MODULE 5:MARKETS 2011

Perfect Competition Market A perfectly competitive market is one in which the number of buyers and sellers is very large, all engaged in buying and selling a homogeneous product without any artificial restrictions and having perfect knowledge of market at a time. In the words of A. Koutsoyiannis, Perfect competition is market structure characterised by a complete absence of rivalry among the individual firms. Characteristics or Features of Perfect Competition 1. Large number of buyers and sellers:There are large number of buyers and sellers of the product, and each seller and buyers is too small in relation to the market to be able to affect the price of the product by his or her own actions. This means that a change in the output of a single firm will not noticeably affect the market price of the product. Similarly, each buyer of the product is too small to be able to extract from the seller such things as quantity discounts and special credit terms. 2. Homogeneous Product: The product of each competitive firm is homogeneous, identical, or perfectly standardized. An example of this might be Grade A wheat. As a result buyers cannot distinguish between the output of one firm and the output of another, so they are indifferent from which firm they buy the product. This refers to not only the physical characteristics of the product but also the environment. 3. Freedom of Entry or Exit: It implies that whenever the industry is earning excess profits, some new firms attracted by these profits and enter the industry. In case of loss faced by the industry, some firms leave it. 4. Perfect Mobility of Goods and Factors: It implies that goods and factors of production can easily move geographically from one job to another and can respond quickly to monetary incentives. In other words, goods are free to move to those places where they can earn the highest price. Factors can also move from a low-paid to a high-paid industry. 5. Perfect Knowledge: Consumers, factors of production and firms in the market have perfect knowledge about present and future prices, costs, and economic opportunities in general. Thus, consumers will not pay a higher price than necessary for the product and producers know exactly how much to produce. 6. Absence of Transport Cost: There are no transport costs in carrying of product from one place to another. If transport costs are added to the price of the product, even a homogeneous commodity will have different prices depending upon transport costs from the place of supply.

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Monopoly Market Monopoly is a market situation in which there is only one seller of a product with barriers to entry of others. The product has no close substitutes. The cross elasticity of demand with the every other product is very low. This means that no other firms produce a similar product. According to D. Salvatore, Monopoly is the form of market organisation in which there is a singly firm selling a commodity for which there are no close substitutes. Characteristics or Features of Monopoly 1. Under monopoly, there is one producer or seller of a particular product and there is no difference between a firm and an industry. 2. A monopoly may be individual proprietorship or partnership or Joint Stock Company or a co-operative society or a government company. 3. A monopolist has full control on the supply of a product. Hence, the elasticity of demand for a monopolists product is zero. 4. There is no close substitute of a monopolists product in the market. 5. There are restrictions on the entry of other firms. 6. A monopolist can influence the price of a product. He is a price-maker, not a price-taker. 7. Monopolist cannot determine both the price and quantity of a product at the same time. 8. Monopolists demand curve slopes downwards to the right. That is why, a monopolist can increase his sales only by increasing the price of his product and thereby maximize his profit. Sources of Monopoly There are four basic reasons that can give rise to monopoly. 1. The firm may control the entire supply of raw materials required to produce the product. For example, until World War II, the Aluminum Company of America (Alcoa) controlled almost every source of bauxite (the raw material to produce aluminum) and thus has monopoly over the production of aluminum in the US. Similarly, till the introduction of new economic policy in 1991, the government of India had a monopoly over most of the services like railways, air, postal, electricity, etc. 2. The firm may own a patent or copyright that prevents other firms from using a particular production process or producing the same product. For example, Xerox has a monopoly on copying machines and Polaroid on instant cameras. Patents are granted by the government for a period of 17 years as an incentive to inventors. 3. In some industries, economies of scale operate (i.e., the long run average cost curve may fall) over a sufficiently large range of outputs as to leave only one firm supplying the entire market. Such a firm is called a natural monopoly. Examples of these are public utilities (electric, gas, water, and local transportation companies).
2

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4. A monopoly may be established by a government franchise. In this case, the firm is set up as the sole producer and distributor of a product or service but is subjected to governmental regulation. The best example of a monopoly established by government franchise is the post office.

Monopolistic Competition Monopolistic competition refers to a market situation where there are many firms selling a differentiated product. No firm can have any significant influence on the price-output policies of the other sellers nor can it be influenced much by theirs actions. Characteristics or Features of Monopolistic Competition 1. Large Number of Sellers:In monopolistic competition the number of seller is large. They are many and small enough but none controls a major portion of the total output. No seller by changing its price-output can have significant effect on the sales of others and it turn be influenced by them. 2. Product Differentiation: Product differentiation implies that products are different in some ways from each other. They are heterogeneous rather than homogeneous so that each firm has an absolute monopoly in the production and sale of a differentiated product. However, there is slight difference between one product and other in the same category. Product differentiation can be both real and imaginary, real difference are with respect to size, design, strength and durability, colour, taste, smell, etc. The imaginary differences with respect to trade mark, brand name, colour scheme of packages, etc.It may also take place due to the differences in conditions surrounding the sale of the product. 3. Free Entry and Exit: There are no entry barrios in monopolistic competition. As firms are of small size and are capable of producing close substitutes, they can quit or enter the industry in the long run. 4. Nature of Demand Curve: Under monopolistic competition each firm share only a small portion of the total output of a product. The products are different but are close substitutes to each others. As a result, a reduction in the product price will increase the sales of the firm but it will have little effect on the price-output conditions of other firms, each will lose only a few of its customers and vice-versa. Therefore, the demand curve (AR curve) of a firm slopes downward to the right. 5. Independent Behaviour: In monopolistic competition, every firm has independent policy, since the number of seller is large, none controls a major portion of the total output. No seller by changing its price-output policy can have any significant effect on the sales of others and in turn influenced by them.
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6. The Groups: Chamberlin introduced the concept of group in the place of traditional concept of Industry. The term industry refers to the collection of firms producing homogeneous products; the term group refers to the collection of firms which produce similar and differentiated products which are close substitutes to each other. 7. Selling Cost: The firm under monopolistic competition has to create demand for the differentiated products. Huge expenditure is to be incurred for this purpose. Therefore selling cost is the expenditure on advertisement which has the objective of increasing the sale of the product. 8. Two Dimensional Competition: Monopolistic competition has two aspects a) Price Competition b) Non-price Competition The price competition takes place when the firms compete with each other to reduce the price and increase the sales. Non-price competition takes place in terms of product variation and selling cost. Oligopoly Oligopoly is a market situation charaterised by a few sellers, producing and selling either homogeneous product or heterogeneous (differentiated) product. Characteristics or Features of Oligopoly 1. Few Sellers:Since the number of firms is limited, each firm has got a substantial share in the total product market. 2. Interdependence: There is very strong interdependence between firms under oligopoly this is mainly because of the limited number of firms operating under oligopoly. Interdependence means that the business and sales of one firm is affected by the decision made by another firm and therefore a change in the business policy of one firm can cost appropriate reaction by another firm. 3. Group Behaviour: Since competition can be mutually destructive, it is possible that the firms in oligopoly can reach some sort of agreement on price and output. Such agreement can be formal or informal so this is known as collusive oligopoly. 4. Advertisement and Selling Cost: There is a very important craze for advertising and selling cost in oligopoly. Perhaps they have greater significance in oligopoly than in monopolistic competition. 5. Indeterminate Demand Curve: Because of the interdependence of the firms and because of the inability of a particular firm to predict the behaviour of another firm the demand curve facing an oligopolistic firm losses its definiteness.

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Kinky Demand Curve Kinky demand curve as a toll of analysis originated from Chamberlin explanation of individual firm demand curve (dd) and the market share demand curve (DD). However Chamberlin himself do not use Kinked demand in his analysis. Hall and Hitch used the Kinked demand curve to explain why the price in oligopoly will remain sticky. Paul Sweezy in the year 1939 used the concept of Kinked demand curve as an operational tool for the determination of equilibrium in the oligopoly market. The following diagram explains the Kinked demand curve. D

Pr ice & Cost

MC 2 MC 1 MC 3

A B
O
Q

D MR
Output

In the above diagram, demand curve faced by the firm is dED with a Kink at E. The Kinked demand curve is due to the behaviour pattern of oligopoly firms. If one oligopoly firm reduces the price, its competitors will also reduce the price. As a result, individual share in the market demand increases by a small amount. Hence the lower portion of the demand curve relates to the market share demand curve DD which is less elastic. On the other hand if the firm raises the price, there will be a greater fall in demand, as nobody else increases the price. Hence the relevant demand curve for an increase in price is dE which is not elastic. The upper portion of the demand curve dE is a part of the individual firm demand curve dd and the lower portion ED is a part of market share demand curve DD which is less elastic. Due to the Kink in demand curve, the MR curve is discontinuous of the level of output corresponding to the Kink. The MR curve has two segments, segment dA relates to the elastic part of the demand (dd) curve and segment BMR related to the lower or inelastic part of the demand curve (DD).
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The equilibrium of the firm is defined by the condition of equality between MC and MR and the MC > MR beyond equilibrium. These conditions are satisfied at the level of output corresponding to Kink to any point to the left of Kink, MR is greater than MC. And to any point to the right of Kink, MC > MR. Therefore OQ is equilibrium output. The discontinuity in the MR curve implies that there is a range within which cost may change without affecting the equilibrium price quantity combination of a firm. The range is given by the gap AB. Suppose the original MC curve is MC1. Even if the cost increases and the MC curve shift to MC3, the output and the price remain the same. Similarly a fall in the cost upto B does not lead to a fall in the price.

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___________________________________________________MODULE 6: PRICING METHODS Full Cost Pricing In the real world, firms may not be able to collect exact market revenue (MR) and marginal cost (MC) data to examine the optimal level of output and price at the point at which MR = MC. Therefore, firms have developed rules of thumb or short-cut methods for pricing their products. The most widely used of such pricing rules is full cost pricing (also called markup pricing and costplus pricing). The common method is for the firm to first calculate approximately the average variable cost (AVC) of producing or purchasing and marketing the product for a normal or standard level of output (generally taken to be between 70 and 80 percent of capacity). The firm then adds to the AVC an average overhead charge (generally expressed as a percentage of AVC), so as to get the estimated fully allocated average cost (C). To this fully allocated average cost, the firm then adds as markup on cost (m) for profits. The formula for the markup on cost can, thus, be expressed as

P C C

Where m is the markup on cost, P is the product price, and C is the fully allocated average cost of the product. The numerator i.e. P C is called profit margin. Solving for P, we get the price of the product in a cost-plus pricing scheme. That is,

P C 1 m
For example, suppose that a firm takes 80 percent of its capacity output of 125 units as the normal or standard output, that it projects total variable and overhead costs for the year to be, respectively, Rs.1000 and Rs.600 for the normal output or standard output is 100 units, the AVC = Rs.10, and average overhead cost is Rs.6. Thus, C = Rs.16 and P = 16 (1 + 0.25) = Rs.20) with m = (Rs.20 Rs.16) / Rs.16 = 0.25. Markups of 25 percent have been traditional in some major industries, such as automobiles, electrical and aluminum, in order for firms in these industries to achieve a target rate of return on investment for the normal or standard level of output.

Marginal Cost Pricing Economic analysis relies upon marginal cost and marginal revenue analysis for determining the equilibrium output. The equilibrium output is at the point where MC = MR. The price is determined by the corresponding point on the demand line (AR) which may be = or > or < than the average cost. Public sector enterprises for various reasons may follow a price policy based on the marginal cost.

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___________________________________________________MODULE 6: PRICING METHODS

MC
R2
P3

AC

Price
P1

N2 P2

R1

P4

N1

D1
0

D2

Q1

Q2

Q3 Q4

Output

The above diagram explains the price based on MC and also the result of charging price equal to AC. Given the demand DD1, OQ1 output is produced and sold at Q1P1 price where DD1 cuts AC at P1. At this price the total cost including normal profit is covered. The price is equal to AC. Public sector undertakings producing essential public goods may decide to charge lower price equal to MC. The lower price will have more demand. Now the output will be OQ2, and sold at P2Q2 price where DD1 cuts MC. Here Price = MC. A loss to the extent of P2N per unit is incurred. The commodity is supplied at a lower price in the interest of public welfare and accordingly the loss is met by the government. Commodities like water, kerosene, cooking gas are some of the examples. If the people are able and willing to buy more and also demand more quantity at price higher than P2Q2, i.e., OQ quantity at PQ price, then optimum output (OQ) is produced and sold at OP price, equal to AC = MC, earning a normal profit. In case, a public sector undertaking decides to produce commodities which are mainly purchased by higher income group such as mineral water, petrol, services like air travel, etc. and the demand is assumed to be sufficiently large as shown by DD2 in the diagram, the price can be equal or higher than AC. With DD2 demand, OQ3 quantity is produced and sold at P3Q3 since where DD2 cuts MC, earning excess profit of R1P3 per unit. It is possible, in this case too, to produce more at a lower price, i.e., P4Q4 which is equal to AC and earn normal profit. At Q4 output people are not willing to pay R2Q4 price which is equal to MC but higher than AC by P4R2. In this case where the commodity is not essential, it is advisable to charge a price equal to MC > AC and earn profit which can be spent for providing more of other essential goods and services.

F.Y.B.COM./BUSINESS ECONOMICS I

___________________________________________________MODULE 6: PRICING METHODS Price Discrimination Price discrimination as a pricing practice is a option available to a monopolist. Monopolist being a single producer and seller is a price maker and not a price taker like a firm in perfect competition. The act of selling the same article, produced under single control at different prices to different buyers is called price discrimination. Degrees of Price Discrimination First Degree Price Discrimination takes place where, each customer can be charged a different price for a good or service. It is usually possible in the case of sevices which cannot be transferred from one person to another. For e.g. a doctor can charge different fees for each patients. Patients will have to pay these fees as long as they do not have any other good doctor.

In the above diagram each unit of the commodity is charged a different price. The seller takes away all the consumers surplus i.e. PRD. Second Degree Price Discrimination practiced by charging different prices by dividing the supply in different quantity or bulk or purposewise. For e.g. Electricity supplying authority can charge different rates Rs. 4.50/unit and Rs.6.50/unit for domestic and commercial uses respectively. Telephone company may charge different rates for calls made during the day and night time.

D
P1 P2 P3 P4

D
X1 X 2 X 3 X 4

In the above diagram different prices are charged for the different segments shown on X axis which may represent different group of people, different uses or different time period.

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___________________________________________________MODULE 6: PRICING METHODS Third Degree Price Discrimination practiced by charging different prices in different markets. Markets are located geographically at a distance so that transfer of goods from one market to the other is not possible.

D
P1 P2

T
N S

X1

X2

In the above diagram if the consumer is charged OP2 price, monopolists revenue is OX2SP2. As against this if the monopolist sells OX1 at OP1 and X1X2 at OP2, his revenue would increase by P2NTP1. The consumer loses his surplus by the amount equal to the increase in sellers revenue. Dumping A case of International Price Discrimination Dumping refers to a situation where the monopolist enjoys a monopoly power in the home market and accepts a competitive price in the other market i.e. the world market. At home the monopolist is price maker and in the world market a price taker. Accordingly he charges a higher price in the domestic market and accepts the price determined by the market forces in the world market. Dumping resulting in international price discrimination is referred to as Persistent Dumping. Dumping is called Predatory when there is temporary sale of a commodity at a lower price abroad.

Price

PH

MC
R T D AR MR W W

PW
S

AR H MR H

F.Y.B.COM./BUSINESS ECONOMICS I

Output

___________________________________________________MODULE 6: PRICING METHODS In the above diagram the download sloping AR and MR show the home market indicated by subscript H where demand is less elastic. Similarly AR W = MRW point out the world market. The horizontal straight line showing ARW = MRW shows the perfectly elastic demand in the world market. The ARTD line indicated combined MR of both home and world market. Equilibrium output is decided at T where MC = MR and MC is increasing. The total output OM is distributed between the two markets in such a way that MR in the home market is equal to MR in the world market (MRH = MRW). Accordingly the OL is sold in the home market and LM in the world market. Home market being less elastic, less quantity is sold at a higher price OPH and larger quantity i.e. LM is sold in the world market at a lower price OP W. At R marginal revenue in both market is equalized LR = MT. Total profit of the discriminating monopolist is equal to STRA i.e. TR TC = OMTRA OMTS = STRA. This is the maximum profit the discriminating monopolist earns from both markets.

F.Y.B.COM./BUSINESS ECONOMICS I

___________________________________________________MODULE 6: PRICING METHODS b) Capital Budgeting Q.1 What is Project Planning? Explain its features and need.

Ans: Project planning is an important branch of business economic. A project refers to a scheme for investing resources. Project planning may be defined as, Determining a route or manner in which the project or scheme is to be executed or implemented. Features of Project Planning: Project planning involves decision making 1. It is concerned with capital expenditure. 2. Project planning is dynamic. 3. It is non-repetition. 4. It is long-term phenomenon. 5. It involves cost benefit approach. 6. It is goal determined. 7. Project planning is futuristic 8. It is one off undertaking. Need or Importance: 1. Project planning involves capital budgeting to avoid losses. 2. Project planning implies decision about capital expenditure, which have long-term effect. 3. Huge outlay is involved in a project so considerable care (necessary) 4. Investment on capital assets is sunk (Double) which influences conduct of business over a long period of time. 5. Profit planning is essential for the completion from various stages of project with a time period. 6. It is necessary for ensuring optimum utilization of resources. 7. The main of project planning is to direct the flow of capital fund into specific uses.

F.Y.B.COM./BUSINESS ECONOMICS I

___________________________________________________MODULE 6: PRICING METHODS Q. 2 Discuss the meanings and importance of Capital Budgeting.

Ans: Introduction:Capital Budgeting is a process involving planning, analysis, evaluation and selection of the most profitable project for investing the funds available to the firms. Capital budgeting refers to systematic investment programme. It is related to a decision making procedures involved in long term investment. According to Peterson, Capital budgeting refers to the process of planning capital projects, raising funds and efficiently allocating resources to those capital projects. It should be noted that capital expenditure items such as inventories and receivables are excluded from the capital budget. Importance of Capital Budgeting: Capital budgeting decisions are of great importance in business planning on account of the following reasons: 1) Profitability: Capital budgeting decisions affect the profitability of the firm. They relate to fixed assets. A right investment decision can yield large returns, while an incorrect investment decisions can yield low returns. Capital budgeting can help to select most profitable projects for investing the funds available to the firm. 2) Limited Resources: Since capital resources are limited and investment opportunities are plenty and varied in terms of returns, so there is need for thoughtful, wise and correct investment decisions. A group investment decision can bring returns to the investors. Incorrect decision would result in low returns and sometimes in losses. 3) Future Cost Structure: Since capital expenditure decisions have their effects spread over long time span, they will affect the firms future cost structure. The future activities and position of the firm depends on capital budgeting. 4) Worth Maximisation of the Shareholders: Capital budgeting is very important as their impact on the well being and economic health of the enterprise is far reaching. The main aim of this process is to avoid over investment and under investment in fixed assets. By selecting the most profitable capital project, the management can maximize the worth of equity shareholders investment. Thus, the significance of Capital budgeting decisions is quite obvious.

F.Y.B.COM./BUSINESS ECONOMICS I