BUSINESS ECONOMICS

UNIT III
COST CURVE

A cost curve is a graph of the costs of production

as a function of total quantity produced.

Types of Costs


Total fixed costs

Given that total fixed costs
(TFC) are constant as
output increases, the curve
is a horizontal line on the
cost graph.



Total variable costs

The total variable cost
(TVC) curve slopes up at
an accelerating rate,
reflecting the law of
diminishing marginal
returns.

Average Fixed Costs

Average fixed costs are found by
dividing total fixed costs by output.
As fixed cost is divided by an
increasing output, average fixed
costs will continue to fall.
OUTPUT TOTAL AVERAGE
FIXED FIXED
COST COST
1 100 100
2 100 50
3 100 33.33
4 100 25
5 100 20
6 100 16.66

The average fixed cost (AFC)
7 100 14.3
curve will slope down
continuously, from left to right.

Average Fixed Costs

OUTPUT TOTAL FIXED COST AVERAGE FIXED COST

1 37

7

Average Fixed Costs

OUTPUT TOTAL FIXED COST AVERAGE FIXED COST

1 37 37

2 37 18.5

3 37 12.33

4 37 9.25

5 37 7.4

6 37 6.16

7 37 5.28

Average Variable Costs

Average variable costs are
found by dividing total fixed
variable costs by output.

OUTPUT TOTAL AVERAGE

VARIABLE VARIABLE
COST COST

1 50 50

2 80 40 The average variable cost (AVC) curve will at first slope down from left to right,
then reach a minimum point, and rise again.
3 100 33.33 AVC is ‘U’ shaped because of the principle of variable Proportions, which
explains the three phases of the curve:
4 110 27.5 Increasing returns to the variable factors, which cause average costs to fall,
followed by:
5 150 30

6 220 36.67
Constant returns, followed

Cby:
Diminishing returns, which cause costs to rise.

7 350 50
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
Average Variable Costs

OUTPUT TOTAL VARIABLE COST AVERAGE VARIABLE COST

1 30

2 60

3 95

4 125

5 250

6 335 
C
7 485 l
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
Average Variable Costs

OUTPUT TOTAL VARIABLE COST AVERAGE VARIABLE COST

1 30 30

2 60 30

3 95 31.67

4 125 31.25

5 250 50

6 335 
C 55.83

7 485 l 69.30

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
Average Total Costs

Average total cost (ATC) is also called average cost or unit cost. Average total costs are a key
cost in the theory of the firm because they indicate how efficiently scarce resources are being
used.

OUTPUT
AVERAGE AVERAGE AVERAGE
FIXED VARIABLE TOTAL
COST COST COST

1 100 50 150

2 50 40 90

3 33.33 33.33 67

4 25 27.5 52.5
Average total cost (ATC) can be found by adding
5 20 30 50 
C
average fixed costs (AFC) and average variable costs
(AVC). The ATC curve is also ‘U’ shaped because it
6 16.66 36.67 53.3
l
takes its shape from the AVC curve, with the upturn
reflecting the onset of diminishing returns to the
7 14.3 50 64.3
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variable factor.

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
Average Total Costs

OUTPUT AVERAGE TOTAL COST

AVERAGE FIXED COST AVERAGE VARIABLE
COST

1 37 30 67

2 18.5 30 48.5

3 12.33 31.67 44

4 9.25 31.25 40.50

5 7.4 50 57.4

6 6.16 55.83 62

C
7 5.28 l 69.30

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
Areas for Total Costs



Total Fixed costs and Total Variable costs are the respective areas
under the Average Fixed and Average Variable cost curves.

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Marginal Costs

Marginal cost is the cost of producing one extra unit of output. It can be found by calculating the change in total cost when output
is increased by one unit.

It is important to note that marginal cost is derived solely from variable costs, and not fixed costs.

The marginal cost curve falls briefly at first, then rises. Marginal costs are derived from variable costs and are subject to the
principle of variable proportions.

OUTPUT TOTAL MARGINAL

COST COST

1 100 100

2 100 50

3 100 33.33

4 100 25 
The significance of marginal cost
5 100 20

The MC curve is significant in the theory of the firm for two
reasons:
6 100 16.66 
1) It is the leading cost curve, because changes in total and
7 100 14.3 average costs are derived from changes in marginal cost.

2) The lowest price a firm is prepared to supply at is the price
that just covers marginal cost.


Marginal Costs

ATC and MC

Average total cost and marginal cost are connected because they are derived from the same basic
numerical cost data. The general rules governing the relationship are:

Marginal cost will always cut average total cost from below.

When marginal cost is below average total cost, average total cost will be falling, and when marginal
cost is above average total cost, average total cost will be rising.

A firm is most productively efficient at the lowest average total cost (ATC), which is also where ATC =
marginal cost (MC).

Total Costs and Marginal Costs

Marginal costs are derived exclusively from variable
costs, and are unaffected by changes in fixed costs.

The MC curve is the gradient of the TC curve, and the

positive gradient of the total cost curve only exists
because of a positive variable cost.

Sunk Costs

Sunk costs are those that cannot be recovered if a firm goes out of
business. Examples of sunk costs include spending on advertising and
marketing, specialist machines that have no scrap value, and stocks
which cannot be sold off.

Sunk costs are a considerable barrier to entry and exit.

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Short Run & Long Run

In 1890 Alfred Marshall's introduced the concept of Short & Long Run in his publication of
“Principles of Economics”.

"Short Run" and "Long Run" are not broadly defined as a rest of time. Rather, they are
unique to each firm.

Short-run concentrates on the ability of a company to complete current contracts while
long-run production focuses on signing new contracts.

Having short-run vision without long-run plans can put an expiration date on a company,
whereas having long-run vision without short-run action can mean a company runs out of
gas.


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Long Run Cost
Long run costs are accumulated when firms change production levels over time in response to expected economic 
profits or losses.
In the long run there are no fixed factors of production.
The land, labor, capital goods, and entrepreneurship all vary to reach the the long run cost.
The long run is a planning and implementation stage for producers.
Examples of long run decisions that impact a firm's costs includes
1)Changing the quantity of production,
2)Decreasing or expanding a company, and
3)Entering or leaving a market.

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Short Run Cost
Short run costs are accumulated in real time throughout the production process.
Fixed costs have no impact of short run costs, only variable costs and revenues affect the short run.
Variable costs change with the output.
The short run costs increase or decrease based on variable cost as well as the rate of production.
Examples of long run decisions that impact a firm's costs includes
1)Employee Wages
2)Cost of Raw Materials.

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Short Run Cost
A short-run cost curve shows the minimum cost impact of output changes for a specific plant size and in a given
operating environment.
Reflect the optimal or least-cost input combination for producing output under fixed circumstances.
Wage rates, interest rates, plant configuration, and all other operating conditions are held constant.

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Short Run Cost

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
Short Run Cost

Kinds of Costs
Accounting Costs:
Accounting costs are those for which the entrepreneur pays direct cash for procuring resources for
production. These include costs of the price paid for raw materials and machines, wages paid to
workers, electricity charges, the cost incurred in hiring or purchasing a building or plot, etc.

Real Cost:
Real cost refers to the payment made to compensate the efforts and sacrifices of all factor owners for
their services in production. The cost of producing goods or services, including the cost of all
necessary materials and equipment and the cost of not using these materials and equipment for other
activities.

Opportunity Cost:
refer to the “opportunity cost” of a resource, they mean the value of the next-highest-valued
alternative use of that resource.for example, you spend time and money going to a movie, you cannot
spend that time at home reading a book, and you can’t spend the money on something else. If your
next-best alternative to seeing the movie is reading the book, then the opportunity cost of seeing the
movie is the money spent plus the pleasure you forgo by not reading the book….

Kinds of Costs
Implicit Cost:
An implicit cost is any cost that has already occurred but not necessarily shown or reported as a
separate expense. It represents an opportunity cost that arises when a company uses internal
resources toward a project without any explicit compensation for the utilization of resources.

Explicit Costs:
Explicit costs are normal business costs that appear in the general ledger and directly affect a
company's profitability. ... Examples of explicit costs include wages, lease payments, utilities, raw
materials, and other direct costs.

Social cost
Social cost in neoclassical economics is the sum of the private costs resulting from a transaction and
the costs imposed on the consumers as a consequence of being exposed to the transaction for which
they are not compensated or charged. In other words, it is the sum of private and external costs.

Replacement cost:
Replacement cost is a term referring to the amount of money a business must currently spend to
replace an essential asset like a real estate property, an investment security, a lien, or another item,
with one of the same or higher value.

Kinds of Costs
Historical Cost:
A historical cost is a measure of value used in accounting in which the value of an asset on the
balance sheet is recorded at its original cost when acquired by the company.

Controllable & Uncontrollable Cost :

Controllable cost is an expense that can be increased or decreased based on a particular business
decision. Uncontrollable cost is a cost that cannot be increased or decreased based on a business
decision.Controllable costs can be altered in the short term. Uncontrollable costs can be altered in
the long term.Variable cost, incremental cost and stepped fixed cost are types of controllable costs.
Fixed Cost is an uncontrollable cost in nature.

Production Cost:
cost of production includes all those expenses which are incurred to manufacture and provide a
product to the consumer to meet his given demand or want, while the selling costs are those which
are incurred to change, alter or create the demand for a product.

Selling Cost:
Selling cost refers to the total expenditure incurred by a monopolistically competitive firm in order to
differentiate its product from the product of its competitors. For instance, advertisement expenses
incurred by a firm are a part of the selling cost of the product.

Concept of Revenue
The money income which a producer gets from the sale of his product is known as revenue of the
firm.

The concept of revenue should not be confused with the concept of profit. Profit of a firm is estimated
as the difference between revenue and cost related to the production of a commodity
(Profit = Revenue – Cost)

Revenue has three aspects:

 Total Revenue
 Average Revenue
 Marginal Revenue

Total Revenue
Total Revenue (TR)
Total revenue refers to money receipts of a firm from the sale of its total output. It is estimated as the
multiple of price and quantity of output.

TR = PxQ, (Here, TR = Total revenue, P = Price per unit of output, and Q = Quantity (or units) of
output.)

Total revenue is the sum of money receipts of a producer corresponding to a given level of output.

Average Revenue

Average revenue is the revenue per unit of output. It is equal to total revenue divided by total output.
AR = TR/Q, (Here, AR = Average Revenue, TR = Total Revenue, and Q = Total Output)

Average revenue is the per unit revenue corresponding to a given level of output of a firm.
Average Revenue is the same as Price of the Commodity.

Let us see how:

AR = TR/Q
AR = (P x Q)/Q [Since TR= P x Q]
AR = P

Implying that average revenue is nothing but price of the commodity.


Marginal Revenue

Marginal revenue is the additional revenue that a producer expects from the sale of one more unit of
a commodity. In other words, it is the change in total revenue which results from the sale of one more
(or one less) unit of a commodity. It is expressed as:

MR = ΔTR/ΔQ = TRn – TRn-1

(Here, MR = Marginal revenue, ΔTR= Change in total revenue, ΔQ= Change in output, TRn= Total
revenue from ‘n’ units of the output and TRn-1= Total revenue from ‘n – 1’ units of the output.)

Marginal revenue is the addition to total revenue on account of sale of one more unit of output.
Relation MR and AR Curves
● AR is the revenue earned per unit of output sold.
● AR = P
● MR is the revenue a firm gains in producing one additional unit of a commodity
Law of Variable Proportions
The law of variable proportions states that as the quantity of one factor is increased,
keeping the other factors fixed, the marginal product of that factor will eventually decline.

This means that up to the use of a certain amount of variable factor, marginal product of
the factor may increase and after a certain stage it starts diminishing. When the variable
factor becomes relatively abundant, the marginal product may become negative.

Assumptions: The law of variable proportions holds good under the following conditions:

Constant State of Technology: First, the state of technology is assumed to be given and
unchanged. If there is improvement in the technology, then the marginal product may rise
instead of diminishing.

Fixed Amount of Other Factors: Secondly, there must be some inputs whose quantity is
kept fixed. It is only in this way that we can alter the factor proportions and know its effects
on output. The law does not apply if all factors are proportionately varied.

Possibility of Varying the Factor proportions: Thirdly, the law is based upon the possibility
of varying the proportions in which the various factors can be combined to produce a
product. The law does not apply if the factors must be used in fixed proportions to yield a
product.
Law of Variable Proportions
 Law of Variable Proportions
Three Stages of the Law of Variable Proportions:

These stages labour is measured on the X-axis and output on the Y-axis.
Stage 1. Stage of Increasing Returns

Stage 2. Stage of Diminishing Returns

Stage 3. Stage of Negative Returns

Causes of increasing returns to a factor :

1. Fuller utilization of the fixed factor
2. Increased efficiency of the variable

Causes of decreasing return to a factor :

1. Fixity of the factor
2. Imperfect factor substitutability

Applicability of the law of Variable Proportion:

Law of variable proportions applies to all fields of production, like agriculture, industry, etc. This law
applies to any field of production where some factors are fixed and other are variable. That is the
reason, why it is called law of universal application.
Application to Agriculture
Application to Industry
Isoquants
An isoquant is a curve that shows the efficient combinations of labor and capital that can
produce a single (iso)- level of output (quantity). Isoquants reflect the flexibility that a firm
has in producing a given level of output in the long-run. Here is an example of “typical”
isoquants reflecting the imperfect substitutability of capital and labor,
Isoquants
Iso-Product Schedule:
Let us suppose that there are two factor inputs—labour and capital. An Iso-product
schedule shows the different combination of these two inputs that yield the same level of
output as shown in table.
The table 1 shows that the five combinations of labour units and units of capital yield the
same level of output, i.e., 200 metres of cloth. Thus, 200 metre cloth can be produced by
combining.
Isoquants

Characteristics of isoquants:

1. Iso-Product Curves Slope Downward from Left to Right:

They slope downward because MTRS of labour for capital diminishes. When we increase
labour, we have to decrease capital to produce a given level of output.
Isoquants

Characteristics of isoquants:
2. Isoquants are Convex to the Origin:
The concept of diminishing marginal rate of technical substitution (MRTS), because convexity of an isoquant
implies that the MRTS diminishes along the isoquant.
MRTSLK = – ∆K/∆L = dK/ dL
Where ∆K is the change in capital and AL is the change in labour.Equation (1) states that for an increase in the use
of labour, fewer units of capital will be used. In other words, a declining MRTS refers to the falling marginal product
of labour in relation to capital. To put it differently, as more units of labour are used, and as certain units of capital
are given up, the marginal productivity of labour in relation to capital will decline.
Isoquants

Characteristics of isoquants:
3. Two Iso-Product Curves Never Cut Each Other:
As two indifference curves cannot cut each other, two iso-product curves cannot cut each
other. In Fig. 6, two Iso-product curves intersect each other. Both curves IQ1 and IQ2
represent two levels of output. But they intersect each other at point A. Then combination
A = B and combination A= C. Therefore B must be equal to C. This is absurd. B and C lie
on two different iso-product curves. Therefore two curves which represent two levels of
output cannot intersect each other.
Isoquants

Characteristics of isoquants:
4. Higher Iso-Product Curves Represent Higher Level of Output:
Isoquants

Characteristics of isoquants:
5. Isoquants Need Not be Parallel to Each Other:
It so happens because the rate of substitution in different isoquant schedules need not be
necessarily equal. Usually they are found different and, therefore, isoquants may not be
parallel as shown in Fig. We may note that the isoquants Iq1 and Iq2 are parallel but the
isoquants Iq3 and Iq4 are not parallel to each other.
Isoquants

Characteristics of isoquants:
6. No Isoquant can Touch Either Axis:
If an isoquant touches X-axis, it would mean that the product is being produced with the
help of labour alone without using capital at all. These logical absurdities for OL units of
labour alone are unable to produce anything. Similarly, OC units of capital alone cannot
produce anything without the use of labour. Therefore as seen in figure, IQ and IQ1 cannot
be isoquants.
Isoquants

Characteristics of isoquants:
7. Each Isoquant is Oval-Shaped:
It means that at some point it begins to recede from each axis. This shape is a
consequence of the fact that if a producer uses more of capital or more of labour or more
of both than is necessary, the total product will eventually decline. The firm will produce
only in those segments of the isoquants which are convex to the origin and lie between the
ridge lines. This is the economic region of production. 
Isoquants
Shapes of Isoquants

Typically, convex towards the origin. This reflects the fact that firms prefer “averages to extremes.” In
other words, capital and labor are complements to each other (i.e., the firm needs a little of both to
operate).
Isoquants
Principle of Marginal Rate of Technical Substitution

The principle of marginal rate of technical substitution (MRTS or MRS) is based on the
production function where two factors can be substituted in variable proportions in such a
way as to produce a constant level of output. The marginal rate of technical substitution
between two factors C (capital) and L (labour), MRTSLC is the rate at which L can be
substituted for C in the production of good X without changing the quantity of output.
As we move along an isoquant downward to the right each point on it represents the
substitution of labour for capital. MRTS is the loss of certain units of capital which will just
be compensated for by additional units of labour at that point. In other words, the marginal
rate of technical substitution of labour for capital is the slope or gradient of the isoquant at
a point. Accordingly, slope = MRTSLC = AC/AL. This can be understood with the aid of the
isoquant schedule,
 Economies & Diseconomies of Scale
Reasons for economies of scale
The most common reason for Economies of scale is that some production costs are fixed (as
production increseases these costs stay constant). Therefore since costs per unit (Average Costs) are
calculated by dividing the cost by the number of units of output.

AC=Costs/quantity
Then any average involving Fixed Costs (Numerator) must decrease as quantity produced
(Denominator) increases

AFC=FC/Quantity
Fixed Cost economies of scale:
1. Managerial - managers are on a fixed salary
2. Marketing - advertising, endorsements promotional events do not directly depend on quantity
produced
3. Techinical - machinery, buildings etc are paid for as a fixed amount.

Purchasing economies of scale:

Large firms are able to negotiate more favourable terms when buying raw materials etc.
4. Bulk buying - remember it is the cost per unit of buying in bulk not the total cost (Great example is
supermarkets and local shop)
5. 2. Financial - similar in principle to buying in bulk but this time interest rates a more favorable.
 Economies & Diseconomies of Sacle
Reasons for diseconomies of scale

1. Communication - becomes more complex

2. Coordination - between departments

3. X- Inefficiency - management costs increase (non-productive costs)

4. Principle agent problem - delegating to employees who are not as committed as the
owner
Law of Returns to Scale
The law of returns to scale explains the proportional
change in output with respect to proportional change in
inputs.

In other words, the law of returns to scale states when

there are a proportionate change in the amounts of
inputs, the behavior of output also changes.

The degree of change in output varies with change in the

amount of inputs. For example, an output may change by
a large proportion, same proportion, or small proportion
with respect to change in input.
Law of Returns to Scale
On the basis of these possibilities, law of
returns can be classified into three categories:

i. Increasing returns to scale

ii. Constant returns to scale

iii. Diminishing returns to scale

Law of Returns to Scale
Increasing Returns to Scale:
If the proportional change in the output of an organization is greater than the
proportional change in inputs, the production is said to reflect increasing returns
to scale.

For example, to produce a particular product, if the quantity of inputs is doubled

and the increase in output is more than double, it is said to be an increasing
returns to scale. When there is an increase in the scale of production, the
average cost per unit produced is lower. This is because at this stage an
organization enjoys high economies of scale.
Law of Returns to Scale
There a number of factors responsible for increasing returns to
scale.
Some of the factors are as follows:

i. Technical and managerial indivisibility:

ii. Specialization:
iii. Concept of Dimensions:
Law of Returns to Scale
2. Constant Returns to Scale:
The production is said to generate constant returns to scale when the proportionate
change in input is equal to the proportionate change in output. For example, when inputs
are doubled, so output should also be doubled, then it is a case of constant returns to
scale.

when there is a movement from a to b, it indicates that input is doubled. Now, when the
combination of inputs has reached to 2K+2L from IK+IL, then the output has increased
from 10 to 2
Law of Returns to Scale
Diminishing Returns to Scale:
Diminishing returns to scale refers to a situation when the proportionate change in output
is less than the proportionate change in input. For example, when capital and labor is
doubled but the output generated is less than doubled, the returns to scale would be
termed as diminishing returns to scale.

Diminishing returns to scale is due to diseconomies of scale, which arises because of the
managerial inefficiency. Generally, managerial inefficiency takes place in large-scale
organizations. Another cause of diminishing returns to scale is limited natural resources.
For example, a coal mining organization can increase the number of mining plants, but
cannot increase output due to limited coal reserves.
UNIT IV
Demand & Supply
In the words of Marshall, “Both the elements of demand
and supply are required for the determination of price of a
commodity in the same manner as both the blades of
scissors are required to cut a cloth.”

Market demand is defined as a sum of the quantity

demanded by each individual organizations in the
industry.

Market supply refers to the sum of the quantity supplied

by individual organizations in the industry.
Price and Output Determination

Price and Output Determination under :

1) Monopoly

2) Perfect Competition

3) Monopolistic Competition
 Price and Output Determination
Monopoly
Monopoly refers to a market structure in which there is a single producer or seller that has a control on the
entire market. This single seller deals in the products that have no close substitutes and has a direct
demand, supply, and prices of a product. Therefore, in monopoly, there is no distinction between an one
organization constitutes the whole industry.

Demand and Revenue under Monopoly:

The producer under monopoly is called monopolist. If the monopolist wants to sell more, he/she can
reduce the price of a product. On the other hand, if he/she is willing to sell less, he/she can increase the
price. The demand curve of the monopolist is Average Revenue (AR), which slopes downward.
In Figure-9, it can be seen that
more quantity (OQ2) can only be
sold at lower price (OP2). Under
monopoly, the slope of AR curve is
downward, which implies that if
the high prices are set by the
monopolist, the demand will fall.
In addition, in monopoly, AR curve
and Marginal Revenue (MR) curve
are different from each other.
However, both of them slope
downward.
 Price and Output Determination
The negative AR and MR curve
depicts the following facts:
i. When MR is greater than AR, the
AR rises
ii. When MR is equal to AR, then AR
remains constant
iii. When MR is lesser than AR, then
AR falls
Here, AR is the price of a product, As
we know, AR falls under monopoly;
thus, MR is less than AR.
In figure-10, MR curve is shown below the AR curve because AR falls.
Table-1 shows the numerical calculation of AR and MR under monopoly:

As shown in Table-1, AR is equal to price. MR is less than AR and falls twice the rate than AR. For instance, when two
units of Output are sold, MR falls by Rs. 2, whereas AR falls by Re. 1.
 Price and Output Determination
Monopoly Equilibrium:

The equilibrium, under monopoly, is attained at the point where profit is maximum that is
where MR=MC. Therefore, the monopolist will go on producing additional units of output as
long as MR is greater than MC, to earn maximum profit.

In Figure-11, if output is increased beyond OQ, MR will be less than MC. Thus, if additional
units are produced, the organization will incur loss. At equilibrium point, total profits earned
are equal to shaded area ABEC. E is the equilibrium point at which MR=MC with quantity as
OQ.
It should be noted that under monopoly, price forms the following relation with the
MC:
Price = AR
MR= AR [(e-1)/e]
e = Price elasticity of demand
As in equilibrium MR=MC
MC = AR [(e-1)/e]
 Price and Output Determination
Monopoly Equilibrium in Case of Zero Marginal Cost:
In certain situations, it may happen that MC is zero, which implies that the cost of production
is zero. For example, cost of production of spring water is zero. However, the monopolist will
set its price to earn profit.
In Figure-12, AR is the average revenue
curve and MR is the marginal revenue
curve. In such a case, the total cost is
zero; therefore, AR and MR are also
zero.

As shown in Figure-12, equilibrium

position is achieved at the point where
MR equals zero that is at output OQ and
price P. We can see that point M is the
mid-point of AR curve, where elasticity of
demand is unity.

Therefore, when MC = 0, the equilibrium

of the monopolist is established at the
output (OQ) where elasticity of demand
is unity.
Price and Output Determination
Short-Run and Long-Run View under Monopoly:

In the short run, the monopolist should make sure that the price should not go
below Average Variable Cost (AVC). The equilibrium under monopoly in long-run is
same as in short-run.

However, in long-run, the monopolist can expand the size of its plants according to
demand. The adjustment is done to make MR equal to the long run MC. In the
long-run, under perfect competition, the equilibrium position is attained by entry or
exit of the organizations. In monopoly, the entry of new organizations is restricted.

The monopolist may hold some patents or copyright that limits the entry of other
players in the market. When a monopolist incurs losses, he/she may exit the
business. On the other hand, if profits are earned, then he/she may increase the
plant size to gain more profit.
 Price and Output Determination
Price Discrimination under Monopoly

The monopolist often charges different prices from different consumers for the same product. This
practice of charging different prices for identical product is called price discrimination.

Types of Price Discrimination:

Price discrimination is a common pricing strategy’ used by a monopolist having discretionary pricing
power. This strategy is practiced by the monopolist to gain market advantage or to capture market
position.

i. Personal
ii. Geographical
iii. On the basis of use

Three degrees of price discrimination:

i. First-degree Price Discrimination
ii. Second-degree Price Discrimination
iii. Third-degree Price Discrimination
 Price and Output Determination
Necessary Conditions for Price Discrimination
Price discrimination implies charging different prices for identical goods
.
It is possible under the following conditions:

i. Existence of Monopoly
ii. Separate Market
iii. No Contact between Buyers
iv. Different Elasticity of Demand

Advantages and Disadvantages of Price Discrimination

Following are some of the advantages of price discrimination:

i. Helps organizations to earn revenue and stabilize the business
ii. Facilitates the expansion plans of organizations as more revenue is generated
iii. Benefits customers, such as senior citizens and students, by providing them discounts
In spite of advantages, there are certain disadvantages of price discrimination.

Some of the disadvantages of price discrimination as follows:

i. Leads to losses as some consumers end up paying higher prices
ii. Involves administration costs for separating markets.
 Price and Output Determination
Perfect Competition
Perfect competition refers to a market situation where there are a large number of buyers and
sellers dealing in homogenous products and there are no legal, social, or technological barriers on
the entry or exit of organizations.

In perfect competition, sellers and buyers are fully aware about the current market price of a
product. Therefore, none of them sell or buy at a higher rate. As a result, the same price prevails in
the market under perfect competition.

Under perfect competition, the buyers and sellers cannot influence the market price by increasing or
decreasing their purchases or output, respectively and is determined by the industry.

This implies that in perfect competition, the market price of products is determined by taking into
account two market forces, namely market demand and market supply.

In perfect competition, the price of a product is determined at a point at which the demand and
supply curve intersect each other. This point is known as equilibrium point as well as the price is
known as equilibrium price. In addition, at this point, the quantity demanded and supplied is called
equilibrium quantity.
 Price and Output Determination
Demand under Perfect Competition:

Demand refers to the quantity of a product that consumers are willing to purchase at a
particular price, while other factors remain constant. A consumer demands more quantity at
lower price and less quantity at higher price. Therefore, the demand varies at different prices.

As shown in Figure-1, when price is OP, the quantity demanded is OQ. On the other hand,
when price increases to OP1, the quantity demanded reduces to OQ1. Therefore, under
perfect competition, the demand curve (DD’) slopes downward.
 Price and Output Determination
Supply under Perfect Competition:

Supply refers to quantity of a product that producers are willing to supply at a particular price.
Generally, the supply of a product increases at high price and decreases at low price.

In Figure-2, the quantity supplied is OQ at price OP. When price increases to OP1, the
quantity supplied increases to OQ1. This is because the producers are able to earn large
profits by supplying products at higher price. Therefore, under perfect competition, the supply
curves (SS’) slopes upward.
 Price and Output Determination
Monopolistic Competition
Monopolistic competition is a type of market structure where many companies are present in an industry,
and they produce similar but differentiated products. None of the companies enjoy a monopoly, and each
company operates independently without regard to the actions of other companies. The market structure
is a form of imperfect competition.

The characteristics of monopolistic competition include the following:

 The presence of many companies
 Each company produces similar but differentiated products
 Companies are not price.
 Free entry and exit in the industry
 Companies compete based on product quality, price, and how the product is marketed

Companies in a monopolistic competition make economic profits in the short run, but in the long run, they
make zero economic profit. 

Because of the large number of companies, each player keeps a small market share and is unable to
influence the product price.

In addition, monopolistic competition thrives on innovation and variety. Companies must continuously
invest in product development and advertising and increase the variety of their products to appeal to
their target market.

Competition with other companies is thus based on quality, price, and marketing
 Price and Output Determination
Equilibrium in Short Run:
The short-run equilibrium of a monopolistic competitive organization is the same as that of an
organization under monopoly. In the short run, an organization under monopolistic competition attains its
equilibrium where marginal revenue equals marginal cost and sets its price according to its demand
curve. This implies that in the short run, profits are maximized when MR=MC.

In Figure-2, it can be seen that MR intersects

SMC at output OM where price is OP’ (which
is equal to MP). This is because P is the,
point on AR curve, which is price.It can be
interpreted from that the organization is
earning supernormal profit. Supernormal
profit per unit of output is the difference
between the average revenue and average
cost. In Figure-2, average revenue at
equilibrium point is MP and average cost is
MT.

Therefore, PT is the supernormal profit per

unit of output. In the present case,
supernormal profit would be measured by the
area of rectangle P’PTT’ (which is output
multiplied by supernormal profit per unit of
output).
 Price and Output Determination
On the other hand, when marginal cost is greater than marginal revenue, organizations
would incur losses, as shown in Figure-3:

Figure-3 shows the condition of losses in the short run under monopolistic competition. Here,
OP’ is smaller than MT, which implies that average revenue is smaller than average cost. TP
is representing the loss that has incurred per unit of output. Therefore total loss is depicted
from rectangle T’TPP’.
 Price and Output Determination
Equilibrium in Long Run:

In the long run, there is a gradual decrease in the profits of organizations. This is because in the long run,
several new organizations enter the market due to freedom of entry and exit under monopolistic
competition.

When these new organizations start production the supply would increase and the prices would fall. This
would automatically increase the level of competition in the market. Consequently, AR curve shifts from
right to left and supernormal profits are replaced with normal profits.

In the long run, the AR curve is more elastic than that of in the short run. This is because of an increase in
the number of substitute products in the long- run. The long-run equilibrium of monopolistically
competitive organizations is achieved when average revenue is equal to average cost. In such a case,
organizations receive normal profits.

In Figure-4, P is the point at which

AR curve touches the average cost
curve (LAC) as a tangent. P is
regarded as the equilibrium point
at which the price level is MP
(which is also equal to OF) and
output is OM.
 Non-Price Competition
What is Non-Price Competition?

Definition: Non-price competition is defined as the rivalry between

firms based on product design, workmanship, quality, etc. The major
focus is on gaining a competitive advantage without altering
the market price.

Firms constantly try to make their customers believe that their

products are much more innovative and better than their rivals by
using product differentiation and product variation strategies.

Two Phases of Non-price Competition

1. Product Differentiation
2. Product Variation
 Non-Price Competition
Pros and Cons of Non-Price Competitions
Pros
Non-price competition promotes innovation among the competing firms.

Brands can successfully establish themselves by building their reputation among the audience.

The quality of the products is not compromised, and they usually subjected to constant improvements.

By providing a large variety of products, companies get to benefit from economies of scope.

Buyers also get the advantage of choosing the product they want from a wide range of options.

The competition among the firms becomes healthy as they constantly try to improve their present state.

Cons
Customers usually take time to identify the changes made, so that it can be time-consuming.

To develop different products, a lot of research is required.

The competitors and customers may have disproportionate information about the products.

Buyers may not be aware of which firm can provide them with a greater quality product.

It can even result in wasteful advertising.