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UNIT-4

Theory of production
Production function - isoquants and isocosts, least cost combination of inputs, and laws of
returns; Internal and external economics of scale.
Market structures
Types of competition; Features of perfect competition, monopoly, and monopolistic
competition; Price-output determination in case of perfect competition and monopoly.
Pricing policies and methods
Cost plus pricing; Marginal cost pricing; Sealed bid pricing; Going rate pricing, Limit pricing,
Market skimming pricing, Penetration pricing, Two-part pricing, Block pricing, Bundling pricing,
Peak load pricing, Cross subsidization.
Theory of production
Production function - isoquants and isocosts, least cost combination of inputs, and laws of
returns; Internal and external economics of scale.
LAW OF RETURNS TO SCALE:
There are 3 laws of returns of production function.
• Law of Increasing Returns to Scale:
It states that the volume of output keeps on increasing with every increase in the inputs.
• Law of Constant Returns to Scale:
When the scope for division of labor gets restricted, the rate of increase in the total output remains
constant.
• Law of Decreasing Returns to Scale:
Where the proportionate increase in the inputs does not lead to equivalent increase in output. The
output increases at a decreasing rate.
INTERNAL & EXTERNAL ECONOMIES OF SCALE:
Internal Economies:
• Managerial Economies :
These economies arise due to better and more elaborate management, which only the large
size firms can afford. There may be a separate head for manufacturing, assembling, packing,
marketing, general administration etc. Each department is under the charge of an expert.
Hence the appointment of experts, division of administration into several departments,
functional specialization and scientific co-ordination of various works make the
management of the firm most efficient.
• Commercial Economics :
The transaction of buying and selling raw materials and other operating supplies such as
spares so on will be rapid and the volume of each transaction also grows as the form grows.
There could be cheaper savings in the procurement, transportation and storage costs. This
will lead to lower cost and increased profits.
• Financial Economies :
The large firm is able to secure the necessary finances either for block capital purposes or
for working capital needs more easily and cheaply. It can barrow from the public, banks and

the firm cannot hire half the manager or half the telephone. Scope for specialization is also available in a large firm. In the matter of buying they could enjoy advantages like preferential treatment. which employs costly and superior plant and equipment. improved means of transport and communications. Engineers go by what is called Two by three(2/3) rule wherein when the volume is increase by 100 per cent. production increases and per unit cost of production falls. Likewise.000 units capacity plant will not be double that of 50. Another technical economy lies in the mechanical advantage of using large machines. Technical Economies : Technical economies arise to a firm from the use of better machines and superior techniques of production.• • • • • • other financial institutions at relatively cheaper rates.000-tonne oil tanker will not be double that of 5. A firm producing below such minimum quantity will have to hear to bear higher costs Economies of Larger Dimension : Large – scale production is requires to take advantage of bigger size plant and equipment. External Economies: • Economies of Concentration : When an industry is concentrated in a particular area. Similarly it sells its products more effectively for a higher margin of profit. . Under such circumstances the risk-bearing economies or survival economies help the bigger firm to survive business crisis. cheap credit. It is. a plant of certain minimum capacity is required whether the firm would like to produce and sell at the full capacity or not. the material required will increase only by Two-thirds. There is also a possibility for market fluctuations in a particular product of the firm. More over a larger firm is able to reduce it’s per unit cost of production by linking the various processes of production. Indivisibilities and Automated Machinery : To manufacture goods. Likewise. Technical economics are available only from large size. supply of power and benefits from subsidiaries. The large firm generally has a separate marketing department. It can buy and sell on behalf of the firm. the cost of a 10. banking and financial services. an accountant and a typist.000-tonne oil tanker. prompt delivery and fine relation with dealers. during business depression. enjoys a technical superiority over a small firm. transport concessions. Risk-bearing Economies : The large firm produces many commodities and serves wider areas. All these facilities tend to lower the unit cost of production of all the firms in the industry.00. This increases the productive capacity of the firm and reduces the unit cost of production. a manager. For example. The cost of operating large machines is less than that of operating mall machine. For example. Just because the production is lesser. Marketing Economies : The large firm reaps marketing or commercial economies in buying its requirements and in selling its final products. to be in business a firm requires a telephone. As a result. Economies of Research and Development : A large firm possesses larger resources and can establish it’s own research laboratory and employ trained research workers. the prices fall for every firm.000 units capacity plant. when the market trends are more favorable. Technical economies may also be associated when the large firm is able to utilize all its waste materials for the development of by-products industry. For example. able to absorb any shock for its existence. A large firm. with a given plant certain minimum quantity can be produced. The firm may even invent new production techniques for increasing its output and reducing cost. therefore. all the member firms reap some common economies like skilled labour. the cost of a 1. It is in this way that a large firm reaps financial economies. improved methods of production processes and when the products are standardized.

constitution and degree of competition prevailing in market. time. Three could be a common facility to share journals.• • Economies of R&D : All the firms can pool resources together to finance research and development activities and thus share the benefits of research. Economies of Welfare : An industry is in a better position to provide welfare facilities to the workers. Markets are also classified on the basis of location. the ease with which firms can enter and exit the markets. the extent to which prices can be controlled and the influence of other non-price variables. This will help the efficiency of the workers. It shows the number of buyers and sellers in a market. and two important market forces: Demand and Supply. It may also establish public health care units. Market Structure indicates the composition. A market consists of two important players: Buyers and Sellers. Market Demand: which is the aggregate demand of all buyers put together. Bases Competition Location Time Technology Regulation E-markets Free markets Tele-markets Regulated markets Perfect market Imperfect market Monopolistic Monopoly Oligopoly National Very short period market International Short period market Long period market Very Long period market . technology and regulation. newspapers and other valuable reference material of common interest. which shows the quantity that they would offer at different prices. It may get land at concessional rates and procure special facilities from the local bodies for setting up housing colonies for the workers. the type of products offered. shows the quantity that buyers would like to buy at different prices? Market Supply: is the aggregate quantity supplied by all sellers. Market structures A market is described as a place where buyers and sellers of goods and services come together to transact. educational institutions both general and technical so that a continuous supply of skilled labour is available to the industry. so that a market price is determined.

many Few/Limited sellers sellers buyers many buyers Scope for product No scope: Large scope May or may not No scope in differentiation Homogeneous use the scope to homogenous products differentiate oligopoly. buyers and Large Many One seller. Consumers can quit because of the wide choice of products offered to them. Perfect Markets: Perfect markets are said to exist in perfect competition and should satisfy certain following conditions: • Large number of buyers and sellers • Free entry and exit • Product homogeneity • Price homogeneity • Mobility of factors reduction • Knowledge of market conditions • Absence of transport costs • No government intervention • Firm is a price-taker 2. if product Of course. as a Very high differentiation is single seller established Influence of nonNo influence Can influence using Advertising and Advertising and price variables product differentiation promotion can be product and promotion used differentiation can be advertising used . • Price differentiation • Sales promotion • Independent decision-making • Imperfect knowledge 3. Monopolistic Markets: Competition in these markets exhibits features of both perfect and monopoly competition. Monopoly Markets: A monopoly (from the Greek word ‘mono´ meaning single and ‘polo’ meaning to sell) is that from of market in which a single seller sells a product (goods and services) which has no substitute: • Single seller and many buyers • Entry barriers • Scope for price differentiation • Independent decision-making • No difference between firm and industry • No substitute 4. Oligopoly Markets: A stated earlier. Table: Basic characteristic features of various types of markets (based on completion) Characteristic Perfect Monopolistic Markets Monopoly Oligopoly Markets Features Markets (2) Markets (4) (1) (3) No. Each firm considers how its actions affect the decisions of its relatively few competitors. large scope in heterogeneous oligopoly Ease of entry and Very easy to Easy to enter and exit Entry is prevented Entry is blocked exit into the markets enter and exit Control over price No Control Yes. Therefore. the main distinguishing feature of oligopoly competition is few or limited sellers with a large number of buyers.1. the firms are interdependent.

If output is set at the point where price is more than average total cost. even though the price does not cover average titak cist. agriculture product market and agricultural products Textiles and retailing Public utilities. stock market. for example. industry output increases. Price Price determination in monopolistic markets: MC P0 AC P1 =Ac1 F DD Ac0 0 MR MR1 Q1 DD1 Q2 Quantity DD is the demand curve. Shifts in market supply or demanded result in price changes and ultimately the price settles at the equilibrium point at which quantity demanded equals quantity supplied. for example. MR is the marginal revenue curve. MC is the average cost curve. it is advisable for the firm to produce. the railways Petroleum and oil Price-output determination in case of perfect competition and monopoly: A perfectly competitive firm will decide its output at the price equal to managerial cost. . The market demand curve slopes downwards to the right because with increase in price the quantity demanded reduces. Firms find it profitable to expand production.Suitability in Practice Hypothetical generally a myth. Price determination in Perfect competition with Market Demand and market supply: D S Price E S D 0 Quantity The market supply curve slopes upwards to the right because as price increases. AC is the average cost curve Q is the output and P is the price.

Every manager endeavors to find the price. which would best meet with his firm’s objective. interest cost. coal. Q0 is the output at which MC = MR at price P0. soaps. if the price is set too low the seller may not be able to recover his costs. The multiple prices is more serious in the case of items like cars refrigerators. demand or supply alone is insufficient to determine the price. This is because the price is such a parameter that it exerts a direct influence on the products demand as well as on its supply. Firms break even at this point and there will be no further entry of firms. Market skimming pricing. that the price difference on account of the above four factors are more significant. intermediaries’ profits etc. tooth pastes. furniture and bricks and is of little significance for items like shaving blade. The profit – making firms attract new competitors and this shifts the demand curve to the left. A lower price attracts some customers from the competitors. Once can still conceive of a basic price. Instead. it is conceivable that there could be situations under which either demand or supply is playing a passive role. one would realize that there is nothing like a unique price for any good. creams and stationeries. Marginal cost pricing.The demand curve is not horizontal because the products of different firms are substitutable to a limited extent. Block pricing. just as one pair of scissors alone can never cut a cloth. The market share of each firm depends not only on the price it charges but also on the number of firms in the industry. Price concepts Price of a well-defined product varies over the types of the buyers. Similarly.00. Nevertheless. if one gives a little. Cross subsidization. Penetration pricing. Bundling pricing. Limit pricing. This happens in the long run at equilibrium F. pricing decision must be reviewed and reformulated from time to time. which is DD1. Price determinants – Demand and supply: The price of a product is determined by the demand for and supply of that product.000 the price of a hair cut is Rs. Sealed bid pricing. etc. Differences in various prices of any good are due to differences in transport cost. since demand and supply conditions are variable over time what is a right price today may not be so tomorrow hence. In the short run. It should be obvious to the readers. Two-part pricing. Going rate pricing. Introduction: It is said that if a firm were good in setting its product price it would certainly flourish in the market. However. According to Marshall the role of these two determinants is like that of a pair of scissors in cutting cloth.2. while one pair is held fixed. On the other hand. if one gives a little thought to this subject. PRICING THEORY Cost plus pricing. leading to firm’s turnover (sales) and profit. . alone appear to be determining the price. There is a need for the right price further. DD is the demand curve. Q1is the output at which MC = MR and price P1 = AC1. and the other. there are multiple prices. If the price is set too high the seller may not find enough customers to buy his product.150 and so on. It is possible that at times. credit sale or cash sale. Thus the current price of a maruti car around Rs. place it is received.25 the price of a economics book is Rs. storage cost accessories. which is active. the other is moving to cut the cloth. time taken between final production and sale. which would be exclusive of all these items of cost and then rationalize other prices by adding the cost of special items attached to the particular transaction. Peak load pricing. in what follows we shall explain the determination of this basis price alone and thus resolve the problem of multiple prices. Price: Price denotes the exchange value of a unit of good expressed in terms of money.

Accordingly. 50 supply would exceed demand and consequently the producers of this good would not find enough customers for their demand. If price is Rs.30. No other price could prevail in the market. demand equals supply and thus both producers and consumers are satisfied.30. forcing price to Rs. would lead to competition among the producers. At price Rs. . forcing price to Rs. which.30 would be the market-clearing price. which influences either demand or supply is in fact a determinant of price. thereby they would accumulate unwanted inventories of output. price Rs. Similarly if price were Rs. It was seen in unit 1 that the demand for a good depends on. The economist calls such a price as equilibrium price. which would give rise to competition among the buyers of good. every factor. in turn. there would be excess demand. a number of factors and thus. a change in demand or/and supply causes price change.Equilibrium Price: The price at which demand and supply of a commodity is equal known as equilibrium price.30. The demand and supply schedules of a good are shown in the table below Demand supply schedule: Price 50 40 30 20 10 Demand 100 120 150 200 300 Suply 200 180 150 110 50 Of the five possible prices in the above example.10.

who quotes the lowest price. In other words. All the tenders are opened on a scheduled date and the person. Cost Plus Pricing: This is also called ‘full cost or mark up’. v. b. iv. In times of stiff competition. Sealed Bid Pricing: This method is more popular in tenders and contracts. selling price is fixing in such a way that it covers fully the variable or marginal cost and contributes towards recovery of fixed costs fully or partly. ii. The firm uses its discretion to charge differently the different customers. The objective of the bidding form is to bag the contract and hence it will quote lower than others. Utilize the maximum capacity. Here the average cost at normal capacity of output is ascertaining and then a conventional margin of profit is added to the cost to arrive at the price. Cost-based Pricing Methods: a. Going rate pricing: Here the price charged by the firm is in tune with the price charged in the industry as a whole. Competition-based Pricing: a.Pricing Methods Pricing Methods Cost-based Pricing Competition-based Pricing Demand-based Pricing Strategy-based Pricing Market Skimming Market Penetration Cost Plus Pricing Marginal Cost Pricing Perceived Value Pricing Price Discrimination Two-part Pricing Block Pricing Commodity bundling Going Rate Pricing Sealed Bid Pricing Peak load pricing Cross subsidisation Transfer Pricing 1. Increase market share. In other words. iii. Marginal Cost Pricing: In marginal cost pricing. The objects of Price Discrimination are to i. find out the product unit’s total cost and add a percentage of profit to arrive at the selling price. other things remaining the same. 3. Each contracting firm quotes its price in a sealed cover called ‘tender’. depending upon the market situations. It is also called Differential Pricing. not leaving it totally to him. Demand-based Pricing: a. Price discrimination: Price discrimination refers to the practice of charging different prices to customers for the same goods. Share consumer’s surplus along with consumer. b. is awarded the contract. the prevailing market rate at a given point of time is taken as the basis to determine the price. marginal cost offers a guideline as to how far the selling price can be lowered 2. Develop a new market including for export. . Meet competition.

d. h. e. Under this strategy. Under this method. g. The package includes the airfare. Entertainment houses such as country clubs. Six Lux soaps in a in a single pack or five magi noodle in a single pack illustrates this pricing method. Strategy-based Pricing: a. The main idea is to charge the customer maximum possible. a firm may expand its activities by financing new product development and diversification into new product markets. Market penetration: This is exactly opposite to the market skimming methods. Commodity bundling: Commodity bundling refers to the practice of bundling two or more different products together and selling them at a single ‘bundle price’. The company attains profits with increasing volumes and increase in the market share. Here the price of the product is fixed so low that the company can increase its market share. firm may enhance profits by peak load pricing. a firm charges a fixed fee for the right to purchase its goods. Two-part pricing: The firm with market power can enhance profits by the strategy of two-part pricing. athletic clubs. This strategy is mostly found in case of technology products.b. f. Perceived value pricing: Perceived value pricing refers to where the price is fixed on the basis of the perception of the buyer of the value of the product. The firm’s philosophy is to charge a higher price during peak times than is charged during off-peak times. hotel. More often. Market Skimming: When the product is traduced for the first time in the market. It refers to a price at which inputs of one department are transferred to another. airlines hold testimony to this practice. the company fixes a very high price for the product. and health clubs usually adopt this strategy. Cross subsidization: In cases where demand for two products produced by firm interrelated through demand or cost. golf courses. the company follows this method. b. This method is more suitable where market is highly price-sensitive. c. sightseeing and so on at a bundled price instead of pricing each of these services separately. Transfer pricing: Transfer pricing is an internal pricing technique. The package deals offered by the tourist companies. We see block pricing in our day-to-day very frequently. The pricing is done in such a way that the business is not lost to the competitors. in order to maximize the overall profits of the company . the firm may enhance the profitability of its operations though cross subsidization. Peak load pricing: During seasonal period when demand is likely to be higher. plus a per unit charge for each unit purchased. Using the profits generated by established products. 4. The firm following such a strategy covers the likely losses during the off-peak times from the likely profits from the peak times. meal. the companies believe that it is necessary to dominate the market in the long-run than making profits in the short-run. Block pricing: Block pricing is another way a firm with market power can enhance its profits.