monopoly. Example of this is a doctor in a village. TYPES OF MONOPOLY Single Price Monopoly: When the monopolist charges same price for all units of his product, it is called single price monopoly. Example of this is that the Tata Company charges the same price to all the Tata Indica Cars of the same model Discriminating Monopoly: When a Monopolist charges different prices to different consumers for the same product, it is called discriminating monopoly. For example, a doctor may take Rs.20 from a rich man and only Rs.2 from a poor man for the same treatment SOURCES OF MONOPOLY Legal Sanction: A monopoly as stated above may be the result of a government sanction. The government of a country may legally permit a private monopoly or monopoly in the public sector for myriad of reasons. National Security (E.g. Manufacture of Defense equipment), Social Equity (E.g. Post office, Water & Electric Supply etc.), or economic considerations (public utility services or essential goods to be produced on a large scale by a single firm for reducing cost and price, E.g. Monopoly of Transport services in India). Monopolies may be created to avoid wastes due to duplication of services. SOURCES OF MONOPOLY Control over supply of Inputs: A monopoly situation may arise due to control over the supply of an essential input – raw materials, skilled labour, technology used, denying access to these inputs to any potential firm. E.g. Government monopoly of Railways in India. Rail tracks are not used by private oil companies. Monopolies may be protected through a protectionist policy of the government by putting tariffs on foreign goods. SOURCES OF MONOPOLY Merger for Large Scale Production: Monopoly undertaking may be a consequence of the necessity to produce on a large scale to reduce costs. Existing small firms may merge into a big firm or may not survive in the longer run. It is only when there is single firm in such a situation that costs are greatly reduced due to economies of large scale production. Rival Firms Eliminated: Pressure tactics and unfair means by a giant firm may lead to elimination of rival firms from the industry to secure a sole position of a giant firm. MONOPOLISTIC COMPETITION In real world, the market is neither perfectly competitive nor a monopoly. Almost every market seems to exhibit characteristics of both perfect competition and monopoly. Hence in the real world it is the state of imperfect competition lying between these two extreme limits that work. Great majority of imperfectly competitive producers in real world produce goods which are analogous to those produced by their rivals. This means the goods produced in the market are close substitutes. MONOPOLISTIC COMPETITION It follows that such producers must be concerned about the way in which the action of these rivals affects their own profits. This kind of market is known as “Monopolistic Competition” or “Group Equilibrium” Here there is no competition, which is keen though not perfect between firms manufacturing very similar products. For example, market for toothpaste, cosmetics, watches etc. FEATURES OF MONOPOLISTIC COMPETITION Large number of Firms: Industry consists of a large number of sellers, each one of whom does not feel dependent upon others. These large number of firms produce close substitutes but not identical products. The size is so large that an individual firm has only a relatively small part in the total market, so that each firm has very limited control over the price of the product. Each firm must control a small but yet significant portion of market share such that by substantially extending or restricting its own sales. As the number is relatively large it is difficult for these firms to determine its price- output policies without considering the possible reactions of the rival forms. FEATURES OF MONOPOLISTIC COMPETITION Product Differentiation: Product differentiation means that products are different in some ways, but not altogether so. The products are not identical but the same time they will not be entirely different from each other. Since every seller produces slightly differentiated prod uct, each seller has minor control over the price. An example of monopolistic competition and product differentiation is the toothpaste produced by various firms. Different toothpastes like Colgate, Close-up, Forehans, Cibaca, etc., provide an example of monopolistic competition. These products are relatively close substitute for each other but not perfect substitutes. FEATURES OF MONOPOLISTIC COMPETITION Large number of Buyers: There are large number buyers in the market. But the buyers have their own brand preferences. So the sellers are able to exercise a certain degree of monopoly over them. Each seller has to plan various incentive schemes to retain the customers who patronize his products. Free Entry and Exit of Firms: As in the perfect competition, in the monopolistic competition too, there is freedom of entry and exit. That is, there is no barrier as found under monopoly. There are no restrictions on entry or exit. Moreover entry is easy because of small size of the firms. FEATURES OF MONOPOLISTIC COMPETITION Selling Costs: Since the products are close substitute much effort is needed to retain the existing consumers and to create new demand. So each firm has to spend a lot on selling cost, which includes cost on advertising and other sale promotion activities. The Group: Under perfect competition the term industry refers to all collection of firms producing a homogenous product. But under monopolistic competition the products of various firms are not identical through they are close substitutes. Prof. Chamberlin called the collection of firms producing close substitute products as a group. FEATURES OF MONOPOLISTIC COMPETITION Imperfect Knowledge: Imperfect knowledge about the product leads to monopolistic competition. If the buyers are fully aware of the quality of the product they cannot be influenced much by advertisement or other sales promotion techniques. But in the business world we can see that thought the quality of certain products is the same, effective advertisement and sales promotion techniques make certain brands monopolistic. For examples, effective dealer service backed by advertisement-helped popularization of some brands through the quality of almost all the cement available in the market remains the same ASSUMPTIONS OF MONOPOLISTIC COMPETITION 1. There are significant number of sellers and buyers in the group. 2. Products of sellers are separated, however they are close substitutes of one another. 3. There is free entry as well as exit of organization in the group. 4. The objective of the firm is to maximize profits both in short run as well as the long run. OLIGOPOLY The term oligopoly is derived from two Greek words, oligos meaning a few, and pollen meaning to sell. It is characterized by mutual interdependence among few sellers who control the total market supply. It is the form of imperfect competition where there are a few firms in the market, producing either a homogeneous product or producing products, which are close but not perfect substitute of each other. Oligopoly is a market where a small group of producers have significant control over a major portion of the market demand with or without differentiated product. OLIGOPOLY According to Mrs. John Robinson, “Oligopoly is a market situation between monopoly and perfect competition in which the number of sellers is more than one but not so large that the market price is not influenced by any one of them”. According to Prof. George J. Stigler, “Oligopoly is a market situation in which a firm determines its marketing policies on the basis of expected behaviour of close competitors”. OLIGOPOLY According to Profs. Stoneur & Hague, “Oligopoly is different from monopoly on one hand in which there is a single seller and on the other hand it differs from perfect and monopolistic competitions also in which there is a large number of sellers. Thus while describing the concept of oligopoly, we include the concept of small group of firms”. According to Prof. Leftwich, “Oligopoly is a market situation where there are a small number of sellers and the activities of every seller are important for others”. CHARACTERISTICS OF OLIGOPOLY Smaller number of Firms: There are only a few firms in the industry. Each firm contributes a sizeable share of the total market. Any decision taken by one firm influence the actions of other firms in the industry. The various firms in the industry compete with each other. Entry and Exit of Firms: The entry as well as exit of organizations is relatively difficult because of non availability of raw materials, labour and etc. Inconsistency in Firms: All the organizations in the market are not precisely similar to each other. One organization could be huge and other could be tiny. CHARACTERISTICS OF OLIGOPOLY Interdependence of Sellers: As there are only very few firms, any steps taken by one firm to increase sales, by reducing price or by changing product design or by increasing advertisement expenditure will naturally affect the sales of other firms in the industry. An immediate retaliatory action can be anticipated from the other firms in the industry every time when one firm takes such a decision. He has to take this into account when he takes decisions. So the decisions of all the firms in the industry are interdependent. CHARACTERISTICS OF OLIGOPOLY Indeterminate Demand Curve: The interdependence of the firms makes their demand curve indeterminate. When one firm reduces price other firms also will make a cut in their prices. So the firm cannot be certain about the demand for its product. Thus the demand curve facing an oligopolistic firm loses its definiteness and thus is indeterminate as it constantly changes due to the reactions of the rival firms. CHARACTERISTICS OF OLIGOPOLY Advertising and Selling Costs: Advertising plays a greater role in the oligopoly market when compared to other market systems. According to Prof. William J. Banumol “it is only oligopoly that advertising comes fully into its own”. A huge expenditure on advertising and sales promotion techniques is needed both to retain the present market share and to increase it. So Banumol concludes “under oligopoly, advertising can become a life-and-death matter where a firm which fails to keep up with the advertising budget of its competitors may find its customers drifting off to rival products.” CHARACTERISTICS OF OLIGOPOLY Price Rigidity: In the oligopoly market price remain rigid. If one firm reduced price it is with the intention of attracting the customers of other firms in the industry. In order to retain their consumers they will also reduce price. Thus the pricing decision of one firm results in a loss to all the firms in the industry. If one firm increases price. Other firms will remain silent there by allowing that firm to lost its customers. Hence, no firm will be ready to change the prevailing price. It causes price rigidity in the oligopoly market. OTHER MARKET STRUCTURES Duopoly: Duopoly refers to a market situation in which there are only two sellers. As there are only two sellers any decision taken by one seller will have reaction from the other E.g. Coca-Cola and Pepsi. Usually these two sellers may agree to co-operate each other and share the market equally between them, So that they can avoid harmful competition. The duopoly price, in the long run, may be a monopoly price or competitive price, or it may settle at any level between the monopoly price and competitive price. In the short period, duopoly price may even fall below the level competitive price with the both the firms earning less than even the normal price. OTHER MARKET STRUCTURES Monopsony: Mrs. John Robinson was the first writer to use the term monopsony to refer to market, which there is a single buyer. Monopsony is a single buyer or a purchasing agency, which buys the show, or nearly whole of a commodity or service produced. It may be created when all consumers of a commodity are organized together and/or when only one consumer requires that commodity which no one else requires. OTHER MARKET STRUCTURES Bilateral Monopoly: A bilateral monopoly is a market situation in which a single seller (Monopoly) faces a single buyer (Monopsony). It is a market of monopoly-monopsony. Oligopsony: Oligopsony is a market situation in which there will be a few buyers and many sellers. As the sellers are more and buyers are few, the price of product will be comparatively low but not as low as under monopoly EQUILIBRIUM OF A FIRM & INDUSTRY UNDER PERFECT COMPETITION Equilibrium is a position where the firm has no incentive either to expand or contrast its output. The firm is said to be in equilibrium when it earn maximum profit. There are two conditions for attaining equilibrium by a firm. EQUILIBRIUM OF A FIRM & INDUSTRY UNDER PERFECT COMPETITION Marginal cost is an additional cost incurred by a firm for producing and additional unit of output. Marginal revenue is the additional revenue accrued to a firm when it sells one additional unit of output. A firm increases its output so long as its marginal cost becomes equal to marginal revenue. When marginal cost is more than marginal revenue, the firm reduces output as its costs exceed the revenue. It is only at the point where marginal cost is equal to marginal revenue, and then the firm attains equilibrium. EQUILIBRIUM OF A FIRM & INDUSTRY UNDER PERFECT COMPETITION Marginal cost curve must cut the marginal revenue curve from below. If marginal cost curve cuts the marginal revenue curve from above, the firm is having the scope to increase its output as the marginal cost curve slopes downwards. It is only with the upward sloping marginal cost curve, there the firm attains equilibrium. The reason is that the marginal cost curve when rising cuts the marginal revenue curve from below EQUILIBRIUM OF A FIRM & INDUSTRY UNDER PERFECT COMPETITION PL and MC represent the Price line and Marginal cost curve. PL also represents Marginal revenue, Average revenue and demand. As Marginal revenue, Average revenue and demand are the same in perfect competition, all are equal to the price line. Marginal cost curve is U- shaped curve cutting MR curve at R and T. At point R marginal cost becomes equal to marginal revenue. EQUILIBRIUM OF A FIRM & INDUSTRY UNDER PERFECT COMPETITION But MC curve cuts the MR curve from above. So this is not the equilibrium position. The downward sloping marginal cost curve indicates that the firm can reduce its cost of production by increasing output. As the firm expands its output, it will reach equilibrium at point T. At this point, on price line PL; the two conditions of equilibrium are satisfied. Here the marginal cost and marginal revenue of the firm remain equal. The firm is producing maximum output and is in equilibrium at this stage. PRICING UNDER PERFECT COMPETITION The price or value of a commodity under perfect competition is determined by the demand for and the supply of that commodity. Under perfect competition there is large number of sellers trading in a homogeneous product. Each firm supplies only very small portion of the market demand. No single buyer or seller is powerful enough to influence the price. PRICING UNDER PERFECT COMPETITION The demand of all consumers and the supply of all firms together determine the price. The individual seller is only a price taker and not a price maker. An individual firm has no price policy of it’s own. Thus, the main problem of a firm in a perfectly competitive market is not to determine the price of its product but to adjust its output to the given price, So that the profit is maximum. PRICING UNDER PERFECT COMPETITION Marshall however gives great importance to the time element for the determination of price. He divided the time periods on the basis of supply and ignored the forces of demand. He classified the time into four periods to determine the price as follows. 1. Very Short (or) Market Period 2. Short Period 3. Long Period 4. Very Long (or) Secular Period PRICING UNDER PERFECT COMPETITION Market Period: It is the period in which the supply is more or less fixed because the time available to the firm to adjust the supply of the commodity to its changed demand is extremely short; say a single day or a few days. The price determined in this period is known as Market Price. Short Period: In this period, the time available to firms to adjust the supply of the commodity to its changed demand is, of course, greater than that in the market period. In this period altering the variable factors like raw materials, labour, etc. can change supply. During this period new firms cannot enter into the industry. PRICING UNDER PERFECT COMPETITION Market Period: In this period, a sufficiently long time is available to the firms to adjust the supply of the commodity fully to the changed demand. In this period not only variable factors of production but also fixed factors of production can be changed. In this period new firms can also enter the industry. The price determined in this period is known as long run normal price. PRICING UNDER PERFECT COMPETITION Secular Period: In this period, a very long time is available to adjust the supply fully to change in demand. This is very long period consisting of a number of decades. As the period is very long it is difficult to lay down principles determining the price.
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