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

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

External Economies:

Economies of Concentration :
When an industry is concentrated in a particular area, all the member firms reap some
common economies like skilled labour, improved means of transport and communications,
banking and financial services, supply of power and benefits from subsidiaries. All these
facilities tend to lower the unit cost of production of all the firms in the industry.

Economies of R&D :
All the firms can pool resources together to finance research and development activities
and thus share the benefits of research. Three could be a common facility to share journals,
newspapers and other valuable reference material of common interest.
Economies of Welfare :
An industry is in a better position to provide welfare facilities to the workers. It may get
land at concessional rates and procure special facilities from the local bodies for setting up
housing colonies for the workers. It may also establish public health care units, educational
institutions both general and technical so that a continuous supply of skilled labour is
available to the industry. This will help the efficiency of the workers.

Market structures
A market is described as a place where buyers and sellers of goods and services come together to transact, so that
a market price is determined.
A market consists of two important players: Buyers and Sellers; and two important market forces: Demand and
Supply.
Market Demand: which is the aggregate demand of all buyers put together, shows the quantity that buyers would
like to buy at different prices?
Market Supply: is the aggregate quantity supplied by all sellers, which shows the quantity that they would offer at
different prices.
Market Structure indicates the composition, constitution and degree of competition prevailing in market. It shows
the number of buyers and sellers in a market, the type of products offered, 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.
Markets are also classified on the basis of location, time, technology and regulation.

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

1. 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. Monopolistic Markets:
Competition in these markets exhibits features of both perfect and monopoly competition. Consumers
can quit because of the wide choice of products offered to them.
Price differentiation
Sales promotion
Independent decision-making
Imperfect knowledge
3.

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, the main distinguishing feature of oligopoly competition is few or limited sellers with
a large number of buyers. Therefore, the firms are interdependent. Each firm considers how its
actions affect the decisions of its relatively few competitors.
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. buyers and
Large
Many
One seller, 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; 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, 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

Suitability in Practice

Hypothetical
generally a myth; for
example, stock
market, agriculture
product market and
agricultural products

Textiles and retailing

Public utilities; for

example, 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.
If output is set at the point where price is more than average total cost, it is advisable for the firm to
produce, even though the price does not cover average titak cist,
Price determination in Perfect competition with Market Demand and market supply:

Price

Quantity

The market supply curve slopes upwards to the right because as price increases, industry output
increases. Firms find it profitable to expand production. The market demand curve slopes
downwards to the right because with increase in price the quantity demanded reduces. 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.

Price

Price determination in monopolistic markets:

MC

P0
AC
P1 =Ac1

F
DD

Ac0

MR
MR1
Q1

DD1
Q2

Quantity

DD is the demand curve, MR is the marginal revenue curve, MC is the average cost curve, AC is the
average cost curve Q is the output and P is the price.

The demand curve is not horizontal because the products of different firms are substitutable to a
limited extent. A lower price attracts some customers from the competitors. The market share of
each firm depends not only on the price it charges but also on the number of firms in the industry. In
the short run, DD is the demand curve, Q0 is the output at which MC = MR at price P0. The profit
making firms attract new competitors and this shifts the demand curve to the left, which is DD1. This
happens in the long run at equilibrium F. Q1is the output at which MC = MR and price P1 = AC1. Firms
break even at this point and there will be no further entry of firms.

PRICING THEORY
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.

Introduction:
It is said that if a firm were good in setting its product price it would certainly flourish in the market.
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, leading to firms turnover (sales) and profit. Every manager endeavors to
find the price, which would best meet with his firms objective. If the price is set too high the seller
may not find enough customers to buy his product. On the other hand, if the price is set too low the
seller may not be able to recover his costs. There is a need for the right price further, since demand
and supply conditions are variable over time what is a right price today may not be so tomorrow
hence, pricing decision must be reviewed and reformulated from time to time.
Price:
Price denotes the exchange value of a unit of good expressed in terms of money. Thus the current
price of a maruti car around Rs.2,00,000 the price of a hair cut is Rs.25 the price of a economics book
is Rs.150 and so on. Nevertheless, if one gives a little, if one gives a little thought to this subject, one
would realize that there is nothing like a unique price for any good. Instead, there are multiple
prices.

Price concepts
Price of a well-defined product varies over the types of the buyers, place it is received, credit sale or
cash sale, time taken between final production and sale, etc. It should be obvious to the readers,
that the price difference on account of the above four factors are more significant. The multiple
prices is more serious in the case of items like cars refrigerators, coal, furniture and bricks and is of
little significance for items like shaving blade, soaps, tooth pastes, creams and stationeries.
Differences in various prices of any good are due to differences in transport cost, storage cost
accessories, interest cost, intermediaries profits etc. Once can still conceive of a basic price, 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, in what follows we shall explain the
determination of this basis price alone and thus resolve the problem of multiple prices.
Price determinants Demand and supply:
The price of a product is determined by the demand for and supply of that product. According to
Marshall the role of these two determinants is like that of a pair of scissors in cutting cloth. It is
possible that at times, while one pair is held fixed, the other is moving to cut the cloth. Similarly, it is
conceivable that there could be situations under which either demand or supply is playing a passive
role, and the other, which is active, alone appear to be determining the price. However, just as one
pair of scissors alone can never cut a cloth, demand or supply alone is insufficient to determine the
price.

Equilibrium Price:
The price at which demand and supply of a commodity is equal known as equilibrium price. 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, price Rs.30 would be the market-clearing price. No
other price could prevail in the market. If price is Rs. 50 supply would exceed demand and
consequently the producers of this good would not find enough customers for their demand,
thereby they would accumulate unwanted inventories of output, which, in turn, would lead to
competition among the producers, forcing price to Rs.30. Similarly if price were Rs.10, there would
be excess demand, which would give rise to competition among the buyers of good, forcing price to
Rs.30. At price Rs.30, demand equals supply and thus both producers and consumers are satisfied.
The economist calls such a price as equilibrium price.

It was seen in unit 1 that the demand for a good depends on, a number of factors and thus, every
factor, which influences either demand or supply is in fact a determinant of price. Accordingly, a
change in demand or/and supply causes price change.

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. Cost-based Pricing Methods:

a. Cost Plus Pricing: This is also called full cost or mark up. 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. In other words, find out the product units
total cost and add a percentage of profit to arrive at the selling price.
b. Marginal Cost Pricing: In marginal cost pricing, 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, depending upon the market situations. In times of stiff
competition, marginal cost offers a guideline as to how far the selling price can be
lowered

2. Competition-based Pricing:
a. Sealed Bid Pricing: This method is more popular in tenders and contracts. Each
contracting firm quotes its price in a sealed cover called tender. All the tenders are
opened on a scheduled date and the person, who quotes the lowest price, other
things remaining the same, is awarded the contract. The objective of the bidding
form is to bag the contract and hence it will quote lower than others.
b. Going rate pricing: Here the price charged by the firm is in tune with the price
charged in the industry as a whole. In other words, the prevailing market rate at a
given point of time is taken as the basis to determine the price.

3. Demand-based Pricing:
a. Price discrimination: Price discrimination refers to the practice of charging different
prices to customers for the same goods. The firm uses its discretion to charge
differently the different customers. It is also called Differential Pricing.
The objects of Price Discrimination are to
i. Develop a new market including for export,
ii. Utilize the maximum capacity,
iii. Share consumers surplus along with consumer, not leaving it totally to him,
iv. Meet competition,
v. Increase market share.

b. 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.

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

development and diversification into new product markets.

h. Transfer pricing: Transfer pricing is an internal pricing technique. It refers to a price
at which inputs of one department are transferred to another, in order to maximize
the overall profits of the company